Mishkin er al the economics of money, banking financial markets, europ ed (2013)

THE ECONOMICS OF MONEY, BANKING AND FINANCIAL MARKETS THE ECONOMICS OF MONEY, BANKING AND FINANCIAL MARKETS EUROPEAN EDITION Frederick S Mishkin Kent Matthews Massimo Giuliodori Pearson education Limited Edinburgh Gate Harlow CM20 2JE Tel: +44 (0)1279 623623 Fax: +44 (0)1279 431059 Website: www.pearson.com/uk First published 2013 (print and electronic) © Pearson Education Limited 2013 (print and electronic) The rights of Frederick S Mishkin, Kent Matthews and Massimo Giuliodori to be identified as authors of this work has been asserted by them in accordance with the Copyright, Designs and Patents Act 1988 The Print publication is protected by copyright Prior to any prohibited reproduction, storage in retrieval system, distribution or transmission in any form or by any means, electronic, mechanical, recording or otherwise, permission should be obtained from the publisher or, where applicable, a licence permitting restricted copying in the United Kingdom should be obtained from the Copyright Licensing Agency Ltd, Saffron House, 6-10 Kirby Street, London EC1N 8TS The ePublication is protected by copyright and must not be copied, reproduced, transferred, distributed, leased, licensed or publicly performed or used in any way except as specifically permitted in writing by the publishers, as allowed under the terms and conditions under which it was purchased, or as strictly permitted by applicable copyright law Any unauthorised distribution or use of this text may be a direct infringement of the author’s and the publisher’s rights and those responsible may be liable in law accordingly Pearson Education is not responsible for the content of third-party Internet sites ISBN: 978-0-273-73180-1 (print) 978-0-273-79302-1 (ePub) 978-0-273-80861-1 (eText) British Library cataloguing-in-Publication data A catalogue record for the print edition is available from the British Library Library of congress cataloging-in-Publication data Mishkin, Frederick S The economics of money, banking and financial markets / Frederick S Mishkin, Kent Matthews, Massimo Giuliodori — European ed p cm ISBN 978-0-273-73180-1 Finance Money Banks and banking I Matthews, Kent II Giuliodori, Massimo III Title HG173.M6322 2013 332—dc23 2012039053 10 16 15 14 13 12 Cover image: © Alamy Images Print edition typeset in 9.5/12.5 pt Charter ITC Std by 73 Print edition printed and bound by Grafos SA, Barcelona, Spain BRIEF CONTENTS Preface About the authors Guided tour Guided tour to MyEconLab Publisher’s acknowledgements xiii xx xxii xxvi xxviii PART INTRODUCTION Why study money, banking and financial markets? An overview of the financial system 23 What is money? A comparative approach to measuring money 46 PART FINANCIAL MARKETS 59 Understanding interest rates 61 The behaviour of interest rates 80 The risk and term structure of interest rates 108 The stock market, the theory of rational expectations and the efficient market hypothesis 130 PART FINANCIAL INSTITUTIONS An economic analysis of financial structure Financial crises and the subprime meltdown 147 149 176 10 Banking and the management of financial institutions 205 11 Economic analysis of financial regulation 232 12 Banking industry: structure and competition 252 PART CENTRAL BANKING 273 13 The goals and structure of central banks 275 14 The money supply process 301 15 The tools of monetary policy 326 16 The conduct of monetary policy: strategy and tactics 351 PART INTERNATIONAL FINANCE AND MONETARY POLICY 379 17 The foreign exchange market: exchange rates and applications 381 18 The international financial system 407 PART MONETARY THEORY 443 19 The demand for money 445 20 The ISLM model 464 21 Monetary and fiscal policy in the ISLM model 485 22 Aggregate demand and supply analysis 507 23 Transmission mechanisms of monetary policy: the evidence 525 24 Money and inflation 555 25 Rational expectations: implications for policy 579 Glossary Index 599 612 This page intentionally left blank CONTENTS Preface About the authors Guided tour Guided tour to MyEconLab Publisher’s acknowledgements PART INTRODUCTION CHAPTER xiii xx xxii xxvi Key terms Questions and problems Web exercises Note Useful websites xxviii CHAPTER 1 44 44 45 45 45 What is money? A comparative approach to measuring money 46 Meaning of money 46 Functions of money 47 Evolution of the payments system 50 Measuring money 52 Why study money, banking and financial markets? Which is the most accurate monetary aggregate? 55 Why study financial markets? Why study financial institutions and banking? Why study money and monetary policy? Summary Key terms Questions and problems Web exercises Notes Useful websites 56 57 57 58 58 58 Why study international finance? 13 How we will study money, banking and financial markets 14 Concluding remarks 15 Web exercise 15 Summary Key terms Questions and problems Web exercises Notes Useful websites 17 17 17 18 18 18 APPENDIX TO CHAPTER Defining aggregate output, income, the price level and the inflation rate CHAPTER An overview of the financial system 23 Function of financial markets 23 Structure of financial markets 25 Financial market instruments 27 Internationalization of financial markets 32 Function of financial intermediaries: indirect finance 34 Types of financial intermediaries 38 Regulation of the financial system Summary PART FINANCIAL MARKETS CHAPTER 59 Understanding interest rates 61 Measuring interest rates 61 The distinction between interest rates and returns 70 The distinction between real and nominal interest rates 73 Summary Key terms Questions and problems Web exercises Notes Useful websites 76 76 76 77 78 79 CHAPTER The behaviour of interest rates 80 41 Determinants of asset demand 80 43 Supply and demand in the bond market 82 viii CONTENTS Changes in equilibrium interest rates 85 Transaction costs 152 Supply and demand in the market for money: the liquidity preference framework 95 Asymmetric information: adverse selection and moral hazard 153 97 The lemons problem: how adverse selection influences financial structure 154 How moral hazard affects the choice between debt and equity contracts 159 How moral hazard influences financial structure in debt markets 161 Changes in equilibrium interest rates in the liquidity preference framework Summary Key terms Questions and problems Web exercises Notes Useful websites CHAPTER 104 104 105 106 106 107 The risk and term structure of interest rates 108 Risk structure of interest rates 108 Term structure of interest rates 116 Summary Key terms Questions and problems Web exercises Notes Useful websites 126 127 127 128 129 129 CHAPTER Conflicts of interest 167 Summary Key terms Questions and problems Web exercise Notes Useful website 172 173 173 174 174 175 CHAPTER Financial crises and the subprime meltdown 176 Factors causing financial crises 176 Dynamics of past financial crises in developed countries 179 The subprime financial crisis of 2007–8 184 Dynamics of financial crises in emerging market economies 188 Dynamics of the eurozone financial crisis 196 Summary Key terms Questions and problems Web exercises Notes Useful websites 202 203 203 204 204 204 The stock market, the theory of rational expectations and the efficient market hypothesis 130 Computing the price of common stock 130 How the market sets stock prices 133 The theory of rational expectations 134 The efficient market hypothesis: rational expectations in financial markets 137 Behavioural finance 143 CHAPTER Summary Key terms Questions and problems Web exercises Notes Useful websites 143 144 144 145 146 146 Banking and the management of financial institutions 205 The bank balance sheet 205 Basic banking 209 General principles of bank management 213 Managing credit risk 220 Managing interest-rate risk 224 Off-balance-sheet activities 226 Summary Key terms Questions and problems Web exercises Notes Useful websites 229 229 230 230 231 231 PART FINANCIAL INSTITUTIONS CHAPTER 147 An economic analysis of financial structure 149 Basic facts about financial structure throughout the world 149 10 CONTENTS CHAPTER 11 Economic analysis of financial regulation 232 Asymmetric information and financial regulation 232 Advantages and disadvantages of bank regulation 245 Banking crises throughout the world 245 Whither financial regulation after the subprime financial crisis? 246 Summary Key terms Questions and problems Web exercises Notes Useful websites 250 250 250 251 251 251 CHAPTER 12 Banking industry: structure and competition 252 The single banking market in Europe 252 Competition and bank consolidation 253 Financial innovation and the growth of the ‘shadow banking system’ 258 Structure of the European commercial banking industry 265 International banking 267 Summary Key terms Questions and problems Web exercises Notes Useful websites 269 270 270 271 271 271 PART CENTRAL BANKING CHAPTER 273 13 The goals and structure of central banks 275 The price stability goal and the nominal anchor 275 Other possible goals of monetary policy 278 Other central banks around the world 290 Should the central banks be independent? 293 Summary Key terms Questions and problems Web exercises Notes Useful websites 297 298 299 299 299 300 CHAPTER 14 The money supply process 301 Three players in the money creation process 301 The central bank’s balance sheet 301 Control of the monetary base 303 Multiple deposit creation: a simple model 307 The money multiplier 312 Factors that determine the money supply 314 Overview of the money creation process 316 Limits of the central bank’s ability to control the money supply 316 Summary Key terms Questions and problems Web exercises Notes Useful websites 322 323 323 324 324 325 CHAPTER 15 The tools of monetary policy 326 The market for reserves and the overnight interest rate 327 Open market operations 333 Standing facilities 339 Reserve requirements 345 Summary Key terms Questions and problems Web exercises Notes Useful websites 347 347 348 348 348 350 CHAPTER 16 The conduct of monetary policy: strategy and tactics 351 Should price stability be the primary goal of monetary policy? 279 Monetary targeting 351 Structure of central banks 281 Inflation targeting 354 The Bank of England 281 Monetary policy with an implicit nominal anchor 363 The Federal Reserve System 282 Tactics: choosing the policy instrument 366 The European Central Bank 286 Tactics: the Taylor rule 369 ix GLOSSARY building dams, roads and other physical capital that would contribute to their economic development 413 yield curve A plot of the interest rates for particular types of bonds with different terms to maturity 116 World Trade Organization (WTO) An organization headquartered in Geneva, Switzerland, that monitors rules for the conduct of trade between countries (tariffs and quotas) 413 yield to maturity The interest rate that equates the present value of payments received from a credit market instrument with its value today 64 zero-coupen bond See discount bond 64 611 612 PART FINANCIAL MARKETS INDEX Page numbers in italics refers to a figure/table anchor currency 411 ‘animal spirits’ 471, 510 adaptive expectations 135 annual percentage rate (APR) 242 adverse selection 36–7, 41, 154 anti-inflation policies (1980–2) 521 and government safety net 236 anticipated policy 581–3, 582, 585–7 in loan markets 220, 221 appreciation 384 solutions to problems of 155–8 arbitrage 138–9 ways of influencing financial structure 154–8 agency theory 154 aggregate demand curve 507–10, 519 deriving 507–9 regulatory 238 Argentina currency board 432 financial crises (2001–2) 191, 419–20 factors that cause shifts 502–4, 509, 510, 519 asset demand 80–2, 85, 389, 390–3 see also demand for money and ISLM model 501–2, 501 asset management, banks 213, 216 aggregate demand function 468 aggregate demand and supply analysis 367–8, 507–24 asset market 85 effects on balance sheets 177–8 and business cycles 520–2 asset pricing 133 see also risk sharing demand shocks 510, 517–18, 517, 521 Asset Purchase Facility (APF) 336 equilibrium in 514–20, 515, 516 asset transformation 36, 210 and new classical macroeconomic model 581–5 asset write-off 178 supply shocks 513–14, 518, 519, 520–2 aggregate income 20, see also quantity theory of money Asset-backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) 342 aggregate output 9, 464–76 asset-liability management (ALM) committee 217 changes in equilibrium level of 489–93 consumer expenditure and consumption function 465–6, 466, 475 asset-price bubbles 181–2 response to by central banks 373–5 assets definition 20 bank see bank capital equilibrium and the Keynesian cross diagram 467–9, 468 and central bank’s balance sheet 302–3 and expenditure multiplier 469–71 definition 4, 80 government’s role 471–4, 473, 475 restrictions of financial intermediary 42–3 and international trade 474, 476 and investment spending 467, 472, 475 restrictions on holdings 237–8 asymmetric information 36–8, 41, 153–4 and ISLM model 476–82 and financial regulation 232–44 and taxes 475 solutions 164 and unemployment 508 see also GDP see also adverse selection; moral hazard automated banking machine (ABM) 261 aggregate price level see price level automated teller machine (ATM) 261 aggregate supply curve 511–14 automatic transfers 437 factors that cause 520 autonomous consumer expenditure 465, 470–1, 475, 486 long run 511, 511, 518–19 short run 511–14, 512, 514 Alt-A mortgages 184 balance of payments 410–11, 426 balance sheets INDEX asset market effects on 177–8 general principles of bank management 213–20 central bank’s 301–3 home 261 deterioration of banks’, and subprime financial crisis 186–7 interest-rate risk management 224–6 deterioration in financial institutions’ 178 internationalization of 269 Great Depression and consumers’ 545 internet 261, 262 and monetary transmission mechanism 544 largest in eurozone 265 see also bank balance sheet liability management 213, 217 balance-of-payments crises 419 liquidity management and role of reserves 213–16 Bank Act (1998) 281 loan commitments 223 bank balance sheet 192, 205–9, 206 loan sales 226 bank capital 208–9, 217–20 long-term customer relationships 222 Bank of England 12, 29, 31, 42, 281–2, 297 as monetary transmission mechanism 542–3 inflation targeting 355, 357, 358, 358 and multiple deposit creation 307–10 monetary policy 274 off-balance-sheet activities 226–8 money aggregates 54 primary assets and liabilities 38 money targeting 352–3 regulation of 245–8 open market operations 333–4 screening and monitoring 221–2 and paying interest on reserves 329 specialization in lending 221–2 and reserve requirements 346 state-owned 165 standing facilities 339 T-account tool 211–13 structure and independence 281–2 ten largest 269 Bank of England Act (1998) 280 trading activities and risk management 227–8 bank failure 217, 232–3 value of assets 39 Bank of Japan 291, 336, 362 virtual 262 bank panics 178 see also building societies; central banks; commercial banks; investment banks Great Depression 319–20 and need for deposit insurance 232–3 Barings Bank 227, 228, 241 Bank of Sweden 290–1 barter economy 48–9 banking industry 252–71 Basel Accord 238, 239, 244 consolidation and downsizing 256–8 (2) 239, 240, 242 deregulation and competition 254–6 (3) 244 international 267–9 Basel Committee on Banking Supervision 238–9, 244 mergers and acquisitions 256–7, 257 Bauman–Tobin model 452–5, 452 shadow system 258–65 behavioural finance 143 single banking market in Europe 252–3 Black Monday (1987) 6, 142, 344 banks/banking 8, 38–9, 38, 205–31 asset management 206, 208–9, 210, 213, 216 basic banking 209–13 capital adequacy management 217–20 bond market 4–5 ‘lemons problem’ 154–5 supply and demand in 82–5 bonds 4–5 collateral and compensating balances 223 bank and building society 32 cost of rescuing around the world 247 corporate 31, 111 credit rationing 223–4 and default risk 110–13, 111 credit risk management 220–4 defined crises 178, 180, 182–3, 245–6, 246 Eurobond 33 electronic 261 foreign 33 fee income generation 226–7 income tax considerations and interest rates 114–15 financial innovation and decline of traditional 264–5 interest rates on 4–5, gap and duration analysis 225 and interest-free risk 73 613 614 INDEX bonds (cont.) as lender of last resort 341, 345, 423 junk 111, 261 limits to controlling money supply 316–21 liquidity and interest rates 114 macroeconomic performance and independence 296–7 local authority 31 monetary policy/monetary policy tools 278–9, 328–46, 459 municipal 114–15 paying interest on reserves 329 ratings 112 policy instruments 366–9 returns on 71–3, 72 price stability goal 275–80 shifts in demand of 85–8, 86 reforms in Latin America 293 shifts in the supply of 88–90 response to asset-price bubbles 373–5 as source of external finance 150, 151 in transition economies 291–2 term to maturity and interest rates 116–24 watchers 372 UK government 31 see also Bank of England; European Central Bank; European System of Central Banks; Federal Reserve System borrowed reserves 315 Brazil, foreign exchange crisis (1999) 419–20 certificates of deposits (CDs) 28, 207–8 Bretton Woods system 413, 416, 422 chaebols 194–5 British-style universal banking system 266 cheques 50–1 brokers 26 Chicago Board of Trade 259–60 bubbles 142, 373–5 China 33, 166–7, 415–16 budget deficits 12 collateral 151–2, 158, 162, 223, 337 and inflation 566–9 collateralized debt obligations (CDOs) 184 as a percentage of GDP 12, 13 commercial banks 38–9, 38, 39, 43, 527 budget surplus 12 balance sheet 206 building societies 32, 38, 39–40, 39 frameworks 266 Bundesbank see Deutsche Bundesbank loans 206, 209 bureaucratic behaviour 295–6 and off-balance-sheet activities 255 business cycles 9, 125 open market purchase from 303 and aggregate supply and demand analysis 520–2 ownership share of 266, 266 and interest rates 91, 92, 93, 93 structure 265–6 commercial paper 28–9 CAMELS rating 241 Commercial Paper Funding Facility (CPFF) 342 Canada 53, 355, 356 commercial paper market 261–2 capital 25 see also bank capital commodity money 50 capital account 411 common stock see stock capital adequacy management 213, 217–20 compensating balances 223 capital controls 420–2 complete crowding out 493–5 capital markets 27 conflicts of interest 167–72 instruments 29–32, 31 capital mobility 405 cash flows 131, 544 central banks 12, 53, 55, 275–300 and accountability 295 balance sheet 301–3 bureaucratic behaviour theory 295–6 and deposit facilities 327 in developing countries 292–3 consols 4–5, 68–9 constant-money-growth rate rule 575 consulting 168–70 Consumer Credit Directive (1987) 242 consumer durable expenditure 537 consumer expenditure and aggregate output 465–6, 466, 475 see also autonomous consumer expenditure in emerging economies 292–3 consumer price index (CPI) 21, 508 hierarchical versus dual mandates 280 consumer protection 242 independence of 293–7 consumption 542 and inflation 55, 294, 296, 296, 297 consumption function 465–6, 466 INDEX contractual savings institutions 38, 39, 40 see also insurance companies; pension funds demand curve 82–4 for domestic assets 389, 390 convertible bonds 31 and market for reserves 327 corporate bonds 31, 111 for money 97–8 correspondent banking 267 movements along 85 cost-push inflation 563–4, 563 costly state verification 160 coupon bond 64 yield to maturity 66–9, 68 coupon rate 64 shifts in and factors causing 85–8, 86, 87 demand for money 445–63 and autonomous changes on LM curve 488–9, 489 and Bauman-Tobin model 452–5, 452 covered bond purchase programme (CBPP) 337 differences between Friedman and Keynesian theories 456–8 credit boom 181, 197 Friedman’s modern quantity theory of money 455–6 credit cards 260 and interest rates 458–9 credit counterparty model 321–2 Keynes’s liquidity preference theory 449–55 credit crunch (2007–8) 220, 244 precautionary motive 449–51, 454 credit easing (CE) 343 quantity theory of 445–7 credit market instruments 63–4 speculative motive 450, 451, 454–5 credit risk 213, 220–4 stability of 459 credit unions 40 transactions motive 449, 452–3 credit view transmission mechanisms 542–6 demand-pull inflation 564–6, 565 credit-driven bubbles 373, 374 demand shocks 510, 517–18, 517, 521 credit-rating agencies 111, 169, 170–2, 177–8, 249 deposit facility 327, 339 currency, unanticipated decline in value of 177–8 deposit insurance 43, 232–3, 234, 235, 246 currency boards 430, 431 deposit outflows 213 currency in circulation 302 deposit rate 331–2 currency crisis deposits and financial crisis in emerging market economies 191–2 certificates of 28, 207–8 currency ratio 315 foreign currency 208 currency swap agreements 337 interbank 29, 207 currency withdrawal 305–6 and multiple deposit creation 307–12 current account 410 sight 207, 312 current account deficit 412, 412 time 207 depreciation 384 data lag 572 dealers 26 debit cards 51, 260 derivatives 259–60 regulation of 249 Deutsche Bundesbank 42, 288–90 debt contracts 152, 161–4 and foreign exchange crisis (1992) 418–19 debt deflation 180, 183 functions 289–90 debt instruments 25, 27 and money targeting 353–4 debt ratings 169 default 28 default-free bonds 110 default risk 110–13 structure 289 developing countries central banks in 292–3 financial development and economic growth 165–6 deleveraging 181 direct finance 24, 151 demand direct method 384 for assets see asset demand disclosure requirements 242 shift in demand for bonds 85–8, 86 discount bonds 64 see also aggregate demand and supply analysis yield to maturity 69–70 615 616 INDEX discount window facility 340 Enhanced Credit Support programme (ECS) 337–8 discounting the future 62 equation of exchange 446 discretionary policy, and inflation 572–6 equilibrium disintermediation 264 in aggregate demand and supply analysis 514–20, 515, 516 disposable income 465 aggregate output and changes in 489–93 diversification 36 in the goods market (IS curve) 476–9, 478 dividends 26, 131 and Keynesian cross diagram 467–8, 468 dollarization 430, 431–2 domestic assets in the market for money (LM curve) 476, 479–81, 480 equilibrium price 84–5 comparing expected returns 404–5 equity capital see net worth demand curve 389, 390 equity contracts, moral hazard in 159–61 shifts in demand for 390–4, 395 equity multiplier (EM) 217–18 Dow Jones Industrial Average 6, 6, 33, 130 euro 33, 398–9, 434 dual mandates 280 euro area/eurozone 286 duration analysis 225 as an optimal currency area 435 budget deficit 12 e-cash 51–2 commercial banks in 265, 265 e-finance composition of money aggregates 53, 54 e-money 51–2 decline in financial institutions 257 East Asia financial crisis (1997–8) 193–6 and financial intermediaries 36 econometric models 579–80 financial and sovereign debt crisis 196–208, 196, 248 economic fluctuations, and monetary policy 529–36 future expansion 436 economic growth inflation and money growth in 557 and financial development in developing countries 165–6 and interest rates 196–7, 196 as goal of central bank’s monetary policy 278 pass-through of retail bank rates in 538 Economic and Monetary Union see EMU price developments in selected areas 200 Economic Recovery Act (2008) 187, 188 reasons for continued recession in 199 Economic Stimulus Act (2008) 491, 493 velocity of M3 in 459, 460 economic stimulus packages (2008/2009) 491–3 Euro Euribor rate 30 economies of scale 35, 153 Euro Repo rate 30 economies of scope 167, 263 Eurobond 33 effectiveness lag 573 Eurocurrencies 33 efficient market hypothesis 137–43 Eurodollars 33, 268 electronic banking 261 European Banking Authority (EBA) 247–8 electronic payment 51 European Central Bank (ECB) 12, 42, 53, 55–6, 286–90, 297, 433 emerging market economies central banks in 292–3 comparison with Federal Reserve System 288 definition 189 and Deutsche Bundesbank 288–90 dynamics of financial crises in 188–96 Enhanced Credit Support programme 337–8 and exchange-rate targeting 430 Executive Board 286, 288 foreign exchange crises 419–20 Governing Council 286, 288, 289 empirical evidence, framework for evaluating 525–8 independence of 290, 293 employment measuring money aggregates 54 central banks and goal of high 278 monetary policy 274, 286, 288, 459 inflation and targets of 563–6 open market operations 334 see also unemployment and reserve requirements 346 EMU (Economic and Monetary Union) 113, 286, 433, 435, 593–4 standing facilities 339 two-pillar monetary policy strategy 360–1, 360 INDEX European currency unit (ECU) 417 Board of Governors 284 European Economic Recovery Plan (EERP) 493 comparison with European Central Bank 288 European Monetary System (EMS) 417–18 increase in reserve requirements (1936–7) 535–6 European System of Central Banks (ESCB) 280, 286, 287 independence of 285–6, 293 European Union (EU) 171–2, 252–7 inflation targeting 364, 365 Eurosystem 286, 287, 288 as lender of last resort 424 excess demand 84–5 monetary policy 274, 363, 364–5 excess reserves 208, 302 and money targeting 351–2 excess reserves ratio 315 open market operations 283–4, 334, 338 excess supply 84 and paying interest on reserves 329 Exchange Rate Mechanism (ERM) 192, 417 and reserve requirements 346 exchange rate peg see exchange-rate targeting response to subprime financial crisis 342–3 exchange rate regimes 411–20 standing facilities 340–1 exchange rates structure 282–4 effect of on net exports 540 using discount policy to prevent a financial panic 344–5 explanations for changes in 390–401, 395 fee income, banks 226–7 and interest rate changes 396–7, 396 fiat money 50 and law of one price 385 finance companies 38, 39, 40, see also commercial paper in the long run 385–8, 388 financial crises 8, 25, 176–204 and monetary policy 427 developed countries 179–83 and money supply changes 397, 397 emerging market economies 188–96, 189 overshooting 397–8 eurozone see 196–208, 196, 248 reasons for importance 384 factors causing 176–9 and shifts in the demand for domestic assets 390–3, 394, 395 financial engineering 184, 259 in the short run 389–90 financial globalization 190–1, 194–5 and theory of purchasing power parity 386–7 financial innovation 8–9, 258–65 transaction types 383–4 financial institutions see also foreign exchange rates subprime see subprime financial crisis and conflicts of interest 167–72 exchange-rate targeting 427–30, 432–7 decline of monetary 257, 257 exchanges/exchange markets 27 see also foreign exchange markets deterioration in balance sheets 178 expectations and inflation 574–5 and term structure of interest rates 116–20 see also rational expectations expected inflation 89, 89, 90–1, 91, 92, 101 expected returns 81, 82, 86, 87–8 expenditure multiplier 469–71 exports see net exports financial intermediaries 7–8, 151, 157–8, 161 and adverse selection 157–8 and asymmetric information 36–8, 41 definition deposit insurance 43 and disclosure 42 ensuring soundness of 41–3 entry restrictions 42 function of 34–8 limits on competition 43 face value 64 and moral hazard in debt contracts 163–4 fair-value accounting see mark-to-market accounting Federal Deposit Insurance Corporation (FDIC) 233 as most important source of external funds used to finance businesses 150, 151 Federal Funds Rate Target 334 and principal-agent problem 161 Federal Open Market Committee (FOMC) 284, 334 restrictions on assets and activities 42–3 Federal Reserve Banks 53, 54, 282–4 and risk sharing 35–6 Federal Reserve System 282–6, 283, 295 and transaction costs 35, 152–3 617 618 INDEX financial intermediaries (cont.) Fisher equation 74 types of 38–41 fixed exchange rate regime 411, 413–15 see also banks fixed-payment loan 64, 65–6 financial liberalization 179–81, 180, 190–1, 194–5 fixed-rate full allotment 337 financial markets floating exchange rate regime 411 function of 23–5, 24 foreign bonds 33 globalization of 13 foreign currency deposits 208 instruments traded in 27–9 foreign exchange crises 418 internationalization of 32–4 reasons for studying 3–7 (1992) 418–19, 418, 428–9 in emerging market countries 419–20 stability of as goal of central bank’s monetary policy 279 foreign exchange interventions 407–10 structure of 25–7 foreign exchange market 6–7, 279, 381–406, 426 financial panic 41 foreign exchange rates 6–7, 7, 13, 382, 383–4 financial regulation 41–3, 232–51 foreign stock markets 33–4 asset holdings, restrictions on 237–8 forward exchange rate 383 and asymmetric information 232–44 forward transactions 383–4 bankers’ compensation 249 free-rider problem 155–6, 160, 164, 242 and banks 245–8 Friedman, Milton 11, 100, 363, 456–8, 529, 530, 532–6, 555 Basel Accord 238–9, 240, 244 futures contracts 259 capital requirements 238–9, 249 consumer protection 242 gap analysis 225 and credit-rating agencies 249 GDP deflator 21, 22, 508 dangers of overregulation 250 GDP (gross domestic product) 12, 13, 20–2 of derivatives 249 generalized dividend valuation model 132 disclosure requirements 242 Germany 200 financial innovation and avoidance 263–4 banking system 256 future directions 246–50 government bailout 188 and government safety net 232–7 hyperinflation (1921–3) 49, 557–8, 558 macro-prudential regulation 375 money targeting 353–4 mortgage brokers 248 reunification (1990) 495–6 prompt corrective action 239–40 gilt repurchase agreements 29 risk management assessment 241–2 Glass-Steagall Act 267 supervision 240–1 global financial crisis 148, 244, 335, 388–9 see also subprime financial crisis worldwide banking crises and 245–6, 246 Financial Service Action Plan (1999) 253 global legal settlement (2002) 171 Financial Services Authority (FSA) 42, 156, 282 goal independence 281 financial structure 149–75 see also financial institutions gold standard 411–13 financial supervision 240–1 goods market equilibrium (IS curve) 476–9, 478 Financial Times Stock Exchange (FTSE) 100-Share Index 33, 130 Gordon growth model 132, 134 fine-tuning operations 334 government safety net 232–7 First Banking Directive (1977) 253 government spending government budget 89–90, 89, 566–7 fiscal imbalances 191, 192, 196–7 affect of changes in on IS curve 486 fiscal policy 437 and aggregate output 471–4, 473 and inflation 560–1 Government Sponsored Entities Purchase Program 342–3 in ISLM model 485–506 Great Depression 183, 319–20, 471, 545, 530 and monetary policy 12–13, 493–5, 494 Greece 188, 199, 200, 202 Fisher effect 90–1, 91 Greenspan, Alan 285, 352, 363 INDEX gross domestic product see GDP inflation targeting 354–63 growth rates 21–2 information 155–6, 160 Gulf Central Bank (GCB) 433 information technology 260–4 Gulf Cooperation Council 433 initial public offerings (IPOs) 168 instrument independence 281 hedge 259 hierarchical mandates 280 insurance/insurance companies 38, 39, 40 see also deposit insurance home banking 261 interbank deposits 29, 207 hyperinflation 49, 275, 567–8 interest parity condition 404–6, 415 Bolivia 593 Germany (1921–3) 49, 557–8, 558 hysteresis 519 interest rates 4–5, 61–79 behaviour of 80–107 and central bank’s monetary policy 279 changes in due to a business cycle expansion 91, 92, 93 IMF (International Monetary Fund) 413, 417, 422–5 changes in due to expected inflation (Fisher effect) 90–1, 91 implementation lag 573 changes in equilibrium level of 489–93 incentive-compatible debt contract 162 and demand for money 458–9 income distinction between real and nominal 73–6 liquidity preference framework 98, 99, 101 distinction between returns and 70–3 and money 47 and eurozone 196–7, 196 income tax considerations, bonds 114–15 and exchange rates 396–7, 396 index-linked bonds 75, 76 financial crises and rises in 178–9, 182 indirect finance 34–5, 151 see also financial intermediaries and government budget deficit 568, 568 indirect method 384 and income tax consideration 114–15 inflation 9–11, 49, 555–78 and ISLM model 476–82, 480 and budget deficits 566–9 and liquidity 114 causes 10–11 and liquidity preference framework 95–103 and central banks 55, 294, 296, 296, 297 measuring 61–70 and credibility 575–6 and monetary transmission mechanisms 537–40 defined 10, 559 and money 11, 12, 100–4, 103, 104 discretionary/non-discretionary policy debate 572–6 and net exports 477 expected and realized, euro area 361 and planned investment spending 477 and fiscal policy 560–1 risk structure of 108–15 and high employment targets 563–6 and supply and demand in bond markets 82–5 Maastricht criterion 593–4 term structure of 116–24, 580–1 and monetary policy 562–71 versus monetary targeting 496–9, 497, 498 and money 9–11, 555–9, 556 volatility of 259–60 and money growth 559–60, 561, 569 and yield to maturity 64–70 origins of inflationary monetary policy 562–71 and rational expectations 135, 574–5, 590–3, 591 interest-rate risk 73, 213, 259 management of by banks 224–6 recent episodes of 558–9 intermediate target 366 shift in supply curve and expected 89, 89 international banking industry 267–9 and supply shocks 561–2, 562 international financial system 14, 407–42 and Taylor rule 369–72 balance of payments 410–11 UK (1960–80) 569–71 capital controls 420–2 and unemployment 520, 521, 522, 572–3 exchange rate regimes 411–20 yield curve as forecasting tool for 125 exchange-rate targeting 427–32 see also hyperinflation and monetary policy 426–7 inflation rate 11, 22 role of IMF 422–5 619 620 INDEX International Monetary Fund see IMF law of one price 385, 386 international reserves 407 lawyers 166 China’s accumulation of 415–16 legislative lag 573 international trade, and aggregate output 474, 476 Lehman Brothers 8, 187, 197, 267 internet banking 261, 262 ‘lemons problem’ 154–8 inventory investment 467 lender of last resort 234–5, 341 inverted yield curve 116 and central banks 341, 345, 423 investment banks 26, 41, 168, 267 and Federal Reserve 424 investment intermediaries 40–1, 38, 39 see also finance companies; money market mutual funds; mutual funds and IMF 423–4 investment spending affect of changes in on IS curve 486 and aggregate output 467, 472, 475 collapse of and Great Depression 471 investment-grade securities 111 investment(s) 467 profitability of and shift in supply curve 88–9, 89 IS curve 476–9, 478 aggregate demand curve 502–3, 502 factors causing shifts 485–7, 487, 492, 502–3 ISLM model 476–84 and the aggregate demand curve 501–4, 501 and aggregate output 476–82 changes in equilibrium level of the interest rate and aggregate output 489–93 equilibrium in the market for money (LM curve) 476, 479–81, 480 equilibrium in the goods market (IS curve) 476–9, 478 lending rate 331 liabilities 24 bank balance sheet 205–8, 302 liquidity 26, 337 and asset demand 81–2, 82 definition 49 and interest rates 114 monetary transmission mechanisms and household 545–6 and shifts in demand curve 86, 88 liquidity management 213–16 liquidity preference theory 95–103, 449–55, 457–8, 479 liquidity premium theory 121–2, 123, 123, 125 liquidity services 35, 153 liquidity trap 458 LM curve 476, 479–81, 480 aggregate demand curve 503, 503 factors causing shift in 487–9, 488, 489, 491 loan commitments, banks 223 loan sales, banks 226 loans factors causing IS curve to shift 485–7, 487, 502–3 as bank assets 206, 209, 212 factors causing LM curve to shift 487–9, 488, 489 bank and building society 32 and interest rates 476–82, 480 fixed-payment 64 in the long run 499–504, 500 simple 62–3 monetary and fiscal policy in 485–506 Japan applying monetary policy lessons to 549–50 banking system 266 deregulation of securities markets 36 explaining low interest rates 93–4 inflation targeting 362 junk bonds 111, 261 ‘just it’ approach 363–5 local authority bonds 31 London Stock Exchange 26, 27 Long Term Capital Management (LTCM) 237 long-run monetary neutrality 500 longer-term refinancing operations 334 loophole mining 263 Lucas, Robert 579–81 M1 monetary aggregate 53, 54, 55, 56, 447–8, 448 M2 monetary aggregate 53, 54, 447–8, 448 Keynes, John Maynard 95, 96, 98, 449–52, 456–8, 464–5, 471–2 M3 monetary aggregate 53, 54, 55, 56, 352, 360 Keynesian cross diagram 467–8, 468 Maastricht Treaty 280, 286, 290, 436, 593–4 Keynesians/Kenesianism 517, 529–31 macro-prudential regulation 375 further developments in 452–5 M3 money multiplier 316–17, 317, 318 main refinancing operations (MROs) 334 INDEX Main Refinancing Rate 334 managed float regime 411, 416–17 Taylor rule 369–72, 371 see also central banks marginal propensity to consume 465 Monetary Policy Committee (MPC) 281 mark-to-market accounting (fair-value accounting) 242, 243 monetary targeting 351–4 market equilibrium 84–5, 328 market fundamentals 139 market for money, equilibrium in (LM curve) 476, 479–81, 480 advantages and disadvantages 366 versus interest rates 496–9, 497, 498 monetary transmission mechanisms 525–54 balance sheet channel 544 market for reserves, demand and supply in the 327–8 cash flow channel 544 maturity bucket approach 225 credit channels 546 maturity transformation 210 credit view 542–6 medium of exchange 47–8 household liquidity effects 545–6 mergers and acquisitions, banks 256–7, 257 interest-rate channels 537–40 Mexico 419–30, 428 and Japanese economy 549–50 Milken, Michael 261 lessons for monetary policy 547–9 minimum bid rate 334 other asset price channels 540–2 monetarists/monetarism 458, 517, 529, 530–6 monetary base 302, 303–7 and money multiplier 312–14, 320–1 unanticipated price level channel 545 monetary unions 432–7 see also Economic and Monetary Union (EMU) monetary financial institutions (MFIs) 53 monetizing the debt 567 monetary and fiscal policy mix 495, 496 money 46–58 monetary neutrality 397 and business cycles monetary policy 326–50 definition 9, 46–7 and aggregate output 489–90 and evolution of payments system 50–2 choosing policy instrument 366–9 functions of 47–9 conduct of 11–12 growth 9, 10 and economic fluctuations 529–36 and income 47 Enhanced Credit Support (ECCS) 337–8 and inflation 9–11, 555–9, 556 and exchange rates 427 and interest rates 11, 12, 100–4, 103, 104 and fiscal policy 12–13, 403–4, 494 Keynesian evidence on importance of 529–31 and Great Depression 530 measuring 52–5 and inflation 562–71 as medium of exchange 47–8 and inflation targeting 354–63 monetarism and importance of 530–6 international considerations 426–7 printing 567 and international financial system 426–7 quantity theory of 445–7, 455–6 in ISLM model 485–506 as a store of value 49 ‘just it’ approach 363–5 as a unit of account 48–9 lender of last resort 234–5 and wealth 46–7 market for reserves and the overnight interest rate 327–33 see also money supply money aggregates, measurement of 52–6, 54, 56 and monetary transmission mechanisms 547–9 money growth, and inflation 559–60, 561, 569 and nominal anchor 363–6 Money Market Investor Funding Facility (MMIFF) 342 open market operations 328, 330, 333–9 money market mutual funds 41, 53 and pricking asset-price bubbles 374–5 money markets 27, 30 quantitative easing 335–6 instruments (MMIs) 27–9 reserve requirements 332, 345–6 money multiplier 312–14 standing facilities 330–2, 339–45 money supply 301–25 and stock prices 134 money supply see money 621 622 INDEX money supply new Keynesian models 585–7, 586 aggregate output equilibrium level 489–90, 490 New Zealand, inflation targeting 355, 356, 359 central bank’s balance sheet 301–3 nominal anchor 277, 363–6, 366, 427 control of the monetary base 303–7 nominal interest rate 73–6, 75 and credit counterparty model 321–2 non-borrowed monetary base 307, 314 currency withdrawal 305–6 Norway 291 definition during Great Depression bank panics 319–20 off-balance-sheet activities 226–8, 238, 255 and exchange rates 397, 397 official reserve transactions balance 411 factors determining 314–16 oil price shocks 520–1 and foreign exchange interventions 407–9, 426 one-period valuation model 131 and interest rates 98, 99, 100, 489–90, 490 open market operations 283–4, 303–4, 328, 330, 330, 333–9 limits of central bank’s ability to control 316–21 open market purchase 303–5 and LM curve 487–8, 488 operational standing facilities (OSFs) 339 loans to banks 306 opportunity cost 96 money multiplier 312–14, 320–1 Optimal Currency Area (OCA) 435 multiple deposit creation 307–12 optimal forecast 135 open market operations 303–5 originate-to-distribute model 185 overview of money creation process 316, 316 outright transactions 338 participants involved in creation process 301 over-the-counter (OTC) market 27 money targeting 351–4 overnight interbank interest rate 326, 328–32, 339–40, 340 monitoring 160, 162, 221–2 Owns Funds Directive (1989, 1991) 253 moral hazard 37–8, 41, 154 and capital requirements 238 payments system 50–2 and debt contract 161–4 PCE (personal consumption expenditure) deflator 21 in equity contracts 159–61 pension funds 38, 39, 40 and financial crises in emerging market economies 191 People’s Bank of China 53, 293 and government safety net 235 perpetuities 68–9 and lender of last resort 345 Phillips curve 370–1 in loan markets 221 planned investment spending 469–70, 470, 477 and principal-agent problem 159–61 Plaza Agreement (1985) 427 and too big to fall 236 policy instrument, choosing 366–9 and too important to fail 237 political business cycle 294 mortgage-backed securities 184 preferred habitat theory 122–3, 125 mortgages 29 present value 61–3 multiple deposit creation 307–12 price level 9–10, 508 municipal bonds 114–15 aggregate supply curve and expected 513 mutual funds 38, 39, 40–1, 153 consumer price index (CPI) 21, 508 definition 21 NAIRU (non-accelerating inflation rate of unemployment) 370 and GDP deflator 21, 508 national central banks (NCBs) 53, 286 growth rate of see inflation rate natural rate of output 499, 511 increase in 10, 10 natural rate of unemployment 278, 511 PCE deflator 21 net exports 474, 476, 477, 486, 540 unanticipated decline in 177 net interest margin 255, 255 price stability 275–7, 279–80 net worth (equity capital) 158, 162 price-level effect 98, 99, 100, 101 new classical macroeconomic model 581–5 Primary Dealer Credit Facility (PDCF) 342 INDEX primary markets 26 return on equity (ROE) 217–18 principal-agent problem 159–61, 184–5, 228 returns 71 producer price index (PPI) 508 asset demand and expected 81 productivity, and foreign exchange rates 388 distinction between interest rates and 70–3 Public Company Accounting Oversight Board (PCAOB) 170 distinction between nominal and real 75 purchasing power parity, theory of 386–7, 386 maturity and the volatility of bond 72–3 revaluation 415 q theory 540, 542 reverse causation 528 quantitative easing (QE) 335–6, 336, 546–9 reverse repurchase agreement (reverse repo) 333 quantity theory of money 445–7, 455–6 Ricardian equivalence 568–9 quotas 388 risk and asset demand 81, 82 rate of return see returns and interest rates 108–15 rational expectations 579–98 and shifts in demand curve 86, 88, 391 and Black Monday (1987) and tech (2000) crashes 142–3 see also credit risk comparison of the two models with traditional model 587–95, 588 risk management assessment 241–2 in financial markets see efficient market hypothesis risk sharing 35–6 formal statement of the 136 rogue traders 228 impact of revolution in 595 Royal Bank of Scotland 234–5 risk premium 110 implications of 136–7 and inflation 590–3, 591 Sarbanes–Oxley Act (2002) 32, 170–1, 172 and Lucas critique 579–81 Second Banking Directive (1988) 253 and new classical macroeconomic model 581–5, 587–95 secondary credit 340–1 new Keynesian model 585–7, 586, 587–95 secondary loan see loan sale rationale behind 136 short-run output and price responses 587–8, 589 secondary markets 26, 27 see also exchanges; over-the-counter (OTC) market stabilization policy 589–90 secondary reserves 208 real business cycle theory 519 secured debt 152 real exchange rate 386 securities 4, 24 real interest rate 73–6, 75 as bank assets 208–9, 212 real money balances 450–1 bank balance sheet 206 real terms 74 long-term and short-term 27 recognition lag 573 primary and secondary markets 26 reduced-form evidence 526, 527–8 securitization 184, 262–3, 264 regulation see financial regulation segmented markets theory 120–1, 124 regulatory arbitrage 238 seignorage 432 repurchase agreements (repos) 29, 333 self-correcting mechanism 516 required reserve ratio 208, 302, 315 shadow banking system 258–65 required reserves 208, 302 short sales 143 reserve average scheme 333–4, 346 sight deposits 207, 212 reserve currency 413 simple deposit multiplier 310 reserve requirements 208, 332, 345–6 simple loan 62–3, 64–5 reserves 208, 212, 213–16, 302, 329 smart card 51 residual claimant 131 Solvency Ratio Directive (1989) 253 restrictive covenants 152, 162–3, 222 South Korean financial crisis 194–5 retail price index 76 Spain 188, 200 return on assets (ROA) 217, 254–5, 254 special drawing rights (SDRs) 417 623 624 INDEX speculative attacks 428 speculative motive, and money demand 450 spread of Treasury Bill-to-Eurodollar rate (TED) 186, 186, 187 spot exchange rate 383 and stock market 134 spot transactions 383 and Treasury Asset Relief Plan (TARP) 188 Stability and Growth Pact (SGP) 435 supply Standard and Poor’s (S&P) 500 index 130 bond market 82–95, 83, 95–6, 110 standing facilities 330–2, 339–45 see also aggregate demand and supply analysis state-owned banks 165 supply curve 84 sticky prices 537 applications in shifts in 90–4 stock market 5–6, 33–4 for domestic assets 389, 389 ‘lemons problem’ 154–5 and market for reserves 327–8 practical guide to investing in 140–2 movements along 85 and subprime financial crisis 134 shifts in and factors causing 88–90, 89, 90 stock market declines and crashes (2008) 60 Black Monday 6, 142, 344 South Korean 194–5 see also financial crises; Great Depression stock prices, setting of 133–4 stock valuation 130–2 stockholders 130–1 stocks 5, 25–6, 29, 31, 150 stored-value card 51 stress testing 242 structural model evidence 525–7, 528 structural unemployment 278 structure equation 580–1 structured credit products 184 structured investment vehicles (SIVs) 186, 227 subprime financial crisis (2007–8) 8, 60, 70, 112–13, 148, 176, 184–8, 197, 274 agency problems 184–5 and credit-rating agencies 170 see also demand curve supply shocks and aggregate supply and demand analysis 513–14, 518, 519, 520–2 and inflation 561–2, 562 Sweden 290–1 T-account 211–13 tariffs 388 taxes affect of changes in on IS curve 486 and aggregate output 475 Taylor principle 370 Taylor rule 369–72, 371 Term Asset-Backed Securities Loan Facility (TALF) 342 Term Auction Facility (TAF) 342 Term Securities Lending Facility (TSLF) 342 term structure (of interest rates) 116–24 Thailand 195 foreign exchange crisis (1997) 419–20 and demise of investment banks in US 267 time deposits 207 see also certificates of deposit deterioration of banks’ balance sheets 186–7 time-inconsistency problem 277 emergence of financial innovations in mortgage markets 184 Tobin tax 421–2 failing of high-profile firms 187 too big to fail policy 236 government bailouts 187, 188 too important to fail policy 237 house price bubble and bursting of 184, 185 trade balance 410 and IMF 425 trade barriers 388 information problems 185 trading activities, banks 227–8 lessons from 373–5 trading assets 209 and mark-to-market accounting 243 transaction costs 35, 48, 152–3 and negative aggregate demand shocks 521–2 transactions motive, and money demand 449 and quantitative easing 546–9 recovery 187–8 transmission, mechanisms of monetary policy see monetary transmission mechanisms response to by Federal Reserve 342–3 Treasury Asset Relief Plan (TARP) 188 Tobin’s q theory 540, 542 INDEX Treasury bills see US Treasury bills Treasury bonds see UK Treasury bonds; US Treasury bonds impact of internationalization of financial markets on 33 money targeting 351–2 UK Treasury bonds 111 unanticipated policy 581–3, 582, 585–7 underwriting securities 26, 168 unemployment 278, 279 and aggregate output 508 frictional 278 and hysteresis 519 and inflation 520, 521, 522, 572–3 natural rate of 278, 511 structural 278 UK (1970–2011) 571 unemployment rate unexploited profit opportunities 138 unit of account, money as 48–9 United Kingdom banking system 266 budget deficit 12 composition of monetary aggregates 53, 54 credibility and inflation 575–6 exchange-rate targeting 428, 429 fiscal austerity programme (2010) 295 government bailout 188 government debt-to-GDP ratio (1970–2011) 570–1, 570 impact of internationalization of financial markets on 33 inflation and money growth 556 inflation targeting 359 money targeting 352–3, 355, 356, 357 reasons for inflation (1960–80) 569–71 unemployment (1970–2011) 571 United States composition of money aggregates 53, 54 decline in dominance of markets 32 subprime financial crisis and demise of investment banks 267 universal banking 266 US dollar, euro’s challenge to 434 US Treasury bills 4–5, 12, 28, 28, 33 US Treasury bonds 11, 12, 115 vault cash 208 velocity of money 445–6, 447–9, 448, 449, 451–2 venture capital firm 161 virtual bank 261, 262 wage flexibility 437 wage–price stickiness 585 Washington Mutual (WAMU) 187 wealth and asset demand 81, 82 effects, as monetary transmission mechanism 542 and money 46–7 and shifts in demand curve 86–7, 86, 390–1 West African Economic and Monetary Union (WAEMU) 433 World Bank 413 World Trade Organization (WTO) 413 yield curve 116, 117, 119–20, 121, 122–3, 124 as forecasting tool for inflation and the business cycle 125 interpreting (1981–2011) 125–6, 126 inverted 116 yield to maturity 64–70 zero-coupon bond see discount bonds Zimbabwe 558–9 625 ... Federal Open Market Committee of the Federal Reserve System From September 2006 to August 2008, he was a member (governor) of the Board of Governors of the Federal Reserve System Professor Mishkin s... at Journal of Business and Economic Statistics, the Journal of Applied Econometrics, and Journal of Money, Credit and Banking; he also served as the editor of the Federal Reserve Bank of New York’s.. .THE ECONOMICS OF MONEY, BANKING AND FINANCIAL MARKETS THE ECONOMICS OF MONEY, BANKING AND FINANCIAL MARKETS EUROPEAN EDITION Frederick S Mishkin Kent Matthews Massimo Giuliodori Pearson education