Money, banking and the financial system (1st edition) r glenn hubbard, anthony patrick o''''brien prentice hall (2011)

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Money, Banking, and the

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—Anthony Patrick O’Brien

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About the Authors

Glenn Hubbard, Professor, Researcher, and Policymaker

R Glenn Hubbard is the dean and Russell L Carson Professor

of Finance and Economics in the Graduate School of Business

at Columbia University and professor of economics inColumbia’s Faculty of Arts and Sciences He is also a researchassociate of the National Bureau of Economic Research and adirector of Automatic Data Processing, Black Rock Closed-EndFunds, KKR Financial Corporation, and MetLife He receivedhis Ph.D in economics from Harvard University in 1983 From

2001 to 2003, he served as chairman of the White HouseCouncil of Economic Advisers and chairman of the OECDEconomy Policy Committee, and from 1991 to 1993, he was deputy assistant secretary

of the U.S Treasury Department He currently serves as co-chair of the nonpartisan

Committee on Capital Markets Regulation and the Corporate Boards Study Group

Hubbard’s fields of specialization are public economics, financial markets and

institu-tions, corporate finance, macroeconomics, industrial organization, and public policy

He is the author of more than 100 articles in leading journals, including American

Economic Review, Brookings Papers on Economic Activity, Journal of Finance, Journal of

Financial Economics, Journal of Money, Credit, and Banking, Journal of Political Economy,

Journal of Public Economics, Quarterly Journal of Economics, RAND Journal of

Economics, and Review of Economics and Statistics His research has been supported by

grants from the National Science Foundation, the National Bureau of Economic

Research, and numerous private foundations

Tony O’Brien, Award-Winning Professor and Researcher

Anthony Patrick O’Brien is a professor of economics at LehighUniversity He received a Ph.D from the University ofCalifornia, Berkeley, in 1987 He has taught principles of eco-nomics for more than 15 years, in both large sections and smallhonors classes He received the Lehigh University Award forDistinguished Teaching He was formerly the director of theDiamond Center for Economic Education and was named aDana Foundation Faculty Fellow and Lehigh Class of 1961Professor of Economics He has been a visiting professor at theUniversity of California, Santa Barbara, and the GraduateSchool of Industrial Administration at Carnegie Mellon University O’Brien’s research

has dealt with such issues as the evolution of the U.S automobile industry, sources of

U.S economic competitiveness, the development of U.S trade policy, the causes of the

Great Depression, and the causes of black-white income differences His research has

been published in leading journals, including American Economic Review, Quarterly

Journal of Economics, Journal of Money, Credit, and Banking, Industrial Relations, Journal

of Economic History, Explorations in Economic History, and the Journal of Policy History.

His research has been supported by grants from government agencies and private

foun-dations In addition to teaching and writing, O’Brien also serves on the editorial board

of the Journal of Socio-Economics.

iii

Part 1: Foundations Chapter 1 Introducing Money and the Financial System 1

Part 2: Financial Markets

Chapter 5 The Risk Structure and Term Structure

Chapter 6 The Stock Market, Information, and

Part 3: Financial Institutions

Chapter 9 Transactions Costs, Asymmetric Information,

and the Structure of the Financial System 252

Chapter 11 Investment Banks, Mutual Funds, Hedge

Chapter 12 Financial Crises and Financial Regulation 347

Part 4: Monetary Policy Chapter 13 The Federal Reserve and Central Banking 384

Chapter 14 The Federal Reserve’s Balance Sheet

Chapter 16 The International Financial System

Part 5: The Financial System and the MacroeconomyChapter 17 Monetary Theory I: The Aggregate Demand

Chapter 1 Introducing Money and the Financial System 1

CAN THE FED RESTORE THE FLOW OF MONEY? 1

1.1 Key Components of the Financial System 2

Financial Assets 2

Financial Institutions 4

Making the Connection: Pawn Shop Finance: What Happens to Small Businesses When Bank Lending Dries Up? 5

Making the Connection: What Do People Do With Their Savings? 9

The Federal Reserve and Other Financial Regulators 10

What Does the Financial System Do? 12

Solved Problem 1.1: The Services Provided by Securitized Loans 13

1.2 The Financial Crisis of 2007–2009 14

Origins of the Financial Crisis 14

The Deepening Crisis and the Response of the Fed and Treasury 16

1.3 Key Issues and Questions from the Financial Crisis 17

An Inside Look at Policy: Fed Ready to Help Economy, But Options Are Limited 20

*Chapter Summary and Problems 22

*Key Terms and Concepts, Review Questions, *Problems and Applications, Data Exercise *These end-of-chapter resource materials repeat in all chapters. Chapter 2 Money and the Payments System 25 THE FEDERAL RESERVE FIGHTS TO PRESERVE ITS INDEPENDENCE 25

Key Issue and Question 25

2.1 Do We Need Money? 26

Barter 26

The Invention of Money 27

Making the Connection: What’s Money? Ask a Taxi Driver! 27

2.2 The Key Functions of Money 28

Medium of Exchange 28

Unit of Account 28

Store of Value 29

Standard of Deferred Payment 29

Distinguishing Among Money, Income, and Wealth 29

What Can Serve as Money? 29

The Mystery of Fiat Money 30

Making the Connection: Apple Didn’t Want My Cash! 30

2.3 The Payments System 31

The Transition from Commodity Money to Fiat Money 31

v

The Importance of Checks 31

Electronic Funds and Electronic Cash 32

2.4 Measuring the Money Supply 33

Measuring Monetary Aggregates 33

Making the Connection: Show Me the Money! 35

Does It Matter Which Definition of the Money Supply We Use? 36

2.5 The Quantity Theory of Money: A First Look at the Link Between Money and Prices 37

Irving Fisher and the Equation of Exchange 37

The Quantity Theory Explanation of Inflation 38

Solved Problem 2.5: The Relationship Between Money and Income 38

How Accurate Are Forecasts of Inflation Based on the Quantity Theory? 39

The Hazards of Hyperinflation 39

What Causes Hyperinflation? 40

Making the Connection: Deutsche Bank During the German Hyperinflation 41

Should Central Banks Be Independent? 42

Answering the Key Question 43

An Inside Look at Policy: Its Independence Was Threatened, but New Law Grants the Fed New Powers 44

Chapter 3 Interest Rates and Rates of Return 51 BANKS IN TROUBLE 51

Key Issue and Question 51

3.1 The Interest Rate, Present Value, and Future Value 52

Why Do Lenders Charge Interest on Loans? 52

Most Financial Transactions Involve Payments in the Future 53

Compounding and Discounting 53

Solved Problem 3.1A: Comparing Investments 55

Solved Problem 3.1B: Valuing a Contract 57

Discounting and the Prices of Financial Assets 59

3.2 Debt Instruments and Their Prices 59

Loans, Bonds, and the Timing of Payments 59

Making the Connection: Do You Want the Principal or Do You Want the Interest? Creating New Financial Instruments 62

3.3 Bond Prices and Yield to Maturity 62

Bond Prices 62

Yield to Maturity 63

Yields to Maturity on Other Debt Instruments 64

Solved Problem 3.3: Yield to Maturity for Different Types of Debt Instruments 66

3.4 The Inverse Relationship Between Bond Prices and Bond Yields 67

What Happens to Bond Prices When Interest Rates Change? 67

Making the Connection: Banks Take a Bath on Mortgage-Backed Bonds 68

Bond Prices and Yields to Maturity Move in Opposite Directions 69

Secondary Markets, Arbitrage, and the Law of One Price 69

Making the Connection:Reading the Bond Tables in the Wall Street Journal 70

CONTENTS vii

3.5 Interest Rates and Rates of Return 72

A General Equation for the Rate of Return 73

Interest-Rate Risk and Maturity 73

3.6 Nominal Interest Rates Versus Real Interest Rates 74

Answering the Key Question 77

An Inside Look at Policy: Higher Interest Rates Increase Coupons, Decrease Capital Gains 78

Chapter 4 Determining Interest Rates 87 IF INFLATION INCREASES, ARE BONDS A GOOD INVESTMENT? 87

Key Issue and Question 87

4.1 How to Build an Investment Portfolio 88

The Determinants of Portfolio Choice 88

Making the Connection: Fear the Black Swan! 90

Diversification 92

Making the Connection: How Much Risk Should You Tolerate in Your Portfolio? 93

4.2 Market Interest Rates and the Demand and Supply for Bonds 94

A Demand and Supply Graph of the Bond Market 94

Explaining Changes in Equilibrium Interest Rates 96

Factors That Shift the Demand Curve for Bonds 96

Factors That Shift the Supply Curve for Bonds 100

4.3 The Bond Market Model and Changes in Interest Rates 102

Why Do Interest Rates Fall During Recessions? 102

How Do Changes in Expected Inflation Affect Interest Rates? The Fisher Effect 104

Solved Problem 4.3: Why Worry About Falling Bond Prices When the Inflation Rate Is Low? 106

4.4 The Loanable Funds Model and the International Capital Market 107

The Demand and Supply of Loanable Funds 107

Equilibrium in the Bond Market from the Loanable Funds Perspective 109

The International Capital Market and the Interest Rate 110

Small Open Economy 110

Large Open Economy 112

Making the Connection: Did a Global “Saving Glut” Cause the U.S Housing Boom? 113

Answering the Key Question 115

An Inside Look at Policy: Investors Forecast Lower Bond Prices, Higher Interest Rates 116

Chapter 5 The Risk Structure and Term Structure of Interest Rates 123 WHY INVEST IN TREASURY BILLS IF THEIR INTEREST RATES ARE SO LOW? 123

Key Issue and Question 123

5.1 The Risk Structure of Interest Rates 124

Default Risk 124

Making the Connection: Do Credit Rating Agencies Have a Conflict of Interest? 127

Liquidity and Information Costs 129

Tax Treatment 129

Solved Problem 5.1: How Would a VAT Affect Interest Rates? 131

Making the Connection: Is the U.S Treasury Likely to Default on Its Bonds? 134

5.2 The Term Structure of Interest Rates 135

Making the Connection: Negative Interest Rates on Treasury Bills? 136

Explaining the Term Structure 137

The Expectations Theory of the Term Structure 137

Solved Problem 5.2A: Is There Easy Money to Be Made from the Term Structure? 141

The Segmented Markets Theory of the Term Structure 142

The Liquidity Premium Theory 143

Solved Problem 5.2B: Using the Liquidity Premium Theory to Calculate Expected Interest Rates 144

Using the Term Structure to Forecast Economic Variables 145

Answering the Key Question 147

An Inside Look at Policy: Executives from Moody’s, Standard and Poor’s Describe Pressure to Grant High Ratings 148

Chapter 6 The Stock Market, Information, and Financial Market Efficiency 156 WHY ARE STOCK PRICES SO VOLATILE? 156

Key Issue and Question 156

6.1 Stocks and the Stock Market 157

Common Stock Versus Preferred Stock 158

How and Where Stocks Are Bought and Sold 158

Measuring the Performance of the Stock Market 159

Does the Performance of the Stock Market Matter to the Economy? 160

Making the Connection: Are You Still Willing to Invest in the U.S Stock Market? 161

6.2 How Stock Prices Are Determined 163

Investing in Stock for One Year 163

The Rate of Return on a One-Year Investment in a Stock 164

Making the Connection: How Should the Government Tax Dividends and Capital Gains? 164

The Fundamental Value of Stock 165

The Gordon Growth Model 166

Solved Problem 6.2: Using the Gordon Growth Model 167

6.3 Rational Expectations and Efficient Markets 168

Adaptive Expectations Versus Rational Expectations 168

The Efficient Markets Hypothesis 169

Are Stock Prices Predictable? 171

Efficient Markets and Investment Strategies 171

Making the Connection: Who Are You Going to Believe: Me or a Dart-Throwing Monkey? 172

Solved Problem 6.3: Are Investment Analysts Useless? 173

6.4 Actual Efficiency in Financial Markets 174

Pricing Anomalies 174

CONTENTS ix

Mean Reversion 176

Excess Volatility 176

Making the Connection: Does the Financial Crisis of 2007–2009 Disprove the Efficient Markets Theory? 176

6.5 Behavioral Finance 177

Noise Trading and Bubbles 178

How Great a Challenge Is Behavioral Finance to the Efficient Markets Hypothesis? 179

Answering the Key Question 179

An Inside Look: Prices Rally but Individual Investors Still Avoid Stocks 180

Chapter 7 Derivatives and Derivative Markets 189 HOW DANGEROUS ARE FINANCIAL DERIVATIVES? 189

Key Issue and Question 189

7.1 Derivatives, Hedging, and Speculating 190

7.2 Forward Contracts 191

7.3 Futures Contracts 192

Hedging with Commodity Futures 193

Making the Connection: Should Farmers Be Afraid of the Dodd-Frank Act? 195

Speculating with Commodity Futures 196

Hedging and Speculating with Financial Futures 196

Making the Connection: Reading the Financial Futures Listings 197

Solved Problem 7.3: Hedging When Interest Rates Are Low 198

Trading in the Futures Market 199

7.4 Options 200

Why Might You Buy or Sell an Option? 201

Option Pricing and the Rise of the “Quants” 203

Making the Connection: Reading the Options Listings 204

Solved Problem 7.4: Interpreting the Options Listings 205

Using Options to Manage Risk 206

Making the Connection: Vexed by the VIX! 207

7.5 Swaps 208

Interest-Rate Swaps 208

Currency Swaps and Credit Swaps 209

Credit Default Swaps 210

Making the Connection: Are Derivatives “Financial Weapons of Mass Destruction”? 211

Answering the Key Question 213

An Inside Look at Policy: Traders Uncertain About Impact of New Derivatives Rules 214

Chapter 8 The Market for Foreign Exchange 224 WHY WOULD THE U.S FEDERAL RESERVE LEND DOLLARS TO FOREIGN CENTRAL BANKS? 224

Key Issue and Question 224

8.1 Exchange Rates and Trade 225

Making the Connection: What’s the Most Important Factor in Determining Sony’s Profits? 226

Is It Dollars per Yen or Yen per Dollar? 227

Nominal Exchange Rates Versus Real Exchange Rates 228

8.2 Foreign-Exchange Markets 228

Forward and Futures Contracts in Foreign Exchange 229

Exchange-Rate Risk, Hedging, and Speculating 230

Making the Connection: Can Speculators Drive Down the Value of a Currency? 231

8.3 Exchange Rates in the Long Run 232

The Law of One Price and the Theory of Purchasing Power Parity 232

Is PPP a Complete Theory of Exchange Rates? 234

Solved Problem 8.3: Should Big Macs Have the Same Price Everywhere? 235

8.4 A Demand and Supply Model of Short-Run Movements in Exchange Rates 236

A Demand and Supply Model of Exchange Rates 236

Shifts in the Demand and Supply for Foreign Exchange 237

The “Flight to Quality” During the Financial Crisis 238

The Interest-Rate Parity Condition 239

Solved Problem 8.4: Can You Make Money from Interest Rate Differences Across Countries? 241

Making the Connection: Why Did the Fed Lend Dollars to Foreign Central Banks During the Financial Crisis? 242

Answering the Key Question 243

An Inside Look at Policy: Investors Buy Dollars and Sell Euros as Europe Faces a Debt Crisis 244

Chapter 9 Transactions Costs, Asymmetric Information, and the Structure of the Financial System 252 BUYER BEWARE IN FINANCIAL MARKETS! 252

Key Issue and Question 252

9.1 Obstacles to Matching Savers and Borrowers 253

The Problems Facing Small Investors 254

How Financial Intermediaries Reduce Transactions Costs 254

9.2 The Problems of Adverse Selection and Moral Hazard 255

Adverse Selection 255

Making the Connection: Has Securitization Increased Adverse Selection Problems in the Financial System? 260

Solved Problem 9.2: Why Do Banks Ration Credit? 261

Moral Hazard 262

Making the Connection: Why So Many Ponzi Schemes? 266

9.3 Conclusions About the Structure of the U.S Financial System 267

Making the Connection: What Was the Problem with the Abacus CDOs? 270

Answering the Key Question 271

An Inside Look at Policy: Ratings Downgrades Happen Too Late for Investors in Mortgage-Backed Securities 272

CONTENTS xi

WHAT HAPPENS WHEN LOCAL BANKS STOP LOANING MONEY? 279

Key Issue and Question 279

10.1 The Basics of Commercial Banking: The Bank Balance Sheet 280

Bank Liabilities 281

Making the Connection: The Incredible Shrinking Checking Account 283

Bank Assets 285

Bank Capital 287

Solved Problem 10.1: Constructing a Bank Balance Sheet 287

10.2 The Basic Operations of a Commercial Bank 288

Making the Connection: The Not-So-Simple Relationship Between Loan Losses and Bank Profits 289

Bank Capital and Bank Profits 290

10.3 Managing Bank Risk 292

Managing Liquidity Risk 292

Managing Credit Risk 292

Managing Interest-Rate Risk 294

10.4 Trends in the U.S Commercial Banking Industry 296

The Early History of U.S Banking 296

Bank Panics, the Federal Reserve, and the Federal Deposit Insurance Corporation 297

The Rise of Nationwide Banking 298

Expanding the Boundaries of Banking 299

Making the Connection: Can Electronic Banking Save Somalia’s Economy? 302

The Financial Crisis, TARP, and Partial Government Ownership of Banks 302

Making the Connection: Small Businesses: Key Victims of the Credit Crunch 303

Answering the Key Question 305

An Inside Look at Policy: Interest-Rate Hikes Threaten Bank Profits 306

Chapter 11 Investment Banks, Mutual Funds, Hedge Funds, and the Shadow Banking System 314 WHEN IS A BANK NOT A BANK? WHEN IT’S A SHADOW BANK! 314

Key Issue and Question 314

11.1 Investment Banking 315

What Is an Investment Bank? 315

“Repo Financing” and Rising Leverage in Investment Banking 318

Solved Problem 11.1: The Perils of Leverage 319

Making the Connection: Did Moral Hazard Derail Investment Banks? 322

The Investment Banking Industry 323

Where Did All the Investment Banks Go? 324

Making the Connection: So, You Want to Be an Investment Banker? 325

11.2 Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies 326

Mutual Funds 326

Hedge Funds 328

Finance Companies 329

11.3 Contractual Savings Institutions: Pension Funds and

Insurance Companies 330

Pension Funds 330

Insurance Companies 332

Making the Connection: Why Did the Fed Have to Bail Out Insurance Giant AIG? 334

11.4 Systemic Risk and the Shadow Banking System 335

Systemic Risk and the Shadow Banking System 335

Regulation and the Shadow Banking System 336

The Fragility of the Shadow Banking System 337

Answering the Key Question 337

An Inside Look at Policy: Did a Shadow Bank Panic Cause the Financial Crisis of 2007–2009? 338

Chapter 12 Financial Crises and Financial Regulation 347 A CLOUDY CRYSTAL BALL ON THE FINANCIAL CRISIS 347

Key Issue and Question 347

12.1 The Origins of Financial Crises 348

The Underlying Fragility of Commercial Banking 348

Bank Runs, Contagion, and Bank Panics 349

Government Intervention to Stop Bank Panics 350

Solved Problem 12.1: Would Requiring Banks to Hold 100% Reserves Eliminate Bank Runs? 351

Bank Panics and Recessions 351

Exchange Rate Crises 352

Sovereign Debt Crises 354

Making the Connection: Why Was the Severity of the 2007–2009 Recession So Difficult to Predict? 354

12.2 The Financial Crisis of the Great Depression 356

The Start of the Great Depression 356

The Bank Panics of the Early 1930s 357

The Failure of Federal Reserve Policy During the Great Depression 358

Making the Connection: Did the Failure of the Bank of United States Cause the Great Depression? 359

12.3 The Financial Crisis of 2007–2009 361

The Housing Bubble Bursts 361

Bank Runs at Bear Stearns and Lehman Brothers 361

The Federal Government’s Extraordinary Response to the Financial Crisis 362

12.4 Financial Crises and Financial Regulation 363

Lender of Last Resort 364

Making the Connection: Was Long-Term Capital Management the Pebble That Caused the Landslide? 367

Reducing Bank Instability 368

Capital Requirements 369

The 2007–2009 Financial Crisis and the Pattern of Crisis and Response 371

CONTENTS xiii

Answering the Key Question 373

An Inside Look at Policy: Congress Struggles to Reform Financial Markets, Prevent Future Crisis 374

Chapter 13 The Federal Reserve and Central Banking 384 IS THE FED THE GIANT OF THE FINANCIAL SYSTEM? 384

Key Issue and Question 384

13.1 The Structure of the Federal Reserve System 385

Creation of the Federal Reserve System 385

Federal Reserve Banks 386

Making the Connection:St Louis and Kansas City? What Explains the Locations of the District Banks? 387

Member Banks 389

Solved Problem 13.1: How Costly Are Reserve Requirements to Banks? 390

Board of Governors 390

The Federal Open Market Committee 391

Making the Connection: On the Board of Governors, Four Can Be a Crowd 392

Power and Authority Within the Fed 393

Changes to the Fed Under the Dodd-Frank Act 394

13.2 How the Fed Operates 395

Handling External Pressure 395

Examples of Conflict Between the Fed and the Treasury 395

Factors That Motivate the Fed 396

Fed Independence 398

Making the Connection: End the Fed? 399

13.3 Central Bank Independence Outside the United States 400

The European Central Bank 401

The European Central Bank and the 2010 Sovereign Debt Crisis 402

Answering the Key Question 403

An Inside Look at Policy: U.S Senate Questions Three Nominees to Fed’s Board of Governors 404

Chapter 14 The Federal Reserve’s Balance Sheet and the Money Supply Process 411 GEORGE SOROS, “GOLD BUG” 411

Key Issue and Question 411

14.1 The Federal Reserve’s Balance Sheet and the Monetary Base 412

The Federal Reserve’s Balance Sheet 413

The Monetary Base 414

How the Fed Changes the Monetary Base 415

Comparing Open Market Operations and Discount Loans 418

Making the Connection: Explaining the Explosion in the Monetary Base 418

14.2 The Simple Deposit Multiplier 420

Multiple Deposit Expansion 420

Calculating the Simple Deposit Multiplier 422

14.3 Banks, the Nonbank Public, and the Money Multiplier 424

The Effect of Increases in Currency Holdings and Increases in Excess Reserves 424

Deriving a Realistic Money Multiplier 425

Solved Problem 14.3: Using the Expression for the Money Multiplier 427

The Money Supply, the Money Multiplier, and the Monetary Base During the 2007–2009 Financial Crisis 429

Making the Connection: Did the Fed’s Worry over Excess Reserves Cause the Recession of 1937–1938? 430

Making the Connection: Worried About Inflation? How Good Is Gold? 432

Answering the Key Question 433

An Inside Look at Policy: Fed’s Balance Sheet Needs Balancing Act 434

Appendix: The Money Supply Process for M2 441

Describe the Money Supply Process 441

Chapter 15 Monetary Policy 442 BERNANKE’S DILEMMA 442

Key Issue and Question 442

15.1 The Goals of Monetary Policy 443

Price Stability 443

High Employment 444

Economic Growth 445

Stability of Financial Markets and Institutions 445

Interest Rate Stability 445

Foreign-Exchange Market Stability 445

15.2 Monetary Policy Tools and the Federal Funds Rate 446

The Federal Funds Market and the Fed’s Target Federal Funds Rate 447

Open Market Operations and the Fed’s Target for the Federal Funds Rate 448

The Effect of Changes in the Discount Rate and in Reserve Requirements 449

Solved Problem 15.2: Analyzing the Federal Funds Market 451

15.3 More on the Fed’s Monetary Policy Tools 452

Open Market Operations 452

Making the Connection: A Morning’s Work at the Open Market Trading Desk 454

Making the Connection: Why Can’t the Fed Always Hit Its Federal Funds Target? 455

Discount Policy 456

Interest on Reserve Balances 458

15.4 Monetary Targeting and Monetary Policy 459

Using Targets to Meet Goals 460

Making the Connection: What Happened to the Link Between Money and Prices? 461

The Choice Between Targeting Reserves and Targeting the Federal Funds Rate 463

The Taylor Rule: A Summary Measure of Fed Policy 464

Inflation Targeting 466

International Comparisons of Monetary Policy 467

Answering the Key Question 471

An Inside Look at Policy: The Fed May Buy More Bonds to Boost Sluggish Economy 472

CONTENTS xv

Chapter 16 The International Financial System

CAN THE EURO SURVIVE? 481

Key Issue and Question 481

16.1 Foreign Exchange Intervention and the Monetary Base 482

16.2 Foreign Exchange Interventions and the Exchange Rate 484

Unsterilized Intervention 484

Sterilized Intervention 485

Solved Problem 16.2: The Bank of Japan Counters the Rising Yen 486

Capital Controls 487

16.3 The Balance of Payments 488

The Current Account 489

The Financial Account 489

Official Settlements 490

Relationship Among the Accounts 490

16.4 Exchange Rate Regimes and the International Financial System 491

Fixed Exchange Rates and the Gold Standard 491

Making the Connection: Did the Gold Standard Make the Great Depression Worse? 494

Adapting Fixed Exchange Rates: The Bretton Woods System 495

Central Bank Interventions After Bretton Woods 498

Fixed Exchange Rates in Europe 499

Currency Pegging 502

Making the Connection: Explaining the East Asian Currency Crisis 503

China and the Dollar Peg 504

Answering the Key Question 505

An Inside Look at Policy: Are the Euro’s Benefits Worth the Pain? 506

Chapter 17 Monetary Theory I: The Aggregate Demand and Aggregate Supply Model 514 IS THE UNITED STATES FACING A “NEW NORMAL” OF HIGHER UNEMPLOYMENT? 514

Key Issue and Question 514

17.1 The Aggregate Demand Curve 516

The Market for Money and the Aggregate Demand Curve 516

Shifts of the Aggregate Demand Curve 518

17.2 The Aggregate Supply Curve 520

The Short-Run Aggregate Supply (SRAS) Curve 520

The Long-Run Aggregate Supply (LRAS) Curve 522

Shifts in the Short-Run Aggregate Supply Curve 522

Making the Connection: Shock Therapy and Aggregate Supply in Poland 523

Shifts in the Long-Run Aggregate Supply (LRAS) Curve 524

17.3 Equilibrium in the Aggregate Demand and Aggregate Supply Model 526

Short-Run Equilibrium 526

Long-Run Equilibrium 526

Economic Fluctuations in the United States 527

17.4 The Effects of Monetary Policy 530

An Expansionary Monetary Policy 530

Solved Problem 17.4: Dealing with Shocks to Aggregate Demand and Aggregate Supply 532

Was Monetary Policy Ineffective During the 2007–2009 Recession? 534

Making the Connection: Is It Like 1939? 535

Answering the Key Question 537

An Inside Look at Policy: Unemployment Stays High Despite Low Interest Rates, Fiscal Stimulus 538

Chapter 18 Monetary Theory II: The IS–MP Model 546 THE FED FORECASTS THE ECONOMY 546

Key Issue and Question 546

18.1 The IS Curve 547

Equilibrium in the Goods Market 548

Potential GDP and the Multiplier Effect 550

Solved Problem 18.1: Calculating Equilibrium Real GDP 552

Constructing the IS Curve 554

The Output Gap 554

Shifts of the IS Curve 556

18.2 The MP Curve and the Phillips Curve 557

The MP Curve 557

The Phillips Curve 558

Okun’s Law and an Output Gap Phillips Curve 560

Making the Connection: Did the 2007–2009 Recession Break Okun’s Law? 562

18.3 Equilibrium in the IS–MP Model 563

Making the Connection:Where Did the IS–MP Model Come From? 564

Using Monetary Policy to Fight a Recession 565

Complications Fighting the Recession of 2007–2009 566

Making the Connection: Trying to Hit a Moving Target: Forecasting with “Real-Time Data” 568

Solved Problem 18.3: Using Monetary Policy to Fight Inflation 569

18.4 Are Interest Rates All That Matter for Monetary Policy? 571

The Bank Lending Channel 571

The Balance Sheet Channel: Monetary Policy and Net Worth 572

Answering the Key Question 573

An Inside Look at Policy: Slow Growth Despite Low Interest Rates Has Fed Searching for New Options 574

Appendix: The IS–LM Model 582

Deriving the LM Curve 582

Shifting the LM Curve 583

Monetary Policy in the IS–LM Model 583

Key Terms 584

Glossary G-1

Index I-1

Credits C-1

Do You Think This Might Be Important?

It’s customary for authors to begin textbooks by trying to convince readers that their

subject is important, even exciting Following the events of the financial crisis and

reces-sion of 2007–2009, we doubt anyone needs convincing that the study of money,

bank-ing, and financial markets is important And exciting maybe it’s a little too exciting

Nothing comparable to the upheaval of 2007–2009 had happened in the financial

sys-tem since the Great Depression of the 1930s The financial crisis changed virtually

every aspect of how money is borrowed and lent, how banks and other financial firms

operate, and how policymakers regulate the financial system There seems little doubt

that the effects of the crisis will linger for a very long time, just as did the effects of the

Great Depression

Our Approach

In this book, we provide extensive analysis of the financial events of the past few years

We believe these events are sufficiently important to be incorporated into the body of

the text rather than just added as boxed-off features In particular, we stress the lesson

policymakers recently learned the hard way: What happens in the ever-expanding part

of the financial system that does not involve commercial banks is of vital importance to

the entire economy

We realize, however, that the details of the financial crisis and recession will

even-tually pass into history What we strive to do in this text is not to add to the laundry

list of facts that students must memorize Instead, we present students with the

under-lying economic explanations of why the financial system is organized as it is and how

the financial system is connected to the broader economy We are gratified by the

suc-cess of our principles of economics textbook, and we have employed a similar

approach in this textbook: We provide students with a framework that allows them to

apply the theory that they learn in the classroom to the practice of the real world

By learning this framework, students will understand not just the 2007–2009 financial

crisis and other past events but also developments in the financial system during the

years to come To achieve this goal, we have built four advantages into this text:

1 A framework for understanding, evaluating, and predicting

2 A modern approach

3 Integration of international topics

4 A focus on the Federal Reserve

Framework of the Text: Understand, Evaluate, Predict

The framework underlying all discussions in this text has three levels First, students

learn to understand economic analysis “Understanding” refers to students developing

the economic intuition they need to organize concepts and facts Second, students

learn to evaluate current developments and the financial news Here, we challenge

students to use financial data and economic analysis to think critically about how to

interpret current events Finally, students learn to use economic analysis to predict

likely changes in the economy and the financial system Having just come through a

period in which Federal Reserve officials, members of Congress, heads of Wall Street

firms, and nearly everyone else failed to predict a huge financial crisis, the idea that

we can prepare students to predict the future of the financial system may seem overly

xvii

ambitious—to say the least We admit, of course, that some important events are ficult to anticipate But knowledge of the economic analysis we present in this bookdoes make it possible to predict many aspects of how the financial system will evolve.For example, in Chapter 12, “Financial Crises and Financial Regulation,” we discussthe ongoing cycle of financial crisis, regulatory response, financial innovation, andfurther regulatory response The latest episode in this cycle was the passage in July

dif-2010 of the Dodd-Frank Wall Street Reform and Consumer Protection Act With our

approach, students learn not just the new regulations contained in Dodd-Frank but,more importantly, the key lesson that over time innovations by financial firms arelikely to supersede many of the provisions of Dodd-Frank In other words, studentswill learn that the financial system is not static—it evolves over time in ways that can

be understood using economic analysis

A Modern Approach

Textbooks are funny things Most contain a mixture of the current and the modernalongside the traditional Material that is helpful to students is often presented along withmaterial that is not so helpful or that is—frankly—counterproductive We believe theideal is to produce a textbook that is modern and incorporates the best of recent research

on monetary policy and the financial system without chasing every fad in economics orfinance In writing this book, we have looked at the topics in the money and bankingcourse with fresh eyes We have pruned discussion of material that is less relevant to themodern financial system or no longer considered by most economists to be theoreticallysound We have also tried to be as direct as possible in informing students of what is and

is not important in the financial system and policymaking as they exist today For ple, rather than include the traditional long discussion of the role of reserve require-ments as a monetary policy tool, we provide a brief overview and note that the FederalReserve has not changed reserve requirements since 1992 Similarly, it has been severaldecades since the Fed paid serious attention to targets for M1 and M2 Therefore, in

exam-Chapter 18, “Monetary Theory II: The IS–MP Model,” we replace the IS–LM model—

which assumes that the central bank targets the money stock, rather than an interest

rate—with the IS–MP model, first suggested by David Romer more than 15 years ago.

We believe that our modern approach improves the ability of students to make the nection between the text material and the economic and financial world they read

con-about (For those who do wish to cover the IS-LM model, we provide an appendix on

that model after Chapter 18.)

By cutting out-of-date material, we have achieved two important goals: (1) We vide a much briefer and more readable text, and (2) we have made room for discussion

pro-of essential topics, such as the “shadow banking system” pro-of investment banks, hedgefunds, and mutual funds, as well as the origins and consequences of financial crises SeeChapter 11, “Investment Banks, Mutual Funds, Hedge Funds, and the Shadow BankingSystem,” and Chapter 12, “Financial Crises and Financial Regulation.” Other texts eitheromit these topics or cover them only briefly

We have both taught money and banking to undergraduate and graduate students formany years We believe that the modern, real-world approach in our text will engage stu-dents in ways that no other text can

Integration of International Topics

When the crisis in subprime mortgages began, Federal Reserve Chairman Ben Bernankefamously observed that it was unlikely to cause much damage to the U.S housing mar-ket, much less the wider economy (We discuss Bernanke’s argument in Chapter 12,

PREFACE xix

“Financial Crises and Financial Regulation,” where we note that he was hardly alone in

making such statements.) As it turned out, of course, the subprime crisis devastated not

only the U.S housing market but the U.S financial system, the U.S economy, and the

economies of most of the developed world That a problem in one part of one sector of

one economy could cause a worldwide crisis is an indication that a textbook on money

and banking must take seriously the linkages between the U.S and other economies

Our text consists of only 18 chapters and is one of the briefest texts on the market We

achieved this brevity by carefully pruning many out-of-date and esoteric topics to focus

on the essentials, which includes a careful exploration of international topics We devote

two full chapters to international topics: Chapter 8, “The Market for Foreign Exchange,”

and Chapter 16, “The International Financial System and Monetary Policy.” In these

chapters, we discuss such issues as the European sovereign debt crisis of 2010 and the

increased coordination of monetary policy actions among central banks We realize,

however, that, particularly in this course, what is essential to one instructor is optional

to another So, we have written the text in a way that allows instructors to skip one or

both of the international chapters

A Focus on the Federal Reserve

We can hardly claim to be unusual in focusing on the Federal Reserve in a money and

banking textbook but we do! Of course, all money and banking texts discuss the

Fed, but generally not until near the end of the book—and the semester Based on

speaking to instructors in focus groups and on our own teaching experience, we

believe that this approach is a serious mistake We have found that students often have

trouble integrating the material in the money and banking course To them, the course

often seems a jumble of unrelated topics Particularly in light of recent events, the role

of the Fed can serve as a unifying theme for the course Accordingly, we provide an

introduction and overview of the Fed in Chapter 1, “Introducing Money and the

Financial System,” and in each subsequent chapter, we expand on the Fed’s role in the

financial system So, by the time students read Chapter 13, “The Federal Reserve and

Central Banking,” where we discuss the details of the Fed’s operation, students already

have a good idea of the Fed’s importance and its role in the system

Special Features

We can summarize our objective in writing this textbook as follows: to produce a

streamlined, modern discussion of the economics of the financial system and of the

links between the financial system and the economy To implement this objective, we

have developed a number of special features Some are similar to the features that have

proven popular and effective aids to learning in our principles of economics textbook,

while others were developed specifically for this book

also drawn into the crisis, 2007–2009 represented the first time in U.S history that a major financial crisis had not originated in the commercial banking system Problems with nonbanks made dealing with the crisis more difficult because the policymaking and regulatory structures were based on the assump- tion that commercial banks were the most impor- tant financial firms In particular, the Federal Reserve System had been set up in 1913 to stabilize and regulate the commercial banking system A key issue for policymakers was what role the Fed should financial crisis that involved many nonbank finan- cial firms.

AN INSIDE LOOK AT POLICYon page 338 cusses whether a panic in the shadow banking system caused the financial crisis.

dis-At a conference of the Federal Reserve Bank of Kansas City in 2007, just as the financial crisis was beginning, Paul McCauley, a managing director of Pacific Investment Management Company (PIMCO), coined the term “shadow banking system” to describe the new role of nonbank financial firms A year later, used it in a speech to the Economic Club of New York.

Bank of New York and later became secretary of the Treasury in the Obama administration.

As the financial crisis worsened, three large financial firms—Bear Stearns, Lehman Brothers, and American International Group (AIG)—were at the center of the storm The first two of these firms were investment banks, and the third is an insurance company Although many commercial banks were Sources: Timothy F Geithner, “Reducing Systemic Risk in a Dynamic Financial System,” talk at The Economic Club of New York, June 9,

Key Issue–and–Question Approach

The financial crisis and recession of 2007–2009 provide us with an opportunity toexplain how the financial system works within the context of topics students readabout online and in newspapers and probably discuss among themselves and withtheir families In Chapter 1, “Introducing Money and the Financial System,” we coverthe key components of the financial system, introduce the Federal Reserve, and pre-view the important issues facing the financial system At the end of Chapter 1, we pres-ent 17 key issues and questions that provide students with a roadmap for the rest ofthe book and help them to understand that learning the basic principles of money,banking, and the financial system will allow them to analyze intelligently the mostimportant issues raised by the financial crisis The goal here is not to make students

memorize a catalog of facts about the crisis Instead, we use thesekey issues and questions to demonstrate that an economic analy-

sis of the financial system is essential to standing recent events See pages 17–19 in Chapter 1for a complete list of the issues and questions

under-We start each subsequent chapter with a keyissue and key question and end each of those chap-ters by using the concepts introduced in the chapter

to answer the question

Key Issue and Question

At the end of Chapter 1, we noted that the financial crisis that began in 2007 raised a number

of important questions about the financial system In answering these questions, we will discuss

essential aspects of the financial system Here are the key issue and question for this chapter:

Issue:During the financial crisis, the bond rating agencies were criticized for having given high

rat-ings to securities that proved to be very risky.

Question:Should the government more closely regulate the credit rating agencies?

Answered on page 147

Answering the Key Question

Continued from page 123

At the beginning of this chapter, we asked the question:

“Should the government more closely regulate credit rating agencies?”

Like other policy questions we will encounter in this book, this question has no definitive answer.

We have seen in this chapter that many investors rely on the credit rating agencies for important

information on the default risk on bonds During the financial crisis of 2007–2009, many bonds—

particularly mortgage-backed securities—turned out to have much higher levels of default risk than

the credit rating agencies had indicated Some observers argued that the rating agencies had given

those bonds inflated ratings because the agencies have a conflict of interest in being paid by the

firms whose bond issues they rate Other observers, though, argued that the ratings may have been

accurate when given, but the creditworthiness of the bonds declined rapidly following the

unex-pected severity of the housing bust and the resulting financial crisis.

Contemporary Opening Cases

Each chapter-opening case provides a real-world context for ing, sparks students’ interest in money and banking, and helps tounify the chapter For example, Chapter 11, “Investment Banks,Mutual Funds, Hedge Funds, and the Shadow Banking System,”opens with a discussion of the rise of the shadow banking system

learn-in a case study entitled “When Is a Bank Not a Bank? When It’s aShadow Bank.” We revisit this topic throughout the chapter

C H A P T E R11

Investment Banks, Mutual Funds,

Hedge Funds, and the Shadow

Banking System

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

11.1Explain how investment banks operate

(pages 315–326)

11.2Distinguish between mutual funds

and hedge funds and describe their

roles in the financial system (pages

326–330)

WHEN IS A BANK NOT A BANK? WHEN IT’S A SHADOW BANK!

What is a hedge fund? What is the difference between

a commercial bank and an investment bank? At the

beginning of the financial crisis of 2007–2009, most

Americans would have been unable to answer these

questions Many members of Congress would have

been in a similar situation Mortgage-backed

securi-ties (MBSs), collateralized debt obligations (CDOs),

credit default swaps (CDSs), and other ingredients in

the new alphabet soup of financial securities were

also largely unknown During the financial crisis,

though, it became clear that commercial banks no longer played the dominant role in routing funds from savers to borrowers Instead, a variety of “non- bank” financial institutions were acquiring funds that had previously been deposited in banks, and they were using these funds to provide credit that banks had previously provided These nonbanks were using newly developed financial securities that even long- time veterans of Wall Street often did not fully understand.

11.3Explain the roles that pension funds and insurance companies play in the financial system (pages 330–335)

11.4Explain the connection between the shadow banking system and systemic risk (pages 335–337)

PREFACE xxi

Making the Connection Features

Each chapter includes two to four Making the Connection features

that present real-world reinforcement of key concepts and help

stu-dents learn how to interpret what they read on the Web and in

newspapers Most Making the Connection features use relevant,

stimulating, and provocative news stories, many focused on

press-ing policy issues Here are examples:

● Banks Take a Bath on Mortgage-Backed Bonds (Chapter 3,

page 68)

● Fear the Black Swan! (Chapter 4, page 90)

● Should Farmers Be Afraid of the Dodd-Frank Act? (Chapter 7,

page 195)

● Why Did the Fed Lend Dollars to Foreign Central Banks

During the Financial Crisis? (Chapter 8, page 242)

● Can Electronic Banking Save Somalia’s Economy? (Chapter 10,

page 302)

● Why Was the Severity of the 2007–2009 Recession So Difficult to Predict? (Chapter 12,

page 354)

● Explaining the Explosion in the Monetary Base (Chapter 14, page 418)

● Why Can’t the Fed Always Hit Its Federal Funds Target? (Chapter 15, page 455)

Each Making the Connection has at least one supporting end-of-chapter problem to

allow students to test their understanding of the topic discussed

prices of the mortgage-backed securities Because the amount of equity the bank

1. or -5%.

2. , or -20%.

3. or -100%.

These results show that the more highly leveraged the bank’s investment—that is, the

greater the potential profit and the greater the potential loss As we will see, even

the highest leverage ratio in this problem—20—is well below the leverage ratios of the large investment banks in the years leading up to the financial crisis!

Making the Connection

Did Moral Hazard Derail Investment Banks?

Until the early 1980s, all the large investment banks were partnerships The funds the

in the firm If a bank made profits, the partners shared them, and if the bank suffered the situation at the Salomon Brothers investment bank in the late 1970s, as the part- account used to be scribbled in a little book, left outside the office of a partner named see how much they had lost.” In 1981, Salomon Brothers was the first of the large the time of the financial crisis, all the large investment banks had become publicly

of ownership from control because although the shareholders own the firm, the top principal–agent problem, as the top managers may take actions that are not in the best interest of the shareholders.

Other commentators are skeptical of this argument Many top managers of ment banks suffered significant losses during the financial crisis, which suggests that Brothers, two of the most highly leveraged investment banks, both of which still held

invest-in most managers owninvest-ing significant amounts of company stock As the stock invest-in these many of the firms’ managers dwindled Richard Fuld, the chairman and CEO of from the decline in the value of his Lehman Brothers stock.

The debate over why investment banks became more highly leveraged and took on more risk in the years before the financial crisis is likely to continue.

Sources: Michael Lewis, “The End,” Portfolio, December 2008; Roger Lowenstein, When Genius

Failed: The Rise and Fall of Long-Term Capital Management, New York: Random House, 2000, p 4;

and Aaron Lucchetti, “Lehman, Bear Executives Cashed Out Big,” Wall Street Journal, November 22,

2009.

Test your understanding by doing related problem 1.12 on page 341 at the end of this chapter.

Solved Problem Features

Many students have great difficulty

handling problems in applied economics

We help students overcome this hurdle by

including two or three worked-out

prob-lems tied to select chapter-opening learning

objectives Our goals are to keep students

focused on the main ideas of each chapter

and to give students a model of how to solve

an economic problem by breaking it down

step by step Additional exercises in the

end-of-chapter Problems and Applications

sec-tion are tied to every Solved Problem.

Students can also complete related Solved

page xxiv of this preface for more on

MyEconLab.)

Solved Problem 11.1

The Perils of Leverage

Suppose that an investment bank is buying $10 million possible ways that the bank might finance its investment:

1 The bank finances the investment entirely out of its

equity.

2 The bank finances the investment by borrowing

$7.5 million and using $2.5 million of its equity.

3 The bank finances the investment by borrowing

$9.5 million and using $0.5 million of its equity.

a Calculate the bank’s leverage ratio for each of these three ways of financing the investment.

Solving the Problem

Step 1 Review the chapter material This problem is about the interaction of

lever-age and risk, so you may want to review the section “ ‘Repo Financing’ and Rising Leverage in Investment Banking,” which begins on page 318.

Step 2 Answer question (a) by calculating the leverage ratio for each way of

financ-the value of equity In this case, financ-the value of financ-the assets is a constant $10 lion, but the bank is investing different amounts of its own funds—different

mil-If the bank uses financing method 1, it uses $10 million of its own funds; if it financing method 3, it uses $0.5 million of its own funds Therefore, its lever- age ratios are:

1.

2.

3.

Step 3 Answer the first part of question (b) by calculating the bank’s return on its

each case, the bank experiences a gain of $0.5 million from the increase in the

i The value of the mortgage-backed securities increases by 5% during the year after they are purchased.

ii The value of the mortgage-backed securities decreases by 5% during the year after they are purchased.

For simplicity, ignore the interest the bank receives rows to finance the purchase of the securities, and any taxes the bank must pay.

An Inside Look Features

An Inside Look is a two-page feature that shows students how to apply the concepts from

the chapter to the analysis of a news article The An Inside Look feature presents an

excerpt from an article, analysis of the article, a table or graph(s), and critical thinkingquestions Many of these features deal with a policy issue The article and analysis link

to the chapter-opening case For example:

Chapter 3, “Interest Rates and Rates of Return”

Opens with “Banks in Trouble”

Closes with An Inside Look at Policy on “Higher Interest Rates Increase Coupons,

Decrease Capital Gains”

Chapter 6, “The Stock Market, Information, and Financial Market Efficiency”

Opens with “Why Are Stock Prices So Volatile?”

Closes with An Inside Look at Policy on “Prices Rally but Individual Investors Still Avoid

Stocks”

Chapter 10, “The Economics of Banking”

Opens with “What Happens When Local Banks Stop Loaning Money?”

Closes with An Inside Look at Policy on “Interest-Rate Hikes Threaten Bank Profits”

Chapter 13, “The Federal Reserve and Central Banking”

Opens with “Is the Fed the Giant of the Financial System?”

Closes with An Inside Look at Policy on “U.S Senate Questions

Three Nominees to Fed’s Board of Governors”

Select articles deal with policy issues and are titled An Inside Look at Policy.

Articles are from sources such as the Wall Street Journal, the Washington Post, the Los Angeles Times, and the Associated Press.

Did a Shadow Bank Panic Cause the Financial Crisis of 2007–2009?

On June 20, 2007, Ben Bernanke

said that the subprime crisis “will

not affect the economy overall.”

and assured investors that “while

sures will continue to weigh heavily

on the housing market this year, it

will not cripple the U.S.”

Yale economist Gary

Gorton is sympathetic to

Bernanke’s statements: Subprime

shouldn’t have been big enough to

cause this sort of crisis In 2005

and 2006, the market originated

about $1.2 trillion in mortgages—

big, but not a vital organ of the

American economy.

Subprime was the trigger for the

crisis, but not the cause What

subprime crisis set off an

old-fashioned bank run in a

newfan-gled market: the shadow banking

market .

The shadow banking market

investors, and other folks who have

a lot of money do their banking .

So let’s say I’m Ezra Bank I’ve got

invest next month, but for now, I need to put it somewhere I head to the “repo market,” and I ask Bear Stearns to hold my money and pay

me interest They agree But how

do I know Bear Stearns won’t just keep my money?

Individual depositors in the mal banking market never have that fear The government insures our deposits But they don’t insure mas- sive institutional deposits So Ezra Bank would ask Bear Stearns for

nor-“collateral” something like, say, AAA mortgage-backed securities.

This manner of banking created

a massive hunger for collateral And

it was this hunger that drove the wild demand for mortgage- backed securities.

The FDIC’s deposit ance exists to prevent bank runs The shadow banking market doesn’t have deposit insurance What we had in 2008, Gorton says, was a bank run No one knew which banks were exposed to the subprime crisis, so everyone froze The underlying problem

insur-is that the collateral insur-is tionally sensitive.” Information can unexpectedly change its worth and then confidence drains out of the whole system.

“informa-“It’s the e coli problem,” Gorton

says “When they recall 10 million pounds of burger, it brings all sales

of ground meat to a halt because

no one knows how much e coli

deposits with our banks are not informationally sensitive:

Where small pieces of new information can scare the shadow- banking market, major revelations are shrugged off in the commercial banking market because the fed- eral government insures deposits.

To offer an analogy, consider someone with a weakened immune system who eats a bad piece of fish and gets really sick Obviously, the first thing you want to do is deal with the illness But when that’s over, the issue you want to deal with isn’t so much what made the patient sick this time as what makes the patient vulnerable

to dangerous illnesses Putting derivatives on exchanges and clear- inghouses will do a lot to make sure that the system doesn’t get the same illness anytime soon, but it doesn’t deal with the system’s vul- nerability to illnesses—that is to say, the system’s vulnerability to bank runs.

Handling that would require either creating a type of safe, infor- mationally-insensitive collateral for the shadow-banking system to use

or examining and insuring the

col-lateral the system does use.

Source: From The Washington Post

© April 26, 2010 The Washington Post.

All rights reserved Used by permission and protected by the Copyright Laws of the United States The printing, copying, redistribution, or retransmission of the

a

b

c

Key Points in the Article

Yale University economist Gary Gorton argues that a bank run in the shadow banking system caused the financial crisis that began in 2007 This bank run was triggered by rising delinquencies and foreclosures in the subprime mortgage market The government offers deposit insurance to commercial banks, but not

to institutional deposits in the shadow banking market Because there was no deposit insurance, depositors demanded collateral in the form of highly rated mortgage-backed securities When the subprime mortgage crisis began, no one knew which banks were most at risk, and investors lost confidence in all insti- tutions in the shadow banking market.

The underlying problem was that eral was “informationally sensitive.”

collat-That is, new information that caused great disruption in the shadow banking market caused little disruption in the commercial banking system because the federal banking system insures commer- cial bank deposits.

Analyzing the News

Chapter 10 explained that the key

to the financial crisis that began in

2007 was the bursting of the housing

bubble, a bubble that resulted from large increases in mortgage loans to subprime and Alt-A borrowers The table below shows that the value of new mortgage-related securities (includ- ing private and government-sponsored housing securitizations) and non- mortgage asset-backed securities issued from 2004 to 2006 were well in excess debt Although in 2007 Ben Bernanke stated that the crisis in the subprime market would not spread to the overall economy, the table shows that there was a widespread decline from 2007 to

2008 in the issuance of securitized and corporate debt.

Ezra Stein describes Gary Gorton’s explanation of the financial crisis as

a bank run in the shadow banking ket Because the government does not insure deposits in the shadow banking system, firms require collateral, often in the form of mortgage-backed securities,

mar-to persuade them mar-to deposit money in the shadow banking system—for exam- ple, via repurchase agreements (repos) and commercial paper As investment banks such as Bear Stearns and Lehman Brothers suffered losses on their mortgage-backed securities, lenders

began to refuse to buy commercial paper or enter into repo financing agree- ments with nonbank financial firms The bank run in the shadow banking system was a result of no one knowing which banks were exposed to the subprime crisis Gorton describes the problem as “information- ally sensitive” collateral Deposits with commercial banks are “informationally insensitive.” That is, federal deposit insurance insulates depositors from the

as the disruption in the subprime gage market, that affect the shadow banking system.

mort-THINKING CRITICALLY ABOUT POLICY

1 In 2008, the Federal Reserve agreed

to convert former investment banks Morgan Stanley and Goldman Sachs into financial holding companies Why would executives of these firms choose to reorganize as financial holding companies?

2 Is a bank run in the shadow banking system more or less likely today than

a

Year

Issuance of Related Securities

Mortgage-Issuance of Non-Mortgage Asset-Backed Securities

Issuance of Corporate Debt

Note: Data are in billions.

Source: Gary Gorton, “Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007,” Paper prepared for the Federal Reserve Bank of Atlanta’s 2009 Financial Markets Conference: Financial Innovation and Crisis, May

b

c

PREFACE xxiii

Graphs and Summary Tables

We use four devices to help students

read and interpret graphs:

1 Detailed captions

2 Boxed notes

3 Color-coded curves

4 Summary tables with graphs

Review Questions and Problems and Applications—

Grouped by Learning Objective to Improve Assessment

All the end-of-chapter material—Summary, Review Questions, and

Problems and Applications—is grouped under learning objectives.

The goals of this organization are to make it easier for instructors

to assign problems based on learning objectives, both in the book

and in MyEconLab, and to help students efficiently review material

that they find difficult If students have difficulty with a particular

learning objective, an instructor can easily identify which

end-of-chapter questions and problems support that objective and assign

them as homework or discuss them in class Exercises in a chapter’s

Problems and Applications section are available in MyEconLab Using

MyEconLab, students can complete these and many other exercises

online, get tutorial help, and receive instant feedback and

assis-tance on exercises they answer incorrectly Also, student learning

will be enhanced by having the summary material and problems

grouped together by learning objective, which will allow students

to focus on the parts of the chapter they find most challenging

Each major section of the chapter, paired with a learning objective,

has at least two review questions and three problems; the most

important sections have at least four review questions and six

problems

rates Bonds that are less liquid will have higher interest rates than will bonds that are more liquid Bonds that have high information costs will have higher interest rates than will bonds that have low information costs.

Bonds that have coupons subject to high tax rates will have higher interest rates than will bonds that have coupons that are subject to low tax rates.

Review Questions

1.1 What is the risk structure of interest rates? Briefly

explain why bonds that have the same maturities often do not have the same interest rates.

1.2 What is default risk? How is default risk measured?

1.3 What is meant by a bond issuer’s

creditworthi-ness? What is a bond rating? Who are the major credit rating agencies?

1.4 Draw a demand and supply graph for bonds

that shows the effect on a bond that has its rating lowered Be sure to show the demand

Problems and Applications

1.8 According to Moody’s, “Obligations rated Aaa

are judged to be of the highest quality, with minimal credit risk.”

a What “obligations” is Moody’s referring to?

b What does Moody’s mean by “credit risk”?

Source: Moody’s Investors Services, Moody’s Rating Symbols and Definitions, June 2009.

1.9 Moody’s has a separate ratings scale for

munici-pal bonds Here is Moody’s definition of its Aaa rating for municipal bonds: “Issuers or issues rated Aaa demonstrate the strongest creditwor- thiness relative to other US municipal or tax- exempt issuers or issues.”

a What is a municipal bond?

b Why might Moody’s want to have a separate ratings scale for municipal bonds, and why

The Risk Structure of Interest Rates

Explain why bonds with the same maturity can have different interest rates.

SUMMARY

The risk structure of interest rates refers to the

rela-tionship among the interest rates on bonds that have different characteristics but the same maturities Bonds

differ in the following key characteristics: default risk (or credit risk), liquidity, information costs, and taxa-

tion of coupons The default risk premium on a bond is

the difference between the interest rate on the bond and the interest rate on a Treasury bond with the same maturity Credit rating agencies, such as Moody’s and

Standard & Poor’s, assign bond ratings, which are

sin-gle statistics that summarize the rating agency’s view of the bond issuer’s likely ability to make the required payments on the bond Bonds with higher default risk will, all other factors being equal, have higher interest

and supply curves and the equilibrium price

of the bond before and after the rating is lowered.

1.5 How does the interest rate on an illiquid bond compare with the interest rate on a liquid bond? How does the interest rate on a bond with high information costs compare with the interest rate

on a bond with low information costs?

1.6 What are the two types of income an investor can earn on a bond? How is each taxed?

1.7 Compare the tax treatment of the coupons on the following bonds: a bond issued by the city issued by the U.S Treasury.

5.1

might those ratings be based on

creditwor-thiness relative to other bond issuers?

Source: Moody’s Investors Services, Moody’s Rating

Symbols and Definitions, June 2009.

1.10 In 2010, Republic Services, a waste management

firm, issued 10-year notes and 30-year bonds.

According to an article in the Wall Street

Journal, the 10-year notes had a risk premium

of 1.40 percentage points over 10-year Treasury

notes, while the 30-year bonds had a risk

premium of 1.65 percentage points over 30-year

Treasury bonds Why would the risk premium

be higher on Republic Services’s 30-year bonds

than on its 10-year notes?

Source: Kellie Geressy-Nilsen, “A Comeback for

Corporate Debt,” Wall Street Journal, March 2, 2010.

1.11[Related to the Making the Connection on

page 127]According to an article in the New

York Times, “It was the near universal agreement

that potential conflicts were embedded in the

[bond] ratings model.” What is the bond ratings

model? What potential conflicts are embedded

in it?

Source: David Segal, “Debt Raters Avoid Overhaul

1.14[Related to Solved Problem 5.1 on page 131]

Suppose a candidate who runs on a platform of

“soak the rich” wins the 2012 presidential tion After being elected, he or she persuades Congress to raise the top marginal tax rate on the federal personal income tax to 65% Use one graph to show the impact of this change in tax rates on the market for municipal bonds and another graph to show the impact on the mar- ket for U.S Treasury bonds.

elec-1.15 In 2010, Romania had been running large budget

deficits In an attempt to reduce the deficits, the Romanian government planned to reduce pen- sions to retired government workers However, Romania’s highest court ruled that the reduc- tions were unconstitutional According to an

article in the Wall Street Journal, “Romanian

bonds also tumbled after the court said that a 15% reduction in pensions ordered by the country’s center-right government was illegal.”

a When the article reports that “Romanian bonds tumbled,” what fell: the price of Romanian bonds, the yield on Romanian bonds, or both the price and the yield?

b Why would the fact that Romania was unable

to cut government spending as planned

3 Bond price falls

1 Higher expected inflation reduces demand for bonds

2 Higher expected inflation increases supply of bonds

Figure 4.7

Expected Inflation and Interest Rates

1 From an initial equilibrium at

E1 , an increase in expected tion reduces investors’ expected real return, reducing investors’

infla-willingness to buy bonds at any bond price The demand curve for bonds shifts to the left, from

D1 toD2

2 The increase in expected tion increases firms’ willingness

infla-to issue bonds at any bond price.

The supply curve for bonds shifts

to the right, fromS1 toS2

3 In the new equilibrium,E2 , the bond price falls fromP1 toP2 •

Table 4.2 Factors That Shift the Demand Curve for Bonds All else being equal,

an increase in

causes the demand for bonds to because

Graph of effect on equilibrium in the bond market

wealth increase more funds are

allocated to bonds.

increase holding bonds is

relatively more attractive.

decrease holding bonds is

relatively less attractive.

decrease holding bonds is

relatively less attractive.

increase holding bonds is

relatively more attractive.

decrease holding bonds is

relatively less attractive.

P

Q S

D2 D1

We include one or more end-of-chapter problems that test students’ understanding of

the content presented in each Solved Problem, Making the Connection, and chapter opener.

Instructors can cover a feature in class and assign the corresponding problem for work The Test Item Files also include test questions that pertain to these special features

home-Supplements

The authors and Pearson Education/Prentice Hall have worked together to integrate thetext, print, and media resources to make teaching and learning easier

MyEconLab

MyEconLab is a powerful assessment and tutorial system that works hand-in-hand

with Money, Banking, and the Financial System MyEconLab includes comprehensive

homework, quiz, test, and tutorial options, allowing instructors to manage all ment needs in one program Here are the key features of MyEconLab:

assess-● Select end-of-chapter Questions and Problems, including rithmic, graphing, and numerical questions and problems, areavailable for student practice or instructor assignment

algo-● Test Item File multiple-choice questions are available for ment as homework

assign-● The Custom Exercise Builder allows instructors the flexibility ofcreating their own problems for assignment

● The powerful Gradebook records each student’s performance andtime spent on the Tests and Study Plan and generates reports bystudent or chapter

A more detailed walk-through of the student benefits and features

of MyEconLab can be found at the beginning of this book Visit www myeconlab.comfor more information on and an online demonstra-tion of instructor and student features

MyEconLab content has been created through the efforts ofMelissa Honig, executive media producer; Noel Lotz, content lead; andJody Lotz, copy edit and revisions

Instructor’s Manual

William Seyfried of Rollins College prepared the Instructor’s Manual,

which includes chapter-by-chapter summaries, key term definitions,teaching outlines with teaching tips, and solutions to all review questions and problems

in the book The solutions were prepared by Nathan Perry of Mesa State College

The Instructor’s Manual is available for download from the Instructor’s Resource

Center (www.pearsonhighered.com/hubbard)

Test Item File

William Seyfried of Rollins College prepared the Test Item File, which includes more than

1,500 multiple-choice and short-answer questions Test questions are annotated with thefollowing information:

● Difficulty: 1 for straight recall, 2 for some analysis, 3 for complex analysis

● Type: multiple-choice, short-answer, essay

PREFACE xxv

● Topic: the term or concept the question supports

● Learning objective: the major sections of the main text and its end-of-chapter

questions and problems are organized by learning objective The test item file

questions continue with this organization to make it easy for instructors to assign

questions based on the objective they wish to emphasize

● Advanced Collegiate Schools of Business (AACSB) Assurance of Learning

Standards:

Communication

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Analytic Skills

Use of Information Technology

Multicultural and Diversity

Reflective Thinking

● Page number: The page in the main text where the answer appears allows

instruc-tors to direct students to where supporting content appears

● Special feature in the main book: chapter-opening story, the Key Issue & Question,

Solved Problem, Making the Connection, and An Inside Look.

The Test Item File is available for download from the Instructor’s Resource Center

(www.pearsonhighered.com/hubbard)

The multiple-choice questions in the Test Item File are also available in TestGen

software for both Windows and Macintosh computers, and questions can be

assigned via MyEconLab The computerized TestGen package allows instructors to

customize, save, and generate classroom tests The TestGen program permits

instruc-tors to edit, add, or delete questions from the Test Item Files; analyze test results; and

organize a database of tests and student results This software allows for extensive

flexibility and ease of use It provides many options for organizing and displaying

tests, along with search and sort features The software and the Test Item Files can be

downloaded from the Instructor’s Resource Center (www.pearsonhighered.com/

hubbard)

PowerPoint Lecture Presentation

The PowerPoint slides were prepared by Fernando Quijano and Shelly Tefft Instructors

can use the slides for class presentations, and students can use them for lecture

pre-view or repre-view These slides include all the graphs, tables, and equations in the

text-book Student versions of the PowerPoint slides are available as pdf files These files

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can download these PowerPoint presentations from the Instructor’s Resource Center

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Accuracy Checkers, Reviewers, and Class Testers

The guidance and recommendations of the following instructors helped us craft thecontent, organization, and features of this text While we could not incorporate everysuggestion from every reviewer, we carefully considered each piece of advice wereceived We are grateful for the hard work that went into your reviews and acknowl-edge that your feedback was indispensable in developing this text We appreciate yourassistance in making this the best text it could be; you have helped teach a whole newgeneration of students about the exciting world of money and banking

Special thanks to Ed Scahill of the University of Scranton for preparing the An

Inside Look news feature that ends each chapter Nathan Perry of Mesa State College

and Robert Gillette of the University of Kentucky helped the authors prepare the of-chapter problems

end-We are also grateful to Robert Gillette of the University of Kentucky, Duane Graddy

of Middle Tennessee State University, Lee Stone of the State University of New York atGeneseo, and their students for class-testing manuscript versions and providing uswith guidance on improving the chapters

18 chapters of the manuscript

Clare Battista, California PolytechnicState University–San Luis ObispoHoward Bodenhorn, Clemson UniversityLee A Craig, North Carolina StateUniversity

Anthony Gyapong, Pennsylvania StateUniversity

Robert Gillette, University of KentuckyWoodrow W Hughes, Jr., ConverseCollege

Andrew Prevost, Ohio UniversityEllis W Tallman, Oberlin CollegeTimothy Yeager, University ofArkansas

Reviewers and Focus Group Participants

We also appreciate the thoughtful comments of our reviewers and focus group ticipants They brought home to us once again that there are many ways to teach amoney and banking class We hope that we have written a text with sufficient flexi-bility to meet the needs of most instructors We carefully read and considered everycomment and suggestion we received and incorporated many of them into the text

par-We believe that our text has been greatly improved as a result of the reviewingprocess

William Paterson University

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Carolina–Pembroke

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State University–San Luis Obispo

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New York–Brockport

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York College–Oswego

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University

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University

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University

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University

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University

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College

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Ann Marie Klingenhagen, DePaulUniversity

Sungkyu Kwak, Washburn UniversityJohn Lapp, North Carolina StateUniversity

Robert J Martel, University ofConnecticut

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James McCague, University of NorthFlorida

Christopher McHugh, Tufts UniversityDoug McMillin, Louisiana StateUniversity

Carrie Meyer, George Mason UniversityJason E Murasko, University of

Houston–Clear LakeTheodore Muzio, St John’s UniversityNick Noble, Miami UniversityHilde Patron, University of West GeorgiaDouglas Pearce, North Carolina StateUniversity

Robert Pennington, University of CentralFlorida

Dennis Placone, Clemson UniversityStephen Pollard, California StateUniversity–Los AngelesAndrew Prevost, Ohio UniversityMaria Hamideh Ramjerdi, WilliamPaterson University

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Ellis W Tallman, Oberlin CollegeRichard Trainer, State University of NewYork–Nassau

Raúl Velázquez, Manhattan CollegeJohn Wagner, Westfield State CollegeChristopher Westley, Jacksonville StateUniversity

Shu Wu, The University of KansasDavid Zalewski, Providence College

A Word of Thanks

We benefited greatly from the dedication and professionalism of the PearsonEconomics team Executive Editor David Alexander’s energy and support were indis-pensable David shares our view that the time has come for a new approach to themoney and banking textbook Just as importantly, he provided words of encouragementwhenever our energy flagged Executive Development Editor Lena Buonanno workedtirelessly to ensure that this text was as good as it could be and to coordinate the manymoving parts involved in a project of this complexity We remain astonished at theamount of time, energy, and unfailing good humor she brought to this project WithoutLena, this book would hardly have been possible Director of Key Markets DavidTheisen provided invaluable insight into the changing needs of money and bankinginstructors Steve Deitmer, Director of Development, brought sound judgment to themany decisions required to create this book Alison Eusden managed the supplementpackage that accompanies the book Lindsey Sloan helped to prepare the solutions andassisted with the review and marketing programs Carla Thompson, Kelly Keeler, andJonathan Boylan turned our manuscript pages into a beautiful published book We

thank Pam Smith, Elena Zeller, and Jennifer Brailsford for their careful proofreading of two rounds of page proofs We appreciate the able research assistance of former Lehigh

Ph.D student Andrey Zagorchev, now of Concord University

We extend our special thanks to Wilhelmina Sanford, executive assistant to the Dean

of Columbia Business School, whose speedy and accurate typing of multiple drafts ismuch appreciated

A good part of the burden of a project of this magnitude is borne by our families

We appreciate the patience, support, and encouragement of our wives and children

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

1 Introducing Money and the

CAN THE FED RESTORE THE FLOW OF MONEY?

Large areas of southern Arizona and California’s central

valley have rich soils but receive very little rain Without

an elaborate irrigation system of reservoirs and canals,

water would not flow to these areas, and farmers could

not raise their vast crops of lettuce, asparagus, cotton,

and more The financial system is like an irrigation

system, although it is money, not water, that flows

through the financial system During the economic

crisis that began in 2007, the financial system was

disrupted as it hadn’t been since the 1930s, and large

sections of the U.S economy were cut off from the flow

of funds they needed to thrive Just as cutting off the

irrigation water in California’s San Joaquin Valley

would halt the production of crops, the financial crisis

resulted in a devastating decline in production of goods

and services throughout the economy

Like engineers trying to repair a damaged irrigation

canal to restore the flow of water, officials of the U.S

Treasury Department and the Federal Reserve (the Fed)

took strong actions during the financial crisis to restore

the flow of money through banks and financial markets

to the firms and households that depend on it

Although some of these policies were controversial,

most economists believe that some government

intervention was necessary to pull the economy out

of a deep recession

How deep was the recession of 2007–2009? More than 8 million jobs were lost, and the unemployment rate rose above 10% for the firsttime in almost three decades Many college studentsgraduating during the recession had difficulty finding jobs, and even those who did often had toaccept less desirable positions at lower salaries than they had expected And this was not just a temporary setback for these graduates Studies show that workers entering the labor force during arecession typically receive salaries that are 10% lessthan the salaries they would have earned had theyentered the labor force during an economic expansion Even worse news: Their salaries mayremain lower for a decade or more

The financial crisis contributed to the bankruptcy

of General Motors and Chrysler, two pillars ofindustrial America, as well as to the disappearance ofdecades-old Wall Street investment houses such asLehman Brothers and Bear Stearns Stock pricesplunged, and many older workers saw their savingsshrink and had to put their retirement dreams on hold

AN INSIDE LOOK AT POLICYon page 20 reviewsthree options Federal Reserve Chairman Ben Bernankeconsidered to further support the economy in late2010

Few households or firms escaped the fallout from the financial crisis and the recession thatresulted from it They did not need to be convinced that the financial system was impor-tant in their lives But although it was important, it was not easy to understand As manypeople came to realize, during the preceding 10 years, the financial system had becomeincreasingly complex To understand what was happening in the economy, it seemed as

if you needed knowledge that once only professional Wall Street investors possessed

In this chapter, we provide an overview of the important components of the financialsystem and introduce key issues and questions that we will explore throughout the book

Financial assetAn asset

that represents a claim

on someone else for a

payment.

Financial marketA place

or channel for buying

or selling stocks, bonds,

and other securities.

SecurityA financial asset

that can be bought and

sold in a financial market.

MoneyAnything that is

generally accepted in

payment for goods and

services or to pay off debts.

Money supplyThe total

quantity of money in the

economy.

Key Components of the Financial System

The purpose of this book is to provide you with the tools you need to understand themodern financial system First, you should be familiar with the three major compo-nents of the financial system:

1 Financial assets

2 Financial institutions

3 The Federal Reserve and other financial regulators

As vendors in baseball parks like to yell: “You can’t tell the players without aprogram.” We will briefly consider each of these components now and then return

to them in later chapters

Financial Assets

An asset is anything of value owned by a person or a firm A financial asset is a

finan-cial claim, which means that if you own a finanfinan-cial asset, you have a claim on someoneelse to pay you money For instance, a bank checking account is a financial assetbecause it represents a claim you have against a bank to pay you an amount of moneyequal to the dollar value of your account Economists divide financial assets into those

that are securities and those that aren’t A security is tradable, which means that it can

be bought and sold in a financial market Financial markets are places or channels for

buying and selling stocks, bonds, and other securities, such as the New York StockExchange If you own a share of stock in Apple or Google, you own a security becauseyou can sell that share in the stock market If you have a checking account at Citibank

or Wells Fargo, you can’t sell it So, your checking account is an asset but not a security

In this book, we will discuss many financial assets, but the following are five keycategories of assets:

We now briefly discuss these five key assets

Money Although we typically think of “money” as coins and paper currency, even thenarrowest government definition of money includes funds in checking accounts

In fact, economists have a very general definition of money: Money is anything

that people are willing to accept in payment for goods and services or to pay off debts

The money supply is the total quantity of money in the economy As we will see in

Chapter 2, money plays an important role in the economy, and there is some debateconcerning the best way to measure it

Stocks Stocks, also called equities, are financial securities that represent partial

ownership of a corporation When you buy a share of Microsoft stock, you become a

Microsoft shareholder, and you own part of Microsoft, although only a tiny part

because Microsoft has issued millions of shares of stock When Microsoft sells

addi-tional stock, it is doing the same thing that the owner of a small firm does when she

takes on a partner: increasing the funds available to the firm, its financial capital, in

exchange for increasing the number of the firm’s owners As an owner of a share of

stock in a corporation, you have a legal claim to a share of the corporation’s assets and

to a share of its profits, if there are any Firms keep some of their profits as retained

earnings and pay the remainder to shareholders in the form of dividends, which are

payments corporations typically make every quarter

Bonds When you buy a bond issued by a corporation or a government, you are lending

the corporation or the government a fixed amount of money The interest rate is the cost

of borrowing funds (or the payment for lending funds), usually expressed as a

percent-age of the amount borrowed For instance, if you borrow $1,000 from a friend and pay

him back $1,100 a year later, the interest rate on the loan was $100/$1,000 = 0.10, or 10%

Bonds typically pay interest in fixed dollar amounts called coupons When a bond

matures, the seller of the bond repays the principal For example, if you buy a $1,000

bond issued by IBM that has a coupon of $65 per year and a maturity of 30 years, IBM

will pay you $65 per year for the next 30 years, at the end of which IBM will pay you the

$1,000 principal A bond that matures in one year or less is a short-term bond A bond

that matures in more than one year is a long-term bond Bonds can be bought and sold

in financial markets, so, like stocks, bonds are securities

Foreign Exchange Many goods and services purchased in a country are produced

outside that country Similarly, many investors buy financial assets issued by foreign

governments and firms To buy foreign goods and services or foreign assets, a

domes-tic business or a domesdomes-tic investor must first exchange domesdomes-tic currency for foreign

currency For example, consumer electronics giant Best Buy exchanges U.S dollars for

Japanese yen when importing Sony televisions Foreign exchange refers to units of

foreign currency The most important buyers and sellers of foreign exchange are large

banks Banks engage in foreign currency transactions on behalf of investors who want

to buy foreign financial assets Banks also engage in foreign currency transactions

on behalf of firms that want to import or export goods and services or to invest in

physical assets, such as factories, in foreign countries

Securitized Loans If you lack the money to pay the full price of a car or house in cash,

you can apply for a loan at a bank Similarly, if a developer wants to build a new office

building or shopping mall, the developer can also take out a loan with a bank Until

about 30 years ago, banks made loans with the intention of making profits by

collect-ing interest payments on a loan until the loan was paid off It wasn’t possible to sell

most loans in financial markets, so loans were financial assets but not securities Then,

as we will discuss in more detail in Chapter 11, the federal government and some

financial firms created markets for many types of loans Loans that banks could sell on

financial markets became securities, so the process of converting loans into securities

is known as securitization.

To take one example, a bank might grant a mortgage, which is a loan a borrower

uses to buy a home, and sell it to a government-sponsored enterprise or a financial

firm that will bundle the mortgage together with similar mortgages granted by other

banks This bundle of mortgages will form the basis of a new security called a

mortgage-backed security that will function like a bond Just as an investor can buy a

Key Components of the Financial System 3

StockFinancial securities that represent partial ownership of a firm;

also called equities.

DividendA payment that

a corporation makes to its shareholders.

BondA financial security issued by a corporation

or a government that represents a promise

to repay a fixed amount

of money.

Interest rateThe cost of borrowing funds (or the payment for lending funds), usually expressed

as a percentage of the amount borrowed.

Foreign exchangeUnits

of foreign currency.

SecuritizationThe process

of converting loans and other financial assets that are not tradable into securities.

bond from IBM, the investor can buy a mortgage-backed security from the

govern-ment agency or financial firm The banks that grants, or originates, the original

mort-gages will still collect the interest paid by the borrowers and send those interestpayments on to the government agency or financial firm to distribute to the investorswho have bought the mortgage-backed security The bank will receive fees for originat-ing the loan and for collecting the loan payments from borrowers and distributingthem to lenders

Note that what a saver views as a financial asset a borrower views as a financial

liability A financial liability is a financial claim owed by a person or a firm For

example, if you take out a car loan from a bank, the loan is an asset from the point of the bank because it represents a promise by you to make a certain payment

view-to the bank every month until the loan is paid off But the loan is a liability view-to you,the borrower, because you owe the bank the payments specified in the loan

Financial Institutions

The financial system matches savers and borrowers through two channels: (1) Banks

and other financial intermediaries and (2) financial markets These two channels are

distinguished by how funds flow from savers, or lenders, to borrowers and by the cial institutions involved.1Funds flow from lenders to borrowers indirectly through

finan-financial intermediaries, such as banks, or directly through finan-financial markets, such as

the New York Stock Exchange

If you get a loan from a bank to buy a car, economists refer to this flow of funds as

indirect finance The flow is indirect because the funds the bank lends you come from

people who have put money in checking or savings deposits in the bank; in that sense,the bank is not lending its own funds directly to you On the other hand, if you buy

stock that a firm has just issued, the flow of funds is direct finance because the funds

are flowing directly from you to the firm

Savers and borrowers can be households, firms, or governments, both domesticand foreign Figure 1.1 shows that the financial system channels funds from savers to

borrowers, and channels returns back to savers, both directly and indirectly Savers

receive their returns in various forms, including dividend payments on stock, couponpayments on bonds, and interest payments on loans

Financial Intermediaries Commercial banks are the most important financial

intermediaries Commercial banks play a key role in the financial system by taking indeposits from households and firms and investing most of those deposits, either bymaking loans to households and firms or by buying securities, such as governmentbonds or securitized loans Most households rely on borrowing money from bankswhen they purchase “big-ticket items,” such as cars or homes Similarly, many firms

rely on bank loans to meet their short-term needs for credit, such as funds to pay for

inventories or to meet their payrolls Many firms rely on bank loans to bridge the gapbetween the time they must pay for inventories or meet their payrolls and when theyreceive revenues from the sales of goods and services Some firms also rely on bankloans to meet their long-term credit needs, such as funds they require to physicallyexpand the firm

Financial liabilityA

financial claim owed by a

person or a firm.

Financial intermediary

A financial firm, such as a

bank, that borrows funds

from savers and lends them

to borrowers.

Commercial bankA

financial firm that serves as

a financial intermediary by

taking in deposits and

using them to make loans.

1 Note that for convenience, we sometimes refer to households, firms, and governments that have funds

they are willing to lend or invest as lenders, and we refer to households, firms, and governments that wish

to use those funds as borrowers These labels are not strictly accurate because the flow of funds does not

always take the form of loans For instance, investors who buy stock are buying part ownership in a firm, not lending money to the firm.

Figure 1.1 Moving Funds Through the Financial System

Financial System

Financial Markets

Financial Intermediaries

Households Firms Governments

Savers

In each chapter, the Making the Connection feature discusses a news story or

another application related to the chapter material Read the following Making the

Connection for a discussion of how firms were affected by the decline in bank lending

during the financial crisis that began in 2007

Key Components of the Financial System 5

The financial system transfers funds from savers to borrowers Borrowers

transfer returns back to savers through the financial system Savers

and borrowers include domestic and foreign households, businesses, and governments.•

Making the Connection

Pawn Shop Finance: What Happens to Small Businesses

When Bank Lending Dries Up?

One day in December 2008, the owner of the Ground Up Construction firm found

himself in a pawn shop in Lewiston, Maine, borrowing money to operate his business

He gave the pawn shop his dump truck as collateral: If he failed to pay back the loan,

the pawn shop could sell the dump truck In normal times, pawn shops are mainly in

the business of making small loans of $50 to $100 to low-income individuals in

exchange for collateral in the form of jewelry or other easy-to-sell property The loans

are usually for a short period of time, and the interest rate is often 10 to 20% per

month, which is about 20 times the interest rate a bank would charge on a typical loan.

Why would the owner of a small business pay such high interest rates? Because

December 2008 was in the middle of the financial crisis, and many local banks had cut

small businesses off from their normal source of credit

Large businesses can raise funds on financial markets by selling stocks and bonds,

but small businesses don’t have this option Because it’s costly for investors to gather

information on small businesses, these businesses cannot sell stocks and bonds and

must rely instead on loans from banks Banks make commercial and industrial loans

to firms, often for fairly short periods of time Firms use these loans for a variety ofpurposes, including to bridge the gap between when the firms must make payments toemployees and suppliers and when they receive revenue from selling their products.Banks also make commercial real estate loans, which allow firms to construct orpurchase office buildings, factories, and shopping malls.

Over the past 20 years, the relationship between banks and small businesses haschanged At one time, government regulations kept many banks small As a result,banks made most of their loans in a small geographic area In those circumstances,bank loan officers usually had extensive personal knowledge of the finances of mostlocal businesses and used that knowledge to determine whether to grant loans Bythe 2000s, changes in banking law meant that many small businesses were receivingloans from banks that operated on a regional, or even national, basis These largerbanks typically applied fixed guidelines for granting loans that left little room for thepersonal judgment traditionally exercised by loan officers of small banks Suchguidelines were both good news and bad news for small businesses On the one hand,businesses that met the guidelines would receive loans even if aspects of their finan-cial situation not covered by the guidelines made them riskier borrowers On theother hand, businesses that failed to meet the guidelines might be turned down forloans even though they were very likely to be able to make their payments

By the mid-2000s, though, many banks became convinced that it would beprofitable to loosen their loan guidelines to make more borrowers eligible to receive

credit These banks believed that the larger number of borrowers who would default

on their loans because of the looser guidelines would be more than offset by the ments received from the additional borrowers who would now qualify for loans.During this period, it became easier for households to receive loans to buy homes, cars,

pay-or furniture and fpay-or firms to receive commercial real estate loans, as well as cial and industrial loans Unfortunately, during the financial crisis that began in mid-

commer-2007, the number of households and firms defaulting on loans turned out to be muchhigher than banks had predicted The following graph shows the value of loan losses

as a percentage of the value of total loans for all U.S commercial banks from the ning of 2000 through the end of 2009 The graph shows that banks experienced anincrease in loan losses during the recession of 2001, but loan losses during the2007–2009 recession were much more severe Loan losses began rising in the spring of

begin-2008, and by the end of 2009 they were four times greater than at the end of 2007

Key Components of the Financial System 7

In fact, the loan losses during 2007–2009 were by far the largest since the Great

Depression of the 1930s Partly as a result of these losses and partly because of pressure

from government bank regulators, most banks tightened their loan guidelines, which

made it much more difficult for households and businesses to qualify for loans The

figure below shows movements in total bank loans from January 2000 through April

2010 During the recession of 2001, total bank loans declined only slightly During the

financial crisis and recession of 2007–2009, bank loans declined much more sharply

Loans actually increased until the fall of 2008, when the financial crisis worsened

From a peak of $7.3 trillion in October 2008, they fell by 10%, to $6.6 trillion, in

February 2010, before increasing in the following months

Cut off from their normal source of funds, many small businesses, such as Ground

Up Construction, had to resort to drastic measures, such as borrowing from pawn

shops, running up balances on their credit cards, or borrowing from friends and

family members, in order to survive It was no surprise, then, when many economists

argued during the crisis that the economy would not recover until banks increased

their lending to small businesses

Source: Gary Fields, “People Pulling Up to Pawnshops Today Are Driving Cadillacs and BMWs,” Wall

Test your understanding by doing related problem 1.10 on page 23 at the end of

this chapter.

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 0

Source: Federal Reserve Bank of St Louis.

Nonbank Financial Intermediaries Some financial intermediaries, such as savings and

loans, savings banks, and credit unions, are legally distinct from banks, although these

“nonbanks” operate in a very similar way by taking in deposits and making loans Other

financial intermediaries include insurance companies, pension funds, mutual funds,

hedge funds, and investment banks Although these institutions don’t at first glance

appear to be very similar to banks, they fulfill a similar function in the financial system

by channeling funds from savers to borrowers We can briefly describe each of these

financial intermediaries:

Insurance companies. Insurance companies specialize in writing contracts to protect

their policyholders from the risk of financial losses associated with particular events,

such as automobile accidents or fires Insurance companies collect premiums from

policyholders, which the companies then invest to obtain the funds necessary to payclaims to policyholders and to cover their other costs So, for instance, when you andother people buy an automobile insurance policy, the insurance company may lend thepremiums you pay to a hotel chain that needs funds to expand.

Pension funds. For many people, saving for retirement is the most important form ofsaving Pension funds invest contributions from workers and firms in stocks, bonds, andmortgages to earn the money necessary to pay pension benefit payments during workers’retirements With about $10 trillion in assets in 2010, private and state and local govern-ment pension funds are an important source of demand for financial securities

Mutual funds. A mutual fund, such as Fidelity Investment’s Magellan Fund, obtainsmoney by selling shares to investors The mutual fund then invests the money in a

portfolio of financial assets, such as stocks and bonds, typically charging a small

management fee for its services By buying shares in a mutual fund, savers reduce thecosts they would incur if they were to buy many individual stocks and bonds Smallsavers who have only enough money to buy a few individual stocks and bonds canalso lower their investment risk by buying shares in a mutual fund because mostmutual funds hold a large number of stocks and bonds If a firm issuing a stock or abond declares bankruptcy, causing the stock or bond to lose all of its value, the effect

on a mutual fund’s portfolio is likely to be small The effect might be devastating,though, on a small investor who had invested most of his or her savings in the stock

or bond Because mutual funds are willing to buy back their shares at any time, theyalso provide savers with easy access to their money

Hedge funds. Hedge funds, such as the Quantum Group run by billionaire GeorgeSoros, are similar to mutual funds in that they accept money from investors and usethe funds to buy a portfolio of assets However, a hedge fund typically has no morethan 99 investors, all of whom are wealthy individuals or institutions such as pensionfunds Hedge funds typically make riskier investments than do mutual funds, and theycharge investors much higher fees

Investment banks. Investment banks, such as Goldman Sachs and Morgan Stanley, differfrom commercial banks in that they do not take in deposits and rarely lend directly tohouseholds Instead, they concentrate on providing advice to firms issuing stocks and

bonds or considering mergers with other firms They also engage in underwriting, in

which they guarantee a price to a firm issuing stocks or bonds and then make a profit byselling the stocks or bonds at a higher price In the late 1990s, investment banks increasedtheir importance as financial intermediaries by becoming heavily involved in the securi-tization of loans, particularly mortgage loans Investment banks also began to engage in

proprietary trading in which they hoped to profit by buying and selling securities.

Financial Markets Financial markets are places or channels for buying and sellingstocks, bonds, and other securities Traditionally, financial markets have been physicalplaces, such as the New York Stock Exchange, which is located on Wall Street in NewYork City, or the London Stock Exchange, which is located in Paternoster Square inLondon On these exchanges, stocks and bonds were traded by dealers who would meetface-to-face Today, most securities trading takes place electronically between dealerslinked by computers and is referred to as “over-the-counter” trading NASDAQ, whichoriginally stood for the National Association of Securities Dealers AutomatedQuotation System, is an over-the-counter market on which the stocks of many high-tech firms such as Apple and Intel are traded Stocks and bonds sold in a particular

PortfolioA collection of

assets, such as stocks and

bonds.

Making the Connection

What Do People Do With Their Savings?

Most college students do not have many financial assets other than a checking account

However, after they begin their careers, they are likely to accumulate a variety of

dif-ferent assets The Federal Reserve System publishes quarterly and annual data on

household holdings of financial assets The table below reports holdings of assets, such

as stocks and bonds, that are supplied by financial markets, and assets, such as bank

deposits and mutual fund shares, that are supplied by financial intermediaries through

the first quarter (Q1) of 2010

These data show that more than one-half of household financial assets are held

through financial intermediaries The data also show the effects of economic conditions

Primary marketA cial market in which stocks, bonds, and other securities are sold for the first time.

finan-Secondary market

A financial market in which investors buy and sell existing securities.

market are said to be “listed” on that market For instance, General Electric is listed on

the New York Stock Exchange, and Apple is listed on NASDAQ

Economists make a distinction between primary markets and secondary markets A

primary market is a financial market in which stocks, bonds, and other securities are

sold for the first time In 2004, when Google first sold stock, which is called an initial

public offering (IPO), the stock was sold in the primary market A secondary market is

a financial market in which investors buy and sell already existing securities Primary

and secondary markets can be in the same physical—or virtual—place, as when an IPO

takes place for a stock listed on the New York Stock Exchange or on NASDAQ

Key Components of the Financial System 9

Household Holdings of Selected Financial Assets (percentage of total financial assets held)

1990 2000 2007 2010: Q1 Saving through financial assets

in financial markets

Agency and government-sponsored

enterprise GSE securities

Subtotal of saving through financial markets 46.2% 46.4% 38.2% 40.6%

Saving through financial assets in financial

intermediaries

Subtotal of saving through financial

intermediaries

Source: Board of Governors of the Federal Reserve, Flow of Funds Accounts of the United States, various

issues.

Federal ReserveThe

central bank of the United

States; usually referred to

as “the Fed.”

on household savings For example, the stock market boom of the late 1990s resulted

in corporate equities—stocks—rising from 13% of all household financial assets in

1990 to almost 25% in 2000, before declining to about 17% in 2010 Households hadrelatively less of their savings in bank deposits, Treasury securities (which are primarilybonds issued by the federal government), and state and local government securities(which are primarily bonds issued by state and local governments) in 2010 than in 1990.But households had relatively more of their savings in corporate bonds and mutualfunds Bank deposits declined in importance following 1990 but increased inimportance during the financial crisis that began in 2007, as households looked for asafe haven for their savings Finally, note that more than one-quarter of householdsavings takes the form of balances in pension fund accounts

Test your understanding by doing related problem 1.11 on page 23 at the end of this chapter.

The Federal Reserve and Other Financial Regulators

During the financial crisis of 2007–2009, many people looked around at failing banks,the frozen markets for some financial assets, and plummeting stock prices and asked:

“Who’s in charge here? Who runs the financial system?” In a sense, these are unusualquestions to ask because the point of a market system is that no one individual orgroup is in charge Consumers decide which goods and services they value the most,and firms compete to offer those goods and services at the lowest price Few peoplethink to ask: “Who’s in charge of the frozen pizza market?” or “Who’s in charge of thebreakfast cereal market?” In most markets, the government plays a very limited role

in deciding what gets produced, how it gets produced, what prices firms charge, orhow firms operate But policymakers in the United States and most other countriesview the financial system as different from the markets for most goods and services

It is different because, when left largely alone, the financial system has experiencedperiods of instability that have led to economic recessions

The federal government of the United States has several agencies that are devoted

to regulating the financial system, including these:

● The Securities and Exchange Commission (SEC), which regulates financial markets

● The Federal Deposit Insurance Corporation (FDIC), which insures deposits in banks

● The Office of the Comptroller of the Currency, which regulates federally charteredbanks

● The Federal Reserve System, which is the central bank of the United StatesAlthough we will discuss all these federal agencies in this book, we will focus on theFederal Reserve System Here we provide a brief overview of the Federal Reserve,before exploring its operations in greater detail in later chapters

What Is the Federal Reserve? The Federal Reserve (usually referred to as “the Fed”)

is the central bank of the United States Congress established the Fed in 1913 to deal withproblems in the banking system As we have seen, the main business of banking is to take

in deposits and to make loans Banks can run into difficulties, though, because tors have the right to withdraw their money at any time, while many of the loans banksgrant to people buying cars or houses will not be repaid for years As a result, if largenumbers of depositors simultaneously demand their money back, banks may not havethe funds necessary to satisfy the demand One solution to this problem is for a country’s

deposi-central bank to act as a lender of last resort and make short-term loans that provide banks

with funds to pay out to their depositors Because Congress believed that the Fed hadfailed to carry out its duties as a lender of last resort during the Great Depression of the

Minneapolis Kansas City

Boston New York Philadelphia

Board of Governors

Richmond

Cleveland Chicago

St Louis Dallas

1

2

3 4

5

6

7 9

1930s, it established the Federal Deposit Insurance Corporation (FDIC) in 1934 The

FDIC insures deposits in banks up to a limit of $250,000 per account

What Does the Federal Reserve Do? The modern Fed has moved far beyond its

original role as a lender of last resort In particular, the Fed is now responsible for

monetary policy Monetary policy refers to the actions the Federal Reserve takes to

manage the money supply and interest rates to pursue macroeconomic policy objectives

These policy objectives include high levels of employment, low rates of inflation, high

rates of growth, and stability in the financial system The Fed is run by the Board of

Governors, which consists of seven members who are appointed by the president of the

United States and confirmed by the U.S Senate One member of the Board of Governors

is designated as chair Currently, the chair is Ben Bernanke, who was first appointed by

President George W Bush in 2006 and then reappointed by President Barack Obama in

2010 The Federal Reserve System is divided into 12 districts, each of which has a District

Bank, as shown in Figure 1.2 The Federal Open Market Committee (FOMC) is the main

policymaking body of the Fed The FOMC consists of the seven members of the Board

of Governors, the president of the Federal Reserve Bank of New York, and four presidents

from the other 11 Federal Reserve District Banks

The FOMC meets in Washington, DC, eight times per year to discuss monetary

policy At these meetings, the FOMC decides on a target for a particularly important

interest rate: the federal funds rate, which is the interest rate that banks charge each

other on short-term loans As we will see in later chapters, the federal funds rate is

important because changes in it can result in changes in many other interest rates

The Fed was heavily involved in the financial crisis of 2007–2009 Before

provid-ing a brief discussion of the financial crisis, we conclude our overview of the financial

system by discussing the key services that the financial system provides

Key Components of the Financial System 11

Monetary policyThe actions the Federal Reserve takes to manage the money supply and interest rates to pursue

macroeconomic policy objectives.

The Federal Reserve System is divided into 12 districts, each of which has a District Bank located in the city shown on the map.•

Federal funds rateThe interest rate that banks charge each other on short-term loans.