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(BQ) Part 2 book The economics of money, banking, and financial markets has contents: Multiple deposit creation and the money supply process, determinants of the money supply, tools of monetary policy, tools of monetary policy, the international financial system, the demand for money,...and other contents.
Ch a p ter 15 PREVIEW Multiple Deposit Creation and the Money Supply Process As we saw in Chapter and will see in later chapters on monetary theory, movements in the money supply affect interest rates and the overall health of the economy and thus affect us all Because of its far-reaching effects on economic activity, it is important to understand how the money supply is determined Who controls it? What causes it to change? How might control of it be improved? In this and subsequent chapters, we answer these questions by providing a detailed description of the money supply process, the mechanism that determines the level of the money supply Because deposits at banks are by far the largest component of the money supply, understanding how these deposits are created is the first step in understanding the money supply process This chapter provides an overview of how the banking system creates deposits, and describes the basic principles of the money supply, needed to understand later chapters Four Players in the Money Supply Process The “cast of characters” in the money supply story is as follows: The central bank—the government agency that oversees the banking system and is responsible for the conduct of monetary policy; in the United States, it is called the Federal Reserve System Banks (depository institutions)—the financial intermediaries that accept deposits from individuals and institutions and make loans: commercial banks, savings and loan associations, mutual savings banks, and credit unions Depositors—individuals and institutions that hold deposits in banks Borrowers from banks—individuals and institutions that borrow from the depository institutions and institutions that issue bonds that are purchased by the depository institutions Of the four players, the central bank—the Federal Reserve System—is the most important The Fed’s conduct of monetary policy involves actions that affect its balance sheet (holdings of assets and liabilities), to which we turn now 357 358 PART IV Central Banking and the Conduct of Monetary Policy The Fed’s Balance Sheet www.federalreserve.gov /boarddocs/rptcongress /annual01/default.htm See the most recent Federal Reserve financial statement The operation of the Fed and its monetary policy involve actions that affect its balance sheet, its holdings of assets and liabilities Here we discuss a simplified balance sheet that includes just four items that are essential to our understanding of the money supply process.1 FEDERAL RESERVE SYSTEM Assets Government securities Discount loans Liabilities www.rich.frb.org/research /econed/museum/ A virtual tour of the Federal Reserve’s money museum Liabilities Currency in circulation Reserves The two liabilities on the balance sheet, currency in circulation and reserves, are often referred to as the monetary liabilities of the Fed They are an important part of the money supply story, because increases in either or both will lead to an increase in the money supply (everything else being constant) The sum of the Fed’s monetary liabilities (currency in circulation and reserves) and the U.S Treasury’s monetary liabilities (Treasury currency in circulation, primarily coins) is called the monetary base When discussing the monetary base, we will focus only on the monetary liabilities of the Fed because the monetary liabilities of the Treasury account for less then 10% of the base.2 Currency in circulation The Fed issues currency (those green-and-gray pieces of paper in your wallet that say “Federal Reserve Note” at the top) Currency in circulation is the amount of currency in the hands of the public (Currency held by depository institutions is also a liability of the Fed, but is counted as part of the reserves.) Federal Reserve notes are IOUs from the Fed to the bearer and are also liabilities, but unlike most, they promise to pay back the bearer solely with Federal Reserve notes; that is, they pay off IOUs with other IOUs Accordingly, if you bring a $100 bill to the Federal Reserve and demand payment, you will receive two $50s, five $20s, ten $10s, or one hundred $1 bills People are more willing to accept IOUs from the Fed than from you or me because Federal Reserve notes are a recognized medium of exchange; that is, they are accepted as a means of payment and so function as money Unfortunately, neither you nor I can convince people that our IOUs are worth anything more than the paper they are written on.3 A detailed discussion of the Fed’s balance sheet and the factors that affect the monetary base can be found in the appendix to this chapter, which you can find on this book’s web site at www.aw.com/mishkin It is also safe to ignore the Treasury’s monetary liabilities when discussing the monetary base because the Treasury cannot actively supply its monetary liabilities to the economy due to legal restrictions The currency item on our balance sheet refers only to currency in circulation; that is, the amount in the hands of the public Currency that has been printed by the U.S Bureau of Engraving and Printing is not automatically a liability of the Fed For example, consider the importance of having $1 million of your own IOUs printed up You give out $100 worth to other people and keep the other $999,900 in your pocket The $999,900 of IOUs does not make you richer or poorer and does not affect your indebtedness You care only about the $100 of liabilities from the $100 of circulated IOUs The same reasoning applies for the Fed in regard to its Federal Reserve notes For similar reasons, the currency component of the money supply, no matter how it is defined, includes only currency in circulation It does not include any additional currency that is not yet in the hands of the public The fact that currency has been printed but is not circulating means that it is not anyone’s asset or liability and thus cannot affect anyone’s behavior Therefore, it makes sense not to include it in the money supply CHAPTER 15 Multiple Deposit Creation and the Money Supply Process 359 Reserves All banks have an account at the Fed in which they hold deposits Reserves consist of deposits at the Fed plus currency that is physically held by banks (called vault cash because it is stored in bank vaults) Reserves are assets for the banks but liabilities for the Fed, because the banks can demand payment on them at any time and the Fed is required to satisfy its obligation by paying Federal Reserve notes As you will see, an increase in reserves leads to an increase in the level of deposits and hence in the money supply Total reserves can be divided into two categories: reserves that the Fed requires banks to hold (required reserves) and any additional reserves the banks choose to hold (excess reserves) For example, the Fed might require that for every dollar of deposits at a depository institution, a certain fraction (say, 10 cents) must be held as reserves This fraction (10%) is called the required reserve ratio Currently, the Fed pays no interest on reserves Assets The two assets on the Fed’s balance sheet are important for two reasons First, changes in the asset items lead to changes in reserves and consequently to changes in the money supply Second, because these assets (government securities and discount loans) earn interest while the liabilities (currency in circulation and reserves) not, the Fed makes billions of dollars every year—its assets earn income, and its liabilities cost nothing Although it returns most of its earnings to the federal government, the Fed does spend some of it on “worthy causes,” such as supporting economic research Government securities This category of assets covers the Fed’s holdings of securities issued by the U.S Treasury As you will see, the Fed provides reserves to the banking system by purchasing securities, thereby increasing its holdings of these assets An increase in government securities held by the Fed leads to an increase in the money supply Discount loans The Fed can provide reserves to the banking system by making discount loans to banks An increase in discount loans can also be the source of an increase in the money supply The interest rate charged banks for these loans is called the discount rate Control of the Monetary Base The monetary base (also called high-powered money) equals currency in circulation C plus the total reserves in banking system R.4 The monetary base MB can be expressed as MB ϭ C ϩ R The Federal Reserve exercises control over the monetary base through its purchases or sale of government securities in the open market, called open market operations, and through its extension of discount loans to banks Federal Reserve Open Market Operations The primary way in which the Fed causes changes in the monetary base is through its open market operations A purchase of bonds by the Fed is called an open market purchase, and a sale of bonds by the Fed is called an open market sale Here currency in circulation includes both Federal Reserve currency (Federal Reserve notes) and Treasury currency (primarily coins) 360 PART IV Central Banking and the Conduct of Monetary Policy Open Market Purchase from a Bank Suppose that the Fed purchases $100 of bonds from a bank and pays for them with a $100 check The bank will either deposit the check in its account with the Fed or cash it in for currency, which will be counted as vault cash To understand what occurs as a result of this transaction, we look at T-accounts, which list only the changes that occur in balance sheet items starting from the initial balance sheet position Either action means that the bank will find itself with $100 more reserves and a reduction in its holdings of securities of $100 The T-account for the banking system, then, is: BANKING SYSTEM Assets Liabilities Ϫ$100 ϩ$100 Securities Reserves The Fed meanwhile finds that its liabilities have increased by the additional $100 of reserves, while its assets have increased by the $100 of additional securities that it now holds Its T-account is: FEDERAL RESERVE SYSTEM Assets Liabilities ϩ$100 Securities ϩ$100 Reserves The net result of this open market purchase is that reserves have increased by $100, the amount of the open market purchase Because there has been no change of currency in circulation, the monetary base has also risen by $100 Open Market Purchase from the Nonbank Public To understand what happens when there is an open market purchase from the nonbank public, we must look at two cases First, let’s assume that the person or corporation that sells the $100 of bonds to the Fed deposits the Fed’s check in the local bank The nonbank public’s T-account after this transaction is: NONBANK PUBLIC Assets Securities Checkable deposits Liabilities Ϫ$100 ϩ$100 When the bank receives the check, it credits the depositor’s account with the $100 and then deposits the check in its account with the Fed, thereby adding to its reserves The banking system’s T-account becomes: CHAPTER 15 Multiple Deposit Creation and the Money Supply Process 361 BANKING SYSTEM Assets Liabilities ϩ$100 Reserves Checkable deposits ϩ$100 The effect on the Fed’s balance sheet is that it has gained $100 of securities in its assets column, while it has an increase of $100 of reserves in its liabilities column: FEDERAL RESERVE SYSTEM Assets Liabilities ϩ$100 Securities ϩ$100 Reserves As you can see in the above T-account, when the Fed’s check is deposited in a bank, the net result of the Fed’s open market purchase from the nonbank public is identical to the effect of its open market purchase from a bank: Reserves increase by the amount of the open market purchase, and the monetary base increases by the same amount If, however, the person or corporation selling the bonds to the Fed cashes the Fed’s check either at a local bank or at a Federal Reserve bank for currency, the effect on reserves is different.5 This seller will receive currency of $100 while reducing holdings of securities by $100 The bond seller’s T-account will be: NONBANK PUBLIC Assets Liabilities Ϫ$100 ϩ$100 Securities Currency The Fed now finds that it has exchanged $100 of currency for $100 of securities, so its T-account is: FEDERAL RESERVE SYSTEM Assets Securities Liabilities ϩ$100 Currency in circulation ϩ$100 If the bond seller cashes the check at the local bank, its balance sheet will be unaffected, because the $100 of vault cash that it pays out will be exactly matched by the deposit of the $100 check at the Fed Thus its reserves will remain the same, and there will be no effect on its T-account That is why a T-account for the banking system does not appear here 362 PART IV Central Banking and the Conduct of Monetary Policy The net effect of the open market purchase in this case is that reserves are unchanged, while currency in circulation increases by the $100 of the open market purchase Thus the monetary base increases by the $100 amount of the open market purchase, while reserves not This contrasts with the case in which the seller of the bonds deposits the Fed’s check in a bank; in that case, reserves increase by $100, and so does the monetary base The analysis reveals that the effect of an open market purchase on reserves depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits If the proceeds are kept in currency, the open market purchase has no effect on reserves; if the proceeds are kept as deposits, reserves increase by the amount of the open market purchase The effect of an open market purchase on the monetary base, however, is always the same (the monetary base increases by the amount of the purchase) whether the seller of the bonds keeps the proceeds in deposits or in currency The impact of an open market purchase on reserves is much more uncertain than its impact on the monetary base Open Market Sale If the Fed sells $100 of bonds to a bank or the nonbank public, the monetary base will decline by $100 For example, if the Fed sells the bonds to an individual who pays for them with currency, the buyer exchanges $100 of currency for $100 of bonds, and the resulting T-account is: NONBANK PUBLIC Assets Liabilities ϩ$100 Ϫ$100 Securities Currency The Fed, for its part, has reduced its holdings of securities by $100 and has also lowered its monetary liability by accepting the currency as payment for its bonds, thereby reducing the amount of currency in circulation by $100: FEDERAL RESERVE SYSTEM Assets Securities Liabilities Ϫ$100 Currency in circulation Ϫ$100 The effect of the open market sale of $100 of bonds is to reduce the monetary base by an equal amount, although reserves remain unchanged Manipulations of Taccounts in cases in which the buyer of the bonds is a bank or the buyer pays for the bonds with a check written on a checkable deposit account at a local bank lead to the same $100 reduction in the monetary base, although the reduction occurs because the level of reserves has fallen by $100 CHAPTER 15 Study Guide Multiple Deposit Creation and the Money Supply Process 363 The best way to learn how open market operations affect the monetary base is to use T-accounts Using T-accounts, try to verify that an open market sale of $100 of bonds to a bank or to a person who pays with a check written on a bank account leads to a $100 reduction in the monetary base The following conclusion can now be drawn from our analysis of open market purchases and sales: The effect of open market operations on the monetary base is much more certain than the effect on reserves Therefore, the Fed can control the monetary base with open market operations more effectively than it can control reserves Open market operations can also be done in other assets besides government bonds and have the same effects on the monetary base we have described here One example of this is a foreign exchange intervention by the Fed (see Box 1) Shifts from Deposits into Currency Even if the Fed does not conduct open market operations, a shift from deposits to currency will affect the reserves in the banking system However, such a shift will have no effect on the monetary base, another reason why the Fed has more control over the monetary base than over reserves Let’s suppose that Jane Brown (who opened a $100 checking account at the First National Bank in Chapter 9) decides that tellers are so abusive in all banks that she closes her account by withdrawing the $100 balance in cash and vows never to deposit it in a bank again The effect on the T-account of the nonbank public is: NONBANK PUBLIC Assets Checkable deposits Currency Liabilities Ϫ$100 ϩ$100 Box 1: Global Foreign Exchange Rate Intervention and the Monetary Base It is common to read in the newspaper about a Federal Reserve intervention to buy or sell dollars in the foreign exchange market (Note that this intervention occurs at the request of the U.S Treasury.) Can this intervention also be a factor that affects the monetary base? The answer is yes, because a Federal Reserve intervention in the foreign exchange market involves a purchase or sale of assets denominated in a foreign currency Suppose that the Fed purchases $100 of deposits denominated in euros in exchange for $100 of deposits at the Fed (a sale of dollars for euros) A Federal Reserve purchase of any asset, whether it is a U.S government bond or a deposit denominated in a foreign currency, is still just an open market purchase and so leads to an equal rise in the monetary base Similarly, a sale of foreign currency deposits is just an open market sale and leads to a decline in the monetary base Federal Reserve interventions in the foreign exchange market are thus an important influence on the monetary base, a topic that we discuss further in Chapter 20 364 PART IV Central Banking and the Conduct of Monetary Policy The banking system loses $100 of deposits and hence $100 of reserves: BANKING SYSTEM Assets Liabilities Ϫ$100 Reserves Ϫ$100 Checkable deposits For the Fed, Jane Brown’s action means that there is $100 of additional currency circulating in the hands of the public, while reserves in the banking system have fallen by $100 The Fed’s T-account is: FEDERAL RESERVE SYSTEM Assets Liabilities Currency in circulation Reserves ϩ$100 Ϫ$100 The net effect on the monetary liabilities of the Fed is a wash; the monetary base is unaffected by Jane Brown’s disgust at the banking system But reserves are affected Random fluctuations of reserves can occur as a result of random shifts into currency and out of deposits, and vice versa The same is not true for the monetary base, making it a more stable variable Discount Loans In this chapter so far we have seen changes in the monetary base solely as a result of open market operations However, the monetary base is also affected when the Fed makes a discount loan to a bank When the Fed makes a $100 discount loan to the First National Bank, the bank is credited with $100 of reserves from the proceeds of the loan The effects on the balance sheets of the banking system and the Fed are illustrated by the following T-accounts: BANKING SYSTEM Assets Reserves FEDERAL RESERVE SYSTEM Liabilities ϩ$100 Discount loans ϩ$100 Assets Discount loans Liabilities ϩ$100 Reserves ϩ$100 The monetary liabilities of the Fed have now increased by $100, and the monetary base, too, has increased by this amount However, if a bank pays off a loan from the Fed, thereby reducing its borrowings from the Fed by $100, the T-accounts of the banking system and the Fed are as follows: CHAPTER 15 Multiple Deposit Creation and the Money Supply Process BANKING SYSTEM Assets Reserves FEDERAL RESERVE SYSTEM Liabilities Ϫ$100 Discount loans 365 Ϫ$100 Assets Discount loans Liabilities Ϫ$100 Reserves Ϫ$100 The net effect on the monetary liabilities of the Fed, and hence on the monetary base, is then a reduction of $100 We see that the monetary base changes one-for-one with the change in the borrowings from the Fed Other Factors That Affect the Monetary Base So far in this chapter, it seems as though the Fed has complete control of the monetary base through its open market operations and discount loans However, the world is a little bit more complicated for the Fed Two important items that are not controlled by the Fed but affect the monetary base are float and Treasury deposits at the Fed When the Fed clears checks for banks, it often credits the amount of the check to a bank that has deposited it (increases the bank’s reserves) but only later debits (decreases the reserves of) the bank on which the check is drawn The resulting temporary net increase in the total amount of reserves in the banking system (and hence in the monetary base) occurring from the Fed’s check-clearing process is called float When the U.S Treasury moves deposits from commercial banks to its account at the Fed, leading to a rise in Treasury deposits at the Fed, it causes a deposit outflow at these banks like that shown in Chapter and thus causes reserves in the banking system and the monetary base to fall Thus float (affected by random events such as the weather, which affects how quickly checks are presented for payment) and Treasury deposits at the Fed (determined by the U.S Treasury’s actions) both affect the monetary base but are not fully controlled by the Fed Decisions by the U.S Treasury to have the Fed intervene in the foreign exchange market also affect the monetary base, as can be seen in Box Overview of the Fed’s Ability to Control the Monetary Base The factor that most affects the monetary base is the Fed’s holdings of securities, which are completely controlled by the Fed through its open market operations Factors not controlled by the Fed (for example, float and Treasury deposits with the Fed) undergo substantial short-run variations and can be important sources of fluctuations in the monetary base over time periods as short as a week However, these fluctuations are usually quite predictable and so can be offset through open market operations Although float and Treasury deposits with the Fed undergo substantial short-run fluctuations, which complicate control of the monetary base, they not prevent the Fed from accurately controlling it Multiple Deposit Creation: A Simple Model With our understanding of how the Federal Reserve controls the monetary base and how banks operate (Chapter 9), we now have the tools necessary to explain how deposits are created When the Fed supplies the banking system with $1 of additional 366 PART IV Central Banking and the Conduct of Monetary Policy reserves, deposits increase by a multiple of this amount—a process called multiple deposit creation Deposit Creation: The Single Bank Suppose that the $100 open market purchase described earlier was conducted with the First National Bank After the Fed has bought the $100 bond from the First National Bank, the bank finds that it has an increase in reserves of $100 To analyze what the bank will with these additional reserves, assume that the bank does not want to hold excess reserves because it earns no interest on them We begin the analysis with the following T-account: FIRST NATIONAL BANK Assets Liabilities Ϫ$100 ϩ$100 Securities Reserves Because the bank has no increase in its checkable deposits, required reserves remain the same, and the bank finds that its additional $100 of reserves means that its excess reserves have increased by $100 Let’s say that the bank decides to make a loan equal in amount to the $100 increase in excess reserves When the bank makes the loan, it sets up a checking account for the borrower and puts the proceeds of the loan into this account In this way, the bank alters its balance sheet by increasing its liabilities with $100 of checkable deposits and at the same time increasing its assets with the $100 loan The resulting T-account looks like this: FIRST NATIONAL BANK Assets Securities Reserves Loans Liabilities Ϫ$100 ϩ$100 ϩ$100 Checkable deposits ϩ$100 The bank has created checkable deposits by its act of lending Because checkable deposits are part of the money supply, the bank’s act of lending has in fact created money In its current balance sheet position, the First National Bank still has excess reserves and so might want to make additional loans However, these reserves will not stay at the bank for very long The borrower took out a loan not to leave $100 idle at the First National Bank but to purchase goods and services from other individuals and corporations When the borrower makes these purchases by writing checks, they will be deposited at other banks, and the $100 of reserves will leave the First National Bank A bank cannot safely make loans for an amount greater than the excess reserves it has before it makes the loan I-6 Index Duration analysis, 221 Dynamic open market operations, 398 East Asia, 480 banking crises, 284 financial crises, 194–198 Eastern Europe, banking crises, 282 E-cash, 51 See also payments systems ECB (European Central Bank), 49, 350, 498 Econometric policy evaluation, 659 Economic expansions, Economic growth, 22 financial development and, 187–188 inflation targeting, 508–509 monetary policy, 412 Economies effect of expansion for bonds, 102 of scale, 30, 173 of scope, 248 ECU (European currency unit), 474 Edge Act corporation, 255 Edwards, Sebastian, 478 Effective exchange rate index, 455 Effectiveness lag, 651 Efficient market hypothesis, 149, 150–152 evidence on the, 153–162 E-finance, Eisenhower, Dwight D., 423 Electronic banking, 234–235 regulation, 270 Electronic money (e-money), 51 Electronic payment systems, 50 Eligible paper, 420 EM (equity multiplier), 214 Emerging country financial crises, 194–198 Emerging market foreign exchange crises, 477–478 Empirical evidence framework for evaluation, 603–607 Keynesian evidence, 607–610 monetarist evidence, 611–616 Employee Retirement Income Security Act (ERISA), 295 Employment Act of 1946, 411 Employment rates, 411 EMS (European Monetary System), 471 Engineering, financial, 232 Engle, Charles, 158 Enron Corporation bankruptcy of, 124–127 collapse after Arthur Andersen conviction, 178 effect on stock market, 146–147 Equal Credit Opportunity Act of 1974, 269 Equation of exchange, 518, 583 Equilibrium in the bond market, 89 changes in interest rates, 93–104 IS curve, 552 Keynesian cross diagram, 540 markets, 90 Equities, 26 See also financial instruments; securities ROE, 214 Equity capital, 141, 180 See also common stock Equity multiplier (EM), 214 Ericsson, 50 ERISA (Employee Retirement Income Security Act), 295 ERM (exchange rate mechanism), 474, 490 Errors of expectations, forecasting, 150 ESCB (European System of Central Banks), 350 Estrella, Arturo, 429 Euro, 28 EMS (European Monetary System), 471 foreign exchange markets, 457 Eurobond, 28 Eurocurrencies, 28 Eurodollars, 28, 53, 254, 255 Europe banking crises, 282 currency (euro), 49 electronic payment systems, 50 financial regulation, 40 price stability, 413 European Central Bank (ECB), 49, 350, 498 European currency unit (ECU), 474 European Economic Commission, 49 European Monetary System (EMS), 471 European options, 320 European System of Central Banks (ESCB), 350 Evaluation, Lucas critique of policy evaluation, 659–660 Evidence, 603 See also empirical evidence reduced-form, 604 statistical, 613 structural model, 604 timing, 611 Evolution of banking system, 232–243 Excess demand, 90, 589 Excess reserves, 204 money supply, 359 Excess supply, 90, 589 Exchange rate See also Foreign exchange markets effects on net exports, 618 overshooting, 454 Exchange rate mechanism (ERM), 474, 490 Exchange-rate targeting, 489–495 Exchanges, 6, 27 Exercise price, 320 Expanded-inflation effect, 113 Expansions, economic, Expectations adaptive, 147 relationship to liquidity premiums, 134 Index theory, 129 theory of rational, 147–150 Expected deposit outflows, 380 Expected price levels, 594 Expected returns See also returns discount bonds, 88 equilibrium in interest rates, 95–96 foreign exchange markets, 448–459 interest rate, 86 segmented markets theory, 132 Expenditure multiplier, 542 Expertise, financial intermediaries, 174 Exports, 537 See also net exports changes in, 563–564 effect of dollar value fluctuations, exchange rate effects on, 618 External financing, 170 External funds, 171–172 Face value, 63 Factoring credit, 297 Factors of production, 20 Failures, banks, 260 Fair Credit Billing Act of 1974, 269 Fallen angels, 235 Fama, Eugene F., 137, 154, 155 Farm Credit System, 301 FDIC (Federal Deposit Insurance Corporation), 38, 40, 231, 261 discount policy, 402 FDICIA (Federal Deposit Insurance Corporation Improvement Act), 278 Federal; funds rate, 393 Federal Advisory Council, 345 Federal credit agencies, 301 Federal Deposit Insurance Corporation (FDIC), 38, 40, 231, 261 discount policy, 402 Federal Deposit Insurance Corporation Improvement Act (FDICIA), 278 Federal Deposit Insurance Corporation Improvement Act of 1991, 279 Federal funds rate, reserve markets, 393–398 Federal Home Loan Bank Board, 275 Federal Home Loan Banks, 278 Federal Home Loan Bank System (FHLBS), 252 Federal Home Loan Mortgage Corporation (FHLMC), 301 Federal Insurance Contribution Act (FICA), 295 Federally sponsored agencies (FSEs), 301 Federal Market Open Committee (FMOC), 424 Federal National Mortgage Association (FNMA), 301 Federal Open Market Committee (FOMC), 337, 341, 398, 463 Federal Reserve Bank, 337, 463 Federal Reserve Bank of New York, 339 monetary policy, 424 Federal Reserve System, 12, 38 assets, 464 borrowing, 203 central bank behavior, 351–352 creation of, 231 foreign central banks, 349–351 formal structure of, 336–344 independence of, 346–349, 352–354 informal structure of, 344–346 liabilities, 464 monetary aggregates, 54 monetary policy procedures, 419–428 money measurement, 51 money supply balance sheets, 358–359 I-7 origin of, 335–336 Regulation B, 269 Regulation K, 255 Regulation Q, 40, 341 Regulation Z, 269 shifts in money supply, 108 Federal Savings and Loan Insurance Corporation (FSLIC), 265 Fed watchers, 430 FHLBS (Federal Home Loan Bank System), 252 FHLMC (Federal Home Loan Mortgage Corporation), 301 FICA (Federal Insurance Contribution Act), 295 FICO (Financing Corporation), 276 Finance companies, 37, 296–297 See also financial intermediaries Financial contracts, 180–184 Financial crises, 189–198 Financial derivatives, 233–234, 309 futures contracts and markets, 311–320 hedging, 309–310 interest-rate forward contracts, 310–311 interest-rate swaps, 328–330 options, 320–328 Financial engineering, 232 Financial futures contracts, 312 See also futures Financial institutions, 7–8 Financial Institutions Reform, Recovery, and Enforcement Act of 1989, 278 Financial instruments, 24 See securities importance of financial intermediaries, 31 liquidity, 27 Financial intermediaries, 7, 27–28, 34–37, 177–180 deposit insurance, 40 disclosure, 39 expertise, 174 I-8 Index Financial intermediaries (continued) function of, 29–34 importance of, 31 indirect finance, 171 insurance companies, 287–293 interest-rate swaps, 330 limits on competition, 40 restrictions on assets and activities, 39–40 restrictions on entry, 39 restrictions on interest rates, 40–41 Financial markets, foreign stock market indexes, 30 function of, 23–25 internationalization of, 28–29 stability, 413–414 structure of, 25–28 Financial panic, 39 Financial scandals, effect on stock market, 146–147 Financial services industry, separation of banks, 250–252 Financial structures, 169–172 debt, 184–188 financial crises and aggregate economic activity, 189–198 lemons problem, 175–180 Financial systems, regulation of, 37–41 Financial Times-Stock Exchange 100-Share Index (London), 29 Financing Corporation (FICO), 276 Finland electronic payment systems, 50 euro, 49 Fire and casualty insurance companies, 36 See also financial intermediaries; insurance companies First Boston Corporation, 231 First National Bank of Boston, 231 Fiscal policy, 12 comparing effectiveness to monetary policy, 568–574 inflation, 636 responses to changes in, 567 Fisher, Irving, 518–519 Fisher, Lawrence, 154 Fisher effect, 99 See also inflation Fisher equation, 79 Fixed exchange rates Bretton Woods system, 473–478 regime, 470 Fixed investment, 539 Fixed-payment loans, 63, 65 Fixed-rate mortgages, 233 Flat money, 48 Float deposits, 365 FMOC (Federal Market Open Committee), 424 FNMA (Federal National Mortgage Association), 301 FOMC (Federal Open Market Committee), 337, 341, 398, 463 Forecasting common stock valuation, 142 errors of expectations, 150 interest rates, 111–112 optimal forecast, 148 technical analysis, 155 Foreign banking systems, 253–257 Foreign bonds, 28 Foreign central banks, 349–351 Foreign exchange crisis of September 1992, 475 Foreign exchange markets, 5, 435–439 balance of payments, 467–468 equilibrium in, 446 Federal Reserve Bank, 463 intervention in, 462–467 prices, 439–442 productivity, 442 returns, 443–448 shift in expected returns, 448–459 stability, 414 Foreign exchange rates, Foreign exchange risk, hedging, 319 Foreign goods, preference for, 441 Formulas See also calculations current yield, 70–75 Forward contracts, 310 Forward transactions, 436 Framework for empirical evidence, 603–607 France EMS, 474 euro, 49 Fraud electronic payment systems, 52 prevention of, 292 Free-rider problem, 176 Frekel, Jacob A., 466 French, Kenneth R., 157 Frictional unemployment, 411 Friedman, Benjamin, 415 Friedman, Milton, 11, 112, 387, 528–532, 608 Friedman-Meiselman measure of autonomous expenditure, 614 FSEs (federally sponsored agencies), 301 FSLIC (Federal Savings and Loan Insurance Corporation), 265 Fuji Bank, 256 Full Employment and Balanced Growth Act of 1978, 411 Fully amortized loans See fixedpayment loans Fully funded pension plans, 294 Fundamentals, market, 152 Funds, sources of, 201 Futures contracts, 233 financial derivatives, 311–320 globalization of, 317 hedging, 314 options, 321 See also options Gap analysis, 221 GDP (gross domestic product), 12, 20 central bank targets, 417–418 GDP deflator, 21–22 nominal GDP, 20–21 real GDP, 21, 583 Index General Electric (GE), 149 Generalized dividend valuation model, 143 General Motors Acceptance Corporation (GMAC), 297 General Theory of Employment, Interest, and Money, The, 536 See also Keynes, John Maynard Generation X, 298 Germany EMS, 474 euro, 49 financial regulation, 40–41 hyperinflation, 633 hyperinflation after World War I, 47 monetary targeting, 497–501 reunification of, 490 Gertler, Mark, 174, 618, 621 Glass Stegall Act of 1933, 231, 250, 269 Globalization of futures, 317 Globex electronic trading system, 317 GMAC (General Motors Acceptance Corporation), 297 GNMA (Government National Mortgage Association), 301 Goal independence, 347 Gold standard, 469 Goldstein, Morris, 466 Goods and services See aggregate output Goodwill, 275 Gordon, David, 488 Gordon Equation 5, 147 Gordon growth model, 143 effect of scandals, terrorism on markets, 146–147 Government bonds, 26 budget constraints, 643 debt, 12 deposit insurance, 262 See also FDIC equilibrium in interest rates, 98 financial intermediation, 301–302 fiscal imbalances, 191 increasing information, 177 moral hazards, 182 retirement funds, 37 spending, 537, 563, 585 Government National Mortgage Association (GNMA), 301 Gramm-Leach-Bliley Act of 1999, 251, 290 Great Depression, 40–41 See also stock market crash of 1929 bank failures, 231 collapse of investment spending, 545 consumers’ balance sheets, 624 debt deflation, 193 discount policy, 402 Federal Reserve System policy procedures, 421 Keynesian evidence, 609 money supply, 387 Green book, FOMC, 344 Greenspan, Alan, 343, 429–430 Gross domestic product (GDP), 12, 20 central bank targets, 417–418 GDP deflator, 21–22 nominal GDP, 20–21 real GDP, 21, 583 Growth constant-money-growth-rate rule, 654 economic and financial development, 187–188 Gordon growth model, 143 inflation targeting, 508–509 monetary policy, 412 rate of money, 116 Guarantees, arbitrage, 313 Hackers, electronic payment systems, 52 Hamilton, Alexander, 229 Hedge funds, 299 I-9 Hedging, 233, 314 financial derivatives, 309–310 foreign exchange risk, 319 interest-rate swaps, 329 macro hedge, 315 micro hedge, 315 options, 325–326 Hicks, John, 536, 554 High employment effect on inflation, 639 rates, 411 High interest rates, See also Interest rates Highly leveraged transaction loans, 274 High-tech sector, venture capitalists, 183 High unemployment, responses to, 650 Historical development of banks, 229–232 Home banking, 235 Hooper, Peter, 618 Hostages, 654 Hot tips, 160 Household liquidity effects, 623 Hubbard, R Glenn, 31, 621 Huberman, Gur, 157 Huizinga, John, 609 Humphrey-Hawkins Act, 411 Hyperinflation, 47, 413, 633 Hysteresis, 597 IBFs (international banking facilities), 255 IDA (International Development Association), 470 IMF (International Monetary Fund), 470 role of, 479–482 Implementation lag, 651 Incentive-compatible, 185 Income, 3, 45 See also money aggregate output, 20 disposable, 538 money markets, 113 I-10 Index Income (continued) shifts in demand for money, 107–108 Income taxes bonds, 125–126 Bush tax cut of 2001, 127 changes in, 563 Independence of the Federal Reserve System, 352–354 Indexes bonds, 82 effective exchange rate, 455 foreign stock markets, 30 TIPS, 82 Indirect finance, 171 Individual retirement accounts (IRAs), 294 Indonesia, financial crises, 194–198 Industrial production, 583 Inflation, 10 anti-inflation polices, 671 Bolivia, 674 causes of, 11–12 credibility in fighting, 673 equilibrium in interest rates, 98 expanded-inflation effect, 113 growth rates, 22 hyperinflation, 47, 413 meaning of, 634–635 monetary policy, 638–650 money, 632–634 NAIRU, 429, 590 rapid, 633 rates, 11 real interest rates, 79 rise in U.S., 1960-1980, 646–650 targeting, 501–509 views of, 635–638 Volcker, Paul, 655 Inflows, controls on capital, 478–479 Information, sale of, 176–177 Information technology, 234 bank consolidation, 247 economies of scope, 248 Initial public offering (IPO), 303 Insider trading, 39 Insolvency, 192 Institutional investors, 298 Institutional money market mutual fund shares, 53 Instrument independence, 347 Instrument targets, 415 Insurance companies, 27–28, 287–293 See also financial intermediaries fire and casualty insurance companies, 36 life insurance, 287–288 property and casualty insurance, 288–293 state banking and insurance commissions, 38 Interest, 238 Interest-bearing NOW accounts, 202 Interest parity condition, 445 Interest-rate forward contracts, 310–311 Interest rates, business cycle expansions, 102 changes in equilibrium, 93–104, 566–568 changes in investment spending, 562 changes in net exports, 563–564 channel/corridor system for setting, 406–408 channels, 617 control of, 116 “Credit Markets” column, Wall Street Journal, 103–104 determinants of asset demand, 85–87 expectations theory, 129–131 forecasting, 111–112 increases in, 189 ISLM model, 557–558 Japan, 103 liquidity, 86, 104–117 liquidity preference analysis, 112–117 liquidity preference framework, 107–117 liquidity premium theory, 133 long-term bonds, 96 lowering, 117 management of, 12 management of risk, 220–223 measuring, 61–75 monetary policy, 413 money demand, 533 negative, 69 nominal interest rates, 79–82 planned investment spending, 552 preferred habitat theory, 134 real interest rates, 79–82 restrictions on, 40–41 returns, 75–79 risk, 78, 120–127, 208 segmented markets theory, 132 supply and demand, 87–93 term structure of, 127–138, 659 TIPS, 82 Wall Street Journal, 72–73 yield curve, 136 Interest-rate swaps financial derivatives, 328–330 financial intermediaries, 330 hedging, 329 Intermediate targets, 414 Intermediate-term debt, 26 International banking, 253–257 crises, 280–284 regulations, 272–273 International banking facilities (IBFs), 255 International Development Association (IDA), 470 International financial system, evolution of, 468–478 Internationalization of financial markets, 28–29 International Monetary Fund (IMF), 470 role of, 479–482 Index International monetary policy, 427 exchange-rate targeting, 489–495 inflation targeting, 501–509 monetary targeting, 496–501 nominal anchor, 487–489 International policy coordination, 428 International reserves, 462 International trade, aggregate output, 548 Internet banking, 234–235 mutual funds, 298 securities market operations, 306 Inventory investment, 539 Inverted yield curve, 127 Investment banks, 26, 303 Investments See also securities; stocks brokers, 26 changes in spending, 563 collapse during Great Depression, 545 diversification, 32 effect of stock market fluctuations, expectations theory, 129–130 expected profitability of, 98 fixed, 539 hot tips, 160 intermediaries, 37 inventory, 539 life insurance, 287–288 low Japanese interest rates, 103 planned investment spending, 536 Investors, information available to, 39 IPO (initial public offering), 303 IRAs (individual retirement accounts), 294 Ireland EMS, 474 euro, 49 IS curve, 551 factors that cause to shift, 561–564 shifts in, 578–579 ISLM model, 568, 571, 575–580 aggregate demand curve, 577–580 aggregate output, 557–558 interest rates, 557–558 Keynesian framework, 551–558 Italy EMS, 474 euro, 49 Jackson, Andrew, 230 January effect, 155–156 Japan banking crises, 282–284 banking systems, 252 Bank of Japan, 350 Dai-Ichi Kangyo Bank, 256 financial regulation, 40 Fuji Bank, 256 interest rates, 103 internationalization of financial markets, 29 monetary policy, 628 monetary targeting, 497 negative T-bill rates, 69 Jegadeesh, N., 158 Jensen, Michael C., 154 Jobs effect of dollar value fluctuations, unemployment rates, See also unemployment Junk bonds, 124, 235–236 Kandel, Shumuel, 157 Kane, Edward, 275 Kansas City Board of Trade, 315 Karjalainen, R., 155 Keogh plans, 294 Keynes, John Maynard, 521 Keynesian approach aggregate demand curve, 582–587 comparing to Friedman, 530–532 developments in, 524–528 inflation, 636 I-11 Keynesian cross diagram, equilibrium in, 540 Keynesian evidence, 607–610 Keynesian framework, 536 aggregate output, 536–551 ISLM model, 551–558 Keynesian model, new, 665–666 Keynesian structural models, 605 Krugman, Paul, 467 Kydland, Finn, 388 Labor market, tightness of, 594 Lakonishok, J., 158 Large, complex, banking organizations (LCBOs), 248 Large-denomination time deposits, 53, 203 Latin America, banking crises, 281–282 Law of one price, 439 LCBOs (large, complex, banking organizations), 248 Leeson, Nick, 225 Legislative lag, 651 Lemons problem, 175–180 Lender of last resort, 402 Lending, specialization in, 218 See also banks; loans Leverage ratio, 265 Liabilities, 24 balance sheets, 201–204 costs, 240–241 Federal Reserve System, 464 management, 208, 212–213 Life cycles, Gordon growth model, 143 Life insurance, 287–288 Life insurance companies, 36 Limits of insurance, 292 Limits on competition, 40 Liquidity, 27, 47 bonds, 96, 125 equilibrium in interest rates, 96–97 expectations theory, 134 household liquidity effects, 623 I-12 Index Liquidity (continued) interest rates, 86, 104–117 management, 208 preference analysis, 112–117, 555 services, 31 Liquidity preference framework interest rates, 107–117 money markets, 105–107 Liquidity preference theory, 521–524 Liquidity premium theory, 133 Lloyd’s of London, 290 See also insurance companies LM curve, 551, 556, 564–566 shifts in, 579–580 Load mutual funds, 299 Loanable funds framework, 91–92 Loans, 8, 169 See also banks; financial institutions commitments, 219 discount, 203 finance companies See finance companies fixed-payment, 63, 65 function of financial markets, 23–25 highly leveraged transaction loans, 274 money supply, 364 moral hazards, 32–33 profitability, 205 sales, 223 securitization, 237–238 simple, 62, 63, 64–65 transaction costs, 30 yield to maturity, 64 London International Financial Futures Exchange, 317 Long positions, 309 Long-run aggregate supply curve, 590 Long-run monetary neutrality, 576 Long-term banking customer relationships, 218 Long-term bonds See also bonds capital market, 27 interest rates, 96 liquidity premium theory, 133 rates, 12 Long-Term Capital Management, 300, 427 Long-term debt, 26 Loophole mining, 237 Losses, options, 322 Louvre Accord, 428 Lowering interest rates, 117 Low interest rates, Japan, 103 Lucas, Robert, 660 Lucas critique of policy evaluation, 659–660 Luxembourg EMS, 474 euro, 49 M1, 52 M2, 52, 426 M3, 53 Maastricht Treaty, 49 Macro hedge, 315 Malaysia, financial crises, 194–198 Managed float, 473 Managed float regime, 462 Management assets, 208, 211–212 banks, 208–216 capital, 215–216 capital adequacy, 213–215 credit, 217–220 insurance, 290 See also insurance companies of interest rate risk, 220–223 liabilities, 208, 212–213 liquidity, 208 Mankiw, N Gregory, 136 Mann, Catherine, 618 March 2001 recession, slow recovery in, 625 Marginal propensity to consume, 538 Margin requirements, 318 Marked to market, 318 Market equilibrium, federal funds rate, 395 Market fundamentals, 152 Market interest rates, money multiplier, 380 Markets See also Financial markets Black Monday Crash of 1987, 163–164 capital, 27 debt See debt efficient market hypothesis, 149, 150–152, 153–162 equilibrium, 90 Eurodollar, 255 exchanges, 27 foreign stock market indexes, 30 futures, 311–320 lemons problem, 175–180 liquidity preference framework, 105–107 money, 27 OTC, 27 overreaction, 157 price-level effect, 108 primary markets, 26 rational expectations, 162–164 reserves, 393–398 secondary markets, 26 securities operations, 302–306 segmented markets theory, 132 setting security prices, 144–147 stability, 413–414 supply and demand, 87–93 technical analysis, 155 theory of efficient capital markets, 149 Martin Jr., William McChesney, 423 MasterCard, 51, 234 Matched sale-purchase transactions, 400 Maturity of bonds, 129 See also bonds dates, 62 of debt, 26 Index liquidity premium theory, 133 preferred habitat theory, 134 Maturity bucket approach, 221 Mayer, Colin, 31 McFadden Act of 1927, 244 Mean reversion, 157 Measurability of targets, 418 Medium of exchange, 45 Medium-Term Financial Strategy, 496 Meetings, FOMC, 343 Meiselman, David, 614 Meltzer, Alan, 480, 622 Member banks, Federal Reserve System, 340, 346 Membership in the Federal Reserve System, 231 Mergers, banks, 248 Mexico financial crises, 194–198 role of IMF, 480 Micro hedge, 315 MidAmerica Commodity Exchange, 315 Milken, Michael, 236 Mishkin, Frederic S., 162, 163, 429, 452, 624 MMDAs (money market deposit accounts), 202 Modern quantity theory of money, 584 Modigliani, Franco, 621 Mondex, 52 Monetarist evidence, 611–616 See also Friedman, Milton Monetarists, 608 view of inflation, 635 Monetary Affairs Division, 343 Monetary aggregates, 52, 54 targets, 426 Monetary base, 358 Monetary neutrality, 453 Monetary policy, 12, 51 central banks’ conduct, 626–628 central bank targets, 414–416 comparing effectiveness to fiscal policy, 568–574 comparison of types, 666–676 Federal Reserve System procedures, 419–428 goals of, 411–414 implications for, 658 inflation, 638–650 international, 427, 482–483 Lucas critique of policy evaluation, 659–660 new classical macroeconomic model, 660–665 nominal anchor, 509–511 Phillips curve, 429–430 rational expectations revolution, 676–677 responses to changes in, 566–567 selection of targets, 416–419 stock prices, 146 Taylor rule, 428–430 transmission mechanisms, 604, 616–626 Monetary theory, 10, 517 Monetizing the debt, 644 Money, 8–13 checks, 48–49 commodity money, 48 constant-money-growth-rate rule, 654 creation in foreign countries, 644 demand for, 532–533 electronic money (e-money), 51 evolution of payments system, 48–51 Federal Reserve System, 12 flat money, 48 functions of, 45–48 growth rate, 116 inflation, 632–634 liquidity, 47, 112–117 management of interest rates, 12 meaning of, 44–45 measuring, 51–55 modern quantity theory of money, 584 printing, 644 I-13 Quantity Theory of Money: A Restatement, The, 528–532 real money balances, 523 reliability of data, 55–56 seignorage, 493 transaction costs, 29–30 velocity of, 518, 520–521, 582 Money center banks, 212 Money market deposit accounts (MMDAs), 202 Money market mutual funds, 37, 52–53, 238–239, 299 See also financial intermediaries Money markets, 27 income effect, 113 liquidity preference framework, 105–107 M1, 52 price-level effect, 108 shifts in demand for, 107–108 Money multiplier, 374 money supply, 375–378 variables, 378–381 Money supply, aggregate output, 567 determinants of, 374, 381–383 discount loans, 364 discount policy, 400403 excess reserves, 359 Federal Reserve balance sheets, 358–359 inflation, 11 money multiplier, 375–378 movements in, 384 multiple deposit creation, 357, 365–371 process, 357, 383–390 required reserves, 359 reserve requirements, 359, 403–408 unemployment, 453 Money theory, 517–520 Monitoring credit risk, 218–219 principal-agent problems, 182 Moody’s bond ratings, 123 I-14 Index Moral hazards, 32–33, 174–175 debt, 180–184 influences in debt markets, 184–188 regulations, 262–263 Morgan, J P., 231, 251 Morris, Charles S., 158 Mortgages See also federal credit agencies; loans ARMs (adjustable-rate mortgages), 233 fixed-rate, 233 structure of financial markets, 25–28 Multiple deposit creation, 357, 365–371 Multipliers, 542 Muncie, Indiana, 607 Municipal bond income tax considerations, 125–126 Muth, John, 147, 150 Mutual funds, 37, 173, 297–301 See also financial intermediaries efficient market hypothesis, 153 money market mutual funds, 238–239 Mutual savings banks, 34–35 See also financial intermediaries NAIRU (nonaccelerarting inflation rate of unemployment), 429, 590 NASDAQ (National Association of Securities Dealers), 26, 306 National Bank Act of 1863, 231 National Credit Union Administration (NCUA), 38, 253 National Credit Union Share Insurance Fund (NCUSIF), 40, 253 Nationwide banking, 245–250 Natural rate level of output, 575, 590 Natural rate of unemployment, 412, 590 NCUA (National Credit Union Administration), 38, 253 NCUSIF (National Credit Union Share Insurance Fund), 40, 253 Negative T-bill rates, 69 Negotiable order of withdrawal (NOW), 202, 425 Net exports, 537 changes in, 563–564 exchange rate effects on, 618 interest rates, 552–554 Netherlands EMS, 474 euro, 49 Net worth, collateral, 180 New classical macroeconomic model, 660–665 New York Futures Exchange, 315 New York Stock Exchange (NYSE), 26, 27, 305 New Zealand, inflation targeting, 501–502 Nikkei 225 Average (Tokyo), 29 Nokia, 50 No-load mutual funds, 299 Nominal anchor monetary policy, 509–511 role of, 487–489 Nominal GDP, 20–21 Nominal interest rates, 79–82 Nonaccelerarting inflation rate of unemployment (NAIRU), 590 Nonactivist policy debate, 650–655 Nonactivists, 592 Nonbank finance, 287 See also financial intermediaries finance companies, 296–297 government financial intermediation, 301–302 insurance companies, 287–293 mutual funds, 297–301 pension funds, 294–296 securities market operations, 302–306 Nonbank loans, 169 Nonborrowed monetary base, 381–382 Non-interest bearing checking accounts, 202 Nonpublic banks, open market purchases from, 360–362 Nontransaction deposits, 203 Notional principal, 328 NOW (negotiable order of withdrawal), 202, 425 NYSE (New York Stock Exchange), 26, 27, 305 Obstfeld, Maurice, 467 OCC (Office of the Comptroller of the Currency), 38, 231, 290 OECD (Organization for Electronic Cooperation and Development), 265 Off-balance-sheet activities, 223–226, 265 Office of the Comptroller of the Currency (OCC), 38, 231, 290 Office of Thrift Supervision (OTS), 38, 252, 278 Official reserve transaction balance, 468 One-period valuation model, 142 Open-end mutual funds, 298 Open market discovery of, 420 federal funds rate, 395 operations, 340, 398–400 purchases form nonpublic banks, 360–362 purchases from banks, 360 sales, 362–364 Operating targets, 415 Opportunity cost, 106 Optimal forecast, 148 Options call, 322 financial derivatives, 320–328 hedging, 325–326 premiums, 326 SEC, 321 Index Organization for Electronic Cooperation and Development (OECD), 265 OTC (over-the-counter) markets, 27 OTS (Office of Thrift Supervision), 38, 252, 278 Outflows controls on capital, 478–479 deposits, 208 money multiplier, 380 Output aggregate, 583 inflation targeting, 507–508 international trade, 548 Keynesian framework, 536–551 natural rate level of, 575 short-run, 668 Overreaction, markets, 157 Overshooting exchange rates, 454 Over-the-counter (OTC) markets, 27 Panic banks, 191 Federal Reserve System policy procedures, 421 Great Depression, 387 Panic, financial, 39 Paper currency, 48 See also currencies; money Partial crowding out, 587 Par value, 63 Payments system, evolution of, 48–51 Payoff methods, 261 PCE (personal consumption expenditures), 21 Pension Benefit Guarantee Corporation (“Penny Benny”), 295 Pension funds, 27–28, 37, 294–296 See also financial intermediaries Perfect substitutes, 129 Permanent life insurance, 288 Perpetual bonds, 67 Personal consumption expenditures (PCE), 21 Person-to-Person Finance Company, 297 Pesando, James, 162 Philippines, financial crises, 194–198 Phillips curve, 429–430 Plain vanilla swaps, 328 See also interest-rate swaps Planned investment spending, 536, 552, 585 Plaza Agreement, 428, 483 Plosser, Charles, 597 Policyholders, 287 See also insurance companies Policy ineffectiveness proposition, 663 Political business cycle, 353 Portfolios, 32 Portugal EMS, 474 euro, 49 Positive risk premiums, 123 PPI (producer price index), 583 PPP (theory of purchasing power parity), 439 Predictability of target goals, 419 Predictions See forecasting Preference analysis, liquidity, 112–117 Preferred habitat theory, 134 Prell, Michael J., 162 Premiums expectations theory, 134 insurance, 288 See also insurance companies liquidity premium theory, 133 options, 320, 326 risk, 121, 123 risk-based premiums, 291–292 Prescott, Edward, 488 Present value, 61–62 coupon bonds, 65–68 discount bonds, 68–69 fixed-payment loans, 65 simple loans, 64–65 I-15 Price-level effect, 108, 113 Prices See also GDP aggregate output, 583 aggregate price level, 21–22 arbitrage, 313 asset price channels, 618 availability of public information, 154 Black Monday Crash of 1987, 163–164 “Credit Markets” column, Wall Street Journal, 103–104 effect of new information, 158 exercise, 320 expected price levels, 594 foreign exchange markets, 439–442 goods and services (aggregate price level), 10 monetary policy, 146, 412–413 random-walk behavior of stock prices, 154 relative price levels, 441 setting security prices, 144–147 settlement, 318 short-run output, 668 stock market fluctuations, strike, 320 technical analysis, 155 unanticipated price level channel, 623 Primary dealers, 399 Primary markets, 26 Principal, 62 Principal-agent problem, 181 monitoring, 182 S&Ls, 277 Printing money, 644 Privacy electronic banking, 270 electronic payment systems, 52 Private pension plans, 295 Private production, 176–177 Procyclical monetary policy, 423 Producer price index (PPI), 583 Production costs, changes in, 594–595 I-16 Index Productivity, foreign exchange markets, 442 Profitability arbitrage, 313 banks, 242 equilibrium in interest rates, 98 loans, 205 options, 322 unexploited profit opportunity, 152 Property and casualty insurance, 288–293 Prudential supervision, 265 Public pension funds, 295 Purchase and assumption methods, 261 Put (sell) options, 327 Quantity of assets, 85–87 Quantity of loans demanded, 92 Quantity theory of money, 519 Quantity Theory of Money: A Restatement, The, 528–532 Radford, R A., 46 Ramey, Valerie, 622 Random-walk behavior of stock prices, 154 Rapid inflation, 633 Rate of capital gain, 76 Rate of return, 75 See also returns Ratings, bonds See bonds Rational bubbles, 164 Rational expectations evidence on markets, 162–164 theory of, 147–150 revolution, 676–677 Rationing credit, 220 Ratios, money multiplier, 378–381 Reagan, Ronald, 276, 348, 675–676 Real bills doctrine, 420 Real business cycle theory, 596, 616 Real GDP, 21, 583 Real interest rates, 79–82 Real money balances, 523 Real terms, aggregate output, 575 Recessions, rate of money growth, 9–10 slow recovery in March 2001, 625 Recognition lag, 650 Rediscounting, 420 Redlining, 269 Reduced-form evidence, 604 RefCorp (Resolution Funding Corporation), 278 Regulation K, 255 Regulation Q, 40, 238, 341 Regulations adverse selection, 263 asymmetric information and banking, 260–271 checking accounts, 52 consolidation, 264–271 of financial systems, 37–41, 172 increasing information, 177 international banking, 272–273 life insurance companies, 287–288 moral hazards, 182, 262–263 securitization, 237–238 thrift industry, 252–257 Regulation Z, 269 Regulatory arbitrage, 265 Regulatory forbearance, 275 Reinsurance, 290 Relative price levels, 441 Repurchase agreements, 52, 400 Required reserves ratio, 359 ration, 204 Research staff, Federal Reserve System, 342 Reserve currency, 470 Reserve repo, 400 Reserve requirements, 422 Reserves, 204 federal funds rate, 397 international, 462 liquidity management, 208 markets, 393–398 money supply, 359 official reserve transaction balance, 468 requirements, 403–408 securitization, 238 sweep accounts, 239–240 Residual claimant, 141 Resolution Funding Corporation (RefCorp), 278 Resolution Trust Corporation (RTC), 278 Restrictions on assets and activities, 39–40 Restrictions on entry, 39 on interest rates, 40–41 Restrictive covenants, 185 Restrictive provisions, insurance companies, 292 Retirement funds, government, 37 Retirement plans See pension funds Return on assets (ROA), 214 Return on equity (ROE), 214 Returns See also expected returns foreign exchange markets, 443–448, 448–459 interest rates, 75–79 segmented markets theory, 132 volatility of, 78 Revaluation, 472 Reverse causation, 606 Ricardian equivalence, 645 Ricardo, David, 645 Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, 251 Right axis, 88 Risk, 31 arbitrage, 313 assets, 85–87 See also assets bonds, 96 credit, 208 determining desired level of, 79 equilibrium in interest rates, 96 hedging foreign exchange, 319 interest rates, 78, 86, 208 management of credit, 217–220 Index management of interest rates, 220–223 moral hazards, 33, 186 See also moral hazards premiums, 121, 123 Risk-based premiums, 291–292 Risk structure of interest rates, 120–127 ROA (return on assets), 214 ROE (return on equity), 214 Roll, Richard, 154, 157 Romania, inflation rates, 11 Romer, Christina, 615 Romer, David, 615 Royal Bank of Canada, 235 RTC (Resolution Trust Corporation), 278 Russia banking crises, 282 hyperinflation, 413 inflation rates, 11 SAIF (Savings Association Insurance Fund), 278 Sales of information, 176–177 loans, 223 Sales finance companies, 297 Sargent, Thomas, 660 Savings accounts, 205 Savings and loan associations (S&Ls), 34–35, 252 See also financial intermediaries FSLIC, 275 political economy of, 276–278 Savings Association Insurance Fund (SAIF), 40, 278 Savings deposits, M1, 52 Scales, economies of, 30 Scandals agent problem, 225 slow recoveries in, 625 effect on stock market, 146–147 Scandinavia banking crises, 280–281 electronic payment systems, 50 Schoenholtz, Kermit L., 136 Schwartz, Anna, 387, 608 Screening, 217, 291 SDRs (special drawing rights), 474 Sears Roebuck Acceptance Corporation, 297 Seasoned issues, 303 Secondary credit, 402 Secondary markets, 26 Secondary reserves, 204 Second Bank of the United States, 230 SEC (Securities and Exchange Commission), 38, 39, 303, 321 Secured debt, 172 Securities, 3, 24 bank holdings, 204–205 brokers, 26 capital market, 27 dealers, 26 efficient market hypothesis, 150–152 hot tips, 160 importance of financial intermediaries, 31 lemons problem, 175–180 market operations, 302–306 mutual funds, 297 See also mutual funds separation from commercial banks, 39–40 setting prices, 144–147 Treasury, 127 underwriting, 26 Securities Amendment Act of 1975, 306 Securities and Exchange Commission (SEC), 38, 39, 303, 321 Securitization, 237–238 Security of electronic payment systems, 52 Segmented markets theory, 132 Seignorage, 493 Self-correcting mechanism, 591 I-17 Sell (put) options, 327 Semistrong-form efficiency, 155 Separation of commercial banking and securities industry, 39–40 September 11, 2001 property and casualty insurance, 290 reserve requirements, 404 effect on stock market, 146–147 Settlement price, futures, 318 Shearson, Loeb, Rhodes, 305 Shifts in demand curves, 94 Shiller, Robert J., 136, 157 Short positions, 309 Short-run output, 668 Short-term debt, 26 Short-term interest rates, 136 Siebert, Horst, 498 Simple deposit multiplier, 369 Simple interest rates, 62 See also interest rates Simple loans, 62, 63, 64–65 Simple model, multiple deposit creation, 371 Slow recovery in March 2001 recession, 625 S&Ls (savings and loan associations), 34–35, 252, 275 See also financial intermediaries FSLIC, 275 political economy of, 276–278 Small-denomination time deposits, 52 Small-firm effect, 156 Smart cards, 51 See also payments systems Social Security, 295, 296 Sources of funds, 201 South Korea, financial crises, 194–198 Spain EMS, 474 euro, 49 Special drawing rights (SDRs), 474 Specialists, dealer-brokers, 306 Specialization in lending, 218 I-18 Index Spot exchange rate, 436 Spot transactions, 436 Spreads, Baa-Aaa bonds, 124–127 Stabilization policy, 670 Standard and Poor’s bond ratings, 123 Standardized gap analysis, 221 State banking and insurance commissions, 38 State banks, 231 See also banks State Farm, 288 Statistical evidence, 613 Sterilized foreign exchange intervention, 465 Stockholders, 141 Stock market crash of 1929, 39 Stock market crash of 1987, Stock markets, 5–6, 29 Stocks, availability of public information, 154 Black Monday Crash of 1987, 163–164 brokers, 26 capital market, 27 effect of new information, 158 effect of scandals, terrorism on prices, 146–147 efficient market hypothesis, 150–152, 153–162 lemons problem, 175–180 monetary policy effect on prices, 146 mutual funds, 297 See also mutual funds options, 321 random-walk behavior of stock prices, 154 restrictions on holdings, 40 supply and demand, 93 technical analysis, 155 theory of rational expectations, 147–150 Stored-value cards, 51 See also payments systems Store of value, 47 Strike price, 320 Strong-form efficiency, 155 Structural model evidence, 603 Sumitomo, 225 Summers, Lawrence H., 136, 158, 452, 597 Superregional banks, 247 Supply and demand “Credit Markets” column, Wall Street Journal, 103–104 effect of expanding economies, 102 excess, 90 interest rates, 87–93 money markets, 105–107 price-level effect, 108 shifts in money markets, 107–108 shifts in supply of bonds, 97 stocks, 93 Supply curve, 90, 394–395 Supply of loanable funds, 92 Supply-side phenomena, inflation, 638 Swaps, 328 See also interest-rate swaps Sweden electronic payment systems, 50 euro, 49 Sweep accounts, 239–240 Switzerland, 497–501 T-account, 205 Taliban, the, 146–147 Targets central bank, 414–416 exchange-rate targeting, 489–495 inflation, 501–509, 639 monetary aggregate, 426 monetary policy, 496–501 selection of, 416–419 Tariffs, 441 Taxes See also income tax changes in, 563 effect of budget deficits and surpluses, 12 Taylor, John B., 429, 618 Taylor rule, 428–430 T-bills, 69 T-bonds, 74 Temporary life insurance, 288 Term life insurance, 288 Terms of loanable funds, 92 Term structure of interest rates, 127–138 Terrorism, effect on stock market, 146–147, 654 Thailand, financial crises, 194–198 Thatcher, Margaret, 496 Theory of asset demand, 87 See also assets Theory of efficient capital markets, 149 Theory of purchasing power parity (PPP), 439 Theory of rational expectations, 147–150 Thrift institutions, 34 See also financial intermediaries Office of Thrift Supervision, 38 regulations, 252–257 Time-consistency problem, 488 Timing evidence, 611 Timmerman, Sullivan A., 155 TIPS (Treasury Inflation Protection Securities), 82 Titman, Sheridan, 158 Tobin, James, 524, 620 Tobin’s q Theory, 620 Tokyo Stock Exchange, 317 Tombstones, securities advertisements, 304 Trade aggregate output, 548 balance, 467 barriers, 441 Trading Room Automated Processing (TRAPS), 399 Traditional monetary policy models, 667 Transaction costs, 29–30, 32, 45 Index Transactions adverse selection and moral hazards, 174–175 costs, 173–174 evolution of payments system, 48–51 forward, 436 highly leveraged transaction loans, 274 Keynesian approach, developments in, 524–528 matched sale-purchase, 400 movement of, 521 nontransaction deposits, 203 official reserve transaction balance, 468 spot, 436 Transmission mechanisms, 604, 616–626 TRAPS (Trading Room Automated Processing), 399 Traveler’s checks, 52 Travelers Group, 305 Treasury bonds, 12 Bush tax cut of 2001, 127 income tax considerations, 125–126 yield curve, 127–128 Treasury deposits, 365 Treasury Inflation Protection Securities (TIPS), 82 Unanticipated price level channel, 623 Uncertainty, increases in, 189 Underfunded pension plans, 294 Underwriters, 303 Underwriting securities, 26 Unemployment aggregate output, 583 money supply, 453 NAIRU, 429, 590 natural rate of, 412, 590 rates, 9, 411, 583 responses to, 650 Unexploited profit opportunity, 152 United Kingdom Bank of England, 349–350 EMS, 474 gold standard, 469 inflation, 11, 502–506 United States electronic payment systems, 50 financial crises in, 191–192 financial regulation, 40–41 foreign banks in, 256 inflation rates, 11 nationwide banking, 245–250 1980s banking crisis, 273–276 structure of commercial banking industry, 243–245 TIPS, 82 Unit of accounts, 46 Universal banking, 251 Universal life insurance, 288 Unsecured debt, 172 Unsterilized foreign exchange intervention, 464 U.S Government bond yield curve, 138 Valuation devaluation, 472 generalized dividend valuation model, 143 Gordon growth model, 143 one-period valuation model, 142 See also common stock revaluation, 472 Value Line Survey, 157 Values face, 63 money See money par, 63 present value, 61–62 store of, 47 Vanguard Group, 79 Variable life insurance, 288 Variables, 378–381 Vault cash, 204 Velocity of money, 518, 520–521, 582 I-19 Venture capital firms, 182, 183 Vertical axes, 88 Virtual banks, 236 See also banks; electronic banking Visa, 51, 234 Volatile exchange rates, 455 Volatility of bond returns, 78 Volcker, Paul, 425, 430, 655 Wage push, 594 Wage-setting processes, 653 Wall Street Journal, 72, 142 “Credit Markets” column, 103–104 Currency Trading, 458 Forecasting Survey for 2003, 111–112 foreign exchange rates, 437 futures, 312 options, 321, 326 stock prices, 159 underwriters, 303 War of 1812, 230 Weak-form efficiency, 155 Wealth, 45 See also money effects of, 620–621 equilibrium in interest rates, 95 interest rates, 86 Wells Fargo, 235 White, H., 155 Whole life insurance, 288 World Bank, 470 World War I, hyperinflation after, 47 World War II, 422–423 World Wide Web (WWW), 247 See also electronic banking; information technology; Internet banking Yield current, 70–75 discounts, 71 returns See returns Yield curves, 127 1980-2003, 137–138 liquidity premiums, 135 I-20 Index Yield curves (continued) short-term interest rates, 136 U.S Government bonds, 138 Yield to maturity, 64 Zero-coupon bonds See discount bonds Zero impact, expanded-inflation effect, 113–114 Zombie S&Ls, 275–276 See also S&Ls ... to the First National Bank, the bank is credited with $100 of reserves from the proceeds of the loan The effects on the balance sheets of the banking system and the Fed are illustrated by the. .. The effect of an open market purchase on the monetary base, however, is always the same (the monetary base increases by the amount of the purchase) whether the seller of the bonds keeps the proceeds... in the hands of the public (Currency held by depository institutions is also a liability of the Fed, but is counted as part of the reserves.) Federal Reserve notes are IOUs from the Fed to the