Money and Bnsiness Cycles In 1981 -1982, total production of goods and services (called aggregate output) in the U.S. economy fell and the unemployment rate (the percentage of the available labor force unemployed) rose to over 10%. After 1982, the economy began to expand rapidly, and by 1989 Lhe unemploymem raLe had declined Lo 5%. In 1990, Lhe eighL-year expansion came to an end , with the unemployment rate rising above 7%. The economy bottomed out in 19 91, and Lhe subsequent recovery was the longest in U.S. history, with Lhe unemploymem raLe falling Lo around 4%. A mild economic dowmnrn began in March 20 01, with unemploymem rising Lo 6%; Lhe economy began Lo recover in November 200 1 with unemployment eventually declining to a low of 4.4% . Starting in December 2007, Lhe economy went into recession and the unemployment rate rose to well all over 7%. Why did the economy expand from 1982 to 1990, contract in 1990 to 19 91, boom again from 1991 Lo 20 01, comracL again in 20 01, recover LhereafLer, and comracL again in 2007l Evidence suggesLs LhaL money plays an imponam role in generaLing business cycles, the upward and downward movement of aggregate output produced in the economy. Business cycles affect all of us in immediate and important ways. When outpUL is rising, for example, iL is easier Lo find a good job; when oULpuL is falling, finding a good job mighL be difficulL. Figure 3 shows Lhe movemems of Lhe raLe of money growLh over Lhe 19 50-2008 period, wiLh Lhe shaded areas represeming recessions , periods of declining aggregaLe oULpuL. WhaL we see is LhaL Lhe raLe of money growLh has declined before every recession, indicating that changes in money might be a driving force behind business cycle fluctuations. However, not every decline in the rate of money growth is followed by a recession. We explore how money mighL affecL aggregaLe olllplll in Chaplers 19 Lhrough 25 in Pan 6 of Lhis book, where we sLudy monetary theory, Lhe Lheory LhaL relaLes changes in the quantity of money to changes in aggregate economic activity and the price level .
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Economic Growtl1 "Williamson MacroeCOIWinics Log onto www.myeconlab.com to learn more Money, Banl{ing & Financial Markets THE ECONOMICS OF NINTH EDITION Frederic S Mishkin Col umbia University Boston London Mexico City Toronto Munich Addison-Wesley San Francisco Sydney Paris : Jew York Tokyo Cape Town Singapore Madrid Hong Kong Montreal Editor in Chief: Donna Battista Acquisitions Editor: Noel Kamm Seibert Pro] ect Manager: Kerri McQueen Managing Editor: Nancy H Fenton Senior Production Supervisor: Kathryn Dinovo Supplements Production Coordinator: Alison Eusden Director of Media: Susan Schoenberg Senior Media Producer: Melissa Honig Coment Leads,MyEconlab: Douglas A Ruby and Noel Lotz Senior Author Suppon!Iechnology Specialist: j oe Vetere Marketing Manager: Elizabeth A Averbeck Permissions Project Manager: Shannon Barbe Permissions Project Supervisor: Michael j oyce Senior Manufacturing Buyer: Carol Melville Senior Media Buyer: Ginny Michaud Cover Designer: Barbara Atkinson Production Coordination,Text Design,Illustrations,and Composition: Thompson Steele Composition: Nesbitt Graphics,Inc Cover images,clock w ise from top,right: © Corbis; Superstock; Superstock; iStock For permission to use copyrighted material, grateful acknow ledgment is made to the copyright holders on p C-1 , which are hereby part of this copyright page Cop)Tight © 20 ,20 7,20 Pearson Education,Inc Al l rights reserved No part of this publication may be reproduced,stored in a retrieval system,or transmitted,in any form or by any means,electronic,mechanical, photocopying, recording,or otherwise, without the prior w ritten permission of the publisher Printed in the U nited States of America For information on obtaining permission for use of material in this w ork,please submit a w ritten request to Pearson Education,Inc.,Rights and Contracts Department,50 Boylston Street,Suite 90 ,Boston,MA 21 ,fax y our request to 7-6 71 -3447, or e-mail at http: //w w w pearsoned.com/legaVpermissions.htm Many of the designations used by manufacturers and sellers to distinguish their products are claimed as trademarks Where those designations appear in this book, and Addison-Wesley w as aware of a trademark claim, the designations have been printed in initial caps or all caps Library of Congress Cataloging-in-Publication Data Mishkin,Frederic S The economics of money, banking,and financial markets I Frederic Mishkin 9th ed (and the 2nd ed of the business ed.) p em (The Addison-Wesley Series in economics) Includes bibliographical references and index ISBN-1 3: 978-0-321 -59979-7 (main edition· alk paper) ISBN-1 : -321 -59979-9 (main edition alk paper) ISBN-1 3: 978-0-321 -59988-9 (business edition alk paper) ISBN-1 : -321 -59988-8 (business edition : alk paper) l Finance Money Banks and banking I Title HGl73.M6 32 20 332 dc22 20 90 86 32 - CRK-1 1 0 Addison Wesley is an imprint of PEARSON ISBCl-1 0 -3 21 -5 9 79 -9 www.pearsonhighered.com ISBCl- 78 -0 -3 21 -5 9 79 -7 To Sally BRIEF CONTENTS PART Introduction Why Study Money,Banking, and Financial Marketsl An Overview of the Financial System What Is Money ? PART Financial Markets 25 53 67 U nderstanding Interest Rates 69 The Behavior of Interest Rates 91 The Risk and Term Structure of Interest Rates 23 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis PART Financial Institutions 47 167 An Economic Analysis of Financial Structure financial Crises and the Subprime Meltdown 99 10 Banking and the Management of Financial Institutions 11 Economic Analysis of Financial Regulation 225 255 281 12 Banking Industry : Structure and Competition PART Central Banking and the Conduct of Monetary Policy 313 13 Central Banks and the Federal Reserve System 31 14 The Money Supply Process 345 16 The Conduct of Monetary Policy: Strategy and Tactics 395 15 The Tools of Monetary Policy PART International Finance and Monetary Policy 373 431 17 The Foreign Exchange Market 433 18 The International Financial System PART Monetary Theory 19 The Demand for Money 46 497 20 The ISLM Model 21 Monetary and Fiscal Policy in the ISLM Model 22 Aggregate Demand and Supply Analysis 23 Transmission Mechanisms of Monetary Policy: The Evidence 499 51 543 56 587 24 Money and ln!lation 617 25 Rational Expectations: Implications for Policy 43 vii I : CONTENTS PART l l Introd uction CHAPTER I Why Study Money, Banking, and Financial Markets? W hy Study Financial Marketsl The Bond 1-larket and !merest Rates The Srock Marker W hy Study Financial Institutions and Banking' St.rucmrc of rhe Financial System Financial Crises Banks and Other Financial Institutions Financial lnnovar.ion W hy Study :v!oney and Monetary Policyl t-,,toncy and Business Cycles Money and Inflation 10 1,toncy and Imeresr Rates Conduct of Monetary Policy 10 Fiscal Policy and Monetary Policy 12 W hy Study International Finance' 13 The Foreign Exchange Marker 13 14 The International Financial System 14 How We Will Study :v!oney, Banking, and Financial Markets 15 Exploring the Wr·b CollecLing and Graphing Data 15 Web Exercises 16 Concluding Remarks Summary 18 • 17 Key Terms Web Exercises 20 • 19 • Questions and Problems 19 • Web References 20 APPENDIX TO CHAPTER I Defining Aggregate Output, Income, the Price Level, and the Inflation Rate 21 Aggregate Output and Income 21 Real Versus Nominal Magnitudes 21 Aggregate Price Level 22 Growth Rates and the Inllation Rate 23 CHAPTER An Overview of the Financial System 25 Function of Financial Nlarkets 25 Structure of Financial Nlarkets 27 ix CO NTE NTS Debt and Equity Markets 27 Primary and Secondary ivlarkers 28 Exchanges and Over-the-Counter Markets 29 29 Money and Capital Markers 30 Financial Market Instruments 30 t-.·toncy Marker Instruments Following the Financial News Money Market Rates Following the Financial News Capital Market Interest Rates 31 Capital t-.-tarkc:.·t Instruments 33 34 Internationalization of Financial Markets Global 36 Are U.S Capital Markets Losing Their Edgel 36 lntcrnar.ional Bond Market, Eurobonds, and Eurocurrencies 37 37 World Srock Markers Following the Financial News Foreign Stock Market Indexes 38 Function of Financial Intermediaries: Indirect Finance 39 Transaction Costs Global 39 The Importance of Financial Intermediaries Relative to Securities Markets: An International Comparison 40 Risk Sharing 40 Asymmclric Information: Adverse Sc1ection and T\.foral Hazard 41 Types of Financial Intermediaries Depository InsLilulions 43 Contracwal Savings Institutions 44 lnvcstmcnt lnrcrmcdiaries 45 Regulation of the Financial System 46 Increasing InformationAvailable w lnvcsr.ors 46 Ensuring the Soundness of Financial lmermcdlaries 47 Financial Regulation Abroad Summary 49 • Key Terms 50 \Veb Exercises 51 42 • 49 • Questions and Problems 51 • \Veb References 52 CHAPTER What Is Money? 53 Meaning of Money Functions of Money 53 54 h,tcdium of Exchange 54 Unit of Accoum 55 Store of Value Evolution of the Papnents System Commodity Money 56 57 57 Fiat Money 57 Checks 57 ... banking, and financial markets I Frederic Mishkin 9th ed (and the 2nd ed of the business ed.) p em (The Addison-Wesley Series in economics) Includes bibliographical references and index ISBN-1... Goal of MonNary Policy Origins of the Federal Reserve System Inside the Fed 320 32 The Political Genius of the Founders of the Federal Reserve System Structure of the Federal Reserve System... Interest Rates 69 The Behavior of Interest Rates 91 The Risk and Term Structure of Interest Rates 23 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis