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World Trade and Payments:
An Introduction
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Laidler
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McCarty
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An Introduction to Economics
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and Finance
Miller
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Studenmund
Using Econometrics:
A Practical Guide
Tietenberg
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Williamson
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The Addison-Wesley Series in Economics
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7 The Stock Market, the Theory of Rational Expectations,
and the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141
Financial Institutions 167
8 An Economic Analysis of Financial Structure . . . . . . . . . . . . . . . . . . . . . . . .169
9 Banking and the Management of Financial Institutions . . . . . . . . . . . . . . . . .201
10 Banking Industry: Structure and Competition . . . . . . . . . . . . . . . . . . . . . . . .229
11 Economic Analysis of Banking Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . .260
12 Nonbank Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287
13 Financial Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .309
Central Banking and the Conduct of
Monetary Policy 333
14 Structure of Central Banks and the Federal Reserve System . . . . . . . . . . . . .335
15 Multiple Deposit Creation and the Money Supply Process . . . . . . . . . . . . . .357
16 Determinants of the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .374
17 Tools of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .393
18 Conduct of Monetary Policy: Goals and Targets . . . . . . . . . . . . . . . . . . . . . .411
International Finance and Monetary Policy 433
19 The Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .435
20 The International Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462
21 Monetary Policy Strategy: The International Experience . . . . . . . . . . . . . . . .487
PART V
PART IV
PART III
PART II
PART I
vii
CONTENTS IN BRIEF
Monetary Theory 515
22 The Demand for Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517
23 The Keynesian Framework and the ISLM Model . . . . . . . . . . . . . . . . . . . . . .536

Defining Aggregate Output, Income, the Price Level,
and the Inflation Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20
Aggregate Output and Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20
Real Versus Nominal Magnitudes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20
Aggregate Price Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21
Growth Rates and the Inflation Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22
PART I
ix
CONTENTS
CHAPTER 2
AN OVERVIEW OF THE FINANCIAL SYSTEM . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
Function of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
Structure of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25
Debt and Equity Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25
Primary and Secondary Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26
Exchanges and Over-the-Counter Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27
Money and Capital Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27
Internationalization of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28
International Bond Market, Eurobonds, and Eurocurrencies . . . . . . . . . . . . . . . . . . . . . . . .28
World Stock Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29
Function of Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29
Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29
Following the Financial News Foreign Stock Market Indexes . . . . . . . . . . . . . . . .30
Box 1 Global: The Importance of Financial Intermediaries to Securities
Markets: An International Comparison . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31
Risk Sharing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31
Asymmetric Information: Adverse Selection and Moral Hazard . . . . . . . . . . . . . . . . . . . . .32
Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34
Depository Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .56
Financial Markets 59
CHAPTER 4
UNDERSTANDING INTEREST RATES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61
Measuring Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61
Present Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61
Four Types of Credit Market Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .63
Yield to Maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .64
Box 1 Global: Negative T-Bill Rates? Japan Shows the Way . . . . . . . . . . . . . . . . . . .69
Other Measures of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .69
Current Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .70
Yield on a Discount Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .71
Application Reading the Wall Street Journal: The Bond Page . . . . . . . . . . . . . . . . .72
Following the Financial News Bond Prices and Interest Rates . . . . . . . . . . . . . . .73
The Distinction Between Interest Rates and Returns . . . . . . . . . . . . . . . . . . . . . . . . .75
Maturity and the Volatility of Bond Returns: Interest-Rate Risk . . . . . . . . . . . . . . . . . . . . . .78
Box 2 Helping Investors to Select Desired Interest-Rate Risk . . . . . . . . . . . . . . . . .79
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .79
The Distinction Between Real and Nominal Interest Rates . . . . . . . . . . . . . . . . . . . .79
Box 3 With TIPS, Real Interest Rates Have Become Observable in the
United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .82
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .82
CHAPTER 5
THE BEHAVIOR OF INTEREST RATES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85
Determinants of Asset Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85
Wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .86
PART II
Contents xi

Following the Financial News Forecasting Interest Rates . . . . . . . . . . . . . . . . . .111
Application Money and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .112
Does a Higher Rate of Growth of the Money Supply Lower Interest Rates? . . . . . . . . . . . .114
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .117
CHAPTER 6
THE RISK AND TERM STRUCTURE OF INTEREST RATES . . . . . . . . . . . . . . . . . . .120
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120
Risk Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120
Default Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120
Application The Enron Bankruptcy and the Baa-Aaa Spread . . . . . . . . . . . . . . . .124
xii Contents
Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .125
Income Tax Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .125
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127
Application Effects of the Bush Tax Cut on Bond Interest Rates . . . . . . . . . . . . .127
Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127
Following the Financial News Yield Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . .128
Expectations Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .129
Segmented Markets Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .132
Liquidity Premium and Preferred Habitat Theories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .133
Evidence on the Term Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .136
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .137
Application Interpreting Yield Curves, 1980–2003 . . . . . . . . . . . . . . . . . . . . . . .137
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .138
CHAPTER 7
THE STOCK MARKET, THE THEORY OF RATIONAL EXPECTATIONS,
AND THE EFFICIENT MARKET HYPOTHESIS . . . . . . . . . . . . . . . . . . . . . . . . . . . .141
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141
Computing the Price of Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141
The One-Period Valuation Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .142

Financial Institutions 167
CHAPTER 8
AN ECONOMIC ANALYSIS OF FINANCIAL STRUCTURE . . . . . . . . . . . . . . . . . . . .169
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .169
Basic Puzzles About Financial Structure Throughout the World . . . . . . . . . . . . . . .169
Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .173
How Transaction Costs Influence Financial Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . .173
How Financial Intermediaries Reduce Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . .173
Asymmetric Information: Adverse Selection and Moral Hazard . . . . . . . . . . . . . . . .174
The Lemons Problem: How Adverse Selection Influences Financial Structure . . . . .175
Lemons in the Stock and Bond Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .175
Tools to Help Solve Adverse Selection Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .176
Box 1 The Enron Implosion and the Arthur Andersen Conviction . . . . . . . . . . .178
How Moral Hazard Affects the Choice Between Debt and Equity Contracts . . . . . .180
Moral Hazard in Equity Contracts: The Principal–Agent Problem . . . . . . . . . . . . . . . . . . .181
Tools to Help Solve the Principal–Agent Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .182
Box 2 E-Finance: Venture Capitalists and the High-Tech Sector . . . . . . . . . . . . . .183
How Moral Hazard Influences Financial Structure in Debt Markets . . . . . . . . . . . .184
Tools to Help Solve Moral Hazard in Debt Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . .184
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .186
Application Financial Development and Economic Growth . . . . . . . . . . . . . . . .187
Financial Crises and Aggregate Economic Activity . . . . . . . . . . . . . . . . . . . . . . . . .189
Factors Causing Financial Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .189
Application Financial Crises in the United States . . . . . . . . . . . . . . . . . . . . . . . .191
Box 3 Case Study of a Financial Crisis: The Great Depression . . . . . . . . . . . . . . .194
Application Financial Crises in Emerging-Market Countries:
Mexico, 1994–1995; East Asia, 1997–1998; and Argentina, 2001–2002 . . . . . . .194
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .199
PART III
xiv Contents

Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .226
CHAPTER 10
BANKING INDUSTRY: STRUCTURE AND COMPETITION . . . . . . . . . . . . . . . . . . . .229
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .229
Historical Development of the Banking System . . . . . . . . . . . . . . . . . . . . . . . . . . . .229
Multiple Regulatory Agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .231
Financial Innovation and the Evolution of the Banking Industry . . . . . . . . . . . . . .232
Responses to Changes in Demand Conditions: Interest Rate Volatility . . . . . . . . . . . . . . .233
Responses to Changes in Supply Conditions: Information Technology . . . . . . . . . . . . . . .234
Box 1 E-Finance: Will “Clicks” Dominate “Bricks” in the Banking Industry? . . . .236
Avoidance of Existing Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .237
Financial Innovation and the Decline of Traditional Banking . . . . . . . . . . . . . . . . . . . . . .239
Contents xv
Structure of the U.S. Commercial Banking Industry . . . . . . . . . . . . . . . . . . . . . . . .243
Restrictions on Branching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .244
Response to Branching Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .245
Bank Consolidation and Nationwide Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . .245
Box 2 E-Finance: Information Technology and Bank Consolidation . . . . . . . . . . .247
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 . . . . . . . . . . . .248
What Will the Structure of the U.S. Banking Industry Look Like in the Future? . . . . . . . .248
Box 3 Global: Comparison of Banking Structure in the United States
and Abroad . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .249
Are Bank Consolidation and Nationwide Banking Good Things? . . . . . . . . . . . . . . . . . . .249
Separation of the Banking and Other Financial Service Industries . . . . . . . . . . . . . .250
Erosion of Glass-Steagall . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .250
The Gramm-Leach-Bliley Financial Services Modernization Act of 1999:
Repeal of Glass-Steagall . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .251
Implications for Financial Consolidation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .251
Separation of Banking and Other Financial Services Industries Throughout the World . . .251
Thrift Industry: Regulation and Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .252

Later Stages of the Crisis: Regulatory Forbearance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .275
Competitive Equality in Banking Act of 1987 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .276
Political Economy of the Savings and Loan Crisis . . . . . . . . . . . . . . . . . . . . . . . . . .276
The Principal–Agent Problem for Regulators and Politicians . . . . . . . . . . . . . . . . . . . . . . .277
Savings and Loan Bailout: The Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .278
Federal Deposit Insurance Corporation Improvement Act of 1991 . . . . . . . . . . . . .279
Banking Crises Throughout the World . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .280
Scandinavia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .280
Latin America . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .281
Russia and Eastern Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .282
Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .282
East Asia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .284
“Déjà Vu All Over Again” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .284
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .284
CHAPTER 12
NONBANK FINANCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287
Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287
Life Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287
Property and Casualty Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .288
The Competitive Threat from the Banking Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . .290
Application Insurance Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .290
Screening . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .291
Risk-Based Premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .291
Restrictive Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .292
Prevention of Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .292
Cancellation of Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .292
Deductibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .292
Coinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .293

Pros and Cons of Forward Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .311
Financial Futures Contracts and Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .311
Following the Financial News Financial Futures . . . . . . . . . . . . . . . . . . . . . . . .312
Application Hedging with Financial Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . .314
Organization of Trading in Financial Futures Markets . . . . . . . . . . . . . . . . . . . . . . . . . . .315
The Globalization of Financial Futures Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .317
Explaining the Success of Futures Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .317
Application Hedging Foreign Exchange Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . .319
Hedging Foreign Exchange Risk with Forward Contracts . . . . . . . . . . . . . . . . . . . . . . . . .319
Hedging Foreign Exchange Risk with Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . .320
Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .320
Following the Financial News Futures Options . . . . . . . . . . . . . . . . . . . . . . . . .321
Option Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .322
Profits and Losses on Option and Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . .322
Application Hedging with Futures Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . .325
xviii Contents
Factors Affecting the Prices of Option Premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .326
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .327
Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .328
Interest-Rate Swap Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .328
Application Hedging with Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . .329
Advantages of Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .329
Disadvantages of Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .330
Financial Intermediaries in Interest-Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .330
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .330
Central Banking and the Conduct of
Monetary Policy 333
CHAPTER 14
STRUCTURE OF CENTRAL BANKS AND THE FEDERAL RESERVE SYSTEM . . . . . . .335
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .335

The Case Against Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .354
Central Bank Independence and Macroeconomic Performance Throughout the World . . .354
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .355
CHAPTER 15
MULTIPLE DEPOSIT CREATION AND THE MONEY SUPPLY PROCESS . . . . . . . . . .357
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .357
Four Players in the Money Supply Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .357
The Fed’s Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .358
Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .358
Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .359
Control of the Monetary Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .359
Federal Reserve Open Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .359
Shifts from Deposits into Currency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .363
Box 1 Global: Foreign Exchange Rate Intervention and the Monetary Base . . . . .363
Discount Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .364
Other Factors That Affect the Monetary Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .365
Overview of the Fed’s Ability to Control the Monetary Base . . . . . . . . . . . . . . . . . . . . . . .365
Multiple Deposit Creation: A Simple Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .365
Deposit Creation: The Single Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .366
Deposit Creation: The Banking System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .367
Deriving the Formula for Multiple Deposit Creation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .370
Critique of the Simple Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .371
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .372
CHAPTER 16
DETERMINANTS OF THE MONEY SUPPLY . . . . . . . . . . . . . . . . . . . . . . . . . . . . .374
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .374
The Money Supply Model and the Money Multiplier . . . . . . . . . . . . . . . . . . . . . . .375
Deriving the Money Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .375
Intuition Behind the Money Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .377
Factors that Determine the Money Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . .378

Advantages and Disadvantages of Reserve Requirement Changes . . . . . . . . . . . . . . . . . . .405
Application Why Have Reserve Requirements Been Declining Worldwide? . . . .406
Application The Channel/Corridor System for Setting Interest Rates in
Other Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .406
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .408
CHAPTER 18
CONDUCT OF MONETARY POLICY: GOALS AND TARGETS . . . . . . . . . . . . . . . . . .411
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .411
Goals of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .411
High Employment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .411
Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .412
Price Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .412
Box 1 Global: The Growing European Commitment to Price Stability . . . . . . . . .413
Interest-Rate Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .413
Stability of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .413
Stability in Foreign Exchange Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .414
Conflict Among Goals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .414
Central Bank Strategy: Use of Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .414
Choosing the Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .416
Criteria for Choosing Intermediate Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .418
Criteria for Choosing Operating Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .419
Contents xxi
Fed Policy Procedures: Historical Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . .419
The Early Years: Discount Policy as the Primary Tool . . . . . . . . . . . . . . . . . . . . . . . . . . . .420
Discovery of Open Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .420
The Great Depression . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .421
Box 2 Inside the Fed: Bank Panics of 1930–1933: Why Did the Fed Let
Them Happen? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .421
Reserve Requirements as a Policy Tool . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .422
War Finance and the Pegging of Interest Rates: 1942–1951 . . . . . . . . . . . . . . . . . . . . . . .422

Shifts in the Expected-Return Schedule for Foreign Deposits . . . . . . . . . . . . . . . . . . . . . .448
Shifts in the Expected-Return Schedule for Domestic Deposits . . . . . . . . . . . . . . . . . . . . .450
PART V
xxii Contents
Application Changes in the Equilibrium Exchange Rate: Two Examples . . . . . .452
Changes in Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .452
Changes in the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .453
Exchange Rate Overshooting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .453
Application Why Are Exchange Rates So Volatile? . . . . . . . . . . . . . . . . . . . . . . .455
Application The Dollar and Interest Rates, 1973–2002 . . . . . . . . . . . . . . . . . . . .455
Application The Euro’s First Four Years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .457
Application Reading the Wall Street Journal: The “Currency Trading” Column .457
Following the Financial News The “Currency Trading” Column . . . . . . . . . . . .458
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .459
CHAPTER 20
THE INTERNATIONAL FINANCIAL SYSTEM . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462
Intervention in the Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462
Foreign Exchange Intervention and the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . .462
Box 1 Inside the Fed: A Day at the Federal Reserve Bank of New York’s
Foreign Exchange Desk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .463
Unsterilized Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .465
Sterilized Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .466
Balance of Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .467
Evolution of the International Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . .468
Gold Standard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .469
Bretton Woods System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .469
Box 2 Global: The Euro’s Challenge to the Dollar . . . . . . . . . . . . . . . . . . . . . . . . .471
Managed Float . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .473
European Monetary System (EMS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .474

Advantages of Monetary Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .500
Disadvantages of Monetary Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .501
Inflation Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .501
Inflation Targeting in New Zealand, Canada, and the United Kingdom . . . . . . . . . . . . . . .501
Advantages of Inflation Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .504
Disadvantages of Inflation Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .506
Nominal GDP Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .508
Monetary Policy with an Implicit Nominal Anchor . . . . . . . . . . . . . . . . . . . . . . . . .509
Advantages of the Fed’s Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .510
Disadvantages of the Fed’s Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .510
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .512
Monetary Theory 515
CHAPTER 22
THE DEMAND FOR MONEY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517
Quantity Theory of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517
Velocity of Money and Equation of Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .518
Quantity Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .519
Quantity Theory of Money Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .519
Is Velocity a Constant? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .520
Keynes’s Liquidity Preference Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .521
Transactions Motive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .521
Precautionary Motive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .522
Speculative Motive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .522
Putting the Three Motives Together . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .523
Further Developments in the Keynesian Approach . . . . . . . . . . . . . . . . . . . . . . . . .524
Transactions Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .524
PART VI
xxiv Contents
Precautionary Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .527

Changes in Equilibrium Level of the Interest Rate and Aggregate Output . . . . . . . .566
Response to a Change in Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .566
Response to a Change in Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .567
Effectiveness of Monetary Versus Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . .568
Monetary Policy Versus Fiscal Policy: The Case of Complete Crowding Out . . . . . . . . . . .568
Application Targeting Money Supply Versus Interest Rates . . . . . . . . . . . . . . . . .571
ISLM Model in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .575
ISLM Model and the Aggregate Demand Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . .577
Deriving the Aggregate Demand Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .577
Factors That Cause the Aggregate Demand Curve to Shift . . . . . . . . . . . . . . . . . . . . . . . .578
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .580
Contents xxv