CONTENTS PART Ⅰ Introduction ... 1 CHAPTER 1 Introducing Money and the Financial System ... 2 Getting Started ... 3 The Financial System and the Economy ... 4 Financial Markets ... 6 Financial Institutions ... 7 Money ... 9 Economic Analysis as a Tool ... 10 Developing an Economic Approach ... 10 Applying an Economic Approach ... 11 Review Questions ... 12 Analytical Problems, Data Question ... 13 Other times, other places…The Only Thing constant in the Financial System Is Change ... 6 Consider this…Is the Financial System Truly Global? ... 7 CHAPTER 2 Money and the Payments System ... 14 Meeting the Needs of Exchange with Money ... 15 Barter ... 15 Government Allocation ... 16 Money ... 16 What Can Serve as Money? ... 20 The Payments System ... 21 Commodity Money ... 21 Fiat Money ... 21 Checks ... 23 Electronic Funds ... 23 Measuring the Money Supply ... 25 Measuring Monetary Aggregates ... 25 Selecting Monetary Aggregates ... 28 Review Questions, Analytical Problems ... 32 Data Questions ... 33 Appendix : Calculating Price Indexes ... 34 Consider this…Did the CIA Damage Irag's Currency? ... 20 Other times, other places…What's Money? Ask a Taxi Driver! ... 22 Using the news…Finding Up-to-Date Information on Money ... 27 Moving from theory to practice…Keep the Change, The Economist, 11／21／98 ... 30 CHAPTER 3 Overview of the Financial System ... 35 What Is the Purpose of the Financial System? ... 36 Key Services Provided by the Financial System ... 38 Risk Sharing ... 39 Liquidity ... 39 Information ... 40 Financial Markets in the Financial System ... 41 Matching Savers and Borrowers : Debt and Equity ... 41 Providing Risk-Sharing, Liquidity, and Information Services ... 43 Financial Intermediaries in the Financial System ... 45 Matching Savers and Borrowers ... 46 Providing Risk-Sharing, Liquidity, and Information Services ... 46 Competition and Change in the Financial System ... 48 Financial Innovation ... 48 Changes in Financial Integration and Globalization ... 49 Financial Regulation ... 51 Provision of Information ... 52 Maintenance of Financial stability ... 52 Advancement of Other Policy Objectives 53 Effects of Regulation ... 54 Review Questions, Analytical Problems ... 58 Data Question ... 59 Appendix : Financial Instruments ... 59 Case Study Where Do Households Put Their Savings? ... 47 Consider this…Financial Innovation : Home Mortgages or Rock Star Bonds? ... 49 Other times, other places…The Growth of International Bond and Stock Markets ... 51 Moving from theory to practice…Stuffing Yen into a Drawer, The Wall Street Journal, 7／21／98 ... 56 PART Ⅱ Interest Rates ... 65 CHAPTER 4 Interest Rates and Rates of Return ... 66 Comparing Debt Instruments ... 66 Timing of Payments ... 67 Present Value ... 70 Using Yield to Maturity as a Yardstick ... 73 Bond Yields and Prices ... 78 Why Can Price and Face Value Differ? ... 78 How Are Bond Yields and Prices Related? ... 80 Finding the Total Rate of Return ... 84 Real versus Nominal Interest Rates ... 85 Review Questions ... 89 Analytical Problems ... 92 Data Questions ... 93 Consider this…Can They STRIP? Creating New Financial Instruments ... 69 Consider this…Who Will Buy Those Fabulous Fifties? ... 80 Using the news…Keeping Up with Bond Prices and Yields ... 82 Other times, other places…Principal Derailed : Inflation and Long-Term Bond Prices ... 86 Moving from theory to practice…Sweet Fifteen : Shorter Mortgages Are Gaining Support, The Wall Street Journal, 9／17／98 ... 90 CHAPTER 5 The Theory of Portfolio Allocation ... 94 Determinants of Portfolio Choice ... 95 Wealth ... 96 Expected Returns on Assets ... 97 Risk Associated with Asset Returns ... 98 Liquidity of Assets ... 101 Costs of Acquiring Information ... 101 Advantages of Diversification ... 102 Putting It All Together : Explaining Portfolio Allocation ... 107 Review Questions ... 109 Analytical Problems ... 112 Data Questions ... 113 Case Study How Much Risk Should You Tolerate in Your Portfolio? ... 100 Case Study Modeling Risk Premiums in Financial Markets ... 105 Other times, other places…Are Investors (Globally) Well Diversified? ... 107 Moving from theory to practice…Getting Europeans to Invest in Stocks, The New York Times, 3／1／98 ... 110 CHAPTER 6 Determining Market Interest Rates ... 114 Supply and Demand in the Bond Market and Loanable Funds ... 115 The Demand Curve ... 115 The Supply Curve ... 117 Market Equilibrium ... 117 Explaining Changes in Equilibrium Interest Rates ... 120 Shifts in Bond Demand ... 120 Shifts in Bond Supply ... 127 Using the Model to Explain Changes in Interest Rates ... 131 Back to the Bond Market's Votes ... 134 The International Capital Market and the Interest Rate ... 136 Small Open Economy ... 137 Large Open Economy ... 138 Review Questions, Analytical Problems ... 143 Data Question ... 145 Consider this…Where Do Savings Come from? ... 123 Other times, other places…Do Interest Rates Rise During Wartime? ... 130 Moving from theory to practice…The Bond Market's Star Turn, The New York Times, 8／23／98 ... 140 CHAPTER 7 Risk Structure and Term Structure of Interest Rates ... 146 Risk Structure of Interest Rates ... 147 Default Risk ... 147 Liquidity ... 153 Information Costs ... 154 Taxation ... 155 Using the Risk Structure for Forecasting ... 159 Term Structure of Interest Rates ... 160 Segmented Markets Theory ... 162 Expectations Theory ... 163 Preferred Habitat Theory ... 167 Using the Term Structure for Forecasting ... 169 Review Questions, Analytical Problems ... 175 Data Question ... 177 Using the news…Using Bond Yields to Assess Risk ... 148 Consider this…Will Consumption Tax Kill Munis' Allure? ... 159 Other times, other places…Asian Flu for European Bonds? ... 160 Using the news…How to Read the Yield Curve ... 161 Consider this…Can the Treasury Change the Shape of the Yield Curve? ... 171 Moving from theory to practice…A Successful Bet on Inflation Bonds, The Wall Street Journal, 7／13／98 ... 172 PART Ⅲ Financial Markets ... 179 CHAPTER 8 The Foreign-Exchange Market and Exchange Rates ... 180 Exchange Rates and Trade ... 181 Nominal versus Real Exchange Rates ... 182 Foreign-Exchange Markets ... 184 Determining Long-Run Exchange Rates ... 185 Supply and Demand ... 185 Economic Fundamentals and Long-Run Exchange Rate Trends ... 187 The Law of One Price and the Purchasing Power Parity Theory ... 189 Does the Theory Match Reality? ... 190 Determining Short-Run Exchange Rates ... 191 Comparing Expected Returns on Domestic and Foreign Assets ... 192 Foreign-Exchange Market Equilibrium ... 195 Interest Rate Parity ... 197 Exchange Rate Fluctuations ... 200 Changes in Domestic Real Interest Rates ... 200 Changes in Domestic Expected Inflation ... 200 Changes in Foreign Interest Rates ... 202 Changes in the Expected Future Exchange Rate ... 204 Currency Premiums in Foreign-Exchange Markets ... 206 A (Big) New kid on the Block : The Euro ... 207 Review Questions ... 210 Analytical Problems ... 211 Data Question ... 212 Using the news…Reading Exchange Rates ... 186 Case Study Should You Bank on International Investments? ... 199 Other times, other places…Interest and Exchange Rates in the 1980s ... 205 Moving from theory to practice…Rate Cut for the Euro, The Wall Street Journal, 12／4／98 ... 208 CHAPTER 9 Derivative Securities and Derivative Markets ... 213 Forward Transactions and Derivatives ... 214 Futures ... 215 Futures Pricing ... 216 Using Futures to Manage Risk ... 217 Options ... 221 Options Pricing ... 222 Using Options to Manage Risk ... 224 Benefits of Derivative Markets for the Financial System ... 225 Standardization and Liquidity ... 227 Anonymous Trading and Information ... 228 Review Questions ... 232 Analytical Problems ... 233 Data Question ... 234 Appendix : Swaps ... 234 Using the news…Reading Financial Futures Listings ... 217 Using the news…Reading Options Listings ... 223 Other times, other places…Futures Trading, Index Arbitrage, and the Stock Market Crash of 1987 ... 224 Case Study Citron Pressed - The Orange County Fiasco ... 225 Case Study Barings Lost - The Queen's Banker Goes Bust ... 226 Moving from theory to practice…A Corporate Bond Future for Europe, Financial Times, 8／3／98 ... 230 CHAPTER 10 Information and Financial Market Efficiency ... 237 Rational Expectations ... 238 The Efficient Markets Hypothesis ... 240 Determining an Asset's Expected Price ... 242 Price Fluctuations ... 243 Investment Strategies ... 244 Actual Efficiency in Financial Markets ... 248 Pricing Anomalies ... 248 Mean Reversion ... 249 Excessive Volatility ... 250 Market Efficiency and the Crash of 1987 ... 250 Value Investing versus Efficient Markets ... 254 Costs of Inefficiency in Financial Markets ... 254 Costs of Excessive Price Fluctuations ... 255 Information Costs ... 258 Review Questions, Analytical Problems ... 259 Data Question ... 260 Consider this…Are Investors Really Rational? ... 246 Other times, other places…Charting the Civil War with the Gold Market ... 247 Case Study What Goes Up… ... 252 Moving from theory to practice…So, Is the Stock Market Overvalued?, The Wall Street Journal, 3／30／98 ... 256 CHAPTER 11 Reducing Transactions Costs and Information Costs ... 261 Obstacles to Matching Savers and Borrowers ... 262 Transactions Costs ... 262 Asymmetric Information and Information Costs ... 263 Adverse Selection ... 264 "Lemons Problems" in Financial Markets ... 264 Reducing Information Costs ... 265 Moral Hazard ... 268 Moral Hazard in Equity Financing ... 268 Moral Hazard in Debt Financing ... 270 Information Costs and Financial Intermediaries ... 273 Financial Intermediaries and Adverse Selection ... 274 Financial Intermediaries and Moral Hazard ... 275 Review Questions ... 279 Analytical Problems, Data Question ... 280 Consider this…Are Stock Market Signals Affected by Adverse Selection? ... 268 Consider this…Can Falling Prices Raise Information Costs? ... 272 Other times, other places…Corporate Raiders Then and Now ... 274 Moving from theory to practice…On the Cutting Edge of Corporate Control in China, The Wall Street Journal, 10／28／98 ... 276 PART Ⅳ Financial Institutions ... 281 CHAPTER 12 What Financial Institutions Do ... 282 Securities Market Institutions ... 284 Information : Investment Banking ... 284 Liquidity and Risk Sharing : Secondary Markets ... 286 Investment Institutions ... 289 Mutual Funds ... 289 Finance Companies ... 292 Contractual Saving : Insurance Companies ... 293 Principles of Insurance Management ... 293 Life Insurance Companies ... 297 Property and Casualty Insurance Companies ... 298 Regulation of Insurance Companies and Recent Trends ... 299 Contractual Saving : Pension Funds ... 299 Ownership of Pension Funds Assets ... 301 Funding of Pension Funds ... 301 Regulation of Private Pension Plans ... 302 Public Pension Plans ... 302 Recent Trends ... 302 Depository Institutions ... 303 Commercial Banks ... 304 Savings Institutions ... 305 Credit Unions ... 305 Government Financial Institutions ... 308 Direct Role : Federal Credit Agencies ... 308 Indirect Role : Loan Guarantees ... 308 Recent Trends ... 305 Financial Institutions : Blurring the Lines ... 309 Review Questions ... 314 Analytical Problems, Data Question ... 315 Using the news…A Tombstone for Something New? ... 287 Consider this…Can Investors Keep "Captives" at Bay? ... 295 Case Study What Kind of Financial Institution Is a Hedge Fund? ... 306 Moving from theory to practice…Trimming the Hedges, The Economist, 12／5／98 ... 312 CHAPTER 13 The Business of Banking ... 316 How Banks Earn Profits ... 317 Bank Liabilities ... 317 Bank Assets ... 320 Bank Net Worth ... 321 Bank Failure ... 322 Determining Bank Profits ... 322 The Relationship Between Banks and Savers ... 325 Managing Moral Hazard ... 325 Managing Liquidity Risk ... 326 The Relationship Between Banks and Borrowers ... 329 Managing Credit Risk ... 330 Managing Interest Rate Risk ... 335 Expanding the Boundaries of Banking ... 338 Opportunities and Financial Innovation ... 339 Off-Balance-Sheet Lending ... 340 Review Questions ... 347 Analytical Problems ... 348 Data Questions ... 349 Appendix : Measuring the Duration of Bank Assets and Liabilities ... 349 Consider this…How Do Banks Account for Loan Losses? ... 323 Consider this…When Is Credit-Risk Analysis "Discrimination"? ... 331 Case Study Credit Card Lending ... 334 Consider this…Teller Line or On-Line? ... 340 Moving from theory to practice…Scrambling for Lifeboats in Jakarta, The New York Times, 9／23／98 ... 344 CHAPTER 14 The Banking Industry ... 351 Origins of Today's Banking Industry ... 352 Who Regulates Banks ... 353 Chartering and Examination ... 354 Regulating Commercial Banks ... 354 Regulating Savings Institutions ... 355 Regulating Credit Unions ... 355 Why the Banking Industry Is Regulated ... 357 Bank Runs ... 357 The Cost of a Bank Run ... 358 Government Intervention in the Banking Industry ... 359 Lender of Last Resort ... 360 Federal Deposit Insurance ... 361 Restrictions on Banking Industry Competition ... 365 The Banking Industry in Other Countries ... 374 Japanese Banking ... 374 German Banking ... 376 Integration of European Banking ... 377 Review Questions ... 380 Analytical Problems, Data Question ... 381 Other times, other place…Lessons from the Free Banking Period ... 353 Consider this…Is Bank Consolidation Good for Business? ... 366 Case Study Is Banking a Declining Industry? ... 372 Moving from the theory to practice…Banks Better Buck Up, The Economist, 11／28／98 ... 378 CHAPTER 15 Banking Regulation : Crisis and Response ... 382 The Pattern of Regulation ... 383 Lender of Last Resort ... 383 The Great Depression ... 384 Success in Recent Years ... 385 Concluding Remarks ... 387 Anticompetitive Bank Regulation ... 387 The Credit Crunch of 1966 ... 390 Banks' Response ... 390 Regulatory Response ... 392 Concluding Remarks ... 393 The U.S. Deposit Insurance Crisis of the 1980s ... 394 Beginning of the Crisis : Worsening Conditions in S&Ls ... 394 Financial System Response ... 394 Regulatory Response : The S&L Bailout ... 396 The Widening Crisis : Commercial Banks ... 398 Options for Regulatory Reform ... 401 Current issues in Regulatory Reform ... 404 Concluding Remarks ... 405 Lessons from Banking Regulation for Other Institutions ... 406 Insurance Regulation ... 406 Pension Fund Regulation ... 407 Review Questions ... 411 Analytical Problems ... 412 Data Questions ... 413 Consider this…How Does a Lender of Last Resort Protect the Payments System? ... 386 Other times, other place…Money Market Mutual Funds : Japan and the United States ... 389 Consider this…How Severe Is the Deposit Insurance Crisis in Japan? ... 400 Moving from theory to practice…Crisis and Response in Japan, The Financial Times, 11／16／98 ... 408 CHAPTER 16 Banking in the International Economy ... 414 Organization of International Banks ... 415 Overseas Organization of U.S. Banks ... 416 Organization of Foreign Banks in the United States ... 417 Leaders in Global Banking ... 418 Managing Exchange Rate Risk ... 418 Services Provided by International Banks ... 420 Reducing Transactions Costs ... 420 Providing Information Services ... 421 The Rise of Euromarkets ... 423 Euromarket Customers ... 425 Loans in Euromarkets ... 426 Financial Regulation in International Banking ... 427 Capital Requirements ... 428 Deposit Insurance ... 429 Central Bank Intervention ... 430 International Coordination ... 430 Review Questions ... 431 Analytical Problems, Data Question ... 434 Consider this…Why Did Closing BCCI Takes So Long? ... 419 Consider this…Will Europe Kill the Eurobond? ... 426 Other times, other places…Do Sovereigns Default? ... 428 Moving from theory to practice…A Lack of Leadership? The Financial Times, 10／7／98 ... 432 PART Ⅴ The Money Supply Process and Monetary Policy ... 435 CHAPTER 17 The Money Supply Process ... 436 The Fed and the Monetary Base ... 437 The Fed's Liabilities ... 438 The Fed's Assets ... 439 How the Fed Changes the Monetary Base ... 439 Comparing Open Market Operations and Discount Loans ... 444 The Simple Deposit Multiplier ... 445 Multiple Deposit Expansion ... 445 Multiple Deposit Contraction ... 451 The Money Multiplier and Decisions of the Nonbank Public ... 452 Determinants of Portfolio Choice ... 454 Concluding Remarks ... 456 Bank Behavior : Excess Reserves and Discount Loans ... 457 Excess Reserves ... 457 Discount Loans ... 458 Deriving the Money Multiplier and the Money Supply ... 459 Review Questions ... 467 Analytical Problems ... 470 Data Question ... 472 Appendix : The Money Supply Process for M2 ... 472 Consider this…What Are the Origins of Multiple Deposit Expansion? ... 447 Other times, other places…The Money Multiplier and Money Supply During the Early 1930s ... 462 Case Study Using the Money Supply Equation to Predict Money Growth ... 464 Moving from theory to practice…The Fed, the Monetary Base, and Economic Recovery, The Financial Times, 11／18／98 ... 468 CHAPTER 18 Changes in the Monetary Base ... 474 Balance Sheet of the Federal Reserve System ... 474 The Fed's Assets ... 475 The Fed's Liabilities ... 476 Determining the Monetary Base ... 477 Changes in the Monetary Base ... 478 Determinants That Increase the Monetary Base ... 479 Determinants That Decrease the Monetary Base ... 482 Concluding Remarks ... 483 The Federal Budget Deficit and the Monetary Base ... 484 Alternative Strategies ... 486 The Government Budget Constraint and the Monetary Base ... 488 Review Questions, Analytical Problems ... 492 Data Questions ... 493 Using the news…Federal Reserve Data and Change in the Monetary Base ... 480 Other times, other places…Dealing with the Debt : The Treasury-Federal Reserve Accord ... 485 Moving from theory to practice…The Budger Deficit and the Monetary Base in Russia, The Financial Times, 12／9／98 ... 490 CHAPTER 19 Organization of Central Banks ... 494 Power Sharing in the Federal Reserve System ... 495 Creation of the System ... 495 Federal Reserve Banks ... 496 Member Banks ... 498 Board of Governors ... 499 Federal Open Market Committee ... 499 Power and Authority Within the Fed ... 500 How the Fed Operates ... 502 Handling External Pressure ... 502 Examples of Treasury-Fed Conflict ... 504 Factors That Motivate the Fed ... 505 Fed Independence ... 506 Central Bank Independence in Other Countries ... 508 Organization and Independence of the European Central Bank ... 509 Review Question ... 511 Analytical Problem ... 514 Data Questions ... 515 Considers this…Importance of Selecting a Fed Chairman ... 503 Other times, other places…Conflicts Between the Treasury and the Central Bank in Japan over Independence ... 507 Moving from theory to practice…A Team for the ECB, The Financial Times, 10／17-18／98 ... 512 CHAPTER 20 Monetary Policy Tools ... 516 Open Market Operations ... 516 Implementing Open Market Operations ... 517 Open Market Operations versus Other Policy Tools ... 520 Fed Watching and FOMC Directives ... 520 Open Market Operations in Other Countries ... 522 Discount Policy ... 522 Using the Discount Window ... 523 Policing the Discount Window ... 523 Benefits of Discount Policy ... 525 Drawbacks of Discount Policy as a Monetary Policy Tool ... 526 Discount Policy in Other Countries ... 526 Reserve Requirements ... 527 Changes in Reserve Requirements ... 527 Measurement and Compliance ... 528 Criticism of Reserve Requirements ... 528 Reserve Requirements in Other Countries ... 531 Fed Watching : Analyzing the Policy Tools