CONTENTS PART ONE Introduction Chapter 1 Introduction and Overview ... 2 What This Book Is About ... 3 Economic and Financial Analysis of an Ever Changing System ... 3 Finance in Our Daily Lives ... 5 Introducing the Financial System ... 6 More on Financial intermediaries ... 8 Depository Institutions and Other Types of Intermediaries ... 10 The Federal Reserve System ... 11 The Role of Policy : Changing Views ... 13 Summary of Major Points ... 16 Chapter 2 Principles of Money ... 20 Conceptualization : A Key Building Block ... 21 Defining Money ... 21 A Closer Look : Money, Exchange, and Economic Development ... 23 The Monetary Aggregates and Domestic Nonfinancial Debt ... 23 The Monetary Aggregates ... 25 A Closer Look : Money and Other Financial Claims ... 27 Domestic Nonfinancial Debt ... 28 The Economy and the Aggregates ... 28 Looking Forward : United States to Get New Currency ... 30 The Evolution of the Payments System ... 30 A Closer Look : Forget Your Checkbook ... 33 Summary of Major Points ... 34 Chapter 3 The Role of Money and Credit ... 37 Money and Credit Matter ... 38 The Demand for and Supply of Money ... 38 The Demand for Money ... 39 Cracking the Code : Graphical Analysis ... 40 The Supply of Money ... 41 Money and Interest Rates ... 42 How Credit Matters : A First Approximation ... 44 Money, Credit, and the Economy : A Peek at the Data ... 45 A Closer Look : Recent Innovations in Credit Extension ... 46 Looking Back : A Brief History of U. S. Currency ... 48 Cracking the Code : Measuring the Inflation Rate ... 50 Are Money and Credit All That Matter? ... 50 Money and Credit Flows : First Fiddle or Second Fiddle ... 51 Summary of Major Points ... 52 Chapter 4 Analysis of the Financial System and the Economy ... 56 The Trees versus the Forest ... 57 Spending, Saving, Borrowing, and Lending ... 57 A Typical Household ... 58 A Typical Firm ... 59 From J. P. and APEI to the Economy as a Whole : Aggregation ... 59 The Circular Flow of Income, Expenditures, and Funds ... 61 The Product Market ... 63 The Factor Market ... 65 The Financial System ... 66 Maximization : Plans, Revisions, and Actions ... 68 Summary of Major Points ... 71 Appendix 4-A : Interest Rates : Which Theory Is Correct? Reconciling Stocks and Flows ... 74 Chapter 5 The Overseer : The Federal Reserve System ... 76 Unraveling the Fed's Mystique ... 77 Organizational Structure of the System ... 77 Looking Back : Early Attempts at Establishing a Central Bank ... 78 Board of Governors ... 78 A Closer Look : The Board of Governors ... 79 Federal Reserve Banks ... 80 Federal Open Market Committee(FOMC) ... 80 The Fed's Functions ... 82 Formulation and Implementation of Monetary Policy ... 82 Supervision and Regulation of the Financial System ... 83 Facilitation of the Payments Mechanism ... 85 Operation as Fiscal Agent for the Government ... 85 The Fed's Major Policy Tools ... 86 Open Market Operations ... 86 The Discount Rate and Discount Rate Policy ... 87 Reserve Requirements ... 88 Who Does What within the Fed ... 89 The Federal Reserve System : An Independent Watchdog, Convenient Scapegoat, or Cunning Political Animal? ... 90 Looking Out : Central Bank Independence and Macroeconomic Performance ... 92 Summary of Major Points ... 94 Chapter 6 Financial Markets, instruments, and Participants ... 97 Game Talk ... 98 Introducing Financial Markets ... 98 Major Financial Market Instruments ... 101 Money Market Instruments ... 101 Cracking the Code : Treasury Bills ... 103 Capital Market Instruments ... 106 Looking Forward : The World's Newest Currency ... 107 A Closer Look : Following the Financial News ... 110 The Role of Market Makers ... 110 Why Market Makers Make Markets ... 112 Market Making and Liquidity ... 112 Substitutability, Market Making, and Market Integration ... 113 Summary of Major Points ... 115 PART TWO Financial Prices Chapter 7 Interest Rates and Bond Prices ... 120 The Present versus the Future ... 121 The Time Value of Money ... 121 Compounding and Discounting ... 122 Compounding : Future Values ... 122 Discounting : Present Values ... 124 Interest Rates, Bond Prices, and Present Values ... 126 Fluctuations in Interest Rates and Managing a Bond Portfolio ... 128 The Determinants of Interest Rates ... 129 Changes in the Demand for Loanable Funds ... 130 Changes in the Supply of Funds ... 131 Inflation and Interest Rates ... 133 The Cyclical Movement of Interest Rates ... 137 Summary of Major Points ... 137 Appendix 7-A : The Inverse Relationship between Bond Prices and Interest Rates : The Case of Consols ... 140 Chapter 8 The Structure of Interest Rates ... 142 From One Interest Rate to Many ... 143 The Role of Term to Maturity in Interest Rate Differentials ... 143 The Yield Curve ... 144 The Expectations Theory ... 145 Determining Interest Rate Expectations ... 150 Tying the Determinants of Expectations to the Changing Shape and Level of Yield Curves ... 151 Some Necessary Modifications to the Expectations Theory ... 153 The Role of Credit Risk and Taxes in Interest Rate Differentials ... 156 Credit Risk ... 156 Taxability ... 157 Summary of Major Points ... 160 Chapter 9 How Exchange Rates Are Determined ... 164 The More Things Change, the More Things Stay the Same ... 165 Defining Exchange Rates ... 165 Cracking the Code : How Movements in the Exchange Rate Affect the Dollar Price of Foreign Goods ... 167 Determining Exchange Rates ... 167 The Demand for Dollars in the Foreign Exchange Market ... 168 Cracking the Code : Finding the Yen／Mark Exchange Rate ... 169 Cracking the Code : The Cost of an IBM Computer in Japan ... 170 The Supply of Dollars in the Foreign Exchange Market ... 171 Changes in Supply and Demand and How They Affect the Exchange Rate ... 172 Defining the Balance of Payments and Its Influence on the Exchange Rate, the Financial System, and the U. S. Economy ... 176 The Current Account ... 177 Looking Out : The Path to a Single European Currency ... 178 The Capital Account ... 179 The Balance of Payments and the Exchange Rate ... 179 Looking Back : The Gold Standard ... 180 A Closer Look : Appreciation, Depreciation, and Appreciation : Causes and Consequences of Dollar Exchange Rate Movements Since 1980 ... 181 Summary of Major Points ... 183 Appendix 9-A : Expansionary Monetary Policy and Restrictive Fiscal Policy : A Scenario ... 187 PART THREE Financial Markets Chapter 10 The Stock, Bond, and Mortgage Markets : Volatile Asset Prices ... 190 The Implications of Volatile Stock, Bond, and Mortgage Prices ... 191 Looking Back : Famous Financial Quotations from Just Before the Stock Market Crash of 1929 ... 192 Looking Out : The Japanese Bubble Economy of the 1980s ... 193 The Stock Market ... 194 The Organized Exchanges ... 195 A Closer Look : Stock Market Indexes : Is the Most Famous the Best? ... 196 Cracking the Code : The Stock Market ... 197 The Over-the-Counter Market ... 198 Looking Back : Would You Buy a "Seat" on the New York Stock Exchange for <FONT face ... serif The Mutual Fund Market ... 199 Looking Forward : Will the Trading Specialist Go the Way of the Dinosaur? ... 200 A Closer Look : New Circuit Breaker Rules Implemented on the New York Stock Exchange ... 201 The Bond Market ... 203 The Corporate Bond Market ... 203 A Closer Look : A Sample of the Types of Mutual Funds ... 204 The Treasury Bond Market ... 205 Cracking the Code : Corporate Bonds ... 206 Municipal and Government Agency Securities ... 207 Cracking the Code : Treasury Bonds ... 208 The Mortgage Market ... 209 Secondary Markets in Mortgages ... 210 Summary of Major Points ... 211 Appendix 10-A : How Expected Rates of Return Affect the Prices of Stocks, Bonds, and Mortgages ... 215 Chapter 11 Futures, Options, and Swaps : Managing Risk ... 217 A Single Solution ... 218 Forward Transactions and Financial Futures ... 218 A Closer Look : Futures, Exchanges That Trade Financial Futures, Minimum Amounts, and Open Interest ... 221 A Closer Look : A Credit Union Enters the Futures Market ... 223 Cracking the Code : Futures Prices ... 224 A Closer Look : LHT Inc. Enters the Futures Market ... 225 Determining the Futures Price ... 226 Options ... 227 A Closer Look : Stock Index Futures and the '87 Crash ... 228 Put Options ... 229 A Closer Look : Major Options, Exchanges, and Open Interest ... 230 Call Options ... 231 The Option Premium ... 231 Swaps ... 232 Cracking the Code : Cracking the Code on Options ... 233 Summary of Major Points ... 235 Appendix 11-A : The Foreign Exchange Futures Market ... 238 Appendix 11-B : Determining the Option Premium ... 240 Chapter 12 The International Financial System ... 241 The Changing International Financial System ... 242 A Closer Look : International Money and Capital Market Assets ... 243 The International Financial System from 1944 to 1973 ... 244 The Managed Float Exchange Rate System since 1973 ... 246 A Closer Look : The Foreign Exchange Market ... 248 Futures, Options, Forward Contracts, and Swaps under the Managed Float ... 249 Cracking the Code : The Foreign Exchange Market ... 252 The Role of the Dollar under the Managed Float ... 252 Major International Financial Institutions ... 254 The International Monetary Fund(IMF) ... 254 The World Bank ... 256 A Closer Look : The Role of the IMF in the Asian Crisis ... 257 The Bank for International Settlements(BIS) ... 258 Looking Forward : A Framework for International Financial Stability ... 259 Summary of Major Points ... 260 PART FOUR Financial Institutions Chapter 13 Financial Intermediaries ... 266 Are All Financial Intermediaries More or Less Alike? ... 267 Common Characteristics ... 267 A Closer Look : FIs as Firms ... 269 Types of Risks Faced by All FIs ... 271 Credit or Default Risk ... 271 Interest Rate Risk ... 272 Liquidity Risk ... 272 Exchange Rate Risk ... 273 A Guide to FIs and Their Balance Sheets ... 273 Deposit-Type FIs ... 274 Contractual-Type FIs ... 279 Investment-Type FIs ... 282 Finance Company-Type FIs ... 283 Pulling Things Together ... 284 Summary of Major Points ... 287 Chapter 14 Commercial Banking Structure, Regulation, and Performance ... 291 The Biggest Intermediary in Town ... 292 The Banking Regulatory Structure ... 293 Looking Back : The Origins of the Dual Banking System ... 294 The Structure of the Commercial Banking System ... 296 The Definition of a Bank Holding Company ... 300 Ongoing Changes in the Structure of the Banking Industry ... 303 A Closer Look : Megamergers of the Late 1990s ... 305 The Evolution of International Banking ... 306 Bank Management : Managing Risk and Profits ... 307 Managing Risk ... 309 Bank Performance ... 309 Summary of Major Points ... 312 Appendix 14-A : A More In-Depth Look at the Major Assets of Commercial Banks ... 315 Chapter 15 Financial Innovation ... 318 The Road from There to Here ... 319 Major Causes of Financial Innovation ... 319 The Beginning Regulatory Structure ... 320 The Analytic Foundations of Financial Innovation ... 321 Early Financial Innovations for Banks ... 325 A Closer Look : The Anatomy of Eurodollar Borrowing ... 327 A Closer Look : The Development of the Eurodollar Market ... 328 Deregulation ... 329 A Closer Look : The Changing Composition of Liabilities of Large Commercial Banks ... 330 Financial Innovation in Recent Years : Derivatives and Securitization ... 331 A Closer Look : Securitization of Small Business Loans ... 333 Looking Forward : The Electronic Purse : An Innovation in the Making ... 334 Other Characteristics of the Financial System ... 334 Looking Forward : The Financial System of the Future ... 335 Summary of Major Points ... 337 Chapter 16 Strains on the Financial System ... 340 Memory Is the Thing You Forget With ... 341 Financial Intermediation, Risk, and Financial Crises ... 342 A Closer Look : The Classic Debt Deflation ... 344 The Problem of Moral Hazard in Financial Intermediation ... 346 A Closer Look : The Bailout of Long-Term Capital Management ... 348 The Savings and Loan Debacle ... 350 Looking Out : The Japanese Banking Crisis ... 352 Other Areas of Concern ... 354 Off-Balance-Sheet Activities ... 354 Derivatives ... 354 A Closer Look : The Lincoln Savings Scandal ... 355 A Closer Look : The Collapse of a California County and a British Bank ... 356 The Eurodollar and Eurobond Markets ... 358 Summary of Major Points ... 359 Chapter 17 Regulation in the Financial Services Industry ... 362 The Role of Regulation ... 363 The How and Why of Financial Services Regulation ... 364 Recent Major Legislation ... 365 Basel Accord ... 365 A Closer Look : Regulators in the Financial Services Industry ... 366 Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ... 366 Looking Out : Basel Committee Announces 25 Core Principles for Effective Bank Supervision ... 368 Federal Deposit Insurance Corporation Improvement Act of 1991 ... 369 A Closer Look : Bank Capital Standards under the Basel Accord ... 370 Community Reinvestment Act ... 372 Interstate Banking and Branching Efficiency Act of 1994 ... 373 Looking Back : Remedies for a Credit Crunch ... 374 Other Possible Areas of Reforms ... 375 Looking Back : A Time Line of Banking Legislation ... 376 Summary of Major Points ... 377 PART FIVE Monetary Theory Chapter 18 The Fed, Depository Institutions, and the Money Supply Process ... 382 Where Money Comes From ... 383 The Fed and Bank Reserves ... 383 Open Market Operations ... 383 Discount Loans ... 385 Other Factors That Change Reserves ... 386 Loan and Deposit Expansion by the Banking System ... 387 The Simple Multiplier Model of the Money Supply Process ... 391 Policy Implications ... 395 Some Complicating Realities in the Multiplier Model ... 396 Modifying the Multiplier Model ... 396 Looking Back : The Money Multiplier During the Great Depression ... 398 The Fed's Control over the Money Supply ... 400 Looking Back : The Evolution of the Money Multiplier ... 401 Summary of Major Points ... 402 Appendix 18-A : Other Factors That Affect the Monetary Base ... 405 Appendix 18-B : The M2 Multiplier ... 410 Chapter 19 The Demand for Real Money Balances and Market Equilibrium ... 412 Where is All the Money? ... 413 The Demand for Real Money Balances ... 413 Households' Demand for Real Money Balances ... 415 Firms' Demand for Real Money Balances ... 417 The Interest Rate, Real Income, and Real Money Balances ... 418 A Closer Look : Keynes's Speculative Demand for Money ... 421 Additional Factors Affecting the Demand for Real Money Balances ... 424 Looking Forward : Will Checks Go the Way of the Dinosaur? ... 425 Equilibrium in the Market for Real Money Balances ... 425 A Final Note ... 430 A Closer Look : Monetarism ... 431 Summary of Major Points ... 432 Appendix 19-A : The Transactions Demand for Money by Households ... 435 Chapter 20 Financial Aspects of Household and Firm Behavior ... 440 To Spend or Not to Spend ... 441 Household Behavior from a Financial Perspective ... 442 Asset Accumulation : Spending and Saving ... 444 A Closer Look : Choosing Among Financial Assets : The Role of Risk Aversion ... 445 Liability Accumulation : Borrowing ... 446 How Economic and Financial Conditions Influence Household Accumulation of Assets and Liabilities ... 447 The Sources and Uses of Funds for Households ... 448 Household Demand Equations for Real and Financial Assets ... 449 Financial Aspects of the Behavior of Nonfinancial Firms ... 453 The Accumulation of Real Assets by Firms : Capital and Inventories ... 454 The Accumulation of Liabilities by Firms ... 457 The Sources and Uses of Funds for the Business Sector ... 460 Summary of Major Points ... 462 Chapter 21 Financial Effects of the Government and Foreign Sectors ... 465 Optimism and Dismay ... 466 Financial Aspects of Government Behavior ... 466 Financial Effects of Government Borrowing : A Graphical Perspective ... 473 Expectations and the Timing of Interest Rate Changes ... 476 The Sources and Uses of Funds in the Government Sector ... 477 A Closer Look : The Long-Term Effects of Government Deficit Spending ... 479 The Foreign Sector and Its Effect on the Financial System ... 480 The Effects of International Events on the Interest Rate ... 481 The Sources and Uses of Funds for the Foreign Sector ... 485 Summary of Major Points ... 486 Chapter 22 Aggregate Demand and Aggregate Supply ... 490 "GDP up 8 Percent" : Is This Indicative of an Economy in Good Health? ... 491 Aggregate Demand ... 491 The Aggregate Demand Curve ... 492 What Causes Aggregate Demand to Change? ... 495 Aggregate Supply ... 497 From the Individual Firm to the Aggregate ... 498 Short-Run Aggregate Supply ... 498 Long-Run Aggregate Supply ... 500 The Relationship between the Short Run and the Long Run : Shifts in Short-Run Aggregate Supply ... 504 Equilibrium and Financial Flows among Sectors ... 507 A Closer Look : The Mechanics of Macroeconomic Equilibrium ... 509 Summary of Major Points ... 510 PART SIX Monetary Policy Chapter 23 The Challenges of Monetary Policy ... 516 Can the Business Cycle Be Mitigated? ... 517 The Goals of Monetary Policy ... 518 Economic Growth ... 518 Stabilization of Unemployment, Inflation, and the External Balance ... 520 Cracking the Code : Measuring Unemployment ... 522 The Source of Numerical Objectives for Unemployment and Inflation ... 525 Changes in Aggregate Demand and Policy ... 526 Demand-Induced Recession ... 529 Looking Back : How History Has Affected U. S. and German Policy Goals ... 531 A Closer Look : Formation of Price Expectations ... 532 Changes in Aggregate Supply and Policy ... 533 A Closer Look : The Phillips Curve ... 534 Looking Forward : Will the Fed Have Less Power to Affect the Economy in the Future? ... 537 Summary of Major Points ... 537 Chapter 24 The Process of Monetary Policy Formulation ... 542 Setting the Stage ... 543 The Policy Process ... 543 Current Conditions versus Forecasts ... 544 Assessing the Economic Situation ... 545 From Assessment to Action ... 546 From Action to Effect ... 546 Pitfalls in Policy Making ... 547 Uncertainty and Lags ... 547 Globalization : A Financially and Economically Integrated World Economy ... 549 Intermediate Targets ... 550 A Closer Look : The Use of Intermediate Targets since 1970 ... 552 Federal Open Market Committee Decisions ... 556 A Closer Look : Targeting the Monetary Aggregates ... 557 A Closer Look : Supplier Delivery Time : An Indicator of Inflation? ... 558 Summary of Major Points ... 559 Chapter 25 Fed Watching and Policy Implementation ... 563 A Morning at the New York Fed ... 564 Interpreting the FOMC Directive ... 564 The Reserves Market and Open Market Operations ... 567 Trading Desk Market Techniques ... 569 A Closer Look : How the Demand and Supply of Reserves Are Calculated ... 570 Outright Transactions in the Market ... 572 Temporary Transactions ... 574 Signposts for Fed Watching and Sources of Information ... 575 Basic Rules of Fed Watching ... 575 The Lesson ... 578 Summary of Major Points ... 578 Chapter 26 Monetary Policy : Exchange Rates and Global Coordination ... 582 Monetary Policy and the Globalization of Trade and Finance ... 583 Monetary Policy under Fixed Exchange Rates from 1944 to 1973 ... 583 A Closer Look : The Growth of Trade and Removal of Barriers to Capital Flows ... 584 A Closer Look : How Unemployment and Inflation May Be Self-Correcting under Fixed Exchange Rates ... 586 Monetary Policy under Flexible Exchange Rates since 1974 ... 588 Looking Out : Capital Flows and the Mexican Peso Crisis ... 591 A Closer Look : Comparing Returns in a Globalized Economy ... 592 The Globalization of Monetary Policy ... 594 A Closer Look : Foreign Exchange Market Intervention ... 596 Summary of Major Points ... 597 Glossary ... 601 Index ... 613 Photo Credits ... 627