CONTENTS
Preface xix
PART l INTRODUCTlON
CHAPTER l MONEY, BANKlNG, AND FlNANClAL MARKETS:
AN OVERVlEW
INTRODUCTlON
MONEY AND BANKlNG: KEY CONCEPTS
Money / Banks / Interest Rates / The Pederal Budget Deficit
KEY FlNANClAL MARKETS
The Stock Market l l / The Bond Markel / The Foreign Exchange Market
CONCLUSlON
KEYTERMS
NOTE TO STUDENTS AND INSTRUCTOR
CHAPTER 2 MONEY: ITS NATURE, FUNCTlONS, AND EVOLUTlON
THE NATURE AND FUNCTlONS OF MONEY
The Meaning of Money / Distinctions among Money, Wealth
and Income / Functions of Money
THE EVOLUTlON OF MONEY AND THE PAYMENTS SYSTEM
Full-Bodied Money / Representative Full-Bodied Money / Fiat Money
or Credit Money / Checking Accounts / Electronic Money
MODERN MEASURES OF MONEY
The Narrow Definition of Money: Ml / Broader Measures of Money: M2,
M3 33 / Which Measure Is Most Useful? / Weighted Measures of Money
SUMMARY
KEY TERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
PART 2 FlNANClAL INSTlTUTlONS, MARKETS,
AND INTEREST RATES
CHAPTER 3 FlNANClAL MARKETS AND INSTRUMENTS
ATTRlBUTES OF FlNANClAL INSTRUMENTS
Liquidity / Risk / Yield / Liquidity, Risk, and Yield:
Their Relationship / Ranking Financial Claims by Their Liquidity
CLASSIFICATlON OF FlNANClAL MARKETS
Debt versus Equity Markets / Primary versus Secondary Markets
Organized versus Over-the-Counter Markets / Money versus Capital Markets
THE U.S. GOVERNMENT SECURlTlES MARKET
Kinds of U.S. Govemment Securities 52 / Nonmarketable Govemment Debt
INSTRUMENTS OF THE MONEY AND CAPlTAL MARKETS
Instruments of the Money Market / Instruments of the Capital Market
SUMMARY
KEYTERMS
STUDY QUESTlONS
SUGGESTTONS FOR ADDlTlONAL READlNG
CHAPTER 4 FlNANClAL INTERMEDlATlON
THE ECONOMlC BASlS FOR FlNANClAL INTERMEDlATlON
Risks and Costs without Intermediation / Benefits of Intennediation
CLASSlFlCATlON OF FlNANClAL INTERMEDlARlES
Depository Institutions / Contractual Savings Institutions / Investment-
Type Financial Intermediaries
THE CHANGlNG NATURE OF FlNANClAL INTERMEDlATlON
The Emergence of Retirement Funds and Mutual Funds / The Decline
of Commercial Banks and Thrifts / Benefits and Costs of Institutional Change
SUMMARY
KEYTERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
CHAPTER 5 THE BEHAVlOR OF INTEREST RATES
PRESENT VALUE, INTEREST RATES, AND SECURlTY PRlCES
The Concept of Present Value / Interest Rates and Secutity Prices
THE LOANABLE FUNDS MODEL
MAJOR DETERMlNANTS OF INTEREST RATES
Inflation Expectations / Federal Reserve Policy / The Business
Cycle / Federal Budget Deficits
MAJOR INTEREST RATE MOVEMENTS, l950-l996
SUMMARY
KEYTERMS
STUDY QUESTlONS
SUGGESTlONS POR ADDmONAL READlNG
CHAPTER 6 REAL INTEREST RATES
THE MEANlNG AND IMPORTANCE OF REAL INTEREST RATES
Why the Real Interest Rate Is Positive / Ex Ante and Ex Post Real
Interest Rates
THE ESTlMATlON OF REAL INTEREST RATES
Measuring Inflation Expectations / Computing the Real Interest Rate
THE HlSTORlCAL BEHAVlOR OF REAL INTEREST RATES
FACTORS THAT INFLUENCE REAL INTEREST RATES
Supply Shocks: Changes in Energy Prices / Changes in Federal Tax Policy
and the Regulatory Environment / Changes in Federal Budget Deficits /
Deregulation of the Financial System 130 / Federal Reserve Policy
ARE PlNANClAL MARKETS SUBJECT TO MONEY ILLUSlON?
SUMMARY
KEYTERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
CHAPTER 7 THE TERM STRUCTURE AND RlSK STRUCTURE
OF INTEREST RATES
THE TERM STRUCTURE OF INTEREST RATES
THEORlES OF TERM STRUCTURE
The Pure Expectations Theory / The Liquidity Premium Theory /
The Segmented Markets Theory / The Preferred Habitat Theory
TERM STRUCTURE THEORlES: HOW WELL DO THEY EXPLAlN
THE FACTS?
Fact l: The Upward-Sloping Yield Curve Predominates / Fact 2: The Yield
Curve Typically Shifts Rather Than Rotates / Fact 3: The Yield Curve Exhibits
a Regular Cyclical Pattem
THE RlSK STRUCTURE OF INTEREST RATES
SUMMARY
KEY TERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
CHAPTER 8 THE FORElGN EXCHANGE MARKET
FORElGN EXCHANGE MARKFTS AND RATES
The Foreign Exchange Market / The Foreign Exchange Kate /
Fixed and Floating Exchange Rates / Soot and Forward Exchange Markets /
The Importance of the Exchange Rate
EXCHANGE RATE DETERMlNATlON
LONG-RUN EXCHANGE RATF. DETERMlNANTS
Relative Price Level Behavior ' Other Long-Run Exchange Rate
Determinants / Long-Run Exchange Rate Determinants: Summary
SHORT-RUN EXCHANGE RATE DETERMlNANTS
Expected Retums from Investing at Home and Abroad / The Interest Parity
Condition l Equilibrium in the Foreign Exchange Market / Factors
Causing Short-Run Exchange Rate Changes / Examples of Forces Producing
Short-Run Exchange Rate Changes
CONSEQUENCES OF EXCHANGE RATE CHANGES
Price Level Effects / Income Distribution Effecti / Tenns-of-Trade
Effects
SUMMARY
KEY TERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
PART 3 BANKlNG: STRUCTURE, REGULATlON,
AND DEPOSlT INSURANCE
CHAPTER 9 COMMERClAL BANKlNG
THE COMMERClAL BANK BALANCE SHEET
COMMERClAL BANK LlABlLlTlES
Transactions Deposits / Nontransactions Deposits 198 / Nondeposit
Borrowing / Other Liabilities
COMMERClAL BANK ASSETS
Cash Assets / Loans / Securities / Other Assets
COMMERClAL BANK CAPlTAL ACCOUNTS
COMMERClAL BANK MANAGEMENT
Liquidity Management / Liability Management 214 / Capital Management
SUMMARY
KEY TERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
CHAPTER 10 THE BANKlNG INDUSTRY:
STRUCTURE AND REGULATlON
AN OVERVlEW OF MODERN U.S. BANKlNG
U.S. BANKlNG HlSTORY AND EVOLUTlON
The Bank of the United States / The Free Banking Era 226 / TheNational
BankingActofl863 / The Glass-Steagall Act / Recent Banking
Legislation
REGULATlON OF THE BANKlNG INDUSTRY
Regulatory Bodies / Regulatory Responsibilities / Regulatory Refonn
THE ECONOMlCS OF BRANCH BANKlNG
Restrictions on Branching / Responses to Restnctions on Branching
THE ECONOMlCS OF CONSOLlDATlON
Economies of Scale / Risk Management and Portfolio Diversification /
Executive Compensation / Monopoly Power / Conclusions
THE ECONOMlCS OF ACTlVlTY RESTRlCTlONS
Economies of Scope / Misallocation of Capital / Conflicts of interest
SUMMARY
KEY TERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
CHAPTER ll THE SAVlNGS AND LOAN DEBACLE, COMMERClAL BANK FAlLURES,
AND DEPOSlT INSURANCE
SAVlNGS AND LOAN FAlLURES
The Savings and Loan Disaster of the l 1980s / The Govemment's Response
to the Savings and Loans' Problems' / Legislative Refomi / Summary:
The Role of Moral Hazard and Adverse Selectior
COMMERClAL BANK FAlLURES
The Escalation of Bank Failures in the 1980s / Regulating Bank Capital Ratios
FEDERAL DEPOSlT INSURANCE
Recent Legislative Reform / The Effectiveness of Reform Measures /
Other Proposed Reforms of Deposit Insurance
SUMMARY
KEY TERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
PART 4 THE FEDERAL RESERVE SYSTEM
AND THE MONEY SUPPLY PROCESS
CHAPTER 12 THE FEDERAL RESERVE SYSTEM:
ITS STRUCTURE AND FUNCTlONS
THE ORlGlNS OF THE FEDERAL RESERVE SYSTEM
THE FlNANClAL STATUS OF THE FEDERAL RESERVE SYSTEM
The Balance Sheet of the Federal Reserve System ' / Federal Reserve Eamings
and Expenses
THE STRUCTURE OF THE FEDERAL RESERVE SYSTEM
The Board of Govemors / The Federal Open Market Committee
(FOMC) / The 12 Federal Reserve Banks: / Member Banks: /
The Allocation of Power within the Federal Reserve System
THE QUESTlON OF FEDERAL RESERVE INDEPENDENCE
The Case for Federal Reserve Independence : / The Case against Federal Reserve
Independence
SUMMARY
KEYTERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
CHAPTER 13 THE DEPOSlT EXPANSlON PROCESS: A SlMPLE ANALYSlS
BANKS AND THE CREATlON OF BANK DEPOSlTS
Multiple Expansion of Bank Deposits 311 / Multiple Contraction of Bank Deposits
HOW THE FEDERAl RFSERVE GETS A GRlP ON THE MONEY SUPPLY
SUMMARY
KEYTERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
CHAPTER 14 MONEY SUPPLY DETERMlNATlON: THE MONETARY BASE
THE BASE AND MULTlPLlER FRAMEWORK
REASONS FOR STUDYlNG THE MONETARY BASE
THE MONETARY BASE: FUNDAMENTAL CONCEPTS
Derivation of the Monetary Base / Sources of the Monetary Base / Uses
for the Monetary Base
TEN FACTORS THAT CAN PRODUCE CHANGES
IN THE MONETARY BASE
The Federal Reserve's Securities Portfolio / Federal Reserve Discounts
and Advances / Federal Reserve Float / The U.S. Gold Stock
and the Federal Reserve's Special Drawing Rights Account / Other Federal
Reserve Assets / Treasury Currency Outstanding / Treasury Deposits
at the Federal Reserve / Foreign and Other Deposits at the Federal
Reserve / Treasury Cash Holdings / Other Liabilities and Capital
FEDERAL RESERVE OPERATlONS AND THE MONETARY BASE
SUMMARY
KEYTERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
CHAPTER 15 MONEY SUPPLY DETERMlNATlON:
THE MONEY SUPPLY MULTlPUER
THE MONEY SUPPLY MULTlPLlER: DERTVAl lUN
ANDAPPLlCATlONS
Comparison with the Simple or Naive Deposit Expansion Multiplier /
The Role of the Federal Reserve 'n Influencing the Money Supply Multiplier /
Some Arithmetic Examples
THE IMPACT OF CHANGES IN k, rr, AND re ON THE MULTlPLlER
The Impact of a Change in k / The Impact of a Change in rr. / The Impact
of a Change in re / Historical Behavior of the Money Supply Multiplier.
THE VARlABLES UNDERLYlNG THE MONEY SUPPLY MULTlPLlER
(k, rr AND re)
Determinants of the Currency Ratio (k) l The Importance of k in the Money
Supply Multiplier / Determinants of the Required Reserve Ratio (rr.) /
Determinants of the Desired Excess Reserve Ratio (re): / The Federal Reserve's
Control of the Money Supply: The Debate
SUMMARY
KEY TERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
CHAPTER 16 THE ROLE OF THE FEDERAL RESERVE IN THE GREAT DEPRESSlON
OF THE 1930s
THE DEBATE ON THE CAUSES OF THE DEPRESSlON
BANK FAlLURES AND MONETARY PHENOMENA: THE FACTS
Bank Failures and the Run on Banks / Causes of the Contraction
of the Money Supply
INTERPRETlNG THE FACTS: KEYNESlANS VERSUS MONETARlSTS
The Keynesian View: You Can't Push on a String / The Monetarist View:
The Fed Didn't Push
SUMMARY
KEY TERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
PART 5 TOOLS AND TARGETS OF FEDERAL RESERVE POLlCY
CHAPlER 17 OPEN MARKET OPERATlONS: THE PRlMARY TOOL
OF FEDERAL RESERVE POLlCY
OPEN MARKET OPERATlONS: FUNDAMENTAL CONSlDERATlONS
The Banking Act of 1935 / The Domain of the Federal Reserve's Open Market
Activity / The Federal Reserve's Operations in the Foreign Exchange Market
THE EFFECTlVENESS OF OPEN MARKET OPERATlONS
The Impact of Open Market Operations / Advantages of Open Market
Operations / Disadvantages of Open Market Operations
TECHNlCAL ASPECTS OF OPEN MARKET OPERATlONS
Defensive Operations versus Dynamic Operations / Outright Transactions versus
Repurchase Agreements
POLlCY DlRECTlVES
Production of a Policy Directive / Implementation of the Directive 405
SUMMARY
KEYTERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
CHAPTER 18 TOOLS OF FEDERAL RESERVE POLlCY: DlSCOUNT WlNDOW POUCY
AND RESERVE REQUlREMENT POUCY
THE DlSCOUNT WlNDOW: POLlCY AND PROCEDURES
Criteria for Bank Borrowing at the Federal Reserve / Adjustment
to Reserve Deficiencies / Factors That Inhibit Bank Borrowing at the Fed
ECONOMlC EFFECTS OF A CHANGE IN THE DlSCOUNT RATE
Impact on Reserves, the Monetary Base, and the Money Supply - / Impact
on Yields, Loan Rates, and Security Prices / The Announcement Effect
CRlTlClSMS AND PROPOSED REFORMS OF DlSCOUNT WlNDOW POLICY
Alleged Shortcomings of Discount Window Policy / Proposed Reforms
of Discount Window Policy
THE RESERVE REQUlREMENT INSTRUMENT
Institutional Aspects of Reserve Requirements / Banks' Management
of the Reserve Position
ECONOMlC EFFECTS OF CHANGES IN THE RESERVE REQUlREMENT
Influence on the Money Supply 432 / Advantages of the Reserve Requirement
Tool / Disadvantages of the Reserve Requirement Tool 436
SUMMARY
KEY TERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
CHAPTER 19 CONDUCTlNG MONETARY POLlCY: ULTlMATE GOALS AND
INTERMEDlATE TARGETS 440
THE ULTlMATE GOAl S OF MONETARY POLlCY
Price Level Stability / Full Employment / Stable Exchange Rate
Long-Term Economic Growth
INTERMEDlATE MONETARY POLlCY TARGETS
Criteria for an Effective Intermediate Target / Net Free Reserves: A Flawed
Intermediate Target
LlNKS AMONG POLlCY, TARGETS, AND GOALS
Short-Range Variables / Intermediate-Range Variables / Monetarists
versus Keynesians on Appropriate Targets / Money Supply Targets versus
Interest Rate Targets
EFFECTS OF FEDERAL RESERVE TARGETlNG PROCEDURES
Pegging Treasury Bond Yields, l942-l95l / Has the Federal Reserve Been
a Destabilizing Influence?
SUMMARY
KEYTERMS
STUDY QUESTlONS SUGGESTTONS FOR ADDmONAL READlNG
PART 6 THE UNKAGE BETWEEN INTERMEDlATE TARGETS
AND ECONOMlC ACTlVlTY
CHAPTER 20 THE AGGREGATE DEMAND-AGGREGATE SUPPLY MODEL
THE AGGREGATE DEMAND-AGGREGATE SUPPLY FRAMEWORK
The Aggregate Demand Curve / The Aggregate Supply Curve
Equilibrium Output and the Equilibrium Price Level / Factors That Shift
the Aggregate Demand Curve / Factors That Shift the Aggregate
Supply Curve
APPLlCATlONS OF THE AGGREGATE DEMAND-AGGREGATE SUPPLY
FRAMEWORK
Equilibrium Output versus the Full Employment Output Level / Stabilization
Policies 475 / The Dilemma Posed by Adverse Aggregate Supply Shocks
THE AGGREGATE DEMAND-AGGREGATE SUPPLY MODEL AND MODERN
U.S. MACROECONOMlC HlSTORY
The Great Depression of the 1930s. / World War ll and Postwar Inflation /
The Post-1960 Era.
SUMMARY
KEYTERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDITlONAL READlNG
CHAPTER 21 THE DEMAND FOR MONEY AND VELOClTY OF MONEY
THE VELOClTY OF MONEY
The Income Velocity of Money / Velocity and the Demand for Money
THE DEMAND FOR MONEY
Motives for Holding Money / The Role of interest Rates in the Demand
for Money / The Role of interest Rates in the Demand for Money:
Conclusion
SUMMARY
KEY TERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
CHAPlER 22 THE BEHAVlOR OF VELOClTY OF MONEY
IN THE UNlTED STATES
DETERMlNANTS OF VELOClTY
institutional Factors / Financial Technology /Interest Rates /
Economic Uncertainty / Expected Inflation / Income.
LONG-RUN BEHAVlOR OF MONEY VELOClTY
Friedman's Luxury Good Explanation / Tobin's Institutional Explanation
SHORT-RUN BEHAVlOR OF MONEY VELOClTY
Induced Changes in Velocity and the Effectiveness of Monetary Policy
The "Ratchet Effect" of Financial Innovations / The Cyclical Behavior
of Velocity
RECENT HlSTORlCAL BEHAVlOR OF MONEY VELOClTY
VELOClTY BEHAVlOR AND MONETARY POLlCY
SUMMARY
KEY TERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
CHAPTER 23 THE IS-LM MODEL OF THE MACROECONOMY
THE IS-LM MODEL: FUNDAMENTAL ELEMENTS
Equilibrium in the Money Market: The LM Curve / Factors That Cause a Shift
in the LM Curve / Equilibrium in the Product Market: The IS Curve /
Factors That Shift the IS Curve / General Equilibrium and the Adjustment
to Disequilibrium
APPLlCATlONS OF THE IS-LM MODEL
Disturbances Originating in the Monetary Sector / Initiation of Overdraft
Protection / Disturbances Originating in the Real Sector
SUMMARY
KEY TERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
CHAPlER 24 THE IS-LM MODEL:MPLlCATlONS FOR MONETARY
AND FlSCAL POLlCY
DETERMlNlNG THE SOURCES OF ECONOMlC DlSTURBANCES
Fiscal and Other Real-Sector Disturbances 560 / Pure Monetary
Disturbances Combined Fiscal and Monetary Disturbances
FlNANClNG AN INCREASE IN GOVERNMENT EXPENDlTURES
Tax Increase / Sale of Govemment Securities to the Public 565 / Sale
of Govemment Securities to the Federal Reserve
KEYNESlAN VERSUS MONETARlST VlEWS IN THE IS-LM MODEL
The Interest Sensitivity of Velocity Expressed in the IS-LM Model ' Position
Slope, and Stability of the Curves / Recommended Policy Measures
SELECTlON OF INTERMEDlATE MONETARY POLlCY TARGETS
The Case of LM Uncertainty / The Case of iS Uncertainty / Uncertainty
in Both the iS and LM Curves
MONETARlST VERSUS KEYNESlAN POLlCY VlEWS: SUMMARY
SUMMARY
KEYTERM
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
CHAPlER 25 THE TRANSMlSSlON OF MONETARY POUCY
EARLY VlEWS OF THE TRANSMlSSlON MECHANlSM
Early Keynesian Views / Early Monetarist Views
STOCK AND BOND PRlCES
CONSUMPTlON, INVESTMENT, AND NET EXPORTS
Consumer Expenditures / Monetary Policy and Investment Spending /
Net Exports (X - M)
THE MONEY VlEW VERSUS THE CREDIT VlEW
The Money View
The Lending, or Credit, View
SUMMARY
KEYTERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDlTlONAL READlNG
CHAPTER 26 MONETARlSM AND THE NEW CLASSlCAL MACROECONOMlCS:
SKEPTICAL VlEWS OF DlSCRETlONARY MONETARY POLlCY
THE SELF-CORRECTlNG MECHANlSM AND THE AGGREGATE
DEMAND-AGGREGATE SUPPlY MODEL
The Self-Correcting Mechanism / The Viability of the Self-Correcting
Mechanism
THE ARGUMENT FOR ABANDONlNG DlSCRETlONARY
MONETARY POLlCY
The Federal Reserve as a Destabilizing Influence / The Federal Reserve's
Tendency to Change Objectives / Lags of Monetary Policy
THE DEBATE OVER THE FlXED MONEY GROWTH RULE
Arguments for a Fixed Money Growth Rule / Arguments against a Fixed
Money Growth Rule
THE CHALLENGE OF RATIONAL EXPECTATlONS MACROECONOMlCS
Assumptions of Rational Expectations Macroeconomics / Policy Implications
of Rational Expectations Macroeconomics / Implications for the Phillips Curvt
THE ACTlVlST CRlTlQUE OF RATlONAL EXPECTATlONS
MACROECONOMlCS
SUMMARY
KEY TERMS
STUDY QUESTlONS
SUGGESTTONS FOR ADDlTlONAL READlNG
PART 7 THE INTERNATlONAL FlNANClAL SYSTEM
CHAPTER 27 THE INTERNATlONAL MONETARY SYSTEM
THE BRETTON WOODS EXCHANGE RATE SYSTFM
Establishment of the Intemational Monetary Fund / The Bretton Woods (Fixed-
Exchange-Rate) System / How the Bretton Woods System Operated /
INTERNATlONAL MONETARY ARRANGEMENTS SlNCE 1973
The U.S. Dollar since 1973 l The European Monetary System
SUMMARY
KEYTERMS
STUDY QUESTlONS
SUGGESTlONS FOR ADDmONAL READlNG
Glossary
Index
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