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MONEY, BANKING andFINANCIAL MARKETSLloyd B. ThomasKansas State University

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Money, Banking, and Financial Markets

Lloyd B. Thomas

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To Sally

Lloyd B. Thomas, Jr., is Professor and Head of theDepartment of Economics at Kansas State University.He received a B.A. and M.A. in economics from theUniversity of Missouri and a Ph.D. in economicsfrom Northwestern University. Professor Thomashas published in numerous economics journals, pri-marily in the areas of macroeconomic policy, mone-tary economics, and international finance. Most re-cently, his research has focused on the accuracy andrationality of survey measures of inflation expecta-tions and other forecasts of inflation. He is the au-thor or coauthor of five previous textbooks, severalof which have been published in multiple editions.

Recognized as an excellent teacher, ProfessorThomas has won numerous teaching awards. His teaching interests lie chiefly inthe areas of money and banking, monetary theory and policy, and principles of eco-nomics. Professor Thomas has gained teaching experience at numerous universi-ties, including Northwestern University, the University of California at Berkeley,Florida State University, the University of Delaware, the University of Idaho,Indiana University at Bloomington, and Adelaide University in Australia. For fun,he enjoys running and playing tennis.

ABOUT THE AUTHORABOUT THE AUTHOR

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PART 1 INTRODUCTION 1Chapter 1 Money, Banking, and Financial Markets: an Overview 2Chapter 2 Money: Its Nature, Functions, and Evolution 18

PART 2 FINANCIAL MARKETS, INSTITUTIONS, AND INTERESTRATES 41

Chapter 3 Financial Markets and Instruments 42Chapter 4 Financial Intermediation 69Chapter 5 Interest Rate Determination 95Chapter 6 The Term Structure and Risk Structure of Interest Rates 123Chapter 7 The Stock Market 147Chapter 8 The Foreign Exchange Market 176

PART 3 BANKING: STRUCTURE, REGULATION, AND DEPOSITINSURANCE 203

Chapter 9 Commercial Banking 204Chapter 10 The Banking Industry: Its Evolution, Structure, and Regulation 230Chapter 11 The Economics of Banking Regulation and Deposit Insurance 256

PART 4 CENTRAL BANKING, THE FEDERAL RESERVE, AND THEMONEY SUPPLY PROCESS 285

Chapter 12 The Federal Reserve System: Its Structure and Functions 286Chapter 13 The European Central Bank 311Chapter 14 The Deposit Expansion Process: The Simple Analytics 326Chapter 15 Money Supply Determination: The Monetary Base 337Chapter 16 Money Supply Determination: The Money Supply Multiplier 357Chapter 17 The Role of the Federal Reserve in The Great Depression Of 1929–1933 378

PART 5 INSTRUMENTS, TARGETS, AND STRATEGIES OF CENTRALBANKING POLICY 397

Chapter 18 The Tools of Federal Reserve Policy 398Chapter 19 Conducting Monetary Policy: Ultimate Goals and Intermediate Targets 423

PART 6 THE LINKAGE BETWEEN INTERMEDIATE TARGETVARIABLES AND ECONOMIC ACTIVITY 451

Chapter 20 The Aggregate Demand-aggregate Supply Model 452Chapter 21 The Ad/As Model and Post-1929 U.S. Macroeconomic History 477Chapter 22 Money Demand and Velocity 497Chapter 23 The Monetary Transmission Mechanism: How Federal Reserve Policy

Influences Economic Activity 527Chapter 24 Differing Views on the Appropriate Conduct of Monetary Policy 552Chapter 25 Inflation Targeting 578

BRIEF CONTENTSBRIEF CONTENTS

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PART 1 INTRODUCTION 1Chapter 1 MONEY, BANKING, AND FINANCIAL MARKETS: AN OVERVIEW 2

Introduction 2Money and Banking: Key Elements 3

Money 4 I Banks and Other Financial Intermediaries 6 I Interest Rates 7 I FederalBudget Deficits 10

Key Financial Markets 12The Stock Market 12 I The Bond Market 13 I The Foreign Exchange Market 14

Summary 16Key Terms 16Note to Students and Instructors 16

Chapter 2 MONEY: ITS NATURE, FUNCTIONS, AND EVOLUTION 18The Nature and Functions of Money 18

Meaning of Money 19 I Distinctions Among Money, Wealth, and Income 19 IFunctions of Money 20

The Evolution of Money and the Payments System 26Full-Bodied or Commodity Money 27 I Representative Full-Bodied Money 27 I Fiator Credit Money 28 I Checking Accounts 29 I Electronic Money 29

Measures of the Money Supply 32The Narrow Definition of Money (M1) 33 I Broader Measures of Money: M2, M3 35 I Which Measure Is Most Useful? 36 I Weighted Measures of Money 37

Summary 38Key Terms 39Study Questions 39Suggestions for Additional Reading 40

PART 2 FINANCIAL MARKETS, INSTITUTIONS, AND INTERESTRATES 41

Chapter 3 FINANCIAL MARKETS AND INSTRUMENTS 42Financial Markets and the Flow of Funds 42Attributes of Financial Instruments 45

Liquidity 46 I Risk 46 I Yield 46 I Liquidity, Risk, and Yield: Their Relationship 47

Classification of Financial Markets 47Debt Versus Equity Markets 47 I Primary Versus Secondary Markets 47 I OrganizedExchanges Versus Over-the-Counter Markets 48 I Cash Versus Derivative Markets 49 I Money Versus Capital Markets 50

Instruments of the Money and Capital Markets 51Instruments of the Money Market 51 I Instruments of the Capital Market 54

CONTENTSCONTENTS

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The U.S. Government Securities Market 56Kinds of U.S. Government Securities 57 I Non-Marketable Government Debt 64


Chapter 4 FINANCIAL INTERMEDIATION 69The Economic Basis for Financial Intermediation 69

Risks and Costs in the Absence of Intermediation 69 I Benefits of Intermediation 71

Classification and Growth of Financial Intermediaries 72Depository Institutions 72 I Contractual Savings Institutions 77 I Investment-TypeFinancial Intermediaries 81

Government Regulation of the Financial System 85Increasing the Availability and Accuracy of Information 85 I Ensuring the Stability ofthe Financial Intermediaries 85 I Improving Monetary Control 86

The Changing Nature of Financial Intermediation 88The Emergence of Retirement Funds and Mutual Funds 88 I The Declining Role ofCommercial Banks and Thrift Institutions 89 I Benefits and Costs of InstitutionalChange 92


Chapter 5 INTEREST RATE DETERMINATION 95Present Value: Interest Rates and Security Prices 97

The Concept of Present Value 97 I Interest Rates and Security Prices 99

The Loanable Funds Model of Interest Rates 99The Market for Loanable Funds 100 I Factors Shifting Supply and Demand forLoanable Funds 103

Fundamental Determinants of Interest Rates 103Inflation Expectations 103 I Federal Reserve Policy 109 I The Business Cycle 109 IFederal Budget Deficits (or Surpluses) 110

Major Interest Rate Movements, 1960–2004 113Real Interest Rates: Ex Ante Versus Ex Post 114

Ex Ante and Ex Post Real Rates in the United States 115 I Two Measures of Ex AnteReal Interest Rates 117 I The Historical Behavior of Expected Real Interest Rates 117


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Chapter 6 THE TERM STRUCTURE AND RISK STRUCTURE OF INTEREST RATES 123The Term Structure of Interest Rates 123Theories of Term Structure 126

Pure Expectations Theory 126 I Liquidity Premium Theory 129 I Segmented MarketsTheory 131 I Preferred Habitat Theory 132

Term Structure Theories: How Well Do They Explain the Facts? 135Fact 1: Upward-Sloping Yield Curve Predominates 136 I Fact 2: Yields of VariousMaturities Typically Move in the Same Direction 137 I Fact 3: Yield Curve Exhibits aRegular Cyclical Pattern 137

The Risk Structure of Interest Rates 139Summary 143Key Terms 144Study Questions 144Suggestions for Additional Reading 146

Chapter 7 THE STOCK MARKET 147Introduction 147

Long-Term Stock Market Behavior 147 I Stock Prices as a Barometer of EconomicSentiment 148

The Connection Between Stock Prices and Economic Activity 149Stock Prices and Consumption Spending 149 I Stock Prices and Investment Spending 150 I Virtuous and Vicious Cycles 150

Measuring Stock Market Performance 152Characteristics of a Good Stock Market Index 152 I U.S. Stock Market Indexes 152 IHistorical Performance of Various Stock Market Indexes 155 I Importance ofDividend Reinvestment 156

The Stock Market: Risk and Returns 157

What Determines the Price of a Share of Stock? 159Why We Discount the Expected Future Payments from Stocks 160 I Impact of VariousEvents on Stock Prices 162

Assessing the Appropriate Level of Stock Prices 164Indicators of Stock Market Valuations 166

Should the Federal Reserve React to Perceived Bubbles in Asset Markets? 169

Arguments for Federal Reserve Intervention Against Bubbles 169 I Arguments for theFederal Reserve’s Laissez-Faire Approach 170 I The Tendency for Mean Reversion inReturns from Stocks 171


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Chapter 8 THE FOREIGN EXCHANGE MARKET 176Foreign Exchange Markets and Rates 176

The Foreign Exchange Market 176 I The Foreign Exchange Rate 177Fixed and Floating Exchange Rates 178 I Spot and Forward Exchange Markets 180 IThe Importance of the Exchange Rate 182

Exchange Rate Determination 183Long-Run Exchange Rate Determination 184

Relative Price Level Behavior 185 I Other Long-Run Exchange Rate Determinants 188 I Long-Run Exchange Rate Determinants: Summary 189

Short-Run Exchange Rate Determinants 189Expected Returns from Investing at Home and Abroad 190 I The Interest ParityCondition 191 I Equilibrium in the Foreign Exchange Market 192 I Factors CausingShort-Run Exchange Rate Changes 193 I Examples of Forces Producing Short-RunExchange Rate Changes 194

Consequences of Exchange Rate Changes 196Price Level Effects 197 I Income Distribution Effects 197 I Terms of Trade Effects 197


PART 3 BANKING: STRUCTURE, REGULATION, AND DEPOSITINSURANCE 203

Chapter 9 COMMERCIAL BANKING 204The Commercial Bank Balance Sheet 204Commercial Bank Liabilities 205

Transactions Deposits 207 I Non-Transactions Deposits 208 I Non-DepositBorrowing 209 I Other Bank Liabilities 209 I Changing Sources of Bank Funds 209

Commercial Bank Assets 210Cash Assets 210 I Loans 211 I Securities 213 I Other Assets 215

Commercial Bank Capital Accounts 215Commercial Bank Management 216

Liquidity Management 216 I Liability Management 222 I Capital Management 224


Chapter 10 THE BANKING INDUSTRY: ITS EVOLUTION, STRUCTURE, ANDREGULATION 230Early History and Evolution of U.S. Banking 230

The Bank of the United States 231 I The Free Banking Era 232 I The NationalBanking Act of 1863 232

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The Regulation of the U.S. Banking System 233Aspects of Bank Chartering and Regulation 233

The Structure of Contemporary American Banking 237Geographic Restrictions on Bank Activity 238 I Banks’ Response to GeographicRestrictions 239 I The Removal of Restrictions 241 I Banking Industry Consolidationand the Forces Driving It 242 I The Size Distribution of U.S. Commercial Banks 245

The Scope of Modern Banking 246The Glass-Steagall Act 246 I The Response to Glass-Steagall 247 I The Removal ofGlass-Steagall Restrictions 248

The Future Shape of Banking 251Summary 253Key Terms 253Study Questions 254Suggestions for Additional Reading 255

Chapter 11 THE ECONOMICS OF BANKING REGULATION AND DEPOSITINSURANCE 256Limiting the Consequences of Asymmetric Information 258

The Government Safety Net for Bank Depositors: FDIC Insurance and Other Measures 258 I Challenges Created by the Government Safety Net 259

Regulatory Measures Intended to Limit Bank Risk Taking 260Restricting Types of Eligible Bank Assets, Requiring Diversification, and MandatingBank Capital Requirements 260 I Banking Supervision and Examination andDisclosure Requirements 261 I Granting of Bank Charters and Restrictions onCompetition in Banking 261

Events Leading Up to the S&L Disaster of the 1980s 262Origins and Operations of the Savings and Loan Industry 262 I The Escalation ofInflation and Interest Rates in the 1970s 263 I The Squeeze on S&Ls’ Profits: Cyclicaland Structural Causes 264

Government Response to the S&L Problems of the Early 1980s 265Deregulation 265 I Forbearance, Deposit Insurance, and Risk-Taking 266 IInadequate Funding for S&L Supervisors and the FSLIC 268

The Financial Institutions Reform, Recovery, and Enforcement Act of1989 (FIRREA) 268Summary: The Role of Moral Hazard and Adverse Selection in the S&LFiasco 269The Escalation of Commercial Bank Failures in the 1980s 271

The Adverse Effect of Financial Innovations and Regulatory Actions 272 I EconomicInstability and Commercial Bank Financial Condition 272

Federal Deposit Insurance 275The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) 277 IEvaluation of FDICIA 278 I Other Proposed Reforms of Deposit Insurance 280


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PART 4 CENTRAL BANKING, THE FEDERAL RESERVE, AND THEMONEY SUPPLY PROCESS 285

Chapter 12 THE FEDERAL RESERVE SYSTEM: ITS STRUCTURE AND FUNCTIONS 286The Origin of the Federal Reserve System 286The Balance Sheet and Income Statement of the Federal Reserve System 288

The Balance Sheet of the Federal Reserve System 288 I Federal Reserve Earnings andExpenses 292

The Structure of the Federal Reserve System 293Board of Governors 293 I Federal Open Market Committee (FOMC) 296 I The 12Federal Reserve Banks 296 I The Member Banks 299 I Allocation of Power within theFederal Reserve System 299

The Question of Federal Reserve Independence 302The Case for Federal Reserve Independence 304 I The Case Against Federal ReserveIndependence 304


Chapter 13 THE EUROPEAN CENTRAL BANK 311The Movement Toward Economic Unification of Europe 311

The Road to Monetary Union and Establishment of the European Central Bank 311 IThe Treaty on Monetary Union (the Maastricht Treaty) 312

The European Central Bank 316The Structure of the European Central Bank 316 I “Ownership” of the EuropeanCentral Bank and Disposition of Its Profits 317 I The Issue of Political Independence 318 I Central Bank Accountability 319 I Central Bank Transparency 321


Chapter 14 THE DEPOSIT EXPANSION PROCESS: THE SIMPLE ANALYTICS 326Banks and the Creation of Bank Deposits 326

Multiple Expansion of Bank Deposits 328 I Multiple Contraction of Deposits 332

How the Federal Reserve Gets a Grip on the Money Supply 333Summary 335Key Terms 335Study Questions 336Suggestions for Additional Reading 336

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Chapter 15 MONEY SUPPLY DETERMINATION: THE MONETARY BASE 337The Monetary Base–Money Multiplier Framework 337The Monetary Base: Fundamental Concepts 338

Derivation of the Monetary Base 340 I Sources of the Monetary Base 340 I Uses forthe Monetary Base 342

Analysis of the 10 Factors that Produce Changes in the Base 344The Federal Reserve Securities Portfolio (P) 344 I Federal Reserve Discount Loans—Loans to Banks (A) 345 I Federal Reserve Float (FL) 346 I The Fed’s GoldCertificates and Special Drawings Rights Accounts (G) 347 I Other Federal ReserveAssets (OA) 348 I Treasury Currency Outstanding (Tcu) 349 I Treasury Deposits atthe Federal Reserve (Ft) 351 I Other Factors Absorbing Base Money (Ff, TCa, andOLC) 353

Federal Reserve Operations and the Monetary Base 354Summary 354Key Terms 355Study Questions 355Suggestions for Additional Reading 356

Chapter 16 MONEY SUPPLY DETERMINATION: THE MONEY SUPPLY MULTIPLIER 357The Money Supply Multiplier: Derivation and Applications 359

Comparison of Money Supply Multiplier with the Simple, Naive Deposit ExpansionMultiplier 361 I Role of the Federal Reserve in Influencing the Money SupplyMultiplier 361 I Arithmetic Examples 364

Impact of Changes in k, rr, and re on the Money Supply Multiplier 364Impact of a Change in k 365 I Impact of a Change in rr 365 I Impact of a Change in re 366 I Historical Behavior of the Money Supplier Multiplier 366

Analysis of the Variables Underlying the Money Supply Multiplier (k, rr,and re) 367

The Currency Ratio (k) 367 I Specific Determinants of the Currency Ratio (k) 369 IImportance of k in Money Supply Multiplier 371 I Determinants of the RequiredReserve Ratio (rr) 371 I The Desired Excess Reserve Ratio (re) 372


Chapter 17 THE ROLE OF THE FEDERAL RESERVE IN THE GREAT DEPRESSION OF 1929–1933 378The Debate Over the Causes of the Depression 379Bank Failures and Monetary Phenomena: The Facts 381

Bank Failures and the Run on Banks 381 I Causes of the Contraction of the MoneySupply 383

Interpreting the Facts: Keynesians Versus Monetarists 385The Keynesian View: You Can’t Push On a String 385 I The Monetarist View: The FedDidn’t Push 387

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PART 5 INSTRUMENTS, TARGETS, AND STRATEGIES OF CENTRALBANKING POLICY 397

Chapter 18 THE TOOLS OF FEDERAL RESERVE POLICY 398Open Market Operations: Fundamental Considerations 398

Discovery of Open Market Operations and The Banking Act of 1935 399 I Domain ofthe Fed’s Open Market Activity 400

The Effectiveness of Open Market Operations 401Impacts of Open Market Operations 401 I Advantages of Open Market Operations 402 I Early Disadvantages of Open Market Operations 403 I OpenMarket Operations and the Federal Funds Rate 404

Technical Aspects of Open Market Operations 406Defensive Operations Versus Dynamic Operations 406 I Outright Transactions VersusRepurchase Agreements 406

The Policy Directive 408Arriving at the Policy Directive 409 I Implementation of the Policy Directive 409

Discount Window Policy 410The 2003 Federal Reserve Change in Discount Window Policy 411

The Reserve Requirement Instrument 412Institutional Aspects of Reserve Requirements 415 I Institutional Aspects of BankReserve Management 416

The Economic Effects of Changes in the Reserve Requirement 417Influence on the Money Supply and Interest Rates 417 I Advantages of the ReserveRequirement Tool 418 I Disadvantages of the Reserve Requirement Tool 419


Chapter 19 CONDUCTING MONETARY POLICY: ULTIMATE GOALS ANDINTERMEDIATE TARGETS 423The Ultimate Goals of Monetary Policy 423

Price Level Stability 423 I High Employment 426 I Long-Term Economic Growth 428 I Stable International Exchange Rate 428 I Stability of Financial Markets and Interest Rates 429

Intermediate Monetary Policy Targets 429Criteria for an Effective Intermediate Target 430 I An Example of a Flawed TargetVariable: Net Free Reserves 431

Links Between Policy, Targets, and Goals 432Operating Target Variables 432 I Intermediate Target Variables 435 I Money SupplyTargets Versus Interest Rate Targets 437 I Monetarists Versus Non-Monetarists onAppropriate Target Variables 439

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Effects of Federal Reserve Policies: A Historical Review 439Pegging Treasury Bond Yields, 1942–1951 440 I The 1950s and 1960s: Targeting“Money Market Conditions” and Net Free Reserves 441 I The 1970s: The Emergence of Monetary Aggregate Targeting 442 I 1979–1982: De-emphasis of Interest Rate Targeting 443 I October 1982 to the Early 1990s: De-Emphasis ofMoney Supply Targets 445 I Early 1990s–2004: The Return to Fed Funds RateTargeting 446


PART 6 THE LINKAGE BETWEEN INTERMEDIATE TARGETVARIABLES AND ECONOMIC ACTIVITY 451

Chapter 20 THE AGGREGATE DEMAND-AGGREGATE SUPPLY MODEL 452The Aggregate Demand–Aggregate Supply Framework 452

The Aggregate Demand Curve 453 I The Aggregate Supply Curve 454 I EquilibriumOutput and the Equilibrium Price Level in the Short Run 454 I Factors that Shift the Aggregate Demand Curve 455 I Factors that Shift the Aggregate Supply Curve 458

Short-Run Versus Long-Run Equilibrium in the AD/AS Model 459Challenges Facing Monetary Policymakers 462

Uncertainties about the Positions, Slopes, and Dynamics of the AD and AS Curves 462 I Uncertainties about the NAIRU Level and Forces that Cause NAIRU toChange 463

The Phillips Curve, the NAIRU, and Macroeconomic Policy 465Monetary Policy: Responding to Shocks to the AD and AS Curves 469

Monetary Policy and Aggregate Demand Shocks 469 I The Dilemma Posed forMonetary Policy by Adverse Supply Shocks 470


Chapter 21 THE AD/AS MODEL AND POST-1929 U.S. MACROECONOMICHISTORY 477Macroeconomic Developments, 1929–1950 477

The Great Depression of the 1930s 477 I World War II and Its Immediate Aftermath 478

Macroeconomic Developments after 1950 479Output and Inflation in the Post-1960 Era 479 I The Early 1960s 480 I The VietnamEra: 1965–1972 481 I The Economic Nightmare of 1973-1982 481 I 1983–1991: TheReagan Expansion and the Era of Supply-Side Economics 484 I 1993–2001: TheClinton Years, the Economic Boom, and “New Economy” Debate 485 I The 2001Recession 489 I The Jobless Recovery of 2002–2003 492

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Chapter 22 MONEY DEMAND AND VELOCITY 497The Equation of Exchange and the Velocity of Money 499

Velocity of Money and the Demand for Money 501

The Demand for Money 503Motives for Holding Money 503 I Demand for Money: Role of Interest Rates 507

Determinants of the Velocity of Money 511Institutional Factors 511 I Financial Technology 511 I Interest Rates 512 IEconomic Uncertainty 512 I Expected Inflation 512 I Income 513

The Long-Run Behavior of Velocity 513The Friedman Luxury-Good Explanation 514 I The Tobin Institutional Explanation 515

The Short-Run Behavior of Velocity 516Induced Changes in Velocity and the Effectiveness of Money Policy 518 I The “RatchetEffect” of Financial Innovation 518 I The Cyclical Behavior of Velocity 519

Velocity Behavior and Monetary Policy 521Summary 524Key Terms 525Study Questions 525Suggestions for Additional Reading 526

Chapter 23 THE MONETARY TRANSMISSION MECHANISM: HOW FEDERALRESERVE POLICY INFLUENCES ECONOMIC ACTIVITY 527Early Views of the Transmission Mechanism 528

Early Keynesian Views 529 I Early Monetarist Views 530

Modern Views on the Transmission Mechanism 530Monetary Policy and Stock and Bond Prices 531 I The Components of GDPExpenditures 532 I Monetary Policy and Consumption Spending 532 I MonetaryPolicy and Investment Spending 536 I Monetary Policy and Net Exports (X-M) 540

The Money View Versus the Credit View 542The Money View 542 I The Lending or Credit View 543

Can Monetary Stimulus be Effective When Interest Rates Are Zero? 546Summary 548Key Terms 549Study Questions 550Suggestions for Additional Reading 551

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Chapter 24 DIFFERING VIEWS ON THE APPROPRIATE CONDUCT OF MONETARY POLICY 552Should Monetary Policy be Active or Passive? 552

The Self-Correcting Mechanism 554 I Viability of the Self-Correcting Mechanism 554

Problems Confronting Monetary Policy Activism 555Problems Posed by Lags of Monetary Policy 555 I The Problems Posed by Difficultiesof Forecasting 557

Has the Federal Reserve Been a Destabilizing Influence? 558Rules Versus Discretion in the Conduct of Monetary Policy 563

The Case for a Monetary Policy Rule 564

A Passive Monetary Policy Rule: The Constant Money Growth Rule 565Active Monetary Policy Rules (Feedback Rules) 567

The Nominal GDP Targeting Rule 567 I The Inflation Targeting Rule 568 I The TaylorRule 568


Chapter 25 INFLATION TARGETING 578Inflation Targeting: Its Meaning and Potential Benefits 579

Arguments in Favor of Inflation Targeting 580 I Arguments Against Inflation Targeting 585

Practical Considerations in Implementing Inflation Targeting 588Who Sets the Target and What Price Index Should be Used? 590 I What Is theAppropriate Level or Band for the Inflation Target? 590 I Should There be EscapeClauses and Sanctions for Central Bank Failure to Hit Inflation Target? 592

Experience with Inflation Targeting 592Inflation Performance Before and After Inflation Targeting Implementation 593 ISacrifice Ratios and Other Considerations 595

The Evolution of the Federal Reserve’s Policy Mandate 597Authority for Implementing Inflation Targeting in the United States 598 I Should theU.S. Implement Inflation Targeting? The Affirmative View 598 I Should the U.S.Implement Inflation Targeting? The Negative View 599

Summary 600Key Terms 601Study Questions 601Suggestions for Additional Reading 602Glossary 603Index 611

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Students come to undergraduate money and banking courses with widely differing back-grounds, majors, and objectives. Money and banking instructors place varying degrees ofemphasis on monetary theory, institutions, and policy. This textbook reflects my view thatthe money and banking course should be the most interesting and timely course in aneconomics or finance curriculum, and that it should be of considerable value to studentswith diverse backgrounds and interests. In addition, Money, Banking, and Financial Marketsshould help instructors teach more easily, regardless of academic focus.

This textbook will provide students with a solid grasp of the fundamental topics,principles, and issues traditionally covered in the money and banking course that arenot thoroughly covered in other courses in the curriculum. This book seeks to minimizeany overlap with intermediate macroeconomics courses. Instead, it aims to provide clearand up-to-date coverage of such fundamental topics as the nature and role of money, fi-nancial institutions and markets, and banking structure and regulation. Money, Banking,and Financial Markets provides an unusually thorough treatment of Federal Reserve in-struments, strategies, and policy transmission, the determinants of interest rates, stockprices, foreign exchange rates, and the nation’s money supply. Compared to other lead-ing money and banking texts, this one seeks to cover fewer topics, but to cover those se-lected topics more clearly and effectively.

This is a policy-oriented text. It provides a thorough explanation of the relevant an-alytical framework, keyed closely to economic policy issues. We pay greater-than-normalattention to the instruments of Federal Reserve policy and the difficulties involved inconducting monetary policy in uncertain economic environments. Separate chapters(12 and 13) cover the institutional makeup of the Federal Reserve System and theEuropean Central Bank. The challenges confronting discretionary conduct of monetarypolicy and the “rules versus discretion” debate are thoroughly covered. The text fea-tures unprecedented coverage and analysis of the Taylor Rule (chapter 24), analyzingits strengths and weaknesses both in formulating monetary policy prospectively and inevaluating policy retrospectively. Modern views of the transmission mechanism of mon-etary policy—the myriad ways in which monetary policy influences economic activity—are thoroughly covered in Chapter 23. Because more than 20 nations have now adoptedinflation-targeting central bank regimes, an entire chapter (25) provides unprece-dented coverage of this topic. In short, this text covers monetary policy in more depththan any existing money and banking text.

Money, Banking, and Financial Markets provides a solid theoretical framework.Students sometimes find economic theory dull or difficult to understand. But an eco-nomic theory, after all, is simply a rigorous explanation of an economic phenomenon.The loanable funds model of interest rates and the various theories of the term struc-ture of interest rates are carefully developed in chapters 5 and 6. We invoke the presentvalue framework to explain stock, bond, and other asset pricing in chapters 5 and 7.Chapter 8 presents theories of long-run and short-run exchange rate determination.Following a brief chapter on the principles of deposit expansion and contraction, we setforth the monetary base—money supply multiplier framework for understandingmoney supply determination in chapters 15 and 16. Chapter 20 develops the aggregatedemand and aggregate supply framework; this chapter also includes a thorough analy-sis of the Phillips curve hypothesis and the factors that cause the natural rate of unem-ployment to fluctuate over time. Chapter 22 provides a comprehensive discussion of thetheory of money demand and velocity. Chapter 23 analyzes the transmission of mone-tary policy, including an in-depth discussion of the “money view” and the “credit view.”

The book adopts a mainstream analytical approach in which both monetary and fis-cal policies significantly influence economic activity, and leaves debates about the vari-

PREFACEPREFACE

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ous theoretical paradigms that diametrically contradict one another to intermediatemacroeconomics courses.

While this text does not skimp on economic theory, it develops the relevant theoryonly to shed light on important economic events and developments. We surround theorywith examples from current events and economic history. For example:

• As soon as we present the analytical framework for understanding how to priceshares of stock in chapter 7, we discuss the 1990s’ run-up of stock prices, the en-suing crash, and the contentious issue of whether central banks should interveneto head off stock market bubbles.

• Immediately after developing the Fisher hypothesis—which links nominal inter-est rates to expected inflation—in chapter 5, we test the theory by examiningbond yields and inflation rates in a cross section of 14 nations.

• As soon as we examine the purchasing power parity (PPP) theory of exchangerates in chapter 8, we provide a graph illustrating the actual and PPP U.S.-Australia exchange rates over a 30-year period. This presentation enables stu-dents to observe that purchasing power parity is strictly a long-run theory of ex-change rate determination.

• As soon as chapters 15 and 16 develop the monetary base—money supply multi-plier framework, we use the framework to analyze the fundamental causes of thecontraction of the U.S. money supply in the Great Depression and the FederalReserve’s role in that catastrophe (chapter 17).

• Immediately after chapter 20 discusses the aggregate supply-aggregate demandmodel, we use the framework to analyze the most important macroeconomic de-velopments of the past 75 years (emphasizing those of the past decade).

Given this approach, students develop the attitude that economic theory is interest-ing and valuable in understanding contemporary economic events.

Reviewers consistently remarked on the clarity of the writing style, the timeliness of thetopics discussed, and the thorough coverage of recent developments. Such develop-ments include the post-1995 acceleration of productivity, the unusual nature of the 2001recession and the “jobless recovery” of 2002–2004, the 2003 Federal Reserve change indiscount window procedures, the corporate and mutual fund scandals of 2002–2004,and recent changes in the list of the nation’s 10 largest banks. Instructors will note sev-eral distinguishing features of this textbook vis-a-vis alternative texts.

Empirical Orientation. More than any other money and banking text, this bookprovides students with a feel for a multitude of key monetary and financial variables, viatables and time-series graphs. More than 70 graphs illustrate how such variables as ex-change rates, bond yields, the currency ratio, the money-supply multiplier, velocity ofmoney, stock prices, and inflation rates have behaved over a period of years. Other fig-ures show the price-earnings ratios of the S&P 500 stock market index; the fed fundsrate vs. that indicated by the Taylor Rule both in the U.S. and in Japan; actual and po-tential GDP; the high correlation between money market yields in the U.S. andGermany, and other economic phenomena. Many of these illustrations are unique—they do not appear in other money and banking texts. While the interest rate chapterof a leading money and banking text includes only one time-series graph featuring in-terest rates or yields, this one includes seven such graphs. Students gain a feel for themagnitude and behavior over time of the variables under discussion.

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DISTINGUISHING FEATURES OF THIS TEXT

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Substantive Exhibits. Numerous reviewers commented on the substantive andunique nature of the boxed exhibits. This book includes more than 50 exhibits that coversuch topics as the “tech wreck” of 2000–2002, the economics of ATMs, the growth of in-ternet banking, an evaluation of the Gramm-Leach-Bliley Act, the 2004 enlargement of theEuropean Union, and salaries of top Federal Reserve officials. Other exhibits discuss IrvingFisher’s genius and versatility; recent trends in U.S. productivity growth; a brief history ofmoney market mutual funds; the demise of the reserve requirement tax; bandwagon phe-nomena in exchange rate movements, and oil prices as aggregate supply shocks. Both in-structors and student readers will find these exhibits superior to those in other texts.

Emphasis on the Worldwide Applicability of Concepts and EconomicPhenomena. The more we study economics, the more we become aware of thesense that “we are in this together.” In the age of the Internet, information travelsaround the world instantaneously. This text emphasizes the high degree of correlationbetween asset prices, business cycle developments, and other economic phenomena inthe United States and in other nations. This point is driven home by time-series graphsillustrating the co-variation of interest rates, stock prices, and other phenomena acrosscountries. Students come to appreciate the worldwide nature of macroeconomic and fi-nancial developments, which enhances the value of the analytical tools that help us un-derstand these phenomena.

Entire Chapter on the Stock Market. As the number and percentage ofAmerican families owning stocks has increased and knowledge of the superior long-term performance of equities has become widespread, interest in the stock market hasincreased apace. Students are keenly interested in the stock market. Chapter 7 is de-voted entirely to the stock market, providing a framework for understanding the factorsdetermining the prices of stocks. The chapter also looks at various stock market indexesand discusses the various measures of stock valuation. We analyze the risk inherent instocks relative to government bonds and discuss the equity risk premium anomaly andthe phenomenon of mean reversion in stock prices.

Unique Chapter on the Great Depression. The economics profession has seena remarkable resurgence of interest in the Great Depression in the past decade or two.This tragic episode presents an excellent case study of monetary policy gone awry. Thistext devotes a full chapter (17) to the causes of the contraction of the money supply inthe early 1930s, the role of the Federal Reserve in that experience, and the ongoing de-bate over whether monetary policy is rendered impotent in an environment of deflation.

Unique Chapter on Inflation Targeting. In recent years, inflation rates in in-dustrial nations have declined to the lowest levels in half a century. This reduction isdue, in part, to the fact that more than 20 nations have implemented inflation target-ing monetary policy regimes. We include a full chapter (25) that analyzes the cases forand against inflation targeting and looks at the contentious issue of whether the FederalReserve should implement such a regime.

This work contains a number of features designed to enhance the effectiveness of thisbook as a teaching instrument.

• Part Openers for each of the six sections of the text outline the importance ofand relationships among the topics covered in each section.

Prefacexviii

PEDAGOGICAL FEATURES

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Preface xix

• Definitions of Key Terms appear in the margins as the terms are introduced, aswell in the textual discussion.

• A glossary of all key terms is compiled in alphabetical order at the end of thebook.

• More than 50 boxed exhibits provide interesting background on various eco-nomic and financial relationships, events, and developments.

• International Perspectives boxes provide a global perspective on key topics andempirical economic phenomena. These boxes provide discussion of such topicsas the worldwide decline in inflation since 1990, the synchronization of eco-nomic phenomena across countries, and the use of the Taylor Rule to evaluatethe Bank of Japan’s contribution to deflation in the past decade.

• A From the Financial News feature introduces students to financial tables fromdaily newspapers, covering such topics as the yield curve, stock prices, foreign ex-change rates, and weekly Federal Reserve data.

• A Your Turn feature gets students into active mode by posing questions that testtheir understanding of various formulas and concepts as the ideas are intro-duced. Answers appear at the end each chapter.

• More than 70 time-series figures introduce students to a multitude of macroeco-nomic and financial data.

• Chapter summaries review key points developed in each chapter.• Study Questions at the end of each chapter test students’ understanding of the

most important concepts and principles discussed in the chapter.• An Additional Reading feature at the end of each chapter points instructors (as

well as highly motivated students) to classic literature as well as recent articles onmajor topics.

• URLs are provided with each time-series figure so that students may access orig-inal data and check to see how the pertinent variables have changed most re-cently.

Supplementary MaterialsThe Study Guide, written by Professor Alan Grant of Eastern Illinois University,provides an overview of each chapter and a variety of measures to increase studentlearning. Each Study Guide chapter supplies a variety of questions for students, in-cluding matching, true-false, fill in the blank, multiple choice, and problems.Answers are provided at the end of each chapter.

A Test Bank written by Amanda Freeman, Alan Grant, and Lloyd Thomas pro-vides some 1900 multiple choice examination questions, or an average of about 75questions per chapter. Lloyd Thomas has contributed about 50 percent of thesequestions and has reviewed all other questions for quality.

An Instructor’s Manual, written by Professor Robert Guell of Indiana StateUniversity includes sample course outlines, answers to end-of-chapter questions,and teaching hints for each chapter. Instructor’s Manual chapters are keyed directlyto PowerPoint Software presentations.

Power Point Presentation Software, also prepared by Professor Robert Guellof Indiana State University, illustrate the key concepts and principles presented ineach chapter.

Thomas Textbook Support Web Site (http://thomas.swlearning.com) provides instructional materials for professors, including the Instructor’sManual, Test Bank, and PowerPoint Presentation Software via a password-protectedsection of the site that is not accessible to students. Approximately 10 onlinequizzing questions for students are also available at this site.

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Thomas Xtra! Web Site (http://thomasxtra.swlearning.com/)Thomas Xtra!, available to be packaged with the textbook, provides access to a ro-bust set of online learning tools for students. Please ask your Thomson sales repre-sentative for more information. Thomas Xtra! contains these key features:

• Interactive E-Lectures. Difficult concepts from each chapter are explained andillustrated via Flash-animated tutorials.

• Xtra! Quizzing. In addition to the open-access chapter-by-chapter quizzes foundat the Thomas Product Support Web site, (http://thomas.swlearning. com),Thomas Xtra! offers students the opportunity to practice for midterms and finalsby taking extensive interactive quizzes.

• Economic Applications. EconNews Online, EconDebate Online, EconDataOnline, and EconLinks Online help to deepen students’ understanding of theo-retical concepts through hands-on exploration and analysis of the latest eco-nomic news stories, policy debates, and data.

TextChoice is a custom format of Thomson Learning’s online digital contentthat provides the fastest, easiest way for you to create your own learning materials.You may select content from hundreds of best-selling titles, choose material fromour numerous databases, and add your own material. http://thomsoncustom.com.

Ecoursepacks Create a customizable, easy-to-use, online companion for anycourse with eCourse packs. ECourse packs give educators access to current contentfrom thousands of popular, professional, and academic periodicals, includingNACRA and Darden cases, and business and industry information from Gale. Youcan easily add your own material—even collecting a royalty if you choose.http://ecoursepacks.swlearning.com.

ExamView ExamView Computerized Testing Software contains all of the questions inthe Test Bank. ExamView is an easy-to-use test creation package compatible withboth Microsoft Windows and Macintosh client software. You can select questions bypreviewing them on the screen, selecting them by number, or selecting them ran-domly. Questions, instructions, and answers can be edited, and new questions caneasily be added. You can also administer quizzes online—over the Internet, througha local area network (LAN), or through a wide area network (WAN).

MarketSim MarketSim, by Tod Porter at Youngstown State University, is an onlinesimulation designed to help students in microeconomics classes better understandhow markets work, by having students take on the roles of consumers and produc-ers in a simulated economy. In the simulations, students “make” and “accept” offersto buy and sell labor and goods asynchronously via the Internet.

CNN Economics Video CNN video segments bring the real world right to stu-dents’ desktops by using the CNN Principles of Economics Video Updates. Thisvideo provides current stories of economic interest, and the accompanying inte-gration guide provides a summary and discussion questions for each clip. The videois produced in cooperation with Turner Learning Inc.

Contact your local Thomson Learning/South-Western sales representative aboutobtaining these support materials.

Prefacexx

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The author is indebted to many individuals who have contributed substantially to thedevelopment of this project over the past three years. Foremost among those to whomI am indebted is Professor Alan Grant of Eastern Illinois University, whose contributionto this project over the years has been enormous. Al carefully critiqued two versions ofevery chapter, contributed numerous end-of-chapter Study Questions, pointed me torelevant journal articles, and is responsible for chapter 10 on banking structure and reg-ulation. In addition, he contributed hundreds of questions for the Test Bank, wrote theStudy Guide for this text, and has generally been a tremendous colleague in the devel-opment of this entire project. Professor Robert Guell of Indiana State University did ameticulous job of putting together the PowerPoint and Instructor’s Manual ancillariesfor this project. Professor Ronnie J. Phillips of Colorado State University reviewed theentire manuscript and provided a multitude of constructive suggestions. AmandaFreeman, a Ph.D. student at Kansas State University and a money and banking instruc-tor, made a major contribution to this project during the final year of its development.In addition to carefully proofreading and critiquing each chapter, she checked all URLsand references for accuracy, put together the Test Bank, and served as an extremely ableand invaluable resource for the author. Professor Mark Wohar of the University ofNebraska–Omaha, through numerous phone calls and e-mails, provided importantprodding and encouragement to bring this work to fruition. My colleague and a veteranmoney and banking teacher, Michael Oldfather, critiqued several chapters and also con-tributed by sharing his extensive knowledge of the business, structure, and regulationof commercial banking. Numerous conversations with colleagues Patrick Gormely,Wayne Nafziger, and Roger Trenary also added value to the final product. Many gradu-ate and undergraduate students at KSU contributed in a variety of ways. Jared Wirthsand Jared Dressman are responsible for developing the multitude of time-series graphsin this book. Boaz Nandwa, Daniel Nibarger, Shane Sanders, Jamie Stamatson, andDanhua Wu also contributed in such ways as checking references, contributing studyquestions, supplying the author with pertinent literature, and reading the page proofs.Kristi Smith and Susan Koch helped with manuscript preparation and typing of tables.

I am greatly indebted to numerous individuals at Thomson Learning/South-Western. At the top of the list is my Senior Development Editor, Trish Taylor. Trish ex-pertly handled the myriad challenges of coordinating the development of the text withthat of the Study Guide, Instructor’s Manual, Test Bank, PowerPoint slides, and otherancillary materials. I am also indebted to Trish for being a stickler about efficiency inwriting style, for prodding me to revise the manuscript conscientiously in response toconstructive suggestions from reviewers, and for calmly dealing with an author of rathervolatile temperament. I am indebted to production editor Cliff Kallemeyn for coollydealing with numerous glitches and roadblocks, carefully implementing needed cor-rections, and delivering the end product in excellent condition. I am grateful to TippyMcIntosh for the outstanding design of this book, including the spectacular cover.Senior Technology Product Editor Peggy Buskey brought her expertise to bear in cre-ating a superior package of electronic supplements. Senior Acquisitions editor MikeWorls and Senior Marketing Manager John Carey supplied important encouragementand counsel during the development of this work.

Most of all, I am grateful to my wife (Sally), daughter (Elizabeth Thomas Horn), andmother (Marianne Moon Thomas) for their encouragement, support, and loyalty.

ACKNOWLEDGEMENTS

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Numerous reviewers made constructive suggestions and contributed materially tothe final product. These include:

Prefacexxii

Burton Abrams (University ofDelaware)

Richard Boylan (University of Alabama)Charles Britton (University of Arkansas)Stacy Brook (University of Sioux Falls)Jim Butkiewicz (University of Delaware)Miles Cahill (College of Holy Cross)Thomas Carroll (University of

Nevada–Las Vegas)Catherine Chambers (Central Missouri

State University)Martin Cherkes (Princeton University)Dal Didia (Jackson State University)Chris Erickson (New Mexico State

University)David Flynn (University of North

Dakota)James Gale (Michigan Technological

University)Ralph Gamble (Fort Hays State

University)Ron Gilbert (Texas Tech University)Ismail Genc (University of Idaho)Dipak Ghosh (Emporia State

University)Wafica Ghoul (Davenport University)Rik Hafer (Southern Illinois

University–Edwardsville)Bradley Hobbs (Florida State

University)Jon Hooks (Albion College)Thomas Ireland (University of

Missouri–St.Louis)Art Janssen (Emporia State University)Nancy Jianakoplos (Colorado State

University)Bryce Kanago (University of Northern

Iowa)Shawn Kantor (University of Arizona)Elizabeth Sawyer Kelly (University of

Wisconsin–Madison)

Kathy Kelly (University of Texas-Austin)Benjamin Kim (University of

Nebraska–Lincoln)Todd Knoop (Cornell College)Sungkyu Kwak (Washburn University)B. Starr McMullen (Oregon State

University)Ed Merkel (Troy State University)Michael Oldfather (Kansas State

University)Douglas Pearce (North Carolina State

University)Mark Perry (University of

Michigan–Flint)Ronnie Phillips (Colorado State

University)Scott Redenius (Bryn Mawr College)Prosper Raynold (Miami University of

Ohio)Russell Rhine (St. Mary’s College of

Maryland)Joseph Santos (South Dakota State

University)Edward Sattler (Bradley University)Donald Scarry (Rutgers–The State

University of New Jersey)Elizabeth Schmitt (SUNY–Oswego)Paul Storer (Western Washington

University)Robert Tokle (Idaho State University)Karen Vorst (University of

Missouri–Kansas City)John Wassom (Western Kentucky

University)Mark Wohar (University of

Nebraska–Omaha)Gil Wolpe (Newbury College)Robert Wright (University of Virginia)Shu Wu (University of Kansas)Bill Yang (Georgia Southern University)David Zalewski (Providence College)

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MONEY, BANKING andFINANCIAL MARKETSLloyd B. ThomasKansas State University

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VP/Editorial Director:Jack W. Calhoun

VP/Editor-in-Chief:Dave Shaut

Acquisitions Editor:Mike Worls

Sr. Developmental Editor:Trish Taylor

Sr. Marketing Manager:John Carey

Production Editor:Cliff Kallemeyn

Sr. Technology Project Editor:Peggy Buskey

Technology Project Editor:Pam Wallace

Sr. Manufacturing Coordinator:Sandee Milewski

Art Director:Tippy McIntosh

Production House:Graphic World, Inc.

Printer:RR DonnelleyWillard, OH

Money, Banking, and Financial Markets

Lloyd B. Thomas

COPYRIGHT © 2006 by South-Western, part of the ThomsonCorporation. South-Western, Thomson,and the Thomson logo are trademarksused herein under license.

Printed in the United States of America1 2 3 4 5 08 07 06 05

Package ISBN: 0-324-17673-2

Book-only ISBN: 0-324-32282-8

Library of Congress Control Number:2004114017

ALL RIGHTS RESERVED.

No part of this work covered by thecopyright hereon may be reproduced orused in any form or by anymeans–graphic, electronic, ormechanical, including photocopying,recording, taping, Web distribution orinformation storage and retrievalsystems–without the written permissionof the publisher.

For permission to use material from thistext or product, submit a request onlineat http://www.thomsonrights.com.

For more informationcontact South-Western,5191 Natorp Boulevard,Mason, Ohio 45040.Or you can visit our Internet site at:http://www.swlearning.com

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Aactive rule (feedback rule) rule in

which the central bank changes theinterest rate level or the moneygrowth rate by strict predeterminedformulas in response to ongoing de-velopments

adjustable-peg (Bretton Woods)exchange rate agreement inwhich each country’s central bankintervenes aggressively in foreign exchange markets to fix or peg its exchange rate at a predeterminedlevel

adverse selection condition in whichpeople who are most undesirablefrom the other party’s viewpoint arethe ones most likely to seek to en-gage in a transaction

aggregate demand curve relation-ship between the nation’s aggregateprice level and the amount of realoutput (real GDP) demanded, otherfactors being held constant

aggregate supply curve relationshipbetween the nation’s aggregateprice level and the amount of realoutput firms collectively desire toproduce and sell, other factors be-ing held constant

amortized mortgage mortgage inwhich part of each monthly pay-ment reduces the principal so thatthe home is owned free and clearafter a period of 15 or 30 years

appreciation an increase in value ofone nation’s currency relative to an-other currency

assets indications of what is owned orclaims on external entities

asymmetric information conditionin which two parties to a transac-tion have differing informationabout the intentions of the otherparty and the likely risks involved

automatic transfer service (ATS)accounts type of account in whichfunds are automatically transferredfrom savings account to checkingaccount as checks are presented forpayment

Bbalance sheet statement of assets, li-

abilities, and net worth at a givenpoint in time

bank charters official authorizationsto open and operate banks

bank holding company corporationthat owns a controlling interest inone or several banks but is itself nota bank

Bank Holding Company Act of1956 legislation prohibiting bankbranching via acquisition of banksby bank holding companies

bank insolvency state of financialcondition in which the value of abank’s total assets is less than thevalue of the bank’s total liabilities

Bank Insurance Fund (BIF) insur-ance fund created by FIRREA forcommercial banks

bank liquidity trap potential situa-tion in which bank demand for ex-cess reserves is perfectly elastic withrespect to the interest rate, render-ing the central bank incapable of in-creasing the money supply

Bank of the United States first na-tional bank chartered in the UnitedStates

banker’s acceptance check, generallywritten by a business firm, payableat a specific future date andstamped “accepted” by a majorbank

Banking Act of 1933 (Glass-Steagall Act) legislation separat-ing commercial banking from in-vestment banking, and separatingbanking from industry

banking panic waves of systemicbank runs that lead to contractionof bank lending and economic con-traction

banks institutions that accept varioustypes of deposits and use the fundsprimarily to grant loans and pur-chase relatively safe debt instru-ments

barter economy economy in whichgoods and services are traded di-rectly for one another

Board of Governors seven-personboard that dominates the conductof monetary policy; this board setsreserve requirements and the dis-count rate, and constitutes the vot-ing majority of the Federal OpenMarket Committee

bond long-term debt instrument is-sued by a corporation, government,or government agency; a contrac-tual agreement to make certain pay-ments at specified future dates

brokers individuals acting as cus-tomers’ agents, locating a securitybuyer or seller and charging a com-mission for the service

budget deficit annual amount bywhich federal government expendi-tures exceed tax revenues

CCAMELS system acronym indicating

the six categories evaluated to as-sess a bank’s overall financial condi-tion: C (capital adequacy), A (assetquality), M (management), E (earn-ings), L (liquidity), and S (sensitivityto risk)

capital accounts (capital) net worthof a bank, or value of the bankowners’ residual claim on thebank’s assets

capital market market in which long-term securities issued by governmentand private concerns are exchanged

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cash market transactions in whichthe buyer pays the seller for the as-set up front

central bank a nation’s monetary au-thority or agency charged with con-ducting monetary policy and otherduties

certificate of deposit (CD) a formof deposit that stipulates that thebearer will receive annual interestpayments of a specified amountplus a lump sum equal to the origi-nal principal at maturity

commercial paper short-termpromissory notes issued by majorcorporations to attract funds forday-to-day business needs

common stocks ownership claimsagainst a firm’s real capital assets;entitles owner to share in profits ofthe firm

Comptroller of the Currency gov-ernment agency within the TreasuryDepartment charged with charter-ing, supervising, and examining na-tional banks

convergence criteria specific andstringent standards each nationmust meet to achieve membershipin the monetary union

corporate bonds long-term debtclaims against a corporation’s as-sets, claims that may or may not besecured by mortgages and otherassets

cost of capital cost of raising fundsto finance capital expenditures

Council of Economics and FinanceMinisters (ECOFIN) group con-sisting of the finance ministers ofeach of the European Union mem-ber countries; group initiates theExecutive Board appointmentprocess

coupon bonds bonds that promise afinite series of constant annual orsemi-annual payments for 10, 20,or 30 years and repayment of prin-cipal at maturity

credit view view that an increase inbank loans has a stronger impacton GDP expenditures and economicactivity than does an equal amountof bank security purchases, eventhough both events have the sameimpact on M1 and M2

currency ratio (k) ratio of currencyheld by the public (Cp) to DDO (de-mand deposits and other checkabledeposits)

current yield yield computed as theannual payment from the instru-ment (in dollars) divided by theprice or initial principal

Ddealers holders of inventories of secu-

rities who stand ready to buy or sellat quoted bid and ask prices

debit card card with which an individ-ual pays for an item by transferringfunds electronically and immediatelyfrom his/her bank account to themerchant’s bank account

debt instrument contractual agree-ment by the issuer to pay a specificamount of money (principal or facevalue) at a specified future date;contract may include periodic inter-est payments as well

default risk risk that issuer of debt in-strument will not make interest pay-ments or pay back the face valuewhen the instrument matures

defensive open market operationsFed’s open market operations madeto “defend” bank reserves and themonetary base against outsideforces over which the Fed has littleor no control

deflation persistent or continuing de-cline in a nation’s general price level

demand deposits deposits that canbe withdrawn in currency or trans-ferred to a third party at the initia-tive of the owner

demand for money amount ofwealth individuals and firms desireto maintain in the form of money

demand-pull inflation inflationcaused by a persistently rightwardshifting AD curve, typically the re-sult of rapid growth of a nation’sgovernment expenditures andmoney supply

Depository Institutions Act of1982 (Garn–St. Germain Act)act accelerating deregulation of the S&Ls by authorizing them to engage in additional activities andcompete with money market mutualfunds

depreciation a decrease in value ofone nation’s currency relative to an-other currency

derivative market trades that arearranged currently with locked-interms, but settlement and deliveryof the instrument are made at aspecified future date

desired excess reserves ratio (re)ratio of banks’ desired excess re-serves to DDO (demand depositsand other checkable deposits)

discount loans (discounts and ad-vances) loans made by the FederalReserve to depository institutions

discount rate interest rate charged onloans made by the Federal Reserveto commercial banks

discount window facility throughwhich the Federal Reserve districtbanks lend reserves to depositoryinstitutions

discretionary monetary policy pol-icy in which the central bank is freeto assess economic circumstancesas they unfold and implement what-ever measures the central bankdeems appropriate at the time

disintermediation active withdrawalof funds from depository institu-tions by customers searching forhigher yields elsewhere

district Federal Reserve banks oneFederal Reserve bank exists for eachof the 12 Federal Reserve districts inthe United States

dividend yield annual dividend ex-pressed as a percentage of thestock’s price

divisia aggregates weighted mea-sures of money used to predictchanges in price level and output ofgoods and services; may eventuallyreplace our current measures ofmoney

dual banking system system inwhich both the federal governmentand state governments have author-ity to charter banks

dual mandate mandate given to thecentral bank to maintain both pricelevel stability and maximum sustain-able employment

dynamic open market operationsoperations by which the FederalReserve deliberately changes the

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course of economic activity in linewith the Fed’s policy objectives

EEconomic and Monetary Union

(EMU) group of European nationsthat use a common currency (theeuro) and have a common mone-tary policy

economies of scale economiesformed when the average cost ofproviding a unit of bank service de-clines as more units of the serviceare provided

economies of scope economiesformed when greater efficiency isachieved by one firm providing agroup of services rather than sepa-rate specialized firms providingthose services

electronic cash (e-cash) form ofmoney that facilitates payment foritems purchased over the Internet

electronic checks form of checks thatare processed electronically, circum-venting the costly procedure ofphysically processing and transport-ing checks

electronic money system a systemin which money is stored and trans-ferred electronically via cards andcomputer accounts

equation of exchange a mathemati-cal identity that sets forth the rela-tionship between the supply ofmoney, velocity, the price level andreal output; MV � PY

equities financial claims representingownership in a business entity; givesbearer the right to share in the netincome of issuer

equity multiplier ratio of financial in-stitution’s total assets to capital; in-dicates magnitude of leverage ap-plied to the rate of return on assets

equity risk premium additional rateof return required to compensateprospective investors for risk and in-duce investors to buy stocks ratherthan safer government bonds

euro single currency used by 12 west-ern European nations

Eurodollars deposits in foreign banksor U.S. bank branches in foreigncountries, in denominations of U.S.dollars rather than local currencies

European Central Bank centralbank that conducts monetary policycollectively for Economic andMonetary Union countries

European System of CentralBanks (ESCB) organization con-sisting of the European CentralBank and the individual centralbanks of the European MonetaryUnion nations

European Union (EU) organizationdedicated to achieving economic in-tegration and unification of itsmember countries

excess reserves depository institutionreserves (cash and deposits at Fed)above the required amount

exchange traded funds (ETFs) in-struments designed to track a par-ticular stock market index or sector;can be purchased by individual in-vestors like shares of stock

Executive Board six-person boardthat participates on the GoverningCouncil of the European CentralBank in formulating monetary policy

expected (ex ante) real interestrate (rex ante) difference betweennominal interest rate and expectedinflation rate

FFederal Deposit Insurance

Corporation Improvement Actof 1991 (FDICIA) legislation thatrecapitalized the nearly insolventFDIC and redesigned the federal de-posit insurance system with the in-tent of minimizing taxpayer expo-sure to future losses

federal funds unsecured loans, in theform of deposits at the FederalReserve Banks, made between de-pository institutions

federal funds market market inwhich banks borrow funds overnightfrom other banks in the form of de-posits at the Federal Reserve

federal funds rate rate of interestprevailing on overnight loans be-tween banks of deposits at theFederal Reserve

Federal Home Loan Bank Board(FHLBB) organization establishedby Congress to regulate the savingsand loan industry

Federal Open Market Committee(FOMC) committee responsiblefor formulating the general postureof monetary policy; consists of theseven members of the Board ofGovernors and the 12 presidents ofthe district Federal reserve banks

Federal Reserve Act legislation es-tablishing the Federal ReserveSystem

Federal Reserve float difference be-tween “cash items in the process ofcollection” and “deferred availabil-ity cash items”

Federal Reserve System (Fed) thecentral bank of the United States,charged with conducting monetarypolicy and other duties associatedwith our financial system

Federal Savings and LoanInsurance Corporation (FSLIC)subsidiary of the FHLBB created toinsure savings and loan deposits

fiat money (credit money) form ofmoney that derives its value by fiator government decree rather thanthrough its value as a commodity

financial futures purchase of (andpayment for) a financial instrumentat a specified future date, at a pricedetermined in advance

Financial Institutions Reform,Recovery, and Enforcement Actof 1989 (FIRREA) legislationabolishing both the FHLBB and theFSLIC and creating The Office ofThrift Supervision, The BankInsurance Fund, and The SavingsAssociation Insurance Fund

financial intermediaries institutionsthat serve as middlemen for thetransfer of funds from individuals,businesses, and other entities withsurplus funds to those who borrow

financial intermediary institutionthat obtains funds by issuing sec-ondary claims and uses the pro-ceeds to purchase primary claims,thereby transferring funds from so-ciety’s savers/lenders toborrowers/spenders

financial intermediation flow offunds from savers to deficitspenders by way of financial inter-mediaries

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Fisher effect tendency for interestrates to be positively related to thelevel of inflation expectations

Fisher hypothesis strong form of thistheory asserts that interest ratesmove one-for-one with the magni-tude of expected inflation; the weakform states that expected inflationsignificantly influences interest rates

fixed exchange rates international fi-nancial arrangement in which ex-change rates are pegged or heldconstant by direct government in-tervention in the foreign exchangemarket

float difference between cash items inthe process of collection and de-ferred credit items; arises fromcheck collection procedures

floating exchange rates interna-tional financial arrangement inwhich exchange rates are allowed tochange continuously in response tothe market forces of supply and de-mand, with occasional governmentintervention

FOMC directive formal statement in-dicating the intended conduct ofmonetary policy until the next meet-ing of the Federal Open MarketCommittee and voted on by theFOMC

foreign exchange market market inwhich national currencies are ex-changed

foreign exchange rate price at whichone nation’s currency is exchangedfor another nation’s currency

forward exchange rate exchangerate at which forward transactionstake place

forward interest rate hypotheticalfuture short-term interest rate thatequalizes average returns earned ona long-term security and a succes-sion of short-term securities

forward transactions purchase andsale of foreign currencies for deliv-ery and payment at a particular fu-ture date and a price specified inadvance

fractional reserve banking systemsystem in which each bank main-tains only a small percentage ofbank deposit liabilities in the formof reserves

Free Banking Era period from 1836to 1863, characterized by minimalsupervision of banking activity

freely floating exchange rates sys-tem in which governments do not in-tervene in the foreign exchange mar-ket, permitting exchange rates to bedriven entirely by free market forces

full-bodied money (commoditymoney) form of money whosevalue is approximately the samewhether it is used as money or fornonmoney (commodity) purposes

GGlass-Steagall Act law mandating

the separation of commercial bank-ing and investment banking

Governing Council committee thatmakes European Central Bank mon-etary policy decisions

Governors heads of the central bankof the 12 individual nations makingup the Economic and MonetaryUnion

Gramm-Leach-Bliley FinancialServices Modernization Act of1999 legislation allowing securitiesand insurance firms to purchasebanks and permitting banks to par-ticipate in securities, insurance, andreal estate activities

Hhysteresis idea that the NAIRU level is

influenced by the level and durationof the actual unemployment rate

Iimpact lag time that elapses between

the point when policy action is im-plemented and the point at whichthe policy begins to influence thenation’s GDP

implementation lag time thatelapses between the point when aneed for policy action is recognizedand the point at which the appro-priate policy is implemented

income flow of earnings, measures asdollars per unit of time

income elasticity of demand formoney ratio of the percentagechange in quantity of money de-manded to the percentage change

in income that induced the changein money demand

inflation persistent or continuing in-crease in a nation’s general pricelevel

inflation neutrality condition inwhich inflation is fully anticipatedand compensated for by economicagents, attenuating the potential re-distributive effects of inflation

inflation targeting monetary policystrategy in which a specific low in-flation rate (or band of rates) isproclaimed as its predominant in-termediate and long-term objective

inflationary gap situation in whichequilibrium output exceeds full-employment output and the actualunemployment rate is below thenatural unemployment rate

instrument or tool of monetarypolicy variable the Fed controlscompletely in order to influencesuch key intermediate variables asshort-term interest rates, the mone-tary base, M1, and M2

interest parity condition conditionin which, in a world of capital mo-bility, expected returns on assets areequal across countries

interest rate cost of borrowing (orthe return from lending), expressedas a percent per year

intermediate target variables inter-mediate-term variables the centralbank attempts to control in its ef-fort to achieve policy goals

international capital flows acquisi-tion of financial and real assetsacross national borders

International Monetary Fund(IMF) organization created in 1944for the purpose of creating a stableinternational monetary order

investment banks institutions thatunderwrite new securities issues andtrade existing issues

Jjunk bonds bonds judged to have a

high risk of default, rated Ba orlower by Moody’s

Llaw of one price principle that a ho-

mogeneous good’s price will be the

Glossary606



Licensed to:

same whether purchased at homeor abroad if free trade and zerotransactions costs prevail

legal reserves (reserves) cash anddeposits that a bank places in alarger bank (formerly) or FederalReserve (today)

legal tender money that cannot law-fully be refused as payment forgoods and services or for dischargeof debts; consists of currency andcoins

lender of last resort provider of tem-porary cash reserves to the bankingsystem in times of crisis

liabilities indications of what is owedor claims that external entities haveon a bank or other entity

limited branching restrictions limit-ing banks to a certain number ofoffices

liquidity relative ease with which anasset can be converted into moneywithout significant commissions orother charges, inconvenience, andrisk of loss of principal

liquidity premium theory theory as-serting that the long-term interestrate equals the average of currentand expected future short-term interest rates plus a premium tocompensate lenders for market risk

loanable funds model model inwhich the supply and demand forfunds determine the interest rate

Lombard system system in which thediscount rate is set significantlyabove money market yields and useof the discount window is a “right”rather than a “privilege” adminis-tered by the central bank

long-run aggregate supply curve(LRAS) relationship between na-tion’s price level and real outputproduced when actual and ex-pected inflation are equal and input prices have fully adjusted tooutput prices

loss function equation indicating thecost or loss to society associatedwith the twin “evils” of deviations ofinflation from desired rate and devi-ations of output from full employ-ment levels

MM1 narrow or transactions measure of

money, which includes only cur-rency, demand deposits and otherchecking accounts in depository in-stitutions, and traveler’s checks

M2 broad measure of money, whichincludes M1 and several highly liq-uid financial assets such as savingsdeposits, money market mutualfund shares owned by individuals,and other instruments

M3 very broad measure of money,which includes M2 and several ad-ditional liquid instruments

managed float system in which gov-ernments intervene to prevent ex-change rate movements perceivedto be excessive or strongly at oddswith the national interest

manager of the System OpenMarket Account officer of theFederal Reserve Bank of New Yorkresponsible for carrying out,through a network of governmentsecurity dealers, the open markettransactions needed to meet thespecifications outlined in the FederalOpen Market Committee directive

margin requirements percentage ofthe value of securities purchasedthat the buyer must pay for usinghis/her own funds, as opposed toborrowed funds

marginal productivity of capitalrate of return expected by firmsfrom purchase of an additional unitof capital goods

market capitalization market valueof the aggregate shares of stockoutstanding of a corporation or auniverse of corporations

market risk risk that the price of a fi-nancial instrument will fluctuate

McFadden Act legislation prohibitingnational banks from operating out-side their home state and com-pelling banks to abide by state reg-ulations on intrastate branching

mean reversion tendency to ulti-mately revert to long-term averages

monetary base those financial assetsthat can potentially be used as re-serves; bank reserves and currencyheld by the public

monetary policy measures imple-mented by the central bank that in-fluence the availability of credit, thelevel of interest rates, and themoney supply in the nation

monetary policy rule arrangement inwhich the central bank announcesin advance specifically how it willrespond to ongoing economic de-velopments and commits the cen-tral bank to following through onthe announcement

monetary union adoption of a singlecurrency by a group of countries

money anything that is generally ac-ceptable as payment for goods andservices or for settlement of debt;most commonly defined to includecurrency, coins, and checking ac-counts in depository institutions

money market market in which short-term debt instruments—those withmaturities less than 1 year—aretraded, typically in massive quan-tities

money market deposit accounts(MMDAs) interest-bearing de-posits with limited check writingfeatures that permit banks to com-pete with money market mutualfunds

money supply multiplier ratio of themoney supply to the monetary base

money view view that informationabout the nation’s monetary aggre-gates, obtained from the deposit in-formation on the liability side of thebank balance sheet, is sufficient topredict the impact of monetary pol-icy on aggregate spending and GDP

moral hazard risk that one party to atransaction will undertake activitiesthat are undesirable from the otherparty’s viewpoint

mortgage long-term loan financingthe purchase of real property, se-cured by a lien on that property

mortgage-backed security financialinstrument that splits the financingand servicing of mortgages; bankspackage groups of mortgages,which are sold in security form tolarge investors

municipal bonds long-term debt in-strument representing a claim on acity or county

Glossary 607



Licensed to:

NNAIRU (non-accelerating inflation

rate of unemployment) rate ofunemployment at which demandfor labor equals the supply, thusmaintaining inflation at its existingrate

National Banking Act of 1863 leg-islation allowing the charting of na-tional banks, thereby facilitating is-suance of a uniform currency

national debt stock of governmentdebt outstanding; cumulative sumof past budget deficits less past sur-pluses

natural rate of output specific out-put level that generates full employ-ment, where the supply of workersequals the demand for workers

natural rate of unemployment un-employment rate that exists whenthe labor market is in equilibriumand there is full employment

negotiable CDs large CDs that canbe traded through a network ofdealers prior to maturity

negotiable order of withdrawal(NOW) accounts interest-bearingsavings account, on which limitedcheck writing privileges are permitted

net free reserves (NFR) differencebetween aggregate excess reservesheld by depository institutions andborrowed reserves (discount loans)

net worth amount by which total as-sets exceed total liabilities

nominal interest rate actual interestrate unadjusted for inflation

nonborrowed base (B-A) differencebetween monetary base and bor-rowed reserves (discount loans)

nonborrowed reserves (R-A) differ-ence between total reserves held bydepository institutions and bor-rowed reserves (discount loans)

OOffice of Thrift Supervision (OTS)

organization created as a bureauwithin the Treasury Department toreplace the FHLBB

Okun’s Law equation describing therelationship between the nation’sunemployment rate and the na-tion’s loss of output

open market operations buying andselling of government securities bythe Fed to influence bank lending,interest rates, and the nation’smoney supply

operating target variables near-term variables the central bank con-trols as part of its strategy toachieve policy goals

options contracts that give the ownerthe right to buy or sell a financialasset at a particular price within aspecified time period

output gap situation in which actualGDP is below potential GDP; thusthe unemployment rate exceeds theNAIRU

Ppassive rule rule in which the central

bank does not respond to ongoingdevelopments; constant money sup-ply growth rule

permanent income long-run averageexpected future income

Phillips curve hypothesis proposi-tion that, other things being equal,a lower unemployment rate is asso-ciated with a higher price level infla-tion rate

policy activists individuals who be-lieve active use of monetary and fis-cal policies contribute positively toeconomic stability

policy directive written statement in-dicating the intended posture ofFederal Reserve policy until the nextFOMC meeting

policy non-activists individuals whobelieve active use of monetary andfiscal policies do not lead to in-creased economic stability

political business cycle manipula-tion of the economy for politicalends

precautionary demand for moneymaintenance of money balances tomeet unforeseen circumstances

preferred habitat theory theory thatborrowers and lenders have strongpreferences for particular maturitiesbut may be induced to switch if ex-pected benefits are large

present value value today of paymentsto be received in the future

present value formula formula ex-pressing the value today of the rightto receive a payment or stream ofpayments in the future

price/earnings (PE) ratio ratio ofthe price of a share of stock to thecurrent annual earnings per shareachieved by the corporation

price-to-book ratio ratio of the priceof a share of stock to the bookvalue of the company

primary credit discount loans tobanks that are in sound financialcondition

primary market market in whichnewly issued securities are ex-changed

prime loan rate key interest rateposted by large U.S. banks, used asa benchmark for setting bank lend-ing rates

principal-agent problem moral haz-ard problem that occurs whenthose in control (agents) act in theirown interest rather than the interestof the owners or the public (prin-cipals)

productivity output per hour of workpurchasing power parity (PPP)

theory theory postulating that ex-change rates adjust completely to off-set the effects of different rates ofinflation in two countries

pure expectations theory theory inwhich market forces dictate that theyield on a long-term security of anyparticular maturity equals the geo-metric mean (the average) of thecurrent short-term yield and succes-sive future short-term yields cur-rently expected to prevail over thelife of the long-term security

Qquotas nation’s restrictions on the

volume of imported goods

Rrate of time preference extent to

which people prefer present con-sumption over future consumption

real interest rate interest rate afteradjusting the nominal interest ratefor expected inflation

Glossary608



Licensed to:

realized (ex post) real interestrate (rex post) difference betweennominal interest rate and realized in-flation rate

recessionary gap situation in whichequilibrium output falls short offull-employment output and the ac-tual unemployment rate is abovethe natural rate of unemploymentbecause output falls short of thenatural rate of output

recognition lag time that elapses be-tween the point when policy actionsideally would have been imple-mented (discovered only with hind-sight) and the point at which pol-icy-making officials become awareof the need for action

representative full-bodied moneypaper money that attests to anownership claim on a commoditysuch as gold or silver

repurchase agreement (RP) moneymarket instrument that governmentsecurity dealers, banks, and otherlarge financial market players use tomobilize temporarily idle funds

required reserve ratio (rr) ratio ofrequired reserves to DDO (demanddeposits and other checkable de-posits)

reserve requirements percentage fig-ure that depository institutions arerequired to hold in reserves to sup-port deposit liabilities

reserves cash on hand and depositsat the Federal Reserve maintainedby depository institutions

Resolution Funding Corporation(RFC) establishment created byCongress to issue bonds to coverthe expenses of financial institutionreform

Resolution Trust Corporation(RTC) temporary institution cre-ated by FIRREA that managed andresolved insolvent thrift institutionsand liquidated assets of failed insti-tutions

reverse repurchase agreement (re-verse RPs) or matched sale-purchase transaction transactionin which securities are sold to buy-ers, who agree to buy back the se-curities at a specific date and price

Ricardian equivalence propositiontheory that asserts that agents an-ticipate future tax liabilities associ-ated with larger budget deficits andincrease their saving rates to com-pensate

Riegle-Neal Interstate Bankingand Branching Efficiency Act of1994 act revoking the rightsgranted states to determine branch-ing laws for banks operating withinindividual states

risk premium additional yield con-tained in financial instruments tocompensate lenders for default risk

Ssacrifice ratio percentage of 1 year’s

output (GDP) that a nation mustforgo or “sacrifice” in order to re-duce its inflation rate by one per-centage point

Savings Association InsuranceFund (SAIF) insurance fund cre-ated by FIRREA for thrift institu-tions

seasonal credit Federal Reserve loansto institutions subject to strong sea-sonal fluctuations in loan demand,such as small banks in farmingcommunities and resort areas

secondary credit discount loans tobanks experiencing liquidity prob-lems or other financial problems

secondary market market in whichsecurities are traded after they havebeen issued

Securities and ExchangeCommission (SEC) governmentorganization charged with prevent-ing financial abuses such as insidertrading of stocks, bonds, and otherfinancial instruments, and failure ofcorporations to clearly and honestlydisclose key financial information

securitization transformation of illiq-uid financial assets into highly mar-ketable capital market instruments

segmented markets theory theorythat borrowers and lenders arecommitted to particular maturities,unwilling to switch in response toyield considerations

self-correcting mechanism mecha-nism that tends automatically to re-store full employment conditionsthrough wage and price flexibility

shares claims of ownership in indi-vidual corporations held by stock-holders

sources of the base factors deter-mining the monetary base; includes10 factors, dominated by FederalReserve security portfolio

speculative demand for moneymoney balances held so that a spec-ulative opportunity can be under-taken and financed in the event itshould arise

spot exchange rate exchange rate atwhich spot transactions take place

spot transactions exchange of cur-rencies for immediate or “on thespot” delivery and payment

stagflation combination of stagnantor falling output and sharply risingprices

stored value cards cards loaded witha predetermined amount of money;used to make payments

supply-shock inflation inflationcaused by sharp increases in inputprices, which shift the AS curve left-ward.

supply-side economics macroeco-nomic policies designed to increasesaving, investment, and work incen-tives, thereby shifting the aggregatesupply curve persistently rightward

sweep account device through whichthe bank’s computer automaticallytransfers funds out of customers’checking accounts into interest-bearing financial assets at the endof each day

TT-accounts a device showing the

change in the balance sheet result-ing from a given event

tariffs taxes on imported goodstax and loan accounts U.S. Treasury

deposits in commercial banks, peri-odically replenished by federal taxreceipts and by the proceeds of newTreasury securities sales to the public

Glossary 609



Licensed to:

Taylor rule monetary policy rule inwhich the Federal Reserve moves itsfederal funds rate target in responseto changes in both inflation and theoutput gap

term premium additional yield em-bedded in long-term debt instru-ments to compensate lenders formarket risk

term structure of interest rates re-lationship at a given point in time be-tween the length of time to maturityand the yield on a security

terms of trade ratio of the price ofthe nation’s exports divided by theprice of the nation’s imports, withboth prices measured in units ofdomestic currency

time inconsistency problem ten-dency of policymakers to announcea particular policy to influence ex-pectations and then to follow dif-ferent policies after the expectationshave been formed

time preference human propensity toexhibit preference for current con-sumption over future consumption

Tobin’s q theory theory that mone-tary policy influences investmentspending by altering stock pricesand firms’ market capitalization rel-ative to replacement cost of capital

too big to fail policy regulatory pol-icy of systematically bailing out verylarge, troubled financial institutionswhose failure might touch off majorfinancial market repercussions

trade deficit amount by which the to-tal value of a nation’s imports ex-ceeds the total value of its exports

transactions (checkable) depositsdeposits on which checks can bewritten with unlimited checkingprivileges

transactions costs value of moneyand time needed for financial trans-actions

transactions demand for moneydemand for money to finance ex-penditures that are not perfectlysynchronized with receipt of funds

transmission mechanism of mone-tary policy various avenues orchannels through which changes inFederal Reserve policy alter aggre-gate demand and economic activity

Treasury bills short-term IOUs issuedby U.S. government, traded at a dis-count from face value in a well-developed secondary market

Treasury bonds IOUs issued by theU.S. government that have originalmaturity of 10 to 40 years

Treasury notes IOUs issued by theU.S. government that have an origi-nal maturity of 1 to 10 years

Treaty on Monetary Union(Maastricht Treaty) agreementthat formed the European Unionand set forth the requisite condi-tions for the creation of the singlecurrency and central bank

Treaty of Rome treaty that createdthe European EconomicCommunity and formed an arrange-ment in which member countriespractice free trade among them-selves while maintaining a commontariff or other trade restrictions vis-à-vis nonmember nations

Uunit banking system in which a bank

is permitted to have only one office,with no branching permitted

uses for the base ways in which themonetary base is allocated or used;bank reserves and currency held bythe public

Vvelocity of money ratio of nominal

GDP to the money stockvirtuous cycle cycle in which expand-

ing economic activity and risingstock prices lead to increased in-vestment expenditures, thereby fur-ther expanding economic activity

Wwealth the value of assets, including

money stock and other financialand real assets, minus the value ofliabilities

wealth effect effect of changes in in-dividuals’ net worth on their con-sumption and saving decisions

Yyield rate of return on an asset, ex-

pressed as a percentage per yearyield curve graphical depiction of the

term structure of interest ratesyield to maturity average annual re-

turn including any capital gain orloss realized at maturity when theface value of the bond is redeemed

Zzero coupon bond bond that pro-

vides no annual payments butagrees to return a specific principalat maturity

Glossary610



Licensed to:

AActive monetary policy rules, 563–564,

567–572Adjustable-peg exchange rate system,

179–180Adverse selection, 70, 258

S&L 1980s crisis, 269Aggregate demand (AD) curve, 453–454. See

also Aggregate demand/aggregate sup-ply (AD/AS) model

factors that shift, 455–457monetary policy and AD shocks, 469–470

Aggregate demand/aggregate supply(AD/AS) model, 452–453. See alsoMacroeconomic historical develop-ments

disequilibrium, 454–455equilibrium output, 454–455, 459–462equilibrium price level, 454–455short-run versus long-run equilibrium out-

put, 459–462Aggregate supply (AS) curve, 454. See also

Aggregate demand/aggregate supply(AD/AS) model

factors that shift, 458, 459monetary policy and AS shocks, 470–472oil prices and AS shocks, 482–483

Amortized mortgages, 75Appreciation, 15Assets, 205

commercial banks, 210–215Fed’s assets, 289–290, 348–349

Asymmetric information, 70limiting the consequences of, 258–259transaction costs, 71

ATMs, 239–241ATS accounts, 207–208Australian interest rates, 134Automated teller machines, 239–241Automatic transfer service (ATS) accounts,

207–208

BBalance sheet, 205

commercial banks, 204–205Federal Reserve (Fed), 288–292

Bank charters, 234, 261–262Bank deposits

CDs. See Certificates of deposit (CDs)commercial banks, 207–209creation of, 326–333

insurance. See Deposit insurance; FDIC in-surance

multiple contraction of, 332–333multiple expansion of, 328–331

Banker’s acceptances, 53–54Bank holding companies, 209, 236, 239Bank Holding Company Act of 1956, 239Banking Act of 1933. See Glass-Steagall ActBanking Act of 1935, 400Banking panic, 86Bank insolvency, 215Bank Insurance Fund (BIF), 268Bank liquidity trap, 386Bank of the United States, 231–323Banks and banking, 6–7

branching restrictions, 238–245chartering, 234, 261–262commercial banks. See Commercial bankscompetition restrictions, 262Comptroller. See Comptroller of the

Currencyconsolidation of banks, 242–245contemporary structure, 237–248deposits. See Bank depositsdisclosure requirements, 261dual banking system, 233early U.S. banking history, 230–233economies of scale, 243electronic banking, 239–241excess reserves, 328FDIC. See Federal Deposit Insurance

Corporation (FDIC)Federal Reserve. See Federal Reserve (Fed)Free Banking Era, 232future directions, 251–252geographic restrictions, 238–245German banking system, 249–250Internet banking, 241–242investment banks, 48, 246–248Japanese banking system, 249–250modern banking, 246–251mutual savings banks, 76National Banking Act of 1863, 232–233“non-bank banks,” 239regulation of, 233–236reserve requirement. See Reserve require-

ment(s)risk-limiting regulatory measures, 260–262supervision and examination, 261unit banking, 232

Barter economy, 20

Bond market, 13–14Bonds, 13

bond prices, monetary policy and, 531–532corporate bonds, 55coupon bonds, 98, 99federal agency bonds, 55–56federal bonds, 55junk bonds, 141municipal bonds, 55treasury bonds, 55, 57, 61–64, 440–441zero coupon bonds, 97–98

Book value, 167common stocks, 168

Branch banking restrictions, 238–245Bretton Woods exchange rate system,

179–180Broad measures of money, 35–36Brokerage services, 247Brokered deposits, 267Brokers, 45“Bubble economy”

Federal Reserve policy, 169–1722000–2002, 164–165

Budget deficit, 10. See also Federal budgetdeficits (or surpluses)

Business loans, 212

CCAMELS system, 235, 261Capital, 205

commercial banks, 215–216, 224–226cost of, 150Fed’s capital accounts, 291–292

Capital deepening, 458Capital market, 50Capital market instruments, 54–56Carryover allowance, 416Cash assets, 210–211Cash markets, 49CDs. See Certificates of deposit

(CDs)Central bank, 3

accountability, 582credibility, 582–584of Europe. See European Central Bank

(ECB)independence and economic performance,

305–306inflation targeting advantages, 581–584inflation targeting escape clauses and

sanctions, 592

IndexIndex

611-620-Index-Thomas.qxd 11/17/04 1:23 PM Page 611


Licensed to:

Central bank—cont’das “lender of last resort,” 258–259transparency, 581

Certificates of deposit (CDs), 52brokered deposits, 267negotiable CDs, 52, 208–209small certificates of deposit, 208

Checkable deposits, 207–208Checking accounts, 29Chile’s inflation targeting experience,

596–597CHIPS (Clearing House Interbank Payments

and Settlements), 30Clinton years, 485–489Commercial banks, 73, 75

assets, 210–215ATS accounts, 207–208balance sheet, 204–205brokerage services, 247business loans, 212capital accounts, 215–216capital management, 224–226cash assets, 210–211consumer loans, 212–213declining role of, 89–90discount loans, 209excess reserves, 2181980s/1990s failures, 271–275legal reserves, 210liabilities, 205, 206–209liability management, 222–224liquidity management, 216–221loan loss reserves, 217loans, 211–213management, 216–226money market deposit accounts

(MMDAs), 208mutual funds, 247negotiable CDs, 208–209nondeposit borrowing, 209nontransactions deposits, 208–209NOW accounts, 207passbook savings accounts, 208real estate loans, 211–212required reserve ratios, 210reserves, 210, 217, 218securities, 213–215securities underwriting, 247size distribution of, 245small certificates of deposit, 208transactions deposits, 207–208

Commercial paper, 51–52Commodities Futures Trading Commission

(CFTC), 87Commodity money, 27Common stocks, 54–55Competition in banking, 262Comptroller of the Currency, 233

overlapping authority, 236supervisory responsibility, 235

Consolidation of banks, 242–245

Constant money growth rule, 565–567Consumer loans, 212–213Consumption spending

monetary policy and, 532–534, 536wealth effect and, 535–536

Contagion effects, 258Contractual savings institutions, 77–81Convergence criteria, 313Corporate bonds, 55Cost of capital, 150Counterfeit money, 34Coupon bonds, 98

and security prices, 99Credit crunch of the 1990s, 539Credit money, 28–29Credit unions, 76–77Credit Union Share Insurance Fund, 86Credit view, 543–545Currency (CP), 369Currency ratio (k), 360

changes in, impact of, 365determinants of, 369–371importance in the money supply multi-

plier, 371required reserve ratio (rr), 371–372

Current interest rates, 96

DDealers, 45Debit cards, 30Debt instruments, 47Debt markets, 47Default risk, 46Defensive open market operations, 406Deficits

budget deficit, 10. See also Federal budgetdeficits (or surpluses)

trade deficit. See Trade deficitDeflation, 6

inflation targeting, impact of, 584–585Delors Report, 312Demand deposits, 207Demand for money, 498, 501, 503

equation, 503income elasticity of, 513interest rates, role of, 507–511motives for holding money, 503–507precautionary demand, 506–507speculative demand, 507transactions demand, 503–506, 509–511and the velocity of money,

501–503Demand-pull inflation, 455Deposit insurance

FDIC. See FDIC insurancein foreign countries, 279private insurance, 281savings and loan associations (S&Ls),

266–267Depository Institutions Act of 1982,

257–258, 266

Depository Institutions Deregulation andMonetary Control Act of 1980(DIDMCA), 257, 258

Depreciation, 15, 178Depression. See Great DepressionDerivative markets, 49–50Desired excess reserves ratio (re), 360

changes in, impact of, 365–366Discount brokerages, 154–155Discount loans, 290, 399Discount rate, 209, 410Discounts and advances, 290Discount window, 410Discount window policy, 410–412Discretionary monetary policy, 563Disintermediation, 207District Federal Reserve banks, 288,

296–299Dividend reinvestment, importance of,

156–157Dividend yield(s), 156–157, 167Divisia aggregates, 38Dow Jones Industrial Average (DJIA),

152–153Dual banking system, 233Dynamic open market operations, 406

EE-cash, 30, 32ECB. See European Central Bank (ECB)Economic and Monetary Union (EMU),

311–312Economies of scale, 243Economies of scope, 248Electronic banking, 239–241Electronic cash, 30Electronic checks, 32Electronic money, 29–30, 32Electronic money system, 29Equation of exchange, 499–503Equities, 47Equity markets, 47Equity risk premium, 160Euro, 24–25Eurodollars, 53Europe

central bank. See European Central Bank(ECB)

economic unification of, 311–314European Central Bank (ECB), 311, 312

accountability, 319–321Council of Economics and Finance

Ministers, 316Executive Board, 316–317Governing Council, 316Governors, 316, 317“ownership” of, 317–318political independence, 318–319profits, distribution of, 318structure of, 316–317transparency, 321–323

Index612



Licensed to:

European System of Central Banks (ESCB),316

European Union (EU), 312Ex ante real interest rate (rex ante), 95,

114–119Excess reserve ratio (re), 372–374Excess reserves, 218, 328

money supply multiplier (m), 359–360,362

Exchange rate(s)Bretton Woods exchange rate system,

179–180fixed, 14–15, 179floating. See Floating exchange ratesforeign. See Foreign exchange ratesforward, 180international rate, stability of, 428spot, 180

Exchange traded funds (ETFs), 154–155Expected real interest rate (rex ante), 114–119Exports. See Net exports (nx)Ex post real interest rate (rex post), 115–117

FFDIC insurance, 258–259, 275–277

FDICIA reform, 277–278, 280proposed reforms, 280–281

Federal agency bonds, 55–56Federal bonds, 55Federal budget deficits (or surpluses),

10–11interest rates, 110, 112securities, issuance of, 58

Federal Deposit Insurance Corporation(FDIC), 86, 87, 233, 259

function of, 259insurance. See FDIC insuranceoverlapping authority, 236supervisory responsibility, 235

Federal Deposit Insurance CorporationImprovement Act of 1991 (FDICIA), 257, 277–278, 280

Federal funds, 53Federal funds market, 209Federal funds rate, 53, 209

open market operations, 404–405Federal Home Loan Bank Board (FHLBB),

262Federal notes, 55Federal Open Market Committee (FOMC),

293, 296Federal regulation, 85–87Federal Reserve Act, 256, 257, 287Federal Reserve banks, 288, 296–299Federal Reserve Data, 343Federal Reserve (Fed), 3–4, 233

AD/AS challenges, 462–465allocation of power within, 299–302assets, 289–290balance sheet, 288–292bank lending, control over, 545

Board of Governors, 293–296broad money supply multiplier, 363“bubble economy” policy, 169–172capital accounts, 291–292currency ratio changes, impact of, 365as a destabilizing influence,

558–563discount loans, 290, 345–346discounts and advances, 290discount window policy, 410–412district Federal Reserve banks, 288,

296–299earnings and expenses, 292–293excess reserves ratio changes, impact of,

366Federal Open Market Committee, 293,

296float, 291, 342, 346–347foreign exchange market operations, 349gold certificates accounts, 347–348Great Depression, role in, 385–393independence, 302–304, 306–307inflation targeting policy mandate,

597–600interest rates policy, 8, 109, 443–445as “lender of last resort,” 287–288liabilities, 290–291manager of the System Open Market

Account, 409member banks, 299monetary base control, 354and the money supply, 333–334,

445–446and the money supply multiplier,

361–362open market operations. See Open mar-

ket operationsorigin of, 286–288other Federal Reserve assets, 348–349other liabilities and capital, 353–354overlapping authority, 236policy directive, 408–410required reserve ratio changes, impact of,

365–366, 417–418reserve requirement instrument, 412,

415–419salaries of top officers, 300–301securities portfolio, 344–345special drawings rights accounts,

347–348structure of, 293–302supervisory responsibility, 234–235Treasury deposits at, 351–353

Federal Reserve System (FRS), 87Federal Savings and Loan Insurance

Corporation (FSLIC), 262Federal securities

agency bonds, 55kinds of, 57–65outstanding debt by security, 57treasury bills, 52, 59–61

treasury bonds, 55, 57, 61–64, 440–441treasury inflation-protected securities, 64,

65treasury notes, 55, 57, 61–64

Federal securities market, 56–57Fed funds rate targeting (1990s to 2004),

446Fedwire, 30Feedback monetary policy rules, 563–564,

567–572Finance companies, 82Financial futures, 49Financial futures contracts, 49–50Financial futures markets, 49–50Financial innovations, “ratchet effect” of,

518–519Financial Institutions Reform, Recovery, and

Enforcement Act of 1989 (FIRREA), 257, 258, 268–269

Financial instrumentsattributes of, 45–47liquidity, 46, 47risk, 46, 47yield, 46–47

Financial intermediaries, 7, 45, 72–77commercial banks. See Commercial

bankscontractual savings institutions, 77–81credit unions, 76–77deposit insurance. See Deposit insurancedisclosure requirements, 86finance companies, 82fire and casualty insurance companies,

78, 80investment-type financial intermediaries,

81–84life insurance companies, 77–78money market mutual funds (MMMFs),

82–84mutual funds, 81mutual savings banks, 76private pension funds, 80–81retirement funds, 80–81S&Ls. See Savings and loan associations

(S&Ls)stability controls, 85–86

Financial intermediation, 45benefits of, 71–72changing nature of, 88–93costs and risks in absence of, 69–71deficit units, benefits to, 72economic basis for, 69–72savers, benefits to, 71–72

Financial markets, 42–45cash versus derivative markets, 49–50classification of, 47–50debt versus equity markets, 47money versus capital markets, 50organized exchanges versus over-the-

counter markets, 48–49primary versus secondary markets, 47–48

Index 613



Licensed to:

Fire and casualty insurance companies, 78,80

“Fire walls,” 90, 91Fisher, Irving, 501Fisher effect, 105Fisher hypothesis, 105–108Fixed exchange rates, 14–15, 179Float, 342, 346–347Floating exchange rates, 15, 178–180

freely floating exchange rates, 183managed float, 183

Flow of funds, 42–45moral hazard, 70–71

FOMC directive, 296Forecasting inflation, 587Foreign exchange market(s), 14–15,

176–177equilibrium in, 192–193Federal Reserve operations in, 349forward exchange markets, 180, 182spot exchange markets, 180, 182

Foreign exchange rates, 14, 177–178changes and effects, 193–198daily quotations, 181determination of, 183–184floating rates. See Floating exchange ratesforward exchange rate, 180importance of, 182long-run determinants, 184–189short-run determinants, 189–196spot exchange rate, 180

Forward exchange markets, 180, 182Forward exchange rate, 180Forward transactions, 180Fractional reserve banking system, 287Free Banking Era, 232Freely floating exchange rates, 183Friedman luxury-good explanation, 514–515Friedman’s permanent income hypothesis,

520–521Full-bodied money, 27Future output, impact of inflation targeting

on, 588Futures, 49Futures contracts, 49–50Futures markets, 49–50Future value (FV), 97

GGarn–St. Germain Act, 257–258, 266GDP. See Gross domestic product (GDP)Geographic banking restrictions, 238–245German banking system, 249–250Glass-Steagall Act, 88, 90–91, 92, 235,

246–247, 257removal of Glass-Steagall restrictions,

248, 250–251response to, 247–248

Government purchases, factors influencing,456

Government regulation, 85–87

Gramm-Leach-Bliley Financial ServicesModernization Act, 90–91, 248, 257,258

Great Depression, 90, 378–379AD/AS model analysis, 477–478bank failures, 381–383causes of, 379Fed’s role, 385–393monetarist view, 387–393money supply, causes of contraction in,

383–384worldwide scope of, 380–381

Greenspan’s performance, 571Gross domestic product (GDP)

expenditures, components of, 532inflation targeting rule, 568nominal GDP, 497–498. See also Velocity

of moneynominal GDP targeting rule, 567real GDP, 497–498Taylor rule, 568–573

H“Hard currency,” 369Hysteresis, 465

IImpact lag, 556Implementation lag, 556Income, 20

Friedman’s permanent income hypothe-sis, 520–521

long-run average income, 520permanent income, 520

Income elasticity of demand for money, 513Income velocity. See Velocity of

moneyInflation, 5–6

demand-pull inflation, 455forecasting, 587interest rates and, 103–108, 115–116,

134international rate, 425stock prices, changes in, 163supply-shock inflation, 455targeting. See Inflation targetingtreasury inflation-protected securities, 64,

65unemployment. See NAIRU (non-

accelerating inflation rate of unem-ployment)

velocity of money, expected inflation and,512

worldwide downward trend, 425Inflationary gap, 460Inflation neutrality, 105Inflation targeting, 6, 578–580

arguments against, 585–588arguments in favor of, 580–585Chile’s experience with, 596–597experience with, 592–594

Fed’s policy mandate, 597–600implementation of, 588–592inflation performance before and after,

593–595practical considerations, 588–592sacrifice ratios, 595what is the appropriate target level,

590–593what price index should be used, 590who sets the target, 590

Inflation targeting rule, 568Information

accuracy and availability of, 85asymmetric. See Asymmetric informationbank disclosure requirements, 261

Insolvency, 215Instrument of monetary policy, 398Insurance

bank deposits. See Deposit insurance;FDIC insurance

Bank Insurance Fund, 268Credit Union Share Insurance Fund, 86Savings Association Insurance Fund, 86,

268state banking and insurance commis-

sions, 87Insurance companies

fire and casualty insurance companies,78, 80

life insurance companies, 77–78Interest parity condition, 191–192Interest rates, 8–9, 95, 97

1960 to 2004, 113–114Australian interest rates, 134business cycles, 109–110current rates, 96demand for money, role in, 507–511federal budget deficits (or surpluses),

110, 112Federal Reserve policy, 8, 109Fed’s policy from 1979 to 1982, 443–445fundamental determinants of, 103–110future value (FV), 97inflation expectations and, 103–108,

115–116, 134international synchronization, 111loanable funds model, 99–103long-term rates, 436money market yields and, 434–435money supply targets versus interest rate

targets, 437–439nominal rates. See Nominal interest ratesopen market operations, impact of, 402present value (PV), 97–98real interest rates. See Real interest ratesreal versus nominal interest rates,

436–437reserve requirements, influence of,

417–418risk structure of, 139–143and security prices, 99

Index614



Licensed to:

stability, goal of, 429term structure of. See Term structure of

interest ratesterm structure theories, 126–139. See also

Term structure theoriesvelocity of money, determinants of, 512,

519–520yield curve, 123, 125, 134, 136–138“zero rates” economies, 546

Intermediate target variables, 423, 435–437International capital flows, 177International deposit insurance systems,

279International inflation rate, 425International Monetary Fund (IMF), 179International payments instruments, 31International stock market performance,

161International synchronization

of economic phenomena, 9–10of interest rates, 111

Internet banking, 241–242Investment, factors influencing, 456Investment banks, 48, 246

banking services by, 247–248Investment spending, 536–540Investment-type financial intermediaries,

81–84

JJapan

banking system, 249–250inflation targeting, 585

“Jobless recovery” of 2002 to 2004,492–494

Junk bonds, 140

KKennedy years, 480–481Keynesian view(s), 385–386

of appropriate target variables, 439transmission mechanism of monetary

policy, 529–530

LLabor force participation rate, 458Lags of monetary policy, 555–557Law of one price, 186–187Legal reserves, 210, 287Legal tender, 19Liabilities, 205

commercial banks, 205, 206–209,222–224

other liabilities and capital of the FederalReserve (OLC), 353–354

Life insurance companies, 77–78Limited branching, 239Liquidity, 26

bank insolvency, 215bank liquidity trap, 386commercial banks, 216–221

financial instruments, 46, 47liquidity-profitability trade-off, 220–221liquidity-risk trade-off, 219–220

Liquidity premium theory, 129–131Loanable funds model, 99–103Loan loss reserves, 217Loan production offices, 239Loans

commercial banks, 211–213discount loans, 290, 399

Lombard system, 412, 413Long-run aggregate supply curve (LRAS),

462Long-run average income, 520Long-run exchange rate determinants,

184–185preferences, 189, 190price level behavior, 185–188, 190product development, 189, 190productivity, 189, 190quotas, 189, 190tariffs, 189, 190

Long-term interest rates, 436Loss function, 586

MMaastricht Treaty, 312–315Macroeconomic historical developments,

4791929–1933, 477–4781941–1945, 4781960s (early), 480–4811965–1972, 4811973–1982, 481, 483–4841983–1991, 484–4851993–2001, 485–4892001 recession, 489–4922002–2004, 492–494

Manager of the System Open MarketAccount, 296, 409

Marginal productivity of capital, 105Margin requirements, 294Market capitalization, 152Market risk, 46Matched sale-purchase transactions, 408McFadden Act, 239Mean reversion, 166, 171MMDAs, 208MMMFs, 82–84Monetary aggregates, 32–33, 435

Fed’s policy in the 1970s, 442–443open market operations, impact of, 402

Monetary base (B), 337–340control by the Fed, 344–354derivation of, 340factors producing changes in, 344–345Federal Reserve discount loans (A),

345–346Federal Reserve float (Fl), 342, 346–347Federal Reserve securities portfolio (P),

344–345

Fed’s gold certificates and special draw-ings rights accounts (G), 347–348

Fed’s monetary policy, 433–434nonborrowed base (B-A), 434open market operations, impact of, 402other Federal Reserve assets (OA),

348–349other liabilities and capital of the Federal

Reserve (OLC), 353–354sources of, 340–342Treasury cash holdings (TCa), 353Treasury currency outstanding (TCu),

349–351Treasury deposits at the Federal Reserve

(Ft), 351–353uses for, 342, 344

Monetary policyactivism, problems confronting, 555–558activism versus passivism, 552–555and bond prices, 531–532and consumption spending,

532–536discount window policy, 410–412discretionary monetary policy, 563Fed as a destabilizing influence, 558–563Fed policy directive, 408–410financial markets, stability of, 429flexibility, 586forecasting-related problems, 557–558goals of, 423–429high employment goal, 426–428historical review of Fed’s policies,

439–446interest rates, stability of, 429intermediate monetary policy targets,

429–432intermediate target variables, 423,

435–437international exchange rate, stability of,

428and investment spending, 536–540Keynesian view of appropriate target vari-

ables, 439“lag” problems, 555–557long-term economic growth, goal of, 428monetarists’ view of appropriate target

variables, 439money supply targets versus interest rate

targets, 437–439and net exports, 540–541net free reserves, 431–432, 434open market operations. See Open mar-

ket operationsoperating target variables, 423, 432–435price level stability, 423–424, 426reserve requirements. See Reserve require-

ment(s)rule. See Monetary policy ruleself-correcting mechanism, 554–555and stock prices, 531–532time inconsistency problem, 565

Index 615



Licensed to:

Monetary policy—cont’dtransmission mechanism. See

Transmission mechanism of mone-tary policy

velocity behavior and, 521, 522Monetary policy rule, 563, 565–567

active rules, 563–564, 567–572case for, 564–565passive rule, 563, 565–567

Monetary union, 311Money, 3, 18, 19

broad measures of, 35–36commodity money, 27counterfeit money, 34credit money, 28–29demand for. See Demand for moneyelectronic money, 29–30, 32evolution of, 26–30fiat money, 28–29full-bodied money, 27functions of, 20–26income, distinguished, 20meaning of, 19as means-of-payment function, 21medium-of-exchange function, 21motives for holding, 503–507representative full-bodied money,

27–28as standard-of-value function, 22–23store-of-value function, 23supply. See Money supplyas unit-of-account function, 22–23velocity of. See Velocity of moneywealth, distinguished, 20weighted measures of, 37–38

Money market deposit accounts (MMDAs),208

Money market instruments, 51–54Money market mutual funds (MMMFs),

82–84Money market(s), 50

capital markets versus, 50Fed policy in the 1950s and 1960s,

441–442Money supply, 3. See also Monetary base

(B); Money supply multiplier (m)and the Federal Reserve, 333–334Fed’s policy from late 1982 to the early

1990s, 445–446interest rate targets versus money supply

targets, 437–439measures of, 32–38M1 measure of, 33–34M2 measure of, 35–36M3 measure of, 35–36weighted measures of, 37–38what determines, 3–5

Money supply multiplier (m), 337, 338,357–359, 369

applications, 364currency ratio (k), 360, 367–371

derivation of, 359–361desired excess reserves ratio (re), 360excess reserve ratio (re), 372–374excess reserves, 359–360, 362Federal Reserve’s role, 361–362historical behavior of, 366–367naive deposit expansion multiplier, com-

pared, 361narrow money supply (M1), 359required reserve ratio (rr), 360required reserves, 359–360, 362reserves, 359–360, 362

Money view, 542–543Moral hazard problem, 70, 258

flow of funds, 42–45principal agent problem, 269, 271

Mortgage-backed securities, 56Mortgages, 56

amortized mortgages, 75commercial banks, 211–212

Motives for holding money, 503–507Municipal bonds, 55Mutual funds, 81

commercial banks, 247emergence of, 88–89

Mutual savings banks, 76

NNAIRU (non-accelerating inflation rate of

unemployment), 460forces that change, 463–465Phillips curve and, 465–469, 472–473

Narrow measure of money, 33–34Narrow money supply (M1), 359National Association of Securities Dealers

Automated Quotations (NASDAQ),153–154

National Banking Act of 1863, 232–233National Credit Union Administration

(NCUA), 87National debt, 10

managing, 132National saving rate, 485Natural rate of output, 460Natural rate of unemployment, 460Negotiable CDs, 52, 208–209Negotiable order of withdrawal (NOW) ac-

counts, 207Net exports (nx)

factors influencing, 456–457and monetary policy, 540–541

Net free reserves (NFR), 431–432, 434Fed policy in the 1950s and 1960s,

441–442Net worth, 205New York Stock Exchange Composite Index

(NYSE), 153Nominal GDP, 497–498

“multiplier” linking money stock to. SeeVelocity of money

targeting rule, 567

Nominal interest rates, 95changes in, 194versus real interest rates, 436–437

“Non-bank banks,” 239Nonborrowed base (B-A), 434Nonmarketable government debt, 64NOW accounts, 207

OOffice of the Comptroller of the Currency

(OCC), 87. See also Comptroller of theCurrency

Office of Thrift Supervision (OTS), 87, 268Oil prices and AS shocks, 482–483Okun’s Law, 426Online trading, 154–155Open market operations, 290, 398–399

advantages of, 401–402Banking Act of 1935, 400defensive operations versus dynamic oper-

ations, 406discovery of, 399early disadvantages, 403–404effectiveness of, 401–405and the federal funds rate, 404–405impacts of, 401–402outright transactions versus repurchase

agreements, 406–408scope of Fed’s activity, 400–401technical aspects of, 406–408

Operating target variables, 423, 432–435Options, 49Organized exchanges, 48Output

equilibrium output, 454–455, 459–462future output, impact of inflation target-

ing on, 588natural rate of, 460

Output gap, 480Outright transactions, 406–407Over-the-counter (OTC) markets, 48–49

PPassbook savings accounts, 208Passive monetary policy rule, 563, 565–567Payments system, 26–30Permanent income, 520Phillips curve hypothesis, 465–469,

472–473Policy activists, 552Policy directive, 408–410Policy nonactivists, 552Political business cycle, 564Precautionary demand for money, 506–507Preferred habitat theory, 133, 135Present value (PV), 97–98Price/earnings (PE) ratio, 166–167Price of inputs, changes in, 458, 459Price-to-book ratio, 167–168Primary credit facility, 411Primary versus secondary markets, 47–48

Index616



Licensed to:

Prime loan rate, 8Principal-agent problem, 269, 271

S&L 1980s crisis, 269, 271Private pension funds, 80–81Problem banks, 235, 261Productivity, 2

growth trends, 488–489long-run exchange rate determinant, 189,

190marginal productivity of capital, 105

P-star analysis, 522–523Purchasing power parity (PPP) theory,

186–188Pure expectations theory, 126–128

implicit forward rate, 128–129

QQuantity of inputs, changes in, 458Quotas, 189

RRate of time preference, 105“Reaganomics,” 484–485Real estate loans, 211–212Real GDP, 497–498Real interest rates, 7, 95

changes in, 194–195expected real interest rate (rex ante), 95,

114–119versus nominal interest rates, 436–437realized real interest rate (rex post), 95,

115–117Recessionary gap, 460Recessions

Carter years, 483economic activity in, 486–487“jobless recovery” of 2002 to 2004,

492–494Reagan years, 4832001 recession, 489–492

Recognition lag, 555–556Regulatory controls, 85–87Representative full-bodied money, 27–28Repurchase agreements (RPs), 52–53,

407–408Required reserve ratio (rr), 210, 360

changes in, impact of, 365–366determinants of, 371–372

Reserve averaging, 416Reserve requirement(s), 328, 412, 415

demise of the “tax,” 414–415institutional aspects of, 415–416interest rates, influence on, 417–418money supply, influence on, 417–418money supply multiplier (m), 359–360,

362Reserves, 53, 287

carryover allowance, 416commercial banks, 210, 217, 218excess reserves. See Excess reservesFed’s monetary policy, 433–434

loan loss reserves, 217money supply multiplier (m), 359–360,

362nonborrowed reserves (R-A), 434open market operations, impact of, 402required reserves. See Reserve require-

ment(s)reserve averaging, 416

Resolution Trust Corporation (RTC),268–269

Retirement funds, 80–81emergence of, 88–89

Reverse repurchase agreements (reverseRPs), 408

Ricardian equivalence proposition, 112

Riegle-Neal Interstate Banking andBranching Efficiency Act of 1994, 241

Riskdefault risk, 46financial instruments, 46, 47interest rates, risk structure of, 139–143liquidity-risk trade-off, 219–220market risk, 46savings and loan associations, 268stock market, 157–159

Risk premium, 141equity risk premium, 160

SSavings accounts, 208. See also Bank de-

positsSavings and loan associations (S&Ls),

75–76brokered deposits, 267deposit insurance, 266–267deregulation, 265–266forbearance, 266origins and operations, 262–263risk taking, 2681980s failures and response, 262–271, 273zombies, 268

Savings Association Insurance Fund (SAIF),86, 268

Search cost, 71Seasonal credit, 411Secondary credit, 411Secondary markets, 47

versus primary markets, 47–48Securities

bond market, 13–14. See also Bondscommercial banks, 213–215, 247federal budget deficits, issuance to cover,

58federal securities. See Federal securitiesFed’s securities portfolio, 344–345mortgage-backed securities, 56prices. See Security pricesstock market. See Stock marketstock market indexes. See Stock market

indexes

stock prices. See Stock pricestreasury inflation-protected securities, 64,

65Securities and Exchange Commission (SEC),

85, 87Securitization, 211Security prices

bond prices, monetary policy and,531–532

interest rates and, 99open market operations, impact of, 402stock prices. See Stock prices

Segmented markets theory, 131–133Self-correcting mechanism, 462, 554–555Shares, 12Short-run exchange rate determinants,

189–190bandwagon effects, 195–196changes in, 193–196expected investment returns, 190–191,

192–193interest parity condition, 191–192

Small certificates of deposit, 208Sources of the base, 340–342Speculative demand for money, 507Spot exchange markets, 180, 182Spot exchange rate, 180Spot transactions, 180Stagflation, 470, 483Standard and Poor’s 500 Index (S&P 500),

153Standing credit facility, 411State banking and insurance commissions,

87Stock market, 12–13

discount brokerages, 154–155dividend reinvestment, importance of,

156–157ETFs (exchange traded funds), 154–155international performance, 161“i shares,” 154long-term behavior, 147–148measuring performance of. See Stock

market indexesonline trading, 154–155risks and returns, 157–159virtuous and vicious cycles, 150–151

Stock market indexesDow Jones Industrial Average (DJIA),

152–153exchange traded funds (ETFs),

154–155good index characteristics, 152historical performance of, 155–156National Association of Securities Dealers

Automated Quotations (NASDAQ),153–154

New York Stock Exchange CompositeIndex (NYSE), 153

Standard and Poor’s 500 Index (S&P500), 153

Index 617



Licensed to:

Stock prices, 12–13as a barometer of economic sentiment,

148–151“bubble economy,” 164–165, 169–172and consumption spending, 149determinants of, 159–164discounting expected future payments,

160, 162dividend yields, 167expected inflation, changes in, 163expected payments, revision of,

162–163indicators of, 166–168and investment spending, 150mean reversion, 166, 171monetary policy and, 531–532price/earnings (PE) ratio, 166–167price-to-book ratio, 167–168risk premium, changes in, 163–164

Stored value cards, 30Supply-shock inflation, 455Supply-side economics, 484–485Sweep account, 511SWIFT (Society for Worldwide Inter-

telecommunications FinancialTransfers), 30

TT-accounts, 216Tariffs, 189Tax and loan accounts, 291Taylor rule, 568–573Technological change, 458Term premium, 130Terms of trade, 197–198Term structure of interest rates, 123–124

as forecaster of macroeconomic phenom-ena, 140

yield curve, 123, 125, 134, 136–138

Term structure theoriesliquidity premium theory, 129–131preferred habitat theory, 133, 135pure expectations theory, 126–129segmented markets theory, 131–133utility/validity of, 135–139

Thrift institutions, 72. See also Savings andloan associations (S&Ls)

declining role of, 89–90Time inconsistency problem, 565Tobin institutional explanation, 515–516Tobin’s q theory, 538

Too-big-to-fail policy, 259proposal to abolish, 280

Tool of monetary policy, 398Trade deficit, 15, 193

unanticipated changes in, 195Transaction costs, 71Transactions demand for money, 503–506

interest rates and, 509–510Transactions deposits, 207–208Transactions measure of money, 33–34Transmission mechanism of monetary pol-

icy, 527–528and bond prices, 531–532and consumption spending, 532–536credit view, 543–545early Keynesian views, 529–530early monetarist views, 530and investment spending, 536–540lending view, 543–545modern views, 530–541money view, 542–543and net exports, 540–541and stock prices, 531–532

Transparency, 581Treasury bills, 52, 59–61Treasury bonds, 55, 57, 61–64

Fed policy from 1942-1951, 440–441Treasury cash holdings (TCa), 353Treasury currency outstanding (TCu),

349–351Treasury deposits at the Federal Reserve

(Ft), 351–353Treasury inflation-protected securities

(TIPS), 64, 65Treasury notes, 55, 57, 61–64Treasury yield curve, 125Treaty of Rome, 312Treaty on Monetary Union, 312–315Trickle-down economics, 485

U“Underground economy,” 369Unemployment

NAIRU. See NAIRU (non-accelerating in-flation rate of unemployment)

natural rate of, 460Phillips curve hypothesis, 465–469,

472–473Unemployment, consequences of, 426–428Unit banking, 232United States. See Federal •••Uses for the base, 342, 344

VVelocity of money, 498–499

cyclical behavior of, 519–521and the demand for money, 501–503determinants of, 511–513economic uncertainty and, 512equation of exchange, 499–503expected inflation and, 512financial innovations, “ratchet effect” of,

518–519financial technology and, 511–512Friedman luxury-good explanation,

514–515Friedman’s permanent income hypothe-

sis, 520–521income and, 513induced changes in, 518institutional factors, 511interest rates, 512, 519–520international comparisons of long-run be-

havior, 517long-run behavior, 513–516, 517monetary policy and, 521, 522P-star analysis, 522–523short-run behavior, 516, 518–521Tobin institutional explanation, 515–516

Vietnam era, 481

WWealth, 20Wealth effect, 149–150, 454

and consumption spending, 535–536Weighted measures of money, 37–38Werner Report, 312World War II, 478–479

YYield, 46–47

dividend yield(s), 156–157, 167interest rates. See Interest rates

Yield curve, 123, 125, 134, 136–138cyclical pattern of, 137–139maturity of yield and direction, 137upward-sloping yield curve, predomi-

nance of, 136–137Yield to maturity, 46–47

ZZero coupon bonds, 97–98“Zero interest rates” economies, 546Zombies, 268

Index618



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