economics_of_money_banking__financial_markets
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Contents xxi
Application The Great Depression Bank Panics, 1930–1933 . . . . . . . . . . . . . . . .387
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .390
CHAPTER 17
TOOLS OF MONETARY POLICY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .393
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .393 The Market for Reserves and the Federal Funds Rate . . . . . . . . . . . . . . . . . . . . . . .393
Supply and Demand in the Market for Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .394 How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate . . . . . . . . . .395
Open Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
398 |
A Day at the Trading Desk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
398 |
Advantages of Open Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
400 |
Discount Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .400
Operation of the Discount Window . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .401
Lender of Last Resort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .402
Advantages and Disadvantages of Discount Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .403
Reserve Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .403
Box 1 Inside the Fed: Discounting to Prevent a Financial Panic: |
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The Black Monday Stock Market Crash of 1987 and the Terrorist Destruction |
|
of the World Trade Center in September 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . |
404 |
Advantages and Disadvantages of Reserve Requirement Changes . . . . . . . . . . . . . . . . . . . |
405 |
Application Why Have Reserve Requirements Been Declining Worldwide? . . . .406
Application The Channel/Corridor System for Setting Interest Rates in |
|
Other Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
.406 |
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . |
408 |
CHAPTER 18
CONDUCT OF MONETARY POLICY: GOALS AND TARGETS . . . . . . . . . . . . . . . . . .411
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .411
Goals of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .411
High Employment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .411
Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .412
Price Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .412
Box 1 Global: The Growing European Commitment to Price Stability . . . . . . . . .413
Interest-Rate Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .413
Stability of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .413
Stability in Foreign Exchange Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .414
Conflict Among Goals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .414
Central Bank Strategy: Use of Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .414
Choosing the Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .416
Criteria for Choosing Intermediate Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .418 Criteria for Choosing Operating Targets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .419
xxii Contents
P A R T V
Fed Policy Procedures: Historical Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . .419
The Early Years: Discount Policy as the Primary Tool . . . . . . . . . . . . . . . . . . . . . . . . . . . .420 Discovery of Open Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .420 The Great Depression . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .421
Box 2 Inside the Fed: Bank Panics of 1930–1933: Why Did the Fed Let |
|
Them Happen? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
421 |
Reserve Requirements as a Policy Tool . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .422 War Finance and the Pegging of Interest Rates: 1942–1951 . . . . . . . . . . . . . . . . . . . . . . .422 Targeting Money Market Conditions: The 1950s and 1960s . . . . . . . . . . . . . . . . . . . . . . .423 Targeting Monetary Aggregates: The 1970s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .424 New Fed Operating Procedures: October 1979–October 1982 . . . . . . . . . . . . . . . . . . . . .425 De-emphasis of Monetary Aggregates: October 1982–Early 1990s . . . . . . . . . . . . . . . . . .426 Federal Funds Targeting Again: Early 1990s and Beyond . . . . . . . . . . . . . . . . . . . . . . . . .427 International Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .427
Box 3 Global: International Policy Coordination: The Plaza Agreement and |
|
the Louvre Accord . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
428 |
The Taylor Rule, NAIRU, and the Philips Curve . . . . . . . . . . . . . . . . . . . . . . . . . . .428
Box 4 Fed Watching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .430
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .431
International Finance and Monetary Policy 433
CHAPTER 19
THE FOREIGN EXCHANGE MARKET . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .435
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .435
Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .435
What Are Foreign Exchange Rates? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .436
Following the Financial News Foreign Exchange Rates . . . . . . . . . . . . . . . . . . .437
Why Are Exchange Rates Important? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .438 How Is Foreign Exchange Traded? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .438
Exchange Rates in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .439
Law of One Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
.439 |
Theory of Purchasing Power Parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
439 |
Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates . . . . . |
440 |
Factors That Affect Rates in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
441 |
Exchange Rates in the Short Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
443 |
Comparing Expected Returns on Domestic and Foreign Deposits . . . . . . . . . . . . . . . . . . .443 Interest Parity Condition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .445 Equilibrium in the Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .446
Explaining Changes in Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .448
Shifts in the Expected-Return Schedule for Foreign Deposits . . . . . . . . . . . . . . . . . . . . . .448 Shifts in the Expected-Return Schedule for Domestic Deposits . . . . . . . . . . . . . . . . . . . . .450
Contents xxiii
Application Changes in the Equilibrium Exchange Rate: Two Examples . . . . . . |
452 |
Changes in Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .452
Changes in the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .453
Exchange Rate Overshooting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .453
Application Why Are Exchange Rates So Volatile? . . . . . . . . . . . . . . . . . . . . . . .455
Application The Dollar and Interest Rates, 1973–2002 . . . . . . . . . . . . . . . . . . . .455
Application The Euro’s First Four Years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .457
Application Reading the Wall Street Journal: The “Currency Trading” Column .457
Following the Financial News The “Currency Trading” Column . . . . . . . . . . . .458
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .459
CHAPTER 20
THE INTERNATIONAL FINANCIAL SYSTEM . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462
Intervention in the Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462
Foreign Exchange Intervention and the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . .462
Box 1 Inside the Fed: A Day at the Federal Reserve Bank of New York’s |
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Foreign Exchange Desk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
463 |
Unsterilized Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .465
Sterilized Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .466
Balance of Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .467
Evolution of the International Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . .468
Gold Standard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .469
Bretton Woods System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .469
Box 2 Global: The Euro’s Challenge to the Dollar . . . . . . . . . . . . . . . . . . . . . . . . . |
471 |
Managed Float . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .473
European Monetary System (EMS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .474
Application The Foreign Exchange Crisis of September 1992 . . . . . . . . . . . . . . .475
Application Recent Foreign Exchange Crises in Emerging Market Countries: Mexico 1994, East Asia 1997, Brazil 1999, and Argentina 2002 . . . . . . . . . . . . . .477
Capital Controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .478
Controls on Capital Outflows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .478 Controls on Capital Inflows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .479
The Role of the IMF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .479
Should the IMF Be an International Lender of Last Resort? . . . . . . . . . . . . . . . . . . . . . . . .480
International Considerations and Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . .482
Direct Effects of the Foreign Exchange Market on the Money Supply . . . . . . . . . . . . . . . .482 Balance-of-Payments Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .483 Exchange Rate Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .483
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .484
xxiv Contents
P A R T V I
CHAPTER 21
MONETARY POLICY STRATEGY: THE INTERNATIONAL EXPERIENCE . . . . . . . . . . .487
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .487
The Role of a Nominal Anchor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .487
The Time-Consistency Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .488
Exchange-Rate Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .489
Advantages of Exchange-Rate Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .489 Disadvantages of Exchange-Rate Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .490 When Is Exchange-Rate Targeting Desirable for Industrialized Countries? . . . . . . . . . . . .492 When Is Exchange-Rate Targeting Desirable for Emerging Market Countries? . . . . . . . . .492 Currency Boards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .492 Dollarization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .493
Box 1 Global: Argentina’s Currency Board . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .494
Monetary Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .496
Monetary Targeting in Canada, the United Kingdom, Japan, Germany, and Switzerland . . .496
Box 2 Global: The European Central Bank’s Monetary Policy Strategy . . . . . . . . .498
Advantages of Monetary Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .500
Disadvantages of Monetary Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .501
Inflation Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .501
Inflation Targeting in New Zealand, Canada, and the United Kingdom . . . . . . . . . . . . . . .501
Advantages of Inflation Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .504
Disadvantages of Inflation Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .506
Nominal GDP Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .508
Monetary Policy with an Implicit Nominal Anchor . . . . . . . . . . . . . . . . . . . . . . . . .509
Advantages of the Fed’s Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
510 |
Disadvantages of the Fed’s Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
510 |
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .512
Monetary Theory 515
CHAPTER 22
THE DEMAND FOR MONEY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517
Quantity Theory of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517
Velocity of Money and Equation of Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .518
Quantity Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .519
Quantity Theory of Money Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .519
Is Velocity a Constant? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .520
Keynes’s Liquidity Preference Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .521
Transactions Motive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .521
Precautionary Motive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .522
Speculative Motive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .522
Putting the Three Motives Together . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .523
Further Developments in the Keynesian Approach . . . . . . . . . . . . . . . . . . . . . . . . .524
Transactions Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .524
Contents xxv
Precautionary Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .527
Speculative Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .527
Friedman’s Modern Quantity Theory of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . .528 Distinguishing Between the Friedman and Keynesian Theories . . . . . . . . . . . . . . . .530 Empirical Evidence on the Demand for Money . . . . . . . . . . . . . . . . . . . . . . . . . . . .532
Interest Rates and Money Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
.533 |
Stability of Money Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
.533 |
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . |
.533 |
CHAPTER 23 |
|
THE KEYNESIAN FRAMEWORK AND THE ISLM MODEL . . . . . . . . . . . . . . . . . . . |
536 |
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .536
Determination of Aggregate Output . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .536
Consumer Expenditure and the Consumption Function . . . . . . . . . . . . . . . . . . . . . . . . . .538
Investment Spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .539
Box 1 Meaning of the Word Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .540
Equilibrium and the Keynesian Cross Diagram . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .540
Expenditure Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .542
Application The Collapse of Investment Spending and the Great Depression . .545
Government’s Role . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .545
Role of International Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .548
Summary of the Determinants of Aggregate Output . . . . . . . . . . . . . . . . . . . . . . . . . . . . .548
The ISLM Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .551
Equilibrium in the Goods Market: The IS Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .552 Equilibrium in the Market for Money: The LM Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . .555
ISLM Approach to Aggregate Output and Interest Rates . . . . . . . . . . . . . . . . . . . . .557 Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .558
CHAPTER 24
MONETARY AND FISCAL POLICY IN THE ISLM MODEL . . . . . . . . . . . . . . . . . . . .561
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .561 Factors That Cause the IS Curve to Shift . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .561 Factors That Cause the LM Curve to Shift . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .564 Changes in Equilibrium Level of the Interest Rate and Aggregate Output . . . . . . . .566
Response to a Change in Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .566 Response to a Change in Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .567
Effectiveness of Monetary Versus Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
568 |
Monetary Policy Versus Fiscal Policy: The Case of Complete Crowding Out . . . . . . . . . . .568
Application Targeting Money Supply Versus Interest Rates . . . . . . . . . . . . . . . . .571
ISLM Model in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
.575 |
ISLM Model and the Aggregate Demand Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
577 |
Deriving the Aggregate Demand Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
577 |
Factors That Cause the Aggregate Demand Curve to Shift . . . . . . . . . . . . . . . . . . . . . . . . |
578 |
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .580
xxvi Contents
CHAPTER 25 |
|
AGGREGATE DEMAND AND SUPPLY ANALYSIS . . . . . . . . . . . . . . . . . . . . . . . . . |
582 |
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .582
Aggregate Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .582
Monetarist View of Aggregate Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .582
Following the Financial News |
Aggregate Output, Unemployment, and the |
Price Level . . . . . . . . . . . . . . . |
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .583 |
Keynesian View of Aggregate Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .585
The Crowding-Out Debate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .586
Aggregate Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .587
Shifts in the Aggregate Supply Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .588
Equilibrium in Aggregate Supply and Demand Analysis . . . . . . . . . . . . . . . . . . . . .588
Equilibrium in the Short Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .589 Equilibrium in the Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .589 Shifts in Aggregate Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .592 Shifts in Aggregate Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .594 Shifts in the Long-Run Aggregate Supply Curve: Real Business Cycle Theory
and Hysteresis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .596 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .597
Application Explaining Past Business Cycle Episodes . . . . . . . . . . . . . . . . . . . . .598
Vietnam War Buildup, 1964–1970 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .598
Negative Supply Shocks, 1973–1975 and 1978–1980 . . . . . . . . . . . . . . . . . . . . . . . . . . .598
Favorable Supply Shocks, 1995–1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .599
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .600
CHAPTER 26
TRANSMISSION MECHANISMS OF MONETARY POLICY: THE EVIDENCE . . . . . . .603
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .603
Framework for Evaluating Empirical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . .603
Structural Model Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .604
Reduced-Form Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .604
Advantages and Disadvantages of Structural Model Evidence . . . . . . . . . . . . . . . . . . . . . .605
Advantages and Disadvantages of Reduced-Form Evidence . . . . . . . . . . . . . . . . . . . . . . .606
Box 1 |
Perils of Reverse Causation: A Russian Folk Tale . . . . . . . . . . . . . . . . . . . . |
606 |
Box 2 |
Perils of Ignoring an Outside Driving Factor: How to Lose a |
|
Presidential Election . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
607 |
|
Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
607 |
|
Early Keynesian Evidence on the Importance of Money . . . . . . . . . . . . . . . . . . . . . |
607 |
|
Objections to Early Keynesian Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .608
Early Monetarist Evidence on the Importance of Money . . . . . . . . . . . . . . . . . . . . .611
Timing Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .611
Statistical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .613
Contents xxvii
Historical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .615
Overview of the Monetarist Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
.615 |
Box 3 Real Business Cycle Theory and the Debate on Money and |
|
Economic Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
.616 |
Transmission Mechanisms of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
616 |
Traditional Interest-Rate Channels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
617 |
Other Asset Price Channels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
618 |
Credit View . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
621 |
Box 4 Consumers’ Balance Sheets and the Great Depression . . . . . . . . . . . . . . . . |
624 |
Why Are Credit Channels Likely to Be Important? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
625 |
Application Corporate Scandals and the Slow Recovery from the |
|
March 2001 Recession . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
625 |
Lessons for Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .626
Application Applying the Monetary Policy Lessons to Japan . . . . . . . . . . . . . . .628
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .629
CHAPTER 27
MONEY AND INFLATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .632
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .632
Money and Inflation: Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .632
German Hyperinflation, 1921–1923 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .633
Recent Episodes of Rapid Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .633
Meaning of Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .634
Views of Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .635
Monetarist View . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .635
Keynesian View . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .636
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .638
Origins of Inflationary Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
638 |
High Employment Targets and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
639 |
Budget Deficits and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
643 |
Application Explaining the Rise in U.S. Inflation, 1960–1980 . . . . . . . . . . . . . .646
Activist/Nonactivist Policy Debate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .650
Responses to High Unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .650
Activist and Nonactivist Positions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .651
Expectations and the Activist/Nonactivist Debate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .652
Box 1 Perils of Accommodating Policy: The Terrorism Dilemma . . . . . . . . . . . . .654
Rules Versus Discretion: Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .654
Application Importance of Credibility to Volcker’s Victory over Inflation . . . . . .655
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .655
xxviii Contents
CHAPTER 28
RATIONAL EXPECTATIONS: IMPLICATIONS FOR POLICY . . . . . . . . . . . . . . . . . . .658
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .658
The Lucas Critique of Policy Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .659
Econometric Policy Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .659
Example: The Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .659
New Classical Macroeconomic Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .660
Effects of Unanticipated and Anticipated Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .661
Box 1 Proof of the Policy Ineffectiveness Proposition . . . . . . . . . . . . . . . . . . . . . .663
Can an Expansionary Policy Lead to a Decline in Aggregate Output? . . . . . . . . . . . . . . . .663
Implications for Policymakers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .664
New Keynesian Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .665
Effects of Unanticipated and Anticipated Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .666
Implications for Policymakers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .666
Comparison of the Two New Models with the Traditional Model . . . . . . . . . . . . . .666
Short-Run Output and Price Responses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .668
Stabilization Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .670
Anti-inflation Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .671
Credibility in Fighting Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .673
Box 2 Global: Ending the Bolivian Hyperinflation: Case Study of a |
|
Successful Anti-inflation Program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
.674 |
Application Credibility and the Reagan Budget Deficits . . . . . . . . . . . . . . . . . . . |
675 |
Impact of the Rational Expectations Revolution . . . . . . . . . . . . . . . . . . . . . . . . . . .676
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . .677
GLOSSARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . G-1
ANSWERS TO SELECTED QUESTIONS AND PROBLEMS . . . . . . . . . . . . . . . . . . . A-1
CREDITS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . C-1
INDEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . I-1
PREFACE
I have continually strived to improve this textbook with each new edition, and the Seventh Edition of The Economics of Money, Banking, and Financial Markets is no exception. The text has undergone a major revision, but it retains the basic hallmarks that have made it the best-selling textbook on money and banking in the past six editions:
•A unifying, analytic framework that uses a few basic economic principles to organize students’ thinking about the structure of financial markets, the foreign exchange markets, financial institution management, and the role of monetary policy in the economy
•A careful, step-by-step development of models (an approach found in the best principles of economics textbooks), which makes it easier for students to learn
•The complete integration of an international perspective throughout the text
•A thoroughly up-to-date treatment of the latest developments in monetary theory
•Special features called “Following the Financial News” and “Reading the Wall Street Journal” to encourage reading of a financial newspaper
•An applications-oriented perspective with numerous applications and specialtopic boxes that increase students’ interest by showing them how to apply theory to real-world examples
What’s New in the Seventh Edition
Expanded
Coverage of the
Stock Market
In addition to the expected updating of all data through the end of 2002 whenever possible, there is major new material in every part of the text. Indeed, this revision is one of the most substantial that I have ever done.
With the wide swings in the stock prices in recent years, students of money and banking have become increasingly interested in what drives the stock market. As a result, I have expanded the discussion of this market by describing simple valuation methods for stocks and examining recent developments in the stock market and the link between monetary policy and stock prices. I have combined this material with the discussion of the theory of rational expectations and efficient capital markets to create a new Chapter 7, “The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis.”
xxix
xxx Preface
New Material on
Financial
Institutions
Increased
International
Perspective
New Material on Monetary Theory and Policy
E-Focus
In light of continuing changes in financial markets and institutions, I have added the following new material to keep the text current:
•Extensive discussion of recent corporate scandals and the collapse of Enron, including their impact on the economy (Chapters 6, 7, 11, and 26)
•Discussion of the role of venture capitalists in the high-tech sector (Chapter 8)
•Examination of how information technology is influencing bank consolidation, and analysis of whether clicks will dominate bricks in the banking industry (Chapter 10)
•New material on the Basel Committee on Bank Supervision and where the Basel Accord is heading (Chapter 11)
•Discussion of the spread of deposit insurance throughout the world (Chapter 11)
•Perspective on the growing concerns about Fannie Mae and Freddie Mac (Chapter 12)
•A new type of special-interest box, the E-Finance box, which relates how changes in technology have affected the conduct of business in banking and financial markets. The placement of these boxes throughout the text helps to demonstrate the impact of technology across a broad range of areas in finance.
The growing importance of the global economy has encouraged me to add more new material with an international perspective:
•Extensive discussion of recent developments in Argentina (Chapters 1, 8, 11, 20, and 21)
•Analysis of how central banks set overnight interest rates in other countries (Chapter 17)
•Discussion of how the euro has fared in its first four years (Chapter 19)
•Additional treatment of recent events in the Japanese economy (Chapters 11 and 26)
Drawing on my continuing involvement with central banks around the world, I have added new material to keep the discussion of monetary theory and policy current:
•New boxes on Fed watching and Federal Reserve transparency (Chapters 14 and 18)
•Discussion of the changes (implemented in 2003) in the way the Fed administers the discount window (Chapter 17)
•An updated discussion of the market for reserves and how the channel/corridor system for setting interest rates works (Chapter 17)
•Discussion of how the recent corporate scandals have hindered the recovery of the economy from the 2001–2002 recession (Chapter 25)
The incredible advances in electronic (computer and telecommunications) technology in recent years have had a major impact on the financial system. This Seventh Edition reflects these developments by adding many new features with an electronic focus.
Web Enhancement. The Seventh Edition embraces the exploding world of information now available over the World Wide Web. There are few areas where the Internet