Lawrence S. RitterLate, New York University

William L. SilberNew York University

Gregory F. UdellIndiana University

Addison-Wesley

New York Boston San FranciscoLondon Toronto Sydney Tokyo Singapore Madrid

Mexico City Munich Paris Cape Town Hong Kong Montreal

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PARTCHAPTER 1

CHAPTER 2

CHAPTER 3

PART IICHAPTER 4

CHAPTER 5

CHAPTER 6

CHAPTER 7

CHAPTER 8

CHAPTER 9

CHAPTER 10

PARTCHAPTER 11

CHAPTER 12

CHAPTER 13

PART IVCHAPTER 14

CHAPTER 15

CHAPTER 16

Contents

Preface

Acknowledgments

About the Authors

The Basics

IX

XXV

XXX

xxxiii

INTRODUCING MONEY, BANKING, AND FINANCIAL MARKETS 3

THE ROLE OF MONEY IN THE MACROECONOMY 13

FINANCIAL INSTRUMENTS, MARKETS, AND INSTITUTIONS 31

Financial Instruments and Markets

THE NATURE OF FINANCIAL INTERMEDIATION

DEPOSITORY FINANCIAL INSTITUTIONS

NONDEPOSITORY FINANCIAL INSTITUTIONS

Financial System Architecture

UNDERSTANDING FINANCIAL CONTRACTS

THE REGULATION OF MARKETS AND INSTITUTIONS

FINANCIAL SYSTEM DESIGN

49INTEREST RATE MEASUREMENT AND BEHAVIOR 51

THE TERM AND RISK STRUCTURE OF INTEREST RATES 75

THE STRUCTURE AND PERFORMANCE

OF SECURITIES MARKETS 93

THE PRICING OF RISKY FINANCIAL ASSETS 107

MONEY AND CAPITAL MARKETS 119

DEMYSTIFYING DERIVATIVES 149

UNDERSTANDING FOREIGN EXCHANGE 169

Banks and Other Intermediaries 189

191

213

243

259

261

285

307

VIII Brief Contents

PARTV The Art of Central Banking 327

CHAPTER 17

CHAPTER 18

CHAPTER 19

CHAPTER 20

CHAPTER 21

PART VI

WHO'S IN CHARGE HERE?

BANK RESERVES AND THE MONEY SUPPLY

THE INSTRUMENTS OF CENTRAL BANKING

UNDERSTANDING MOVEMENTS IN BANK RESERVES

MONETARY POLICY STRATEGY

Monetary Theory

329

340

364

380

401

415

CHAPTER 22

CHAPTER 23

CHAPTER 24

CHAPTER 25

CHAPTER 26

CHAPTER 27

CHAPTER 28

PART VII

THE CLASSICAL FOUNDATIONS 417

THE KEYNESIAN FRAMEWORK 439

THE ISLM WORLD 469

MONEY AND ECONOMIC STABILITY IN THE ISLM WORLD 505

AN AGGREGATE SUPPLY AND DEMAND PERSPECTIVE

ON MONEY AND ECONOMIC STABILITY 521

RATIONAL EXPECTATIONS: THEORY ANDPOLICY IMPLICATIONS 542

EMPIRICAL EVIDENCE ON THE EFFECTIVENESSOF MONETARY POLICY 553

Grand Finale 567

CHAPTER 29 TYING IT ALL TOGETHER

Glossary

Index

569

583

601

PART

Preface

Acknowledgments

About the Authors

The Basics

XXV

XXX

xxxiii

CHAPTER 1

CHAPTER 2

INTRODUCING MONEY, BANKING, AND FINANCIAL MARKETS 3

An Overview 4

Why Study Money, Banking, and Financial Markets? 5

Careers in Banking and Financial Markets 5General Opportunities 6Specific Opportunities 7

TRADING 7

SALES 8

FINANCIAL ECONOMIST 9

FIXED-INCOME RESEARCH 10

LOAN OFFICER 10

BANK EXAMINER 11

Key Terms 11

THE ROLE OF MONEY IN THE MACROECONOMY 13

Introducing Money 14Who Determines Our Money Supply? 16

Going Out on a Limb: The Launch of the Euro 18The Importance of Money I: Money Versus Barter 18The Importance of Money II: Financial Institutions

and Markets 20Money, the Economy, and Inflation 21

Bank Reserves and the Money Supply 22How Large Should the Money Supply Be? 23Velocity: The Missing Link 24Money and Inflation 26

Going Out on a Limb: Will Paper MoneyEver Disappear? 28

Contents

Summary 29

Key Terms 29

Questions 30

CHAPTER 3 FINANCIAL INSTRUMENTS, M A R K E T S , AND INSTITUTIONS 31

Flow of Funds 31

Financial Instruments and Markets 33Bonds Represent Borrowing 34Stocks Represent Ownership 35Mortgages Involve Real Estate 36Derivatives: Options and Futures 38The Money and Capital Markets: A Summary 39

Financial Intermediaries: Purposes and Profile 41The Role of Financial Intermediaries 41Financial Intermediaries in Profile 43

Summary 46

Key Terms 47

Questions 48

lAK I 11 Financial Instruments and Markets 49

CHAPTER 4 INTEREST RATE MEASUREMENT AND BEHAVIOR 51

Calculating Interest Rates 51Simple Interest 52Compound Interest 52Coupon Rate on Bonds 54Current Yield 54Yield to Maturity 54

Off the Record: The Million Dollar Lottery:A Case of Misleading Advertising? 57Zero-Coupon Bonds 57

Reading the Financial News: GovernmentBond Market Quotations 58The Inverse Relationship Between Yields

and Bond Prices 59Why Long-Term Bonds Are Riskier Than Shorts 60Nominal Versus Real Interest Rates 61Annual Return Versus Yield to Maturity 62

Contents XI

CHAPTER 5

CHAPTER 6

Ir

What Determines the Level of Interest Rates? 63Supply and Demand Determine the Interest Rate 63Why Does the Interest Rate Fluctuate? 66Behind Supply and Demand 68The Importance of Inflationary Expectations 69

In the News: Bonds Move Higher 69Cyclical and Long-Term Trends in Interest Rates 70

Summary 72Key Terms 73Questions 73

THE TERM AND RISK STRUCTURE OF INTEREST RATES 75

The Term Structure of Rates and the Yield Curve 75Supply and Demand 76The Pure Expectations Approach 11The Liquidity Premium Modification 78The Preferred Habitat Approach 79Real-World Observations 79

Going Out on a Limb: Is the Shape of the YieldCurve a Crystal Ball? 82An Aside on Marketability 83

Risk and Tax Structure of Rates 83Summary 86Key Terms 87Questions 87Appendix: Bond Price Volatility:

Duration Versus Maturity 89Key Terms 92

THE STRUCTURE AND PERFORMANCEOF SECURITIES MARKETS 93

Nature and Function of Securities Markets 93Types of Markets 94

AUCTION MARKET 94

BROKERED MARKET 94

DEALER MARKET 95

Primary Versus Secondary Markets 96

'"'i':.\

XII Contents

CHAPTER 7

CHAPTER 8

Efficiency of Secondary Market Trading 98

In t h e News: Senator Pushing for Accurate Prices 102

Going Out on a Limb: The Computer Will Prevail 103

Efficient Capital Markets and Regulation 104

Summary 105

Key Terms 106

Questions 106

THE PRICING OF RISKY FINANCIAL ASSETS 107

Economic Uncertainty 107A World of Certainty 109Consequences of Uncertainty and Risk Aversion 109An Aside on Measuring Risk 111

Principles of Diversification 112

In t h e News: When a Simpler 401(k) Is Just Dumb 114

The Risk Premium on Risky Securities 115

Going Out on a Limb: Buy an Index Fund 116

Summary 117

Key Terms 117

Questions 117

MONEY AND CAPITAL MARKETS 119

The Government Bond Market 120Types of Securities and Investors 120How the Market Works 122Treasury Bills: Auctions and Yields 123Repurchase Agreements 126

Bank-Related Securities: CDs and Eurodollars 127

Corporate Securities 129Corporate Bonds 129

Going Out on a Limb: Junk Is Good 130

Reading the Financial News:Corporate Bond Market Quotations 131Commercial Paper 132

Municipal Securities 133

Contents XIII

In t h e News: General Obligation Bonds MightYield More than Revenue Bonds 135

Mortgage Securities 135

In t h e News: Perusing the Subprime Detritus 136

The Stock Market 137Structure of the Stock Market 137What Determines Whether Stock Prices

Rise or Fall? 138Reading the Financial News:

Stock Market Quotations 139Off t h e Record: The Dow Jones Versus the S&P 500 141

Money and Stock Prices 142

Going Out on a Limb: Bubbles and the Stock Market 143

Summary 146

Key Terms 147

Questions 147

CHAPTER 9 DEMYSTDTYING DERIVATIVES 149

An Overview of Financial Futures 150Using Financial Futures Contracts 152

In t h e News: Weatherproof® Adopts ApparelIndustry's First-Ever Weather Hedge 153

Reading the Financial News: Financial FuturesQuotations 154Pricing Financial Futures Contracts 155

An Overview of Options Contracts 156Using and Valuing Options 158

Reading the Financial News: Options Quotations 159What Determines Options Premiums? 160

Going Out on a Limb: Don't Blame Derivatives 162

An Overview of Swaps 163Why Swap? 164Valuing a Swap 165

Summary 166

Key Terms 167

Questions 167

->-l'.r

XIV Contents

CHAPTER 10 UNDERSTANDING FOREIGN EXCHANGE

What Determines Foreign Exchange Rates?Reading the Financial News:

Foreign Exchange QuotationsWhy Do Exchange Rates Fluctuate?

In the News: Whistler Adjusts Prices toLure Washington Skiers BackHow Global Investors Cause Exchange

Rate VolatilityFixed Versus Floating Exchange Rates

How Fixed Rates Are Supposed to WorkIn the News: Let China's Yuan Float

International Financial CrisesSummaryKey TermsQuestions

169170

172174

178

178

182

182

183

185

186

187

187

PART III Banks and Other Intermediaries 189CHAPTER 11 THE NATURE OF FINANCIAL INTERMEDIATION 191

The Economics of Financial Intermediation 191Going Out on a Limb: Lemons and MP3 Players:

Two Examples of Adverse Selection 193In the News: Housing Tilting Economy Down 194The Evolution of Financial Intermediaries

in the United States 197The Shifting Sands of Interest Rates 198

THE REGULATION Q SECURITY BLANKET 199

THE BIRTH OF THE MONEY MARKET MUTUAL FUND 200

THE SAVINGS AND LOAN CRISIS 201

THE RISE OF COMMERCIAL PAPER 203

The Institutionalization of Financial Markets 204The Transformation of Traditional Banking 205

Financial Intermediaries: Assets, Liabilities,and Management 208

Contents xv

Summary 211

Key Terms 211

Questions 212

CHAPTER 12 DEPOSITORY FINANCIAL INSTITUTIONS 213

The Fundamentals of Bank Management 213Use of Bank Funds 214Sources of Bank Funds 216Bank Profitability 218Bank Risk 221

LEVERAGE RISK 221

CREDIT RISK 222

INTEREST RATE RISK 223

In the News: Local Banks Weigh Hedging Risks 224TRADING RISK 225

LIQUIDITY RISK 225

Major Trends in Bank Management 225The Consolidation Within the Banking Industry 226

THE MCFADDEN ACT 226

THE EROSION OF MCFADDEN 226

MEASURING CONSOLIDATION 227

THE ECONOMICS OF CONSOLIDATION 228

In the News: Bank Mergers Make Raising Fundsfor Projects Harder 230Nontraditional Banking 231Globalization 232

AMERICAN BANKS ABROAD 232

FOREIGN BANKS IN THE UNITED STATES 233

THE EUROMARKETS 233

The Subprime Mortgage Crisis 236In the News: Rate of Mortgage Delinquencies

Rises; Foreclosures Are Also Increasing,New Report Shows 239

Nonbank Depository Institutions—The Thrifts 240

Summary 241

Key Terms 241

Questions 242

; • -

Is. :

XVI Contents

CHAPTER 13 NoNDEPOsrroRY FINANCIAL INSTITUTIONS 243Insurance Companies and Pension Funds 243In the News: The Coming Deluge 246Mutual Funds 249Finance Companies 250In the News: Getting In on the New Gold Rush 251Securities Brokers and Dealers and Investment

Banks 252Venture Capital Funds, Mezzanine Debt Funds,

and Hedge Funds 253Banks Versus Nondepository Institutions 254Summary 255Key Terms 256Questions 256

PART IVCHAPTER 14

Financial System Architecture 259

UNDERSTANDING FINANCIAL CONTRACTS

How Business Obtains FinancingFinancing Small BusinessesFinancing Midsize BusinessesFinancing Large Businesses

The Economics of Financial ContractingAsymmetric Information and Financial

ContractingIn the News: A Journey into the Secret Heart

of Capitalism Turns into a Roller CoasterRideContracting and the Firm ContinuumConsumer Lending, Financial Contracting,

and SecuritizationSummaryKey TermsQuestions

261

262

262

268

270

273

274

275

278

281

283

283

284

Contents XVII

CHAPTER 15

CHAPTER 16

THE REGULATION OF MARKETS AND INSTITUTIONS 285

The Regulation of Financial Markets in theUnited States 287The Regulation of the Primary Market 287The Regulation of the Secondary Markets 288

The Regulation of Commercial Banks in theUnited States 288

Off the Record: Insider Trading: EfficiencyVersus Equity 289The U.S. Banking Regulatory Structure 289Regulations to Protect Individual Depositors

and Financial System Stability 291DEPOSIT INSURANCE 292

MORAL HAZARD AND DEPOSIT INSURANCE 294

RISK-BASED CAPITAL REQUIREMENTS 295

PROMPT CORRECTIVE ACTION 296

RISK-BASED DEPOSIT INSURANCE PREMIUMS 298

In the News: FDIC Premiums Seen HavingLittle Effect on Industry ( 300

Regulation of Nondepository FinancialIntermediaries 301

Where Securities Market and Banking RegulationMeet: The Glass-Steagall Act, A CollapsingBarrier 302The Genesis of Glass-Steagall 302The Erosion of Glass-Steagall 303The Risk of Universal Banking 304

Summary 305

Key Terms 306

Questions 306

FINANCIAL SYSTEM DESIGN 307

Information and Financial System Design 308Stockholder-Lender Conflict 308Manager-Stockholder Conflict 309Conflict Resolution and Financial System Design 310

SMALL FIRMS: STOCKHOLDER-LENDER CONFLICT 311

r 4 •„•&;>..:

XVIII Contents

LARGE FIRMS: STOCKHOLDER-LENDER CONFLICT 312

LARGE FIRMS: MANAGER-STOCKHOLDER CONFLICT 312

Financial System Design: A Descriptive Summaryof Germany, Japan, the United Kingdom, andthe United States 313Germany 314Japan 315United Kingdom 317United States 317

Financial System Design and Conflict Resolution:Germany, Japan, the United Kingdom, and the

. United States 318Conflict Resolution in the Big Four 320And the Winner Is . . . 321

Going Out on a Limb: Do Corporate ScandalsMean that the Markets-Oriented Model Is aBad Example? 323

Financial System Design for Eastern Europeand Other Emerging Economies 323

Summary 324Key Terms 325Questions 325

PARTV The Art of Central Banking 327

CHAPTER 17 WHO'S IN CHARGE HERE? 329

Formal Structure of the Federal Reserve System 330The Realities of Power 333The Problem of Federal Reserve Independence 335Going Out on a Limb: Central Bank Independence

and Inflation: Lessons from History 337Summary 338Key Terms 338Questions 338

WWM1

Contents XIX

CHAPTER 18

CHAPTER 19

CHAPTER 20

BANK RESERVES AND THE MONEY SUPPLY 340

Check Clearing and Collection 341Going Out on a Limb: How Does Technology

Affect the Payments Process? 344Deposit Expansion: The Single Bank 345Deposit Expansion: The Banking System 348Deposit Contraction 351Summary 353Key Terms 353Questions 353Appendix: The Complete Money Supply Process 355Shifts Between Currency and Checking Deposits 356Shifts Between Time Deposits and Checking

Accounts 359The Role of Interest Rates 361Key Term 363Questions 363THE INSTRUMENTS OF CENTRAL BANKING 364

Reserve Requirements 364Discounting and the Discount Rate 366In the News: Brokers Rush to Borrow Funds

from the Fed 368The Discount Rate and Market Interest Rates 370Open Market Operations 371Off the Record: Three Key Interest Rates 373

A Day at the Trading Desk 376Summary 378Key Terms 379Questions 379UNDERSTANDING MOVEMENTS IN BANK RESERVES 380

The Fed's Balance Sheet 381The U.S. Treasury's Monetary Accounts 388The Bank Reserve Equation 389

XX Contents

CHAPTER 21

PART VI

In the News: The Federal Reserve, Bank Reserves,and the Y2K Scare 391

Putting It All to Use 392Focusing on the Monetary Base 393

Summary 393Key Terms 394Questions 394Appendix: Monetary Effects of Treasury Financing 395

MONETARY POLICY STRATEGY 401

The FOMC Directive 402The Fed's Strategy 403

Reserves Versus the Federal Funds Rate 405In the News: Deflation, Zero Interest Rates, and the

Choice of Targets 410The Taylor Rule and the Fed's Track Record 410In the News: How Low Can Ben Go? 412Summary 412Key Terms 413Questions 413

Monetary Theory 415CHAPTER 22 THE CLASSICAL FOUNDATIONS 417

Classical Economics 418Classical Interest Theory 419

Off the Record: Investment Versus Investment 421The Quantity Theory of Money AllThe Cambridge Approach 423Money Demand and the Quantity Theory 425

Aggregate Demand and Supply: A Summary 426Real Versus Nominal Rates of Interest 429Modern Modifications: Monetarists and

New Classicists 430Going Out on a Limb: The Money Supply and the

Great Depression 431

Contents xxi

CHAPTER 23

CHAPTER 24

Summary 432Key Terms 433Questions 433Appendix: GDP Definitions and Relationships 434The Circular Flow of Spending, Income,

and Output 434Saving and Investment 435

THE KEYNESIAN FRAMEWORK 439

When Saving Doesn't Equal Investment 440Consumption and Simple GDP Determination 442

Changes in GDP 445Autonomous Versus Induced Changes in GDP 448Exports and Imports 449

Government to the Rescue 449Off the Record: Taking the Pulse of the Economy 452Money and the Rate of Interest 453Monetary Policy 457

Monetary Policy and International Trade 460Transactions Demand and Monetary Policy 461Expectations and Monetary Policy 463

Aggregate Demand and Supply 464

Summary 467

Key Terms 467

Questions 468

T H E ISLM WORLD 469

The LM Curve 470The Slope of the LM Curve AllMonetary Policy and the LM Curve A1A

The IS Curve 476The Slope of the IS Curve 479

The Simultaneous Determination of Incomeand Interest: IS and LM Together 483

Monetary and Fiscal Policy 484Monetary Policy 484

XXII Contents

CHAPTER 25

CHAPTER 26

Fiscal Policy 487What About Velocity? 490When Will Full Employment Prevail? 492

Going Out on a Limb: ISLM Analysis Lives 494ISLM and Aggregate Demand 497Summary 499Key Terms 499Questions 500Appendix: The Simple Algebra of Income

Determination 501The Model 501The IS and LM Functions 502Equilibrium Income and Interest 502Multiplier Effects on Income and the

Interest Rate 502Policy Implications 503Questions 504MONEY AND ECONOMIC STABILITY

IN THE ISLM WORLD 505Monetary Policy, Fiscal Policy, and Crowding Out 505In the News: Japan's Liquidity Trap 509Is the Private Sector Inherently Stable? 512Flexible Prices, the Natural Rate of Interest,

and Real Crowding Out 514Summary 516Key Term 517Questions 517Appendix: Interest Rates Versus the Money

Supply Under Uncertainty 518AN AGGREGATE SUPPLY AND DEMAND

PERSPECTIVE ON MONEY AND ECONOMIC STABILITY 521

Is the Private Sector Inherently Stable? 522Monetary Policy, Fiscal Policy, and Crowding Out 526Going Out on a Limb: Are Bank Loans Special? 529Inflation, Money, and the Phillips Curve 530

Contents XXIII

CHAPTER 27

CHAPTER 28

r

Inflation and Interest Rates 533

Should a Robot Replace the Federal Reserve? 536

Summary 540

Key Terms 540

Questions 541

RATIONAL EXPECTATIONS: THEORY AND POLICY

IMPLICATIONS 542

When Are Expectations Rational? 543

Anticipated Versus Unanticipated Monetary Policy 544

Off the Record: Applying Rational Expectations

to the Securities Markets 544

Implications for Stabilization Policy 546

Inflation, the Phillips Curve, and Credibility 547

In the News: Laureate Phelps 549

Interest Rates and Anticipated Monetary Policy 550

Summary 551

Key Term 551

Questions 552

EMPIRICAL EVIDENCE ON THE EFFECTIVENESSOF MONETARY POLICY 553

Living with Velocity 554The Demand for Money 556Econometrics and Time Lags 557

Going Out on a Limb: Where Is All ThatCash Hiding? 558

The Impact of Monetary Policy on GDP 559Fiscal Policy and Crowding Out 560Interest Rates 561Business Investment 562Residential Construction 563Consumer Spending 564

Summary 564

Key Terms 565

Questions 565

XXIV Contents

PART VII Grand Finale 567

CHAPTER 29 TYING IT ALL TOGETHER 569

The Economic Indicators 571The Employment Report 571Housing Starts and Building Permits 573

In the News: Reading the Indicators: Is EmploymentRising or Falling? 574Purchasing Managers' Index (PMI) 575Index of Leading Economic Indicators 575

Valuation, the Fed, and Market Reaction 576Good News Versus Bad News: The Role

of Expectations 576Stock and Bond Valuation—A Refresher 577

In the News: Wall Street Rebounds as InvestorsGo Bargain-hunting 578

Putting It All Together 580Summary 581Key Terms 581Questions 582

Glossary

Index

583

601

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