Seventh Edition - The Addison-Wesley Series in Economics Phần 10 doc

The accommodating, activist alternative is to try to elim- inate the high unemployment by attempting to shift the aggregate demand curve rightward to AD2by pursuing expansionary policy a

in interest rates and by rapid financial innovation that made the correct measurement of money far more difficult (see Chapter 3) In their view, this period was an aberration, and the close correspondence of money and infla- tion is sure to reassert itself However, this has not yet occurred.

What is the underlying cause of the increased rate of money growth that we see occurring from 1960 to 1980? We have identified two possible sources of inflationary monetary policy: government adherence to a high employment target and budget deficits Let’s see if budget deficits can explain the move to an inflationary monetary policy by plotting the ratio of govern- ment debt to GDP in Figure 9 This ratio provides a reasonable measure of whether government budget deficits put upward pressure on interest rates.

Only if this ratio is rising might there be a tendency for budget deficits to raise interest rates because the public is then being asked to hold more gov- ernment bonds relative to their capacity to buy them Surprisingly, over the course of the 20-year period from 1960 to 1980, this ratio was falling, not rising Thus U.S budget deficits in this period did not raise interest rates and

so could not have encouraged the Fed to expand the money supply by ing bonds Therefore, Figure 9 tells us that we can rule out budget deficits as

buy-a source of the rise in inflbuy-ation in this period.

Because politicians were frequently bemoaning the budget deficits in this period, why did deficits not lead to an increase in the debt–GDP ratio?

The reason is that in this period, U.S budget deficits were sufficiently small that the increase in the stock of government debt was still slower than the growth in nominal GDP, and the ratio of debt to GDP declined You can see that interpreting budget deficit numbers is a tricky business.6

We have ruled out budget deficits as the instigator; what else could be the underlying cause of the higher rate of money growth and more rapid inflation in the 1960s and 1970s? Figure 10, which compares the actual unemployment rate to the natural rate of unemployment, shows that the economy was experiencing unemployment below the natural rate in all but one year between 1965 and 1973 This suggests that in 1965–1973, the American economy was experiencing the demand-pull inflation described in Figure 6.

Policymakers apparently pursued policies that continually shifted the aggregate demand curve to the right in trying to achieve an output target that was too high, thus causing the continual rise in the price level outlined in Figure 6 This occurred because policymakers, economists, and politicians had become committed in the mid-1960s to a target unemployment rate of 4%, the level of unemployment they thought was consistent with price sta- bility In hindsight, most economists today agree that the natural rate of unemployment was substantially higher in this period, on the order of 5 to 6%, as shown in Figure 10 The result of the inappropriate 4% unemployment

6Another way of understanding the decline in the debt–GDP ratio is to recognize that a rise in the price levelreduces the value of the outstanding government debt in real terms—that is, in terms of the goods and services itcan buy So even though budget deficits did lead to a somewhat higher nominal amount of debt in this period, thecontinually rising price level (inflation) produced a lower real value of the government debt The decline in the realamount of debt at the same time that real GDP was rising in this period then resulted in the decline in thedebt–GDP ratio For a fascinating discussion of how tricky it is to interpret deficit numbers, see Robert Eisner and

Paul J Pieper, “A New View of the Federal Debt and Budget Deficits,” American Economic Review 74 (1984): 11–29.

http://w3.access.gpo.gov

/usbudget/

The Economic Report of the

President reports debt levels

and gross domestic product,

along with many other

economic statistics

F I G U R E 9 Government Debt-to-GDP Ratio, 1960–2002

Source: Economic Report of the President.

Unemployment

Rate (%)

0

Activist/Nonactivist Policy Debate

All economists have similar policy goals—they want to promote high employment and price stability—and yet they often have very different views on how policy should

be conducted Activists regard the self-correcting mechanism through wage and price adjustment (see Chapter 25) as very slow and hence see the need for the government

to pursue active, accommodating, discretionary policy to eliminate high ment whenever it develops Nonactivists, by contrast, believe that the performance of the economy would be improved if the government avoided active policy to eliminate unemployment We will explore the activist/nonactivist policy debate by first looking

unemploy-at whunemploy-at the policy responses might be when the economy experiences high ployment.

unem-Suppose that policymakers confront an economy that has moved to point 1 in Figure

11 At this point, aggregate output Y1is lower than the natural rate level, and the economy is suffering from high unemployment Policymakers have two viable choices: If they are nonactivists and do nothing, the aggregate supply curve will even- tually shift rightward over time, driving the economy from point 1 to point 1, where full employment is restored The accommodating, activist alternative is to try to elim- inate the high unemployment by attempting to shift the aggregate demand curve

rightward to AD2by pursuing expansionary policy (an increase in the money supply, increase in government spending, or lowering of taxes) If policymakers could shift

the aggregate demand curve to AD2instantaneously, the economy would immediately move to point 2, where there is full employment However, several types of lags pre- vent this immediate movement from occurring.

1 The data lag is the time it takes for policymakers to obtain the data that tell

them what is happening in the economy Accurate data on GDP, for example, are not available until several months after a given quarter is over.

2 The recognition lag is the time it takes for policymakers to be sure of what the

data are signaling about the future course of the economy For example, to minimize errors, the National Bureau of Economic Research (the organization that officially

After 1975, the unemployment rate was regularly above the natural rate

of unemployment, yet inflation continued It appears that we have the nomenon of a cost-push inflation described in Figure 5 (the impetus for which was the earlier demand-pull inflation) The persistence of inflation can

phe-be explained by the public’s knowledge that government policy continued to

be concerned with achieving high employment With a higher rate of expected inflation arising initially from the demand-pull inflation, the aggre- gate supply curve in Figure 5 continued to shift leftward, causing a rise in unemployment that policymakers would try to eliminate by shifting the aggregate demand curve to the right The result was a continuation of the inflation that had started in the 1960s.

dates business cycles) will not declare the economy to be in recession until at least six months after it has determined that one has begun.

3 The legislative lag represents the time it takes to pass legislation to implement

a particular policy The legislative lag does not exist for most monetary policy actions such as open market operations It can, however, be quite important for the imple- mentation of fiscal policy, when it can sometimes take six months to a year to get leg- islation passed to change taxes or government spending.

4 The implementation lag is the time it takes for policymakers to change policy

instruments once they have decided on the new policy Again, this lag is unimportant for the conduct of open market operations because the Fed’s trading desk can pur- chase or sell bonds almost immediately upon being told to do so by the Federal Open Market Committee Actually implementing fiscal policy may take time, however; for example, getting government agencies to change their spending habits takes time, as does changing tax tables.

5 The effectiveness lag is the time it takes for the policy actually to have an impact

on the economy An important element of the monetarist viewpoint is that the tiveness lag for changes in the money supply is long and variable (from several months to several years) Keynesians usually view fiscal policy as having a shorter effectiveness lag than monetary policy (fiscal policy takes approximately a year until its full effect is felt), but there is substantial uncertainty about how long this lag is.

effec-Now that we understand the considerations that affect decisions by policymakers on whether to pursue an activist or nonactivist policy, we can examine when each of these policies would be preferable.

When the economy has moved to

point 1, the policymaker has two

choices of policy: the nonactivist

policy of doing nothing and letting

the economy return to point 1 or

the activist policy of shifting the

aggregate demand curve to AD2to

move the economy to point 2

Case for an Activist Policy. Activists, such as the Keynesians, view the wage and price adjustment process as extremely slow They consider a nonactivist policy costly, because the slow movement of the economy back to full employment results in a large loss of output However, even though the five lags described result in delay of a year

or two before the aggregate demand curve shifts to AD2, the aggregate supply curve likewise moves very little during this time The appropriate path for policymakers to pursue is thus an activist policy of moving the economy to point 2 in Figure 11.

Case for a Nonactivist Policy. Nonactivists, such as the monetarists, view the wage and price adjustment process as more rapid than activists do and consider nonactivist pol- icy less costly because output is soon back at the natural rate level They suggest that

an activist, accommodating policy of shifting the aggregate demand curve to AD2is costly, because it produces more volatility in both the price level and output The rea- son for this volatility is that the time it takes to shift the aggregate demand curve to

AD2 is substantial, whereas the wage and price adjustment process is more rapid Hence before the aggregate demand curve shifts to the right, the aggregate supply

curve will have shifted rightward to AS2, and the economy will have moved from point 1  to point 1, where it has returned to the natural rate level of output Yn After

adjustment to the AS2curve is complete, the shift of the aggregate demand curve to

AD2finally takes effect, leading the economy to point 2  at the intersection of AD2and

AS2 Aggregate output at Y2is now greater than the natural rate level (Y2> Yn) , so

the aggregate supply curve will now shift leftward back to AS1, moving the economy

to point 2, where output is again at the natural rate level.

Although the activist policy eventually moves the economy to point 2 as makers intended, it leads to a sequence of equilibrium points—1 , 1, 2, and 2—at which both output and the price level have been highly variable: Output overshoots its

policy-target level of Yn, and the price level falls from P1to P1and then rises to P2and

even-tually to P2 Because this variability is undesirable, policymakers would be better off pursuing the nonactivist policy, which moved the economy to point 1 and left it there.

Our analysis of inflation in the 1970s demonstrated that expectations about policy can be an important element in the inflation process Allowing for expectations about policy to affect how wages are set (the wage-setting process) provides an additional reason for pursuing a nonactivist policy.

Do Expectations Favor a Nonactivist Approach? Does the possibility that expectations about policy matter to the wage-setting process strengthen the case for a nonactivist policy? The case for an activist policy states that with slow wage and price adjustment, the activist policy returns the economy to full employment at point 2 far more quickly than it takes to get to full employment at point 1 under nonactivist policy However, the activist argument does not allow for the possibility (1) that expectations about policy matter to the wage-setting process and (2) that the economy might initially have moved from point 1 to point 1 because an attempt by workers to raise their

wages or a negative supply shock shifted the aggregate supply curve from AS2to AS1.

We must therefore ask the following question about activist policy: Will the aggregate supply curve continue to shift to the left after the economy has reached point 2, lead- ing to cost-push inflation?

The answer to this question is yes if expectations about policy matter Our

dis-cussion of cost-push inflation in Figure 5 suggested that if workers know that policy will be accommodating in the future, they will continue to push their wages up, and

Expectations and

the Activist/

Nonactivist

Debate

the aggregate supply curve will keep on shifting leftward As a result, policymakers are forced to accommodate the cost push by continuing to shift the aggregate demand curve to the right to eliminate the unemployment that develops The accommodating, activist policy with its high employment target has the hidden cost or disadvantage that it may well lead to inflation.7

The main advantage of a nonaccommodating, nonactivist policy, in which cymakers do not try to shift the aggregate demand curve in response to the cost push,

poli-is that it will prevent inflation As depicted in Figure 4, the result of an upward push

on wages in the face of a nonaccommodating, nonactivist policy will be a period of unemployment above the natural rate level, which will eventually shift the aggregate supply curve and the price level back to their initial positions The main criticism of this nonactivist policy is that the economy will suffer protracted periods of unem- ployment when the aggregate supply curve shifts leftward Workers, however, would probably not push for higher wages to begin with if they knew that policy would be nonaccommodating, because their wage gains will lead to a protracted period of unemployment A nonaccommodating, nonactivist policy may have not only the advantage of preventing inflation but also the hidden benefit of discouraging leftward shifts in the aggregate supply curve that lead to excessive unemployment.

In conclusion, if workers’ opinions about whether policy is accommodating or nonaccommodating matter to the wage-setting process, the case for a nonactivist policy is much stronger.

Do Expectations About Policy Matter to the Wage-Setting Process? The answer to this question is crucial to deciding whether activist or nonactivist policy is preferred and

so has become a major topic of current research for economists, but the evidence is not yet conclusive We can ask, however, whether expectations about policy do affect people’s behavior in other contexts This information will help us know if expecta- tions regarding whether policy is accommodating are important to the wage-setting process.

As any good negotiator knows, convincing your opponent that you will be accommodating is crucial to getting a good deal If you are bargaining with a car dealer over price, for example, you must convince him that you can just as easily walk away from the deal and buy a car from a dealer on the other side of town This prin- ciple also applies to conducting foreign policy—it is to your advantage to convince your opponent that you will go to war (be nonaccommodating) if your demands are not met Similarly, if your opponent thinks that you will be accommodating, he will almost certainly take advantage of you (for an example, see Box 1) Finally, anyone who has dealt with a two-year-old child knows that the more you give in (pursue an accommodating policy), the more demanding the child becomes People’s expecta-

non-tions about policy do affect their behavior Consequently, it is quite plausible that

expectations about policy also affect the wage-setting process.8

The following conclusions can be generated from our analysis: Activists believe in the use of discretionary policy to eliminate excessive unemployment whenever it devel- ops, because they view the wage and price adjustment process as sluggish and unre- sponsive to expectations about policy Nonactivists, by contrast, believe that a discretionary policy that reacts to excessive unemployment is counter-productive, because wage and price adjustment is rapid and because expectations about policy can matter to the wage-setting process Nonactivists thus advocate the use of a policy rule to keep the aggregate demand curve from fluctuating away from the trend rate of growth of the natural rate level of output Monetarists, who adhere to the nonactivist position and who also see money as the sole source of fluctuations in the aggregate demand curve, in the past advocated a policy rule whereby the Federal Reserve keeps the money supply growing at a constant rate This monetarist rule is referred to as a

constant-money-growth-rate rule Because of the misbehavior of velocity of M1 and

M2, monetarists such as Bennett McCallum and Alan Meltzer of Carnegie-Mellon University have advocated a rule for the growth of the monetary base that is adjusted for past velocity changes.

As our analysis indicates, an important element for the success of a

nonaccom-modating policy rule is that it be credible: The public must believe that policymakers

will be tough and not accede to a cost push by shifting the aggregate demand curve

to the right to eliminate unemployment In other words, government policymakers need credibility as inflation-fighters in the eyes of the public Otherwise, workers will

be more likely to push for higher wages, which will shift the aggregate supply curve leftward after the economy reaches full employment at a point such as point 2 in Figure 11 and will lead to unemployment or inflation (or both) Alternatively, a cred- ible, nonaccommodating policy rule has the benefit that it makes a cost push less likely and thus helps prevent inflation and potential increases in unemployment The following application suggests that recent historical experience is consistent with the importance of credibility to successful policymaking.

Rules Versus

Discretion:

Conclusions

Box 1

Perils of Accommodating Policy

The Terrorism Dilemma. A major dilemma

con-fronting our foreign policy in recent years is whether to

cave in to the demands of terrorists when they are

hold-ing American hostages Because our hearts go out to the

hostages and their families, we might be tempted to

pursue an accommodating policy of giving in to the

ter-rorists to bring the hostages safely back home.

However, pursuing this accommodating policy is likely

to encourage terrorists to take hostages in the future.

The terrorism dilemma illustrates the principle that opponents are more likely to take advantage of you in the future if you accommodate them now Recognition of this principle, which demonstrates the perils of accommodating policy, explains why gov- ernments in countries such as the United States and Israel have been reluctant to give in to terrorist demands even though it has sometimes resulted in the death of hostages.

Importance of Credibility to Volcker’s Victory over Inflation

Application

In the period from 1965 through the 1970s, policymakers had little ity as inflation-fighters—a well-deserved reputation, as they pursued an accommodating policy to achieve high employment As we have seen, the outcome was not a happy one Inflation soared to double-digit levels, while the unemployment rate remained high To wring inflation out of the system, the Federal Reserve under Chairman Paul Volcker put the economy through two back-to-back recessions in 1980 and 1981–1982 (see Chapter 18) (The data on inflation, money growth, and unemployment in this period are shown in Figures 8 and 10.) Only after the 1981–1982 recession—the most severe in the postwar period, with unemployment above the 10% level—did Volcker establish credibility for the Fed’s anti-inflation policy By the end of

credibil-1982, inflation was running at a rate of less than 5%.

One indication of Volcker’s credibility came in 1983 when the money growth rate accelerated dramatically and yet inflation did not rise Workers and firms were convinced that if inflation reared its head, Volcker would pur- sue a nonaccommodating policy of quashing it They did not raise wages and prices, which would have shifted the aggregate supply curve leftward and would have led to both inflation and unemployment The success of Volcker’s anti-inflation policy continued throughout the rest of his term as chairman, which ended in 1987; unemployment fell steadily, while the inflation rate remained below 5% Volcker’s triumph over inflation was achieved because

he obtained credibility the hard way—he earned it.

Summary

1. Milton Friedman’s famous proposition that “inflation is

always and everywhere a monetary phenomenon” is

supported by the following evidence: Every country

that has experienced a sustained, high inflation has also

experienced a high rate of money growth

2. Aggregate demand and supply analysis shows that

Keynesian and monetarist views of the inflation process

are not very different Both believe that high inflation

can occur only if there is a high rate of money growth

As long as we recognize that by inflation we mean a

rapid and continuing increase in the price level, almost

all economists agree with Friedman’s proposition

3. Although high inflation is “always and everywhere a

monetary phenomenon” in the sense that it cannot

occur without a high rate of money growth, there arereasons why inflationary monetary policy comes about.The two underlying reasons are the adherence ofpolicymakers to a high employment target and thepresence of persistent government budget deficits

4.Activists believe in the use of discretionary policy toeliminate excessive unemployment whenever it occursbecause they view wage and price adjustment assluggish and unresponsive to expectations about policy.Nonactivists take the opposite view and believe thatdiscretionary policy is counterproductive In addition,they regard the credibility of a nonaccommodating(nonactivist) anti-inflation policy as crucial to itssuccess

printing money, p 644Ricardian equivalence, p 645

Questions and Problems

Questions marked with an asterisk are answered at the end

of the book in an appendix, “Answers to Selected Questions

and Problems.”

1. “There are frequently years when the inflation rate is

high and yet money growth is quite low Therefore,

the statement that inflation is a monetary

phenome-non cannot be correct.” Comment

*2. Why do economists focus on historical episodes of

hyperinflation to decide whether inflation is a

mone-tary phenomenon?

3. “Since increases in government spending raise the

aggregate demand curve in Keynesian analysis, fiscal

policy by itself can be the source of inflation.” Is this

statement true, false, or uncertain? Explain your

answer

*4. “A cost-push inflation occurs as a result of workers’

attempts to push up their wages Therefore, inflation

does not have to be a monetary phenomenon.” Is this

statement true, false, or uncertain? Explain your

answer

5. “Because government policymakers do not consider

inflation desirable, their policies cannot be the source

of inflation.” Is this statement true, false, or uncertain?

Explain your answer

*6. “A budget deficit that is only temporary cannot be the

source of inflation.” Is this statement true, false, or

uncertain? Explain your answer

7. How can the Fed’s desire to prevent high interest rates

lead to inflation?

*8. “If the data and recognition lags could be reduced,

activist policy would more likely be beneficial to the

economy.” Is this statement true, false, or uncertain?Explain your answer

9.“The more sluggish wage and price adjustment is, themore variable output and the price level are when anactivist policy is pursued.” Is this statement true, false,

or uncertain? Explain your answer

*10.“If the public believes that the monetary authoritieswill pursue an accommodating policy, a cost-pushinflation is more likely to develop.” Is this statementtrue, false, or uncertain? Explain your answer

11.Why are activist policies to eliminate unemploymentmore likely to lead to inflation than nonactivist policies?

*12.“The less important expectations about policy are tomovements of the aggregate supply curve, the strongerthe case is for activist policy to eliminate unemploy-ment.” Is this statement true, false, or uncertain?Explain your answer

13.If the economy’s self-correcting mechanism worksslowly, should the government necessarily pursue anactivist policy to eliminate unemployment?

*14.“To prevent inflation, the Fed should follow TeddyRoosevelt’s advice: ‘Speak softly and carry a big stick.’”What would the Fed’s “big stick” be? What is the state-ment trying to say?

15.In a speech early in the Iraq-Kuwait crisis in 1990,President George Bush stated that although his heartwent out to the hostages held by Saddam Hussein, hewould not let this hostage-taking deter the UnitedStates from insisting on the withdrawal of Iraq fromKuwait Do you think that Bush’s position made sense?Explain why or why not

QUIZ

Web Exercises

1.Figure 8 reports the inflation rate from 1960 to 2002

As this chapter states, inflation continues to be a

major a factor in economic policy Go to ftp://ftp.bls

.gov/pub/special.requests/cpi/cpiai.txt Move data into

Excel using the method described at the end of

Chapter 1 Delete all but the first and last column

(date and annual CPI) Graph this data and compare it

to Figure 8

a Has inflation increased or decreased since the end

of 2002?

b When was inflation at its highest?

c When was inflation at its lowest?

d Have we ever had a period of deflation? If so,

pur-a If a new home cost $125,000 in 2002, what would

it have cost in 1950?

b The average household income in 2002 was about

$37,000 How much would this have been in1945?

c An average new car cost about $18,000 in 2002.What would this have cost in 1945?

d Using the results you found in Questions b and c,does a car consume more or less of average house-hold income in 2002 than in 1945?

The Lucas Critique of Policy Evaluation

econometric models

The way in which expectations are formed (the relationship of expectations to past information) changes when the behavior of forecasted variables changes.

Example: The Term

The Lucas critique points out not only that ventional econometric models cannot be used for policy evaluation, but also that the public’s expectations about a policy will influence the response to that policy.

con-New Classical Macroeconomic Model

new classical macroeconomic model

real

to Unanticipated Expansionary Policy

in the New Classical Model

YnP

to Anticipated Expansionary Policy in

the New Classical Model

Yn

policy ineffectiveness proposition

AS

Journal of Political Economy

Study Guide

Implications for

Policymakers

F I G U R E 3 Short-Run Response

to an Expansionary Policy That Is Less

Expansionary Than Expected in the

New Classical Model

P2

2

AD2

Y2

New Keynesian Model

new Keynesians

wage–price stickiness

www.federalreserve.gov/pubs

/feds/2001/200113

/200113pap.pdf

new Keynesian model

does

AD AS

Keynesian model anticipated policy does have an effect on aggregate output.

like the new classical model, the new Keynesian model distinguishes between the effects of antic- ipated versus unanticipated policy, with unanticipated policy having a greater effect

Comparison of the Two New Models with the Traditional Model

Unanticipated Anticipated Can Activist Unanticipated Anticipated Successful Expansionary Expansionary Policy Be Anti-inflation Anti-inflation Anti-inflation

F I G U R E 5

Comparison of the Short-Run

Response to Expansionary Policy in

the Three Models

AD AD

(c) New Keynesian model

Monetary Policy Issues in the 1980s

Box 2: Global

Ending the Bolivian Hyperinflation

Case Study of a Successful Anti-inflation Program.

Inflation: Causes and Consequences,

Impact of the Rational Expectations Revolution

Inflation, Debt, and Indexation,

Journal of Political Economy

American Economic Review

Rational Expectations and Economic Policy,

Journal of Political Economy

Journal of Political Economy

Reading the Wall Street Journal: The Bond Page, p 72

Changes in the Equilibrium Interest Rate Due to

Expected Inflation or Business Cycle Expansions,

p 99

Explaining Low Japanese Interest Rates, p 103

Reading the Wall Street Journal “Credit Markets” Column,

p 103

Changes in the Equilibrium Interest Rate Due to

Changes in Income, the Price Level, or the Money

Supply, p 108

Money and Interest Rates, p 112

The Enron Bankruptcy and the Baa-Aaa Spread, p 124

Effects of the Bush Tax Cut on Bond Interest Rates,

p 127

Interpreting Yield Curves, 1980–2003, p 137

Monetary Policy and Stock Prices, p 146

The September 11 Terrorist Attacks, the Enron Scandal,

and the Stock Market, p 146

Should Foreign Exchange Rates Follow a Random

Walk?, p 155

Practical Guide to Investing in the Stock Market, p 158

What Do the Black Monday Crash of 1987 and the Tech

Crash of 2000 Tell Us About Rational Expectations

and Efficient Markets?, p 163

Financial Development and Economic Growth, p 187

Financial Crises in the United States, p 191

Financial Crises in Emerging-Market Countries: Mexico,

1994–1995; East Asia, 1997–1998; and Argentina,

2001–2002, p 194

Strategies for Managing Bank Capital, p 215

Did the Capital Crunch Cause a Credit Crunch in the

Early 1990s?, p 216

Strategies for Managing Interest-Rate Risk, p 222

Insurance Management, p 290

Hedging with Interest-Rate Forward Contracts, p 310

Hedging with Financial Futures, p 314

Hedging Foreign Exchange Risk, p 319

Hedging with Futures Options, p 325

Hedging with Interest-Rate Swaps, p 329

Explaining Movements in the Money Supply,

1980–2002, p 384

The Great Depression Bank Panics, 1930–1933, p 387

Why Have Reserve Requirements Been Declining Worldwide?, p 406

The Channel/Corridor System for Setting Interest Rates

in Other Countries, p 406 Changes in the Equilibrium Exchange Rate: Two Examples, p 452

Why Are Exchange Rates So Volatile?, p 455 The Dollar and Interest Rates, 1973–2002, p 455 The Euro’s First Four Years, p 457

Reading the Wall Street Journal: The “Currency Trading”

Column, p 457 The Foreign Exchange Crisis of September 1992, p 475 Recent Foreign Exchange Crises in Emerging Market Countries: Mexico 1994, East Asia 1997, Brazil 1999, and Argentina 2002, p 477

The Collapse of Investment Spending and the Great Depression, p 545

Targeting Money Supply Versus Interest Rates, p 571 Explaining Past Business Cycle Episodes, p 598 Corporate Scandals and the Slow Recovery from the March 2001 Recession, p 625

Applying the Monetary Policy Lessons to Japan, p 628 Explaining the Rise in U.S Inflation, 1960–1980,

p 646 Importance of Credibility to Volcker’s Victory over Inflation, p 655

Credibility and the Reagan Budget Deficits, p 675

Following the Financial News

Foreign Stock Market Indexes, p 30 The Monetary Aggregates, p 54 Bond Prices and Interest Rates, p 73 The “Credit Markets” Column, p 104 Forecasting Interest Rates, p 111 Yield Curves, p 128

Stock Prices, p 159 New Securities Issues, p 304 Financial Futures, p 312 Futures Options, p 321 Foreign Exchange Rates, p 437 The “Currency Trading” Column, p 458 Aggregate Output, Unemployment, and the Price Level,

p 583

The Importance of Financial Intermediaries to Securities

Markets: An International Comparison, p 31

Birth of the Euro: Will It Benefit Europe?, p 49

Negative T-Bill Rates? Japan Shows the Way, p 69

Barings, Daiwa, Sumitomo, and Allied Irish: Rogue

Traders and the Principal–Agent Problem, p 225

Comparison of Banking Structure in the United States

and Abroad, p 249

Ironic Birth of the Eurodollar Market, p 255

The Spread of Government Deposit Insurance

Throughout the World: Is This a Good Thing?,

p 262

Basel 2: Is It Spinning Out of Control?, p 266

Foreign Exchange Rate Intervention and the Monetary

Base, p 363

The Growing European Commitment to Price Stability,

p 413

International Policy Coordination: The Plaza Agreement

and the Louvre Accord, p 428

The Euro’s Challenge to the Dollar, p 471

Argentina’s Currency Board, p 494

The European Central Bank’s Monetary Policy Strategy,

p 498

Ending the Bolivian Hyperinflation: Case Study of a

Successful Anti-inflation Program, p 674

E-Finance Boxes

Why Are Scandinavians So Far Ahead of Americans in

Using Electronic Payments?, p 50

Are We Headed for a Cashless Society?, p 52

Venture Capitalists and the High-Tech Sector, p 183

Will “Clicks” Dominate “Bricks” in the Banking

Industry?, p 236

Information Technology and Bank Consolidation, p 247

Electronic Banking: New Challenges for Bank

Regulation, p 270

Mutual Funds and the Internet, p 298

The Internet Comes to Wall Street, p 306

Inside the Fed Boxes

The Political Genius of the Founders of the Federal

Reserve System, p 336

York, p 339 The Role of the Research Staff, p 342 Green, Blue, and Beige: What Do These Colors Mean at the Fed?, p 344

The Role of Member Banks in the Federal Reserve System, p 346

Federal Reserve Transparency, p 352 Discounting to Prevent a Financial Panic: The Black Monday Stock Market Crash of 1987 and the Terrorist Destruction of the World Trade Center in September 2001, p 404

Bank Panics of 1930–1933: Why Did the Fed Let Them Happen?, p 421

A Day at the Federal Reserve Bank of New York’s Foreign Exchange Desk, p 463

Special-Interest Boxes

Helping Investors to Select Desired Interest-Rate Risk,

p 79 With TIPS, Real Interest Rates Have Become Observable

in the United States, p 82 Should You Hire an Ape as Your Investment Adviser?,

p 160 The Enron Implosion and the Arthur Andersen Conviction, p 178

Case Study of a Financial Crisis, p 194 Should Social Security Be Privatized?, p 296 The Long-Term Capital Management Debacle, p 300 Are Fannie Mae and Freddie Mac Getting Too Big for Their Britches?, p 302

The Return of the Financial Supermarket?, p 305 Fed Watching, p 430

Meaning of the Word Investment, p 540

Perils of Reverse Causation: A Russian Folk Tale, p 606 Perils of Ignoring an Outside Driving Factor: How to Lose a Presidential Election, p 607

Real Business Cycle Theory and the Debate on Money and Economic Activity, p 616

Consumers’ Balance Sheets and the Great Depression,

p 624 Perils of Accommodating Policy: The Terrorism Dilemma, p 654

Proof of the Policy Ineffectiveness Proposition, p 663

Page where

a 538 autonomous consumer expenditure

AD 578 aggregate demand curve

AS 588 aggregate supply curve

i D 443 interest rate on domestic assets

i F 443 interest rate on foreign assets

I 536 planned investment spending

MB 359 monetary base (high-powered money)

MB n 382 nonborrowed monetary base

mpc 538 marginal propensity to consume

P e 617 expected price level

P t 76 price of a security at time t

r 238 reserve requirement ratio for checkable deposits

R D 444 expected return on domestic deposits

R F 444 expected return on foreign deposits

Y n 575 natural rate level of output

accommodating policy An activist policy in pursuit of a high

employment target 640

activist An economist who views the self-correcting

mecha-nism through wage and price adjustment to be very slow

and hence sees the need for the government to pursue

active, discretionary policy to eliminate high

unemploy-ment whenever it develops 592

adaptive expectations Expectations of a variable based on

an average of past values of the variable 147

adverse selection The problem created by asymmetric

infor-mation before a transaction occurs: The people who are the

most undesirable from the other party’s point of view are

the ones who are most likely to want to engage in the

financial transaction 32

agency theory The analysis of how asymmetric information

problems affect economic behavior 175, 189

aggregate demand The total quantity of output demanded in

the economy at different price levels 537, 582

aggregate demand curve A relationship between the price

level and the quantity of aggregate output demanded

when the goods and money markets are in equilibrium

577, 582

aggregate demand function The relationship between

aggre-gate output and aggreaggre-gate demand that shows the quantity

of aggregate output demanded for each level of aggregate

output 541

aggregate income The total income of factors of production

(land, labor, capital) in the economy 20

aggregate output The total production of final goods and

services in the economy 9

aggregate price level The average price of goods and

serv-ices in an economy 10

aggregate supply The quantity of aggregate output supplied

by the economy at different price levels 582

aggregate supply curve The relationship between the

quan-tity of output supplied in the short run and the price level

588

American option An option that can be exercised at any time

up to the expiration date of the contract 320

“animal spirits” Waves of optimism and pessimism that

affect consumers’ and businesses’ willingness to spend

544, 586

annuities Financial contracts under which a customer pays

an annual premium in exchange for a future stream of

annual payments beginning at a set age, say 65, and

end-ing when the person dies 288

appreciation Increase in a currency’s value 436

arbitrage Elimination of a riskless profit opportunity in a

purchase other assets that may have far more risk 32

asset market approach An approach to determine asset

prices using stocks of assets rather than flows 93

asymmetric information The unequal knowledge that each

party to a transaction has about the other party 32

autonomous consumer expenditure The amount of sumer expenditure that is independent of disposable

con-income 538

balance of payments A bookkeeping system for recording allpayments that have a direct bearing on the movement of

funds between a country and foreign countries 467

balance-of-payments crisis A foreign exchange crisis ming from problems in a country’s balance of payments

stem-476 balance sheet A list of the assets and liabilities of a bank (orfirm) that balances: Total assets equal total liabilities plus

capital 201

bank failure A situation in which a bank cannot satisfy itsobligations to pay its depositors and other creditors and so

goes out of business 260

bank holding companies Companies that own one or more

banks 245

bank panic The simultaneous failure of many banks, as

dur-ing a financial crisis 191

banks Financial institutions that accept money deposits andmake loans (such as commercial banks, savings and loan

associations, and credit unions) 8

bank supervision Overseeing who operates banks and how

they are operated 265

Basel Accord An agreement that required that banks hold as

capital at least 8% of their risk-weighted assets 265

Basel Committee on Banking Supervision An internationalcommittee of bank supervisors that meets under the aus-pices of the Bank for International Settlements in Basel,

Switzerland 265

G-1

G L O S S A RY

basis point One one-hundredth of a percentage point 74

Board of Governors of the Federal Reserve System A

board with seven governors (including the chairman) that

plays an essential role in decision making within the

Federal Reserve System 337

bond A debt security that promises to make payments

peri-odically for a specified period of time 3

branches Additional offices of banks that conduct banking

operations 244

Bretton Woods system The international monetary system

in use from 1945 to 1971 in which exchange rates were

fixed and the U.S dollar was freely convertible into gold

(by foreign governments and central banks only) 470

brokerage firms Firms that participate in securities markets

as brokers, dealers, and investment bankers 304

brokers Agents for investors; they match buyers with sellers

26

bubble A situation in which the price of an asset differs from

its fundamental market value 164

budget deficit The excess of government expenditure over

tax revenues 12

budget surplus The excess of tax revenues over government

expenditures 12

business cycles The upward and downward movement of

aggregate output produced in the economy 9

call option An option contract that provides the right to buy

a security at a specified price 322

capital account An account that describes the flow of capital

between the United States and other countries 467

capital adequacy management A bank’s decision about the

amount of capital it should maintain and then acquisition

of the needed capital 208

capital market A financial market in which longer-term debt

(generally with original maturity of greater than one year)

and equity instruments are traded 27

capital mobility A situation in which foreigners can easily

purchase a country’s assets and the country’s residents can

easily purchase foreign assets 445

cash flow The difference between cash receipts and cash

expenditures 141, 190

central bank The government agency that oversees the

bank-ing system and is responsible for the amount of money

and credit supplied in the economy; in the United States,

the Federal Reserve System 12, 230

closed-end fund A mutual fund in which a fixed number of

nonredeemable shares are sold at an initial offering, then

traded in the over-the-counter market like common stock

299

coinsurance A situation in which only a portion of losses are

covered by insurance, so that the insured suffers a

per-centage of the losses along with the insurance agency 293

collateral Property that is pledged to the lender to guaranteepayment in the event that the borrower is unable to make

debt payments 172

commodity money Money made up of precious metals or

another valuable commodity 48

common stock A security that is a claim on the earnings and

assets of a company 5

compensating balance A required minimum amount offunds that a firm receiving a loan must keep in a checking

account at the lending bank 219

complete crowding out The situation in which expansionaryfiscal policy, such as an increase in government spending,does not lead to a rise in output because there is an

exactly offsetting movement in private spending 571, 587

consol A perpetual bond with no maturity date and norepayment of principal that periodically makes fixed

coupon payments 67

constant-money-growth-rate rule A policy rule advocated

by monetarists, whereby the Federal Reserve keeps the

money supply growing at a constant rate 654

consumer durable expenditure Spending by consumers ondurable items such as automobiles and household appli-

ances 617

consumer expenditure The total demand for (spending on)

consumer goods and services 536, 585

consumption Spending by consumers on nondurable goods

and services (including services related to the ownership

of homes and consumer durables) 620

consumption function The relationship between disposable

income and consumer expenditure 538

costly state verification Monitoring a firm’s activities, an

expensive process in both time and money 182

cost-push inflation Inflation that occurs because of the push

by workers to obtain higher wages 639

coupon bond A credit market instrument that pays theowner a fixed interest payment every year until the matu-

rity date, when a specified final amount is repaid 63

coupon rate The dollar amount of the yearly coupon ment expressed as a percentage of the face value of a

pay-coupon bond 64

creditor A holder of debt 188

credit rationing A lender’s refusing to make loans eventhough borrowers are willing to pay the stated interest rate

or even a higher rate or restricting the size of loans made

to less than the full amount sought 220

credit risk The risk arising from the possibility that the

bor-rower will default 208

credit view Monetary transmission mechanisms operatingthrough asymmetric information effects on credit markets

618 currency Paper money (such as dollar bills) and coins 44

currency board A monetary regime in which the domestic

currency is backed 100% by a foreign currency (say

dol-lars) and in which the note-issuing authority, whether the

central bank or the government, establishes a fixed

exchange rate to this foreign currency and stands ready to

exchange domestic currency at this rate whenever the

public requests it 492

currency swap The exchange of a set of payments in one

currency for a set of payments in another currency 328

current account An account that shows international

trans-actions involving currently produced goods and services

467

current yield An approximation of the yield to maturity that

equals the yearly coupon payment divided by the price of

a coupon bond 70

dealers People who link buyers with sellers by buying and

selling securities at stated prices 26

debt deflation A situation in which a substantial decline in

the price level sets in, leading to a further deterioration in

firms’ net worth because of the increased burden of

indebtedness 192

deductible The fixed amount by which the insured’s loss is

reduced when a claim is paid off 292

default A situation in which the party issuing a debt

instru-ment is unable to make interest payinstru-ments or pay off the

amount owed when the instrument matures 120

default-free bonds Bonds with no default risk, such as U.S

government bonds 121

default risk The chance that the issuer of a debt instrument

will be unable to make interest payments or pay off the

face value when the instrument matures 120

defensive open market operations Open market operations

intended to offset movements in other factors that affect

the monetary base (such as changes in Treasury deposits

with the Fed or changes in float) 398

defined-benefit plan A pension plan in which benefits are

set in advance 294

defined-contribution plan A pension plan in which benefits

are determined by the contributions into the plan and

their earnings 294

demand curve A curve depicting the relationship between

quantity demanded and price when all other economic

variables are held constant 87

demand-pull inflation Inflation that results when

policy-makers pursue policies that shift the aggregate demand

curve 639

deposit outflows Losses of deposits when depositors make

withdrawals or demand payment 208

deposit rate ceiling Restriction on the maximum interest

rate payable on deposits 238

depreciation Decrease in a currency’s value 436

devaluation Resetting of the fixed value of a currency at a

lower level 472

dirty float See managed float regime 462

discount bond A credit market instrument that is bought at

a price below its face value and whose face value is repaid

at the maturity date; it does not make any interest

pay-ments Also called a zero-coupon bond 64

discount loans A bank’s borrowings from the Federal

Reserve System; also known as advances 203

discount rate The interest rate that the Federal Reserve

charges banks on discount loans 210, 359

discount window The Federal Reserve facility at which

dis-count loans are made to banks 400

discount yield See yield on a discount basis 71

disintermediation A reduction in the flow of funds into thebanking system that causes the amount of financial inter-

mediation to decline 238

disposable income Total income available for spending,

equal to aggregate income minus taxes 538

diversification Investing in a collection (portfolio) of assets

whose returns do not always move together, with theresult that overall risk is lower than for individual assets

32 dividends Periodic payments made by equities to sharehold-

ers 26, 142

dollarization The adoption of a sound currency, like the U.S

dollar, as a country’s money 493

dual banking system The system in the United States inwhich banks supervised by the federal government and

banks supervised by the states operate side by side 231

duration analysis A measurement of the sensitivity of themarket value of a bank’s assets and liabilities to changes in

interest rates 221

dynamic open market operations Open market operationsthat are intended to change the level of reserves and the

monetary base 398

e-cash Electronic money that is used on the Internet to

pur-chase goods or services 51

econometric model A model whose equations are estimated

using statistical procedures 659

economies of scale The reduction in transaction costs perdollar of transaction as the size (scale) of transactions

increases 30

economies of scope The ability to use one resource to

pro-vide many different products and services 248

Edge Act corporation A special subsidiary of a U.S bank

that is engaged primarily in international banking 255

effective exchange rate index An index reflecting the value

of a basket of representative foreign currencies 455

efficient market hypothesis The application of the theory of

rational expectations to financial markets 149