Economics of money banking and financial markets

As we will see in our discussion of monetary theory in subsequent chapters, a onetime increase in the moneysupply will not produce a continually rising price level; only a higher rate of

Editor in Chief: Denise Clinton

Acquisitions Editor: Victoria Warneck

Executive Development Manager: Sylvia Mallory

Development Editor: Jane Tufts

Production Supervisor: Meredith Gertz

Text Design: Studio Montage

Cover Design: Regina Hagen Kolenda and Studio Montage

Composition: Argosy Publishing

Senior Manufacturing Supervisor: Hugh Crawford

Senior Marketing Manager: Barbara LeBuhn

Cover images: © PhotoDisc

Media Producer: Melissa Honig

Supplements Editor: Diana Theriault

Credits to copyrighted material appear on p C-1, which constitutes a continuation of the copyright page

Library of Congress Cataloguing-in-Publication Data

Mishkin, Frederic S

The economics of money, banking, and financial markets / Frederic S Mishkin.—7th ed

p cm — (The Addison-Wesley series in economics)

Supplemented by a subscription to a companion web site

Includes bibliographical references and index

To Sally

Introduction 1

Why Study Money, Banking, and Financial Markets? 3

An Overview of the Financial System 23

What Is Money? 44

Financial Markets 59 Understanding Interest Rates 61

The Behavior of Interest Rates 85

The Risk and Term Structure of Interest Rates 120

The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 141

Financial Institutions 167 An Economic Analysis of Financial Structure 169

Banking and the Management of Financial Institutions 201

Banking Industry: Structure and Competition 229

Economic Analysis of Banking Regulation 260

Nonbank Finance 287

Financial Derivatives 309

Central Banking and the Conduct of Monetary Policy 333 Structure of Central Banks and the Federal Reserve System 335

Multiple Deposit Creation and the Money Supply Process 357

Determinants of the Money Supply 374

Tools of Monetary Policy 393

Conduct of Monetary Policy: Goals and Targets 411

International Finance and Monetary Policy 433 The Foreign Exchange Market 435

The International Financial System 462

Monetary Policy Strategy: The International Experience 487

Monetary Theory 515

The Demand for Money 517

The Keynesian Framework and the ISLM Model 536

Monetary and Fiscal Policy in the ISLM Model 561

Aggregate Demand and Supply Analysis 582

Transmission Mechanisms of Monetary Policy: The Evidence 603

Money and Inflation 632

Rational Expectations: Implications for Policy 658

viii Contents in Brief

Introduction 1

CHAPTER 1

WHY STUDY MONEY, BANKING, AND FINANCIAL MARKETS? 3

Appendix to Chapter 1

Defining Aggregate Output, Income, the Price Level,

and the Inflation Rate 20

CHAPTER 2

AN OVERVIEW OF THE FINANCIAL SYSTEM 23

Following the Financial News Foreign Stock Market Indexes 30

The Importance of Financial Intermediaries to Securities Markets: An International Comparison 31

CHAPTER 3 WHAT IS MONEY? 44

Birth of the Euro: Will It Benefit Europe? 49

x Contents

Why Are Scandinavians So Far Ahead of Americans in

Using Electronic Payments? 50

Are We Headed for a Cashless Society? 52

Following the Financial News The Monetary Aggregates 54

Financial Markets 59 CHAPTER 4 UNDERSTANDING INTEREST RATES 61

Negative T-Bill Rates? Japan Shows the Way 69

Application Reading the Wall Street Journal: The Bond Page 72

Following the Financial News Bond Prices and Interest Rates 73

Helping Investors to Select Desired Interest-Rate Risk 79

With TIPS, Real Interest Rates Have Become Observable in the United States 82

CHAPTER 5 THE BEHAVIOR OF INTEREST RATES 85

Contents xi

Application Changes in the Equilibrium Interest Rate Due to Expected

Inflation or Business Cycle Expansions 99

Application Explaining Low Japanese Interest Rates 103

Application Reading the Wall Street Journal “Credit Markets” Column 103

Following the Financial News The “Credit Markets” Column 104

Application Changes in the Equilibrium Interest Rate Due to Changes in Income, the Price Level, or the Money Supply 108

Following the Financial News Forecasting Interest Rates 111

Application Money and Interest Rates 112

CHAPTER 6 THE RISK AND TERM STRUCTURE OF INTEREST RATES 120

Application The Enron Bankruptcy and the Baa-Aaa Spread 124

xii Contents

Application Effects of the Bush Tax Cut on Bond Interest Rates 127

Following the Financial News Yield Curves 128

Application Interpreting Yield Curves, 1980–2003 137

CHAPTER 7

THE STOCK MARKET, THE THEORY OF RATIONAL EXPECTATIONS,

AND THE EFFICIENT MARKET HYPOTHESIS 141

Application Monetary Policy and Stock Prices 146

Application The September 11 Terrorist Attacks, the Enron Scandal,

and the Stock Market 146

Application Should Foreign Exchange Rates Follow a Random Walk? 155

Application Practical Guide to Investing in the Stock Market 158

Contents xiii

Following the Financial News Stock Prices 159

Should You Hire an Ape as Your Investment Adviser? 160

Application What Do the Black Monday Crash of 1987 and the Tech Crash of 2000 Tell Us About Rational Expectations and Efficient Markets? 163

Financial Institutions 167 CHAPTER 8 AN ECONOMIC ANALYSIS OF FINANCIAL STRUCTURE 169

The Enron Implosion and the Arthur Andersen Conviction 178

Venture Capitalists and the High-Tech Sector 183

Application Financial Development and Economic Growth 187

Application Financial Crises in the United States 191

Case Study of a Financial Crisis: The Great Depression 194

Application Financial Crises in Emerging-Market Countries: Mexico, 1994–1995; East Asia, 1997–1998; and Argentina, 2001–2002 194

xiv Contents

CHAPTER 9

BANKING AND THE MANAGEMENT OF FINANCIAL INSTITUTIONS 201

Application Strategies for Managing Bank Capital 215

Application Did the Capital Crunch Cause a Credit Crunch in the

Early 1990s? 216

Application Strategies for Managing Interest-Rate Risk 222

Barings, Daiwa, Sumitomo, and Allied Irish:

Rogue Traders and the Principal–Agent Problem 225

CHAPTER 10

BANKING INDUSTRY: STRUCTURE AND COMPETITION 229

Will “Clicks” Dominate “Bricks” in the Banking Industry? 236

Information Technology and Bank Consolidation 247

Comparison of Banking Structure in the United States and Abroad 249

Ironic Birth of the Eurodollar Market 255

CHAPTER 11 ECONOMIC ANALYSIS OF BANKING REGULATION 260

The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing? 262

Basel 2: Is It Spinning Out of Control? 265

Electronic Banking: New Challenges for Bank Regulation 270

xvi Contents

QUIZ

1. One of the single best sources of information about

financial institutions is the U.S Flow of Funds report

produced by the Federal Reserve This document

con-tains data on most financial intermediaries Go to

www.federalreserve.gov/releases/Z1/ Go to the most

current release You may have to load Acrobat Reader

if your computer does not already have it The site has

a link for a free patch Go to the Level Tables and

answer the following

a What percent of assets do commercial banks hold

in loans? What percent of assets are held in

mort-gage loans?

b What percent of assets do Savings and Loans hold

in mortgage loans?

c What percent of assets do credit unions hold in

mortgage loans and in consumer loans?

2. The most famous financial market in the world is theNew York Stock Exchange Go to www.nyse.com

a What is the mission of the NYSE?

b Firms must pay a fee to list their shares for sale onthe NYSE What would be the fee for a firm with 5million shares common outstanding?

C H A P T E R 2 An Overview of the Financial System 43

Web Exercises

(daily average in billions)

1 Week Ended:

Dec 23 Dec 16 Money supply (M1) sa 1227.1 1210.1

Money supply (M1) nsa 1256.0 1214.9

Month Nov Oct Money supply (M1) sa 1200.7 1199.6 Money supply (M2) sa 5800.7 5753.8 Money supply (M3) sa 8485.2 8348.4 nsa-Not seasonally adjusted

15

20

we ably should not pay much attention to short-run movements in the money supply numbers, but should be concerned only with longer-run movements.

prob-QUIZ

P a r t I I

Financial Markets

principal maturity date

simple interest rate i

i

PV FV i

i

i,

for simple loans, the simple interest rate equals the yield to maturity i

i

i

internal rate of return

FP i

FP

i n

PV i

PV i

P C F n

i.

i

C i

C i

C i

P C

i

i

F P

i

P

114 P A R T I I Financial Markets

reversed We thus see that in contrast to the price-level effect, which reachesits greatest impact next year, the expected-inflation effect will have its small-est impact (zero impact) next year The basic difference between the twoeffects, then, is that the price-level effect remains even after prices havestopped rising, whereas the expected-inflation effect disappears

An important point is that the expected-inflation effect will persist only

as long as the price level continues to rise As we will see in our discussion

of monetary theory in subsequent chapters, a onetime increase in the moneysupply will not produce a continually rising price level; only a higher rate ofmoney supply growth will Thus a higher rate of money supply growth isneeded if the expected-inflation effect is to persist

We can now put together all the effects we have discussed to help us decidewhether our analysis supports the politicians who advocate a greater rate ofgrowth of the money supply when they feel that interest rates are too high

Of all the effects, only the liquidity effect indicates that a higher rate of moneygrowth will cause a decline in interest rates In contrast, the income, price-level, and expected-inflation effects indicate that interest rates will rise whenmoney growth is higher Which of these effects are largest, and how quickly

do they take effect? The answers are critical in determining whether interestrates will rise or fall when money supply growth is increased

Generally, the liquidity effect from the greater money growth takes effectimmediately, because the rising money supply leads to an immediate decline inthe equilibrium interest rate The income and price-level effects take time towork, because it takes time for the increasing money supply to raise the pricelevel and income, which in turn raise interest rates The expected-inflationeffect, which also raises interest rates, can be slow or fast, depending onwhether people adjust their expectations of inflation slowly or quickly whenthe money growth rate is increased

Three possibilities are outlined in Figure 12; each shows how interestrates respond over time to an increased rate of money supply growth starting

at time T Panel (a) shows a case in which the liquidity effect dominates the other effects so that the interest rate falls from i1at time T to a final level of

i2 The liquidity effect operates quickly to lower the interest rate, but as timegoes by, the other effects start to reverse some of the decline Because the liq-uidity effect is larger than the others, however, the interest rate never risesback to its initial level

Panel (b) has a smaller liquidity effect than the other effects, with theexpected-inflation effect operating slowly because expectations of inflation areslow to adjust upward Initially, the liquidity effect drives down the interestrate Then the income, price-level, and expected-inflation effects begin to raise

it Because these effects are dominant, the interest rate eventually rises above

its initial level to i2 In the short run, lower interest rates result from increasedmoney growth, but eventually they end up climbing above the initial level.Panel (c) has the expected-inflation effect dominating as well as operatingrapidly because people quickly raise their expectations of inflation when therate of money growth increases The expected-inflation effect begins immedi-ately to overpower the liquidity effect, and the interest rate immediately starts

Does a Higher Rate

of Growth of the

Money Supply Lower

Interest Rates?

C H A P T E R 5 The Behavior of Interest Rates 115

F I G U R E 1 2

Liquidity Effect

Income, Price-Level, and Expected- Inflation Effects

( a ) Liquidity effect larger than other effects

Income, Price-Level, and Expected- Inflation Effects

( b ) Liquidity effect smaller than other effects and slow adjustment

Income and Level Effects

Price-( c ) Liquidity effect smaller than expected-inflation effect and fast adjustment of expected inflation

Time

i1

i2

T Interest Rate, i

Interest Rate, i

Interest Rate, i

116 P A R T I I Financial Markets

F I G U R E 1 3 Money Growth (M2, Annual Rate) and Interest Rates (Three-Month Treasury Bills), 1950–2002

Sources:Federal Reserve: www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

1950

2 4 6 8 10 12 14

0

to climb Over time, as the income and price-level effects start to take hold,the interest rate rises even higher, and the eventual outcome is an interest ratethat is substantially above the initial interest rate The result shows clearly thatincreasing money supply growth is not the answer to reducing interest rates;rather, money growth should be reduced in order to lower interest rates!

An important issue for economic policymakers is which of these threescenarios is closest to reality If a decline in interest rates is desired, then anincrease in money supply growth is called for when the liquidity effect dom-inates the other effects, as in panel (a) A decrease in money growth is appro-priate if the other effects dominate the liquidity effect and expectations ofinflation adjust rapidly, as in panel (c) If the other effects dominate the liq-uidity effect but expectations of inflation adjust only slowly, as in panel (b),then whether you want to increase or decrease money growth depends onwhether you care more about what happens in the short run or the long run.Which scenario is supported by the evidence? The relationship of interestrates and money growth from 1950 to 2002 is plotted in Figure 13 When therate of money supply growth began to climb in the mid-1960s, interest ratesrose, indicating that the liquidity effect was dominated by the price-level,income, and expected-inflation effects By the 1970s, interest rates reached

C H A P T E R 5 The Behavior of Interest Rates 117

Summary

1.The theory of asset demand tells us that the quantity

demanded of an asset is (a) positively related to wealth,

(b ) positively related to the expected return on the

asset relative to alternative assets, (c) negatively related

to the riskiness of the asset relative to alternative assets,

and (d) positively related to the liquidity of the asset

relative to alternative assets

2.The supply and demand analysis for bonds, frequently

referred to as the loanable funds framework, provides

one theory of how interest rates are determined It

predicts that interest rates will change when there is a

change in demand because of changes in income (or

wealth), expected returns, risk, or liquidity or when

there is a change in supply because of changes in the

attractiveness of investment opportunities, the real cost

of borrowing, or government activities

3. An alternative theory of how interest rates aredetermined is provided by the liquidity preferenceframework, which analyzes the supply of and demandfor money It shows that interest rates will change whenthere is a change in the demand for money because ofchanges in income or the price level or when there is achange in the supply of money

4. There are four possible effects of an increase in themoney supply on interest rates: the liquidity effect, theincome effect, the price-level effect, and the expected-inflation effect The liquidity effect indicates that a rise

in money supply growth will lead to a decline in interestrates; the other effects work in the opposite direction.The evidence seems to indicate that the income, price-level, and expected-inflation effects dominate theliquidity effect such that an increase in money supplygrowth leads to higher rather than lower interest rates

levels unprecedented in the post-World War II period, as did the rate ofmoney supply growth

The scenario depicted in panel (a) of Figure 12 seems doubtful, and thecase for lowering interest rates by raising the rate of money growth is muchweakened Looking back at Figure 6, which shows the relationship betweeninterest rates and expected inflation, you should not find this too surprising

The rise in the rate of money supply growth in the 1960s and 1970s ismatched by a large rise in expected inflation, which would lead us to predictthat the expected-inflation effect would be dominant It is the most plausibleexplanation for why interest rates rose in the face of higher money growth

However, Figure 13 does not really tell us which one of the two scenarios,panel (b) or panel (c) of Figure 12, is more accurate It depends critically onhow fast people’s expectations about inflation adjust However, recentresearch using more sophisticated methods than just looking at a graph likeFigure 13 do indicate that increased money growth temporarily lowers short-term interest rates.7

7 See Lawrence J Christiano and Martin Eichenbaum, “Identification and the Liquidity Effect of a

Monetary Policy Shock,” in Business Cycles, Growth, and Political Economy, ed Alex Cukierman, Zvi

Hercowitz, and Leonardo Leiderman (Cambridge, Mass.: MIT Press, 1992), pp 335–370; Eric M.

Leeper and David B Gordon, “In Search of the Liquidity Effect,” Journal of Monetary Economics 29

(1992): 341–370; Steven Strongin, “The Identification of Monetary Policy Disturbances: Explaining the

Liquidity Puzzle,” Journal of Monetary Economics 35 (1995): 463–497; Adrian Pagan and John C.

Robertson, “Resolving the Liquidity Effect,” Federal Reserve Bank of St Louis Review 77 (May-June 1995): 33–54; and Ben S Bernanke and Ilian Mihov, “Measuring Monetary Policy,” Quarterly Journal of Economics113, 3 (August 1998), pp 869–902.