Finance, Banking, and Money - 2012 Book Archive

503 Pages·2012·8.29 MB·English

Finance, Banking, and
Money
v. 1.1
This is the bookFinance, Banking, and Money(v. 1.1).
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Table of Contents
About the Authors................................................................................................................. 1
Acknowledgments................................................................................................................. 3
Preface..................................................................................................................................... 4
Chapter 1: Money, Banking, and Your World................................................................. 5
Dreams Dashed...............................................................................................................................................6
Hope Springs..................................................................................................................................................9
Suggested Browsing.....................................................................................................................................11
Suggested Reading.......................................................................................................................................12
Chapter 2: The Financial System..................................................................................... 13
Evil and Brilliant Financiers?......................................................................................................................14
Financial Systems.........................................................................................................................................16
Asymmetric Information: The Real Evil....................................................................................................19
Financial Markets.........................................................................................................................................22
Financial Intermediaries.............................................................................................................................26
Competition Between Markets and Intermediaries.................................................................................30
Regulation.....................................................................................................................................................32
Suggested Reading.......................................................................................................................................34
Chapter 3: Money................................................................................................................ 35
Of Love, Money, and Transactional Efficiency..........................................................................................36
Better to Have Had Money and Lost It Than to Have Never Had Money at All.....................................41
A Short History of Moolah..........................................................................................................................44
Commodity and Credit Monies...................................................................................................................47
Measuring Money........................................................................................................................................53
Suggested Reading.......................................................................................................................................55
Chapter 4: Interest Rates................................................................................................... 56
The Interest of Interest...............................................................................................................................57
Present and Future Value............................................................................................................................58
Compounding Periods.................................................................................................................................64
Pricing Debt Instruments............................................................................................................................66
What’s the Yield on That?...........................................................................................................................71
Calculating Returns.....................................................................................................................................75
Inflation and Interest Rates........................................................................................................................78
Suggested Reading.......................................................................................................................................81
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Chapter 5: The Economics of Interest-Rate Fluctuations........................................... 82
Interest Rate Fluctuations...........................................................................................................................83
Shifts in Supply and Demand for Bonds....................................................................................................87
Liquidity Preference....................................................................................................................................95
Predictions and Effects..............................................................................................................................100
Suggested Reading.....................................................................................................................................103
Chapter 6: The Economics of Interest-Rate Spreads and Yield Curves................. 104
A Short History of Interest Rates.............................................................................................................105
Interest-Rate Determinants I: The Risk Structure..................................................................................108
The Determinants of Interest Rates II: The Term Structure.................................................................114
Suggested Reading.....................................................................................................................................120
Chapter 7: Rational Expectations, Efficient Markets, and the Valuation of
Corporate Equities............................................................................................................ 121
The Theory of Rational Expectations.......................................................................................................122
Valuing Corporate Equities.......................................................................................................................126
Financial Market Efficiency......................................................................................................................132
Evidence of Market Efficiency..................................................................................................................138
Suggested Reading.....................................................................................................................................145
Chapter 8: Financial Structure, Transaction Costs, and Asymmetric
Information........................................................................................................................ 146
The Sources of External Finance..............................................................................................................147
Transaction Costs, Asymmetric Information, and the Free-Rider Problem........................................150
Adverse Selection.......................................................................................................................................154
Moral Hazard..............................................................................................................................................160
Agency Problems........................................................................................................................................164
Suggested Reading.....................................................................................................................................170
Chapter 9: Bank Management........................................................................................ 171
The Balance Sheet......................................................................................................................................172
Assets, Liabilities, and T-Accounts...........................................................................................................175
Bank Management Principles...................................................................................................................180
Credit Risk...................................................................................................................................................190
Interest-Rate Risk......................................................................................................................................194
Off the Balance Sheet.................................................................................................................................199
Suggested Reading.....................................................................................................................................201
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Chapter 10: Innovation and Structure in Banking and Finance............................. 202
Early Financial Innovations......................................................................................................................203
Innovations Galore.....................................................................................................................................206
Loophole Mining and Lobbying................................................................................................................209
Banking on Technology.............................................................................................................................212
Banking Industry Profitability and Structure.........................................................................................216
Suggested Reading.....................................................................................................................................224
Chapter 11: The Economics of Financial Regulation................................................. 225
Public Interest versus Private Interest....................................................................................................226
The Great Depression as Regulatory Failure...........................................................................................230
The Savings and Loan Regulatory Debacle..............................................................................................235
Better but Still Not Good: U.S. Regulatory Reforms...............................................................................240
Basel II’s Third Pillar..................................................................................................................................243
Suggested Reading.....................................................................................................................................248
Chapter 12: The Financial Crisis of 2007–2009........................................................... 249
Financial Crises..........................................................................................................................................250
Asset Bubbles..............................................................................................................................................253
Financial Panics..........................................................................................................................................257
Lender of Last Resort.................................................................................................................................260
Bailouts........................................................................................................................................................263
The Crisis of 2007–2008.............................................................................................................................265
Suggested Reading.....................................................................................................................................271
Chapter 13: Central Bank Form and Function............................................................ 272
America’s Central Banks...........................................................................................................................273
The Federal Reserve System’s Structure.................................................................................................277
Other Important Central Banks................................................................................................................280
Central Bank Independence......................................................................................................................282
Suggested Reading.....................................................................................................................................286
Chapter 14: The Money Supply Process....................................................................... 287
The Central Bank’s Balance Sheet............................................................................................................288
Open Market Operations...........................................................................................................................290
A Simple Model of Multiple Deposit Creation.........................................................................................295
Suggested Reading.....................................................................................................................................300
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Chapter 15: The Money Supply and the Money Multiplier...................................... 301
A More Sophisticated Money Multiplier for M1.....................................................................................302
The M2 Money Multiplier.........................................................................................................................310
Summary and Explanation........................................................................................................................313
Suggested Reading.....................................................................................................................................316
Chapter 16: Monetary Policy Tools............................................................................... 317
The Federal Funds Market and Reserves.................................................................................................318
Open Market Operations and the Discount Window..............................................................................323
The Monetary Policy Tools of Other Central Banks...............................................................................327
Suggested Reading.....................................................................................................................................329
Chapter 17: Monetary Policy Targets and Goals........................................................ 330
A Short History of Fed Blunders...............................................................................................................331
Central Bank Goal Trade-offs....................................................................................................................336
Central Bank Targets.................................................................................................................................338
The Taylor Rule..........................................................................................................................................342
Suggested Reading.....................................................................................................................................347
Chapter 18: Foreign Exchange........................................................................................ 348
The Economic Importance of Currency Markets....................................................................................349
Determining the Exchange Rate...............................................................................................................352
Long-Run Determinants of Exchange Rates............................................................................................356
Short-Run Determinants of Exchange Rates...........................................................................................360
Modeling the Market for Foreign Exchange...........................................................................................368
Suggested Reading.....................................................................................................................................372
Chapter 19: International Monetary Regimes............................................................ 373
The Trilemma, or Impossible Trinity.......................................................................................................374
Two Systems of Fixed Exchange Rates.....................................................................................................378
The Managed or Dirty Float......................................................................................................................382
The Choice of International Policy Regime.............................................................................................387
Suggested Reading.....................................................................................................................................393
Chapter 20: Money Demand............................................................................................ 394
The Quantity Theory..................................................................................................................................395
Liquidity Preference Theory.....................................................................................................................399
Head to Head: Friedman versus Keynes..................................................................................................403
Suggested Reading.....................................................................................................................................409
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Chapter 21: IS-LM.............................................................................................................. 410
Aggregate Output and Keynesian Cross Diagrams.................................................................................411
The IS-LM Model........................................................................................................................................420
Suggested Reading.....................................................................................................................................426
Chapter 22: IS-LM in Action............................................................................................ 427
Shifting Curves: Causes and Effects..........................................................................................................428
Implications for Monetary Policy.............................................................................................................432
Aggregate Demand Curve..........................................................................................................................435
Suggested Reading.....................................................................................................................................437
Chapter 23: Aggregate Supply and Demand, the Growth Diamond, and Financial
Shocks.................................................................................................................................. 438
Aggregate Demand.....................................................................................................................................439
Aggregate Supply.......................................................................................................................................442
Equilibrium Analysis..................................................................................................................................445
The Growth Diamond.................................................................................................................................449
Financial Shocks.........................................................................................................................................454
Suggested Reading.....................................................................................................................................459
Chapter 24: Monetary Policy Transmission Mechanisms ........................................ 460
Modeling Reality........................................................................................................................................461
How Important Is Monetary Policy?........................................................................................................465
Transmission Mechanisms........................................................................................................................468
Suggested Reading.....................................................................................................................................473
Chapter 25: Inflation and Money................................................................................... 474
Empirical Evidence of a Money-Inflation Link.......................................................................................475
Why Have Central Bankers So Often Gotten It Wrong?.........................................................................481
Suggested Reading.....................................................................................................................................485
Chapter 26: Rational Expectations Redux: Monetary Policy Implications........... 486
Rational Expectations................................................................................................................................487
New Keynesians..........................................................................................................................................490
Inflation Busting........................................................................................................................................493
Suggested Reading.....................................................................................................................................496
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About the Authors
About Robert E. Wright
I attribute my enduring interest in money and banking, political economy, and
economic history to the troubled economic conditions of my youth. Born in 1969 in
Rochester, New York, to two self-proclaimed factory rats, I recall little of my
earliest days except the Great Inflation and oil embargo, which stretched the family
budget past the breaking point. My only other noneconomic memories are of the
Planet of the Apesfilms (all five of them!) and the 1972 Olympics massacre in Munich;
my very young mind conflated the two because of the aural similarity of the words
gorillaandguerilla. The recession in the early 1980s also injured my family’s material
welfare and was seared into my brain.
After taking degrees in history from Buffalo State College (B.A., 1990) and the
University of Buffalo (M.A., 1994; Ph.D., 1997), I began teaching a variety of courses
in business, economics, evolutionary psychology, finance, history, and sociology at
a variety of schools until 2009, when I became the Nef Family Chair of Political
Economy at Augustana College in Sioux Falls, South Dakota. I’ve also been an active
researcher, editing, authoring, and co-authoring books about the development of
the U.S. financial system (Origins of Commercial Banking,Hamilton Unbound,Wealth of
Nations Rediscovered,The First Wall Street,Financial Founding Fathers,One Nation Under
Debt), construction economics (Broken Buildings, Busted Budgets), life insurance
(Mutually Beneficial), and publishing (Knowledge for Generations). Due to my unique
historical perspective on public policies and the financial system, I’ve also become
something of a media maven, showing up on NPR and other radio shows, as well as
various television programs, and getting quoted in major newspapers like theWall
Street Journal,New York Times,Chicago Tribune, and theLos Angeles Times. I publish op-
eds and make regular public speaking appearances nationally and, increasingly,
internationally, and I serve as director of the Thomas Willing Institute for the Study
of Financial Markets, Institutions and Regulations
I wrote this textbook because I strongly believe in the merits of financial literacy for
all. Our financial system struggles sometimes in part because so many people
remain feckless financially. My hope is that people who read this book carefully,
dutifully complete the exercises, and attend class regularly will be able to follow the
financial news and even critique it when necessary. I also hope they will make
informed choices in their own financial lives.
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About the Authors
About Dr. Vincenzo Quadrini
I was born and raised in a small town in the Marche region in Italy. In 1990 I
received a B.A. in Economics and Business from Ancona University and in 1991 a
one-year Master in Economics from Coripe-Piemonte in Turin. After fulfilling a one-
year mandatory military service between 1991 and 1992, I moved to the United
States to start my Ph.D. in Economics at the University of Pennsylvania, where I
graduated in 1996. Since my Ph.D. graduation I have been teaching at several
institutions: Pompeu Fabra University in Barcelona, Duke University, New York
University, and University of Southern California. I have been teaching courses on
monetary economics, macroeconomics, international trade, and international
finance. My research interests are in similar topics, and since my graduation in 1996
I have published several articles in scholarly journals includingAmerican Economic
Review,Journal of Monetary Economics,Journal of Political Economy, andReview of
Economic Studies.
My current research projects focus on the macroeconomic impact of credit and
financial shocks similar to the ones that are currently affecting the U.S. economy. I
am also interested in understanding how these shocks are propagated
internationally to other economies. Another research interest focuses on the
understanding of how differences in financial markets across countries can lead to
large financial imbalances, that is, a situation in which some countries, like the
United States, borrow heavily from other countries like China and Japan.
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Acknowledgments
Many people have helped to make this project a reality. AtUnnamed Publisher,
Shannon Gattens and Jeff Shelstad helped to shepherd the concept and the
manuscript through the standard trials and tribulations. Along the way, a score of
anonymous academic readers helped to keep our economic analyses and prose on
the straight and narrow. Paul Wachtel and Richard Sylla, two colleagues at New
York University’s Stern School of Business, also aided us along the way with
measured doses of praise and criticism. We thank them all. Thanks too to the
University of Virginia’s Department of Economics, especially the duo of economic
historians and “money guys” there, Ron Michener and John James, for putting up
with Wright one very hot summer in Charlottesville. Very special thanks go to the
members of Wright’s Summer I 2007 Money and Banking class at the University of
Virginia, who suffered through a free but error-prone first draft, mostly with good
humor and always with helpful comments: Kevin Albrecht, Adil Arora, Eric Bagden,
Michelle Coffey, Timothy Dalbey, Karina Delgadillo, Christopher Gorham, Joshua
Hefner, Joseph Henderson, Jamie Jackson, Anthony Jones, Robert Jones, Risto
Keravuori, Heather Koo, Sonia Kwak, Yiding Li, Patrick Lundquist, Maria McLemore,
Brett Murphy, Daniel Park, Bensille Parker, Rose Phan, Patrick Reams, Arjun
Sharma, Cole Smith, Sandy Su, Paul Sullivan, Nedim Umur, Will van der Linde, Neal
Wood, and June Yang. The students and professors who provided feedback on
version 1.0 of this book also have our hearty gratitude.
It’s customary at this point for authors to assume full responsibility for the facts
and judgments in their books. We will not buck that tradition: the buck stops here!
Unlike a journal article or academic monograph, textbooks afford ample room for
revision in subsequent editions, of which we hope there will be many. So if you spot
a problem, contact the publisher and we’ll fix it at the earliest (economically
justifiable) opportunity.
Robert E. Wright, January 2011, Sioux Falls, South Dakota.
Vincenzo Quadrini, February 2009, Los Angeles, California
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