The Economics of Money, Banking, and Financial Markets

850 Pages·2003·25.64 MB·English

by  Angus Maddison

Seventh Edition
The Addison-Wesley Series in Economics
Abel/Bernanke Gordon Parkin
Macroeconomics Macroeconomics Economics
Bade/Parkin Gregory Parkin/Bade
Foundations of Microeconomics Essentials of Economics Economics in Action Software
Bade/Parkin Gregory/Stuart Perloff
Foundations of Macroeconomics Russian and Soviet Economic Performance Microeconomics
Bierman/Fernandez and Structure Phelps
Game Theory with Economic Applications Hartwick/Olewiler Health Economics
Binger/Hoffman The Economics of Natural Resource Use Riddell/Shackelford/Stamos/
Microeconomics with Calculus Hubbard Schneider
Boyer Money, the Financial System, Economics: A Tool for Critically
and the Economy Understanding Society
Principles of Transportation Economics
Hughes/Cain Ritter/Silber/Udell
Branson
American Economic History Principles of Money, Banking,
Macroeconomic Theory and Policy
Husted/Melvin and Financial Markets
Bruce
International Economics Rohlf
Public Finance and the American Economy
Jehle/Reny Introduction to Economic Reasoning
Byrns/Stone
Advanced Microeconomic Theory Ruffin/Gregory
Economics
Klein Principles of Economics
Carlton/Perloff
Mathematical Methods Sargent
Modern Industrial Organization
for Economics Rational Expectations
Caves/Frankel/Jones Krugman/Obstfeld and Inflation
World Trade and Payments:
International Economics: Scherer
An Introduction
Theory and Policy Industry Structure, Strategy,
Chapman Laidler and Public Policy
Environmental Economics:
The Demand for Money: Schotter
Theory, Application, and Policy
Theories, Evidence, and Problems Microeconomics:
Cooter/Ulen Leeds/von Allmen A Modern Approach
Law and Economics
The Economics of Sports Stock/Watson
Downs Lipsey/Courant/Ragan Introduction to Econometrics
An Economic Theory of Democracy
Economics Studenmund
Eaton/Mishkin McCarty Using Econometrics:
Online Readings to Accompany A Practical Guide
Dollars and Sense:
The Economics of Money, Banking, and
An Introduction to Economics Tietenberg
Financial Markets
Melvin Environmental and Natural
Ehrenberg/Smith Resource Economics
International Money
Modern Labor Economics
and Finance Tietenberg
Ekelund/Tollison Miller Environmental Economics and Policy
Economics:Private Markets
Economics Today Todaro/Smith
and Public Choice
Miller/Benjamin/North Economic Development
Fusfeld
The Economics of Public Issues Waldman/Jensen
The Age of the Economist
Mills/Hamilton Industrial Organization:
Gerber Theory and Practice
Urban Economics
International Economics
Williamson
Mishkin
Ghiara Macroeconomics
The Economics of Money, Banking, and
Learning Economics:
Financial Markets
A Practical Workbook
Frederic S. Mishkin
Columbia University
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.
ISBN 0-321-12235-6
1. Finance. 2. Money. 3. Banks and banking. I. Title. II. Series.
HG173.M632 2004
332—dc21
2003041912
Copyright © 2004 by Frederic S. Mishkin. All rights reserved. No part of this publication may be repro-
duced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical,
photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in
the United States of America.
1 2 3 4 5 6 7 8 9 10—DOW—06050403
To Sally

CONTENTS IN BRIEF
PART I Introduction 1
1 Why Study Money, Banking, and Financial Markets? . . . . . . . . . . . . . . . . . . . .3
2 An Overview of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
3 What Is Money? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44
PART II Financial Markets 59
4 Understanding Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61
5 The Behavior of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85
6 The Risk and Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . .120
7 The Stock Market, the Theory of Rational Expectations,
and the Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141
PART III Financial Institutions 167
8 An Economic Analysis of Financial Structure . . . . . . . . . . . . . . . . . . . . . . . .169
9 Banking and the Management of Financial Institutions . . . . . . . . . . . . . . . . .201
10 Banking Industry: Structure and Competition . . . . . . . . . . . . . . . . . . . . . . . .229
11 Economic Analysis of Banking Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . .260
12 Nonbank Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287
13 Financial Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .309
PART IV Central Banking and the Conduct of
Monetary Policy 333
14 Structure of Central Banks and the Federal Reserve System . . . . . . . . . . . . .335
15 Multiple Deposit Creation and the Money Supply Process . . . . . . . . . . . . . .357
16 Determinants of the Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .374
17 Tools of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .393
18 Conduct of Monetary Policy: Goals and Targets . . . . . . . . . . . . . . . . . . . . . .411
PART V International Finance and Monetary Policy 433
19 The Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .435
20 The International Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .462
21 Monetary Policy Strategy: The International Experience . . . . . . . . . . . . . . . .487
vii
viii Contents in Brief
PART VI Monetary Theory 515
22 The Demand for Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .517
23 The Keynesian Framework and the ISLMModel . . . . . . . . . . . . . . . . . . . . . .536
24 Monetary and Fiscal Policy in the ISLMModel . . . . . . . . . . . . . . . . . . . . . . .561
25 Aggregate Demand and Supply Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . .582
26 Transmission Mechanisms of Monetary Policy: The Evidence . . . . . . . . . . . .603
27 Money and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .632
28 Rational Expectations: Implications for Policy . . . . . . . . . . . . . . . . . . . . . . . .658
CONTENTS
PART I Introduction 1
CHAPTER 1
WHY STUDY MONEY,BANKING,AND FINANCIAL MARKETS? . . . . . . . . . . . . . . . . .3
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3
Why Study Financial Markets? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3
The Bond Market and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3
The Stock Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5
The Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5
Why Study Banking and Financial Institutions? . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7
Structure of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7
Banks and Other Financial Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8
Financial Innovation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8
Why Study Money and Monetary Policy? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8
Money and Business Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9
Money and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10
Money and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12
Conduct of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12
Fiscal Policy and Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12
How We Will Study Money, Banking, and Financial Markets . . . . . . . . . . . . . . . . . .13
Exploring the Web . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14
Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .17
Appendix to Chapter 1
Defining Aggregate Output,Income,the Price Level,
and the Inflation Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20
Aggregate Output and Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20
Real Versus Nominal Magnitudes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20
Aggregate Price Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21
Growth Rates and the Inflation Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22
ix
x Contents
CHAPTER 2
AN OVERVIEW OF THE FINANCIAL SYSTEM . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
Function of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
Structure of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25
Debt and Equity Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25
Primary and Secondary Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26
Exchanges and Over-the-Counter Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27
Money and Capital Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27
Internationalization of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28
International Bond Market, Eurobonds, and Eurocurrencies . . . . . . . . . . . . . . . . . . . . . . . .28
World Stock Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29
Function of Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29
Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29
Following the Financial News Foreign Stock Market Indexes . . . . . . . . . . . . . . . .30
Box 1 Global: The Importance of Financial Intermediaries to Securities
Markets: An International Comparison . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31
Risk Sharing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31
Asymmetric Information: Adverse Selection and Moral Hazard . . . . . . . . . . . . . . . . . . . . .32
Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34
Depository Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34
Contractual Savings Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35
Investment Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37
Regulation of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37
Increasing Information Available to Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39
Ensuring the Soundness of Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39
Financial Regulation Abroad . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40
Summary, Key Terms, Questions and Problems, and Web Exercises . . . . . . . . . . . . .41
CHAPTER 3
WHAT IS MONEY? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44
Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44
Meaning of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44
Functions of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45
Medium of Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45
Unit of Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .46
Store of Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .47
Evolution of the Payments System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48
Commodity Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48
Fiat Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48
Checks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48
Box 1 Global: Birth of the Euro: Will It Benefit Europe? . . . . . . . . . . . . . . . . . . . . .49
Electronic Payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50