The Economics of Money, Banking, and Financial Markets PDF

GLOBAL GLOBAL EDITION...

GLOBAL GLOBAL EDITION EDITION EDITION G LO B A L The Economics of Money, Banking, and Financial Markets strengthens students’ application and decision-making skills, and it does so with a focus on real-world examples. Easy- The Economics of Money, Banking, and Financial Markets to-follow graphics, crisp definitions, and a thoroughly accessible text highlight the The Economics of Money, applications of economics, making them relatable through everyday examples and concerns. Banking, and Financial Markets New to This Global Edition The twelfth edition provides more rigor and clarity through internationally relevant topics and examples, including the following new sections, boxes, and applications:  lobal box features covering topics like negative interest rates in Japan, the United G States, and Europe; the European sovereign debt crisis; Latvia’s expansionary contraction; TWELFTH EDITION and China’s “noncrisis” in 1997–98  new section in Chapter 1 on money, banking, and financial markets to help students A understand how this text can help advance their career Frederic S. Mishkin  hapters 12 and 13 cover topics like worldwide decline in asset prices; bank failures C across Belgium, Germany, Austria, and other countries; the 1997–98 crisis in South Korea; and global responses and recovery  hapter 14 focuses on major central banks around the world—the European Central C Bank, the People’s Bank of China, and the Bank of Japan—and their origins, structure, and functions TWELFTH EDITION Mishkin This is a special edition of an established title widely used by colleges and universities throughout the world. Pearson published this exclusive edition for the benefit of students outside the United States and Canada. If you purchased this book within the United States or Canada, you should be aware that it has been imported without the approval of the Publisher or Author. Pearson Global Edition Mishkin_12_1292268859_Final.indd 1 24/07/18 7:30 AM  Question Help MyLab Economics homework and practice questions are correlated to the textbook, and many generate algorithmically to give students unlimited opportunity for mastery of concepts. If students get stuck, Learning Aids including Help Me Solve This and eText Pages walk them through the problem and identify helpful infor- mation in the text, giving them assistance when they need it most. “[MyLab Economics] provides ample practice and explanation of the concepts at hand.” — Heather Burkett, University of Nebraska at Omaha 92% Dynamic Study Modules help students study 90% chapter topics effectively on their own by continu- 88% ously assessing their knowledge application and performance in real time. These are available as prebuilt Prepare assignments, and are accessible on smartphones, tablets, and computers. eText Study Dynamic Plan Study Pearson eText enhances student learning—both Modules in and outside the classroom. Worked examples, videos, and interactive tutorials bring learning to % of students who life, while algorithmic practice and self-assessment opportunities test students’ understanding of the found learning material. Accessible anytime, anywhere via MyLab tool helpful or the app. 87% The MyLab Gradebook offers an easy way for students and instructors to view course performance. Item Analysis allows instructors to quickly see trends by analyz- ing details like the number of students who answered correctly/incorrectly, time on task, and median time spend on a question by of students would tell question basis. And because it’s correlated their instructor to keep with the AACSB Standards, instructors can track students’ progress toward outcomes using MyLab Economics that the organization has deemed important in preparing students to be leaders. For additional details visit: www.pearson.com/mylab/economics A01_MISH8859_12_GE_FM.indd 1 30/07/18 5:28 PM  The Pearson Series in Economics Abel/Bernanke/Croushore Gordon Mishkin Macroeconoms*† Macroeconomics* The Economics of Money, Banking, and Financial Markets*† Acemoglu/Laibson/List Greene Economics*† Econometric Analysis† The Economics of Money, Banking, and Financial Markets, Business School Edition* Bade/Parkin Gregory/Stuart Macroeconomics: Policy and Practice* Foundations of Economics*† Russian and Soviet Economic Performance and Structure Murray Berck/Helfand Econometrics: A Modern Introduction The Economics of the Environment Hartwick/Olewiler The Economics of Natural Resource Use O’Sullivan/Sheffrin/Perez Bierman/Fernandez Economics: Principles, Applications and Game Theory with Economic Applications Heilbroner/Milberg The Making of the Economic Society Tools*† Blair/Rush Parkin The Economics of Managerial Decisions*† Heyne/Boettke/Prychitko The Economic Way of Thinking Economics*† Blanchard Hubbard/O’Brien Perloff Macroeconomics*† Economics*† Microeconomics*† Boyer InEcon Microeconomics: Theory and Applications Principles of Transportation Economics with Calculus*† Money, Banking, and the Financial System* Brander/Perloff Pindyck/Rubinfeld Managerial Economics and Strategy*† Hubbard/O’Brien/Rafferty Microeconomics*† Macroeconomics* Branson Hughes/Cain Riddell/Shackelford/Stamos/Schneider Macroeconomic Theory and Policy American Economic History Economics: A Tool for Critically Understanding Society Bruce Husted/Melvin Public Finance and the American Economy International Economics Roberts The Choice: A Fable of Free Trade Carlton/Perloff Jehle/Reny and Protection Modern Industrial Organization Advanced Microeconomic Theory Scherer Case/Fair/Oster Keat/Young/Erfle Industry Structure, Strategy, and Principles of Economics*† Managerial Economics Public Policy Chapman Klein Schiller Environmental Economics: Theory, Mathematical Methods for Economics The Economics of Poverty and Discrimination Application, and Policy Krugman/Obstfeld/Melitz Sherman Daniels/VanHoose International Economics: Theory & Policy*† Market Regulation International Monetary & Financial Economics Laidler Stock/Watson The Demand for Money Introduction to Econometrics† Downs An Economic Theory of Democracy Lynn Studenmund Economic Development: Theory and Practice A Practical Guide to Using Econometrics† Farnham for a Divided World Economics for Managers Todaro/Smith Miller Economic Development Froyen Economics Today* Macroeconomics: Theories and Policies Walters/Walters/Appel/Callahan/ Miller/Benjamin Centanni/Maex/O’Neill Fusfeld The Economics of Macro Issues Econversations: Today’s Students Discuss The Age of the Economist Today’s Issues Miller/Benjamin/North Gerber The Economics of Public Issues Williamson International Economics*† Macroeconomics† *denotes MyLab™ Economics titles Visit www.pearson.com/mylab/economics to learn more. † denotes Global Edition titles A01_MISH8859_12_GE_FM.indd 2 28/08/18 2:31 PM  THE ECONOMICS OF MONEY, BANKING, AND FINANCIAL MARKETS Twelfth Edition Global Edition Frederic S. Mishkin Columbia University Harlow, England London New York Boston San Francisco Toronto Sydney Dubai Singapore Hong Kong Tokyo Seoul Taipei New Delhi Cape Town Sao Paulo Mexico City Madrid Amsterdam Munich Paris Milan A01_MISH8859_12_GE_FM.indd 3 20/08/18 11:46 AM Vice President, Business, Economics, and UK Courseware: Donna Battista Operations Specialist: Carol Melville Director of Portfolio Management: Adrienne D’Ambrosio Senior Manufacturing Controller, Global Edition: Caterina Pellegrino Senior Portfolio Manager: Christina Masturzo Design Lead: Kathryn Foot Editorial Assistant: Courtney Paganelli Manager, Learning Tools: Brian Surette Associate Acquisitions Editor, Global Edition: Ananya Srivastava Content Developer, Learning Tools: Sarah Peterson Project Editor, Global Edition: Paromita Banerjee Managing Producer, Digital Studio and GLP, Media Production and Development: Ashley Santora Assistant Editor, Global Edition: Jyotis Elizabeth Jacob Managing Producer, Digital Studio: Diane Lombardo Vice President, Product Marketing: Roxanne McCarley Digital Studio Producer: Melissa Honig Senior Product Marketer: Tricia Murphy Digital Studio Producer: Alana Coles Product Marketing Assistant: Marianela Silvestri Digital Content Team Lead: Noel Lotz Manager of Field Marketing, Business Publishing: Adam Goldstein Digital Content Project Lead: Noel Lotz Executive Field Marketing Manager: Senior Field Marketing Manager: Carlie Marvel Manager, Media Production, Global Edition: Vikram Kumar Vice President, Production and Digital Studio, Arts and Business: Etain O’Dea Project Manager: Kathy Smith, Cenveo® Publisher Services Director of Production, Business: Jeff Holcomb Interior Design: Cenveo® Publisher Services Managing Producer, Business: Alison Kalil Content Producer: Carolyn Philips Cover Design: Lumina Datamatics Content Producer, Global Edition: Nikhil Rakshit Cover Art: metamorworks/Shutterstock Acknowledgments of third-party content appear on the appropriate page within the text. Pearson Education Limited KAO Two KAO Park Harlow CM17 9NA United Kingdom and Associated Companies throughout the world Visit us on the World Wide Web at: www.pearsonglobaleditions.com © Frederic S. Mishkin, 2019 The rights of Frederic S. Mishkin, to be identified as the author of this work, have been asserted by him in accordance with the Copyright, Designs and Patents Act 1988. Authorized adaptation from the United States edition, entitled The Economics of Money, Banking, and Financial Markets, 12th Edition, ISBN 978-0-13-473382-1 by Frederic S. Mishkin, published by Pearson Education © 2019. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a license permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS. All trademarks used herein are the property of their respective owners. The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with or endorsement of this book by such owners. For information regarding permissions, request forms, and the appropriate contacts within the Pearson Education Global Rights and Permissions department, please visit www.pearsoned.com/permissions. This eBook is a standalone product and may or may not include all assets that were part of the print version. It also does not provide access to other Pearson digital products like MyLab and Mastering. The publisher reserves the right to remove any material in this eBook at any time. British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library ISBN 10: 1-292-26885-9 ISBN 13: 978-1-292-26885-9 eBook ISBN 13: 978-1-292-26892-7 Typeset in Times NR MT Pro by Cenveo® Publisher Services  To Sally A01_MISH8859_12_GE_FM.indd 5 30/07/18 5:28 PM  This page intentionally left blank A01_MISH4182_11_GE_FM.indd 6 10/06/15 11:46 am  About the Author Frederic S. Mishkin is the Alfred Lerner Professor of Banking and Financial Institutions at the Graduate School of Business, Columbia University. He is also a Research Associate at the National Bureau of Economic Research, co-director of the U.S. Monetary Policy Forum, a member of the Squam Lake Working Group on Financial Reform, and past president of the Eastern Economics Association. Since receiving his Ph.D. from the Massachusetts Institute of Technology in 1976, he has taught at the University of Chicago, Northwestern University, Princeton University, and Columbia. He has also received an honorary professorship from the People’s (Renmin) University of China. From 1994 to 1997, he was Executive Vice President and Director of Research at the Federal Reserve Bank of New York and an associate economist of the Federal Open Market Committee of the Federal Reserve System. From September 2006 to August 2008, he was a member (governor) of the Board of Governors of the Federal Reserve System. Professor Mishkin’s research focuses on monetary policy and its impact on financial markets and the aggregate economy. He is the author of more than twenty books, including Macroeconomics: Policy and Practice, Second Edition (Pearson, 2015); Financial Markets and Institutions, Ninth Edition (Pearson, 2018); Monetary Policy Strategy (MIT Press, 2007); The Next Great Globalization: How Disadvantaged Nations Can Harness Their Financial Systems to Get Rich (Princeton University Press, 2006); Inflation Targeting: Lessons from the International Experience (Princeton University Press, 1999); Money, Interest Rates, and Inflation (Edward Elgar, 1993); and A Rational Expectations Approach to Macroeconometrics: Testing Policy Ineffectiveness and Efficient Markets Models (University of Chicago Press, 1983). In addition, he has published more than 200 articles in such journals as American Economic Review, Journal of Political Economy, Econometrica, Quarterly Journal of Economics, Journal of Finance, and Journal of Monetary Economics. Professor Mishkin has served on the editorial board of American Economic Review and has been an associate editor at Journal of Business and Economic Statistics, Journal of Applied Econometrics, Journal of Economic Perspectives, Journal of International Money and Finance, and Journal of Money, Credit and Banking; he also served as the editor of the Federal Reserve Bank of New York’s Economic Policy Review. He is currently an associate editor (member of the editorial board) at six academic journals, including International Finance; Finance India; Review of Development Finance; Borsa Economic Review; PSU Research Review and Emerging Markets, and Finance and Trade. He has been a consultant to the Board of Governors of the Federal Reserve System, the World Bank, and the International Monetary Fund, as well as to many central banks throughout the world. He was also a member of the International Advisory Board to the Financial Supervisory Service of South Korea and an advisor to the Institute for Monetary and Economic Research at the Bank of Korea. Professor Mishkin was a Senior Fellow at the Federal Deposit Insurance Corporation’s Center for Banking Research and was an academic consultant to and serves on the Economic Advisory Panel and Monetary Advisory Panel of the Federal Reserve Bank of New York. 7 A01_MISH8859_12_GE_FM.indd 7 30/07/18 5:28 PM  This page intentionally left blank A01_MISH4182_11_GE_FM.indd 6 10/06/15 11:46 am  Brief Contents PART 1 Introduction 51 1 Why Study Money, Banking, and Financial Markets?.................................................. 52 2 An Overview of the Financial System............................................................................... 72 3 What Is Money?..................................................................................................................... 99 PART 2 Financial Markets 113 4 The Meaning of Interest Rates......................................................................................... 114 5 The Behavior of Interest Rates......................................................................................... 136 6 The Risk and Term Structure of Interest Rates............................................................. 167 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis.............................................................................................. 191 PART 3 Financial Institutions 213 8 An Economic Analysis of Financial Structure............................................................... 214 9 Banking and the Management of Financial Institutions........................................... 238 10 Economic Analysis of Financial Regulation.................................................................. 267 11 Banking Industry: Structure and Competition............................................................. 286 12 Financial Crises in Advanced Economies...................................................................... 318 13 Financial Crises in Emerging Economies....................................................................... 346 PART 4 Central Banking and the Conduct of Monetary Policy 369 14 Central Banks........................................................................................................................ 370 15 The Money Supply Process............................................................................................... 388 16 Tools of Monetary Policy................................................................................................... 413 17 The Conduct of Monetary Policy: Strategy and Tactics............................................. 439 PART 5 International Finance and Monetary Policy 473 18 The Foreign Exchange Market.......................................................................................... 474 19 The International Financial System................................................................................ 502 PART 6 Monetary Theory 531 20 Quantity Theory, Inflation, and the Demand for Money......................................... 532 21 The IS Curve.......................................................................................................................... 550 22 The Monetary Policy and Aggregate Demand Curves.............................................. 570 23 Aggregate Demand and Supply Analysis...................................................................... 585 24 Monetary Policy Theory.................................................................................................... 629 25 The Role of Expectations in Monetary Policy.............................................................. 658 26 Transmission Mechanisms of Monetary Policy........................................................... 678 9 A01_MISH8859_12_GE_FM.indd 9 30/07/18 5:28 PM  10 Brief Contents Additional Chapters on MyLab Economics 1 The ISLM Model 2 Nonbank Finance 3 Financial Derivatives 4 Conflicts of Interest in the Financial Services Industry A01_MISH8859_12_GE_FM.indd 10 30/07/18 5:28 PM  Contents in Detail PART 1 Introduction 51 CHAPTER 1 Why Study Money, Banking, and Financial Markets? 52 Why Study Financial Markets?................................................................................................... 52 Debt Markets and Interest Rates............................................................................................ 53 The Stock Market.................................................................................................................. 53 Why Study Financial Institutions and Banking?..................................................................... 55 Structure of the Financial System.......................................................................................... 55 Banks and Other Financial Institutions.................................................................................. 56 Financial Innovation............................................................................................................. 56 Financial Crises..................................................................................................................... 56 Why Study Money and Monetary Policy?............................................................................... 57 Money and Business Cycles................................................................................................... 57 Money and Inflation.............................................................................................................. 57 Money and Interest Rates....................................................................................................... 59 Conduct of Monetary Policy.................................................................................................. 59 Fiscal Policy and Monetary Policy.......................................................................................... 60 Why Study International Finance?............................................................................................ 61 The Foreign Exchange Market............................................................................................... 62 The International Financial System........................................................................................ 63 Money, Banking, and Financial Markets and Your Career.................................................. 64 How We Will Study Money, Banking, and Financial Markets............................................ 64 Exploring the Web................................................................................................................ 65 Concluding Remarks..................................................................................................................... 65 Summary 65     Key Terms 66     Questions 66     Applied Problems 67      Data Analysis Problems 67      Web Exercises 68      Web References 68 APPENDIX TO CHAPTER 1 Defining Aggregate Output, Income, the Price Level, and the Inflation Rate 69 Aggregate Output and Income.................................................................................................. 69 Real Versus Nominal Magnitudes............................................................................................. 69 Aggregate Price Level.................................................................................................................... 70 Growth Rates and the Inflation Rate........................................................................................ 71 CHAPTER 2 An Overview of the Financial System 72 Function of Financial Markets.................................................................................................... 72 Structure of Financial Markets.................................................................................................... 75 11 A01_MISH8859_12_GE_FM.indd 11 30/07/18 5:28 PM  12 Contents in Detail Debt and Equity Markets....................................................................................................... 75 Primary and Secondary Markets............................................................................................ 75 Exchanges and Over-the-Counter Markets............................................................................. 76 Money and Capital Markets................................................................................................... 77 Financial Market Instruments..................................................................................................... 77 Money Market Instruments................................................................................................... 77 Following the Financial News Money Market Rates 78 Capital Market Instruments................................................................................................... 79 Following the Financial News Capital Market Interest Rates 80 Internationalization of Financial Markets............................................................................... 81 Global Are U.S. Capital Markets Losing Their Edge? 82 International Bond Market, Eurobonds, and Eurocurrencies................................................. 82 World Stock Markets............................................................................................................. 83 Function of Financial Intermediaries: Indirect Finance....................................................... 83 Following the Financial News Foreign Stock Market Indexes 84 Transaction Costs.................................................................................................................. 84 Global The Importance of Financial Intermediaries Relative to Securities Markets: An International Comparison 85 Risk Sharing.......................................................................................................................... 86 Asymmetric Information: Adverse Selection and Moral Hazard............................................. 86 Economies of Scope and Conflicts of Interest........................................................................ 88 Types of Financial Intermediaries.............................................................................................. 88 Depository Institutions.......................................................................................................... 88 Contractual Savings Institutions............................................................................................ 90 Investment Intermediaries..................................................................................................... 91 Regulation of the Financial System........................................................................................... 92 Increasing Information Available to Investors......................................................................... 92 Ensuring the Soundness of Financial Intermediaries.............................................................. 93 Financial Regulation Abroad.................................................................................................. 95 Summary 95     Key Terms 96     Questions 96     Applied Problems 97      Data Analysis Problems 98      Web Exercises 98      Web References 98 CHAPTER 3 What Is Money? 99 Meaning of Money........................................................................................................................ 99 Functions of Money.................................................................................................................... 100 Medium of Exchange........................................................................................................... 100 Unit of Account................................................................................................................... 101 Store of Value...................................................................................................................... 102 Evolution of the Payments System.......................................................................................... 103 Commodity Money............................................................................................................. 103 Fiat Money.......................................................................................................................... 103 A01_MISH8859_12_GE_FM.indd 12 30/07/18 5:28 PM  Contents in Detail 13 Checks................................................................................................................................ 103 Electronic Payment.............................................................................................................. 104 E-Money............................................................................................................................. 104 FYI Are We Headed for a Cashless Society? 105 APPLICATION Will Bitcoin Become the Money of the Future?................................ 105 Measuring Money........................................................................................................................ 106 The Federal Reserve’s Monetary Aggregates......................................................................... 106 Following the Financial News The Monetary Aggregates 107 FYI Where Are All the U.S. Dollars? 108 Summary 109     Key Terms 110     Questions 110     Applied Problems 111     Data Analysis Problems 112     Web Exercises 112     Web References 112 PART 2 Financial Markets 113 CHAPTER 4 The Meaning of Interest Rates 114 Measuring Interest Rates........................................................................................................... 114 Present Value....................................................................................................................... 114 APPLICATION Simple Present Value.......................................................................... 116 APPLICATION How Much Is That Jackpot Worth?................................................... 116 Four Types of Credit Market Instruments............................................................................ 117 Yield to Maturity................................................................................................................. 118 APPLICATION Yield to Maturity on a Simple Loan................................................... 118 APPLICATION Yield to Maturity and the Yearly Payment on a Fixed-Payment Loan... 120 APPLICATION Yield to Maturity and Bond Price for a Coupon Bond...................... 121 APPLICATION Yield to Maturity on a Perpetuity...................................................... 123 APPLICATION Yield to Maturity on a Discount Bond............................................... 124 The Distinction Between Interest Rates and Returns......................................................... 125 Global Negative Interest Rates? Japan First, Then the United States, Then Europe 126 Maturity and the Volatility of Bond Returns: Interest-Rate Risk............................................ 128 Summary............................................................................................................................. 129 The Distinction Between Real and Nominal Interest Rates............................................. 130 APPLICATION Calculating Real Interest Rates.......................................................... 131 Summary 133     Key Terms 133     Questions 133     Applied Problems 134     Data Analysis Problems 135     Web Exercises 135     Web References 135 CHAPTER 4 APPENDIX Measuring Interest-Rate Risk: Duration Go to MyLab Economics: www.pearson.com/mylab/economics A01_MISH8859_12_GE_FM.indd 13 30/07/18 5:28 PM  14 Contents in Detail CHAPTER 5 The Behavior of Interest Rates 136 Determinants of Asset Demand............................................................................................... 136 Wealth................................................................................................................................. 137 Expected Returns................................................................................................................ 137 Risk..................................................................................................................................... 137 Liquidity............................................................................................................................. 138 Theory of Portfolio Choice.................................................................................................. 138 Supply and Demand in the Bond Market............................................................................. 139 Demand Curve.................................................................................................................... 139 Supply Curve...................................................................................................................... 140 Market Equilibrium............................................................................................................. 141 Supply and Demand Analysis.............................................................................................. 142 Changes in Equilibrium Interest Rates................................................................................... 142 Shifts in the Demand for Bonds........................................................................................... 143 Shifts in the Supply of Bonds.............................................................................................. 146 APPLICATION Changes in the Interest Rate Due to a Change in Expected Inflation: The Fisher Effect............................................................... 148 APPLICATION Changes in the Interest Rate Due to a Business Cycle Expansion..... 150 APPLICATION Explaining Current Low Interest Rates in Europe, Japan, and the United States: Low Inflation and Secular Stagnation........................... 151 Supply and Demand in the Market for Money: The Liquidity Preference Framework............................................................................. 152 Changes in Equilibrium Interest Rates in the Liquidity Preference Framework......... 155 Shifts in the Demand for Money.......................................................................................... 155 Shifts in the Supply of Money............................................................................................. 155 APPLICATION Changes in the Equilibrium Interest Rate Due to Changes in Income, the Price Level, or the Money Supply.............................. 156 Changes in Income.............................................................................................................. 157 Changes in the Price Level................................................................................................... 157 Changes in the Money Supply............................................................................................. 157 Money and Interest Rates.......................................................................................................... 158 APPLICATION Does a Higher Rate of Growth of the Money Supply Lower Interest Rates?........................................................................................ 160 Summary 163     Key Terms 163     Questions 163     Applied Problems 164      Data Analysis Problems 165      Web Exercises 166      Web References 166 CHAPTER 5 APPENDIX 1 Models of Asset Pricing Go to MyLab Economics, www.pearson.com/mylab/economics CHAPTER 5 APPENDIX 2 Applying the Asset Market Approach to a Commodity Market: The Case of Gold Go to MyLab Economics, www.pearson.com/mylab/economics A01_MISH8859_12_GE_FM.indd 14 28/08/18 2:31 PM  Contents in Detail 15 CHAPTER 5 APPENDIX 3 Loanable Funds Framework Go to MyLab Economics, www.pearson.com/mylab/economics CHAPTER 6 The Risk and Term Structure of Interest Rates 167 Risk Structure of Interest Rates................................................................................................. 167 Default Risk......................................................................................................................... 167 FYI Conflicts of Interest at Credit-Rating Agencies and the Global Financial Crisis 171 APPLICATION The Global Financial Crisis and the Baa-Treasury Spread 172 Liquidity............................................................................................................................. 172 Income Tax Considerations................................................................................................. 173 Summary............................................................................................................................. 174 APPLICATION Effects of the Obama Tax Increase on Bond Interest Rates 174 Term Structure of Interest Rates............................................................................................... 175 Following the Financial News Yield Curves 175 Expectations Theory............................................................................................................ 177 Segmented Markets Theory................................................................................................. 180 Liquidity Premium and Preferred Habitat Theories.............................................................. 181 Evidence on the Term Structure.......................................................................................... 184 FYI The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle 185 Summary............................................................................................................................. 185 APPLICATION Interpreting Yield Curves, 1980–2017.............................................. 185 Summary 187     Key Terms 187     Questions 187     Applied Problems 189      Data Analysis Problems 189      Web Exercises 190      Web References 190 CHAPTER 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 191 Computing the Price of Common Stock............................................................................... 191 The One-Period Valuation Model........................................................................................ 192 The Generalized Dividend Valuation Model......................................................................... 193 The Gordon Growth Model................................................................................................. 193 How the Market Sets Stock Prices........................................................................................... 194 APPLICATION Monetary Policy and Stock Prices..................................................... 196 APPLICATION The Global Financial Crisis and the Stock Market........................... 196 The Theory of Rational Expectations...................................................................................... 196 Formal Statement of the Theory.......................................................................................... 198 Rationale Behind the Theory............................................................................................... 198 Implications of the Theory.................................................................................................. 199 The Efficient Market Hypothesis: Rational Expectations in Financial Markets........... 200 A01_MISH8859_12_GE_FM.indd 15 30/07/18 5:28 PM  16 Contents in Detail Rationale Behind the Hypothesis......................................................................................... 201 Random-Walk Behavior of Stock Prices............................................................................... 202 Global Should Foreign Exchange Rates Follow a Random Walk? 203 APPLICATION Practical Guide to Investing in the Stock Market.............................. 203 How Valuable Are Reports Published by Investment Advisers?............................................ 203 Should You Be Skeptical of Hot Tips?.................................................................................. 204 FYI Should You Hire an Ape as Your Investment Adviser? 205 Do Stock Prices Always Rise When There Is Good News?.................................................... 205 Efficient Market Prescription for the Investor....................................................................... 205 Why the Efficient Market Hypothesis Does Not Imply That Financial Markets Are Efficient........................................................................................ 206 APPLICATION What Do Stock Market Crashes Tell Us About the Efficient Market Hypothesis and the Efficiency of Financial Markets?........................... 207 Behavioral Finance...................................................................................................................... 207 Summary 208     Key Terms 209     Questions 209     Applied Problems 210      Data Analysis Problems 211      Web Exercises 211      Web References 211 CHAPTER 7 APPENDIX Evidence on the Efficient Market Hypothesis Go to MyLab Economics, www.pearson.com/mylab/economics PART 3 Financial Institutions 213 CHAPTER 8 An Economic Analysis of Financial Structure 214 Basic Facts About Financial Structure Throughout the World......................................... 214 Transaction Costs......................................................................................................................... 217 How Transaction Costs Influence Financial Structure.......................................................... 217 How Financial Intermediaries Reduce Transaction Costs..................................................... 218 Asymmetric Information: Adverse Selection and Moral Hazard.................................... 219 The Lemons Problem: How Adverse Selection Influences Financial Structure.......... 219 Lemons in the Stock and Bond Markets............................................................................... 220 Tools to Help Solve Adverse Selection Problems.................................................................. 220 FYI The Enron Implosion 222 How Moral Hazard Affects the Choice Between Debt and Equity Contracts............. 225 Moral Hazard in Equity Contracts: The Principal–Agent Problem........................................ 225 Tools to Help Solve the Principal–Agent Problem................................................................ 226 How Moral Hazard Influences Financial Structure in Debt Markets............................. 228 Tools to Help Solve Moral Hazard in Debt Contracts........................................................... 228 Summary............................................................................................................................. 230 APPLICATION Financial Development and Economic Growth................................ 231 FYI The Tyranny of Collateral 232 A01_MISH8859_12_GE_FM.indd 16 28/08/18 2:32 PM  Contents in Detail 17 APPLICATION Is China a Counterexample to the Importance of Financial Development?................................................................................ 233 Summary 234     Key Terms 235     Questions 235     Applied Problems 236      Data Analysis Problems 237      Web Exercises 237      Web References 237 CHAPTER 9 Banking and the Management of Financial Institutions 238 The Bank Balance Sheet............................................................................................................. 238 Liabilities............................................................................................................................. 238 Assets.................................................................................................................................. 241 Basic Banking................................................................................................................................ 242 General Principles of Bank Management.............................................................................. 245 Liquidity Management and the Role of Reserves.................................................................. 245 Asset Management............................................................................................................... 248 Liability Management.......................................................................................................... 249 Capital Adequacy Management........................................................................................... 250 APPLICATION Strategies for Managing Bank Capital............................................... 252 APPLICATION How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis...................................................................................... 253 Managing Credit Risk.................................................................................................................. 253 Screening and Monitoring................................................................................................... 254 Long-Term Customer Relationships..................................................................................... 255 Loan Commitments............................................................................................................. 256 Collateral and Compensating Balances................................................................................ 256 Credit Rationing.................................................................................................................. 256 Managing Interest-Rate Risk..................................................................................................... 257 Gap and Duration Analysis.................................................................................................. 258 APPLICATION Strategies for Managing Interest-Rate Risk........................................ 259 Off-Balance-Sheet Activities..................................................................................................... 259 Loan Sales........................................................................................................................... 260 Generation of Fee Income................................................................................................... 260 Trading Activities and Risk Management Techniques........................................................... 260 Global Barings, Daiwa, Sumitomo, Société Générale, and JP Morgan Chase: Rogue Traders and the Principal–Agent Problem 261 Summary 262     Key Terms 263     Questions 263     Applied Problems 264      Data Analysis Problems 265      Web Exercises 265      Web References 266 CHAPTER 9 APPENDIX 1 Duration Gap Analysis Go to MyLab Economics, www.pearson.com/mylab/economics CHAPTER 9 APPENDIX 2 Measuring Bank Performance Go to MyLab Economics, www.pearson.com/mylab/economics A01_MISH8859_12_GE_FM.indd 17 30/07/18 5:28 PM  18 Contents in Detail CHAPTER 10 Economic Analysis of Financial Regulation 267 Asymmetric Information as a Rationale for Financial Regulation.................................. 267 Government Safety Net....................................................................................................... 267 Global The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing? 269 Drawbacks of the Government Safety Net........................................................................... 270 Types of Financial Regulation................................................................................................... 272 Restrictions on Asset Holdings............................................................................................ 272 Capital Requirements.......................................................................................................... 273 Global Where Is the Basel Accord Heading After the Global Financial Crisis? 274 Prompt Corrective Action.................................................................................................... 275 Financial Supervision: Chartering and Examination............................................................ 275 Assessment of Risk Management......................................................................................... 276 Disclosure Requirements..................................................................................................... 277 Consumer Protection........................................................................................................... 278 Restrictions on Competition................................................................................................ 278 Summary............................................................................................................................. 279 Global International Financial Regulation 280 Summary 282     Key Terms 283     Questions 283     Applied Problems 284      Data Analysis Problems 284      Web Exercises 285      Web References 285 CHAPTER 10 APPENDIX 1 The 1980s Banking and Savings and Loan Crisis Go to MyLab Economics, www.pearson.com/mylab/economics CHAPTER 10 APPENDIX 2 Banking Crises Throughout the World Go to MyLab Economics, www.pearson.com/mylab/economics CHAPTER 11 Banking Industry: Structure and Competition 286 Historical Development of the Banking System.................................................................. 286 Multiple Regulatory Agencies.............................................................................................. 288 Financial Innovation and the Growth of the “Shadow Banking System”...................... 289 Responses to Changes in Demand Conditions: Interest-Rate Volatility................................. 290 Responses to Changes in Supply Conditions: Information Technology................................ 291 Securitization and the Shadow Banking System................................................................... 293 Avoidance of Existing Regulations....................................................................................... 295 FYI Bruce Bent and the Money Market Mutual Fund Panic of 2008 296 Financial Innovation and the Decline of Traditional Banking............................................... 297 A01_MISH8859_12_GE_FM.indd 18 30/07/18 5:28 PM  Contents in Detail 19 Structure of the U.S. Commercial Banking Industry........................................................... 300 Restrictions on Branching.................................................................................................... 302 Response to Branching Restrictions..................................................................................... 302 Bank Consolidation and Nationwide Banking..................................................................... 303 The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994........................... 305 What Will the Structure of the U.S. Banking Industry Look Like in the Future?.................. 305 Global Comparison of Banking Structure in the United States and Abroad 306 Are Bank Consolidation and Nationwide Banking Good Things?......................................... 306 Separation of Banking and Other Financial Service Industries....................................... 307 Erosion of Glass-Steagall...................................................................................................... 307 The Gramm-Leach-Bliley Financial Services Modernization Act of 1999: Repeal of Glass-Steagall.................................................................................................. 308 Implications for Financial Consolidation............................................................................. 308 Separation of Banking and Other Financial Services Industries Throughout the World....... 308 FYI The Global Financial Crisis and the Demise of Large, Free-Standing Investment Banks 309 Thrift Industry: Regulation and Structure.............................................................................. 309 Savings and Loan Associations............................................................................................. 310 Mutual Savings Banks.......................................................................................................... 310 Credit Unions...................................................................................................................... 310 International Banking................................................................................................................. 311 Eurodollar Market............................................................................................................... 311 Global Ironic Birth of the Eurodollar Market 312 Structure of U.S. Banking Overseas...................................................................................... 312 Foreign Banks in the United States...................................................................................... 313 Summary 314      Key Terms 315      Questions 315      Data Analysis Problems 316      Web Exercises 317      Web References 317 CHAPTER 12 Financial Crises in Advanced Economies 318 Global The European Sovereign Debt Crisis 319 What Is a Financial Crisis?.......................................................................................................... 319 Dynamics of Financial Crises.................................................................................................... 320 Stage One: Initial Phase....................................................................................................... 320 Stage Two: Banking Crisis.................................................................................................... 322 Stage Three: Debt Deflation................................................................................................. 324 APPLICATION The Mother of All Financial Crises: The Great Depression.............. 324 The U.S. Stock Market Crash............................................................................................... 324 Worldwide Decline in Asset Prices....................................................................................... 325 Bank Failures....................................................................................................................... 326 Economic Contraction and Debt Deflation.......................................................................... 326 The Global Financial Crisis of 2007–2009............................................................................. 327 Causes of the 2007–2009 Financial Crisis........................................................................... 327 FYI Collateralized Debt Obligations (CDOs) and Credit Default Swaps 328 Effects of the 2007–2009 Financial Crisis............................................................................ 329 A01_MISH8859_12_GE_FM.indd 19 28/08/18 2:33 PM  20 Contents in Detail Inside the Fed Was the Fed to Blame for the Housing Price Bubble? 330 Height of the 2007–2009 Financial Crisis........................................................................... 334 Government Intervention and the Recovery....................................................................... 335 Short-Term Responses and Recovery................................................................................... 335 Global Latvia’s Different and Controversial Response: Expansionary Contraction 336 Stabilizing the Global Financial System: Long-Term Responses......................................................................................................... 337 Global Financial Regulatory Framework.............................................................................. 337 Policy Areas at the National Level........................................................................................ 337 FYI The Libor Scandal 340 Future Regulations and Policy Areas at the International Level..................................... 340 Bilateral and Multilateral Supervisory Cooperation.............................................................. 341 Collective Supervisory Cooperation..................................................................................... 341 Collectively Coordinated Macroeconomic Stability Plans..................................................... 341 Self-Discipline..................................................................................................................... 341 Summary 342      Key Terms 343      Questions 343      Data Analysis Problems 344      Web Exercises 345 CHAPTER 13 Financial Crises in Emerging Economies 346 Dynamics of Financial Crises in Emerging Market Economies...................................... 346 Stage One: Initial Phase....................................................................................................... 346 Stage Two: Currency Crisis.................................................................................................. 350 Stage Three: Full-Fledged Financial Crisis........................................................................... 351 APPLICATION Crisis in South Korea, 1997–1998.................................................... 352 Financial Liberalization and Globalization Mismanaged...................................................... 354 Perversion of the Financial Liberalization and Globalization Process: Chaebols and the South Korean Crisis.............................................................. 354 Stock Market Decline and Failure of Firms Increase Uncertainty......................................... 356 Adverse Selection and Moral Hazard Problems Worsen, and the Economy Contracts.......... 356 Currency Crisis Ensues....................................................................................................... 357 Final Stage: Currency Crisis Triggers Full-Fledged Financial Crisis..................................... 357 Recovery Commences......................................................................................................... 358 Global China and the “Noncrisis” in 1997–1998 359 APPLICATION The Argentine Financial Crisis, 2001–2002...................................... 359 Severe Fiscal Imbalances..................................................................................................... 359 Adverse Selection and Moral Hazard Problems Worsen....................................................... 360 Bank Panic Begins............................................................................................................... 360 Currency Crisis Ensues....................................................................................................... 361 Currency Crisis Triggers Full-Fledged Financial Crisis........................................................ 361 Recovery Begins.................................................................................................................. 364 Global When an Advanced Economy Is Like an Emerging Market Economy: The Icelandic Financial Crisis of 2008 364 A01_MISH8859_12_GE_FM.indd 20 21/08/18 3:48 PM  Contents in Detail 21 Preventing Emerging Market Financial Crises...................................................................... 365 Beef Up Prudential Regulation and Supervision of Banks.................................................... 365 Encourage Disclosure and Market-Based Discipline............................................................. 365 Limit Currency Mismatch.................................................................................................... 366 Sequence Financial Liberalization........................................................................................ 366 Summary 366      Key Terms 367      Questions 367      Data Analysis Problems 367      Web References 368 PART 4 Central Banking and the Conduct of Monetary Policy 369 CHAPTER 14 Central Banks 370 Origins Of The Central Banking System................................................................................. 370 Variations in The Functions and Structures of Central Banks................................................................................................................... 371 The European Central Bank, the Euro System, and the European System of Central Banks................................................................................. 371 Global Who Should Own Central Banks? 372 Decision-making Bodies of the ECB.................................................................................... 374 Global The Importance of the Bundesbank Within the ECB 376 How Monetary Policy Is Conducted Within the ECB........................................................... 376 Global Are Non-Euro Central Banks Constrained by Membership In the EU? 377 The Federal Reserve System................................................................................................. 378 Comparing the ECB and the Fed......................................................................................... 379 The Bank of England........................................................................................................... 379 Global Brexit and the BoE 380 Structure of Central Banks in Larger Economies................................................................. 381 Structure and Independence of Central Banks in Emerging Market Economies....................................................................................... 383 Should Central Banks Be Independent.................................................................................. 384 The Case for Independence................................................................................................. 384 The Case Against Independence.......................................................................................... 385 The Trend Toward Greater Independence............................................................................ 385 Summary 386      Key Terms 386      Questions 387      Web Exercises 387 CHAPTER 15 The Money Supply Process 388 Three Players in the Money Supply Process......................................................................... 388 The Fed’s Balance Sheet............................................................................................................. 388 Liabilities............................................................................................................................. 389 Assets.................................................................................................................................. 390 Control of the Monetary Base.................................................................................................. 390 Federal Reserve Open Market Operations............................................................................ 391 Shifts from Deposits into Currency...................................................................................... 392 A01_MISH8859_12_GE_FM.indd 21 28/08/18 5:32 PM  22 Contents in Detail Loans to Financial Institutions............................................................................................. 393 Other Factors That Affect the Monetary Base....................................................................... 393 Overview of the Fed’s Ability to Control the Monetary Base................................................. 394 Multiple Deposit Creation: A Simple Model........................................................................ 395 Deposit Creation: The Single Bank...................................................................................... 395 Deposit Creation: The Banking System................................................................................ 396 Deriving the Formula for Multiple Deposit Creation........................................................... 399 Critique of the Simple Model.............................................................................................. 400 Factors That Determine the Money Supply.......................................................................... 401 Changes in the Nonborrowed Monetary Base, MBn.............................................................. 401 Changes in Borrowed Reserves, BR, from the Fed................................................................ 401 Changes in the Required Reserve Ratio, rr........................................................................... 402 Changes in Excess Reserves................................................................................................. 402 Changes in Currency Holdings............................................................................................ 402 Overview of the Money Supply Process................................................................................ 402 The Money Multiplier................................................................................................................. 403 Deriving the Money Multiplier............................................................................................ 403 Intuition Behind the Money Multiplier................................................................................ 405 Money Supply Response to Changes in the Factors.............................................................. 406 APPLICATION Quantitative Easing and the Money Supply, 2007–2017................... 407 Summary 409     Key Terms 409     Questions 409     Applied Problems 410      Data Analysis Problems 411      Web Exercises 411      Web References 412 CHAPTER 15 APPENDIX 1 The Fed’s Balance Sheet and the Monetary Base Go to MyLab Economics, www.pearson.com/mylab/economics CHAPTER 15 APPENDIX 2 The M2 Money Multiplier Go to MyLab Economics, www.pearson.com/mylab/economics CHAPTER 15 APPENDIX 3 Explaining the Behavior of the Currency Ratio Go to MyLab Economics, www.pearson.com/mylab/economics CHAPTER 15 APPENDIX 4 The Great Depression Bank Panics, 1930–1933, and the Money Supply Go to MyLab Economics, www.pearson.com/mylab/economics CHAPTER 16 Tools of Monetary Policy 413 The Market for Reserves and the Federal Funds Rate....................................................... 413 Demand and Supply in the Market for Reserves.................................................................. 414 How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate...................... 415 A01_MISH8859_12_GE_FM.indd 22 30/07/18 5:28 PM  Contents in Detail 23 APPLICATION How the Federal Reserve’s Operating Procedures Limit Fluctuations in the Federal Funds Rate................................................... 419 Conventional Monetary Policy Tools..................................................................................... 420 Open Market Operations..................................................................................................... 421 Inside the Fed A Day at the Trading Desk 422 Discount Policy and the Lender of Last Resort..........................................