The Economics Of Money, Banking, And Financial Markets PDF

GLOBAL EDITION The Economics of Money, Banking, and Financial Markets TWELFTH EDITION Frederic S. Mishkin PART 1 Introduction Crisis and Response: Global Financial Crisis and Its Aftermath In August 2007, financial markets bega...

GLOBAL EDITION The Economics of Money, Banking, and Financial Markets TWELFTH EDITION Frederic S. Mishkin PART 1 Introduction Crisis and Response: Global Financial Crisis and Its Aftermath In August 2007, financial markets began to seize up, and over the next two years the world economy experienced a global financial crisis that was the most severe since the Great Depression years of the 1930s. Housing prices plummeted, the stock market crashed, unemployment skyrocketed, and both businesses and households found they couldn’t get credit. Not only did the central bank of the United States, the Federal Reserve, respond by sharply lowering interest rates and intervening in credit markets to provide them with massive amounts of liquidity but the federal government also entered into the act with a $700 billion bailout of weakened financial institutions and huge fiscal stimulus packages totaling over $1 trillion. However, even with these aggressive actions aimed at stabilizing the financial system and boosting the economy, seven years after the crisis the U.S. economy was still experiencing an unemployment rate above 6%, with many homeowners losing their homes. The financial systems of many governments throughout the world were also in tatters. The global financial crisis and its aftermath demonstrate the importance of banks and financial systems to economic well-being, as well as the major role of money in the economy. Part 1 of this book provides an introduction to the study of money, banking, and financial markets. Chapter 1 outlines a road map of the book and discusses why it is so worthwhile to study money, banking, and financial markets. Chapter 2 provides a general overview of the financial system. Chapter 3 then explains what money is and how it is measured. Learning Objectives Recognize the impor- Preview Y tance of financial ou have just heard on the evening news that the Federal Reserve is raising the markets in the federal funds rate by 12 of a percentage point. What effect might this have on the economy. interest rate of an automobile loan when you finance your purchase of a sleek Describe how finan- new sports car? Does it mean that a house will be more or less affordable in the future? cial intermediation Will it make it easier or harder for you to get a job next year? and financial innova- This book provides answers to these and other questions by examining how tion affect banking financial markets (such as those for bonds, stocks, and foreign exchange) and and the economy. financial institutions (banks, insurance companies, mutual funds, and other insti- Identify the basic links tutions) work and by exploring the role of money in the economy. Financial mar- among monetary kets and institutions affect not only your everyday life but also the flow of trillions policy, the business of dollars of funds throughout our economy, which in turn affects business profits, cycle, and economic the production of goods and services, and even the economic well-being of coun- variables. tries other than the United States. What happens to financial markets, financial Explain the impor- institutions, and money is of great concern to politicians and can have a major tance of exchange impact on elections. The study of money, banking, and financial markets will rates in a global reward you with an understanding of many exciting issues. In this chapter, we pro- economy. vide a road map of this book by outlining these issues and exploring why they are Explain how the study worth studying. of money, banking, and financial markets may advance your career. WHY STUDY FINANCIAL MARKETS? Describe how the Part 2 of this book focuses on financial markets—markets in which funds are text approaches the transferred from people who have an excess of available funds to people who have teaching of money, a shortage. Financial markets, such as bond and stock markets, are crucial to pro- banking, and financial moting greater economic efficiency by channeling funds from people who do not markets. have a productive use for them to those who do. Indeed, well-functioning financial markets are a key factor in producing high economic growth, and poorly perform- ing financial markets are one reason that many countries in the world remain des- perately poor. Activities in financial markets also have a direct effect on personal wealth, the behavior of businesses and consumers, and the cyclical performance of the economy. 52  CHAPTER 1 Why Study Money, Banking, and Financial Markets? 53 Debt Markets and Interest Rates A security (also called a financial instrument) is a claim on the issuer’s future income or assets (any financial claim or piece of property that is subject to ownership). A bond is a debt security that promises to make periodic payments for a specified period of time.1 Debt markets, also often generically referred to as bond markets, are especially impor- tant to economic activity because they enable corporations and governments to borrow money to finance their activities, and because it is where interest rates are determined. An interest rate is the cost of borrowing or the price paid for the rental of funds (usu- ally expressed as a percentage of the rental of $100 per year). Many types of interest rates are found in the economy—mortgage interest rates, car loan rates, and interest rates on many different types of bonds. Interest rates are important on a number of levels. On a personal level, high inter- est rates might deter you from buying a house or a car because the cost of financing would be high. Conversely, high interest rates might encourage you to save because you can earn more interest income by putting aside some of your earnings as savings. On a more general level, interest rates have an impact on the overall health of the economy because they affect not only consumers’ willingness to spend or save but also businesses’ investment decisions. High interest rates, for example, might cause a corpo- ration to postpone building a new plant that would provide more jobs. Because changes in interest rates affect individuals, financial institutions, businesses, and the overall economy, it is important to explain substantial fluctuations in interest rates over the past 40 years. For example, the interest rate on three-month Treasury bills peaked at over 16% in 1981. This interest rate fell to 3% in late 1992 and 1993, rose to above 5% in the mid-to-late 1990s, fell to below 1% in 2004, rose to 5% by 2007, fell to near zero from 2009 to 2015, and then began rising again to above 1% by 2017. Because different interest rates have a tendency to move in unison, economists fre- quently lump interest rates together and refer to “the” interest rate. As Figure 1 shows, however, interest rates on several types of bonds can differ substantially. The interest rate on three-month Treasury bills, for example, fluctuates more than the other inter- est rates and is lower on average. The interest rate on Baa (medium-quality) corporate bonds is higher, on average, than the other interest rates, and the spread between it and the other rates became larger in the 1970s, narrowed in the 1990s, rose briefly in the early 2000s, narrowed again, and then rose sharply starting in the summer of 2007. It then began to decline toward the end of 2009, returning to low levels by 2017. In Chapter 2 we study the role of bond markets in the economy, and in Chapters 4 through 6 we examine what an interest rate is, how the common movements in interest rates come about, and why the interest rates on different bonds vary. The Stock Market A common stock (typically called simply a stock) represents a share of ownership in a corporation. It is a security that is a claim on the earnings and assets of the corpora- tion. Issuing stock and selling it to the public is a way for corporations to raise funds to finance their activities. The stock market, in which claims on the earnings of cor- porations (shares of stock) are traded, is the most widely followed financial market in almost every country that has one; that’s why it’s often called simply “the market.” A 1 The definition of bond used throughout this book is the broad one commonly used in academic settings, which covers both short- and long-term debt instruments. However, some practitioners in financial markets use the word bond to describe only specific long-term debt instruments such as corporate bonds or U.S. Treasury bonds. 54 PART 1 Introduction MyLab EconomicsɄReal-time data Interest Rate (% annual rate) 20 15 Corporate Baa Bonds 10 U.S. Government Long-Term Bonds 5 Three-Month Treasury Bills 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 FIGURE 1 Interest Rates on Selected Bonds, 1950–2017 Although different interest rates have a tendency to move in unison, they often differ substantially, and the spreads between them fluctuate. Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/TB3MS; https://fred.stlouisfed.org/ series/GS10; https://fred.stlouisfed.org/series/BAA big swing in the prices of shares in the stock market is always a major story on the eve- ning news. People often speculate on where the market is heading and get very excited when they can brag about their latest “big killing,” but they become depressed when they suffer a big loss. The attention the market receives can probably be best explained by one simple fact: It is a place where people can get rich—or poor—very quickly. As Figure 2 indicates, stock prices are extremely volatile. After rising steadily dur- ing the 1980s, the market experienced the worst one-day drop in its entire history on October 19, 1987—“Black Monday”—with the Dow Jones Industrial Average (DJIA) falling by 22%. From then until 2000, the stock market experienced one of the great- est rises (often referred to as a “bull market”) in its history, with the Dow climbing to a peak of over 11,000. With the collapse of the high-tech bubble in 2000, the stock market fell sharply, dropping by over 30% by late 2002. It then rose to an all-time high above the 14,000 level in 2007, only to fall by over 50% of its value to a low below 7,000 in 2009. Another bull market then began, with the Dow reaching new highs above 22,000 by 2017. These considerable fluctuations in stock prices affect the size of people’s wealth and, as a result, their willingness to spend. The stock market is also an important factor in business investment decisions, because the price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending. A higher price for a firm’s shares means that the firm can raise a larger amount of funds, which it can then use to buy production facilities and equipment. In Chapter 2 we examine the role that the stock market plays in the financial sys- tem, and in Chapter 7 we return to the issue of how stock prices behave and respond to information in the marketplace.  CHAPTER 1 Why Study Money, Banking, and Financial Markets? 55 0\/DE(FRQRPLFVɄReal-time data Dow Jones Industrial Average 20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 FIGURE 2 Stock Prices as Measured by the Dow Jones Industrial Average, 1950–2017 Stock prices are extremely volatile. Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/DJIA WHY STUDY FINANCIAL INSTITUTIONS AND BANKING? Part 3 of this book focuses on financial institutions and the business of banking. Banks and other financial institutions are what make financial markets work. Without them, financial markets would not be able to move funds from people who save to people who have productive investment opportunities. Thus financial institutions play a cru- cial role in the economy. Structure of the Financial System The financial system is complex, comprising many different types of private sector financial institutions, including banks, insurance companies, mutual funds, finance companies, and investment banks, all of which are heavily regulated by the govern- ment. If an individual wanted to make a loan to IBM or General Motors, for example, he or she would not go directly to the president of the company and offer a loan. Instead, he or she would lend to such a company indirectly through financial intermediaries, which are institutions that borrow funds from people who have saved and in turn make loans to people who need funds. Why are financial intermediaries so crucial to well-functioning financial markets? Why do they extend credit to one party but not to another? Why do they usually write 56 PART 1 Introduction complicated legal documents when they extend loans? Why are they the most heavily regulated businesses in the economy? We answer these questions in Chapter 8 by developing a coherent framework for analyzing financial structure in the United States and in the rest of the world. Banks and Other Financial Institutions Banks are financial institutions that accept deposits and make loans. The term banks includes firms such as commercial banks, savings and loan associations, mutual sav- ings banks, and credit unions. Banks are the financial intermediaries that the average person interacts with most frequently. A person who needs a loan to buy a house or a car usually obtains it from a local bank. Most Americans keep a large portion of their financial wealth in banks in the form of checking accounts, savings accounts, or other types of bank deposits. Because banks are the largest financial intermediaries in our economy, they deserve the most careful study. However, banks are not the only important financial institutions. Indeed, in recent years, other financial institutions, such as insurance companies, finance companies, pension funds, mutual funds, and investment banks, have been growing at the expense of banks, so we need to study them as well. In Chapter 9, we examine how banks and other financial institutions manage their assets and liabilities to make profits. In Chapter 10, we extend the economic analysis in Chapter 8 to understand why financial regulation takes the form it does and what can go wrong in the regulatory process. In Chapter 11, we look at the banking industry and examine how the competitive environment has changed this industry. We also learn why some financial institutions have been growing at the expense of others. Financial Innovation In Chapter 11, we also study financial innovation, the development of new financial products and services. We will see why and how financial innovation takes place, with particular emphasis on how the dramatic improvements in information technology have led to new financial products and the ability to deliver financial services electroni- cally through what has become known as e-finance. We also study financial innova- tion because it shows us how creative thinking on the part of financial institutions can lead to higher profits but can also sometimes result in financial disasters. By studying how financial institutions have been creative in the past, we obtain a better grasp of how they may be creative in the future. This knowledge provides us with useful clues about how the financial system may change over time. Financial Crises At times, the financial system seizes up and produces financial crises, which are major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures of many financial and nonfinancial firms. Financial crises have been a feature of capitalist economies for hundreds of years and are typically followed by severe business cycle downturns. Starting in August 2007, the U.S. economy was hit by the worst financial crisis since the Great Depression. Defaults in subprime residential mortgages led to major losses in financial institutions, producing not only numerous bank failures but also the demise of Bear Stearns and Lehman Brothers, two of the largest investment banks  CHAPTER 1 Why Study Money, Banking, and Financial Markets? 57 in the United States. The crisis produced the worst economic downturn since the Great Depression, and as a result, it is now referred to as the “Great Recession.” We discuss why these crises occur and why they do so much damage to the econ- omy in Chapter 12. WHY STUDY MONEY AND MONETARY POLICY? Money, also referred to as the money supply, is defined as anything that is generally accepted as payment for goods or services or in the repayment of debts. Money is linked to changes in economic variables that affect all of us and are important to the health of the economy. The final two parts of this book examine the role of money in the economy. Money and Business Cycles During 1981–1982, the total production of goods and services (called aggregate out- put) in the U.S. economy fell and the unemployment rate (the percentage of the available labor force unemployed) rose to over 10%. After 1982, the economy began to expand rapidly, and by 1989, the unemployment rate had declined to 5%. In 1990, the eight-year expansion came to an end, with the unemployment rate rising to above 7%. The economy bottomed out in 1991, and the subsequent recovery was the longest in U.S. history, with the unemployment rate falling to around 4%. A mild economic downturn began in March 2001, with unemployment rising to 6%; the economy began to recover in November 2001, with unemployment eventually declining to a low of 4.4%. Starting in December 2007, the economy went into a steep economic downturn and unemployment rose to over 10% before the economy slowly began to recover in June 2009. By 2017, the unemployment rate had fallen below 4½%. Why did the economy undergo such pronounced fluctuations? Evidence suggests that money plays an important role in generating business cycles, the upward and downward movement of aggregate output produced in the economy. Business cycles affect all of us in immediate and important ways. When output is rising, for example, it is easier to find a good job; when output is falling, finding a good job might be difficult. Figure 3 shows the movements of the rate of growth of the money supply over the 1950–2017 period, with the shaded areas representing recessions, or periods of declining aggregate output. We see that the rate of money growth declined before most recessions, indicating that changes in money growth might be a driving force behind business cycle fluctuations. However, declines in the rate of money growth are often not followed by a recession. We explore how money and monetary policy might affect aggregate output in Chapters 20 through 26 (Part 6) of this book, where we study monetary theory, the theory that relates the quantity of money and monetary policy to changes in aggregate economic activity and inflation. Money and Inflation The movie you paid $10 to see last week would have set you back only a dollar or two 30 years ago. In fact, for $10, you probably could have had dinner, seen the movie, and bought yourself a big bucket of hot buttered popcorn. As shown in Figure 4, which illustrates the movement of average prices in the U.S. economy from 1950 to 2017, the prices of most items are quite a bit higher now than they were then. The average price of goods and services in an economy is called the aggregate price level or, more 58 PART 1 Introduction 0\/DE(FRQRPLFVɄReal-time data Money Growth Rate (% annual rate) 15 Money Growth Rate (M2) 10 5 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 FIGURE 3 Money Growth (M2 Annual Rate) and the Business Cycle in the United States, 1950–2017 Although money growth has declined before almost every recession, not every decline in the rate of money growth is followed by a recession. Shaded areas represent recessions. Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL simply, the price level (a more precise definition is found in the appendix to this chap- ter). From 1960 to 2017, the price level has increased more than sixfold. Inflation, a continual increase in the price level, affects individuals, businesses, and the govern- ment. It is generally regarded as an important problem to be solved and is often at the top of political and policymaking agendas. To solve the inflation problem, we need to know something about its causes. What explains inflation? One clue to answering this question is found in Figure 4, which plots the money supply versus the price level. As we can see, the price level and the money supply generally rise together. These data seem to indicate that a continuing increase in the money supply might be an important factor in causing the continuing increase in the price level that we call inflation. Further evidence that inflation may be tied to continuing increases in the money supply is found in Figure 5, which plots the average inflation rate (the rate of change of the price level, usually measured as a percentage change per year) for a number of countries over the ten-year period 2006–2016 against the average rate of money growth over the same period. As you can see, a positive association exists between inflation and the growth rate of the money supply: The countries with the highest inflation rates are also the ones with the highest money growth rates. Russia and Turkey, for example, experienced high inflation during this period, and their rates of money growth were high. By contrast, Japan and the Euro area experienced low inflation rates over the same period, and their rates of money growth were low. Such evidence led Milton Friedman,  CHAPTER 1 Why Study Money, Banking, and Financial Markets? 59 0\/DE(FRQRPLFVɄReal-time data Index (2009 5 100) 200 175 150 125 100 75 Aggregate Price Level 50 (GDP Deflator) 25 Money Supply (M2) 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 FIGURE 4 Aggregate Price Level and the Money Supply in the United States, 1960–2017 From 1960 to 2017, the price level has increased more than sixfold. Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL; https://fred.stlouisfed.org/ series/GDPDEF a Nobel laureate in economics, to make the famous statement, “Inflation is always and everywhere a monetary phenomenon.”2 We look at the quantity of money and mon- etary policy’s role in creating inflation in Chapters 20 and 24. Money and Interest Rates In addition to other factors, money plays an important role in interest-rate fluctuations, which are of great concern to businesses and consumers. Figure 6 shows changes in the interest rate on long-term Treasury bonds and the rate of money growth from 1950 to 2017. As the money growth rate rose in the 1960s and 1970s, the long-term bond rate rose with it. However, the relationship between money growth and interest rates has been less clear-cut since 1980. We analyze the relationship between money growth and interest rates when we examine the behavior of interest rates in Chapter 5. Conduct of Monetary Policy Because money affects many economic variables that are important to the well-being of our economy, politicians and policymakers throughout the world care about the conduct of monetary policy, the management of money and interest rates. The 2 Milton Friedman, Dollars and Deficits (Upper Saddle River, NJ: Prentice Hall, 1968), p. 39. 60 PART 1 Introduction Average Inflation Rate (% annual rate) 10 Russia 9 8 Turkey 7 South Africa Brazil 6 Indonesia 5 Mexico 4 United 3 Kingdom South Korea 2 United States Poland Euro area 1 Canada Japan 0 2 4 6 8 10 12 14 16 18 20 Average Money Growth Rate (% annual rate) FIGURE 5 Average Inflation Rate Versus Average Rate of Money Growth for Selected Countries, 2006–2016 A positive association can be seen between the ten-year averages of inflation and the growth rate of the money supply: The countries with the highest inflation rates are also the ones with the highest money growth rates. Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/ organization responsible for the conduct of a nation’s monetary policy is the central bank. The United States’ central bank is the Federal Reserve System (also called sim- ply “the Fed”). In Chapters 14 through 17 (Part 4), we study how central banks such as the Federal Reserve System can affect the quantity of money and interest rates in the economy, and then we look at how monetary policy is actually conducted in the United States and elsewhere. Fiscal Policy and Monetary Policy Fiscal policy involves decisions about government spending and taxation. A budget deficit is an excess of government expenditures with respect to tax revenues for a par- ticular time period, typically a year, while a budget surplus arises when tax revenues exceed government expenditures. The government must finance any budget deficit by borrowing, whereas a budget surplus leads to a lower government debt burden. As Figure 7 shows, the budget deficit, relative to the size of the U.S. economy, peaked in 1983 at 6% of national output (as calculated by the gross domestic product, or GDP, a measure of aggregate output described in the appendix to this chapter). Since then, the budget deficit at first declined to less than 3% of GDP, rose again to 5% of GDP by the early 1990s, and fell subsequently, leading to budget surpluses from 1999 to 2001.  CHAPTER 1 Why Study Money, Banking, and Financial Markets? 61 0\/DE(FRQRPLFVɄReal-time data Interest Money Growth Rate Rate (%) (% annual rate) 16 16 14 14 Money Growth Rate (M2 ) 12 12 10 10 8 8 6 6 4 4 Interest Rate 2 2 0 0 22 22 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 FIGURE 6 Money Growth (M2 Annual Rate) and Interest Rates (Long-Term U.S. Treasury Bonds), 1950–2017 As the money growth rate rose in the 1960s and 1970s, the long-term bond rate rose with it. However, the relationship between money growth and interest rates has been less clear-cut since 1980. Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL; https://fred.stlouisfed.org/ series/GS10; https://fred.stlouisfed.org/series/M2SL In the aftermath of the terrorist attacks of September 11, 2001, the war in Iraq that began in March 2003, and the 2007–2009 financial crisis, the budget swung back into deficit, with deficits at one point exceeding 10% of GDP and then falling substantially thereafter. What to do about budget deficits has been the subject of legislation and the source of bitter battles between the president and Congress in recent years. You may have read statements in newspapers or heard on TV that budget surpluses are a good thing, while deficits are undesirable. In Chapter 20, we examine why deficits might result in a higher rate of money growth, a higher rate of inflation, and higher interest rates. WHY STUDY INTERNATIONAL FINANCE? The globalization of financial markets has accelerated at a rapid pace in recent years. Financial markets have become increasingly integrated throughout the world. Ameri- can companies often borrow in foreign financial markets, and foreign companies bor- row in U.S. financial markets. Banks and other financial institutions, such as JP Morgan Chase, Citigroup, UBS, and Deutschebank, have become increasingly international, with operations in many countries throughout the world. Part 5 of this book explores the foreign exchange market and the international financial system. 62 PART 1 Introduction Percent of GDP 4 3 2 Surplus 1 0 1 2 3 Deficit 4 5 6 7 8 9 10 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 FIGURE 7 Government Budget Surplus or Deficit as a Percentage of Gross Domestic Product, 1950–2016 The budget deficit, relative to the size of the U.S. economy, has fluctuated substantially over the years. It rose to 6% of GDP in 1983 and then fell, eventually leading to budget surpluses from 1999 to 2001. Subse- quently, budget deficits climbed, peaking at nearly 10% of GDP in 2009 and falling substantially thereafter. Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL; https://fred.stlouisfed.org/ series/FYFSGDA188Sl The Foreign Exchange Market For funds to be transferred from one country to another, they have to be converted from the currency of the country of origin (say, dollars) into the currency of the coun- try they are going to (say, euros). The foreign exchange market is where this con- version takes place, so it is instrumental in moving funds between countries. It is also important because it is where the foreign exchange rate, or the price of one country’s currency in terms of another’s, is determined. Figure 8 shows the exchange rate for the U.S. dollar from 1973 to 2017 (measured as the value of the U.S. dollar in terms of a basket of major foreign currencies). The fluc- tuations in prices in this market have been substantial: The dollar’s value rose slightly until 1976, and then reached a low point in the 1978–1980 period. From 1980 to early 1985, the dollar’s value appreciated dramatically, and then declined again, reach- ing another low in 1995. The dollar then subsequently appreciated until 2002 and then depreciated substantially from 2002 until 2011, with only a temporary upturn in 2008 and 2009. From 2011 until 2017, the dollar appreciated again, but still remained below its value in 2002. What have these fluctuations in the exchange rate meant to the American public and businesses? A change in the exchange rate has a direct effect on American consum- ers because it affects the cost of imports. In 2001, when the euro was worth around 85 cents, 100 euros of European goods (say, French wine) cost $85. When the dollar  CHAPTER 1 Why Study Money, Banking, and Financial Markets? 63 0\/DE(FRQRPLFVɄReal-time data Index (March 1973 5 100) 150 135 120 105 90 75 1975 1980 1985 1990 1995 2000 2005 2010 2015 FIGURE 8 Exchange Rate of the U.S. Dollar, 1973–2017 The value of the U.S. dollar relative to other currencies has fluctuated substantially over the years. Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/TWEXMMTH subsequently weakened, raising the cost of one euro to a peak of nearly $1.50, the same 100 euros of wine now cost $150. Thus a weaker dollar leads to more expensive foreign goods, makes vacationing abroad more expensive, and raises the cost of indulg- ing your desire for imported delicacies. When the value of the dollar drops, Americans decrease their purchases of foreign goods and increase their consumption of domestic goods (such as travel within the United States or American-made wine). Conversely, a strong dollar means that U.S. goods exported abroad will cost more in foreign countries, and hence foreigners will buy fewer of them. Exports of steel, for example, declined when the dollar strengthened during the 1980–1985, 1995–2002 and 2011–2017 periods. A strong dollar benefited American consumers by making foreign goods cheaper but hurt American businesses and eliminated some jobs by cutting both domestic and foreign sales of the businesses’ products. The decline in the value of the dollar from 1985 to 1995 and from 2002 to 2011 had the opposite effect: It made foreign goods more expensive but made American businesses more competitive. Fluctuations in the foreign exchange markets have major consequences for the American economy. In Chapter 18, we study how exchange rates are determined in the foreign exchange market, in which dollars are bought and sold for foreign currencies. The International Financial System The tremendous increase in capital flows among countries has heightened the inter- national financial system’s impact on domestic economies. Issues we will explore in Chapter 19 include: How does a country’s decision to fix its exchange rate to that of another nation shape the conduct of monetary policy? What is the impact of capital controls that restrict mobility of capital across national borders on domestic financial systems and the performance of the economy? What role should international financial institutions, such as the International Monetary Fund, play in the international financial system? 64 PART 1 Introduction MONEY, BANKING, AND FINANCIAL MARKETS AND YOUR CAREER Before taking this class, you might have asked yourself the practical question, “How will the study of money, banking, and financial markets help my career?” For some of you, the answer is straightforward. Financial institutions are among the largest employ- ers in the country, and studying money, banking, and financial markets can help you get a good job in the financial sector. Even if your interests lie elsewhere, the study of money, banking, and financial institutions can help advance your career because there will be many times in your life, as an employee or the owner of a business, when the critical thinking skills learned in this study will improve your performance. For example, understanding monetary policy may help you predict when interest rates will rise or fall, helping you to make decisions about whether it is better to borrow now or to wait until later. Knowing how banks and other financial institutions are managed may help you get a better deal when you need to borrow from them or if you decide to supply them with funds. Knowledge of how financial markets work may enable you to make better investment decisions, whether for yourself or for the company you work for. HOW WE WILL STUDY MONEY, BANKING, AND FINANCIAL MARKETS This textbook stresses the “economic way of thinking” by developing a unifying frame- work in which you will study money, banking, and financial markets. This analytic framework uses a few basic economic concepts to organize your thinking about the determination of asset prices, the structure of financial markets, bank management, and the role of money in the economy. It encompasses the following basic concepts: A simplified approach to the demand for assets The concept of equilibrium Basic supply and demand analysis to explain behavior of financial markets The search for profits An approach to financial structure based on transaction costs and asymmetric information Aggregate supply and demand analysis The unifying framework used in this book will keep your knowledge from becom- ing obsolete and make the material more interesting. It will enable you to learn what really matters without having to memorize a mass of dull facts that you will forget soon after the final exam. This framework will also provide you with the tools you need to understand trends in the financial marketplace and in variables such as interest rates, exchange rates, inflation, and aggregate output. To help you understand and apply the unifying analytic framework, simple models are constructed in which the variables held constant are carefully delineated. Each step in the derivation of the model is clearly and carefully laid out, and the models are then used to explain various phenomena by focusing on changes in one variable at a time, holding all other variables constant. To reinforce the models’ usefulness, this text uses case studies, applications, and special-interest boxes to present evidence that supports or casts doubts on the theories being discussed. This exposure to real-life events and empirical data should dissuade  CHAPTER 1 Why Study Money, Banking, and Financial Markets? 65 you from thinking that all economists do is make abstract assumptions and develop theories that have little to do with actual behavior. To function better financially in the real world outside the classroom, you must have the tools with which to follow the financial news that is reported in leading financial pub- lications and on the Web. To help and encourage you to read the financial news, this book contains special boxed inserts titled “Following the Financial News” that provide detailed information and definitions to help you evaluate data that are discussed frequently in the media. This book also contains over 700 end-of-chapter questions and applied problems that ask you to apply the analytic concepts you have learned to real-world issues. Exploring the Web The World Wide Web has become an extremely valuable and convenient resource for financial research. This book emphasizes the importance of this tool in several ways. First, you can view the most current data for a high percentage of the in-text data figures by using eText to access the Federal Reserve Bank of St. Louis’s FRED database. Figures for which you can do this are labeled MyLab Economics Real-Time Data. Second, at the end of almost every chapter there are several real-time data analysis problems, which ask you to download the most recent data from the Federal Reserve Bank of St. Louis’s FRED database and then use these data to answer interesting questions. Third, there are additional exercises at the end of many chapters that prompt you to visit sites related to the chapter and use them to learn more about macroeconomic issues. Additional references are also supplied at the end of each chapter; these list the URLs of sites related to the material being discussed. You can visit these sites to further explore a topic you find of particular interest. Note: Website URLs are subject to frequent change. We have tried to select stable sites, but we realize that even government URLs change. The publisher’s website (www.pearson.com/mylab/economics) will maintain an updated list of current URLs for your reference. CONCLUDING REMARKS The study of money, banking, and financial markets is an exciting field that directly affects your life and career. Interest rates influence the earnings you make on your savings and the payments on loans you may seek for a car or a house, and monetary policy may affect your job prospects and the prices you will pay for goods in the future. Your study of money, banking, and financial markets will introduce you to many of the controversies related to economic policy that are hotly debated in the political arena and will help you gain a clearer understanding of the economic phenomena you hear about in the news media. The knowledge you gain will stay with you and benefit you long after this course is over. SUMMARY 1. Activities in financial markets directly affect indi- exchange market (because fluctuations in the foreign viduals’ wealth, the behavior of businesses, and the exchange rate have major consequences for the U.S. efficiency of our economy. Three financial markets economy). deserve particular attention: the bond market (where 2. Banks and other financial institutions channel funds interest rates are determined), the stock market from people who might not put them to productive use (which has a major effect on people’s wealth and to people who can do so and thus play a crucial role on firms’ investment decisions), and the foreign in improving the efficiency of the economy. When the 66 PART 1 Introduction financial system seizes up and produces a financial cri- 4. The study of money, banking, and financial markets can sis, financial firms fail, which causes severe damage to help advance your career by helping you: get a high- the economy. paying job in the financial sector, decide when you or 3. Money and monetary policy appear to have a major your firm should borrow, get a better deal from finan- influence on inflation, business cycles, and interest rates. cial institutions, or make better investment decisions. Because these economic variables are so important to 5. This textbook stresses the “economic way of thinking” the health of the economy, we need to understand how by developing a unifying analytic framework in which to monetary policy is and should be conducted. We also study money, banking, and financial markets, using a few need to study government fiscal policy because it can be basic economic principles. This textbook also emphasizes an influential factor in the conduct of monetary policy. the interaction of theoretical analysis and empirical data. KEY TERMS aggregate income, p. 69 e-finance, p. 56 inflation, p. 58 aggregate output, p. 57 Federal Reserve System (the Fed), inflation rate, p. 58 aggregate price level, p. 57 p. 60 interest rate, p. 53 asset, p. 53 financial crises, p. 56 monetary policy, p. 59 banks, p. 56 financial innovation, p. 56 monetary theory, p. 57 bond, p. 53 financial intermediaries, p. 55 money (money supply), p. 57 budget deficit, p. 60 financial markets, p. 52 recession, p. 57 budget surplus, p. 60 fiscal policy, p. 60 security, p. 53 business cycles, p. 57 foreign exchange market, p. 62 stock, p. 53 central bank, p. 60 foreign exchange rate, p. 62 unemployment rate, p. 57 common stock, p. 53 gross domestic product (GDP), p. 60 QUESTIONS Select questions are available in MyLab Economics 8. Can you date the latest financial crisis in the United at www.pearson.com/mylab/economics. States or in Europe? Are there reasons to think that 1. What is the typical relationship among interest rates on these crises might have been related? Why? three-month Treasury bills, long-term Treasury bonds, 9. What is one of the reasons for inflation in your country? and Baa corporate bonds? Provide empirical evidence to support your answer. 2. What effect might a fall in stock prices have on business 10. If history repeats itself and we see a decline in the rate investment? of money growth, what might you expect to happen to 3. Explain the main difference between a bond and a com- a. real output? mon stock. b. the inflation rate? 4. Explain the link between well-performing financial c. interest rates? markets and economic growth. Name one channel 11. When interest rates decrease, how might businesses and through which financial markets might affect economic consumers change their economic behavior? growth and poverty. 5. What was the main cause of the recession that began in 12. Is everybody worse off when interest rates rise? 2007? 13. Why do managers of financial institutions care so much 6. Can you think of a reason why people in general do about the activities of the Federal Reserve System? not lend money to one another to buy a house or a 14. How does the current size of the U.S. budget deficit car? How would your answer explain the existence of compare to the historical budget deficit or surplus for banks? the time period since 1950? 7. Name two institutions that are not important financial 15. How would a fall in the value of the pound sterling intermediaries in an economy. affect British consumers?  CHAPTER 1 Why Study Money, Banking, and Financial Markets? 67 16. When there is an increase in the value of the European 19. In July 2018 Yi Gang, Governor of the People’s Bank of Union’s euro, all else equal, how will American businesses China, said the fluctuations in the foreign exchange mar- be affected? What will happen when there is a decrease in ket were mainly due to factors like stronger U.S. dollar and the value of the American dollar relative to the Japanese external uncertainties. How can fluctuations in currency yen, given all else is equal? exchange rate affect your country’s economy? 17. How can changes in foreign exchange rates affect the 20. Much of the U.S. government debt is held by foreign profitability of financial institutions? investors as treasury bonds and bills. How do fluctua- 18. According to Figure 8, in which years would you have tions in the dollar exchange rate affect the value of that chosen to visit the Grand Canyon in Arizona rather debt held by foreigners? than the Tower of London? APPLIED PROBLEMS Select applied problems are available in MyLab Economics April 2017. Which day would have been the best for at www.pearson.com/mylab/economics. converting $250 into British pounds? Which day would 21. The following table lists the foreign exchange rate have been the worst? What would be the difference in between U.S. dollars and British pounds (GBP) during pounds? Date $/£ Date $/£ 4-01 1.9406 4-18 1.7346 4-04 1.9135 4-19 1.7097 4-05 1.8982 4-20 1.6756 4-06 1.9216 4-21 1.6562 4-07 1.9452 4-22 1.6526 4-08 1.8767 4-25 1.6516 4-11 1.8664 4-26 1.6699 4-12 1.8400 4-27 1.6767 4-13 1.7802 4-28 1.7043 4-14 1.7744 4-29 1.7354 4-15 1.7627 DATA ANALYSIS PROBLEMS The Problems update with real-time data in MyLab Economics the mortgage rate indicator, set the frequency to and are available for practice or instructor assignment. ‘monthly’. 1. Go to the St. Louis Federal Reserve FRED data- a. In general, how do these interest rates base and find data on the three-month treasury behave during recessions and during expan- bill rate (TB3MS), the three-month AA nonfi- sionary periods? nancial commercial paper rate (CPN3M), the b. In general, how do the three-month rates 30-year treasury bond rate (GS30), the 30-year compare to the 30-year rates? How do the conventional mortgage rate (MORTGAGE30US), treasury rates compare to the respective and the NBER recession indicators (USREC). For commercial paper and mortgage rates? 68 PART 1 Introduction c. For the most recent available month of data, variable into the M1 growth rate by adjusting the take the average of each of the three-month units for the M1 money supply to “Percent Change rates and compare it to the average of the from Year Ago.” three-month rates from January 2000. How a. In general, how have the growth rate of the do the averages compare? M1 money supply and the 10-year treasury d. For the most recent available month of data, bond rate behaved during recessions and take the average of each of the 30-year rates during expansionary periods since the year and compare it to the average of the 30-year 2000? rates from January 2000. How do the aver- b. In general, is there an obvious, stable rela- ages compare? tionship between money growth and the 2. Go to the St. Louis Federal Reserve FRED database 10-year interest rate since the year 2000? and find data on the M1 money supply (M1SL) and c. Compare the money growth rate and the the 10-year treasury bond rate (GS10). Add the two 10-year interest rate for the most recent series into a single graph by using the “Add Data month available to the rates for January Series” feature. Transform the M1 money supply 2000. How do the rates compare? WEB EXERCISES 1. In this exercise, we will practice collecting data from 2. In Exercise 1, you collected data on and then graphed the Web and graphing it using Excel. Go to http://www the Dow Jones Industrial Average (DJIA). This same site.forecasts.org/data/index.htm, click on Stock Index reports forecast values of the DJIA. Go to http://www Data at the top of the page, and choose the U.S. Stock.forecasts.org/data/index.htm, and click on FFC Home Indices—Monthly option. Finally, choose the Dow at the top of the page. Click on the Dow Jones Industrial Jones Industrial Average option. link under Forecasts in the far-left a. Move the data into an Excel spreadsheet. column. b. Using the data from part (a), prepare a graph. Use a. What is the Dow forecast to be in six months? the Excel Chart Wizard to properly label your axes. b. What percentage increase is forecast for the next six months? WEB REFERENCES http://www.federalreserve.gov/releases/ https://www.nationalpriorities.org/budget-basics/federal- Daily, weekly, monthly, quarterly, and annual releases and budget-101/ historical data for selected interest rates, foreign exchange This site discusses budget basics for the federal government, rates, and so on. including the federal budget process, where the money http://stockcharts.com/charts/historical/ comes from and goes, borrowing and the federal debt, and a federal budget glossary. Historical charts of various stock indexes over differing time periods. http://www.usdebtclock.org/ National debt clock. http://www.federalreserve.gov This site reports the exact national debt at each point in time. General information, monetary policy, banking system, research, and economic data of the Federal Reserve. http://www.bls.gov/data/inflation_calculator.htm This calculator lets you compute how the dollar’s buying power has changed since 1913. APPENDIX TO CHAPTER B ecause these terms are used so frequently throughout the text, we need to have a clear understanding of the definitions of aggregate output, income, the price level, and the inflation rate. AGGREGATE OUTPUT AND INCOME The most commonly reported measure of aggregate output, the gross domestic product (GDP), is the market value of all final goods and services produced in a country during the course of a year. This measure excludes two sets of items that at first glance you might think it would include. Purchases of goods that have been produced in the past, whether a Rembrandt painting or a house built 20 years ago, are not counted as part of GDP; nor are purchases of stocks or bonds. Neither of these categories enters into the GDP because these categories do not include goods and services produced during the course of the year. Intermediate goods, which are used up in producing final goods and services, such as the sugar in a candy bar or the energy used to produce steel, are also not counted sepa- rately as part of the GDP. Because the value of the final goods already includes the value of the intermediate goods, to count them separately would be to count them twice. Aggregate income, the total income of factors of production (land, labor, and capi- tal) from producing goods and services in the economy during the course of the year, is best thought of as being equal to aggregate output. Because the payments for final goods and services must eventually flow back to the owners of the factors of production as income, income payments must equal payments for final goods and services. For example, if the economy has an aggregate output of $10 trillion, total income payments in the economy (aggregate income) are also $10 trillion. REAL VERSUS NOMINAL MAGNITUDES When the total value of final goods and services is calculated using current prices, the resulting GDP measure is referred to as nominal GDP. The word nominal indicates that values are measured using current prices. If all prices doubled but actual production of goods and services remained the same, nominal GDP would double, even though people would not enjoy the benefits of twice as many goods and services. As a result, nominal variables can be misleading measures of economic well-being. 69 70 PART 1 Introduction A more reliable measure of economic production expresses values in terms of prices for an arbitrary base year, currently 2009. GDP measured with constant prices is referred to as real GDP, the word real indicating that values are measured in terms of fixed prices. Real variables thus measure the quantities of goods and services and do not change because prices have changed, but rather only if actual quantities have changed. A brief example will make the distinction clearer. Suppose that you have a nominal income of $30,000 in 2019 and that your nominal income was $15,000 in 2009. If all prices doubled between 2009 and 2019, are you better off? The answer is no: Although your income has doubled, your $30,000 buys you only the same amount of goods because prices have also doubled. A real income measure indicates that your income in terms of the goods it can buy is the same. Measured in 2009 prices, the $30,000 of nominal income in 2019 turns out to be only $15,000 of real income. Because your real income is actually the same for the two years, you are no better or worse off in 2019 than you were in 2009. Because real variables measure quantities in terms of real goods and services, they are typically of more interest than nominal variables. In this text, discussion of aggre- gate output or aggregate income always refers to real measures (such as real GDP). AGGREGATE PRICE LEVEL In this chapter, we defined the aggregate price level as a measure of average prices in the economy. Three measures of the aggregate price level are commonly encoun- tered in economic data. The first is the GDP deflator, which is defined as nominal GDP divided by real GDP. Thus, if 2019 nominal GDP is $10 trillion but 2019 real GDP in 2009 prices is $9 trillion, $10 trillion GDP deflator = = 1.11 $9 trillion The GDP deflator equation indicates that, on average, prices have risen 11% since 2009. Typically, measures of the price level are presented in the form of a price index, which expresses the price level for the base year (in our example, 2009) as 100. Thus the GDP deflator for 2019 would be 111. Another popular measure of the aggregate price level (which officials in the Fed frequently focus on) is the PCE deflator, which is similar to the GDP deflator and is defined as nominal personal consumption expenditures (PCE) divided by real PCE. The measure of the aggregate price level that is most frequently reported in the press is the consumer price index (CPI). The CPI is measured by pricing a “basket” of goods and services bought by a typical urban household. If, over the course of the year, the cost of this basket of goods and services rises from $500 to $600, the CPI has risen by 20%. The CPI is also expressed as a price index with the base year equal to 100. The CPI, the PCE deflator, and the GDP deflator measures of the price level can be used to convert or deflate a nominal magnitude into a real magnitude. This is accomplished by dividing the nominal magnitude by the price index. In our example, in which the GDP deflator for 2019 is 1.11 (expressed as an index value of 111), real GDP for 2019 equals $10 trillion = $9 trillion in 2009 prices 1.11 which corresponds to the real GDP figure for 2019 assumed earlier.  CHAPTER 1 Defining Aggregate Output, Income, the Price Level, and the Inflation Rate 71 GROWTH RATES AND THE INFLATION RATE The media often talk about the economy’s growth rate, and particularly the growth rate of real GDP. A growth rate is defined as the percentage change in a variable, i.e., xt - xt - 1 growth rate of x = * 100 xt - 1 where t indicates today and t - 1 indicates a year earlier. For example, if real GDP grew from $9 trillion in 2019 to $9.5 trillion in 2020, then the GDP growth rate for 2020 would be 5.6%: $9.5 trillion - $9 trillion GDP growth rate = * 100 = 5.6% $9 trillion The inflation rate is defined as the growth rate of the aggregate price level. Thus, if the GDP deflator rose from 111 in 2019 to 113 in 2020, the inflation rate using the GDP deflator would be 1.8%: 113 - 111 inflation rate = * 100 = 1.8% 111 If the growth rate is for a period of less than one year, it is usually reported on an annualized basis; that is, it is converted to the growth rate over a year’s time, assuming that the growth rate remains constant. For GDP, which is reported quarterly, the annu- alized growth rate would be approximately four times the percentage change in GDP from the previous quarter. For example, if GDP rose 12% from the first quarter of 2019 to the second quarter of 2019, then the annualized GDP growth rate for the second quarter of 2019 would be reported as 2% ( = 4 * 12%). (A more accurate calculation would be 2.02%, because a precise quarterly growth rate should be compounded on a quarterly basis.) Learning Objectives Compare and contrast Preview I direct and indirect nez the Inventor has designed a low-cost robot that cleans the house (even does the finance. windows!), washes the car, and mows the lawn, but she has no funds to put her Identify the structure wonderful invention into production. Walter the Widower has plenty of savings, and components of which he and his wife accumulated over the years. If Inez and Walter could get together financial markets. so that Walter could provide funds to Inez, Inez’s robot would see the light of day, and List and describe the the economy would be better off: We would have cleaner houses, shinier cars, and different types of more beautiful lawns. financial market Financial markets (bond and stock markets) and financial intermediaries (such instruments. as banks, insurance companies, and pension funds) serve the basic function of Recognize the inter- getting people like Inez and Walter together so that funds can move from those national dimensions who have a surplus of funds (Walter) to those who have a shortage of funds (Inez). of financial markets. More realistically, when Apple invents a better iPad, it may need funds to bring its Summarize the roles new product to market. Similarly, when a local government needs to build a road of transaction costs, or a school, it may require more funds than local property taxes provide. Well- risk sharing, and functioning financial markets and financial intermediaries are crucial to economic information costs as health. they relate to financial To study the effects of financial markets and financial intermediaries on the intermediaries. economy, we need to acquire an understanding of their general structure and List and describe the operation. In this chapter, we learn about the major financial intermediaries and different types of finan- the instruments that are traded in financial markets, as well as how these markets cial intermediaries. are regulated. Identify the reasons This chapter presents an overview of the fascinating study of financial markets and for and list the types institutions. We return to a more detailed treatment of the regulation, structure, and of financial market evolution of the financial system in Chapters 8 through 12. regulations. FUNCTION OF FINANCIAL MARKETS Financial markets perform the essential economic function of channeling funds from households, firms, and governments that have saved surplus funds by spending less than their income to those that have a shortage of funds because they wish to spend more than their income. This function is shown schematically in Figure 1. Those who have saved and are lending funds, the lender-savers, are at the left, and those who must borrow funds to finance their spending, the borrower-spenders, are at the right. The 72  CHAPTER 2 An Overview of the Financial System 73 MyLab EconomicsɄMini-lecture INDIRECT FINANCE FUNDS Financial FUNDS Intermediaries FUNDS Lender-Savers Borrower-Spenders 1. Households 1. Business firms Financial 2. Business firms FUNDS FUNDS 2. Government Markets 3. Government 3. Households 4. Foreigners 4. Foreigners DIRECT FINANCE FIGURE 1 Flows of Funds Through the Financial System The arrows show that funds flow from lender-savers to borrower-spenders via two routes: direct finance, in which borrowers borrow funds directly from financial markets by selling securities, and indirect finance, in which a financial intermediary borrows funds from lender-savers and then uses these funds to make loans to borrower-spenders. principal lender-savers are households, but business enterprises and the government (particularly state and local government), as well as foreigners and their governments, sometimes also find themselves with excess funds and so lend them out. The most important borrower-spenders are businesses and the government (particularly the fed- eral government), but households and foreigners also borrow to finance their purchases of cars, furniture, and houses. The arrows show that funds flow from lender-savers to borrower-spenders via two routes. In direct finance (the route at the bottom of Figure 1), borrowers borrow funds directly from lenders in financial markets by selling the lenders securities (also called financial instruments), which are claims on the borrower’s future income or assets. Secu- rities are assets for the person who buys them but liabilities (IOUs or debts) for the individual or firm that sells (issues) them. For example, if Ford needs to borrow funds to pay for a new factory to manufacture electric cars, it might borrow the funds from savers by selling them a bond, a debt security that promises to make periodic payments for a specified period of time, or a stock, a security that entitles the owner to a share of the company’s profits and assets. 74 PART 1 Introduction Why is this channeling of funds from savers to spenders so important to the economy? The answer is that the people who save are frequently not the same people who have profitable investment opportunities available to them, the entrepreneurs. Let’s first think about this on a personal level. Suppose that you have saved $1,000 this year, but no borrowing or lending is possible because no financial markets are available. If you do not have an investment opportunity that will permit you to earn income with your savings, you will just hold on to the $1,000 and it will earn no interest. However, Carl the Carpenter has a productive use for your $1,000: He can use it to purchase a new tool that will shorten the time it takes him to build a house, thereby earning an extra $200 per year. If you could get in touch with Carl, you could lend him the $1,000 at a rental fee (interest) of $100 per year, and both of you would be better off. You would earn $100 per year on your $1,000, instead of the zero amount that you would earn otherwise, while Carl would earn $100 more income per year (the $200 extra earnings per year minus the $100 rental fee for the use of the funds). In the absence of financial markets, you and Carl the Carpenter might never get together. You would both be stuck with the status quo, and both of you would be worse off. Without financial markets, it is hard to transfer funds from a person who has no investment opportunities to one who has them. Financial markets are thus essential to promoting economic efficiency. The existence of financial markets is beneficial even if someone borrows for a pur- pose other than increasing production in a business. Say that you are recently married, have a good job, and want to buy a house. You earn a good salary, but because you have just started to work, you have not saved much. Over time, you would have no problem saving enough to buy the house of your dreams, but by then you would be too old to get full enjoyment from it. Without financial markets, you are stuck; you cannot buy the house and must continue to live in your tiny apartment. If a financial market were set up so that people who had built up savings could lend you the funds to buy the house, you would be more than happy to pay them some interest so that you could own a home while you are still young enough to enjoy it. Then, over time, you would pay back your loan. If this loan could occur, you would be better off, as would the persons who made you the loan. They would now earn some interest, whereas they would not if the financial market did not exist. Now we can see why financial markets have such an important function in the economy. They allow funds to move from people who lack productive investment opportunities to people who have such opportunities. Financial markets are critical for producing an efficient allocation of capital (wealth, either financial or physical, that is employed to produce more wealth), which contributes to higher production and efficiency for the overall economy. Indeed, as we will explore in Chapter 12, when financial markets break down during financial crises, as they did during the recent global financial crisis, severe economic hardship results, which can sometimes lead to dangerous political instability. Well-functioning financial markets also directly improve the well-being of con- sumers by allowing them to time their purchases better. They provide funds to young people to buy what they need (and will eventually be able to afford) without forcing them to wait until they have saved up the entire purchase price. Financial markets that are operating efficiently improve the economic welfare of everyone in the society.  CHAPTER 2 An Overview of the Financial System 75 STRUCTURE OF FINANCIAL MARKETS Now that we understand the basic function of financial markets, let’s look at their structure. The following descriptions of several categories of financial markets illustrate essential features of these markets. Debt and Equity Markets A firm or an individual can obtain funds in a financial market in two ways. The most common method is through the issuance of a debt instrument, such as a bond or a mortgage, which is a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals (interest and principal payments) until a specified date (the maturity date), when a final payment is made. The maturity of a debt instrument is the number of years (term) until that instrument’s expiration date. A debt instrument is short-term if its maturity term is less than a year and long- term if its maturity term is ten years or longer. Debt instruments with a maturity term between one and ten years are said to be intermediate-term. The second method of raising funds is through the issuance of equities, such as common stock, which are claims to share in the net income (income after expenses and taxes) and the assets of a business. If you own one share of common stock in a company that has issued one million shares, you are entitled to 1 one-millionth of the firm’s net income and 1 one-millionth of the firm’s assets. Equities often make periodic payments (dividends) to their holders and are considered long-term securities because they have no maturity date. In addition, owning stock means that you own a portion of the firm and thus have the right to vote on issues important to the firm and to elect its directors. The main disadvantage of owning a corporation’s equities rather than its debt is that an equity holder is a residual claimant; that is, the corporation must pay all its debt holders before it pays its equity holders. The advantage of holding equities is that equity holders benefit directly from any increases in the corporation’s profitability or asset value because equities confer ownership rights on the equity holders. Debt hold- ers do not share in this benefit, because their dollar payments are fixed. We examine the pros and cons of debt versus equity instruments in more detail in Chapter 8, which provides an economic analysis of financial structure. The total value of equities in the United States has fluctuated between $3 and $40 trillion since 1990, depending on the prices of shares. Although the average person is more aware of the stock market than of any other financial market, the size of the debt market is often substantially larger than the size of the equities market: At the end of 2016, the value of debt instruments was $44 trillion, while the value of equities was $39 trillion. Primary and Secondary Markets A primary market is a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds. A secondary market is a financial market in which securities that have been previously issued can be resold. The primary markets for securities are not well known to the public because the selling of securities to initial buyers often takes place behind closed doors. An impor- tant financial institution that assists in the initial sale of securities in the primary market 76 PART 1 Introduction is the investment bank. The investment bank does this by underwriting securities: It guarantees a price for a corporation’s securities and then sells them to the public. The New York Stock Exchange and NASDAQ (National Association of Securities Dealers Automated Quotation System), in which previously issued stocks are traded, are the best-known examples of secondary markets, although the bond markets, in which previously issued bonds of major corporations and the U.S. government are bought and sold, actually have a larger trading volume. Other examples of secondary markets are foreign exchange markets, futures markets, and options markets. Securities brokers and dealers are crucial to a well-functioning secondary market. Brokers are agents of investors who match buyers with sellers of securities; dealers link buyers and sellers by buying and selling securities at stated prices. When an individual buys a security in the secondary market, the person who has sold the security receives money in exchange for the security, but the corporation that issued the security acquires no new funds. A corporation acquires new funds only when its securities are first sold in the primary market. Nonetheless, secondary markets serve two important functions. First, they make it easier and quicker to sell these finan- cial instruments to raise cash; that is, they make the financial instruments more liquid. The increased liquidity of these instruments then makes them more desirable and thus easier for the issuing firm to sell in the primary market. Second, secondary markets determine the price of the security that the issuing firm sells in the primary market. The investors who buy securities in the primary market will pay the issuing corporation no more than the price they think the secondary market will set for this security. The higher the security’s price in the secondary market, the higher the price the issuing firm will receive for a new security in the primary market, and hence the greater the amount of financial capital it can raise. Conditions in the secondary market are therefore the most relevant to corporations issuing securities. For this reason, books like this one, which deal with financial markets, focus on the behavior of secondary markets rather than that of primary markets. Exchanges and Over-the-Counter Markets Secondary markets can be organized in two ways. One method is through exchanges, where buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades. The New York Stock Exchange for stocks and the Chicago Board of Trade for commodities (wheat, corn, silver, and other raw materials) are examples of organized exchanges. The other forum for a secondary market is an over-the-counter (OTC) market, in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone who comes to them and is will- ing to accept their prices. Because over-the-counter dealers are in contact via comput- ers and know the prices set by one another, the OTC market is very competitive and not very different from a market with an organized exchange. Many common stocks are traded over-the-counter, although a majority of the larg- est corporations have their shares traded at organized stock exchanges. The U.S. gov- ernment bond market, with a larger trading volume than the New York Stock Exchange, by contrast, is set up as an over-the-counter market. Forty or so dealers establish a “market” in these securities by standing ready to buy and sell U.S. government bonds. Other over-the-counter markets include those that trade other types of financial instru- ments, such as negotiable certificates of deposit, federal funds, and foreign exchange instruments.  CHAPTER 2 An Overview of the Financial System 77 Money and Capital Markets Another way of distinguishing between markets is on the basis of the maturity of the securities traded in each market. The money market is a financial market in which only short-term debt instruments (generally those with original maturity terms of less than one year) are traded; the capital market is the market in which longer-term debt instruments (generally those with original maturity terms of one year or greater) and equity instruments are traded. Money market securities are usually more widely traded than longer-term securities and so tend to be more liquid. In addition, as we will see in Chapter 4, short-term securities have smaller fluctuations in prices than long-term securities, making them safer investments. As a result, corporations and banks actively use the money market to earn interest on surplus funds that they expect to have only temporarily. Capital market securities, such as stocks and long-term bonds, are often held by financial intermediaries such as insurance companies and pension funds, which have little uncertainty about the amount of funds they will have available in the future. FINANCIAL MARKET INSTRUMENTS To complete our understanding of how financial markets perform the important role of channeling funds from lender-savers to borrower-spenders, we need to examine the securities (instruments) traded in financial markets. We first focus on the instruments traded in the money market and then turn to those traded in the capital market. Money Market Instruments Because of their short terms to maturity, the debt instruments traded in the money market undergo the least price fluctuations and so are the least risky investments. The money market has undergone great changes in the past three decades, with the amounts of some financial instruments growing at a far more rapid rate than others. The principal money market instruments are listed in Table 1, along with the amount at the end of 1990, 2000, 2010, and 2016. The Following the Financial News box discusses the money market interest rates most frequently reported in the media. TABLE 1 Principal Money Market Instruments Amount ($ billions, end of year)