MONEY, BANKING, AND FINANCIAL MARKETS PDF

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MONEY, BANKING, AND FINANCIAL MARKETS Laurence M. Ball Johns Hopkins University 1429260807 Worth Publishers Senior Publisher: Craig Bleyer Acquisitions Editor: Sarah Dorger Senior Marketing Manager: Scott Guile Market Research and Development: Steven Rigolosi Development Editor: Barbara Brooks Devel...

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MONEY, BANKING, AND FINANCIAL MARKETS Laurence M. Ball Johns Hopkins University 1429260807 Worth Publishers

Senior Publisher: Craig Bleyer Acquisitions Editor: Sarah Dorger Senior Marketing Manager: Scott Guile Market Research and Development: Steven Rigolosi Development Editor: Barbara Brooks Development Editor, Media and Supplements: Marie McHale Consulting Editor: Paul Shensa Associate Editor: Matthew Driskill Photo Editor: Cecilia Varas Photo Researcher: Julie Tesser Art Director: Babs Reingold Senior Designer, Cover Designer: Kevin Kall Interior Designer: Lissi Sigillo Associate Managing Editor: Tracey Kuehn Project Editors: Dana Kasowitz                             Laura Hakala, Pre-PressPMG Production Manager: Barbara Anne Seixas Composition: Pre-PressPMG Printing and Binding: RR Donnelley Cover Photos: Second Bank of the United States PHILADELPHIA USA, © Aflo Co. Ltd./Alamy Gold certificate and coins, © Corbis Premium RF/Alamy Euro note, Image source photography/Veer US 10 dollars, Veer South African rand, Veer Library of Congress Control Number: 2008926450 ISBN-13: 978-0-7167-5934-8 ISBN-10: 0-7167-5934-9 © 2009 by Worth Publishers All rights reserved Printed in the United States of America First printing Worth Publishers 41 Madison Avenue New York, NY 10010 www.worthpublishers.com

Table of Contents preface

ix

PART I: FOUNDATIONS

1

chapter 1: The Financial System

3

chapter 2: Money and Central Banks

25

PART II: FINANCIAL MARKETS

53

chapter 3: Asset Prices and Interest Rates

55

chapter 4: What Determines Interest Rates?

83

chapter 5: Securities Markets

119

chapter 6: Foreign Exchange Markets

153

PART III: BANKING

185

chapter 7: Asymmetric Information in the Financial System

187

chapter 8: The Banking Industry

213

chapter 9: The Business of Banking

241

chapter 10: Bank Regulation

273

PART IV: MONEY AND THE ECONOMY

299

chapter 11: The Money Supply and Interest Rates

301

chapter 12: Short-Run Economic Fluctuations

329

chapter 13: Economic Fluctuations, Monetary Policy, and the Financial System

373

chapter 14: Inflation and Deflation

401

PART V: MONETARY POLICY

431

chapter 15: Policies for Economic Stability

433

chapter 16: Monetary Institutions and Strategies

463

chapter 17: Monetary Policy and Exchange Rates

493

chapter 18: Financial Crises

523

glossary

545

index

571

iii

iii

Money, Banking, and Financial Markets

The building on this book’s cover is the Second Bank of the United States, located in Philadelphia. It operated from 1816 to 1836, serving some of the functions of the modern Federal Reserve. President Andrew Jackson vetoed legislation to extend the Bank’s charter because he believed it served “moneyed interests” at the expense of common people (see Chapter 8). The cover also shows several of the world’s currencies: South Africa’s rand (at top), the Japanese yen (the 500 yen coin), the euro (touching the yen coin), and a $10 bill and dime from the United States. Pictured on the $10 bill is Alexander Hamilton, Secretary of the Treasury under George Washington, who created the first national currency of the United States (see Chapter 2). The dime features President Franklin Roosevelt, whose banking and monetary policies helped end the 1930s’ Great Depression (see Chapter 18). The currency that says “Washington” is a gold certificate, a type of money used in the United States in the late 19th and early 20th centuries.

iv

Laurence Ball is Professor of Economics at Johns Hopkins University. He holds a Ph.D. in economics from the Massachusetts Institute of Technology and a B.A. in economics from Amherst College. Professor Ball is a Research Associate of the National Bureau of Economic Research and has been a visiting scholar at the Federal Reserve, the Bank of Japan, the Central Bank of Norway, the Reserve Bank of Australia, and the Hong Kong Monetary Authority. His academic honors include the Houblon-Norman Fellowship (Bank of England), a Professorial Fellowship in Monetary Economics (Victoria University of Wellington and Reserve Bank of New Zealand), the NBER Olin Fellowship, and the Alfred P. Sloan Research Fellowship. He lives in Baltimore with his wife, Patricia, and their son, Leverett. To Patricia

v

preface Perhaps the greatest challenge facing teachers of economics is connecting the theories we present to the real world. Students have a natural interest in the economic events they see in the news and the economic problems they face in their lives, but they often have trouble seeing the relevance of the graphs and equations in economics textbooks. A course on money, banking, and financial markets is an ideal opportunity for closing this gap. The topics of the course fill today’s headlines: the behavior of the stock market, banking crises, Federal Reserve policies, and the causes of recessions, for example. At the same time, a real understanding of these issues requires a foundation in economics, including some of the major theoretical advances of recent decades. •

Problems in securities markets and the banking system stem from asymmetric information between borrowers and lenders. To analyze these problems, students need to understand the fundamental concepts of moral hazard and adverse selection.

•

Economic fluctuations and Federal Reserve policy involve the interplay of interest rates, output, and inflation. We can best analyze fluctuations using the framework of modern macro theorists, in which the interest rate is the Fed’s policy instrument.

•

In the last two decades, central banks around the world have become more independent, their policymaking has become more transparent, and many have adopted inflation targeting. A major motivation for these changes has been academic research on the dynamic consistency problem in monetary policy.

THIS BOOK’S APPROACH My goal in Money, Banking, and Financial Markets is to link great economic ideas to real events and policies in a manner accessible to undergraduates. My approach is based on three related principles: •

Present core theory simply but rigorously. I never use a formal model when a commonsense verbal explanation does the job just as well. At the same time, I don’t shy away from models when they allow me to present ideas more crisply. One case is the analysis of asymmetric information in Chapter 7. I use precise numerical examples to show how moral hazard and adverse selection can cause loan markets to break down.

•

Emphasize the relevance of theory to reality. This book does not include a stand-alone segment on “monetary theory.” Instead, I seek to integrate theory and applications in every chapter. To this end, the book features 81 case studies. Examples throughout the text also emphasize the connection between economic models and actual events. Like most texts, this one presents graphs and discusses the factors that cause curves to shift. For every curve shift, I have asked myself what historical episode the shift explains. When I don’t have an answer, I’m likely to skip the exercise.

•

Strip away unnecessary material. To better focus on core principles and their application, I have worked to eliminate nonessential coverage. While the book delves into important historical topics, it avoids “standard” but outdated material. I also aim for a lean discussion of the financial system, conveying what’s important while avoiding encyclopedic coverage of every type of financial institution and instrument. Focusing on the key material has produced a book of 18 chapters, one that is approximately 100 pages shorter than a standard money and banking text.

CASE STUDIES CLOSE THE GAP BETWEEN THEORY AND REALITY Multiple case studies in each chapter help students examine the book’s topics from a variety of perspectives: The Viewpoint of Financial Firms When I discuss how banks raise funds, I present a case on Commerce Bank, which has been unusually successful in attracting deposits. A case on Citigroup illustrates the consolidation of financial institutions. The discussion of exchange rates includes a case on the strategies of currency traders. The Viewpoint of Aggregate Economies Case studies discuss Germany’s hyperinflation in the 1920s and Japan’s deflation in the 1990s and 2000s. Cases cover financial crises from the Great Depression to the breakdown of Argentina’s currency board to the subprime mortgage fiasco. Some cases address current controversies around the world, such as China’s exchange-rate policy. Others discuss episodes that students have read about in history books—money and banking in the days of Alexander Hamilton, Andrew

vii

Money, Banking, and Financial Markets subprime mortgage fiasco. Some cases address current controversies around the world, such as China’s exchange-rate policy. Others discuss episodes that students have read about in history books—money and banking in the days of Alexander Hamilton, Andrew Jackson, and William Jennings Bryan. The Viewpoint of Economic Policymakers Cases discuss issues facing financial regulators, ranging from insider trading to the separation of banking and commerce. (Should Wal-Mart be able to open a bank?) Other cases address controversies about monetary policy. Does inflation targeting improve economic performance? Should central banks try to dampen asset-price bubbles? The Viewpoint of Individuals Confronting the Financial System Many case studies address questions that are likely to arise in students’ lives. How should people allocate their wealth, and how should this allocation change with age? Should you finance a home with a fixed-rate or adjustable-rate mortgage? And most pressing to many students, how is the government’s student loan program changing?

_

Online Case Studies Will Keep the Book Current

The topics discussed in this book are changing rapidly. To keep the material fresh, the text is supplemented by 18 online case studies, one per chapter, that will be updated regularly. One online case reports on the Federal Open Market Committee’s actions in recent months. Others discuss areas in which major changes are anticipated, such as investment banking. Still others cover events that were breaking news as the text went to press, such as the government’s response to the U.S. financial crisis.

AN OVERVIEW OF THE TEXT The book’s 18 chapters are organized into five parts.

PART I: Foundations Chapters 1 and 2 outline the basic purposes of the financial and monetary systems. Chapter 1 describes how the financial system channels funds from savers to investors and its role in economic growth. It also introduces the problem of asymmetric information and banks’ role in overcoming this problem. Chapter 2 introduces students to money—what it is, why we need it, and how it’s changing— and to central banks and their multiple functions.

PART II: Financial Markets Chapters 3–6 describe markets for stocks, bonds, derivatives, and currencies. Who participates in these markets? What are these players trying to do? What determines asset prices, interest rates, and exchange rates? These financial markets chapters emphasize important controversies. For example, when asset prices rise, does this reflect news about the assets’ fundamental values, or is an irrational bubble occurring? Are there bubbles in U.S. stock and real estate prices? What about 17th century tulip prices?

PART III: Banking Chapters 7–10 discuss the roles of banks and other financial intermediaries. Chapter 7 explains why banks exist, Chapter 8 describes the structure of the banking industry, Chapter 9 explains how banks seek profits, and Chapter 10 discusses why and how they are regulated. Part III starts with a detailed treatment of asymmetric information. The concepts of adverse selection and moral hazard are tied to practical topics such as the Enron scandal and the Sarbanes-Oxley Act. The discussion of banking ranges from the growth of subprime lending to banks’ increased reliance on fee income to the merging of commercial and investment banking.

PART IV: Money and the Economy I believe that students need to see how the Fed affects the economy before discussing what the Fed ought to do. Thus, one innovation of this book is to present basic theories of money and economic fluctuations before turning to monetary policy debates. Chapters 11–14 analyze fluctuations—booms and recessions, inflation and deflation.

viii

preface analyze fluctuations—booms and recessions, inflation and deflation. The centerpiece of Part IV is a short-run model of the economy based on an Aggregate Expenditure (AE) curve and a Phillips curve. In the model, the central bank sets an interest rate-target; the AE curve shows how the interest rate and expenditure shocks determine output; and the Phillips curve shows how output and supply shocks determine the inflation rate. This AE/PC model is a more natural tool for analyzing modern monetary policy than the traditional AD/AS model. The AE/PC model fits better both with academic research and with discussions of economic events in the news media. In Chapter 12, an extended case study uses the model to interpret U.S. economic history from 1960 to the present.

PART V: Monetary Policy Chapters 15–18 survey central banking and debates about monetary policy and institutions. The discussion starts with theoretical issues, such as the dynamic consistency problem, and then moves to a wide range of practical questions. How does the FOMC decide when to change interest rates? Why did Ben Bernanke advocate inflation targeting when he was a professor, and what will he do about it as Fed chair? What policy mistakes produced the economic instability of the 1970s? Why did European countries abolish their national currencies and create the euro? Chapter 18, the book’s capstone, examines financial and banking crises—how they happen and how policymakers should respond. An extended case study reviews the dramatic events in the United States over 2007–2008. To understand crises, students need to understand financial markets, banks, monetary policy, and the overall economy—all the major subjects of this book. By illuminating the topic of financial crises, Chapter 18 shows students the payoff from a course on money, banking, and financial markets.

ALTERNATE USES OF THIS BOOK Although this book contains just 18 chapters, there is more than enough material for a money and banking course. Most instructors will want to emphasize some parts of the text and touch more lightly on others. I suggest that any course cover Chapters 1–2, the foundations part of the book, and Chapters 3–4, which present core concepts about interest rates and asset prices. Most instructors will also want to delve into Chapter 7, which discusses why banks exist, and Chapters 11–12, the core material on money and economic fluctuations. I recommend leaving some time for Chapter 18, given the importance of the topic of financial crises. Otherwise, the best chapters to cover depend on the emphasis of a course. Here are a few examples: A course emphasizing the financial system: The key material for this course is Chapter 5 on securities markets and Part III (Chapters 7–10) on banking. I also recommend Chapter 13, which shows how the financial system influences economic fluctuations. A course emphasizing the behavior of the aggregate economy: This course should cover Part IV (Chapters 11–14) on money and the economy and as much as possible of Part V (Chapters 15–18) on monetary policy. A course emphasizing monetary policy: This course should cover Part V in detail. A course with an international perspective: The key material is Chapter 6 on foreign-exchange markets and Chapter 17 on international monetary policy. I also recommend two chapters that emphasize cross-country comparisons: Chapter 14 on inflation and Chapter 16 on monetary institutions.

SUPPLEMENTS AND MEDIA ACCOMPANYING THIS BOOK INSTRUCTOR SUPPLEMENTS Instructor’s Manual with Solutions Manual Prepared by Jane Himarios (University of Texas–Arlington), for each chapter in the textbook the Instructor’s Manual provides: •

Brief Chapter Summary: summarizing the contents of the chapter.

•

Detailed Section Summaries: detailed lecture notes including coverage of all case studies and references to online case studies.

ix

Money, Banking, and Financial Markets •

Detailed Section Summaries: detailed lecture notes including coverage of all case studies and references to online case studies.

•

Inside and Outside the Classroom Activities: problems, exercises, and discussion questions relating to lecture material, designed to enhance student learning.

•

Detailed Solutions: to all end-of-chapter questions and problems; prepared by Doris Geide-Stevenson (Weber State University).

Printed Test Bank Prepared by Robert (Tino) Sonora (Fort Lewis College), the Test Bank provides questions ranging in levels of difficulty and format to assess students’ comprehension, interpretation, analysis, and synthesis skills. Containing roughly 100 questions per chapter, the Test Banks offers a variety of multiple-choice, true/false, and short-answer questions. Computerized Test Bank The printed test bank will be available in CD-ROM format for both Windows and Macintosh users. With this flexible, test-generating software, instructors can easily create and print tests as well as write and edit questions. Instructor’s Resource CD-ROM Using the Instructor’s Resource CD-ROM, instructors can easily build classroom presentations or enhance online courses. This CD-ROM contains all of the text figures and tables (in JPEG and PPT formats), PowerPoint lecture presentations prepared by James Butkiewicz (University of Delaware), and detailed solutions to all end-of-chapter questions in the textbook prepared by Doris Geide-Stevenson (Weber State University).

STUDENT SUPPLEMENTS Study Guide Prepared by Richard Stahl (Louisiana State University), the Study Guide complements the textbook by providing students additional opportunities to develop and reinforce lessons learned in the money and banking text. For each chapter of the textbook, the Study Guide provides: •

Brief Chapter Summary: summarizing the contents of the chapter.

•

Key Terms: listed and defined, with space for students to write in the definitions in their own words.

•

Detailed Section Summaries with Student Tips and Concept-Related Questions: including coverage of all case studies, tips to help students with difficult concepts, and 3–5 questions per section to reinforce learning of key concepts.

•

Self-test End-of-Chapter Questions: 15–20 application-oriented, multiple-choice questions.

•

Worked-out Solutions: including solutions to all Study Guide review questions.

COMPANION WEB SITE FOR STUDENTS AND INSTRUCTORS: http://www.worthpublishers.com/ball The companion site is a virtual study guide for students and an excellent resource for instructors. For each chapter in the t...