economic money, banking,

The

ECONOMICSMONEY,

BANKING,and

FINANCIALMARKETS

Fifth Edition

Frederic S. MishkinColumbia University

ADDISON-WESLEY

An Imprint of Addison Wesley Longman, Inc.

Reading, Massachusetts • Menlo Park, California • New York • Harlow, EnglandDon Mills, Ontario • Sydney • Mexico City • Madrid • Amsterdam

CONTENTS IX

Following the Financial News Foreign Stock Market

Indexes 33Function of Financial Intermediaries 33

BOX 2; The Importance of Financial Intermediaries to SecuritiesMarkets: An International Comparison 34

Transaction Costs 34Asymmetric Information: Adverse Selection and

Moral Hazard 35Financial Intermediaries 37

Depository Institutions 37Contractual Savings Institutions 40Investment Intermediaries 41

Regulation of the Financial System 42Increasing Information Available to Investors 42Ensuring the Soundness of Financial Intermediaries 42Improving Control of Monetary Policy 45Financial Regulation Abroad 45

Summary, Key Terms, Questions and Problems 45

CHAFTER3 WHAT IS MONEY? 48

Preview 48Meaning of Money 48Functions of Money 49

Medium of Exchange 49Unit of Account 50Store of Value 51

Evolution of the Payments System 52,BOX I; Birth of a New'European Currency: The Euro? 54Electronic Money: A Coming Global Phenomenon 55Are We Moving to a Cashless Society? 56

Measuring Money 57Theoretical and Empirical Definitions of Money 57The Federal Reserves Monetary Aggregates 58Following the Financial News The Monetary

Aggregates 61Money as a Weighted Aggregate 61

How Reliable Are the Money Data? 62Summary, Key Terms, Questions and Problems 63

PART fl Financial Markets 67

CHAPTER 4 UNDERSTANDING INTEREST RATES 69Preview 69Measuring Interest Rates 70

Present Value 71Application The Cost of the S&L Bailout: Was It Really

$500 Billion? 72

CONTENTS

Yield to Maturity 72Other Measures of Interest Rates 79

Current Yield 79Yield on a Discount Basis 80Application Reading the Wall Street Journal: The

Bond Page 81Following the Financial News Bond Prices and

Interest Rates 82The Distinction Between Interest Rates and Returns 84

Maturity and the Volatility of Bond Returns:Interest-Rate Risk 87

Summary 88Application Should Retirees Invest in "Gilt-Edged"

Long-Term Bonds? 88The Distinction Between Real and Nominal Interest Rates 89Summary, Key Terms, Questions and Problems 92

CHAPTER 5 PORTFOLIO CHOICE 94Preview 94Determinants of Asset Demand 94

Wealth 95Expected Returns 96Risk 96Liquidity 97Theory of Portfolio Choice 97

Benefits of Diversification 98Systematic Risk 100Risk Premiums: Capital Asset Pricing Model and Arbitrage

Pricing Theory 101Summary, Key Terms, Questions and Problems 102

CHAPTER 6 THE BEHAVIOR OF INTEREST RATES 104Preview 104Loanable Funds Framework: Supply and Demand in the

Bond Market 104Demand Curve 105Supply Curve 106Market Equilibrium 107Supply and Demand Analysis 108

Changes in Equilibrium Interest Rates 109Shifts in the Demand for Bonds 110Shifts in the Supply of Bonds 113Application Changes in the Equilibrium Interest Rate Due

to Expected Inflation or Business Cycle Expansions 115Application Reading the Wall Street Journal: The

"Credit Markets"Column 119

CONTENTS Xi

Following the Financial News The "Credit Markets"Column 120

Application Have Low Savings Rates in the United States Ledto Higher Interest Rates? 121

Liquidity Preference Framework: Supply and Demandin the Market for Money 122

Changes in Equilibrium Interest Rates 124Shifts in the Demand for Money 124Shifts in the Supply of Money 125Application Changes in the Equilibrium Interest Rate Due

to Changes in Income, the Price Level, or theMoney Supply 125

Application Money and Interest Rates I 28Following t h e F i n a n c i a l N e w s Forecasting I n t e r e s t R a t e s . . . . 1 3 2

Summary, Key Terms-, Questions and Problems 135Appendix to Chapter 6: Applying the Asset Market Approach

to a Commodity Market: The Case of Gold 137Application Changes in the Equilibrium Price of Gold Due to

a Rise in Expected Inflation 140Following the Financial News The "Commodities"Column . . . 141

Application Reading the Wall Street Journal: The

"Commodities" Column 142

CHAPTER 7 T H E RISK A N D T E R M S T R U C T U R E O F

I N T E R E S T R A T E S 143

Preview 143Risk Structure of Interest Rates 143

Default Risk 144Application The Stock Market Crash of 1987 and the

Junk Bond-Treasury Spread 147Application What If Treasury Securities Were No Longer

Default-Free? 148Liquidity 148Income Tax Considerations 149Summary 150Application Effects of the Clinton Tax Increase on Bond

Interest Rates I 50Term Structure of Interest Rates 151

Following the Financial News Yield Curves I 53Expectations Hypothesis 153Segmented Markets Theory 157Preferred Habitat and Liquidity Premium Theories 158Recent Evidence on the Term Structure 160Summary 160Application Interpreting Yield Curves, 1980-1997 161


xii CONTENTS

CHAPTERS THE FOREIGN EXCHANGE MARKET 165Preview 165Foreign Exchange Market 165

What Are Foreign Exchange Rates? 167Why Are Exchange Rates Important? 167Following the Financial News Foreign Exchange Rates 168

How Is Foreign Exchange Traded? 169Exchange Rates in the Long Run 169

Law of One Price I 70Theory of Purchasing Power Parity 170Why the Theory of Purchasing Power Parity Cannot Fully

Explain Exchange Rates 171Factors That Affect Exchange Rates in the Long Run I 72

Exchange Rates in the Short Run 1 74Comparing Expected Returns on Domestic and

Foreign Deposits 174Interest Parity Condition I 76Equilibrium in the Foreign Exchange Market 177

Explaining Changes in Exchange Rates 179Shifts in the Expected-Return Schedule for

Foreign Deposits I 79Shifts in the Expected-Return Schedule for

Domestic Deposits 181Application Changes in the Equilibrium Exchange Rate:

Two Examples 182

Application Why Are Exchange Rates So Volatile? 187

Application The Dollar and Interest Rates, 1973-1996 187

BOX 1 Forecasting Exchange Rates 188Application Reading the Wall Street Journal: The

"Foreign Exchange" Column 189

Folloiving the Financial News The "Foreign Exchange"

Column 190


PART III Financial Institutions 193

CHAPTER 9 AN ECONOMIC ANALYSIS OF

FINANCIAL STRUCTURE 195

Preview 195Basic Puzzles About Financial Structure Throughout

the World 195Transaction Costs 199

How Transaction Costs Influence Financial Structure 199How Financial Intermediaries Reduce Transaction Costs 200

Asymmetric Information: Adverse Selection and MoralHazard 201

CONTENTS XHii

The Lemons Problem: How Adverse Selection InfluencesFinancial Structure 201Lemons in the Stock and Bond Markets 202Tools to Help Solve Adverse Selection Problems 203

How Moral Hazard Affects the Choice Between Debt andEquity Contracts 207Moral Hazard in Equity Contracts: The Principal-AgentProblem 207Tools to Help Solve the Principal-Agent Problem 208'BOX f, "Hollywood Accounting": Has Forrest Gump Been

a Loser? 209How Moral Hazard Influences Financial Structure in

Debt Markets 210Tools to Help Solve Moral Hazard in Debt Contracts 211Summary 213Application Financial Development and

Economic Growth 213

Financial Crises and Aggregate Economic Activity 215Factors Causing Financial Crises 215

Application Financial Crises in the United States 217

Application Financial Crises in Developing Countries:

The Case of Mexico, 1994-1995 219

BOX Z Case Study of a Financial Crisis: The GreatDepression 220


CHAPTER i o THE BANKING FIRM AND THE MANAGEMENTOF FINANCIAL INSTITUTIONS 226Preview 226The Bank Balance Sheet 226

Liabilities 227Assets 229'BOX l ; Understanding Loan Loss Reserves 230

Basic Operation of a Bank 231General Principles of Bank Management 234

Liquidity Management and the Role of Reserves 235Asset Management 238Liability Management 239Capital Adequacy Management 240Application Strategies for Managing Bank Capital 243

Application Did the Capital Crunch Cause a Credit Crunch

in the Early 1990s? 243

Managing Credit Risk 244Screening and Monitoring 245Long-Term Customer Relationship 246Loan Commitments 247

C O N T E N T S

Collateral and Compensating Balances 247(BOX 2. Japanese and German Banking Arrangements: A Better

Way to Deal with Asymmetric Information? 248Credit Rationing 249

Managing Interest-Rate Risk 249Gap and Duration Analysis 250Application Strategies for Managing Interest-Rate Risk 251

Off-Balance-SheetActivities 252Loan Sales 252Generation of Free Income 252Trading Activities and Risk Management Techniques 253

(BOX 3: Barings, Daiwa, and Sumitomo: Rogue Traders andthe Principal-Agent Problem 254

Financial Innovation 255Responses to Changes in Demand Conditions 256Responses to Changes in Supply Conditions 257Avoidance of Existing Regulations 259


CHAPTER 11 BANKING INDUSTRY: STRUCTURE

AND COMPETITION 264Preview " 264Historical Development of the Banking System 264

Multiple Regulatory Agencies 267Structure of the U.S. Commercial Banking Industry 267

Restrictions on Branching 268Response to Branching Restrictions 269

Nationwide Banking and Bank Consolidation 271The Riegle-Neal Interstate Banking and Branching

Efficiency Act of 1994 272What Will the Structure of the U.S. Banking Industry Look

Like in the Future? 273BOX I. Comparison of Banking Structure in the United

States and Abroad 274Are Bank Consolidation and Nationwide Banking

Good Things? 274Separation of the Banking and Securities Industries 275

Repeal of the Glass-Steagall Act 278Separation of the Banking and Securities Industries in

Other Countries 278Thrift Industry: Regulation and Structure 278

Savings and Loan Associations 278Mutual Savings Banks 279Credit Unions 279

International Banking 280Eurodollar Market 281

CONTENTS XVi

BOX 2 Ironic Birth of the Eurodollar Market 282Structure of U.S. Banking Overseas 282Foreign Banks in the United States 283

Financial Innovation and the Decline of Traditional Banking 284Behind the Decline: Four Financial Innovations 284Decline of Traditional Banking 288Reasons for the Decline 288Banks' Responses 292Decline of Traditional Banking in Other Industrialized

Countries 293Summary, Key Terms, Questions and Problems 294

CHAPTER 12 ECONOMIC ANALYSIS OF BANKINGREGULATION 296Preview 296Asymmetric Information and Bank Regulation 296

Government Safety Net: Deposit Insurance andthe FDIC 297

BOX I A Tale of Two Bank Collapses: Bank of New Englandand Freedom National Bank 300

Restrictions on Asset Holdings and Bank CapitalRequirements 301

Bank Supervision: Chartering and Examination 302BOX 2 The Basel Accord on Risk-Based Capital

Requirements 303A New Trend in Bank Supervision: Assessment of

Risk Management 304Disclosure Requirements 305BOX 3 New Zealands Disclosure-Based Experiment in

Bank Regulation 306BOX 4 The Community Reinvestment Act: A Political

Hot Button 307Consumer Protection 307Restrictions on Competition 307Separation of the Banking and Securities Industries:

The Glass-Steagall Act 308International Banking Regulation 308

Problems in Regulating International Banking 310Summary 310BOX 5 The BCCI Scandal 311

The 1980s U.S. Banking Crisis: Why? 312Early Stages of the Crisis 312Later Stages of the Crisis: Regulatory Forbearance 314Competitive Equality in Banking Act of 1987 315

Political Economy of the Savings and Loan Crisis 315Principal-Agent Problem for Regulators and Politicians 316

CONTENTS

Application Principal-Agent Problem in Action: CharlesKeating and the Lincoln Savings and Loan Scandal 317

Savings and Loan Bailout: Financial Institutions Reform,Recovery, and Enforcement Act of 1989 318

Federal Deposit Insurance Corporation ImprovementAct of 1991 319BOX 6 The SAIF Fix and the Future of the S&L Industry 321Application Evaluating FDICIA and Other Proposed

Reforms of the Banking Regulatory System 322Banking Crises Throughout the World 326

Scandinavia 326Latin America 328Eastern Europe 328Japan 328"Deja Vu All Over Again" 329


CHAPTER 13 NONBANK FINANCIAL INSTITUTIONS 332Preview 332Insurance Companies 332

Ufe Insurance Companies 333Property and Casualty Insurance Companies 334The Competitive Threat from the Banking Industry 335BOX I The Woes of Lloyds of London 336BOX 2 Are Independent Insurance Agents Going the Way

of the Milkman? 337Application Insurance Management J 337

Pension Funds 341Private Pension Plans 342Public Pension Plans : 342BOX 3 Will Social Security Be Privatized? 343

Finance Companies 343Mutual Funds 345

Money Market Mutual Funds 346Government Financial Intermediation 346

Federal Credit Agencies 346Government Loan Guarantees: Another Crisis Waiting

to Happen? 347BOX 4 The Downside of Government Downsizing 348

Securities Market Institutions 348Investment Banks 348BOX 5 America Is Number One—at Least in

Investment Banking 349Following the Financial News New Securities Issues 350

Securities Brokers and Dealers 350Organized Exchanges 351


CONTENTS XViii

CHAPTER 14 FINANCIAL DERIVATIVES 354

Preview 354Forward Markets 354

Interest-Rate Forward Contracts 354Application Hedging with Interest-Rate Forward

Contracts 355

Pros and Cons of Forward Contracts 355Financial Futures Markets 356

Financial Futures Contracts 356Following the Financial News Financial Futures 357

Application Hedging with Financial Futures 359Organization of Trading in Financial Futures Markets 359The Globalization of Financial Futures Markets 360Explaining the Success of Futures Markets 360BOX i: The Hunt Brothers and the Silver Crash 363Some Problems with Financial Futures Markets 364

Stock Index Futures 365BOX 2. Program Trading and Portfolio Insurance: Were They

to Blame for the Stock Market Crash of 1987? 366Stock Index Futures Contracts 366

Options 367Following the Financial News Futures Options 368Option Contracts 368Profits and Losses on Option and Futures Contracts 369Application Hedging with Futures Options 372Factors Affecting the Prices of Option Premiums 373Summary 375

Interest-Rate Swaps 375Interest-Rate Swap Contracts 375Application Hedging with Interest-Rate Swaps 376Advantages of Interest-Rate Swaps 377Disadvantages of Interest-Rate Swaps 377Financial Intermediaries in Interest-Rate Swaps 378Application Hedging Foreign Exchange Risk 379

Application Are Financial Derivatives a Worldwide

Time Bomb? 382

BOX 3 The Orange County Bankruptcy 383Summary, Key Terms, Questions and Problems 384

PART IV Central Banking and the Conductof Monetary Policy 387

CHAPTER 15 STRUCTURE OF CENTRAL BANKS AND THEFEDERAL RESERVE SYSTEM 389

Preview 389Origins of the Federal Reserve System 389

xviii CONTENTS

CHAPTER 16

Formal Structure of the Federal Reserve System 390BOX 1 INSIDE THE FED The Political Genius of the

Founders of the Federal Reserve System 391Federal Reserve Banks 391BOX 2 INSIDE THE FED Special Role of the Federal Reserve

Bank of New York 394Member Banks 394Board of Governors of the Federal Reserve System 395Federal Open Market Committee (FOMC) 396BOX 3 INSIDE THE FED Role of the Research Staff 397The FOMC Meeting 398BOX 4 INSIDE THE FED Green, Blue, and Beige 399

Informal Structure of the Federal Reserve System 399BOX 5 INSIDE THE FED Decoding the FOMC Derivative 400BOX 6 INSIDE THE FED Role of Member Banks in the

Federal Reserve System 402How Independent Is the Fed? 403Structure and Independence of Foreign Central Banks 405

Bank of England 405Deutsche Bundesbank 406Bank of Canada 406Bank of Japan 406The Trend Toward Greater Independence 407

Explaining Central Bank Behavior 407Should the Fed Be Independent? 408

The Case for Independence 408BOX 7 INSIDE THE FED Games the Fed Plays 409The Case Against Independence 410Central Bank Independence and Macroeconomic

Performance in Seventeen Countries 411Summary, Key Terms, Questions and Problems 412

MULTIPLE DEPOSIT CREATION AND THEMONEY SUPPLY PROCESS 414Preview 414Four Players in the Money Supply Process 414The Fed's Balance Sheet and the Monetary Base 415

Assets 415Liabilities 415Monetary Base 417

Control of the Monetary Base 418Federal Reserve Open Market Operations 418BOX I Foreign Exchange Rate Intervention and the

Monetary Base 423Shifts from Deposits into Currency 423

• Discount Loans 424

CONTENTS XiX

Overview of the Feds Ability to Control theMonetary Base 425

Multiple Deposit Creation: A Simple Model 425Deposit Creation: The Single Bank 425Deposit Creation: The Banking System 427Multiple Deposit Contraction 430Deriving the Formula for Multiple Deposit Creation 431Critique of the Simple Model 433

Summary. Key Terms, Questions and Problems 433

CHAPTER 17 DETERMINANTS OF THE MONEY SUPPLY 435Preview 435The Money Supply Model and the Money Multiplier 436

Deriving the Money Multiplier 436Intuition Behind the Money Multiplier 438

Factors That Determine the Money Multiplier 439Changes in the Required Reserve Ratio rD 439Changes in the Currency Ratio {C/D} 440Changes in the Excess Reserves Ratio {ER/D} 441

Additional Factors That Determine the Money Supply 444Changes in the Nonborrowed Monetary Base MBn 444Changes in Discount Loans DL from the Fed 444Market Interest Rates and the Discount Rate 445

Overview of the Money Supply Process 445Application Explaining Movements in the Money Supply,

1980-1996 447Application The Great Depression Bank Panics,

1930-1933 449Summary, Key Terms, Questions and Problems 453Appendix to Chapter 17: The M2 Money Multiplier 455

CHAPTER is TOOLS OF MONETARY POLICY 458Preview 458Open Market Operations 458

A Day at the Trading Desk 459Advantages of Open Market Operations 461

Discount Policy 461Operation of the Discount Window 461BOX 1 INSIDE THE FED Why Has Adjustment Credit

Borrowing Shrunk to Such Low Levels in the 1990s? 462Lender of Last Resort 464BOX 2 INSIDE THE FED Discounting to Troubled Banks:

Franklin National and Continental Illinois 464BOX 3 INSIDE THE FED Discounting to Prevent a Financial

Panic: The Black Monday Stock Market Crash of 1987 . . . . 466Announcement Effect 467Advantages and Disadvantages of Discount Policy 467

XX. CONTENTS

Application Evaluating Proposed Reforms ofDiscount Policy 467

Reserve Requirements 469

Advantages and Disadvantages of ReserveRequirement Changes 469

Application Evaluating Proposed Reforms ofReserve Requirements 470

Application Why Have Reserve Requirements BeenDeclining Worldwide? 471


CHAPTER 19 CONDUCT OF MONETARY POLICY:GOALS AND TARGETS 474Preview 474Goals of Monetary Policy 474

High Employment 474Economic Growth 475Price Stability 476Interest-Rate Stability 476Stability of Financial Markets 476(BOX~0 The Growing European Commitment to

Price Stability 477Stability in Foreign Exchange Markets 477ConflictAmong Goals 477

Central Bank Strategy: Use of Targets 478Choosing the Targets 480

Criteria for Choosing Intermediate Targets 481Criteria for Choosing Operating Targets 483

Fed Policy Procedures: Historical Perspective 483The Early Years: Discount Policy as the Primary Tool 484Discovery of Open Market Operations 484The Great Depression 485Reserve Requirements as a Policy Tool 485BOX 2 INSIDE THE FED Bank Panics of 1930-1933:

Why Did the Fed Let Them Happen? 486War Finance and the Pegging of Interest Rates:

1942-1951 487Targeting Money Market Conditions: The 1950s

and 1960s 487Targeting Monetary Aggregates: The 1970s 489New Fed Operating Procedures: October 1979-

October 1982 490Deemphasis of Monetary Aggregates: October 1982-

Early 1990s 492Federal Funds Targeting Again: Early 1990s and Beyond 493

CONTENTS XXii

International Considerations 493BOX 3: International Policy Coordination: The Plaza

Agreement and the Louvre Accord 494Monetary Targeting in Other Countries 494

United Kingdom 495Canada 495Germany 496Japan 496Lessons from Monetary Targeting Experiences 497

The New International Trend in Monetary Policy Strategy:Inflation Targeting 498New Zealand 498Canada 499United Kingdom 499Lessons from Inflation Targeting Experiences 499


CHAPTER 20 THE INTERNATIONAL FINANCIAL SYSTEM 502Preview 502

Intervention in the Foreign Exchange Market 502Foreign Exchange Intervention and the Money Supply 502BOX I INSIDE THE FED A Day at the Federal Reserve Bank

of New York's Foreign Exchange Desk 504Unsterilized Intervention 505Sterilized Intervention 506

Balance of Payments 507Current Account 508Following the Financial News The Balance of Payments 509Capital Account 510Official Reserve Transactions Balance 510Methods of Financing the Balance of Payments 511

Evolution of the International Financial System 511Gold Standard • 511Bretton Woods System and the IMF 512Box 2,Argentinas Currency Board 516Managed Float 517European Monetary System (EMS) 518

Application September 1992 Foreign Exchange Crisis 519Application Mexican Peso Crisis of December 1994 520

International Considerations and Monetary Policy 521Direct Effects of the Foreign Exchange Market on the

Money Supply 522Balance-of-Payments Considerations 522Exchange Rate Considerations 523


xxii CONTENTS

PARTV Monetary Policy 527

CHAPTER 21 THE DEMAND FOR MONEY 529Preview 529Quantity Theory of Money 529

Velocity of Money and Equation of Exchange 530Quantity Theory 531Quantity Theory of Money Demand 531

Cambridge Approach to Money Demand 532Is Velocity a Constant? 533Keyness Liquidity Preference Theory 535

Transactions Motive 535Precautionary Motive 535Speculative Motive 535Putting the Three Motives Together 536

Further Developments in the Keynesian Approach 539Transactions Demand 539Precautionary Demand 542Speculative Demand 542

Friedman's Modern Quantity Theory of Money 544Distinguishing Between the Friedman and Keynesian

Theories 545Empirical Evidence on the Demand for Money 548

Interest Rates and Money Demand 548Stability of Money Demand 550


CHAPTER 22 THE KEYNESIAN FRAMEWORK AND

THE ISLM MODEL 555Preview 555Determination of Aggregate Output 555

Consumer Expenditure and the Consumption Function 557Investment Spending 558BOX I Meaning of the Word Investment 559Equilibrium and the Keynesian Cross Diagram 560Expenditure Multiplier 561Application The Collapse of Investment Spending and

the Great Depression 564Governments Role 564Role of International Trade 567Summary of the Determinants of Aggregate Output 567

The ISLM Model 571Equilibrium in the Goods Market: The IS Curve 571Equilibrium in the Market for Money: The LM Curve 575

ISLM Approach to Aggregate Output and Interest Rates 577Summary, Key Terms, Questions and Problems 578

CONTENTS xxiiiI

CHAPTER 23 MONETARY AND FISCAL POLICY IN THE

ISLM MODEL 580Preview 580Factors That Cause the IS Curve to Shift 581Factors That Cause the LM Curve to Shift 583Changes in Equilibrium Level of the Interest Rate and

Aggregate Output 585Response to a Change in Monetary Policy 585Response to a Change in Fiscal Policy 586Application The Vietnam War Buildup and the Rise in

Interest Rates, 1965-1966 588Effectiveness of Monetary Versus Fiscal Policy 590

Monetary Policy Versus Fiscal Policy: The Case ofComplete Crowding Out 590

Application Targeting Money Supply Versus

Interest Rates 592ISLM Model in the Long Run 596ISLM Model and the Aggregate Demand Curve 598

Deriving the Aggregate Demand Curve 598Factors That Cause the Aggregate Demand Curve

to Shift 599Summary, Key Terms, Questions and Problems 601

CHAPTER 24 AGGREGATE DEMAND AND SUPPLY ANALYSIS 603Preview 603Aggregate Demand 603

Following the Financial News Aggregate Output,

Unemployment, and the Price Level 604

Monetarist View of Aggregate Demand 604Keynesian View of Aggregate Demand 606The Crowding-Out Debate 607

Aggregate Supply 608Shifts in the Aggregate Supply Curve 609

Equilibrium in Aggregate Supply and Demand Analysis 610Equilibrium in the Short Run 610Equilibrium in the Long Run 611Shifts in Aggregate Demand 614Shifts in Aggregate Supply 616Shifts in the Long-Run Aggregate Supply Curve: Real

Business Cycle Theory and Hysteresis 617Conclusions 620Application Explaining Past Business Cycle Episodes 620Application Predicting Future Economic Activity 622

Summary, Key Terms, Questions and Problems 623Appendix to Chapter 24: Aggregate Supply and the Phillips

Curve: Historical Perspective 625

XXiV CONTENTS

CHAPTER 25 TRANSMISSION MECHANISMS OF MONETARYPOLICY: THE EVIDENCE 629Preview 629Framework for Evaluating Empirical Evidence 630

Structural Model Evidence 630

Reduced-Form Evidence 631Advantages and Disadvantages of Structural

Model Evidence 631Advantages and Disadvantages of Reduced-

Form Evidence 632'BOX I) Perils of Reverse Causation: A Russian Folk Tale 633Conclusions 633BOX X Perils of Ignoring an Outside Driving Factor:

How to Lose a Presidential Election 634Early Keynesian Evidence on the Importance of Money 634

Objections to Early Keynesian Evidence 635Early Monetarist Evidence on the Importance of Money 637

Timing Evidence 638Statistical Evidence 641Historical Evidence 642

Overview of the Monetarist Evidence 643Transmission Mechanisms of Monetary Policy 643

.'BOX X Real Business Cycle Theory and the Debate onMoney and Economic Activity 644

Traditional Interest-Rate Channels 644Other Asset Price Channels 647Credit View 649'BOX 4) Consumers' Balance Sheets and the

Great Depression 652Why Are Credit Channels Likely to Be Important? 653Application Credit Crunch and Slow Recovery from the

1990-1991 Recession 653Lessons for Monetary Policy 654Summary, Key Terms, Questions and Problems 656

CHAPTER 26 MONEY AND INFLATION 659Preview 659Money and Inflation: Evidence 659

German Hyperinflation, 1921-1923 660BOX [;. Inflation and Money Growth Rates in Latin America,

1986-1996 661Recent Episodes of Rapid Inflation 662

Meaning of Inflation 663Views of Inflation 663

Monetarist View 663Keynesian View 664

CONTENTS XXVi

Summary 667Origins of Inflationary Monetary Policy 667

High Employment Targets and Inflation 668Budget Deficits and Inflation 671Application Explaining the Rise in U.S. Inflation,

1960-1980 675

Actrvist/Nonactivist Policy Debate 679Responses to High Unemployment 679Activist and Nonactivist Positions 680Expectations and the Activist/Nonactivist Debate 681

^BOX % Peri's of Accommodating Policy: The TerrorismDilemma 683

Rules Versus Discretion: Conclusions 683Application Importance of Credibility to Volcker's Victory

over Inflation 684


CHAPTER 27 THEORY OF RATIONAL EXPECTATIONS

AND EFFICIENT CAPITAL MARKETS 686Preview 686Role of Expectations in Economic Activity 687Theory of Rational Expectations • 689

Formal Statement of the Theory 691Rationale Behind the Theory 691Implications of the Theory 692

Efficient Markets Theory: Rational Expectations inFinancial Markets 692Rationale Behind the Theory 694Stronger Version of Efficient Markets Theory 695

Evidence on Efficient Markets Theory 695Evidence in Favor of Market Efficiency 696BOX 1 An Exception That Proves the Rule: Ivan Boesky 697Application Should Foreign Exchange Rates Follow

a Random Walk? 699

Evidence Against Market Efficiency 699Overview of the Evidence on Efficient Markets Theory 701Application Practical Guide to Investing in the

Stock Market 702

Following the Financial Netvs Stock Prices 703

..BOX 2 Should You Hire an Ape as YourInvestment Adviser? 704

Evidence on Rational Expectations in Other Markets 705Application What Does the Stock Market Crash of 1987

Tell Us About Rational Expectations and

Efficient Markets? 707


XXVI CONTENTS

CHAPTER 28 RATIONAL EXPECTATIONS: IMPLICATIONSFOR POLICY 710Preview 710The Lucas Critique of Policy Evaluation 711

Econometric Policy Evaluation 711Example: The Term Structure of Interest Rates 712

New Classical Macroeconomic Model 713Effects of Unanticipated and Anticipated Policy 713

(BQXj) Proof of the Policy Ineffectiveness Proposition 715Can an Expansionary Policy Lead to a Decline in

Aggregate Output? 716Implications for Policymakers 717

New Keynesian Model 717Effects of Unanticipated and Anticipated Policy 718Implications for Policymakers 720

Comparison of the Two New Models with theTraditional Model 720Short-Run Output and Price Responses 721Stabilization Policy 722Anti-inflation Policies 724Credibility in Fighting Inflation 727

(BOX 2) Ending the Bolivian Hyperinflation: Case Study of aSuccessful Anti-inflation Program 728

Application Credibility and the Reagan

Budget Deficits 728Impact of the Rational Expectations Revolutions 729Summary, Key Terms, Questions and Problems 731

MATHEMATICAL APPENDLX TO CHAPTER 21:A Mathematical Treatment of the Baumol-Tobinand Tobin Mean Variance Models MA-1

MATHEMATICAL APPENDLX TO CHAPTER 23:Algebra of the ISLM Model MA-7

GLOSSARY G-lANSWERS TO SELECTED QUESTIONS AND

PROBLEMS A-lCREDITS C-l

INDEX 1-1

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