Finance, Banking, and Money v 1.1 This is the book Finance, Banking, and Money (v 1.1) This book is licensed under a Creative Commons by-nc-sa 3.0 (http://creativecommons.org/licenses/by-nc-sa/ 3.0/) license See the license for more details, but that basically means you can share this book as long as you credit the author (but see below), don't make money from it, and make it available to everyone else under the same terms This book was accessible as of December 29, 2012, and it was downloaded then by Andy Schmitz (http://lardbucket.org) in an effort to preserve the availability of this book Normally, the author and publisher would be credited here However, the publisher has asked for the customary Creative Commons attribution to the original publisher, authors, title, and book URI to be removed Additionally, per the publisher's request, their name has been removed in some passages More information is available on this project's attribution page (http://2012books.lardbucket.org/attribution.html?utm_source=header) For more information on the source of this book, or why it is available for free, please see the project's home page (http://2012books.lardbucket.org/) You can browse or download additional books there ii Table of Contents About the Authors Acknowledgments Preface Chapter 1: Money, Banking, and Your World Dreams Dashed Hope Springs Suggested Browsing 11 Suggested Reading 12 Chapter 2: The Financial System 13 Evil and Brilliant Financiers? 14 Financial Systems 16 Asymmetric Information: The Real Evil 19 Financial Markets 22 Financial Intermediaries 26 Competition Between Markets and Intermediaries 30 Regulation 32 Suggested Reading 34 Chapter 3: Money 35 Of Love, Money, and Transactional Efficiency 36 Better to Have Had Money and Lost It Than to Have Never Had Money at All 41 A Short History of Moolah 44 Commodity and Credit Monies 47 Measuring Money 53 Suggested Reading 55 Chapter 4: Interest Rates 56 The Interest of Interest 57 Present and Future Value 58 Compounding Periods 64 Pricing Debt Instruments 66 What’s the Yield on That? 71 Calculating Returns 75 Inflation and Interest Rates 78 Suggested Reading 81 iii Chapter 5: The Economics of Interest-Rate Fluctuations 82 Interest Rate Fluctuations 83 Shifts in Supply and Demand for Bonds 87 Liquidity Preference 95 Predictions and Effects 100 Suggested Reading 103 Chapter 6: The Economics of Interest-Rate Spreads and Yield Curves 104 A Short History of Interest Rates 105 Interest-Rate Determinants I: The Risk Structure 108 The Determinants of Interest Rates II: The Term Structure 114 Suggested Reading 120 Chapter 7: Rational Expectations, Efficient Markets, and the Valuation of Corporate Equities 121 The Theory of Rational Expectations 122 Valuing Corporate Equities 126 Financial Market Efficiency 132 Evidence of Market Efficiency 138 Suggested Reading 145 Chapter 8: Financial Structure, Transaction Costs, and Asymmetric Information 146 The Sources of External Finance 147 Transaction Costs, Asymmetric Information, and the Free-Rider Problem 150 Adverse Selection 154 Moral Hazard 160 Agency Problems 164 Suggested Reading 170 Chapter 9: Bank Management 171 The Balance Sheet 172 Assets, Liabilities, and T-Accounts 175 Bank Management Principles 180 Credit Risk 190 Interest-Rate Risk 194 Off the Balance Sheet 199 Suggested Reading 201 iv Chapter 10: Innovation and Structure in Banking and Finance 202 Early Financial Innovations 203 Innovations Galore 206 Loophole Mining and Lobbying 209 Banking on Technology 212 Banking Industry Profitability and Structure 216 Suggested Reading 224 Chapter 11: The Economics of Financial Regulation 225 Public Interest versus Private Interest 226 The Great Depression as Regulatory Failure 230 The Savings and Loan Regulatory Debacle 235 Better but Still Not Good: U.S Regulatory Reforms 240 Basel II’s Third Pillar 243 Suggested Reading 248 Chapter 12: The Financial Crisis of 2007–2009 249 Financial Crises 250 Asset Bubbles 253 Financial Panics 257 Lender of Last Resort 260 Bailouts 263 The Crisis of 2007–2008 265 Suggested Reading 271 Chapter 13: Central Bank Form and Function 272 America’s Central Banks 273 The Federal Reserve System’s Structure 277 Other Important Central Banks 280 Central Bank Independence 282 Suggested Reading 286 Chapter 14: The Money Supply Process 287 The Central Bank’s Balance Sheet 288 Open Market Operations 290 A Simple Model of Multiple Deposit Creation 295 Suggested Reading 300 v Chapter 15: The Money Supply and the Money Multiplier 301 A More Sophisticated Money Multiplier for M1 302 The M2 Money Multiplier 310 Summary and Explanation 313 Suggested Reading 316 Chapter 16: Monetary Policy Tools 317 The Federal Funds Market and Reserves 318 Open Market Operations and the Discount Window 323 The Monetary Policy Tools of Other Central Banks 327 Suggested Reading 329 Chapter 17: Monetary Policy Targets and Goals 330 A Short History of Fed Blunders 331 Central Bank Goal Trade-offs 336 Central Bank Targets 338 The Taylor Rule 342 Suggested Reading 347 Chapter 18: Foreign Exchange 348 The Economic Importance of Currency Markets 349 Determining the Exchange Rate 352 Long-Run Determinants of Exchange Rates 356 Short-Run Determinants of Exchange Rates 360 Modeling the Market for Foreign Exchange 368 Suggested Reading 372 Chapter 19: International Monetary Regimes 373 The Trilemma, or Impossible Trinity 374 Two Systems of Fixed Exchange Rates 378 The Managed or Dirty Float 382 The Choice of International Policy Regime 387 Suggested Reading 393 Chapter 20: Money Demand 394 The Quantity Theory 395 Liquidity Preference Theory 399 Head to Head: Friedman versus Keynes 403 Suggested Reading 409 vi Chapter 21: IS-LM 410 Aggregate Output and Keynesian Cross Diagrams 411 The IS-LM Model 420 Suggested Reading 426 Chapter 22: IS-LM in Action 427 Shifting Curves: Causes and Effects 428 Implications for Monetary Policy 432 Aggregate Demand Curve 435 Suggested Reading 437 Chapter 23: Aggregate Supply and Demand, the Growth Diamond, and Financial Shocks 438 Aggregate Demand 439 Aggregate Supply 442 Equilibrium Analysis 445 The Growth Diamond 449 Financial Shocks 454 Suggested Reading 459 Chapter 24: Monetary Policy Transmission Mechanisms 460 Modeling Reality 461 How Important Is Monetary Policy? 465 Transmission Mechanisms 468 Suggested Reading 473 Chapter 25: Inflation and Money 474 Empirical Evidence of a Money-Inflation Link 475 Why Have Central Bankers So Often Gotten It Wrong? 481 Suggested Reading 485 Chapter 26: Rational Expectations Redux: Monetary Policy Implications 486 Rational Expectations 487 New Keynesians 490 Inflation Busting 493 Suggested Reading 496 vii About the Authors About Robert E Wright I attribute my enduring interest in money and banking, political economy, and economic history to the troubled economic conditions of my youth Born in 1969 in Rochester, New York, to two self-proclaimed factory rats, I recall little of my earliest days except the Great Inflation and oil embargo, which stretched the family budget past the breaking point My only other noneconomic memories are of the Planet of the Apes films (all five of them!) and the 1972 Olympics massacre in Munich; my very young mind conflated the two because of the aural similarity of the words gorilla and guerilla The recession in the early 1980s also injured my family’s material welfare and was seared into my brain After taking degrees in history from Buffalo State College (B.A., 1990) and the University of Buffalo (M.A., 1994; Ph.D., 1997), I began teaching a variety of courses in business, economics, evolutionary psychology, finance, history, and sociology at a variety of schools until 2009, when I became the Nef Family Chair of Political Economy at Augustana College in Sioux Falls, South Dakota I’ve also been an active researcher, editing, authoring, and co-authoring books about the development of the U.S financial system (Origins of Commercial Banking, Hamilton Unbound, Wealth of Nations Rediscovered, The First Wall Street, Financial Founding Fathers, One Nation Under Debt), construction economics (Broken Buildings, Busted Budgets), life insurance (Mutually Beneficial), and publishing (Knowledge for Generations) Due to my unique historical perspective on public policies and the financial system, I’ve also become something of a media maven, showing up on NPR and other radio shows, as well as various television programs, and getting quoted in major newspapers like the Wall Street Journal, New York Times, Chicago Tribune, and the Los Angeles Times I publish opeds and make regular public speaking appearances nationally and, increasingly, internationally, and I serve as director of the Thomas Willing Institute for the Study of Financial Markets, Institutions and Regulations I wrote this textbook because I strongly believe in the merits of financial literacy for all Our financial system struggles sometimes in part because so many people remain feckless financially My hope is that people who read this book carefully, dutifully complete the exercises, and attend class regularly will be able to follow the financial news and even critique it when necessary I also hope they will make informed choices in their own financial lives About the Authors About Dr Vincenzo Quadrini I was born and raised in a small town in the Marche region in Italy In 1990 I received a B.A in Economics and Business from Ancona University and in 1991 a one-year Master in Economics from Coripe-Piemonte in Turin After fulfilling a oneyear mandatory military service between 1991 and 1992, I moved to the United States to start my Ph.D in Economics at the University of Pennsylvania, where I graduated in 1996 Since my Ph.D graduation I have been teaching at several institutions: Pompeu Fabra University in Barcelona, Duke University, New York University, and University of Southern California I have been teaching courses on monetary economics, macroeconomics, international trade, and international finance My research interests are in similar topics, and since my graduation in 1996 I have published several articles in scholarly journals including American Economic Review, Journal of Monetary Economics, Journal of Political Economy, and Review of Economic Studies My current research projects focus on the macroeconomic impact of credit and financial shocks similar to the ones that are currently affecting the U.S economy I am also interested in understanding how these shocks are propagated internationally to other economies Another research interest focuses on the understanding of how differences in financial markets across countries can lead to large financial imbalances, that is, a situation in which some countries, like the United States, borrow heavily from other countries like China and Japan Acknowledgments Many people have helped to make this project a reality At Unnamed Publisher, Shannon Gattens and Jeff Shelstad helped to shepherd the concept and the manuscript through the standard trials and tribulations Along the way, a score of anonymous academic readers helped to keep our economic analyses and prose on the straight and narrow Paul Wachtel and Richard Sylla, two colleagues at New York University’s Stern School of Business, also aided us along the way with measured doses of praise and criticism We thank them all Thanks too to the University of Virginia’s Department of Economics, especially the duo of economic historians and “money guys” there, Ron Michener and John James, for putting up with Wright one very hot summer in Charlottesville Very special thanks go to the members of Wright’s Summer I 2007 Money and Banking class at the University of Virginia, who suffered through a free but error-prone first draft, mostly with good humor and always with helpful comments: Kevin Albrecht, Adil Arora, Eric Bagden, Michelle Coffey, Timothy Dalbey, Karina Delgadillo, Christopher Gorham, Joshua Hefner, Joseph Henderson, Jamie Jackson, Anthony Jones, Robert Jones, Risto Keravuori, Heather Koo, Sonia Kwak, Yiding Li, Patrick Lundquist, Maria McLemore, Brett Murphy, Daniel Park, Bensille Parker, Rose Phan, Patrick Reams, Arjun Sharma, Cole Smith, Sandy Su, Paul Sullivan, Nedim Umur, Will van der Linde, Neal Wood, and June Yang The students and professors who provided feedback on version 1.0 of this book also have our hearty gratitude It’s customary at this point for authors to assume full responsibility for the facts and judgments in their books We will not buck that tradition: the buck stops here! Unlike a journal article or academic monograph, textbooks afford ample room for revision in subsequent editions, of which we hope there will be many So if you spot a problem, contact the publisher and we’ll fix it at the earliest (economically justifiable) opportunity Robert E Wright, January 2011, Sioux Falls, South Dakota Vincenzo Quadrini, February 2009, Los Angeles, California ... 300 v Chapter 15 : The Money Supply and the Money Multiplier 3 01 A More Sophisticated Money Multiplier for M1 302 The M2 Money Multiplier 310 Summary and Explanation... simultaneously be entrepreneurs and lend to entrepreneurs Chapter Money, Banking, and Your World 1. 1 Dreams Dashed LEARNING OBJECTIVE How can ignorance of the principles of money and banking destroy your... Nation (20 01) ,www.amazon.com/Fast-Food-NationEric-Schlosser/dp/0060838582/sr=8 -1/ qid =11 68386508/ref=pd_bbs_sr _1/ 10 4-979 510 5-9365527?ie=UTF8&s=books as obsolete as The Jungle (19 01) ,http://sinclair.thefreelibrary.com/Jungle;http://sunsite.berkeley.edu/