Finance, Banking, and Money v 2.0 This is the book Finance, Banking, and Money (v 2.0) 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 Author Acknowledgments Preface Chapter 1: Money, Banking, and Your World Dreams Dashed Hope Springs 11 Suggested Browsing 14 Suggested Reading 15 Chapter 2: The Financial System 16 Evil and Brilliant Financiers? 17 Financial Systems 19 Asymmetric Information: The Real Evil 22 Financial Instruments 25 Financial Markets 28 Financial Intermediaries 32 Competition Between Markets and Intermediaries 36 Regulation 39 Suggested Reading 41 Chapter 3: Money 42 Of Love, Money, and Transactional Efficiency 43 Better to Have Had Money and Lost It Than to Have Never Had Money at All 48 A Short History of Moolah 51 Commodity and Credit Monies 54 Measuring Money 61 Suggested Reading 63 iii Chapter 4: Interest Rates 64 The Interest of Interest 65 Present and Future Value 66 Compounding Periods 72 Pricing Debt Instruments 74 What’s the Yield on That? 79 Calculating Returns 83 Inflation and Interest Rates 86 Suggested Reading 89 Chapter 5: The Economics of Interest-Rate Fluctuations 90 Interest Rate Fluctuations 91 Shifts in Supply and Demand for Bonds 97 Predictions and Effects 105 Suggested Reading 108 Chapter 6: The Economics of Interest-Rate Spreads and Yield Curves 109 Interest-Rate Determinants I: The Risk Structure 110 The Determinants of Interest Rates II: The Term Structure 117 Suggested Reading 124 Chapter 7: Rational Expectations, Efficient Markets, and the Valuation of Corporate Equities 125 The Theory of Rational Expectations 126 Valuing Corporate Equities 130 Financial Market Efficiency 135 Evidence of Market Efficiency 142 Suggested Reading 150 Chapter 8: Financial Structure, Transaction Costs, and Asymmetric Information 151 The Sources of External Finance 152 Transaction Costs, Asymmetric Information, and the Free-Rider Problem 155 Adverse Selection 160 Moral Hazard 166 Agency Problems 170 Suggested Reading 176 iv Chapter 9: Bank Management 177 The Balance Sheet 178 Assets, Liabilities, and T-Accounts 182 Bank Management Principles 187 Credit Risk 196 Interest-Rate Risk 200 Off the Balance Sheet 206 Suggested Reading 208 Chapter 10: Innovation and Structure in Banking and Finance 209 Early Financial Innovations 210 Innovations Galore 213 Loophole Mining and Lobbying 216 Banking on Technology 219 Banking Industry Profitability and Structure 223 Suggested Reading 231 Chapter 11: The Economics of Financial Regulation 232 Market Failures and Public Choice 233 The Great Depression as Regulatory Failure 238 The Savings and Loan Regulatory Debacle 243 Better but Still Not Good: U.S Regulatory Reforms 248 Basel II, Basel III, and Dodd-Frank 251 Suggested Reading 256 Chapter 12: Financial Derivatives 257 Derivatives and Their Functions 258 Forwards and Futures 260 Options and Swaps 263 Suggested Reading 266 Chapter 13: Financial Crises: Causes and Consequences 267 Financial Crisis Taxonomies 268 Asset Bubbles 275 Financial Panics 279 Lender of Last Resort (LLR) 282 Bailouts and Resolutions 285 The Crisis of 2007-2009 287 Suggested Reading 294 v Chapter 14: Central Bank Form and Function 295 America’s Central Banks 296 The Federal Reserve System’s Structure 300 Other Important Central Banks 303 Central Bank Independence 305 Suggested Reading 310 Chapter 15: The Money Supply Process and the Money Multipliers 311 The Central Bank’s Balance Sheet 312 Open Market Operations 315 A Simple Model of Multiple Deposit Creation 320 A More Sophisticated Money Multiplier for M1 325 The M2 Money Multiplier 333 Summary and Explanation 336 Suggested Reading 339 Chapter 16: Monetary Policy Tools 340 The Federal Funds Market and Reserves 341 Open Market Operations and the Discount Window 346 The Monetary Policy Tools of Other Central Banks 351 Suggested Reading 353 Chapter 17: Monetary Policy Targets and Goals 354 A Short History of Fed Blunders 355 Central Bank Goal Trade-offs 360 Central Bank Targets 362 The Taylor Rule 366 Suggested Reading 372 Chapter 18: Foreign Exchange 373 The Economic Importance of Currency Markets 374 Determining the Exchange Rate 378 Long-Run Determinants of Exchange Rates 382 Short-Run Determinants of Exchange Rates 386 Modeling the Market for Foreign Exchange 394 Suggested Reading 398 vi Chapter 19: International Monetary Regimes 399 The Trilemma, or Impossible Trinity 400 Two Systems of Fixed Exchange Rates 404 The Managed or Dirty Float 408 The Choice of International Policy Regime 413 Suggested Reading 419 Chapter 20: Money Demand 420 The Simple Quantity Theory and the Liquidity Preference Theory of Keynes 421 Friedman’s Modern Quantity Theory of Money 425 The Policy Failure of the Modern Quantity Theory of Money 428 Suggested Reading 433 Chapter 21: IS-LM 434 Aggregate Output and Keynesian Cross Diagrams 435 The IS-LM Model 444 Suggested Reading 450 Chapter 22: IS-LM in Action 451 Shifting Curves: Causes and Effects 452 Implications for Monetary Policy 456 Aggregate Demand Curve 459 Suggested Reading 461 Chapter 23: Aggregate Supply and Demand and the Growth Diamond 462 Aggregate Demand 463 Aggregate Supply 466 Equilibrium Analysis 469 The Growth Diamond 474 Suggested Reading 479 Chapter 24: Monetary Policy Transmission Mechanisms 480 Modeling Reality 481 How Important Is Monetary Policy? 485 Transmission Mechanisms 488 Suggested Reading 493 Chapter 25: Inflation and Money 494 Empirical Evidence of a Money-Inflation Link 495 Why Have Central Bankers So Often Gotten It Wrong? 501 Suggested Reading 505 vii Chapter 26: Rational Expectations Redux: Monetary Policy Implications 506 Rational Expectations 507 New Keynesians 511 Inflation Busting 514 Suggested Reading 517 viii About the Author 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 The recession in the early 1980s also injured my family’s material welfare and was seared into my brain My only vivid, 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 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 Temple University, the University of Virginia, sundry liberal arts colleges, New York University’s Stern School of Business, and, since 2009, Augustana College (the one in South Dakota, not the one in Illinois), where I am additionally the director of the Thomas Willing Institute for the Study of Financial Markets, Institutions, and Regulations I’ve also been an active researcher, editing, authoring, and coauthoring 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), publishing (Knowledge for Generations), bailouts (Bailouts), public policy (Fubarnomics), and investments (The Wall Street Journal Guide to the 50 Economics Indicators That Really Matter) 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 talk radio stations, 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 op-eds and make regular public speaking appearances nationally and, increasingly, internationally I am also active in the Museum of American Finance and sit on the editorial board of its magazine, Financial History About the Author 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 ... didn’t lack intelligence, and he wasn’t even atypical Many people, even some otherwise well-educated ones, not understand the basics of money, banking, and finance And they and their loved ones pay... understand the principles of money and banking A contract that promises to pay a sum of money to beneficiaries upon the death of an insured person 1.1 Dreams Dashed Chapter Money, Banking, and Your... Describe how ignorance of the principles of money and banking has injured the lives of everyday people Describe how understanding the principles of money and banking has enhanced the lives of everyday