THE ECONOMICS OF MONEY, BANKING, AND FINANCIAL MARKETS FREDERIC S. MISHKIN APOSTOLOS SERLETIS COLUMBIA UNIVERSITY UNIVERSITY OF CALGARY THE ECONOMICS OF MONEY, BANKING, AND FINANCIAL MARKETS FOURTH CANADIAN EDITION PearsonCanada Toronto ToAglaia LibraryandArchivesCanadaCataloguinginPublication Mishkin,FredericS. Theeconomicsofmoney,bankingandfinancialmarkets/FredericS. Mishkin,ApostolosSerletis. 4thCanadianed. Includesbibliographicalreferencesandindex. ISBN978-0-321-58471-7 1.Finance Textbooks. 2.Money Textbooks. 3.Banksandbanking Textbooks. I.Serletis,Apostolos,1954 II.Title. HG173.M582011 332 C2009-906674-2 Copyright 2011,2008,2005,2002PearsonCanadaInc.,Toronto,Ontario. 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Brief Contents PART I Introduction. . . . . . . . . . . . . . . . 1 Chapter14 Risk Management with Financial Derivatives. . . . . . . . . . . . . . . . . . 346 Chapter1 Why Study Money, Banking, and Financial Markets? . . . . . . . . . . . . . . . . . . 2 Chapter2 An Overview of the PART V Central Banking and the Financial System. . . . . . . . . . . . . . . . . . . . . . 17 Conductof Monetary Policy . . . . . . . 380 Chapter3 What is Money?. . . . . . . . . . . . . . 43 Chapter15 Central Banks and the Bank of Canada . . . . . . . . . . . . . . . . . . . . . 381 PART II Financial Markets . . . . . . . . . 57 Chapter16 The Money Supply Process . . . 404 Chapter17 Tools of Monetary Policy . . . . . 431 Chapter4 Understanding Interest Rates . . . . 58 Chapter18 The Conduct of Monetary Chapter5 The Behaviour of Interest Rates. . 82 Policy: Strategy, and Tactics. . . . . . . . . . . . . 462 Chapter6 The Risk and Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . . 113 PART VI International Finance and Chapter7 The Stock Market, the Theory of Rational Expectations, and the Efficient MonetaryPolicy . . . . . . . . . . . . . . . . . 493 Market Hypothesis . . . . . . . . . . . . . . . . . . . 140 Chapter19 The Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494 PART III Financial Institutions . . . . 165 Chapter20 The International Financial System. . . . . . . . . . . . . . . . . . . . . . . . . . . . 518 Chapter8 An Economic Analysis of Financial Structure . . . . . . . . . . . . . . . . . . . 166 Chapter9 Financial Crises and the PART VII MonetaryTheory. . . . . . . . 549 Subprime Meltdown . . . . . . . . . . . . . . . . . . 196 Chapter21 The Demand for Money. . . . . . 551 Chapter10 Economic Analysis of Financial Chapter22 The ISLM Model. . . . . . . . . . . . 572 Regulation . . . . . . . . . . . . . . . . . . . . . . . . . 225 Chapter23 Monetary and Fiscal Policy in Chapter11 Banking Industry: Structure the ISLM Model. . . . . . . . . . . . . . . . . . . . . . 596 and Competition. . . . . . . . . . . . . . . . . . . . . 252 Chapter24 Aggregate Demand and Chapter12 NonbankFinancialInstitutions . 288 Supply Analysis . . . . . . . . . . . . . . . . . . . . . 619 Chapter25 Transmission Mechanisms of PART IV The Management of Monetary Policy: The Evidence . . . . . . . . . . 638 Financial Institutions. . . . . . . . . . . . . 313 Chapter26 Money and Inflation. . . . . . . . . 666 Chapter13 Banking and the Management Chapter27 Rational Expectations: of Financial Institutions. . . . . . . . . . . . . . . . 314 Implications for Policy . . . . . . . . . . . . . . . . 691 Contents Preface . . . . . . . . . . . . . . . . . . . . . . . . xxi Questions . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Quantitative Problems . . . . . . . . . . . . . . . . . 16 About theAuthors . . . . . . . . . . . . . . xxx Web Exercises . . . . . . . . . . . . . . . . . . . . . . . 16 PART I Introduction. . . . . . . . . . . . 1 CHAPTER 2 AnOverviewoftheFinancialSystem ...17 The Subprime Crisis: An Introduction . . . . . . . 1 Learning Objectives . . . . . . . . . . . . . . . . . . .17 CHAPTER 1 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 WhyStudyMoney,Banking,andFinancial Function of Financial Markets . . . . . . . . . . . . 18 Markets? ............................2 Structure of Financial Markets . . . . . . . . . . . . 20 Learning Objectives . . . . . . . . . . . . . . . . . . . .2 DebtandEquityMarkets ..............20 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 PrimaryandSecondaryMarkets..........20 ExchangesandOver-the-CounterMarkets ..21 Why Study Financial Markets? . . . . . . . . . . . . 2 MoneyandCapitalMarkets .............21 TheBondMarketandInterestRates .......3 TheStockMarket .....................3 Financial Market Instruments . . . . . . . . . . . . 22 MoneyMarketInstruments..............22 Why Study Financial Institutions and Banking? . . . . . . . . . . . . . . . . . . . . . . . . . . 5 FinancialNews MoneyRates ..............24 StructureoftheFinancialSystem .........5 CapitalMarketInstruments .............25 FinancialCrises.......................5 Internationalization of Financial Markets . . . . 27 BanksandOtherFinancialInstitutions......5 InternationalBondMarket,Eurobonds, FinancialInnovation ...................6 andEurocurrencies.................27 Why Study Money and Monetary Policy? . . . . 6 Global AreU.S.CapitalMarketsLosing MoneyandBusinessCycles..............6 TheirEdge?...........................28 MoneyandInflation ...................7 WorldStockMarkets ..................28 MoneyandInterestRates ...............9 Function of Financial Intermediaries: ConductofMonetaryPolicy..............9 Indirect Finance . . . . . . . . . . . . . . . . . . . . 29 FiscalPolicyandMonetaryPolicy ........10 FinancialNews ForeignStockMarket Why Study International Finance? . . . . . . . . . 10 Indexes ..............................30 TheForeignExchangeMarket ...........11 TheInternationalFinancialSystem........12 Global TheImportanceofFinancial How We Will Study Money, Banking, and IntermediariestoSecuritiesMarkets: Financial Markets . . . . . . . . . . . . . . . . . . . 12 AnInternationalComparison ............31 TransactionCosts ....................31 Exploring the Web . . . . . . . . . . . . . . . . . . . . 13 RiskSharing ........................32 CollectingandGraphingData ...........13 AsymmetricInformation:Adverse Sample Web Exercise . . . . . . . . . . . . . . . . . . 13 SelectionandMoralHazard...........32 Concluding Remarks . . . . . . . . . . . . . . . . . . 14 Types of Financial Intermediaries . . . . . . . . . 34 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 DepositoryInstitutions(Banks) ..........34 ContractualSavingsInstitutions ..........35 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . 15 viii Contents InvestmentIntermediaries ..............37 CHAPTER 4 Regulation of the Financial System . . . . . . . . 37 UnderstandingInterestRates ..........58 IncreasingInformationAvailableto Learning Objectives . . . . . . . . . . . . . . . . . . .58 Investors ........................37 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 EnsuringtheSoundnessofFinancial Intermediaries.....................38 Measuring Interest Rates . . . . . . . . . . . . . . . . 59 FinancialRegulationAbroad ............40 PresentValue .......................59 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Application HowtoUseYourFinancial Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Calculator ............................60 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Application SimplePresentValue...........61 Web Exercises . . . . . . . . . . . . . . . . . . . . . . . 42 Application HowMuchIsThatJackpot Worth? ...............................61 CHAPTER 3 FourTypesofCreditMarketInstruments ...62 YieldtoMaturity ....................63 WhatIsMoney? .....................43 Application YieldtoMaturityona Learning Objectives . . . . . . . . . . . . . . . . . . 43 SimpleLoan ..........................63 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 Application YieldtoMaturityona Meaning of Money . . . . . . . . . . . . . . . . . . . . 43 Fixed-PaymentLoan ...................65 Functions of Money . . . . . . . . . . . . . . . . . . . 44 Application YieldtoMaturityona MediumofExchange..................44 CouponBond .........................66 UnitofAccount......................45 Application YieldtoMaturityona FYI MoneyinaPrisoner-of-WarCampand Perpetuity ............................69 ModernPrisons .......................46 Global NegativeT-BillRates?Japan StoreofValue.......................46 ShowstheWay ........................70 Evolution of the Payments System . . . . . . . . 47 CommodityMoney ...................47 The Distinction Between Interest Rates and FiatMoney .........................48 Returns . . . . . . . . . . . . . . . . . . . . . . . . . . 71 Cheques...........................48 Application CalculatingtheRateofReturn ...72 ElectronicPayment ...................49 Application CalculatingtheRateof E-Money...........................49 CapitalGain ..........................73 Measuring Money . . . . . . . . . . . . . . . . . . . . 49 MaturityandtheVolatilityofBondReturns: FYI AreWeHeadedforaCashlessSociety? ..50 Interest-RateRisk ..................74 TheBankofCanadasMonetary FYI HelpingInvestorstoSelectDesired Aggregates.......................50 Interest-RateRisk ......................75 FYI WhereAreAlltheDollars? .............52 Summary ..........................76 MoneyasaWeightedAggregate .........53 The Distinction Between Real and Nominal How Reliable Are the Money Data? . . . . . . . . 54 Interest Rates . . . . . . . . . . . . . . . . . . . . . . 76 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Application CalculatingRealInterestRates ...77 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . 55 FYI WithRealReturnBonds,RealInterest Questions . . . . . . . . . . . . . . . . . . . . . . . . . . 55 RatesHaveBecomeObservablein Canada ..............................79 Quantitative Problems . . . . . . . . . . . . . . . . . 56 Application CalculatingthePrincipaland Web Exercises . . . . . . . . . . . . . . . . . . . . . . . 56 CouponPaymentofRealReturnBonds ....79 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 PART II Financial Markets. . . . . . . . . . 57 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . 80 Crisis and Response: Credit Market Turmoil Questions . . . . . . . . . . . . . . . . . . . . . . . . . . 80 and the Stock Market Crash in October 2008 . . . . . . . . . . . . . . . . . . . . . . 57 Quantitative Problems . . . . . . . . . . . . . . . . . 80 Web Exercises . . . . . . . . . . . . . . . . . . . . . . . 81 Contents ix CHAPTER 5 CHAPTER 6 TheBehaviourofInterestRates ........82 TheRiskandTermStructureof Learning Objectives . . . . . . . . . . . . . . . . . . .82 InterestRates ......................113 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 Learning Objectives . . . . . . . . . . . . . . . . . .113 Determinants of Asset Demand . . . . . . . . . . 83 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 Wealth ............................83 Risk Structure of Interest Rates . . . . . . . . . . 113 ExpectedReturn .....................83 DefaultRisk........................114 Risk ..............................83 Application TheSubprimeCollapseand Liquidity...........................84 theBAA-TreasurySpreadinthe TheoryofAssetDemand...............84 UnitedStates ........................117 Supply and Demand in the Bond Market . . . 85 Liquidity ..........................117 DemandCurve ......................85 IncomeTaxConsiderations ............118 SupplyCurve .......................86 MarketEquilibrium ...................87 Application Tax-ExemptversusTaxable SupplyandDemandAnalysis............88 Bonds ..............................118 Summary .........................119 Changes in Equilibrium Interest Rates . . . . . . 88 ShiftsintheDemandforBonds..........88 Term Structure of Interest Rates . . . . . . . . . 119 ShiftsintheSupplyofBonds ...........92 Application EffectsoftheBushTaxCuton Application ChangesintheInterestRate BondInterestRatesintheUnitedStates ..119 DuetoExpectedInflation: TheFisher FinancialNews YieldCurves..............120 Effect ................................94 ExpectationsTheory .................121 Application ChangesintheInterestRate Application ExpectationsTheory ..........122 DuetoaBusinessCycleExpansion .......95 Application ExpectationsTheoryandthe Application ExplainingLowJapanese YieldCurve ..........................124 InterestRates .........................97 SegmentedMarketsTheory ............126 Application HaveLowSavingsRatesin LiquidityPremiumandPreferredHabitat CanadaLedtoHigherInterestRates? .....98 Theories .......................127 Application LiquidityPremiumTheory......128 Supply and Demand in the Market for ThePredictivePoweroftheYieldCurve ..131 Money: the Liquidity Preference Summary..........................131 Framework . . . . . . . . . . . . . . . . . . . . . . . 99 FYI TheYieldCurveasaForecastingTool Changes in Equilibrium Interest Rates . . . . . 101 forInflationandtheBusinessCycle ......132 ShiftsintheDemandforMoney ........101 ShiftsintheSupplyofMoney...........102 Application InterpretingYieldCurves, 1990 2009 ...........................132 Application ChangesintheEquilibrium InterestRateDuetoChangesinIncome, Application UsingtheTermStructureto thePriceLevel,ortheMoneySupply ....102 ForecastInterestRates.................133 Application MoneyandInterestRates ......105 Application ForwardRate ................136 DoesaHigherRateofGrowthofthe Summary . . . . . . . . . . . . . . . . . . . . . . . . . . 136 MoneySupplyLowerInterestRates? ...106 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . 137 FYI ForecastingInterestRates .............109 Questions . . . . . . . . . . . . . . . . . . . . . . . . . 137 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . 110 Quantitative Problems . . . . . . . . . . . . . . . . 138 Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . 110 Web Exercises . . . . . . . . . . . . . . . . . . . . . . 139 Questions . . . . . . . . . . . . . . . . . . . . . . . . . 110 Quantitative Problems . . . . . . . . . . . . . . . . 111 Web Exercises . . . . . . . . . . . . . . . . . . . . . . 112 x Contents CHAPTER 7 Quantitative Problems . . . . . . . . . . . . . . . . 162 TheStockMarket,theTheoryof Web Exercises . . . . . . . . . . . . . . . . . . . . . . 162 RationalExpectations,andthe EfficientMarketHypothesis ..........140 PART III Financial Institutions . . . . . 165 Learning Objectives . . . . . . . . . . . . . . . . . .140 Crisis and Response: Bailout Packages in Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . 140 the Trillions of Dollars . . . . . . . . . . . . . . 165 Computing the Price of Common Stock . . . . 141 TheOne-PeriodValuationModel........141 CHAPTER 8 AnEconomicAnalysisofFinancial Application StockValuation...............142 TheGeneralizedDividendValuation Structure ..........................166 Model..........................142 Learning Objectives . . . . . . . . . . . . . . . . . .166 TheGordonGrowthModel ............143 Preview . . . . . . . . . . . . . . . . . . . . . . . . . . . 166 Application StockValuation,Constant Basic Facts About Financial Structure Growth .............................144 Throughout the World . . . . . . . . . . . . . . 166 PriceEarningsValuationMethod ........144 Application StockValuation,PERatio Transaction Costs . . . . . . . . . . . . . . . . . . . . 169 Approach............................145 HowTransactionCostsInfluence FinancialStructure.................169 How the Market Sets Stock Prices . . . . . . . . 145 HowFinancialIntermediariesReduce Application MonetaryPolicyandStock TransactionCosts .................170 Prices ...............................146 Asymmetric Information: Adverse Application TheSubprimeFinancial Selection and Moral Hazard . . . . . . . . . . 171 CrisisandtheStockMarket.............147 The Lemons Problem: How Adverse The Theory of Rational Expectations . . . . . . 147 Selection Influences Financial Structure . . 171 LemonsintheStockandBondMarkets ...172 FYI AdaptiveExpectations................148 ToolstoHelpSolveAdverseSelection FormalStatementoftheTheory.........149 Problems .......................173 RationaleBehindtheTheory ...........149 ImplicationsoftheTheory.............150 FYI TheEnronImplosion .................174 Summary .........................177 The Efficient Market Hypothesis: Rational Expectations in Financial Markets . . . . . . 151 How Moral Hazard Affects the Choice Between Debt and Equity Contracts . . . . 177 Application TheEfficientMarket MoralHazardinEquityContracts: Hypothesis ..........................153 ThePrincipal AgentProblem...........177 RationaleBehindtheTheory ...........153 ToolstoHelpSolvethePrincipal Agent StrongerVersionoftheEfficient Problem........................178 MarketHypothesis ................154 How Moral Hazard Influences Financial Application PracticalGuidetoInvesting Structure in Debt Markets . . . . . . . . . . . . 180 intheStockMarket ...................155 ToolstoHelpSolveMoralHazardin FinancialNews StockPrices ..............156 DebtContracts ...................180 FYI ShouldYouHireanApeasYour Summary..........................182 InvestmentAdviser? ..................157 Application FinancialDevelopmentand EconomicGrowth ....................184 Application WhatDotheBlackMonday Crashof1987andtheTechCrashof FYI LettheLawyersLive! ................185 2000TellUsAboutRationalExpectations Application IsChinaaCounterExample andEfficientMarkets? .................158 totheImportanceofFinancial Behavioural Finance . . . . . . . . . . . . . . . . . . 159 Development? .......................186 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . 160 Conflicts of Interest . . . . . . . . . . . . . . . . . . 186 WhyDoWeCareAboutConflictsof Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . 161 Interest? ........................187 Questions . . . . . . . . . . . . . . . . . . . . . . . . . 161 WhyDoConflictsofInterestArise?.......187