This leading textbook rests upon the idea that students must develop economic instuition for organizing concepts and facts, evaluating current and historical events, and predicting future outcomes and changes in the economic system. The fifth edition provides a timely perspective on recent events - corporate accounting scandals, developments in the international financial systems, the post-9/11 recession, and more - using current and up-to-the minute real-world applications.



Table of Contents



Contents

Introduction 1

Introducing Money and the Financial System 2

Getting Started 3

The Financial System and the Economy 3

Financial Markets 5

Financial Institutions 7

Money 8

Economic Analysis as a Tool 9

Developing an Economic Approach 10

Applying an Economic Approach 10

Review Questions 12

Analytical Problems, Data Question 13

Other times, other places . . . The Only Thing Constant in the Financial System Is Change 6

Consider this . . . Is the Financial System Truly Global? 7

Money and the Payments System 14

Meeting the Needs of Exchange with Money 14

Barter 15

Government Allocation 16

Money 16

What Can Serve as Money? 19

The Payments System 20

Commodity Money 21

Fiat Money 21

Checks 22

Electronic Funds and Electronic Cash 23

Measuring the Money Supply 25

Measuring Monetary Aggregates 25

Selecting Monetary Aggregates 28

Review Questions, Analytical Problems 32

Data Questions 33

Appendix: Calculating Price Indexes 34

Other times, other places . . . Will the Euro Be a Success? 20

Consider this . . . What's Money? Ask a Taxi Driver! 22

Using the news . . . Finding Up-to-Date Information on Money 27

Moving from theory to practice . . . E-Cash 2.0, The Economist, 2/19/00 30

Overview of the Financial System 35

What Is the Purpose of the Financial System? 35

Key Services Provided by the Financial System 38

Risk Sharing 39

Liquidity 39

Information 40

Financial Markets in the Financial System 41

Matching Savers and Borrowers: Debt and Equity 41

Providing Risk-Sharing, Liquidity, and Information Services 43

Financial Intermediaries in the Financial System 45

Matching Savers and Borrowers 46

Providing Risk-Sharing, Liquidity, and Information Services 46

Competition and Change in the Financial System 48

Financial Innovation 49

Changes in Financial Integration and Globalization 49

Financial Regulation 51

Provision of Information 52

Maintenance of Financial Stability 52

Advancement of Other Policy Objectives 53

Effects of Regulation 54

Review Questions 58

Analytical Problems, Data Question 59

Appendix: Financial Instruments 60

Case Study Where Do Households Put Their Savings? 47

Consider this . . . Financial Innovation: Home Mortgages or Rock Star Bonds? 50

Other times, other places . . . The Growth of International Bond and Stock Markets 51

Moving from theory to practice . . . Mrs. Watanabe Learns to Invest, The Economist,

12/18/99 56

Interest Rates 67

Interest Rates and Rates of Return 68

Comparing Debt Instruments 68

Timing of Payments 69

Present Value 72

Using Yield to Maturity as a Yardstick 75

Bond Yields and Prices 80

Why Can Price and Face Value Differ? 80

How Are Bond Yields and Prices Related? 82

Finding the Total Rate of Return 86

Real versus Nominal Interest Rates 87

Review Questions, Analytical Problems 94

Data Questions 96

Consider this . . . Can They STRIP? Creating New Financial Instruments 71

Consider this . . . Who Will Buy Those Fabulous Fifties? 82

Using the news . . . Keeping Up with Bond Prices and Yields 84

Other times, other places . . . Principal Derailed: Inflation and Long-Term Bond Prices 88

Moving from theory to practice . . . A Bond Anybody Can Love, Business Week, 6/19/00 92

The Theory of Portfolio Allocation 97

Determinants of Portfolio Choice 97

Wealth 99

Expected Returns on Assets 100

Risk Associated with Asset Returns 101

Liquidity of Assets 102

Costs of Acquiring Information 102

Advantages of Diversification 104

Putting It All Together: Explaining Portfolio Allocation 108

Review Questions 111

Analytical Problems 114

Data Questions 115

Case Study How Much Risk Should You Tolerate in Your Portfolio? 103

Case Study Modeling Risk Premiums in Financial Markets 108

Other times, other places . . . Are Investors (Globally) Well Diversified? 110

Moving from theory to practice . . . Sex Matters, Mutual Funds, 4/00 112

Determining Market Interest Rates 116

Supply and Demand in the Bond Market and Loanable Funds 116

The Demand Curve 117

The Supply Curve 119

Market Equilibrium 119

Explaining Changes in Equilibrium Interest Rates 121

Shifts in Bond Demand 122

Shifts in Bond Supply 127

Using the Model to Explain Changes in Interest Rates 132

Back to the Bond Market's Votes 135

The International Capital Market and the Interest Rate 136

Small Open Economy 137

Large Open Economy 138

Review Questions 143

Analytical Problems 144

Data Questions 145

Consider this . . . Where Do Savings Come from? 125

Other times, other places . . . Do Interest Rates Rise During Wartime? 131

Moving from theory to practice . . . Interest Rates: Up or Down?, The Economist,

12/2/00 140

Risk Structure and Term Structure of Interest Rates 146

Risk Structure of Interest Rates 146

Default Risk 147

Liquidity 152

Information Costs 153

Taxation 156

Using the Risk Structure for Forecasting 158

Term Structure of Interest Rates 159

Segmented Markets Theory 161

Expectations Theory 162

Preferred Habitat Theory 166

Using the Term Structure for Forecasting 168

Review Questions, Analytical Problems 174

Data Question 176

Using the news . . . Using Bond Yields to Assess Risk 148

Consider this . . . Will a Consumption Tax Kill Munis' Allure? 159

Other times, other places . . . Asian Flu for European Bonds? 160

Using the news . . . How to Read the Yield Curve 161

Consider this . . . Can the Treasury Change the Shape of the Yield Curve? 170

Moving from theory to practice . . . What If Treasury Debt Disappears?, The Wall Street Journal, 8/3/00 172

Financial Markets 177

The Foreign-Exchange Market and Exchange Rates 178

Exchange Rates and Trade 179

Nominal versus Real Exchange Rates 180

Foreign-Exchange Markets 182

Determining Long-Run Exchange Rates 183

Supply and Demand 183

Economic Fundamentals and Long-Run Exchange Rate Trends 184

The Law of One Price and the Purchasing Power Parity Theory 186

Does the Theory Match Reality? 187

Determining Short-Run Exchange Rates 188

Comparing Expected Returns on Domestic and Foreign Assets 190

Foreign-Exchange Market Equilibrium 192

Interest Rate Parity 194

Exchange Rate Fluctuations 196

Changes in Domestic Real Interest Rates 196

Changes in Domestic Expected Inflation 198

Changes in Foreign Interest Rates 199

Changes in the Expected Future Exchange Rate 200

Currency Premiums in Foreign-Exchange Markets 202

A (Big) New Kid on the Block: The Euro 204

Review Questions 205

Analytical Problems 208

Data Question 209

Using the news . . . Reading Exchange Rates 185

Case Study Should You Bank on International Investments? 197

Other times, other places . . . Interest and Exchange Rates in the 1980s 203

Moving from theory to practice . . . The Euro Recovers, Financial Times, 12/16-17/00 206

Derivative Securities and Derivative Markets 210

Forward Transactions and Derivatives 210

Futures 212

Futures Pricing 212

Using Futures to Manage Risk 214

Options 217

Options Pricing 218

Using Options to Manage Risk 220

Benefits of Derivative Markets for the Financial System 221

Standardization and Liquidity 224

Anonymous Trading and Information 224

Review Questions 228

Analytical Problems 229

Data Question 230

Appendix: Swaps 230

Using the news . . . Reading Financial Futures Listings 213

Using the news . . . Reading Options Listings 219

Other times, other places . . . Futures Trading, Index Arbitrage, and the Stock Market Crash

of 1987 221

Case Study Citron Pressed-The Orange County Fiasco 222

Case Study Barings Lost-The Queen's Banker Goes Bust 223

Moving from theory to practice . . . Futures of Pollution, The Banker, 10/99 226

Information and Financial Market Efficiency 234

Rational Expectations 235

The Efficient Markets Hypothesis 237

Determining an Asset's Expected Price 238

Price Fluctuations 239

Investment Strategies 241

Actual Efficiency in Financial Markets 244

Pricing Anomalies 245

Mean Reversion 246

Excessive Volatility 246

Market Efficiency and the Crash of 1987 247

Value Investing versus Efficient Markets 250

Costs of Inefficiency in Financial Markets 251

Costs of Excessive Price Fluctuations 251

Information Costs 252

Review Questions, Analytical Problems 256

Data Question 257

Consider this . . . Are Investors Really Rational? 242

Other times, other places . . . Charting the Civil War with the Gold Market 243

Case Study What Goes Up . . . 249

Moving from theory to practice . . . So, Is the Stock Market Overvalued?, The Wall Street Journal, 3/17/99 254

Reducing Transactions Costs and Information Costs 258

Obstacles to Matching Savers and Borrowers 258

Transactions Costs 259

Asymmetric Information and Information Costs 260

Adverse Selection 260

"Lemons Problems" in Financial Markets 261

Reducing Information Costs 262

Moral Hazard 264

Moral Hazard in Equity Financing 264

Moral Hazard in Debt Financing 266

Information Costs and Financial Intermediaries 269

Financial Intermediaries and Adverse Selection 270

Financial Intermediaries and Moral Hazard 270

Review Questions 273

Analytical Problems, Data Question 276

Consider this . . . Are Stock Market Signals Affected by Adverse Selection? 265

Consider this . . . Can Falling Prices Raise Information Costs? 268

Other times, other places . . . Investor Protection and Economic Growth 271

Moving from theory to practice . . . On the Cutting Edge of Corporate Control in China, The Economist, 6/3/00 274

Financial Institutions 277

What Financial Institutions Do 278

Securities Market Institutions 279

Information: Investment Banking 280

Liquidity and Risk Sharing: Secondary Markets 282

Investment Institutions 285

Mutual Funds 285

Finance Companies 288

Contractual Saving: Insurance Companies 289

Principles of Insurance Management 289

Life Insurance Companies 292

Property and Casualty Insurance Companies 293

Regulation of Insurance Companies and Recent Trends 295

Contractual Saving: Pension Funds 295

Ownership of Pension Funds Assets 296

Funding of Pension Plans 297

Regulation of Private Pension Plans 297

Public Pension Plans 298

Recent Trends 298

Depository Institutions 299

Commercial Banks 299

Savings Institutions 300

Credit Unions 300

Government Financial Institutions 301

Direct Role: Federal Credit Agencies 301

Indirect Role: Loan Guarantees 305

Recent Trends 305

Financial Institutions: Blurring the Lines 305

Review Questions 310

Analytical Problems, Data Question 311

Using the news . . . A Tombstone for Something New? 283

Consider this . . . Can Investors Keep "Captives" at Bay? 291

Case Study What Kind of Financial Institution Is a Hedge Fund? 302

Case Study What Kind of Financial Institution Is a Venture Capital Fund? 303

Moving from theory to practice . . . Federal Credit Agencies: Is "Too Much" Lending Possible?, The Wall Street Journal, 7/14/00 308

The Business of Banking 312

How Banks Earn Profits 313

Bank Liabilities 313

Bank Assets 316

Bank Net Worth 317

Bank Failure 317

Determining Bank Profits 318

The Relationship Between Banks and Savers 320

Managing Moral Hazard 321

Managing Liquidity Risk 323

The Relationship Between Banks and Borrowers 325

Managing Credit Risk 326

Managing Interest Rate Risk 330

Expanding the Boundaries of Banking 333

Opportunities and Financial Innovation 334

Off-Balance-Sheet Activities 334

Review Questions 342

Analytical Problems 343

Data Questions 344

Appendix: Measuring the Duration of Bank Assets and Liabilities 344

Consider this . . . How Do Banks Account for Loan Losses? 319

Consider this . . . When Is Credit-Risk Analysis "Discrimination"? 327

Consider this . . . Grading Bank Derivatives: Extra Credit? 338

Moving from theory to practice . . . Banking: "Clicks" or "Bricks"?, The Economist,

11/11/00 340

The Banking Industry 346

Origins of Today's U.S. Banking Industry 347

Who Regulates Banks 348

Chartering and Examination 349

Regulating Commercial Banks 349

Regulating Savings Institutions 350

Regulating Credit Unions 350

Why the Banking Industry Is Regulated 351

Bank Runs 352

The Cost of a Bank Run 352

Government Intervention in the Banking Industry 354

Lender of Last Resort 355

Federal Deposit Insurance 356

Restrictions on Banking Industry Competition 361

The Banking Industry in Other Countries 368

Japanese Banking 371

German Banking 373

Integration of European Banking 374

Review Questions, Analytical Problems 378

Data Question 379

Other times, other places . . . Lessons from the Free Banking Period 348

Consider this . . . Is Bank Consolidation Good for Business? 362

Case Study Is Banking a Declining Industry? 369

Moving from theory to practice . . . The Bigger They Come . . . , The Economist, 10/28/00 376

Banking Regulation: Crisis and Response 380

The Pattern of Regulation 381

Lender of Last Resort 381

The Great Depression 381

Success in Recent Years 383

Concluding Remarks 385

Anticompetitive Bank Regulation 385

The Credit Crunch of 1966 387

Banks' Response 387

Regulatory Response 389

Concluding Remarks 390

The U.S. Deposit Insurance Crisis of the 1980s 391

Beginning of the Crisis: Worsening Conditions in S&Ls 391

Financial System Response 391

Regulatory Response: The S&L Bailout 394

The Widening Crisis: Commercial Banks 395

Options for Regulatory Reform 397

Current Issues in Regulatory Reform 401

Concluding Remarks 402

Lessons from Banking Regulation for Other Institutions 404

Insurance Regulation 404

Pension Fund Regulation 405

Review Questions 408

Analytical Problems 409

Data Question 410

Consider this . . . How Does a Lender of Last Resort Protect the Payments System? 384

Other times, other places . . . The Cycle of Crisis and Response: Russia and Japan 403

Moving from theory to practice . . . Japanese Bank Reform, Vital to the Economy, Snags on Political Reef, The Wall Street Journal, 12/11/00 406

Banking in the International Economy 411

Organization of International Banks 412

Overseas Organization of U.S. Banks 413

Organization of Foreign Banks in the United States 414

Leaders in Global Banking 415

Managing Exchange Rate Risk 415

Services Provided by International Banks 417

Reducing Transactions Costs 417

Providing Information Services 418

The Rise of Euromarkets 420

Euromarket Customers 422

Loans in Euromarkets 423

Financial Regulation in International Banking 424

Capital Requirements 425

Deposit Insurance 426

Central Bank Intervention 427

International Coordination 427

Review Questions 430

Analytical Problems, Data Question 431

Consider this . . . Why Did Closing BCCI Take So Long? 416

Consider this . . . Will Europe Kill the Eurobond? 423

Other times, other places . . . Do Sovereigns Default? 425

Moving from theory to practice . . . New Basle Committee Proposals, The Financial Times,

2/17/01 428

The Money Supply Process and Monetary Policy 433

The Money Supply Process 434

The Fed and the Monetary Base 435

The Fed's Liabilities 435

The Fed's Assets 436

How the Fed Changes the Monetary Base 437

Comparing Open Market Operations and Discount Loans 441

The Simple Deposit Multiplier 443

Multiple Deposit Expansion 443

Multiple Deposit Contraction 448

The Money Multiplier and Decisions of the Nonbank Public 450

Determinants of Portfolio Choice 450

Concluding Remarks 452

Bank Behavior: Excess Reserves and Discount Loans 453

Excess Reserves 454

Discount Loans 455

Deriving the Money Multiplier and the Money Supply 456

Review Questions 466

Analytical Problems 467

Data Question 469

Appendix: The Money Supply Process for M2 469

Consider this . . . What Are the Origins of Multiple Deposit Expansion? 445

Other times, other places . . . The Money Multiplier and Money Supply During the Early

1930s 459

Case Study Using the Money Supply Equation to Predict Money Growth 461

Moving from theory to practice . . . The Fed and the Monetary Base: Thwarting a Slowdown,

The New York Times, 1/4/01 464

Changes in the Monetary Base 471

Balance Sheet of the Federal Reserve System 471

The Fed's Assets 472

The Fed's Liabilities 473

Determining the Monetary Base 474

Changes in the Monetary Base 475

Determinants That Increase the Monetary Base 476

Determinants That Decrease the Monetary Base 479

Concluding Remarks 480

The Federal Budget Deficit and the Monetary Base 481

Alternative Strategies 483

The Government Budget Constraint and the Monetary Base 485

Review Questions, Analytical Problems 487

Data Questions 490

Using the news . . . Federal Reserve Data and Change in the Monetary Base 477

Other times, other places . . . Dealing with the Debt: The Treasury-Federal Reserve Accord 482

Moving from theory to practice . . . ECB Warns on Budget Deficits, The Financial Times,

3/18/99 488

Organization of Central Banks 491

Power Sharing in the Federal Reserve System 492

Creation of the System 492

Federal Reserve Banks 493

Member Banks 495

Board of Governors 495

Federal Open Market Committee 496

Power and Authority Within the Fed 497

How the Fed Operates 498

Handling External Pressure 499

Examples of Treasury-Fed Conflict 500

Factors That Motivate the Fed 501

Fed Independence 503

Central Bank Independence in Other Countries 505

Organization and Independence of the European Central Bank 506

Review Questions, Analytical Problems 510

Data Questions 511

Consider this . . . Importance of Selecting a Fed Chairman 501

Other times, other places . . . Conflicts Between the Treasury and the Central Bank in Japan

over Independence 504

Moving from theory to practice . . . The ECB's Terrible Twos, The Economist, 1/6/01 508

Monetary Policy Tools 512

Open Market Operations 512

Implementing Open Market Operations 513

Open Market Operations versus Other Policy Tools 516

Fed Watching and FOMC Directives 516

Open Market Operations in Other Countries 517

Discount Policy 518

Using the Discount Window 518

Policing the Discount Window 519

Benefits of Discount Policy 520

Drawbacks of Discount Policy as a Monetary Policy Tool 522

Discount Policy in Other Countries 522

Reserve Requirements 522

Changes in Reserve Requirements 523

Measurement and Compliance 524

Criticism of Reserve Requirements 524

Reserve Requirements in Other Countries 527

Fed Watching: Analyzing the Policy Tools 527

The Federal Funds Market 527

Open Market Operations 528

Changes in the Discount Rate 529

Changes in Reserve Requirements 529

Other Disturbances of the Monetary Base 530

The Federal Funds Rate and Monetary Policy 531

Concluding Remarks 533

Review Questions 536

Analytical Problems 537

Data Question 538

Consider this . . . A Day's Work at the Open Market Trading Desk 515

Consider this . . . How Do You Decode FOMC Statements? 517

Other times, other places . . . An Early Mistake in Setting Reserve Requirements 526

Moving from theory to practice . . . Fed Rate Cut Combats a Contagion, The Wall Street Journal, 2/1/01 534

The Conduct of Monetary Policy 539

Goals of Monetary Policy 539

Price Stability 540

High Employment 540

Economic Growth 541

Financial Market and Institution Stability 541

Interest Rate Stability 542

Foreign-Exchange Market Stability 542

Problems in Achieving Monetary Policy Goals 542

Using Targets to Meet Goals 543

Monetary Aggregates and Interest Rates as Targets 545

Selecting Intermediate Targets 547

Selecting Operating Targets 550

The Monetary Policy Record 550

Early Interest in Targets: 1951-1970 551

Experimenting with Monetary Targets: 1970-1979 552

De-emphasizing Interest Rates: 1979-1982 553

Policy After 1982: Back to Interest Rates 554

Increasing International Concerns: The 1980s and 1990s 556

Concluding Remarks 557

Reevaluating Fed Targeting Policy 557

Alternative Intermediate Targets 557

The Taylor Rule 558

The Future of Targeting 559

International Comparison of Monetary Policy Conduct 562

Review Questions 565

Analytical Problems, Data Question 568

Other times, other places . . . Does the Conduct of Monetary Policy Respond to Political Pressures? 556

Case Study Is Inflation Targeting a Good Idea? 560

Moving from theory to practice . . . The Chairman's Upbeat View, The Wall Street Journal, 2/14/01 566

The International Financial System and Monetary Policy 569

Foreign-Exchange Intervention and the Money Supply 570

Foreign-Exchange Intervention and the Exchange Rate 572

Unsterilized Intervention 572

Sterilized Intervention 574

Capital Controls 575

Recent Fed Interventions 576

Balance of Payments 577

The Current Account 579

The Capital Account 580

The Official Settlements Balance 580

Relationships Among the Accounts 581

Exchange Rate Regimes and the International Financial System 582

Fixed Exchange Rates and the Gold Standard 582

Adapting Fixed Exchange Rates: The Bretton Woods System 584

Central Bank Intervention After Bretton Woods 591

Fixed Exchange Rates in Europe 593

How Successful Are Fixed Exchange Rates Likely to Be in the Long Run? 599

Review Questions 602

Analytical Problems 603

Data Questions 604

Case Study Do Sterilized Interventions Affect the Exchange Rate? 577

Using the news . . . The U.S. Balance of Payments 578

Consider this . . . Are the IMF and the World Bank Obsolete? 586

Other times, other places . . . Speculative Attack: 1990s Style 595

Case Study Financial Collapse in Mexico 596

Case Study Financial Collapse in Asia 597

Consider this . . . Back to the (Currency) Drawing Board 598

Moving from theory to practice . . . Central Banks Boost the Euro, The Wall Street Journal,

9/25/00 600

The Financial System and the Macroeconomy 605

The Demand for Money 606

Transactions Motives 606

Real Money Balances 607

Velocity and the Demand for Real Balances 608

Changes in Velocity over Time 609

Portfolio Allocation Motives 614

Motives for Holding Money: Keynes's Liquidity Preference Theory 615

Broader Portfolio Factors: Friedman's Money Demand Model 617

Comparing the Two Models: Keynes versus Friedman 617

Explaining Money Demand 618

The Money Demand Function 619

Measuring Money Demand 619

Review Questions 624

Analytical Problems 625

Data Question 626

Consider this . . . The Money Growth Slowdown in the Early 1990s: Was Velocity the Culprit? 610

Other times, other places . . . The Case of the Missing Money 621

Moving from theory to practice . . . A Legal Tender of One's Own, The New York Times,

1/30/01 622

Linking the Financial System and the Economy:

The IS-LM-FE Model 627

A Model for Goods and Asset Markets: Assumptions 628

The IS Curve 629

Saving, Investment, and Aggregate Demand 629

Determinants of National Saving 630

Determinants of National Investment 631

Constructing the IS Curve 632

The IS Curve for an Open Economy 634

Shifts of the IS Curve 636

Determining Output: The Full Employment Line 637

The LM Curve 639

Asset Market Equilibrium 640

Constructing the LM Curve 641

Shifts of the LM Curve 645

The Financial System and the Economy: The IS-LM-FE Model 647

Using the Model to Explain the Economy's Equilibrium 648

Restoring Equilibrium: Price-Level Adjustment 650

Money, Output, and Prices in the Long Run 652

Review Questions, Analytical Problems 656

Data Question 658

Appendix: Derivation of the IS Curve 659

Consider this . . . Are Savings Internationally Mobile? 636

Other times, other places . . . The Gulf War and "Confidence" 638

Moving from theory to practice . . . Productivity: The Magic Elixir, The Wall Street Journal,

2/15/01 654

Aggregate Demand and Aggregate Supply 662

The Aggregate Demand Curve 662

Deriving the Aggregate Demand Curve 663

Shifts of the Aggregate Demand Curve 664

The Aggregate Supply Curve 668

Short-Run Aggregate Supply Curve 668

Long-Run Aggregate Supply Curve 674

Shifts in the Short-Run Aggregate Supply Curve 674

Shifts in the Long-Run Aggregate Supply Curve 675

Equilibrium in Aggregate Demand and Aggregate Supply 677

Short-Run Equilibrium 678

Long-Run Equilibrium 679

The Real Business Cycle View 680

Economic Fluctuations in the United States 681

Shocks to Aggregate Demand, 1964-1969 682

Supply Shocks, 1973-1975 and 1995-2000 682

Credit Crunch and Aggregate Demand, 1990-1991 683

Are Investment Incentives Inflationary? 684

Review Questions, Analytical Problems 685

Data Questions 689

Consider this . . . Do Tax Cuts Stimulate Aggregate Demand? 666

Other times, other places . . . Shock Therapy and Aggregate Supply in Poland 676

Consider this . . . Can Shifts in Aggregate Demand Affect Output in the Long Run? 679

Moving from theory to practice . . . Memo to Tokyo: Print Money, The Financial Times, 2/7/00 686

Money and Output in the Short Run 690

Tracking Money and Output Movements in the Short Run 690

The Real Business Cycle Model 692

Money and Output: The New Classical Model 694

Money and Output: The New Keynesian Model 696

Should Public Policy Stabilize Economic Fluctuations? 700

The Real Business Cycle and New Classical Views 700

The New Keynesian View 701

Explaining Events of the 1980s and 1990s 704

Effects of Policy Shifts in the Early 1980s 705

Effects of Policy Shifts in the Early 1990s 706

Concluding Remarks 707

Review Questions 710

Analytical Problems 711

Data Questions 713

Consider this . . . Can One Size Fit All in Europe? 698

Case Study How Does Money Affect Aggregate Demand in the New Keynesian View? 699

Other times, other places . . . Yasushi Mieno and the Stabilization Policy Debate in Japan 703

Moving from theory to practice . . . Will the Fed Step on the Gas?, The Financial Times, 2/5/01 708

Information Problems and Channels for Monetary Policy 714

Macroeconomic Costs of Information Problems 715

Information Problems in Lending: Role of Financial Intermediaries 716

Information Problems in Lending: Role of Net Worth 716

Consequences of a Drop in Bank Lending 717

Consequences of a Fall in Borrowers' Net Worth 718

Financial Panics 719

Credit Controls and Credit Crunches 720

Expanded Channels for Monetary Policy 722

The Money Channel: Monetary Policy and Interest Rates 722

The Bank Lending Channel: Monetary Policy and Banks 724

Money Channel and Bank Lending Channel Predictions 724

The Balance Sheet Channel: Monetary Policy and Net Worth 727

Validity of the Bank Lending and Balance Sheet Channels 729

Implications for Public Policy 733

Review Questions, Analytical Problems 737

Data Question 738

Other times, other places . . . The Global Banking Crisis and the Great Depression 721

Consider this . . . Was There a Credit Crunch During the 1990-1991 Recession? 732

Moving from theory to practice . . . A New Credit Crunch for Japan?, The Financial Times, 12/22/00 734

Inflation: Causes and Consequences 739

Explaining Price Level Changes 739

Causes of Price Level Changes 740

Causes of Price Level Fluctuations 741

Sustained Changes in the Price Level: Inflation 744

Costs of Inflation 746

Expected Inflation 746

Unexpected Inflation 747

Inflation Uncertainty 748

Inflation and Monetary Policy 749

Cost-Push Inflation 749

Demand-Pull Inflation 750

Costs of Reducing Inflation 752

New Classical Disinflation: Reducing Inflation Cold Turkey 752

New Keynesian Disinflation: Reducing Inflation Gradually 753

Central Bank Credibility 754

Strategies for Building Credibility 755

Rules versus Discretion 758

Price Controls and Credibility 760

Review Questions 761

Analytical Problems 764

Data Questions 765

Appendix: Inflation versus Unemployment: The Phillips Curve 766

Other times, other places . . . Central Bank Credibility in the United States and Japan 755

Consider this . . . Can Credibility Enhance Central Bank Flexibility? 759

Moving from theory to practice . . . Growth or Inflation?, The New York Times, 1/30/00 762

Glossary A-1

Answer Section A-17

Index A-39