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PART Ⅰ Introduction1

CHAPTER 1 WHY STUDY MONEY，BANKING，AND FINANCIAL MARKETS？3

Preview3

Why Study Financial Markets？3

The Bond Market and Interest Rates4

The Stock Market4

The Foreign Exchange Market6

Why Study Banking and Financial Institutions？7

Structure of the Financial System7

Banks and Other Financial Institutions8

Financial Innovation8

Why Study Money and Monetary Policy？9

Money and Business Cycles9

Money and Inflation10

Money and Interest Rates12

Conduct of Monetary Policy12

Budget Deficits and Monetary Policy13

How We Will Study Money，Banking，and Financial Markets14

Concluding Remarks15

Summary，Key Terms，Questions and Problems15

Appendix to Chapter 1：Defining Aggregate Output，Income，and the Price Level17

CHAPTER 2 AN OVERVIEW OF THE FINANCIAL SYSTEM20

Preview20

Function of Financial Markets21

Structure of Financial Markets23

Debt and Equity Markets23

Primary and Secondary Markets23

Exchanges and Over-the-Counter Markets24

Money and Capital Markets25

Financial Market Instruments25

Money Market Instruments25

Following the Financial News Money Market Rates27

Capital Market Instruments29

BOX 1 Mortgage-Backed Securities31

Internationalization of Financial Markets32

International Bond Market and Eurobonds32

World Stock Markets32

Following the Financial News Foreign Stock Market Indexes33

Function of Financial Intermediaries33

BOX 2 The Importance of Financial Intermediaries to Securities Markets：An International Comparison34

Transaction Costs34

Asymmetric Information：Adverse Selection and Moral Hazard35

Financial Intermediaries37

Depository Institutions37

Contractual Savings Institutions40

Investment Intermediaries41

Regulation of the Financial System42

Increasing Information Available to Investors42

Ensuring the Soundness of Financial Intermediaries42

Improving Control of Monetary Policy45

Financial Regulation Abroad45

Summary，Key Terms，Questions and Problems45

CHAPTER 3 WHAT IS MONEY？48

Preview48

Meaning of Money48

Functions of Money49

Medium of Exchange49

Unit of Account50

Store of Value51

Evolution of the Payments System52

BOX 1 Birth of a New European Currency：The Euro？54

Electronic Money：A Coming Global Phenomenon55

Are We Moving to a Cashless Society？56

Measuring Money57

Theoretical and Empirical Definitions of Money57

The Federal Reserve’s Monetary Aggregates58

Following the Financial News The Monetary Aggregates61

Money as a Weighted Aggregate61

How Reliable Are the Money Data？62

Summary，Key Terms，Questions and Problems63

PARTⅡ Financial Markets67

CHAPTER 4 UNDERSTANDING INTEREST RATES69

Preview69

Measuring Interest Rates70

Present Value71

Application The Cost of the S＆L Bailout：Was It Really $500 Billion？72

Yield to Maturity72

Other Measures of Interest Rates79

Current Yield79

Yield on a Discount Basis80

Application Reading the Wall Street Journal：The Bond Page81

Following the Financial News Bond Prices and Interest Rates82

The Distinction Between Interest Rates and Returns84

Maturity and the Volatility of Bond Returns：Interest-Rate Risk87

Summary88

Application Should Retirees Invest in “Gilt-Edged”Long-Term Bonds？88

The Distinction Between Real and Nominal Interest Rates89

Summary，Key Terms，Questions and Problems92

CHAPTER 5 PORTFOLIO CHOICE94

Preview94

Determinants of Asset Demand94

Wealth95

Expected Returns96

Risk96

Liquidity97

Theory of Portfolio Choice97

Benefits of Diversification98

Systematic Risk100

Risk Premiums：Capital Asset Pricing Model and Arbitrage Pricing Theory101

Summary，Key Terms，Questions and Problems102

CHAPTER 6 THE BEHAVIOR OF INTEREST RATES104

Preview104

Loanable Funds Framework：Supply and Demand in the Bond Market104

Demand Curve105

Supply Curve106

Market Equilibrium107

Supply and Demand Analysis108

Changes in Equilibrium Interest Rates109

Shifts in the Demand for Bonds110

Shifts in the Supply of Bonds113

Application Changes in the Equilibrium Interest Rate Due to Expected Inflation or Business Cycle Expansions115

Application Reading the Wall Street Journal：The “Credit Markets” Column119

Following the Financial News The “Credit Markets” Column120

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

Liquidity Preference Framework：Supply and Demand in the Market for Money122

Changes in Equilibrium Interest Rates124

Shifts in the Demand for Money124

Shifts in the Supply of Money125

Application Changes in the Equilibrium Interest Rate Due to Changes in Income，the Price Level，or the Money Supply125

Application Money and Interest Rates128

Following the Financial News Forecasting Interest Rates132

Summary，Key Terms，Questions and Problems135

Appendix to Chapter 6：Applying the Asset Market Approach to a Commodity Market：The Case of Gold137

Application Changes in the Equilibrium Price of Gold Due to a Rise in Expected Inflation140

Following the Financial News The “Commodities” Column141

Application Reading the Wall Street Journal：The “Commodities”Column142

CHAPTER 7 THE RISK AND TERM STRUCTURE OF INTEREST RATES143

Preview143

Risk Structure of Interest Rates143

Default Risk144

Application The Stock Market Crash of 1987 and the Junk Bond-Treasury Spread147

Application What If Treasury Securities Were No Longer Default-Free？148

Liquidity148

Income Tax Considerations149

Summary150

Application Effects of the Clinton Tax Increase on Bond Interest Rates150

Term Structure of Interest Rates151

Following the Financial News Yield Curves153

Expectations Hypothesis153

Segmented Markets Theory157

Preferred Habitat and Liquidity Premium Theories158

Recent Evidence on the Term Structure160

Summary160

Application Interpreting Yield Curves，1980-1997161

Summary，Key Terms，Questions and Problems163

CHAPTER 8 THE FOREIGN EXCHANGE MARKET165

Preview165

Foreign Exchange Market165

What Are Foreign Exchange Rates？167

Why Are Exchange Rates Important？167

Following the Financial News Foreign Exchange Rates168

How Is Foreign Exchange Traded？169

Exchange Rates in the Long Run169

Law of One Price170

Theory of Purchasing Power Parity170

Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates171

Factors That Affect Exchange Rates in the Long Run172

Exchange Rates in the Short Run174

Comparing Expected Returns on Domestic and Foreign Deposits174

Interest Parity Condition176

Equilibrium in the Foreign Exchange Market177

Explaining Changes in Exchange Rates179

Shifts in the Expected-Return Schedule for Foreign Deposits179

Shifts in the Expected-Return Schedule for Domestic Deposits181

Application Changes in the Equilibrium Exchange Rate：Two Examples182

Application Why Are Exchange Rates So Volatile？187

Application The Dollar and Interest Rates，1973-1996187

BOX 1 Forecasting Exchange Rates188

Application Reading the Wall Street Journal：The “Foreign Exchange” Column189

Following the Financial News The “Foreign Exchange”Column190

Summary，Key Terms，Questions and Problems191

PART Ⅲ Financial Institutions193

CHAPTER 9 AN ECONOMIC ANALYSIS OF FINANCIAL STRUCTURE195

Preview195

Basic Puzzles About Financial Structure Throughout the World195

Transaction Costs199

How Transaction Costs Influence Financial Structure199

How Financial Intermediaries Reduce Transaction Costs200

Asymmetric Information：Adverse Selection and Moral Hazard201

The Lemons Problem：How Adverse Selection Influences Financial Structure201

Lemons in the Stock and Bond Markets202

Tools to Help Solve Adverse Selection Problems203

How Moral Hazard Affects the Choice Between Debt and Equity Contracts207

Moral Hazard in Equity Contracts：The Principal-Agent Problem207

Tools to Help Solve the Principal-Agent Problem208

BOX 1 “Hollywood Accounting”：Has Forrest Gump Been a Loser？209

How Moral Hazard Influences Financial Structure in Debt Markets210

Tools to Help Solve Moral Hazard in Debt Contracts211

Summary213

Application Financial Development and Economic Growth213

Financial Crises and Aggregate Economic Activity215

Factors Causing Financial Crises215

Application Financial Crises in the United states217

Application Financial Crises in Developing Countries：The Case of Mexico，1994-1995219

BOX 2 Case Study of a Financial Crisis：The Great Depression220

Summary，Key Terms，Questions and Problems223

CHAPTER 10 THE BANKING FIRM AND THE MANAGEMENT OF FINANCIAL INSTITUTIONS226

Preview226

The Bank Balance Sheet226

Liabilities227

Assets229

BOX 1 Understanding Loan Loss Reserves230

Basic Operation of a Bank231

General Principles of Bank Management234

Liquidity Management and the Role of Reserves235

Asset Management238

Liability Management239

Capital Adequacy Management240

Application Strategies for Managing Bank Capital243

Application Did the Capital Crunch Cause a Credit Crunch in the Early 1990s？243

Managing Credit Risk244

Screening and Monitoring245

Long-Term Customer Relationship246

Loan Commitments247

Collateral and Compensating Balances247

BOX 2 Japanese and German Banking Arrangements：A Better Way to Deal with Asymmetric Information？248

Credit Rationing249

Managing Interest-Rate Risk249

Gap and Duration Analysis250

Application Strategies for Managing Interest-Rate Risk251

Off-Balance-Sheet Activities252

Loan Sales252

Generation of Free Income252

Trading Activities and Risk Management Techniques253

BOX 3 Barings，Daiwa，and Sumitomo：Rogue Traders and the Principal-Agent Problem254

Financial Innovation255

Responses to Changes in Demand Conditions256

Responses to Changes in Supply Conditions257

Avoidance of Existing Regulations259

Summary，Key Terms，Questions and Problems261

CHAPTER 11 BANKING INDUSTRY：STRUCTURE AND COMPETITION264

Preview264

Historical Development of the Banking System264

Multiple Regulatory Agencies267

Structure of the U.S.Commercial Banking Industry267

Restrictions on Branching268

Response to Branching Restrictions269

Nationwide Banking and Bank Consolidation271

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994272

What Will the Structure of the U.S.Banking Industry Look Like in the Future？273

BOX 1 Comparison of Banking Structure in the United States and Abroad274

Are Bank Consolidation and Nationwide Banking Good Things？274

Separation of the Banking and Securities Industries275

Repeal of the Glass-Steagall Act278

Separation of the Banking and Securities Industries in Other Countries278

Thrift Industry：Regulation and Structure278

Savings and Loan Associations278

Mutual Savings Banks279

Credit Unions279

International Banking280

Eurodollar Market281

BOX 2 Ironic Birth of the Eurodollar Market282

Structure of U.S.Banking Overseas282

Foreign Banks in the United States283

Financial Innovation and the Decline of Traditional Banking284

Behind the Decline：Four Financial Innovations284

Decline of Traditional Banking288

Reasons for the Decline288

Banks’Responses292

Decline of Traditional Banking in Other Industrialized Countries293

Summary，Key Terms，Questions and Problems294

CHAPTER 12 ECONOMIC ANALYSIS OF BANKING REGULATION296

Preview296

Asymmetric Information and Bank Regulation296

Government Safety Net：Deposit Insurance and the FDIC297

BOX 1 A Tale of Two Bank Collapses：Bank of New England and Freedom National Bank300

Restrictions on Asset Holdings and Bank Capital Requirements301

Bank Supervision：Chartering and Examination302

BOX 2 The Basel Accord on Risk-Based Capital Requirements303

A New Trend in Bank Supervision：Assessment of Risk Management304

Disclosure Requirements305

BOX 3 New Zealand’s Disclosure-Based Experiment in Bank Regulation306

BOX 4 The Community Reinvestment Act：A Political Hot Button307

Consumer Protection307

Restrictions on Competition307

Separation of the Banking and Securities Industries：The Glass-Steagall Act308

International Banking Regulation308

Problems in Regulating International Banking310

Summary310

BOX 5 The BCCI Scandal311

The 1980s U.S.Banking Crisis：Why？312

Early Stages of the Crisis312

Later Stages of the Crisis：Regulatory Forbearance314

Competitive Equality in Banking Act of 1987315

Political Economy of the Savings and Loan Crisis315

Principal-Agent Problem for Regulators and Politicians316

Application Principal-Agent Problem in Action：Charles Keating and the Lincoln Savings and Loan Scandal317

Savings and Loan Bailout：Financial Institutions Reform，Recovery，and Enforcement Act of 1989318

Federal Deposit Insurance Corporation Improvement Act of 1991319

BOX 6 The SAIF Fix and the Future of the S＆L Industry321

Application Evaluating FDICIA and Other Proposed Reforms of the Banking Regulatory System322

Banking Crises Throughout the World326

Scandinavia326

Latin America328

Eastern Europe328

Japan328

“Deja Vu All Over Again”329

Summary，Key Terms，Questions and Problems329

CHAPTER 13 NONBANK FINANCIAL INSTITUTIONS332

Preview332

Insurance Companies332

Life Insurance Companies333

Property and Casualty Insurance Companies334

The Competitive Threat from the Banking Industry335

BOX 1 The Woes of Lloyd’s of London336

BOX 2 Are Independent Insurance Agents Going the Way of the Milkman？337

Application Insurance Management337

Pension Funds341

Private Pension Plans342

Public Pension Plans342

BOX 3 Will Social Security Be Privatized？343

Finance Companies343

Mutual Funds345

Money Market Mutual Funds346

Government Financial Intermediation346

Federal Credit Agencies346

Government Loan Guarantees：Another Crisis Waiting to Happen？347

BOX 4 The Downside of Government Downsizing348

Securities Market Institutions348

Investment Banks348

BOX 5 America Is Number One—at Least in Investment Banking349

Following the Financial News New Securities Issues350

Securities Brokers and Dealers350

Organized Exchanges351

Summary，Key Terms，Questions and Problems352

CHAPTER 14 FINANCIAL DERIVATIVES354

Preview354

Forward Markets354

Interest-Rate Forward Contracts354

Application Hedging with Interest-Rate Forward Contracts355

Pros and Cons of Forward Contracts355

Financial Futures Markets356

Financial Futures Contracts356

Following the Financial News Financial Futures358

Application Hedging with Financial Futures359

Organization of Trading in Financial Futures Markets359

The Globalization of Financial Futures Markets360

Explaining the Success of Futures Markets360

BOX 1 The Hunt Brothers and the Silver Crash363

Some Problems with Financial Futures Markets364

Stock Index Futures365

BOX 2 Program Trading and Portfolio Insurance：Were They to Blame for the Stock Market Crash of 1987？366

Stock Index Futures Contracts366

Options367

Following the Financial News Futures Options368

Option Contracts368

Profits and Losses on Option and Futures Contracts369

Application Hedging with Futures Options372

Factors Affecting the Prices of Option Premiums373

Summary375

Interest-Rate Swaps375

Interest-Rate Swap Contracts375

Application Hedging with Interest-Rate Swaps376

Advantages of Interest-Rate Swaps377

Disadvantages of Interest-Rate Swaps377

Financial Intermediaries in Interest-Rate Swaps378

Application Hedging Foreign Exchange Risk379

Application Are Financial Derivatives a Worldwide Time Bomb？382

BOX 3 The Orange County Bankruptcy383

Summary，Key Terms，Questions and Problems384

PARTⅣ Central Banking and the Conduct of Monetary Policy387

CHAPTER 15 STRUCTURE OF CENTRAL BANKS AND THE FEDERAL RESERVE SYSTEM389

Preview389

Origins of the Federal Reserve System389

Formal Structure of the Federal Reserve System390

BOX 1 INSIDE THE FED The Political Genius of the Founders of the Federal Reserve System391

Federal Reserve Banks391

BOX 2 INSIDE THE FED Special Role of the Federal Reserve Bank of New York394

Member Banks394

Board of Governors of the Federal Reserve System395

Federal Open Market Committee（FOMC）396

BOX 3 INSIDE THE FED Role of the Research Staff397

The FOMC Meeting398

BOX 4 INSIDE THE FED Green，Blue，and Beige399

Informal Structure of the Federal Reserve System399

BOX 5 INSIDE THE FED Decoding the FOMC Derivative400

BOX 6 INSIDE THE FED Role of Member Banks in the Federal Reserve System402

How Independent Is the Fed？403

Structure and Independence of Foreign Central Banks405

Bank of England405

Deutsche Bundesbank406

Bank of Canada406

Bank of Japan406

The Trend Toward Greater Independence407

Explaining Central Bank Behavior407

Should the Fed Be Independent？408

The Case for Independence408

BOX 7 INSIDE THE FED Games the Fed Plays409

The Case Against Independence410

Central Bank Independence and Macroeconomic Performance in Seventeen Countries411

Summary，Key Terms，Questions and Problems412

CHAPTER 16 MULTIPLE DEPOSIT CREATION AND THE MONEY SUPPLY PROCESS414

Preview414

Four Players in the Money Supply Process414

The Fed’s Balance Sheet and the Monetary Base415

Assets415

Liabilities415

Monetary Base417

Control of the Monetary Base418

Federal Reserve Open Market Operations418

BOX 1 Foreign Exchange Rate Intervention and the Monetary Base423

Shifts from Deposits into Currency423

Discount Loans424

Overview of the Fed’s Ability to Control the Monetary Base425

Multiple Deposit Creation：A Simple Model425

Deposit Creation：The Single Bank425

Deposit Creation：The Banking System427

Multiple Deposit Contraction430

Deriving the Formula for Multiple Deposit Creation431

Critique of the Simple Model433

Summary，Key Terms，Questions and Problems433

CHAPTER 17 DETERMINANTS OF THE MONEY SUPPLY435

Preview435

The Money Supply Model and the Money Multiplier436

Deriving the Money Multiplier436

Intuition Behind the Money Multiplier438

Factors That Determine the Money Multiplier439

Changes in the Required Reserve Ratio rD439

Changes in the Currency Ratio ｛C/D｝440

Changes in the Excess Reserves Ratio ｛ER/D｝441

Additional Factors That Determine the Money Supply444

Changes in the Nonborrowed Monetary Base MB n444

Changes in Discount Loans DL from the Fed444

Market Interest Rates and the Discount Rate445

Overview of the Money Supply Process445

Application Explaining Movements in the Money Supply，1980-1996447

Application The Great Depression Bank Panics，1930-1933449

Summary，Key Terms，Questions and Problems453

Appendix to Chapter 17：The M2 Money Multiplier455

CHAPTER 18 TOOLS OF MONETARY POLICY458

Preview458

Open Market Operations458

A Day at the Trading Desk459

Advantages of Open Market Operations461

Discount Policy461

Operation of the Discount Window461

BOX 1 INSIDE THE FED Why Has Adjustment Credit Borrowing Shrunk to Such Low Levels in the 1990s？462

Lender of Last Resort464

BOX 2 INSIDE THE FED Discounting to Troubled Banks：Franklin National and Continental Illinois464

BOX 3 INSIDE THE FED Discounting to Prevent a Financial Panic：The Black Monday Stock Market Crash of 1987466

Announcement Effect467

Advantages and Disadvantages of Discount Policy467

Application Evaluating Proposed Reforms of Discount Policy467

Reserve Requirements469

Advantages and Disadvantages of Reserve Requirement Changes469

Application Evaluating Proposed Reforms of Reserve Requirements470

Application Why Have Reserve Requirements Been Declining Worldwide？471

Summary，Key Terms，Questions and Problems472

CHAPTER 19 CONDUCT OF MONETARY POLICY：GOALS AND TARGETS474

Preview474

Goals of Monetary Policy474

High Employment474

Economic Growth475

Price Stability476

Interest-Rate Stability476

Stability of Financial Markets476

BOX 1 The Growing European Commitment to Price Stability477

Stability in Foreign Exchange Markets477

Conflict Among Goals477

Central Bank Strategy：Use of Targets478

Choosing the Targets480

Criteria for Choosing Intermediate Targets481

Criteria for Choosing Operating Targets483

Fed Policy Procedures：Historical Perspective483

The Early Years：Discount Policy as the Primary Tool484

Discovery of Open Market Operations484

The Great Depression485

Reserve Requirements as a Policy Tool485

BOX 2 INSIDE THE FED Bank Panics of 1930-1933：Why Did the Fed Let Them Happen？486

War Finance and the Pegging of Interest Rates：1942-1951487

Targeting Money Market Conditions：The 1950sand 1960s487

Targeting Monetary Aggregates：The 1970s489

New Fed Operating Procedures：October 1979-October 1982490

Deemphasis of Monetary Aggregates：October 1982-Early 1990s492

Federal Funds Targeting Again：Early 1990s and Beyond493

International Considerations493

BOX 3 International Policy Coordination：The Plaza Agreement and the Louvre Accord494

Monetary Targeting in Other Countries494

United Kingdom495

Canada495

Germany496

Japan496

Lessons from Monetary Targeting Experiences497

The New International Trend in Monetary Policy Strategy：Inflation Targeting498

New Zealand498

Canada499

United Kingdom499

Lessons from Inflation Targeting Experiences499

Summary，Key Terms，Questions and Problems500

CHAPTER 20 THE INTERNATIONAL FINANCIAL SYSTEM502

Preview502

Intervention in the Foreign Exchange Market502

Foreign Exchange Intervention and the Money Supply502

BOX 1 INSIDE THE FED A Day at the Federal Reserve Bank of New York’s Foreign Exchange Desk504

Unsterilized Intervention505

Sterilized Intervention506

Balance of Payments507

Current Account508

Following the Financial News The Balance of Payments509

Capital Account510

Official Reserve Transactions Balance510

Methods of Financing the Balance of Payments511

Evolution of the International Financial System511

Gold Standard511

Bretton Woods System and the IMF512

Box 2 Argentina’s Currency Board516

Managed Float517

European Monetary System（EMS）518

Application September 1992 Foreign Exchange Crisis519

Application Mexican Peso Crisis of December 1994520

International Considerations and Monetary Policy521

Direct Effects of the Foreign Exchange Market on the Money Supply522

Balance-of-Payments Considerations522

Exchange Rate Considerations523

Summary，Key Terms，Questions and Problems523

PART Ⅴ Monetary Policy527

CHAPTER 21 THE DEMAND FOR MONEY529

Preview529

Quantity Theory of Money529

Velocity of Money and Equation of Exchange530

Quantity Theory531

Quantity Theory of Money Demand531

Cambridge Approach to Money Demand532

Is Velocity a Constant？533

Keynes’s Liquidity Preference Theory535

Transactions Motive535

Precautionary Motive535

Speculative Motive535

Putting the Three Motives Together536

Further Developments in the Keynesian Approach539

Transactions Demand539

Precautionary Demand542

Speculative Demand542

Friedman’s Modern Quantity Theory of Money544

Distinguishing Between the Friedman and Keynesian Theories545

Empirical Evidence on the Demand for Money548

Interest Rates and Money Demand548

Stability of Money Demand550

Summary，Key Terms，Questions and Problems553

CHAPTER 22 THE KEYNESIAN FRAMEWORK AND THE ISLM MODEL555

Preview555

Determination of Aggregate Output555

Consumer Expenditure and the Consumption Function557

Investment Spending558

BOX 1 Meaning of the Word Investment559

Equilibrium and the Keynesian Cross Diagram560

Expenditure Multiplier561

Application The Collapse of Investment Spending and the Great Depression564

Government’s Role564

Role of International Trade567

Summary of the Determinants of Aggregate Output567

The ISLM Model571

Equilibrium in the Goods Market：The IS Curve571

Equilibrium in the Market for Money：The LM Curve575

ISLM Approach to Aggregate Output and Interest Rates577

Summary，Key Terms，Questions and Problems578

CHAPTER 23 MONETARY AND FISCAL POLICY IN THE ISLM MODEL580

Preview580

Factors That Cause the IS Curve to Shift581

Factors That Cause the LM Curve to Shift583

Changes in Equilibrium Level of the Interest Rate and Aggregate Output585

Response to a Change in Monetary Policy585

Response to a Change in Fiscal Policy586

Application The Vietnam War Buildup and the Rise in Interest Rates，1965-1966588

Effectiveness of Monetary Versus Fiscal Policy590

Monetary Policy Versus Fiscal Policy：The Case of Complete Crowding Out590

Application Targeting Money Supply Versus Interest Rates592

ISLM Model in the Long Run596

ISLM Model and the Aggregate Demand Curve598

Deriving the Aggregate Demand Curve598

Factors That Cause the Aggregate Demand Curve to Shift599

Summary，Key Terms，Questions and Problems601

CHAPTER 24 AGGREGATE DEMAND AND SUPPLY ANALYSIS603

Preview603

Aggregate Demand603

Following the Financial News Aggregate Output，Unemployment，and the Price Level604

Monetarist View of Aggregate Demand604

Keynesian View of Aggregate Demand606

The Crowding-Out Debate607

Aggregate Supply608

Shifts in the Aggregate Supply Curve609

Equilibrium in Aggregate Supply and Demand Analysis610

Equilibrium in the Short Run610

Equilibrium in the Long Run611

Shifts in Aggregate Demand614

Shifts in Aggregate Supply616

Shifts in the Long-Run Aggregate Supply Curve：Real Business Cycle Theory and Hysteresis617

Conclusions620

Application Explaining Past Business Cycle Episodes620

Application Predicting Future EconomicActivity622

Summary，Key Terms，Questions and Problems623

Appendix to Chapter 24：Aggregate Supply and the Phillips Curve：Historical Perspective625

CHAPTER 25 TRANSMISSION MECHANISMS OF MONETARY POLICY：THE EVIDENCE629

Preview629

Framework for Evaluating Empirical Evidence630

Structural Model Evidence630

Reduced-Form Evidence631

Advantages and Disadvantages of Structural Model Evidence631

Advantages and Disadvantages of Reduced-Form Evidence632

BOX 1 Perils of Reverse Causation：A Russian Folk Tale633

Conclusions633

BOX 2 Perils of Ignoring an Outside Driving Factor：How to Lose a Presidential Election634

Early Keynesian Evidence on the Importance of Money634

Objections to Early Keynesian Evidence635

Early Monetarist Evidence on the Importance of Money637

Timing Evidence638

Statistical Evidence641

Historical Evidence642

Overview of the Monetarist Evidence643

Transmission Mechanisms of Monetari Policy643

BOX 3 Real Business Cycle Theory and the Debate on Money and Economic Activity644

Traditional Interest-Rate Channels644

Other Asset Price Channels647

Credit View649

BOX 4 Consumers’ Balance Sheets and the Great Depression652

Why Are Credit Channels Likely to Be Important？653

Application Credit Crunch and Slow Recovery from the 1990-1991 Recession653

Lessons for Monetary Policy654

Summary，Key Terms，Questions and Problems656

CHAPTER 26 MONEY AND INFLATION659

Preview659

Money and Inflation：Evidence659

German Hyperinflation，1921-1923660

BOX 1 Inflation and Money Growth Rates in Latin America，1986-1996661

Recent Episodes of Rapid Inflation662

Meaning of Inflation663

Views of Inflation663

Monetarist View663

Keynesian View664

Summary667

Origins of Inflationary Monetary Policy667

High Employment Targets and Inflation668

Budget Deficits and Inflation671

Application Explaining the Rise in U.S.Inflation，1960-1980675

Activist/Nonactivist Policy Debate679

Responses to High Unemployment679

Activist and Nonactivist Positions680

Expectations and the Activist/Nonactivist Debate681

BOX 2 Perils of Accommodating Policy：The Terrorism Dilemma683

Rules Versus Discretion：Conclusions683

Application Importance of Credibility to Volcker’s Victoryover Inflation684

Summary，Key Terms，Questions and Problems684

CHAPTER 27 THEORY OF RATIONAL EXPECTATIONS AND EFFICIENT CAPITAL MARKETS686

Preview686

Role of Expectations in Economic Activity687

Theory of Rational Expectations689

Formal Statement of the Theory691

Rationale Behind the Theory691

Implications of the Theory692

Efficient Markets Theory：Rational Expectations in Financial Markets692

Rationale Behind the Theory694

Stronger Version of Efficient Markets Theory695

Evidence on Efficient Markets Theory695

Evidence in Favor of Market Efficiency696

BOX 1 An Exception That Proves the Rule：Ivan Boesky697

Application Should Foreign Exchange Rates Follow a Random Walk？699

Evidence Against Market Efficiency699

Overview of the Evidence on Efficient Markets Theory701

Application Practical Guide to Investing in the Stock Market702

Following the Financial News Stock Prices703

BOX 2 Should You Hire an Ape as Your Investment Adviser？704

Evidence on Rational Expectations in Other Markets705

Application What Does the Stock Market Crash of1987 Tell Us About Rational Expectations and Efficient Markets？707

Summary，Key Terms，Questions and Problems708

CHAPTER 28 RATIONAL EXPECTATIONS：IMPLICATIONS FOR POLICY710

Preview710

The Lucas Critique of Policy Evaluation711

Econometric Policy Evaluation711

Example：The Term Structure of Interest Rates712

New Classical Macroeconomic Model713

Effects of Unanticipated and Anticipated Policy713

BOX 1 Proof of the Policy Ineffectiveness Proposition715

Can an Expansionary Policy Lead to a Decline in Aggregate Output？716

Implications for Policymakers717

New Keynesian Model717

Effects of Unanticipated and Anticipated Policy718

Implications for Policymakers720

Comparison of the Two New Models with the Traditional Model720

Short-Run Output and Price Responses721

Stabilization Policy722

Anti-inflation Policies724

Credibility in Fighting Inflation727

BOX 2 Ending the Bolivian Hyperinflation：Case Study of a Successful Anti-inflation Program728

Application Credibility and the Reagan Budget Deficits728

Impact of the Rational Expectations Revolutions729

Summary，Key Terms，Questions and Problems731

MATHEMATICAL APPENDIX TO CHAPTER 21：A Mathematical Treatment of the Baumol-Tobin and Tobin Mean Variance Models733

MATHEMATICAL APPENDIX TO CHAPTER 23：Algebra of the ISLM Model739

GLOSSARY743

ANSWERS TO SELECTED QUESTIONS AND PROBLEMS755

CREDITS771

INDEX773