PART Ⅰ Introduction 1
CHAPTER 1 WHY STUDY MONEY，BANKING，AND FINANCIAL MARKETS？ 3
Preview 3
Why Study Financial Markets？ 3
The Bond Market and Interest Rates 4
The Stock Market 4
The Foreign Exchange Market 6
Why Study Banking and Financial Institutions？ 7
Structure of the Financial System 7
Banks and Other Financial Institutions 8
Financial Innovation 8
Why Study Money and Monetary Policy？ 9
Money and Business Cycles 9
Money and Inflation 10
Money and Interest Rates 12
Conduct of Monetary Policy 12
Budget Deficits and Monetary Policy 13
How We Will Study Money，Banking，and Financial Markets 14
Concluding Remarks 15
Summary，Key Terms，Questions and Problems 15
Appendix to Chapter 1：Defining Aggregate Output，Income，and the Price Level 17
CHAPTER 2 AN OVERVIEW OF THE FINANCIAL SYSTEM 20
Preview 20
Function of Financial Markets 21
Structure of Financial Markets 23
Debt and Equity Markets 23
Primary and Secondary Markets 23
Exchanges and Over-the-Counter Markets 24
Money and Capital Markets 25
Financial Market Instruments 25
Money Market Instruments 25
Following the Financial News Money Market Rates 27
Capital Market Instruments 29
BOX 1 Mortgage-Backed Securities 31
Internationalization of Financial Markets 32
International Bond Market and Eurobonds 32
World Stock Markets 32
Following the Financial News Foreign Stock Market Indexes 33
Function of Financial Intermediaries 33
BOX 2 The Importance of Financial Intermediaries to Securities Markets：An International Comparison 34
Transaction Costs 34
Asymmetric Information：Adverse Selection and Moral Hazard 35
Financial Intermediaries 37
Depository Institutions 37
Contractual Savings Institutions 40
Investment Intermediaries 41
Regulation of the Financial System 42
Increasing Information Available to Investors 42
Ensuring the Soundness of Financial Intermediaries 42
Improving Control of Monetary Policy 45
Financial Regulation Abroad 45
Summary，Key Terms，Questions and Problems 45
CHAPTER 3 WHAT IS MONEY？ 48
Preview 48
Meaning of Money 48
Functions of Money 49
Medium of Exchange 49
Unit of Account 50
Store of Value 51
Evolution of the Payments System 52
BOX 1 Birth of a New European Currency：The Euro？ 54
Electronic Money：A Coming Global Phenomenon 55
Are We Moving to a Cashless Society？ 56
Measuring Money 57
Theoretical and Empirical Definitions of Money 57
The Federal Reserve’s Monetary Aggregates 58
Following the Financial News The Monetary Aggregates 61
Money as a Weighted Aggregate 61
How Reliable Are the Money Data？ 62
Summary，Key Terms，Questions and Problems 63
PARTⅡ Financial Markets 67
CHAPTER 4 UNDERSTANDING INTEREST RATES 69
Preview 69
Measuring Interest Rates 70
Present Value 71
Application The Cost of the S＆L Bailout：Was It Really $500 Billion？ 72
Yield to Maturity 72
Other Measures of Interest Rates 79
Current Yield 79
Yield on a Discount Basis 80
Application Reading the Wall Street Journal：The Bond Page 81
Following the Financial News Bond Prices and Interest Rates 82
The Distinction Between Interest Rates and Returns 84
Maturity and the Volatility of Bond Returns：Interest-Rate Risk 87
Summary 88
Application Should Retirees Invest in “Gilt-Edged”Long-Term Bonds？ 88
The Distinction Between Real and Nominal Interest Rates 89
Summary，Key Terms，Questions and Problems 92
CHAPTER 5 PORTFOLIO CHOICE 94
Preview 94
Determinants of Asset Demand 94
Wealth 95
Expected Returns 96
Risk 96
Liquidity 97
Theory of Portfolio Choice 97
Benefits of Diversification 98
Systematic Risk 100
Risk Premiums：Capital Asset Pricing Model and Arbitrage Pricing Theory 101
Summary，Key Terms，Questions and Problems 102
CHAPTER 6 THE BEHAVIOR OF INTEREST RATES 104
Preview 104
Loanable Funds Framework：Supply and Demand in the Bond Market 104
Demand Curve 105
Supply Curve 106
Market Equilibrium 107
Supply and Demand Analysis 108
Changes in Equilibrium Interest Rates 109
Shifts in the Demand for Bonds 110
Shifts in the Supply of Bonds 113
Application Changes in the Equilibrium Interest Rate Due to Expected Inflation or Business Cycle Expansions 115
Application Reading the Wall Street Journal：The “Credit Markets” Column 119
Following the Financial News The “Credit Markets” Column 120
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 Money 122
Changes in Equilibrium Interest Rates 124
Shifts in the Demand for Money 124
Shifts in the Supply of Money 125
Application Changes in the Equilibrium Interest Rate Due to Changes in Income，the Price Level，or the Money Supply 125
Application Money and Interest Rates 128
Following the Financial News Forecasting Interest Rates 132
Summary，Key Terms，Questions and Problems 135
Appendix to Chapter 6：Applying the Asset Market Approach to a Commodity Market：The Case of Gold 137
Application Changes in the Equilibrium Price of Gold Due to a Rise in Expected Inflation 140
Following the Financial News The “Commodities” Column 141
Application Reading the Wall Street Journal：The “Commodities”Column 142
CHAPTER 7 THE RISK AND TERM STRUCTURE OF INTEREST RATES 143
Preview 143
Risk Structure of Interest Rates 143
Default Risk 144
Application The Stock Market Crash of 1987 and the Junk Bond-Treasury Spread 147
Application What If Treasury Securities Were No Longer Default-Free？ 148
Liquidity 148
Income Tax Considerations 149
Summary 150
Application Effects of the Clinton Tax Increase on Bond Interest Rates 150
Term Structure of Interest Rates 151
Following the Financial News Yield Curves 153
Expectations Hypothesis 153
Segmented Markets Theory 157
Preferred Habitat and Liquidity Premium Theories 158
Recent Evidence on the Term Structure 160
Summary 160
Application Interpreting Yield Curves，1980-1997 161
Summary，Key Terms，Questions and Problems 163
CHAPTER 8 THE FOREIGN EXCHANGE MARKET 165
Preview 165
Foreign Exchange Market 165
What Are Foreign Exchange Rates？ 167
Why Are Exchange Rates Important？ 167
Following the Financial News Foreign Exchange Rates 168
How Is Foreign Exchange Traded？ 169
Exchange Rates in the Long Run 169
Law of One Price 170
Theory of Purchasing Power Parity 170
Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates 171
Factors That Affect Exchange Rates in the Long Run 172
Exchange Rates in the Short Run 174
Comparing Expected Returns on Domestic and Foreign Deposits 174
Interest Parity Condition 176
Equilibrium in the Foreign Exchange Market 177
Explaining Changes in Exchange Rates 179
Shifts in the Expected-Return Schedule for Foreign Deposits 179
Shifts in the Expected-Return Schedule for Domestic Deposits 181
Application Changes in the Equilibrium Exchange Rate：Two Examples 182
Application Why Are Exchange Rates So Volatile？ 187
Application The Dollar and Interest Rates，1973-1996 187
BOX 1 Forecasting Exchange Rates 188
Application Reading the Wall Street Journal：The “Foreign Exchange” Column 189
Following the Financial News The “Foreign Exchange”Column 190
Summary，Key Terms，Questions and Problems 191
PART Ⅲ Financial Institutions 193
CHAPTER 9 AN ECONOMIC ANALYSIS OF FINANCIAL STRUCTURE 195
Preview 195
Basic Puzzles About Financial Structure Throughout the World 195
Transaction Costs 199
How Transaction Costs Influence Financial Structure 199
How Financial Intermediaries Reduce Transaction Costs 200
Asymmetric Information：Adverse Selection and Moral Hazard 201
The Lemons Problem：How Adverse Selection Influences Financial Structure 201
Lemons in the Stock and Bond Markets 202
Tools to Help Solve Adverse Selection Problems 203
How Moral Hazard Affects the Choice Between Debt and Equity Contracts 207
Moral Hazard in Equity Contracts：The Principal-Agent Problem 207
Tools to Help Solve the Principal-Agent Problem 208
BOX 1 “Hollywood Accounting”：Has Forrest Gump Been a Loser？ 209
How Moral Hazard Influences Financial Structure in Debt Markets 210
Tools to Help Solve Moral Hazard in Debt Contracts 211
Summary 213
Application Financial Development and Economic Growth 213
Financial Crises and Aggregate Economic Activity 215
Factors Causing Financial Crises 215
Application Financial Crises in the United states 217
Application Financial Crises in Developing Countries：The Case of Mexico，1994-1995 219
BOX 2 Case Study of a Financial Crisis：The Great Depression 220
Summary，Key Terms，Questions and Problems 223
CHAPTER 10 THE BANKING FIRM AND THE MANAGEMENT OF FINANCIAL INSTITUTIONS 226
Preview 226
The Bank Balance Sheet 226
Liabilities 227
Assets 229
BOX 1 Understanding Loan Loss Reserves 230
Basic Operation of a Bank 231
General Principles of Bank Management 234
Liquidity Management and the Role of Reserves 235
Asset Management 238
Liability Management 239
Capital Adequacy Management 240
Application Strategies for Managing Bank Capital 243
Application Did the Capital Crunch Cause a Credit Crunch in the Early 1990s？ 243
Managing Credit Risk 244
Screening and Monitoring 245
Long-Term Customer Relationship 246
Loan Commitments 247
Collateral and Compensating Balances 247
BOX 2 Japanese and German Banking Arrangements：A Better Way to Deal with Asymmetric Information？ 248
Credit Rationing 249
Managing Interest-Rate Risk 249
Gap and Duration Analysis 250
Application Strategies for Managing Interest-Rate Risk 251
Off-Balance-Sheet Activities 252
Loan Sales 252
Generation of Free Income 252
Trading Activities and Risk Management Techniques 253
BOX 3 Barings，Daiwa，and Sumitomo：Rogue Traders and the Principal-Agent Problem 254
Financial Innovation 255
Responses to Changes in Demand Conditions 256
Responses to Changes in Supply Conditions 257
Avoidance of Existing Regulations 259
Summary，Key Terms，Questions and Problems 261
CHAPTER 11 BANKING INDUSTRY：STRUCTURE AND COMPETITION 264
Preview 264
Historical Development of the Banking System 264
Multiple Regulatory Agencies 267
Structure of the U.S.Commercial Banking Industry 267
Restrictions on Branching 268
Response to Branching Restrictions 269
Nationwide Banking and Bank Consolidation 271
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 272
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 Abroad 274
Are Bank Consolidation and Nationwide Banking Good Things？ 274
Separation of the Banking and Securities Industries 275
Repeal of the Glass-Steagall Act 278
Separation of the Banking and Securities Industries in Other Countries 278
Thrift Industry：Regulation and Structure 278
Savings and Loan Associations 278
Mutual Savings Banks 279
Credit Unions 279
International Banking 280
Eurodollar Market 281
BOX 2 Ironic Birth of the Eurodollar Market 282
Structure of U.S.Banking Overseas 282
Foreign Banks in the United States 283
Financial Innovation and the Decline of Traditional Banking 284
Behind the Decline：Four Financial Innovations 284
Decline of Traditional Banking 288
Reasons for the Decline 288
Banks’Responses 292
Decline of Traditional Banking in Other Industrialized Countries 293
Summary，Key Terms，Questions and Problems 294
CHAPTER 12 ECONOMIC ANALYSIS OF BANKING REGULATION 296
Preview 296
Asymmetric Information and Bank Regulation 296
Government Safety Net：Deposit Insurance and the FDIC 297
BOX 1 A Tale of Two Bank Collapses：Bank of New England and Freedom National Bank 300
Restrictions on Asset Holdings and Bank Capital Requirements 301
Bank Supervision：Chartering and Examination 302
BOX 2 The Basel Accord on Risk-Based Capital Requirements 303
A New Trend in Bank Supervision：Assessment of Risk Management 304
Disclosure Requirements 305
BOX 3 New Zealand’s Disclosure-Based Experiment in Bank Regulation 306
BOX 4 The Community Reinvestment Act：A Political Hot Button 307
Consumer Protection 307
Restrictions on Competition 307
Separation of the Banking and Securities Industries：The Glass-Steagall Act 308
International Banking Regulation 308
Problems in Regulating International Banking 310
Summary 310
BOX 5 The BCCI Scandal 311
The 1980s U.S.Banking Crisis：Why？ 312
Early Stages of the Crisis 312
Later Stages of the Crisis：Regulatory Forbearance 314
Competitive Equality in Banking Act of 1987 315
Political Economy of the Savings and Loan Crisis 315
Principal-Agent Problem for Regulators and Politicians 316
Application Principal-Agent Problem in Action：Charles Keating and the Lincoln Savings and Loan Scandal 317
Savings and Loan Bailout：Financial Institutions Reform，Recovery，and Enforcement Act of 1989 318
Federal Deposit Insurance Corporation Improvement Act of 1991 319
BOX 6 The SAIF Fix and the Future of the S＆L Industry 321
Application Evaluating FDICIA and Other Proposed Reforms of the Banking Regulatory System 322
Banking Crises Throughout the World 326
Scandinavia 326
Latin America 328
Eastern Europe 328
Japan 328
“Deja Vu All Over Again” 329
Summary，Key Terms，Questions and Problems 329
CHAPTER 13 NONBANK FINANCIAL INSTITUTIONS 332
Preview 332
Insurance Companies 332
Life Insurance Companies 333
Property and Casualty Insurance Companies 334
The Competitive Threat from the Banking Industry 335
BOX 1 The Woes of Lloyd’s of London 336
BOX 2 Are Independent Insurance Agents Going the Way of the Milkman？ 337
Application Insurance Management 337
Pension Funds 341
Private Pension Plans 342
Public Pension Plans 342
BOX 3 Will Social Security Be Privatized？ 343
Finance Companies 343
Mutual Funds 345
Money Market Mutual Funds 346
Government Financial Intermediation 346
Federal Credit Agencies 346
Government Loan Guarantees：Another Crisis Waiting to Happen？ 347
BOX 4 The Downside of Government Downsizing 348
Securities Market Institutions 348
Investment Banks 348
BOX 5 America Is Number One—at Least in Investment Banking 349
Following the Financial News New Securities Issues 350
Securities Brokers and Dealers 350
Organized Exchanges 351
Summary，Key Terms，Questions and Problems 352
CHAPTER 14 FINANCIAL DERIVATIVES 354
Preview 354
Forward Markets 354
Interest-Rate Forward Contracts 354
Application Hedging with Interest-Rate Forward Contracts 355
Pros and Cons of Forward Contracts 355
Financial Futures Markets 356
Financial Futures Contracts 356
Following the Financial News Financial Futures 358
Application Hedging with Financial Futures 359
Organization of Trading in Financial Futures Markets 359
The Globalization of Financial Futures Markets 360
Explaining the Success of Futures Markets 360
BOX 1 The Hunt Brothers and the Silver Crash 363
Some Problems with Financial Futures Markets 364
Stock Index Futures 365
BOX 2 Program Trading and Portfolio Insurance：Were They to Blame for the Stock Market Crash of 1987？ 366
Stock Index Futures Contracts 366
Options 367
Following the Financial News Futures Options 368
Option Contracts 368
Profits and Losses on Option and Futures Contracts 369
Application Hedging with Futures Options 372
Factors Affecting the Prices of Option Premiums 373
Summary 375
Interest-Rate Swaps 375
Interest-Rate Swap Contracts 375
Application Hedging with Interest-Rate Swaps 376
Advantages of Interest-Rate Swaps 377
Disadvantages of Interest-Rate Swaps 377
Financial Intermediaries in Interest-Rate Swaps 378
Application Hedging Foreign Exchange Risk 379
Application Are Financial Derivatives a Worldwide Time Bomb？ 382
BOX 3 The Orange County Bankruptcy 383
Summary，Key Terms，Questions and Problems 384
PARTⅣ Central Banking and the Conduct of Monetary Policy 387
CHAPTER 15 STRUCTURE OF CENTRAL BANKS AND THE FEDERAL RESERVE SYSTEM 389
Preview 389
Origins of the Federal Reserve System 389
Formal Structure of the Federal Reserve System 390
BOX 1 INSIDE THE FED The Political Genius of the Founders of the Federal Reserve System 391
Federal Reserve Banks 391
BOX 2 INSIDE THE FED Special Role of the Federal Reserve Bank of New York 394
Member Banks 394
Board of Governors of the Federal Reserve System 395
Federal Open Market Committee（FOMC） 396
BOX 3 INSIDE THE FED Role of the Research Staff 397
The FOMC Meeting 398
BOX 4 INSIDE THE FED Green，Blue，and Beige 399
Informal Structure of the Federal Reserve System 399
BOX 5 INSIDE THE FED Decoding the FOMC Derivative 400
BOX 6 INSIDE THE FED Role of Member Banks in the Federal Reserve System 402
How Independent Is the Fed？ 403
Structure and Independence of Foreign Central Banks 405
Bank of England 405
Deutsche Bundesbank 406
Bank of Canada 406
Bank of Japan 406
The Trend Toward Greater Independence 407
Explaining Central Bank Behavior 407
Should the Fed Be Independent？ 408
The Case for Independence 408
BOX 7 INSIDE THE FED Games the Fed Plays 409
The Case Against Independence 410
Central Bank Independence and Macroeconomic Performance in Seventeen Countries 411
Summary，Key Terms，Questions and Problems 412
CHAPTER 16 MULTIPLE DEPOSIT CREATION AND THE MONEY SUPPLY PROCESS 414
Preview 414
Four Players in the Money Supply Process 414
The Fed’s Balance Sheet and the Monetary Base 415
Assets 415
Liabilities 415
Monetary Base 417
Control of the Monetary Base 418
Federal Reserve Open Market Operations 418
BOX 1 Foreign Exchange Rate Intervention and the Monetary Base 423
Shifts from Deposits into Currency 423
Discount Loans 424
Overview of the Fed’s Ability to Control the Monetary Base 425
Multiple Deposit Creation：A Simple Model 425
Deposit Creation：The Single Bank 425
Deposit Creation：The Banking System 427
Multiple Deposit Contraction 430
Deriving the Formula for Multiple Deposit Creation 431
Critique of the Simple Model 433
Summary，Key Terms，Questions and Problems 433
CHAPTER 17 DETERMINANTS OF THE MONEY SUPPLY 435
Preview 435
The Money Supply Model and the Money Multiplier 436
Deriving the Money Multiplier 436
Intuition Behind the Money Multiplier 438
Factors That Determine the Money Multiplier 439
Changes in the Required Reserve Ratio rD 439
Changes in the Currency Ratio ｛C/D｝ 440
Changes in the Excess Reserves Ratio ｛ER/D｝ 441
Additional Factors That Determine the Money Supply 444
Changes in the Nonborrowed Monetary Base MB n 444
Changes in Discount Loans DL from the Fed 444
Market Interest Rates and the Discount Rate 445
Overview of the Money Supply Process 445
Application Explaining Movements in the Money Supply，1980-1996 447
Application The Great Depression Bank Panics，1930-1933 449
Summary，Key Terms，Questions and Problems 453
Appendix to Chapter 17：The M2 Money Multiplier 455
CHAPTER 18 TOOLS OF MONETARY POLICY 458
Preview 458
Open Market Operations 458
A Day at the Trading Desk 459
Advantages of Open Market Operations 461
Discount Policy 461
Operation of the Discount Window 461
BOX 1 INSIDE THE FED Why Has Adjustment Credit Borrowing Shrunk to Such Low Levels in the 1990s？ 462
Lender of Last Resort 464
BOX 2 INSIDE THE FED Discounting to Troubled Banks：Franklin National and Continental Illinois 464
BOX 3 INSIDE THE FED Discounting to Prevent a Financial Panic：The Black Monday Stock Market Crash of 1987 466
Announcement Effect 467
Advantages and Disadvantages of Discount Policy 467
Application Evaluating Proposed Reforms of Discount Policy 467
Reserve Requirements 469
Advantages and Disadvantages of Reserve Requirement Changes 469
Application Evaluating Proposed Reforms of Reserve Requirements 470
Application Why Have Reserve Requirements Been Declining Worldwide？ 471
Summary，Key Terms，Questions and Problems 472
CHAPTER 19 CONDUCT OF MONETARY POLICY：GOALS AND TARGETS 474
Preview 474
Goals of Monetary Policy 474
High Employment 474
Economic Growth 475
Price Stability 476
Interest-Rate Stability 476
Stability of Financial Markets 476
BOX 1 The Growing European Commitment to Price Stability 477
Stability in Foreign Exchange Markets 477
Conflict Among Goals 477
Central Bank Strategy：Use of Targets 478
Choosing the Targets 480
Criteria for Choosing Intermediate Targets 481
Criteria for Choosing Operating Targets 483
Fed Policy Procedures：Historical Perspective 483
The Early Years：Discount Policy as the Primary Tool 484
Discovery of Open Market Operations 484
The Great Depression 485
Reserve Requirements as a Policy Tool 485
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：1942-1951 487
Targeting Money Market Conditions：The 1950sand 1960s 487
Targeting Monetary Aggregates：The 1970s 489
New Fed Operating Procedures：October 1979-October 1982 490
Deemphasis of Monetary Aggregates：October 1982-Early 1990s 492
Federal Funds Targeting Again：Early 1990s and Beyond 493
International Considerations 493
BOX 3 International Policy Coordination：The Plaza Agreement and the Louvre Accord 494
Monetary Targeting in Other Countries 494
United Kingdom 495
Canada 495
Germany 496
Japan 496
Lessons from Monetary Targeting Experiences 497
The New International Trend in Monetary Policy Strategy：Inflation Targeting 498
New Zealand 498
Canada 499
United Kingdom 499
Lessons from Inflation Targeting Experiences 499
Summary，Key Terms，Questions and Problems 500
CHAPTER 20 THE INTERNATIONAL FINANCIAL SYSTEM 502
Preview 502
Intervention in the Foreign Exchange Market 502
Foreign Exchange Intervention and the Money Supply 502
BOX 1 INSIDE THE FED A Day at the Federal Reserve Bank of New York’s Foreign Exchange Desk 504
Unsterilized Intervention 505
Sterilized Intervention 506
Balance of Payments 507
Current Account 508
Following the Financial News The Balance of Payments 509
Capital Account 510
Official Reserve Transactions Balance 510
Methods of Financing the Balance of Payments 511
Evolution of the International Financial System 511
Gold Standard 511
Bretton Woods System and the IMF 512
Box 2 Argentina’s Currency Board 516
Managed Float 517
European Monetary System（EMS） 518
Application September 1992 Foreign Exchange Crisis 519
Application Mexican Peso Crisis of December 1994 520
International Considerations and Monetary Policy 521
Direct Effects of the Foreign Exchange Market on the Money Supply 522
Balance-of-Payments Considerations 522
Exchange Rate Considerations 523
Summary，Key Terms，Questions and Problems 523
PART Ⅴ Monetary Policy 527
CHAPTER 21 THE DEMAND FOR MONEY 529
Preview 529
Quantity Theory of Money 529
Velocity of Money and Equation of Exchange 530
Quantity Theory 531
Quantity Theory of Money Demand 531
Cambridge Approach to Money Demand 532
Is Velocity a Constant？ 533
Keynes’s Liquidity Preference Theory 535
Transactions Motive 535
Precautionary Motive 535
Speculative Motive 535
Putting the Three Motives Together 536
Further Developments in the Keynesian Approach 539
Transactions Demand 539
Precautionary Demand 542
Speculative Demand 542
Friedman’s Modern Quantity Theory of Money 544
Distinguishing Between the Friedman and Keynesian Theories 545
Empirical Evidence on the Demand for Money 548
Interest Rates and Money Demand 548
Stability of Money Demand 550
Summary，Key Terms，Questions and Problems 553
CHAPTER 22 THE KEYNESIAN FRAMEWORK AND THE ISLM MODEL 555
Preview 555
Determination of Aggregate Output 555
Consumer Expenditure and the Consumption Function 557
Investment Spending 558
BOX 1 Meaning of the Word Investment 559
Equilibrium and the Keynesian Cross Diagram 560
Expenditure Multiplier 561
Application The Collapse of Investment Spending and the Great Depression 564
Government’s Role 564
Role of International Trade 567
Summary of the Determinants of Aggregate Output 567
The ISLM Model 571
Equilibrium in the Goods Market：The IS Curve 571
Equilibrium in the Market for Money：The LM Curve 575
ISLM Approach to Aggregate Output and Interest Rates 577
Summary，Key Terms，Questions and Problems 578
CHAPTER 23 MONETARY AND FISCAL POLICY IN THE ISLM MODEL 580
Preview 580
Factors That Cause the IS Curve to Shift 581
Factors That Cause the LM Curve to Shift 583
Changes in Equilibrium Level of the Interest Rate and Aggregate Output 585
Response to a Change in Monetary Policy 585
Response to a Change in Fiscal Policy 586
Application The Vietnam War Buildup and the Rise in Interest Rates，1965-1966 588
Effectiveness of Monetary Versus Fiscal Policy 590
Monetary Policy Versus Fiscal Policy：The Case of Complete Crowding Out 590
Application Targeting Money Supply Versus Interest Rates 592
ISLM Model in the Long Run 596
ISLM Model and the Aggregate Demand Curve 598
Deriving the Aggregate Demand Curve 598
Factors That Cause the Aggregate Demand Curve to Shift 599
Summary，Key Terms，Questions and Problems 601
CHAPTER 24 AGGREGATE DEMAND AND SUPPLY ANALYSIS 603
Preview 603
Aggregate Demand 603
Following the Financial News Aggregate Output，Unemployment，and the Price Level 604
Monetarist View of Aggregate Demand 604
Keynesian View of Aggregate Demand 606
The Crowding-Out Debate 607
Aggregate Supply 608
Shifts in the Aggregate Supply Curve 609
Equilibrium in Aggregate Supply and Demand Analysis 610
Equilibrium in the Short Run 610
Equilibrium in the Long Run 611
Shifts in Aggregate Demand 614
Shifts in Aggregate Supply 616
Shifts in the Long-Run Aggregate Supply Curve：Real Business Cycle Theory and Hysteresis 617
Conclusions 620
Application Explaining Past Business Cycle Episodes 620
Application Predicting Future EconomicActivity 622
Summary，Key Terms，Questions and Problems 623
Appendix to Chapter 24：Aggregate Supply and the Phillips Curve：Historical Perspective 625
CHAPTER 25 TRANSMISSION MECHANISMS OF MONETARY POLICY：THE EVIDENCE 629
Preview 629
Framework for Evaluating Empirical Evidence 630
Structural Model Evidence 630
Reduced-Form Evidence 631
Advantages and Disadvantages of Structural Model Evidence 631
Advantages and Disadvantages of Reduced-Form Evidence 632
BOX 1 Perils of Reverse Causation：A Russian Folk Tale 633
Conclusions 633
BOX 2 Perils of Ignoring an Outside Driving Factor：How to Lose a Presidential Election 634
Early Keynesian Evidence on the Importance of Money 634
Objections to Early Keynesian Evidence 635
Early Monetarist Evidence on the Importance of Money 637
Timing Evidence 638
Statistical Evidence 641
Historical Evidence 642
Overview of the Monetarist Evidence 643
Transmission Mechanisms of Monetari Policy 643
BOX 3 Real Business Cycle Theory and the Debate on Money and Economic Activity 644
Traditional Interest-Rate Channels 644
Other Asset Price Channels 647
Credit View 649
BOX 4 Consumers’ Balance Sheets and the Great Depression 652
Why Are Credit Channels Likely to Be Important？ 653
Application Credit Crunch and Slow Recovery from the 1990-1991 Recession 653
Lessons for Monetary Policy 654
Summary，Key Terms，Questions and Problems 656
CHAPTER 26 MONEY AND INFLATION 659
Preview 659
Money and Inflation：Evidence 659
German Hyperinflation，1921-1923 660
BOX 1 Inflation and Money Growth Rates in Latin America，1986-1996 661
Recent Episodes of Rapid Inflation 662
Meaning of Inflation 663
Views of Inflation 663
Monetarist View 663
Keynesian View 664
Summary 667
Origins of Inflationary Monetary Policy 667
High Employment Targets and Inflation 668
Budget Deficits and Inflation 671
Application Explaining the Rise in U.S.Inflation，1960-1980 675
Activist/Nonactivist Policy Debate 679
Responses to High Unemployment 679
Activist and Nonactivist Positions 680
Expectations and the Activist/Nonactivist Debate 681
BOX 2 Perils of Accommodating Policy：The Terrorism Dilemma 683
Rules Versus Discretion：Conclusions 683
Application Importance of Credibility to Volcker’s Victoryover Inflation 684
Summary，Key Terms，Questions and Problems 684
CHAPTER 27 THEORY OF RATIONAL EXPECTATIONS AND EFFICIENT CAPITAL MARKETS 686
Preview 686
Role of Expectations in Economic Activity 687
Theory of Rational Expectations 689
Formal Statement of the Theory 691
Rationale Behind the Theory 691
Implications of the Theory 692
Efficient Markets Theory：Rational Expectations in Financial Markets 692
Rationale Behind the Theory 694
Stronger Version of Efficient Markets Theory 695
Evidence on Efficient Markets Theory 695
Evidence in Favor of Market Efficiency 696
BOX 1 An Exception That Proves the Rule：Ivan Boesky 697
Application Should Foreign Exchange Rates Follow a Random Walk？ 699
Evidence Against Market Efficiency 699
Overview of the Evidence on Efficient Markets Theory 701
Application Practical Guide to Investing in the Stock Market 702
Following the Financial News Stock Prices 703
BOX 2 Should You Hire an Ape as Your Investment Adviser？ 704
Evidence on Rational Expectations in Other Markets 705
Application What Does the Stock Market Crash of1987 Tell Us About Rational Expectations and Efficient Markets？ 707
Summary，Key Terms，Questions and Problems 708
CHAPTER 28 RATIONAL EXPECTATIONS：IMPLICATIONS FOR POLICY 710
Preview 710
The Lucas Critique of Policy Evaluation 711
Econometric Policy Evaluation 711
Example：The Term Structure of Interest Rates 712
New Classical Macroeconomic Model 713
Effects of Unanticipated and Anticipated Policy 713
BOX 1 Proof of the Policy Ineffectiveness Proposition 715
Can an Expansionary Policy Lead to a Decline in Aggregate Output？ 716
Implications for Policymakers 717
New Keynesian Model 717
Effects of Unanticipated and Anticipated Policy 718
Implications for Policymakers 720
Comparison of the Two New Models with the Traditional Model 720
Short-Run Output and Price Responses 721
Stabilization Policy 722
Anti-inflation Policies 724
Credibility in Fighting Inflation 727
BOX 2 Ending the Bolivian Hyperinflation：Case Study of a Successful Anti-inflation Program 728
Application Credibility and the Reagan Budget Deficits 728
Impact of the Rational Expectations Revolutions 729
Summary，Key Terms，Questions and Problems 731
MATHEMATICAL APPENDIX TO CHAPTER 21：A Mathematical Treatment of the Baumol-Tobin and Tobin Mean Variance Models 733
MATHEMATICAL APPENDIX TO CHAPTER 23：Algebra of the ISLM Model 739
GLOSSARY 743
ANSWERS TO SELECTED QUESTIONS AND PROBLEMS 755
CREDITS 771
INDEX 773