Principles Of Money, Banking & Financial Markets: Pearson New International Edition [PDF] [6gueuknq35a0] (2024)

Money, Banking & Financial Markets Ritter Silber Udell 12e

ISBN 978-1-29204-204-6

9 781292 042046

Money, Banking & Financial Markets Principles of Ritter Silber Udell Twelfth Edition

Pearson New International Edition Money, Banking & Financial Markets Principles of Ritter Silber Udell Twelfth Edition

Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at: www.pearsoned.co.uk © Pearson Education Limited 2014 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS. All trademarks used herein are the property of their respective owners. The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with or endorsem*nt of this book by such owners.

ISBN 10: 1-292-04204-4 ISBN 10: 1-269-37450-8 ISBN 13: 978-1-292-04204-6 ISBN 13: 978-1-269-37450-7

British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Printed in the United States of America

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Table of Contents

1. Introducing Money, Banking, and Financial Markets Lawrence S. Ritter/William L. Silber/Gregory F. Udell

1

2. The Role of Money in the Macroeconomy Lawrence S. Ritter/William L. Silber/Gregory F. Udell

11

3. Financial Instruments, Markets, and Institutions Lawrence S. Ritter/William L. Silber/Gregory F. Udell

29

4. Interest Rate Measurement and Behavior Lawrence S. Ritter/William L. Silber/Gregory F. Udell

47

5. The Term and Risk Structure of Interest Rates Lawrence S. Ritter/William L. Silber/Gregory F. Udell

71

6. The Structure and Performance of Securities Markets Lawrence S. Ritter/William L. Silber/Gregory F. Udell

89

7. The Pricing of Risky Financial Assets Lawrence S. Ritter/William L. Silber/Gregory F. Udell

103

8. Money and Capital Markets Lawrence S. Ritter/William L. Silber/Gregory F. Udell

115

9. Demystifying Derivatives Lawrence S. Ritter/William L. Silber/Gregory F. Udell

145

10. Understanding Foreign Exchange Lawrence S. Ritter/William L. Silber/Gregory F. Udell

165

11. The Nature of Financial Intermediation Lawrence S. Ritter/William L. Silber/Gregory F. Udell

185

12. Depository Financial Institutions Lawrence S. Ritter/William L. Silber/Gregory F. Udell

207

13. Nondepository Financial Institutions Lawrence S. Ritter/William L. Silber/Gregory F. Udell

237

I

14. Understanding Financial Contracts Lawrence S. Ritter/William L. Silber/Gregory F. Udell

253

15. The Regulation of Markets and Institutions Lawrence S. Ritter/William L. Silber/Gregory F. Udell

277

16. Financial System Design Lawrence S. Ritter/William L. Silber/Gregory F. Udell

299

17. The Classical Foundations Lawrence S. Ritter/William L. Silber/Gregory F. Udell

319

18. The Keynesian Framework Lawrence S. Ritter/William L. Silber/Gregory F. Udell

341

19. The ISLM World Lawrence S. Ritter/William L. Silber/Gregory F. Udell

371

20. Money and Economic Stability in the ISLM World Lawrence S. Ritter/William L. Silber/Gregory F. Udell

407

21. An Aggregate Supply and Demand Perspective on Money and Economic Stability Lawrence S. Ritter/William L. Silber/Gregory F. Udell

423

22. Rational Expectations: Theory and Policy Implications Lawrence S. Ritter/William L. Silber/Gregory F. Udell

445

23. Empirical Evidence on the Effectiveness of Monetary Policy Lawrence S. Ritter/William L. Silber/Gregory F. Udell

457

24. Tying It All Together

II

Lawrence S. Ritter/William L. Silber/Gregory F. Udell

471

Glossary Lawrence S. Ritter/William L. Silber/Gregory F. Udell

485

Index

503

Introducing Money, Banking, and Financial Markets Oscar Wilde wrote that a cynic knows the price of everything and the value of nothing. Although that’s certainly worthy of further reflection, for our purposes, price and value refer to the same thing: how much a security or financial asset is worth. Financial markets generate prices whenever securities are bought or sold. Financial institutions value financial assets whenever making loans to businesses or consumers. Thus pricing and valuation of financial assets are at the heart of the financial marketplace. One of our objectives is to link the behavior of securities prices, such as for stocks and bonds, to the performance of the economy as a whole, as well as with the behavior of financial institutions and markets. But first things first. What exactly do we mean by money, banking, and financial markets? The money in money, banking, and financial markets refers not only to the greenbacks we spend, but more broadly to the monetary economy. Money plays a key role in the performance of the economy. It not only facilitates transactions among the millions of economic players in the economy, but it represents the principal mechanism through which central banks attempt to influence aggregate economic activity, including economic growth, employment, and inflation. The banking in money, banking, and financial markets refers to banks and other financial intermediaries. A financial intermediary is an institution that takes funds from one group of investors and redeploys those funds by investing in financial assets. Banks serve as the principal caretaker of the economy’s money supply and, along with other financial intermediaries, provide an important source of funds for consumers and businesses. The financial markets in money, banking, and financial markets refer to the markets in which financial assets can be traded. Financial markets provide a mechanism for those with excess funds to purchase securities, such as stocks and bonds, issued by those who need funds. Moreover, financial markets provide prices for those stocks and bonds, so that we know whether to conceal or brag about our most recent purchases.

From Chapter 1 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

1

Introducing Money, Banking, and Financial Markets

LEARNING OBJECTIVES In this chapter you will learn to see the importance of money, banking, and financial markets understand possible careers that use the skills and knowledge gained through studying this topic

An Overview Money in the modern economy is sometimes viewed as a lubricant that greases the wheels of economic activity. Without money, the transactions that make up our daily economic routine would be unimaginably difficult, and saving and investing would be almost full-time jobs. Money, however, is more than just a lubricant that enables the economy to operate smoothly. Money also plays a key role in influencing the behavior of the economy as a whole and the performance of financial institutions and markets. More specifically, changes in the supply of money and credit can affect how rapidly the economy grows, the level of employment, and the rate of inflation—and these, in turn, can affect the value of financial assets held by individuals and institutions. Banks play a particularly critical role in the economy. Banks provide a place where individuals and businesses can invest their funds to earn interest with a minimum of risk. Banks, in turn, redeploy these funds by making loans. In this regard, banks are remarkably similar to other financial intermediaries like finance companies and insurance companies, which also acquire funds from individuals and businesses and pass on these funds to other individuals and businesses. Like finance companies and life insurance companies, banks are well-equipped to invest in the most challenging types of financial investments—loans to individuals and small businesses. Why are banks singled out for special treatment? As it turns out, most of what we call money in the United States is represented by the deposits issued by banks. Consequently, banks serve as the principal caretakers of the payments system because we write checks on our bank accounts to pay for things we buy. Moreover, because money has linkages to the overall performance of the economy, banks are intimately involved in how the central bank of the United States, called the Federal Reserve (“the Fed”), influences overall economic activity. In particular, the Federal Reserve directly influences the lending and deposit creation activities of banks. This, in turn, helps determine how much people are willing to save and how much businesses are willing to invest and whether the prices of stocks and bonds go up, down, or sideways in the financial markets.

2

Introducing Money, Banking, and Financial Markets

Why Study Money, Banking, and Financial Markets? Why would you want to study money, banking, and financial markets? Will it make you a better person? The answer is: of course! For example, this book will help prepare you for that fateful moment when someone asks you whether interest rates will go up or down. Not impressed? You will be able to make sense out of the business section of your favorite newspaper. Still not impressed? Well, another reason for studying money and banking is that it will help you get a job after you graduate. And that should interest everyone! So, let’s see what you can do—in money, banking, and financial markets.

Careers in Banking and Financial Markets There are lots of jobs at banks having nothing at all to do with banking—like repairing computer terminals and running the executive dining room. Although these are important activities, they are not what we usually think of when banking is mentioned as a career. Our most visible contacts with banks—the teller who takes our money and the branch officer in charge of student loans—are somewhat closer to what banking is all about, but these are only two of the many specialized tasks that fall under banking and financial markets more generally.

3

Introducing Money, Banking, and Financial Markets

We cannot offer a comprehensive review of all career opportunities in banking and financial markets. And even if we could, it would turn out to be more tedious than the upcoming discussion of the bank reserve equation (if that’s possible). Instead we will provide a brief overview of the terrain and then offer some details on specific interesting opportunities. In particular, we will not describe what lawyers and accountants who work for banks or other financial institutions actually do; rather, we will focus on the derring-do of bond traders and Fed watchers—after all, that’s where the money is (or was).

General Opportunities The first thing to consider with a career in banking and financial markets is whose side you want to be on. Jobs in the private sector with a bank, mutual fund, or insurance company focus on profits; jobs in the public sector with the Federal Reserve system, Federal Deposit Insurance Corporation (FDIC), or state insurance departments focus on safety. Although both public and private sector jobs deal with financial institutions and markets, with people on both sides of the fence often looking at similar things, their perspectives are quite different. A bank examiner with the FDIC or Federal Reserve will review a commercial bank’s books to determine whether loans with delinquent payments impair the bank’s capital; a commercial loan officer at a bank will examine a prospective borrower’s books to determine whether timely repayments of interest and principal will add to the bank’s profits. Although both the bank examiner and the loan officer use corporate finance and accounting skills, their objectives and motivations are not the same. Suppose pursuing the profit motive is your favorite pastime. You would then have an array of subindustries within financial markets to consider, including commercial banking, investment banking, insurance, and pension funds. Although each of these financial institutions has a different overall objective, there are particular skills that are easily transferable among them. For example, both a bank economist and an insurance company economist would forecast interest rates, talk with the institution’s corporate customers about their particular industry’s outlook, and evaluate the costs and benefits of some internal investment project. Economic and statistical analyses come into play in each and every case. Similarly, an investment officer or portfolio manager for an insurance company, bank, or pension fund will evaluate the merits of putting money into stocks or fixed income securities and, if the latter, whether the investments should be long term or short term. Once you focus attention on a particular industry, an equally important decision centers on whether to concentrate on the retail or wholesale end of the business. Most financial institutions operate on both levels. A commercial bank has people dedicated to explaining the advantages of different types of certificates of deposit (CDs) to depositors with as little as $1,000 to invest.

4

Introducing Money, Banking, and Financial Markets

Banks also have CD traders and salespeople who specialize in placing large certificates of deposit ($100,000 and up) with institutional investors, such as money market mutual funds and large corporations. Both activities raise funds for the banks, but they require very different skills. Retail CDs are marketed by people with strong interpersonal skills, while wholesale CDs are sold by people who are equally comfortable with interest rate calculations, movements in the term structure of interest rates, and whether the Federal Reserve’s Open Market Committee is likely to vote yes or no to a tighter or easier monetary policy. The CD salespeople for commercial banks must be capable of discussing these factors in order to tailor the CDs to the needs of sophisticated corporate treasurers. A final distinguishing characteristic among institutions, as well as jobs within a particular firm, centers on domestic versus international business. Despite the growing interrelationship between foreign and domestic activities, there are different regulations that apply in each area, as well as foreign exchange rate movements that must be considered when you are dealing with foreign institutions. If you work for an international bank or if you are a foreign exchange trader, you must feel comfortable with the Japanese yen, British pound, Swiss franc, and whatever else comes along. There are, no doubt, other ways to categorize the opportunities available within banking and financial markets. But once you’ve decided upon public versus private, banking versus insurance, wholesale versus retail, and domestic versus international, you’ve come far enough along to focus on exactly what you might want to do. In the next section we outline one or two glamorous opportunities (at least as far as financial markets are concerned).

Specific Opportunities As financial markets have moved toward deregulation, business has become more transactions-oriented. The increased emphasis on transactions has generated a bonanza for people with skills in sales and trading, as well as for those with the analytical techniques to support these activities. Sales and trading jobs at the major investment banks and large commercial banks are exciting, well-paid opportunities; so are the jobs as financial economists, statisticians, and mathematicians that form the underlying brain trust. Let’s take a somewhat closer look at what these people do and what it takes to get on the road to financial market stardom. Trading We will encounter the role of a trader when we describe how a dealer makes a market by quoting a bid and offer for a particular security. Many of the large financial institutions are market makers in a wide variety of instruments. For example, commercial banks might be market makers in Treasury securities, mortgage-related instruments, and municipal bonds. Investment banks add corporate bonds to the list, while the major thrift institutions usually restrict their

5

Introducing Money, Banking, and Financial Markets

attention to mortgage-backed securities. In addition to buying and selling these investment-type instruments, large banks also make markets in CDs and other short-term money market instruments. The trader’s job at these institutions is to quote bids and offers for securities on a continuous basis and to accommodate incoming purchase and sale orders from other banks, thrifts, pension funds, and insurance companies. You will see that the dealer earns a profit by buying securities at the bid price ($97) and turning around and selling at the offer price ($99) before the equilibrium price ($98) has changed. A trader has to be extremely sensitive to shifting market conditions; otherwise a profit can quickly turn into a loss. For example, if a trader for the First National Profit Bank buys some government bonds at a price of $97 from an insurance company, and before the trader has a chance to sell the bonds to an incoming purchase order from a pension fund, the government announces a rise in the consumer price index, the equilibrium price of the bonds may drop to $95. With a bid and offer now at $94 and $96, respectively, the dealer winds up selling the securities that were bought at $97 for $96: a one dollar loss instead of a two dollar profit. Traders must continuously monitor market conditions and alter their quotes so that they don’t get stuck with unwanted inventory. In addition to concentrating on the market, traders must have the discipline to take profits when they are there and cut losses before they turn into disasters. It is sometimes said that the three most important characteristics of a successful trader are discipline, discipline, and discipline. Traders are frequently viewed as interchangeable parts. A person with discipline, concentration, and sensitivity who can trade government bonds successfully can switch to trading municipals, corporates, or CDs. The details of each instrument can be quickly absorbed (see Chapter 8 first) as long as the trader’s intuition is finely tuned. Traders start their day early—7:30 A.M. on the East Coast, 4:30 A.M. on the West Coast. Much of their time is spent under intense pressure, trying to extract information about likely price movements of the securities they are responsible for from the price movements of related instruments. In trying to gauge market sentiment, they work closely with salespeople who deal with their institution’s customers. Let’s take a closer look at what these salespeople actually do. Sales On the retail level, securities are sold to individuals by people whom we call stockbrokers. They are more formally called account executives by the securities firms that they work for. These investment banks also employ account executives to sell stocks and bonds to institutional investors such as pension funds and insurance companies. Commercial banks and large thrifts similarly employ salespeople to sell government bonds, municipals, and mortgages to institutional investors.

6

Introducing Money, Banking, and Financial Markets

The salesperson’s job is twofold: On the one hand, he or she tries to uncover information about the types of securities that institutional investors are most interested in buying and selling; and on the other hand, she or he tries to convince the bank’s customers to buy the securities that the bank has already acquired through the activities of its traders. Thus salespeople provide information to traders about the sentiment within the investment community as well as creating an outlet for the securities that traders have acquired. Obviously, these two activities go together. If salespeople report little investor interest in long-term government bonds, the commercial bank’s traders will be less aggressive buyers of such securities. People employed in sales have to be gregarious and people-oriented. They spend considerable time talking on the phone to customers throughout the country and must feel comfortable with simple chitchat. In addition, however, salespeople must bring investment ideas to the party. In order to make a sale, the salesperson must convince the insurance company’s portfolio manager, for example, that shifting out of a long-term government bond into a GNMA pass-through security will increase yields without unduly increasing risk exposure. To be effective, therefore, salespeople must have some perspective on the likely movements in interest rates over various investment horizons as well as a working knowledge of how specific bond characteristics, such as particular coupons, call provisions, and tax treatment will influence an investment’s performance. (They also have to know that GNMA stands for Government National Mortgage Association.) Salespeople obviously benefit considerably, therefore, from a solid course in money, banking, and financial markets. In addition, however, they pay close attention to what the bank’s brain trust of professional economists, statisticians, and other fixed-income researchers have to say about markets in general and specific instruments in particular. Let’s see what kind of information the research staff provides. Financial Economist Most fixed-income divisions within large commercial and investment banks and thrift institutions employ an economist who is designated as a Fed watcher. The primary job of this money market specialist is to alert traders and salespeople to the expected activities of the Federal Reserve. Thus the Fed watcher pays close attention to the bank reserve equation as well as to the Federal Open Market Committee’s most recent policy directive. Much of the Fed watcher’s analysis is communicated to traders and salespeople in brief memos. In addition, when an important news item comes across the news ticker, such as the release of the consumer price index or the employment report, the Fed watcher may use the firm’s intercom to provide instant analysis to traders and salespeople. All these items provide salespeople with important discussion points for use with customers. However, salespeople have to translate the Fed watcher’s general overview of interest rate movements and economic activity into concrete strategies for institutional investors.

7

Introducing Money, Banking, and Financial Markets

For this perspective, the salesperson turns to the fixed-income group’s rocket scientists. Fixed-Income Research Swapping a government bond for a GNMA passthrough security has wide-ranging implications for the composition of a pension fund’s portfolio, despite the fact that GNMAs and government bonds are both insured by the federal government. We will highlight the fact that the prepayment uncertainty associated with mortgage-related securities makes the maturity of these securities uncertain. The econometricians, statisticians, and mathematicians who work in the fixed-income research area provide, among other things, estimates of prepayments on GNMA pass-through securities so that salespeople can help explain the ramifications of GNMA purchases to their customers. The fixed-income research group also reports on such obscure items as the probability of a particular corporate bond being called by the issuer prior to maturity, the advantages of swapping low-coupon bonds for high-coupons or vice versa, and the price sensitivity of a bond portfolio to a one-percentagepoint change in interest rates. Armed with such precision tools, a bond salesperson can back up simple chitchat with hard facts about how to improve portfolio yields without unduly increasing risk. Thus the rocket scientist econometricians, statisticians, and mathematicians earn their way into the hearts and minds of institutional investors even though their native language is one of differential equations, autocorrelated residuals, and lognormal distributions. Salespeople translate these obscure formulas into higher yields for their customers. Cooperation between traders and salespeople, Fed watchers, and rocket scientists generates clever investment strategies for institutional investors, consistent profits for large banks and thrifts, and high bonuses for all of the fixed-income employees. It sounds as though life after Money, Banking, and Financial Markets can work out pretty well—as long as you know where to look. Loan Officer Banks specialize in tailoring commercial loans to businesses. Unlike corporate bonds, commercial bank loans are chock-full of special features such as covenants, collateral requirements, and guarantees that enable banks to extend credit to companies that are too small, or whose credit characteristics are too challenging, to have access to the public debt markets. The commercial loan officer is responsible for making this happen by working closely with the borrowing company’s management—and working within the lending policies of the bank. The loan officer must have a solid understanding of financial accounting, strong interpersonal skills, and a knack for negotiating. At many banks, loan officers are also responsible for generating new business. Therefore, this job often has a big sales component. This requires that the loan officer cultivate strong ties with the local business community.

8

Introducing Money, Banking, and Financial Markets

Bank Examiner Banks are audited about once per year by their regulators to determine whether the bank is solvent and whether its policies and procedures are prudent. These auditors, called bank examiners, work in teams. In the United States, there are about 9,000 banks and thrift institutions to examine. And, as you will discover, there is no shortage of bank regulators in the United States (nor elsewhere in the world). At the national level the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Federal Reserve each have extensive bank examination staffs. At the state level, all 50 states have their own state banking authorities who also regulate and examine banks. Bank examiners rate banks on a number of different dimensions, including the adequacy of the bank’s capital, its asset quality, its overall management skill, its risk management procedures, and its liquidity. Now that you’ve reviewed the opportunities in banking and financial markets, it makes good sense to concentrate on what’s coming up in this text. The lessons you learn will pay off sooner than you think.

KEY TERMS bank examiner

Federal Reserve (the Fed)

banking

financial economist

GNMA pass-through security

certificates of deposit (CDs

financial institutions

loan officer

financial markets

money

Comptroller of the Currenc

fixed-income research

sales

Government National Mortgage Association (GNMA)

trading

Federal Deposit Insurance Corporation (FDIC

9

10

The Role of Money in the Macroeconomy

“The lack of money is the root of all evil,” said George Bernard Shaw. Although that may be something of an exaggeration, there have been numerous periods in history when it appeared to be more true than false. There have also been rather lengthy episodes when the opposite seemed true: when economic disruption apparently stemmed not from too little money, but from too much of it. From this line of thought, the question naturally arises, what is the “right” amount of money? Not too little, not too much, but just right? And how can we go about getting it? Actually those are fairly sophisticated questions requiring careful consideration to produce answers that stand the test of time. Although we will devote a fair amount of attention to the relationship between money and economic activity, a number of somewhat more fundamental issues spring to mind as well. For example, exactly what is this thing called money that has obsessed princes and paupers throughout the centuries? In the good old days money was gold, kept under lock and key until it was sent by ship or stagecoach to meet the payroll. Nowadays money is paper that we carry around until it is worn and frayed. Can these really be the same thing? In truth, our discussion will have to extend far beyond the traditional confines of money if we want to understand the workings of our financial system. Financial institutions and markets have become so complex during the first decade of the twentyfirst century that commercial banks are no longer the only financial institutions that matter, and stocks and bonds no longer tell the entire story of how financial markets operate.

From Chapter 2 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

11

The Role of Money in the Macroeconomy

LEARNING OBJECTIVES In this chapter you will learn to understand the role of money in an economy comprehend the different measurements of money used in the United States see how the money supply drives inflation and economic expansion

Introducing Money What is money, anyway? And how much of it do we actually have? Money is just what you think it is—what you spend when you want to buy something. American Indians once used beads, Eskimos used fishhooks, and we use currency (coins and bills) and checking accounts. Money is used as (1) a means of payment, but it has other functions as well. It is also used as (2) a store of value, when people hold on to it, and (3) a standard of value (a unit of account), when people compare prices and thereby assess relative values. But most prominently, money is what you can spend, a generally acceptable means of payment or medium of exchange that you can use to buy things or settle debts. How large a money supply do we have? It amounted to $1,364 billion at the end of January 2008, roughly $758 billion in the form of currency and about $600 billion in checkable deposits at banks and other financial institutions. This definition of money—currency outside banks plus checking accounts—is frequently called M1 (to distinguish it from another definition of money, M2, which we will get to in a moment). If you want to know what the money supply is today, check the New York Times or the Wall Street Journal; both newspapers list it every Friday. Since currency and checking accounts are spendable at face value virtually anywhere, at any time, they are the most “liquid” assets a person can have. A liquid asset is something you can turn into the generally acceptable medium of exchange quickly without taking a loss, as compared with illiquid assets, which usually can be sold or liquidated on short notice only at a substantially lower price. Currency and checking accounts are the most liquid assets you can have (because they are the medium of exchange), but they are not the only liquid assets around. Savings deposits and government bonds are rather liquid, although you can’t spend them directly. To spend them, you first have to exchange them for money. At the other extreme, real estate and vintage automobiles typically rank fairly low on the liquidity scale; if you have to sell quickly, you might suffer a loss. Thus liquidity is a continuum, ranging from currency and checkable deposits at the top of the scale to a variety of frozen assets at the bottom. As a result, what we call money is not a fixed and immutable thing, like

12

The Role of Money in the Macroeconomy

TABLE 1

Two Definitions of the Money Supply (February 14, 2008)

M1

Currency outside banks ($758 billion), plus demand deposits at banks ($292 billion), plus other checkable deposits at banks and at all thrift institutions ($308 billion), plus travelers’ checks ($6 billion)

$1,364 billion

M2

Adds to M1 small-denomination time deposits ($1,225 billion), plus money market deposit accounts and savings deposits at all depository institutions ($3,903 billion), plus retail money market mutual funds shares ($1,006 billion)

$7,498 billion

Note: Money market mutual funds, money market deposit accounts, repurchase agreements, and Eurodollars are all explained and discussed in subsequent chapters. Source: Federal Reser ve Release H.6.

what we call water (H2O), but to a great extent a matter of judgment; there are several different definitions of money, each of which drops one notch lower on the liquidity scale in drawing the line between “money” and “all other assets.” Table 1 summarizes two different definitions of the money supply. M1 refers to the most liquid of all assets, currency plus all types of checking accounts at financial institutions. In addition to commercial banks, the so-called thrift institutions—savings banks, savings and loan associations, and credit unions—can also issue checking accounts. However, most demand deposits (noninterest-bearing checking accounts) are still in commercial banks. As indicated in Table 1, other checkable deposits, such as negotiable order of withdrawal (NOW) accounts, are also considered part of M1. These interest-bearing checking accounts were made available to individuals and households during the 1970s as banks and thrifts circumvented a prohibition which existed at the time against paying interest on demand deposits. Since M1 is confined to these highly liquid assets—ones that can be used in an unrestricted way as a means of payment—it is the narrowest definition of money (as well as the most traditional one, by the way). M2 drops a shade lower on the liquidity scale by adding assets that are most easily and most frequently transferred into checking accounts when a payment is about to be made. This category includes household savings accounts and small-denomination (under $100,000) certificates of deposit (CDs). Unlike savings accounts, CDs have a scheduled maturity date. If you want to withdraw your funds earlier, you suffer a substantial penalty by having to forfeit part of your accrued interest. M2 also includes money market deposit accounts at banks and thrift institutions as well as shares in consumer (retail) money market mutual funds. Actually, most money market deposit accounts and money market mutual fund shares carry limited check-writing privileges, so many people believe they should really be listed in M1. However, the data as presently compiled include them in M2.

13

The Role of Money in the Macroeconomy

So what is the money supply in the United States? Is it $1,364 billion (M1), $7,498 billion (M2), or something in between? Each definition of money has its adherents, but we use the narrow definition of the money supply—M1 because that and only that is generally acceptable as a means of payment. Once you go beyond currency and checking accounts, it is hard to find a logical place to stop. For the most part, we will stick to the narrow definition of money: currency plus checkable deposits.1 However, the Federal Reserve has shown a preference for M2 in recent years.

Who Determines Our Money Supply? Why do we have $1,364 billion of M1 money in the United States? Who, or what, determines how much there will be? Regardless of what you may have heard, gold does not determine the money supply. Indeed, it has very little influence on it. In 1968, the last remaining link between the money supply and gold was severed when a law requiring 25 percent gold backing behind most of our currency was repealed. If that is all news to you, it is a good indication of just how unimportant the connection between gold and money has been, at least in the past half century. Both currency and checking accounts can be increased (or decreased) without any relation to gold. Does that disturb you? Does it lead you to distrust the value of your money? Then send it to us. We’ll be delighted to pay you 90 cents on the dollar, which should be a bargain if you believe all you read in the papers or hear on television about a dollar being worth only 60 cents, or 50 cents, or whatever the latest figure may be.2 If gold is not the watchdog, then who (or what) does determine how much money we will have?

1Which

is not to say that M1 is a perfect measure of how much of the means of payment is in existence. As just one example of its shortcomings, notice that M1 does not include any estimate of existing bank “overdraft” facilities (which are arrangements that allow people to write checks— legally—even when they don’t have enough in their checking accounts to cover them). These as well as other funds available for immediate payment are not included in M1 mainly because of the absence of reliable data on them.

2Actually, when you read that the dollar is worth only 50 cents you have a clue to why gold has little to do with the value of money, in addition to having little to do with determining the amount outstanding. Money is valuable only because you can buy things with it, like clothes and books and CD players. The value of a dollar is therefore determined by the prices of the things we buy. When people say a dollar is worth only 50 cents they mean that nowadays it takes a dollar to buy what 50 cents could have bought a few years ago (because prices have doubled).

14

The Role of Money in the Macroeconomy

The monetary authority in most countries is called the central bank. A central bank does not deal directly with the public; it is rather a bank for banks, and it is responsible for the execution of national monetary policy. In the United States, the central banking function is carried out by the Federal Reserve System, created by Congress in 1913. It consists of 12 district Federal Reserve banks, scattered throughout the country, and a Board of Governors in Washington, D.C. This hydra-headed monster, which some view as benign but others consider an ever-lurking peril, possesses significant control over the money supply. As noted earlier, the money supply (M1) consists of currency and checking accounts. Currency is manufactured by money factories—the Bureau of Engraving and Printing and the U.S. Mint—and then shipped under heavy guard to the U.S. Treasury and the Federal Reserve for further distribution. For the most part, currency enters circulation when people and business firms cash checks at their local banks. Thus it is the public that ultimately decides what proportion of the money supply will be in the form of currency, with the Federal Reserve banks wholesaling the necessary coins and paper to local banks. The Federal Reserve is not particularly concerned with the fraction of the money supply that is in one form or another, but rather with total M1.3 As Table 1 shows, about 44 percent of the M1 money supply is in the form of checking accounts. These deposits come into being, as we will see later in the chapter, when banks extend credit; that is, when they make loans or buy securities. Checking deposits vanish, as silently as they came, when banks contract credit—when loans are repaid or banks sell securities. It is precisely here, through its ability to control bank behavior, that the Federal Reserve wields its primary authority over the money supply and thereby implements monetary policy. This process of money creation by banks, and the execution of monetary policy by the Federal Reserve, will be introduced shortly. But before we get into the details, we should back off for a moment and ask, why all the fuss? Why is money so important to begin with?

3Just in case you’re curious, here are some miscellaneous facts about coins and bills. Coins are manufactured by the U.S. Mint, which has production facilities in Philadelphia, Denver, and San Francisco. All bills are manufactured by the U.S. Bureau of Engraving and Printing, which has facilities in Fort Worth, Texas, and in Washington, D.C. The largest denomination of currency now issued is the $100 bill; there used to be $500, $1,000, $5,000, and $10,000 bills in circulation, but their printing was discontinued in 1945. The average life of a $1 bill is about a year and a half, before it is torn or worn out, which is why the government introduced the Sacagawea dollar coins in 2000. Coins last much longer than bills. Banks send worn-out bills back to the Federal Reserve, which destroys them and distributes newly printed bills in their place.

15

The Role of Money in the Macroeconomy

Going out on a limb The Launch of the Euro On January 1, 1999, eleven of the fifteen member countries of the European Union introduced a new common currency, the euro. This new currency reinforced the economic and political links among these countries and simplified trade and travel within the euro bloc. Giving up national currencies like francs (France) and marks (Germany) was a significant adjustment for Europeans, but the benefits were viewed as greater than the costs. Interestingly, while the euro was introduced in 1999, euro notes and coins didn’t actually begin to circulate until 2002. This raises an interesting question: how can a currency exist without the physical presence of circulating notes and coins? The answer to this question requires consideration of the three roles of money. The euro didn’t exist as a medium of exchange until 2002 because national curren-

cies were still used in everyday transactions until 2002. The euro did play the role of a unit of account, because the euro-adopting countries began to publish their official financial statistics in euros. Likewise, newly issued securities were denominated in euros, which meant that the euro was able to play some role as a store of value, even if people couldn’t stash euro notes under their mattresses. During the 1999–2002 transition period, people from all sectors of the economy became familiar with the value of the euro. This familiarity meant that the euro was more readily accepted as a medium of exchange when notes and coins were introduced in 2002. The transition period reinforces the important point that people need to have faith in the unit of account before they’ll accept money as a medium of exchange.

The Importance of Money I: Money Versus Barter What good is money in the first place? To appreciate the importance of money in an economic system, it is instructive to speculate on what the economy might be like without it. In other words, why was money invented (by Sir John Money in 3016 B.C.)? For one thing, without money individuals in the economy would have to devote more time to buying what they want and selling what they don’t. In other words, people would have less time to work and play. A barter economy is one without a medium of exchange or a unit of account (the measuring-rod function of money). Let’s see what it might be like to live in a barter economy. Say you are a carpenter and agree to build a bookcase for your neighbor. This neighbor happens to raise chickens and pays you with four dozen eggs. You decide to keep a dozen for yourself, so you now have three dozen to exchange for the rest of the week’s groceries. All you must do is find a grocer who is short on eggs. What’s more, you have to remember that a loaf of bread exchanges for six eggs (it also exchanges for 11 books of matches or three boxes of crayons or one Yankee Yearbook, but never mind because you don’t have any of these things to spare). And of course all the other items on the grocer’s shelf have similar price tags, listing the various possible exchanges. The tags are bigger than the items.

16

The Role of Money in the Macroeconomy

Along comes something called money and simplifies matters. Workers are paid in money, which they can then use to pay their bills and make their purchases. Money becomes the medium of exchange. We no longer need price tags giving rates of exchange between an item and everything else that might conceivably be exchanged for it. Instead, prices of goods and services are expressed in terms of money, a common denominator. The most important thing about the medium of exchange is that everyone must be confident that it can be passed on, that it is generally acceptable in trade. Paradoxically, people will accept the medium of exchange only when they are certain that it can be passed on to someone else. One key characteristic is that the uncertainty over its value in trade must be very low. People will be more willing to accept the medium of exchange if they are certain of what it is worth in terms of things they really want. The uncertainty of barter transactions makes people wary of exchange. If I want to sell my house and buy a car and you want to do just the reverse, we might be able to strike a deal, except for the fact that I’m afraid you might sell me a lemon. Hence I don’t make a deal; I’m uncertain about the value of the thing I’m being asked to accept in exchange. A medium of exchange, which is handled often in many transactions, becomes familiar to us all and can be checked carefully for fraud. Uncertainty in trading is thereby reduced to a minimum. Closely related to the low-uncertainty–high-exchangeability requirement is the likelihood that the medium of exchange will not deteriorate in value. It must be a good store of value; otherwise as soon as I accept the medium of exchange I’ll try to get rid of it. It thereby might be worth fewer and fewer goods and services tomorrow or the day after. Thus if price inflation gets out of hand and I have little confidence that the medium of exchange will hold its value, I’ll be reluctant to accept it in exchange; in other words, it won’t be the medium of exchange for very long. If that happens, we’ll begin to slip back into a barter economy. The medium of exchange also usually serves as a unit of account. In other words, the prices of all other goods are expressed in terms of, say, dollars. Without such a unit of account, you’d have to remember the exchange ratios of soap for bread, knives for shirts, and bookcases for haircuts (and haircuts for soap). The unit of account reduces the information you have to carry around in your brain, freeing that limited space for creative speculation. So money is a good thing. It frees people from spending too much time running around bartering goods and services and allows them to undertake other endeavors—production, relaxation, contemplation, and temptation. It is important to emphasize, once again, that people use the medium of exchange—money—not because it has any intrinsic value but because it can be exchanged for things to eat, drink, wear, and play with. The value of a unit of money is determined, therefore, by the prices of each and every thing— more accurately, the average level of all prices. If prices go up, a unit of money—a dollar—is worth less because it will buy less; if prices go down (use your imagination) a dollar is worth more because it will buy more. Thus the value of money varies inversely with the price level.

17

The Role of Money in the Macroeconomy

The Importance of Money II: Financial Institutions and Markets Money also contributes to economic development and growth. It does this by stimulating both saving and investment and facilitating transfers of funds out of the hoards of savers and into the hands of borrowers, who want to undertake investment projects but do not have enough of their own money to do so. Financial markets give savers a variety of ways to lend to borrowers, thereby increasing the volume of both saving and investment and encouraging economic growth. People who save are often not the same people who can see and exploit profitable investment opportunities. In an economy without money, the only way people can invest (for example, to buy productive equipment) is by consuming less than their income (saving). Similarly, in an economy without money the only way people can save—that is, consume less than their income—is by acquiring real goods directly. The introduction of money, however, permits the separation of the act of investment from the act of saving: Money makes it possible for a person to invest without first refraining from consumption (saving) and likewise makes it possible for a person to save without also investing. People can now invest who are not fortunate enough to have their own savings. In a monetary economy, a person simply accumulates savings in cash because money is a store of value. Through financial markets, this surplus cash can be lent to a business firm borrowing the funds to invest in new equipment, equipment it might not have been able to buy if it did not have access to borrowed funds. Both the saver and the business firm are better off: The saver receives interest payments, and the business firm expects to earn a return over and above the interest cost. And the economy is also better off: The only way an economy can grow is by allocating part of its resources to the creation of new and more productive facilities. In an advanced economy such as ours, this channeling of funds from savers to borrowers through financial markets reaches highly complex dimensions. A wide variety of financial instruments, such as stocks, bonds, and mortgages, are utilized as devices through which borrowers can gain access to the surplus funds of savers. Various markets specialize in trading one or another of these financial instruments. And financial institutions have sprung up—such as commercial banks, savings banks, savings and loan associations, credit unions, insurance companies, mutual funds, and pension funds—that act as intermediaries in transferring funds from ultimate lenders to ultimate borrowers. Such financial intermediaries themselves borrow from saver-lenders and then turn around and lend the funds to borrower-spenders. They mobilize the savings of many small savers and package them for sale to the highest bidders. In the process, again both saver-lenders and borrower-spenders gain: Savers have the added option of acquiring savings deposits or pension rights, which are less risky than individual stocks or bonds, and business-firm borrowers can tap large sums of money from a single source. None of this would be possible were it

18

The Role of Money in the Macroeconomy

not for the existence of money, the one financial asset that lies at the foundation of the whole superstructure.4 Uncontrolled, money may cause hyperinflation or disastrous depression and thereby cancel its blessings. If price inflation gets out of hand, for example, money ceases to be a reliable store of value and therefore becomes a less efficient medium of exchange. People become reluctant to accept cash in payment for goods and services, and when they do accept it, they try to get rid of it as soon as possible. As we noted above, the value of money is determined by the price level of the goods money is used to purchase. The higher the prices, the more dollars one has to give up to get real goods or buy services. Inflation (rising prices) reduces the value of money. Hyperinflation (prices rising at a fast and furious pace) reduces the value of money by a lot within a short time span. Hence people don’t want to hold very much cash; they want to exchange it for goods or services as quickly as possible. Thus if money breaks down as a store of value, it starts to deteriorate as a medium of exchange as well, and we start to slip back into barter. People spend more time exchanging goods and less time producing, consuming, and enjoying them. Deflation, falling prices often associated with severe recessions or even depressions, causes different but no less severe consequences. So once we have money, the question constantly challenges us: How much of it should there be?

Money, the Economy, and Inflation Many people persist in thinking that money must somehow be based on gold, or maybe silver, or at least on something that has tangible physical substance. As we saw above, however, money has value because people believe it will be accepted as a means of payment, as a store of value, and as a standard of value. There simply isn’t any backing behind our currency, and checking accounts, which constitute most of our money, are nothing more than liabilities on the books of financial institutions. How do such checking accounts come into existence? How does the central bank—the Fed—regulate their amount? How does the Federal Reserve know how large the money supply should be in the first place? Finally, just what is the relationship between the money supply, economic activity, and inflation? The remainder of this chapter is devoted to a preliminary exploration of such questions. Later we will dig deeper into many of these same matters; meanwhile, we will provide some background information intended to make the material in the intervening chapters more meaningful.

4Strictly

speaking, it is theoretically possible for transfers between savers and borrowers to occur within a barter framework. Thus credit arrangements could exist without money. But only the existence of money permits the complex and efficient channeling of funds between savers and borrowers.

19

The Role of Money in the Macroeconomy

Bank Reserves and the Money Supply Checking accounts come into being when banks extend credit; that is, when they make loans or buy securities. Checking accounts disappear when banks contract credit, when bank loans are repaid or banks sell securities. Here is how it works. When a bank makes a loan to a consumer or business firm, it typically creates a checking account for the borrower’s use. For example, when you borrow $1,000 from your friendly neighborhood bank, the bank will take your promissory note and give you a checking account in return. From the bank’s point of view, it has an additional $1,000 of assets (namely, your promissory note); this is matched by an additional $1,000 of liabilities (namely, your checking account). The creation of this $1,000 in checking deposits means the money supply, M1, has increased by $1,000. Similarly, when a bank buys a corporate or government bond, it pays for it by opening a checking account for the seller. Assume you are holding a $1,000 corporate or government bond in your investment portfolio, and you need cash. You might sell the bond to your local bank, which would then add $1,000 to your checking account. Once again, from the point of view of the bank, its assets (bonds) and liabilities (checking accounts) have gone up by $1,000. Again, money has been created; the supply of money in the economy has increased by $1,000. Conversely, when you repay a bank loan by giving the bank a check, the bank gives you back your promissory note and at the same time lowers your deposit balance. If a bank sells a bond to an individual, the same reduction in deposits occurs. The supply of money declines. Conclusion: Banks create money (checking accounts) when they lend or buy securities and destroy money when their loans are repaid or they sell securities. A bank cannot always expand its checking account liabilities by making loans or buying securities. Banks are required by the Federal Reserve to hold reserves against their checking account liabilities—the current reserve requirement is about 10 percent reserves against checking deposits. These reserves must be held in the form of vault cash or a deposit in their regional Federal Reserve bank. Therefore, only if a bank has “excess” reserves—reserves over and above its requirements—can it create new checking deposits by making loans and buying securities. Once a bank is “loaned up,” with no more excess reserves, its ability to create money ceases. And if it has deficient reserves, not enough to support its existing deposits, the bank must somehow get additional reserves. To obtain reserves, the bank could call in loans or sell securities in order to bring its deposits back in line with its reserves. Banks can also borrow reserves from the Fed or through the federal funds market, the market for very short-term (usually overnight) loans between banks. Changes in the level of available reserves will affect supply in the “fed funds” market and thereby affect the federal funds rate, the interest rate charged on inter-bank loans of reserves. For reasons discussed later in this book, the Fed emphasizes targets for this federal funds rate in carrying out monetary policy. It is through the fulcrum of these reserves that the Federal Reserve influences the federal funds rate and the money supply. How the Federal Reserve

20

The Role of Money in the Macroeconomy

manipulates the reserves of the banking system will be explored in detail later. For now, let’s just take it for granted that the Federal Reserve controls bank reserves, hence the money supply, and move on to the next question.

How Large Should the Money Supply Be? In theory, the answer is simple enough. Presumably the supply of money affects the rate of spending, and therefore we should have enough money so that we buy, at current prices, all the goods and services the economy is able to produce. If we spend less, we will have idle capacity and that can lead to deflation and unemployment; if we spend more, we will wind up with higher prices but no more real output. In other words, we need a money supply large enough to generate a level of spending on new domestically produced goods and services—the economy’s gross domestic product (GDP)—that produces high employment at stable prices. More money than that would mean too much spending and inflation, and less money would mean too little spending and recession or depression. In practice, unfortunately, the answer is not nearly that simple. In the first place, decisions about the appropriate amount of money are often linked with the notion of countercyclical monetary policy, that is, a monetary policy that deliberately varies the amount of money in the economy—increasing it (or, more realistically, increasing the rate at which it is growing) during a recession, to stimulate spending, and decreasing it (or increasing it at a less than normal rate) during a boom, to inhibit spending. As we will see in later chapters, such attempts at economic stabilization are quite controversial. The more fundamental issue for us is to understand how changes in the money supply can influence people’s spending in a consistent way. What a change in the money supply can do is to alter the liquidity of people’s assets. Money, after all, is the most liquid of all assets. A liquid asset, as mentioned previously, is something that can be turned into cash; that is, sold or liquidated, quickly, with no loss in dollar value. Money already is cash. You can’t get more liquid than that! Since monetary policy alters the liquidity of the public’s portfolio of total assets—including, in that balance sheet, holdings of real as well as financial assets—it should thereby lead to portfolio readjustments that involve spending decisions. An increase in the money supply implies that the public is more liquid than before; a decrease in the money supply implies that the public is less liquid than before. If the public had formerly been satisfied with its holdings of money relative to the rest of its assets, a change in that money supply will presumably lead to readjustments throughout the rest of its portfolio.5 In other words, these changes in liquidity should lead to more (or less) spending on either real assets (cars and television sets) or financial assets

5Of

course, if monetary policy could increase the money supply while all other assets of the public remained unchanged, people would not only have more liquid assets but also be wealthier. However, monetary policy can alter only the composition of the public’s assets; it cannot change total wealth directly.

21

The Role of Money in the Macroeconomy

(stocks and bonds). If spending on real assets expands, demand for goods and services increases, production goes up, and GDP is directly affected. If spending on financial assets goes up, the increased demand for stocks and bonds drives up securities prices. Higher securities prices mean lower interest rates. The fall in interest rates may induce more spending on housing and plant and equipment, thereby influencing GDP through that route.6 Underlying the effectiveness of monetary policy, therefore, is its impact on the liquidity of the public. But whether a change in the supply of liquidity actually does influence spending depends on what is happening to the demand for liquidity. If the supply of money is increased but demand expands even more, the additional money will be held and not spent. “Easy” or “tight” money is not really a matter of increases or decreases in the money supply in an absolute sense, but rather increases or decreases relative to the demand for money. In the past half century we have had hardly any periods in which the money supply actually decreased for any sustained length of time, yet we have had many episodes of tight money because the rate of growth was so small that the demand for money rose faster than the supply. If people always respond in a consistent manner to an increase in their liquidity (the proportion of money in their portfolio), the Federal Reserve will be able to gauge the impact on GDP of a change in the money supply. But if people’s spending reactions vary unpredictably when there is a change in the money supply, the central bank will never know whether it should alter the money supply a little or a lot (or even at all!) to bring about a specified change in spending. The relationship between changes in the money supply and induced changes in spending brings us to the speed with which money is spent, its velocity or rate of turnover. When the Federal Reserve increases the money supply by $1 billion, how much of an effect will this have on people’s spending, and thereby on GDP? Say we are in a recession, with GDP $100 billion below prosperity levels. Can the Fed induce a $100-billion expansion in spending by increasing the money supply by $10 billion? Or will it take a $20-billion—or a $50-billion—increase in the money supply to do the job?

Velocity: The Missing Link Clearly, this is the key puzzle that monetary policymakers must solve if the policy is to operate effectively. Money is only a means to an end, and the end is 6Since this point will come up again and again, it is worth devoting a moment to the inverse relationship between the price of an income-earning asset and its effective rate of interest (or yield). For example, a long-term bond that carries a fixed interest payment of $10 a year and costs $100 yields an annual interest rate of 10 percent. However, if the price of the bond were to rise to $200, the current yield would drop to 10/200, or 5 percent. And if the price of the security were to fall to $50, the current yield would rise to 10/50, or 20 percent. Conclusion: A rise (or fall) in the price of a bond is reflected, in terms of sheer arithmetic, in an automatic change in the opposite direction in the effective rate of interest. To say that the price of bonds rose or the rate of interest fell is saying the same thing in two different ways.

22

The Role of Money in the Macroeconomy

the total volume of spending, which should be sufficient to give us high employment but not so great as to produce excessively rising prices. When the Federal Reserve increases the money supply, the recipients of this additional liquidity probably spend some of it on domestically produced goods and services, increasing GDP. The funds thereby move from the original recipients to the sellers of the goods and services. Now the sellers have more money than before, and if they behave the same way as the others, they, too, are likely to spend some of it. GDP thus rises further, and the money moves on to yet another set of owners, who, in turn, may also spend part of it, thereby increasing GDP again. Over a period of time, say a year, a multiple increase in spending and GDP could thus flow from an initial increase in the stock of money. This relationship between the increase in GDP over a period of time and the initial change in the money supply is important enough to have a name: the velocity of money. Technically speaking, velocity is found after the process has ended, by dividing the cumulative increase in GDP by the initial increase in the money supply. Velocity is most easily understood by considering the equation MV = GDP where M represents the money supply and V stands for velocity. In order to buy goods and services, money changes hands and velocity increases. During economic slowdowns, velocity decreases and, for a given amount of money, GDP falls. We can compute the velocity of the total amount of money in the country by dividing total GDP (not just the increase in it) by the total money supply. This gives us the average number of times each dollar is used to buy goods and services during the year. In 2007, for example, with a GDP of $13,843 billion and an average M1 of $1,369 billion during the year, the velocity of money was $13,843 divided by $1,369 or 10.1 per annum. Each dollar of M1, on average, was spent 10.1 times purchasing goods and services during 2007. With this missing link—velocity—now in place, we can reformulate the problem of monetary policy more succinctly. The Federal Reserve influences the supply of money. Its main job is to regulate the flow of spending. The flow of spending, however, depends not only on the supply of money but also on the velocity of money, and the Federal Reserve does not have control of this under its thumb. A central problem of monetary theory is the exploration of exactly what determines the velocity of money—or, looked at another way, what determines the volume of spending that flows from a change in the supply of money. As we shall see, disagreements over the determinants and behavior of velocity underlie part of the debate over economic stabilization policy. But there’s more. The Federal Reserve has to worry not only about the relationship between money and spending but also about whether prices or production respond to increased spending. More GDP is good if it corresponds to more production but not so good if it means higher prices. Either outcome is possible. And that brings us to the subject of inflation.

23

The Role of Money in the Macroeconomy

Money and Inflation Consumer prices are now over ten times higher than in 1945 and more than quadruple what they were in 1975. Since 1975 prices have risen at an average annual rate of 4.3 percent a year; at that rate, prices double roughly every 17 years.7 Who is responsible for inflation? Is money the culprit? Can we bring an inflationary spiral to a halt if we clamp down on the money supply? The classic explanation of inflation is that “too much money is chasing too few goods.” The diagnosis implies the remedy: Stop creating so much money and inflation will disappear. Such a diagnosis has been painfully accurate during those hard-to-believe episodes in history when runaway hyperinflation skyrocketed prices out of sight and plunged the value of money to practically zero. Example: Prices quadrupled in Revolutionary America between 1775 and 1780, when the Continental Congress opened the printing presses and flooded the country with currency. The phrase “not worth a continental” remains to this day. The situation in Germany after World War I was even more extreme; prices in 1923 were 34 billion times what they had been in 1921. In Hungary after World War II, it took 1.4 nonillion pengo in 1946 to buy what one pengo could purchase a few years earlier (one nonillion is 1,000,000,000,000,000,000,000,000,000,000). Severe breakdowns of this sort are impossible unless they are fueled by continuous injections of new money in ever-increasing volume. In such cases, money is undoubtedly the inflation culprit, and the only way to stop inflation from running away is to slam a quick brake on the money creation machine. However, hyperinflation is not what we have experienced in this country in recent years. From 1950 through 2007, the cost of living increased in every year but one (1955). The annual rate of inflation over the entire period averages out at more than 4 percent per year. Moreover, even during periods of recession, such as 1974, 1981, 1991, and 2001, inflation was still with us, with prices rising 12, 9, 4, and 2 percent respectively in those years. Only during the Great Depression has the United States experienced persistent deflation. On the other hand, Japan has had deflation during the chronic recessions that took hold after the mid-1990s. Unlike its role in hyperinflation, money is not so obviously the only culprit when it comes to this everyday variety of creeping inflation we have experienced in recent years. Let’s take a look at some evidence before jumping to conclusions. The following list shows annual money supply growth and the inflation rate from 1930 to 2007, using M1 as the definition of money. It shows that the two tend to move together. If we use M2 as our definition of

7

As a special bonus, we give you “the rule of 72” for growth rates. If something (anything) is growing at a compound annual rate of x percent, to find out how many years it will take to double, divide 72 (the magic number) by x. For example, if prices are rising at 5 percent a year, they will double in 72 , 5 L 14 years. It isn’t precise to the dot, but it’s a useful rule of thumb.

24

The Role of Money in the Macroeconomy

money, the relationship is also close.8 Using the 1930–2007 period and M1 as our definition of money: 1. During the 1930s, the money supply (M1) increased by 35 percent, but consumer prices fell 20 percent. 2. In the 1940s the money supply increased by 200 percent, but prices rose by “only” 70 percent. 3. The 1950s provide the best fit: The money supply and prices both rose by about 25 percent. 4. In the 1960s, the relationship deteriorated slightly: The money supply increased by 45 percent, and consumer prices rose by slightly less than 30 percent. 5. During the 1970s, the money supply rose by 90 percent, and prices rose by 105 percent. 6. In the 1980s, the money supply doubled, and prices rose by 60 percent. 7. In the last decade of the 20th century, the money supply rose by 40 percent, and prices rose by about 30 percent. 8. From the beginning of 2000 to the end of 2007, M1 grew 22 percent and prices rose 24 percent, nearly a one-to-one ratio. You can be your own judge, but the data seem to imply that money has a lot to do with all types of inflation. People will not continue buying the same amount of goods and services at higher and higher prices unless they have more money to spend. If the money supply today were no larger than it was in 1950 ($115 billion), prices would have stopped rising long ago. A qualification is in order: While most inflations are tied to increases in the money supply, more money does not guarantee prices will rise. Increases in the money supply will not raise prices if velocity falls (as in the 1930s). Even if velocity remains constant, an increase in the money supply will not raise prices if production expands faster than the increase in money supply. When we are in a depression, for example, the spending stimulated by an increase in the money supply is likely to raise output and employment rather than prices. Furthermore, in the short run at least—and sometimes the short run is a matter of several years—increased spending and inflation can be brought about by increases in velocity without any increase in the money supply.

8There

is a reason why in recent years inflation has tracked M2 more closely than M1. M2 includes money market deposit accounts and money market mutual funds, both of which pay short-term market rates of interest. When interest rates go up lots of “money” flows from noninterest-paying demand deposit and low-interest-paying NOW accounts into the more profitable money market accounts. This dramatically decreases M1 but has no effect on M2. Why? Because M2 includes both money market accounts and demand deposits. When rates go down, the opposite happens. The net effect: M1 bounces all over the place with interest rates while M2 does not. Hence, most economists now place more weight on M2 than M1 because it isn’t so unstable.

25

The Role of Money in the Macroeconomy

Going Out on a Limb Will Paper Money Ever Disappear? For many years, “money” meant coins, paper currency, and perhaps checking accounts. Recently, technology has opened up new ways of paying for goods and services. Debit cards, automated bill payments, and Internet “cybermoney” or “e-money” are all examples of electronic media of exchange that can replace traditional means of payment. Some people have predicted that traditional payment methods will decline in importance and could one day become obsolete. This possibility has led to speculation that central banks like the Fed might lose control of their national money supplies if the Internet puts a significant amount of cyber-money beyond government regulation. Recent experience has shown that it is unlikely that people will ever completely give

up the use of coins, paper currency, or checks. The convenience and anonymity of these forms of payment are appealing. Growth of electronic currency has not been as rapid as initially predicted, in part due to concerns about security or the trustworthiness of some providers of electronic payment services. The possibility that central banks could lose control of the money supply is exaggerated. As we’ll see later in the book, the Fed does not currently attempt to target the size of the money supply but instead chooses to influence interest rates. Research suggests that the Fed’s ability will remain a potent tool of policymakers for the future.

Let us end this section with a summary statement of the role of money in the inflation process. Does more money always lead to inflation? No, but it can under certain circ*mstances, and if the increase is large enough it probably will. Case 1: If the central bank expands the money supply while we are in a recession, the increased spending it induces is likely to lead to more employment and a larger output of goods and services rather than to higher prices. Case 2: As we approach full employment and capacity output, increases in the money supply become more and more likely to generate rising prices. However, if this increase is only large enough to provide funds for the enlarged volume of transactions accompanying real economic growth, inflation still need not result. Case 3: Only when the money supply increases under conditions of high employment and exceeds the requirements of economic growth can it be held primarily responsible for kindling an inflationary spiral. The time factor and the extent of inflation are also relevant. In the short run, an increase in monetary velocity alone (generated by increasing government or private spending), with a constant or even declining money supply, can finance a modest rate of inflation. The longer the time span, however, and the higher the rise in prices, the less likely that velocity can do the job by itself. Over the longer run, the money supply must expand for inflation to persist.

26

The Role of Money in the Macroeconomy

SUMMARY 1. Money serves a number of functions in the economy. Perhaps the most important is its use as a medium of exchange. It also serves as a store of value and as a unit of account. In general, money is considered the most liquid asset, because it can be spent at face value virtually anywhere at any time.

2. The precise definition of the asset called money varies with the economic system. In the United States, we have two definitions: M1 and M2. Each represents a slightly different definition of liquidity and spendability. M1 is the narrowest and most traditional definition: the sum of currency and all checkable deposits at banks and thrift institutions. This is the definition we use throughout the book unless we say otherwise.

3. Without money, the economy would have to rely on the more cumbersome barter system to exchange goods and services. Only a primitive mechanism would exist for channeling savings into productive investments. The level of economic welfare would be lower on both counts.

4. Control over the money supply rests with the central bank. In the United States, the central banking function is carried out by the Federal Reserve, which tries to regulate the supply of money so that we have enough spending to generate high employment without inflation. The Federal Reserve regulates bank lending and the money supply through its control over bank reserves. By changing bank reserves and thereby the money supply, the Fed alters people’s liquidity and, it is hoped, their spending on goods and services, which in turn helps determine GDP, the level of unemployment, and the rate of inflation.

5. The relationship between money and spending depends on how rapidly people turn over their cash balances. This rate of turnover of money is called the velocity of money. Since any given supply of money might be spent faster or more slowly—that is, velocity might rise or fall—a rather wide range of potential spending could conceivably flow from any given stock of money.

6. Inflation has historically been one of our most troublesome economic problems. Increases in the money supply are a necessary but not a sufficient condition for the creeping type of inflation we have been experiencing. In cases of hyperinflation, the money supply is clearly the main culprit. More money does not always lead to inflation, because velocity can fall and output can expand. In the long run, however, inflation cannot continue unless it is fueled by an expanding money supply.

KEY TERMS Board of Governors

federal funds market

money

central bank certificate of deposit (CD)

gross domestic product (GDP)

money market deposit account

checking account

hyperinflation

currency

inflation

money market mutual fund

deflation

liquid asset

savings account

demand deposit

liquidity

velocity

27

The Role of Money in the Macroeconomy

QUESTIONS Questions with a red oval are in

28

at www.myeconlab.com.

2.1

Which definition of money supply, M1 or M2, is most appropriate if the most important function of money is its role as medium of exchange? Why?

2.2

What are the most important characteristics of a good medium of exchange?

2.3

Explain why the value of money is inversely related to the price level.

2.4

Assuming the Federal Reserve can successfully control the money supply, does this mean that the Fed can also control aggregate spending and GDP?

2.5

Is inflation clearly due to “too much money”?

2.6

Prices have roughly quadrupled in the last 30 years. If they do the same over the next 30, how much will it cost annually to go to your college 30 years from now?

2.7

When interest rates rise there is a tendency for people to switch their money out of demand deposits and other checkable deposits into money market deposit accounts and money market mutual funds. How does this affect the money supply as defined by M1? As defined by M2?

2.8

If a country were to adopt U.S. dollars as its own currency, how would the U.S. money supply be affected?

2.9

Discussion question: Communist leader Vladimir Lenin is supposed to have said that inflation will undermine a country’s financial system and eventually ruin the nation. But we have had inflation for many years, and the country is still standing. Does this mean that the statement is wrong?

Financial Instruments, Markets, and Institutions Financial markets are basically the same as other kinds of markets. People buy and sell, bargain and haggle, and win and lose, just as in the flea markets of Casablanca and Amsterdam or the gold markets of London and Zurich. In financial markets, they buy and sell securities, such as stocks and bonds, which are less tangible than hot bracelets or cold gold bars but are no less valuable. In this chapter, we introduce the instruments and institutions of the financial sector. But before getting into the details, we’ll provide an overall perspective.

LEARNING OBJECTIVES In this chapter you will learn to envision the flow of funds between savers and borrowers in a modern macroeconomy describe the basic differences between debt and equity and how these tools facilitate the flow of funds between savers and borrowers identify how financial intermediaries assist the transfer of funds from lenders to borrowers

Flow of Funds All financial systems must provide a mechanism by which funds flow from those who have money, called saver-lenders, to those who want money, called borrower-spenders. While financial systems vary from country to country, there are basically two fundamental transmission mechanisms through which the process can take place. Funds can flow directly through financial markets or indirectly through what we call intermediated markets via financial intermediaries.

From Chapter 3 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

29

Financial Instruments, Markets, and Institutions

Financial intermediaries

$

$ Saver-Lenders: Households, firms, governments, foreigners

$

Borrower-Spenders: Households, firms, governments, foreigners

$

$ Financial markets

FIGURE 1

Flow of funds from lenders to borrowers.

The process is called the “flow of funds” and is described schematically in Figure 1. Funds flow from left to right and financial claims flow from right to left. When funds flow through financial markets, borrower-spenders sell financial claims called securities, such as stocks and bonds, to saver-lenders. In this case, the link between lenders and borrowers is “direct,” because funds flow from lenders to borrowers and securities flow from borrowers to lenders. When funds flow through intermediaries, the process is “indirect.” This is because lenders purchase the financial claims of financial intermediaries, who, in turn, purchase the financial claims of borrowers. For example, lenders might purchase a bank certificate of deposit while the bank, in turn, makes a business loan, which is like purchasing the IOU of a business firm. Here lenders do not purchase business loans directly, but rather provide the funds indirectly by investing in bank deposits. In addition, however, financial intermediaries buy securities from the financial markets—such as a life insurance company buying a corporate bond. Hence, you will note in Figure 1 that there is an arrow between financial intermediaries and financial markets. Through a wide variety of techniques, instruments, and institutions, the financial system channels the savings of millions into the hands of borrowers who need more funds than they have on hand. Financial and intermediated markets are conduits through which those who do not spend all their income can make their excess funds available to those who want to spend more than their income. Saver-lenders stand to benefit because they earn interest or dividends on their funds. Borrower-spenders stand to gain because they get access to money to carry out investment plans they otherwise could not finance (and that presumably earn more than the interest they pay). Without financial and intermediated markets, savers would have no choice but to hoard their excess money, and borrowers would be unable to realize any investment plans except those they could finance by themselves. Saver-lenders are typically households, although from time to time foreigners, business firms, and governmental bodies—federal, state, and local—also

30

Financial Instruments, Markets, and Institutions

lend substantial amounts. Borrower-spenders are mostly business firms and government, although households are also important as consumer credit and mortgage borrowers. The existence of highly developed, widely accessible, and smoothly functioning financial and intermediated markets is of crucial importance in transferring savings from those with excess funds into the hands of those desiring to make investment expenditures. Those who can visualize and exploit potentially profitable investment opportunities are frequently not the same people who generate current saving. If the financial transmission mechanisms are underdeveloped, inaccessible, or imperfect, the flow of funds from household saving to business investment will be impeded, and the level of economic activity will fall below its potential. In order for this flow of funds process to function smoothly, there must be adequate information about these markets and how they operate, and adequate information about the financial claims issued by borrowerspenders. For example, if borrowers are unaware of the financial and intermediated markets in which they can issue their financial claims—or if knowledge about sources of funds is not widely disseminated—then some investments that could have been undertaken won’t be, even though there are savers who would have willingly lent the funds at rates of interest equal to or less than what borrowers would have been willing to pay. A similar situation could arise as far as savers are concerned. Some might not be aware of lending opportunities. Instead of being put to work, funds are put under the mattress and less investment takes place (which, in turn, lowers saving as income declines). Furthermore, if savers are ill-informed about the quality of borrowers, then they might be unwilling to purchase their claims at a fair price—or at any price at all. Thus an efficient financial system must disseminate information to lenders about the quality of the financial claims issued. Lots of interesting questions arise concerning the flow of funds. How are financial claims issued and how are securities traded in the financial markets? What determines the mix between direct finance and indirect finance? Does access to information play a role in determining this mix? What are the differences in the mix across countries? We will begin to address some of these questions in this chapter by first providing an overview of financial instruments and markets and by then profiling the major financial intermediaries.

Financial Instruments and Markets Since we will be discussing bonds, stocks, and mortgages throughout this book, we will devote this section to explaining the similarities and differences among such financial instruments. In addition, we provide a bird’s-eye view of the money and capital markets, where billions of dollars worth of these and other instruments are bought and sold every day.

31

Financial Instruments, Markets, and Institutions

When borrower-spenders raise funds in the financial markets, they do so by issuing securities in what is referred to as the primary market. Issuing securities in the primary market involves choosing the appropriate security and then distributing it to saver-lenders. One particular kind of financial institution, an investment bank, specializes in helping borrowers in the primary market. For example, investment banks, such as Goldman Sachs and Morgan Stanley, gather information about the demand for particular securities by potential buyers and for a fee, help borrowers structure and price those securities and then sell them at the most favorable price. In essence, investment bankers are information and marketing specialists for newly issued securities. Once securities are issued, another related set of institutions helps to provide a secondary market, where existing securities can be bought and sold. Perhaps the most prominent secondary market is the New York Stock Exchange, but there are also so-called over-the-counter markets in many securities as well. At this point, let’s review the instruments themselves, so that we can better appreciate why stocks, bonds, and mortgages are so valuable, even if they are only pieces of paper.

Bonds Represent Borrowing Bonds exist in a wide variety of forms. For example, there are corporate bonds, U.S. government bonds, and state and local government (often called municipal) bonds. But in each and every case, they represent the same thing, namely, the borrowing of money by the corporation or governmental body that originally sold the bond. When Microsoft, let’s say, or Uncle Sam, or the state of Wyoming, for example, wants to raise a few million dollars, what they frequently do is print up fancy pieces of paper—called bonds—and try to sell them. Many individuals and financial institutions are interested in buying these securities because the paper states that the issuer, such as Microsoft, promises to pay whoever owns the bond (the lender) certain interest payments at specified dates in the future. The paper also states when the bond will mature; that is, the date when the loan will be paid off to whoever owns the bond at that time. Some bonds have an original maturity of only a few years, while others may not come due for 20 or 30 years. At times in the past, some governments have even sold bonds without a maturity date at all, called perpetuities or consols, which therefore keep paying interest forever. Most bonds promise to pay a certain number of dollars of interest each year for a stated number of years and then to repay the principal at maturity. In the United States, bonds traditionally have been issued with coupons that

32

Financial Instruments, Markets, and Institutions

bondholders redeem every six months to collect the interest that is due. For that reason, bonds are often referred to as coupon securities. More recently, however, some bonds have been issued without coupons. Naturally enough, they are referred to as zero-coupon bonds. These securities are sold at a price below their stated face value, with the difference representing the interest that will be earned by the bondholder over the life of the instrument. U.S. savings bonds and U.S. Treasury bills are the most familiar securities of this sort. There are many other differences among bonds. One of the most important has to do with the way their interest is taxed. State and local bonds, or municipals, are often called tax-exempts, because their interest is exempt by law from federal income taxation. Their interest is also usually exempt from state income taxes in the state where they are issued. Interest on corporate bonds and on federal government securities are subject to federal income taxes. On the other hand, interest on federal government bonds is not subject to state and local income taxation.

Stocks Represent Ownership While bonds denote borrowing, stocks represent ownership.1 Holding a stock certificate means that the holder owns part of the corporation. Thus there are only corporate stocks, no U.S. government or state and local government stocks, since individuals cannot “own” governments (at least not legally). Corporations raise money in several ways: by borrowing from banks, for instance, or by selling bonds, or by selling shares in ownership—that is, selling stocks. While bondholders receive interest, the income that stockholders receive is called dividends. The two main types of stocks (often they are called equities or shares) are preferred stock and common stock. Preferred stockholders get a fixed dividend, and they are entitled to it before the common stockholders get anything. Common stockholders, which is what most of us are who buy stocks, get what is left over after preferred stockholders have received their fixed payments; in other words, common stockholders get a residual or variable dividend that fluctuates with the company’s profits. That’s nice if the company has been doing well, but not so pleasant otherwise. There is also convertible preferred stock, which can be converted into common stock at a predetermined price. Once stocks are issued they can be bought or sold on a secondary market like the New York Stock Exchange. The prices of stocks rise and fall with the fortunes of particular companies, expected future dividends, and with

1Stocks

are purchased by saver-lenders. Technically a stockholder is not a “lender” because a stockholder purchases equity, not debt. Nevertheless, we prefer to use the term saver-lender because it is simpler than saver-lender-owner. Sometimes, as you may have noticed we drop all the hyphens and collapse everyone into the word lenders or savers.

33

Financial Instruments, Markets, and Institutions

economic conditions in general. Actually, many buyers of common stocks seem to be more interested in capital gains (the difference between the purchase price and the selling price) than in dividends, possibly because they think they can get rich more quickly with capital gains than with dividends. There are several measures of trends in overall common stock prices. Two of the broader measures are Standard & Poor’s 500 Stock Index (called the S&P 500 for short), which is based on the prices of 500 stocks, and the NASDAQ Composite Index, which is based on all the stocks (more than 4,000) listed on the NASDAQ stock market. However, the most popular and widely followed measure of all, even though it is the least representative, is the Dow Jones Industrial Average, which is based on the prices of only 30 stocks. A market in which stock prices are rising, by the way, is called a bull market, while one in which stock prices are falling is a bear market. Similarly, bulls are traders who expect stock prices to rise, while bears expect them to fall. (It is often said on Wall Street that bulls make money and bears make money, but pigs never do, so don’t be a hog!) With bonds and preferred stocks having fixed income payments, and common stocks variable income payments, we have come upon one of the main similarities as well as one of the main differences among securities. All securities share a common characteristic in that they represent a claim to a stream of payments, often called cash flows, in the future. In particular, the purchaser or owner of a security has a claim against the issuer or original seller of the security. It is the precise nature of that claim that distinguishes different types of securities. Bonds and preferred stocks generate fixed dollar payments in the future, while common stocks produce variable dollar payments. The key message, however, is that all securities represent claims to cash flows, and the nature of those cash flows is what helps to determine the value of the securities.

Mortgages Involve Real Estate Mortgages are debts incurred by someone who is borrowing in order to buy land or buildings, with the land or buildings serving as “security,” or collateral, for the lender. Like bonds, mortgages are debt instruments that promise to pay interest for a stated number of years and then repay the face value or principal at maturity. They are frequently amortized, which means that the principal is gradually repaid, along with the interest, during the life of the mortgage. Mortgages are classified into three types: one- to four-family home mortgages, multifamily residential mortgages (apartment houses), and commercial (including farm) mortgages. They often run 25 to 30 years until maturity, although some are considerably shorter. Mortgages are also classified by whether they are insured by a government agency, either the Federal Housing Authority (FHA) or the Veterans Administration (VA). These so-called FHA-VA mortgages are

34

Financial Instruments, Markets, and Institutions

contrasted with conventional mortgages, which do not carry any government insurance. Traditionally mortgages were normal fixed-rate securities, with the interest rate fixed over the life of the loan. But they now come in many varieties, including adjustable-rate mortgages (ARMs), with the interest rate adjusted periodically—say, every six months—to reflect changes in the overall level of interest rates. An unusual characteristic of mortgages is the uncertainty that exists for the lender with respect to inflows of cash. Whether or not the interest rate is fixed, homeowners have the right to repay their mortgages early, which they might very well do if they move to a new location or if interest rates fall and they can refinance their indebtedness (borrow again) on better terms. From the lender’s viewpoint, this prepayment uncertainty makes mortgages less desirable than other forms of debt. Some of the uncertainty is reduced when individual mortgages are packaged together into a “pool” and sold as a unit. Mortgage pools have become a popular form of financial investment, with buyers (lenders) relying on the large number of mortgages in the pool to help smooth out cash flows. One of the most popular type of mortgage pool is insured by the Government National Mortgage Association (Ginnie Mae), a division of the Department of Housing and Urban Development. Some mortgage pools are referred to as pass-through securities (such as Ginnie Mae Pass-Throughs), because the interest and principal on the underlying mortgages are passed through to the saver-lenders in the pool by the originators of the mortgages. For example, after a savings and loan association (which we meet in the next section) makes a series of mortgage loans to individuals, it applies for insurance from Ginnie Mae and is then allowed to form a pool of mortgages that can be sold to the investing public. All interest payments and principal prepayments on the mortgages are passed through to the saver-lenders who have purchased the pool. Obviously there’s a lot of bookkeeping involved, so the originator of the pool (the savings and loan association) receives a servicing fee for its time and trouble. Mortgage pools come in still more complicated varieties, such as the collateralized mortgage obligation (CMO). At this point it is useful to note that these pools represent a form of securitization. Securitization occurs when funds that used to flow through intermediated markets now flow through financial markets. Until residential mortgages were securitized, they were exclusively owned by depository institutions such as banks, savings and loan associations, and mutual savings banks. Now, however, individual saverlenders can own residential mortgages by buying a pass-through or CMO, which can be later resold in the secondary market. Other types of financial claims have also been securitized over the past decade, including automobile loans and student loans. When securitization occurs, it changes the mix between direct finance and indirect finance.

35

Financial Instruments, Markets, and Institutions

Derivatives: Options and Futures Options and futures contracts are not used by corporations or individuals to raise funds. Nevertheless, they have become such important financial instruments in managing risk exposure that it is helpful to have at least a nodding acquaintance with them. Options and futures are often lumped together, because they both represent contractual agreements between two parties concerning some third asset. For example, there are options contracts on gold and on Treasury bonds, and there are also futures contracts on gold and Treasury bonds. Thus both options and futures are often called derivative financial instruments, because they derive their value from a so-called underlying asset. Options and futures are also similar in that they are both traded on organized exchanges. For example, the Chicago Board Options Exchange conducts trading in options on common stock and the Chicago Board of Trade sponsors trading in Treasury bond futures. But the differences between these two instruments far outweigh their similarities. First let’s look at futures contracts, because they are less complicated. A futures contract deals in both rights and obligations regarding the underlying asset. In particular, the buyer of a futures contract, also called the long, has the right and obligation to receive the underlying asset, say Treasury bonds, at some future date. The seller of the contract, also called the short, has the right and obligation to deliver the Treasury bonds on a specific date in the future. The price at which the Treasury bonds will be transferred is negotiated when the contract is sold by the short to the long on the floor of a futures exchange. Thus both parties know exactly how much Treasury bonds (or gold) will cost them in six months or a year. If prices go up in the meantime, the long (who is entitled to pay the lower agreed-upon price) makes money and the short (who has agreed to deliver at the lower price) loses money. One reason people buy and sell futures contracts, therefore, is that they disagree on the future course of prices for an underlying asset and hope to profit as prices move in their anticipated direction. Another reason is that selling or buying the asset at a known price at a specific date in the future eliminates the risk of price fluctuations for someone who must buy or sell the asset in the future. Options contracts also deal in rights and obligations with respect to an underlying asset, but these rights and obligations are separated. In particular, a call option gives the owner the right to buy the underlying asset, such as IBM stock or gold or Treasury bonds, at a fixed price (called the strike price) for a specific time interval, such as six months. A put option gives the owner the right to sell the underlying asset at a fixed price. The sellers of these options, called option writers, have the obligation to sell or buy the underlying assets as the case may be, and in return receive a payment, called the option premium. Like futures, options can be used by speculators. If individuals believe the price of gold will rise, they may buy a call option that expires in six months. If the price of gold does rise, then the option to buy gold at a fixed price can be very valuable. Options are also used to reduce risk. A jewelry

36

Financial Instruments, Markets, and Institutions

manufacturer may hedge against future price increases in gold by purchasing an option to buy gold at a fixed price. Obviously, options are a complicated business, one that we won’t get into in detail right now. But it should be clear that options are potentially important instruments for dealing with the risks of price movements in the underlying assets.

The Money and Capital Markets: A Summary Before leaving the subject, let’s take another look at how the financial markets as a whole are organized. Generally, an arbitrary distinction is drawn between the market for long-term securities and the market for shorter-term issues. The capital market refers to that segment of the marketplace where financial instruments have original maturities of more than a year (including equities, which have no maturity at all), and the money market, which is where financial instruments have original maturities of less than one year. By far the largest part of the capital market, in terms of dollar volume of securities outstanding, is the stock market, as Table 1 indicates. About half of all the outstanding stocks are owned by individuals; the rest are held by institutions such as pension funds, mutual funds, and insurance companies (in that order), all of which we will meet in greater detail in the next section. As homeowners, individuals are most familiar with residential mortgages. As far as investment goes, however, some residential mortgages are held to maturity by savings and loan associations and by commercial banks, while other residential mortgages are securitized. Commercial mortgages (shown in Table 1) arise in connection with financing business properties. Most commercial mortgages (and farm mortgages as well) are held by commercial banks and life insurance companies.

TABLE 1

The Capital Market: Securities Outstanding (2007)

Type of Instrument

Amount Outstanding*

Corporate stocks (at market value)

22,445

Residential mortgages

11,028

Corporate bonds

3,446

U.S. government agency securities

4,448

U.S. government securities (marketable, long-term)

4,560

Commercial, farm, and multifamily mortgages

3,180

State and local government bonds

2,142

*In billions of dollars, September 30, 2007.

Source: Federal Reser ve Flow of Funds Accounts and Federal Reser ve Bulletin .

37

Financial Instruments, Markets, and Institutions

In the corporate bond market, life insurance companies are the main lenders (they own almost one-half of the corporate bonds), followed by pension and retirement funds. State and local government bonds are bought primarily by wealthy individuals for their tax-exempt feature: Their interest is exempt from federal income taxes. U.S. government securities are generally bought by a wide variety of purchasers, including the Federal Reserve, commercial banks, individual Americans, and foreigners. The same is true of the securities of various government agencies, such as the Federal Home Loan Banks, the Federal National Mortgage Association, and the Federal Land Banks. Most of these are guaranteed, formally or informally, by the full faith and credit of the federal government. In many of these sectors of the capital market, active trading takes place daily for outstanding issues—especially for stocks and U.S. government securities, and to a lesser extent for corporate and municipal (state and local) bonds. Trading is facilitated by a variety of institutions, including securities dealers and brokers, with extensive communications facilities, under the watchful eye of government regulators such as the Securities and Exchange Commission. In contrast to the capital market, with its long-term securities, the money market deals with short-term instruments that almost by definition are highly liquid—that is, readily marketable. Table 2 displays typical money market instruments. If you need to raise cash quickly and are forced to dispose of long-term securities, you can take a beating, but if you have short-term securities, chances are you can sell them without taking much of a loss. The shortterm securities will mature pretty soon anyway, so if you can hold off a little while you can redeem them at face value when they mature. In addition, it is simply a fact of life, embedded in the mathematics of bond yields and prices, that for long-term securities a small change in interest rates involves a large change in price, whereas for short-term securities even a large change in yield involves only a small change in price. For this reason, business firms and others with temporary surplus funds buy money market instruments rather than long-term securities. Commercial banks are particularly important participants in the money market, both as

TABLE 2

The Money Market: Securities Outstanding 2007

Type of Instrument

Amount Outstanding*

Commercial paper

1,872

Negotiable bank CDs (large-denomination)

1,804

U.S. Treasury bills * In

billions of dollars, September 30, 2007.

Source: Federal Reser ve Flow of Funds Accounts and Federal Reser ve Bulletin .

38

958

Financial Instruments, Markets, and Institutions

lenders and as borrowers, as they adjust their legal reserve positions, invest temporarily idle balances, or sell some of their securities to raise funds in anticipation of forthcoming business demands for loans. Commercial paper is mostly held by money market mutual funds. It represents short-term liabilities of the most creditworthy business firms and finance companies and has grown rapidly in recent years. Negotiable CDs are bank deposits with a fixed maturity date, and thus are liabilities of the issuing banks. But they are interest-earning assets to whomever buys them. They are attractive because they are negotiable, which is a legal term meaning they can be transferred to a third party. Negotiable CDs are also readily marketable through securities dealers who specialize in buying and selling them. Thus a corporate treasurer who needs cash quickly can sell these CDs before they mature. The negotiable CD offers an alternative to Treasury bills or other money market instruments. By raising the rate they pay on CDs, banks can entice funds that might otherwise go into Treasury bills. U.S. Treasury bills are the most liquid money market instrument, with about $958 billion outstanding. Treasury bills are short-term debts of the U.S. government. Typically, they are issued for three months or six months or a year. They are highly marketable and are actively traded by both financial institutions and nonfinancial corporations. This overview of the money and capital markets has included a number of references to the financial institutions that invest in these markets. Let’s turn now to a somewhat more formal introduction to these financial intermediaries in order to complete our overview of the financial system as a whole.

Financial Intermediaries: Purposes and Profile Financial institutions such as banks, insurance companies, and pension funds are called by a special name: financial intermediaries. They dominate the financial scene at home and abroad. It is virtually impossible to invest money nowadays without getting involved with some kind of financial intermediary in one way or another. In this section, we formally introduce the various kinds of financial intermediaries that are prominent in this country and show how they go about their business. In order to set the stage, let’s try to understand why the transmission of funds between lenders and borrowers, as described earlier in this chapter, frequently is accomplished through the good offices of financial intermediaries.

The Role of Financial Intermediaries Financial intermediaries are nothing more than financial institutions— commercial banks, savings banks, savings and loan associations, credit unions, pension funds, insurance companies, and so on—that transfer funds from saver-lenders to borrower-spenders. They borrow from Peter in order to lend to Paula. What all financial intermediaries have in common is that they

39

Financial Instruments, Markets, and Institutions

acquire funds by issuing their own claims to the public (savings deposits, savings and loan shares) and then turn around and use this money to buy traded securities, such as stocks and bonds, or nontraded financial instruments, such as consumer loans and commercial loans. The role of financial intermediaries as “go-betweens” is reflected in their balance sheets. Unlike most companies, financial intermediaries have financial instruments on both sides of their balance sheet. Like any other company, financial intermediaries have financial claims (liabilities and/or equity) on the liabilities side of the balance sheet. However, unlike most companies, financial intermediaries also have financial claims as assets—financial claims they invest in. A manufacturing company, for example, has mostly real assets (heavy things that you can kick and touch). In contrast, a commercial bank has mostly loans and government bonds as assets. This balance sheet characteristic of financial intermediaries creates a special management challenge. Two questions spring to mind at this point: Why do financial intermediaries exist, and why do they have such big buildings, like the Citicorp Center in New York and the John Hanco*ck Center in Chicago? Unfortunately, we don’t have a very good explanation for the financial intermediary edifice complex, so let’s focus on the first question, why do financial intermediaries exist? This question is more puzzling after we take another look at Figure 1, where we see that saver-lenders could accomplish their investment objectives by putting their savings directly in the financial markets and avoiding financial intermediaries altogether. So why bother with these institutions? We can identify three reasons that explain why financial intermediaries play a major role in one financial sector: transactions costs, diversification, and information. Each is discussed in turn. Let’s take transactions costs first. Suppose you decide to buy a nice car this summer, say a Jaguar XF, primarily because Jaguar is now owned by the Ford Motor Company. You bargain hard and get the dealer down to $48,000. To pay the dealer, you could just give her securities from your portfolio worth $48,000. This approach, however, raises several problems. First, it turns out that all of your bonds are in $5,000 and $10,000 denominations. Second, the dealer doesn’t want bonds, because she’s afraid they’ll get stolen and she owes Ford cash. Third, once she gets the bonds, she has to sell them and pay a brokerage commission. As a result, the dealer says she has to add $500 to the price of your XF for all the trouble your bonds cause her. The solution? Write a check drawn on a bank and save the $500 in transactions costs. We can think of other examples. Suppose that you have $10,000 to invest and you want to buy a little bit of 100 different stocks. The brokerage commissions associated with buying one or two shares of each of these stocks would be prohibitively expensive. The solution? Buy $10,000 shares in a mutual fund, which invests in the 100 stocks you want and pay a commission on only one purchase. Diversification is the second big reason saver-lenders often choose to invest in financial intermediaries. We will see that investing in a portfolio of many securities (as opposed to putting all of your eggs in one basket) diversifies away a substantial amount of risk without necessarily sacrificing expected

40

Financial Instruments, Markets, and Institutions

return. Investing in a bank certificate of deposit, for instance, effectively gives the depositor a claim against a large portfolio of assets (the assets owned by the bank, which consist of bonds and loans). Mutual funds are another example. A widely diversified mutual fund can spread investor risk over hundreds of securities (as well as reducing the transactions costs associated with buying all of those securities individually). The third reason for the existence of financial intermediaries is the production of information. Many borrower-spenders have financing needs that are difficult to evaluate. Consumers and small businesses are good examples. Unlike large corporations, little is publicly known about their financial condition. Evaluating their creditworthiness requires time and expertise, which individual saver-lenders generally do not have. Consequently, it makes sense for individual lenders to delegate to the financial intermediary the responsibility of producing information about the borrowers whose financial claims they will purchase. Some financial intermediaries exist strictly to reduce transactions costs and provide diversification, while others add information production to their menu of services. An example of the former is an index fund. An index fund is a mutual fund that simply buys the stocks (or bonds) that compose a wellknown index, such as the S&P 500 mentioned previously. No information is produced by an index fund on the securities it invests in; it simply buys the securities in the index, so that investors can mimic the performance of the index with minimum transactions cost. At the other extreme, some financial intermediaries specialize in producing information needed to purchase the IOUs of individuals and small businesses. For example, consumer finance companies focus on consumer loans that very well might not exist without finance company expertise. The existence of financial intermediaries has a very beneficial effect on economic growth. Their ability to lower transactions costs, provide diversification, and produce information lowers the cost of funds that are channeled from saver-lenders to borrower-spenders. Without financial intermediaries, some enterprises might not get any funds at all—including new start-up companies that provide the seeds for the economy’s growth.

Financial Intermediaries in Profile Let’s now turn to the different types of intermediaries. Our purpose here is to introduce these institutions. We will pay special attention to the composition of their liabilities and their assets. Recall that the liabilities reflect how they acquire funds from ultimate lenders and the assets reflect how they deploy those funds. Because both their assets and their liabilities are financial claims, financial intermediaries profit by earning a higher rate of interest on their assets than they pay on their liabilities. In fact, from this perspective, financial intermediaries are just like any other firm—they are motivated by profits. In the process of turning a profit, they just happen to accomplish an important economic objective, channeling funds from lenders to borrowers. Although all financial intermediaries have a lot in common, there are also substantial differences among them. Ranked in terms of asset size, for

41

Financial Instruments, Markets, and Institutions

TABLE 3

Financial Institutions, Ranked by Asset Size (2007)

Institution Commercial banks

Asset Size* 10,873

Mutual funds (stock and bond)

7,967

Private pension funds

5,874

Life insurance companies

4,950

State and local government retirement funds

3,243

Money market mutual funds

2,802

Commercial and consumer finance companies

1,924

Savings and loan associations and mutual savings banks

1,868

Property and casualty insurance companies

1,384

Credit unions

748

*Total financial assets, in billions of dollars, September 30, 2007.

Source: Federal Reser ve Flow of Funds Accounts.

example, as in Table 3, commercial banks are easily the largest. However, in addition to size, financial intermediaries differ significantly in terms of the composition of their assets and liabilities. 1. Commercial banks are the most prominent of all financial institutions. There are about 7,500 of them, ranging from Citigroup, with over two trillion dollars in assets, to thousands of small banks scattered throughout the country, many of which have less than a hundred million dollars in assets. Commercial banks are also the most widely diversified in terms of both liabilities and assets. Their major source of funds used to be demand deposits (checking accounts), but in the past few decades savings and time deposits—including certificates of deposit—and other liabilities have become even more important than demand deposits. The main difference between savings deposits and time deposits is that time deposits have a scheduled maturity date. With these funds, commercial banks buy a wide variety of assets, ranging from short-term government securities to long-term business loans and home mortgages. 2. Mutual funds are frequently stock market–related institutions, but there are also mutual funds specializing in bonds of all kinds and in mortgages as well. A mutual fund pools the savings of many people of moderate means and invests the money in a wide variety of securities, thereby obtaining diversification that individuals acting alone might not be able to achieve. Shareholders can always redeem or sell back their shares if they wish, but the price they’ll receive from the fund depends on what has happened to the securities

42

Financial Instruments, Markets, and Institutions

it holds. Buying shares in a mutual fund is thus more risky than buying a savings deposit or a money market instrument like a Treasury bill, but because of diversification, it is less risky than buying individual stocks or bonds on one’s own. 3. Private pension funds are similar to life insurance companies in that they are mainly concerned with the long run rather than the short run. Their inflow of money comes from working people building a nest egg for their retirement years. Since they face few short-term uncertainties, they invest mainly in long-term corporate bonds and high-grade stocks. 4. Life insurance companies insure people against the financial consequences of death. They receive their funds in the form of periodic payments (called premiums) that are based on mortality statistics. Insurance companies can predict with a high degree of actuarial accuracy how much money they will have to pay out in benefits this year, next year, or even ten or twenty years from now. They invest accordingly, aiming for the highest yield consistent with safety over the long run. Thus a high percentage of their assets is in the form of long-term corporate bonds and long-term mortgages, although the mortgages are typically on commercial rather than residential properties. 5. State and local government retirement funds perform the same function as private pension funds except that they are sponsored by government agencies. 6. Money market mutual funds are something else again. They were introduced in the early 1970s and grew to a startling $200 billion in about ten years. They are like the old-fashioned kind of mutual fund just described, in that people buy shares in a fund. However, the fund’s management does not invest the money in the stock market or in corporate or municipal bonds. Instead, it purchases highly liquid short-term money market instruments that we discussed previously, such as large-size bank negotiable CDs, Treasury bills, and high-grade commercial paper. 7. Commercial and consumer finance companies specialize in lending money to people to buy cars and take vacations and to business firms to finance their working capital and equipment. Many of them, like the General Motors Acceptance Corporation, are owned by a manufacturing firm and lend money mainly to help retailers and customers buy that firm’s products. Others, like Household Finance, mainly make small consumer loans. They get their funds primarily by selling their own short-term promissory notes (commercial paper) to business firms that have funds to invest for a short while. 8. Savings and loan associations (S&Ls) have traditionally acquired almost all their funds through savings deposits, usually called shares, and used them to make home mortgage loans. This was their original purpose—to encourage family thrift and home ownership. They now issue checking accounts and also make a limited amount of consumer loans and business loans. They encountered serious problems in the 1980s. Savings banks are practically identical with

43

Financial Instruments, Markets, and Institutions

savings and loan associations, except that they are concentrated mostly on the East Coast and they have a somewhat longer history of making nonmortgage consumer loans. 9. Property and casualty insurance companies insure homeowners against burglary and fire, car owners against theft and collision, doctors against malpractice suits, and business firms against negligence lawsuits. With the premiums they receive—big ones from car owners under 25 years old—they buy high-grade municipal and corporate bonds, high-grade stocks, and short-term money market instruments, such as Treasury bills. 10. Credit unions are generally included, along with S&Ls and mutual savings banks, in the category of “thrift institutions.” There are about 9,500 of them, some in every state in the union, most quite small but a few with assets exceeding $1 billion. They are organized as cooperatives for people with some sort of common interest, such as employees of a particular company or members of a particular labor union, fraternal order, or church. Credit union members buy shares, which are the same as deposits, and thereby become eligible to borrow from the credit union. Until the early 1980s, credit unions offered only savings deposits and made only consumer loans. They now offer checking accounts (called credit union share drafts) and also make long-term mortgage loans.

SUMMARY 1. Financial markets are the transmission mechanism between saver-lenders and borrowerspenders. Saver-lenders supply funds to borrower-spenders either directly, by buying securities, or indirectly, by buying the liabilities of specialized financial intermediaries. These intermediaries, in turn, either buy securities from, or make loans to, borrowerspenders. Well-functioning financial markets facilitate the growth of GDP by giving both saver-lenders and borrower-spenders options they would not otherwise have.

2. Government, corporate, and municipal bonds all indicate the same thing—that the issuer has borrowed funds at a specified interest rate for a stated period of time. When saverlenders buy these debt claims, they become lenders. Traditionally, bonds have been coupon-bearing securities. Recently, however, zero-coupon bonds have become popular.

3. Stocks represent ownership rather than indebtedness. Owners of preferred stock receive fixed dividends, similar to bond interest, but owners of common stock get variable dividends that depend on the company’s profitability. When saver-lenders buy stock, they become owners.

4. Mortgages are debts incurred by borrowers who are buying land or buildings. The property serves as collateral for the lender in case of borrower bankruptcy. Mortgage pools are groups of mortgages put together and purchased by an investor as a unit.

5. Options and futures contracts, called derivatives, are contractual agreements between two parties concerning a third underlying asset. Although they are not used for borrowing by corporations or individuals, they are important tools in managing risk.

44

Financial Instruments, Markets, and Institutions

6. The capital market refers to the market for long-term securities, such as corporate stocks and bonds. The money market refers to the market for short-term securities (one year or less in original maturity), such as Treasury bills and negotiable bank CDs. Money market instruments are more liquid than capital market securities.

7. Financial intermediation involves financial institutions acquiring funds from the public by issuing their own financial claims and then using the funds to buy the claims of borrowerspenders. Financial intermediation leads to lower interest rates because: (i) intermediaries reduce transactions costs associated with buying financial claims; (ii) intermediaries facilitate diversification; and (iii) intermediaries efficiently produce information about borrower-spenders, whose claims would otherwise be difficult or impossible to sell.

8. Financial intermediaries come in all shapes and sizes, including commercial banks, insurance companies, mutual funds, and finance companies. Some specialize in diversification (mutual funds) while some specialize in information production (finance companies).

KEY TERMS adjustable-rate mortgages (ARMs)

FHA-VA mortgages

pass-through security

financial intermediary

perpetuity

bear market

financial market

preferred stock

bonds

fixed-rate security

primary market

bull market

futures contract

private pension fund

call option

property and casualty insurance company

collateral

Government National Mortgage Association (Ginnie Mae)

commercial bank

index fund

real asset

commercial paper

interest

savings bank

common stock

intermediated market

consol

life insurance company

savings and loan association (S&L)

convertible preferred stock

long

secondary market

money market

securitization

coupon security

money market mutual funds

short

derivative financial instrument

mortgage

strike price

municipal bond

tax-exempt

dividend

mutual fund

U.S. Treasury bill

Federal Home Loan Banks

negotiable CD

zero-coupon bond

Federal Land Banks

options contract

Federal National Mortgage Association

option writer

capital market

credit union

put option

stock

option premium

45

Financial Instruments, Markets, and Institutions

QUESTIONS Questions with a red oval are in

46

at www.myeconlab.com.

3.1

Define direct finance, indirect finance, saver-lenders, and borrower-spenders.

3.2

What is the function of financial markets?

3.3

People buy bonds to get interest. Why, then, would anyone buy a bond that has no interest coupons attached (that is, a zero-coupon bond)?

3.4

Why do saver-lenders sometimes choose to invest indirectly through financial intermediaries?

3.5

Discussion question: Explain how financial intermediaries might promote overall economic growth. Should the government subsidize intermediaries in order to promote growth?

Interest Rate Measurement and Behavior

Interest rates are the most pervasive element in the financial world. They affect everything that financial institutions do, and their implications extend into just about every nook and cranny of financial markets. Bank managers wouldn’t dream of making investment decisions without first considering the outlook for interest rates. Consumers decide where to put their savings depending in large part on where they can get the best interest rate on their funds. Business managers take interest rates into account in deciding when to borrow, how much, from whom, and for how long. Most importantly, interest rates serve as a yardstick for comparing different types of securities. Given the importance of interest rates, it is worthwhile exploring how they are calculated and their relationship to the prices of securities. We can then turn to see what determines whether rates are high or low and how they have behaved historically.

LEARNING OBJECTIVES In this chapter you will learn to describe present value and the mechanics of calculating interest rates comprehend the different types of bonds and loans and how their structure influences their present value understand interest rate determination and the supply and demand causes of interest rate fluctuations

Calculating Interest Rates Suppose you lend someone $100 for a year at 8 percent annual interest. How much would you get back at the end of the year? The answer depends on how the interest is paid. The most elementary case is called, not surprisingly, simple interest.

From Chapter 4 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

47

Interest Rate Measurement and Behavior

Simple Interest There is a formula, which you probably remember from high school, for calculating the dollar amount of interest earned based on simple interest: Principal * Rate * Time 1in years2 = Interest $100

* .08 *

1

=

$8

The amount you’d get back at the end of the year would be the principal ($100) plus the interest ($8) or a total future amount of $108: Total Future Amount = Principal + Interest = Principal + 1Principal * Rate2 = Principal 11 + Rate2 = $100 11 + .082 = $108

This example illustrates that if you are offered a choice between a dollar today and a dollar a year from now, you should take the dollar today, because you could lend it out and turn it into more than a dollar a year from now. Time, in other words, is worth money. A dollar in hand is worth more than a dollar due a year from now. Another way of expressing the same thought is to say that a dollar due a year from now is worth less than a dollar today (because interest can make today’s dollar grow over the course of a year). What if you lent money for more than a year, say, for three years? With simple interest at an 8 percent annual rate, $100 loaned out today will yield $8 interest at the end of a year, another $8 interest at the end of the second year, and $8 interest at the end of the third year: Principal * Rate * Time 1in years2 = Interest $100

*

.08 *

3

=

$24

Thus, the total amount you’d have at the end of three years would be the principal ($100) plus the interest ($24) or $124. It’s hard enough to get rich to begin with, but even harder if you lend your money out at simple interest. At least insist on compound interest, which is just as easily available—usually more so—and over time generates much more rapid growth.

Compound Interest Compound interest produces more rapid growth than simple interest because it involves interest on interest. With annual compounding, the interest that accumulates during a year is added to the principal at year’s end, so that the following year your money earns interest on interest.

48

Interest Rate Measurement and Behavior

Banks, for example, usually pay compound interest to depositors who put their money into bank savings accounts. The interest depositors earn is periodically added to their principal, so that it in turn starts to earn interest. Some banks convert the interest to principal annually, while others do so semiannually, quarterly, monthly, or even daily. They advertise that interest is compounded annually, semiannually, or whatever it may be. We’ll stick to annual compounding to illustrate how compound interest works. With annual compounding at an 8 percent interest rate, $100 loaned out today will yield $8 interest at the end of a year, an additional $8.64 interest at the end of a second year, a further $9.33 at the end of a third year, and so on. Compare this $25.97 of total interest after three years to the $24 that accumulates with simple interest. The difference appears small, but over long periods of time it becomes stupendous. For instance, $100 lent at 8 percent simple interest would grow to $900 in a hundred years; at 8 percent compound interest over the same time period, $100 would grow to $219,976! Let’s examine compound interest a bit more closely to understand why it’s so powerful. If you deposit $100 in a bank at 8 percent annual interest, what is your deposit worth after a year? The answer, of course, is $108. More formally: $100 (1 + .08) = $108. What is it worth after two years? Because of compounding (receiving interest on interest), it becomes $108 (1 + .08) = $116.64. What the second year really amounts to is $100 (1 + .08) (1 + .08), or $100 (1 + .08)2 = $116.64. On the same basis, after three years the deposit would be worth $100 (1 + .08)3, after four years $100 (1 + .08)4, and so on. After 100 years, the deposit would be worth $100 (1 + .08)100, which is equal to $219,976—almost all because of interest on interest. If $100 today at 8 percent interest is worth $108 a year from now, and $116.64 two years from now, we can work backward and say that $108 a year from now must be worth only $100 today, and that $116.64 two years from now must also be worth only $100 today. In the previous paragraph, we applied an interest rate to increase a present sum into the future; we can also work backward to reduce or discount a future sum back to its present value (time is money). Putting it a bit more formally, we have simply transposed the previous paragraph’s $100 11 + .082 = $108

into

$108 = $100 11 + .082

$100 11 + .0822 = $116.64

into

$116.64 = $100 11 + .0822

and

and, in general Future Value = Present Value 11 + r2n

49

Interest Rate Measurement and Behavior

where r represents interest rates and n the number of years the investment takes to mature. We will return to the concept of present value shortly. First, though, let’s become better acquainted with some interest rates on marketable couponbearing securities, like corporate, municipal, and government bonds. The interest rate that is most frequently referred to in bond markets is called yield to maturity, but a couple of other bond interest rates are often mentioned by securities buyers and sellers and are quoted in the financial sections of many newspapers—namely, the coupon rate and the current yield. Let’s look first at the coupon rate and the current yield and then return to yield to maturity.

Coupon Rate on Bonds Suppose you pay $900 for a $1,000-face-value 8 percent coupon bond that will mature in ten years and that you expect to hold until maturity. What annual interest rate will you be getting on that security? In particular, what return will you be earning if you invest in the security? You have to be careful to keep clear exactly which interest rate you are talking about. In this instance, the coupon rate, which is equal to the annual coupon divided by the face value, is 8 percent ($80/$1,000 8 percent). This also means that printed on the face of the bond is a statement that each year the holder of the bond will get an interest payment from the bond’s issuer amounting to 8 percent of the $1,000 face value, or $80. (Most bonds pay interest semiannually, which in this case would mean payments of $40 twice a year, but for simplicity we’ll assume only one payment a year of $80.) If you had paid the full $1,000 face value for the bond, you would indeed be getting 8 percent interest. But bond prices may rise and fall for many reasons, as we’ll see later in the chapter. In our case, you are paying only $900, so although the coupon rate printed on the bond specifies 8 percent, you will actually be earning more than 8 percent because you paid less than the face value. But how much more than 8 percent?

Current Yield We take a step in the right direction by examining the current yield. The current yield is calculated as the annual dollar interest payment divided by the price you paid for the bond, or $80/$900 8.89 percent. At first glance, this looks like a reasonable way to figure the interest rate, until you realize that it neglects the fact that when the bond matures in ten years you’ll have a $100 capital gain (because you paid only $900, but when the bond matures it will be redeemed at its $1,000 face value).

Yield to Maturity Yield to maturity is the most accurate and widely used measure of interest rates in financial markets. It takes into account the factors that the current yield and coupon rate neglect. In our discussion of compound interest, we

50

Interest Rate Measurement and Behavior

noted that at 8 percent annual interest, $100 today will be worth $108 a year from now, $116.64 two years from now, $125.97 three years from now, and so on. Putting this formally: $100(1 + .08) = $108; $100 (1 + .08)2 = $116.64; and $100 (1 + .08)3 = $125.97. We also noted that we could work backward and discount a future sum back to its present value: At 8 percent interest, $108 due a year from now would be worth $100 today (its present value), $116.64 due two years from now would be worth $100 today, and $125.97 due three years from now would also be worth $100 today. That is: $108 = $100; 11 + .082

$116.64 = $100; 11 + .0822

$125.97 = $100 11 + .0823

This concept of present value enables us to compare securities with different time dimensions. The previous illustration, for example, shows that when the annual interest rate is 8 percent, three pieces of paper—one promising $108 in a year, one promising $116.64 in two years, and one promising $125.97 in three years—are all equally valuable. Each of them is worth exactly the same ($100). With this background in mind, let’s now turn to the concept of yield to maturity. The yield to maturity of a security is that particular interest rate (or rate of discount, as it is sometimes called) that will make the sum of the present values of all the future payments of the security equal to its purchase price. The easiest way to understand the above italicized sentence is with a concrete example. We have been discussing paying $900 for a $1,000-face-value 8 percent coupon bond that will mature in ten years. What annual interest rate will it provide? Unless we can answer that question, we have no way of comparing it with other bonds that are available in the market, so we won’t be able to tell if it’s a good buy or a poor one. Assuming that the interest is paid annually rather than semiannually, this piece of paper promises ten future payments—interest payments of $80 each and one final payment consisting of $80 in interest and $1,000 face value (or principal). The price of the bond is $900, which means that anyone who wants to receive those future payments has to give up $900 today. The yield to maturity of this bond is defined as that particular rate of discount (let’s call it r) that will make the sum of the present values of all ten expected future payments equal $900. If we can find r in the following equation, we will have calculated the annual yield to maturity of this security: $900 =

$1,080 $80 $80 $80 + + ... + + 2 3 11 + r2 11 + r2 11 + r2 11 + r210

Notice, each term of this equation represents the present value of one of the 10 payments this coupon bond will make. For instance, the first term, $80/(1 r), is the present value of the $80 coupon payment that will be paid in one year. This equation simply states that the present value of the entire coupon bond is simply the sum of all the present values of its future payments.

51

Interest Rate Measurement and Behavior

We could figure out r by trial and error, trying one rate of discount (say 9 percent) and then another (10 percent) until we isolate one that makes all the terms on the right-hand side of the equation add up to $900. But that would be a time-consuming process. In the old days, r would be found using a book of bond yield tables, where it is all worked out for us. Such tables show the yield to maturity in this particular case to be 9.58 percent per annum.1 What if you don’t have a book of bond yield tables handy? Well, most business-oriented hand calculators are programmed to do the job.2 If you have such a hand calculator, with keys labeled in the usual way, enter $80 for the yearly coupon payments (use the PMT key); $1,080 for the final payment (with the FV key); 10 for the number of periods to maturity (the N key); and $900 for the bond’s purchase price or present value (the PV key). Press the appropriate key (usually r or %) and in a flash the display will show the annual yield to maturity: 9.60 percent. The hand calculator’s 9.60 percent yield to maturity differs slightly from the bond table’s 9.58 percent. The reason is that we assumed only one interest payment a year when entering data into the calculator, whereas bond tables are constructed on the assumption of semiannual interest payments. Since we’ve been simplifying all along in this example by assuming interest is paid annually, we might as well stick with that assumption and, to be consistent, use 9.60 percent as the appropriate yield to maturity. In terms of yield to maturity, therefore, if you invested $900 in this particular security, you’d get an annual yield of 9.60 percent on your money from now until the bond matures ten years from now. The yield to maturity is an accurate measure of the return on your investment in the security, because it compares all future dollar payments (including any capital gain) with the amount of money needed to get those future payments (namely, the price of the security). So far we’ve been discussing yield to maturity in very specific terms, using the example of a particular security. The concept is too important, however, to leave it at that. We should generalize the concept so it can be applied to a variety of cases. Here is the general formula we can use to calculate the yield to maturity (r) of a fixed-income security that pays a dollar coupon (C) in each of n years, has a face value (F) that will be paid off at maturity n years from now, and has a current price (P): P =

1Cn + Fn2 C1 C2 C3 + + + ... + 2 3 11 + r2 11 + r2n 11 + r2 11 + r2

1Notice

that the yield to maturity is well above the current yield of 8.89 percent because it implicitly takes account of the capital gain—the difference between the $1,000 face value and the $900 paid for the bond. The yield to maturity is also well above the coupon rate, which completely ignores the capital gain.

2Microsoft

52

Excel’s “yield” function also quickly computes yield to maturity.

Interest Rate Measurement and Behavior

Off The Record The Million Dollar Lottery: A Case of Misleading Advertising? One illustration of the time value of money arises in connection with state lotteries in which the lucky winner gets paid over a period of time rather than getting the entire sum all at once. “Buy a ticket and win a million dollars!” reads the advertisem*nt. But often it turns out that what the winner really gets is $50,000 now followed by $50,000 a year for the next 19 years. However, $50,000 now followed by $50,000 a year for 19 years is worth considerably less than a million dollars. Following

the present value formula in the text and assuming an 8 percent interest rate: Present Value = $50,000 + $50,000/(1 + .08) + $50,000/(1 + .08)2 + . . . + $50,000/(1 + .08)19

Converting each of the payments to present value and adding produces a sum total of $530,180. Not bad, but it’s a long way from a million!

What the general formula tells us is that if we know the price of a security, its coupon payments, its face value, and its maturity, we can find its annual yield to maturity (r). The yield to maturity is whatever rate of discount will make the sum of the present values of all future payments equal the purchase price. We could also use the same general formula to determine a security’s price, provided we know the yield to maturity to begin with. In other words, if we know r, the coupon payments (C), the face value (F), and the years to maturity (n), we can solve for the present value of the bond or the price (P) we should be willing to pay for it. We’ll come back to this way of looking at the equation later in the chapter.3

Zero-Coupon Bonds Most bonds are like the $1,000-face-value 8 percent coupon bond that we have been using for illustrative purposes; most corporate, government, and municipal bonds do indeed have coupons attached to them that entitle the holder to periodic interest payments. In the case of our bond, the coupon rate of 8 percent means that each year the holder of the bond will get an interest payment from the bond’s issuer amounting to 8 percent of the bond’s $1,000 face value, or $80.

3Actually

the “present value” formula in the text can be used quite generally to value anything with future cash flows, not just securities. An investor might project future cash flows for an investment in a firm or building as C1 through Cn. If the purchase price of the firm or building were given, then the formula would generate what is known as the internal rate of return on the investment. In fact, the yield to maturity on a bond is nothing more than the internal rate of return on the cash flows of the bond.

53

Interest Rate Measurement and Behavior

Reading the Financial News Government Bond Market Quotations Maturity

Coupon

Bid

Asked

Chg.

2011 Jul 31n

4.875

108:07

108:08

8

2012 Mar 31n

4.500

107:09

107:10

-2

2.6

2016 May 15n

5.125

110:20

110:21

-4

3.61

2016 Aug 15n

4.875

108:23

108:24

13

3.66

2018 Feb 15n

3.500

97:16

97:17

-7

3.8

2013 Aug 15

12.000

104:19

104:20

-2

2.05

2014 May 15

13.250

113:20

113:21

-2

1.86

2028 Jan 15i

1.750

96:00

96:01

-24

1.99

2037 Feb 15

4.750

102:18

102:19

-18

4.59

2037 May 15

5.000

106:23

106:24

-20

4.58

The “Maturity” column identifies each government bond in terms of its year, month, and date of maturity. The U.S. Treasury issues bonds and notes, two types of fixed-income securities that make coupon payments once every six months. Bonds have an original maturity greater than ten years, while notes—indicated by an “n” after the maturity date—have an original maturity of more than one year but no more than ten years. Maturity is the only difference between notes and bonds. The Treasury also issues inflation-indexed bonds, identified by a letter “i” after the maturity date. The “Coupon” column indicates the coupon rate the note or bond pays. The first row identifies a note that matures in July 2011, which pays a coupon rate of 4.875 percent. Had you purchased this bond, you would have paid the “Asked” price, which is the price bond dealers asked for in exchange for this bond. Government bonds normally have a face value of $1,000. Bond prices are expressed as a percentage of

Yield 2.35

face value; however, the numbers after the colons are not decimals but 32nds of a percent. Thus, in order to buy the first note on the list, you would pay (108 + 7/32)/100 × $1,000 or $1,082.19. The “Bid” price represents the price bond dealers were paying (or bidding) for that bond. Not surprisingly, their bid price is slightly below their asked price, allowing dealers to generate a profit when transacting with the public. The “Chg.” column is the change in the dealers’ bid price at the close of trading relative to the previous day’s close. It is also measured in 32nds. For example, the 2037 bonds maturing in May closed at (106 23/32)/100 $1,000 or $1,067.19, down 20/32nds (about $6.25) over the previous day. The final column is the bond’s yield to maturity. The asked price is used in determining the yield to maturity calculation since that is the price you would have to pay when buying the bond. In this column, the period represents a true decimal point, so there is an implied percent sign (%) after each yield.

However, recent years have witnessed the growing popularity of a new kind of bond—zero-coupon bonds, which do not entitle the holder to get any coupon interest payments whatsoever. The only thing the owner of such a bond gets is the face value, when the bond eventually matures. Why would anyone ever think of buying a bond that doesn’t make any interest payments? As with all things, whether or not it is worth buying depends on how much it costs. We’ve already seen that if you pay $900 for an

54

Interest Rate Measurement and Behavior

8 percent coupon bond with a $1,000 face value, you’ll get an annual yield to maturity of 9.60 percent on your money over the next ten years. What if someone offers you the same bond but without any coupons—that is, a piece of paper promising $1,000 in ten years and nothing else? In fact, if you can get that piece of paper at a price of only $400, you will also get 9.60 percent on your money over the next ten years! Yields to maturity on zero-coupon bonds follow the same principles as on coupon securities, but they are easier to calculate, because there is only one payment—the face value, which is due on maturity. Thus the basic formula simplifies to:

Price =

Face Value (1 + r)n

In the case of zero-coupon bonds, yield to maturity is that rate of discount (r) which makes the present value of a single payment (the face value), due in n years, equal to the current price. If we already know what r is, we can use the same formula to solve for the present value or price of the bond. In our example, with a face value of $1,000 due in ten years, if we know the annual interest rate—say it is 9.60 percent—then we can solve for the price. With a hand calculator, the price turns out to be $399.85.

The Inverse Relationship Between Yields and Bond Prices We mentioned earlier that higher interest rates mean lower bond prices and lower interest rates mean higher bond prices. We can use the general present value formula just developed to demonstrate why this is so: If a bond’s coupon payment (C) and face value (F) are fixed, a higher yield to maturity (r) must imply a lower bond price (P). Similarly, a lower yield must imply a higher bond price. If either r or P changes, the other will automatically change in the opposite direction. For instance, what if you paid not $900 but $925 for our illustrative tenyear 8 percent coupon bond with a face value of $1,000? What annual yield to maturity would you be getting then? Plug $925 instead of $900 into your trusty calculator and the yield to maturity would fall from 9.60 to 9.18 percent. What if you paid only $875? Then yield to maturity would rise to 10.04 percent. We have been assuming that we know P and want to find the resulting interest rate. We could do it the other way around: We could ask what price is implied by a particular yield. For instance, we could assume an interest rate of 12 percent and calculate the price that would produce that annual yield to maturity (assuming, of course, that C and F are fixed). The answer must be a price below $875, since $875 gives us only a 10.04 percent yield. We find that a price of $774 would produce a 12 percent yield to maturity. The special case of a consol, or perpetual bond, best illustrates the inverse relationship between yields and bond prices. A consol is a bond with no maturity

55

Interest Rate Measurement and Behavior

date at all. It promises that the holder will receive a fixed annual dollar payment forever, with no redemption date. In that case, with n approaching infinity, the general present value formula collapses (you’ll have to take our word for it) into simply: Price =

C r

Here it becomes obvious that with C given, the rate of interest (r) and the price have to move inversely. For example, if C = $1 and r = 0.05, then P = $20; but if r rises to 0.10, then P falls to $10. The inverse relationship between P and r follows directly from the mathematical formula for bond pricing.

Why Long-Term Bonds Are Riskier Than Shorts We can also use the general formula for the present value or price of a bond to explain why a change in interest rates affects long-term bond prices so much more than it affects prices of short-term securities. For long-term securities, a small change in interest rates involves a large change in price, whereas for short-term securities, even a big change in interest rates involves only a small change in price. Here’s an illustration. Take two bonds, each of which has a face value of $1,000 and an 8 percent coupon; one has 20 years until maturity and the other has only two years. Both are currently priced at par (that is, at $1,000), so that yield to maturity in each case is 8 percent, the same as the coupon rate. Assume that suddenly, for reasons no one fully understands just yet, all interest rates rise by two percentage points. Yield to maturity in each case goes up to 10 percent. This rise in yield involves a fall in price from $1,000 to $830 for the 20-year bond, but a fall in price from $1,000 to only $965 for the two-year security. In brief, the longer a bond’s maturity, the more its price will be affected by a change in the general level of interest rates. This has enormous implications for capital gains and losses. When all interest rates fall, long-term securities rise dramatically in price, but not short-term ones. Similarly, when all interest rates rise across the board, long-term bonds—but not the shorter ones—drop drastically in price.4 The general present value formula explains why this is so. The formula shows that the price or present value of a bond consists of the sum of the 4Length

of time to maturity is the most important factor affecting bond prices when interest rates change, but it is not the only one. Coupon size is also relevant: The smaller the coupon, the more a bond’s price will be affected by a change in interest rates. An 8 percent coupon bond will be more volatile in price than a bond with a 10 percent coupon. (Most volatile of all would be a longterm zero-coupon bond.) Portfolio managers often mathematically combine maturity and coupon size in order to estimate a bond’s riskiness more precisely than is possible with maturity alone. The combination of the two is called a bond’s duration.

56

Interest Rate Measurement and Behavior

discounted present values of all its future payments. The longer the maturity of a security, the greater will be the effect of a change in r on the price, because there are more future payments and they will be discounted over a longer period of time. The longer period of time is crucial: Remember that discounting a payment due in 20 years isn’t just dividing by (1 + r) but by (1 + r)20. A second way of thinking of this is to remember the power of compound interest. A change in the interest rate has little impact on bonds that mature soon because there is little time for interest to compound. A change in interest rates on a 20-year bond has a large impact on price because the owner of that bond can gain (or lose) interest that compounds over those 20 years. In other words, you can get rich quickly with long bonds, but you can also go down the drain. Long-term bonds are riskier than short-term bonds, because the threat of potential loss is greater. Then why do people buy them? Because they often yield more than short-term bonds, and also because hope springs eternal: Maybe interest rates will fall and long-term bond prices will skyrocket!

Nominal Versus Real Interest Rates So far we have discussed only nominal interest rates. Nominal means measured in money as distinct from purchasing power. Nominal interest rates— that is, market interest rates as quoted in the newspapers—provide an accurate measure with respect to purchasing power when prices are stable, because then the purchasing power of money remains constant over time. But when prices are rising, as during periods of inflation, nominal interest rates become misleading with respect to purchasing power. Inflation means that lenders will get back dollars that have less purchasing power than the dollars they loaned out. Assume a 10 percent nominal interest rate and a 6 percent annual rate of inflation. If you lend someone $100 for a year, at 10 percent interest, you’ll receive back $110 a year later. But with prices 6 percent higher, it will take you all of $106 to buy what you could have gotten for $100 last year. In terms of purchasing power, the $110 you now have buys only $4 more of goods and services than the $100 you loaned out a year ago. Although the nominal interest rate is 10 percent, 6 percent inflation has shrunk the inflation-adjusted or real interest rate to only $4/$100, or 4 percent. The nominal interest rate measures the increment in dollars as a percent of dollars loaned out ($10/$100). The real interest rate measures the increment in purchasing power as a percent of purchasing power loaned out ($4/$100). In a nutshell, the real interest rate is the nominal interest rate minus the inflation rate.5 5The

4 percent real interest rate in this example is an approximation. It takes $106 to buy what $100 could have bought a year ago, leaving an apparent $4 increment in purchasing power. But that $4 can no longer buy what $4 could have bought a year ago. Because of the 6 percent inflation, $4 now can only buy what $3.77 could have bought last year ($4/1.06 = $3.77). Thus the precise real rate of interest in this example is not 4 percent but only 3.77 percent. Nevertheless, it has become customary to ignore this refinement, so that the real rate of interest is generally calculated simply as the nominal interest rate minus the inflation rate.

57

Interest Rate Measurement and Behavior

Actually, there are two concepts of the real interest rate: the ex ante or expected real rate and the ex post or realized real rate. The ex ante or expected real interest rate is the nominal interest rate minus the expected rate of inflation. The ex post real rate is the nominal interest rate minus the actual or realized rate of inflation. (More on this later in the chapter.)

Annual Return Versus Yield to Maturity The fact that people often sell bonds before the final maturity date creates a divergence between the concept of yield to maturity developed above and what the bond returns to the investor over the time period the bond is actually held. To illustrate this point, we first define “return” and then present a series of numerical examples. The concept of annual return or rate of return measures the cash flows received during a period relative to the amount invested at the beginning. For our purposes, it makes sense to measure returns per annum, so that we have a uniform standard for comparison. Thus, the annual rate of return on a bond that is held for one year is measured as the selling price minus the purchase price plus the coupon payment, all divided by the initial price. Or, more formally: Annual Return =

Selling Price - Purchase Price + Coupon Purchase Price

For example, a bond that is purchased for $1,000 at the beginning of the year, pays a coupon of $80 at the end of the year, and is sold for $1,000 at the end of the year has an annual return of 8 percent:6 Annual Return =

1,000 - 1,000 + 80 = 0.08 1,000

If the bond were sold for $1,100, the return would be 18 percent: Annual Return =

1,100 - 1,000 + 80 = 0.18 1,000

Now let’s go back to our favorite 8 percent coupon ten-year bond that we purchased for $900. Recall that the yield to maturity on that bond was 9.60 percent. Suppose that after buying the bond for $900 the investor decides to 6Note

that our example specifies that the coupon is paid at the end of the year, because if it were paid earlier in the year the return measure would have to include interest earned on the coupon from the time it is paid until the end of the year. All return measures assume that cash distributions are made at the end of the period.

58

Interest Rate Measurement and Behavior

sell it after one year. What will be the annual return earned on the investment? The answer depends crucially on the selling price. More specifically, suppose the investor sells the bond at a lower price, say $880, because the level of interest rates has gone up at the end of one year (remember that bond prices move inversely with interest rates). The annual return is then 6.6 percent: Annual Return =

880 - 900 + 80 = 0.066 900

On the other hand, if yields had gone down at year’s end and bond prices had increased, the annual return would be much higher. For example, if the investor had sold the bond for $950, the annual return would be 14.4 percent: Annual Return +

950 - 900 + 80 = 0.144 900

Yield to maturity is, in general, a poor guideline to the annual returns earned on a bond when selling before maturity. Whether the investor is pleasurably surprised or utterly disappointed depends on what happens to bond prices between one year and the next; and whether bond prices go up or down depends on whether interest rates rise or fall. And that brings us to our next major topic: What determines movements in the overall level of interest rates?

What Determines the Level of Interest Rates? Now that we are experts in how to calculate interest rates, let’s see what determines whether they are high or low and how they have behaved historically. There are interest rates on many different types of loans—rates on car loans, home mortgages, government securities, corporate bonds, and so on. However, most interest rates move up and down together, so that we can simplify matters by discussing “the” interest rate, with “the” rate conveniently standing for all rates taken as a group. We will look separately at interest rates on alternative securities and explore differences among them. In all cases, however, whenever we use the term interest rate, we mean yield to maturity.

Supply and Demand Determine the Interest Rate The interest rate is a price, like the price of Lamborghinis or Maseratis or copies of your favorite video game. With the interest rate, however, the price we are talking about is the price of credit or borrowing money—the price that lenders receive and borrowers have to pay. Because the interest rate is a price, like all prices, it is determined by supply and demand. Supply of and demand for what? Of credit or loanable funds—funds that lenders are willing to make available for borrowers to borrow.

59

Interest Rate Measurement and Behavior

Interest rate

Supply of loanable funds (lending)

6% 5% 4% Demand for loanable funds (borrowing) Credit or loanable funds in $

FIGURE 1

Supply and demand determine the interest rate.

In any competitive market, whether for automobiles or personal computers, interaction between supply and demand determines price and quantity exchanged. Financial markets are no exception. In fact, we can best illustrate the story by drawing familiar supply and demand curves. In Figure 1, the interest rate is shown on the vertical axis and the quantity of credit or loanable funds on the horizontal axis. The upward-sloping supply-of-funds curve represents the common-sense notion that lenders will be willing to extend more credit the higher the interest rate they receive (holding everything else constant, including things like borrower creditworthiness). The downwardsloping demand-for-funds curve represents borrower behavior: The lower the interest rate, the more funds borrowers are willing to borrow (once again holding everything else constant, like the prospects for business activity). It should not be terribly surprising that the equilibrium interest rate is at the intersection point of the supply and demand curves—producing a yield of 5 percent in Figure 1. Equilibrium, you may recall from basic economics (or high school physics, if that’s a better memory), means no tendency for change. Thus, in Figure 1, the interest rate will stay at 5 percent, because that’s where the quantity of funds lenders want to lend just equals the quantity of funds borrowers want to borrow. At any other interest rate, there is an excess of either borrowers or lenders, and competitive pressure will force the rate toward its equilibrium level. For example, at 6 percent, lenders want to lend more than borrowers want to borrow; competition among lenders forces the interest rate down. Similarly, at 4 percent, borrowers want to borrow more than lenders want to lend; competition among borrowers forces the

60

Interest Rate Measurement and Behavior

interest rate up. Once the interest rate gets to 5 percent, there is no tendency for it to change as long as the supply and demand curves stay where they are.7 Analyzing interest rates by supply and demand assumes that financial markets are competitive, so that supply and demand pressures will be reflected in price (interest rate) changes. It rules out the conspiracy theory of interest rates—the view that rates are rigged by a few insiders with substantial market power. It is hard to believe that any one person, institution, or group of institutions has anywhere near enough power to rig interest rates in this country. There are simply too many lenders engaged in the business of lending, and therefore too many alternatives open to most would-be borrowers, to permit any tightly knit clique of lenders to control the price of credit. Lenders charging more than prevailing rates would price themselves out of the market and lose business to their competitors. Similarly, borrowers trying to borrow at cheaper than prevailing rates would find themselves outbid for funds by others who are willing to pay the market price. 7Instead

of talking about how the supply of and demand for credit or loanable funds determine the rate of interest, we could talk about the same thing in terms of how the demand for securities and the supply of securities determine the price of securities (see the following diagram). To supply credit (lend) is equivalent to demanding debt securities—households lend, for example, by purchasing debt instruments. To demand credit (borrow) is the same as supplying securities— business firms borrow by selling their bonds or other IOUs. Look at the diagram and compare it with Figure 1 in the text. At a price of $833 (which corresponds, let us say, to the 6 percent yield in Figure 1) relative eagerness to buy securities—or lend—would drive up the price of securities, just as Figure 1 shows that it would drive down the rate of interest. And at a price of $1,250, corresponding to a 4 percent yield, relative eagerness to sell securities—to borrow—would drive down the price of securities, just as Figure 1 shows that such circ*mstances would drive up the rate of interest. Price of securities

Supply of securities (borrowing)

$1,250 $1,000 $833 Demand for securities (lending) Securities

61

Interest Rate Measurement and Behavior

10-Year Treasury Bond Yields Yield (%) 4.4 4.3 4.2 4.1 4.0 3.9 3.8 3.7 3.6 3.5 June 1

June 11

June 21

July 1

July 11

July 21 Day

FIGURE 2

U.S. Treasury bond yields fluctuate from day to day (2007).

Why Does the Interest Rate Fluctuate? Once the interest rate reaches equilibrium—like 5 percent in Figure 1—does it stay put? Hardly, Figure 2, which records the daily yield movements on tenyear Treasury bonds during the summer of 2007, shows that yields can fluctuate considerably from day to day. Why do rates change so often? The interest rate fluctuates, like other competitive prices, because of shifts in the demand and/or supply curves. Before going into detail, let’s focus on the mechanics. Perhaps you remember from your introductory economics course that we should distinguish between movements along a demand or supply curve and a shift in the curve. When the amount demanded or supplied changes in response to a change in the interest rate, then we have a movement along a demand or supply curve. On the other hand, a shift in a curve occurs when the amount demanded or supplied changes, at each interest rate, in response to something else—such as, for example, a change in expectations regarding inflation. Figure 3 illustrates (a) a movement along a demand curve and (b) a shift in the curve. Moving down demand curve (a) from x to y to z is a movement along the demand curve. As the interest rate falls, the amount of credit demanded increases. A shift in demand takes place when the amount

62

Interest Rate Measurement and Behavior

Interest rate

(b)

(a)

x

y

z

Credit or loanable funds in $

FIGURE 3

Movement along a demand curve versus a shift in demand.

demanded increases at each interest rate, as from demand curve (a) to demand curve (b). Of course, the amount demanded could also decrease at each interest rate, in which case the curve would shift to the left. When talking about a movement along a single demand or supply curve, we’ll always refer to a change in “amount demanded” or “amount supplied.” On the other hand, when we say demand or supply has increased (or decreased), we’ll mean the whole curve has shifted to the right (or the left). Making this distinction helps to avoid confusion. When mortgage interest rates fall, for example, many potential home buyers decide to borrow funds and buy a home, because now they can afford the monthly mortgage interest payments. That’s an increase in the amount of loanable funds demanded in response to a change in the interest rate—a movement down along a single demand curve. In this case, a fall in the interest rate causes an increase in the amount demanded. On the other hand, say many tenants suddenly find themselves with more money and decide they can afford to buy their own homes, even at higher mortgage rates. This is a rightward shift in the demand curve. It should be fairly obvious that anything that causes the demand or supply curves to shift position will cause the equilibrium interest rate to change. For example, in Figure 4, starting out with supply curve S and demand curve D produces a 5 percent equilibrium interest rate. If the demand curve shifts from D to D′ and the supply curve stays put, the equilibrium interest rate will rise to 6 percent. If, on the other hand, the supply curve shifts from S to S′ and the demand curve stays where it was (at D), then the new equilibrium interest rate will be 4 percent.

63

Interest Rate Measurement and Behavior

Interest rate

S

1

S' 2

6%

5% D' 4%

D

Credit or loanable funds in $

FIGURE 4

Shifts in demand (1) or supply (2) curves can change the equilibrium interest rate.

Behind Supply and Demand Now that we know that shifting supply and demand curves for loanable funds underlie gyrations in interest rates, let’s see if we can go one step further. The level of interest rates will go up when the demand for loanable funds increases or when the supply of loanable funds decreases. What might lie behind such shifts in the demand and supply curves? First, let’s look at demand. Most borrowing comes from: 1. Business firms, borrowing to acquire inventories or buy capital equipment; 2. Households, borrowing to buy cars, consumer goods, or homes; 3. State and local governments, borrowing to build sewer systems, roads, schools, and so on; and 4. The federal government, borrowing to finance federal budget deficits. Anything that increases the eagerness to borrow in any of these sectors would shift the demand for loanable funds to the right and drive interest rates higher. Some such factors might be anticipated improved profits on the part of business firms; expectations of higher incomes on the part of consumers; large population increases resulting in the need for more state and local services; or a big buildup in military outlays producing larger federal budget deficits.

64

Interest Rate Measurement and Behavior

Now let’s turn to supply. Why might the supply of loanable funds—lending— decrease? Most lending comes from financial institutions or directly from individuals. Banks and other financial institutions sometimes have to curtail their lending because government authorities, like the Federal Reserve, make it difficult for them to lend. The ability of individuals to lend depends in part on how much they save; if they save less, they will generally lend less, exerting upward pressure on interest rates. We will not go behind supply and demand in similar detail with respect to declines in interest rates. We trust your own ingenuity. In general, of course, what makes interest rates fall are decreases in the demand for loanable funds (for example, because of slower economic activity) and/or increases in the supply (for example, because individuals save more). You can take it from there.

The Importance of Inflationary Expectations One element underlying both supply and demand deserves special mention because it is so important. That element is expectations of inflation. In our earlier discussion of nominal versus real interest rates, we showed how to calculate the real rate of interest given a particular nominal interest rate and a specific rate of inflation. Now we have a somewhat different concern: Will a change in expectations of inflation alter the equilibrium nominal interest rate itself?

In The News Bonds Move Higher Treasury prices rose Wednesday after an auction of $19 billion of three-year notes by the federal government as well as positive comments by a Federal Reserve official. The benchmark 10-year Treasury gained 6/32, or $1.87 on a $1,000 note, to yield 4.64 percent, versus 4.65 percent late Tuesday. The 30-year bond price rose 13/32, or $4.06 on a $1,000 investment, yielding 4.73 percent down from 4.75 percent in the previous session. Bond prices and yields move in opposite directions. With no more economic data due out today (11/08/06), the market has its eyes on the outcome of the close Senate race between challenger Jim Webb and Senator George Allen in Virginia, the results of which could tip the balance of both chambers of Congress

into the hands of Democrats, significantly altering the fiscal stance of Washington. The Democratic Party victory in the House of Representatives could make it harder for Republicans to cut taxes, while President Bush will likely balk at many Democratic spending proposals. Together the effect will create the so-called gridlock that some experts say leads to less upward pressure on the federal budget deficit. The bond market typically reacts well to more fiscal discipline since a lower budget deficit means the government has to sell fewer bonds to finance the deficit, which in turn helps support bond prices. Source: CNNMoney.com, Nov. 8, 2006. © 2006 Cable News Network. A Tme Warner Company. All rights reserved with permission.

65

Interest Rate Measurement and Behavior

Changes in inflationary expectations affect equilibrium interest rates by shifting the curves for both the demand for and the supply of loanable funds. Borrowers expecting inflation to accelerate will increase their demand for loanable funds, shifting the demand curve to the right, because they look forward to repaying their borrowings in depreciated dollars. On the other hand, lenders expecting a speedup in inflation will decrease their supply of loanable funds, shifting the supply curve to the left, because they anticipate getting repaid with money of diminished purchasing power. On both counts, the end result of increased inflationary expectations will be higher nominal interest rates. Similarly, expectations of a slowdown in inflation will decrease demand, increase supply, and produce lower rates. Usually, however, matters are not so neat and tidy. Our example assumes that everyone agrees in their expectations about inflation. In the real world, such unanimity about the future—or about anything else for that matter— hardly ever exists. Under such circ*mstances, the consequences for interest rates are more complicated.

Cyclical and Long-Term Trends in Interest Rates Now let’s see if our supply–demand framework can shed some light on how interest rates have behaved over the past four decades. Figure 5 plots the yields on ten-year government bonds since 1960 to represent the overall movement in interest rates. The chart also shows the annual rate of inflation represented by the rate of increase in the consumer price index. The shaded areas on the chart indicate periods of business-cycle recession—that is, periods when the economy is growing relatively slowly and unemployment is increasing. Each shaded area begins at the peak of a business cycle expansion and ends at the bottom (or trough) of the ensuing recession. Three generalizations can be drawn from Figure 5: 1. The level of interest rates tends to rise during periods of business cycle expansion and fall during periods of cyclical recession. Yields go up when business conditions are good, because that’s when business firms and households generally increase their demand for loanable funds. Businesses borrow more to accumulate inventories in anticipation of increased sales, and households buy more goods and services on credit, because the future looks bright for them, too. The opposite takes place in recessions, when both businesses and consumers rein in their use of credit so that the demand for loanable funds shifts to the left and interest rates fall. Supply-curve shifts reinforce these effects on interest rates. The Federal Reserve usually tightens credit in business cycle expansions, shifting the supply of loanable funds to the left, raising interest rates. And the Federal Reserve typically eases credit during recessions, which increases the supply of credit, lowering interest rates. 2. The level of interest rates was on an upward long-term trend from 1960 to 1980. For the most part, each cyclical trough in interest rates was higher than the

66

Interest Rate Measurement and Behavior

Percent 14 12 10

Ten-year government bond yield

8 6 4

Annual rate of inflation

2 0

FIGURE 5

1965

1970

1975

1980

1985

1990

1995

2000

2005 Year

Trends in interest and inflation rates since 1960.

previous trough, and each cyclical peak was similarly higher than the one before. This upward trend was probably due to a number of factors, the two most important of which were large federal budget deficits, which forced the U.S. Treasury to borrow huge amounts every year, and investor concern with future inflation. Inflationary expectations, as we have seen, can generate forces that raise interest rates. Figure 5 shows that inflation accelerated between the 1960s and the early 1980s, so it is not surprising that nominal interest rates followed suit as investors’ expectations of inflation caught up with the trend in actual inflation. 3. Since the early 1980s, nominal rates have trended downward. This decline is primarily due to a decrease in inflation (and expectations of future inflation). Recall that when lenders expect less future inflation they are more willing to supply loanable funds, which reduces the interest rate. Simultaneously, borrowers decrease their demand for loanable funds, thereby reinforcing the downward pressure on interest rates. Needless to say, there is much more to the story of how interest rates are determined.

67

Interest Rate Measurement and Behavior

SUMMARY This chapter focuses on two general issues concerning interest rates: how to calculate rates and how to analyze what influences the level of interest rates. We first summarize the calculations and then the analysis.

1. Even simple interest demonstrates that time is money, that a dollar today is worth more than a dollar due a year from now (because today’s dollar can grow to more than a dollar by earning interest during the year). Compound interest produces more money than simple interest, because compounding involves the payment of interest on interest.

2. The yield to maturity of a security is that rate of discount that will make the sum of the present values of all future payments flowing from the security equal to its purchase price. Conversely, the present value or price of a security consists of the sum of the discounted present values of all its expected future payments. The yield to maturity is a useful yardstick for comparing returns on different securities.

3. Because many buyers do not hold securities to maturity, annual return is often used as an alternative yardstick. Return on a bond is defined as price change plus coupon expressed as a fraction of price.

4. The present value formula shows why there is an inverse relationship between yields and bond prices. It also shows why a change in interest rates affects the prices of long-term securities by more than the prices of short-term ones, making long-term securities riskier than short-term securities.

5. It is important to distinguish between “real” and “nominal” interest rates. The real interest rate is the nominal rate minus the rate of inflation.

6. The interest rate is the price of credit and as such is determined by the supply of and demand for credit or loanable funds. It fluctuates because of shifts in demand and/or supply.

7. Interest rates rise when the demand curve for loanable funds shifts to the right and/or when the supply curve shifts to the left. Rates fall when the demand curve shifts to the left and/or the supply curve shifts to the right. Behind demand and supply are the borrowing requirements of businesses, households, and governments, as well as the monetary policies of the Federal Reserve. Expectations also underlie the demand for and supply of loanable funds, especially expectations regarding inflation.

8. Interest rates tend to rise during periods of business cycle expansion and fall during recessions. This pattern reflects increased demand for loanable funds during expansions and decreased demand during recessions.

9. The long-term trend of all interest rates was upward from 1960 to 1980. Much of this uptrend was a reflection of the increase in inflation between 1960 and the early 1980s. Interest rates have fallen since the early 1980s, primarily because inflation declined.

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Interest Rate Measurement and Behavior

KEY TERMS annual return

duration

simple interest

capital gain

equilibrium interest rate

supply and demand

compound interest

loanable fund

yield to maturity

coupon-bearing security

nominal interest rate

zero-coupon bond

coupon rate

real interest rate

present value

current yield

QUESTIONS Questions with a red oval are in

at www.myeconlab.com.

4.1

Explain why yield to maturity is higher than current yield when you buy a coupon-bearing bond for less than its $1,000 face value.

4.2

Explain why zero-coupon bonds sell for less than coupon-bearing bonds of identical maturity.

4.3

If interest rates suddenly fall, would you rather be holding a portfolio consisting of short-term securities or long-term securities?

4.4

A zero-coupon bond with face value of $10,000 that matures in 2 years goes on sale today for $9,100. What is this bond’s yield to maturity?

4.5

Using the bond described in 4.4, imagine that you purchase this bond. Within an hour of purchasing it, the market interest rate changes to 5 percent. If you decide to sell your bond, what profit (loss) can you expect to make?

4.6

Again, using the bond described in 4.4, imagine that you purchased the bond and then held it for one year. At the end of that year market interest rates are 5.5 percent and an acquaintance of yours offers to buy the bond for $9,500. Do you sell the bond or do you keep it? Either way, calculate your annual rate of return on this bond as if you sold it.

4.7

As an aspiring, brilliant economist, you receive simultaneous job offers from two companies. Get Rich Amazingly Fast Technologies (GRAFT) makes a contract offer where you receive a $50,000 signing bonus and $80,000 at the end of each subsequent year for the next 5 years when your employment with GRAFT will come to an end. SAFe (Securing Assets Forever) makes a 5-year employment offer without a signing bonus but agrees to pay you $95,000 at the end of each year. If the interest rate is 4 percent and, besides the pay, the jobs are equally appealing, should you accept the GRAFT or SAFe offer? (Harder: For what range of interest rates is the GRAFT offer superior to the SAFe offer?)

69

Interest Rate Measurement and Behavior

4.8

An irresponsible financial journalist writes a column suggesting that stocks are unduly risky. If the public believes this journalist, what do you expect to happen to interest rates in the bond market? Use a supply and demand for loanable funds diagram to answer.

4.9

Explain what happens in the supply/demand for loanable funds when firms believe that their future profitability will be higher than previously expected.

4.10 Given an increase in inflation of 1 percent, what is likely to happen to nominal interest rates? What about real interest rates?

70

The Term and Risk Structure of Interest Rates

Whether interest rates go up or down often depends on which ones you focus on. Short-term interest rates can go up while long-term rates may stay put. Or vice versa. It’s time to examine the details. After all, that’s where the money is. The structure of yields on different maturities of the same class of securities is explored first. We then turn to the relationship among yields on different categories of securities (such as government bonds versus corporate bonds).

LEARNING OBJECTIVES In this chapter you will learn to envision and draw the yield curve and describe the determinants of its slope explain how risk is important in influencing interest rates comprehend the impact on interest rates of income taxes

The Term Structure of Rates and the Yield Curve The relationship among yields on different maturities of the same type of security is called the term structure of interest rates (from “term to maturity”). For government bonds, we might compare the yields on three-month Treasury bills, two-year notes, and 20-year bonds. The relationship between yield and maturity is sometimes depicted graphically by a yield curve, as in Figure 1, where yield is measured on the vertical axis and term to maturity is on the horizontal axis. The yield curve is most often upward sloping—that is, short-term securities yield less than long-term securities (curve A). Sometimes it is rather flat—short-term yields equal longterm yields (curve B). And sometimes the yield curve is even downward sloping—short-term interest rates are above long-term rates (curve C).

From Chapter 5 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

71

The Term and Risk Structure of Interest Rates

Yield

C B A

3 mos.

FIGURE 1

1 year

5 years

20 years Years to maturity

Three alternative yield curves.

What determines the shape of the yield curve? A number of analytical explanations have been proposed, ranging from the application of basic supply and demand to more complicated theories based on expectations and preferred maturity ranges of different investors. Each approach is aimed at explaining real-world observations, such as why yields on all maturities tend to move together, while at the same time there are distinct, divergent, patterns between movements in short-term and long-term yields. First we will develop the alternative theories of the term structure, and then we will describe how they best explain actual events.

Supply and Demand In the previous chapter, we showed how the overall level of interest rates was determined by the supply of and demand for loanable funds or, alternatively, by the supply of and demand for securities as a whole. A simple extension of that approach suggests that the interest rates on different maturity categories of securities are determined by the relative supply of and demand for each maturity class. For example, the interest rate on three-month Treasury bills is determined by the supply of and demand for three-month Treasury bills, while the interest rate on 20-year bonds is determined by the supply of and demand for 20-year bonds. Thus when the supply of three-month bills goes up, the yield on bills rises to induce investors to buy the additional supply; when the supply of bills falls, the yield on bills falls to ration the smaller supply among eager

72

The Term and Risk Structure of Interest Rates

investors.1 If nothing happens to the supply of and demand for 20-year bonds, these shifts change the relationship between yields on securities of different maturity; that is, the term structure of interest rates changes. Although there is much to be said in favor of supply and demand in general, there are severe limitations to using that approach by itself to explain the term structure of interest rates. The problem is that supply and demand analysis focuses attention on the particular market in question, such as threemonth Treasury bills, and deals with other markets, such as 20-year securities, as an afterthought. When there is a close relationship between two markets, as there is in the case of different maturities of the same security, it is perhaps more useful to focus on the interrelationships more directly. Thus instead of treating the maturity structure of interest rates from the vantage point of supply and demand in separate markets, we examine the relationships among securities within the framework of a single market.

The Pure Expectations Approach There are many—and here financial analysts and economists often find much common ground—who argue that short-term securities and long-term securities are very good substitutes for each other in investor portfolios, not for every investor but for enough so that their decisions collectively make a significant impact on the market. For such investors the important feature of the security they buy is not the maturity date of the final payment, but rather what it returns over the period for which they want to invest (see the previous chapter for a definition of returns). This concern with returns implies that expectations of future short-term rates determine how long-term rates are related to short-term rates. Let’s illustrate that with a particular example. Say you are the portfolio manager of a bank and you want to invest funds for two years. Suppose you could buy a one-year Treasury security today yielding 8 percent, and you expect that next year the rate on one-year securities will be 10 percent. If you buy the one-year security today and reinvest in a one-year security next year, you expect an average return over the two years of about 9 percent. If you had the option of buying a two-year Treasury security today that yielded 9 1兾2 percent, you’d jump at it (so would everyone else). On the other hand, if two-year Treasury securities were yielding only 8 1兾2 percent, you wouldn’t touch them (neither would anyone else). This means that unless the two-year security yielded 9 percent (the average of the current and expected short-term rate), portfolio managers would try to buy it (if it yielded more) or sell it (if it yielded less). This buying and selling pressure by portfolio managers maintains the long-term (two-year) rate as an average of the current short-term (one-year) rate and the expected future short-term (one-year) rate.

1Do

not be confused by the fact that a decrease in supply causes yields to fall; yields decline because the decrease in supply raises security prices and prices and yields are inversely related.

73

The Term and Risk Structure of Interest Rates

A somewhat more general statement is as follows: The relationship between the yield on a two-year (long-term) security and a one-year (short-term) security depends on the expected future short-term rate. If next year’s expected shortterm rate is above the current short-term rate, then the current long-term rate will be above the current short-term rate, and the yield curve will be upward sloping. On the other hand, if next year’s expected short-term rate is below the current short-term rate, the yield curve will be downward sloping.2 The key to this expectations theory of the term structure is that shortterm securities and long-term securities are very good substitutes for each other in investor portfolios. In fact, they are perfect substitutes: If expected returns are the same, the portfolio manager is indifferent between “shorts” and “longs.” Instead of separate markets for short-term and long-term securities, there is a single market. Note in this case that if the supply of long-term securities goes up and the supply of short-term securities goes down, it makes absolutely no difference as far as yields are concerned. Because investors are indifferent among maturity categories of the same security, they will happily exchange long-term securities for short-term securities, with no change in yields, as long as expected future short-term rates are unchanged.

The Liquidity Premium Modification It is difficult to argue that investors are unconcerned about differences between short-term securities and long-term securities. It is simply a fact of life—embedded in the mathematics of bond prices—that the prices of longterm securities are more volatile than those of short-term securities. If you have to sell a security before it reaches maturity and interest rates have increased, a long-term security will have fallen in price much more than a short-term one. If you might have to sell to raise cash, you’ll prefer short-term securities. They are safer. Commercial banks, for example, prefer short-term securities precisely because their needs for cash are often unpredictable. Recognition of the greater capital uncertainty of long-term securities leads to the “liquidity premium” modification in the expectations theory of the term structure. If most investors are like commercial banks and prefer the capital certainty of short-term securities, while most bond issuers prefer to issue long-term securities, then investors on balance will demand a premium for holding long-term securities. This is often called a liquidity premium, but

2The

story of the downward-sloping yield curve is as follows. If the current one-year rate is 8 percent and investors expect next year’s one-year rate to be 6 percent, portfolio managers could earn an average return of 7 percent by investing in two successive one-year securities. If the current rate on a two-year security were above 7 percent, all investors would buy it, forcing up the price and reducing the yield. If the current two-year rate were below 7 percent, no one would buy it, forcing down the price and raising the yield. Thus the two-year security must yield 7 percent when the current one-year security yields 8 percent and the expected one-year rate is 6 percent. Since the short-term (one-year) rate is 8 percent and the long-term (two-year) rate is 7 percent, we have exactly what we call a downward-sloping yield curve.

74

The Term and Risk Structure of Interest Rates

it is really a risk premium—a reward for exposure to the capital uncertainty of long-term securities. Thus in our previous numerical example a two-year security would have to yield more than the average of the current one-year rate and next year’s expected one-year rate. Otherwise, investors wouldn’t want to hold the riskier two-year security.

The Preferred Habitat Approach It seems reasonable to suggest that many investors prefer short-term securities. But to leave it at that would be misleading, because some investors actually have a preference for long-term securities. Life insurance companies and pension funds, for example, don’t worry that much about surprising needs for cash. Their liabilities are actuarially predictable. In fact, they want to make sure they earn at least 8 (or 10 or 12) percent on their assets over the next ten (or 20 or 30) years. That way they are sure of a profit, because they promise to pay pension holders something less than that. These institutions therefore prefer long-term securities. Because some institutions prefer long-term securities while others prefer short-term issues (like members of the animal kingdom, they have preferred habitats), it would seem that the supply-demand emphasis in explaining the term structure could make a healthy comeback. For example, when the supply of five-year securities increases relative to other maturities, the yield on such issues will have to increase above the “expectations theory average” in order to induce investors to leave their preferred maturity ranges and to invest in the unfamiliar “five-year” territory. The same would be true for any increased supply of a particular maturity category. Thus the yields on various maturities would seem to have relatively little to do with expectations, and much more to do with relative supply and demand. Not so fast, say the proponents of the expectations theory. While many institutions have preferred maturity ranges for their investments, they can also be induced rather easily to switch between short-term securities and long-term securities when yields get out of line with expectations. Commercial banks, for example, require only a “liquidity premium” to invest in longer-term securities. A large increase in the supply of five-year bonds may therefore initially push up their yield to a higher level than is warranted by the expectations theory alone. But commercial banks will then be lured away from their preferred oneyear securities by the attractive yields on five-year bonds. And pension funds will be enticed as well. Both these actions mitigate the upward pressure on five-year bond yields caused by the increased supply of securities in that maturity category. In the process, the role of expectations is restored.

Real-World Observations Each of the theories outlined previously is aimed at explaining the real world. We started with the pure expectations approach and then modified it to make the theory conform more closely to reality. A further step is to recognize that

75

The Term and Risk Structure of Interest Rates

investors do not usually have precise numerical predictions of short-term rates for next year or the year after. More likely, investors form expectations of when the “level” of rates is in general relatively high and when the “level” of rates is in general relatively low. While this is a rather casual version of the expectations theory, it provides a powerful explanation of when the yield curve is likely to be upward sloping (curve A in Figure 1) or downward sloping (curve C). When interest rates are high relative to what they have been, investors generally expect them to decline in the future. Falling interest rates mean rising bond prices, and those investors who are holding long-term bonds in their portfolio will reap their just reward—big capital gains. Therefore, when all rates are relatively high, investors will prefer to hold long-term securities rather than short-term securities (because the potential capital gains on shortterm securities are relatively low). This additional demand for long-term securities drives their prices up and their yields down relative to short-term securities. Thus long-term yields are below short-term yields (that is, the yield curve is downward sloping) when the overall level of rates is high. Similarly, when the general level of rates is low and yields are expected to rise in the future, investors prefer not to hold long-term securities, because they are likely to incur large capital losses. This drives the price of long-term securities down (and the yield up), thereby producing long-term rates above short-term rates (an upward-sloping yield curve). Figure 2 demonstrates the accuracy of these conjectures. The yield curve on December 1, 2006, was downward sloping, and that’s when the overall

Percent 6

5

December 1, 2006

4

3 February 1, 2008 2

1 May 14, 2004 0 1 mo.

FIGURE 2

3 mos.

6 mos.

1 yr.

2 yrs.

3 yrs.

5 yrs.

7 yrs.

10 yrs. 20 yrs. Time to maturity

Yields on U.S. government securities.

Note: When the “level” of rates is high, the yield cur ve is likely to be downward sloping.

76

The Term and Risk Structure of Interest Rates

Percent 10 9 8 7 6

10-year

5 4 3

5-year

2 1-year

1 0 1989

FIGURE 3

1991

1993

1995

1997

1999

2001

2003

2005

2007 Year

Three different Treasury rates.

“level” of rates was quite high relative to other periods during the decade. On the other hand, a sharply upward sloping curve occurred two years earlier in May, 2004, when the “level” of rates was very low (a 1-month Treasury bill paid a yield to maturity of .89 percent). Figure 2 also emphasizes another empirical regularity: short-term rates fluctuate more than long-term rates. Indeed, during the period covered by these yield curves, short-term rates fluctuated by almost 4.5 percentage points, while 20-year bond yields moved only 1.2 percentage points. The expectations theory (along with its liquidity premium modification) provides the best explanation for this phenomenon. Since long-term rates are averages of current short-term rates and expected future short-term rates, as long as expectations are less volatile than actual short-term rate movements, longterm rates will move less than short-term rates.3 Figure 3 highlights the volatility of short-term rates relative to long-term rates since 1989. One-year Treasury rates have had much wider swings than 3Expected

future short-term rates move less than current short-term rates as long as people view some of the influences on interest rates as temporary events—for example, a temporary slowdown in economic activity. The arithmetic of the rate movements is as follows: We saw earlier in the chapter that if the one-year rate were 8 percent and the expected one-year rate next year were 10 percent, then two-year rates would be 9 percent. If the one-year rate jumped to 12 percent and the expected one-year rate rose to 11 percent, then the equilibrium long-term rate would be 111兾2 percent (the average of 12 and 11). Thus when the short-term rate jumped by 4 percentage points, the long-term rate rose by only 21兾2 percentage points. And that is what we said in the text: Shortterm rates fluctuate more than long-term rates.

77

The Term and Risk Structure of Interest Rates

five-, or ten-year Treasuries. During this twenty-year period, one-year rates reached 9.57 percent and fell to 1.01 percent, a swing of over 8.5 percentage points. Ten-year rates have moved less, ranging between 9.36 percent and 3.33 percent for a swing of only 6 percentage points. A final observation comes from market participants. Most practitioners would stress that over the very short run, large supplies in a specific maturity range would raise the interest rate on that particular category of security. Such anecdotal evidence supports the supply/demand or preferred habitat approach to the term structure of interest rates. In point of fact, in the very short run (such as over a week or two), there is little doubt that relative supplies of securities must be brought into the picture. After all, it takes time for the expectations-based substitution between short-term and long-term securities to occur. But after all is said and done, and all portfolio adjustments have been completed, the impact of relative supplies is swamped by expectations of future short-term rates. To summarize, the best approach to the term structure is ecumenical. The expectations theory forms the foundation; liquidity premiums then enter as a permanent modification to the yield curve; and finally, over short periods of time, even relative supplies of securities have an impact.

Going Out on a Limb Is the Shape of the Yield Curve a Crystal Ball? Predicting the course of economic activity is serious business. Many corporations pay large sums for the forecasts generated by high-priced consultants. Perhaps they would be better off, and would save money, if they simply looked at the shape of the yield curve. Figure 3 shows that short-term rates fluctuate more than long-term rates over the course of the business cycle. It also shows that in October 2000 (a few months before the official NBER business cycle peak), the yield curve was downward sloping, largely due to the anti-inflationary policy pursued by the Federal Reserve. This inverted yield curve was followed by a recession and then by a steep upwardsloping yield curve as the Fed aggressively cut

78

short-term interest rates to help revive the weak economy. Coincidence? The Federal Reserve Bank of Cleveland reports that negatively sloped segments of the yield curve preceded all but four of the 17 business-cycle downturns since 1910 (the exceptions were 1926, 1945, 1948, and 1953). Indeed, stock market forecasters (who make economic forecasters look like geniuses) have jettisoned many of their arcane charts in favor of the yield curve as the key predictor of stock price movements. The message is clear: A negatively sloped yield curve is a danger sign for the economy and the stock market. If you see one, proceed with caution (sell first).

The Term and Risk Structure of Interest Rates

An Aside on Marketability We could continue with more details on the term structure relationship. But we’ve gone about as far as we should without recognizing that nicely shaped curves such as those drawn in Figure 2 hardly ever occur in nature. Not that the yield curve for any of the dates shown in the figures is wrong. It’s just that the yield curve depicts the relationship between yield and maturity, and there are other factors that influence yields—even on a relatively hom*ogeneous group of securities such as government bonds. One of the most important explanations for differences in yield to maturity on government bonds with the same maturity are differences in the marketability of specific issues. The most recently issued government bonds in each maturity range, often referred to as the current coupon, or on the run, issue, are usually the most actively traded securities in the secondary market. Although we discuss the details of marketability and the related concept of liquidity in the next chapter, it is sufficient to recognize that government securities dealers are most willing to buy and sell the most recently issued securities, so that investors can count on finding a ready market for these issues in case they want to alter their existing portfolios. Because these “current coupon” issues are highly marketable, they carry somewhat lower yields to maturity than the older, so-called “off the run” issues.

Risk and Tax Structure of Rates Once we step away from the safety of governments, default risk plays an important role in explaining yield relationships. Indeed, for lack of a better name, this is often called the risk structure of interest rates, even though other factors, such as differential tax treatment, come into play in addition to the relative risk of default. We’ll take a look at the relationship among yields on governments, corporates, and municipals, staying away from term structure influences by looking at long-term bonds only. As with term structure theory, a straightforward supply-demand analysis can be tried in explaining yield relationships. For example, as the supply of corporate bonds rises relative to, say, governments, the yield on corporates should increase. But as with the term structure, a simplistic supply-demand approach ignores important relationships between these markets that dominate the yield structure. In particular, because all bonds are substitutes for each other in investor portfolios, as soon as one yield begins to rise relative to others, investors switch into that security. This substitution process holds down the widening yield differentials among securities. In fact, when you think about it, every security entitles the holder to receive exactly the same thing—a stream of dollar payments in the future. One reason investors pay a different price for each of these contracts is that sometimes people break their promises. They don’t wind up doing what they

79

The Term and Risk Structure of Interest Rates

Percent 20 18

Corporate (Baa)

16 14

Corporate (Aaa)

12 10 8 6 4 2

Governments Municipals

0 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 Year

FIGURE 4

Riskier securities carry higher yields.

said they’d do. In some religions you do penance for such transgressions; in the financial world you go bankrupt. So, bonds are risky—they may not pay either the interest or the principal. Since the federal government has substantial taxing power there is little risk of default on government securities.4 But for corporations, individuals, and even municipal governments, the risk of default is prominent. Since people usually have to be paid to bear more risk, yields on corporate bonds exceed those on governments, as is evident in Figure 4. In a similar vein, within the corporate sector firms have differing degrees of default risk. As is summarized in Table 1, private credit-rating agencies such as Standard & Poor’s and Moody’s Investors Service put the bonds of these firms into different risk categories, depending on the strength of the company’s balance sheet, cash flows, and management. The highest rating, Aaa in Moody’s rating system, goes to companies such as General Electric and Exxon Mobil. The credit rating used by some investors (such as pension funds) as a cutoff for so-called “investment grade issues” is Baa. At the other end of the scale, those bonds that are in default get a C rating. Figure 4 illustrates what we would expect: Lower-rated corporate bonds (Baa) have higher yields than bonds in the higher-rated category (Aaa).

4Although

the government always has the ability to repay its debt, it can simply refuse to do so. This is called sovereign risk (as in sovereign monarch). Because repudiating debt has severe consequences for future borrowing, however, this option is rarely considered a viable strategy.

80

The Term and Risk Structure of Interest Rates

TABLE 1

A Guide to Bond Ratings

Moody’s

S&P

Description

Aaa

AAA

Best quality with least risk; strong ability to pay interest and principal

Aa

AA

High quality, slightly more long-term risk than the top rating

A

A

Strong capacity to pay interest and principal, but a bit vulnerable to changes in economic conditions

Baa

BBB

Adequate current financial strength, but could be threatened by changes in the economy

Ba

BB

Currently paying interest but with an uncertain future

B

B

Little assurance that interest and principal will continue to be paid

Caa to C

CCC to C

Highly speculative bonds that may be in or near default

D

Used only by S&P for bonds in default

Investment Grades

Speculative Grades

Municipal bonds—the debt issued by state and local governments—have a number of interesting features. The default risk of such bonds used to be considered quite low, with the only significant bankruptcies occurring during the Great Depression. The taxing power of state and local governments is the ultimate backing for municipal bonds. But the taxing power of states and cities is limited by people’s willingness to stay put and subject themselves to the burden of ever-increasing local taxes. As a result of this and the de facto defaults of New York City in 1975, Cleveland in 1978, and Orange County, California, in 1995, default risk considerations exert considerable influence on the yield relationships among municipals and between municipals and other bonds. The tax-exempt status of interest payments on municipal bonds is, however, the most important influence on municipal yields versus governments and corporates. Assume it’s the bad old days and you pay 50 percent of your income in federal income taxes. If the yield on a government bond is 8 percent, you get $80 per $1,000 invested, but after taxes you’ll wind up with only $40— or an after-tax yield of 4 percent. But if you own a municipal bond that pays $80 per $1,000 invested, you keep it all, because interest on municipal bonds is immune from the Internal Revenue Service. If the municipal bond had no chance of default and if everyone were in the 50 percent bracket, then

81

The Term and Risk Structure of Interest Rates

investors would refuse to buy government bonds and would buy all the municipals they could lay their hands on if both yielded 8 percent before taxes. This would drive down the price of governments and push up the price of municipals. When would investors be indifferent between these two securities? Clearly when the municipal bond yielded 4 percent and the government bond yielded 8 percent; they would both pay their owners $40 after taxes, and the market would be in equilibrium. At a lower income tax rate, the yield on municipals would have to be higher—say, 5 1兾2 percent versus 8 percent on governments.5 Furthermore, municipal bonds are not what they used to be in terms of their default-free reputation. This tends to push such rates even closer to the yield on fully taxable U.S. government bonds. As can be seen in Figure 4, the yields on municipal bonds have usually stayed well below comparable maturity governments, as dictated by tax considerations. But back in the Great Depression and in more recent times when default risk jitters surfaced and income tax rates were reduced, the yields on municipal bonds were forced toward yields on fully taxable governments.

5If

your tax rate is t, the yields on governments is G, and the yield on municipals is M, then aftertax yields are equal when G(1 - t) = M. Hence the ratio of M to G equals (1 - t). With a marginal tax rate of 30 percent, the equilibrium yield on governments would be 8 percent, compared with 5.6 percent on municipals.

SUMMARY 1. The relationship between yields on short-term and long-term securities is frequently illustrated graphically by a yield curve. The yield curve can be upward sloping (shortterm rates are below long-term rates), downward sloping (short-term rates are above long-term rates), or flat (the yields on shorts and longs are the same).

2. The basic expectations theory maintains that the shape of the yield curve is determined by investors’ expectations of future short-term interest rates. In particular, if short-term rates are expected to rise, the yield curve will be upward sloping, while if short-term rates are expected to fall, the yield curve will be downward sloping. A specific result is that long-term rates are averages of current and expected future short-term rates.

3. There are a number of modifications to the pure expectations theory that reflect other influences on rate structure. For example, since investors are usually considered risk averse, and since long-term securities have greater capital uncertainty than short-term securities, a liquidity premium is likely to be attached to long-term yields. In addition, some investors, such as life insurance companies, prefer long-term securities because they can “lock in” a guaranteed return on funds. This suggests that there are preferred maturity ranges for investors, and changes in supplies of securities will alter yields on different maturities.

82

The Term and Risk Structure of Interest Rates

4. The fundamental role of expectations in shaping the yield curve is emphasized by the following empirical regularity: When the overall level of rates is high compared with the recent past, the yield curve slopes downward; when the level of rates is low compared with recent experience, the yield curve slopes upward.

5. Default risk helps to explain the excess of corporate bond yields over the yield on government bonds of comparable maturity. The probability of default also influences the structure of yields within the corporate bond market.

6. Municipal bonds yield less than government bonds because the interest payments on municipals are exempt from federal income taxes. Nevertheless, when default probabilities on municipal debt increase, their tax-free yields can approach taxable yields on governments.

KEY TERMS current coupon

liquidity premium

sovereign risk

default

on the run

term structure

default risk

preferred habitat

yield curve

expectations theory

risk premium

QUESTIONS Questions with a red oval are in

at www.myeconlab.com.

5.1

Describe the market pressures that, according to the pure expectations approach to the term structure of interest rates, force the equilibrium long-term rate to equal an average of the current short-term rate and the expected future short-term rate.

5.2

Consider the following three yield curves:

Rate

Rate

Rate

Time to maturity

Time to maturity

Time to maturity

(a)

(b)

(c)

a. Using the pure expectations approach, what do each of the yield curves predict for future short-term interest rates?

83

The Term and Risk Structure of Interest Rates b. Using the expectations approach with liquidity premium modification, what do each of the yield curves predict for future short-term interest rates? c. Using the preferred habitat approach, what do each of the yield curves predict for future short-term interest rates?

5.3

Why do long-term rates tend to fluctuate less than short-term rates?

5.4

According to today’s Wall Street Journal, if you purchased a one-year Treasury note today, it would pay 3.2 percent interest over the year; a two-year T-note would pay a rate of 3.6 percent; and a three-year note would pay 4.2 percent. a. Using the pure expectations approach, what is the future expected one-year interest rate starting one year from today? (Harder: What is the future expected one-year interest rate starting two years from today?) b. Imagine that investors required a .1 percent premium for holding a twoyear note (relative to a one-year note) and a .3 percent premium for holding a three-year note (relative to a one-year note). What is the future expected one-year interest rate starting one year from today? (Harder: What is the future expected one-year interest rate starting two years from today?)

84

5.5

If the marginal income tax rate were 25 percent, what would be the equilibrium yield relationship between municipals (ignoring default risk) and governments?

5.6

Discussion question: If your parents called and asked for advice on what types of bonds they should buy for their retirement fund, what would you tell them?

APPENDIX

BOND PRICE VOLATILITY: DURATION VERSUS MATURITY

We have mentioned on a number of occasions that long-term bonds are riskier than short-term bonds—not because we don’t like long-term bonds, but because numerical examples show that a one-percentage-point change in the yield to maturity on a long-term bond produces a larger change in the price of the bond than the impact of a one-percentage-point change in yield on the price of a short-term bond. Now, this statement is correct—usually. It is okay most of the time, but not good enough for mathematicians and bond market professionals, who like things somewhat more precise. The problem with the relationship between bond price volatility and maturity stems from the rather casual way people define maturity. In particular, we identify the maturity of a bond with the date of final repayment of principal. Thus, a bond with ten years to maturity and an 8 percent coupon makes a series of coupon payments equal to $80 per year and then pays the principal borrowed ($1,000) plus the final $80 coupon at the end of the tenth year. Our definition of maturity ignores the fact that the bond makes coupon payments in each of ten years before it repays the principal. This is not necessarily bad; we can define maturity as we wish. In fact, this definition of maturity reminds holders of corporate bonds that they have ten years to worry about potential defaults on promised payments. But by ignoring the coupon payments, we have in a sense overstated the maturity of the bond; lenders get some of their money back before the ten-year maturity date. A more comprehensive measure of a bond’s maturity, called duration, takes into account the timing of both coupon and principal payments. We will define duration very precisely next. But first let us focus on a key relationship: A bond with longer duration has greater price volatility than a bond with shorter duration when yields on both bonds change by the same amount in percentage points. We can even write down a simple formula relating the percentage change in the price of a bond to the bond’s duration. Let P stand for price, D for duration, i for yield to maturity, and Δ (delta) for “change in.” Then, we have: - ¢i * D ¢P>P = (1 + i)

85

The Term and Risk Structure of Interest Rates

This says that the percentage change in the price of a bond is opposite in sign (yields go up and bond prices fall) and equal to the percentage change in yield to maturity times the duration of the bond.1 Thus, if the duration of a bond is five years, for example, and the yield to maturity falls from 8 percent (0.0800) to 7.99 percent (0.0799), we can readily calculate the percentage change in the price of the bond as follows: ¢P>P = - [¢i>11 + i2] * D = - [ - .0001>11.082] * 5 = - [ - .000092] * 5 = + .00046 In particular, if the price of the bond were 100 and the yield to maturity decreased by one basis point (equal to 0.01 percent or 0.0001), from 8 percent to 7.99 percent, then the price of the bond would increase to 100.046 (with ¢P>P = .00046 and P = 100, ¢P = .046 and the new price is 100.046). If the duration of the bond were ten years, the price would have increased to 100.09, and so on. This is obviously a handy formula to have. It lets you calculate how a bond’s price varies with changes in the yield to maturity. Note that this relationship has nothing at all to do with economics. It all follows from the definition of the price of a bond and the definition of duration. Although we cannot show you why combining the definitions produces this magic result (we trust the mathematicians), we can move one step in that direction by presenting the formula for duration. Duration is defined as a weighted average of the time periods when a bond’s payments are made. That’s the easy part. The more difficult part is the weight applied to each time period. In particular, the weight attached to each time period is the present value of the payment at that time divided by the price of the bond. This is most easily understood by way of specific example. Suppose we have our five-year bond with $80 annual coupon payments and a $1,080 principal-plus-coupon payment at the end. Thus, there are five time periods: years 1, 2, 3, 4, and 5. The formula for duration is: c D =

$1,080 $80 $80 $80 $80 d112 + c d122 + c d132 + c d142 + c d152 2 3 4 11 + i2 11 + i2 11 + i2 11 + i2 11 + i25 $1,080 $80 $80 $80 $80 + + + + 11 + i2 11 + i22 11 + i23 11 + i24 11 + i25

This looks messy, but it’s really not that bad. First, the numerator: Each of the time periods—1, 2, 3, 4, and 5—is in parentheses and preceded by a term in brackets. The bracketed terms are either the present value of $80 (for the

1This

formula is precisely correct only for infinitesimally small yield changes. Otherwise, it is an approximation.

86

The Term and Risk Structure of Interest Rates

first four years) or the present value of $1,080 (for the fifth year). These weights are each divided by the price of the bond, which appears in the denominator of the formula. The duration of a bond clearly depends on more than just the date of the final principal payment (five years). For example, if the yield to maturity (i) were 8 percent, so that the bond were selling at par, the duration of our bond would measure 4.2 years. Duration is less than five years, because the earlier time periods in the formula receive some weight in the computation. For example, year 2 receives the weight [$80>(1.08)2] divided by the denominator. If the yield to maturity increased to 12 percent, the duration of the bond would decrease to 4.1 years, because the especially large weight attached to the last time period (5) would become smaller in present value terms. Thus, it is generally the case that the higher the yield to maturity, the lower the duration of a bond (holding everything else constant, of course). The coupon payment clearly plays an important role in the duration calculation. Returning to our initial case of an 8 percent yield, if the coupon of the bond were $40 rather than $80, the duration would be 4.5 years. It is generally the case that lower coupons mean longer duration (everything else the same), because the weights attached to the earlier years in the formula would be smaller. One special case is worth emphasizing. When the coupon payments are zero, the duration of our bond is equal to five years. In fact, duration always equals maturity for a zero-coupon bond (and is less than maturity for bonds with coupons). To convince yourself of this, simply write out our duration formula without the first four terms in both the numerator and denominator (they are equal to zero for a zero-coupon bond). We then have the same term in the numerator and denominator, except that the numerator is multiplied by 5. Thus, everything cancels except the 5 in the numerator, which is the date of the final payment. This makes considerable sense, of course, since we started our discussion by noting that the date of the final principal payment is an imprecise measure of “true” maturity, because it ignores coupon payments. If there are no coupon payments, however, the date of the final principal payment is all that matters. Finally, to show how duration varies with the conventional definition of maturity, Table A.1 lists five bonds with 8 percent coupons, all priced at par

TABLE A.1

Duration of Bonds with Different Maturities

Coupon

Yield

Maturity

Duration

8%

8%

5 years

4.2 years

8%

8%

10 years

7.1 years

8%

8%

15 years

9.0 years

8%

8%

20 years

10.3 years

8%

8%

30 years

11.8 years

87

The Term and Risk Structure of Interest Rates

and thus yielding 8 percent, but with maturity dates varying between five and 30 years. Obviously, longer maturity means longer duration as long as the bonds have the same yield and same coupon. But duration hardly increases at the same pace as maturity. For example, doubling the maturity of a 15-year bond to 30 years increases its duration by less than a third (from 9.0 to 11.8). Moreover, if our 30-year bond had a 17 percent coupon and yielded the same 8 percent, its duration would be 10.1 years, less than the duration of the 20-year bond shown in the table. The moral of the story is to keep your eye on duration, not maturity. First, you have a handy little formula that describes how price risk varies with duration. Second, to focus attention on maturity can sometimes be quite misleading.

KEY TERMS duration par

88

The Structure and Performance of Securities Markets Reese Witherspoon needs a script, Tiger Woods a golf club, and Keith Richards a guitar. Each performer uses the props appropriate for the medium in question. Performances can be stimulating, comical, pleasurable, disappointing. That’s how it is in the world of entertainment. Well, it’s not so different in securities markets. Brokers, dealers, specialists, and traders are the actors. Telephones and computer terminals are the props. Stocks, bonds, and mortgages are the media. Performances are described as resilient, deep, broad, thin, liquid. Our task is to describe who goes with what and why. You can then decide whether to applaud or hiss after your next financial transaction.

LEARNING OBJECTIVES In this chapter you will learn to differentiate between the types of financial markets including auction, brokered, and dealer markets describe the differences and functions of the primary and secondary markets understand the function and determination of bid/ask spreads explain the efficient markets hypothesis and its relevance to the allocational efficiency of financial markets

Nature and Function of Securities Markets We have examined the forces that influence the equilibrium prices of different types of securities. For the most part, we ignored the structure of these markets, taking for granted that somehow the interested buyers and sellers of the

From Chapter 6 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

89

The Structure and Performance of Securities Markets

securities would find their way to the marketplace. And that is precisely the main assumption underlying the equilibrium price that emerges from the intersection of supply and demand curves: The price balances the supplies of and demands for the security by market participants. In practice, bringing buyers and sellers together is not quite so simple. Trading interests are not uncovered costlessly, because buyers and sellers may be in different locations and therefore not aware of each other. Similarly, time may elapse between a buyer’s arrival at the marketplace and the appearance of a compatible seller. Such geographical and temporal fragmentation makes the prices at which transactions actually take place differ from the equilibrium price. Real-world trading at prices that straddle the true equilibrium is the best we can hope for. In fact, we might think of the ideal situation as actual transactions prices doing a little dance around the theoretical equilibrium price.

Types of Markets Securities markets are organized to help bring buyers and sellers together, so that both parties to the transaction will be satisfied that a fair transactions price, close to the true equilibrium price, has been arranged. There are three main types of market organization that facilitate the actual purchase and sale of securities: an auction market, a brokered market, and a dealer market. In each case, the aim is to match up buyers and sellers. Auction Market The main feature of an auction market is that buyers and sellers confront each other directly to bargain over price. There is nothing that stands between buyers and sellers, just an auctioneer who records bids and offers tendered by potential buyers and sellers. The particular rules of the auction determine exactly how buyers and sellers are matched up. For example, there can be a single trade between all buyers and sellers at a single price or a series of trades at different prices. Under all circ*mstances, the key characteristic of the auction is that orders are centralized, so that the highest bidders and lowest offerers are exposed to each other. A popular example of an auction market is the on-line auction services of eBay. In the financial world, the most well-known auction market is the New York Stock Exchange, where auctions for individual securities take place at specific locations, called posts, on the floor of the exchange. The auctioneer in this case is the specialist who is designated by the exchange to represent (as an agent) orders tendered by public customers. A second example of an auction market is the twice-daily London gold fixing. Representatives of five London bullion dealers gather together to expose public orders to competitive bidding. One of the dealers is designated by the group as the auctioneer. Brokered Market When there are insufficient participants in an auction market, so that potential traders do not always find “reasonable” bids and offers, it may pay traders to employ the services of a broker to search for the other side of a trade. Thus a seller of securities may ask a broker to show the

90

The Structure and Performance of Securities Markets

securities to potential buyers or a buyer may ask a broker to uncover potential sellers. Unlike the auctioneer, whose role is completely passive, the broker provides information about potential buyers and sellers and earns a commission in return. Many of us are familiar with real estate brokers who provide information for potential buyers and sellers of homes. Municipal bonds are the best example of securities that trade primarily in a brokered market. Dealer Market During the time it takes a broker to uncover a compatible trading partner, the equilibrium price of the security may change. It can be profitable, therefore, for a person to remain in the marketplace to provide the service of continuously bidding for securities that investors want to sell and offering securities that investors want to buy. This person acts as a dealer (also called market-maker), buying securities for his or her own account when the public is selling and selling from her or his own account when the public is buying. Unlike brokers, dealers commit capital to the process of bringing buyers and sellers together and take on the risk of price changes in the securities they hold in inventory. Dealers expect to earn a profit, because they always quote a bid price (at which they buy) that is below their offer price (at which they sell). Many securities trade in dealer markets, including government bonds, corporate bonds, and equities traded in the so-called over-the-counter (OTC) market. There are usually many dealers in each security. They are linked together either by telephone or by computer hookup. In fact, many over-thecounter stocks trade in a partially automated electronic stock market called NASDAQ (National Association of Securities Dealers Automated Quotation system). On the New York Stock Exchange, the specialists who are the designated auctioneers also quote bids and offers in their capacity as dealers. Thus trading on the New York Stock Exchange is a cross between a dealer market and an auction market. The organizational structure of a market, the existence of brokers, dealers, exchanges, as well as the technological paraphernalia, such as quotation screens, computer terminals, and telecommunications, are all mobilized to keep transactions prices as close to true (but unknown) equilibrium prices as is economically feasible. Easy access to a trading forum, with many potential buyers and sellers, means that a security can be bought or sold quickly with little deviation from its equilibrium value. That is what is meant by marketability, a catch-all term indicating small deviations of actual transactions prices about the true equilibrium. Good marketability implies that a security can be sold, liquidated, and turned into cash very quickly without triggering a collapse in price. Because a highly marketable security is more desirable to investors, its equilibrium price will be higher, and its return lower, relative to less marketable securities. The rest of our discussion is devoted to examining the efficiency of securities markets. First we look at how effective markets are in bringing buyers and sellers together, the so-called operating efficiency of securities markets. We then turn to pricing efficiency and related regulatory concerns.

91

The Structure and Performance of Securities Markets

Primary Versus Secondary Markets Before detailing the nature of trading in securities markets, it is important to emphasize the distinction between primary markets and secondary markets. Most of the popular markets, such as the New York Stock Exchange and the Tokyo Stock Exchange, are secondary markets where existing securities are exchanged between individuals and institutions. The primary markets— markets for newly issued securities—are much less well-known.1 In the United States, for example, new issues of stocks or bonds to raise funds for General Motors, General Electric, or General Mills are not sold to saver-lenders on the floor of the New York Stock Exchange, the American Stock Exchange, or even the Midwest Stock Exchange in Chicago. Rather, the matchmaking takes place behind closed doors, aided by Wall Street’s investment banks. Morgan Stanley, Goldman Sachs, and Merrill Lynch are examples of investment banks. They often act as brokers and dealers in secondary markets as well. But in their role as investment banks, they help distribute newly issued stocks and bonds to ultimate investors, insurance companies, pension funds, mutual funds, and individuals throughout the country. These distributions are called underwritings: The investment bank guarantees an issuer of securities a price on the new issue. Often a number of investment banks band together in a syndicate to market a new issue; by sticking together, they share the risk of adverse movements in stock prices or interest rates between the time an issue is bought from the corporation and the time it goes out of the investment banks’ inventory, safely tucked away in the portfolio of an individual investor or a financial intermediary. The idea is to get rid of the issue as quickly as possible, within a day or two. That minimizes the risk exposure of the investment banking firm’s capital. Sometimes two syndicates are formed—one to sell the issue domestically and one to sell the issue internationally. Announcements of successful underwritings, called tombstones, appear frequently in the financial press. A number of features of this new-issue market are noteworthy. First, as with many, or most, markets, it is not located in any particular spot. Underwritings of new issues do not take place on the floor of an organized exchange. Rather, the marketplace is a series of conference rooms of investment banking firms, linked by telephone with each other, with corporations, and with ultimate investors. Second, the most important commodity sold by these investment banking firms is information about the price required to sell an issue and who the likely buyers are. That’s one of the most important functions of markets: dissemination of price and trading information. To market the new issue,

1As

we will see in our discussion of financial intermediaries, there are many kinds of newly issued (primary) financial assets, such as commercial loans made by banks to small and medium-size businesses, that rarely, if ever, trade in secondary markets. These nontraded assets are purchased by financial intermediaries and held until maturity. In addition to commercial loans, this group includes privately placed debt of midsize companies that is purchased by life insurance companies and commercial mortgages, also purchased by life insurance companies.

92

The Structure and Performance of Securities Markets

investment bankers in effect sell the services of their capital by purchasing the issue outright from the corporation and thereby ensuring that the corporation receives the agreed-upon price. Subsequent adverse or favorable price movements do not affect the issuing firm, just the vacation prospects of the investment bankers. As compensation for their time and trouble, investment bankers earn a fee, called an underwriting spread, on each newly issued security.

Newspaper advertisem*nt (A “tombstone”). An under writing syndicate floats a new issue.

Source: Wall Street Journal , November 26, 2002.

93

The Structure and Performance of Securities Markets

The near-invisibility of primary markets, compared with the immense popular recognition of secondary markets for equities, does not change the fact that both serve essential functions. Moreover, there is a close interrelationship between prices and yields on securities in secondary markets and those in primary markets. One important clue to the required new-issue yield on a corporation’s bonds, for example, is the recent yield on the firm’s obligations in the secondary market. How useful these yields are depends, in part, upon the “quality” of secondary market prices. Are they close to equilibrium prices, or do they reflect one or two transactions that might not be representative? Only by recognizing the nature of the secondary market can the prices and yields recorded there be evaluated.

Efficiency of Secondary Market Trading As we indicated at the beginning of the chapter, secondary markets work well if they bring together buyers and sellers of securities so that they transact at prices close to the true equilibrium price. Markets that accomplish this objective have low transactions costs and are considered liquid. One measure of the liquidity costs of a market is the spread between the bid price and the offer (or asked) price quoted by a dealer who “makes a market” in the particular security. In order to understand how the dealer’s bid-asked spread measures liquidity costs, let’s begin with a market that operates as an auction and then introduce dealers as participants. The equilibrium price that we identify with the intersection of supply and demand curves emerges from the following type of auction. At a prearranged point in time, buyers and sellers interested in a particular security gather before an auctioneer. The auctioneer announces a price for the security (perhaps the price from the previous auction) and asks buyers and sellers to submit quantities they want to buy or sell at that price. If the quantity supplied exceeds what is demanded, the auctioneer announces a lower trial price and asks market participants to resubmit orders to buy or sell. If at the new lower price there are more buyers than sellers, the auctioneer tries a slightly higher price and asks for still a new set of orders. This iterative “recontracting” process continues until a price emerges at which buying and selling interest are equal. At that point, the auctioneer instructs buyers to tender cash and sellers to tender the securities, and the exchange takes place at what has been established as the equilibrium price. This auction is known as a Walrasian auction, after Leon Walras, a nineteenth-century French economist who conceptualized the auction underlying the determination of equilibrium prices in this way. There is, in fact, one very real marketplace that operates as a Walrasian auction; namely, the twice-daily London gold fixing, where the price of gold bullion is determined. Most markets operate quite differently from the Walrasian auction. Transactions usually occur continuously throughout the day rather than at a single

94

The Structure and Performance of Securities Markets

Price Supply

$99 asked $98 equilibrium $97 bid

Demand

Quantity

FIGURE 1

Bid-asked spreads cause actual transactions prices to hover about the true equilibrium price.

point in time. In most cases, buyers and sellers of securities do not want to wait until a scheduled auction takes place. They prefer to transact immediately in order to eliminate the uncertainty over where the new equilibrium price might be. To provide this service of immediate execution, dealers (marketmakers) enter the marketplace to quote a bid price at which they will buy from potential sellers and an offer price at which they will sell to potential buyers. Figure 1 shows the bid price ($97) at which a dealer will buy from the sellers (on the supply curve) and the asked or offer price ($99) at which the dealer will sell to the buyer (on the demand curve). Unlike the buyers and sellers on the demand and supply curves, the dealer is not interested in the security itself. Rather the dealer’s sole objective is to sell whatever inventory has been purchased before the equilibrium price has a chance to change. The dealer’s reward is the spread between the bid and offer; in the case of Figure 1, the $2 difference between the $99 asked price and the $97 bid. Note that if trading in this security were conducted in a Walrasian auction, all transactions would have occurred at the equilibrium price of $98 (that’s the price where the quantity people want to sell just matches what others want to buy). But since buyers and sellers were concerned that the equilibrium price might change before the auction took place, they chose to transact at the dealer’s bid and offer prices. The cost of transacting immediately, therefore, is measured by the spread between the dealer’s bid and offer. Wider bidasked spreads mean that the cost of transacting is high and that transactions prices differ considerably from equilibrium prices. A market is liquid, therefore, if bid-asked spreads are narrow. A security is considered liquid or marketable

95

The Structure and Performance of Securities Markets

TABLE 1

Sample Bid and Asked Quotations on Securities Particular issue

Name of market

Coupon

Maturity

7.25

Aug 2022

Bid

Ask

Spread

1. Governments and Agencies Treasury Bond Federal National Mortgage Association

6.25

129 26/32 21

129 27/32 24

1

/32

3

May 2029

112 /32

112 /32

/32

Aaon Inc.

—

15.10

15.19

.09

Microsoft Inc.

—

24.75

24.76

.01

2. NASDAQ Stocks

Source: Wall Street Journal, www.nasdaq.com.

if the bid-asked spread is narrow. Let’s see what kinds of securities trade in liquid markets versus illiquid markets.2 The dealer will quote a narrow bid-asked spread if: (1) the expected volume of transactions is large; and (2) the anticipated risk of large equilibrium price changes is low. Large volume means it is easy to turn over inventory, since there are frequent orders to buy and sell. Low volatility of price changes means that the risk exposure of the dealer’s inventory is small. Both mean that the dealer can be forced to quote narrow bid-asked spreads and still stay in business, committing capital and skill to market-making. Since dealers are no more benevolent than the rest of us, the element forcing dealers to quote narrow spreads is competitive pressure. Table 1 shows a number of sample bid-asked quotations. First we need to give some basic explanations of the numbers. All bonds are quoted as a percent of par. Thus the Treasury 7.25-percent coupon bonds due August 2022 could be sold at 12926兾32 (the bid price) per $100 face value and could be bought at 12927兾32 (the asked price) per $100 face value. Since minimum denominations of most bonds are $1,000, that means it costs $1,298.44 to buy such a bond, while a seller would receive $1,298.13. The spread (asked minus bid) recorded in the last is 1兾32 or 3.13 cents per $100 of face value (31.3 cents on a $1,000 transaction). In other words, if I buy a $1,000 Treasury bond and decide to sell it immediately because I get a hot stock tip, my schizophrenia will cost me $0.31. A $2,000 round trip, as they call it, costs $0.63, a $3,000

2One

puzzling question is how a dealer knows where the equilibrium price is. An important source of information about the equilibrium price comes from the dealer’s inventory of securities. For example, if a dealer quotes a very high bid and offer relative to where the equilibrium price is, the dealer will buy a lot more at the bid than he or she sells at the offer, producing an increase in the inventory of securities held. This provides a signal to the dealer to lower the bid and offer. If the bid and offer are too low, the dealer’s inventory falls, and that signals the dealer to raise the bid and offer. So the answer is that by trial and error, the dealer’s bid and offer prices hover around the equilibrium price.

96

The Structure and Performance of Securities Markets

trade, $0.94, and so on. This is a measure of the liquidity costs of the security: the transactions costs of buying and selling. The bond of the Federal National Mortgage Association in the second line of Table 1 trades on a 3兾32-point spread or $0.94 per $1,000. Since this is three times the spread of the Treasury bond, this suggests that these securities have somewhat less liquidity than Treasury obligations. The explanation for the variation in the spreads lies primarily in the volume of trading in the particular issues. Since Treasuries trade more than just about any other kind of security, it is not surprising that they have smaller bid-asked spreads. The last section of Table 1 records the bids and offers for two over-thecounter equities. Aaon Inc. trades on a 9 cent spread, while Microsoft has a 1 cent spread. Like point spreads in football, these quotations must be scrutinized before you jump to costly conclusions. It’s important to recall that quotations for bonds are per $100 of face value, while quotations in the equity market are per share. Thus to buy 200 shares of Aaon costs $3,038 (15.19 times 200), with an immediate sale netting $3,020. Thus it costs $18 for a $3,038 round trip in Aaon, while a $3,000 round trip in Treasuries costs only $0.93. The lesson is clear: Bidasked spreads must be related to the price of the security and the implied cost of trading or liquidating a specific dollar amount. In general, there are higher transaction costs for equities compared with bonds. In part, this disparity reflects the greater risk of price fluctuation a dealer is exposed to with equities.3 But there’s more to the story than bid-asked spreads. It is true that an actively traded NASDAQ stock, such as Microsoft, trades on a 1-cent spread per share. That’s $4.04 per $10,000 round trip, just a bit more than the $3.125 it would cost to trade $10,000 in Treasury bonds. For trades of that size, equities can be just about as liquid as Treasury securities, if not more so. The real difference between liquidity in Treasuries and liquidity in any equity lies in the size of transaction that can be handled without causing either a widening of the bid-asked spread or a shift up (in the case of a buy) or down (for a sale) in the implicit equilibrium price. Quotes in equities must be good for at least a round lot—100 shares. Quotes in the Treasury market must also be good for a round lot, usually $1 million in face value. A $10 million order in Treasuries can also be filled without much trouble. But for equities, there’s simply no way to liquidate a $5 million block of stock, or even a $1 million position, without causing dealers to back away after the purchase of 100 or 200 shares. Thus the bid-asked spread measures the liquidity cost of normal-size transactions, and what’s normal in the Treasury market would be abnormal in any common stock. In fact, blocks of stock are not brought to the auction market on the floor of the New York Stock Exchange unless a trade has been arranged beforehand by dealers. While the public auction of organized exchanges looks good and has distinct advantages, it simply cannot handle the large trades of institutional investors.

3In

addition to these bid-asked spreads, your broker charges a fee, called a commission, for executing your trades. This expense depends more on whether you deal with a discount broker or a full-service broker than whether you are buying a stock or bond.

97

The Structure and Performance of Securities Markets

This discussion suggests a somewhat more sophisticated measure of market performance, one that focuses on the ability of a market to absorb large trading volume without causing wild gyrations in transactions prices. The qualitative description of such markets is relatively easy: They have depth, breadth, and resiliency. A market is deep if it is easy to uncover buy and sell orders above and below current transactions prices; if these orders exist in large volume, then the market has breadth; if new orders quickly pour in when prices move up or down, the market is called resilient. All of these characteristics imply low transactions price volatility. For example, even if a dealer’s bid and asked quotes are good for 100 shares only, if a large purchase order causes institutions that continuously monitor dealer quotes to call in sell orders, then prices won’t gyrate much. Markets that are

In The News Senator Pushing for Accurate Prices The dairy market has its ups and downs, but Sen. Russ Feingold is concerned that some prices also are open to tampering. That could mean unfair prices for farmers or consumers. The spot cheddar cheese market on the Chicago Mercantile Exchange serves as the benchmark for cheese prices and, therefore, influences milk prices. Manipulation by buyers and sellers is possible because it’s a “thin market,” said Brian Gould, an associate professor of agriculture and applied economics at the UWMadison. A thin market involves few brokers trading a quantity not large enough to provide an accurate price for the rest of the industry. The spot cheddar market has about 20 traders at any given time, Chicago Mercantile Exchange spokesperson Mary Hoffenberg said, and the cheese they trade makes up less than 1 percent of cheese produced in the United States, according to a report by the Government Accountability Office. Hypothetically, a company or group could buy or sell enough cheese to tilt prices in its favor, Gould said. Feingold, a Democrat, wants to see more oversight of the market. Feingold’s staff is working with Agriculture Committee chair Sen. Tom Harkin, D-Iowa, to explore solutions and to make sure the Farm Bill calls on the USDA to improve communication with agencies such as the Commodity Futures Trading Commission,

98

which monitors the market. “Wisconsin’s hardworking farmers deserve to know that the price they receive for their milk is fair,” Feingold said in a statement. It’s difficult to assess the likelihood of price manipulation, Gould said. Hoffenberg said the Chicago Mercantile Exchange watches for peculiar trading, and the trading commission has not filed a complaint of price manipulation, according to the Government Accountability Office report. The report states that the mercantile exchange provides better oversight than its predecessor, the National Cheese Exchange in Green Bay. But the possibility of tampering remains, and the report calls for regular scrutiny of all numbers that go into pricing. Feingold’s efforts are focused on oversight, at least for now. But making the market more accurate for pricing would involve either attracting more buyers and sellers or introducing more types of cheese into the market, Gould said. Opening the market to more cheese, however, would further complicate an already complex system, he said. “I don’t think it will happen,” he said, “because there’s a push to be less complicated.” Source: GAINESVILLE GAZETTE ONLINE by Brian Reisinger/Gazette. Copyright 2007 by McClatchy-Tribune Regional News. Reproduced with permission of McClatchyTribune Regional News in the format Textbook via Copyright Clearance Center.

The Structure and Performance of Securities Markets

not deep, broad, and resilient are called thin markets; only a small volume of trading can be absorbed without producing wide price swings. Having said all that, there’s not much else to do. There just aren’t any good measures of this aspect of liquidity. Simply looking at price volatility is not enough; equilibrium price changes are part of everyday price movements and do not reflect poorly on a market’s liquidity. One important observation can be made, however, concerning the impact of communications technology on the ability of any market to absorb large orders without becoming “disorderly.” Traders who can continuously monitor quotation screens can participate more quickly in buying and selling if prices deviate from their view of equilibrium. When prices fall, they buy; when prices rise, they sell. This very process contributes to price stability and liquidity. Moreover, the reduction in price volatility also leads to narrow bid-asked spreads, since dealer inventories are subject to less risk. We have extended our discussion of secondary market trading, efficiency, marketability, and liquidity to the point of no return. Price changes should be small when trading is motivated by liquidity needs; that’s the characteristic of highly marketable securities. But new information affecting the underlying value of the security should be reflected quickly in equilibrium price changes. Indeed, if prices of financial assets did not reflect news about bankruptcies, earnings trends, lawsuits, and whatever else affects the payments

Going Out on a Limb The Computer Will Prevail The New York Stock Exchange celebrated its 200th anniversary in 1992, but not much has changed since the exchange abandoned the buttonwood tree for its home at Eleven Wall Street. Buyers and sellers still bargain face-to-face on the stock exchange floor, with orders recorded on pads of paper in barely legible script. A similar situation prevails in the nation’s commodities exchanges, where open outcry among buyers and sellers determines the price of everything from pork bellies to Treasury bond futures. Not all modern trading markets mimic the procedures of the eighteenth century. London stocks now trade via computers and telecommunications, as do futures markets in Japan and Germany. There is little doubt that electronics will eventually prevail, even where the New York Stock Exchange is concerned.

The real question is why haven’t computers already replaced all trading floors, the way word processors have replaced electric typewriters in the offices of the 1990s? The answer is liquidity. The New York Stock Exchange and the U.S. commodities exchanges are extremely liquid, with narrow bid-asked spreads that attract orders from public investors. Competing computer-based exchanges have difficulty breaking into the vicious cycle: Liquidity attracts trading volume that generates more liquidity. At some point, however, technology will prevail with a quantum improvement in the technique for matching buyers and sellers. At that point the exchange floor will go on the chopping block, the same one the buttonwood tree ended on.

99

The Structure and Performance of Securities Markets

promised by the issuer of the financial instrument, then the market would be inefficient. Some call this aspect of a market allocational efficiency. Up to now, we have analyzed the operating efficiency of financial markets. Actually, the popular discussion of “efficient capital markets” focuses on allocational efficiency, without calling it by that name. In the next section, we provide an overview of efficient capital markets within the framework of regulation of securities markets.

Efficient Capital Markets and Regulation A vast literature has developed during the past twenty years based on a relatively straightforward proposition: The current price of a security fully reflects all publicly available information. Put somewhat differently: There is no unexploited publicly available information that would lead to superior investment performance. If securities prices fully reflect all available information, the capital market is called efficient. It’s hard to argue with the statement that markets will be efficient. If securities prices didn’t reflect all publicly available information, market pressures would quickly force them to do so. Suppose that dealers ignored a news flash that an OTC-traded company had discovered how to make oil out of used textbooks. Everyone else would find the price of the security relatively cheap in view of the fantastic profits the company will reap. Buy orders would pour into brokerage offices and sell orders would disappear. Dealers would meet their commitment to sell 100 shares at the old asked price and then would more than double the quoted asking price to avoid selling what they didn’t have at ridiculously low prices. As soon as the dealer quoted a price sufficiently high to reflect the rosy profit outlook, buy orders would drop to normal (the security would no longer be such a bargain), sell orders would reappear (let’s take some profits), and the new equilibrium price would fully reflect all publicly available information. There’s nothing wrong with that story. It happens all the time, and that’s precisely what we mean when we say that capital markets are efficient. The problem arises in the implications for buying and selling securities. The implication is quite simple: don’t trade. If prices quickly incorporate all information affecting the fortunes of a company, then you can’t earn above-average returns by selling so-called overvalued securities or buying undervalued ones. There aren’t any bargains. Moreover, the fancy charts sold by investment advisers, suggesting that you buy when the price of a stock rises by 5 or 10 percent, aren’t worth the paper they are printed on. Needless to say, securities analysts have little use for such academic ranting and raving. How quickly do you think markets absorb new information? Within a day is the best estimate of academic researchers. If that’s the case, there is little to gain from buying or selling after reading the investment bulletins of your favorite brokerage house. By the time you’ve finished reading, there’s nothing to do but watch which way the price of your security went.

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Our discussion of market efficiency made specific reference to publicly available information. It’s quite possible, indeed, quite probable, that nonpublicly available information can be used to make extra profits or avoid undesirable losses. The Securities and Exchange Act of 1934 provided for the establishment of the Securities and Exchange Commission (SEC) to prevent fraud and promote equitable and fair operations in securities markets. The focal point of SEC regulations is the disclosure of information that might be relevant for the pricing of securities. The SEC insists that investors should not be at a disadvantage when purchasing or selling securities. Not only must there be full disclosure of all pertinent information, but misinformation and dissemination of false or misleading reports are specifically prohibited. The SEC’s job is not an easy one. The SEC has enlisted the aid of the various organized exchanges and the National Association of Securities Dealers (NASD) in supervising brokers and dealers, and in monitoring transactions in secondary markets. The exchanges and the NASD take these disciplinary and supervising responsibilities seriously. And with good reason. The specter of more detailed SEC involvement in day-to-day operations is more than enough to encourage vigorous self-regulation. It would be a mistake, however, to assume that manipulation, fraud, misinformation, and deception have disappeared from financial transactions simply because the SEC plays watchdog. Markets are efficient because investors and traders scrutinize and search and screen all information for themselves. Caveat emptor et venditor are still the watchwords that ensure market efficiency.

SUMMARY 1. The equilibrium price that emerges from the familiar supply-demand picture assumes that all buyers and sellers have been brought together in the marketplace. Actual transactions prices in real-world markets may differ from the theoretical equilibrium price, because it is costly to bring together all potential traders.

2. Markets that trade existing securities are organized as either auction, broker, or dealer markets. In all cases, resources are devoted to uncovering compatible trading interests. The New York Stock Exchange is the best example of an auction market, while government and corporate bonds are traded primarily in dealer markets. Brokers are frequently used in the municipal bond market.

3. It is important to distinguish these secondary markets for securities from the primary market, where newly issued securities are initially placed with investors. Virtually all corporations use investment bankers to help market new issues of stocks and bonds.

4. The operating efficiency of secondary markets is measured by how closely actual transactions prices conform to theoretical equilibrium prices. A narrow bid-asked spread in a dealer market produces transactions prices that are close to the true equilibrium price. Other dimensions to operating efficiency include the size of order that can be accommodated at a given quotation. In terms of these criteria, the market for Treasury securities is the most liquid secondary market.

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5. Because investors place a positive value on liquidity, securities that are more liquid sell for higher prices than less liquid securities, all other things being equal, of course.

6. Securities markets are highly efficient processors of new information. Most evidence suggests that current prices fully reflect all publicly available information. Regulatory supervision by the Securities and Exchange Commission is aimed at preventing fraud and promoting fair and equitable trading.

KEY TERMS allocational efficiency

marketability

secondary market

asked price

market-maker

auction market

NASDAQ

Securities and Exchange Commission (SEC)

bid-asked spread

National Association of Securities Dealers (NASD)

specialist

offer price

underwriting

operating efficiency

underwriting spread

dealer market

over-the-counter (OTC) market

Walrasian auction

investment bank

post

liquid

primary market

bid price brokered market commission dealer

thin market tombstone

QUESTIONS Questions with a red oval are in

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at www.myeconlab.com.

6.1

Describe the characteristics that distinguish auction, broker, and dealer markets. What is the main common objective of these different forms of market organization?

6.2

What determines whether a dealer will quote a narrow or a wide bid-asked spread?

6.3

Ignoring for a moment the size of the bid-asked spread, explain why Treasury bonds are more liquid than equities.

6.4

How do investment bankers help companies issue new securities?

6.5

Investment bankers are compensated for underwriting a new issue in the form of an underwriting spread. What do you imagine determines how big this fee is?

The Pricing of Risky Financial Assets

Risk is a double-edged sword: It complicates decision making but makes things interesting. That’s true of life in general and financial markets in particular. In the last three chapters, we have described how the price of a financial asset, like the price of just about everything else, depends upon supply and demand. We have also seen that shifts in supply and demand produce price changes and that this price variability means that financial assets are risky. Our main objective in this chapter is to explain how investors are compensated for holding risky securities and how investor portfolio decisions influence the outcome.

LEARNING OBJECTIVES In this chapter you will learn to understand what risk aversion means and the resulting necessity of compensating risk averse investors with higher expected returns to hold risky assets calculate the basic measures of risk see how diversification can reduce or eliminate all nonsystematic risk in a portfolio of investments

Economic Uncertainty At the most general level, a financial asset is a contractual agreement that entitles the investor to a series of future cash payments from the issuer. The value of the asset depends upon the nature of the future cash payments and

From Chapter 7 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

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on the credibility of the issuer in making those payments. Bonds versus equities illustrate different future payment profiles, with bonds promising fixed dollar payments at prespecified dates, while equities offer variable payments depending upon the fortunes of a particular company. Similarly, government bonds versus corporate bonds illustrate that similar cash flows can differ, because issuers have different degrees of credibility in meeting their scheduled obligations. Nevertheless, because all securities involve future cash flows, they share certain common valuation principles. Every risky security must compensate investors for two things: (1) delayed payment of future cash flows and (2) uncertainty over those future cash flows. The form of the compensation is expected return, that is, what the investor expects to earn when holding those securities. To anticipate our results, we will show that an investor’s expected return on a security consists of a riskless rate of return to compensate for saving rather than spending plus a return for bearing risk. We distinguish riskless and risky securities in the following way. Recall the definition of annual return on a bond: Return =

Selling Price - Purchase Price + Coupon Purchase Price

For a one-year security with a guaranteed cash flow, such as a government bond, the nominal annual return is riskless because the return is known with certainty. For example, if the current price is $1,000 for a government bond that repays $1,000 in principal plus $50 in interest at the end of one year, substitute the $1,000 principal payment for the selling price, add the $50 coupon, and our formula generates a return of 5 percent. This return is riskless because the repayment of principal and the coupon payment are guaranteed. On the other hand, suppose that a company would like to issue stock costing $1,000 that has a selling price of either $1,080 or $1,020 at the end of the year, depending upon how much money the company makes. The return on this security is uncertain: It is either 8 percent or 2 percent.1 The key question is whether investors will pay $1,000 for this uncertain return of 8 percent or 2 percent, given that 5 percent is available with certainty. The answer depends, in part, on the probabilities that the risky security will earn 8 percent versus 2 percent as well as on whether investors like or dislike the uncertainty. If investors end up paying less than $1,000 they will expect to earn more than 8 percent and 2 percent. If they pay more than $1,000 they will expect to earn less. Our ultimate objective is to determine, therefore, the equilibrium price, hence the equilibrium expected return, on this risky security. We proceed from here in two steps. The first step is to specify the factors influencing the return on a riskless investment. This is equivalent to seeing what determines the yield or interest rate on a one-period riskless loan. 1In

the formula for return, substitute $1,080 for the selling price, $1,000 for the purchase price, and set the coupon equal to zero and that produces a return of 8 percent. Substituting $1,020 for the selling price rather than $1,080 produces a return of 2 percent.

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The second step is to see how risk enters the picture. This formal analysis of decision making in a risky environment will generate some powerful insights into how investors are compensated for risk.

A World of Certainty Without risk there are no disappointments. All plans proceed as conceived; all expectations are fulfilled; no promises are broken. Life is perfectly predictable, and so is the financial sector. One person’s promise to repay a loan is as good as anyone else’s. No one is a welcher—not even your in-laws. Under such ideal conditions the same interest rate is applicable to each and every loan. Anyone trying to charge more will not succeed in making a loan; anyone charging less will be deluged with requests for funds. All securities are perfect substitutes for each other; hence they must offer the same return. Thus the interest rate is the same for all—it is the yield earned by lenders on a riskless loan, one that will be repaid in full by all borrowers, without a shadow of a doubt. Since this is a rather peculiar world, to say the least, it’s worth asking whether there will be any borrowing or lending at all under such mythical conditions. The answer is yes, as long as people and businesses differ regarding the desired time patterns of their consumption. Those preferring instant gratification (IG) may want to consume more today than their current income, while prudent providers (PP) may want to consume less than their current income. The PPs lend to the IGs at the rate of interest. That rate is determined, in fact, by the balancing of the total demand for funds by the IGs with the total supply of funds from the PPs. The rate of interest doesn’t have anything to do with risk, because there isn’t any. Rather, the interest rate influences people’s consumption decisions. If more people want to borrow—either to buy a new hat (consumption) or to build a new factory (real investment)—than want to lend, the rate of interest will be pushed up by the unsatisfied (and still-eager) borrowers. The rise in the rate of interest causes some to rethink their borrowing and spending plans, while others may decide to save and lend more; with a higher interest rate it pays to be a prudent provider. Thus the key decisions influenced by the riskless rate of interest are consumption versus saving.

Consequences of Uncertainty and Risk Aversion At the very least, the world as we know it is rife with unanticipated disappointment. Borrowers, however well intentioned, may be unable to fulfill their promises to repay borrowed funds. Factories built to produce polyester fabrics may become obsolete because of renewed enchantment with natural fibers. Thus the manufacturer who raised capital with every intention of paying dividends out of expected polyester sales may not make the expected payments. In general, investors will be disappointed whenever their returns turn out lower than expected. Of course, they will be happy if their returns wind up

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higher than expected, but the uncertainty itself makes investors unhappy. This characteristic is referred to as risk aversion. It doesn’t mean investors will never take on risk; it means that they must be compensated for the risk. We will see later that there is good evidence suggesting that investors are, in fact, risk averse. The principle of risk aversion is so important that it is worth examining in some detail. It will lead us directly to the strategy employed by most investors to reduce risk, namely, portfolio diversification. After seeing how diversification helps investors reduce risk exposure, we can return to our basic question of how investors are compensated for the risk that they cannot diversify away. To illustrate risk aversion, let’s return to our earlier example and show that investors who are risk averse prefer a security that is certain to return 5 percent compared with one having an equal chance of returning either 8 percent or 2 percent. The second security has an average return of 5 percent: About half the time its return is 8 percent, and about half the time its return is 2 percent. Its expected return is 5 percent, where the formal definition of expectation is the sum of the possible outcomes multiplied by their respective probabilities: 8 percent * 1兾2 plus 2 percent * 1兾2 = 5 percent. Note that the expected return is nothing more than the average return.2 Why does a risk averter prefer the certain return of 5 percent to an equal chance of 8 percent or 2 percent, even though the expected values of the two securities are identical? Simply put, with the risky security, the extra pleasure when the return is 8 percent is less than the additional pain when the return is 2 percent. Sound familiar? It should, because it’s nothing more than the principle of diminishing marginal utility of income that we all remember from basic economics: Each additional dollar is worth less (although you always want more!). Would the risk averter ever be indifferent between a security paying a fixed return with certainty, such as a 5 percent savings deposit in a commercial bank, and a security whose return is uncertain? Yes, but only if the risky security had a higher expected return to compensate for the undesirable uncertainty. For example, if the risky security’s equally probable outcomes were either 10 percent or 2 percent, so that the expected return would be 6 percent (10 percent * 1兾2 plus 2 percent * 1兾2 = 6 percent), then our riskaverting investor might be indifferent. If the possible outcomes are 12 percent and 2 percent, so that the expected return is 7 percent, the investor might even prefer the risky venture, since the compensation in terms of higher expected return might be enough to induce risk-taking. The required trade-off of higher return per unit of risk—the degree of risk aversion—is a subjective measure, quite different for every individual. represent this with the formula E[X] = P1X1 + P2X2 where E[X] is the expected return of X and the P’s are the individual probabilities. For a security that has a 50 percent chance of returning 8 percent and a 50 percent chance of returning 2 percent, this formula would read E[X] = .5 * 8 percent + .5 * 2 percent = 5 percent. The mathematical expectation of this security’s return is 5 percent.

2Mathematicians

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Does all this mean that someone who is not a risk averter must have deepseated emotional problems? Not at all—he or she is simply a risk lover (also known as a compulsive-degenerate gambler). We conclude that most people in the real world are risk averters, not because they tell us so in any direct way, but because most people hold diversified portfolios—many diferent securities rather than just one with the highest possible return. Diversification, the simple idea of not putting all your eggs in one basket, is what helps risk-averting investors cope with risky investments.

An Aside on Measuring Risk Before proceeding to the principles of diversification, it is useful to note that we have just used what is formally called a probability distribution to represent the outcomes of our risky security. Each of the possible “events” (8 percent and 2 percent) has a probability of occurring (1>2 in our case), and the sum of the probabilities is unity (at least one of the possible outcomes must occur). Moreover, we have used a statistic called the arithmetic mean (the common average) to summarize the most likely outcome—the expected value. In this vein, we can try to specify more carefully the meaning of risk. Uncertain outcomes make for risky investments. While the expected value of our equally probable 8 percent and 2 percent investment is 5 percent, sometimes the return will be 3 percent more than the mean (8 minus 5 is 3) and sometimes the return will be 3 percent less (2 minus 5 is –3). The deviation of actual returns from expected returns is a useful measure of risk. But the deviations of actual outcomes from the mean can be either positive or negative, and if one were to add them up, the pluses and minuses would cancel! We could apply either of two arithmetic operations to sum up the deviations and avoid the canceling problem: (1) take absolute values; (2) square the deviations (recalling that a negative number squared is a positive number). The second is used in calculating what is called the standard deviation, which we now describe in somewhat greater detail. We begin our calculation of the standard deviation by taking the deviation of each outcome from the mean and squaring it. Each of these squared deviations is weighted by the probability of occurring; that is, each is multiplied by its respective probability. This makes the standard deviation a still more intuitive measure of risk. We then add up all of the weighted squared deviations and restore the numbers to their original scale by taking the square root of the entire mess. In our example, we have the following: (8 - 5)2 * 1>2 + (2 - 5)2 * 1 >2 = 9 * 1>2 + 9 * 1>2 = 9, the square root of which is 3. In particular, for this investment the standard deviation of the probability distribution of returns is 3 percent. With a more complicated probability distribution, the numerical results are not quite so simple but follow this basic form. A potential drawback of the standard deviation is the use of both positive and negative deviations around the expected value. Shouldn’t risk measure only the disappointments; that is, when actual outcomes are below expectations? That’s a reasonable suggestion. But when the probability distribution is

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symmetrical above and below the mean, it makes no difference (below the mean is just half the total). Since there is evidence suggesting that security returns have this symmetry (they are normally distributed), much of the analysis used to see how to put securities together into a portfolio—called portfolio analysis—works with the standard deviation to measure risk. We are now prepared for one of the most useful bits of investment advice you will ever encounter. It also turns out to be the most fundamental proposition of modern portfolio theory: An asset may seem very risky when viewed in isolation, but when combined with other assets, the risk of the portfolio may be substantially less—even zero! Holding many securities in a portfolio is what is meant by portfolio diversification. Since portfolio diversification is crucial to risk reduction, let’s examine the principle in some detail.

Principles of Diversification The idea behind diversification can be illustrated by considering a portfolio of just two assets. The first we’ll call asset A for Adventure Inc. We’re not quite sure what business they’re in, but it’s a good one. In good times (probability = 0.5) it pays 16 percent and in bad times (probability = 0.5) it pays 2 percent— clearly a cyclical industry. The expected return is 9 percent, but with fairly large uncertainty over the actual outcome, which varies directly with the pulse of economic activity. Now consider asset B for Badlands Inc. In good times they lose money, producing a return of –2 percent. But in bad times they rake it in, earning 12 percent for their misanthropic investors. The expected return is 5 percent, with substantial variance in the actual results. Note, however, that asset B’s outcomes are countercyclical—they are better when the economy is worse. Could it make sense to buy both of these highly risky investments— apparently exposing oneself to all sorts of disappointment? The answer is definitely yes. In fact, dividing your funds equally between assets A and B yields a return of 7 percent, in both good times and bad; there is no uncertainty at all.3 Does that mean the investor would definitely prefer the half-and-half portfolio to either A or B by itself? The investor clearly prefers the portfolio to B alone, because B’s expected return is only 5 percent and it is uncertain at that, while the half-and-half portfolio returns 7 percent without risk. In this case, the risk averter clearly chooses the combination portfolio. Less clear is whether the investor would choose the fifty-fifty strategy or put everything in A.

3Here’s

the arithmetic: Start with $200. Put $100 in A and $100 in B. In “good times” A pays $16 ( = 16 percent of $100) and B loses $2. The investor earns $14 ($16 minus $2) on $200 invested, or 7 percent (14> 200). In “bad times” the $100 in A earns $2 while the $100 in B earns $12, for a total of $14, which is once again 7 percent. Note: The standard deviation of the returns on the half-andhalf portfolio is zero, even though each security’s return has a positive standard deviation.

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While A has uncertainty, it also has a higher expected return (9 percent versus 7 percent). The choice of A versus the combination depends upon the precise nature of the risk averter’s preferences—whether the extra 2 percent expected return compensates for the increase in risk. The principal lesson derived from the example is twofold. First, the uncertainty of return of an individual asset (its standard deviation) is not by itself a measure of its riskiness. Rather it is the contribution of the asset’s uncertain return to total portfolio risk that matters. Second, a key determinant of the latter is how asset returns are interrelated with each other. This is so important it has a name of its own—covariance.4 In the example just given, assets A and B are perfectly negatively correlated: When asset A’s return is low, that of B is high, and vice versa, and the magnitudes are such that there is perfect offset. That’s why combining the two reduces risk (in this case to zero). Indeed, this is the principle of portfolio diversification: Hold a number of assets (rather than one), so that the exposure to risk is reduced. An asset such as B, whose returns are countercyclical (high when everything else is low), is an ideal addition to a risk averter’s portfolio. But assets such as B are relatively hard to come by. If portfolio diversification to reduce risk depended on finding assets with “negative covariance of returns,” we’d be in for tough times (and lots of risk). But the magic of portfolio diversification extends to other cases as well. In particular, as long as assets do not have precisely the same pattern of returns, that is these assets are not perfectly positively correlated, then holding a group of assets can reduce risk. Take the case where each asset returns either 6 percent or 2 percent, but the outcomes are independent of good times or bad times, and of each other, like the flip of a pair of coins. Does dividing the portfolio between two such assets, X and Y, reduce risk? Well, if the investor holds both X and Y in equal amounts and both happen to return 6 percent or both happen to return 2 percent, the investor is in the same situation as with holding just one asset. But it’s also possible that when X returns 6 percent, Y returns 2 percent, or when X returns 2 percent, Y returns 6 percent. In these cases, uncertainty is zero, because half of the portfolio is in X and half is in Y, hence the return is the average—4 percent. In fact, holding many, many such assets, perhaps one

4Covariance

has a simple intuitive definition: comovement. It also has a precise mathematical measurement. In our case, the deviation of each security’s return from its mean is derived; the product of the paired observations is then weighted (as in the standard deviation) by the probability of each of the paired observations actually occurring. Positive covariance indicates that when one security’s return is above its mean, so is the other. Negative covariance indicates that when one security’s return is above its mean, the other is below. The term correlation, which is used in the following sentence of the text, also has a specific mathematical connotation. It is the covariance divided by the product of the standard deviations. It rescales covariance so that perfect comovement is ⫹1.0 and perfectly offsetting movement is –1.0, with intermediate relationships between these two extremes. A zero correlation means that the returns of the two securities are independent.

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thousand assets, all with an equal chance of 6 percent or 2 percent, and the outcome of each one is independent of every other asset, makes the portfolio virtually certain of always earning 4 percent. About half of the outcomes will be 6 percent and half will be 2 percent. This is the law of large numbers at work, driving the risk of the portfolio to zero. You should recognize that the key assumption in this last example is the word independent. When asset returns are relatively independent (zero covariance), putting many together tends to produce the average return just about all of the time. Risk is thereby reduced to zero. Does that mean that most people who hold diversified portfolios have zero risk? No, it doesn’t, because most assets are affected in a systematic way by economic conditions— hence most asset returns are not completely independent of each other. But as long as returns are not perfectly correlated, portfolio diversification reduces risk.

In The News When a Simpler 401(k) Is Just Dumb Employers have long hoped that simpler 401(k) plans would entice more workers to save. But for more savvy investors, that may not be good news. Many companies have pruned the number of investment options in their plans to keep workers from feeling overwhelmed by too much choice. General Motors Corp. and Delphi Corp., for instance, recently cut these options by nearly half. But simple isn’t always better. In paring choices, companies may be reducing workers’ ability to diversify their assets, leaving them exposed to the downdrafts that sometimes roil stocks and bonds simultaneously. As 401(k) plans become the primary retirement vehicle for more Americans, the problem is they don’t work like traditional pension plans, which often diversify beyond stocks, bonds, and cash. But with a little creativity, you can better mimic the kind of portfolios that pension plans rely on to ensure the long-term survival of their assets. How do you own such assets in a retirement account when your 401(k) doesn’t make them available? For sophisticated investors—those

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who prefer to manage their own assets—the answer is to use IRA contributions to hold the assets you can’t access in the 401(k). David Kudla, chief investment strategist at Mainstay Capital Management, a Grand Blanc, Michigan, investment firm that works with many auto-industry workers, says he’s seen “newfound interest” from 401(k) participants in opening IRAs to gain broader access to different assets. He says some companies even allow a so-called in-service rollover, in which you roll a portion of your 401(k) account into an IRA while still employed. As a rule of thumb, no alternative assets (e.g., commodities, high yield bonds, and currencies) individually should exceed 5 percent to 10 percent of your portfolio. Cumulatively, investors should have no more than about 40 percent of their portfolio in alternative assets, though more conservative types will want to scale that back to 15 percent or 20 percent. Source: Jeff D. Opdyke, The Wall Street Journal Online, Aug. 7, 2007. Reprinted with permission of The Wall Street Journal, Copyright © 2007, Dow Jones & Company, Inc. All rights reserved worldwide.

The Pricing of Risky Financial Assets

The Risk Premium on Risky Securities The examples of portfolio diversification just given permit some refinement in the principles discussed earlier. The standard deviation of returns is a good measure of risk for analyzing a security by itself. It is also a good measure of risk for an entire portfolio. But it is a relatively poor measure of the risk contribution of a single security to an entire portfolio. That depends much more on the covariance of returns with other securities; more precisely, the average covariance of a security’s returns with all others. The reason lies in the magic of diversification: The risk contribution to a portfolio of a security’s returns that are substantially independent of all other returns is nearly zero. This nonsystematic risk is diversified away as the number of securities held increases (as in our coin flipping example). Only the systematic movement of the return on a security with all others adds to portfolio risk. This suggests that the best portfolio may in fact be the mostly widely diversified portfolio imaginable—one that includes literally every security in the marketplace. Not surprisingly this is called the market portfolio. If most asset holders are risk averse, then it also follows that they will demand extra compensation—higher expected returns—in proportion to the systematic risk of a security. They will not, however, demand compensation for nonsystematic risk because they can diversify nonsystematic risk away by sticking the security in a portfolio. In other words, the risk premium that investors demand will be in proportion to the systematic risk of the security. This leads us back to the question that we started with: How are investors compensated for holding risky securities? The simplest answer is that riskier securities must offer investors higher expected returns compared with less risky securities. Put somewhat differently, it is a sad fact of financial life that investors who want to earn higher returns will have to take on more risk. But there is more to the story than this seemingly obvious conclusion. We can specify a more precise relationship between risk and return based on the portfolio behavior of risk-averse investors just discussed. In particular, the extra expected return on a risky security above the risk-free rate will be proportional to the risk contribution of a security to a well-diversified portfolio. And the risk contribution depends primarily on how closely a security’s returns move with all other securities. This specific relationship between expected return and risk produces some very surprising results. Suppose an investor considers lending money to the typical mad scientist in your university’s biology department, perhaps to find a vaccine against watching too much TV. Obviously, the chances of success are very low and the risk is very high. The investor might, in fact, choose not to lend at all. On the other hand, if the scientist went to a venture capital firm that specializes in mad scientists whose schemes are unrelated to one another, the risk of a portfolio of mad scientists would be quite low. In fact, the law of large numbers suggests that investing in 1,000 of these crazy professors will almost

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Going Out on a Limb Buy an Index Fund Although many people recognize the validity of diversification, relatively few small investors take full advantage of the principle. In particular, many investors hold “blue chip” stocks such as IBM and General Electric, but few hold the smaller, less well-known, stocks. This is a mistake. The IBMs of the world are all subject to similar economic risks, hence diversifying among them reduces portfolio risk relatively insignificantly. Two reasons often explain why investors do not fully diversify. First, they don’t know about the less popular stocks. Second, brokerage commissions make it expensive to hold so many different issues. Investors can circumvent these problems by holding a well-diversified mutual fund, especially

one that delivers no frills diversification. In particular, so-called index funds are designed to mimic the performance of some benchmark index of the stock market, such as the S&P 500. These funds hold all 500 securities that make up Standard & Poor’s index of the U.S. equity market. Thus, investors are well diversified across all segments of the stock market and do not have to pay exorbitant fees to the management of the mutual fund. The reason: Managers of index funds have the relatively easy job of diversifying to match overall market performance rather than trying to beat the stock market as a whole. For those who want diversification, buy an index fund—it’s the most efficient way to diversify.

certainly produce at least ten discoveries that will hit the jackpot. So the professors get their money on reasonable terms. Similar reasoning also explains why companies that have poor credit ratings who issue so-called junk bonds are able to raise funds in the capital markets. Viewed in isolation each company is quite risky, but some of these risks cancel each other within a portfolio. The final example applies to an investor who holds all of the securities available in the marketplace; that is, the investor who holds the market portfolio. Our principles of portfolio diversification suggest that the investor earns a return above the risk-free rate that compensates for the comovement of returns among all securities, rather than the risks inherent in each and every security. The risk of the market portfolio (the standard deviation of its returns) is less than the sum of each security’s risk (each security’s standard deviation) because some of the individual variability tends to cancel out. All of this comes from the magic of diversification. Thus it should not be terribly surprising to discover that when risk-free securities pay investors about 5 percent, those investors might expect to earn about 12 percent on a well-diversified portfolio of stocks. The portfolio is simply not risky enough to offer 20, 30, or 40 percent that would make us really ecstatic. We have to be content to earn about 7 percent as compensation for holding the extra risk of the market portfolio.

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SUMMARY 1. Securities represent claims to future cash flows. All securities, therefore, must compensate investors for delaying consumption as well as for bearing risk.

2. In a world without risk, one asset is as good as any other. In fact, each and every asset offers the same return. Risk stems from uncertainty over the payments that will actually be received from investing in an asset.

3. Investors must, in general, be compensated for bearing risk. An investor will prefer an asset that always returns 5 percent to one that returns 5 percent on average but at any particular time may return less or more. This preference is called risk aversion.

4. Risk-averse investors will try to combine securities in a portfolio in order to reduce risk. Such risk reduction through portfolio diversification occurs because the uncertain outcomes on each security can offset each other somewhat. Therefore, do not judge the riskiness of a security by its own variability of possible outcomes. More important to a risk averter is whether the security’s uncertain outcomes offset some of the risks on other securities in the portfolio.

5. A risky security must offer investors an expected return above the risk-free rate in proportion to the risk contribution of the risky security to a well-diversified portfolio.

KEY TERMS arithmetic mean,

nonsystematic risk

risk premium

correlation

portfolio analysis

risky securities

covariance

portfolio diversification

standard deviation

market portfolio

probability distribution

systematic risk

modern portfolio theory

risk aversion

QUESTIONS Questions with a red oval are in

at www.myeconlab.com.

7.1

What is the definition of risk aversion? Why are people risk averse?

7.2

How is it possible that if you combine two risky securities (each with a high standard deviation of returns) into a portfolio, the risk of the portfolio can be zero (the standard deviation of returns on the portfolio is zero)?

7.3

What is the main characteristic of investor behavior that forces riskier securities to pay higher returns?

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The Pricing of Risky Financial Assets

114

7.4

What is the difference between systematic risk and nonsystematic risk?

7.5

Why would investors demand compensation for systematic risk but not for nonsystematic risk?

7.6

Consider two companies: Yesterday’s Equestrian Products (YEP) and Northern Optical Producers (NOPe). Seemingly, these companies have little to do with each other but, it turns out, that their stock returns move closely together. When the economy is in a recession (which occurs 20 percent of the time) YEP loses 6 percent and NOPe loses 4 percent. When the economy is growing slowly (20 percent of the time) YEP gains 2 percent and NOPe gains 2 percent. When the economy is expanding rapidly (60 percent of the time) YEP gains 8 percent and NOPe gains 12 percent. What is the expected return of YEP and NOPe? What is the standard deviation of returns for YEP and NOPe? If an investor bought equals amounts of YEP and NOPe, what would the expected returns and standard deviation of that portfolio be?

7.7

Not only can diversification make sense for individuals, it also makes sense for governments. Can you think of why state and local governments may want to induce new businesses to move to their locales (perhaps through tax credits) especially if one type of business previously existed in that location (perhaps like the auto industry in Michigan or farming in the Midwest)?

7.8

Discussion question: If portfolio diversification makes so much sense, how come many people invest in only one or two stocks?

Money and Capital Markets

The market for U.S. government securities is at the center of the money and capital markets. The U.S. Treasury has to sell many hundred billion dollars’ worth of securities each year to pay off maturing issues and to finance current government operations. The sheer magnitude of these activities has made the government securities market the reference point for both the money market, where securities under one year to maturity are traded, and the capital market, which includes both longer-term debt instruments and equities. Our first step in this chapter, therefore, is to discuss in some detail the workings of the government securities market. We then turn to a brief discussion of bank-related securities because bank debt, which is mostly short term, is closely linked to short-term government bonds. With this background we then examine the markets for corporate securities, municipals, mortgages, and finally—as a reward for your reading to the very end—we explain how the stock market really works and why you might want to look at what’s happening to interest rates before you decide to buy or sell.

LEARNING OBJECTIVES In this chapter you will learn to visualize the structure of the government bond market explain the interaction of Eurodollars, CDs, and Repurchase agreements and their connection to short-term government debt understand the market structure of the corporate and municipal debt markets describe the structure of equity markets and the fundamentals that help determine their price

From Chapter 8 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

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Money and Capital Markets

The Government Bond Market When the U.S. government runs a deficit, which it has in just about every year since 1930, it has to get the funds somehow. It usually gets the money not by printing brand-new dollar bills but by borrowing—which means selling government securities to individuals, to banks, to insurance companies, to foreigners, indeed to anyone willing to lend to the Treasury by buying government bonds. To attract buyers, the Treasury issues a wide variety of maturities and types of government securities.

Types of Securities and Investors At the beginning of 2008, there was $9.2 trillion or $9,200 billion worth of government securities outstanding. Of this amount, almost 50 percent or $4,532 billion was in marketable form, consisting of securities that can be bought and sold on financial markets. The remaining $4,705 billion was in nonmarketable securities, such as the familiar U.S. savings bonds, in which no secondary market trading is permitted. If you want to sell some savings bonds, you have to sell them directly back to the Treasury at a fixed price. Naturally enough, marketable securities are interesting from the point of view of how financial markets function. The $4,532 billion of marketable government securities consists of Treasury bills ($984 billion), Treasury notes ($2,503 billion), Treasury bonds ($573 billion), and $472 billion of inflation indexed notes and bonds. Treasury bills are the shortest-term government securities. As a rule, they are issued with original maturities of three months or six months. Bills are a kind of zero-coupon security, in that they are sold originally at a price below their face value, with face value payable at maturity. The difference between the price and face value (called the discount) constitutes the interest payment. Treasury notes are issued with an original maturity of between one and ten years. Generally, the Treasury issues two-year and five-year notes on a regular schedule, such as at the end of each month. Unlike bills, which are issued on a discount basis, both notes and bonds are coupon instruments. That is, they have a statement printed on them specifying the rate of interest (as a percent of face value) that they carry. A coupon rate of 8 percent, for example, means that each year the holder of the note or bond will get an interest payment, from the Treasury, amounting to 8 percent of the security’s face value. Interest is usually paid semiannually, so that with a $1,000 face value note or bond, each semiannual coupon would entitle the holder to receive $40 from the Treasury. Treasury bonds may be issued with maturities longer than 10 years. After a five-year hiatus, beginning in 2006 the Treasury re-introduced the 30-year bond. Like notes, bonds are issued on a regular schedule throughout the year. Although Treasury notes and bonds begin life as coupon securities, government securities dealers often take newly issued notes and bonds and convert

116

Money and Capital Markets

them to zero-coupon form by “stripping” the coupons from the body of the security. Dealers then market the coupons and the body of the security separately, as zero-coupon securities. For example, a newly issued 10-year Treasury note can be “stripped” into 21 separate zero-coupon securities. Why 21? Because there are two coupons per year (remember that interest is payable semiannually), and 10 ⫻ 2 ⫽ 20 plus the corpus or body of the bond ⫽ 21 (of course, there are only 20 different maturities, since the corpus and last coupon have the same maturity). The most complicated security issued by the Federal government are the Treasury Inflation Protected Securities, or TIPS for short. TIPS are issued in three maturities: 5-year, 10-year, and 20-year and, like bonds and notes, make interest payments twice per year. TIPS differ from other securities by having the principal grow at the same rate as inflation. As the principal grows, so do the semi-annual interest payments. When a TIPS matures, the bearer receives the higher of either the original principal (if there was deflation) or the principal that grew at the rate of inflation. The $4,532 billion of marketable U.S. government securities are widely held not only in this country but throughout the world. In the first place, the Federal Reserve owns $780 billion as a result of current and past

““A billion is a thousand million? Why wasn’t I informed of this?” Source: The New Yorker Collection 1995 Robert Mankoff from cartoon.bank.com. All rights reser ved.

117

Money and Capital Markets

open market operations. Virtually all Federal Reserve open-market purchases and sales are conducted with government securities, mostly bills. The Fed’s portfolio of governments provides the central bank with most of its income; after all, even a modest 2 percent yield on a $780 billion portfolio amounts to $15.6 billion a year. The U.S. Treasury and other federal agencies and trust funds hold $3,958 billion of government securities. This leaves about $4,500 billion of government debt held by the private sector—by commercial banks, individuals, insurance companies, nonfinancial corporations, pension funds, money market mutual funds, and foreign investors. Since the late seventies, foreigners have been particularly large buyers of Treasury issues. They now own approximately $2,250 billion, about 50 percent of the marketable national debt (in 1969, they owned less than 5 percent). Foreigners have acquired hundreds of billions of U.S. dollars by successfully selling automobiles, television sets, computers, and just about everything else to Americans. They have invested many of these dollars in U.S. stocks and bonds, especially government bonds. Money from abroad has been attracted here because of this country’s political stability, financial freedom, and relatively high real interest rates. In recognition of these substantial foreign investments in Treasury securities, it is often said, quite accurately, that recent U.S. budget deficits have been financed largely by foreigners. If it weren’t for foreign purchases of Treasury securities, U.S. interest rates would be much higher than they have been.

How the Market Works Most of the trading in governments takes place in the over-the-counter dealer market. At the heart of the market are forty or so government securities dealers. Some of the dealers are departments of major banks, like Citibank and Chase, while others are departments of large brokerage firms, like Merrill Lynch and Goldman Sachs. Most have their principal offices in New York, but some are headquartered in Chicago, San Francisco, and Los Angeles. Trading in governments averages more than twenty times a typical day’s trading on the New York Stock Exchange. Normal trading hours are from 9 A.M. to 4 P.M. New York time, but trading often extends beyond those hours when there is a lot of market activity. In fact, U.S. government securities are increasingly traded around the clock on virtually a nonstop basis, with trading following the sun around the globe. Dealers get much of their inventory of bonds by bidding at competitive auctions. All marketable government securities are initially issued at auctions held by the Treasury. These auctions take place regularly, not just to raise new funds for the government, but to replace the funds of maturing securities. Three- and six-month Treasury bills, for example, are auctioned weekly (on Mondays), while notes are auctioned on a regularly scheduled basis. Potential buyers at the auctions range from government securities dealers and large banks, with hundreds of millions to invest, to individuals with no more than a few thousand dollars to spare. The large investors wait until the very last

118

Money and Capital Markets

minute before submitting their bids, trying to get the best price, while individuals usually submit theirs several days before the auction begins. If you would like a schedule of the forthcoming auctions simply visit the TreasuryDirect website (currently www.treasurydirect.gov). The best way to understand what happens at an auction is to be there, so we’ll do the next best thing and report on the details of a typical Treasury bill auction. First, though, let’s refresh our memories about the basics of calculating yields on zero-coupon securities in general and on Treasury bills in particular.

Treasury Bills: Auctions and Yields We saw that the general formula for the yield to maturity (r) on a zero-coupon bond with n years until maturity is: Price =

Face Value 11 + r2n

It is fairly easy to specify the formula for calculating the annual yield on a hypothetical one-year Treasury bill since, in this case, n = 1. Thus, we have: Price =

Face Value 11 + r2

We can also solve this formula for an explicit value for r:1 r =

Face Value - Price Price

When this expression is multiplied by 100, it generates r in percentage terms. For example, if a $100 face value Treasury bill is purchased for $95, the formula produces a yield of 5.263 percent. In effect, this formula measures the rate at which an initial sum of money (the purchase price) grows to the final sum (the face value). But the expression must be modified when the growth takes less than a year, because all yields are commonly understood as being per annum and because the Treasury issues bills only with three- or six-month maturities. Thus if a six-month Treasury bill costs $95 and grows into $100 in just half a year, the annual yield should be 5.263 * 2 = 10.53 percent. The general formula for the annual yield on Treasury bills of three-, six-, or 12-months’ maturity is: r =

Face Value - Price * t Price

1Take

P = F>(1 + r), multiply both sides by (1 + r), producing P(1 + r) = F. Now divide both sides by P, giving (1 + r) = F>P. Subtract 1 from both sides, so r = F>P - 1. Getting the common denominator for the right-hand side gives F>P - P>P, which yields the formula in the text.

119

Money and Capital Markets

TABLE 1

Results of a Typical Treasury Bill Auction Three-month bills

Six-month bills

Amount applied for at auction

$69.6 billion

$70.9 billion

Amount scheduled to be sold

$24.0 billion

$22.0 billion

$2.8 billion

$2.3 billion

Noncompetitive tenders Sales by competitive bidding

$21.2 billion

$19.7 billion

High price

99.469

98.999

Low price paid (stop out price)

99.454

98.9535

Annual yield on a discount basis

2.16%

2.07%

Coupon equivalent yield

2.20%

2.12%

Source: United States Treasur y, Feb. 25, 2008 Auction.

where t is the inverse of the fraction of a year the bill takes to mature. This entire expression is often called the coupon equivalent yield of a Treasury bill, as we shall see in a moment. With this background in mind, let’s turn to an illustrative Treasury bill auction. Table 1 shows the results of a typical weekly auction of three- and sixmonth bills. Before the auction, the Treasury announced that it would sell $24 billion of three-month bills and $22 billion of six-month bills (see the second line of the table). Some potential buyers, fearful of not getting their bills by competitive bidding, submitted noncompetitive tenders (line 3), which guaranteed they would receive bills at the market-clearing price resulting from the auction. Because $2.8 billion of noncompetitive tenders were submitted for the threemonth bill, the Treasury had to use competitive bidding for only the remaining $21.2 billion; and because $2.3 billion of such orders were submitted for the six-month bill, the Treasury had to sell only the remaining $19.7 billion competitively (line 4). Competitive bids can be submitted through a broker, or by mail for individuals who participate in the Treasury’s Treasury Direct program, until 1 P.M. on the day of the auction. At that time, the Treasury closes the books and begins ranking the bids from the highest price on down. The first line in Table 1 shows that $69.6 billion of bids (both competitive and noncompetitive) were received for the three-month bill and $70.9 billion for the six-month issue—in both cases more than double what the Treasury wanted to sell. As shown in fifth row of Table 1, the highest bid for the three-month bill was $99.469 for a $100 face value bill. (Actually, $10,000 is the minimum denomination for Treasury bills, so $99.469 really means $9,946.90. However, it is easier to do the calculations on the basis of $100 rather than $10,000.) Everyone bidding at that price was a successful bidder. The Treasury continued to accept bids at lower and lower prices until they aggregated

120

Money and Capital Markets

$21.2 billion for three-month bills and $19.7 billion for six-month bills. At that point—the stop-out price—the auction was over, and those who submitted lower bids got nothing. Even though each competitive bidder might have submitted a different bid, all successful bidders pay the same price for their bids (the lowest accepted price) and receive the same yield. Two kinds of yield computations are used in the Treasury bill market: (1) yield on a discount basis, and (2) coupon equivalent yield (also called bond equivalent yield). 1. Annual yield on a discount basis is calculated as the face value minus the purchase price (let’s call this D, for discount) divided by the face value. For example, Table 1 shows that successful bidders for the new three-month bill received a $100 face value Treasury bill for $99.454. They paid $99.454, but in three months, they’ll get back $100. The difference (D) is $0.546. .546 = .546 percent 100 However, all yields are commonly understood to be on an annual basis. Threemonth bills are really 13-week bills; they mature 91 days from issue date. Assuming as a rough approximation that a year has 360 days, a yield of .546 percent for 91 days can be annualized by multiplying it by 360/91 or 3.956. Thus the annual yield on a discount basis for the three-month Treasury bill high bidders is .546 percent * 3.956 = 2.16 percent (see Table 1). The general formula for calculating yield on a discount basis is: D 360 * Face Value Number Days to Maturity Yields have been quoted on a discount basis in the money market for generations. They keep being used because custom and tradition are hard to overcome. Neverthless, the yield on a discount basis is a poor indicator of the true yield for two reasons. First of all, an investor doesn’t pay the full face value of a bill when buying it, so 100 shouldn’t be the denominator in the first term of the expression. Second, there aren’t 360 days in a year, so 360 should not be the numerator in the second term of the equation. 2. The coupon equivalent yield of a Treasury bill, which we mentioned earlier, corrects for these two flaws in yield on a discount basis. The formula for calculating the annual coupon equivalent yield is: 365 D * Purchase Price Number Days to Maturity For example, successful bidders for the six-month bill who paid $98.9535 for a $100 face value security received a coupon equivalent yield of: 365 1.0465 * = 2.12 percent 1see Table 1) 98.9535 182

121

Money and Capital Markets

As Table 1 shows, coupon equivalent yield is always larger than yield on a discount basis, because the denominator of the first term is necessarily smaller (it is the purchase price instead of the face value) and the numerator of the second term is larger (365 or 366 rather than 360). The details of auctions for other types of Treasury securities differ somewhat from bill auctions, but the basics are still the same. Highest bidders buy first until the supply to be auctioned is exhausted. The yield calculations for the coupon-bearing Treasury issues follow the calculations described earlier, but without the discount yield complication. At this point, let’s spend some time on a market that is intimately connected with Treasury securities—the market for repurchase agreements.

Repurchase Agreements With the Treasury auctioning billions of dollars in securities to government securities dealers, it should not be surprising that the dealers have developed repurchase agreements (repos or RPs) as an efficient mechanism for financing such activities. It also should not be surprising that once in place, this financing mechanism has taken on a life of its own. In particular, the market for repurchase agreements is, along with the federal funds market, the focal point of overnight borrowing and lending. In a typical repurchase agreement, a government securities dealer, such as a major commercial bank, sells government securities (perhaps those just purchased at an auction) and agrees to repurchase them at a higher price the next day. The price that the dealer agrees to pay for the securities the next day has nothing to do with what those securities sell for in the marketplace the next day. Rather the price is set to reflect the overnight cost of funds. And that’s because the repurchase agreement is really a vehicle for borrowing money. In particular, when the owners of securities sell them, they take in dollars; when they repurchase the securities the next day at a fixed price, they are simply repaying those dollars plus interest. Notice that the other side of the repo transaction is called a reverse RP, and involves lending funds overnight. The repo market is closely related to the market for borrowing and lending reserves owned by banks, called the federal funds market. To really understand that market requires a discussion of bank reserves. At this point, it is useful to recognize that the RP and federal funds markets share a number of common characteristics. First, both markets are sources of overnight funds. Second, both markets settle payments the same day the transaction is completed. For example, in the case of the repo, the same day the dealer sells the securities with an agreement to repurchase them at a fixed price, the funds are transferred into the dealer’s accounts by whoever did the other side of the transaction (the reverse RP). The main difference between a repo and a federal funds transaction is that the latter is an unsecured overnight loan between financial institutions, while the former is essentially a collateralized loan, with the securities that are subject to repurchase acting as the collateral. Thus the overnight federal funds rate and the rate on repurchase agreements

122

Money and Capital Markets

tend to move closely together. Whenever one rate moves up significantly relative to the other, borrowers borrow in the cheaper market, lenders lend in the more expensive market, and the rates are driven together—except that the federal funds rate is always slightly above the repo rate (about 1>4 of one percent) to reflect the fact that repos are collateralized. Although the repo market began as a mechanism for financing government securities on an overnight basis, the transaction has evolved into much broader use. First, repos are now done over a wide variety of maturities, ranging from the traditional one day to three months. Second, it is somewhat misleading to view the underlying collateral as what the repo is financing. In a sense, the repurchase agreement is used to raise funds for anything the borrower chooses. The underlying securities are simply acting as collateral for the lender. With this in mind, it is useful to extend our discussion to other bank-related securities that are especially related to short-term Treasuries.

Bank-Related Securities: CDs and Eurodollars When commercial banks consider how to finance their activities, they examine an array of opportunities in the money market rather than just looking at federal funds and repurchase agreements. In fact, the most important segment of the money market is for Eurodollar time deposits, or Eurodollars for short. In recent years, Eurodollars have mounted a legitimate challenge to Treasury bills as the centerpiece of the money market. Although the details of bank borrowing and lending activities is best left to a more complete discussion, we focus here on how bank-related securities interact with other money market securities. Most of us are personally familiar with at least some form of short-term bank liability—perhaps the popular savings account that we opened back in grade school. Banks also raise funds by issuing certificates of deposit, called CDs, which are essentially savings deposits with a specific time to maturity; hence they are formally called time certificates of deposit. Large-sized CDs, referred to as jumbo CDs if they are more than $100,000 in value, are negotiable instruments (that is, they can be transferred to a third party) and are traded through a network of dealers just like Treasury bills. Negotiable certificates of deposit have been an important part of the short-term money market since the early 1960s. They have been eclipsed, however, by their offshore counterparts known as Eurodollar time deposits. Eurodollars are dollar-denominated time deposits held abroad in foreign banks or in foreign branches of U.S. banks. Thus, these offshore deposits can be used by U.S. banks to raise funds in the same way that domestic CDs are used. But the market for Eurodollar time deposits has skyrocketed in recent years as trading among banks in the London money market has taken on a life

123

Money and Capital Markets

of its own. In particular, there is an active interbank market in Eurodollars that operates around the clock and around the world. Eurodollars are bought and sold as banks borrow and lend among themselves in response to shortterm inflows and outflows of funds. A number of large banks in London act as dealers in Eurodollars, quoting rates at which they are willing to borrow and lend. The rate they will lend at is called the London interbank offered rate, more commonly referred to as LIBOR, and the rate they will borrow at is the London interbank bid rate (known as LIBID, although hardly anyone ever mentions LIBID). Thus overnight LIBOR represents the cost of overnight funds to banks just like federal funds or overnight repurchase agreements. Three-month LIBOR represents the cost of three-month funds to banks—an alternative to selling three-month Treasury bills to generate cash. Because banks try to raise cash in the cheapest way, if any one of these rates were very much different from any of the others, borrowers would rush to the cheapest source and lenders would flock to the most expensive one. Borrowers would drive up rates where they were cheap and lenders would drive them down where they were high. Not surprisingly, therefore, Figure 1 shows rates on three-month LIBOR and three-month Treasury bills moving closely together. The Eurodollar market has become so active in recent years that LIBOR is now the reference rate in many financial contracts. As we will see in the next chapter, derivatives contracts known as swaps often use LIBOR as the reference rate.

Yields 8 3-month LIBOR 7 6 5 4 3 3-month T-bill 2 1 0 1998

FIGURE 1

124

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008 Year

Yields on three-month Treasury bills and LIBOR move closely together.

Money and Capital Markets

Corporate Securities Corporations borrow across all maturity ranges, just like the U.S. government. The lion’s share of attention is at the longer end where corporate bonds are traded, perhaps because that’s also where the junk bond market is. After discussing corporate bonds—including the junk variety—we’ll take a look at the short end of the maturity spectrum, known as commercial paper.

Corporate Bonds About $3.5 trillion of corporate bonds issued by domestic business firms were outstanding at the end of 2007. High-quality corporate bonds attract buyers because they usually yield more than government or municipal bonds and they are considered safer than stocks. Bonds have a prior claim before stocks on a corporation’s earnings, and bondholders also have a preferred claim before stockholders on the assets of a company that fails. A major shortcoming of bonds is that they are often fairly long term and therefore subject to interest-rate risk—if interest rates rise, their prices plummet. All corporate bonds are not identical. Differences among them include call provisions and conversion features. Many corporate bonds are callable after a certain specified date; that is, the issuer (the borrower) has the right to pay off part or all of the bond before the scheduled maturity date. Call provisions are exercised by the borrower when it is in the borrower’s interest to do so—for instance, when the level of interest rates has fallen, so that the borrower can reborrow more cheaply. In partial compensation to the lender, the borrower has to pay a higher interest rate on a callable bond compared with one that is not callable. Some corporate bonds are convertible; that is, they offer holders the right to convert their bonds into shares of the company’s common stock at a predetermined price. This feature, which is attractive to many lenders, enables a corporation to sell such bonds at a lower interest rate than it would otherwise have to pay. Corporate bonds also differ from one another in quality. Some borrowers are more likely and some are less likely to make their scheduled interest payments on time and to pay back the principal (face value) when the bond comes due (that is, when it matures). There is no question about the ability of the U.S. government to service its debts, but the same cannot always be said about corporate borrowers. Standard & Poor’s and Moody’s rate bonds according to their ability to repay interest and principal. Bonds in the top four rating categories (Aaa, Aa, A, and Baa according to Moody’s, for example) are often called investment grade. Bonds rated below Baa are called either high-yield or junk bonds. Before the late 1970s, almost all junk bonds were obligations of corporations that had fallen on hard times and consequently were having trouble meeting their interest payments; these bonds, often referred to as fallen angels, had started out as Baa or better and

125

Money and Capital Markets

Going Out on a Limb Junk Is Good Junk bonds have a bad name. In polite circles, they are referred to as high-yield securities. And that’s why people buy them, because they promise to pay more in interest to compensate for their lower credit rating. In fact, junk bonds have been a very attractive component of an investment portfolio over the years. Since 1977, broadly diversified junk bond portfolios have ended the year with a loss for less than half a dozen years, and there are even fewer periods of multiple-year losses. Junk bonds have tended to be particularly

good investments at the beginning of an economic recovery as risk premiums narrow and junk bond prices rise as a result. More importantly, an investor who combines high-yield bonds with stocks and other securities will have a portfolio that has higher expected returns for any level of risk than the same portfolio without the junk bonds. This is a concrete (if somewhat surprising) example of the gains from diversification. So after all the smoke has cleared, junk is really something to consider as part of an overall portfolio.

were downgraded when the issuing firms encountered financial difficulties. Starting in 1977, however, companies began issuing original junk—that is, bonds rated below Baa to begin with—especially in connection with corporate takeovers and mergers. Investors buy such bonds because of their high yield, which presumably compensates for their extra risk. Investment banker Michael Milken and the firm he worked for, Drexel Burnham Lambert, pioneered the issuance of such securities. The market for junk bonds held up well for a decade, but when the economy slowed down and many issuers could not make the required high interest payments, the securities plunged in price, forcing Drexel Burnham Lambert into bankruptcy in 1990. At about the same time, Milken pleaded guilty in federal court to six felony charges of securities fraud and conspiracy and agreed to pay $600 million in fines and restitution. With respect to corporate bonds in general, life insurance companies and pension and retirement funds hold most of the outstanding bonds. Such institutions have a minimum need for liquidity, because a large fraction of their expenditures can be scheduled many years in advance on the basis of average life expectancies and similar mortality statistics. Thus they can afford to buy long-term bonds and not worry about interest rates so much, since they won’t have to sell prior to maturity in order to meet a sudden need for cash. Foreigners have also become large buyers of American corporate bonds, just as they have become big buyers of U.S. government securities. While the bonds of some large corporations are listed and traded on the New York Stock Exchange, most corporate bond trading takes place in the over-the-counter market, through market-making dealers. The telephone is still the dominant mechanism for uncovering the best bids and offers of the

126

Money and Capital Markets

numerous bond-dealing firms. A life insurance company portfolio manager, for example, may telephone a number of bond dealers to locate the best bid for a bond the company has decided to sell. There are so many individual corporate debt issues that trades in a particular bond are sometimes days or weeks apart. It does not really pay to invest in highly automated trading facilities when the volume of transactions doesn’t warrant the huge outlay. On the other hand, most dealers do maintain extensive computer-based information systems to record the bond preferences and holdings of ultimate investors (insurance companies, pension funds, and other institutions). This helps the dealer unearth buyers and sellers when needed. More importantly, it helps dealers place the corporate bonds they buy in their capacity as underwriters. Almost all corporate bonds are sold through underwriting syndicates of securities dealers.

Reading the Financial News Corporate Bond Market Quotations Coupon %

Maturity

Moody’s rating

High

S.HM

6.000

Dec. 2016

Baa

75.250

73.000

74.250

.250

10.586

Sprint Capital

S.IU

7.625

Jan. 2011

Baa

93.825

87.500

91.793

2.293

11.000

Wachovia

WB.NR

3.625

Feb. 2009

Aa

101.801

98.616

100.261

.286

3.340

Target Corp.

TGT.IG

6.000

Jan. 2018

A

107.850

104.548

104.735 - 1.377

5.374

Lehman Brothers Hlds.

LEH.GCV

5.500

Apr. 2016

A

100.124

96.095

96.500 - 2.036

6.053

HSBC Finance Corp.

HBC.QT

5.500

Jan. 2016

Aa

100.000

95.660

97.203

5.949

Thornburg Mortgage

TMA.GB

8.000

May. 2013

B

78.000

64.000

74.000

General Motors Acceptance GMA.HE

6.875

Sept. 2011

B

82.922

79.500

81.002

1.002

13.868

Tropicana Entertainment

TROU.GA

9.625

Dec. 2014

Caa

56.500

53.625

55.000

7.063

23.040

Ford Motor Credit Co.

F.GSL

9.750

Sept. 2010

B

98.500

93.000

98.500

1.050

10.438

Issuer name

Symbol

Sprint Nextel Corp.

Corporate bonds are identified by the company that issued the bond, their coupon, and their maturity date. For example, the first bond listed was issued by Sprint Nextel Corporation (the telecommunications company); it carries a 6 percent “Coupon” and matures in 2016 (conversationally, it is referred to as “Sprint’s sixes of sixteen”). The “Moody’s rating” column lists each company’s credit rating. Ratings below Baa are considered “junk” bonds; in this case the last four bonds fall into that category. The “High,” “Low,” and “Last” columns list the highest, lowest, and final trading price of the bond during the trading day. Corporate bonds normally have a face value of $1,000

Low

Last

Change

.494

Yield %

- 7.500 15.454

and their price is conventionally expressed as a percentage of face value. Ford’s nine and threequarters (the last line in the table) closed at 98.50 or $985 per bond. The “Change” column indicates how much the price changed from the previous day. Ford’s nine and three-quarters gained 1.05 or $10.50 per bond. The final column lists the yield to maturity of each bond based upon its closing (last) price. Be careful, some financial news organizations list the current yield—the coupon interest payment divided by the closing price—rather than the yield to maturity as is done here. Source: online.wsj.com, March 4, 2008.

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Commercial Paper Commercial paper is to corporate bonds as Treasury bills are to Treasury bonds. That is, the government can borrow short term (bills) or long term (bonds), and corporations can similarly borrow short term (commercial paper) or long term (bonds). Commercial paper is a form of unsecured corporate borrowing that typically has an original maturity of between five and 270 days, with 30 days the most common. By convention, issuers of commercial paper are divided into two categories: financial companies (such as finance companies and bank holding companies) and nonfinancial companies. The first group—financial companies—issues three-quarters of the dollar volume outstanding. Many finance companies are associated with well-known manufacturing firms, such as General Motors Acceptance Corporation (GMAC), the financing arm of General Motors. Most commercial paper is bought by institutional investors, especially money market mutual funds, but nonfinancial firms and state and local governments also buy significant amounts. Since institutional investors dominate the market, the most popular denomination is $1 million. Historically, yields on commercial paper are somewhat above yields on Treasury bills of comparable maturity, because there is a greater risk of default with commercial paper than with Treasury bills, even for the highest-quality commercial paper. As can be seen in Figure 2, the commercial paper rate moves closely over time with the three-month Treasury bill rate.

Yields 7

3-month commercial paper

6 5 4 3 3-month T-bill 2 1 0 1998

FIGURE 2

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008 Year

Yields on three-month Treasury bills and commercial paper.

Since investors can buy either Treasur y bills or commercial paper, the two rates are competitive and move closely together.

Source: Federal Reser ve.

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Money and Capital Markets

In the primary market, new issues of commercial paper are often sold directly from the issuer to the buyer without any intermediary (called directly placed paper) or are sold through commercial paper dealers (dealer-placed paper). Most finance companies, for example, issue their paper directly to investors, but many other corporations go through commercial paper dealers who underwrite the issues. Unlike Treasury bills, commercial paper does not have much of a secondary market. Investors who want to sell their paper before it comes due generally turn to the issuers, who will usually redeem their own obligations before maturity as a gesture of good will. Corporations that use dealers to sell their paper needn’t be concerned about this nuisance, because the dealers often make a limited secondary market, agreeing to buy back paper from customers only.

Municipal Securities State and local government bonds, usually called municipals, carry the lowest yields of all securities of similar maturity and risk. This low yield reflects the fact that their interest is legally exempt from federal income taxation. (Interest on municipal bonds is also usually exempt from state and local income taxes in the state where they are issued.) The federal tax exemption of interest on municipal securities was established by the Supreme Court in the 1895 Pollock v. Farmers’ Loan and Trust Company case and was reaffirmed in 1913 in the first federal income tax law. In South Carolina v. Baker (1988), the Supreme Court reversed the Pollock decision and ruled that Congress does indeed have the power to tax the interest on municipal bonds if it wishes to do so. But so far, Congress has decided not to tap this source of revenue. Municipals are usually issued in “serial” maturity form, as contrasted with the single maturity of government and corporate bonds. Serial maturity means that a portion of the total issue matures each year until the entire issue is eventually retired. Each portion carries its own interest rate and is separate from the rest of the issue. Thus when a state issues a ten-year serial bond, it is really issuing a series of one-year, two-year, and so on up to ten-year maturities. Denominations of single bonds are usually $5,000, as compared with $1,000 denominations for corporate bonds. Municipal bonds are sold initially through underwriting syndicates, just like corporate bonds. The underwriting syndicates buy new issues in large blocks from the borrowing governmental authorities and market the securities to ultimate investors at a slightly higher price, making their profit on the differential, the so-called underwriting spread. It is important to distinguish between the two kinds of municipal bonds: general obligation bonds, which are the majority of municipal bonds, and revenue bonds. General obligation municipals are issued for a wide variety of reasons, such as borrowing to build schools or to provide social services. They are backed by the general taxing power of the state or local government. Revenue bonds, on the other hand, are issued to finance a specific project—a

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toll highway, for example—and the interest and principal are paid exclusively out of the receipts that the project generates. As might be expected, general obligation bonds are usually considered the safer of the two. Revenue bonds are riskier, because the particular project they are tied to might falter financially. A case in point is the 1983 default of the state of Washington on $2.25 billion of Washington Public Power Supply System (WPPSS) bonds, the largest municipal bond failure in U.S. history. The WPPSS (often called “Whoops” for obvious reasons) bonds were originally sold to finance several nuclear power plants in the state of Washington, and the payment of interest and principal depended on the financial success of those specific projects. Two of the plants were plagued by troubles for years; their financial difficulties eventually resulted in defaults. Revenue bonds usually carry a higher interest rate than general obligation bonds to compensate for the higher risk, but as the accompanying news item indicates, this relationship is sometimes reversed. Secondary trading in municipals is conducted entirely in the over-thecounter dealer market. There are so many small issues of tiny and virtually unknown municipalities that the secondary market is not particularly active. Although the securities of some large states and cities have above-average liquidity (for a municipal bond, that is), many municipals are traded infrequently or not at all. As a result, the bid-asked spreads on municipal bonds are much wider than they are on either government or corporate bonds. To minimize this problem, when institutional investors want to sell some of their municipal bonds, they frequently employ the services of a specialized municipal bond broker. Perhaps the best-known broker is J. J. Kenny Drake. The broker disseminates information on the bonds—coupon, maturity, and issuer—to potential investors, namely other institutions. Bids for the bonds are reported back to the seller, who can then decide whether to sell or not. Most municipal bond prices and yields are not printed in the daily newspapers, but trade papers contain such information. The Daily Bond Buyer publishes data on new issues, and the Blue List of Current Municipal Offerings specializes in secondary market activity. The two most popular short-term securities issued by state and local governments are tax-anticipation notes (TANs) and bond-anticipation notes (BANs). Tax receipts flow in intermittently, rather than regularly, so TANs are used to borrow funds in the intervals between tax payment dates. The notes have maturities ranging from a few days to a few months and are paid off when tax receipts come in. BANs similarly provide stopgap financing for large projects, such as sewers or roads, and are paid off when long-term bonds are floated. Money market funds that specialize in the purchase of short-term tax exempts have grown rapidly in recent years. Their popularity stems from the fact that they allow people of moderate wealth to diversify their portfolios of such securities. Many require a minimum investment of only $1,000, whereas the smallest denomination in which one can buy municipals directly is $5,000 for each security.

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In The News General Obligation Bonds Might Yield More than Revenue Bonds Orange County Gets a Message What would you do if someone owed you a lot of money and showed no intention of paying it back? Would you lend more money? That’s what municipal bond investors did last week, as they lent $295 million to bankrupt Orange County, California, which shows every intention of stiffing its previous lenders. Orange County, as you no doubt recall, went broke by speculating on interest rates and is in bankruptcy court trying to weasel out of its obligations. Looked at in isolation, the buyers last week got a pretty good deal. Orange County’s latest bond issue was insured by MBIA, the nation’s largest municipal bond insurer, and locks up some revenue streams that might otherwise have gone to pay the creditors that the county wants to avoid paying. The county paid a premium of about one-quarter percentage point over normal rates. But the lending also sent a message to the county, that money will be available to it in the future no matter what it does about its past debts. Next week the county’s voters are expected to turn down a proposal to raise sales taxes by one-half of a percent. Without that, default looms. That message should surprise no one. To be sure, the bond industry has been talking

tough, threatening not to lend any more money to Orange County, and maybe not to anyone in California, unless the state and the county live up to their responsibilities. But this market’s history is one of a total inability to act tough when confronted with the most outrageous conduct. Never forget the Washington Public Power Supply System, a group of local utilities that was able to borrow again only shortly after walking away from its obligations and getting the State Supreme Court to approve the repudiation. Still, it is breathtaking to see MBIA, a company that has the most to lose from a widespread repudiation of obligations by municipalities, stepping up to guarantee the bonds of a deadbeat that is certainly wealthy enough to pay but whose elected leaders see no reason why it should do so. Joe Mysak, the editor of Grant’s Municipal Bond Observer, thinks this could lead to a historic reversal in which revenue bonds, those backed by a project like a toll bridge, yield less than comparably rated general obligation bonds. After all, those bonds have something that may be seized by angry creditors. Source: From The New York Times, June 18, 1995. © 1995, The New York Times. All rights reserved. Used by permission and protected by the Copyright Laws of the United States. The printing, copying, redistribution, or retransmission of the Material without express written permission is prohibited.

Mortgage Securities Mortgages are the most complicated of all debt instruments: not because real estate acts as collateral and not because individuals, rather than governments or corporations, are the primary borrowers. Although these characteristics do make mortgages different, most mortgages are insured by some type of government agency, such as the Government National Mortgage Association (Ginnie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac). Thus, potential defaults by borrowers are usually not a primary concern for investors.

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In The News Perusing the Subprime Detritus A homeowner in Irvine, California, defaults on her mortgage; two Bear Stearns hedge funds implode. French banking giant BNP Paribas halts withdrawals from three of its investment funds; the world’s central banks have to inject hundreds of billions of dollars into the money markets over a two-day period to keep interbank lending rates from soaring. Unrelated events? Hardly. What was once touted as a problem with a niche product (subprime loans) in a small sector of the U.S. economy (residential real estate) is somehow strewing its detritus across the globe. How did it come to this? How is it that home loans to Main Street became a crisis for Wall Street? The answer owes as much to human nature as to the nature and complexity of structured finance. Our story begins with an extended period of low worldwide interest rates designed to ease the pain of the burst bubble in Internet and technology stock. Housing is an interestrate sensitive industry. In the United States, residential real estate weathered the 2001 recession with flying colors, courtesy of the Federal Reserve, which cut its benchmark rate to a level not seen in almost half a century. Potential homeowners responded to the incentive of low rates to buy the house of their dreams. Sometimes they bought two: one to live in, one to rent and/or eventually flip for a profit. The ability to meet timely payment of principal and interest wasn’t an issue for homebuyers when prices were appreciating at rates of 10 to 15 percent a year, which was standard from 2002 through early

2006. It clearly wasn’t an issue for lenders either, who helped would-be buyers secure the financing—no money down, no questions asked. The more exotic the mortgage, the juicier the commission. There were plenty of signs along the way that a bubble was developing. The appearance of the website condoflip.com, for example, with its pitch of facilitating the purchase and sale of preconstruction condos, epitomized the froth that was building in the housing market. Enter Wall Street, which is essentially in the sausage-making business. It takes meat and meat by-products and processes them into wurst, which it hawks to investors both sophisticated and naive. In the case of subprime loans, which were packaged into mortgage bonds and sliced and diced into collateralized mortgage obligations, there was just enough real meat for the securities to be certified as kosher (AAA) by the rating companies. On further examination, the entire sausage production and distribution chain—from homebuyers to mortgage lenders, from mortgage brokers to securitizers—was found to be operating under unsanitary conditions and pretty much shut down until further notice. Investors want to know who and what’s next. It seems the risks the derivatives market was supposed to transfer and diffuse are creating new and untested risks of their own. Source: Caroline Baum, Seattle Post Intelligencer, Aug. 19, 2007, p. C.1. © 2007 Bloomberg L.P. All Rights Reserved. Reprinted with permission.

The biggest problem for investors is that mortgages can be repaid at the option of the borrower prior to the scheduled maturity date. Thus investors are never really certain of the maturity of their investment. This characteristic, known as prepayment risk, makes mortgages especially undesirable from the standpoint of institutional investors, such as pension funds which require fixed long-term cash flows to match the profile of their liabilities.

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Numerous innovations in the basic mortgage instrument have taken place to make these securities more attractive to investors. The basic mortgage, is typically a 15- or 30-year amortizing loan, that is, the mortgage borrower repays interest and returns principle over a 15- or 30-year period. Unlike most conventional bonds, therefore, the loan is gradually repaid according to a predetermined schedule over time. Of course, just to complicate matters there are so-called balloon payment mortgages which resemble conventional bonds in that they do not amortize principal but require a lump sum payment at the end. In either case, however, the problem for investors is that the borrower has the option to repay (prepay) the entire loan earlier than scheduled. To reduce prepayment uncertainty and, therefore, to broaden the appeal of mortgages among potential investors, securities dealers invented the collateralized mortgage obligation (CMO). In this case a number of mortgages are placed in a trust. The interest and principal repayments are then divided by the trustee (often a bank) into four (or more) segments according to a pre-determined formula. The formula allocates prepayments to the first segment until it is paid off, then to the second segment until it is paid off, and so on. Investors then choose whether to receive their payments from the first, second, third, and so on, segments. These segments, by the way, are called tranches (tranche is slice in French). In this way the cash flow becomes more (but not perfectly) predictable for each investor. Trading in CMOs takes place in the over-the-counter market between dealers just like corporate bonds. Because they are complicated securities, however, it is best to leave them and turn to something we may not know very much more about, but is certainly a lot more fun—the stock market.

The Stock Market People have been known to make money in the stock market and also to lose some. It is a fact of life that the total number of stocks in existence changes rather slowly. What does change from year to year is not so much the number of shares but rather the price of each. Why do stock prices go up and down? Not so much particular stocks, like IBM and Xerox, but why does the entire market, more or less, rise or fall? How important is monetary policy in driving stock prices up or down? We will examine these pricing issues in a moment, but first let’s take a look at the marketplace itself.

Structure of the Stock Market According to the New York Stock Exchange, there are now about 90 million individual shareholders in the United States. Nevertheless, in the past twenty years institutional investors—especially pension funds, mutual funds, and

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insurance companies—have edged individuals to the side and begun to dominate the stock market. The stock market refers principally to the secondary market for common stocks. The primary market—that is, the original distribution of new stock issues—operates through investment banks. It is mostly the subsequent trading of securities that constitutes what is generally called the stock market. The New York Stock Exchange (NYSE)—the Big Board—is the most visible part of the stock market, in part because shares of the largest and bestknown corporations are traded there. High visibility also comes from the fact that you can actually see the marketplace. Trading in the shares of about 2,600 corporations takes place on the floor of the exchange at 11 Wall Street. Business is conducted by members of the exchange, and transactions are recorded on an electronic ticker tape flashed on the floor itself as well as in brokerage offices throughout the country. This is a real marketplace—the same as at the county fair, except that it’s a lot more hectic. Individual stocks are traded at particular locations, called posts, on the football-field-sized floor. Traders receiving orders via telephone from brokerage offices throughout the country scurry about placing orders with particular specialists. The job of specialists is to maintain orderly trading for the securities in their charge. Specialists may simply match publicly tendered buy and sell orders submitted at the same price. Floor traders stand at the post and compete for orders that are not matched on the specialist’s order book. When neither of these occur, specialists step in and buy for their own account (at the bid price) or sell from their inventory (at the asked price) in order to prevent excessive gyrations in transactions prices. Smaller companies are not listed for trading on the New York Stock Exchange. Some trade on the American Stock Exchange, which is also located in New York City, but an increasing number of companies, even some large ones such as Microsoft, have their shares trade in the over-the-counter market (OTC). As compared with the organized exchanges, the OTC market has no single place of business where trading activity takes place. Rather, it is a linkage of many dealers and brokers who communicate with each other via telephone and computer terminals. The National Association of Securities Dealers Automated Quotation System (NASDAQ) shows bid and asked prices for thousands of OTC-traded securities on video screens hooked up to a central computer system. For some of the larger OTC stocks, like Intel, more than twenty firms make a market—that is, they quoted bid and asked prices that account executives at brokerage firms could rely on when selling or buying for their customers. For smaller OTC securities, perhaps only a couple of firms would make a market.

What Determines Whether Stock Prices Rise or Fall? Now that we know something about the marketplace, let’s see whether we can explain what makes the stock market go up or down. This won’t necessarily help us make a lot of money, but at least we’ll understand why it’s so tough.

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Reading The Financial News Stock Market Quotations Div. amt. ($)

Div. % yld.

Index/Core stock

Symbol

Close ($)

Chg. ($)

% Chg.

52-Week Low ($) High ($)

YTD % chg.

P/E ratio

.34

4.33

Wausau Paper Corp.

WPP

7.85

6.97

15.58

- 44.2

–*

1.68

4.46

Dow Chemical

DOW

37.71

.03

.08

33.01

47.96

- 10.4

13

.92

3.76

Quaker Chemical

KWR

24.46

.73

3.08

15.27

25.00

9.2

16

2.29

10.41

Linn Energy LLC

LINE

22.00

- .50

- 2.22

18.57

40.21

- 34.1

–*

9.24

10.37

BP Prudhoe Bay Ryl

BPT

89.14

2.89

3.35

59.75

89.98

46.0

–*

2.78

7.55

Teppco Partners

TPP

36.80

.02

.05

35.30

46.20

- 13.8

14

.80

7.43

Warwick Valley Tel.

WWVY

10.77

- .53

- 4.69

10.10

17.25

- 35.3

13

.60

5.41

LouisianaPacific

LPX

11.10

.32

2.97

10.46

21.57

- 43.9

–*

1.40

2.72

SherwinWilliams

SHW

51.50

.36

.70

50.61

73.96

- 20.5

11

Stock market quotations appear on a daily basis in many newspapers. Many are less detailed than the one reproduced above. Detailed reports, like this one, are available on many Internet websites. The first column lists the current annual cash dividend being paid by the company. Wausau Paper pays its shareholders $0.34 per share. This $0.34 per share amounts to a 4.33 percent dividend yield, which is the current annual dividend payment divided by yesterday’s closing price (“Close”); .34>7.85 = 4.33 percent. ”Chg.” lists the price gains (or losses) compared with the previous trading day. The price of a share of Wausau Paper did not change yesterday whereas BP Prudhoe Bay gained $2.89 from the previous day’s close. This $2.89 gain

represented a 3.35 percent gain relative to the previous day’s close (“% Chg.”). To provide some history of the stock’s price, a “52-Week High and Low” are also given. These represent the highest and lowest price over the past 52 weeks. Sherwin Williams, which closed at $51.50 yesterday, is near its lowest point over the past year ($50.61) and has fallen considerably from its 52-week high of $73.96. “YTD % chg.” lists the year-to-date percentage price change. ”P/E ratio” is the company’s price-earnings ratio—yesterday’s closing stock price divided by the company’s after-tax earnings over the past 12 months. The -* signifies that the P/E ratio cannot be calculated because the company had a loss in the previous four quarters.

Although we are most interested in the stock market as a whole we must start at the beginning with individual stocks and work our way up. Stocks, more formally called equities, represent ownership in a company. If the company is profitable it generates earnings which can be passed on to the stockholders in the form of dividends. Thus equities entitle investors to

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future cash flows in the form of dividends. We showed that in order to value the future cash flows on a bond, it was necessary to discount those cash flows to take account of the time value of money. This principle can be applied to equities as well. To get to the bottom line (when to buy or sell) we make some simplifying assumptions. Suppose we expect a company to earn $10 annually per share forever and that its management decides to keep stockholders happy by paying out all earnings as dividends. Based on earlier chapter we can calculate the price of these future cash flows with the following equation: P =

$10 $10 $10 + + + ... 2 1 + r 11 + r2 11 + r23

where r represents the average annual rate used to discount the $10 dividend payments. The three dots at the end of the formula indicate that this series of numbers continues indefinitely (because earnings go on forever), with (1 + r) continuing to be raised to higher and higher powers. Although this looks like a complicated formula, it isn’t. In fact, we mentioned that a bond known as a perpetuity or consol has precisely the same formula. Moreover, the formula simplifies to P =

$10 r

For example, if the rate required to discount those cash flows is 10 percent, then the stock price will be $100, while if the rate were 5 percent, the price would be $200.2 Although we made a number of simplifying assumptions to get a relatively simple formula for pricing stocks, there is enough truth in this approach to warrant using it to explain what causes gyrations in stock prices.3 Here are some general principles. The numerator of our formula is quite straightforward.

2This

simple formula makes considerable sense if looked at from the following perspective. How much should you pay for a believable promise to pay $10 forever? The price, P, should be no more and no less than what it would take to generate $10 forever by investing the money at the going rate of interest. Thus, the price P should be such that P * r = $10, where r is the annual rate of interest. Or, P = $10/r, which is the formula in the text.

3One complication that we omitted is that earnings tend to grow over time, so that stocks should be priced as a growing perpetuity. Our formula is easily modified to account for growth by replacing r in the denominator with r - g, where g is the growth in earnings. So if earnings (and dividends) are expected to grow by 3 percent and if r were 10 percent, then the stock price would be $10 P = = $142.86 .10 - .03

rather than $100 when growth is zero. Not surprisingly, if dividends and earnings are expected to grow, the stock price will be higher. Otherwise, not much else changes and our discussion in the text is just fine as it is.

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Money and Capital Markets

Off The Record The Dow Jones Versus the S&P 500 The Dow Jones Industrial Average (DJIA) is the most widely watched measure of what is happening in the stock market. Although it is very popular, the Dow is not nearly as comprehensive as other stock market indicators. Some other—and in many ways better— market indicators are Standard & Poor’s 500 Stock Index and the New York Stock Exchange Composite Index. Others are the NASDAQ Composite Index and the American Exchange’s AMEX Market Value Index. The DJIA is an average of the prices of only 30 stocks. Included in the 30 are such bluechip (that is, high-quality) corporations as General Electric, IBM, and Walt Disney. However, 30 stocks is an extremely small sample to use as a measure of what is happening in the whole stock market. One reason for the Dow’s popularity is that it has been around so long, Charles H. Dow, the first editor of the Wall Street Journal, and Edward D. Jones began to calculate it as far back as the 1880s. From 1905 to 1925 the Dow fluctuated mostly between 80 and 100. In the stock market boom of the late twenties, it rose to a peak of 381 on September 3, 1929, and then nose-dived to a low of 41 on July 8, 1932. It took more than two decades for the market to recover from the crash. It was November 1954 before the Dow again reached 381. The average hit 500 in March 1956, 1,000 in November 1972, and reached

2,722 on August 25, 1987. A few weeks later, on Black Monday (October 19, 1987), it fell more than 500 points! In November 1995 the Dow more than made up for its 500-point loss in 1987 by pushing through the 5,000 level. It closed over the 10,000 level for the first time on March 29, 1999 but fell below the 8,000 level in October 2002 and has since reached12,500. The DJIA is expressed in terms of “points,” not dollars. It is computed in such a way that all stocks have the same influence on the average. This is not the case with the S&P 500 or the NYSE Composite Index, which are calculated so that corporations with a greater total value of shares outstanding have more influence on the index than corporations with less total value. The S&P 500 consists, not surprisingly, of the prices of 500 stocks. The NYSE Composite includes all stocks listed on the New York Stock Exchange. Broader than both is the Wilshire 5000 Equity Index which includes 5,800 stocks—all those listed on the NYSE and the AMEX as well as many actively traded over-the-counter issues. Most financial experts prefer the S&P 500 as their favorite indicator of overall market behavior; it is usually the measure that index funds use as they try to match the market’s performance, and mutual fund and trust fund managers are “graded” on whether or not they have done as well as or better than the S&P 500.

Higher expected future earnings mean higher stock prices. This makes considerable sense for a single stock, like IBM, or for all stocks taken together, such as the 30 stocks in the famous Dow Jones Industrial Average (DJIA) or the less famous but more representative 500 stocks in Standard & Poor’s 500 Stock Index. Not surprisingly, stock prices respond positively to higher projected earnings and negatively to lower projected earnings. The denominator of the formula is somewhat more complicated. If stocks were just like government bonds, then the denominator would be simply the

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Money and Capital Markets

government bond rate. But common sense suggests that risky securities such as equities require higher expected returns than government bonds to compensate for investor’s risk aversion. So, for example, if government securities yield 5 percent, the required return on equities that appears in the denominator of our formula might be 12 percent—a 5 percent riskless government bond rate plus a 7 percent risk premium. This perspective provides a second explanation for movements in stock prices: Higher government bond rates will increase the denominator of our formula and reduce stock prices while lower government bond rates will decrease the denominator and raise stock prices. This makes considerable common sense as well. If equities are expected to earn $10 per annum in dividends, that stream of payments is worth a lot more if government bonds pay 5 percent per annum than if government bonds pay 10 percent per annum. Said another way, stocks and bonds are economic substitutes for each other. If one becomes more attractive, then demand for the other will decline. As the government bond rate increases (making bonds more attractive), demand for stocks will fall and, as suggested by our price equation, so will the price of stocks. Now that we know precisely why stock prices move in the same direction as company earnings and move inversely with interest rates, do we have the keys to instant riches? Unfortunately, the answer is a resounding no. Current stock prices respond to expected future earnings and to interest rates that discount those future earnings. To predict stock prices, therefore, requires knowing where the economy as a whole is headed, because that’s what will determine the future course of earnings and interest rates. And economic forecasters are the only people that make weather forecasters look good. Nevertheless, let’s turn to a discussion of how knowledge about money and monetary policy might help (or hurt) so that you can be prepared to apply what you learn in the rest of this course.

Money and Stock Prices There are some economists who believe that fluctuations in the money supply provide the key to movements in stock prices. The reasoning goes like this: When the Federal Reserve increases the money supply at a faster than normal rate, the public, finding itself with more cash than it needs for current transactions, spends some of its excess money buying financial assets, including stocks. Since the supply of equities is more or less fixed, especially in the short run, this incremental demand raises their price. Some stocks will go up more than others and some may go down, depending on the prospects for particular companies, but overall the average of stock prices will rise. Conversely, decreases in the money supply—or increases at a slower rate than necessary to provide for the transactions needs of a growing economy— leave the public with shortages of funds. The result is, among other things, a cutback in stock purchases. This reduced demand for stocks lowers their prices.

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Money and Capital Markets

Going Out on a Limb Bubbles and the Stock Market Stock prices have been the subject of studies for about as long as stocks have existed. One perplexing occurrence is the frequency with which stocks seem to rise by large amounts only to fall just as fast. For instance, the Dow Jones Industrial Average rose from 1895, in December 1987, to over 2,596 just 9 months later—a gain of 36 percent in under one year. It then proceeded to give all these gains back over the course of two months. Similarly, the Dow reached 10,400 in March 2002, only to fall to 7,500 six months later and then pick up all of these losses in a little over one year. One explanation for these swings in stock prices is bubbles. The idea behind bubbles is that asset prices deviate from their fundamental value because investors believe that some other market force becomes more important than future dividend payments and interest rates. For instance, an investor may choose to hold an overpriced stock if she believes that others will want to do the same. If in fact others do, then the stock may continue increasing in price well beyond its fundamental value and, because the stock keeps increasing in

price, holders are reluctant to sell (and nonholders are encouraged to buy it, which perpetuates the increase in price). Eventually the bubble “pops” when some event causes the price to decline, which in turn causes holders of the stock to sell. Stocks are not the only assets subject to bubbles. Some have speculated that the rise in home prices between 2000 and 2005 was not caused by the fundamental value of houses (providing shelter) but had more to do with speculation that prices would rise indefinitely. Investors continued to buy houses, pushing prices higher until they collapsed and triggered the subprime mortgage crisis in 2007. Bubbles are difficult to identify because it is often difficult to know what the true fundamental value of an asset is. In the case of stocks, nobody knows what the future level of dividend payments will be nor does anybody know what the risk-adjusted interest rate should be to discount these future payments. For houses, it is difficult to value the intrinsic value of a home apart from its speculative value. In short, while bubbles may exist, we may never be completely sure that they are there.

Conclusion: A rapidly expanding money supply leads to higher stock values; inadequate monetary growth leads to a falling market. Persuasive as the underlying reasoning seems, all too often the facts simply do not bear it out. Evidently too many other cross-currents simultaneously impinge on the stock market, such as business expectations and political developments. Further, as we will see in future chapters, the Federal Reserve is likely to change the money supply concurrently with other economic events that impact expected future business earnings, making it difficult to identify the impact of monetary policy on stock prices. Like so many other singlecause explanations in economics, this simplified view of stock price determination contains too much truth to ignore but not enough to make it very reliable in the clutch. For example, there are a number of instances that seem to support the notion that money supply matters a lot for stock prices. In particular, it is quite

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true that declines in stock prices were preceded or accompanied by declines in the rate of growth of the money supply in 1957, 1960, 1969, and 1981. And often increases in stock prices were indeed associated with increases in the growth of the money supply, as in 1967, 1968, 1975, and the early and mid-1980s. In at least some of these instances, however, both stock prices and the money supply might conceivably have been reacting to a third causal force, perhaps an upturn in business conditions stimulated by the outbreak of war/peace, a spurt in consumer spending, or something else. An improvement in business conditions, regardless of cause, typically leads to an expansion in bank business loans, a larger money supply, brighter profit prospects, and thereby higher stock prices. As the history of business cycles indicates, such upswings (or downturns) are capable of generating a cumulative push that can work up considerable momentum, carrying both the money supply and stock prices along with it. Figure 3 provides a classic example of the pitfalls involved in reading a cause-and-effect relationship into two sets of statistics simply because they move together. The line labeled S indicates the movement of stock prices, annually, from the end of 1960 through the end of 1966, using stock prices at the end of 1960 as the base (⫽ 100). The line labeled M, on a similar index basis, is the movement of the money supply annually, also from the end of 1960 through the end of 1966.

Index 160 150

S

140 W

130 120

M 110 100 90 1960

FIGURE 3

1961

1962

1963

1964

1965

1966 Year

Stock prices and other variables, 1960–1966.

Sources : For stock prices: Dow Jones Industrials, monthly closing averages for December of each year (December 1960 = 100 ). For money supply: Demand deposits plus currency, monthly averages for December of each year (December 1960 = 100 ).

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Money and Capital Markets

Over this particular six-year period, changes in the money supply clearly bore little relationship to turning points in stock prices. Finally, the chart includes a third line, W. Its movements are obviously closely related to changes in stock prices. Almost without exception, the line labeled W and the line tracing stock prices move up and down together. Cause and effect? The line labeled W, make of it what you will, is an annual index (1960 ⫽ 100) of the number of times members of the old Washington Senators baseball team struck out each year, over the period 1960 through 1966. (Source: The Sporting News’s Official Baseball Guide and Record Book, Annual, 1960–1966.) For at least those years, evidently, an investor trying to forecast turning points in the stock market would have been better off reading Sports Illustrated instead of the Wall Street Journal. Once we expand our horizon to encompass more than the money supply alone, however, there is widespread agreement that the Federal Reserve’s execution of monetary policy in general does have considerable influence on the stock market.4 It is by no means the only influence, and it is often overshadowed by other forces and events, but nevertheless, on balance, monetary policy is widely believed to have had a substantial impact on stock prices at times in the past and is expected to continue to do so in the foreseeable future. The impact of overall monetary policy on stock prices stems from its influence over the money supply, the entire spectrum of interest rates and financial markets, current and expected business conditions, and—last but far from least—the expected rate of inflation. Most market participants are tuned in to Fed-watching because they want to anticipate—preferably before anyone else—the future course of interest rates and the potential strength of inflation. The Federal Reserve does not fully determine either of these variables, but it certainly exerts a major influence on both. The lesson is that Fed-watching helps to anticipate stock market trends, but it is no quick and easy road to wealth and fame, because too many other things also impinge on stock prices at the same time.

4This

influence is quite aside from the power of the Federal Reserve to set margin requirements on stock purchases. In an attempt to prevent a repetition of the speculative wave, financed heavily with borrowed funds, that carried the market to dizzy heights until the fall of 1929, Congress in the 1930s authorized the Federal Reserve to impose margin (or minimum down payment) requirements on the purchase of stocks. If the margin requirement is 100 percent, then 100 percent cash must be put up and no borrowing at all is permitted. If the margin requirement is 80 percent, that much of one’s own cash must be put up when one buys a security, and only the remaining 20 percent can be financed by borrowing from a bank or a broker. Of course, you could always finance the entire amount by borrowing from your sister-in-law and no one would be the wiser (except perhaps, in the long run, your sister-in-law). High margin requirements have probably helped restrain speculation in stocks, especially by those who could least afford it. Nevertheless, if the Federal Reserve had only this device to influence the market, it would be relying on a weak reed indeed. Margin requirements are 100 percent at Santa Anita and Hialeah racetracks, but at last report speculative activity by those who could not afford it as well as by those who could appeared unimpaired.

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SUMMARY 1. The federal budget has generally been in deficit since 1930, so that the U.S. Treasury has had to borrow large sums by selling government securities. Commercial banks hold large amounts of governments, as do foreigners. It is often said that recent U.S. budget deficits have been financed largely by foreigners. Money from abroad has been attracted here because of this country’s political stability, financial freedom, low inflation, and relatively high real interest rates.

2. Most trading in governments takes place in the over-the-counter dealer market. Government securities dealers are at the heart of the market. Dealers stand ready to buy and sell all the various maturities at quoted “bid” and “asked” prices. Dealers get much of their inventory by bidding at competitive auctions, which is how the Treasury initially issues all marketable government securities. Dealers often use repurchase agreements to finance their holdings of governments.

3. Treasury bill yields are calculated in two different ways: yield on a discount basis and, more accurately, coupon equivalent yield (also called bond equivalent yield).

4. The markets for Eurodollars and bank CDs are closely related to the Treasury bill market. In fact, the Eurodollar market together with the London interbank money market has mounted a legitimate challenge to Treasury bills as the centerpiece of the money market. LIBOR, the London interbank offered rate, is the most frequently used reference rate in financial contracts.

5. Corporate bonds differ from each other in many respects, including default probabilities, call provisions, and conversion features. Private companies rate corporate bonds with respect to quality, that is, with respect to the ability of the borrower to pay interest when scheduled and repay principal when due. Although some corporate bond trading takes place on the New York Stock Exchange, most trading is over the counter through market-making dealers. These are the same dealers who act as underwriters when a corporate bond is first issued.

6. Municipal bonds appeal mainly to high-income individuals and to institutions subject to high tax rates, because of their federal income tax exemption. Underwriting syndicates dominate the primary market, and subsequent trading takes place in the over-the-counter market. General obligation municipal bonds are backed by the general taxing power of the state or local government. Revenue bonds are related to a specific project, with interest and principal payments generated by that project’s revenues.

7. Mortgages are more complicated than other debt instruments primarily because borrowers have the option to repay the loan prior to its scheduled maturity. Collateralized Mortgage Obligations (CMOs) were invented to minimize the effect of this uncertainty on mortgage investors.

8. Stocks are traded primarily on the New York Stock Exchange and in the over-the-counter market. These are secondary markets because only existing securities trade there.

9. Stock prices rise and fall with interest rates and company earnings. Monetary policy plays an important role in influencing stock price movements because of its effect on overall economic activity, inflation, and, of course, interest rates.

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KEY TERMS bond-anticipation note (BAN)

open market operation

bond equivalent yield

Federal Home Loan Mortgage Corporation (Freddie Mac)

callable bond

general obligation bond

revenue bond

call provision

Government National Mortgage Association (Ginnie Mae)

reverse RP

collaterized mortgage obligation (CMO) commercial paper conversion feature convertible bond coupon equivalent yield dealer-placed paper directly placed paper discount Dow Jones Industrial Average (DJIA)

high-yield bond investment-grade bond

Standard & Poor’s 500 Stock Index stock market

jumbo CDs

tax-anticipation note (TAN)

junk bond

tax exempt

LIBOR

Treasury bill

margin requirement

Treasury bond

marketable security

Treasury Inflation Protected Securities

municipal

eurodollar

National Association of Securities Dealers Automated Quotation System (NASDAQ)

federal funds

nonmarketable security

equities

repurchase agreement (repo or RP)

Treasury note yield on discount basis

QUESTIONS Questions with a red oval are in

at www.myeconlab.com.

8.1

Which is the more accurate way to calculate yield on a Treasury bill: discount yield or coupon equivalent yield? Why?

8.2

How are repurchase agreements used by dealers to finance their inventory of government bonds?

8.3

Why does the yield on three-month Treasury bills move together with the yield on three-month Eurodollar deposits?

8.4

Why are junk bonds not really junk (or are they)?

8.5

Why do municipal general obligations bonds have lower yields than municipal revenue bonds? Might this relationship be reversed?

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Money and Capital Markets

8.6

How do collateralized mortgage obligations (CMOs) make some investors more willing to hold mortgages? Can this result in a bank’s increased willingness to lend to more risky homebuyers?

8.7

Why do we pay so much attention to the Dow Jones Industrial Average if it contains only 30 stocks?

8.8

After painstaking research, you realize that the dividends paid from company ABC are expected to grow 5 percent for many years to come. If the last dividend was $12 and the risk-adjusted rate of return needed to hold ABC is 9 percent, what should the current price of the stock be?

8.9

Coupon payments on bonds are similar to dividend payments from stocks in that they both represent future payments to investors. What are the differences in dividend and coupon payments and how does that translate into the price of each security? Use the present value and stock-price formula to answer.

8.10 Discussion question: Explain why higher interest rates cause stock prices to go down. Do you think you can use this analysis to make money in the stock market?

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Life was a lot simpler when bonds were bonds, stocks were stocks, and futures were pork bellies. But those days are gone forever. Futures contracts on Treasury securities have grown to the point where the Federal Reserve was asked by Congress to study the effects of Treasury bond futures on the cost of the federal debt. A similar explosion in options trading on stock indices forced the Securities and Exchange Commission to consider the implications for the liquidity of the capital markets. And swaps have forced regulators to rethink traditional measures of bank risk exposure. Although futures, options, and swaps are complicated instruments, they have found their way into the risk management toolbox of just about every major financial institution. They are called derivatives because each of these instruments is a financial contract that derives its value from some other underlying asset. Considering the importance of derivatives in the daily operation of our financial markets, it seems like a good idea to understand what they are, how they work, and most importantly, how to avoid losing money in the process. First we look at futures, then at options, and finally at swaps.

LEARNING OBJECTIVES In this chapter you will learn to visualize the structure of futures markets describe how future contracts can be used to diversify portfolios understand options contracts and their use in diversifying portfolios recognize swap contracts and see their ability to limit interest rate risk

From Chapter 9 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

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Demystifying Derivatives

An Overview of Financial Futures A futures contract is a contractual agreement that calls for the delivery of a specific underlying commodity or security at some future date at a currently agreed-upon price. There are contracts on interest-bearing securities (such as Treasury bonds, Treasury notes, and Eurodollar Time Deposits), on stock indices (such as Standard & Poor’s 500 and Japan’s Nikkei index), and on foreign currencies (such as the euro and the Japanese yen). Trading in these contracts is conducted on the various commodity exchanges alongside the conventional agricultural commodities. For example, Treasury bonds trade on the Chicago Board of Trade (CBT) along with futures contracts on wheat, corn, and soybeans. Eurodollar Time Deposits are traded on the Chicago Mercantile Exchange alongside the venerable pork belly and live cattle futures contracts. Although futures contracts on agricultural commodities have been in existence since the middle of the nineteenth century and financial futures were introduced about 30 years ago, the volume of trading in financial futures now exceeds the more traditional agricultural commodities. Financial futures have obviously become quite popular in a very short time period. They share a number of common characteristics with all futures contracts that help determine how they are used. The best way to understand these characteristics is by way of specific example. All futures contracts are standardized agreements to buy or sell a particular asset or commodity at a future date at a currently agreed-upon price.1 The terms of the contract specify the amount and type of asset to be delivered, as well as the location and delivery period. In the case of financial futures, the underlying asset is either a specific security or the cash value of a group of securities. For example, the Treasury bond contract calls for the delivery of $100,000 in Treasury bonds. In the case of stock index futures, the contract calls for the delivery of the cash value of a particular stock index. For example, the popular S&P 500 contract calls for the delivery of $250 times the value of the S&P 500 Stock Index. The precise terms of each contract are established by the exchange that sponsors trading in the contract. Let’s take a closer look at the Treasury bond futures contract. If you buy one December Treasury bond futures contract, you have the right and obligation to receive $100,000 of 15-year maturity government bonds during December. The seller of the contract has the right and obligation to deliver those bonds at that time. In futures market terminology the buyer of the contract is called long and the seller is called short. All of the terms of the contract—$100,000 of 15-year government bonds, December delivery, and so on—are established by the Chicago Board of Trade, which 1A

nonstandardized agreement to buy or sell an asset at a future date at a currently agreed-upon price is called a forward contract. Market participants use forward contracts in much the same way as futures, except that forwards are customized and traded over the counter rather than on organized exchanges.

146

Demystifying Derivatives

sponsors Treasury bond futures trading. The only matter left for negotiation between the buyer and seller of the contract is the price at which the bonds will be delivered. Supply and demand determine this in the often-frenetic bidding and offering that occurs at the location (called a pit) on the floor of the Chicago Board of Trade where the auction in Treasury bond futures is conducted. Note that the standardization of contract terms is designed to promote liquidity, the ability to buy and sell quickly with low transactions costs. Large trading volume promotes narrow bid-asked spreads. Futures exchanges promote large trading volume by standardizing the terms of futures contracts, allowing many individuals to trade the identical commodity. Of equal importance in promoting the liquidity of futures contracts is the nature of the auction process itself. All orders for a particular contract are directed to a single pit on the exchange floor. The trading pit is circular in shape, with tiered steps where traders stand facing each other. Buying and selling interests must be represented quite literally by open outcry. The scene most closely resembles controlled chaos. But the result is that all orders are exposed to the highest bid and lowest offer, thereby guaranteeing execution at the best possible price. For example, if you are interested in buying the December Treasury bond futures contract, you might be told by your account executive that the prevailing bid in the Treasury bond pit is 12023兾32 per $100 face value of bonds, with the best offer at 12024兾32. You may then instruct your account executive to buy one contract from someone in the trading pit who is offering at 12024兾32. You will then be long one December bond future at a price 12024兾32, and the trader in the crowd will be short one December bond future at 12024兾32. At this point a number of institutional arrangements in futures markets take over. Although both you—the long—and the short have a contractual agreement to receive and deliver the underlying bonds, respectively, you no longer look to each other to exercise those rights and obligations. Rather the clearing corporation associated with the futures exchange, consisting of well-capitalized members of the exchange, interposes itself between you and the short. In particular, the long looks to the clearing corporation to satisfy the delivery obligation, and the short looks to the clearing corporation to pay the amount due on the delivery date. In this way the clearing corporation reduces the credit risk exposure associated with future deliveries of the underlying securities. Shorts and longs do not have to worry that the other party will not perform their contractual obligations. The clearing corporation, in turn, has a number of special institutional practices to reduce its own credit risk exposure. First, both the short and long must place a deposit, called margin, with the clearing corporation. Margin is a performance bond that both buyers and sellers must deposit. If it were a down payment on the ultimate purchase price, it would be required of the buyer only. Second, the clearing corporation requires that gains and losses be settled each day in what is called mark-to-market settlement. Thus, if the price of the December Treasury bond future rises from 12024兾32 to 12124兾32, the value of

147

Demystifying Derivatives

your (long) position has increased by $1 per $100 face value of bonds. On the $100,000 contract you have a profit of $1,000, and the short has a loss of $1,000. The clearing corporation collects this sum from the short and transfers it to you at the end of the trading day as part of its mark-to-market settlement. The rights and obligations represented by having a long or short position in Treasury bond futures can be intimidating to say the least. The short must actually deliver $100,000 in Treasury bonds during the delivery month, while the long must come up with the cash when delivery takes place. This can be embarrassing if the long doesn’t have the money or the short doesn’t have the bonds. Most traders in futures markets, therefore, choose settlement by offset rather than delivery. In particular, longs may settle their rights and obligations at any time by making an offsetting sale of the identical December Treasury bond contract, while shorts may cancel their rights and obligations at any time by making an offsetting purchase. The clearing corporation keeps track of all buyers and sellers and closes out a trader’s position when there is both a purchase and a sale of the identical contract on its books for the same account. Don’t ask what happens when the clearing corporation’s computer goes haywire. Settlement by offset permits hedgers, speculators, and arbitrageurs to make legitimate use of the futures market without getting into the technical details of making or taking delivery of the underlying asset. Now let’s see exactly what these legitimate activities by hedgers, speculators, and arbitrageurs actually are.

Using Financial Futures Contracts The most important activity provided by futures markets is the opportunity to hedge legitimate commercial activities. Hedgers buy or sell futures contracts to reduce their exposure to the risk of future price movements in the underlying asset. For example, a government securities dealer who has just purchased newly issued government bonds at the Treasury’s auction must hold those bonds in inventory until ultimate investors (pension funds, insurance companies, and individuals) place orders to buy the securities. In the meantime, the dealer is exposed to the risk that interest rates will rise and the bonds will fall in price. Nothing makes dealers more unhappy than losses on their inventory. The dealer can avoid that outcome by taking a short position in Treasury bond futures. Since the price of bond futures moves almost in lockstep with the price of the underlying bonds (thanks to the activities of arbitrageurs, as we will see in the next section), a decrease in the value of the dealer’s inventory because bond prices decline will be offset by the dealer’s short position in Treasury bond futures. For example, if the bonds in the dealer’s inventory fall in price from $110 to $109, the dealer loses $1 for each $100 in inventory. If the dealer sold Treasury bond futures short, however, the associated $1 decline in the futures contract will provide an offsetting profit. Notice that as soon as the dealer’s inventory of government bonds has been sold to ultimate investors, the dealer should offset the short position in the futures market by buying back the identical Treasury bond futures. Reversing the position

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Demystifying Derivatives

In The News Weatherproof ® Adopts Apparel Industry’s First-Ever Weather Hedge Weatherproof Garment Company, a designer and manufacturer of classically styled, high-performance outerwear, sweaters, and cold weather accessories, today announced an agreement to execute a weather derivative of up to a possible $10 million in coverage to hedge against the financial impact of adverse weather conditions. Brokered through Storm Exchange, the market leader in weatherbased financial hedging solutions, the weather derivative will insulate Weatherproof from potential decreases in revenue stemming from unseasonably warm weather during the month of December. Weatherproof will use the financial guarantee to offset possible decreases in revenue stemming from reduced demand for outerwear during periods of unseasonably warm weather. “Retailers make their purchase decisions months in advance, and it is a very psychological process. If it’s an unseasonably warm fall, they’re going to be gun-shy about taking on too much inventory for the winter months,” said Eliot Peyser, CEO of Weatherproof. “By tapping into the derivatives market, we can eliminate the wild card posed by the weather. Ultimately, this will enable us to give our retail partners rebate

incentives in exchange for a commitment to our products. This is a huge breakthrough for retail.” “Apparel sales have demonstrated a strong historical correlation to seasonality and weather. Approximately 40 percent of the yearover-year variance in retail same-store sales during the holiday shopping months of November and December can be explained by the weather,” said Storm Exchange President and CEO David Riker. “We’re providing the retail industry with the tools to protect itself from the financial impact of volatile weather. More importantly, we help companies understand the influence of weather on their income statements with transparent pricing to support critical financial and operational decisions.” While weather derivatives have been used over the last 10 years in the energy market, the execution of this weather derivative contract represents the first time an apparel maker has hedged its financial exposure to the weather using a derivative instrument. Source: Anonymous, Business Wire, Dec. 3, 2007. Reprinted with the permission of Storm Exchange, Inc. and Weatherproof Garment Corporation. All rights reserved.

is proper, because once the bonds have been sold there is no need to maintain the short position in bond futures as a hedge against price decreases. The moral of the story is that legitimate hedging use of the futures market occurs with a sale of a futures contract and a subsequent offsetting purchase. Despite contrary propaganda by assorted members of Congress, a hedger does not have to make delivery, or even intend to make delivery, when using futures contracts to offset risk. Another type of hedge involves taking a long position in a futures contract rather than a short position. For example, a pension fund may anticipate a need to buy bonds one month in the future, after it has accumulated sufficient cash from pension-holder contributions. If the pension fund manager waits until the month is out to buy the bonds and bond prices rise in the interim, then the funds will be invested at lower yields. To hedge the risk that bond prices will rise before the funds are actually invested, the pension fund manager buys Treasury bond futures. If bond prices go up under these circ*mstances, the long position in Treasury bond futures generates a profit to offset the higher price the pension fund pays for the bonds.

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Demystifying Derivatives

Reading the Financial News Financial Futures Quotations Contract

Month (2008)

Last

Chg.

Open

High

Low

10-Yr. Note

Mar.

118’30.5

0’13.5

118’26.5

119’01.5

118’26.5

Volume 274

Open int. 297,706

10-Yr. Note

Jun.

117’07.5

0’15.0

117’00.5

117’11.0

117’00.5

34,251

2,011,080

5-Yr. Note

Mar.

114’25.7

0’11.5

114’24.0

115’00.0

114’24.0

17,222

266,063

5-Yr. Note

Jun.

113’31.5

0’08.7

114’04.7

114’04.7

113’28.5

18,018

1,766,180

5-Yr. Note

Sept.

113’21.5

0’08.7

113’21.5

113’21.5

113’21.5

S&P 500

Mar.

1307.9

-27.7

1326.5

1329.3

1302.5

59,483

472,212

S&P 500

Jun.

1309.9

-27.9

1329

1331.5

1304.5

26,209

118,338

S&P 500

Sept.

1310.7

-28.4

1310.7

1310.7

1310.7

514

Futures market quotations appear in a variety of formats in daily newspapers and on the Internet so you have to read the column headings carefully to understand the quote. In the above example, the contract type is listed under “Contract.” In this example, three different contract types are displayed: $100,000 of U.S. Treasury notes that mature in 10 years, $100,000 of U.S. Treasury notes that mature in 5 years, and contracts for the S&P 500 stock index that are valued at $250 times the S&P index. The “Month” column indicates when the contract needs to be fulfilled. The first line of 10-Year Note requires delivery of $100,000 of notes in March 2008. “Last” reports the closing price (or settlement) price of the contract

at the end of day. Like bonds, bond futures contracts prices are reported per $100 of face value. The numbers after the ‘ represent 32nds. The March, 2008 10-year future traded for 100 * (118 ⫹ 30.5/32) ⫽ $11,895.31. S&P futures prices simply represent dollars and cents. The March 2008, S&P 500 contract traded for $250 * 1307.9 ⫽ $326,975 at the end of the day. “Chg.”, “Open,” “High,” and “Low” refer to the amount the contract changed over the previous day, where it started (“Open”) and its highest and lowest price. “Volume” lists the number of contracts traded and “Open int.” refers to the number of contracts outstanding. Source: http://online.wsj.com/, March 6, 2008.

We have just seen that legitimate hedgers in financial futures can be either buyers or sellers of futures contracts. “Short hedgers” offset inventory risk by selling futures, while “long hedgers” offset anticipated purchases of securities by buying futures. Sometimes short hedgers sell contracts to long hedgers. But that would be an accidental occurrence. There is nothing to guarantee that legitimate hedging activities by shorts and longs will coincide in the marketplace. That is where speculators enter the picture. Unlike hedgers, speculators purposely take on risk when buying or selling futures contracts. For example, if short hedgers depress the price of the Treasury bond contract by their sales, speculators will be induced to buy those contracts in anticipation of a price increase once the hedging pressure has subsided. Similarly, speculators will be induced to sell contracts if the buying activity of long hedgers temporarily drives up the price of the Treasury bond contract. Speculators take on the risk of price movements from hedgers. They expect to earn a profit in the process. If they’re good at their craft they earn a return for their time, skill, and invested capital; if they’re not so good they go into some other line of business very quickly—with a lot less capital than before.

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Demystifying Derivatives

Pricing Financial Futures Contracts The buying and selling activities of hedgers and speculators together determine the price of a futures contract. More selling drives the price lower; more buying drives the price higher. Although this sounds trite, it’s the best way to describe price determination in the futures market (or any market, for that matter). We can be somewhat more sophisticated, however, when describing the relationship between the price of the futures contract and the price of the assets that underlie the futures contract. The relationship between the price in the so-called “cash market” and the price in the futures market is determined by arbitrageurs. Their activities are crucial for hedgers, because, as we saw in our example in the previous section, the price of the futures contract and the price of the underlying securities must move together if hedgers are to be able to reduce their risk by taking offsetting positions in the futures market. The main reason the price of the futures contract moves closely with the price of the underlying security is that during the delivery period (say, December 2010) there are rights and obligations to deliver the actual securities specified in the contract. During the delivery period, in fact, these rights and obligations force the price of the futures contract and the price of the underlying security to be one and the same. Here’s why. If the price of the futures contract were higher than the price of the actual securities during the delivery period, then it would pay arbitrageurs to sell the futures at the higher price, simultaneously buy the securities at the lower price, pocket the price difference, and deliver the securities in satisfaction of their obligations as shorts. This activity drives down the futures price and drives up the price of the underlying securities until they are equal. On the other hand, if the price of the futures contract were below the price of the underlying security, it would pay the arbitrageur to buy the futures contract and sell the actual security. This time, as the buyer of the futures contract, the arbitrageur would take delivery of the securities and then turn around and deliver them to whoever bought them in the cash market, pocketing the price differential in the process. In this case the arbitrageurs drive up the futures price and drive down the price of the underlying commodity until they are equal. It doesn’t take a genius to make money as an arbitrageur. Just about anyone who can participate in the cash and futures markets simultaneously will recognize the wisdom of instant profits and will undertake these arbitrage activities. Thus, the activities of arbitrageurs will be massive and cause the price of the futures contract and the price of the underlying securities to converge on the delivery date. A similar arbitrage prior to the final delivery date reinforces the comovement between futures prices and the price of the underlying securities, as long as the securities can be stored by arbitrageurs. The main difference is that prior to the delivery period, the arbitrageur would compare the futures price with the price of the underlying securities plus the cost of carrying those securities to the final delivery date. Price discrepancies will lead to buying and selling in the cash and futures markets until prices are brought into proper

151

Demystifying Derivatives

alignment. In particular, at any point the price of the futures contract would be equal to the price of the underlying security plus carrying costs.2 More importantly for hedgers, whenever the price of the underlying security changes, arbitrageurs will push the price of the futures in the same direction. The activities of hedgers, speculators, and arbitrageurs combine to make futures markets important risk management arenas for financial institutions. It pays for banks, insurance companies, pension funds, and others to participate in futures markets, because the standardization of the contracts creates a facility for managing risk exposure at low transactions costs. The fact that the futures contract mirrors the cash market, but with lower transactions costs, is the main contribution of futures markets to the financial marketplace. A very different dimension to risk management is offered by options contracts, as we will see in the next few sections.

An Overview of Options Contracts Options contracts have both a shorter and a longer history in financial markets than futures contracts. Options on individual stocks have been traded in the over-the-counter market since the nineteenth century. The public visibility of options increased dramatically, however, in 1972 when the Chicago Board Options Exchange (CBOE) standardized the terms of the contracts and introduced futures-type pit trading. In addition to the CBOE, options contracts are now listed on the American Stock Exchange, the Philadelphia Stock Exchange, the Pacific Exchange, and the New York Stock Exchange. In addition, most of the nation’s futures exchanges sponsor options on futures contracts. At this point, the options listings in the newspaper rival the stocks themselves for investors’ attention. To appreciate what this options activity is all about, we must examine the contractual obligations of buyers and sellers of options. These contractual obligations are more complicated than futures contracts. Like futures contracts, options are derivative financial instruments; that is, they derive their value from some underlying asset. In traditional stock options, the underlying asset refers to 100 shares of a particular stock, such as General Motors or IBM. In other cases, the underlying asset is a basket of equities represented by some overall stock index, such as the S&P 500 Index or the S&P 100 Index. These are called stock index options, and the contractual obligations are defined by some dollar value of the index, often $100 times the index. Finally, in options on futures contracts, the contractual obligations call

2The

main cost of carrying securities is the interest rate on the funds tied up in the purchase. Thus, in September 2010, the price of the December 2010 Treasury bond futures would equal the price of the underlying Treasury bonds plus the net interest cost of carrying those bonds from September 2010 until they can be delivered in December.

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for the delivery of one futures contract. Although the precise value of an option depends upon the underlying asset, there are a number of elements common to all options contracts that we can explore. All types of options come in two varieties: puts and calls. Let’s begin our story with calls, because they are somewhat more popular. The buyer of a call option has the right (but not the obligation) to buy a given quantity of the underlying asset at a predetermined price, called the exercise or strike price, at any time prior to the expiration date of the option. For example, you may instruct your account executive at a brokerage firm to place an order at the CBOE to buy a call on IBM with a strike price of $110 and an expiration date of July (see “Reading the Financial News” box for an example with options on IBM stock). Once your order is executed, you are “long” the IBM $110 call. This option gives you the right to purchase 100 shares of IBM at a price of $110 at any time prior to July. The seller of that option, called the short (or the option writer), has the obligation (not the right) to deliver those shares to you at a price of $110.3 Note that, unlike futures contracts, the rights and obligations of option buyers and option sellers are not symmetrical. The buyer of the option acquires rights and the seller of the option takes on obligations. The buyer of the call option pays a price to the seller for the rights acquired. This makes considerable sense, because the option seller would be foolish to take on obligations without any compensation. The price paid for the option is often called the value of the option or the option premium. The premium is paid by the long to the short as soon as the option is purchased.4 Before examining the determination of option premiums, let’s see what rights and obligations are conveyed by put options. The buyer of a put option on IBM with a strike price of $110 and an expiration date of July has the right (but not the obligation) to sell 100 shares of IBM at a price of $110 on or before July. The seller of the put option, called the short or the option writer, has the obligation (but not the right) to receive or buy those shares at a price of $110. In consideration of those rights, the buyer of the put option pays a premium to the seller of the put option. This has been pretty complicated, so let’s summarize: Option buyers have rights; option sellers have obligations. Call buyers have the right to buy the underlying asset: put buyers have the right to sell the underlying asset. In both puts and calls the option buyer pays a premium to the option seller. Note that in our example of the IBM call and put we used the same strike price and the same expiration date. Although there are a number of different

3The

option described here is called an American option, because it gives the right to buy IBM at any time until July. European options (which are also traded in the United States) give the right to buy the underlying asset on (but not before) the expiration date.

4Note

that in futures contracts both the long and short have rights and obligations, so that there is no premium paid at the time the contractual obligation is struck. In a futures contract only the price at which the future delivery will take place is agreed upon.

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strike prices and expiration dates for each exchange-traded option, the exchange sponsoring the trading establishes rules for determining which strike prices and expiration dates will be traded for each option. This standardization is designed to elicit interest by many potential traders, thereby promoting contract liquidity. As with futures contracts, there is also a clearing corporation that guarantees the performance of contractual obligations, so that buyers and sellers of exchange traded options do not have to be concerned with the creditworthiness of their trading partners.5 The only matter up for negotiation on the floor of the exchange is the option premium—the price the option buyer pays to the seller for the rights conferred. Let’s turn to the determinants of the option premium and see how options are used by individuals and institutions.

Using and Valuing Options Perhaps the best way to understand why individual investors and financial institutions use options is to look at what an option is worth on the expiration date of the contract. In doing so it is important to remember that investors who buy options, either calls or puts, have rights but no obligations. Therefore option buyers will do whatever is in their best interest on the expiration date. Let’s take a look at the value of our IBM call with $110 exercise price. Although options are complicated, there are only two possibilities on the expiration date that must be evaluated: The price of IBM can be above $110 or the price can be below $110. If the price of IBM stock is below $110, say $105, the call option to buy IBM at $110 on the expiration date is worthless. The call buyer obviously chooses not to exercise the right to buy IBM at $110. Thus the value of the call is zero. On the other hand, if the price of IBM on the New York Stock Exchange is above $110, say $115, then the option to call (buy) the stock at $110 has value. In fact, if IBM is trading at $115, the call is worth exactly $5 per share of stock on expiration. The call is worth $5 per share because the investor can exercise the option—that is, demand that the option writer deliver IBM at $110—and then immediately sell the shares for $115. This discussion implies that the payoff on expiration to a long call position is either equal to zero (if the stock is below the exercise price) or equal to the stock price minus the exercise price (if the stock price is above the exercise price); this is called the intrinsic value of the option. A similar argument shows that on expiration, a long put position has a value of zero if the stock price is above the exercise price and a value equal to the exercise price minus the stock price (this is just the opposite of the call) if the stock price is below the exercise price. For example, the owner of an $110 put on IBM will not want to exercise the right to sell IBM at $110 if IBM is selling at $115 on the

5Unlike

futures contracts, options do not have mark-to-market settlement, nor are there any price limits associated with options.

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Reading The Financial News Options Quotations Options on IBM Stock, Current Price = $112.58 Calls

Put

Expiration

Strike

Last

Volume

Open int.

Last

Volume

Open int.

July

105

12.80

5

2377

4.7

41

3395

July

110

9.89

14

2394

6.3

45

1266

July

115

6.90

45

2708

8.2

1

926

Oct.

105

15.98

1

107

6.4

10

602

Oct.

115

9.80

4

226

—

—

—

Options on T-bonds $100,000; Points and 64ths of 100 percent Calls

Puts

Price

Apr.

June

Sept.

Apr.

June

Sept.

110

6-39

7-24

7-11

0-03

0-54

2-03

111

5-43

—

6-33

0-06

1-03

2-24

112

4-48

5-55

—

0-11

1-19

2-47

Although options quotations differ slightly depending upon whether the underlying asset is a particular stock or a futures contract, they all share a number of common characteristics. For stock options such as the IBM option above, the first column lists the month of “expiration.” The first option expires in July and has a “Strike” price of $105. The “Last” price at which a call was purchased was $12.80 per share. Since each contract represents 100 shares, the price of this contract is $1,280. “Volume” measures the number of contracts that traded and “Open int.” counts the number of open long (equal to short) positions. Compare the prices for July calls as the strike

price changes. The call premium falls as the strike price moves further above the current value of the IBM stock ($112.58). Options on Treasury bonds are typically presented in a different format. In this case price represents the strike price of an option that expires in one of three months (April, June, and September). In order to purchase an April call option on a Treasury bond with a strike price of 110, a purchaser would pay 6-39 or 6 39/64. Since each full percentage point on the Treasury bond contract is worth $1,000, the April 110 call costs $6,609.37. Notice that for some options no trading occurred the day before, so no price is listed.

stock exchange; but if IBM is selling for $100, then the put owner’s right to sell IBM at $110 is worth exactly $10 on expiration. One of the main advantages of buying options is the asymmetrical payoff just outlined. Buying a call provides unlimited upside potential, if the underlying asset rises in price, but a limited downside risk of the premium paid initially if the underlying asset falls in price. Similarly, buying a put provides everincreasing profit as the underlying asset falls in price but only a loss of the initial premium if the asset rises in price. This asymmetrical payoff has the characteristic of insurance, which may be the reason the price paid for an option is called the option premium. As with all insurance policies, if nothing happens (your car does not get hit by a tree), the premium paid is gone and you receive no benefits. For option buyers, the premium paid is a cost and there are

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no offsetting benefits if the price of the underlying asset does not move up significantly (in the case of a call) or down significantly (in the case of a put). This analogy with insurance, in fact, provides the best insight into how options are used by hedgers. Let’s return to our earlier example of hedging with Treasury bond futures. We showed that securities dealers who have just bought Treasury securities in the auction could protect their inventory by selling Treasury bond futures. As an alternative strategy, a dealer could buy puts on Treasury bond futures. In this case, if bond prices fall, the value of the inventory falls, causing a loss. But as our discussion of puts has just showed, the value of the put increases as the price of the underlying asset falls. This offsets the loss in the dealer’s inventory. The main difference in the two hedging strategies occurs if bond prices rise rather than fall. The dealer who bought puts is clearly better off: Rising bond prices increase the value of the inventory, while the worst the puts can do is go out worthless on expiration day. The asymmetrical payoff on the put means that the dealer has protected his or her downside risk by buying the put while retaining upside potential through inventory. The dealer who sold bond futures as a hedge has an offsetting gain on the future if bond prices fall but also has an identical offsetting loss on the future if bond prices rise. Thus, selling futures as a hedge gives downside protection but also eliminates upside potential. Why, then, doesn’t everyone hedge with put options rather than futures? The answer, of course, is the premium. The option buyer pays something for the asymmetrical payoff. If bond prices don’t fall, the put option expires worthless and the premium is lost. Hedging with futures, on the other hand, does not involve any premium payments. If option premiums are low it may very well pay to hedge with options, while if premiums are high futures may turn out to be more attractive hedging vehicles. Note that hedging is not the only reason people buy options. Speculating that the price of Treasury bonds will go up is a lot less nerve-racking if an investor buys calls rather than the underlying securities (or the futures contract). In particular, buying a call limits your loss to the premium if prices go in the wrong direction (which is usually the case for most of us). Thus, even from the speculator’s vantage point, option premiums represent the cost of insurance.

What Determines Option Premiums? Since option premiums are important to both hedgers and speculators, let’s take a look at what determines whether they are large or small. The obvious answer is that option premiums are determined just like any other price—by supply and demand. What we would like, however, is to provide an idea of what underlies the desire to pay a high price for an option (demand) compared with the willingness to sell options (supply). Since this is an extremely complicated subject, our discussion will be brief and intuitive rather than rigorous and mathematical. We’ll examine calls first and then extend the discussion to puts. Let’s take our favorite option, the IBM calls with a strike price of $110. The price of such equity options is usually quoted per share, which means that multiplying by 100 (the number of shares the call owner is entitled to buy)

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Demystifying Derivatives

gives the dollar price of the option. For example, the July IBM 105 call option is quoted at $9.89, and so it costs $989 to buy; if the option were quoted at $15, it would cost $1,500, and so on. What determines whether the price of the IBM 110 calls is $9.89, $15, or $35? The three main factors are the current price of IBM stock, the volatility of IBM’s stock price, and the time to expiration of the option. We will look at each factor in turn. It should be fairly intuitive that a call option with a given exercise price will be worth more the higher the price of the underlying asset. If IBM stock is selling for $120, the $110 call gives you the right to buy 100 shares at a price that is $10 below the price at which you could sell the shares. Thus everyone would pay at least $10 for the IBM $110 calls if IBM stock sells for $120, since they could lock in an immediate profit if the call were selling for less. If IBM stock were selling for $140, for example, the $110 call would be worth at least $30. Somewhat more generally, options will sell for at least their intrinsic value at any time, even prior to expiration. And that means that a higher stock price implies a higher call value at all times. But that can hardly be the entire story. If IBM stock were selling at $110 per share, the intrinsic value of the $110 calls would be zero, but the options could still be quite valuable. And that is especially true if the calls have a significant amount of time left before expiration. In particular, if the price of IBM is very volatile, and there is a lot of time before the option expires, then there is always a chance that the price could move up significantly between now and expiration. The greater the volatility of IBM stock, the higher its price can go, hence the more the call could be worth on expiration. Therefore, given the current price of the stock, call buyers will pay more for a call option if the underlying stock is more volatile than otherwise. A similar argument makes option sellers less willing to write options on stock with large price volatility. Thus for any given price of the underlying asset, call option premiums will be larger for stocks with high price volatility.6 The impact of time to expiration on the value of a call is easily seen as an extension of what we have just said. A call option that expires six months from now has more time for the price of the underlying asset to rise above the exercise price than an option with only three months to expiration. Thus call option premiums will be higher the longer the maturity of the option. To summarize, call options will be worth more the higher the price of the underlying asset, the greater the volatility of the underlying asset, and the longer the time to expiration of the option. A similar discussion would show that premiums on put options will be higher the lower the price of the underlying asset, since the put gives the owner the right to sell at the exercise price. In particular, an IBM put with an

6Note

that even though high volatility can mean large declines in price as well as large gains, the greater downside risk is less important to the call buyer than the enhanced upside potential because of the asymmetrical payoff to the call. The worst that can occur to the call buyer is that the call goes out worthless, while the upside potential is unlimited.

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Going Out on a Limb Don’t Blame Derivatives In the fallout from the collapse of housing prices many observers concluded that complex, financial contracts and derivatives contributed to the resulting financial woes of banks and borrowers alike. Similar charges were made in the aftermath of the Enron Corporation scandal, California’s Orange County municipal fund bankruptcy, and the demise of Barings, the 300-year-old British investment bank. Allegations that derivatives are dangerous stem from their supposedly complicated payoffs, so that even sophisticated investors can be unpleasantly surprised by the outcome of a particular derivatives strategy. In the case of Enron, the complexity of contracts seems to have been less important than fraud and conflicts of interest that led auditors to approve misleading financial statements. Furthermore,

derivatives were knowingly misused by sophisticated investors both in Orange County and at Barings. These cases all point to problems of corporate governance and control rather than to the inherent evil of derivatives. It is highly doubtful that derivatives are too complicated for sophisticated investors to use properly in designing a risk reduction strategy. Options, futures, and swaps are employed routinely on a daily basis by thousands of risk managers, often applying the basic strategies outlined in this chapter. Just because a few participants misuse these instruments should not lead to wholesale condemnation. That would be similar to banning scalpels just because Jack the Ripper probably used that particular surgical tool to murder his victims.

exercise price of $110 will be worth more if IBM is selling at $100 rather than $110. Higher price volatility of the underlying asset and longer time to expiration make put options more valuable for the same reason they make call options more valuable: There is more chance that the option will have higher intrinsic value on the expiration date.7 Option pricing comes in much more complicated varieties than we have described here. Mathematical arbitrage arguments produce a more rigorous set of results. But for our purposes we have gone far enough to recognize that options will be an expensive way to hedge portfolio risks if those risks are substantial. There is, after all is said and done, no such thing as a free lunch. In particular, if stock and bond prices are highly volatile, then option premiums will be large. Financial institutions will then have a difficult choice: Hedge with options to keep the upside potential while paying a substantial premium, or hedge with futures and forget about premiums and extra profitability. At last glance both options and futures markets had active participants from major financial institutions. Conclusion: Risk reduction takes many forms, depending upon its price (or put somewhat differently, you pay your money and take your chances).

7As

in footnote 6, only the favorable outcome of volatility gets priced in the option; the unfavorable price movements at worst only make the option value go to zero.

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An Overview of Swaps Swaps are relatively new on the derivatives landscape, having been invented in 1981 to help firms reduce interest rate risk. Since then swaps have grown to the point where they now involve transactions worth several trillion dollars per year. Swaps come in two broad varieties: interest rate swaps and currency swaps. Although both are important, to keep matters under control we will stick to the interest rate variety to illustrate how swaps work. Like futures and options, a swap is a contractual agreement. In the case of a swap the two parties (referred to as counterparties) agree to exchange interest payments over a specific time period. One party to the transaction is called the fixed-rate payer and the other is called the floating-rate payer. Their obligations to each other might look like the following: The fixed-rate payer agrees to pay 10 percent per annum in each of the next five years; the floating-rate payer agrees to make payments based on some reference rate, such as the Treasury bill rate or LIBOR (the London interbank offered rate). The dollar amount of the payments made between the counterparties is determined by multiplying the interest rates by an agreed-upon principal, known as the notional principal amount. Before trying to understand why individuals or companies might enter into such a contract, let’s see exactly what the counterparties have agreed to. Unlike exchange traded futures and options contracts, swaps are customized agreements designed to the requirements of the counterparties. Nevertheless, there are some conventions adhered to. For example, suppose the American Gothic (AG) Commercial Bank agrees to pay 10 percent per annum over the next five years to Sleepy Hollow (SH) Timber Company, while SH agrees to pay to AG whatever six-month LIBOR is. Thus AG is the fixed-rate payer and SH is the floating-rate payer. The counterparties agree that the notional principal amount is $100 million. By convention the interest payments are made every six months. Thus, AG will pay SH $5 million (10 percent times $100 million divided by 2) every six months for the next five years. The payments by SH to AG depend upon six-month LIBOR. So if six-month LIBOR is currently 8 percent, then SH pays AG $4 million (8 percent times $100 million divided by 2) six months from now. The second payment by SH to AG will depend on what six-month LIBOR turns out to be. Thus if six-month LIBOR is 7 percent in six months, the payment will be $3.5 million (7 percent times $100 million divided by 2) at the end of one year. Note that the fixed-rate payer (AG) always pays the same amount, while payments by the floating-rate payer (SH) vary according to the reference rate. The notional principal amount is never exchanged, just the interest payments. Figure 1 illustrates the specific obligations between the two counterparties. Swaps can be structured just about any way to accommodate the counterparties. Although LIBOR has emerged as the most popular reference rate for establishing payments by the floating-rate payer, Treasury bill rates and commercial paper rates are some obvious alternatives.

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Fixed Payer American Gothic Commercial Bank

FIGURE 1

(10% ⫻ $100 million)/2 (LIBOR ⫻ $100 million)/2

Floating Payer Sleepy Hollow Timber Co.

Obligations of payments every six months for the duration of the swap.

What determines whether the fixed-rate payer pays 10 percent or 11 percent when receiving LIBOR? Two important factors are the shape of the yield curve and default risk. In the case of our five-year swap, if five-year Treasury securities were yielding 9.0 percent and American Gothic were an Aaa-rated company, AG might pay 1 percent over five-year Treasuries for a total of 10 percent. On the other hand, if AG were a less creditworthy bank it might have to pay 1.5 percent above five-year Treasuries for a total fixed payment of 10.5 percent. Notice that default risk plays a role even though the notional principal amount is not exchanged because the counterparties might default on the scheduled interest payments. Financial institutions, such as banks and securities dealers, help bring the counterparties to a swap together, often interposing their own credit between counterparties who may not know each other. Thus, American Gothic and Sleepy Hollow may prefer to exchange payments with the Safe and Sound National Bank, rather than each other. Safe and Sound will be more than happy to accommodate them and will charge a fee accordingly. This makes AG and SH more comfortable, but may leave Safe and Sound with the obligation to make either fixed or floating payments in case one of the counterparties defaults. Needless to say, Safe and Sound checks out AG and SH and varies their fee according to the respective credit ratings.

Why Swap? As conservative businesses, American Gothic and Sleepy Hollow enter into a swap to reduce risk exposure. For example, suppose AG makes a five-year $100million commercial loan and raises funds the old-fashioned way, by issuing sixmonth certificates of deposits to its favorite depositors. The five-year commercial loan yields 12 percent and the six-month CDs cost 7 percent. Although this is profitable, closer examination by AG’s chief financial officer shows that the package is risky because six months from now CD rates might rise, causing AG’s profit to decline or disappear. AG could reduce this risk by finding a counterparty who would be willing to pay AG the six-month interest rate (so AG could cover its CD costs) and in exchange AG would pay a fixed rate for five years. If that fixed payment were 10 percent per annum (as in our example above) AG would still make a profit on its loan (which yields 12 percent). Now let’s turn to the Sleepy Hollow Timber Company. Suppose Sleepy Hollow has just completed a successful debt offering, issuing ten-year notes at a fixed

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Demystifying Derivatives

rate of 93兾4 percent. Having been in business for over one hundred years, SH has a long-term outlook and does not anticipate needing any of its newly raised cash for five years. So it takes the proceeds and invests in six-month Eurodollar deposits because the London branch of its long-standing banker promises a very attractive rate, especially since SH promises to renew the Eurodollar deposits every six months for the next five years. The main problem with this strategy is that Eurodollar rates may decline over the next five years, leaving SH to pay the fixed 93兾4 percent on its debt but earning less on its shortterm investments. Clearly SH could reduce its risk exposure by finding a counterparty who would pay SH a fixed rate (say 10 percent over the next five years) and in exchange SH would pay a floating rate based on six-month LIBOR (which is the rate earned by SH on its six-month Eurodollar deposits). Along comes the Safe and Sound National Bank and brings AG and SH together in a swap agreement: AG pays fixed and receives floating; SH pays floating and receives the fixed; and Safe and Sound earns a commission for realizing that a 10 percent fixed payment works for both. More generally, Safe and Sound earns a commission for arranging a transaction that allows both AG and SH to reduce their risk exposure while maintaining a profit. What we have just described is a generic swap, sometimes referred to as a “plain vanilla” swap. The objective of both participants in this example was to undo maturity mismatches in their respective balance sheets. The controversy over derivatives, in general, and swaps, in particular, does not revolve around cases such as these. Rather, swaps become unpleasant when they generate losses and when one of the counterparties is a closet speculator rather than a hedger. To understand the danger involved let’s see what causes the value of a swap contract to go up or down.

Valuing a Swap Swap contracts are traded in the over-the-counter market just like corporate bonds. Thus American Gothic could sell its swap obligation (to receive floating and pay fixed) to someone else. The question is whether AG would have to pay someone to take over its contractual obligations or might it receive something in exchange? Let’s see what determines how much the swap contract is worth, using the numerical example developed earlier. American Gothic has the following contractual agreement: It has agreed to pay $5 million every six months for the next five years and, in exchange, will receive every six months a dollar payment equal to six-month LIBOR times $100 million divided by 2. If AG asked Citibank to take on this contract one day after the contract was entered into, what would Citibank do? The first step would be to see what today’s swaps are paying for the right to receive sixmonth LIBOR. If five-year interest rates have increased, say, to 12 percent, then a payment of $6 million would be needed (12 percent times $100 million divided by 2) to receive six-month LIBOR, while if five-year interest rates declined to 8 percent, then a payment of $4 million would be needed. Thus if interest rates rise, the fixed-rate payer (AG) has a valuable swap on its hands

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Demystifying Derivatives

because it pays $5 million rather than $6 million every six months to receive six-month LIBOR. In this case, AG will be able to sell its swap contract to Citibank at a profit. On the other hand, if interest rates decline, AG has an unprofitable swap contract because it pays $5 million rather than $4 million every six months to receive six-month LIBOR. Thus AG would have to pay Citibank to take on its swap contract. A similar exercise would show the reverse for the floating-rate payer, although in the interest of mercy we’ll spare the details. The point of the exercise is that swaps produce gains and losses just like options and futures contracts.8 Now we understand why swaps can be dangerous. Both American Gothic and Sleepy Hollow entered into a swap agreement with the objective of reducing risk. And that not only wasn’t dangerous, it was eminently sensible. However, there is nothing to prevent some swashbuckling speculator from entering into a swap agreement hoping to profit on future movements of interest rates. In this case, swaps can easily inflict losses. And if that speculator happens to work for a bank, insurance company, or pension fund manager, the headline that reads “Swaps Cause Bankruptcies” should read “Speculators Cause Bankruptcies.” Now that might not make the losses any smaller, but it certainly puts swaps in a very different light.

8In

fact, swaps are identical to a series of a custom-designed futures contracts—called forward contracts—on interest rate securities. For example, if interest rates go down and bond prices go up, the fixed-rate payer loses money, just like someone who has sold Treasury bond futures, while if interest goes up and bond prices go down the fixed-rate payer makes money, just like someone who has sold Treasury bond futures. This is not surprising since the fixed-rate payer has contracted to pay a fixed amount to receive a payment that will be higher if interest rates are higher and smaller if interest rates are lower.

SUMMARY 1. Financial futures contracts include the following: interest rate futures, such as Treasury bonds and Eurodollars; stock index futures, such as the S&P 500; and foreign currency futures, such as the Japanese yen. They are used by financial institutions to reduce risk of price changes in the underlying securities. Long hedgers reduce risk by buying futures contracts, short hedgers reduce risk by selling contracts.

2. Futures contracts are priced by the balance of supply of and demand for contracts by hedgers, speculators, and arbitrageurs. The activities of arbitrageurs produces a close relationship between the price of futures contracts and the underlying financial asset.

3. Options are divided into puts and calls. Buyers of puts have the right to sell at a fixed exercise price, while buyers of calls have the right to buy at a fixed exercise price. The option sellers (or writers) have the obligation to do what the buyers want. In consideration of the rights received, option buyers pay a premium to option sellers.

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Demystifying Derivatives

4. Financial institutions can use options to hedge their risks. The asymmetric payoffs to both puts and calls—unlimited gains with limited losses—can make options especially attractive.

5. The prices of all options—their premiums—are larger the greater the price volatility of the underlying asset and the longer the time to expiration of the option. In addition, puts are worth more when the price of the underlying asset is low, and calls are worth more when the price of the underlying asset is high.

6. Interest rate swaps are contractual agreements between two parties who agree to exchange interest payments over a specific time period. Financial institutions can use swaps to reduce the risk exposure associated with a mismatch of maturities on their balance sheets.

7. The value of a swap changes when interest rates move up and down. Hedgers don’t mind so much when this happens, but speculators do.

KEY TERMS arbitrageur

forward contract

option premium

calls

generic swap

options contract

clearing corporation

hedger

pit

counterparty

interest rate swap

puts

currency swap

intrinsic value

settlement by offset

derivative

long

short

exercise price

mark-to-market settlement

speculator

financial futures fixed-rate payer

margin

floating-rate payer

notional principal amount

strike price

QUESTIONS Questions with a red oval are in

at www.myeconlab.com.

9.1

Do legitimate hedgers in the futures market normally expect to deliver (or take delivery of) the underlying asset? Why or why not?

9.2

Explain the process forcing the price of the futures contract into equality with the price of the underlying asset during the delivery period.

9.3

Explain the rights and obligations of the buyer and seller of a call option. Compare these with the rights and obligations of the buyer and seller of a futures contract.

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Demystifying Derivatives

164

9.4

What is the difference in terms of potential profit and loss of hedging an inventory of Treasury bonds by selling futures contracts versus buying put options?

9.5

Why is an option worth more the greater the volatility of the underlying stock?

9.6

Explain why the fixed-rate payer in an interest rate swap is happy when interest rates go up.

9.7

If the life insurance company that you manage expects to receive $5 million in premiums nine months from now, what derivative would you seek to lock in at current interest rates?

9.8

As the manager of your local bank, you have received $10 million of deposits in savings accounts. These savings accounts pay a variable interest rate; as interest rates in the economy rise, so will the interest you need to pay your depositors. Using this $10 million, you make loans at a fixed interest rate. Can you use derivatives to reduce the risk of rising interest rates (that make your deposits more expensive but don’t impact the amount received on your loans)?

9.9

Discussion question: Since swaps, options, and futures are complicated instruments, should we have laws that restrict participation in these markets to “suitable” investors?

Understanding Foreign Exchange

Big banks and corporations used to do only a small part of their business overseas, but now many of them have branches worldwide. Before World War II, only the wealthy could afford to vacation in Europe, but now tens of thousands of college students fly there every summer. Any time a transaction takes place between the residents of two different countries, one kind of money has to be exchanged for another. What matters to most of us is whether we will have to pay a little or a lot for a Canadian dollar or a Japanese yen. Exchanges of one kind of money for another are made on the foreign exchange market, which consists of a network of foreign exchange dealers, such as banks, that buy and sell foreign monies in the form of foreign currencies and deposits in foreign banks throughout the business day. More familiar to most people are currency exchanges, which deal mainly with tourists; they are found downtown, at airports, and at railroad stations in all the major tourist centers. The price of foreign money, the foreign exchange rate, like the price of anything that is bought and sold, is determined by demand and supply. The main problem is to identify the underlying determinants of the demand for and the supply of foreign money.

LEARNING OBJECTIVES In this chapter you will learn to measure and determine foreign exchange rates understand the equilibrium connection between balance of payments and exchange rate movements analyze fixed and floating rate exchange systems and their impact on trade balances and financial crises

From Chapter 10 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

165

Understanding Foreign Exchange

What Determines Foreign Exchange Rates? Whenever we import foreign goods, buy foreign stocks or bonds, or travel abroad, we have to make payments to people in other countries. Naturally enough, these people want to get paid in their own money. So we have to get hold of foreign exchange, which we can do by going to a bank or currency exchange and buying some. Our imports thus give rise to a demand for foreign currency. Notice, by the way, that when we buy foreign money we do so by offering dollars, so that a demand for foreign money also amounts to a supply of dollars on foreign exchange markets. On the other hand, whenever we export our goods, sell our securities to others, or are host to foreigners traveling here, payments have to be made to us. Naturally, we also want to get paid in our own money. So foreigners have to buy American dollars, which they can do by going to a bank or currency exchange and offering their own money to get dollars. Our exports thus give rise to a supply of foreign currency. Notice that when they offer foreign money they are trying to buy dollars, so that the supply of foreign money also amounts to a demand for dollars on foreign exchange markets. Payments to and from foreigners are conveniently summarized in a national balance of payments. Each country’s balance of payments consists of two accounts: the current account and the capital account. The current account measures international transactions that involve currently produced goods and services. The vast majority of the current account is the difference between exports and imports, or what is commonly termed the trade balance. When imports are greater than exports, as has been the case in the United States recently, we have a current account deficit (or more commonly termed trade deficit). A current account deficit is similar to a deficit in a household’s budget. The capital account measures international transactions that involve assets like stocks and bonds. In exchange for a U.S. stock or bond, a foreigner sends currency to the United States. Because the United States has an inflow of funds from a foreigner, the United States experiences a capital account surplus. The current and capital accounts are intimately tied together and tied to markets for foreign exchange. A deficit in our current account means that we are buying more foreign products than we are selling. This produces a demand for foreign currencies (since foreigners want to be paid in their own currencies). As a result, the price of foreign money will rise—foreign exchange will appreciate relative to the dollar. We can also think of this as an increase in the supply of dollars. When Americans want to buy French wine, Americans give up their dollars in exchange for euros; the increase in supply of dollars reduces the dollar’s value relative to foreign currencies. Changes in the capital account also impact the exchange rate. If foreigners want to buy more American bonds (perhaps because American interest rates are high), then foreigners will increase the supply of their currency relative to the dollar. A higher supply of foreign currency causes the price of foreign currency to fall relative to the dollar. In this foreign currency is said to depreciate relative to the dollar.

166

Understanding Foreign Exchange

When exchange rates freely react to demand and supply, as just described, they often generate self-correcting changes in imports and exports and in other types of international transactions, which reduce or eliminate balanceof-payments deficits and surpluses. For example, assume we are importing more goods than we are exporting, so that we are running a current account deficit. The price of foreign exchange will rise. The dollar will depreciate. As a result, foreign goods and services will become more expensive for us, so we are likely to import less. At the same time, we will probably export more because foreigners will find our products less expensive (they can now get more dollars for the same amount of their money). With fewer imports and more exports, our current account deficit should shrink. The same reasoning applies if we have a current account surplus because we are exporting more goods than we are importing. The price of foreign money will fall, increasing our imports (because foreign goods are now cheaper for us to buy) and decreasing our exports (our products are now more expensive for foreigners), thereby reducing our surplus. Figure 1 illustrates these principles in the case of Argentinean pesos. The dollar price for one peso is on the vertical axis (for example, 30 cents for one peso), and the number of pesos is on the horizontal axis. The demand and supply curves for pesos have the conventional shapes: The amount of pesos demanded increases as their dollar price falls, because when pesos become less expensive, Argentinean products become cheaper for us, we import more from Argentina, hence we demand more pesos. The amount of pesos supplied decreases as their dollar price falls, because when pesos become cheaper our

Foreign exchange rate or price for one peso in U.S. $ .60 .50

Supply of pesos

.40 Equilibrium

.30 .20 .10

Demand for pesos

0 Quantity of pesos

FIGURE 1

Supply of and demand for foreign exchange and foreign exchange rates.

167

Understanding Foreign Exchange

Reading The Financial News Foreign Exchange Quotations A Sample Table of Foreign Exchange Rates U.S. $ % Change In U.S. $

1-Day

YTD

Per U.S. $

Americas Argentina peso

.3169

.16

- .2

3.1556

.594

- .57

- 5.4

1.6835

1.0105

.24

-.4

.9896

1-month forward

1.0098

.25

-.3

.9803

3-months forward

1.0085

.27

-.1

.9916

6-months forward

1.0065

.28

.9935

.00226

-.88

-11.2

442.48

.0005302

-.36

-6.5

1886.08

Brazil real Canada dollar

Chile peso Colombia peso Ecuador U.S. dollar

1

1

Mexico peso

.0924

- .18

-.8

10.8213

Peru new sol

.3519

- .31

-5.2

2.8417

Uruguay peso

.0483

- 3.9

20.7

.4662874

2.1446

- 6.5 - 2.6 - .2

1.0778 7.7842 40.4367

Venezuela b. fuerto

Asia-Pacific Australian dollar

.09278

- .27

China yuan

.1406

.08

Hong Kong dollar

.1285

India rupee

7.1114

.02473

.73

2.6

.0001104

.009724

.25

1-month forward

.009742

.25

3-months forward

.009771

.26

- 3.5 - 7.7 - 7.6 - 7.3

6-months forward

.009806

.29

- 6.8

101.98

.3158

- 4.2

3.1666

.7944

.14

- 3.5

1.2588

.01598

- .5

1.5

62.578

Indonesia rupiah Japan yen

Malaysia ringgit New Zealand dollar Pakistan rupee

9058 102.84 102.65 102.34

Philippines peso

.0246

.73

- 1.3

40.7

Singapore dollar

.7215

- .12

- 3.9

1.386

South Korea won

.0010442

.84

2.3

957.67

Taiwan dollar

.03256

- 5.3

30.713

Thailand baht

.03172

- .09

4.9

31.526

Europe Czech. Rep. koruna

168

.06132

- .2

- 10.3

16.308

Denmark krone

.2059

.24

- 4.9

4.8567

Euro area euro

1.5347

0.2

- 4.9

.6516

Hungary forint

.005782

.31

- .2

172.95

Understanding Foreign Exchange

U.S. $ % Change In U.S. $ Malta lira Norway krone

1-Day

YTD

3.4137

Per U.S. $ .2929

.1936

.77

- 4.9

5.1653

Poland zioty

.4302

.07

- 5.8

2.3245

Russia ruble

.04189

.19

- 2.8

23.872

Slovak Rep. koruna

.04738

- .7

- 8.3

21.106

.1632

.37

- 5.2

6.1275

.975

.3

- 9.5

1.0256

1-month forward

.9763

.32

- 9.3

1.0253

3-months forward

.9754

.33

- 9.1

1.0252

6-months forward

.9745

.37

- 8.6

1.0262

Turkey lira

.7892

.58

7.2

1.2513

U.K. pound

2.0146

- .24

- 1.4

.4964

2.01

- .24

- 1.2

.4975

3-months forward

2.0005

- .22

- .9

.4999

6-months forward

1.9857

- .22

- .5

.5036

Bahrain dinar

2.6527

.3

.377

Egypt pound

.1827

- 1.1

5.4726

Israel shekel

.2776

- .18

- 6.6

3.6023

Jordan dinar

1.4104

.709

Kuwait dinar

3.6823

- .7

.2716

Sweden krona Switzerland franc

1-month forward

Middle East/Africa

Lebanon pound

.0006634

- .3

1507.39

Saudi Arabia riyal

.2667

3.7495

South Africa rand

.1247

- .48

17.2

8.0192

UAE dirham

.2724

- .1

3.6711

The left-hand column of numbers shows how many U.S. dollars are exchanged for one foreign currency. The entries in this column indicate that on this particular day, it took just under 32 cents to buy one Argentinean peso and just under 60 cents to buy one Brazilian real. The center two columns indicate the percent change in the price of foreign currencies over the course of the last day and past year. Over the previous day, the value of an Argentinean peso rose by .16 percent meaning that it took .16 percent more American dollars to purchase a peso than it did the previous day. Relative to one year before, it took .2 percent more dollars to purchase a peso. The column furthest to the right shows how much foreign money exchanges for one U.S. dollar. One dollar would buy you 3.15 Argentinean

pesos and 1.68 Brazilian reals. Notice the two columns (the furthest left and the furthest right) are reciprocals—1 divided by .3169 is 3.1556 (Argentina). Major currencies have four different price quotations: the “spot” price, 1-month forward, 3-months forward, and 6-months forward. The spot price is what you pay to buy the money today. Forward prices are what you pay if you sign a contract today to acquire the money on a specific future date. Many business firms deal in the forward market for foreign currencies because they anticipate the need for foreign currencies to conduct their normal business. By contracting now to buy or sell foreign exchange at some date in the future, business firms avoid the risk that the foreign exchange rate might change.

169

Understanding Foreign Exchange

goods become more expensive for Argentineans, so we export less to them, hence they supply fewer pesos on the foreign exchange market. As drawn, the demand and supply curves for pesos imply an equilibrium price of 30 cents for one peso. At that exchange rate, the demand for pesos equals supply and our balance of payments shows neither a deficit nor a surplus (at least with respect to Argentina).

Why Do Exchange Rates Fluctuate? It is obvious from Figure 2, which shows historical movements in the exchange rate between the dollar and other major currencies, that exchange rates vary considerably over time. Although equilibrium occurs at the intersection of supply and demand curves as depicted in Figure 1, whenever those curves shift the equilibrium exchange rate will change. For example, Figure 3 shows that a rightward shift in the demand curve for pesos causes the price of pesos in terms of dollars to increase, say from 30 cents to 40 cents. This occurs because at the old equilibrium of 30 cents, the quantity of pesos demanded on the new demand curve is greater than the supply (there is an excess demand for pesos), forcing up the price of pesos. Figure 4 shows that a rightward shift in the supply curve for pesos causes the dollar price of pesos to decline, say from 30 cents to 20 cents, because at the old equilibrium of 20 cents there is a larger quantity of pesos supplied than is demanded (there is an excess supply of pesos). The key to understanding movements in exchange rates, therefore, is to identify the factors causing shifts in the supply and demand curves for foreign currency. At the most general level, whatever causes U.S. residents to buy more or less foreign goods (at every exchange rate) shifts the demand curve for foreign currency, while whatever causes foreigners to buy more or less U.S. goods shifts the supply curve of foreign currency. More specifically, we can identify three factors that influence long-run supply and demand conditions: 1. Relative Prices of U.S. versus Foreign Goods. Suppose prices of American motorcycles rise relative to Japanese bikes, so that a 1,200-cc Harley now costs more than a similar-size Yamaha. American bikers will switch to buying Yamahas (even though they make less noise), creating an excess demand for yen, driving up its price in terms of dollars. Thus the yen tends to appreciate and the dollar depreciates whenever U.S. price levels rise relative to foreign price levels, or more generally, whenever the rate of inflation in the United States exceeds foreign rates of inflation. 2. Productivity. Suppose U.S. computer companies discover a secret process to recycle your Sunday newspaper into a megabyte of RAM. They can lower prices relative to foreign competitors, which will increase the supply of foreign currency as foreigners buy more dollars to purchase our cheaper computers. Thus the dollar appreciates and foreign currency depreciates when U.S. productivity improves relative to foreign productivity.

170

Understanding Foreign Exchange

Canadian dollar per U.S. dollar 1.60 1.50 1.40 1.30 1.20 1.10 1.00 .90 .80

1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Year

(a) Canadian dollar per U.S. dollar. Euro per U.S. dollar 1.3 1.2 1.1 1.0 .9 .8 .7 .6 1999

2000

2001

2002

2003

2004

2005

2006

2007

2008 Year

(b) Euro per U.S. dollar. FIGURE 2

Recent exchange rate history between the U.S. dollar and other major currencies.

Note: Each of these charts shows the amount of foreign currency per U.S. dollar. Therefore, higher numbers mean a stronger dollar and lower numbers a weaker dollar.

171

Understanding Foreign Exchange

Japanese yen per U.S. dollar 375 325 275 225 175 125 75

1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Year

(c) Japanese yen per U.S. dollar.

British pound per U.S. dollar 1.0 .9 .8 .7 .6 .5 .4 .3

1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Year

(d) British pound per U.S. dollar. FIGURE 2

172

(continued ).

Understanding Foreign Exchange

Price of one peso in U.S. $

Supply of pesos

New equilibrium .40

Old equilibrium .30

Demand for pesos Demand for pesos

Quantity of pesos

Excess demand for pesos

FIGURE 3

A rightward shift in the demand curve for pesos raises the dollar price of pesos, implying an appreciation of the peso and a depreciation of the dollar.

Price of one peso in U.S. $

Supply of pesos Supply of pesos

Old equilibrium .30

New equilibrium .20 Demand for pesos

Excess supply of pesos

FIGURE 4

Quantity of pesos

A rightward shift in the supply curve of pesos lowers the dollar price of pesos, implying a depreciation of the peso and an appreciation of the dollar.

173

Understanding Foreign Exchange

IN THE NEWS Whistler Adjusts Prices to Lure Washington Skiers Back With the U.S. dollar now worth less than the Canadian dollar it’s getting harder for Americans to find a bargain on British Columbia slopes. The exchange rate used to soften the sticker shock on $83 Canadian day passes at Whistler Blackcomb. But as of Monday, that lift ticket would cost $83.90 U.S. if the resort had not decided to accept U.S. funds on par with Canadian. Brenton Murphy of Tourism Whistler says the declining U.S. dollar is one of the primary reasons Whistler is seeing the number of Washington visitors plateau this winter. ”We are losing some traction in the Washington market right now, and we are keeping our eye on that,” Murphy said. The United States accounts for one-third of Whistler’s tourists and Washington is the largest American market. Tourism Whistler does not release statistics, but

Murphy said visitors from Washington have increased annually since 2001 before flattening out this winter. ”We see the issues of the dollar, passport requirements and the rising cost of fuel as barriers to travel,” Murphy said. “We are trying to get out the message of value to travelers.” Murphy says Whistler has tried to create prepay bargain hotel/ski packages to keep up tourism traffic. Tourism Whistler has worked to get most of the village to accept U.S. money as if it were equal with Canadian. “We want to do whatever we can do to maximize the value and help offset those barriers to travel,” Murphy said. Source: Craig Hill, The News Tribune, Mar. 6, 2008. © Copyright 2008 Tacoma New, Inc. A subsidiary of the McClatchy Company. All Rights Reserved. Reprinted with permission.

3. Tastes for U.S. Versus Foreign Goods. Suppose foreigners decide that NCAA championship caps are more important to their wardrobe than the latest French designer fashions. This newly acquired taste increases the supply of foreign currency as foreigners buy dollars to purchase our hats. Thus the dollar appreciates and the foreign currency depreciates whenever there is a shift in preference for U.S. products. Inflation, productivity, and tastes are clearly at the root of the long-run movements in exchange rates such as depicted in Figure 2. By their nature, however, these factors change rather slowly over time, so that they cannot explain the often violent daily and weekly movements in exchange rates. For example, Figure 5 shows the considerable day-to-day volatility in major foreign exchange rates during 2007 and the beginning of 2008. At the root of the shortterm volatility in foreign exchange markets is the behavior of global investors seeking the highest return commensurate with risk.

How Global Investors Cause Exchange Rate Volatility Investment funds flow across national borders because U.S. citizens are free to purchase foreign securities and overseas investors can easily purchase U.S. securities. In this environment of capital mobility, investors compare the expected return on domestic securities versus foreign securities to determine which are more attractive. And whenever U.S. investors prefer foreign securities

174

Understanding Foreign Exchange

they must first go into the foreign exchange market to buy foreign currency. Similarly, when foreign investors prefer our securities they must first go to the foreign exchange market to buy dollars. Thus changes in preferences for foreign securities give rise to excess demand for or supply of foreign currency in the same way as varying preferences for hats and motorcycles. Only in this case expectations of future exchange rates play a central role in the decision making, so the entire process becomes somewhat more volatile. This is best illustrated by way of example. Suppose your school’s athletic department receives a $1 million gift to build an indoor tennis complex. After an appropriate celebration the president recommends that the university invest the funds for one year until the building plans are complete. The university’s treasurer considers investing in one-year U.S. Treasury securities earning 4 percent until she is told by the university’s investment adviser that Switzerland’s one-year treasury securities return 6 percent. Since each investment is a government bond, the treasurer is not concerned with default risk. And since these are both one-year securities, there is no uncertainty over how much each will produce in one year: 4 percent for the U.S. security; 6 percent for the Swiss security. The main difference is the U.S. security generates 4 percent more dollars while the Swiss security produces 6 percent more Swiss francs. Which is the better investment? To compare the return on the Swiss security with the return on the U.S. security, the treasurer must add or subtract the expected change in the exchange rate during the next year. For example, suppose the current exchange rate between U.S. dollars and Swiss francs (called the dollar/Swiss exchange rate) is 1.4 francs per dollar. To invest in one-year Swiss bonds the treasurer first converts $1 million into SF1.4 million (where SF stands for Swiss francs). At the end of one year the Swiss bond produces SF1.484 million (SF1.4 multiplied by 1.06 ⫽ SF1.484). If the treasurer can convert this back into dollars at the same 1.4 exchange rate, then the investment will generate $1.06 million (SF1.484 divided by 1.4 SF per $ equals $1.06). This is clearly better than buying U.S. Treasury securities that would return only $1.04 million. But what if the exchange rate in one year turned out different from where it started? Suppose the dollar appreciated over the year, say, by 3 percent. Then the extra 6 percent earned in Swiss francs would lose 3 percent when converted back into dollars at the end of the year, producing a return in dollars of approximately 6 percent minus 3 percent, for a net return of 3 percent.1 On the other hand, if the dollar depreciated by 3 percent over the year, the extra 6 percent earned in Swiss francs would gain another 3 percent when converted into dollars, producing a return in dollars of approximately 6 percent plus 3 percent, for a total return of 9 percent.

1The

precise calculation is as follows: The Swiss government securities generate SF1.484 million. But if the U.S. dollar appreciates by 3 percent, then the exchange rate at the end of the year is 1.442 francs per dollar (1.40 multiplied by 1.03). Dividing SF1.48 million by 1.442 produces $1.029 million—or a return of 2.9 percent on the $1 million investment.

175

Understanding Foreign Exchange

Canadian dollar per U.S. dollar 1.20 1.15 1.10 1.05 1.00 .95 .90 Jan. Feb. Mar. Apr. May June July Aug. Sep. Oct. Nov. Dec. Jan. Feb. Mar. 2007 2008 Month

(a) Canadian dollar per U.S. dollar.

Japanese yen per U.S. dollar 125

120

115

110

105

100 Jan. Feb. Mar. Apr. May June July Aug. Sep. Oct. Nov. Dec. Jan. Feb. Mar. 2007 2008 Month

(b) Japanese yen per U.S. dollar. FIGURE 5

176

Daily fluctuations in foreign exchange rates can be quite volatile (2008).

Understanding Foreign Exchange

Euro per U.S. dollar .78 .76 .74 .72 .70 .68 .66 .64 Jan. Feb. Mar. Apr. May June July Aug. Sep. Oct. Nov. Dec. Jan. Feb. Mar. 2007 2008 Month

(c) Euro per U.S. dollar.

British pound per U.S. dollar .53 .52 .51 .50 .49 .48 .47 Jan. Feb. Mar. Apr. May June July Aug. Sep. Oct. Nov. Dec. Jan. Feb. Mar. 2007 2008 Month

(d) British pound per U.S. dollar. FIGURE 5

(continued ).

177

Understanding Foreign Exchange

The moral of the story is that a comparison of returns on domestic investments with returns on foreign investments must incorporate an expected appreciation or depreciation of the foreign currency. In our particular case, if the dollar is expected to depreciate relative to the Swiss franc, U.S. investors (and Swiss investors) will prefer to invest in Swiss government bonds. This will lead to an excess demand for francs and an excess supply of dollars on the foreign exchange market. This means the franc will, in fact, appreciate and the dollar will depreciate. On the other hand, if the dollar is expected to appreciate a lot (by more than the 2 percent interest rate differential in our example), U.S. investors (and Swiss investors) will prefer U.S. Treasuries. This will lead to an excess demand for dollars and an excess supply of francs on the foreign exchange market, implying that the franc will, in fact, depreciate and the dollar will appreciate. This example suggests that the equilibrium foreign exchange rate is sensitive to investor expectations of future movements in exchange rates. Since these expectations might be quite unstable and susceptible to change, it is not surprising to observe considerable volatility in actual exchange rates.

Fixed Versus Floating Exchange Rates Volatility in foreign exchange rates represents a cost of doing business internationally. For many years governments tried to avoid that cost by fixing exchange rates at some predetermined level. A system of fixed exchange rates was maintained globally from 1944 until the early 1970s under the supervision of the International Monetary Fund (IMF). When that system collapsed it was resurrected with a more limited scope in 1979 for the major European countries. The European Monetary System (EMS) operated quite smoothly until 1992, when a number of countries, such as the United Kingdom and Italy, were forced to abandon the system and allow their currencies to float freely. The ultimate example of the fixed exchange rate is the new euro. Introduced in January 1999, the euro is the common currency of the 12 members of the European Monetary Union (Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, The Netherlands, Portugal, and Spain). Individual national currencies were used for cash transactions until January 2002. Now there’s only the euro.

How Fixed Rates Are Supposed to Work Under floating exchange rates, if a country runs a balance-of-payments deficit, the supply of its money offered on world financial markets exceeds the demand, and its money depreciates in value relative to other monies. But with fixed exchange rates, as they existed from the end of World War II until 1973, fluctuations in exchange rates were stopped before they could get started.

178

Understanding Foreign Exchange

In the News Let China’s Yuan Float For years, the Chinese government has resisted calls from American politicians to allow its currency to rise against the dollar. Those calls are getting louder again and Chinese leaders remain deaf to the advice. However, the advice is good, even if it’s not well-intended. China’s exchange-rate policy has begun to outlive its usefulness. For the benefit of China’s own economic interests, now is the right time for Beijing to manage a much quicker and sharper currency revaluation. Until very recently, China had good reasons to keep the peg in place. The yuan’s undervaluation has fueled the nation’s economic boom: Exports have shot up, the current surplus has expanded explosively and foreign reserves have skyrocketed. Chinese manufacturers, aided by a super-competitive currency, have rapidly gained market share around the world. Chinese exports accounted for less than 3 percent of global trade in 1997. Today, the figure is close to 9 percent.

Under a floating exchange-rate regime, the Chinese currency would have appreciated sharply to reflect China’s strong economic growth and high productivity gains, but that would have slowed growth to more normal rates. With such success, it is perfectly understandable that the Chinese government has been very cautious in allowing any significant currency appreciation. However, economic and financial circ*mstances are changing. The Chinese currency actually has fallen sharply, along with the U.S. dollar, since 2002 because the yuan has been pegged to the greenback. This rather perverse move has led to a massive undervaluation of the yuan, probably by about 30 percent, relative to the euro and the yen. Source: Chen Zhao, Barron’s, June 25, 2007, p. 47. Reprinted with permission of Barron’s. Copyright © 2007, Dow Jones & Company, Inc. All Rights Reserved Worldwide.

By international agreement, under the supervision of the International Monetary Fund, a deficit country that saw its money start to depreciate had to step in promptly and prevent the decline. How? By buying up its own money in order to absorb the excess of supply over demand at the pegged exchange rate. As an illustration, say Britain is initially in a situation where the supply of and demand for pounds is equal, so that the foreign exchange rate is in equilibrium. Suddenly the British people decide they no longer like British sherry and Yorkshire pudding but prefer American soda pop and Twinkies, which they begin to import in huge quantities. As Figure 6(a) shows, this change in tastes would shift the entire supply curve of pounds to the right, as the British offer more pounds (at every exchange rate) to buy the increased number of dollars they need to pay American soda pop and Twinkies exporters. At the old equilibrium exchange rate, Britain now has a deficit in its balance of payments, which translates into a supply of pounds greater than the demand. With exchange rates free to fluctuate, the pound will depreciate and move down toward a new lower equilibrium level. In Figure 6(b) however, the rate is fixed, or pegged, at an agreed-upon level. Again the shift in the supply curve results in an excess supply of pounds at the old equilibrium exchange rate. Now, though, the British central bank steps in and buys up this excess, thereby preventing the pound from depreciating.

179

Understanding Foreign Exchange

Price of one pound in U.S. $

Supply of pounds

Supply of pounds

Old equilibrium

New equilibrium Demand for pounds

Quantity of pounds (a)

Price of one pound in U.S. $

Supply of pounds

Supply of pounds

Peg

Demand for pounds

(b)

FIGURE 6

180

Excess supply of pounds

Quantity of pounds

In (a), with floating rates, the pound depreciates; in (b), with pegged rates, the British central bank prevents the decline by buying up the excess supply of pounds.

Understanding Foreign Exchange

Of course, the British central bank can’t buy up its own money by offering more of the same in exchange—which it could simply print—because that’s what people are selling, not buying. It has to use other money to buy up its own, and this other money is called its international reserves. Traditionally, nations held their international reserves in the form of gold, because of its general acceptability. Since the end of World War II, however, most foreign countries have held a substantial portion of their reserves in the form of U.S. dollars, which generally have been just about as acceptable as gold in making international payments. They also held other kinds of “foreign exchange” among their reserves—most notably Japanese yen and German marks. Now, of course, they’ll hold euros. In general, countries use their international reserves in the same way individuals and businesses use their cash balances—to bridge temporary gaps between the receipt and expenditure of funds, to tide them over periods when inflows of funds are slack, and to meet unexpected or emergency needs. But with a system of fixed exchange rates, countries must use their international reserves to intervene in foreign exchange markets whenever the value of their money threatens to slide away from its agreed-upon fixed value.

International Financial Crises A major difficulty with the fixed rate system is that it contains no self-correcting mechanism to help eliminate a country’s balance-of-payments deficit and bring about an equilibrium in its exchange rate. With floating rates, a currency such as the pound is allowed to depreciate, which then eliminates the downward pressure on the pound. But if no depreciation is allowed, Britain must continue to pay out its reserves to buy up excess pounds—and that’s the catch. Britain’s foreign exchange reserves are not infinite. Sooner or later, when it starts to run out of reserves, it will have to stop “defending the pound.” In international financial terminology, Britain will have to devalue the pound, that is, lower its agreedupon value. At the new lower value, the deficit will disappear, or so it is hoped. If not, they may have to devalue again; that is, once more lower the international value or price of the pound. Once the international financial community senses that devaluation is a possibility, no matter how remote, it is likely to take actions that increase the probability of its occurrence. People who own pounds, or liquid assets payable in pounds, and suspect that the pound may be devalued would be inclined to get out of pounds and into some other kind of money—say, Swiss francs—until the devaluation has been completed. Then, with the francs, they could buy back more pounds than they originally had. Such “speculative” sales of pounds by private holders must of course be purchased by the British monetary authorities, as they try to prevent the pound from depreciating. This puts an added strain on their reserves, thereby increasing the likelihood of devaluation which, in turn, stimulates renewed “speculative” activity. The collapse of the Indonesian rupiah and the Thai baht during 1997, and the

181

Understanding Foreign Exchange

tumultuous end of Argentina’s ten-year fixed exchange rate in 2002, are clear examples of the difficulty of maintaining fixed rate exchanges. Since devaluations are an ever-present fact of life under a fixed exchange rate system, countries with balance-of-payments deficits were viewed with some suspicion by those who manage large pools of mobile funds—treasurers of multinational corporations, bankers, oil sheiks, financial consultants to private investors, and others with similar responsibilities. Indeed, fund managers often got nervous about holding a country’s money as soon as that country’s rate of inflation exceeded that of other countries, since, as we saw earlier, a faster rate of inflation leads to a depreciating currency. Despite the difficulties inherent in a fixed exchange rate system, governments have found it nearly impossible to follow a hands-off policy with respect to exchange rates. Although the industrialized countries have permitted most major exchange rates to float since the early 1970s, there are frequent interventions by central banks trying to nudge exchange rates one way or another. This system has been dubbed managed floating, but that hardly describes what’s really going on. The foreign currency markets are simply too big for anyone to manage, including the world’s central banks. And if it looks as though the central banks are having their way, it’s probably because the marketplace was going in that direction anyway.

SUMMARY 1. Our payments abroad create a demand for foreign exchange (which can also be viewed as a supply of dollars). Payments from foreigners to us create a supply of foreign exchange (or a demand for dollars).

2. An international balance of payments is an accounting record of all payments made across national borders. A deficit in our balance of payments creates a demand for foreign exchange greater than the supply, leading to appreciation in the value of foreign exchange. Alternatively, we could say that it leads to depreciation of the dollar. A surplus in our balance of payments creates a supply of foreign exchange greater than the demand, leading to depreciation in the value of foreign exchange. Alternatively, we could say that it leads to appreciation of the dollar.

3. Differential movements in the rate of inflation, changes in tastes, and differences in productivity account for the long-run movements in exchange rates. The short-run volatility of exchange rates is caused by global investors seeking the best international investments.

4. If foreign exchange rates are free to respond to market forces, movements in exchange rates should eliminate both deficits and surpluses. With fixed exchange rates, a deficit country must intervene and buy up its own money to prevent its depreciation on the foreign exchange market. It uses its international reserves for this purpose, but the process ends when a country runs out of reserves. International financial crises tend to develop under fixed rates when fears of devaluation lead to speculative dumping of a country’s money.

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Understanding Foreign Exchange

KEY TERMS appreciate

euro

foreign exchange rate

balance of payment

European Monetary System (EMS)

International Monetary Fund (IMF)

European Monetary Union

international reserve

capital account current account deficit depreciate devalue

managed floating

fixed exchange rate floating exchange rate

QUESTIONS Questions with a red oval are in

at www.myeconlab.com.

10.1

Assume that you are back in a system of fixed exchange rates and that you own a lot of Mexican pesos. A rumor starts circulating that Mexico will soon devalue the peso. What will you do? Why?

10.2

What will happen to the dollar/euro exchange rate if Europeans decide to dump a lot of the U.S. securities they have purchased over the years?

10.3

Under a system of fixed exchange rates, how did countries keep the rates fixed? Why is that so difficult?

10.4

Why do expected movements in foreign exchange rates influence the investment decisions of global investors?

10.5

If the Japanese yen appreciates relative to the dollar, are you more likely to buy a new Ford or a Toyota?

10.6

If the Brazilian government prints substantially more reals, what will happen to the dollar/real exchange rate?

10.7

Discussion question: Explain why the dollar declined relative to the Canadian dollar and the euro during 2007.

183

184

The Nature of Financial Intermediation

It is virtually impossible to spend or save or lend nowadays without getting involved with some kind of financial intermediary. We’ve explained briefly why intermediaries are such pervasive phenomena. Now it’s time to dig a little deeper into the nature of these institutions. We begin by examining the economics underlying financial intermediation. Our objective is to understand why these institutions exist in the first place and where they fit in the overall financial landscape. Using this framework we then take a look at how intermediaries have evolved in the United States over the past 50 years and explore the dynamic forces driving their development. We conclude by analyzing how the economic role performed by these institutions translates into a specific set of managerial challenges.

LEARNING OBJECTIVES In this chapter you will learn to explain the benefits of financial intermediation and how it partially solves the adverse selection and moral hazard problems understand the role and history of commercial banking in the United States describe the nondeposit financial intermediaries

The Economics of Financial Intermediation From the vantage point of Adam Smith, it is difficult to explain the existence of financial intermediaries. More specifically, applying the principles of perfect markets to the financial sector means that buyers and sellers of securities can

From Chapter 11 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

185

The Nature of Financial Intermediation

transact with each other without cost, that securities are infinitely divisible (bonds, stocks, and so on, can be bought in any denomination), and that buyers and sellers of financial instruments know the true quality of what they are buying and selling. Thus in a world where markets are perfect, there seems little reason for financial intermediaries to exist—who needs a middleman? From this perspective, it seems logical to attribute the existence of financial intermediaries to so-called market imperfections, especially transactions costs. In the fanciful world of perfect markets, funds would flow effortlessly from lenders to borrowers through the financial markets in exchange for traded securities. However, when small savers and small borrowers are involved, the transactions costs associated with selling securities in small amounts are often prohibitively expensive. It would take a lot of time, for example, for small savers to look through the Yellow Pages to find small borrowers to lend money to. Instead, small savers give their money to banks, then banks give that money to small borrowers, and all the small savers and borrowers involved are better off because they avoid a major transaction cost— the cost of searching. Thus banks and other financial intermediaries reduce transactions costs—a boring job, but somebody has to do it! Portfolio diversification is another important function of financial intermediaries. The principle of not putting all your eggs in one basket implies that investors should hold many different securities to spread out their risk exposure. More formally, modern portfolio theory emphasizes that investors are only compensated for the risk that remains after diversifiable risk has been eliminated in a large portfolio. The direct implication is that prudent investors should hold widely diversified portfolios. This can be difficult if an investor has only a few thousand dollars to invest. Along come financial intermediaries that make it easy and simple to hold financial claims backed by many different securities. More specifically, a stock index mutual fund is an intermediary that offers small investors a way to participate in the performance of the stock market as a whole, thereby benefiting from diversification with all available securities. But there are even more fundamental forces underlying the role of financial intermediaries than just greasing the wheels of finance and providing an easy way to diversify (although these surely are important). Financial intermediaries are major contributors to information production. Specifically, many intermediaries are in the business of producing information about borrower creditworthiness. The need for this information arises because of public enemy number one: asymmetric information. Asymmetric information occurs when buyers and sellers are not equally informed about the true quality of what they are buying and selling. The asymmetry typically runs in the same direction—the seller knows more than the buyer. With respect to financial instruments, asymmetric information refers to the security issuer (borrower) having more information than an investor (lender) about the issuer’s (borrower’s) future performance. A survey of commercial bankers conducted by your favorite textbook authors during spring vacation showed not a single reported instance of a

186

The Nature of Financial Intermediation

borrower warning a loan officer, “I am really much riskier than you think. Please charge me a higher interest rate, make me pledge more collateral, and do not lend me as much money as I am requesting.” Instead, borrowers tend to understate their risk and make promises they may not keep. This would not pose a problem if a borrower’s true quality was always obvious. Unfortunately, it often is not. This is particularly true in the case of loans to consumers and small businesses where lenders are typically at a huge informational disadvantage. Asymmetric information is much less of a problem for large businesses because there is so much publicly available information about their quality and behavior. Asymmetric information occurs in two forms, adverse selection and moral hazard. Adverse selection arises before a financial transaction is consummated. For example, adverse selection is related to information about a business before the bank makes the loan. All small businesses tend to represent themselves as high quality (that is, low risk) despite the fact that bankers know that some are good and some are bad. However, in the absence of information about exactly who is good and who is bad, bankers face a problem. On the one hand, if they charge too high an interest rate, the good borrowers may withdraw from the loan market, leaving only the bad borrowers. On the other hand, if bankers charge too low a rate they will lose more money on their bad borrowers than they will make on their good borrowers. In the worst case scenario, bankers may decide not to lend to any small business who seeks credit. This is known as market failure. Moral hazard arises after a financial transaction is consummated. It arises because borrowers covertly engage in activities that increase the probability of

GOing Out on A Limb Lemons and MP3 Players: Two Examples of Adverse Selection George Akerlof, the 2001 winner of the Nobel Prize in economics, employed a market for used cars to demonstrate adverse selection. Imagine that two types of used cars exist: good cars and lemons (cars that look like good cars but have mechanical problems). A good car is valued at $2,000 and a lemon is valued at $1,000. While sellers of the cars know if their car is good or a lemon, potential buyers of the car do not. Because buyers cannot distinguish between good cars and lemons, sellers will make each car look like a good one and charge $2,000 for each car. Since buyers know some lemons exist, they will be unwilling to pay $2,000 for an unknown car and, in turn, sellers will choose not to sell their

good cars (since they are worth $2,000). This leaves only lemons for sale and a breakdown in the used car market. eBay is having similar troubles with adverse selection. It is common for unscrupulous sellers on eBay to sell hacked MP3 players that report the operating system has more memory than actually exists. Since there is no way for the buyer to know if the player is hacked or not prior to purchasing it, the “good” nonhacked MP3 players are driven out of the market by less expensive, hacked players. This problem is solved only after the transaction takes place and the buyer leaves angry feedback that serves as information for future buyers to identify the seller of lemon MP3s.

187

The Nature of Financial Intermediation

poor performance. For example, a small business borrower may deliberately choose riskier projects after receiving a bank loan. At first blush this may seem surprising. Why would a small business take on more risk when that would necessarily increase its chances of defaulting on the loan and going bankrupt in the process? Simply put, the reason is that owners share disproportionately in the upside potential while lenders share disproportionately in the downside. To see this, note that a lender is no better off when a business is a modest success than when it is a big success because the lender receives only principal and interest. The owner, however, is much better off when the company is a big success than when it is a modest success because the owner gets to pocket all of the big profits. On the other hand, the owner loses the same amount whether the company is a moderate disaster or a major disaster. And that is because with limited liability the owner can lose only the equity that was put in, and no more. Thus, as a result of the way owners and lenders participate in success and failure, taking on more risk works to the owner’s advantage. Naturally enough, this asymmetry is likely to keep lenders awake at night figuring out how to protect themselves.

In the News Housing Tilting Economy Down A curious phrase, moral hazard, gained popularity last year in arguments about the economy and financial market outlook. Investors and everyone else would be better off if the notion returned to obscurity this year, but that’s unlikely. Instead, fear of moral hazard will influence your investment choices and their chances for success. So, it will pay to understand it. “Moral hazard is a term that originated in the insurance industry,” said George Kaufman, professor of finance at Loyola University Chicago and a veteran observer of economic trends and the banking system. “If you do not bear the full cost of your actions, you are going to act differently, so that if you have fire insurance, you’re not going to be as concerned about putting up smoke detectors and fire alarms, and if you have theft insurance, you are not going to be so concerned about locking your door.” Two important points emerge. First, moral hazard isn’t about morality any more than any concept in the world of capitalism. Second, the hazard is perceived by the insurer, not by the policyholder.

188

The concept emerged last year in response to actions by the Federal Reserve and Congress to address the housing bust. Critics asserted that by cutting interest rates and making loans cheaper earlier this decade, the Fed under former Chairman Alan Greenspan gave speculators license to take undue risks with their money and with money held in trust in pension funds. Likewise, we’re told that easymoney policies encouraged ordinary Americans to load up imprudently on home mortgages, which inflated home prices to an unsustainable bubble. Now, it seems, the Fed under Chairman Ben Bernanke is bailing out speculators, and Congress is debating legislation that would rescue home buyers who can’t pay their debts. Moral hazard suggests we’ll get more speculators and deadbeats as a result. In sum, proposals of government action to prevent or reduce economic suffering are denounced glibly as creating moral hazard. Source: Bill Barnhart, McClatchy—Tribune Business News, Jan. 7, 2008.Excerpted with permission of the Chicago Tribune, copyright Chicago Tribune, all rights reserved.

The Nature of Financial Intermediation

In the absence of solutions to the adverse selection and moral hazard problems, lenders will simply make considerably fewer loans to individuals and small businesses. More information, however, solves the problem. And in most cases, it is financial intermediaries that become specialists in the production of this additional information—both at the loan origination stage to address the adverse selection problem, and after lending the money by monitoring borrowers to address the moral hazard problem. Financial intermediaries use information in conjunction with tailor-made financial contracts designed to help them sort out the good from the bad (and the ugly) before any money is lent—and to provide appropriate incentives for responsible borrower behavior afterward. Sometimes these contracts can be quite restrictive. For example, a bank might restrict a corporate borrower from making a substantial investment in new equipment without the bank’s permission. However, as the bank develops a relationship with the borrower by monitoring the borrower’s performance over time, it may grant permission if the borrower has done well and can justify the investment. But why is it that information production is delegated to financial intermediaries? Why don’t individual investors produce their own information about borrowers instead of intermediaries? The principal reason is that financial intermediaries enjoy economies of scale in information production. Suppose a small business wants to borrow $1 million. It could go to 100 small saver-lenders and borrow $10,000 from each. However, each of these savers would have to evaluate the borrower and each one would incur the cost of information production. Suppose this cost is $4,000 per evaluation. Then the total cost of information production, 100 * 4,000 = $400,000, would most likely be prohibitive. On the other hand, if these 100 small savers each deposited $10,000 in a bank and delegated to the bank the responsibility for evaluating the borrower, then information would have to be produced only once, by the bank. Thus total information production costs are reduced from $400,000 to $4,000, and the bank becomes the sole lender. Because the financial intermediary has the exclusive use of the information it has produced, it also makes sense to delegate the responsibility of monitoring borrower behavior over the life of the loan to the intermediary. Thus it is not surprising that bank loans, for example, are nontraded financial contracts that are held by the bank until maturity so that the bank can keep a close watch on its money until the end of the loan. The role of financial intermediaries can be summarized in the flow of funds diagram in Figure 1. When saver-lenders invest directly in the financial markets by purchasing securities issued by borrower-spenders that can be resold on secondary markets (which we call traded securities), Case III applies. Borrowers (issuers) in this market are well-known entities, such as large companies or federal and municipal governments, with an abundance of publicly available information. However, other borrowers, such as individuals

189

The Nature of Financial Intermediation

Case I

Indirect finance Financial intermediaries $

Nontraded contracts $

Saverslenders

Borrowersspenders

Financial markets Direct finance

Case II

Indirect finance Financial intermediaries $

Saverslenders

Borrowersspenders

$

$ Financial markets

Traded contracts

Direct finance

Case III

Indirect finance Financial intermediaries

Saverslenders

Borrowersspenders $

$ Financial markets Direct finance

FIGURE 1

190

Flow of funds from savers to borrowers.

Traded contracts

The Nature of Financial Intermediation

and smaller businesses are information problematic. They can obtain funding only from financial intermediaries that specialize in information production. Case I applies for them, where savers delegate to financial intermediaries the responsibility for information production and for the design of nontraded financial contracts. Financial intermediaries also exist to facilitate diversification and reduce transactions costs. They can do this under Case I, in conjunction with buying nontraded financial contracts, or in conjunction with buying traded securities, where Case II applies. Interestingly, some financial intermediaries exist strictly for purposes of diversification and reduction of transactions costs under Case II, such as the money market mutual fund, while other financial intermediaries buy both traded and nontraded financial instruments and exist for all three reasons, such as a commercial bank (where both Case I and Case II apply).

The Evolution of Financial Intermediaries in the United States Having examined the economic theory of financial intermediation, it is now time for us to survey the landscape and identify the institutional players. Rather than starting off by describing what financial intermediaries look like today, it is more revealing to see how financial intermediaries have evolved over the past half century. We discover that these institutions are quite dynamic. While the fundamental reasons for their existence (information production, diversification, and transactions cost reduction) have not changed, the form and mix of financial intermediaries has changed rather dramatically. The evolution of financial intermediation in the United States is reflected in Tables 1 and 2. Table 1 shows the major financial intermediaries by dollar assets and Table 2 by percentage share from 1960 to 2007. To the extent that we can view the pace of financial intermediation as a horse race, there seem to be clear winners and losers. For example, in terms of relative importance (Table 2) the winners are mutual funds, pension funds, and money market mutual funds. Savings and loan associations (S&Ls) and mutual savings banks (sometimes referred to, along with credit unions, as thrift institutions) are obviously big losers. The banking industry also appears to have fared poorly along with, though to a lesser extent, the life insurance industry. Tables 1 and 2 raise some interesting questions. For instance, what caused the change in the mix of financial intermediaries? How do these changes reflect the fundamental economics of financial intermediation? And are these changes interrelated in any way, and what do they portend for the future? It turns out that the profitability of financial intermediaries has been significantly influenced by a number of environmental factors—specifically, a

191

The Nature of Financial Intermediation

TABLE 1

Financial Intermediary Assets in the United States, 1960–2007 (in billions of dollars) 1960 1970

1980

1990

2000

2007

Depository institutions Commercial banks

229

517

1,482

3,338

6,469

11,194

Savings and loans and mutual savings

112

253

792

1,358

1,218

1,815

6

18

68

217

441

760

116

201

464

1,367

3,136

4,984

26

51

182

533

862

1,381

41

123

495

1,566

4,490

5,842

Credit unions Insurance companies Life insurance Property and casualty Pension funds Private Public (state and local government) Finance companies

20

60

197

820

2,293

3,152

28

64

197

547

1,445

1,911

23

53

70

654

4,433

7,798

Mutual funds Stock and bond Money market Total

76

498

1,812

3,053

601

1,340

4,023

10,898

26,202

41,890

Note: Columns may not add due to rounding.

Source: Federal Reser ve Flow of Funds Accounts.

series of economic “shocks,” changing regulatory barriers, and key financial and technological innovations. Rather than simply chronicling these events, we will examine this evolutionary process via three overriding themes: (1) the shifting sands of interest rates, (2) the institutionalization of financial markets, and (3) the transformation of traditional banking.

The Shifting Sands of Interest Rates The period encompassing the 1950s and early 1960s is often thought of as the age of innocence. Cars had big engines. Motorcycle riders didn’t wear helmets. Rock and roll spawned songs about Peggy Sue and dances like the Peppermint Twist. Life was simple. And so was the world of finance. Interest rates were stable. Federal Reserve regulations imposed ceilings on deposit rates so that banks and thrifts had little competition for the short-terms funds provided by small savers. Managers of these institutions also had things easy. Go to work at 9:00 A.M. Make a mortgage or business loan by noon. Play 18 holes of golf in the afternoon. The only challenge in banking was finding a way to put all those cheap deposits to work.

192

The Nature of Financial Intermediation

TABLE 2

Share of Financial Intermediary Assets in the United States, 1960–2007 (percent) 1960 1970

1980

1990

2000

2007

Depository institutions Commercial banks

38.1

38.6

36.8

30.6

24.6

26.7

Savings and loans and mutual savings

18.7

18.9

19.7

12.5

4.5

4.3

1.0

1.3

1.7

2.0

1.6

1.8

19.3

15.0

11.5

12.5

12.0

11.9

4.4

3.8

4.5

4.9

3.0

3.3

6.8

9.2

12.3

14.4

17.0

13.9

Credit unions Insurance companies Life insurance Property and casualty Pension funds Private Public (state and local government) Finance companies

3.3

4.5

4.9

7.5

8.7

7.6

4.6

4.8

4.9

5.0

5.4

4.6

3.9

4.0

1.7

6.0

16.8

18.6

Mutual funds Stock and bond Money market Total

0.0

0.0

1.9

4.6

6.8

7.2

100.0

100.0

100.0

100.0

100.0

100.0

Note: Columns may not add due to rounding.

Source: Federal Reser ve Flow of Funds Accounts.

By the mid-1960s, however, this comfortable world began to change. As the economy grew, loan demand grew with it—demand for mortgages, demand for consumer loans, and demand for business loans. As a result, the amount of total loans as a percentage of bank assets jumped from approximately 45 percent in 1960 to nearly 60 percent by 1980. Thus the challenge in banking shifted from finding enough loans to finding enough deposits to satisfy an increasing loan dermand. Meeting this challenge initially was the typical good news–bad news phenomenon. The bad news was that the interest rate environment for deposits became increasingly unstable. The good news was that depository institutions still enjoyed the protection of deposit rate ceilings under the Federal Reserve’s Regulation Q, which was designed to insulate intermediaries from interest rate competition. The Regulation Q Security Blanket Regulation Q gave the Federal Reserve the responsibility of imposing ceilings on deposit rates. The intent of the regulation was to promote stability in the banking industry by preventing “destructive competition” among despository institutions trying to outbid each other by offering increasingly higher deposit rates. The fear was that the

193

The Nature of Financial Intermediation

resulting higher cost of funds would lead to more bank and thrift failures and increase the chances of a systemwide banking panic, such as had occurred during the Great Depression. The consequences of Regulation Q were somewhat different. When shortterm market interest rates exceeded Regulation Q ceilings, money market instruments, such as Treasury bills and commercial paper, became more attractive investments than deposits. Small savers, however, were out of luck because these money market instruments were not sold in small denominations. Wealthy individuals and corporate depositors, on the other hand, who could afford to buy money market instruments led the exodus from deposits, in a process known as financial disintermediation. The Birth of the Money Market Mutual Fund Figure 2 traces the history of short-term interest rates (represented by the three-month Treasury bill rate) and the Regulation Q ceiling on bank passbook savings accounts from 1950 to 2007. While market rates occasionally exceeded Regulation Q ceilings in the 1950s, these periods tended to be brief, and the differences between market rates and the Regulation Q ceilings were not that large. Thus hardly anyone noticed when the first crack in Regulation Q appeared in 1961 as banks offered negotiable certificates of deposit (CDs) that escaped Regulation Q because they were issued in denominations of $100,000 or more. However, when interest rate volatility escalated in the mid-1960s, wealthy investors switched from savings

Interest rates 18 16 14 12

3-month Treasury bill rate

10 8 6

Reg. Q passbook ceiling rate

4

Ceiling ends

2 0 1950

FIGURE 2

1955

1960

1970

1975

Interest rates and Regulation Q.

Source: Federal Reser ve Bulletin.

194

1965

1980

1985

1990

1995

2000

2005 Year

The Nature of Financial Intermediation

accounts to large CDs; and when interest rates soared in 1969, banks found still other loopholes to Regulation Q, such as issuing commercial paper through their holding companies and obtaining funding with Eurodollar deposits (dollar-denominated deposits held abroad). But it was the invention of the money market mutual fund in 1971 that put the nail in Regulation Q’s coffin. In a money market fund, small investors pool their funds to buy a diversified portfolio of money market instruments, such as Treasury bills, commercial paper, and negotiable CDs, that would otherwise be inaccessible because they are sold only in large denominations. The fund pays its investors the interest earned on its investments less a small management fee. Investors can withdraw their funds at any time: Most funds even offer limited withdrawal by check. Thus for the first time, small savers had easy access to money market interest rates as an alternative to Regulation Q-constrained bank deposits. This new investment vehicle for the small saver permanently altered the financial landscape. The Savings and Loan Crisis Figure 3 shows that in the late 1970s the growth in money market mutual funds accelerated as small savers shifted funds out of

$ Billions 3,500

3,000 Money market mutual funds

2,500

2,000

1,500

1,000

Commercial paper

500

0 1970

FIGURE 3

1975

1980

1985

1990

1995

2000

2005 Year

Commercial paper and money market mutual funds (billions of $ outstanding).

Source: Federal Reser ve Flow of Funds Accounts, various.

195

The Nature of Financial Intermediation

banks and thrifts in response to rising market interest rates. For S&Ls, this marked the beginning of a disaster because, unlike banks, they were almost entirely dependent on small savers for their funds. To stem the tide of deposit withdrawals, Congress dismantled Regulation Q in the Depository Institutions Deregulation and Monetary Control Act of 1980 (refered to as DIDMCA, which sounds ridiculous if you try to pronounce it) and the Garn–St. Germain Depository Institutions Act of 1982.1 Junking Regulation Q, however, was another good news–bad news situation. The good news was that it allowed the S&Ls (as well as other depository institutions) to compete for funds as money market rates skyrocketed (see Figure 2) in the early 1980s. The bad news was that S&Ls had been induced by regulations to invest primarily in long-term (usually 30-year) fixed-rate residential mortgages. Thus, S&Ls were stuck with mortgages made in the 1970s or earlier, most of which were earning less than 8 percent, while they were renewing their short-term deposits at rates that were nearly double that. By 1980 the rate spread between the average yield on assets and the average cost of funds for the S&L industry had turned from a positive number, where it represented profits, to a negative number, where it generated losses. More importantly, as a result of rising rates and the structure of S&L balance sheets, the value of S&L assets fell below the value of liabilities, making the industry economically insolvent. To see this, recall that bond values decline when interest rates rise, with longer maturities suffering larger declines for any given increase in rates. The mortgages held by S&Ls behaved like long-term bonds, so that market values plummeted as mortgage rates rose from 8 percent to more than 16 percent. There was little benefit on the liability side of S&L balance sheets because S&Ls had issued very few long-term deposits, so they failed to lock in the old low rates. How badly were the S&Ls underwater? Estimates by academics at that time indicate that the industry had a negative net worth of as much as $150 billion by the end of 1981.2 However, these academic estimates were largely ignored by

1Regulation

Q was not eliminated immediately but was phased out over time. The DIDMCA specified a six-year phaseout. In addition it authorized NOW (negotiable order of withdrawal) accounts nationwide. (“Invented” in 1970, NOW accounts exploited a technical loophole in Regulation Q that permitted interest on what, for all practical purposes, was a checking account. However, federal legislation had limited these accounts to New England.) The Garn–St. Germain Act accelerated the phase-out period started by the DIDMCA and provided for the immediate introduction of the money market deposit account (MMDA). The MMDA is a deposit which pays a money market–linked interest rate and offers limited checkability. Its introduction had an immediate and dramatic impact. Bank MMDAs grew from zero in December 1982 when they were first permitted to $340 billion by April 1983. 2See

Table 2 in Edward J. Kane, “The Role of Government in the Thrift Industry’s Net-worth Crisis” in Financial Services: The Changing Institutions and Government Policy, edited by George J. Benston (New York: Prentice Hall, 1983). Kane notes that this estimate was subject to several upward biases, most notably that it did not incorporate a maturity distribution for mortgage portfolios. He cites one other study made at the time, however, that attempted to correct for these biases and still estimated losses at approximately $100 billion.

196

The Nature of Financial Intermediation

the regulatory and financial communities. Instead, the general perception in the early 1980s was that the S&Ls were just suffering from a short-run hiccup in profitability. After all, only 11 S&Ls were closed in 1980. Depositors were not concerned, moreover, because they were insured by an agency of the federal government, the Federal Savings and Loan Insurance Corporation (FSLIC). How could just about everyone have been so much in the dark about the industry’s insolvency? In great part the answer has to do with the rules governing S&L financial statements (no doubt your favorite subject). Instead of showing a huge negative net worth, the industry’s collective financial statement showed a positive net worth of more than $30 billion because S&L financial statements were constructed on an historical cost basis, meaning that any loss in the market value of a mortgage was not recorded unless the mortgage was actually sold by the S&L. Not surprisingly, very few mortgages were sold under such conditions, hence losses went unreported and undetected. Essentially the S&L industry crisis was managed as a big gamble. If interest rates fell soon enough the whole problem would disappear, except for a year or two of losses from the negative interest-rate spread. To allow the S&Ls to buy some time, Congress passed the Garn–St. Germain Act, which freed S&Ls to invest in higher yielding consumer loans, business loans, construction loans, real estate equity, junk bonds, and more. Thus the S&Ls were permitted to invest in areas in which they had little expertise. And, like gamblers deep in debt, they had every incentive to bet on a long shot by investing in these risky assets in hopes that a big payoff would offset the monumental, but unreported, economic losses they had suffered in their mortgage portfolios. How did the gamble turn out? Interest rates eventually came down, but not until the mid-1980s, and by then it is not surprising that S&Ls racked up huge losses on their risky new investments. After all, what did S&Ls know about junk bonds? The general public became aware of the problem in 1986, as the Reagan administration sought $15 billion in Congressional funding—only a fraction of what was ultimately needed—to shore up the S&L insurance fund. Most estimates put the ultimate losses on the order of $150 billion. In further chapter we return to the S&L crisis to examine the lessons for deposit insurance. The Rise of Commercial Paper The competitive impact of money market mutual funds was by no means confined to the S&L industry. There was also a dramatic effect on the banking business. The flow of money into money market funds created an enormous reservoir of funds looking for short-term money market investments. This increasing appetite for money market instruments was satisfied in part by an equally dramatic increase in the issuance of commercial paper. Before money market funds, some very large corporations issued commercial paper, but these were relatively few and in small amounts compared to today. As shown in Figure 3, growth in the commercial paper market parallels growth in money market funds. At whose expense did this growth occur? Mostly commercial banks. Essentially, banks lost their largest and highest quality borrowers to the commercial paper market via money market mutual funds.

197

The Nature of Financial Intermediation

Banks responded to the loss of their loans to high-quality borrowers, in part, by replacing them with loans to less creditworthy businesses, commercial real estate loans, and loans to lesser developed countries (LDCs). As a result, by the end of the 1980s bank loan portfolios, on average, consisted of riskier borrowers than they did in the 1970s.3 The migration of corporate financing from the short-term bank loan market to the commercial paper market represented a shift from nontraded loans (Case I in Figure 1) to traded commercial paper (Cases II and III in Figure 1). While the creation of the money market mutual fund was the trigger that prompted this shift, technological innovations were also important in a number of dimensions. First, advances in computers and communications technology permitted money market funds to offer transactions services coupled with a diversified money market investment vehicle at very low cost. Second, new and sophisticated analytical techniques were introduced during this period, including mathematical models of asset valuation and default prediction, which, when combined with high-powered computers, meant that the specialized monitoring services of a commercial bank were no longer necessary to evaluate many borrowers. Just about anyone could tell which firms warranted access to the commercial paper market. This opened the floodgates for new commercial paper issuers. Innovations in information technology also had an impact on how banks compensated for the loss of their large corporate clients. Borrowers who had previously been too difficult even for banks, became “bankable” for the first time. For example, collateral is an important mechanism that banks use to solve the asymmetric information problem, especially for small business. But the cost of monitoring collateral in the form of accounts receivables and inventory had been very labor-intensive. However, as computer and information technology improved during the 1970s, these costs plummeted, making it profitable for banks to provide collateralized financing to an increasing number of companies. Today, more than half of all short-term bank loans to small business are collateralized by accounts receivable and/or inventory.

The Institutionalization of Financial Markets When individual savers buy securities themselves, funds flow directly from savers to borrowers, as in Case III of Figure 1. When savers put their money into a financial intermediary that buys traded securities, the process is indirect, as in Case II of Figure 1. Institutionalization refers to the fact that more and more funds in the United States have been flowing indirectly into the financial markets through financial intermediaries, particularly pension funds, mutual funds, and insurance companies (Case II) rather than directly 3See

Allen N. Berger and Gregory F. Udell, “Collateral, Loan Quality, and Bank Risk,” Journal of Monetary Economics, 25 (January 1990), pp. 21–42, for an analysis of the changes in bank loan portfolios between the 1970s and 1980s.

198

The Nature of Financial Intermediation

from savers (Case III). As a result, these “institutional investors” have become much more important in the financial markets relative to individual investors. For example, individual investors owned 86 percent of all equities outstanding in 1960, but they owned only 32 percent in 2005. Institutionalization has made it easier for companies to distribute newly issued securities via their investment bankers. What caused institutionalization? Quite simply, it was driven by the growth of these financial intermediaries, particularly pension funds and mutual funds. And this growth stemmed, in part, from the financial and technological innovations just discussed. But there’s more to the story than that. Pension fund growth was also encouraged by government policy. Tax laws, for instance, encourage employers to help their employees by substituting pension benefits for wages. This is good for employees because they do not pay taxes on their pension benefits until they are received after retirement. By deferring taxes until retirement employees earn compound interest on more money. Employers are happy to help out because both pension benefits and wages are nontaxable to the employer. Legislation in the 1970s and 1980s also created a number of new and attractive alternatives to the traditional employer-sponsored defined benefit plan, the most significant of these being the defined contribution plan. In the traditional defined benefit plan, the sponsoring company contributed to a pension fund that promised specified benefits to its employees upon their retirement. In contrast to these plans, employees covered under a defined contribution plan may choose (within limits) the assets they want to invest in. This flexibility is extremely attractive to employees, even though the benefits they receive upon retirement depend on how well the assets perform (as well as on how much has been contributed to the plan). The two major defined contribution plans are the 403(b) plan for nonprofit organizations and the 401(k) plan for everyone else. Mutual funds gained considerably from these changes in pension plan laws. Defined contribution plans were allowed to include mutual funds on the menu of assets from which plan members could choose. As a result, approximately 22 percent of all defined contribution plan assets are in mutual funds. In addition, aggressive marketing by mutual fund families (different funds managed under the same umbrella, such as Fidelity Investments or the Vanguard Group) and the increasing attractiveness of specialized funds, such as bond funds and index funds, have also fueled mutual fund growth.

The Transformation of Traditional Banking ”Banking Buried by Bad Loans” could have been the epitaph of the banking industry in the early 1990s. As we noted previously, as high-quality borrowers moved to the commercial paper market during the 1970s and 1980s, banks extended loans to borrowers with riskier prospects. Thus, banks were especially vulnerable to the international debt crises that emerged during the 1980s and the economic shocks that plagued the oil, farming, and real estate industries.

199

The Nature of Financial Intermediation

Number of institutions 225

150

75

0 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Year

FIGURE 4

Commercial bank failures.

Source: Federal Deposit Insurance Corporation, Historical Statistics on Banking.

As a result, by the late 1980s bank failures had reached unprecented levels, as shown in Figure 4. Dire predictions abounded as many critics argued that a weakened banking industry was in no position to ward off competition from other providers of financial services. Despite the fact that bank failures had dwindled to a trickle and bank profitability had rebounded by the mid-1990s, arguments persist that commercial banks are dinosaurs and banking is a declining industry. Perhaps the most telling statistic for the doomsayers is shown in Table 2, which shows the decline of banking’s fraction of total intermediated assets from 50 percent to 26.7 percent in 2007. To paraphrase Mark Twain, the reports of banking’s demise are greatly exaggerated. First, the so-called decline of commercial banking is limited to a decline in the relative importance of commercial banking. Although Table 2 shows that the fraction of intermediated assets in banking has declined, Table 1 shows that banking industry assets actually increased between 1970 and 2007 (even after adjusting for inflation). In other words, bank assets have actually increased—just not as fast as the assets of other financial intermediaries. Second, as we will see in the next chapter, many of the new innovative activities in which banks engage are not reflected on bank balance sheets as assets (and, therefore, are not included in Tables 1 and 2) even though they add significantly to bank revenue. These include, for example, trading in interest rate and currency swaps, selling credit derivatives, and issuing credit guarantees.

200

The Nature of Financial Intermediation

Third, banks still have a strong comparative advantage in lending to individuals and small businesses. Our discussion above shows that as specialists in the production of information, banks are ideally suited for making nontraded loans to these types of information-problematic borrowers. And, unlike finance companies banks sell a whole menu of products to their customers, including personal and commerical loans, checking accounts, retirement products, trust activities, payroll processing, and so on. Thus banks are uniquely equipped to develop comprehensive relationships that make it easier for them to monitor their borrowers and mitigate some of the problems arising from asymmetric information. Finally, in the words of another famous pundit (so famous we don’t know who it was), if you can’t beat ’em, join ’em. Banks have joined forces with a number of other types of financial intermediaries. For example, in the past decade banks have combined with mutual funds (Mellon Bank purchased Dreyfus); they’ve combined with investment banks (NationsBank purchased Montgomery Securities); and they’ve combined with commercial finance companies (Wachovia and Congress Financial). With the dramatic merger of Citicorp and Travelers Insurance, they’ve even combined with insurance companies—although the Citicorp-Travelers merger did require congressional intervention (i.e., a change in federal law).4 It is worth noting that banks aren’t the only ones getting into the act. Bank acquisitions of nonbank financial intermediaries are part of a broader consolidation of the entire financial services industry. For example, the Citicorp-Travelers merger was preceded by Travelers’ acquisition of investment bank Salomon Smith Barney; and Morgen Stanley (a large investment bank) acquired DeanWitter (a large brokerage and fund management firm). In 1999, banking law caught up with the changes taking place in the industry when Congress passed the Gramm-Leach-Bliley Financial Services Modernization Act. This law essentially repealed the Glass-Steagall Act of 1933 by eliminating restrictions on cross-ownership of different types of financial institutions. As banks, insurance companies, and investment banks take advantage of the provisions of this law, the traditional dividing lines between different types of intermediaries will become increasingly blurred. For the reasons outlined above, it is hard to imagine that banks will become irrelevant as some of their more ardent critics contend. The trend toward consolidation suggests, however, that we are likely to see an increasing number of large and complex financial organizations that will sell an entire menu of financial services ranging from consumer loans to mutual funds to corporate securities underwriting—and everything in between. Nevertheless, it is not so clear that this necessarily implies the disappearance of the small community bank with its focus on traditional banking products: checking accounts and consumer and business loans. 4For

the most part these nontraditional activities are excluded from bank assets in Tables 1 and 2 mostly because by regulation they must be conducted in holding company subsidiaries separated from the assets of the commercial bank.

201

The Nature of Financial Intermediation

Financial Intermediaries: Assets, Liabilities, and Management We have analyzed the economic role of financial intermediaries and how intermediaries have evolved to fill that role. Now we turn to the managerial challenges shared by these institutions. The management and operation of a financial intermediary differs from that of a manufacturing company because of the nature of the institution’s balance sheet. Just like any other business, a financial intermediary issues financial claims on the liability side of its balance sheet in return for funds provided by savers. However, on the asset side of the balance sheet a financial intermediary differs substantially from conventional businesses. A manufacturing company, for instance, has mostly real assets—things you can see and kick. A cardboard manufacturer, for example, has buildings (its plant), corrugating machines (its equipment), and raw paper (its inventory) as assets. Financial intermediaries, on the other hand, have mostly financial assets. A bank, for example, has mostly loans and securities as assets. Therefore, a bank, like other financial intermediaries, has financial claims on both sides of its balance sheet. This characteristic forces financial intermediaries to focus on credit risk and interest rate risk in their normal course of business. Both of these risks affect the value of assets and liabilities, and hence the net worth of the financial institution. When a financial intermediary purchases the nontraded claims of either a business or an individual, its main concern is with credit risk because it tends to hold these assets to maturity and expects to earn the cash flows promised by the borrower. A default means no cash flow (such as a failure by the borrower to make an interest payment), which is bad news for the intermediary. All of this suggests that a financial intermediary has an incentive to monitor its borrowers continuously. This relationship enables the financial intermediary to acquire information over time about the true quality of its customers so that it can then charge its high-quality customers a low rate and its low-quality customers a high rate. Managers of financial intermediaries must also worry about interest rate risk. If a bank, for example, invests in five-year fixed-rate loans and acquires funds by issuing six-month deposits, it will be extremely vulnerable to swings in interest rates. In particular, let’s start out on a happy note by assuming the loans earn 9 percent and the deposits cost 6 percent. This strategy currently earns the bank an interest rate spread of plus 3 percent (9 percent minus 6 percent). If short-term interest rates increase to 10 percent six months from now, however, the bank will be forced to renew its deposits at 10 percent but will still be stuck with its 9 percent loans for another four and a half years. The bank’s spread will thus decrease from plus 3 percent to minus 1 percent, making shareholders very unhappy because instead of making big profits, the bank will lose money. On the other hand, if short-term interest rates decrease to 4 percent, shareholders will be ecstatic about the increase in the bank’s interest rate spread to 5 percent and the improvement

202

The Nature of Financial Intermediation

in the bank’s profitability. In reality, shareholders should have been concerned at the outset because of the mismatch between the maturities of assets and liabilities. A maturity mismatch is simply a form of interest rate speculation. To avoid this, most financial intermediaries tend to have assets whose maturities on average mirror the maturities of their liabilities. A notable exception, as we discussed in the previous section, was the S&L industry which got into trouble during the early 1980s. Financial intermediaries must implement risk management procedures so that they can monitor these risks and set appropriate limits for each. How credit and interest rate risks differ across financial intermediaries is reflected in their balance sheets. Figure 5 shows condensed balance sheets (T-accounts) for some of the major financial intermediaries in the United States. Assets are shown on the left-hand side of the T-accounts, and liabilities and equity are on the right-hand side. Depository institutions are shown at the top of the figure. As their name implies, these institutions all have deposits on the right-hand side of their balance sheets. Because these deposits tend to be short term in maturity, it is not surprising that depository institutions usually invest in relatively short-term assets. Depository institutions also face credit risk because they invest heavily in nontraded private loans. Specifically, banks make commercial (business) loans, commercial real estate loans, and consumer loans. Mutual savings banks, savings and loan associations, and credit unions make consumer and mortgage loans. The nondepository financial intermediaries are shown at the bottom of Figure 5. Like depository institutions, some of these institutions face credit risk associated with nontraded financial claims. Life insurance companies, for instance, invest in nontraded bonds (called private placements) to midsized companies; commercial finance companies make business loans; consumer finance companies make consumer loans; and venture capital firms invest in the nontraded equity of small start-up firms. As with the depository financial intermediaries, the asset maturities of nondeposit financial intermediaries reflect the maturity of their liabilities. Because the liabilities of life insurance companies consist mostly of insurance policies and long-term annuities, life insurance companies prefer long-term bonds, mortgages, and real estate equity. Similarly, pension funds invest in stocks, long-term bonds, mortgages, and commercial real estate equity because their pension liabilities are so long term. On the other hand, both consumer and commercial finance companies have much of their assets in short-term nontraded loans, so they raise funds by issuing short-term debt, particularly commercial paper. With mutual funds, interest rate risk is effectively eliminated because the right-hand side of the balance sheet is all equity. Thus there are no liabilities requiring fixed-dollar payments, so there is no risk to the fund itself when interest rates move up or down. Of course the investors in the mutual fund (the equity shareholders) make more or less as rates fluctuate. Now that we have completed this overview of financial intermediaries, we can turn to a more detailed analysis of the structure and performance of the most important institutions.

203

The Nature of Financial Intermediation

Assets shown on left-hand side of T-account, and liabilities and equity on right-hand side of T-account Depository Financial Intermediaries Commercial Banks Gov’t Securities Consumer Loans Commercial Loans Mortgages

Deposits Equity

Savings & Loans Associations Gov’t Securities Mortgages

Mutual Savings Banks Gov’t Securities Consumer Loans Mortgages

Deposits*

Deposits Equity*

Credit Unions Gov’t Securities Consumer Loans

Deposits*

Nondepository Financial Intermediaries Life Insurance Companies Property and Casualty Insurance Companies Securities Private Placements Real Estate Equity Mortgages

Insurance Policies Annuities Equity*

Pension Funds Securities Real Estate Equity Mortgages

Pension Liability

Securities

Commercial Finance Companies Commercial Loans & Leases

Consumer Finance Companies Consumer Loans

Debt Equity

Equity

Debt Equity

Mutual Funds Securities

Money Market Mutual Funds Money Market Instruments

Insurance Policies Equity*

Equity

Investment Banks Securities

Debt Equity

Venture Capital Funds Nontraded Equity in Start-Up Firms

Equity

*Mutuals do not issue equity but are technically owned by their depositors or their policyholders.

FIGURE 5

204

Selected intermediary balance sheets.

The Nature of Financial Intermediation

SUMMARY 1. Asymmetric information presents a major challenge to lenders in credit markets, particularly to those making loans to individuals and small businesses. Asymmetric information comes in two forms, adverse selection and moral hazard. Adverse selection arises before a loan is extended because lenders cannot easily distinguish between high- and low-quality borrowers. Moral hazard arises after the loan has been made because borrowers have an incentive to become riskier.

2. Financial intermediaries exist in part because they are specialists in the production of information. Intermediaries also reduce transactions costs and facilitate diversification.

3. The mix of financial intermediaries since World War II has changed significantly. In particular pension funds, stock and bond mutual funds and money market mutual funds have grown significantly while depository institutions and life insurance companies have declined in relative importance.

4. The increased level and volatility of interest rates, which began in the mid-1960s and subsided in the mid-1980s, led to the creation of the money market mutual fund, which altered the structure of the financial system. Following skyrocketing interest rates beginning in 1979, Regulation Q was dismantled, the S&L industry nearly collapsed, and banks significantly changed the menu of liabilities they offered to their depositors.

5. The rising importance of pension funds, life insurance companies, and mutual funds led to the institutionalization of financial markets as funds flowing through these institutions increasingly displaced direct investment in stocks and bonds by individual investors.

6. The decline of banking’s share of intermediated assets over the past fifty years suggests that if the trend continues banks may become a less significant player on the financial landscape. However, the importance of banks as lenders to small businesses and individuals (in conjunction with offering checking account services) suggests that they will be around for a long time.

7. Unlike other types of companies, financial intermediaries typically have financial instruments on both sides of the balance sheets. This creates special challenges for these institutions including the neccessity to manage credit risk and interest rate risk.

KEY TERMS adverse selection

depository institution

financial intermediation

asymmetric information

Federal Savings and Loan Insurance Corp. (FSLIC)

institutionalization

collateral credit risk credit union

financial asset

defined benefit plan

financial disintermediation

defined contribution plan

financial intermediary

interest rate risk lesser developed country (LDC) market failure money market deposit account (MMDA)

205

The Nature of Financial Intermediation money market mutual fund

nontraded financial contract

savings and loan associations (S&Ls)

monitoring

NOW account

thrift institutions

moral hazard

portfolio diversification

traded securities

mutual fund family

private placement

transactions cost

mutual savings bank

real asset

nondepository financial intermediary

Regulation Q

QUESTIONS Questions with a red oval are in

206

at www.myeconlab.com.

11.1

One of the principal reasons for imposing Regulation Q deposit ceilings was to prevent destructive competition among depository institutions. Do you agree with this logic?

11.2

By some estimates the S&L crisis would have cost us $150 billion (in 1981 dollars) if we had shut down all of the economically insolvent S&Ls in 1981. It now turns out that it cost us on a present value basis somewhere around $150 billion (in 1995 dollars). Did we win or lose by procrastinating?

11.3

We noted in Chapter 6 that the quicker the market absorbs new information, the more efficient it is. Do you think institutionalization has had any impact on the informational efficiency of the stock and bond markets?

11.4

Asymmetric information is much less of a problem for large companies than for small companies. How difficult do you think it would be for you as a private investor to assess the true credit quality of your neighborhood bicycle shop or your local greeting card store?

11.5

The menu of financial services offered by banks has grown dramatically over the past decade. This trend is based on the assumption that customers desire this type of “one-stop shopping.” Will bankers ultimately replace stockbrokers and insurance agents now that regulatory barriers have been removed?

11.6

Despite asymmetric information in the used car market, we observe individuals purchasing used cars. What conventions or institutions have arisen to aid these transactions? Are there similar institutions in financial markets?

11.7

Discussion question: We have witnessed a phenomenal growth in private pension plans, particularly the newer defined contribution plans, which offer flexibility in asset allocation. These private plans were promoted by government tax policy. Given their extraordinary success, should policymakers consider downsizing social security by increasing the amount of eligible contributions allowed to private plans?

Depository Financial Institutions

Depository institutions are the most important sources of credit to consumers and small businesses. In addition, the deposit liabilities of these institutions form the cornerstone of the money supply. Because commercial banks are by far the largest depository institutions in the United States, we spend most of our time on them—examining how they are managed and exploring key industry trends. We then turn briefly to nonbank depository institutions to complete the picture.

LEARNING OBJECTIVES In this chapter you will learn to evaluate the traditional uses and sources of bank funds understand bank profitability and the risks inherent in banking describe the recent consolidation in the banking industry and the expansion of banks into nontraditional banking markets put international banking into perspective understand and analyze the subprime mortgage crisis

The Fundamentals of Bank Management Banks are business firms. Like Frisbee manufacturers, fast-food chains, and textbook publishers, bankers buy inputs, massage them a bit, burn a little incense, say the magic words, and out pops some output. If their luck holds, they can sell the finished product for more than it cost to buy the raw materials in the first place. For bankers, the principal raw material is money. They buy it at a long counter they set up in the store, then rush around to the other side of the

From Chapter 12 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

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Depository Financial Institutions

counter, sit down behind a huge desk (a little out of breath), and sell it as soon as they can to someone else. If they’re really good at their business, sometimes they can even sell it back to the same person they bought it from (a trick bankers picked up from Los Angeles’ used-car dealers). About the only way you can tell whether bankers are buying money or selling it is to observe whether they’re standing up or sitting down. For some unknown reason, probably an inherited trait, bankers always stand up when they buy your money (take your deposit at the teller’s window) but invariably sit down when they sell it (make loans or buy securities). We can think of banks as repackagers of money. This makes them a financial intermediary because they have financial claims on both the asset and liability sides of their balance sheet. The liabilities represent a bank’s sources of funds and the assets represent a bank’s uses of funds. Banks engage in this process of buying and selling money for one simple reason: They hope to make a profit by buying money from Peter at a lower price than they sell it to Paula. Our first task is to see how bankers manage to pull this off. We then turn to some of the major trends in banking and discover that in addition to standing up and sitting down, bankers have had to start doing serious gymnastics just to stay competitive.

Uses of Bank Funds Tables 1 and 2 show the assets that banks invest in and the major trends in asset allocation over the past three decades. Table 1 contains the dollar amounts and Table 2 shows the percentage distribution. What trends are

TABLE 1

Assets of Insured Commercial Banks, 1980–2007 (billions of dollars) 1980

1990

2000

2007

332

318

369

482

U.S. govt. and agency securities

163

427

711

949

State and local govt. securities

146

84

92

141

Cash assets

Other securities

16

94

274

498

Business loans

391

615

1,051

1,370

Real estate loans

269

829

1,673

3,674

Consumer loans

187

403

606

959

Other loans

169

263

438

568

Miscellaneous assets

183

356

1,031

2,535

1,856

3,389

6,245

11,176

Total

Source: FDIC Statistics on Depositor y Institutions. All figures are as of year end.

208

Depository Financial Institutions

TABLE 2

Assets of Insured Commercial Banks, 1980–2007 (percentage distribution) 1980

Cash assets U.S. govt. and agency securities

1990

2000

2007

18

9

6

4

9

13

11

9

State and local govt. securities

8

2

1

1

Other securities

1

3

4

4

Business loans

21

18

17

12

Real estate loans

14

24

27

33

Consumer loans

10

12

10

9

9

8

7

5

Other loans Miscellaneous assets Total

10

11

17

23

100

100

100

100

Source: FDIC Statistics on Depositor y Institutions. All figures are as of year end.

apparent over the past three decades? We have mentioned the troubles the savings and loan industry had in the 1980s that resulted in many savings and loan failures. Commercial banks began to supply many residential mortgages during this time and, as of 2007, these loans account for a majority of the loans listed as real estate loans which, in turn, account for one-third of bank assets. While these loans have been a large part of bank business, they also have turned out to be a big problem. As real estate prices have collapsed, banks have seen a significant increase in defaults on these mortgages. This has been exacerbated by banks’ willingness to make subprime loans, that is, loans to individuals that have spotty credit ratings (more on this later). In addition to the long-term trends, there are also cyclical fluctuations that are not captured by the tables. For example, between 2000 and 2003 total loans declined from 61 percent to 57 percent, with the bulk of the drop accounted for by the decline in business loans from 17 percent to 11 percent. This drop and the associated increase in the securities portfolio occurred after the 2001 recession, which is perfectly consistent with the historical substitution of securities for loans that occurs when loan demand declines during a recession. In other words, banks have traditionally treated their government securities portfolio as a residual use of funds—buying government securities during recessions when private loan demand is slack, and then selling them off during business recoveries, when private loan demand is vigorous. Why is it that no stocks (equities) are included among bank assets? The reason is that commercial banks traditionally have been barred by law from owning stocks on the ground that stocks are too risky. This prohibition dates

209

Depository Financial Institutions

TABLE 3

Liabilities and Capital of Insured Commercial Banks, 1980–2007 (billions of dollars) 1980

1990

2000

2007

Transactions deposits

435

685

679

708

Nontransactions deposits

752

1,672

2,794

5,098

Foreign deposits

293

294

706

1,502

Borrowed funds

178

385

1,046

1,879

90

135

490

845

108

218

530

1,144

1,856

3,389

6,245

11,176

Miscellaneous liabilities Equity capital Total

Source: FDIC Statistics on Depositor y Institutions. All figures are as of year end.

from the National Currency Act of 1863 and the National Bank Act of 1864 and has been reaffirmed repeatedly in subsequent legislation. Banks do buy billions of dollars worth of stocks, but not for themselves; they buy them for the trusts, estates, and pension funds that they manage for others. Such trust department holdings are not included among a bank’s own assets.

Sources of Bank Funds Tables 3 and 4 show the sources of bank funds and their changes since 1980. Table 3 contains the dollar amounts and Table 4 the percentage distribution. Notice first how transactions deposits, which used to be the major source of bank funds have dropped in importance, declining to 6 percent by 2007.

TABLE 4

Liabilities and Capital of Insured Commercial Banks, 1980–2007 (percentage distribution) 1980

1990

2000

Transactions deposits

23

20

11

6

Nontransactions deposits

41

49

45

46

Foreign deposits

15

10

11

13

Borrowed funds

10

11

17

17

Miscellaneous liabilities

5

4

8

8

Equity capital

6

6

8

10

100

100

100

100

Total

Source: FDIC Statistics on Depositor y Institutions. All figures are as of year end.

210

2007

Depository Financial Institutions

Transactions deposits are deposits with unlimited check-writing privileges. As described in the previous chapter, the decline began in the 1970s and is directly attributable to Regulation Q combined with the general increase in interest rates on other types of assets that occurred over this period. Even in today’s low interest rate environment, individuals and business firms are reluctant to hold any more transactions deposits than they really need for their day-to-day payments. They have learned that it pays to economize on their checking accounts because to hold more than is absolutely necessary means sacrificing interest income. Nontransactions deposits consist of domestic deposits that either have limited check-writing privileges or no check-writing privileges at all: principally savings and time deposits. Savings accounts are deposits that can be withdrawn at any time. Included in this category are money market deposit accounts. These accounts pay a money market rate and offer limited checking functions. Time deposits consist of deposits that have a maturity date that specifies when the depositor receives back her deposit plus interest. Many of these are small CDs under $100,000 purchased by consumers. However, at the end of 2007, $1,046 billion of total deposits consisted of large time deposits (each greater than $100,000) called negotiable certificates of deposit. About half of these are domestic deposits and are included in the nontransactions deposits entry in Table 3 with the remainder included under foreign deposits. The negotiable CD was a particularly important source of funding for banks in the late 1970s and early 1980s. As we noted in the previous chapter, the negotiable CD represented the first major loophole in Regulation Q. Usually issued in denominations of $100,000 and higher, the negotiable CD can be sold in a secondary market if one has to raise cash before it matures. Thus, it serves as an alternative to Treasury bills for corporate treasurers with excess funds to invest for a short time. Its importance as a funding source has declined more recently. Borrowed funds, however, have become increasingly important over the past 30 years. These include a wide variety of sources of funds other than domestic deposits, such as: 1. Borrowings from the Federal Reserve. 2. Borrowings in the federal (Fed) funds market. Federal funds are unsecured loans between banks (often on an overnight basis) that are settled by transfers of funds the same day a loan is made. 3. Borrowings by banks from their foreign branches, their parent holding companies, and their subsidiaries and affiliates. 4. Repurchase agreements. Banks often sell securities and agree to buy them back at a later date (often the next day). As we described in earlier chapter, when a bank sells securities to a corporation or to another bank under an agreement to repurchase—called RPs or repos—the bank commits itself to buying the securities back on a specified future date at a predetermined

211

Depository Financial Institutions

price. In effect, since the bank has the use of the funds until the securities are repurchased, the bank is borrowing funds with the securities as collateral; the interest rate is determined by the difference between today’s selling price and tomorrow’s higher repurchase price. With overnight RPs, the bank gains access to short-term funds, which it hopes to use profitably, and the corporation earns interest while sacrificing virtually no liquidity. When such a transaction is made between a bank and one of its own corporate depositors, the bank’s balance sheet shows a rise in borrowings and a corresponding drop in transactions deposit liabilities. Another source of bank funds, and one that has become increasingly important, although it does not show up on the tables, arises from the sale of assets through securitization. Securitization involves the transformation of a nontraded financial instrument into a traded security. Banks raise new funds by packaging some of their loans into securities and then selling these securities, which are collateralized by the underlying assets, to investors. In addition to securitizing residential mortgages, banks also securitize commercial mortgages, automobile loans, student loans, and credit card loans. However, some loans, such as those to small and midsize companies, remain difficult to securitize, perhaps because of the nagging unresolved asymmetric information problems. The final source of funding comes from equity capital. This represents the amount of ownership interest in the bank.1 Recall that equity gives the owners all the fruits of prosperity, including a claim on all future dividends, but limits their liability to the amount invested.

Bank Profitability As we mentioned at the outset of this chapter, bank management is all about buying money for less than you sell it. Success or failure is recorded in the income statement. Table 5 shows the income statement for all commercial banks insured by the Federal Deposit Insurance Corporation (FDIC), which includes virtually all banks in the United States. Table 6 shows the income statement expressed as a percentage of total assets.

1More

precisely, the equity listed in Table 3 is calculated based on accounting rules. These rules, however, suffer from several deficiencies. First, they are so complicated that they can put even the most dedicated accountants to sleep, often for days at a time. Second, they are based primarily on the historical cost accounting methods that we discussed in the preceding chapter, which fail to reflect changes in the market value of many bank assets and liabilities. Nor do historical cost accounting rules generally reflect a bank’s franchise value that may have been built up over the years. Third, the stock market usually ignores the accountants’ numbers anyway. The stock market’s valuation (which equals the stock price times the number of outstanding shares) is often considerably less (or considerably more) than the accountant’s valuation (often called book value which equals the equity capital on the balance sheet). This explains why banks often acquire other banks for huge multiples of their book value.

212

Depository Financial Institutions

TABLE 5

Income Statement of Insured Commercial Banks, 1980–2007 (billions of dollars) 1980

Interest on loans Interest on securities and investments Total interest income Interest expense Net interest income Service charges and fees Other operating income Net operating income before expenses Salaries and wages Other operating expenses Net operating income Securities gains (losses) Taxes Net income after taxes

152 23 175 -120 55 8 8 71 - 25 - 26 20 - 1 - 5 14

1990

2000

2007

235 69 304 -205 99 16 56 171 - 52 - 96 23 1 - 8 16

338 90 428 - 225 203 24 130 357 - 89 - 157 111 - 2 - 38 71

500 111 611 - 308 303 39 172 514 - 142 - 229 143 - 1 - 43 99

Source: FDIC Statistics on Depositor y Institutions.

TABLE 6

Income Statement of Insured Commercial Banks, 1980–2007 (percentage of assets)

Interest on loans Interest on securities Total Interest Income Interest expense Net interest income (NIM*) Service charges and fees Other operating income Net operating income before expenses Salaries and wages Other operating expenses Net operating income Securities gains (losses) Taxes Net income after taxes (ROA*)

1980

1990

2000

2007

9.88 1.50 11.38 - 7.80 3.57 0.49 0.53 4.59 - 1.60 - 1.72 1.27 - 0.03 - 0.32 0.91

6.93 2.04 8.97 - 6.05 2.92 0.47 1.65 5.05 - 1.53 - 2.83 0.68 .03 - 0.24 0.47

5.41 1.44 6.85 - 3.60 3.25 .38 2.08 5.71 - 1.43 - 2.51 1.77 - .03 - .61 1.14

4.47 .99 5.46 - 2.75 2.71 .35 1.54 4.60 - 1.27 - 2.05 1.28 0 - .39 .89

*When expressed as a percent of total assets.

Source: FDIC Statistics on Depositor y Institutions.

213

Depository Financial Institutions

How much did banks pay for their money? The answer is listed under interest expense—$308 billion in 2007. For how much did they sell their money? The answer is listed under total interest income—$611 billion in 2007. Note that total interest income is divided into two categories, interest on loans and interest on securities and investments. The difference between total interest income and interest expense, net interest income, is one of the most revealing numbers on a bank’s financial statement. It is loosely analogous to a manufacturing company’s gross profit. Net interest income expressed as a percent of total bank assets is referred to as a bank’s net interest margin (NIM in Table 6). This is the bank’s interest rate spread. In 2007 the net interest margin for the entire banking industry was 2.71 percent ( $303 billion $11,176 billion) compared with 2.92 percent in 1990 and 3.25 percent in 2000. Many factors affect a bank’s net interest margin. If a bank provides better service than its competitors, it may be able to get away with charging a higher rate on its loans and paying a lower rate on its deposits. If it has some monopoly power, possibly because its only competitor in town went belly-up, it may be able to take advantage of this—again, by charging a higher rate on its loans and paying a lower rate on its deposits. Banks today, however, are less likely to have monopoly power because of the enormous competition they face from other banks and from nonbank competitors. The net interest margin is also affected by a bank’s risk. As discussed in the previous chapter, the interest rate spread will change if the average maturity of assets is different from the average maturity of liabilities and the level of interest rates change. This is the consequence of interest rate risk. For the S&Ls, the increasing cost of short-term deposits in the early 1980s combined with little improvement in the yield on their mortgages quickly turned their net interest margin negative. Credit risk can also affect the net interest margin. If a bank invests more in lower yielding government securities and less in loans, its net interest margin will fall. Likewise the net interest margin will fall if a bank shifts within its loan portfolio from riskier to safer loans. Moving down the income statement in Table 5 we see that service charges and fees plus other operating income have both become more important in recent decades as banks have shifted from traditional interest income to more nontraditional sources of revenue. (More on this later in the chapter.) If we add these other sources of revenue to net interest income we get net operating income before expenses. The next items are operating expenses. Salaries and wages are particularly important because banks are very labor-intensive enterprises. In great part banks become successful when their employees are productive and their staffs are lean. Thus the ratio of salary and wages divided by total assets shown in Table 6 is a key efficiency ratio in banking. Other operating expenses include the amount that banks contribute to their reserve for loan losses (called the provision for loan losses), the amount of depreciation on equipment, and the amount of building expenses.

214

Depository Financial Institutions

Before arriving at the “bottom line,” we must add securities gains (or subtract losses) and taxes. Because banking statements are partially constructed on the basis of historical cost accounting, securities held for investment are shown on the balance sheet at the price at which they were purchased—regardless of whether their market value has increased or decreased. The only time a profit or loss is reflected in the financial statements is when an investment security is sold.2 If it is sold at a gain over book value (the amount the bank purchased it for), then a “gain” is added on the income statement. If it is sold at a loss over book value, then a “loss” is subtracted on the income statement. The “bottom line” is net income after taxes. When net income after taxes is expressed as a percent of total assets, we have a profitability measure called the return on assets or ROA (see Table 6). A ROA above 1 percent is generally regarded favorably by bank analysts. The ROA for all banks in 2007 was 0.89 percent. The low ROA in 1990 was a reflection of the difficulties banks encountered in the late 1980s as described in the last chapter. ROA can be interpreted as measuring the success of a bank in deploying its assets. If we want to focus more narrowly on a bank’s success in earning profits for its shareholders, we would look at the return on equity or ROE. ROE is net income divided by equity capital and was 8.65 percent ( $99 billion $1,144 billion) in 2007 compared to 13.40 percent in 2000.

Bank Risk Profitability is only part of the bank performance story. There is a trade-off between risk and return—higher returns come at the expense of more risk. Thus just because a bank’s ROA and ROE go up does not mean that stockholders will be happy. Any increase in profitability must compensate for the associated increase in risk before handing the bank president a big bonus. Banks face many kinds of risk. Like any company with debt on its balance sheet, banks are riskier because of their leverage. As do other financial intermediaries, banks face credit risk and interest rate risk. But unlike other financial intermediaries, banks and other depository institutions face a unique form of liquidity risk. And large money center banks add still another layer of risk associated with acting as dealers in foreign currencies and securities. We refer to this as trading risk. Each of these risks is sufficiently important to warrant separate treatment. Leverage Risk Leverage means that debt is combined with equity to purchase assets. A highly leveraged bank is a bank with high amounts of debt relative to equity capital. Because debt requires future payments for the issuer,

2Some

securities are marked-to-market; that is, changes in their market value are recorded as they occur. Any securities that are traded actively, or any securities that the bank does not intend to hold until maturity, fall into this category.

215

Depository Financial Institutions

a highly leveraged bank is less able to withstand unexpected shocks to its balance sheet. In short, a highly leveraged bank is more risky than a less leveraged one. The most straightforward measure of leverage risk is the ratio of equity capital to total assets, known as the leverage ratio. In Table 4 the line just above the total shows the leverage ratio for the banking industry—10 percent in 2007. The leverage ratio for the banking industry as a whole masks considerable differences in leverage across banks. In the 1980s the leverage ratio for large banks was much lower than for small banks. This concerned regulators both in the United States and other countries who imposed risk-based capital (RBC) requirements in the early 1990s. The result of these requirements is that banks deemed more risky are required to maintain less leverage. Credit Risk Credit risk arises because some bank borrowers may not be able to pay back their loans. Moreover, many of these loans are made to borrowers whose risk is difficult to assess and whose performance is difficult to monitor. That is, they are loans characterized by the asymmetric information problems of adverse selection and moral hazard, discussed in the previous chapter. Success in making these loans depends on a bank’s ability to produce information about these borrowers and structure their loans appropriately. In particular, the riskier loans should be charged a higher interest rate and/or face higher collateral requirements. How do we know how risky a bank’s portfolio is? It’s not easy—particularly for outsiders. One measure is loan charge-offs as a percent of total loans. Loan charge-offs are the amount of the loan portfolio that was “written off” during the year because some borrowers could not repay their loans. The virtue of this ratio is its precision—these are the loans that actually went bad over the past year. However, it is a backward-looking measure. It shows how loans made in the past have performed; it does not necessarily indicate how the bank’s current loan portfolio will perform in the future. A forward-looking measure of credit risk is the ratio of nonperforming loans to total loans. Nonperforming loans are those with interest payments delinquent 90 days or more. Loans that are slow in paying interest today are more likely to default in the future. However, because neither the charge-off ratio nor the nonperforming loan ratio are perfect indicators of risk, both are typically used to assess credit risk.

TABLE 7

Credit Risk Ratios, 1980–2007 (percentage of loans)

Charge-offs Nonperforming loans

216

1980

1990

2000

.65

1.43

.66

2007 .58

not available

not available

1.14

1.32

Depository Financial Institutions

Interest Rate Risk As we discussed in the last chapter, interest rate risk stems from a mismatch in the maturity of a bank’s assets and liabilities. For example, if interest rates increase, a bank whose assets have a longer maturity than its liabilities will suffer a decline in net interest margin because the bank has to pay higher rates to renew its deposits before it gets a chance to replace its low-yielding assets. In addition, the present value of its assets will decline by more than the present value of its liabilities because long-term securities are more sensitive to changes in interest rates than short-term securities. Thus interest rate risk affects both the income statement and the market value of assets and liabilities on the balance sheet of a bank. We can be more precise and identify interest rate risk with differences in the repricing maturity of assets and liabilities. Repricing maturity is a more accurate term than maturity because many bank loans carry a floating interest rate. To see why this is important, note that in a floating interest rate loan, the interest rate is linked to an index or benchmark rate that changes from time to time, such as the prime rate, LIBOR, or the federal funds rate.3 Thus if the interest rate on a two-year loan is specified as “prime plus 2 percent floating,” then the loan rate would be 103/4 percent if the bank’s prime rate was 83/4 percent today. But if the prime rate increases tomorrow to 9 percent, then the interest rate on this loan will increase tomorrow to 11 percent. So, despite a maturity of two years, this loan’s repricing maturity is really only one day for interest rate risk purposes. Many floating rate loans are adjusted at specified intervals, such as every 90 days or every six months. The repricing maturity for these loans would be 90 days and six months respectively. There are many measures of interest rate risk. The simplest and most commonly used measure is the one-year repricing GAP. It is calculated by taking the bank’s assets that will be repriced in less than one year (either because they mature in less than one year or because they have a floating rate) and subtracting the bank’s liabilities that will be repriced in less than one year. That difference is often expressed as a percent of total assets and is called the GAP ratio. For example, if a bank has a negative GAP ratio, it means that it will reprice more liabilities than assets over the next year.4 If interest rates rise while a bank has a negative GAP, then the bank can expect to pay more for its liabilities than it can expect to generate from higher interest rates on its assets.

3LIBOR

and the federal funds rate are freely determined in the marketplace, while the prime rate is more of an administered rate that is posted by banks to indicate the cost of borrowing for their most creditworthy borrowers.

4The

GAP ratio tells us nothing about the impact of interest rates on the net interest margin two years or more from now. As a result, the managers of larger and more sophisticated banks often focus on the duration GAP, which is a more complicated measure of interest rate risk based on the concept of duration, or average cash flow maturity. The duration GAP is a measure of the sensitivity of the market value of a bank’s equity to changes in interest rates. This implicitly takes into account not only the impact on next year’s net interest margin but also all succeeding years.

217

Depository Financial Institutions

In The News Local Banks Weigh Hedging Risks As interest rates continue to rise, banks are looking at hedging their bets through derivatives. The instruments typically allow banks to buy a guarantee that a portion of their portfolio is linked to the interest rate market. Banks that want to hedge their loan portfolio typically seek out a large institution such as a Wall Street financier or a multinational bank that is willing to guarantee additional interest payments [as] rates rise. In return, the bank seeking the hedge will pay a fixed percentage of the interest on the loan. The hedging of interest rates has traditionally been the domain of major banks. With the Federal Reserve pushing interest rates higher, and lower hedging minimums, smaller banks have used a similar strategy. Arvind Menon, the president and CEO of Nevada First Bank, is beginning to use derivative hedging to protect his $462 million bank from the rising rates. If a customer wants to borrow at a fixed rate for the long-term, Nevada First’s loan officers will seek to hedge the interest on the loan. The move is designed to protect his institution from interest rate shocks as shortterm deposit rates rise at a quicker pace than long-term rates. ”As a bank, you don’t want to take that type of interest rate risk,” he says. Hedging can safeguard against that margin squeezing because the lending bank is guaranteed to receive the equivalent of the LIBOR on the loan. That rate is based on an international index that allows investors to match their cost of lending with the cost of funds.

For example, Menon says, if he makes a 15-year, fixed-rate loan for 6 3/4 percent, the bank can turn around and hedge the interest. Nevada First will be guaranteed the floating LIBOR rate, while it agrees to pay the other institution the current fixed LIBOR of around 4 percent and an extra 2 percent more. So, Nevada First starts out paying the other institution 2 percent of its loan interest for the hedge. ”If rates go up 200 basis points, (the) Wall Street (financial institution) reimburses me and I’m fine,” explains Menon. “By doing (derivative) swaps, we are willing to take a lesser profit from rates going down to protect us from going bust if rates go up.” Some other community bankers were skittish, if not outright opposed to, derivative hedging. Silver State Bank CEO Tod Little warns that the practice is more difficult than a lot of bankers think. “I have seen very smart people get hammered doing derivatives,” he says. Dropping interest rates can turn the hedge into a bad investment for the lending bank, Little cautions. “You are not insuring with Safeco Insurance. Somebody will make money and somebody will lose money. You are still guessing which way rates will go.” A recent study by the University of Michigan’s Ross School of Business analyzed data from 8,000 commercial banks from 1997 to 2003 and found that about 400 of those banks used hedging at the end of 2003. Source: Valerie Miller, Las Vegas Business Press, Dec. 12, 2005, p. 1.Copyright © 2005, Las Vegas Business Press. All Rights Reserved. Reprinted with permission.

Banks can reduce their interest rate risk by changing the maturities of their assets or liabilities. However, if the bank’s borrowers and depositors prefer the current maturity structure of loans and deposits, then the bank will not be able to entice them to change without decreasing loan rates and increasing deposit rates, thus narrowing its net interest margin. Banks can avoid this by hedging interest rate risk through the use of derivatives such as interest rate swaps, financial futures, and financial options.

218

Depository Financial Institutions

Trading Risk Banks are exposed to trading risk because they act as dealers in financial instruments such as bonds, foreign currency, and derivatives. Dealers buy at their bid and sell at their offer to accommodate public orders. Somewhat less formally, trading by dealers means buying a financial instrument with the intent of selling it in the immediate future at a higher price. Every so often, of course, prices drop before the dealer sells, and that means losses rather than profits. For larger banks, trading risk can be significant because they are among the biggest dealers in the foreign currency, government bond, and swap markets. Banks and bank regulators are trying to develop improved forward-looking measures of trading risk. In particular, the focus is on generating an estimate of a bank’s daily earnings at risk (DEaR). DEaR represents the amount of money a bank could lose in one day on its trading portfolio if markets move in the wrong direction. The challenge in developing a good measure of DEaR is in estimating statistically the likelihood of adverse price changes in these markets. Liquidity Risk Banks and other depository institutions share liquidity risk because transactions deposits and savings accounts can be withdrawn at any time. Thus when withdrawals significantly exceed new deposits over a short period, banks must scramble to replace the shortfall in funds. For years bankers solved this liquidity problem by having lots of government bonds on hand that they could easily sell for cash. It is not surprising, therefore, that the ratio of cash plus securities to total assets is a traditional measure of bank liquidity. We see in Table 2 that this ratio fell from 36 percent in 1980 to 17 percent in 2007, primarily because banks sold government securities to finance the growth in loan demand during this period. Banks also financed this loan growth with nontraditional sources of funds such as negotiable CDs, repurchase agreements, foreign deposits, and borrowings in the federal funds market. And these new sources of funds became useful tools for liquidity management in their own right. Thus the capacity to borrow in these “nontraditional” markets has become a more important source of bank liquidity than selling government securities, making the traditional (cash securities) assets ratio a poor indicator of bank liquidity.

Major Trends in Bank Management The U.S. banking industry is in a period of transition. For most of this century, banking was a comfortable business that consisted of just taking in deposits and making loans. Government regulations insulated banks from competition among themselves and from competition from other financial institutions. Recent changes in these regulations in combination with the dynamic forces at work in the financial marketplace generated three major trends in the industry: consolidation, nontraditional banking, and globalization.

219

Depository Financial Institutions

The Consolidation Within the Banking Industry The McFadden Act One of the principal inhibitions to competition in banking during most of the twentieth century was the McFadden Act of 1927, which prohibits banks from branching across state lines. Ironically, the McFadden Act was passed to prevent the formation of a few large, nationwide banking conglomerates that might monopolize the financial markets. The McFadden Act prevents a bank in Texas from establishing a branch in Oklahoma, or in any other state for that matter. For years, many states also had restrictions that limited or prohibited branching within their state boundaries. The result of all this? Lots and lots of tiny banks. By the beginning of the 1980s there were about 14,400 banks in the United States, about 40 percent of which had assets less than $25 million. In contrast, the average size of the ten largest banks in the United States at the time was about $60 billion. To see the implications of all this, imagine that you owned a small bank in the middle of Illinois in 1970. At the time, Illinois prohibited any branching within the state. Therefore, you did not have to worry about the big Chicago banks such as First National, Continental Illinois, Harris Bank, or Northern Trust stealing your customers. Moreover, the McFadden Act conveniently prohibited Iowa- and Indiana-based banks from setting up shop across the street. There were no automated teller machines yet, and money market mutual funds were still a few years away. Town residents had virtually no choice. Pretty nice time to own a small bank, huh? The Erosion of McFadden This tidy world was not destined to last. The McFadden Act had a number of loopholes that were being increasingly exploited over time. Large banks were able to operate loan production offices across state borders. All of the major New York banks, for example, had loan production offices in most of the larger metropolitan areas by the 1970s. These offices were used to sell loan services to large and midsize local companies (although they could not accept deposits). Also, the S&L bailout legislation in the 1980s permitted bank acquisitions of failed thrifts across state lines. Most importantly, however, was an exception under the McFadden Act and subsequent legislation, permitting a bank holding company to acquire a bank in another state if that acquisition was expressly permitted by state law.5 A bank holding company, by the way, is a parent company that can own one or more subsidiary banks. In 1975, Maine became the first state to permit holding companies effectively to branch across state lines by buying Maine banks, if Maine bank holding companies received reciprocal rights.

5Actually,

federal branching laws are contained not only in the McFadden Act of 1927 but also in the National Bank Act of 1864, the Banking Act of 1933, and the Douglas Amendment to the Bank Holding Company Act of 1956. It was the Douglas Amendment that prohibited bank holding companies from acquiring banks across state lines, unless expressly permitted by state law. However, the McFadden Act is commonly understood to mean the whole network of restrictive federal branching laws.

220

Depository Financial Institutions

Nothing much happened in response to the Maine legislation until 1982 when New York passed a similar reciprocity law and Massachusetts passed legislation inviting a regional reciprocity pact in New England. The New York overture terrorized many state legislators across the country who feared that the big New York banks would take over the banking industry. As it played out, regional pacts were formed all across the country, though not surprisingly, all of the regional pacts formed in the 1980s excluded New York. However, there were some states, in addition to Maine, that passed national reciprocity laws (for example, Kentucky and Louisiana), and some that went even further and permitted acquisitions without reciprocity (for example, Idaho and New Jersey). As the country became a patchwork quilt of different interstate banking laws, the number of cross-border acquisitions accelerated rapidly. As a result, some banks that were only regional players in the 1970s became superregional, quasi-nationwide players by the 1990s. In the process they also became some of the biggest banks in the country, in part because the New York banks were partially constrained from playing in the acquisition game because they were excluded from many of the regional pacts. The ten largest banks at the beginning of the 1980s were all located in major financial centers, while by the mid-1900s four of the largest banks were from nonfinancial centers. Also, by the mid-1990s, almost 30 percent of domestic banking assets were owned by out-of-state bank holding companies, and seven bank holding companies had banks in ten or more states.6 Even the large financial center banks got into the act during the 1990s with the mergers such as Chemical and Manufacturers Hanover, First Chicago and NBD (although NBD was a Detroit-based bank), and Chase and Chemical. In 1994 Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act, which essentially overturned the McFadden Act. Under Riegle-Neal, bank holding companies were permitted to acquire banks in any other state, and in 1997, banks were permitted to establish cross-state branches of the same banking corporation (unless their state passed legislation prohibiting such interstate banking—which only two states did), without resorting to the holding company charade. Measuring Consolidation How far has consolidation gone? One measure is the number of banks. While there were 14,404 individual banks in the United States in 1980, there were only 7,282 by 2007, almost a 50 percent decline. However, this measure understates the magnitude of decline, because many individually chartered banks are held under the same holding company umbrella. A better measure of consolidation, then, is the number of independent banking organizations, where an independent banking organization is either an independent bank (a bank not owned by a holding company) or a holding 6See

Allen N. Berger, Anil K. Kashyap, and Joseph M. Scalise, “The Transformation of the U.S. Banking Industry: What A Long Strange Trip It’s Been” in the Brookings Papers on Economic Activities 2 (1995).

221

Depository Financial Institutions

Commercial banks and savings institutions

Number of offices 100,000

80,000 Savings institutions 60,000

40,000 Commercial banks 20,000

0 1985

FIGURE 1

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005 Year

Offices of FDIC-insured institutions (as of year end, 1985–2005).

company that owns subsidiary banks. Under this measure, a holding company which owns 20 banks would only be counted as one independent organization. The number of independent banking organizations declined from 12,380 in 1980 to 6,490 in 2002, a reduction of 48 percent. During this same period the percentage of total assets in banking organizations of $100 million or less dropped from 17 percent to less than 3 percent. Interestingly, despite the dramatic decrease in the number of banks and banking organizations the number of banking offices (headquarters plus branches) has slowly grown since the mid-1990s (see Figure 1). This suggests that, so far, the availability of banking services has not been adversely affected by consolidation. In fact, the increasing availability of Internet and telephone banking and the proliferation of ATM machines, combined with the stable number of traditional physical bank offices, suggest that consumers have better access to banking services than they ever did in the past. The Economics of Consolidation What’s behind this consolidation? Nearly everyone agrees that the artificial walls built by the McFadden Act created too many banks. But most bankers provide more fundamental justifications for consolidation. Some argue that banks must be large enough to offer a wide menu of different products. Others argue just the opposite—that while banks have to get big, financial supermarkets do not work. Instead banks must focus on a niche at which they are particularly good. Interestingly, there is one thing that most bankers believe as an article of faith: economies of scale in

222

Depository Financial Institutions

banking. Economies of scale means that the average cost of production falls as more is produced, implying that banks will get more efficient as they get larger. Conventional wisdom in the industry also argues that there are significant economies of scope in banking. Economics of scope means that offering two or more products is more efficient than offering just one. Banks have always been providers of a variety of products related to banking (commercial loans, consumer loans, checking accounts, CDs, and so on) and recently the menu has expanded to include a variety of nontraditional activities (which we describe in the next section). Therefore, it seems quite plausible that banks may enjoy economies of scope, with mergers offering a quick means to expand product menus. There is only one problem with the scale and scope argument—a lack of empirical evidence. Academic studies suggest economies of scale up to $5 billion. For banks with assets above $5 billion the evidence is mixed. If scale economies exist for these banks, they do not seem large enough to be the main motivation behind the recent spurt in mergers of very large banks. To get a sense of the size of a $5 billion bank, note that the 1998 NationsBank– BankAmerica merger resulted in a bank holding $570 billion of assets. There is also relatively little empirical evidence to suggest that there exist any economies of scope in banking. So how can we reconcile the academic view with the bankers’ view? First, the $5 billion level includes the vast majority of banks. Table 8 shows the size distribution of individual banks at the end of 2007. Of the 7,282 banks in the United States, 42.1 percent are under $100 million in asset size and 93 percent are under $1 billion. For these banks, the economies of scale argument may hold and many of them are likely to disappear. Second, mergers and acquisitions involving banks with assets greater than $5 billion, such as the J. P. Morgan–Chase merger and the NationsBank–BankAmerica merger, produce leaner and meaner banking organizations by eliminating jobs and streamlining back office operations. However, bankers may be incorrect to attribute these savings to economies of scale and scope. If one or both parties to a megabank merger are inefficient before they merge, then the merger may prove an opportunity to do precisely what they should have done prior to the merger: cut costs and streamline operations.

TABLE 8

Size Distribution of Insured Commercial Banks (December 31, 2007)

Asset size

No. of banks

% of total banks

% of total assets

Less than $100 million

3,065

42.1

1.5

$100 million to $1 billion

3,706

50.9

9.4

425

5.8

10.0

86

1.2

79.1

$1 billion to $10 billion More than $10 billion

223

Depository Financial Institutions

In The News Bank Mergers Make Raising Funds for Projects Harder As New Jersey–based banks continue to be acquired, community development financial institutions (CDFIs) and other organizations are finding it increasingly hard to raise capital for local community development projects. Such groups say that consolidations lead to less frequent contact with the banks and more administrative work, and increase the time needed to raise capital. In the face of these obstacles, some organizations are turning more attention to other financial sources. The New Jersey League of Community Bankers says at least nine local banks have gone through mergers this year. Nationwide, the number of commercial banks and savings institutions has dropped from more than 15,000 in 1990, when about 450 mergers took place, to about 8,600 in 2007, which had about 150 mergers, according to the Federal Deposit Insurance Corp. (FDIC) in Washington, D.C. “We’ve seen our list of financial institution supporters shrink,” says David Scheck, president at New Jersey Community Capital, a Trenton-based community development financial institution that provides funding for affordable housing, early child-care centers and charter schools throughout the state. The organization raises funds by selling a product similar to uninsured certificates of deposit to banks. These make up 45 percent of the

CDFI’s supporters—religious groups, individuals, government units, and other investors. Between 2000 and 2006, he says, 19 of the CDFI’s 40 or so banking investors were involved in mergers. Fourteen remain investors, while five others discontinued their funding post-merger. This year’s acquisitions of New York City–based U.S. Trust by Bank of America and Cherry Hill–based Commerce Bank by Canada’s TD Banknorth could remove two more from New Jersey Community Capital’s investor roster. On the other hand, newly merged institutions can provide larger amounts of capital to organizations following acquisitions. Patrick Kelly, a senior vice president in Bank of America’s Princeton office, began working for what was then Summit Bank 25 years ago. Kelly says Summit invested $250,000 a year in New Jersey Community Capital before Summit’s 2001 acquisition by FleetBoston Financial Corp., which increased the investment to $1.25 million annually. He says funding then quadrupled after Bank of America acquired Fleet three years ago. In addition, says Kelly, Bank of America currently invests in four CDFIs in New Jersey, whereas the predecessor banks invested in one. “We’ve only increased our impact,” he says. Source: Evelyn Lee, NJBIZ, Nov. 12, 2007, p. 1© 2007 Journal Publications Inc. All Rights Reserved. Reprinted from NJBIZ with permission.

Evidence suggests that while economies of scope and scale do not seem to characterize banks with assets greater than $5 billion, inefficiencies do.7 This explains why an efficient bank may want to acquire an inefficient bank (at a cheap price), throw out the old management, and impose its own operating system to make the acquired assets more efficient. Why were there so many inefficient banks? Quite probably because bank regulations such as Regulation Q and the McFadden Act protected inefficient bankers for years. 7See

Allen N. Berger and David Humphrey, “The Dominance of Inefficiencies over Scale and Product Mix in Banking,” Journal of Monetary Economies 28, 1991, and the Journal of Banking and Finance (Special Issue on Efficiency), 1993.

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Depository Financial Institutions

Nontraditional Banking For most of this century banks have been severely limited in terms of permissible activities. The bank holding company form of organization mentioned earlier, however, has provided banks with more regulatory freedom. The Federal Reserve has the power to determine what activities are permissible in a bank holding company beyond the narrowly restricted banking activities conducted in the bank subsidiary. A permissible activity, however, must be “closely related to banking.” For example, bank holding companies can offer data processing services, credit insurance, credit card services, and investment advice. However, before 1999, the Glass-Steagall Act of 1933 prevented large commercial banks from engaging in the activity they seemed to covet most, investment banking—although there are some important exemptions. Banks could underwrite municipal general obligation bonds and banks could also act as agents for private placements (unregistered securities that cannot be sold to the public at large). For years, however, the Glass-Steagall Act prohibited one of the most lucrative parts of the investment banking business— the underwriting of domestic corporate debt and equity. The forces of competition, however, are hard to suppress. Beginning in 1963, banks embarked on a strategy of testing the gray areas of Glass-Steagall and letting courts serve as arbiters. Banks challenged restrictions on a wide variety of activities including municipal revenue bond underwriting, commercial paper underwriting, discount brokerage, managing and advising openand closed-end mutual funds, and underwriting mortgage-backed securities. In some cases they were successful; in other cases they were not. Finally in 1987, the Federal Reserve succumbed to the pressure (or recognized the inevitable, depending on your view) and allowed bank holding companies to form investment banking subsidiaries, or Section 20 affiliates, to engage in so-called ineligible activities (should these now be called “eligible” activities?). The Federal Reserve granted corporate bond underwriting privileges to a handful of commercial banks in 1989 and soon thereafter, J. P. Morgan was granted the right to underwrite corporate equity. Essentially the Federal Reserve reinterpreted the meaning of “closely related to banking,” but kept Glass-Steagall alive by limiting Section 20 activity in corporate underwriting and other ineligible activities to 5 percent (or less), of total investment banking revenues. This constraint was subsequently increased to 10 and then 25 percent. The relaxation in 1997 to 25 percent precipitated a number of bank acquisitions of investment banking firms, including NationsBank’s (now BankAmerica) acquisition of Montgomery Securities and Citibank’s combination with Salomon Smith Barney (via Citibank’s merger with the Travelers Group, which included Salomon Smith Barney). It does not surprise us if these acquisitions and name changes leave you wondering who swallowed whom and why. The last vestiges of the Glass-Steagall Act were swept away when the Gramm-Leach-Bliley Act was passed by Congress in 1999. Another major push into nontraditional banking has been in the area of off-balance sheet activities. Broadly defined, off-balance sheet activities create

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Depository Financial Institutions

a potential (or contingent) exposure to the bank but are not classified for accounting purposes as an asset or a liability. Thus, during the 1970s and 1980s, banks became major players in selling and trading new instruments such as interest rate swaps, financial futures, and financial options. Banks also dramatically increased their guarantee and commitment business. A good example is a stand-by letter of credit to back a municipal bond issue. A municipality issues bonds backed by a guarantee in the form of a bank letter of credit. If the municipality defaults, the owners of the bond can seek payment from the bank. Why did banks, particularly larger ones, pursue nontraditional activities so earnestly? One reason is the loss of the large corporate loan business to the financial markets. Another factor was the new capital adequacy (leverage) requirements imposed during the early and mid-1980s, as bank regulators increased the minimum required ratio of equity capital to total assets. This constrained “on-balance sheet activities” of larger banks that were less well capitalized than smaller banks and promoted nontraditional banking activities that did not affect “on-balance sheet” bank asset size.

Globalization Only 30 years ago, U.S. banks, with few exceptions, stayed within their own national borders. The field of international banking was dominated by British banks. But things have changed dramatically since then. Now many large U.S. banks do a significant part of their business overseas, lending to foreigners and underwriting securities in foreign markets. Similarly, foreign banks do a lot of business in this country, lending to Americans and underwriting in domestic U.S. markets. American Banks Abroad In 1960 only eight U.S. banks had branches abroad, and the assets of those branches totaled less than $4 billion. Now more than 100 American banks have foreign branches, and the assets of those branches total over $1.5 trillion. What accounts for this remarkable expansion of U.S. banks into foreign countries? One reason is the rapid growth of foreign trade and expansion of U.S. multinational corporations that has taken place since 1960. American firms engaged in importing or exporting as well as American multinationals with subsidiaries and affiliates abroad often need banking services overseas. Foreign banks can do the job if necessary, but a branch of an American bank abroad can be even more convenient: There are no language problems; the firm and the branch share common business customs and practices; and, in the case of multinationals, the parent firm and parent bank may already have longstanding ties with each other. In addition to branches abroad, U.S. banks also participate in international financing through Edge Act corporations, which are domestic subsidiaries engaged strictly in international banking operations. In 1919 Congress passed the Edge Act (named after Senator Walter Edge of New Jersey) to allow U.S. banks to establish special subsidiaries to facilitate their involvement in international finance. Edge Act corporations are located in the United States,

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Depository Financial Institutions

but they have been exempt from the McFadden Act’s prohibition against interstate branching, so that a bank can have Edge Act subsidiaries in several different states—one in Florida, for example, specializing in financing trade with Latin America, one in New York, one on the West Coast, and so on. Foreign Banks in the United States Just as U.S. banks have a major presence abroad, so foreign banks play a significant role in this country. For example, in a typical year about a third of the dollar volume of all commercial bank business loans in the United States is made by branches or subsidiaries of foreign-owned banks. Many large and well-known banks are foreign-owned: The United California Bank, the First Hawaiian Bank, and the Bank of the West are all owned by the French bank BNP Paribas; the Union Bank of California is substantially owned by the Bank of Tokyo–Mitsubishi, Ltd.; Harris Bank of Chicago is owned by the Bank of Montreal; Marine Midland Bank of Buffalo is owned by the Hongkong and Shanghai Banking Corporation (HSBC), which changed its name to HSBC. All in all, close to a thousand offices of foreign banks are currently operating in the United States. Foreign banks do business here through four main organizational forms: They may open a branch of the parent bank, open or buy a subsidiary bank, establish an agency, or open a representative office. A branch is an integral part of the foreign bank and usually carries that bank’s name. A subsidiary is legally separate from the foreign bank that owns its stock; the subsidiary usually has its own charter and may or may not carry the name of its foreign owner. Both branches and subsidiaries are full-service banking institutions. Agencies have more limited powers than either branches or subsidiaries; they can make loans but cannot accept deposits. Representative offices cannot accept deposits or make loans; they mostly make contacts with potential customers of the parent organization (by holding dinner parties) and perform public relations functions (by sponsoring rock or philharmonic concerts). Foreign banks can also complicate matters further by having Edge Act corporations in the United States. Until 1978, foreign banks operating in the United States were largely unregulated. They did not have to hold reserves with the Federal Reserve, they were able to branch across state lines, and they had numerous other rights and privileges denied to domestic banks. This was changed by the International Banking Act of 1978, which brought foreign banks under essentially the same federal regulations that apply to domestic banks. However, there was a very important grandfather provision included in the act. This provision allowed foreign banks to keep their “illegal” interstate branches and continue their securities-activity operations. That is, interstate banking and securitiesactivities restrictions only applied to new foreign banks operating in the United States that started operations after 1978. The Euromarkets The spread of international trade and the growth of American multinationals encouraged branching by American banks overseas, but these were not the only factors stimulating foreign branches. The maximum deposit rates prescribed by Regulation Q played a part as well.

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Depository Financial Institutions

In the 1960s when Regulation Q still imposed interest-rate ceilings in the United States, European banks were able to offer more attractive yields to potential depositors than U.S. banks were allowed to pay. Not only were there no interestrate ceilings in most countries abroad, but other regulations, such as reserve requirements against deposits, were typically less onerous than in the United States. As a result, foreign banks could outbid American banks for time deposits. These deposits in foreign banks, mainly in London, not only paid higher yields than American banks, but, as an added inducement for the convenience and safety of Americans, were recorded as payable in dollars rather than in pounds or francs or whatever the money of the host country. Naturally enough, such deposits came to be known as Eurodollars. The term has since been broadened to mean deposits in banks abroad—still mostly in London, but now in other places in Europe and in Asia and the Caribbean as well—that are on the banks’ books as payable in U.S. dollars rather than in the money of the country where the bank is located. Eurodollars are created when an American transfers a dollar deposit from an American bank to a foreign bank and keeps it there in dollars (rather than switching to pounds, say, if the bank to which the money is transferred is in London). Eurodollars are also created when a foreign holder of a deposit in a U.S. bank does the same thing, as when a French exporter gets paid with a check drawn on an American bank and deposits the check in a Parisian bank with instructions to retain it as a dollar deposit instead of exchanging it into an equivalent amount of francs. Why would anyone want to do this? Because dollars are still considered safer than most other kinds of money and are still more generally acceptable in international transactions than any other kind of money. In response, many American banks decided to open their own branches abroad to escape domestic regulations and to bid for funds on a more equal basis with their foreign competition. During periods of tight money, when their ordinary domestic sources of funds dried up because of Federal Reserve restraint, Regulation Q, and financial disintermediation, American banks turned around and borrowed these Eurodollars back from their foreign branches. As we noted earlier in this chapter, these loans from foreign affiliates became an important new source of bank funding and are included under “miscellaneous liabilities” in Tables 3 and 4. Of the $1.5 trillion held in foreign branches of U.S. banks at the end of 2007, a substantial fraction was in London branches and in branches in the Bahamas and the Cayman Islands. Branches in London are easy to understand: London has been an international financial center for centuries and remains the heart of the Eurodollar market. But how did the Bahamas and the Caymans ever get into the act? The Bahamas and the Caymans are tax havens, with almost zero taxation and practically no regulation. Virtually all the assets in branches there are held not by full-service branches but by “shell” branches, which are primarily bookkeeping operations with fund-raising and lending decisions emanating from the banks’ head offices in the United States. A rise in British taxes in the early 1970s led to a substantial shift in loan operations from London to the Bahamas. The Cayman Islands subsequently

228

Depository Financial Institutions

came into the picture when the Bahamas achieved their independence, giving rise to anxiety (since proven to be unfounded) that this might lead to increased Bahamian regulation and taxation. Just as the Eurodollar market is the money market of the Euromarket, the Eurobond is the long-term part of the Euromarket. Eurobonds are bonds that are sold (a) outside a borrowing corporation’s home country, and (b) usually outside the country in whose money the bond’s principal and interest are expressed. A typical issue today might involve, for example, a bond that is sold to investors in Great Britain by General Mills, a Minneapolis-based corporation, with the principal and interest payable in dollars. The Eurobond market has been increasingly used by American companies because it has a number of tax advantages and relatively little government regulation. The market is not confined to business borrowers; it is also a major source of funds for foreign governments. In fact, the first Eurobond appeared in 1963 when a British investment bank underwrote a U.S. dollar–denominated bond issue for the Italian highway agency. Eurobonds are frequently brought to market by consortiums that cooperate across several national boundaries. For instance, dollar-denominated bonds (meaning that the principal and interest are expressed in dollars) could be issued by a Swedish corporation or by a Latin American government. They might be sold through an underwriting group that consists of the overseas affiliate of a New York investment banking firm, several banks in France and Italy, and a consortium of German banks. Parts of the issue thus wind up in the hands of individual and institutional investors in a number of different European nations. The overseas affiliates of several large U.S. commercial banks are quite active as underwriters in the Eurobond market. In 1981 in an effort to bring some of the offshore Euromarket business back home, the Federal Reserve approved the establishment of International Banking Facilities (IBFs) on American soil. Caribbean branches flourished because they operate in an environment almost entirely free from regulation and taxation. The purpose of IBFs is to offer banks comparable conditions here and thus lure offshore banking back to the United States. Both American and foreign banks can now have IBFs that are within the geographic confines of the United States but are regulated as though they were located abroad. In effect, an IBF is a domestic branch that is treated by the Federal Reserve as if it were a foreign branch. Their transactions are considered offshore transactions, free from such domestic regulations as reserve requirements and deposit insurance assessments. It is not necessary for a parent bank to open up a separate office to establish an IBF. Essentially, IBFs are bookkeeping operations, just like shell branches. A bank wanting to start an IBF simply notifies the Federal Reserve and then segregates its IBF assets, liabilities, and related transactions from all others. This creates a new set of books that are exempt from the usual rules and regulations that apply to domestic transactions. Moreover, many states have enacted legislation exempting the income of IBFs from state and local taxes, thereby providing an environment that closely resembles tax havens abroad.

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Depository Financial Institutions

So much for the good news; the bad news is that the services of IBFs are not available to domestic residents. IBFs can transact only business that is international in nature with respect to both sources and uses of funds. They are permitted to accept deposits from and lend funds to foreign-based customers only. Foreign subsidiaries of American multinationals are included among the eligible depositors and borrowers, provided the funds do not come from domestic sources and are not used for domestic purposes.

The Subprime Mortgage Crisis As we noted earlier in this chapter, banks have significantly increased their exposure to residential mortgages, particularly in the last decade. Some of this increase was a consequence of direct mortgage lending. However, much of it involved banks buying securitized mortgages. Recall that securitized mortgages are mortgages that are pooled into trusts. Claims are issued against these pools of mortgages that become traded securities in the market. These claims are referred to as mortgage-backed securities (MBS). Banks and investment banks were also very actively involved in putting these pools together and selling them (i.e., underwriting mortgage-backed securities)—often to other banks. Earlier in the decade mortgage lending began to shift from low-risk mortgages to high-risk mortgages, particularly in the MBS segment of the market. Low-risk mortgages are called prime mortgages and high-risk mortgages are called subprime mortgages. Subprime mortgages are mortgages in which (1) the borrower has a low credit rating; (2) the lender does not verify the borrower’s income; and (3) the amount of the mortgage exceeds 80 percent of the appraised value of the home. In fact, it was not uncommon for the value of a subprime mortgage to exceed 100 percent of the value of the home. Many of these subprime mortgages were also adjustable rate mortgages where the interest rate would periodically adjust as market rates changed. Often these adjustable rate mortgages had “teaser rates” that were set artificially low during the first year or two of the mortgage. Subprime mortgage origination grew from about 6 percent of total residential mortgage lending at the beginning of the decade to over 20 percent by 2005. Banks were quite happy adding these subprime mortgages to their portfolios as rapidly rising real estate prices made these mortgages look relatively safe earlier in the decade. This continued across most of the country until about mid-2005 as shown in Figure 2. For some parts of the country the increases in prices were particularly dramatic. The pattern of rapid price increases is referred to as a pricing bubble. However, real estate price increases started to decline. Essentially the bubble popped. Along with falling real estate prices mortgage defaults began to increase significantly. Not surprisingly most of the increase in default rates was focused on subprime mortgages with the worst default rates being associated with adjustable rate mortgages made later in the decade when real estate prices were at their peak. The increase in mortgage defaults and home foreclosures began to take their toll on commercial banks in the fall of 2007. The charge-off and nonperforming

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Depository Financial Institutions

Percent 35 30 25 20 15 10 5 0 5 10 15 20 25 30 35

FIGURE 2

Phoenix

San Diego

Year 1990

1998 1992

1994

2000

2002

2004

2006

2008

1996 Miami

National

Case-Shiller home price index (percent change over prior year).

Source : Standard & Poor’s.

loan figures for 2007 shown earlier in Table 7 are considerably higher than they were in 2006. This trend is more clearly demonstrated in Figures 3 and 4 which show nonperforming loans and charge-offs by quarter. Banks were not the only financial institutions that were affected by the subprime crises. 2.0

1.5

1.0

0.5

0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Year

FIGURE 3

Portion of loans and leases that are nonperforming.

N ote: Figures are for U.S. banks with $10 billion or more in assets.

Source: FDIC; Wall Street Journal, March 4, 2008. Reprinted with permission of The Wall Street Journal, Copyright © 2008, Dow Jones & Company, Inc. All Rights Reser ved Worldwide.

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Depository Financial Institutions

2.0

1.5

1.0

0.5

0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Year

FIGURE 4

Charge-offs as a percentage of all loans and leases.

Note: Figures are for U.S. banks with $10 billion or more in assets. Source: FDIC; Wall Street Journal, March 4, 2008. Reprinted with permission of The Wall Street Journal, Copyright © 2008, Dow Jones & Company, Inc. All Rights Reser ved Worldwide.

$22.4

Merrill Lynch Citigroup UBS Morgan Stanley HSBC Credit Agricole Deutsche Bank Bank of America CIBC Wachovia AIG Barclays Royal Bank of Scotland Credit Suisse Bear Stearns J.P. Morgan Chase Countrywide Others: $4.6 billion Total: $107.8 billion

19.9 14.4 9.4 7.5 3.6 3.2 3.0 3.0* 2.7* 2.7 2.7 2.5 1.9 1.9 1.4 1.0 0

5

10

15

20

25

* Includes fourth quarter forecasts.

FIGURE 5

2007 bank charge-offs (in billions).

Source: Wall Street Journal , Januar y 18, 2008. Reprinted with permission of The Wall Street Journal, Copyright © 2008, Dow Jones & Company, Inc. All Rights Reser ved Worldwide.

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In The News Rate of Mortgage Delinquencies Rises; Foreclosures Are Also Increasing, New Report Shows Even as federal and state governments come under growing pressure to respond to the mortgage crisis, new data show that the pace at which mortgages are going delinquent is speeding up. A new report by Equifax, the credit bureau, and Moody’s Economy.com shows that 4.46 percent of mortgages were at least 30 days past due at the end of the first quarter, up from 3.98 percent in the fourth quarter and up 2.92 percent [from] a year earlier. Delinquencies in the first quarter varied sharply by state, but were highest in Puerto Rico (8.03 percent), Florida (7.03 percent), and Nevada (6.59 percent.) The foreclosure rate, meanwhile, jumped to 1.39 percent, from 1.08 percent at the end of last year and 0.58 percent a year earlier. The increases in mortgage delinquencies and foreclosures were the biggest since at least 2000, when the firms began collecting these data. A report released Wednesday by UBS AG suggests that foreclosures won’t peak until the middle of next year. The latest increases in delinquencies are being driven in part by falling home prices and rising unemployment. The U.S. economy lost 80,000 jobs last month, according to the Labor Department, the biggest drop in five years. Meanwhile, some 8.8 million borrowers had mortgages that exceeded the value of

their homes in the first quarter, with the number expected to increase to 10.6 million in the second quarter, according to Moody’s Economy.com. “It’s an incredibly bad mix that is causing foreclosures to go skyward,” says Mark Zandi, chief economist of Moody’s Economy.com. Mr. Zandi is serving as an unpaid economic adviser to Republican Sen. John McCain. The problems are also spilling over into other sectors, with delinquencies rising for credit cards, autos, and student loans. A record $715 billion of consumer debt is now in delinquency or default, according to Equifax and Moody’s Economy.com, up from nearly $300 billion three years ago. There are signs that a broader swath of homeowners are getting caught in the housing market’s undertow. In Cleveland, suburban homeowners accounted for 53 percent of those calling United Way 211 First Call for Help with mortgage problems in the first quarter, up from 46 percent in the fourth quarter. In Maryland, borrowers in financial distress include government employees, Ph.D.s and others who never had credit problems, says Thomas Perez, Maryland’s Secretary of Labor, Licensing and Regulation. Source: Ruth Simon, Wall Street Journal, April 10, 2008, p. D3. Reprinted with permission of The Wall Street Journal, Copyright © 2008, Dow Jones & Company, Inc. All Rights Reserved Worldwide.

Figure 5 shows the write-downs (i.e., charge-offs) by banks as a result of the crisis through year-end 2007. While the “top ten” financial institutions include many of the largest banks in the world (e.g., Citigroup, UBS, and HSBC) it also includes well-known investment banks such as Merrill Lynch and Morgan Stanley. The crisis had gotten so bad that the Federal Reserve had to assist in the disposition of a large New York investment bank, Bear Stearns, when it collapsed in late March 2008 after creditors lost confidence in the bank because of its losses in subprime mortgages. Specifically, the Federal Reserve assisted in JP Morgan’s takeover of Bear Stearns by insuring JP Morgan against losses on $29 billion of its mortgage-backed securities portfolio.

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Depository Financial Institutions

Nonbank Depository Institutions—The Thrifts In addition to commercial banks there are three other types of depository institutions: savings and loan associations, mutual savings banks, and credit unions. Together these three institutions comprise the thrift industry. They are called thrifts because their principal source of funds is consumer deposits. On the asset side, savings and loans principally invest in residential mortgages and are constrained today to having at least 70 percent of their assets in housing-related loans. Mutual savings banks, which exist mostly in the East, are similar to savings and loans although they have historically had more power to make consumer loans. Credit unions principally invest in consumer loans. The savings and loan industry all but collapsed during the 1980s. In the early part of that decade it faced the consequences of an extreme balance sheet maturity mismatch (long-term, fixed-rate mortgages financed by short-term deposits) combined with a huge spike in interest rates. In the second half of the decade it suffered big losses in newly permitted activities, particularly commercial mortgages and real estate. While the industry started the decade with assets that were 43 percent as large as the commercial banking industry, it finished the decade with assets only 32 percent as large. The mutual savings bank industry suffered a similar fate, with assets declining relative to commercial banks from 11.8 percent to 9.3 percent. The trend has accelerated to the point where by 2007 the combined assets of the savings and loan associations and mutual savings banks were less than 17 percent of bank assets. In fact, many of the best savings and loans have converted their charters to commercial banks. Credit unions were unaffected by the problems suffered by the savings and loan associations and mutual savings banks because they didn’t have mortgages on their balance sheets when interest rates soared in the early 1980s. Credit unions are cooperatives organized around a common group (most often employees of the same company). Most credit unions are quite small, although some exceed $1 billion in assets. The management issues for the thrifts are similar to commercial banks. Like commercial banks, their success depends on their ability to lend money for more than it costs, which is reflected in their net interest margin. Also, like banks, the thrifts face leverage risk, credit risk, interest rate risk, and liquidity risk. Because of their extensive investment in mortgages, interest rate risk is a particularly important problem for mutual savings banks and the savings and loans. Thus our earlier discussion regarding the GAP ratio also applies to these thrift institutions. In view of their declining importance in the financial landscape, however, little more needs to be said about them.

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SUMMARY 1. Over the past few decades, commercial banks have reduced their holdings of cash and state and local securities and increased their holdings of loans, especially real estate loans.

2. On the liabilities side, transactions deposits, which were 43 percent of bank liabilities in 1970, declined to 6 percent in 2007. Their place was taken by large-size negotiable CDs and borrowed funds, such as federal funds purchases and the sale of securities under repurchase agreements.

3. Key determinants of bank profitability include: (a) the net interest margin, which measures the spread between the yield on assets and the cost of liabilities; (b) the provision for loan losses; and (c) salary and wages.

4. Successful bank management requires good risk management. There are five major sources of risk in banking: leverage risk, credit risk, interest rate risk, trading risk, and liquidity risk.

5. Since the early 1980s, banking has experienced a period of consolidation, stemming in part from the erosion of regulatory barriers to interstate banking. This consolidation will produce industrywide gains in efficiency from economies of scale at small banks and from the elimination of inefficient management at both small and large banks.

6. Over the past two decades, as regulatory barriers have come down, banks increasingly pursued nontraditional off-balance sheet activities, such as underwriting and investment advisory services.

7. Since the 1960s, U.S. banks have become much more active in foreign markets and foreign banks have become much more active in U.S. markets.

8. Banks began lending aggressively to subprime mortgage borrowers in the early part of this decade. Problems did not appear early in the decade because real estate prices were rising rapidly. However, by 2006 real estate prices began falling and defaulting subprime mortgages became a serious problem for banks.

KEY TERMS bank holding company

economies of scope

floating interest rate

book value

Edge Act

GAP ratio

bubble

Eurobond

Glass-Steagall Act

collateral

Eurodollar

historical cost accounting

credit risk

Euromarket

interest rate risk

daily earnings at risk (DEaR)

federal (Fed) funds market

interest rate spread

economies of scale

federal funds rate

International Banking Facilities (IBFs)

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Depository Financial Institutions letter of credit

net interest margin

return on equity (ROE)

leverage

nonperforming loan

risk-based capital (RBC)

LIBOR

nontransactions deposit

savings deposit

liquidity risk

off-balance sheet

Section 20 affiliates

loan charge-off

one-year repricing GAP

securitization

marked-to-market

prime

subprime

money market deposit accounts

prime rate

time deposit

repricing maturity

transactions deposit

negotiable certificate of deposit

repurchase agreement

trading risk

net interest income

return on assets (ROA)

QUESTIONS Questions with a red oval are in

236

at www.myeconlab.com.

12.1

How have the major sources of bank funds changed in the past 30 years?

12.2

Why have banks replaced many fixed-rate loans with floating-rate loans?

12.3

Bankers hold more liquid assets than most business firms. Why?

12.4

Why should a consumer patronize a credit union rather than a real bank?

12.5

How do banks minimize liquidity risk? Is there a tradeoff between liquidity risk and interest rate risk?

12.6

Discussion question: Has the reduction of regulatory barriers, including deposit rate ceilings, restrictions on interstate banking, and restrictions against nontraditional activities, produced a safer or riskier financial system?

12.7

Banks have incurred serious losses in their subprime mortgage portfolios. What could they have done to prevent this? What could bank regulators have done?

12.8

Discussion question: For most of this century commercial banking has been separated from other financial service providers. Now banks have combined with everything from mutual funds to investment banks. Does it make sense to go the final big step and let nonfinancial companies (such as IBM, Microsoft, or Boeing) own banks and vice versa?

Nondepository Financial Institutions

Once upon a time, so the story goes, there were deposit financial institutions and nondeposit financial institutions and never the twain did meet. Those days began to disappear several decades ago. The sharp differences between deposit and nondeposit institutions have faded, as various financial institutions have aggressively invaded each other’s territories. In this chapter we will look at each of the major nondeposit financial institutions as well as the overlaps and conflicts that have erupted.

LEARNING OBJECTIVES In this chapter you will learn to understand the broad range and function of nondepository financial institutions describe the tools of insurance companies define the types and obligations of pension funds distinguish finance companies and alternate financing institutions such as venture capital funds, hedge funds, and mezzanine debt funds

Insurance Companies and Pension Funds The first life insurance company in the United States (the Presbyterian Ministers’ Fund) was established shortly before the Revolutionary War and is still in existence. There are now about 1,100 life insurance companies in the country, with combined assets of about $5 trillion at the end of 2007. Some, like Prudential Insurance Company and Metropolitan Life, are among the largest and best-known corporations in the world. Life insurance companies are structured as either stock companies or mutual associations. In stock companies, the business is owned and controlled by regular stockholders; in mutuals, ownership and control technically rest with

From Chapter 13 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

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the policyholders. More than 90 percent of the life insurance companies now in existence are stock companies, but the mutuals are much larger and control almost half the assets. Life insurance companies are supervised and regulated almost entirely by the states in which they operate. A company must be licensed and file reports in all states in which it sells life insurance. Regulation covers virtually every aspect of the business, including sales practices, premium rates, and allowable investments, and is usually overseen by a state insurance commissioner, who is sometimes also the state banking commissioner. Firms marketing life insurance used to specialize almost exclusively in selling whole life policies to individuals. Such policies have a constant premium, which the policyholder pays through the entire life of the policy. In the early years of the policy, this constant premium is higher than actuarial probabilities warrant, but later on it becomes lower than required by actuarial probabilities. (Actuaries are statisticians who specialize in mortality probabilities.) Since the earlier premiums are higher than necessary in terms of actuarial statistics, whole life policies build up reserves. These reserves provide savings that yield a cash value the policyholder can borrow against or take outright at any time by canceling the policy. Whole life policies contrast with term life insurance, in which premiums are relatively low at first but then rise as policyholders grow older and have a higher statistical probability of dying. Term life insurance policies are pure insurance and involve no reserves or savings element. In the 1980s the life insurance industry increasingly emphasized group insurance (offered through employers, for example) as much as policies for individuals. In addition, life insurance companies began offering new types of life insurance policies, called universal life and variable life insurance policies. Up until then, whole life had been a very profitable product for life insurance companies, in great part because these policies paid so little interest on the savings component.1 Most consumers, however, were quite unaware of this because the effective interest rate was not disclosed. But in a low and stable interest rate environment no one really seemed to care. However, in the rapidly rising interest rate environment of the late 1970s the small saver took notice. Many small savers canceled their whole life policies (or borrowed against their cash values), and bought a combination of a term life insurance and money market mutual funds. The life insurance industry responded by creating the universal life policy and the variable life policy. The universal life and variable life policies essentially “unbundle” the term insurance and the tax-deferred savings component

1To

be fair, it should be noted that the U.S. tax laws gave (and still give) the purchasers of many life insurance products (including whole life insurance) a tax break. Income taxes on the earnings of the accumulated cash value is deferred until the cash value is paid out at the end of the policy or when the policy is canceled. Even with this tax break, however, the after-tax yield on the savings component of a whole life insurance policy in the mid-1970s was considerably below market rates.

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found in the whole life insurance policy. The savings component in a universal life policy pays a money market rate of interest that changes with market conditions. The savings component in a variable life policy is allocated among a menu of investment options, including a money market mutual fund, a bond fund, and at least one stock fund. In line with these developments, life insurance companies have also altered their investment policies. Traditionally they used the policy premiums they received (in excess of what they paid in benefits) mainly to buy long-term corporate bonds and commercial mortgages. Lately, however, they have branched out into riskier ventures, such as common stocks and real estate. Metropolitan Life, for instance, paid $400 million in 1981 to buy the Pan Am Building in New York City.2 Property and casualty insurance companies cannot plan ahead as easily as life insurance companies because they have no simple equivalent of actuarial mortality tables to tell them how much they will probably have to pay out every year into the indefinite future. About 3,000 companies nationwide offer insurance against casualties such as automobile accidents, fire, theft, personal negligence, malpractice, and almost anything else you can dream up. Lloyd’s of London, it is said, will insure against any contingency—at a price. Property and casualty insurance companies, like life insurance companies, are regulated and supervised almost exclusively by the states in which they operate. There is little federal involvement. State insurance commissions set ranges for rates, enforce operating standards, and exercise overall supervision over company policies. Their investment policies reflect the fact that they are fully taxed and that casualty losses can be unexpected and highly variable. Thus they are heavy buyers of tax-free municipal bonds and liquid short-term securities. A lot of people are financially better off dead than alive, because when they die their life insurance policies pay out a hefty amount. Problems arise when they stay alive too long after they’ve finished their working careers and find out that social security doesn’t come close to meeting their day-to-day retirement needs, not to mention buying an occasional luxury item. Pension plans are intended to fill this gap, enabling retirees to maintain a decent standard of living. Most pension fund assets are in employer-sponsored plans. These plans come in two varieties: defined benefit plans and defined contribution plans. In a defined benefit plan, retirement benefits are defined (specified by the plan) and employer contributions are adjusted to meet those benefits. In a defined contribution plan the contributions are defined (specified by the plan) and the benefits depend on the performance of the assets in the plan. Until the 1980s the vast majority of private pension assets were in defined benefit plans. Since then, however, defined benefit plans have been eclipsed in terms of new pension contributions by defined contribution plans. (Some employers, however, offer both.) Now the amount of funds in defined contribution plans is greater than the amount of funds in defined benefit plans.

2In

1992 the company changed the name to the Met Life Building.

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In The News The Coming Deluge If one of the “Big Three” U.S. automakers— General Motors, Ford, and Chrysler—declares bankruptcy in the future, a major contributing factor will be the spiraling costs of health benefits for their retired workers. The “Big Three” aren’t the only major institutions facing dire financial problems directly attributed to the health costs of their retired workers. Virtually every state in the nation and countless cities across America confront the same problems after having granted public employees earlyretirement deals replete with taxpayer-funded health benefits. Blue-collar auto workers often need to retire after 30 years of physical labor because their bodies can no longer take the daily wear and tear of the assembly line. But state and local governments have no such excuse for burdening their taxpayers with breathtaking health-care costs by permitting their largely pencil-pushing, keyboard-striking bureaucrats to retire 10 to 15 years before they become eligible for Medicare at the age of 65. Moreover, in recent decades, the private sector has relentlessly replaced company-paid definedbenefit pension plans with 401(k) retirement plans that require employees to finance their own pensions through defined contributions. During that period, the taxpayer-financed public sector has achieved a near monopoly on gold-plated, early-retirement pension plans, which are buttressed by extravagant, taxpayer-funded health benefits for 10 years and longer. And most taxpayers do not have a clue what they will be facing in the near future. In an eye-popping analysis of the financial crisis barreling down upon New Jersey’s taxpayers, the New York Times last week reported that the state has accumulated a health-care-related unfunded liability of $58 billion. That’s the amount of money, in today’s dollars, that is needed to pay for the health costs of its public employees after they retire. Noting that the state’s $58 billion retiree-healthcare millstone is nearly double New Jersey’s

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annual budget and its outstanding debt, the Times further reports that New Jersey local governments have incurred another $10 billion in largely unfunded health costs for their own retired public workers. Meanwhile, the state’s pension fund is so underfinanced that it would need annual infusions of $2.2 billion just to bring it back to balance. Despite making pensionfund contributions that are larger than the combined averages of the previous four administrations, Democratic Gov. Jon Corzine is still able to provide only half of what is needed for pensions. Regarding the health-benefits crisis, for now it is pay-as-you-go. New Jersey’s state government will spend about $1.1 billion on the health costs of its retired public employee this year; and that amount will double within five years. To get a handle on health benefits for retirees, a former New Jersey treasurer estimates that the state would have to begin today setting aside $6 billion per year. With pensions so unfunded, however, not a dime is available to resume financing a health trust fund. We say “resume” because from 1987 through 1994 New Jersey was one of only a few states that had the fiduciary foresight to set aside money for retiree health costs. But newly elected Republican Gov. Christine Todd Whitman decided in 1994 to end that practice. Instead, the money that had been going into a health trust fund was used to finance the tax cut she promised to win election. No longer setting aside any money for retiree health care, New Jersey effectively pretended those future obligations did not exist. That mindset encouraged politicians to improve retiree health benefits. New Jersey public workers can generally retire at 55. New Jersey taxpayers fund the entire health-care premium for retired public workers. Those with 25 years of service— and sometimes their spouses—enjoy lavish health benefits (such as co-payments of $5 when exercising their right to see any doctor they want whenever thay want and generous caps for out-of-pocket expenses) until they qualify for

Nondepository Financial Institutions

Medicare, at which time New Jersey funds supplementary health benefits. Needless to say, New Jersey isn’t the only state facing huge health-care liabilities for its retired public workers. Excluding New York City public workers, New York State faces $47 billion in retiree health costs. Excluding teachers, whose health benefits in retirement are publicly funded elsewhere, California confronts $48 billion in public-employee retirement health costs. North Carolina, Connecticut, and Alabama face costs of $24 billion, $21 billion, and $20 billion, respectively, according to the Times.

These health costs are above and beyond underfunded public pension systems. Taxpayers, relatively few of whom will enjoy comparable early-retirement opportunities and post-retirement health benefits, will be picking up the tab. It is long past time that taxpayers become aware of the public-employee retirement obligations that politicians from both parties have been complicit in thrusting upon them. Source: The Washington Times, July 29, 2007, p. B.02. Copyright © 2007 The Washington Times LLC. This reprint does not constitute or imply any endorsem*nt or sponsorship of any product, service, company, or organization.

Defined benefit pension plans involve the twin problems of vesting and funding of future benefits. An employee’s pension benefits are said to be vested when the employee can leave the job and still retain pension benefits already earned. Many firms require that a person be on the payroll for a given number of years before benefits are vested; if he or she quits or is fired before then, all pension rights are forfeited. Other plans provide for something like 25 percent vesting after so many years, with a gradual increase to 100 percent after a number of additional years. The specific provisions about vesting are obviously among the most important clauses in any pension plan contract. Employers generally prefer to delay vesting as long as possible so that an employee will think twice (or three times) before quitting to go elsewhere. Equally important are stipulations about funding. A defined benefit pension liability is fully funded when enough money has been set aside so that, after earning an assumed rate of return, there will be sufficient funds to pay the promised pension when it comes due. Because of the power of compound interest over time, the entire final amount does not have to be set aside today. If the money is expected to earn 7 percent interest, then only $1,000 has to be set aside today to fully fund a pension of $1,070 due a year from now . . . or a pension of $7,612 due 30 years from now (because $1,000 (1 + .07)30 = $7,612). Given the exponential growth of a pension balance, it may seem easy for companies to fund their future retirement obligations. However, many companies only partly fund their defined benefit plans, planning to meet their pension commitment out of current earnings when the pensions come due. This works, of course, only if earnings remain sufficient to meet such liabilities. Clearly, the higher the level of funding the safer the pension. Defined benefit pension plans invest in a variety of financial assets including stocks, bonds, and other instruments. Because of abuses and mismanagement in many private pension plans, in 1974 Congress enacted the Employee Retirement Income Security Act (ERISA), which established minimum reporting, disclosure, vesting, funding, and investment standards to safeguard employee pension rights. The same legislation also created the Pension Benefit Guaranty Corporation—known, believe it or not, as Penny Benny. It guarantees some benefits in defined

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benefit plans in case a company goes bankrupt or is otherwise unable to meet its accrued pension liabilities. One aspect of pensions worthy of special mention is the matter of gender, Women, on average, live seven years longer than men. Because of this, many defined benefit pension plans used to pay a smaller monthly retirement income to women than to men (because on average women live to collect more monthly checks). In 1983, however, the U.S. Supreme Court, by a 5 to 4 vote, ruled that unequal monthly benefits for men and women are illegal on the grounds that it is a form of discrimination based on sex. The Court held that an individual woman may not be paid lower monthly benefits than a man simply because women as a group live longer than men. It ruled that monthly benefits have to be equal, even though this means that on average women will collect more than men over their lifetimes. Similar gender issues also exist in the field of insurance, by the way, where premiums based on relative risk are standard practice. Life insurance policies typically cost women less than men in monthly premiums because, since women live longer than men on average, their premiums will earn interest for the insurance company longer before they have to be used to pay death benefits. In other words, because they live longer, women are better life insurance risks than men. In auto insurance women also generally pay smaller premiums than men of the same age because accident records show that women are better risks—that is, they are involved in fewer accidents. On the other hand, health insurance policies are often more expensive for women than for men. There is considerable controversy about these sex differentials in insurance; unlike the controversy over pensions, however, thus far they have not been resolved by either legislation or court decision. Legislation in the early 1980s made defined contribution plans a very attractive alternative to defined benefit plans. Defined contribution plans avoid the problems of vesting and funding because the benefits depend solely on the performance of the assets in the individual’s account within the plan. In addition, each individual employee covered under a defined contribution plan has the ability to choose (within limits) the assets in which he or she wishes to invest. The menu of choices can be quite extensive depending on the plan set up by the employer. One employee’s asset choices may (and probably will) be quite different than another’s, even though they are covered under the same employer plan. Moreover, most plans permit employees to shift asset allocation. Ultimately the benefits for each individual retiree, therefore, will depend on the performance over time of the specific assets chosen by the individual. Under defined contribution plans, employees, as well as employers, can contribute funds to the plan. This is a particularly appealing feature of these plans. Employer contributions are tax deductible to the employer, and employee contributions are exempt from personal income tax when they are made. As with defined benefit plans, employees do not pay income taxes on pension benefits until they receive them after retirement. That is, dollars contributed to pension plans are tax-deferred until retirement. The two major defined contribution plans are the 403(b) plan for employees of nonprofit

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organizations and the 401(k) plan for employees of for-profit organizations. An increasing amount of defined contribution plan funds go into mutual funds. In addition to employer-sponsored pension plans, some individuals are also given tax incentives to set up their own pension plans—Keogh plans for selfemployed people and Individual Retirement Accounts (IRAs) for working people who are not covered by company-sponsored pension plans.3 These are usually established in the form of a deposit account in a bank or thrift institution or in the form of shares in a mutual fund of some sort, with the interest or dividends tax-deferred until retirement.

Mutual Funds Money market mutual funds have been prominent on the American financial scene since the 1970s, but way back in the 1950s stock market mutual funds— generally called just mutual funds or investment companies—were all the rage. A mutual fund pools the funds of many people; the managers of the fund invest the money in a diversified portfolio of securities and try to achieve some stated objective, like long-term growth of capital or high current income or perhaps only modest current income but minimum risk. Open-end mutual funds, which are the typical kind, sell redeemable shares in the fund to the general public. Such shares represent a proportionate ownership in a portfolio of securities held by the mutual fund. With an open-end fund, a shareholder can at any time go directly to the fund and buy additional shares or cash in (redeem) shares at their net asset value (NAV). The NAV per share is what each share is worth; it is calculated daily on the basis of the market value of securities owned by the fund and is published each day in the financial section of major newspapers. Suppose a mutual fund owns securities with an aggregate market value of a million dollars at the close of today’s stock market, that it has no liabilities, and has 10,000 shares outstanding. The NAV of one share in this particular fund would be a million dollars divided by 10,000 shares, or $100 a share. If the stocks that make up the fund’s portfolio fall in value, its NAV per share will drop correspondingly. Many funds sell their shares directly to the public at the current NAV. These are called no-load funds. Others, however, known as load funds, charge a sales commission, often as much as 8.5 percent of NAV. Closed-end investment companies, which are in the minority, are completely unlike those just described. Closed-end funds issue only a limited number of shares and do not redeem their own shares on demand, like open-end funds. Instead, the shares of closed-end funds are traded in the stock market, 3Keogh

plans are named after Representative Eugene F. Keogh of New York, who sponsored the legislation that created pension plans for self-employed individuals.

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and if you want to buy or sell them you have to deal with a third party, just as you would in buying or selling shares in IBM or Xerox. Mutual funds are regulated by the Securities and Exchange Commission under the provisions of the Securities and Exchange Acts of 1933 and 1934 and the Investment Company Act of 1940. The primary objective of regulation is the enforcement of reporting and disclosure requirements and protection of investors against fraudulent practices by fund managers. Mutual funds grew very rapidly in the 1950s and most of the 1960s, but they came on hard times in the 1970s and early 1980s (aside from money market mutual funds, which grew for very special reasons, as we saw in earlier chapter). However, the resurgence of the stock market in the 1980s and 1990s carried mutual funds to new heights of popularity. Many investors have been especially attracted in recent years to families of mutual funds, where a number of mutual funds operate under one management umbrella and where investors can easily transfer money among funds within the family. Typically a family of mutual funds will include bond and money market funds along with a variety of stock mutual funds. The two largest fund families, Fidelity Investments and the Vanguard Group, had 175 and 150 different funds, respectively, in 2007. Having a large menu of funds in the family is particularly valuable to mutual funds trying to capture assets invested in defined contribution pension plans. A twist on mutual funds that has grown in popularity among investors are Exchange-traded funds (ETFs). ETFs are trusts that are listed on an exchange and, unlike mutual funds, trade like a single equity. This provides ETFs with the more favorable features of stock trading such as liquidity, continually updated prices, and the opportunity to trade on a moments notice (rather than at the end of the day as is the case with mutual funds). Between 2002 and 2007 the size of assets held by ETFs has quadrupled.

Finance Companies There are two broad categories of finance companies, commercial finance companies and consumer finance companies, although both are often contained under the same corporate umbrella. Consumer finance companies make consumer loans. Some companies specialize in credit card financing; these are referred to as specialty finance companies. Commercial finance companies make commercial loans usually on a secured (collateralized) basis. The loans made by finance companies have traditionally been riskier than those made by commercial banks. Because much of their lending is short term, finance companies borrow substantial amounts in the commercial paper market. In fact, they are the largest category of commercial paper issuer. Some of the most successful financial institutions in the United States are finance companies, the most notable being General Electric Capital Corporation. Historically, commercial finance companies have played an important role in financing growing undercapitalized companies. Many people believe that the leveraged buyout (LBO) started with Michael Milken and the investment bank

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Nondepository Financial Institutions

In The News Getting In on the New Gold Rush Gold is soaring, driven up by the weak dollar, record-high crude oil prices and nervousness about the U.S. economy, with the price marching from less than $650 an ounce in January 2007 to $1,000 an ounce and beyond today. With prices feeding investor demand, experts predict that the metal could reach $1,500 or even $2,000. Here are some ways to invest. Those hoping to get in on today’s gold rush have several options, from the traditional practice of buying gold to more modern offerings such as gold exchange-traded funds (ETFs) and gold certificates. The best option depends on your personal circ*mstances, investment goals, and comfort level. Despite the somewhat antiquated notion of it, many investors still prefer to buy gold bullion bars or coins. It gives investors a portable, durable, and highly liquid asset, according to Jon Nadler, a senior analyst with Kitco Bullion Dealers, which has more than 45,000 clients worldwide. Another hassle-free innovation quickly gaining popularity is gold ETFs, which allow investors to buy and sell shares designed to track the market price of the metal. The shares

are backed by gold locked away in a vault. The biggest gold ETF in the U.S., streetTRACKS Gold Shares, says it currently has 20.8 million ounces of gold in trust worth more than $20 billion. The good news is that gold ETFs usually offer cheaper transactions fees than buying and selling gold itself, because there are no dealer markups or fabrication costs. There also are no costs for shipping, insurance and storage. The downside is that, like gold coins and bullion, owners of gold ETFs are taxed at the higher long-term capital gains tax rate— 28 percent—because the shares are still considered collectibles. Regardless of which investment option you choose, experts urge caution when buying gold. Prices can and do swing wildly, so investors are encouraged to keep no more than 5 percent to 10 percent of their assets in gold to minimize the impact. “If you buy too much, your portfolio will skew toward volatility instead of conferring the benefits of owning gold,” Nadler said. Source: Steven Jacobs, The Salt Lake Tribune, March 15, 2008. © 2008 The Associated Press. All rights reserved. Reprinted with permission.

that he worked for, Drexel Burnham Lambert, in the late 1970s. In an LBO the acquisition of a company is financed substantially with debt. In the process, the company is transformed from having low leverage (low debt-equity ratio) to having very high leverage. If the acquirers in the LBO are the firm’s former managers, then it is referred to as a management LBO. In fact, LBOs existed for many years prior to Milken’s arrival on the scene. However, they went by a different name: bootstrap financings. Instead of the debt being provided by junk bonds, the debt was typically provided by a commercial finance company. There was one other important difference: Commercial finance company bootstrap financing was (and is) offered to small and midsize companies in deals typically involving $50 million or less. The junk bond–financed LBO market, which roared through the mid-1980s has enjoyed a resurgence and is designed for larger companies. In fact, the true insight of Milken was recognizing that LBO financing for large companies could be conducted in the traded securities markets through junk bonds, while it formerly had been limited to nontraded loans to smaller companies extended by commercial finance companies.

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Some finance companies are referred to as captive finance companies. General Motors Acceptance Corporation (GMAC) is a good example. GMAC is the finance company subsidiary of General Motors. Its principal activities are financing car loans and leases to purchasers of GM cars and financing the inventory of GM dealers. Many different types of commercial- and retailoriented businesses have captive finance companies, for example, J.C. Penney and Caterpillar companies.

Securities Brokers and Dealers and Investment Banks Securities brokers, dealers, and investment banks are crucially important in the distribution and trading of huge amounts of securities, including corporate stocks, bonds, state and local government securities, and U.S. government securities. One difference between investment banks on the one hand and brokers and dealers on the other involves the distinction between primary and secondary securities markets. Primary markets refer to the sale and distribution on securities when they are originally issued by the money-raising corporation or governmental unit. Secondary markets involve the subsequent trading of those securities once they are already outstanding. The New York Stock Exchange is an example of a secondary market. Through their underwriting activities investment banks operate in primary markets, selling and distributing new stocks and bonds directly from the issuing corporations to their original purchasers. Their success is most often measured by the volume of securities they underwrite in various categories as reflected in league tables. Underwriting is typically conducted through a syndicate, which includes many investment banks and brokerage firms. The syndicate is organized by a managing group of investment banks with one manager designated as the lead manager. The lead manager has special responsibilities that involve determining the final allocation of securities in the syndicate. League tables come in two forms: full credit to each manager and full credit to the lead manager. Investment banks derive a substantial amount of their income from offering advice to firms involved in mergers and acquisitions. They advise firms on a variety of issues including the appropriate price that one firm should pay for another and how the transaction should be structured. They also give strategic advice to either the acquired (the “target”) firm or the acquiring firm in a hostile takeover. A hostile takeover occurs when one firm seeks to acquire another (the target) against the wishes of the target’s management. Brokers and dealers are involved in secondary markets, trading “used” or already outstanding securities. The difference between brokers and dealers is that brokers do not buy or sell for their own account. They match buyers and sellers of a particular security and earn a commission or fee for bringing the two together. Dealers, on the other hand, “take positions” in securities. In particular,

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dealers post bid prices at which they will buy from the public and offer (or ask) prices at which they will sell to the public. Somewhat less formally, they buy securities for their own account and hope to resell them quickly at a higher price. If they are wrong and the price falls before they can unload, their hoped-for profit becomes a loss instead. Many of the nationwide stock exchange firms, like Merrill Lynch and Morgan Stanley act in all of these capacities. They are called broker-dealers because sometimes they act as agents (brokers) in executing orders to buy or sell securities on the various stock exchanges and sometimes they act as dealers, quoting prices for various stocks and bonds. They also act as investment bankers for some of the securities they deal in. A number of large stock exchange firms have branched out to provide new kinds of financial services that were once considered beyond their province. Merrill Lynch was the innovator, starting the ball rolling in 1977 with its Cash Management Account (CMA). The CMA consists of a financial package that includes a credit card, instant loans, check-writing privileges, investment in a money market mutual fund, and complete record keeping—including monthly statements. Today many brokerage firms market families of their own mutual funds. Merrill Lynch and Morgan Stanley rank among the top providers of mutual fund families. Finally, as we noted in the previous chapter, commercial banks, investment banks, and broker dealers have now combined under single holding company umbrellas, the most dramatic example being the combination of Salomon Smith Barney and Citibank (along with Travelers Insurance).

Venture Capital Funds, Mezzanine Debt Funds, and Hedge Funds While mutual funds are popular with both experienced and novice investors, some funds appeal to a much narrower market. Venture capital funds, mezzanine debt funds, and hedge funds are usually not available to the public investor and, therefore, are not registered with the SEC. Their funding typically comes from wealthy individuals or other financial institutions. Both venture capital funds and mezzanine debt funds provide an important source of funding to small and midsize companies. The assets in these companies are quite risky. Specifically, venture capital funds invest in the equity of start-up companies. Start-up companies are firms in the very early stages of growth, typically after product development but before implementation of a marketing plan. Bank financing for firms at this stage will be limited. Venture capitalists (the managers of these funds) provide funds to these firms in return for a substantial equity stake in the firm. Most of the companies that a venture capital fund invests in will eventually fail. However, the fund makes its money on the considerable profits it receives on the relatively few firms that succeed. It receives those profits when it takes the successful companies public in an initial public offering (IPO). An IPO occurs when a

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company’s stock is sold to the public for the first time (underwritten by an investment bank). The proceeds from the IPO pay off the venture capital fund and the entrepreneur who started the company. Mezzanine debt funds get their name because they provide debt funds to small and midsize companies with claims on assets that lie somewhere between the “upper level” of financing (straight debt) and the “lower level” of financing (equity). The two best examples are convertible debt and subordinated debt.4 Sometimes the managers of mezzanine funds simply invest in a combination of high-yielding debt and equity issued by the same company. Though separately these would not be mezzanine instruments, buying them in combination makes them a form of mezzanine financing. Mezzanine fund financing is used to provide long-term funds for small and midsize companies, sometimes as part of a management-buyout financing package. Like venture capital equity, mezzanine financing is nontraded and held until maturity by the fund. Fund managers of both venture capital funds and mezzanine debt funds are typically active participants in the management of the firms in which they are invested. Hedge funds are investment pools with only wealthy individuals or institutions as members. Membership in hedge funds typically is open only to individuals with at least $5 million in investments or an annual income above $200,000. With such an exclusive class of investors, the regulations designed to protect unsophisticated investors do not apply and so the funds can use trading strategies that might be too risky for the average investor. This ability to take on extra risk may seem inconsistent with the meaning of the word “hedge,” because hedging is usually viewed as the opposite of speculation. The key to resolving this paradox is the fact that most hedge funds are hedged against overall market risk but still face exposure to significant idiosyncratic risk depending on the particular market position taken by the fund. For example, a hedge fund could finance a long position in one group of stocks by selling short other stocks. If the market as a whole rises or falls, this portfolio would likely remain constant, but if the fund bets on the wrong stocks it could face huge losses. In 1998 a hedge fund called Long Term Capital Management (LTCM) found that it made the wrong bets in its highly leveraged bond portfolio and the implications for the U.S. financial system were so serious that the Fed and a group of large banks organized a rescue of LTCM.

Banks Versus Nondepository Institutions Many of these nondepository institutions offer services that compete directly with banks. For example, banks today compete with finance companies for loan business. Traditionally, however, these markets were segmented. Finance

4Subordinated

debt is a class of debt whose repayment priority in bankruptcy is behind, or junior to, other classes of debt. Convertible debt is a debt instrument that can be converted into equity (at a predetermined price) if the investor chooses to do so.

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companies made the risky class of loans, while banks made the safe loans. Today they often compete for the same business. In fact, some of the largest finance companies are now owned by banks. On the liability side, banks have been forced to compete with many institutions for consumer savings. For example, money market deposit accounts at banks compete directly with money market mutual funds. Since 1986 banks have been allowed to offer their own mutual funds. In the investment banking arena some banks have been allowed to underwrite corporate securities since 1989. They can also offer merger and acquisition advisory services. The Gramm-Leach-Bliley Act (GLBA) of 1999 allowed the creation of financial holding companies (FHCs) that can own commercial banks, investment banks, and insurance underwriters. Under certain conditions, an FHC can also set up a merchant bank that can use its own funds, as opposed to money held in trusts, estates, or pensions, to buy and sell securities with the goal of (hopefully) making a trading profit. While some restrictions remain on the activities of individual affiliates, the creation of FHCs brings the United States much closer to the universal banking regulatory model adopted by the European Union. In fact, globalization and the resulting need to compete with European universal banks are frequently listed among the factors that led to the GLBA. Under universal banking, commercial banks can engage in corporate securities underwriting. Are there risks associated with permitting commercial banks to compete directly with other financial intermediaries? What are the benefits? These questions will be discussed more fully in further chapters.

SUMMARY 1. Defined contribution pension plans have become more popular than defined benefit plans. With defined contribution plans, employees can choose the assets they invest in. They also have some flexibility in making their own tax-deferred contributions.

2. Mutual fund families have become increasingly important as a marketing tool. The fact that some funds offer dozens of different choices, from bond funds to stock funds, has been particularly important in capturing the defined contribution pension plan business.

3. Finance companies play an important role in providing funds to consumers and businesses. Some finance companies, known as captives, provide financing for the customers of their parent companies.

4. Venture capital funds and mezzanine debt funds are important long-term financing sources for small and midsize companies. The managers of these funds typically take an active role in the firms to which they supply funds.

5. Over the past several decades, banks have faced increasing competition from other financial institutions to the point where the line between banking and these other institutions has become blurred.

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KEY TERMS captive finance company casualty insurance company closed-end investment company commercial finance company consumer finance company

Gramm-Leach-Bliley Act (GLBA)

Pension Benefit Guaranty Corp.

hedge fund

pension fund

hostile takeover

property insurance company

Individual Retirement Account (IRA)

securities broker

initial public offering (IPO)

specialty finance company

investment bank

start-up company

convertible debt

Keogh plan

subordinated debt

dealer

league table

syndicate

defined benefit plan

leveraged buyout (LBO)

term life insurance

defined contribution plan

life insurance company

universal banking

Employee Retirement Income Security Act (ERISA)

load fund

universal life

merchant bank

variable life

Exchange-traded funds

mezzanine debt fund

venture capital fund

finance company

mutual fund

venture capitalist

financial holding company

net asset value (NAV)

vesting

no-load fund

whole life insurance

funding

open-end mutual fund

QUESTIONS Questions with a red oval are in

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at www.myeconlab.com.

13.1

Under most defined contribution plans, employees have a number of different investment options. How many options should employees be given?

13.2

Life insurance companies and pension plans offer individuals the ability to save money for retirement with tax-deferred dollars. Are tax incentives really necessary to induce people to save for retirement?

13.3

Explain the meaning of net asset value (NAV) per share for mutual funds.

13.4

The business loans that commercial finance companies make have been traditionally riskier than the business loans that commercial banks make. Is the commercial finance company business, therefore, a good business to be in?

Nondepository Financial Institutions

13.5

What is a hostile takeover? Why would one company resist being taken over by another? Is this good for shareholders?

13.6

Discussion question: Some financial institutions focus on a very few lines of business. Others have become financial supermarkets, combining many different kinds of activities under one corporate umbrella (usually a parent holding company). Which approach is better?

251

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Understanding Financial Contracts

If you’re thinking of pursuing the American dream to run a family business, this chapter is a must. Even if your professor doesn’t assign it—read it. You’ll learn a lot about financial contracts, which is a crucial subject if you ever want to negotiate a bank loan. From a somewhat broader perspective, financial contracts are the glue that holds the financial system together. Although we address a number of issues here, one of the most important focuses on the relative advantages and disadvantages of a financial markets-oriented system, as exists in the United States, versus an intermediary or banking-oriented system, as exists in Germany. We can then draw implications for the emerging economies of Eastern Europe and Asia. Should they model themselves after the United States or Germany? But first we must discuss the subject of financial contracts. Some borrowers obtain funds directly from the financial markets using traded securities, while other borrowers must obtain funding from financial intermediaries using nontraded financial contracts. These nontraded financial contracts are tailor-made to fit the characteristics of the borrower. It is now time to examine precisely what this means. In this chapter we will focus principally on business financing where the differences in contracting can be striking, both in terms of how the financial instruments are originated and in terms of contract characteristics. Much of the story stems from our old friend, asymmetric information, or, more specifically, the problems associated with the availability of information about the borrowers who seek funding. We will also briefly apply this analysis to consumer financing to highlight key differences from business financing and to explore the limits to securitization of both markets imposed by financial contracting considerations.

From Chapter 14 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

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LEARNING OBJECTIVES In this chapter you will learn to differentiate among the different mechanisms of external financing of firms explain why mechanisms of external financing depend upon firm size understand how financial contracts may reduce the adverse selection and moral hazard problems of asymmetric information

How Business Obtains Financing Businesses need funds for a variety of reasons. They may have to finance permanent assets such as plant and equipment. Sometimes they require funding to finance the acquisition of another business. Many need funding to finance their inventory and their accounts receivable.1 While financing needs are common to all size companies, the way each individual business does its financing and the markets each accesses vary directly with firm size. For that reason we will consider separately how small-, medium-, and large-size businesses get their funds.

Financing Small Businesses Before examining small, medium, and large companies, let’s first define these categories. Unfortunately, there is no universal definition. The Federal Reserve Board in its survey of small business uses the number of employees as a measure of smallness. In the Fed’s view, a firm with fewer than 500 employees is considered small. The problem with this definition is that there are some relatively large

1Accounts

receivable are funds that are owed to a firm by its customers (to whom the firm has extended “trade credit”).

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firms with fewer than 500 employees. We prefer a definition based on asset size because asset size is probably the most important factor in determining where businesses seek external financing. Our cutoff point for small firms is $10 million in assets.2 What do firms with assets less than $10 million look like? Statistically, the vast majority are privately owned (they do not issue publicly traded stock), with ownership concentrated in a single family. In addition, the overwhelming majority are managed by their owners. They include everything from yogurt stores to bowling alleys to small textile manufacturers.3 Many small firms do not need external financing beyond trade credit, namely the delayed payment offered by a company’s suppliers. Some small firms that have been consistently profitable over a long period of time often have sufficient capital to be self-financing. However, many small firms do not have that luxury and require external financing. For the tiniest firms, that financing is often provided by the owner’s credit cards. For those other than the tiniest, banks are the most likely source of external financing, although commercial finance companies also lend to riskier small businesses. Banks provide working capital financing either via a separately negotiated short-term loan or via a line of credit (L/C). Working capital financing refers to financing accounts receivable and inventory. With a separately negotiated short-term loan, the bank makes a one-time loan with a short maturity, most often 90 days or less. Under an L/C, the bank extends a credit capacity for a

2Much

of our description of small-firm financing is based on data in the National Survey of Small Business Finance conducted in 1988–1989 by the Federal Reserve Board and the Small Business Administration. This survey is unique among business data sets in that it contains extensive information about both the characteristics of surveyed firms and the characteristics of the financial contracts that they used to finance themselves. 3A

numerically small exception to this profile are those young companies with new products or technologies that are rapidly moving through the early stages of firm growth. The entrepreneurs who start these companies may turn to a high net worth individual investor for very early-stage equity financing. These investors are called “angels” and this type of equity investment (sometimes up to $1 million) is called angel financing. Perhaps a year or two later the entrepreneur, if successful, will turn to a venture capital fund for more external equity. Venture capital funds provide equity financing, usually in the $1 million to $4 million funding range, typically under the condition that fund managers actively participate in the management of the firm. Because of their high risk, most of these companies eventually fail. For those that succeed, however, the venture capitalist is rewarded handsomely when the company is “taken public” in an initial public offering (IPO). An IPO occurs when a company’s stock is sold to the public for the first time, with the proceeds often being in the $5 to $20 million range. The proceeds from the IPO pay off the venture capital fund and the entrepreneur who started the company. While venture capital–financed start-up firms are a tiny fraction of the small business population, their new product/new technology orientation makes them disproportionately important economically because they represent the Microsofts of the future. For a further discussion of private equity and venture capital see Silvia B. Sagari and Gabriela Guidotti, “Venture Capital: The Lessons from the Developed World for the Developing Markets” in Financial Markets, Institutions & Instruments 1, 1992, and George W. Fenn, Nellie Liang, and Stephen Prowse, “The Economics of the Private Equity Market,” Federal Reserve Board Staff Study 168 (1995).

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Understanding Financial Contracts

BorrowerBank Search Typically occurs through referrals.

FIGURE 1

Credit Analysis Bank conducts loan evaluation.

BorrowerBank Negotiation

Bank Funding

Terms negotiated.

Bank funds loan.

Bank loan origination.

specified period of time. For instance, a $1 million, one-year L/C gives the borrowing firm the preapproved ability to borrow up to $1 million at any time during the year. It borrows and pays interest, however, only when it needs the money. It may borrow $200,000 for two weeks and then pay it off, in which case it pays only two weeks’ interest. Once the L/C is approved, the borrowing firm can draw down funds with a simple telephone request. Firms with a continuing need for working capital financing usually prefer a line of credit. This reduces the headaches associated with getting an approval from the bank each time the firm wants to borrow. It also provides a form of insurance against credit rationing; that is, the bank must honor its loan commitment even if the bank would prefer to curtail new lending in general.4 In addition to working capital loans, banks also extend funding to small companies to purchase or lease plant and equipment. The maturity of loans to finance plant and equipment is typically less than the life span of the assets themselves. The process of commercial bank lending is depicted in Figure 1 The first step involves finding a bank to fit the borrower. When the owner of a small business becomes dissatisfied with her current bank, she will turn to her most trusted financial advisor. This usually means, for better or worse, her accountant. A good accountant has cultivated relationships with loan officers at different banks and will recommend two or three to choose from. Thus the first step in arranging a bank loan, “borrower-bank search” in Figure 1, is usually accomplished through referrals—most often through the firm’s accountant, and if not the accountant, the firm’s lawyer. Once the connection is made, the bank’s loan officer conducts a complete credit analysis of the borrower. This typically starts with a review of the borrower’s financial statements followed closely thereafter with a visit to the borrower’s place of business. During that visit the loan officer tries to assess the managerial strengths and weaknesses of the owner/manager. This visit also gives the owner/manager a chance to meet her prospective loan officer and evaluate his ability (what’s good for the goose is good for the gander).

4For

a further discussion of credit rationing see Allen N. Berger and Gregory F. Udell, “Some Evidence on the Empirical Significance of Credit Rationing” in Journal of Political Economy 100 (October 1992), pp. 1047–1077.

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Understanding Financial Contracts

The loan officer will usually want additional information about the firm in order to assess its future prospects. This includes information about the firm’s product or service, as well as its customers, suppliers, production capabilities, and track record. It may also include supplementary financial information, such as cash flow projections and breakdowns of accounts receivable, accounts payable, and inventory. In addition, the loan officer may purchase a credit report from a commercial credit agency, such as Dunn & Bradstreet, which contains a variety of information including how promptly the firm pays its bills and whether it has any lawsuits pending. During this process of credit evaluation the loan officer will probably question the owner/manager several times to clarify the accumulated information—so don’t get nervous when the telephone rings and the loan officer is on the line. The loan must then be approved internally by the bank. If the loan is small enough, the loan officer may have the authority to approve it on his own. Larger loans may require the approval of more senior loan officers. And, in most banks, loans above a certain amount must be approved by a loan committee, which will typically be composed of bank managers and loan officers. If the loan requires committee approval, the loan officer will present the loan to the committee and try to convince committee members that the loan should be approved.5 The loan officer is likely to negotiate the terms with the owner/ manager prior to the loan committee meeting under the assumption that the final contract will be approved. The loan committee can then accept, reject, or modify the loan proposal. Once all the details are approved, the loan is funded, which means you get the money and have the honor of starting to pay interest. Several features of small business loans distinguish them from loans to larger companies. Perhaps the most important is the relationship that develops between the loan officer and the owner/manager during the process of originating the loan. Over time that relationship will grow as the loan officer monitors borrower performance and assesses future loan requests. Bankers have an advantage in developing a relationship with their business borrowers because banks provide a whole menu of services, such as checking accounts, retirement products, trust activities, and payroll processing. This makes it easier for banks to learn about a company and its owner/managers. It is not surprising to find, therefore, that small businesses with longer-term bank relationships will on average pay a lower interest rate on their bank loans and will be less dependent on expensive trade credit for external financing.6

5A

minority of banks do not have loan committees. These banks give individual loan officers credit approval authority, usually depending on their seniority. Sometimes for large loans, approval from two loan officers may be required. See Gregory F. Udell, “Designing the Optimal Loan Review Policy: An Analysis of Loan Review in Midwestern Banks,” Prochnow Reports monograph 1987.

6See

Mitchell N. Petersen and Raghuram G. Rajan, “The Effect of Credit Market Competition on Firm-Creditor Relationships,” University of Chicago working paper (February 1993); Mitchell N. Petersen and Raghuram G. Rajan, “The Benefits of Firm-Creditor Relationships,” Journal of Finance 47 (March 1994), pp. 3–37; and Allen N. Berger and Gregory F. Udell, “Relationship Lending and Lines of Credit in Small Firm Finance,” Journal of Business (July 1995), pp. 351–381.

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Understanding Financial Contracts

A second distinguishing feature of the small business loan is the nature of the loan contract itself; specifically, the terms of the contract. Small business loans are very often collateralized, are frequently guaranteed by the owner/ manager, and often contain restrictive covenants. Let’s take a look at each of these items. Over one-third of all bank L/Cs to small businesses are collateralized— that is, secured—by accounts receivable and inventory. Typically, riskier firms that want an L/C will be required to pledge these assets as collateral. Most loans to purchase plant and equipment, regardless of firm risk, are secured by the plant and equipment purchased with the proceeds. When a company pledges any or all of these assets as collateral to a lender, that lender then has a more advantageous position than other creditors should the company enter bankruptcy. The secured lender has the right to petition the bankruptcy court to sell the collateral and use the proceeds to pay off its loan (or to obtain value equivalent to this). If the proceeds from selling the collateral are not sufficient, then the remaining balance reverts to the status of an unsecured loan with a claim equal to all other unsecured loans. If the proceeds from the sale of the collateral exceed the outstanding balance of the secured loan, then the excess becomes available to pay off the unsecured lenders.7 It is not uncommon in small business lending for the bank to require that the owner/manager pledge some of her personal assets as collateral. This type of collateral is referred to as outside collateral because it represents pledged assets outside of the firm. This is quite different from pledging company assets, or inside collateral, such as accounts receivable or inventory, because with inside collateral, the bank gains security at the expense of other firm creditors, while with outside collateral the bank gains security at the expense of the owner/manager. Stocks, bonds, and real estate are typical forms of outside collateral. Another contract feature often found in small business loans is the requirement that the owner of the borrowing firm guarantee the company’s loan. When a bank requires an owner/manager to guarantee the loan personally, then the owner will become personally liable for any unpaid balance. To assess the value of the owner’s guarantee, the bank often requires a personal financial statement showing the owner/manager’s personal assets, liabilities, and income. About 40 percent of all L/Cs to small businesses are personally guaranteed by the owner.8

7Commercial

finance companies also lend to riskier small and midsize businesses under collateralized loans and L/Cs.

8It

should be noted that there is a subtle, but important, difference between when an owner/manager personally guarantees and when she pledges outside collateral. In both cases the owner/manager puts her own wealth at risk. However, with a personal guarantee, the owner/manager still has control over all of her assets. However, if she pledges any of these assets as outside collateral, then she cannot sell them without the bank’s permission. For example, when personal stocks and bonds are used as collateral, they are held in the bank’s vault. Sometimes a bank will require that the owner/manager both guarantee the loan and pledge some of her assets as outside collateral.

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Understanding Financial Contracts

Bank loans to small businesses frequently contain restrictive covenants. Covenants are essentially promises that the company makes to the bank. Many covenants restrict certain types of actions or strategies. For example, the company may be prohibited from selling certain fixed assets or from spending too much money on new fixed assets. The company may not be allowed to acquire other companies. It may be prohibited from paying the owner/managers too much in dividends and/or salaries or from pledging company assets as collateral to some other company. To help the bank monitor the covenants, the firm must submit audited financial statements to the bank. These are financial statements prepared by a certified public accountant who verifies that the numbers reflect accurately the condition of the company. Audited financial statements are quite expensive to prepare. They would be prohibitively expensive, in general, for most companies much below $1 million in assets, which is why covenants are not feasible for companies below this size. In general, covenants are linked to actions indicating that the company has become riskier. When a covenant is violated the bank typically has the right to demand immediate payment of the loan. The violation, or the potential violation, of a covenant can occur for one of two reasons—either the company is in financial distress, or the company wants to pursue a new activity that is currently restricted. If the reason is financial distress, the covenant violation gives the bank the power to cut its losses rather than waiting until the loan or L/C matures. In the vast majority of cases, however, the violation of a covenant is by design: The company wants to do something new. The owner/manager will try and convince the bank that the new strategy will improve the firm’s value. The bank’s loan officer, on the other hand, needs assurance that the new strategy will not make the loan riskier. In order to make this assessment, he will probably conduct a thorough examination similar to the initial credit analysis. If the new strategy does not make the loan riskier, he will waive or relax the covenant. If the new strategy increases the riskiness of the loan, then the loan officer can either deny the request to waive the covenant or renegotiate the terms of the loan (or L/C) to reflect this risk. One other characteristic of small business loans is that the maturity of the loan rarely extends beyond five years. The reason for this relatively short maturity compared with the longer-term debt of larger companies will be discussed below. Before leaving the subject of small business financing, we should say a word about very small firms, like your local bakery shop or laundromat. For firms with assets below about $100,000, outside financing becomes a very different ball game. In this size range it is difficult to distinguish between the activities of the business and the activities of the owner/manager. For example, many firms in this size range are effectively financed through the owner’s personal credit cards and lines of credit. The owner/managers often operate without a clear distinction between the accounts of the business and personal accounts. As a result, banks will often base loans to companies of this size on the creditworthiness of the individual and not on a separate evaluation of the company.

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Understanding Financial Contracts

Financing Midsize Businesses We choose an asset range of $10 million to $150 million to identify midsize businesses because companies that fall into this asset category are usually big enough that they are no longer bank-dependent for external debt financing but are not big enough to issue traded debt in the public bond market. Although these companies usually can’t issue bonds, some are likely to be publicly owned— that is, they can and do issue equity in the primary market which is traded over-the-counter. Therefore, some midsize companies are managed by someone other than the owner while some are owner managed. For short-term debt financing, midsize companies, like small businesses, principally turn to commercial banks. The origination of bank loans to midsize businesses is similar to the process we described for small businesses. Also, like small businesses, midsize companies at the small end of the range tend to borrow from local banks if local banks are large enough to provide the needed funding, while larger midsize companies are more likely to seek financing from nonlocal banks. Bank L/Cs to midsize companies typically have covenants of the same type we discussed above. The restrictiveness of these covenants vary with the riskiness and size of the borrower—smaller and riskier businesses will have more restrictive covenants, all other things being equal. Riskier midsize business may also be required to pledge collateral to secure their L/Cs. Midsize businesses differ from small businesses in one very important way. They have access to longer-term debt financing (beyond equipment loans and mortgages), such as through a financing package from their commercial banks that combines an L/C with an intermediate-term loan. These packages are often referred to as revolving lines of credit. A typical “revolver,” for example, might give a company a $20 million credit line for three years with the ability to convert any portion of it into a five-year term loan. Long-term debt financing to midsize companies is often provided by nonbank institutions. Mezzanine debt funds provide long-term debt to midsize companies at the smaller end of the midsize range. A much more important source of long-term debt financing to midsize companies comes from the private placement market.9 A private placement is a bond (in our case) that does not have to be registered with the Securities and Exchange Commission. Private placements, therefore, avoid SEC registration costs (which we will discuss later in this chapter) and they avoid the public disclosure of financial information that is required of registered bonds. However, private placements can be sold only to financial institutions and high net worth, “sophisticated” investors, and they cannot, in general, be resold by the original investor for at least two years. In short, there is no public secondary market for private placements. Over 80

9Much

of our discussion of the private placement market is taken from “The Economics of the Private Placement Market,” Federal Reserve Board Staff Study 165, by Mark Carey, Stephen Prowse, John Rea, and Gregory Udell (1993).

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Understanding Financial Contracts

IssuerAgent Search Commercial banks and investment banks are agents. They solicit through client bases.

Agent Marketing Agent finds one or more buyers. Terms may be tailored to investor needs. Investors commit subject to their own due diligence.

FIGURE 2

Agent Due Diligence Agent conducts credit analysis of issuer.

Investor Due Diligence Investors conduct their own credit analysis to confirm issuers creditworthiness.

Contract Construction Agent recommends contract terms based on marketability.

Investor Funding Investors, mostly insurance companies, purchase the nontraded private placements.

Private placement origination.

percent of all private placements are purchased by life insurance companies and the vast majority of these are held until maturity. If you want to raise money via a private placement, you’ve got to think big. Almost all issues exceed $10 million, so this source of funds is generally unavailable to small businesses. Firms with access to this market typically get their short-term financing from a commercial bank as described above, and get their long-term financing (usually above seven years to maturity) by issuing a private placement. Like commercial bank loans, private placements have covenants although they are generally somewhat “looser” (less restrictive) than bank loan covenants.10 The terms of the typical private placement will be renegotiated one or more times during its life span, usually because the company wishes to embark on a new strategy that would violate one or more covenants. Many private placements are collateralized. In general, the riskier the borrower, the more restrictive the covenants and the more likely that collateral will be pledged. As described in Figure 2, private placements are originated in a markedly different way than commercial bank loans. In particular, private placements are issued through agents, commercial banks, or investment banks, who structure the contract and market it to investors, such as wealthy individuals and life insurance companies. It pays to hire an agent and pay their (often outrageous) 10Typically

there will be cross-default covenants in the bank loan and private placement contracts that give the private placement holder the right to declare default if the bank loan is in default (because of a covenant violation), and vice versa.

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Understanding Financial Contracts

fee because agents are far better informed about current pricing and current investor tastes than the issuing company. Commercial banks and investment banks actively solicit client business by regularly calling on midsize and large companies trying to sell them their private placement expertise. Once an issuer chooses an agent, Figure 2 shows that the agent conducts its due diligence. Due diligence is just a fancier term for an overall credit analysis of the borrower, but because it’s fancy it costs more. Due diligence includes an evaluation of the firm’s management, its financial condition, its marketing and production capabilities, and an overall assessment of its financing needs. The end result is a formal credit rating from a credit rating agency or from the National Association of Insurance Commissioners (an umbrella organization of state insurance regulators). The next step is to put together a package of contract terms that will be attractive to investors, including the interest rate, maturity, covenants, and any other special features that may be necessary. To help market the issue an offering memorandum and a term sheet are sent to prospective investors— again mostly to loan officers of larger life insurance companies. The offering memorandum contains information about the firm and the purpose of the issue and the term sheet summarizes the terms of the contract. A clever strategy in selling the issue is to get one large life insurance company to take the biggest chunk of the deal and then offer the remainder to several other smaller life insurance companies. Once the issue has been tentatively placed, the investors do their own due diligence. This may seem somewhat redundant, but the purpose here is to verify the information conveyed to the investors in the offering memorandum and to give the investors a chance to meet with the firm’s management. The whole process takes about six to eight weeks and results in a “tailored contract,” like the commercial bank loan, which meets both the needs of the investors and the needs of the borrower.

Financing Large Businesses A company with assets exceeding $150 million qualifies for the label “large business” principally because at about this size it becomes cost effective to enter the public bond market. For large businesses, debt financing in the public bond market is attractive because liquid instruments can be issued at a lower yield than illiquid, nontraded instruments (such as private placements and commercial bank loans). This yield difference due to liquidity was discussed in earlier chapter and occurs because investors demand compensation for buying a security that they cannot easily sell in a secondary market. So why don’t smaller companies issue in the public bond market? One reason is that the distribution costs associated with underwriting a public issue are much higher than the distribution costs in the private markets. This is because selling a new private placement to a handful of life insurance companies is a lot easier than selling a bond to hundreds (and sometimes thousands) of

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Understanding Financial Contracts

Registration Statement IssuerUnderwriter Search

Underwriter Due Diligence

Issuers are typically investment bank clients.

Accountants, lawyers, and investment bankers generate credit and noncredit information about the issuing firm and the offering.

Filed with SEC.

Syndicate Formed

Offering Prospectus Includes financial condition, nonprice terms, and other material information. Filed with SEC and distributed to prospective syndicated members and buyers.

Price Amendment Underwriters commit to price on the offering date and sign underwriting agreement.

Sale of Securities

FIGURE 3

Securities underwriting.

different investors, and because of the rather substantial costs associated with registering the bond with the Securities and Exchange Commission (SEC). We will get to the details of SEC registration in a moment, but because some of these registration costs are fixed, the per dollar cost of underwriting a publicly traded bond declines with issue size. For issue sizes much below $100 million, the lower distribution costs in the private placement market (principally the agent’s fee) more than offsets the higher liquidity premium. Figure 3 shows the process of issuing a corporate bond. First, the issuer chooses an underwriter, usually an investment bank, but recently a handful of commercial banks have also entered the picture. Underwriters actively market their services to companies large enough to issue in the public bond market, so big firms will be inundated by underwriters trying to solicit their business. Once the firm chooses its favorite, the underwriter then does its due diligence in much the same way that agents do their due diligence in the private placement market. There are some differences, however. In the public bond market the process of due diligence culminates in a formal document, called a registration statement, rather than the offering memorandum of a private placement market. The registration statement must conform to specific disclosure requirements. Included in the registration statement is an offering (or preliminary) prospectus containing all relevant factual information about the firm and its financing. The registration statement is blessed by the underwriter,

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Understanding Financial Contracts

the accountants, and the issuing firm’s attorneys, all of whom become liable for any misrepresentation of facts once they have signed the document. Another difference between the prospectus in a public bond issue and the offering memorandum in a private placement is that a prospectus may not contain any projections about the company’s future while there is no such restriction in an offering memorandum. Once the registration statement has been approved by the SEC, the bond can be distributed. An underwriting syndicate is formed by the managing underwriter to share the responsibility for distributing the security and to share the underwriting risk. Underwriting risk occurs when the underwriters provide the issuer with a firm commitment to sell the bonds at an agreed-upon commitment price, which implicitly determines the bond’s interest rate. If the underwriters sell the bonds for a lower price, they have to make up the loss. Thus the underwriters buy the bonds for the commitment price and try to sell them (they hope) at a somewhat higher offering price. The difference between the offering price and the commitment price is the underwriter’s fee, or underwriting spread. Underwriters try to minimize their risk by waiting to set the commitment price until just before the underwriting (typically the morning of the offering). If all goes well, the issue is distributed in a day or two, and the underwriters earn the spread. Occasionally, however, a big change in market conditions or a company-specific event may prevent the underwriter from selling the issue at the offering price and losses drown out the spread. Another reason small and midsize companies do not issue in the public bond market is the difficulty of incorporating highly restrictive covenants in publicly traded bonds. There is a straightforward reason for this. Because bonds are often held by thousands of different investors, renegotiation of a covenant, which as we saw above is often necessary, would be extremely difficult. Consequently, the restrictive covenants that are needed when financing small and midsize companies could not be provided in a public bond issue—even if issuing a small amount of public bonds was cost effective (which it is not). A major change in the underwriting process occurred in 1982 when the SEC, in response to competition for issuers from the largely unregulated Eurobond market, introduced Rule 415, also known as shelf registration. Shelf registration permits the issuer to register a dollar capacity with the SEC, then draw down on this capacity (take bonds “off the shelf”) at any time without any additional registration requirements. For example, if a company does a $2 billion shelf registration, it may issue $1 billion tomorrow, then draw down another $500 million six months from now, and the final $500 million a year from now. Thus issuers who have done a shelf registration can respond instantaneously to changing market conditions. All the issuer has to do is call several investment bankers to get competitive bids and complete the entire transaction in a matter of hours. The investment banks evaluate market interest in the issue by calling a number of large institutional investors (mutual funds, pension funds, and life insurance companies) before entering a bid. The winning underwriter puts together a very small syndicate and commits to the deal. In many cases the syndicate is formed after the winning investment

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Understanding Financial Contracts

bank has won the bidding. This is referred to as a bought deal. A bought deal occurs because of the competitive pressure to commit quickly. Unlike small- and medium-size companies, large companies with good credit ratings tend to rely on the commercial paper market for short-term financing. Many large commercial paper issuers use a commercial bank or an investment bank as an agent to operate a commercial paper program. These agents will then distribute their paper to investors (mostly money market mutual funds). Commercial paper ranges in maturity from one day to 270 days with a significant concentration at the short end of this range. Issuers set their maturities based on their financing needs and the daily (hourly) fluctuations in investor appetite—hungry investors will get lower yields for lunch. A handful of the largest commercial paper issuers (mostly the biggest finance companies) distribute their own commercial paper without the assistance of an agent. Some very large businesses also issue medium-term notes, which are very much like commercial paper except they have maturities ranging from one year to five years. Companies set up medium-term note programs with agents in a fashion similar to commercial paper programs. Most large businesses are publicly held, so that issuing equity is another form of external finance. The process described in Figure 3 also applies to equities, but because companies issue new equity much less frequently than new debt, shelf registration, for the most part, is irrelevant. Equity underwriting involves relatively large syndicates of underwriters who conduct road shows with presentations in big hotels across the country where they trumpet equity issues that they are bringing to market. The underwriting spreads on equity issues are much larger than debt issues because they have to pay for the hotels and trumpets and because equity underwriting is riskier than bond underwriting because stock prices are so volatile.

The Economics of Financial Contracting Our discussion thus far is summarized in Figure 4, showing how the method and nature of financial contracting differs according to firm size. Now it is time to formulate a framework explaining why these differences exist. Why don’t small firms issue public equity? Why do bank loans and private placements have covenants, and why are they sometimes collateralized? Why not just raise the loan rate instead of imposing restrictive covenants or taking collateral? Why do very large firms sometimes issue in the private placement market and not public bond market? The answer to some of these questions is related to transactions costs, such as the nontrivial expenses associated with registering with the SEC and distributing securities to hundreds of investors. But transactions costs are not an entirely satisfying explanation. For example, it is hard to see why transactions costs make it more likely that collateral will be pledged by small companies (for their bank loans) than large companies (for their bonds). Nor can

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Understanding Financial Contracts

Characteristic

Small-size Businesses (Bank Loans)

Medium-size Businesses (Privates)

Large-size Businesses (Publics)

Maturity

short

long

long

Rate

floating

fixed

fixed

Covenants

many, tight

fewer, looser

fewest

Collateral

very often

often*

infrequent*

Monitoring by Investors

intensive

significant

minimal

Renegotiation Frequency

high

medium

low

Origination

direct

agents

underwriters

* Excluding asset-backed securities.

FIGURE 4

Credit market comparison.

transactions costs easily explain the presence of restrictive covenants in bank loans and private placements. Nor can they explain why small businesses do not have access to long-term debt. To really understand what’s going on we have to resuscitate the subject of asymmetric information. Recall that asymmetric information occurs when buyers and sellers are not equally informed about the true quality of what they are buying and selling, or in our case when the issuer has more information than the investor about the issuer’s quality and likely future performance.

Asymmetric Information and Financial Contracting There are two forms of asymmetric information: adverse selection and moral hazard. Adverse selection is caused by asymmetric information before a transaction is consummated, such as when bank loan officers cannot easily tell the difference between high-quality (that is, low-risk) borrowers and lowquality (high-risk) borrowers. Part of the loan officer’s job during the credit analysis stage is to uncover information so that safer borrowers are charged an appropriately low interest rate and risky borrowers are forced to pay a high interest rate.

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Understanding Financial Contracts

In The News A Journey into the Secret Heart of Capitalism Turns into a Roller Coaster Ride The Rise and Fall of Mark Saylor In August of 1998 Mark Leibovich of the Washington Post wrote a story about the initial public offering (IPO) of stock in MicroStrategy Inc. The article described how 33-year-old MicroStrategy CEO Michael Saylor was conducting the publicity “roadshow” needed to sell investors on the upcoming issue of shares. Leibovich wrote that: “In 11 working days, ricocheting across the nation in a leased corporate jet, Saylor would hold 70 meetings in 11 cities, pushing the MicroStrategy ‘story’ to managers at financial institutions that controlled, in sum, about $2.5 trillion in investors’ assets.” Leibovich described Saylor’s IPO experience as a “journey into the secret heart of capitalism.” An IPO marks the moment when a company makes the transition into the category of large-size firms who are able to issue publicly traded securities. The IPO is the heart of capitalism because the U.S. financial system relies upon price signals from public equity and bond markets to allocate funds to deserving borrowers. If investors decide that a company like MicroStrategy is a good bet, its shares will rise in the secondary market and the company will be able to raise funds and embark upon an expansion. On the other hand, it is also the job of markets to weed out the undeserving by having their stock price drop when bad news arrives. Initially, Saylor and MicroStrategy were among the success stories of the bull market of the late 1990s. MicroStrategy stock started trading on the NASDAQ stock market on June 11 and its value rose quickly, making Saylor

and many of his employees very wealthy. However, in a 2002 follow-up article, Leibovich described the fall from grace of MicroStrategy in March of 2000. Just before market sentiment turned against MicroStrategy, Saylor’s “paper fortune had just hit $13.6 billion, which was $4.5 billion more than it was the previous weekend.” Everything looked rosy for the company and it had already begun another roadshow for a $2 billion stock offering. Stormclouds began to gather when an auditor’s review raised questions about three of the company’s recent large deals. This eventually led to a restatement of MicroStrategy’s earnings with a previous profit of $12.6 million turning into a loss of somewhere between $34 million and $40 million. The day of the press release that described the revision, shares in MicroStrategy fell from $226.75 to $86.75. Saylor’s wealth fell by over $6 billion in a single day and the upcoming stock offering was postponed. By June of 2003, shares in MicroStrategy that cost over $200 in 2000 were selling for less than $4 after hitting lows below $1 in 2002 (the price in 2003 was around $40 because of a 10:1 reverse stock split). The wild ride of MicroStrategy stock is a perfect example of how financial markets can express their approval of a company when it is performing well but then punish it rapidly if investors change their opinions. Sources: Mark Leibovich, “Journey into the Secret Heart of Capitalism,” Washington Post, August 9, 1998, pp. A17-A18; and Mark Leibovich, “At the Height of a Joy Ride, MicroStrategy Dives,” Washington Post, Jan. 7, 2002, p. A1.

Asymmetric information is particularly acute for small firms because there is very little publicly available information that can be used to assess credit quality. Moreover, no matter how many questions the loan officer asks, and no matter how much financial information the loan officer digests, only the borrower knows the whole truth (and nothing but the truth)—particularly if the bank has not had a long relationship with the company. As a result, credit

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analysis by itself cannot solve the adverse selection problem. Thus loans are often structured in such a way that borrowers can signal their true quality by the types of terms they are willing to accept. For example, an owner who is willing to pledge her own personal assets as collateral (like marketable securities or real estate), and/or is willing to be personally liable for her own company’s bank loan, sends a powerful and positive signal about the true (but unobservable) quality of her firm. On the other hand, an owner who is unwilling to put up such outside collateral and/or is unwilling to offer a personal guarantee indicates clearly that the firm’s future prospects are uncertain at best. The moral hazard problem occurs after the loan is made. It arises because the loan contract may give the firm (the owner/manager in the case of a small business) the incentive to pursue actions that take advantage of the lender, and which are not easily observable or controllable by the lender. This is best illustrated by way of a specific numerical example. Consider the case of the Opaque Manufacturing Corporation, a small company owned and managed by Ian Slick, who has put $200,000 into the company. Before opening for business the company’s balance sheet looks like this: Opaque Manufacturing Corporation December 31, 2007 Assets Cash

Liabilities and Equity $200,000

Debt

$

Equity Total

$200,000

200,000

Total

$200,000

To keep things simple, let’s assume that Slick meets with his trusting loan officer, Dave Checkette, at Safe and Sound National Bank and convinces him that with an $800,000 loan, Opaque can deploy its total of $1 million in a riskless venture called SS1 (Secret Strategy 1), which will yield a net return on assets of 10 percent in one year. Checkette agrees to give Opaque Manufacturing Corporation an $800,000 one-year commercial loan at the bank’s best rate of 5 percent because he believes Slick’s 10 percent return calculation for SS1. In effect, Checkette believes the firm’s balance sheet would look like this at the end of the year; just before paying off the bank (Opaque owes $840,000 at that time— the $800,000 principal plus 5 percent of $800,000, or $40,000, in interest): Opaque Manufacturing Corporation December 31, 2008 Assets Assets (Strategy SS1)

Liabilities and Equity $1,100,000

Debt Equity

Total

268

$1,100,000

Total

$ 840,000 260,000 $1,100,000

Understanding Financial Contracts

If Slick sticks to his word, our story ends with the bank loan being paid off just as promised. However, suppose that after obtaining the loan, Slick can switch without the bank’s knowledge or control to another strategy, say, 3S1 (Super Secret Strategy 1), which is considerably riskier and has an expected return on assets of only 7.5 percent.11 In particular, 3S1 has a 50 percent chance of increasing the firm’s assets to $1,650,000, and a 50 percent chance of reducing the firm’s assets to $500,000. Thus the expected value of assets at the end of the year will be $1,075,000 = ([0.5 * $1,650,000] + [0.5 * $500,000])— an expected increase of 7.5 percent. It would appear that SS1 clearly dominates 3S1 because the expected year-end asset value is higher under SS1 and it is riskless. Would it ever make sense for Slick to switch secretly to 3S1 and expose his firm to a 50 percent chance of bankruptcy? Let’s see. If the firm pursues 3S1 and is successful, it will look like this at year’s end: Opaque Manufacturing Corporation December 31, 2008 Assets Assets (Strategy 3S1, Success)

Liabilities and Equity $1,650,000

Debt

$ 840,000

Equity Total

$1,650,000

810,000

Total

$1,650,000

If the firm pursues 3S1 and is unsuccessful, it will look like this: Opaque Manufacturing Corporation December 31, 2008 Assets Assets (Strategy 3S1, Failure) Total

Liabilities and Equity $500,000 $500,000

Debt

$840,000

Equity

⫺340,000

Total

$500,000

Several things should be noted about the firm if it pursues 3S1 and is unsuccessful. As can be seen in the above balance sheet, the firm is insolvent because its stockholders’ equity is negative. Slick, as the sole shareholder, gets what he deserves—nothing, and the bank gets what’s left, which is only $500,000. Because of limited liability, Slick can lose no more than his original

11The example that begins here and continues for the next few paragraphs uses the principals of expected return and risk aversion from the section entitled Consequences of Uncertainty and Risk Aversion in Chapter 7.

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investment ($200,000), but the bank takes a loss of $300,000 on its principal plus a $40,000 loss on accumulated interest, for a total loss of $340,000.12 Now we can answer whether it pays Slick to be true to his name and to switch to 3S1. Let’s focus on the equity account. Our first balance sheet shows that SS1 generates equity of $260,000. Our next two balance sheets show that 3S1 is a gamble. The gamble pays $810,000 with a 50 percent probability and nothing with a 50 percent probability. Is the gamble worth it? The answer depends on how risk-averse Slick is. In this case, however, he’d have to be very, very risk-averse not to take the gamble. His expected return on SS1 is only 30 percent (= 100 + {[$260,000 - $200,000] , $200,000}) on his original $200,000 investment. However, his expected return on 3S1 is 102.5 percent (= 100 * {.5 * [($810,000 - $200,000) , $200,000] + .5 * [($0 - $200,000) , $200,000]})! This example illustrates how the debt contract itself provides an incentive for Ian Slick to alter his investment strategy. This incentive is what economists refer to as moral hazard. Note that the bank did not jack up the loan rate to reflect the switch to 3S1 because our hard-working loan officer, Dave Checkette, just couldn’t detect the deception no matter how much he checked it out (sorry about that). Thus it made sense for Slick to switch from SS1 to 3S1—even though the firm can now be expected to fail 50 percent of the time! All of this because owners disproportionately share in the upside of increased risk, while lenders disproportionately share in the downside. Carried to its logical extreme, this risk-shifting problem forces all of the Dave Checkettes of the world to assume the worst. Namely that all small business borrowers like Opaque Manufacturing will secretly switch to the riskiest investment strategy they can hide. Thus banks must charge all small firms a commensurately high interest rate. What does Opaque (even without Slick) do in response? The answer: It still chooses the riskiest strategy—after all, it’s being charged for it, so why not?

Contracting and the Firm Continuum Fortunately, there are some things firms can do to convince potential lenders that they won’t resort to bait-and-switch investment tactics. In fact, because the activities of large firms are relatively easy to observe, any risk shifting by them is easily detected. Their labor contracts are often public knowledge; their supplier relationships are often well known; and their marketing success or failure is regularly documented in the financial press. Most large firms therefore cannot covertly switch from low-risk to high-risk strategies and maintain their reputations in the process. Thus the public market for stocks and bonds for the most part reflects the true riskiness of the underlying investment strategies, with prices and yields determined accordingly.

12Although -$340,000 appears in the equity account, this is not Slick’s personal obligation because of limited liability. Therefore, it must be absorbed by the bank.

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Understanding Financial Contracts

For small firms, however, external reputations are much more difficult to establish. Much of what they do lies beyond the public’s scrutiny. These firms need mechanisms to demonstrate that they are low risk and to credibly commit to not shifting their risk profile. It is in this context that the contract features we observed earlier in this chapter make sense. In particular, outside collateral and personal guarantees reduce the incentive to understate risk during loan negotiations and diminish the incentive to risk shift after the loan is made. The more of the owner’s wealth at risk, either directly in the form of more equity in the company, or indirectly in the form of outside collateral or a personal guarantee, the lower the incentive to deceive the lender. Inside collateral can also be useful in preventing unwanted risk shifting. When a company pledges some of its assets to the bank as collateral, the bank notifies public authorities by filing a lien on the collateral. This publicly filed lien effectively restricts the company from selling the asset in order to change the firm’s risk profile. To sell the asset the company must get the lien released by the bank, which the bank could refuse to do. Finally, loan covenants prevent risk shifting by explicitly constraining borrower behavior. For example, by restricting the plant and equipment that a firm can buy or sell over the duration of the loan, the bank can prevent its favorite dry cleaning establishment from entering the motorcycle leasing business. However, even with restrictive covenants and collateral the information asymmetry is typically too difficult to justify long-term debt for small businesses. There is simply too much flexibility in a long-term debt contract given the incentives to shift risk. Therefore, bank loans to small business are typically made on a short-term basis. And if the borrower wants to renew the loan, the bank will conduct a complete credit analysis to assure, as much as possible, that the company’s risk profile has not changed. Over time and after many renewals, the company should build up a relationship with the bank, establishing a sort of private reputation to behave responsibly. This explains the empirical observation of lower interest rates and less collateral as the bank-borrower relationship grows over time. Midsize companies tend to lie somewhere between small companies and large companies in terms of their information problems. They are more visible publicly than small companies but are still more informationally impaired than large companies. Therefore, they still need a financial intermediary to scrutinize them at the origination stage to address the adverse selection problem and to design a tailor-made contract with covenants (and possibly inside collateral) to address the moral hazard (risk-shifting) problem. However, there is less of an informational gap associated with lending to midsize companies so they have access to long-term debt in the private placement market. The relationship between information and market access is described in Figure 5 in terms of a firm continuum. On the left-hand side we have the tiniest of businesses. These are start-up firms with no track record—Bill Gates with nothing but an idea. It is often impossible for an outsider to assess the prospects for a new genetically engineered vaccine or a new software program when these are mere ideas in some inventor’s mind. Financing at this stage must

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Understanding Financial Contracts

Firm size Information availability Very small firm, possibly with no collateral and no track record.

Small firms, possibly with high growth potential but often with limited track record.

Medium-size firms, some track record, collateral available, if necessary.

Large firms of known risk and track record.

Sources of Capital Insider Seed Money Commercial Paper Short-Term Commercial Loan Intermediate-Term Commercial Loan Medium-Term Notes Mezzanine Fund Financing Private Placements Public Debt Venture Capital

FIGURE 5

Public Equity

Firm continuum.

Source: Mark Carey, Steven Prowse, John Rea, and Gregor y Udell, “The Economics of Private Placements,” Financial Markets, Institutions & Instruments 2 (1993).

be internal—the owner’s own capital or personal credit cards or friends and relatives. Small companies beyond infancy, however, begin to have access to the shortterm bank loan market. Start-up companies with a prototype product and a marketing plan can go to a venture capitalist for outside equity. Somewhat larger firms may be able to get an intermediate term loan from a commercial bank or a combination of subordinated debt and equity from a mezzanine debt fund. As firms mature into midsize companies they gain access to a long-term debt contract from a life insurance company in the private placement market. Midsize companies are likely to “go public,” that is, issue public equity for the first time. Large companies, of course, have access to the traded securities markets because there is a wealth of information about them. They get their short-term credit from the money markets by issuing commercial paper, their

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Understanding Financial Contracts

intermediate term credit from the medium-term note market, their long-term debt from the bond market, and their equity from the stock market. These are all liquid instruments that can be traded in a secondary market. Large companies do not need the specialized information production services of a financial intermediary like a commercial bank or a life insurance company. Occasionally, there are exceptions. For example, sometimes large firms prefer to issue debt in the private placement market when the transactions are complex. However, this is perfectly consistent with the spirit behind the firm continuum. A “complex transaction” is just the market’s phraseology for lack of information; that is, when a transaction is so complicated that it is difficult to assess its true risk. That is precisely the type of transaction that requires a tailored contract and the specialized services of a financial intermediary—a private placement purchased by a life insurance company.13

Consumer Lending, Financial Contracting, and Securitization Up until now we have focused exclusively on business financing. Asymmetric information, however, also characterizes consumer lending. Some consumers are low-risk borrowers and some are high-risk borrowers. Adverse selection is a problem because it is not always easy for lenders to tell them apart, especially because high-risk borrowers will try their best to look like low-risk customers. Moral hazard is also a problem because consumers may borrow money for one purpose—an SAT preparatory course—and then use those funds for something else—buying high-speed rollerblades. Consumer lenders, such as banks and consumer finance companies, use some of the same techniques as business lenders to solve asymmetric information problems. For example, in mortgage financing, the homeowner always pledges a house as collateral for the loan. Invariably, auto financing always involves a lien on the car. Moreover, in both of these cases the lender will disburse the funds with a check payable to the seller of the house or the car dealer to insure that the funds are used as promised. Banks also use subtle pricing mechanisms to sort out low-risk borrowers from high-risk borrowers. Sorting is a good thing because if a loan package can be designed so that low-risk customers, for example, choose Bank A and highrisk customers choose Bank B, then each bank can price its customers according to their true risk characteristics, and each group gets what it deserves. How can such contracts be designed? Suppose that high-risk customers tend to overdraw their checking accounts frequently—possibly because they 13For an empirical analysis of large firms who access the private placement market, as well as an overall empirical analysis of the firm continuum, see Mark Carey, Stephen Prowse, John Rea, and Gregory Udell, “The Economics of the Private Placements: A New Look,” Financial Markets, Institutions & Instruments 2 (1993). Also for an empirical analysis of the firm continuum, see “Securitization, Risk, and the Liquidity Problem in Banking” by Gregory Udell and Allen N. Berger in Structural Change in Banking, edited by Michael Klausner and Lawrence J. White (New York: Business One Irwin, 1993).

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Understanding Financial Contracts

are somewhat irresponsible. When someone writes checks in an amount that exceeds the balance in their checking account, the bank will “bounce” these checks; that is, return them unpaid, stamp them “not sufficient funds” (NSF), and charge an NSF fee for each check. Low-risk borrowers, we assume, never overdraw their checking account. Now suppose Bank A offers customers a low-interest, three-year loan provided that the borrower also opens a checking account with a very high NSF fee. Bank B, on the other hand, offers a high-interest loan combined with a checking account having a low NSF fee. If these rates are set just right, they will encourage high-risk borrowers to choose Bank B to avoid the NSF fee, while low-risk customers are attracted to Bank A because of the low interest rate. Thus the loan rates are set to reflect the respective risks of the two types of customers even though the customer’s true risk is not observable by the two banks.14 Somewhat more generally, asymmetric information is arguably less of a problem in consumer lending than in business lending. First, it is probably easier to assess consumer risk than business risk because personal financial information is much less complex than business financial information. Second, there are relatively few types of consumer loans while there are many types (and subtypes) of business loans, so that evaluating consumer risk lends itself to statistical analysis much more easily than business risk. In short, consumer loans tend to be generic while business loans, particularly to small and midsize businesses, are more idiosyncratic. Third, collateral reduces the asymmetric information problem in consumer lending while it is less likely to do so in business lending. For example, a residential mortgage may require that the loan not exceed 80 percent of the purchase price of the house thereby eliminating much of the risk. Business collateral, such as inventory and accounts receivable, is much harder to evaluate and is arguably much more volatile in value than a single family home. Thus there is a much higher probability that the value of the collateral may fall below the value of the loan in business lending compared with consumer lending. Given these differences, it is not terribly surprising that consumer loans have been securitized while small and midsize business loans have not. Securitization involves pooling a group of loans into a trust and then selling securities issued against the trust. A prerequisite for securitization is the ability to standardize the asset. Because of their generic characteristics it has been possible to securitize mortgages, auto loans, credit card receivables, and student loans. But because loans to small and midsize businesses are tailored contracts that require frequent renegotiation, they do not lend themselves to securitization. Our analysis suggests there is little chance this will change in the future.

14For a further analysis of the nature of asymmetric information in consumer lending see Gregory F. Udell, “Pricing Returned Check Charges Under Asymmetric Information,” Journal of Money, Credit and Banking (November 1986); and Linda Allen, Anthony Saunders, and Gregory F. Udell, “The Pricing of Retail Deposits: Concentration and Information,” Journal of Financial Intermediation (December 1991).

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Understanding Financial Contracts

SUMMARY 1. Small businesses are typically owner managed. They are generally bank-dependent although some borrow from commercial finance companies. Their loans are often collateralized, personally guaranteed, covenant restrictive, and usually have a short maturity. The covenants are frequently renegotiated.

2. Midsize businesses have access to the private placement market where they borrow (with some restrictive covenants) on a long-term basis from life insurance companies under terms that are typically renegotiated several times during the life of the loan. Midsize businesses obtain their short-term financing from banks and often issue publicly traded equity.

3. Large businesses are usually publicly owned and have access to the public bond market. Public bonds contain few covenants, and those they do contain are not very restrictive. Therefore, there is little need to renegotiate publicly issued bonds.

4. Information asymmetry plays a major role in determining which markets businesses have access to. Firm size, in great part, determines the degree of information asymmetry. Much of what large firms do is visible to the public and is often reported in the financial section of the newspaper. Small firms, on the other hand, operate mostly beyond the public view.

5. Information asymmetry explains much of the observed difference in the financial contracts. Collateral, personal guarantees, restrictive covenants, and short maturities are all used in small business loans to undermine adverse selection and moral hazard. These contract terms are not necessary in public bonds because large companies are more easily evaluated and monitored.

6. Consumer lending is also characterized by information asymmetry, but the problems are less acute and the loans tend to be more generic than business lending. As a result, many types of consumer loans have been securitized while business loans have not, and most likely will not, be securitized.

KEY TERMS adverse selection

line of credit (L/C)

registration statement

angel financing

loan officer

restrictive covenant

banking-oriented system

loan committee

revolving line of credit

bought deal

markets-oriented system

secured lender

collateralized

medium-term note

securitization

commercial paper program

moral hazard

shelf registration

offering memorandum

term sheet

credit rationing

underwriter

credit report

offering (preliminary) prospectus

due diligence

personal guarantee

unsecured loan

lien

private placement

underwriting spread

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Understanding Financial Contracts

QUESTIONS Questions with a red oval are in

14.1

Since the agent’s fee in a private placement offering is less than the underwriter’s fee in a public bond issue, why don’t large companies prefer to issue in the private placement market rather than in the public bond market?

14.2

Bank loans and private placements will often have a covenant restricting the amount that the company can pay in dividends in any given quarter. Why?

14.3

Many small business owners do not want to raise money by issuing more stock. They would rather borrow from a bank even though it will make their company more leveraged. Why do you think this is so?

14.4

What is the incentive for a small business owner to understate the risk of his or her company?

14.5

As a banker, you know that your clients have two opportunities: (1) borrow $1,000 and invest it in a safe venture that guarantees a return of $1,200 or (2) borrow $1,000 and invest it in a risky venture that returns $2,500, 20 percent of the time, $1,200, 50 percent of the time, or returns zero dollars, the other 30 percent of the time. Finally, assume the market interest rate on loans is 15 percent so, at the end of one year, the borrower will incur $150 of interest payments. a. Calculate the end-of-year expected returns for your clients if they take the safe opportunity versus the risky opportunity. From the bank’s perspective, which opportunity would the bank desire their customers to undertake? (Hint: Calculate the bank’s expected return, assuming that the bank receives nothing if the borrower defaults.) b. Imagine that in order for the borrower to receive the $1,000 loan from the bank, the bank places a lien on the borrowers bicycle such that if the borrower does not repay the bank, the bank can take ownership of the bicycle. If the bicycle is worth $850, will the borrower undertake the safe or the risky opportunity? Discussion question: Does the owner of a small business have an obligation to tell the bank that the company is changing its risk strategy if this change will not violate a covenant?

14.6

14.7

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at www.myeconlab.com.

Discussion question: There have been some recent proposals to securitize small business loans that involve a government guarantee. Specifically, the U.S. government would guarantee investors in a securitized pool of small business loans against default. The philosophy behind these proposals is to ensure that small businesses always have access to credit. Is this a good idea?

The Regulation of Markets and Institutions

Governments have followed a simple rule when it comes to regulating the financial sector: If something moves, regulate it; and if it doesn’t move, keep your eye on it until it does, and then regulate it. There is little doubt that the financial system is one of the most intensely regulated sectors of the U.S. economy. As in other areas, there are regulations designed to promote competition and regulations aimed at protecting individual consumers; in this case, investors. However, there are two additional reasons for regulating the financial sector: to assure financial system stability and to facilitate monetary policy. To accomplish all of these goals, the government has established a number of different agencies with specific regulatory authority, as summarized in Table 1. Table 1 shows that regulation of the U.S. financial system can be divided into two parts: the regulation of financial markets and the regulation of financial intermediaries. This chapter will begin by looking at the regulation of financial markets and then turn to the regulation of financial intermediaries, especially commercial banks. Our chapter ends with a discussion of a historically distinguishing feature of the U.S. regulatory structure that has almost completely disappeared: the separation of commercial banking and investment banking as mandated by the Glass-Steagall Act of 1993. In contrast with our historical structure, many other countries, such as those in the European Union, have not segregated their banking system from the rest of the financial services industry. Thus our discussion provides a prelude to next chapter, where we compare the U.S. financial system with that of other countries and consider the broader issue of designing the optimal regulatory framework.

From Chapter 15 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

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The Regulation of Markets and Institutions

LEARNING OBJECTIVES In this chapter you will learn to describe the different methods of regulating primary, secondary, and intermediated financial markets understand the United States dual banking system and the array of regulators who oversee it explain universal banking and its possible benefits and risks

TABLE 1

Principal Financial Regulators in the United States

Regulator

Regulatory scope Financial markets

Type of regulations

Securities and Exchange Commission (SEC)

Primary and secondary securities markets

Disclosure requirements and restrictions on insider trading

Commodities Futures Trading Commission (CFTC)

Futures markets

Regulates futures trading

Self-regulatory organizations (such as New York Stock Exchange and National Association of Securities Dealers)

Secondary markets

Monitors trading activity

Intermediated markets

*

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Office of the Comptroller of the Currency

Federally chartered banks

Charters, examines and regulates federally chartered banks

Federal Reserve System

All commercial banks

Examines and regulates state chartered member banks; regulates all bank holding companies and financial holding companies and determines permissible activities*

Federal Deposit Insurance Corporation (FDIC)

All commercial banks, mutual savings banks, and savings and loan associations

Provides explicit deposit insurance up to $100,000 per depositor; examines and regulates state-chartered, nonmember banks

State banking commissions

State-chartered commercial banks

Examines and regulates statechartered commercial banks

Office of Thrift Supervision

Savings and loan associations

Examines and regulates savings and loan associations

National Credit Union Administration (NCUA)

Credit unions

Examines and regulates credit unions

State insurance commissions

Insurance companies

Examines and regulates insurance companies

Also sets reser ve requirements and discount rate (see Chapter 19).

The Regulation of Markets and Institutions

The Regulation of Financial Markets in the United States Much of the regulation of U.S. financial markets is driven by the desire to protect individual investors and the philosophy that the best protection is through information about the securities in the marketplace. Regulation in the United States is also guided by a corollary philosophy that financial markets will benefit from full disclosure because that broadens investors’ participation in the financial markets. Let’s first look at regulation in the primary markets and then turn to the secondary markets.

The Regulation of the Primary Market The disclosure of information for newly issued securities is required under the provisions of the Securities Act of 1933. A second piece of legislation, the Securities Exchange Act of 1934, created the Securities and Exchange Commission (SEC) to administer the provisions of the 1933 Act. In particular, a publicly traded security must file a registration statement and a preliminary prospectus with the SEC disclosing all material information about the issue. The only thing missing in the preliminary prospectus is the final interest rate for a bond issue and price for equity issues. The preliminary prospectus is made available to potential investors so they can decide whether to buy the security. If the SEC determines that there has been adequate disclosure, it approves the registration statement and the issue can be sold to the public. By way of contrast, a privately held firm that borrows only in the bank loan and private placement markets is not required to reveal financial information to the public at large, although it will certainly be required by its lenders (banks and life insurance companies, respectively) to provide financial information to them. What sort of information must be revealed in a public offering of corporate securities? In short, any factual information that investors may need to make an informed decision about purchasing the security. This includes, but is not limited to: 1. Audited financial statements for as many as five years. 2. Information on and terms of any outstanding financial obligations. 3. All employment contracts including pension obligations, stock options, and stock purchase plans. 4. The names of highly compensated employees and officers and the amount of their compensation. (Check to see if there’s anyone you know.) 5. Shareholder rights beyond those of ordinary stockholders. 6. Justification for any contracts with firm insiders (for example, leases on buildings owned by firm officers or major shareholders). It is important to note that SEC approval of the prospectus does not imply that the SEC views the new issue as an attractive investment. It merely

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The Regulation of Markets and Institutions

means that the disclosure of information in the prospectus is satisfactory to the SEC.

The Regulation of the Secondary Markets Full disclosure does not end with the filing of the prospectus. The Securities Exchange Act of 1934 extended the provisions in the 1933 Act to include periodic disclosure of relevant financial information for firms trading in the secondary market. Issuers of publicly traded securities must file an annual public report with the SEC known as a 10K report, which discloses its most recent financial statements and other relevant information about the firm’s performance and activities. To further ensure that individual investors are not taken advantage of, insider trading laws prohibit so-called insiders from trading on private information they may have about the firm and its future prospects. Unfortunately, there is some ambiguity as to the precise definition of insider trading. It is clear, however, that certain parties are unambiguously considered insiders— for example, officers, directors, and major stockholders—and they are prohibited from trading on private information that has not yet been released to the public. To further minimize any advantage that insiders might have, the SEC requires all officers, directors, and major stockholders to report all of their transactions in their own firm’s stock. A summary of these reports is published monthly by the SEC in its Official Summary of Securities Transactions and Holdings. The idea is to expose favorable or unfavorable “votes” that might be indicated by these transactions. Insider trading laws, therefore, do not prohibit all trading in firm shares by insiders, rather they prohibit only trading based on private information that has not been divulged to the public. The 1934 Act also empowered the SEC with the authority to regulate securities exchanges, over-the-counter (OTC) trading, dealers, and brokers. The SEC shares this power, to some extent, with other regulatory agencies. For example, the Commodities Futures Trading Commission (CFTC) regulates trading in futures markets and the Federal Reserve has responsibility for setting margin requirements on stocks (where margin specifies how much of the purchase price of the security an investor can borrow). For the most part, the SEC relies on self-regulation. It delegates daily oversight to the exchanges themselves, so that the New York Stock Exchange monitors itself, for example, while daily oversight for equities traded over-the-counter is delegated to the National Association of Securities Dealers.

The Regulation of Commercial Banks in the United States The protection of individual depositors, fostering a competitive banking system and above all ensuring bank safety and soundness, are the main goals that have shaped U.S. bank regulatory policies. It will be helpful first to summarize

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Off The Record Insider Trading: Efficiency Versus Equity A number of insider trading scandals have wracked the securities industry. Indictments and jail sentences were handed out to lawyers, traders, and even CEOs who fell victim to the temptation to misappropriate privileged information for personal profit. The violations in each case are less important than the legal principle: It is a criminal offense to trade on information that is considered confidential. Although the precise definition of confidential information is subject to legal interpretation, it clearly includes information received by officers, directors, lawyers, and investment advisers working directly or indirectly for a company that might affect the price of the company’s stock. The curious thing about the prohibition against insider trading is that it has nothing to do with promoting the efficiency of stock prices. Stock prices are efficient if they fully reflect all available information. Prices will be efficient if either public investors bid up the price of a stock or if insiders bid up the price when favorable information is uncovered. In fact, some have argued that if insiders were allowed to trade on confidential information, prices would be more efficient because insiders

with access to such information would force up stock prices instantaneously. Why then the laws against insider trading? Fairness, not efficiency, is the key. As a matter of public policy, we would like investors to feel that in the stock market they have a fair chance to earn a decent return for their risks. More particularly, public investors should not feel that they are always at a disadvantage relative to insiders who can dump stocks of companies about to disclose unfavorable information or who will snap up bargains prior to the disclosure of favorable information. Without an impression of fairness, investors might be reluctant to participate in securities markets—making it difficult for companies to raise capital. The problem is, of course, that there are considerable monetary incentives to circumvent the law. Are public investors better off with an impression of fairness when deception is rampant? Or are investors better off following the ancient dictum “let the buyer and seller beware”? Unfortunately, there is no simple answer.

the relatively complex nature of the bank regulatory apparatus and then follow with a discussion of how each goal has been translated into specific policy. Our primary focus will be on the regulation of commercial banks, but for the most part, the regulation of thrifts parallels that of commercial banks.

The U.S. Banking Regulatory Structure The American commercial banking system is known as a dual banking system because one of its main features is side-by-side federal and state chartering (and supervision) of commercial banks. It has no counterpart in any other country. Indeed, it arose quite by accident in the United States, the unexpected result of legislation in the 1860s that was intended to shift the authority to charter banks from the various state governments to the federal government. The National Currency Act of 1863, the National Bank Act of 1864, and related post—Civil War legislation established a brand-new federally chartered banking system under the supervision of the comptroller of the currency

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TABLE 2

Status of Insured Commercial Banks, 2007 (dollars in billions)

All commercial banks

Number of banks 7,282 No. Percent

Total assets $11,176 Amount Percent

National banks

1,632

22

$7,782

70

State banks

5,650

78

3,393

30

Source: Federal Deposit Insurance Corporation data for December 31, 2007.

(within the U.S. Treasury). The idea was to drive the existing state-chartered banks out of business by imposing a prohibitive tax on their issuance of state banknotes (currency issued by state-chartered banks), which in those days was the principal form of circulating money. However, state-chartered banks survived and eventually flourished, because public acceptance of demand deposits instead of currency enabled state banks to remain in business despite their inability to issue banknotes. Thus today we have a dual banking system: federally chartered banks, under the umbrella of the comptroller of the currency, and state-chartered banks, under the supervision of each of the various states. Federally chartered banks are, for the most part, the larger institutions, but state-chartered banks are more numerous. At the end of 2007, as Table 2 shows, 78 percent of the commercial banks had state charters, but the 1,632 with national charters held 70 percent of the assets in the banking system. In 1913 with the passage of the Federal Reserve Act, another supervisory layer was added as national banks were required to become member banks of the Federal Reserve system, while state banks were permitted the option of joining or not. At present, most state banks are not members of the Federal Reserve system. Nevertheless, member banks, both state and national, hold a majority of the total assets in the banking system. An additional supervisory structure was laid atop the entire edifice with the establishment of federal deposit insurance in the 1930s. All Federal Reserve member banks, and thus all national banks, are required to be insured by the Federal Deposit Insurance Corporation (FDIC). State nonmembers retain the option of having federal deposit insurance or not, but virtually all commercial banks have chosen to have federal deposit insurance coverage, because it would be difficult to attract deposits without it. You don’t have to be a genius to recognize that the current regulatory apparatus is cumbersome at best. All banks, regardless of charter, have a primary federal regulator who imposes federal regulation and is principally responsible for ensuring compliance. For federally chartered banks, the primary federal regulator is the comptroller of the currency. For state-chartered banks who are members of the Federal Reserve system, the primary federal regulator is the Federal Reserve. And, for state-chartered banks who are not

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members of the Federal Reserve system, the primary federal regulator is the FDIC. In addition, state-chartered banks are regulated by their state banking authorities.1 Moreover, the Federal Reserve is responsible for determining what sort of activities are permissible for banks to engage in. It’s hard to believe anyone can figure out what to report to whom. Even though regulators try to coordinate their activities, differences are bound to arise (and have arisen) in terms of regulatory policies and the quality of supervision. As a result there have been periodic attempts to unify the regulatory structure. Three of the most notable were the Bush Commission proposal in 1984, the U.S. Treasury Proposal in 1991, and the D’Amato proposal (by Senator Alfonse D’Amato of New York) in 1995. To date, all of these have failed—in great part over the issue of which supervisory agency would emerge as the surviving numero uno. So far, the legislative will to dismantle the regulatory apparatus and replace it with a more straightforward unified structure has been lacking.

Regulations to Protect Individual Depositors and Financial System Stability In contrast with the regulation of financial markets, the thrust of bank regulation has not been focused on disclosure.2 In fact, the most important information about a bank’s financial condition—the results of a regulator’s bank examination—are not divulged to the public by explicit regulatory policy. Banks are “examined” periodically by regulators to determine whether the bank is solvent and whether its business practices are prudent and safe. Instead, much of the regulatory emphasis in banking focuses on limiting depositor risk with two goals in mind: to protect unsophisticated individual depositors and to protect the safety and soundness of the overall financial system. These two goals are closely linked because the bank’s chief liability—the checking account—is paid on a first-come/first-serve basis. This characteristic creates the potential for a run on the bank and, in the extreme, a systemwide bank panic. To be more specific, banks are obligated to pay their checking account customers on demand. If depositors fear that a bank may be insolvent, they may all literally line up at the tellers’ windows and demand their deposits, which is

1If

we include other depository institutions in our description, the regulatory landscape becomes even more cluttered. Mutual savings banks are regulated by their state banking authorities as well as the FDIC. Savings and loan associations are regulated by state banking authorities as well as the Office of Thrift Supervision, and they are insured by the Savings Association Insurance Fund, which is managed by the FDIC. Credit unions are regulated by the National Credit Union Administration and state banking authorities.

2There

are, however, regulations designed to promote full disclosure of the terms of financial contracts offered to consumers. These regulations require that banks and other financial institutions accurately, uniformly, and completely disclose the yields on products that they offer their consumer customers, such as the interest rates and fees on loans and mortgages.

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their right. Because most bank assets are in illiquid form (nontraded loans), they cannot be sold quickly for what they are worth. Thus even solvent banks will find it extremely difficult to pay out deposits if all depositors show up at once. All of this means that it is quite rational for depositors to lead a socalled run on a bank because those at the head of the line will be paid out in full, while those at the end of the line will suffer losses. Bank panics arise when runs spread from bad banks to good banks, because no one can tell the difference between the two types of institutions. Bank runs are potentially contagious because the quality of bank loans are so hard to assess. Deposit Insurance In the United States deposit insurance provided by the FDIC is the principal mechanism designed to protect individual depositors and prevent bank panics. The FDIC was created by the Banking Act of 1933 in response to the painful experience of the 1920s, when bank failures averaged 600 a year, and the catastrophic experience of 1930 to 1933, when bank failures exceeded 2,000 a year! Read that sentence over again, so you really appreciate how huge those numbers are and get some idea of how many people lost their life savings as bank after bank disappeared. At the end of 1933 there were

“There’s a run on the bank!” © The New Yorker Collection 1969 Robert J. Day from cartoonbank.com. All Rights Reser ved.

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The Regulation of Markets and Institutions

fewer than 15,000 commercial banks remaining out of 30,000 that had been in existence in 1920. It is not surprising, therefore, that Congress established the FDIC in response to this historic debacle. Companion legislation created the Federal Savings and Loan Insurance Corporation (FSLIC) to do the same for savings and loan associations. Following the savings and loan crisis in the 1980s, the FSLIC was eliminated and deposit insurance for savings and loan associations is now provided through the FDIC. In 1970 the National Credit Union Administration initiated deposit insurance through the National Credit Union Share Insurance Fund (NCUSIF) for federally chartered credit unions. Deposit insurance accomplishes two things. First, by insuring deposits up to a maximum amount per account—currently $100,000—deposit insurance protects unsophisticated small savers (presumably if you have more than $100,000 you are smart enough to look after yourself). Second, it reduces the incentive for insured depositors to join a bank run. However, a substantial number of U.S. bank deposits exceed $100,000 and are thus not explicitly covered by deposit insurance. The FDIC estimates that while 99 percent of all depositors are fully insured (because their deposits are less than $100,000), the 1 percent of depositors not fully covered hold uninsured balances that constitute one-fourth of the dollar value of total deposits. A depositor who is not fully insured, for example, is someone holding a $150,000 negotiable certificate of deposit (which is insured for $100,000 and uninsured for the remaining $50,000 balance). Uninsured deposits made bank regulators concerned about runs and panics, so regulators have administered bank failures in ways that expanded de facto insurance. In particular, most bank failures have been handled under the purchase and assumption method rather than the payoff method. Under the payoff method the FDIC sends its agents to the bank, verifies the deposit records, and then pays out funds directly to each depositor up to a limit of $100,000. Deposits above $100,000 must share in the losses of the bank. However, under the purchase and assumption method, the FDIC provides compensation to a healthy bank to merge with a failed bank and in the process to take over all of the deposit obligations of the failed bank. The net effect under the purchase and assumption method has been 100 percent deposit coverage.3 When Continental Illinois Bank failed in 1984 bank regulators went beyond just insuring the bank’s depositors. They insured (after the fact) just about everyone Continental owed money to. Regulators felt that because Continental was one of the ten largest banks in the United States, there would be serious economic repercussions not only for the U.S. financial system but the entire global financial system if depositors and other creditors were exposed to losses. Soon thereafter the FDIC articulated a “too big to fail” doctrine providing insurance for all deposits at the largest banks in the country. While the

3This

failure policy was changed by the FDIC Improvement Act of 1991, which required federal regulators to use a least cost resolution (LCR) strategy for all but the biggest banks. Under LCR a modified payoff might be used in which the uninsured depositors are exposed to losses but the insured deposits are assumed by another bank.

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The Regulation of Markets and Institutions

FDIC has not explicitly clarified which banks fall into this category, the too big to fail doctrine was applied to the Bank of New England in 1991 when it was only the thirty-third largest bank in the country. Moral Hazard and Deposit Insurance A compelling argument can be made that deposit insurance has been extremely successful in achieving its dual goals of protecting small depositors and preventing bank panics. After all, we have not seen anything comparable to the banking crisis of 1930 to 1933. Nevertheless, deposit insurance may be a double-edged sword. When depositors are fully insured by a government guarantee, they have little incentive to monitor the riskiness of their banks, creating a moral hazard problem very much like the problem in lending that we discussed in the previous chapter. As long as deposit insurance premiums do not depend on risk, that is they are fixed (which had been the case until quite recently), bank stockholders have every incentive to make their banks riskier at the expense of the FDIC. And that is because stockholders share disproportionately in the upside (success) while the FDIC shares disproportionately in the downside (failure).4 The “too big to fail” doctrine may exacerbate the moral hazard problem. Bankers will have fewer reservations about taking on more risk to increase profits if they believe that the FDIC will reimburse all depositors if their bank goes belly up. In short, the too big to fail policy transfers the downside risk to the FDIC and gives bankers at the largest banks some incentive to increase profits through riskier activities. There may, of course, be offsetting forces that would discourage banks from irresponsible risk taking. For small banks that tend to be privately owned, the owners’ equity acts as collateral that prevents the owner from taking excessive risks. For larger banks that are professionally managed, keeping a well-paid job may prevent promiscuous behavior. Owner and manager risk aversion, therefore, plus bank examinations and other regulatory efforts, may be enough to offset the moral hazard problem. Ultimately, the issue of whether moral hazard has been a serious problem in bank regulation is empirical. However, empirical investigation is extremely difficult because it is not easy to tell, even after the fact, whether a bank failed because of deliberate risk taking or whether it failed because of bad luck. Investment strategies that are deemed safe at the time of their implementation (like lending to Indonesia in the early 1990s) can later backfire (when Indonesia collapsed in 1998).

4The

development of the formal economic model of moral hazard is relatively recent, but the basic idea and its specific application to deposit insurance can be traced all the way back to the original debate over the initiating legislation. Consider the typical point of view of the banking community in 1933, with respect to the feasibility of federal deposit insurance, as summarized in this gloomy conclusion: “The plan is inherently fallacious . . . one of those plausible, but deceptive, human plans that in actual application only serve to render worse the very evils they seek to cure” (The Guaranty of Bank Deposits, Economic Policy Commission, American Bankers Association, 1933, p. 45). On this basis, organized banking groups generally opposed legislation establishing the FDIC.

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The Regulation of Markets and Institutions

Until the 1980s, concern with the potentially perverse incentives associated with deposit insurance was understandably minimal because the bank failure rate was so low. However, during the 1980s the situation changed dramatically. First, it became apparent that losses from the S&L crisis would far exceed the accumulated funds in the FSLIC, the federal insurance fund akin to the FDIC for savings and loan institutions. In addition, consistent with the predictions of the moral hazard argument, S&Ls seemed to have taken advantage of the new freedoms to invest in risky assets granted in the Garn–St. Germain Act of 1982. Second, in addition to the S&L crisis, the banking industry itself suffered more than it had since the Great Depression. Commercial banking had become a much riskier business, and, not surprisingly, by the end of the 1980s 200 banks were failing per year versus fewer than ten per year in earlier decades. These events stimulated the sentiment for a new approach to bank regulation. Moreover, the moral hazard argument, which seemed unconvincing until the mid-1980s, suddenly became part of the language of bank regulators and policymakers in Washington. Thus a coalition was born, not to be confused with the Moral Majority, aimed at regulatory reform. But unlike the regulatory reform of the 1930s that invented deposit insurance to protect the safety of the banking system from runs and panics, the motivating force in the 1980s was to protect the integrity of the deposit insurance fund (and ultimately U.S. taxpayers) from the moral hazard problem caused by fixed-rate deposit insurance. Let’s look at the regulatory policies that resulted. Risk-Based Capital Requirements Bank capital essentially provides a cushion against failure. Up until the 1990s, U.S. bank regulators based their capital adequacy policy principally on the simple leverage ratio defined as: Leverage Ratio =

Capital Total Assets

The larger this ratio, the larger the cushion against failure. The definition of capital varied somewhat over time and across regulators. However, in general capital meant stockholders equity plus loan loss reserves plus (sometimes) a limited number of liabilities that were considered permanent capital, such as subordinated debt. Regulators required banks to have sufficient capital to meet a minimum leverage ratio (which sometimes varied by bank size category) plus additional capital based on a qualitative assessment of the bank’s asset and management quality. This qualitative assessment stemmed from the bank’s risk profile drawn from recent bank examinations. This approach to capital adequacy fundamentally changed in 1990 with the implementation of risk-based capital requirements.5 Risk-based capital

5Just

for good measure, bank regulators still impose a traditional leverage ratio along with the newer risk-based capital ratio.

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The Regulation of Markets and Institutions

requirements were agreed to by the United States and other members of the Bank for International Settlements (BIS) so that capital requirements would be linked to objective measures of bank risk in a consistent way across national boundaries. In particular, bank assets were classified into different risk classes (an example appears in Table 3), and riskier assets would require more capital. Thus a ratio is formed with capital in the numerator and risk adjusted assets in the denominator, producing Risk - Based Capital Ratio =

Capital Risk - Adjusted Assets

What is important here, rather than exactly how to calculate risk-based capital ratios, is that this change in regulatory policy directly addresses the moral hazard problem. In particular, as a bank’s assets get riskier (as measured by the risk categories), the risk-based capital ratio declines because the denominator, risk-adjusted assets, has increased. Regulators will then force banks to offset this increased asset risk with more capital to restore the ratio to the proper level. Theoretically, if the asset risk categories and the capital definitions are set precisely enough, these two forces would offset each other, thereby eliminating the moral hazard problem altogether. In particular, whenever a bank elects to get riskier by investing in riskier assets, it would be required to get safer by having more capital. In practice, the risk categories are too broad to capture differences in asset risk entirely (for example, all commercial loans are grouped together regardless of any differences in risk among them), but at least the regulators are moving the banks in the right direction by forging a link between bank risk and capital adequacy. In 2003 the BIS proposed a new set of capital adequacy rules known as Basel II (Basel being the home base of the BIS). A major problem with the current rules is that banks may have an incentive to substitute from safer to riskier categories of consumer and commercial loans. The proposed new rules address this and other concerns by using statistical tools to distinguish among loan categories and by making greater use of market-based measures of risk. U.S. federal regulators issued new regulations in December 2007 for the large international banks that will be regulated under Basel II. Small banks will be regulated in a manner quite similar to the example in Table 3.6 Prompt Corrective Action The FDIC Improvement Act of 1991 established a new set of procedures to handle troubled banks called prompt corrective action (PCA). This is obviously a great name for a program designed to close banks and thrifts before they expose the FDIC to excessive losses. PCA addressed two problems associated with closing failed banks. The first problem is identifying insolvent banks. In the past banks have been closed when an

6For

the gory details see “Risk-Based Capital Standards: Advanced Capital Adequacy Framework— Basel II,” Federal Register, December 7, 2007.

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The Regulation of Markets and Institutions

TABLE 3

Capital Ratios—An Example Safety First National Bank, December 31, 2008 (dollars in millions) Assets Liabilities and equity

Cash

$ 100,000

Deposits & Other Liabilities $ 950,000

U.S. Treasury Securities

300,000

General Obligation Municipal Bonds

100,000

Residential Mortgages

200,000

Consumer and Commercial Loans

300,000

Capital

50,000

$1,000,000

Total

$1,000,000

Total

Leverage Ratio. The leverage ratio is simply: capital/(total assets) = $50,000/$1,000,000 = .05

Risk-Based Capital Ratio. The risk-based capital ratio is capital divided by “risk-adjusted assets.” Risk-adjusted assets are calculated by weighting the dollar amount in each asset category by the risk weight assigned to that category. There are four risk categories for assets: Risk category

Description

Category 1

Case & Treasuries

Category 2

Municipal Securities

Category 3

Mortgages

Category 4

Loans

Weight 0% 20% 50% 100%

In our example, Safety First National Bank’s assets fall neatly into these categories. Risk-adjusted assets are calculated by multiplying the dollar amount in each category by risk weight, and summing up, as follows: Risk-adjusted assets Risk category Dollar amount Risk weight

Asset

Adjusted assets

Cash

1

100,000

×

=

U.S. Treasury Securities

1

300,000

×

=

General Obligation Municipal Bonds

2

100,000

×

.20

=

20,000

Residential Mortgages

3

200,000

×

.50

=

100,000

Consumer and Commercial Loans

4

300,000

×

1.00

=

300,000

Risk-adjusted assets =

420,000

The risk-adjusted capital ratio is: capital/(risk-adjusted assets) = $50,000/$420,000 = 0.119

Note: The minimum acceptable ratio for what is called the Tier I risk-based ratio is 4 percent so Safety First, with an 11.9 percent ratio, passes muster. There is also a total risk-based ratio (not shown), which is currently set at 8 percent, that includes other items in the numerator.

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The Regulation of Markets and Institutions

examination revealed that a bank’s assets were worth less than its liabilities; otherwise it was permitted to operate. Bank examinations, however, are expensive—so they are conducted only about once per year, suggesting that a bank could deteriorate significantly before regulators know about it. Because banks were not closed until bank capital had entirely disappeared, the FDIC lost money when banks failed. A second problem arose over a fear that bank regulators would adopt a forbearance policy as the S&L regulators did in the 1980s. Regulatory forbearance occurs when regulators keep an insolvent institution operating in the hope that it can return to solvency. In reality, this is the “hope springs eternal” approach to bank management—which was not one of the preferred methods of dealing with asset-liability mismatches. Congress introduced PCA to solve these problems by forcing regulators to make timely adjustments to problem banks as they become riskier. It accomplishes this by establishing five categories, or zones, of capital adequacy, extending from the safest banks in the first zone (classified as well-capitalized) to the riskiest banks in the fifth zone (classified as critically undercapitalized). As illustrated in Table 4, when banks fall below the well-capitalized zone, regulators are required to take specific remedial actions. The further a bank’s capitalization deteriorates, the more severe the actions become, that is, the more the bank’s activities will be restricted. Finally, if the bank drops into the worst zone (where its leverage ratio is below 2 percent), regulators are forced to begin closure proceedings, except under specific conditions.7 PCA thus addresses regulatory forbearance by substantially limiting regulator discretion, and it addresses the consequences of the identification problem by changing the closure rule. Under the old closure rule, banks were only closed when their capital fell below zero. Under PCA banks are forced to take remedial actions gradually and are closed when the leverage ratio falls below 2 percent even though equity is still positive. Risk-Based Deposit Insurance Premiums The FDIC Improvement Act of 1991 also required that the FDIC establish risk-based deposit insurance premiums. In the past, all banks paid the same premium per dollar of deposits—regardless of their risk. As we noted above, this fixed premium feature of deposit insurance helped create a moral hazard problem because banks could get riskier without paying for it. In theory, however, if deposit insurance premiums were precisely set so that any increase in bank risk were fully priced into an increase in the deposit insurance premium, then the benefits to stockholders from risk shifting would be exactly taxed away by the insurance premium. Thus precisely set risk-based deposit insurance premiums would

7Of

course, there are the normal loopholes and legal tactics that managers and stockholders may use to delay the closure of their bank, which is why Congress is also considering a bill to execute all lawyers (except those that are members of Congress).

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The Regulation of Markets and Institutions

TABLE 4

Summary of Prompt Corrective Action* (any restrictions in one category apply to all lower categories as well)

Zone

Mandatory provisions

1. Well-capitalized

—

Discretionary provisions —

2. Adequately capitalized

No brokered deposits except with FDIC approval†

—

3. Undercapitalized

Subject to increased monitoring Suspend dividends and management fees Must submit capital restoration plan within 45 days Restrict asset growth Prior supervisory approval needed for acquisitions, new branches, and new lines of business No brokered deposits

Order recapitalization Restrict interaffiliate transactions Restrict deposit interest rates Replacement of senior officers and directors Require divestiture or sale of the institution Restrict certain other activities Other actions that would better carry out prompt corrective action

4. Significantly undercapitalized

Bonuses and raises for senior officers restricted Order recapitalization‡ Restrict interaffiliate transactions‡ Restrict deposit rates‡

Require reduction in total assets Restrict any activity that poses excessive risk Prohibit deposits from correspondent depository institutions§ Prohibit holding company from paying dividends without prior Federal Reserve approval Require divestiture or liquidation of any subsidiary

5. Critically undercapitalized

Must be placed in conservatorship or Additional restrictions may be receivership within 90 days unless placed on activities appropriate agencies concur that other action would better achieve the purpose of prompt corrective action Continual review by heads of banking agencies must occur to avoid receivership after 90 days Prohibited from paying principal or interest on subordinated debt without FDIC approval Certain other activities restricted

*This table includes all provisions of the FDIC Improvement Act of 1991 that are commonly referred to as part of prompt corrective action. † In a brokered deposit an investor gives money to a stockbroker who purchases a certificate of deposit on behalf of her client. ‡ May

not be required if certain conditions are met or if implementation would be inconsistent with purpose of prompt corrective action. §A

correspondent depositor y institution is a depositor y institution that regularly buys (or sells) ser vices from the bank. Many banks sell ser vices to other banks.

Source: Federal Reser ve press releases.

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The Regulation of Markets and Institutions

In The News FDIC Premiums Seen Having Little Effect on Industry Despite industry complaints that the Federal Deposit Insurance Corporation is charging too much in premiums, analysts said they do not expect the new assessments to affect banks much. The cost “will be perceptible but not a dealkiller,” said Tanya Azarchs, a credit analyst with Standard and Poor’s Corporation. “At the margin, banks have been going years now without very much in costs at all, so an increase will be felt. But it’s at the margin. There are much greater things at stake than a couple of basis points on the expense ratio.” The FDIC announced last week that it will charge banks about $600 million of premiums next year to help restore the ratio of reserves to insured deposits to 1.25 percent by 2009. Healthy banks—about 95 percent of the industry—will be charged 5 to 7 cents for every $100 of domestic deposits. The industry has objected to the plan, saying that the Deposit Insurance Fund is healthy, and that the agency can afford to be less aggressive in rebuilding the fund. Analysts said the premiums were a case of bad timing, noting that institutions are already grappling with the effects of an inverted yield curve. However, the analysts also said the premiums are certain to be dwarfed by industry earnings next year. The industry earned a record $38.1 billion in the second quarter, according to the FDIC. Additionally, most banks will have their premiums lowered in the first two years, as a result of an assessment credit received for past premiums to the fund. The premiums total is “extremely small,” said Alenka Grealish, who manages the banking group for Celent LLC of Boston. “Banks’ net revenues are hundreds of billions

when you take out the top 10. It’s not substantive. ”All in all, this is not good timing,” she said. “But it makes sense, because the FDIC has the responsibility to assure that whatever it costs to insure these deposits is passed through to the banks. FDIC insurance is why banks make money. They’re basically triple-A safe havens for money to sit in.” Richard X. Bove, an analyst with Punk, Ziegel & Company, who covers the top 25 banking companies, was less complimentary of the FDIC’s plan. He said that banks, already overburdened by anti-laundering and accounting requirements, do not need “another drop in the bucket” putting them at a disadvantage against less regulated institutions. ”Whether it’s the Bank Secrecy Act, the Patriot Act, FDIC premiums, or SarbanesOxley, they’re all doing the same thing,” he said. “All these things do is constantly increase the cost of doing banking and make banks less and less competitive against the investment banks and hedge funds.” Ms. Grealish disagreed that premiums will cause the same kind of burden as other regulatory regimes, since FDIC insurance has a clearly defined result. ”Any bank that’s honest would admit that FDIC insurance is what makes them different from every other financial institution and allows them to have a cheap source of funds.” Unlike Sarbanes-Oxley and other rules, “where you can say the benefit is unclear and uneven, . . . here it’s so clearly in favor of the bank,” she said. “They just have to eat it. They’ve been spoiled.” Source: Joe Adler, American Banker, Nov. 7, 2006, p. 4. © 2006 American Banker and SourceMedia, Inc. All Rights Reserved. Reprinted with permission.

not only protect the deposit insurance fund by charging actuarially sound premiums but would simultaneously attack the moral hazard problem. Practically speaking, it would be very difficult to link premiums precisely with risk. Risk in banking, particularly the credit risk associated with nontraded

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The Regulation of Markets and Institutions

loans, is quite difficult to quantify. Nevertheless, some linkage between premium levels and risk would be an improvement over the status quo. The FDIC now relates deposit insurance premiums to risk through the PCA capitalization zones and qualitative regulator judgment. Theoretically, imposing both risk-based capital requirements and riskbased deposit insurance premiums is not necessary. After all, either one could theoretically eliminate the moral hazard problem; imposing both smacks of overkill. However, as we noted earlier, the risk-based capital requirements fall far short of fully incorporating all of the differences in risks across banks. The same is true for risk-based deposit insurance premiums. The existence of these measurement problems suggests that simultaneously implementing both risk-based capital and risk-based deposit insurance premiums, each linked to risk in a somewhat different way, may be a more effective way of dealing with the moral hazard problem.

Regulation of Nondepository Financial Intermediaries How nondepository financial intermediaries are regulated depends very much on the types of liabilities they issue. Pension funds and life insurance companies, for example, are heavily regulated because their liabilities are purchased by small investors. Thus, a key goal driving the regulation of these two institutions is the protection of small investors—just as with bank regulation. Finance companies, on the other hand, get their funds by issuing debt and equity, pretty much like any manufacturing company, so we find virtually no regulation beyond the securities laws governing publicly traded securities. Because of the importance of protecting the small investor, there are close parallels between the way pension funds and life insurance companies are regulated and the way commercial banks are regulated. The most striking similarity is the existence of a government-sponsored guarantee of the liabilities. In the case of pension funds, the Employee Retirement Income Security Act (ERISA) of 1974 established the Pension Benefit Guaranty Corporation (called Penny Benny by her friends), which guarantees defined benefits pension plans currently up to just over $30,000 per person. The guarantee is a bit more complicated in the case of life insurance companies which, for the most part, are regulated at the state level. In order to manage the risk of failure and protect the guarantors, the activities of pension funds and life insurance companies are highly regulated. ERISA established minimum reporting, disclosure, and investment standards. State insurance commissions impose risk-based capital requirements and perform periodic audits much as bank regulators do in their regulation of commercial banks. Insurance regulation typically extends beyond financial restrictions to include implicit and explicit restrictions on pricing of particular products.

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The Regulation of Markets and Institutions

Mutual funds are regulated by the SEC under the provisions of the Securities Act of 1940, and they are also subject to state regulations. The motivation behind mutual fund regulation is similar to securities regulation—the protection of individual investors through full disclosure. This, of course, is different from banks, pension funds, and life insurance companies where regulation is designed to protect small individual investors and policyholders by circ*mscribing risk taking by the intermediary. The similarity between mutual fund regulation and individual securities regulation stems from the fact that mutual funds invest almost exclusively in traded securities.8

Where Securities Market and Banking Regulation Meet: The Glass-Steagall Act, A Collapsing Barrier Legislation passed in 1933 and 1934 provided the regulatory framework for much of the financial services industry for a half century. A big part of that framework, the Glass-Steagall Act of 1933, segregated the banking industry from the rest of the financial services industry, especially the securities and insurance businesses. Banks were also barred from owning corporate stock and other activities deemed too risky, with the Federal Reserve acting as referee. In this section we examine the restrictions that split the financial services industry, why they were imposed, and why they have now been almost completely dismantled.

The Genesis of Glass-Steagall Prior to 1933, investment banking and commercial banking were conducted under the same roof. J. P. Morgan & Company, for example, was both an investment bank and a commercial bank. Congress passed the Glass-Steagall Act in 1933 after congressional hearings laid the blame for the financial collapse of the 1930s at the feet of commercial banks and their securities activities. The prevailing sentiment at the time was that investment banking, particularly corporate securities underwriting, was just too risky for banks, and thus represented a substantial threat to financial system stability. Although hard empirical evidence supporting this contention was in short supply, passionate rhetoric was not—and Congress needed a fall guy. The result:

8Money

market mutual fund regulation is somewhat different. Specifically, money funds are prohibited from investing any of their assets in noninvestment grade instruments. The logic behind this restriction stems from the nature of money market fund liabilities. Because investors can redeem their shares at a fixed value (often by check), these shares are very much like bank deposits. So like demand deposits, regulation is focused on eliminating investor risk.

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The Regulation of Markets and Institutions

Glass-Steagall specifically prohibited commercial banks and securities firms from playing in each other’s backyard, including prohibiting banks from underwriting corporate debt and corporate equity. As a direct consequence of that legislation, the mighty house of Morgan was split in two— J. P. Morgan (the bank), which retained the right to issue checking accounts, and Morgan Stanley (the investment bank), which took over all corporate underwriting.

The Erosion of Glass-Steagall To counter the competitive inroads from less-regulated institutions, commercial banks have exerted pressure on the Federal Reserve and the courts to push back the barriers imposed by Glass-Steagall and related legislation. More specifically, in the 1960s banking organizations began using one-bank holding companies as a means of entering nonbank activities, such as mortgage banking, leasing, and data processing. Specifically, the holding company would conduct these activities through nonbank subsidiaries. This raised the concern of regulators and bank competitors (not necessarily in that order) that expansion of nonbank activities would break down the barriers established by Glass-Steagall. These concerns led to the passage of the 1970 amendments to the Bank Holding Company Act, which gives the Federal Reserve the power to determine what activities are permissible in all bank holding companies. For an activity to be permissible, the Federal Reserve had to determine whether the activity was “closely related to banking.” This effectively created a game between banks, regulators, and the courts. Banks would test the waters by engaging in a new activity, and then wait to see (after the fact) whether the Federal Reserve would oppose them. Sometimes the securities industry or other affected groups would protest the Federal Reserve’s decision, leaving the final resolution to the courts. Through this process banks acquired more and more freedom in the 1970s and 1980s to engage in nontraditional banking activities. A major breakthrough came in 1989 when the Federal Reserve granted five banks the power to underwrite corporate debt. The underwriting had to be done in a subsidiary of the holding company, called a Section 20 affiliate, and there were limitations on the volume of underwriting and on interaffiliate transactions. Nevertheless this was a watershed event. The Federal Reserve subsequently granted permission to still more banks to underwrite corporate debt, relaxed the volume restrictions somewhat, and even granted permission to a few banks to underwrite corporate equity. Since 1999, the Gramm-Leach-Bliley Act has allowed affiliates of financial holding companies to engage in commercial banking, investment banking, merchant banking, and insurance underwriting. The overall responsibility for regulating these new financial holding companies lies with the Federal Reserve through its role as the “umbrella” regulator. In addition, individual affiliates of holding companies are subject to regulation by functional

295

The Regulation of Markets and Institutions

supervisors such as the Securities and Exchange Commission. This regulatory framework blends the two disclosure-based and inspection-based approaches to regulation discussed earlier in this chapter. Initially there was some concern that the Federal Reserve might be too heavy-handed in its regulation of nondepository affiliates, but so-called “Fed-lite” provisions limit the Fed’s role to preventing financial problems at these nondepository affiliates from impairing the condition of deposit insurance funds. The Federal Reserve was given oversight powers because deposit insurance allows depository institutions to raise funds at a lower cost. When the benefits of deposit insurance are extended to investment bank and insurance affiliates, the risk to the deposit insurance fund (and hence the taxpayers) rises. Previously, financial controls known as firewalls were used to insulate commercial banks from the ups and downs of investment banking subsidiaries. The new legislation makes almost no use of formal firewalls but instead gives the Federal Reserve the power to ensure capital adequacy for the consolidated holding company and to make sure that depository institutions are not threatened by the activities of other affiliates. This regulatory framework will require a great deal of cooperation between different regulatory bodies in the U.S. and, in some cases, between regulators in different countries.

The Risk of Universal Banking The issue of risk has become a key issue in the debate over Gramm-LeachBliley. Some argue that the risk of securities activities, especially the underwriting business, would jeopardize the stability of the banking system. With deposit insurance and the “too big to fail doctrine,” however, system risk is not the real issue. The more relevant issue is the exposure of the deposit insurance fund, that is, would bank losses in securities activities lead to more bank failures and significant losses to the FDIC? The risk of a portfolio of securities depends not only on the riskiness of the returns of the individual securities, but also on the correlation of returns among those securities. Substitute the word activities for securities in the previous sentence and apply it to a banking organization viewed as a portfolio of activities. The implication is clear: Just because investment banking is riskier than commercial banking does not mean that the combination of the two will necessarily be riskier than banking by itself. If the correlation of returns in these two activities is low enough, then the benefits of diversification may produce a safer organization when commercial banking and investment banking are combined under the same umbrella. Moreover, permitting other nonbank activities beyond investment banking may produce further diversification benefits. The European Union, for instance, has permitted universal banking organizations in which commercial banking can be combined with investment banking and life insurance activities. Now, under the Gramm-Leach-Bliley Act, universal banking is also permitted in the U.S., but only a few of the largest banks have decided to exploit all of the provisions of the law.

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The Regulation of Markets and Institutions

Ultimately, then, the issue of risk and universal banking is an empirical one. There is no doubt that the securities business is one of the riskiest financial service activities—riskier, in particular, than banking, life insurance, and fire and casualty insurance. However, there is evidence suggesting that there are benefits to diversification. Specifically, there are combinations (that is, portfolios) of banking and other nonbanking activities that would reduce the risk of the combination below the risk of banking by itself and might still increase expected return.9 Whether these risk-reducing combinations would, in fact, be the ones chosen if banks were allowed to participate fully in these activities is not as clear. But it seems like the time has come to let banks decide for themselves.

9See Anthony Saunders and Ingo Walter, Universal Banking in the United States (New York: Oxford University Press, 1994).

SUMMARY 1. The driving motivation behind securities market regulation is the protection of the individual investor. For the most part this is accomplished by promoting full disclosure of information both in the primary market when securities are issued and after origination when the securities are traded in the secondary markets.

2. Banks can be nationally or state chartered. The primary regulator for nationally chartered banks is the Office of the Comptroller of the Currency. State-chartered banks are regulated by their respective state banking authority and by a federal regulator, either the Federal Reserve (if they are a member of the Federal Reserve system) or the FDIC (if they are not a member of the Federal Reserve system).

3. Protection of individual depositors and safeguarding the stability of the banking system are two of the most important goals of bank regulation. Federal deposit insurance is the cornerstone of regulation designed to address these goals. Deposit insurance has been very successful in preventing bank panics. However, it causes moral hazard because it removes the incentive of depositors to discipline the bank against excessive risk taking. Significant changes in bank regulation were implemented in the early 1990s, in great part to address the moral hazard problem. The three most important changes were risk-based capital requirements, prompt corrective action, and risk-based deposit insurance premiums.

4. The Glass-Steagall Act of 1933 split the commercial banking industry and the investment banking industry. In the past several decades this split has been eroded by loopholes and changes in Federal Reserve policy. The Gramm-Leach-Bliley Act of 1999 dismantled Glass-Steagall and enabled financial holding companies to engage in universal banking. There is evidence of gains from diversification to giving financial holding companies full authority to engage in investment banking activities.

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The Regulation of Markets and Institutions

KEY TERMS 10K report

European Union

bank examination Bank for International Settlements (BIS)

Federal Deposit Insurance Corporation (FDIC)

capital adequacy

Federal Reserve

Commodities Futures Trading Commission (CFTC)

firewall

comptroller of the currency

prompt corrective action (PCA) registration statement risk-based capital requirement

insider trading law

risk-based deposit insurance premium

modified payoff

Section 20 affiliate

moral hazard

Securities and Exchange Commission (SEC)

deposit insurance

National Association of Securities Dealers

dual banking system

payoff method

Employee Retirement Income Security Act (ERISA)

preliminary prospectus

universal banking

QUESTIONS Questions with a red oval are in

298

at www.myeconlab.com.

15.1

What type of information are companies that issue traded securities required to disclose?

15.2

What events in the early 1930s prompted the regulatory legislation that has shaped a half century of regulation in the United States?

15.3

How does deposit insurance prevent a bank run?

15.4

How do risk-based capital requirements, prompt corrective action, and riskbased deposit insurance address the moral hazard problem associated with deposit insurance?

15.5

What is a universal bank and why might it be safer than a commercial bank by itself?

15.6

Discussion question: Disclosure requirements in the United States impose a number of costs on issuers, including registration filing costs and accounting and reporting costs. Are the benefits worth these costs? If so, why have the Eurobond markets been so successful without imposing disclosure requirements?

Financial System Design

Can you imagine someone asking you to design a financial system from scratch? Believe it or not, that’s just the kind of question that has been asked a lot recently, especially by Eastern Europeans whose countries have abandoned communism and central economic planning in favor of capitalism. Quite literally, these countries are faced with the challenge of building a financial system from square one. On second thought, this might not be such a big deal. After all, this text covers all the key components. Build a new financial system—no problem. Just model it after the U.S. financial system. Start with a stock market like the New York Stock Exchange. Then add some laws patterned after the Securities Act of 1933 to protect investors through full disclosure and create a regulator like the SEC to enforce those laws. For the banking business, establish a deposit insurance system to protect small depositors and to ensure financial stability. To make sure that banks don’t take advantage of deposit insurance by becoming too risky, monitor banking organizations and limit their ability to hold equity in other (nonfinancial) business. End of story? Not quite—things are rarely that simple. As it turns out, the U.S. model is not the only one in town. In fact, some of the most advanced economies have chosen a system very different from ours. For example, the German and Japanese economies follow a banking-oriented financial system. The United States and the United Kingdom, on the other hand, have a decidedly markets-oriented system. Why? Which is better? And which is a better fit for the new Eastern European economies and other emerging capitalistic countries? These are the questions we address in this chapter. Because banking-oriented systems and markets-oriented systems are the two major choices, we begin our discussion by analyzing the pluses and minuses of each. Then we take a look at the four most advanced financial systems in the world, Germany, Japan, the United Kingdom, and the United States, to see why Germany and Japan are bankingoriented systems and why the United Kingdom and the United States are markets-oriented systems. Finally, we return to the emerging capitalistic countries with some observations about how to design a financial system of their very own. From Chapter 16 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

299

Financial System Design

LEARNING OBJECTIVES In this chapter you will learn to analyze the stockholder-lender and manager-stockholder conflicts understand the different financial structures that limit these conflicts compare and contrast the financial system design of Germany, Japan, the United Kingdom, and the United States

Information and Financial System Design Financial systems have many things in common. For example, all financial systems have a payments system—that is, a system that facilitates the processing of checks and electronic transfers of funds among consumers and businesses. Most have specialized financial intermediaries, such as savings institutions and credit cooperatives. Virtually all have some form of deposit insurance. Also, they all have central banks. Despite these similarities, however, there are also very significant differences, especially related to how businesses obtain financing. In particular, private ownership of business leads to two fundamental problems that must be handled by the financial sector: stockholder-lender conflict and manager-stockholder conflict. Not surprisingly, our old nemesis, asymmetric information, is at the root of both. First, we review how the information asymmetries create stockholder-lender and manager-stockholder conflicts and then turn to how a financial system can be organized to address these problems.

Stockholder-Lender Conflict In this chapter we will refer to the problem of assymetric information in leading by a new name, stockholder-lender conflict, because this highlights precisely which parties are involved, namely, stockholders and lenders. By way of review, recall that asymmetric information in business lending comes in two varieties. Adverse selection occurs because firm owners (stockholders) have an incentive to understate their true riskiness in order to borrow on a more favorable basis. Moral hazard means that firms have an incentive to become riskier after their loans are funded because limited liability makes stockholders more interested in the chances of success than they are worried about failure. Recall also that the magnitude of these problems is much greater for small companies than for large ones because there is much more publicly available information about large companies. This means that it is easier for lenders (before they lend any money) to assess firm risk when the firm is large than when it is small, and it is much easier for lenders (after the loan has been made) to observe any change in firm behavior when the firm is large than when it is small.

300

Financial System Design

Manager-Stockholder Conflict The stockholder-lender conflict is not the only challenge rooted in information asymmetries. A similar problem emerges because in most large businesses, stockholders delegate the management of the company to a professional manager. The owners would like the manager to operate the firm in the owners’ best interests. That is, they would like the manager to maximize the value of the firm, sometimes referred to as maximizing shareholder wealth by maximizing the value of the stock. Unfortunately, the manager may have other objectives in mind, for example, firm managers may want to minimize their own effort and maximize their salary and the time they spend on the golf course or running charity tennis tournaments. Managers may want to maximize firm size—not because it will increase shareholder wealth but because it will maximize the manager’s personal power and possibly the manager’s visibility on national TV commercials. They may want to maximize the so-called “perks” that come with the job, such as driving the most expensive company car, or flying in the most expensive corporate jet, or sitting in the fanciest office. Most importantly, managers want to preserve their jobs. This may result, for example, in the manager choosing excessively safe strategies for the firm as opposed to value-maximizing strategies that may involve more risk—but also substantially more expected return. It might seem that differences between stockholder and manager objectives would be easy to resolve. If a manager refuses to run the company in the best interest of the stockholders: Fire the manager! However, several considerations make this harder than it sounds. First, asymmetric information makes it very difficult to monitor the activities of a firm’s CEO (chief executive officer) to determine whether the manager’s actions are value enhancing or self serving. For example, golf games can bring in a lot of new business and charity tennis tournaments can generate a lot of goodwill. Corporate jets may save precious executive time. Rapid firm growth is sometimes the best strategy for maximizing shareholder wealth. And sometimes the safest project is the best project. Stockholders must actively monitor their manager’s performance to pierce this veil of asymmetric information—but this is hard work. And here’s where the second problem arises. In large publicly traded companies with thousands of stockholders, there may be no incentive for any individual to monitor the manager. Each shareholder thinks, “I own only a little piece of the company; why should I spend half my life psychoanalyzing management motives when the benefit to me is too small to justify the cost? Let somebody else do it.” This is a perfectly rational decision. Unfortunately, every stockholder reaches the same conclusion, and the CEO and other managers are then free to do as they please. In closely held firms where a significant amount of stock is held by one investor, however, there is usually sufficient incentive to monitor because the owner has enough stock so that the stock price increase stemming from improved managerial efficiency more than offsets the cost of monitoring.

301

Financial System Design

Moreover, the owner in a closely held firm often has the power to control the firm’s board of directors and fire management when they are behaving in a self-serving way. In privately held firms, where the owner and the manager are often the same person, the problem (of course) entirely disappears—the manager should always act in the best interest of the owner, because the manager is the owner! Thus, the manager-stockholder problem is really a large-firm problem that is most acute in diffusely held publicly traded firms run by professional managers.

Conflict Resolution and Financial System Design Figure 1 summarizes the relationship between firm size and the two problems just identified. Stockholder-lender conflict, sometimes referred to as the riskshifting problem, is significant for small firms (upper left-hand cell) because there is so little information available about them, but not for large firms (upper right-hand cell) because information is easily accessible. Managerstockholder conflict, sometimes labeled the corporate governance (who’s in charge here?) problem, typically does not arise for small firms (lower lefthand cell) because they are managed by their owners but is pervasive for large firms (lower right-hand cell) because they are professionally managed and their ownership is so diffuse. It is interesting to note that these two conflicts are associated with external finance—the fact that almost all firms raise funds from outsiders in the form of debt and/or equity. From our perspective, what is most interesting is that the two conflicts are dealt with very differently in banking-oriented financial systems compared with markets-oriented financial systems. For example, in Germany and Japan which are banking-oriented systems, banks actually own companies they monitor, and the stock and bond markets are relatively underdeveloped. In the United States and United Kingdom, which have marketsoriented systems, banks do not own companies and the public bond and stock markets are very prominent institutions.

FIGURE 1

302

Firm

Smaller Firms

Larger Firms

Stockholder-lender conflict (risk shifting)

major problem

minor problem

Manager-stockholder conflict (corp. governance)

none

major problem

Conflict

Financial system design: the problems.

Financial System Design

How do these two systems resolve stockholder-lender and manager-stockholder conflict? Let’s look at small firms first, then large firms. Small Firms: Stockholder-Lender Conflict Basically, both systems treat small firms similarly. The only relevant problem for small firms is stockholderlender conflict, and this is addressed by having small firms borrow from banks and other monitoring-intensive financial intermediaries, such as life insurance companies and commercial finance companies. Because banks are specialists in information production, they are ideally suited to assess borrower risk before making the loan, and they also design the loan contracts to minimize the incentive to get riskier after the loan is made. These tailor-made contracts often require that the firm, or the owner of the firm, pledge collateral to secure the loan and that the owner personally guarantee the firm’s loan. These tailored contracts also frequently include restrictive covenants that are often renegotiated as banks continuously monitor their customers. Figure 2 summarizes how banking-oriented systems (a) and marketsoriented systems (b) solve the stockholder-lender and manager-stockholder

(a) Banking-oriented Systems Firm

Smaller Firms

Larger Firms

Stockholder-lender conflict (risk shifting)

financial intermediation (monitoring)

financial intermediation (ownership consolidation)

Manager-stockholder conflict (corp. governance)

not applicable

financial intermediation (ownership consolidation)

Conflict

(b) Markets-oriented Systems

FIGURE 2

Firm

Smaller Firms

Larger Firms

Stockholder-lender conflict (risk shifting)

financial intermediation (monitoring)

Reputation and rating agencies

Manager-stockholder conflict (corp. governance)

not applicable

Takeover market and managerial compensation

Conflict

Financial system design: conflict resolution.

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Financial System Design

conflicts. Our discussion thus far is reflected in identical entries under the column for small firms in both (a) and (b). More specifically, stockholder-lender conflict for small firms is solved in both systems by having them borrow from financial intermediaries who intensively monitor and lend under tailored contracts. Manager-stockholder conflict, of course, is “not applicable” for small firms. Large Firms: Stockholder-Lender Conflict While the two types of financial systems treat small firms similarly, they differ significantly in the way they treat large firms. Turning first to the stockholder-lender conflict, under a markets-oriented system, large firms tend to borrow short term in the commercial paper market and borrow long term in the corporate bond market, with the production of information about business risk delegated to a third party—the bond rating agency (see the upper right-hand cell in Figure 2(b)). Bond rating agencies measure risk when corporate bonds are first issued and they monitor changes in risk afterwards. The widespread availability of public information, plus the information produced by credit rating agencies, enables large firms to develop reputations for not becoming too risky. For large firms in banking-dominated systems, the solution to stockholder-lender conflict is different. When the lender and the stockholder are one and the same (the bank), as is often the case in banking-oriented systems, the problem entirely disappears, that is, there is no incentive for stockholders to exploit themselves. Practically speaking, this is an oversimplification because in most banking-oriented systems the bank doesn’t own all of the firm’s equity. Usually some of the equity is owned by individual investors, and the stock is traded publicly. Nevertheless, consolidation of ownership is often large enough so that the bank owns a controlling interest. Thus the upper right-hand cell of Figure 2(a) records financial intermediation as the solution to the stockholder-lender conflict in banking-oriented systems. Large Firms: Manager-Stockholder Conflict The solution to managerstockholder conflict for large firms is also quite different in banking-oriented versus markets-oriented systems. In banking-oriented systems the solution to the manager-stockholder conflict is driven principally by the bank’s ownership of the business. By owning a significant amount of a firm’s equity, the bank has an incentive to monitor the behavior of the firm’s management. The bank also has control so it can fire an incompetent or misbehaving manager. Thus, the two right-hand cells of (a) in Figure 2 reflect the fact that stockholder-lender conflict and manager-stockholder conflict are both resolved in banking-oriented systems via consolidation of firm ownership in a financial intermediary. The solution to the manager-stockholder conflict in markets-oriented systems is strikingly different. Because ownership is diffuse, that is, not consolidated,

304

Financial System Design

there is little incentive for individual stockholders to monitor a manager. To make matters worse, in a markets-oriented system, managers often influence who is picked to serve on a company’s board of directors and if the board is mostly composed of a CEO’s golfing buddies, they may turn a blind eye to poor performance.1 This creates the distinct possibility that inefficient managers may become entrenched and the firm becomes manager-controlled as opposed to stockholder-controlled. How are entrenched underperforming managers eliminated? Principally through the corporate takeover market; that is, when a company is purchased by another company or by a group of private investors.2 These new owners, then, can replace the old entrenched management and unlock the efficiency gains that were denied under the old management. Not surprisingly, entrenched managers typically will resist corporate takeovers with various legal and financial maneuvers so that a company is often taken over against the current management’s wishes. Quite naturally this is called a hostile takeover. To minimize manager-stockholder conflict, markets-oriented systems also place more emphasis on management compensation packages that link compensation to firm performance than do banking-oriented systems. This is accomplished principally by giving managers stock and stock options in the companies they manage. All of this is recorded in the lower right-hand cell of Figure 2(b).

Financial System Design: A Descriptive Summary of Germany, Japan, the United Kingdom, and the United States In the previous section we analyzed the two biggest challenges in financial system design: stockholder-lender conflict and manager-stockholder conflict. We have seen that there are two models to choose from to solve these problems jointly: a banking-oriented system and a markets-oriented system. It is now time to see how real countries fit these alternatives by examining the countries with the four largest and most well-developed economies in the world—Germany, Japan, the United Kingdom, and the United States. First

1While

a company’s board of directors technically must be approved by a vote of stockholders, the ability of senior management to nominate a slate of board members, and the inability of thousands of stockholders to monitor management and nominate their own slate, often effectively conveys to senior management control over the board.

2When

a group of investors buys the outstanding stock of a company (takes over the company) and finances the acquisition mostly with debt, the takeover is called a leveraged buyout.

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Financial System Design

we provide an overview of each system and then turn in the next section to a specific analysis of how they compare with each other in terms of conflict resolution.3

Germany Germany is very much a banking-oriented financial system. At the core of the system is the Hausbank. Under the Hausbank concept a business relies on a single bank (its Hausbank) as its primary source of all forms of external finance, including both debt and equity finance. Thus the relationship between a business firm and its Hausbank is a very powerful one. Unlike countries where banking relationships are strictly limited to debt financing, the Hausbank system fosters bank participation in the strategic activities of German firms through stock ownership and control; bankers can also sit on company supervisory boards (the German equivalent of a board of directors). Bank ownership participation is both direct and indirect. It is direct because banks can, and do, own a significant share of many German companies; in particular, banks own about 10 percent of public companies in Germany. However, indirect ownership is even more important. Many individuals and institutions in Germany deposit their stock holdings in a trust account with a bank. As part of this custody arrangement, the voting rights associated with these shares are conveyed to the bank. Thus banks exercise control over German companies by combining the direct voting rights from share ownership with the proxy votes they acquire through their custody accounts. These proxy votes add about another 14 percent to the amount of equity controlled by German banks, for a total of 24 percent.4 The German banking system is so important that it makes sense to go into it in some detail. Banks are organized into four major categories: commercial banks, savings banks, cooperative banks, and specialized banks. They represent 28, 36, 12, and 24 percent of the system’s total assets, respectively. Commercial banks consist of the four biggest German banks (the Grossbanken) and a number of regional banks and private banks. You may have heard of one or more of the Grossbanken: Deutsche Bank, BHV, Dresdner Bank, and Commerzbank. These four banks are also significant players internationally. Some of the regional banks are also quite large and are active participants in international markets. The savings banks are typically owned by regional or town governments and operate locally. Originally established as thrift institutions

3Much

of the information contained in this section and in the following section is based on three sources. They are: Anthony Saunders and Ingo Walter, Universal Banking in the United States (Oxford: Oxford University Press, 1994); Itzhak Swary and Barry Topf, Global Financial Deregulation (Cambridge: Blackwell Publishers, 1992); and Stephen Prowse, “Corporate Governance in an International Perspective: A Survey of Corporate Control Mechanisms Among Large Firms in the U.S., U.K., Japan, and Germany,” in Financial Markets, Institutions and Instruments 4 (1995).

4See

306

Prowse (1995).

Financial System Design

(collecting deposits and making mortgage loans), they now offer full commercial banking services although their orientation still emphasizes thrift activities. The cooperative banks were first established in the nineteenth century to collect savings and extend credit to individuals. The most important type of specialized banks are the mortgage banks that make residential mortgage loans and other real estate loans. The mortgage banks are financed principally by bonds. They also include banks that emphasize consumer lending, small business loan guarantees, export finance, and industry-specific finance. The dominance of banks in Germany comes at the expense of the securities markets. The stock, bond, and commercial paper markets in Germany can best be described as suppressed. There are eight regional stock exchanges, dominated by the Frankfurt exchange. Less than a quarter of the largest German companies are listed on an exchange. Even among those listed, a large proportion are not actively traded. Although the corporate bond market has grown rapidly since 1990, it was so tiny to begin with that it remains very small by international standards. As a result, most German companies are highly dependent on their banks for credit (which is just fine with the banks). The dominance of the banking system in Germany is enhanced by a regulatory framework that permits universal banking. As we discussed in the previous chapter, a universal bank engages in a variety of financial service activities. In Germany banks are not only permitted to own nonfinancial companies, but they are also permitted to underwrite corporate securities and to underwrite insurance through a subsidiary. The ability to underwrite securities enables a German bank (the Hausbank) to handle all of a company’s financial needs effectively throughout its business life cycle. Many who advocated giving U.S. banks full underwriting privileges cited German universal banking as the model of success. Some caution, however, should be exercised in drawing strong conclusions based on the German system. While it is true that German banks have long had the ability to underwrite corporate securities, they have done so in a decidedly banking-oriented system in which the stock and bond markets are poorly developed. It is not obvious that this success would translate to a system with well-developed stock and bond markets.

Japan The two most important features of the Japanese financial system are the keiretsu form of industrial organization and the emphasis on a firm’s relationship with its main bank. A keiretsu is a group of companies that are controlled through interlocking ownership; that is, the companies own stock in each other. This form of industrial organization encourages strong loyalty among the companies in the group, including favoritism in customer-supplier relationships.

307

Financial System Design

Like the German financial system, the Japanese system emphasizes firm loyalty to a single bank, the main bank. In fact, each keiretsu has a main bank that typically owns stock in other members of the keiretsu. The current structure of the banking system emerged immediately prior to World War II when the government consolidated power in both the industrial and the financial sectors and reinforced the existing ties between the main banks and their company groups, then called zaibatsu (now, in its weakened form, called keiretsu). As in Germany, Japanese banks may own equity in nonfinancial companies, although in 1987 the maximum investment permitted in any single firm was reduced to 5 percent. This, however, understates the control exerted by a main bank through the keiretsu. Every month the top managers of the firms in the keiretsu get together with large shareholders and chief creditors at the Presidents’ Club meeting. While these meetings are not part of the formal governance structure, they act very much like the supervisory board in German companies where planned projects and general firm policy are discussed. The banking system is divided into three basic categories, the very largest city banks, the regional banks, and the special-purpose financial institutions. The three groups comprise 30, 18, and 52 percent of the banking sector, respectively. Several of the world’s biggest banks are Japanese city banks. Possibly you’ve heard of some of these, such as Mizuho Bank, Bank of TokyoMitsubishi, and Sumitomo Mitsui Bank. The special-purpose institutions include the three long-term credit banks, specialized small business institutions, and specialized agriculture, forestry, and fishery institutions. Historically, the corporate debt markets have been suppressed in Japan much as they have been in Germany, further enhancing the power of commercial banks. Only relatively recently (1987) have Japanese regulations permitted companies to issue commercial paper and corporate bonds. As a result the vast majority of debt financing comes from the banking system for all but the largest firms. Unlike Germany, the stock market in Japan is quite large. The Tokyo Stock exchange is comparable in size to the New York Stock Exchange (and is sometimes larger depending on stock price levels and the exchange rate). However, some caution should be exercised in comparing the U.S. and Japanese equity markets because the extensive cross-ownership of shares through keiretsu masks the high degree of concentration of ownership of large Japanese firms. Japan has also adopted laws similar to the U.S. Glass-Steagall Act separating commercial banking from investment banking. As in the U.S. system, however, the separation between securities underwriting and commercial banking has been eroded. As of 1993, commercial banks in Japan were permitted to underwrite corporate securities in an affiliate, subject to specific permission from the Ministry of Finance (the regulator of banks in Japan along with the Bank of Japan).

308

Financial System Design

United Kingdom Unlike the economies in Germany and Japan, the financial system of the United Kingdom is very much markets-oriented, although banks still play a very important role. London is somewhat unique because it serves as both a domestic financial market for U.K. business as well as the center of the Eurobond market. Because of a regulatory environment that encourages foreign participation and competition in financial services, the domestic markets are not really distinct from the foreign markets. U.K. companies issue in the Eurobond market and foreign companies, as well as domestic, list stock on the London Stock Exchange. The banking system consists of five categories: clearing banks, merchant banks, other British banks, foreign banks, and other deposit-taking institutions. They comprise 28, 4, 4, 46, and 18 percent of banking system assets, respectively. The clearing banks, dominated by Barclays Bank, NatWest (owned by the Royal Bank of Scotland), HSBC, and Lloyds-TSB, are universal banks and conduct securities activities through investment banking subsidiaries, in addition to having extensive branch networks throughout the United Kingdom. The merchant banks provide wholesale banking services to large corporations, including offering loan commitments and guarantees, derivatives products, and international trade finance. In many ways they are more like U.S. investment banks than traditional commercial banks. The “other” British banks, as their name implies, are an eclectic group consisting of some institutions similar to the merchant banks and others, which are specialized institutions that emphasize such activities as consumer lending. The other deposit-taking institutions are mostly building societies, which are mutual organizations similar (for better or worse) to savings and loan associations in the United States. Banks in the United Kingdom do not, for the most part, own nonfinancial corporations. While there are no explicit restrictions prohibiting bank equity ownership, the Bank of England (the regulator of banks in the United Kingdom) has generally discouraged the practice in order to promote a safer banking system. The lack of formal restrictions explicitly prohibiting bank stock ownership must be viewed in the overall context of British bank regulation. Historically, the Bank of England has supervised banks on an informal basis by influencing banks through that great English tradition—“the old boy network.” Thus through meetings and consultation with management, the Bank of England exercises “moral suasion” over its flock. While the supervision process has become more formalized in recent years, it would still be misleading to consider only explicit restrictions in analyzing constraints on bank ownership of business, as well as other bank activities.

United States The very large stock, bond, and commercial paper markets make the United States the prototype of a markets-oriented system. Moreover, the securitization

309

Financial System Design

of residential mortgages and other types of financial assets, such as credit card receivables and auto loans, have further strengthened the importance of the traded securities markets. On the other hand, although U.S. banks are not the primary providers of external finance to large corporations, they do play a key role in external finance for small and midsize companies. While the Gramm-Leach-Bliley Act continues to prohibit commercial banks from owning equity in nonfinancial companies, certain financial holding companies can own equity as long as they intend eventually to re-sell their ownership stake for a profit.

Financial System Design and Conflict Resolution: Germany, Japan, the United Kingdom, and the United States As we have just seen, Germany and Japan have banking-oriented economies and the United Kingdom and the United States have marketsoriented economies. One way to measure the extent of these differences is to look at the relative sizes of the banking sector and the stock markets in each of these countries. The columns in the foreground of Figure 3 show

% of GDP 200 180 160 140 120 100 80 60 40 20 0 Germany

Japan Banking Market

FIGURE 3

310

United Kingdom

United States

Stock Market

Size of banking and stock markets (percentage of GDP), 2007.

Financial System Design

the size of the stock markets in each of these four countries at the end of 2007. The columns in the background show the size of the banking sectors (total bank lending) at the end of 2007. Both the stock market and bank loan figures are as a fraction of national income (GDP) to account for the different sizes of the four economies. As you can see, banking clearly dominates the stock market in Germany while the two are much more comparable in Japan and the United Kingdom. The stock market clearly dominates in the United States. A second measure distinguishing banking-oriented versus marketsoriented systems is bank ownership of nonfinancial firms. In banking-oriented systems we should expect to see a substantial amount of firm ownership by banks while in markets-oriented systems bank ownership should be negligible. Estimated ownership patterns for the four countries are shown in Table 1, which requires some explanation. The first category (Individuals) is an estimate of the direct ownership by individuals who make their own investment decisions. The second category (Financial institutions—agents) includes both ownership by financial intermediaries who act as agents and ownership by individuals whose investment decisions are based on advice from their brokers. The financial intermediaries and brokers in this category are not actively involved in monitoring or supervising firm management; that is, they are not involved in corporate governance. This category, for instance, includes mutual funds acting as passive owners. The third category (Financial institutions— ownership/control) includes financial intermediaries such as banks or insurance companies, which either own shares outright or exercise voting control through

TABLE 1

Estimated Ownership Patterns (percentage)

Individuals Financial institutions—agents

Germany

Japan

United Kingdom

United States

3.0

22.4

22.4

30–55

3.0

9.5

57.8

55–62

33.0

38.5

0.7

2.0

Nonfinancial corporations

42.0

24.9

10.1

7.0

Foreign

14.0

4.0

6.5

5.4

5.0

0.7

2.5

Financial institutions—ownership/control

Government

Note: Financial institutions—agents are institutions such as pension funds, mutual funds, or other money managers that hold equity as agents for other investors. Financial institutions—ownership/control are institutions that hold equity for their own accounts. For the United Kingdom and the United States, individual and corporate ownership of shares has been reduced (and added to the financial institutions as agents category) by the estimated proportion of shares that are traded on brokers’ recommendations. For Germany, the total for institutional owners includes stock which is owned by individuals but held and voting rights exercised by banks (approximately 14 percent of outstanding equity). Source: Reprinted from Prowse (1995).

311

Financial System Design

proxy rights. This category includes the shares that German banks control through their custody accounts. The fourth category (Nonfinancial corporations) is stock ownership by nonfinancial companies. The final two categories are self-explanatory. The key conclusion from Table 1 is the substantial ownership control by financial institutions (Financial institutions—ownership/control) in Germany and Japan and the insignificant amount in the United Kingdom and the United States. In Germany and Japan, financial intermediaries either own or control 33.0 and 38.5 percent of the outstanding shares, respectively, while in the United Kingdom and the United States financial intermediaries control only 0.7 and 2.0 percent, respectively. Thus the evidence supports labeling financial systems in Germany and Japan as banking-oriented and in the United States and the United Kingdom as markets-oriented.

Conflict Resolution in the Big Four Let’s go back to Figure 1 and summarize how our four favorite financial systems resolve the stockholder-lender conflict and the manager-stockholder conflict identified there. This is a recap for those of you who have fallen asleep trying to design the most exciting financial system. The four financial systems are remarkably similar in providing financing to small businesses. Each country has a tier of banks and other financial intermediaries that emphasize lending to this sector of the economy. These institutions design tailored contracts to address the asymmetric information problems that lead to stockholder-lender conflict, and they continuously assess the riskiness of the borrowing firms. For large companies, however, substantial differences emerge. In bankcontrolled Germany and Japan, the stockholder-lender conflict disappears because banks are owners and creditors at the same time. For companies in these countries that are not bank controlled, and there are some of these, the stockholder-lender conflict is relevant—although Figure 1 indicates that the problem is not as acute as it is in small firms. Nevertheless, the solution to stockholder-lender conflict for nonbank-controlled large firms in the bankingoriented systems is the same as for small firms: tailored contracts offered by banks that monitor borrower performance. For the markets-oriented economies of the United Kingdom and the United States, on the other hand, stockholder-lender conflict is still something of a problem even for large firms. Large companies in these countries are, for the most part, publicly owned, and company performance is monitored by independent credit rating agencies, such as the U.S.’s Moody’s and Standard & Poor’s. An interesting dimension to the stockholder-lender conflict is how financial distress is managed. A company is in distress (deep trouble) when poor performance jeopardizes the firm’s ability to meet its financial obligations. During these periods, stockholder-bondholder (lender) conflict is extreme because the owners have very little stake left in their firm. However, in the banking-oriented

312

Financial System Design

TABLE 2

Merger and Acquisition Activity: 2002

Volume (in billions of U.S.$) Percentage of total market capitalization

United States

United Kingdom

Japan

560.1

140.8

69.9

5.1

7.8

3.3

Germany 78 11.3

Source: Thomson Financial.

systems of Germany and Japan, it might be much easier for a company to navigate through troubled times under the protective wing of its Hausbank or main bank. On the other hand, when companies rely on widely held debt, as in the United Kingdom and the United States, it is often very difficult to get large numbers of bondholders to agree on a strategy that will enable a company to work its way out of trouble—short of bankruptcy, that is. Turning now to manager-stockholder conflict, once again there are substantial differences between the two competing systems when it comes to large firms. The concentration of ownership under the German and Japanese financial systems gives banks a major incentive to monitor corporate managers actively. In the United Kingdom and the United States, however, diffuse ownership of company stock eliminates much of the incentive for any individual shareholder to monitor a firm’s management, leaving the corporate takeover as the most powerful mechanism for solving manager-stockholder conflict.5 It is not surprising, therefore, that Table 2 shows a substantially larger volume of mergers and acquisitions in the markets-oriented economies of the United Kingdom and the United States than in the banking-oriented economy of Japan. At first blush, the figures for Germany paint a different picture. However, the figures in Table 2 understate the differences between the market and banking systems because they do not isolate the hostile takeovers that are most likely to result when managers are under-performing. In Germany, hostile takeovers have been extremely rare: most sources suggest that there were no more than four hostile takeovers from 1950–2000.

And the Winner Is . . . Now that we’ve been through the theory and practice of banking-oriented and markets-oriented financial systems, how do they measure up against each other? Unfortunately, the game is still under way, so it’s too early to declare a winner. However, there are a few qualitative conclusions we can draw. First,

5Another

mechanism used in markets-oriented systems, particularly the United States,’ is linking managerial compensation to firm performance through stock-based compensation packages.

313

Financial System Design

financial intermediaries (like banks) with substantial ownership stakes in firms are better at solving stockholder-lender or manager-stockholder conflicts than are rating agencies or individual stockholders. However, this type of intensive monitoring is expensive. Continuous scrutiny of financial information, periodic compliance checks, and active participation in firm management all require a substantial investment in time and resources by the intermediaries. Second, stocks and bonds issued by firms in banking-oriented systems are much less liquid than securities issued in markets-oriented systems—either because they are not traded at all or because they are traded less frequently. And illiquidity is costly because issuers must compensate investors for the inability to resell their securities easily. Some estimates put this liquidity cost at more than 30 percent, implying that a $100 stock would sell for only $70 if it could not be sold in a secondary market.6 Thus there is a trade-off: The cost of raising capital is higher in Germany and Japan because of poor liquidity, while in the United States and the United Kingdom the cost of raising capital is higher because investors must be compensated for unresolved stockholder-bondholder-manager conflicts. Although there is no definitive answer to which of these forces dominates, some of the trends in the marketplace provide a clue. First, as described in previous chapters, securitization is on the rise in U.S. financial markets and is starting to catch on elsewhere. Securitization is a distinct movement away from banking-oriented finance toward markets-oriented finance. However, securitization may never catch on for small business lending because these companies are too information problematic. Second, the Eurobond markets have increasingly provided a markets-oriented alternative to domestic bank financing in Germany, Japan, and other developed banking-oriented economies. As more and more German and Japanese companies seek such financing, the tight grip of the Hausbanks and main banks could very well diminish. Third, the recent rapid increase in the level of merger and acquisition activity, particularly in Europe, indicates that the takeover market may provide an alternative to bank monitoring even in banking-oriented economies. Finally, the recent growth in European stock exchanges suggests that markets may become more important in the future for continental Europe. Of course, it would be unwise to celebrate victory for markets-oriented systems because we’re still in the first half of the game, so just about anything can happen. We can end this discussion on a cautionary note by noting that authors who have rushed to judgment on this question in the past have often been proven wrong by subsequent events (see the previous “Going Out on a Limb” feature for details).

6See

William L. Silber, “Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices,” Financial Analysts Journal, July–August 1991, and Francis A. Longstaff, “How Much Can Marketability Affect Security Values?” Journal of Finance, December 1995.

314

Financial System Design

Going Out on a Limb Do Corporate Scandals Mean that the Markets-Oriented Model Is a Bad Example? When the U.S. economy was booming in the late 1990s, countries in Europe and Asia faced pressure to adopt reforms inspired by the U.S. markets-oriented system. The recent wave of corporate scandals in the United States has led some people in these countries to question the merits of the U.S. system. This conclusion may be a little hasty. Way back in the early 1990s, for example, the U.S. economy was in a recession and seemed unable to compete with dynamic countries such as Japan. In 1992, Michael Jacobs—a former official in the (first) Bush administration—claimed in his book Short-Term America that the U.S. markets-oriented financial system made companies focus on shortterm profits at the expense of longer-term growth. The banking-oriented systems of Germany and Japan were viewed as more patient and therefore able to make investments that would pay off in the long term. It wasn’t long, though, before some new developments got in the way of an emerging popular consensus in favor of Japanese-style reform in the U.S. financial system. A stock market crash at the beginning of the 1990s and the subsequent “lost decade” of economic decline made Japan much less attractive as a model to emulate. When a number of Asian countries experienced financial crises in 1997 and 1998 a new consensus emerged: bankingoriented systems led to crony capitalism in which funds were allocated based on relationships rather than sound financial analysis. The booming U.S. economy was suddenly an example

for the world of how financial markets could allocate funds to deserving companies. Countries like Korea were encouraged by the IMF to reduce the importance of their banking systems and move toward a markets-oriented system. This new orthodoxy was itself challenged by events in 2000 and 2001. As U.S. equity markets crashed, stories emerged of fraud at major corporations, accounting firms, and investment banks. These institutions are the core of a marketsoriented system. It also became clear that many investments made by U.S. corporations in the telecom sector led to wasteful over-capacity. This situation raised doubts about the ability of the market to choose the most deserving recipients of investment dollars. In a February 2003 speech, Federal Reserve Governor Susan Schmidt Bies emphasized that a markets-oriented financial system cannot function properly without improvements to corporate governance practices. Dr. Bies went on to explain that while it may in theory be easier for banks to solve asymmetric information problems, in practice they also suffer from conflicts of interest and can be co-opted by managers (just as auditors were at companies like Enron). The bottom line seems to be that no financial system is perfect and that we should avoid the tendency to jump on the bandwagon of a particular approach that seems to be doing well at the moment. Designing a financial system requires careful cost-benefit analysis and consideration of complex issues of market structure, information transparency, and corporate governance.

Financial System Design for Eastern Europe and Other Emerging Economies With the breakup of communism and the Soviet Union, the Eastern European countries faced the daunting challenge of building a financial system from square one. One of the first initiatives was to develop privatization programs

315

Financial System Design

designed to transform government-owned companies into privately owned firms. These privatization programs typically involved the distribution of shares (or vouchers for shares) to the major stakeholders (employees, managers, and creditors) in the industrial firms that were privatized. Most of the early privatization efforts focused on small and midsize companies rather than large industrial companies. Some Western economic advisors emphasize that privatization must go hand in hand with the development of new securities markets—particularly equity markets in which the stock of companies could be traded. After all, what could be more symbolic of capitalism than an active stock market? However, there is a growing sentiment that banking-oriented financial systems may make much more sense for these formerly planned economies. Not surprisingly, the argument boils down to asymmetric information. At best, Eastern Europe can be viewed as an information-poor environment where even the activities of large firms are cloaked in a dense fog. Most Eastern European countries, for example, have just recently adopted accounting rules. Rating agencies, for the most part, don’t exist. Reputation building is extremely difficult because most Eastern European companies haven’t existed long enough to develop reputations—except for producing shoddy goods under communism. Moreover, the lack of managerial talent and experience in Eastern Europe suggests that investor monitoring will be especially critical in these countries. All of these factors indicate that a banking-oriented system like Germany and Japan may be much more suitable for Eastern Europe and other formerly planned economies. Although it might be nice to play the Russian stock market, the odds of success in that arena are much lower than the odds you get in Atlantic City or Las Vegas (which, as we know from elementary statistics, virtually guarantees that you will be a loser if you play long enough). So sit back and relax before taking a flyer in some Eastern European stock market.

SUMMARY 1. There are two types of financial systems to choose from. In banking-oriented systems banks are the principal lenders to both small and large businesses, and banks own and control large corporations. In markets-oriented systems large companies are diffusely held, and they borrow most of their funds in the securities markets rather than from banks.

2. Financial systems must solve two fundamental problems related to asymmetric information. The first, stockholder-lender conflict, occurs because business owners have an incentive to understate firm risk to their lenders and to get riskier after their loans have been funded. The second, manager-stockholder conflict, occurs because professional managers have an incentive to manage firms in their own best interest, rather than in the interest of the firms’ owners.

3. The stockholder-lender conflict is a more severe problem for small firms than large firms. The manager-stockholder conflict does not typically arise in small firms because they are usually either owner-managed or because they are tightly controlled by their owners.

316

Financial System Design

4. Stockholder-lender conflict for small firms is resolved under both banking-oriented and markets-oriented systems by financial intermediaries that specialize in producing information about borrower quality and tailoring loan contracts to minimize the conflict. The solution to the stockholder-lender problem for large firms depends on the financial system. In a markets-oriented system credit rating agencies and reputation building are used to resolve the conflict. In banking-oriented systems the problem largely disappears because the bank becomes both the owner and the lender.

5. Manager-stockholder conflict is resolved differently under the two systems. In bankingoriented systems, business ownership is consolidated in the bank (that is, the bank owns a controlling interest in companies). This allows the bank to participate on boards of directors and provides an incentive to monitor manager performance. In markets-oriented systems there is little incentive for any individual shareholder to monitor firm managers because they typically own such a small fraction of the firm. The principal mechanism for resolving manager-stockholder conflict in markets-oriented systems is the hostile takeover.

6. With their huge banking systems and extensive bank ownership of business enterprise, Germany and Japan are decidedly banking-oriented systems. The relative importance of securities markets in the United Kingdom and the United States make these systems markets-oriented.

7. Although much of the publicity about Eastern Europe has focused on privatization and the birth of their stock markets as a symbol of capitalism, a strong argument can be made that a banking-oriented system may make more sense than a markets-oriented one. The information-poor environment that characterizes these formerly communist countries suggests that the more powerful monitoring capacity of a banking-oriented system may be worth the costs it imposes.

KEY TERMS central bank

keiretsu

privatization

corporate takeover

leveraged buyout

Hausbank

payments system

stockholder-lender conflict

hostile takeover

QUESTIONS Questions with a red oval are in

at www.myeconlab.com.

16.1

Why is stockholder-lender conflict less acute for large firms than for small firms?

16.2

Does stockholder-lender conflict arise in those large German firms that are either privately owned or controlled by a small group of nonbank investors? How is it solved?

317

Financial System Design

318

16.3

Why isn’t it in every stockholder’s best interest to monitor the managers of the firms they invest in? How hard is it in the United States for individual stockholders to observe the behavior of corporate CEOs and to evaluate the motivation behind their actions?

16.4

Why are mergers and acquisitions so prevalent in the United Kingdom and the United States and much less so in Japan?

16.5

What sorts of characteristics make Eastern Europe an “information-poor” environment?

16.6

Discussion question: In recent years there has been a considerable amount of publicity surrounding the perception that senior management compensation in Japan is much less than it is in the United States. To what factors might such a difference be attributable? From an investor’s point of view, is this a good thing or a bad thing?

The Classical Foundations

One of the first questions we asked in this book was: What is the “right” amount of money? The answer depends on how money influences the economy, which monetary theorists have wondered about ever since economic science emerged from moral philosophy. The origins of monetary theory lie in the classical economics of Adam Smith (1723–1790) and his friends. The two cornerstones of the classical system are Say’s law, which deals with interest rates, employment, and production, and the quantity theory, which explains the role of money. Both concepts are essential to the proper understanding of classical economics; both were attacked by John Maynard Keynes when the classical wisdom was supposedly laid to rest in 1936; and both were resurrected and refined by modern monetarists and new classical macroeconomists beginning in the 1970s. Obviously, this is the place to start. To understand the role of money according to classical thinking, we must first see what determines gross domestic product, GDP (the total value of goods and services domestically produced). We start, therefore, with Say’s law of markets and work our way toward the somewhat more famous quantity theory of money. Along the way we’ll stop to consider some specifics: classical interest theory as well as the demand for money.

LEARNING OBJECTIVES In this chapter you will learn to define Say’s law and the classical understanding of aggregate supply understand the supply of saving and demand for investment that leads to the equilibrium interest rate explain the quantity theory of money and its implication for the aggregate demand curve differentiate between the nominal and real rate of interest

From Chapter 22 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

319

The Classical Foundations

Classical Economics Jean Baptiste Say (1767–1832) summarized the classical school’s income and employment theory with the now familiar maxim, “Supply creates its own demand.” Dubbed Say’s law, it meant quite simply that the economy could never suffer from underemployment or succumb to Thomas Malthus’ fear of underconsumption. Total spending (demand) would always be sufficient to justify production at full employment (supply). Let’s spend some time making clear why this is the case. Given current technology, potential output of the economy is determined by the size of the labor force available to work with the existing stock of capital goods (plant and equipment). This production function, in technical terms, defines the total supply of goods and services that can be produced. Say argued that production would be at the full employment level, since spending would always be great enough to buy all the goods and services that could be produced. Why? Because of the interplay of market forces, guided by what Adam Smith referred to as an invisible hand. If people who wanted to work couldn’t find a job, they would offer their services for less money and would be snapped up by eager entrepreneurs. Entrepreneurs who found it difficult to sell slow-moving items would promptly lower their prices and watch their inventories disappear. Flexible wages and prices would assure that all markets would be cleared, all goods sold, all people employed—except economists, who would have nothing to do, since everything worked just fine without them. The interplay of market forces under the guiding principle of laissez-faire (noninterference) would bring about the best of all possible worlds. To represent classical economics as having an entirely uniform outlook, however, would be unjust to some prominent precursors of modern Keynesian ideas. The Reverend Thomas Malthus (1766–1834) could hardly believe that he, a man of the cloth, was unable to see the invisible hand, so he proceeded to launch a sustained and vigorous attack on it. Spurning the microeconomic details, Malthus argued as follows: While the production of goods and services generates income in the same amount as total output, there does not seem to be anything to force spending to equal total production. Supply might create its own purchasing power (income), but not its own demand (spending). In particular, if people try to save too large a fraction of their income—more than firms want to invest— part of the goods produced will be left unsold, entrepreneurs will cut back their production, and unemployed labor and capital will result. This argument was later refined and formalized by Keynes.1 1There

is a distinction between the accounting identity that income or output equals actual expenditure and the possibility that income may not equal desired expenditure. The appendix to this chapter discusses these relationships, which are relevant both for classical and Keynesian economics. Because of the accounting identity between income and output, we use these terms interchangeably throughout the text.

320

The Classical Foundations

However, the classical economists cannot be disposed of so simply. People save part of their income, but such funds do not disappear. They are borrowed by entrepreneurs to use for capital investment projects. Savers receive interest on their funds, and borrowers are willing to pay, as long as they expect to earn a return on their investment in excess of the rate of interest. But what made the classical economists so sure that all saving would actually be invested by entrepreneurs? If saving went up, would investment go up by the same amount? In classical economics, the overall level of the rate of interest is the key; according to classical theory, interest rates would fluctuate to make entrepreneurs want to invest what households wanted to save. As is emphasized in the appendix to this chapter, this equality between desired saving and desired investment is sufficient to maintain production at the assumed level—in this case, full employment. The next section explains in greater detail this classical theory of interest rate determination. It is really an elaboration of one of the market mechanisms underlying Say’s law.

Classical Interest Theory The overall level of interest rates was determined by the supply of and demand for loanable funds. Classical economists obviously recognize the importance of supply and demand but focus their attention on saving and investment—the two main factors that, in the long run, underlie the supply of and demand for loanable funds. With saving creating a supply of funds and investment generating the demand for funds, classical economists had a firm handle on the forces underlying the level of interest rates. Let’s see how classical economists presented this more fundamental approach to interest rate determination in the long run. Note that throughout this discussion, we refer to the interest rate as a proxy for the overall level of rates. Saving, according to classical economics, is a function of the rate of interest. The higher the rate of interest, the more will be saved (see Figure 1), since at higher interest rates people will be more willing to forgo present consumption. The rate of interest is an inducement to save, a reward for not giving in to baser instincts for instant gratification by consuming all your income. It does not pay, by the way, to make too much of this assumption, because classical interest theory worked just as well if saving did not depend on the interest rate—that is, if saving were a vertical line in Figure 1. As long as investment is a function of the rate of interest, increasing as the rate of interest declines (as illustrated by the negatively sloped demand investment demand line in Figure 1), classical interest theory and Say’s law remain alive and well. Since it is crucial to our story, let’s examine why the amount of investment should increase with a fall in the rate of interest. Investment in physical capital is undertaken because capital goods— buildings, machines, or anything that is not used up immediately—produce services in the future. A new plant or machine is used by an entrepreneur to

321

The Classical Foundations

Interest rate Investment

Saving

Equilibrium rate

Below equilibrium rate

Saving, investment

FIGURE 1

Classical interest theory.

produce goods and services for sale. A business firm will invest in more capital if the expected return exceeds the rate of interest paid on the funds borrowed to make the investment. A lower rate of interest induces entrepreneurs to undertake more investment. They will accept projects of lower expected profitability, because the cost of borrowing funds is less.2 Figure 1 includes a supply of funds curve (people’s saving) and a demand for funds curve (entrepreneurs’ demand for investment). The rate of interest is in equilibrium (no tendency to change) at the point of intersection between saving and investment, where total saving is equal to total investment: Everyone who wants to borrow funds is able to, and everyone who wants to lend can do so. If the rate of interest were below equilibrium, as shown by the dashed red line in Figure 1, entrepreneurs would want more funds than savers were ready to provide, and competition would force the interest rate upward. If the rate of interest were above equilibrium, savers would want to lend more funds than entrepreneurs wanted to invest, and competition would force the cost of funds downward.

2The

entrepreneur need not borrow for the interest rate to be important in the calculation. If funds are already available, the alternative to increasing capital equipment is to lend the funds at the going rate of interest. At a lower rate of interest, lending becomes a less attractive use of the entrepreneur’s funds and real investment becomes more attractive. The rate of interest must fall to elicit more investment spending because of our old friend from microeconomics, the law of diminishing returns. More investment means a larger capital stock, and, given the labor force and current technology, there is reduced marginal productivity (profitability).

322

The Classical Foundations

Off The Record Investment Versus Investment It is obvious from the text that monetary theorists use the word investment to mean purchasing resources for production rather than consumption. Investment referred to purchasing financial assets, such as stocks and bonds, just as the word is used in conversation. From now on, unless indicated otherwise, investment will take on its formal meaning in monetary theory: spending on real resources that generate services in the future. It is not unusual, by the way, for the same word to have different meanings, even in the same sentence. For example, the well-known

warning to children: “Don’t go out in the cold without a coat or you will catch a cold.” We all recognize (except perhaps for parents) that the two meanings for the word cold in that sentence may not have anything to do with each other. Similarly, investment in the sense of people purchasing stocks and bonds may not necessarily mean greater spending by business on plant and equipment. In fact, this distinction is what underlies much of the debate between John Maynard Keynes (see the next chapter) and the classical economists.

But things don’t usually stay in equilibrium for very long. If people really listened to some of Thomas Malthus’ dire predictions of the consequences of unrestrained population growth, they might decide to save more at every rate of interest. The entire saving function would then shift to the right (Figure 2). At the old equilibrium interest rate, desired saving now exceeds the amount of

Interest rate Investment

Saving Saving⬘

Old equilibrium New equilibrium

Excess of desired saving over investment

FIGURE 2

Saving, investment

Increased saving calls forth increased investment.

323

The Classical Foundations

investment that entrepreneurs are ready to make. That is precisely what Thomas Malthus said was wrong with the classical system—people would spend too little in the form of consumption, they would save too much (more than entrepreneurs cared to invest), and unemployment would follow. But not really. The excess of saving over investment puts downward pressure on the rate of interest, as savers try to lend out their funds. As the rate of interest declines, some people will give in to their baser instincts and spend a greater part of their income (saving less and enjoying it more). At the same time, the decline in the rate of interest will encourage business firms to expand their investments. As Figure 2 shows, the rate of interest will settle at a lower equilibrium, at which point all that is saved out of current income is still invested by entrepreneurs. Where in all this does money fit in? The interest rate is influenced in the long run only by the saving of the public (determined by their habits of thriftiness) and by capital investment of entrepreneurs (determined by the productivity of capital). Money plays no role in this area of the classical system. It influences neither employment, the rate of interest, nor production. Real things are determined by real forces. Total goods and services produced and total employment are determined by the supply of capital, the labor force, and existing technology; the interest rate is determined by the thriftiness of the public and the productivity of capital. Money plays no role in the real sector of the economy. Instead it is treated separately—via the second pillar of the classical edifice, the quantity theory—where it determines the price level.

The Quantity Theory of Money Money, according to the classicists, is a veil that must be pierced to examine the determinants of real economic activity. Money affects the price level, but nothing else. An increase in the supply of money leads to an increase in the prices of all goods and services, but everything else—most notably the level of real economic activity, the rate of interest, and people’s real income—remains unchanged. This conclusion expresses the quantity theory of money. It implies that money is neutral with respect to the real sector of the economy. The logic behind this is as follows. We start with the equation of exchange, which is not the quantity theory but simply an identity, a truism: MV = PY

(1)

where M is the supply of money, V is velocity or its rate of turnover, P is the price level, and Y is the level of real income. On the right-hand side of equation (1) total output of goods and services is represented by Y; that is what is produced by labor and capital given the technology currently available. Y is usually referred to as real gross domestic product, or real GDP. The price level, P, is an index of the current prices of all goods. When Y is multiplied by P we have the nominal level of GDP, or GDP

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The Classical Foundations

measured in current prices.3 On the left-hand side of the equation, the stock of money (in dollars) is represented by M. When multiplied by its velocity, the number of times such dollars are used in the purchase of goods and services, the product MV also equals total spending. The equation of exchange says that total spending (MV) equals the value of what is bought (PY). The equation of exchange was originally put forth in a slightly different form. The level of real income on the right-hand side was replaced by T, the total level of transactions. The total level of transactions exceeds the level of GDP, because there are many transactions that are excluded from GDP. Purchases and sales of financial assets and of existing assets—such as stocks and bonds, old homes, and works by the Great Masters, are not part of current production and hence are not included in GDP. When the equation of exchange is written as: MV = PT

(2)

the velocity figure on the left-hand side is called transactions velocity. Equation (1) is the most frequently used version of the equation of exchange. It is really the most meaningful approach, since our main concern is with GDP and not with total transactions. Thus all our subsequent discussion will be in terms of equation (1) and the “income” velocity of money. Irving Fisher, the brilliant Yale economist who is unfortunately known for his advice to buy just before the stock market crashed in 1929, was the most eloquent expositor of the equation of exchange as we have just presented it.

The Cambridge Approach There is still another version of the equation of exchange, however, associated with economists at Cambridge University in England. So before discussing how we progress from the simple identity expressed by equation (1) or (2) to the quantity theory as used by Fisher and other classical economists, let us give equal time to our friends across the Atlantic. The Cambridge economists viewed the equation of exchange in a slightly different light. Instead of concentrating on the rate of turnover of a given stock of money during the year (its velocity), they concentrated on the fraction of total expenditure that people hold in the form of money. Simple algebraic manipulation of equation (1) produces the Cambridge cash-balance approach to the equation of exchange: M = kPY

(3)

3Throughout

this book when we use the term GDP by itself we mean the real value of goods and services produced. The phrase nominal GDP is used to distinguish real output from the nominal value. As long as prices remain unchanged, movements in nominal GDP and real GDP are one and the same. When the price level changes, movements in real GDP and nominal GDP differ, as we will see with concrete examples in the rest of this chapter. For a discussion of how price indices are constructed, see any basic text on economics.

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The Classical Foundations

where k is the fraction of spending that people have command over in the form of money balances. Obviously, k = 1/V, so equations (1) and (3) are equivalent from an algebraic standpoint (for some unknown reason, when the Cambridge economists divided both sides of equation (1) by V they changed 1/V to the letter k). And (3), like its predecessors, is still a truism—an identity that must be true by definition. This latest version does represent a different orientation, however. In fact, equation (3) readily lends itself to interpretation as a demand-for-money equation. But we are running a bit ahead of ourselves. It is time to convert the equation of exchange, whatever its form, from an algebraic identity—which it has been so far—into an analytical tool. Let’s move, in other words, from the equation of exchange (an identity) to the quantity theory of money (a causeand-effect hypothesis). We started this section by saying that the quantity theory implied that increases in the supply of money cause increases in the price level. We can now be even more precise: According to the quantity theory of money, a change in the money supply produces a proportionate change in the price level—for example, if the money supply doubles, so does the price level. This cause-and-effect conclusion follows from two basic propositions (a nice word for assumptions) of the classical school. First, on the right-hand side of equation (1), MV = PY, Y is assumed fixed at full employment (now you know why we started out with Jean Baptiste Say). Second, velocity is assumed to be fixed by the payment habits of the community. If MV = PY, and V and Y are assumed to be fixed, then if M doubles it follows that P must double. For example, if V and Y are fixed at 4 and 100 respectively, then a supply of money equal to 25 is consistent with a P equal to 1. If M doubles to 50, P must double to 2. To understand the process involved, we need only recall how people react to changes in the money supply brought about by central bank operations. Start out in equilibrium, with all people satisfied with the liquidity of their portfolio. Assume the Federal Reserve doubles the money supply. Liquidity rises. If people were formerly satisfied with their liquidity position, now they will try to get rid of their excess money balances by spending more. This increase in the demand for goods and services drives up prices, because total real output cannot expand—it is fixed at the full employment level by virtue of Say’s law. If people were in equilibrium before a doubling of M, they will stop trying to spend the increased money balances only after their total expenditures have also doubled. Since real output is fixed, a doubling of total spending must cause prices to double. End result: Money stock held by the public has doubled, nominal GDP has doubled, the price level has doubled, V is the same as before, and so is real GDP. Note carefully that classical economists insist on clearly distinguishing the real versus nominal consequences of anything in general, and money in particular. A change in the money supply leaves the real amount of goods and services produced (real GDP) unchanged, but increases the dollar value of nominal GDP.

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Money Demand and the Quantity Theory The two versions of the quantity theory, MV = PY and M = kPY, are algebraically equivalent and also produce the same cause-and-effect implications for the relationship between money and prices. For explaining the transmission mechanism as we just have, and for what is to come later, the cash-balance version (M = kPY) is superior (in keeping with the best British tradition). The cash-balance equation can be interpreted as a demand for money function, as we mentioned above. Assume that k = 1/4. Then if PY or nominal GDP equals $400, this means that people want to hold one-fourth of nominal GDP, or $100, in cash balances; if GDP climbs to $600, the amount of money demanded rises to $150; and if GDP doubles to $800, money demand doubles to $200. The fraction of nominal GDP that people want to hold in the form of money, k, is determined by many forces. It is essentially a transactions demand for money, meaning that people hold money for purchasing goods and services. Thus, since money is used as a medium of exchange, the value of k is influenced by the frequency of receipts and expenditures; if you are paid weekly, you can manage with a smaller daily average cash balance than if you are paid monthly. Second, the ease with which you can buy on credit (the use of credit cards) also influences k by permitting people to reduce the average balance in their checking accounts. Money is also used as a temporary abode of purchasing power—waiting in the wings until you summon it and exercise control over real goods and services. Thus an individual may hold more or less, depending on whether he or she expects to be out of a job for four months or two months of the year. For the community as a whole, so the argument goes, all these factors average out and are fairly stable, hence the public winds up wanting to hold a stable and/or predictable level of money balances. Looking at the cash-balance version of the quantity theory (M = kPY) as a demand for money equation, it is easy to see that the doubling of prices (and hence norminal GDP) produced by a doubling of the money supply follows directly from the equilibrium condition that the amount of money demanded must equal the supply. When M doubles, people have twice as much money as they want to hold (money supply exceeds the amount demanded), given that nothing else has changed. So they start to spend it. They stop spending when they want to hold the increased money supply (when the amount of money demanded grows into equality with the supply). That occurs when nominal GDP has doubled. It is also possible to look at this new equilibrium position in a slightly different way. Namely, the real amount of money that people hold is the same in both the initial and final positions. The real amount of money is given by the actual money supply deflated by the price level, or M/P, where that tells you the amount of real goods and services that is “controlled” by the cash balances people hold. For example, if you hold a $1,000 checking account you control $1,000 worth of goods and services; if you have a $2,000 checking account but the price level has doubled, you still control the same real volume of goods and services.

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The cash-balance version of the quantity theory, in fact, emphasizes that people try to fix their real money balances, not the dollar value of their cash holdings. Thus when the supply of money doubles, the public has twice as many real balances as it wants, given the old price level and real GDP. People try to get rid of those excess real balances by spending. But since the real output of goods and services is fixed at full employment, only prices respond to the increased demand for goods. Prices will continue to rise until people stop trying to spend those extra real balances. And that happens when they have none left, that is, after prices have doubled so that real balances are back to their original level (M/P = 2M/2P is a famous theorem in Boolean algebra).

Aggregate Demand and Supply: A Summary In keeping with the best traditions of economics, it is useful to summarize the discussion thus far within an aggregate supply/demand framework. This will serve us well in explaining policy debates and will also form the foundation for analyzing inflation. Figure 3 may not look exactly like the supply/demand graph you learned to love in basic economics, but it really is. Price is measured on the vertical axis and quantity is on the horizontal axis. In the macroeconomic framework, price refers to the price level of all goods, P, and quantity refers to the aggregate real output of all goods and services, Y. Since output (or production) and income are one and the same (two ways of measuring GDP—as shown in the appendix

Price level

Aggregate supply

P⬘

P

P⬙ Aggregate demand YFE

FIGURE 3

328

The equilibrium price level.

Income

The Classical Foundations

to this chapter), we label the horizontal axis income. However, in our discussion we will use the terms income and output interchangeably. The supply schedule in Figure 3 is a vertical line to represent the classical assumption that the volume of goods and services that can be produced is fixed at full employment (YFE). In particular, changes in the price level do not influence the supply of goods and services. (We encounter similar vertical supply schedules at the microeconomic level for many commodities in the very short run as well as for things like land in the long run.) The demand schedule in Figure 3 is negatively sloped. While this is the normal shape, the reason is somewhat different in the macroeconomic context. The aggregate demand schedule is drawn for a given level of the money supply (M). And as we have just seen, a given stock of money buys more goods and services with a lower price level. Hence a lower price level means that the amount of goods and services demanded is greater.4 The intersection of aggregate supply and aggregate demand in Figure 3 indicates the equilibrium price level. Since the supply of goods is fixed by Say’s law, the demand schedule tells us only what price level will clear the market. If the price level were higher than P (as at P ¿ in Figure 3), the aggregate demand for goods and services would be too low, and businesses would have to lower prices to sell all their output. If the price level were lower than P (as at P – ), the aggregate demand for goods and services would exceed what is available, and businesses would raise prices to ration the existing supply (and to make a handsome profit). Thus P is the equilibrium price level. Note that price flexibility is the key to the classical school’s argument that the level of real output would be at full employment. If the price level in Figure 3 were for some reason stuck at P ¿, then aggregate demand for real goods would be below full employment output (YFE). That’s why we said earlier, in our discussion of Say’s law, that flexible wages and prices would ensure that all goods would be sold and all labor employed. Now we see clearly that if this weren’t the case, aggregate demand for real goods would be too low. Downward rigidity in prices is one of the elements Keynes focused on in analyzing the behavior of economic activity at less than full employment, as we’ll see in the next chapter. Figure 4 allows us to identify the demand schedule more precisely. In particular, when there is a shift in the entire demand curve, we see that the

4Note

that the normal microeconomic reasons for demand rising when prices fall are not relevant in the macroeconomic context. First, lower prices usually generate a larger amount demanded because a particular commodity is cheaper and consumers substitute it for other goods. But in the macro framework we are dealing with all goods together, and all prices are falling, hence the “substitution effect” is not relevant. Second, lower prices usually increase the amount demanded because people’s incomes can now buy more. But in the macro framework all prices, including the price of labor (wages), are falling. Thus the “income effect” of price decreases is irrelevant. That’s why we appealed to our real money supply discussion. In particular, even though prices are falling, the stock of money is fixed by the central bank. Thus, as the value of real balances increases, because prices are falling, the amount demanded for all goods taken together rises.

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The Classical Foundations

Price level

Aggregate supply

P⬘

P Aggregate demand⬘ Aggregate demand YFE

FIGURE 4

Income

An increase in aggregate demand raises prices.

price level rises from P to P ¿ . Our discussion in the previous sections showed that increases in the money supply raise the price level. From Figure 4 we see that this occurs because higher levels of M increase the aggregate demand for goods and services. In particular, in Figure 4 at the old price level, P, the public had just the right amount of real cash balances (given the old money supply). When the supply of money is increased, the demand for goods and services at every price level goes up, because real cash balances are higher. This is represented in the figure by a rightward shift of the demand curve. The net result of this increased demand, however, is simply to raise the price level to P ¿ because the aggregate supply of goods and services is fixed at full employment. Our algebraic discussion in the previous sections was more specific than the graphics, because we could show that changes in the money supply lead to proportional changes in prices under the quantity theory. But the pictures emphasize an important dimension as well: The quantity theory is really a specific statement of the aggregate demand for goods and services. In particular, this theory emphasizes that changes in the money supply raise prices by changing aggregate demand. We have also just identified the source of the popular notion that inflation stems from “too much money chasing too few goods.” In the context of classical thinking, continued expansion in the money supply raises the aggregate demand for goods; with a fixed supply of goods, the result is rising prices, which is exactly what we mean by inflation. The classical message, therefore,

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The Classical Foundations

is that inflation is a monetary phenomenon: Unless the money supply increases, the price level is stable.

Real Versus Nominal Rates of Interest Once inflation enters the picture, we must return to amend our discussion of interst rate determination. Until now there was no need to consider the distinction between the real rate of interest and the nominal rate. The reason is that real and nominal yields are the same when the inflation rate is zero. Thus our discussion above, showing how saving and investment determine the rate of interest, is unambiguous: A given nominal rate of interest (in terms of dollars earned) is the same as the real yield (in terms of real goods and services earned) when the price level remains unchanged. However, if inflation occurs, the real yield on a bond is not equal to the nominal rate. In particular, a $1,000 one-year bond that promises $50 in interest and costs $1,000 has a 5 percent nominal yield. But if the rate of increase in the price level is 2 percent, then it takes $1,020 next year just to buy what $1,000 would have purchased a year earlier. Thus only $30 of the $50 interest payment represents additional real goods and services that can be bought. A convenient rule of thumb is as follows: The real yield approximated by the nominal rate minus the rate of inflation; in our case, the real yield is 3 percent. All of this is more arithmetic than economics. But Irving Fisher, of quantity theory fame, was the first to put the commonsense arithmetic together with some economic analysis. In particular, Fisher argued that if savers and investors expected inflation, they would force up the equilibrium nominal rate of interest to include an inflation premium. The equilibrium real rate would remain unchanged at the level determined by saving and investment, just as the nineteenth-century classical economists said. But the nominal rate would increase by the expected rate of inflation. The argument is as follows. Savers who were previously satisfied with, say, a 5 percent yield on bonds when inflation was zero will save less and lend less when the expected rate of inflation jumps to 2 percent—after all, their savings will buy fewer real goods next year. Investors, meanwhile, will want to borrow even more funds when they expect 2 percent inflation—after all, they’ll be investing in goods and services that can be sold at even higher prices next year. Thus at the old interest rate of 5 percent there is a greater demand for funds and a smaller supply. The level of interest rates is forced up to bring saving and investment back into equality. When the nominal yield rises to 7 percent, and the real rate of interest is back at 5 percent, lenders and borrowers will once again have consistent saving and investment plans. More specifically, unless the nominal rate of interest rises by the expected rate of inflation, the real rate of interest (the nominal rate minus the expected

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The Classical Foundations

rate of inflation) will be too low. As we saw in Figure 1, when the real rate is below equilibrium, desired investment exceeds saving and the real rate of interest is pushed up. So Fisher’s addendum to the purely classical interest theory was that, in equilibrium, the nominal rate of interest would increase by the expected rate of inflation and the real rate would remain unchanged (determined by saving and investment at full employment).

Modern Modifications: Monetarists and New Classicists Since the late 1940s, a group of economists, associated in varying degrees with the University of Chicago, has built upon the traditions of classical economics with the benefit of modern theoretical and statistical techniques. Originally labeled the Chicago school, but currently referred to either as monetarists or new classical macroeconomists, this informal group has produced a set of ideas with important implications for the role of money in the economy. For simplicity we sometimes refer to this group as monetarists. Monetarists adhere to virtually all the tenets of classical economics. However, they have made some modifications. For example, some have used the quantity theory as a framework for describing the relationship between M and PY rather than just M and P. This approach recognizes the fact that real output may deviate temporarily from full employment and represents an attempt at describing what influences overall economic activity rather than just the price level. It must be emphasized, however, that this broader view of the quantity theory can never wander very far from the first pillar of classical economics: Say’s law. Modern monetarists still view the invisible hand as pushing the economy toward the full employment level of production (YFE). Any increases or decreases in Y stemming from expansions or contractions in M are viewed as temporary. Much of this discussion hinges on a more precise specification of the aggregate supply and demand schedules that were just introduced. A second modification of classical thought occurred with Milton Friedman’s revival of the quantity theory during the 1950s. Friedman replaced the idea of the stability of velocity with the less militant notion that it is predictable. Or, looked at another way, money demand may not be a fixed fraction of total spending, but it is related to PY in a close and predictable way. Obviously this provides a looser linkage between changes in money and prices, one that must be described in statistical terms rather than with a simple arithmetical example. Nevertheless, if people respond in a predictable way to changes in the money supply, much of the classical heritage is sustained. Perhaps the most important classical tradition that is upheld by modern monetarists is the inherent stability of the economy at full employment.

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Going Out On a Limb The Money Supply and the Great Depression Most people believe that the Great Depression of the 1930s was started by the stock market crash of 1929. In fact, although the stock market crash might have initiated the depression, according to many economists the depth and duration of the depression must be largely attributed to the major contraction in the money supply that followed in the wake of the stock market’s collapse. First the dimensions of the depression. Gross domestic product in the United States was $104 billion in 1929. In 1930 it declined 13 percent to $90 billion, and in the three subsequent years GDP continued to shrink to a low point of only $56 billion in 1933. Unemployment soared from 3 percent of the civilian labor force in 1929 to an intolerable 25 percent in 1933! In 1939, a decade after the stock market crash, GDP was still below its 1929 level and

unemployment was still 17 percent of the civilian labor force. To a large extent, the depth and duration of the depression were due to what happened to the money and the associated impact on spending. M1 (currency plus checking accounts) was $26 billion in 1929. By 1933, though, M1 had declined by 23 percent, to only $19 billion. In other words, almost a fourth of the money supply simply disappeared. This money supply contraction resulted from the collapse of the banking system. In the four years 1930 through 1933, more than 9,000 commercial banks failed, wiping out billions of dollars of deposits (there was no federal deposit insurance yet, since the FDIC didn’t begin operations until 1934). It was 1936 before the money supply recovered to its 1929 level. No wonder the depression was so deep and lasted so long.

This explains the monetarist rejection of governmental attempts to fine-tune economic activity. A higher level of economic activity requires more capital and labor or technological improvements; more money only leads to inflation. The answer to cyclical downturns is to wait for the natural upturn. Government intervention is unnecessary and potentially damaging. The new classical macroeconomists have added still another wrinkle to the futility of government efforts at fine-tuning—rational expectations. This perspective emphasizes that people formulate expectations based on all available information, including their knowledge of how the economy behaves. Recognizing that the economy tends toward full employment implies that any attempt at increasing the money supply to reduce unemployment will not be successful. People will immediately equate increases in money supply with an offsetting rise in prices. Thus there will not be any expansionary impact on real economic activity, because increases in money supply simultaneously generate expectations of higher prices. To some extent, these are the implications of classical economics that sparked the Keynesian revolution.

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“Mr. Semple, who wants to stimulate the economy, help the cities, and clean up the environment, I’d like you to meet Mr. Hobart, who wants to let the economy, the cities, and the environment take care of themselves. I’m sure you two will have a lot to talk about.” © The New Yorker Collection 1976 Stan Hunt from cartoonbank.com. All Rights Reser ved.

SUMMARY 1. The two main concepts of classical thinking on money and aggregate economic activity are Say’s law and the quantity theory. Say’s law emphasizes that the economy is inherently stable at full employment. Any deviations from that level of economic activity are only temporary. A key mechanism promoting stability is the flexibility of interest rates. Saving and investment are brought into equality through variations in the interest rate.

2. The quantity theory of money states that the impact of money in classical economics is limited to the price level. Increases in the money supply raise prices, and decreases in money reduce the price level. Money is neutral with respect to the real sector of the economy. There is a clear distinction between real and nominal magnitudes.

3. At the heart of the quantity theory is a stable demand for money. More particularly, the demand for real cash balances is a predictable fraction of real GDP. The quantity theory can also be viewed as a statement about what determines the aggregate demand for goods and services. In particular, it says that increases in the money supply raise aggregate demand. With aggregate supply fixed at full employment, the impact of an increase in the money supply is to raise prices.

4. The real rate of interest is determined by saving and investment. When expectations of inflation emerge, the nominal rate of interest is forced up to include an inflation premium, leaving the real rate unchanged.

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5. Modern monetarists treat the quantity theory more flexibly than their classical ancestors did. Money influences spending in a predictable way rather than in a rigid numerical fashion. Moreover, if the economy is at less than full employment, even real output might respond to changes in the money supply. But the natural tendency toward full employment eliminates any systematic impact on real output of changes in money supply.

KEY TERMS cash-balance approach

laissez-faire

real GDP

classical economics

monetarist

Say’s law

demand-for-money equation

nominal GDP

transactions demand

quantity theory of money

velocity

equation of exchange

rational expectations

gross domestic product (GDP)

QUESTIONS Questions with a red oval are in

at www.myeconlab.com.

22.1

Explain why an increased desire to save (implying less desired consumption spending) would not generate unemployment according to classical economists.

22.2

Why do classical economists maintain that prices would double if the money supply doubles?

22.3

What factors determine the demand for money according to the original quantity theory?

22.4

Use aggregate supply and demand curves to show why classical economists contend that inflation is a monetary phenomenon.

22.5

Consider the equation of exchange with a fixed velocity and real GDP that grows 2 percent per year. Each year the central bank increases the quantity of money by 3 percent. If the equilibrium real interest rate is 6 percent, what is the equilibrium nominal interest rate?

22.6

Use the aggregate demand/aggregate supply diagram to predict the impact on the price level and level of real GDP for each of the following actions: a. The Fed increases the money supply by 4 percent. b. Immigration causes the labor force to increase by 10 percent. c. Consumer sentiment increases, causing an increase in purchases by households.

335

APPENDIX

GDP DEFINITIONS AND RELATIONSHIPS

This is a review of aggregate economic relationships from basic economics. We discuss the circular flow of income and output, the separation between saving and investment, and other macroeconomic relationships needed for the next few chapters.

The Circular Flow of Spending, Income, and Output Let’s start by taking a simplified view of the economy, dividing its participants into two groups: business firms and households. Firms produce goods and services for sale; households buy these goods and services and consume them. Households are able to buy the goods and services produced by firms because they also supply firms with all the land, labor, capital, and entrepreneurship required for production; hence they receive as income the total proceeds of production. The total value of the goods and services produced within the United States is called gross domestic product (GDP), or more simply national income (Y ), and it can be measured by either the total output sold by firms or the total income received by households (in the form of wages, rent, interest, and profits). These relationships are summarized in Figure A.1, the inner circle recording flows of real things (factors of production to firms and goods and services to households), the outer circle recording the associated money flows (income payments to households and money expenditures to firms). The money flow relationship can be written symbolically as C = Y, where C stands for household spending on consumer goods and Y stands for national income or GDP. As long as firms sell all their output, they will continue to produce at that level. As long as we assume that all the income received by households is spent on the goods and services produced, production equals sales, output equals demand, and we are in equilibrium (there is no tendency for anything

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The Classical Foundations

$ $ $ $ $ $ Payments Income Factor Services

Households

Firms

Good

s and Services

Cons umer Expenditures $ $ $ $ $ $

FIGURE A.1

The circular flow of spending, income, and output.

to change). But if we keep this up much longer, you will have fallen asleep in the very position you are now in, maybe still holding this book (also equilibrium). So we modify things a bit to make our hypothetical economy more like the real one.

Saving and Investment Households don’t spend all their income; they usually save some fraction. Saving represents a leakage in the circular flow. Total income of households (which is equal to the total value of goods and services produced by firms) does not all return to firms in the form of consumption expenditures. Saving (S) is defined simply as total income (Y ) minus consumption spending (C)—that is,

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The Classical Foundations

S = Y - C. It may not have anything specifically to do with putting the money in a bank, under the mattress, or in the stock market. Households may do any of these things with their savings—that is, with the excess of their income over their spending on consumer goods. For now we are not concerned with their financial transactions, just with the fact that failure to spend all income implies that total expenditure is less than total income (and total production). If things remained that way, output would exceed sales and firms would want to cut back production. But all is not lost. Consumer goods are not the only thing that firms produce. Firms themselves add to their stock of production facilities or to inventories—they buy goods and services for their own use, which we call investment spending (I). If firms want to invest (I) exactly what households want to save (S), then all that is produced will once again be sold, but this time to both households (for consumption) and business firms (for investment). And, of course, the level of output will be one of equilibrium (hooray). This happy state of affairs is summarized in Figure A.2 and can be represented as C + I = Y. Note that we can also describe the situation as one in which the leakage from the household spending stream (saving) is equal to business spending on investment, or, in symbols, S = I. In Figure A.2 we have labeled the connecting link between saving and investment the financial markets. Decisions to save are often made by people very different from those who invest—saving is done by the little people in the economy who scrimp to hold their spending down in order to prepare for a rainy day, while investment is done by corporate executives sitting at huge oval desks with thirteen phones and four secretaries. These seemingly diverse groups are brought together by financial markets, with the savings of ordinary people borrowed by the corporate executives and then spent on investment goods, so that both groups may continue along their merry way. The word investment is frequently confusing, because it is used to mean different things. Here it means the purchase of “real” productive facilities, like factories and machine tools, whereas in common usage investment often refers to purely financial transactions, like buying stocks and bonds. Buying stocks and bonds can have implications for real investment (the purchase of factories and machine tools), but they are clearly different things. Throughout Part VI, investment refers to the purchase of productive facilities. It is important to emphasize that for equilibrium output to occur when saving equals investment it is necessary that households want to save the same amount as business firms want to invest. As we noted earlier in this chapter, classical economics assumed that the interest rate would bring desired saving and investment together. We have to distinguish this condition (where desired S = desired I) from one in which S and I are equal simply by definition. That is, saving is defined as Y - C. But C + I = Y, so that I also equals Y - C. Thus, by definition, S must always equal I, since both equal Y - C. But this equality is an ex post accounting identity, always true by definition. It is not an ex ante behavioral equality arising from what people want to do. Only when people want to save

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$ $ $ $ $ $ Payments Income Factor Services

Households

Firms

Good

s and Services

Cons umer Expenditures $ $ $ $ $ $

Saving

FIGURE A.2

Financial Markets

Investment Expenditures

The circular flow including saving and investment.

what firms want to invest will income be in equilibrium (remain unchanged). A concrete example is given in the next chapter. So far we have ignored the government (wishful thinking?). It, too, introduces a leakage between income payments and household consumption expenditures—namely, taxes (T). When the government collects taxes, households have less to spend on consumer goods (and less to save). If some other

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The Classical Foundations

form of spending did not increase when taxes were levied, production once again would exceed the sum of all types of expenditures, and economic activity would decline. But the government could lend these funds to business firms so they could increase investment spending, or the government itself could buy goods and services from business firms. If desired spending in the form of consumption (C), investment (I), and government expenditure (G) equals total output, or C + I + G = Y, then that level of production will be maintained. Note that we can also describe the situation as one in which total leakages from the spending stream, saving plus taxes, equal total spending injections in the form of investment and government expenditure, or S + T = I + G. For simplicity, we may sometimes refer to the left-hand side as total saving and the right-hand side as total investment. One final note: Our exports to foreign countries minus our imports from foreign countries, referred to as net exports (NX), also adds to aggregate demand (imports must be subtracted because they are included in C, I, and G but do not generate domestic production). Thus our new equilibrium including the foreign sector is as follows: If desired spending in the form of C + I + G + NX equals what is produced, then that level of output will be maintained.

340

The Keynesian Framework

John Maynard Keynes, first baron of Tilton (1883–1946), did many things differently. We are not concerned here with his ability to make a fortune speculating in the market while simultaneously teaching at King’s College, Cambridge; nor with his infatuation with the finer things in life—ballet, drama—and his editorial supervision for many years of the technical Economic Journal; nor with his unique abilities in the fields of mathematics, philosophy, and literature. Rather, we are concerned with his contribution to economics in his book The General Theory of Employment, Interest and Money, published in 1936: how it revolutionized the thinking of all economists since, how it replaced classical economics as the conventional wisdom, and how it led to a different outlook on employment, interest, and money. Before going into the details of Keynes’s contributions to monetary theory and the refinement of his ideas at the hands of other economists (collectively labeled Keynesians), it will be helpful to set the stage by noting an essential difference in Keynes’s outlook compared with that of his classical teachers. Keynes was concerned with the short run, while classical economists were preoccupied with the long run. Keynes’s attitude toward the concern of his classical mentors is best illustrated by his now-famous dictum: “In the long run, we are all dead.” Classical economics explained why fluctuating prices and interest rates would continuously push economic activity toward full employment. But Keynes argued that these free market forces could take considerable time to work themselves out. And in the short run there could be lengthy periods of underemployment. While it is difficult to delineate the borderline between the short run and long run, the six years of worldwide depression preceding the publication of Keynes’s magnum opus seemed too long to wait for classical market forces to restore full employment. Keynes was preoccupied with what determined the level of real economic activity during those lengthy recession or depression intervals between the full employment points of the classical school. Real output could increase without any increase in the price level if

From Chapter 23 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

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The Keynesian Framework

we started out in a sufficiently depressed state. All of Keynes’s basic analysis assumes that the price level is fixed.1 Therefore, throughout this chapter, all changes in GDP represent real changes. Moreover, throughout this book, whenever GDP appears without a modifier, it refers to real GDP. As in the last chapter, real GDP is represented by the letter Y. Keynes obviously had to focus on the aggregate demand for goods and services, since during the Great Depression full employment supply was irrelevant. Theoretically, he could have chosen the quantity theory to describe aggregate demand, just as he had done in his classical life before 1936. But in his new incarnation he had other plans for money, quite different from the quantity theory. Moreover, he believed he had to introduce a new set of analytical tools to deal with unemployment, since classical economics had almost nothing to say about such matters. Keynes wanted to design a model of GDP determination that would explain how economic activity could be in equilibrium at less than full employment. Who or what was to blame for a depressed level of economic activity? To what extent is money the culprit?

LEARNING OBJECTIVES In this chapter you will learn to see the differences among saving, investment, desired saving, and desired investment and explain how these differences can generate short-run fluctuations in real GDP understand the Keynesian cross and determination of an equilibrium level of income analyze autonomous changes in macroeconomic variables and their potential to cause economic fluctuations define the liquidity preference theory and its role in determining interest rates comprehend the Keynesian theory of monetary policy and its role in impacting the economy understand the Keynesian version of aggregate demand/aggregate supply analysis

When Saving Doesn’t Equal Investment For GDP to be at an equilibrium level—that is, no tendency for change—all that is produced must be sold to consumers or willingly added to the capital stock as investment by business firms. We also said that this equilibrium condition could be stated in another way: Total saving desired by households must equal total investment desired by firms. In that way the leakage out of the

1Toward

the end of this chapter we will describe how this looks in terms of the aggregate supply and demand framework.

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The Keynesian Framework

spending stream in the form of saving would be made up by desired investment spending by firms, and everyone would be happy. We also mentioned in the appendix that ex post (after all is said and done) saving is always equal to investment. Only in the ex ante (desired) sense is equality of saving and investment an equilibrium condition. Let’s take a very specific example of these relationships to set the stage for our discussion in the rest of the chapter. Assume entrepreneurs produce $1,000 billion of output (Y) at full employment and expect to sell $800 billion to consumers (C) and want to use the remaining $200 billion for investment (including inventory accumulation). They will continue producing at that rate only if their sales are realized. If consumers plan to buy $800 billion in consumer goods and services and therefore desire to save $200 billion, all is well. But what if consumers decide they want to spend only $700 billion on consumer goods, which means they want to save $300 billion? What will give? Assuming that consumers succeed in implementing their spending plans, entrepreneurs will wind up selling only $700 billion, although they have produced $800 billion in consumer goods and services. Clearly their selling plans have been disappointed, and they wind up with an extra $100 billion in (unwanted) inventories. In fact, they wind up investing $300 billion (the same as saving): their planned capital accumulation of $200 billion plus $100 billion of unintended inventory accumulation. Saving (S) equals investment (I) ex post, but desired saving exceeds desired investment by $100 billion. The key classical–Keynesian confrontation involves precisely such circ*mstances: What happens when desired saving exceeds desired investment? The classics had a series of simple answers based on a single principle—prices adjust when there is an excess supply of or demand for any good (or all goods together). Therefore, when there is an excess supply that isn’t being sold, entrepreneurs reduce their prices to get rid of unsold inventories, workers lower their wage demands to stave off unemployment, and the rate of interest (the price of borrowing) decreases when saving exceeds investment. The fall in the interest rate lowers desired saving (increasing desired consumer spending directly) and raises desired investment, until desired saving and investment are again equal and entrepreneurs are content with their previous (full employment equilibrium) level of production. But Keynes was not sympathetic. Prices are sticky and probably wouldn’t decline as inventories piled up. Wages are notoriously resistant to decreases and, even more important, fluctuations in the rate of interest do not equilibrate desired saving and desired investment. The rate of interest is determined in the money market; it equilibrates the supply and demand for money, not saving and investment. (And that is why Keynes dropped the quantity theory, as we will see in greater detail later.) Assuming that the rate of interest doesn’t bring saving into equality with investment, what happens as a result of the undesired inventory accumulation? Keynes thought that the level of real output, rather than prices, would respond most quickly. Entrepreneurs with unwanted accumulating inventories would

343

The Keynesian Framework

probably cut back production. Output would fall as long as desired saving exceeded desired investment. Since the price level was unchanged, both real output and income would decline. How far? Until desired S equaled desired I, when a new equilibrium GDP, lower than before, would be reached. To help us see how far GDP would fall when desired saving exceeds desired investment, Keynes invented the consumption function (or, looked at another way, the saving function).

Consumption and Simple GDP Determination We start by determining equilibrium production, or GDP, where GDP is measured by both income received and output sold. Figure 1 is the familiar Keynesian cross diagram. On the horizontal axis we measure real income and real output (both represented by Y) and on the vertical axis we measure different types of expenditure. For simplicity we label the horizontal axis income and the vertical axis expenditure. The line drawn from the origin at an angle of 45 degrees marks off equal magnitudes on each axis (remember isosceles triangles from basic geometry?), hence it traces the equilibrium condition E = Y, or expenditure equals income. Expenditure takes two forms: consumption and investment (we’ll ignore the government and foreign sectors for a while), Keynes argued that consumption

Expenditure E=Y

E=C+I Z C = a + bY

I

X

b 1

I

a 45˚ Yeq

FIGURE 1

344

Spending determines income.

Income

The Keynesian Framework

spending (C) depends mainly on the level of income (Y)—more income, more consumption. In Figure 1, therefore, desired consumption is a simple linear function of Y: C = a + bY The letter b is the slope of the line, or ¢C/¢Y, the change in consumption per unit change in income (see point X in Figure 1). It is called the marginal propensity to consume and is assumed to be less than 1. For example, if b is 0.8, that means an increase in Y of $100 raises C by $80. (It also means that saving goes up by $20.) The a in the consumption function is the constant term. It records the level of C if Y were zero and it sums up all other influences on consumption besides income. For example, if you had bought Microsoft in 1990, when it was worth less than $1 per share, you would now be consuming a lot more than if you bought silver when it was $50 an ounce (January 1980). Thus the consumption function might shift up or down, recorded by larger or smaller values for a, if people are wealthier or poorer, or perhaps simply desire to spend more. As far as investment (I) is concerned, Keynes agreed with the classics that it is a function of the rate of interest on bonds. Entrepreneurs compare the expected rate of return on a prospective investment with the rate of interest.2 2The

rate of return on an investment is determined by the expected future dollar revenues on the project and the current cost of the investment. In particular, if an investment is expected to generate $105 next year and requires a cash outlay of $100, we can calculate the rate of return quite simply. It is that rate of discount which equates the expected future revenues with the current 105 cost, or 100 = 1 + q , where q is the rate of discount or, in our terminology, the rate of return. In our case it is clearly equal to 0.05, or 5 percent. We call q the rate of discount because it reduces (discounts) the $105 that is due next year to its current value (time is money). Looked at another way, $100 put out at 5 percent for 1 year (100 * 1.05) produces $105 one year hence. This perspective also gives a clue as to how one ought to treat revenues two years hence. Namely, $100 left at 5 percent for two years produces 100 * 1.05 after one year, or $105, which is then reinvested and generates $110.25 after the next year ($105 * 1.05 = $110.25). In general, therefore, if R2 is the expected revenue two years from now, it must be discounted twice or C =

R2 (1 + q)(1 + q)

R2 =

(1 + q)2

The general formula for the rate of return is as follows. If revenues of R1, R2, . . . , Rn are expected over the next n years, then the rate of discount q which equates C, the current cost, to the expected stream of revenues, as in C =

R1 R2 Rn + + Á + (1 + q) (1 + q)n (1 + q)2

is called the rate of return on the investment project. Relax—you have at least 13 seconds to perform the necessary computations. This equation is very similar to the one used to calculate the yield (rate of return) on a bond. Just substitute P (the price of the bond) for C, put the coupons (C1 through Cn) where the Rs are, and replace q with the rate of interest (r). In fact, once you do that, the formulas are the same, which is just fine since in both cases we’re measuring rates of return. Of course, that doesn’t make it any easier to calculate these things.

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The Keynesian Framework

They invest as long as the rate of return exceeds the rate of interest and continue up to the point at which the expected return on the last investment just equals the rate of interest. If the rate of interest declines, then investment projects with lower expected returns become profitable and investment will increase. For now we take the rate of interest as given. We also take expectations as given, which is an even more questionable proposition. Under such conditions, investment is some constant amount (say $200 billion), as indicated by the horizontal line labeled I in Figure 1. Equilibrium output is represented by the line E = Y, where total desired expenditure (E) equals total income, Y. Total desired expenditure is the sum of desired C and desired I, or, in Figure 1, line E = C + I, which is the vertical addition of C (= a + bY ) and I. The point at which the total desired expenditure line (E = C + I) crosses the expenditure-equals-production line (E = Y ) is equlibrium income (Yeq). Point Z in Figure 1 is an example. At the level of production Yeq, desired expenditure equals income. It is also true that desired saving equals desired investment at that same income level. Desired saving is given by the difference between income and desired consumption (that is, S = Y - C). It can be measured by the vertical difference between the 45-degree line and the consumption function. In Figure 1 the only point at which saving (the vertical difference between the 45degree line and the consumption function) equals investment (the difference between the E = C + I line and the consumption function) is at income Y eq. In Figure 2 we have plotted the saving function explicitly, where Y is measured along the horizontal axis and dollars saved or invested are on the

Saving, investment

S = –a + (1 – b) Y

I

Yeq Income

FIGURE 2

346

Saving and investment determine income.

The Keynesian Framework

vertical axis. Saving is defined as Y - C, so that desired saving, S, equals Y - (a + bY ). Rearranging terms (and factoring the Y term) gives: S = -a + (1 - b)Y which is called the saving function. The marginal propensity to save equals 1 minus the marginal propensity to consume (out of each dollar increment in Y, a person spends b cents and saves 1 - b cents). From Figure 2 it is also clear that only at income Yeq is desired saving equal to investment. At higher levels of income, desired saving exceeds desired investment; at lower levels of income, desired saving is less than desired investment.

Changes in GDP Will production and income stay at level Yeq in Figure 1 forever? It will if the consumption function (and hence the saving function) remains where it is, and if desired investment is also unchanged. Is that good? Yes, if Yeq is the full employment level of economic activity. But not only wouldn’t Keynes guarantee that it would be full employment, he was convinced that it would be only a fortuitous accident if it were. He reasoned that the level of economic activity is subject to wide swings because the level of investment is highly unstable. The consumption function is quite stable—you can always count on households to consume a predictable percentage of income. But if entrepreneurs became uncertain about future sales prospects, for example, then desired investment spending would decline and GDP would fall. There are two ways to see how far GDP declines when desired investment spending falls. Let us first look at what happens in terms of total spending (investment and consumption) when desired investment falls—the wide-angle approach of Figure 1. We can then look at it from the standpoint of the investment-saving relationship—the isolated camera on S and I of Figure 2. In Figure 3 we have replotted Figure 1’s equilibrium point Z and the equilibrium income associated with the old total spending function E = C + Iold. If desired investment now falls to I new, then the total desired spending function declines to E = C + I new, the new equilibrium point is at N, and income declines to Y new eq. The decline in income is written as ΔY (the change in Y ) and is measured by the change in income along the horizontal axis or by the distance MN (constructed parallel to the horizontal axis). As can be seen in Figure 3, the decline in income exceeds the decline in investment: The decline in income is ZM, which is equal to MN by construction, while the drop in investment is only part of ZM. Why does income change by some multiple of the change in investment spending? Quite simply, because when investment changes and income begins to decrease (or increase), there is a further induced change in consumer spending. Consumption is a function of income, and whenever there is a change in Y, consumption spending is affected by the amount b¢Y, where b is the marginal propensity to consume.

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The Keynesian Framework

Expenditure E = C + Iold Z E = C + Inew N

C = a + bY M

ΔI Iold Inew

a ΔY

45˚ Ynew eq

FIGURE 3

Yold eq

Income

A decline in investment spending reduces Y by a multiple of the change in investment.

How large is the ¢ Y associated with a particular ¢ I? GDP will change by the sum of the changes in both components of expenditure, namely ¢I + ¢C. Algebraically: ¢Y = ¢I + ¢C But we know that, after all is said and done, ¢C = b¢Y (from our consumption function). Substituting b¢Y for ¢ C we have: ¢Y = ¢I + b¢Y We can now solve for the unknown value of ¢ Y by isolating the ¢ Y terms on the left side. We do this by subtracting b ¢ Y from each side, which yields: ¢Y-b¢Y = ¢I Factoring the ¢ Y terms on the left side gives us: ¢Y(1 - b) = ¢I

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The Keynesian Framework

Dividing both sides by (1 - b) produces: ¢Y = ¢I

1 1 - b

where 1/(1 - b) is known as the multiplier. If b, the marginal propensity to consume, equals 0.8, then the change in income will be five times the initial change in investment. If b = 0.5, the change in income will be two times the initial ¢ I.3 The second way of looking at this process is to impose our desired S equals desired I condition for equilibrium. In Figure 4 we see that at income Y old eq investment I old equals desired saving. When investment falls to I new and income is still at Y old eq, desired saving exceeds desired investment and income must fall. Income falls enough to reduce desired saving until it is equal to investment. But we know from our saving function (see point R in Figure 4) exactly how much saving changes per unit ΔY: ¢S = (1 - b)¢Y Since desired ¢ S must equal desired ¢ I in equilibrium, we can impose the following condition: ¢I = ¢S and then directly relate ¢ I to ¢ Y by substituting (1 - b) ΔY for ¢ S. Hence: ¢I = (1 - b)¢Y

3The

multiplier is sometimes derived by more explicit use of the successive rounds of consumption flowing from the initial ¢ I. For example, initially ¢ I produces a direct change in income, ¢ Y, equal to the ΔI. But then consumption changes by b¢Y (which is equal to b¢I). This leads to a further change in consumption, b (b ¢ I). This goes on, with the successive additions to GDP getting smaller and smaller because b is less than unity, hence b2 is smaller than b, b3 is smaller than b2, and so on. The total ¢ Y is equal to the initial change in investment plus all of the subsequent changes in consumption (which stem from the initial ¢I = ¢Y). Or ¢Y = ¢I + b¢I + b2 ¢I + b3 ¢I + . . . + bn ¢I. The right-hand side is a geometric progression whose sum is given by ¢I *

(1 - bn) (1 - b)

Since b is less than unity, bn approaches zero as n gets large; hence we have ¢Y = ¢I *

1 (1 - b)

which (surprisingly enough) is the same expression we derived in the text! These successive rounds of consumption were lumped together in the text into one b¢Y, by saying “after all is said and done,” while here we build it up from each round of ¢ Y.

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The Keynesian Framework

Saving, investment

S = –a + (1 – b) Y

(1 – b) R 1 I = Iold ΔI I = Inew ΔY Ynew eq

Yold eq Income

FIGURE 4

A decline in investment spending reduces Y by a multiple of the change in investment.

Dividing both sides by (1 - b) produces: ¢Y = ¢I

1 1 - b

which is the same formula as before.

Autonomous Versus Induced Changes in GDP Figures 3 and 4 suggest that anything that shifts the position of the total desired spending function will alter GDP. Such shifts in the position of the spending function are produced by autonomous spending changes (autonomous = independent; in our case, independent of GDP). The larger the size of the autonomous change in spending, the greater will be the change in economic activity. But the multiplier story was based on the fact that autonomous spending changes also induce further changes in spending—in our case, via the consumption function. The larger the propensity to spend out of increments in income, or the larger the slope of the spending function (the larger b is), the greater will be the induced change in spending, and thus the greater will be ΔY. Now you can see why Keynes divided spending into the two categories of consumption and investment. What he was really interested in was induced versus autonomous spending decisions. He argued that consumption spending is largely induced, while investment spending is largely autonomous

350

The Keynesian Framework

(independent of income, but a function of the expected rate of return on capital and the rate of interest). Of course, investment prospects might be influenced by sales (current and future), which are certainly related to GDP. Similarly, desired consumption may change independently of current income; the constant term in the consumption function, a, shifts when Xerox goes from $10 per share to $100 per share. Nevertheless, Keynes still felt consumer spending was largely induced (by Y ), while investment spending was largely independent (of Y ).

Exports and Imports It is worth noting that the multiplier expression derived above can be modified quite simply to take account of other sources of ΔY. In particular, ΔY is related to any autonomous change in spending (ΔA) by the same 1/(1 - b) factor. Or: ¢Y = ¢A

1 1 - b

For example, exports add to aggregate demand as exporters buy goods domestically and ship them abroad, while imports reduce domestic aggregate demand because spending by importers on consumption or investment is directed overseas. Thus in the appendix to the last chapter we noted that net exports (NX ), exports minus imports, adds to domestic aggregate demand. Thus an autonomous increase in net exports will generate a multiple increase in GDP while an autonomous decrease in net exports will produce a multiple decrease in GDP. What might cause shifts in net exports? Our discussion on foreign exchange in earlier chapter emphasized that when foreigners want more of our products, either because of changing tastes or prices, our exports increase, while when we want more foreign products because of changing tastes and prices, our imports go up. Although changes in net exports can clearly influence aggregate demand, most of our discussion (with the exception of monetary policy effectiveness) proceeds with net exports in the background. Somewhat more formally, unless we say otherwise we assume NX = 0, or net exports equals zero, or our exports just about equal our imports.

Government to the Rescue The great problem of macroeconomics, according to Keynes, was that changes in autonomous spending would spark fluctuations in economic activity— rather wide fluctuations, via the multiplier, if the induced component of expenditure were large. These wide fluctuations in GDP would be associated

351

The Keynesian Framework

with unemployment when GDP fell below its full employment level as a result of a decline in autonomous spending. What to do? The classical response to such a situation was to do nothing—laissez faire. Keep hands off and let the long run work things out. But that was not the Keynesian response. Keynes was the original Big Spender. If the private sector doesn’t spend enough to keep everyone employed, let George do it (King George, of course). Government spending and taxation could be manipulated to offset the autonomous forces buffeting GDP and thereby restore full employment. It is not very difficult to add government expenditure and taxes to our simple model. GDP is equal to the total of all expenditures in the economy— consumption, investment, and government: C + I + G = Y Assuming that government spending is some fixed level G, we can simply add another line to Figure 1 for autonomous government spending. This is done in Figure 5, where Y new eq is the new equilibrium level of income when government spending is added. The government usually finances its expenditures by taxation. Taxes do not lower spending directly, in the same sense that government expenditure directly changes spending. Rather, taxes reduce the amount of income that households have available for consumption expenditure. Consumption is not

Expenditure

E=Y E=C+I+G E=C+I C = a + bY

G I

a 45˚ Yold eq

FIGURE 5

352

Ynew eq

Adding government spending raises income.

Income

The Keynesian Framework

so much a function of GDP but of disposable income, where that is defined as equal to income minus taxes (Y - T). We therefore have a new consumption function, written as: C = a + b(Y - T) Or, after carrying out the multiplication we can write the consumption function as: C = a + bY - bT It is easy to see that when taxes go up by $10, consumption declines by b times that amount (or if b = 0.8, by $8). The reason is quite simple: People treat a dollar of income taken away by the government the same way they treat any other decline of a dollar’s worth of income—they reduce consumption expenditure by the marginal propensity to consume times the change. Taxes, in fact, introduce the same type of leakage between income and spending that saving does. From the standpoint of our model it makes no difference whether people reduce their consumption because they just happen to feel like it or because the government says it would be nice if they did (curiously, if you don’t feel like it in the second case, you wind up getting a striped uniform and free room and board for between one and five years). In either case, the consumption function shifts downward. Figure 6 shows the equilibrium

Expenditure

E=Y E=C+I+G ET = CT + I + G C = a + bY CT = a + bY – bT

I –bT a 45˚ Yeq (tax) Yeq (no taxes)

FIGURE 6

Income

Introducing taxes lowers income.

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The Keynesian Framework

Off The Record Taking the Pulse of the Economy Reading the financial news is somewhat complicated when the subject is overall economic activity. In fact, when measuring the performance of the aggregate economy there is no single number that does the job. Instead, a variety of statistics released by the government on a monthly or quarterly basis, and published in major newspapers, serve as important indicators. It is useful to divide these statistics into measures of aggregate output and unemployment on the one hand, and the price level and inflation on the other. Aggregate Output and Unemployment The most comprehensive measure of economic activity is real GDP. Estimates are released in April for the first quarter ( January–March), in July for the second quarter (April–June), and so on. Although real GDP is released as a dollar figure, the most important feature is its rate of growth. Thus, if real GDP grows at an annual rate of 4 percent during a quarter, that is considered a fast pace of economic activity; if it grows by only 1 percent that would be slow. The most important number released on a monthly basis is the unemployment rate. An unemployment rate between 5 and 6 percent is considered both politically acceptable as well as indicative of no inflationary pressures. An increase in the unemployment rate of one-half

of one percent during a one-or two-month period implies that economic activity is slowing down sufficiently to take its toll on the work force. The Price Level The GDP deflator is the most comprehensive measure of the price level. It is a weighted average of prices of all goods and services produced in the economy. It is released quarterly along with data on GDP. A rate of increase in the deflator of about 1 or 2 percent on an annual basis has been considered acceptable in recent years. Two somewhat narrower measures of inflation are released monthly: the consumer price index and the producer price index. As suggested by their names, the former measures the rate of change in prices of goods purchased by the typical consumer (as defined by the Department of Commerce), while the latter measures price changes at the wholesale level. For obvious reasons, although the consumer price index is a less comprehensive measure of the price level than the GDP deflator, it receives the lion’s share of attention because it measures how inflation influences each of us directly in our role as a consumer. Once again, a 1 to 2 percent increase on an annual basis might be considered acceptable; 5 or 6 percent is not.

levels of GDP with and without taxes. Figures 5 and 6 also suggest that changes in both government spending and taxes produce multiplier effects on GDP. In this respect they are just like any other kind of autonomous expenditure. But there is one big difference: Both taxes and government spending can be changed by government policy.4

4We

will ignore the fact that taxes vary with the level of income. It does change the nature of the model slightly, but for our purposes we are better off without that complication.

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The Keynesian Framework

The moral of the model of GDP including government expenditure and taxation is that the economy need not be buffeted about by autonomous changes in investment spending. Entrepreneurs may cut their desired investment spending if they get nervous, but nothing need happen to GDP as long as the government keeps its collective head and either increases its spending or lowers taxes so that consumers can increase theirs. In either case, the autonomous decline in investment spending could be offset by government fiscal policy (fiscal means pertaining to the public treasury or revenue, from the Latin fiscus). Whether or not the timing and magnitude of changes in G and T would be appropriate, given the institutional setup, is another matter. But the possibility of improving on the workings of the free market is certainly evident. This returns us to an important issue mentioned earlier: Is fiscal policy even necessary? Why doesn’t income remain at full employment, with desired saving and investment brought into equality via fluctuations in the rate of interest, as the classical economists said would happen? Why did Keynes, a truly classical economist before he became a Keynesian, reject the classical theory of interest rate determination? And what did he put in its place?

Money and the Rate of Interest Our exposition of the Keynesian model so far is very much like its classical counterpart in at least one respect: Money doesn’t matter. While the classics said economic activity was set at the full employment level, and Keynes said it would settle at the point where total desired expenditure equaled production—which might be less than full employment—up to this point neither model has the money supply affecting real economic activity. The classics, as we saw in the previous chapter, deflected its impact to the price level. Keynes, the financial wizard of Cambridge, took a bolder position: The rate of interest is a monetary phenomenon. It is not determined by saving and investment, the way the classics said, but by the supply of and demand for money.5 Keynes also said that money might affect the level of real economic activity, but only to the extent that it first influenced the rate of interest. Changes in the rate of interest would then alter desired investment spending and thereby change the level of GDP. The first order of business in investigating the rate of interest is to establish the framework by noting how Keynes divided the decision making in his model of macroeconomic activity. So far, the analysis of income and expenditure revolves around two decisions: (1) household choice between spending

5Obviously,

since prices are fixed and inflation is not part of the picture, Keynes is referring to the real rate of interest when claiming it is a monetary phenomenon. The classical picture of the real rate is Figure 1, which shows saving and investment as determining the real rate of interest.

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The Keynesian Framework

income and saving it, with the latter defined simply as nonconsumption; and (2) business firm decisions regarding the level of investment spending. These parts of the Keynesian system deal only with flows: consumption, saving, investment, and income over a given time period. It is, in the accountant’s terminology, the “income statement” of the economy, with an implicit time dimension. We have also noted that none of these decisions involve any financial transactions; they deal only in real goods and services. Money introduces an entirely new dimension to the macro model. Money is a financial asset, which is held in an individual’s portfolio just as one holds a savings account at a bank, corporate equity, or Treasury bond. In other words, money is part of an individual’s wealth—part of a person’s balance sheet, in accountant’s terms. The interest rate is determined by the third decision in the Keynesian scheme of things: (3) decisions of the public regarding the composition of its financial asset holdings. Let’s divide the public’s portfolio into two types of assets: money and everything else. As we’ve seen before, money can be defined in many specific ways. For our purposes, the main distinction is that money has a fixed rate of interest, without any risk. Sometimes the rate is fixed at zero, as with currency, but that’s not necessarily so, as with some checking accounts. The key is that no capital losses or gains are incurred on the asset called money. Money is also used as the medium of exchange (to conduct transactions). Thus money is the most liquid of all assets, where liquidity is defined as the ability to turn an asset into the medium of exchange quickly with little or no loss in value. For lack of a better name, we’ll call all other assets “bonds.” The price of a bond can vary in terms of the medium of exchange, so the owner can suffer capital losses or reap capital gains. The return on a bond can be above or below what was expected at the time it was purchased, depending on whether interest rates rise or fall subsequently. Money is a riskless asset, and bonds are risky assets. If people are risk averters—that is, if they dislike risk—then they will demand a higher expected return on risky assets compared with riskless assets.6 Thus a choice is necessary: How much of one’s portfolio should go into money and how much into bonds? It is important to note that the more bonds and less money held in a portfolio, the greater the uncertainty over total portfolio return. For example, if I have $100, all in cash, my return is certain. If I put it all into bonds yielding 10 percent, I expect my return to be just that: 10 percent. But if interest rates rise substantially after my purchase, my $100 bond might be worth (could be sold for) only $75. In this case my expected 10 percent return would be reduced

6Risk

aversion and higher expected returns on risky securities are sophisticated components of modern portfolio analysis, in addition to their commonsense interpretations.

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The Keynesian Framework

Interest rate Supply of money

Equilibrium interest rate

Liquidity preference

Money supply and demand

FIGURE 7

Keynesian interest theory.

by the capital loss of $25. If I had held $50 in cash and invested only $50 in bonds, I would have lost only half as much. More bonds in a portfolio mean more risk. Our composite bond in this analysis includes all risky assets—equities, corporate bonds, municipals, even long-term government bonds. We’ll assume that an efficient combination of risky assets has been derived. For now we are concerned only with the choice between money and the composite bond of Keynes. It is this decision that determines the overall expected return, the “average” interest rate, on bonds. The demand for money, called liquidity preference by Keynes, is a function of the rate of interest. In Figure 7 the horizontal axis measures the quantity of money, while the rate of interest is on the vertical axis. The demand-for-money function is negatively sloped—the lower the rate of interest, the larger the amount of money demanded. There are a number of reasons for this negative relationship between quantity of money demanded and rate of interest. Keynes argued that people had an idea of some “normal” rate of interest, as though the rate of interest were attached to its “normal” level by a rubber band. When the rate of interest declines, more and more people become convinced that it will snap back to its “normal” level, that is, that interest rates will rise in the future. If they hold bonds when rates are rising, they will suffer capital losses. In other words, the public, trying to avoid capital losses, would want to hold fewer bonds

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The Keynesian Framework

(but more money) as interest rates decline. This relationship has been called the speculative demand for money because people are speculating on future bond prices. A more general approach to the negative relationship between demand for speculative money balances and the interest rate stresses interest rates as compensation for risk bearing.7 A high rate of interest means that the cost of being liquid and safe (holding money) is great, in terms of the interest forgone. A high interest rate is an inducement to hold a large portion of one’s assets in bonds (bond demand is high) and only a little in cash. At lower interest rates, the opportunity cost of (what one gives up by) holding money is much less. Since it feels good to be liquid, the amount of money demanded is greater at lower rates of interest. In more formal terms, people are risk averse—they don’t like risk. There must be an inducement to hold a riskier portfolio, one with a larger amount of bonds. The inducement is a higher rate of interest. Either approach to the demand for money explains its negative relationship to interest rates (as interest rates fall the amount of money demanded rises). Coupled with a fixed supply of money, determined by the central bank (a rather bold assumption), the rate of interest is in equilibrium when the amount of money demanded equals the supply. We know that the interest rate is in equilibrium then (as in Figure 7), because below the equilibrium rate the demand for money exceeds the fixed supply. If the rate of interest momentarily fell below the equilibrium rate, people would want more money than they have and would try to sell bonds to get it. The attempt to sell bonds drives bond prices down and interest rates up, until—at the equilibrium rate— people are satisfied with their portfolios of money and bonds. At a rate of interest above the equilibrium rate, people would have more money than they want. They would try to get rid of their excess money balances by purchasing bonds. Bond prices would be driven up and interest rates down, until people were again happy with their holdings of money and bonds. This is at the equilibrium interest rate, of course. The interest rate is said to be determined by the supply of and demand for loanable funds, or looked at another way by the supply of and demand for bonds. It should not be too difficult to see why Keynesian analysis can look at the supply of and demand for money, rather than looking at the bond market directly, and say that the rate of interest is determined by equilibrium in the money market. As long as the total size of the public’s portfolio, its wealth, is fixed—and in the short run this is a reasonable assumption— then a change in the demand for money relative to supply would be reflected

7This

approach was first formally presented in James Tobin’s article “Liquidity Preference as a Behaviour Toward Risk,” Review of Economic Studies (1958). The modern discussion of the pricing of risky financial assets was presented in Chapter 7 of our text.

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The Keynesian Framework

in a one-to-one relationship by an opposite change in the demand for bonds relative to supply. In other words, if the demand for money goes up, it necessarily implies that people want to hold fewer bonds, and vice versa. Looking only at the supply of and demand for money is perfectly consistent with our earlier discussion, because a change in one market is automatically reflected in the other.

Monetary Policy What causes the rate of interest to change? Clearly, if either the demand for money or the supply of money shifts position, the equilibrium interest rate would change. For now, assume that the money-demand function is given, and let us examine the impact of changes in the money supply on interest rates and economic activity. In Figure 8, let’s start out with the money supply at $60 billion and the equilibrium interest rate as indicated. Assume the central bank increases the money supply from $60 to $70 billion. At the old rate of interest, the amount of money that people are now holding is greater than what they want. People try to dispose of their excess money balances (reduce their liquidity) by buying bonds, driving the price of bonds up and the interest rate down until the interest rate has fallen sufficiently to make people content to hold the new level of cash (and stop trying to buy bonds). This happy state of affairs occurs

FIGURE 8

Effect on the interest rate of changing the money supply.

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The Keynesian Framework

at the lower equilibrium interest rate(70), when the amount of money demanded now equals the new supply.8 The implications of the increased money supply for economic activity are clear—a lower interest rate on bonds means higher investment spending, ceteris paribus (a key phrase meaning everything else held constant, often used by economists to produce unexpected results). In terms of our GDPdetermining diagrams earlier in the chapter, the investment line shifts up and GDP goes up by the increase I (induced by the decline in the interest rate) times the multiplier. A decrease in the money supply produces just the opposite results. We start once again with a money supply of $60 billion in Figure 8, and this time let the central bank decrease the money supply to $50 billion. At the old equilibrium rate of interest, the amount of money that people are now holding is less than the amount they want to hold. People try to sell bonds to get more cash, bond prices decline, and interest rates rise until people are satisfied with their new money balances. They stop trying to sell bonds when a new equilibrium is established at the higher interest rate(50). The implications for aggregate economic activity are the reverse of the case in which the money supply was increased. This time we have a higher interest rate on bonds, and investment will decline; GDP goes down by the drop in I (induced by the rise in the interest rate) times the conventional multiplier. The negative relationship between the demand for money and the rate of interest is an important component of the Keynesian model of GDP determination. It provides a link between changes in the supply of money and the level of economic activity. But what Keynes giveth, Keynes can take away. If an increase in the money supply does not lower the interest rate, investment spending will not be affected. Keynes proceeded to question the efficacy of monetary policy under certain conditions. He argued, for example, that at very low interest rates the money-demand function becomes completely flat. In Figure 9 it is easy to see that a very flat demand-for-money function means that increases in the money supply could no longer reduce the rate of interest. In particular, an increase in the money supply from $50 billion to $60 billion lowers the interest rate, but a further increase to $70 billion fails to produce any additional decline.

8Since

some forms of money balances pay interest—such as some checking accounts—it is at least conceivable that the larger supply of money could be absorbed by a higher interest payment on money balances rather than a lower interest rate on bonds. The excess supply of money requires only a decrease in the differential between the rate on bonds and the rate on money (so that people are induced to hold relatively more of the latter). One reason all bond rates fall, rather than the rate on money rising, has to do with the zero interest rate on currency and the fact that currency and demand deposits exchanges on a one-to-one basis. Thus the rate of interest paid by banks on demand deposit balances cannot wander very far from the zero rate paid on currency. As a result, the major burden of adjustment to changes in the supply of money falls on all other rates of interest, rather than the own-rate on money.

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FIGURE 9

Keynesian liquidity trap.

What causes the money-demand function to be horizontal? Keynes argued that at very low interest rates everyone would expect interest rates to rise to more “normal” levels in the future. In other words, everyone would expect bond prices to fall, therefore no one would want to hold bonds and the demand for liquidity (money) would be infinite. Any increase in money supply would simply be held by the public (hoarded), and none of the increased liquidity would spill over to the bond market. No one, in fact, would willingly hold bonds. In this liquidity trap, as Keynes called the flat portion of moneydemand function, monetary policy does not alter interest rates and therefore is completely ineffective. More generally, the flatter the liquidity-preference function, the less effective monetary policy is in changing interest rates, hence in influencing GDP. It should be obvious that monetary policy will also be less effective in changing GDP if investment spending is not very responsive to changes in the rate of interest. An interest-insensitive investment function means that even a large change in the rate of interest will not alter investment spending very much. Thus a given change in the money supply will raise GDP by less if investment spending does not respond to interest rates. Modern Keynesians have pointed out, however, that investment spending is not the only linkage between money supply and GDP. Consumers may also change their spending in response to variations in the interest rate. In particular, we noted above that consumer wealth—the value of stocks and bonds— influences consumption expenditure. A lower rate of interest means that the prices of bonds rise. Thus consumers will spend more when interest rates fall because they feel wealthier. In terms of our earlier diagrams, this wealth

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The Keynesian Framework

effect of a decrease in the interest rate causes the consumption function to shift upward.

Monetary Policy and International Trade We mentioned earlier in the chapter that an increase in exports, or more precisely net exports (exports minus imports), adds to aggregate demand just like any category of autonomous spending. Although exports and imports comprise smaller segments of the U.S. economy than in most other countries of the world, modern Keynesians invoke the potentially significant impact of monetary policy on GDP through net exports. This so-called exchange rate effect works as follows. The exchange rates between the dollar and, say, the euro or the Japanese yen are influenced by the expected returns investors earn on domestic and foreign bonds. More specifically, when U.S. interest rates go up because of a decrease in our money supply, foreigners will now want to buy U.S. bonds because they can earn a higher return on them, assuming nothing else changes. This means that German and Japanese investors, for example, must go into the foreign exchange market to buy U.S. dollars with euros and yen, so they can pay for the now attractive U.S. securities. When exchange rates are flexible, the increased demand for dollars and increased supply of euros and yen in the foreign exchange market will drive up the cost of dollars in terms of foreign currencies; that is, the dollar will appreciate. This appreciation of the dollar reduces our exports of goods and services to the EU and Japan because our products become more expensive to them (because dollars cost more) and it increases our imports of goods and services from the EU and Japan because their products are less expensive for us (because euros and yen are cheaper). Thus net exports decline when domestic interest rates rise, driving down GDP. When interest rates go down because of an expansion in the money supply, the reverse happens. U.S. investors buy foreign bonds because they earn more abroad. This drives down the value of the dollar in the foreign exchange market, making our exports more attractive and discouraging imports. Thus when domestic interest rates fall, net exports increase, driving up GDP. We can conclude by summing up all of the channels through which monetary policy influences GDP. A change in money supply will have a larger effect on GDP when interest rates change by a lot and when investment, consumption, and net exports are very sensitive to interest rates. These three components of monetary policy are sometimes referred to as the transmission mechanisms of monetary policy and are often referred to by special names. The effect on investment spending is often called the cost of capital effect because monetary policy influences investment through the cost of raising capital to business. The effect on consumption is referred to as the wealth effect because monetary policy operates through interest rates on consumer wealth and how that affects their spending. And of course, the effect on net exports is called the exchange rate effect.

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The Keynesian Framework

Interest rate Supply of money

New equilibrium

Old equilibrium

ΔLP a

b Liquidity preference⬘ Liquidity preference Money supply and demand

FIGURE 10

A shift in the demand for money changes the interest rate.

Transactions Demand and Monetary Policy The concept of a speculative demand for money, related to the rate of interest, was a Keynesian innovation. Before Keynes came along, classical economists had emphasized that the only reason people would want to hold money was for transactions purposes—to buy goods and services—as we saw in the previous chapter. An increase in GDP leads to an increase in the amount of money demanded (at every rate of interest), because people need more cash to carry out the higher level of transactions. Keynes also acknowledged this transactions demand, although he did not himself appear to realize all its implications.9 Figure 10 shows how a change in the demand for money (at every rate of interest) affects the interest rate. We start out with a given money supply and a given money-demand (liquidity-preference) function. Together they determine the equilibrium interest rate. Now suppose that people become more nervous than normal, perhaps because they expect a decrease in money supply. They seek ultimate relief by building up the proportion of cash in their portfolios. In other words, at every rate of interest people want more money (and fewer bonds) than before. Say the demand for money increases (ΔLP) by the amount ab. This happens at each rate of interest, so that we now have a 9Keynes

also discussed a precautionary demand for money: People hold cash to provide for unforeseen contingencies. This demand was considered constant or was lumped together with transactions balances. In the next chapter we expand on the implications of transactions demand. In particular, since changes in income alter transactions demand and interest rates, we determine the level of income and interest rates simultaneously.

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new money-demand function to the right of the old. At the old equilibrium rate of interest, the amount of money demanded is larger than the fixed supply. To get more cash, people try to sell bonds, driving bond prices lower and interest rates higher until a higher equilibrium interest rate is established. The case of a decrease in the demand for money can be treated symmetrically. The money-demand function shifts to the left and the interest rate declines. Something similar happens when the level of income changes. Let’s say that income rises. People now demand more money balances at every rate of interest to carry out the higher level of transactions, the demand-for-money function shifts to the right, and the rate of interest rises. In an economy that is growing, perhaps because investment spending is rising, the rate of interest would rise because of the increase in transactions demand for money— unless, of course, the central bank expands the supply of money to provide for those transactions balances. “Easy” or “tight” money is not really a matter of increases or decreases in the money supply in an absolute sense, but rather of increases or decreases relative to demand. In a growing economy, the money supply must increase because the demand for money will rise along with the growth in GDP. Unless the central bank increases the money supply, interest rates will rise. The transactions demand for money is probably affected by the interest rate as well as by income. It is very likely that higher interest rates reduce the demand for transactions balances. For example, assume you are paid $4,000 monthly. You deposit the entire amount in the bank, spend it evenly over the month, and wind up at zero. Your average daily cash balance is $2,000. This is your transactions demand. But if interest rates on bonds were sufficiently high, you’d be willing to go to the cost and trouble to take half your salary at the beginning of the month ($2,000) and buy a bond, put the other $2,000 in your bank to be spent during the first 15 days, and then when that runs out sell the bond and spend the second $2,000 over the last half of the month. What this means is that your average daily cash balance is only $1,000 (you go from $2,000 to zero evenly over 15 days). What you gain from this is the higher interest on the funds invested in the bond market. And as long as the gain exceeds the costs, it’s worth doing. Your initial reaction might be: It would take an awfully high rate of interest to make me go through such shenanigans. That could be. But if you were a large corporation with a few million dollars in idle cash, the investment of that money could be very profitable. Most economists agree that the transactions demand for money, like the speculative demand, is a function of the rate of interest. For some purposes it can be ignored or played down—but not if you are a corporate treasurer. An interesting sidelight on the transactions demand discussion is the role played by credit cards. The easiest way to look at this is that credit cards permit a transaction to take place without a cash balance. In other words, people could theoretically invest all their cash at the beginning of the month in bonds, pay for everything via those little plastic cards, and then at the end of

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the month sell the bonds, put the proceeds into the bank, and write one check to the credit card company (which could be the bank itself). Although this is an extreme example, it indicates how credit cards get into the model and how their growth affects the economy. Greater use of credit cards reduces the demand for money (at every interest rate), thereby lowering interest rates, permitting investment and GDP to increase.

Expectations and Monetary Policy Most simple economic models assume that expectations are exogenous; that is, they are determined outside the system.10 This one is no exception. An important implicit assumption is that changes in the money supply are imposed by our central bank, the Federal Reserve, and that such policy changes are unanticipated. Under such circ*mstances, monetary policy alters the interest rate by more or less, depending on the conditions described above. But whether an increase or decrease in the stock of money causes a simultaneous movement in interest rates in the predicted direction depends crucially on whether or not the change in policy was anticipated. In particular, if everyone expects the Federal Reserve to cut back on the money supply next week or next month, a change in interest rates is likely to occur beforehand, with little or no effect at the time the money supply is actually altered. The reasoning is straightforward: If everyone expects the Fed to reduce the money supply in the future—and therefore expects interest rates to rise—then profitmaximizing bondholders will try to sell bonds now to avoid expected capital losses. Bond sales will drive down bond prices, driving up interest rates until they just about equal the expected rate next period. Thus when the money supply is, in fact, cut back next week or next month, rates don’t move at all. Incorporating expectations about policy movements into our model is possible but cumbersome. It is simulated by a shift in the demand-for-money function at every interest rate. In our particular example, when we say that bondholders want to sell to avoid capital losses, we are saying, in effect, that the demand for bonds decreases—or, in terms of our picture, that the demand for money increases at every rate of interest. That means the money-demand function shifts to the right, as in Figure 10, increasing the rate of interest with the same supply of money.11

10More sophisticated economic models require that expectations for variables in the model (such as interest rates) conform with the predictions of the model. This is called rational expectations. 11In the example of the previous paragraph, when the anticipated decrease in the money supply actually takes place, there is no increase in the level of rates at that time precisely because the demand for money simultaneously decreases by the same amount at that time. The reason is that people no longer expect the Fed to reduce the money supply. Thus the demand for money returns to its original position.

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Thus an anticipated monetary policy will change interest rates before it is implemented. This is not especially surprising once it is put into the framework of our model, but it can be troublesome for policymakers when portfolio managers get into the habit of forecasting stabilization behavior.

Aggregate Demand and Supply So far we have described all the factors that can influence the aggregate demand for goods and services according to Keynes. As we mentioned at the very beginning of this chapter, since Keynesian analysis assumes prices are fixed because of a depressed state of the economy, all the impacts on aggregate demand discussed up to now correspond to changes in real income and output as well. It will be useful, nevertheless, to put the Keynesian model into a formal supply/demand framework. This will highlight the similarities and differences between Keynes and the classics, permit a brief insight into Keynesian causes of inflation, and also let us see what is meant by supply-side economics. In Figure 11 we put the price level on the vertical axis and GDP on the horizontal axis, just as we did in Figure 3. Don’t get nervous simply because

Price level D⬙ D⬘ S D

2

P⬘ 1 P

S

S

Y

YFE Income

FIGURE 11

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Increases in aggregate demand raise real income or prices, depending on the shape of aggregate supply.

The Keynesian Framework

until now aggregate spending (C + I + G) has been plotted in the figures against income (Y ). Now we are interested in how aggregate demand varies when the price level changes, so Figure 11 plots income (output) as a function of price. We have different pictures tailored to answer different questions. The aggregate supply schedule in Figure 11 is in two parts: a horizontal segment, which reflects the fact that prices do not increase at less than full employment, and a vertical part, which is the classical school’s supply schedule, showing that only prices (not real income) increase after full employment (assumed equal to Y FE) is reached. The aggregate demand schedule (D) is negatively sloped for the same reason as in the classical world: A lower price level raises the real supply of money balances, which in turn increases the aggregate demand for goods and services. But in the Keynesian world, this rise in the real supply of money has a very specific channel of influence on GDP. It occurs through the impact of rising real balances on the interest rate (as in Figure 8) and the impact of a lower interest rate on investment spending and hence GDP. Equilibrium GDP is given by the intersection of aggregate demand and supply in Figure 11. If we start with D, the level of real income is Y and the price level is P. Thus far, Figure 11 adds nothing to our analysis, since we had assumed all along that prices were fixed. The only plus is that we now know that prices are fixed at some level P (big deal). If aggregate demand increases from D to D ¿ in Figure 11, when aggregate supply is horizontal, the level of real output rises from Y to YFE and the price level remains at P. The rightward shift in the aggregate demand schedule can result from an increase in any of the autonomous expenditure categories discussed earlier. For example, D could shift to D ¿ because of an increase in investment (I) or government expenditure (G). Note also that an increase in the money supply (M) will also shift D to D ¿ .12 What Figure 11 emphasizes for us is that the multiplier effects of autonomous expenditures correspond to increases in real income (without any change in the price level) as long as the aggregate supply schedule is horizontal. But if aggregate demand increases further, from D ¿ to D –, after aggregate supply has become vertical, then shifts in aggregate demand will result in price increases (from P to P ¿ ) rather than increased real income. Thus when the aggregate supply function is vertical, the multiplier effects of autonomous spending translate into changes in nominal GDP rather than real GDP. What emerges from this is that when the economy is at or near full employment, Keynesian aggregate demand analysis can be used together with the aggregate supply curve to explain upward pressure on prices, or inflation. Anything that shifts the aggregate demand schedule to the right—whether it is increased government spending, increased consumer spending, or increased

12Recall

that an increase in M shifts D because at every price level there are more real cash balances, which lowers interest rates and raises investment spending.

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money supply that increases investment spending—will force up the price level. Notice that this explanation of what influences the price level is somewhat different from that of classical economics. According to classical thinking, shifts in the aggregate demand schedule reflect changes in the money supply; in fact, the aggregate demand schedule embodies the quantity theory. This is a fundamental distinction between the classical/monetarist view of inflation and the Keynesian theory. At this point it is appropriate to mention the role of so-called supply-side policies in macroeconomics. Keynes himself had little reason to focus on aggregate supply, since in the depressed economy of the simple Keynesian model there are more than enough goods and services to go around. But in a full employment setting, the only way to increase real output is to expand productive capacity. That would be represented in Figure 11 by a rightward shift in the vertical segment of aggregate supply (YFE would shift to the right). Supply-side economics focuses primarily on the impact of government policies on the aggregate supply schedule. Although this is very different from the Keynesian focus, the two are by no means contradictory.13 The productive capacity of the economy is determined by the supply of labor, capital, and available technology. Policies that increase any of these production factors will increase potential real output. The government does not directly control any of these, but its tax policies influence the willingness of households and business firms to supply labor and invest in capital. In particular, higher tax rates may very well discourage work and investment, because labor and entrepreneurs are denied some fraction of the income they earn. According to supply-siders, the main consequence of reducing tax rates is increased production incentives. This view contrasts with the Keynesian emphasis that a reduction in taxes raises aggregate demand. Up to now we have considered the effect of a tax reduction only on the aggregate demand schedule in Figure 11; supply-siders contend that the tax impact on the aggregate supply schedule can be even more important. Thus they could argue that reducing taxes when the economy is at full employment need not cause prices to rise. In particular, if the vertical portion of the aggregate supply schedule shifted to the right by more than the movement in aggregate demand, prices could even fall. Whether this is in fact the case can be clarified only by empirical evidence.

13Note that the quantity theory is in the same boat as Keynesian analysis, because it focuses almost exclusively on aggregate demand.

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The Keynesian Framework

SUMMARY 1. Keynesian analysis maintains that the level of production is determined by the aggregate demand for goods and services. This differs from classical economics, which argued that production occurs at full employment. The main difference between Keynes and the classics is that Keynes did not think that fluctuating prices and interest rates would push the level of economic activity toward full employment, especially in the short run.

2. The Keynesian model focuses on the determinants of aggregate demand in order to pinpoint the level of production. Demand is divided into consumption, investment, and government expenditure. To Keynesians the consumption function is a key behavioral relationship, because it allows them to explain how consumer spending varies with income. Thus when there is a change in autonomous spending (such as an increase in investment), income changes by some multiple (because of induced consumption spending).

3. Government expenditure and taxation play an important role in influencing the level of aggregate demand. Changes in taxes and government expenditures have multiplier effects on income and can be used to offset the effects on GDP of autonomous changes in investment.

4. According to Keynesians, the demand for and supply of money determine the level of interest rates. This view differs from the classical quantity theory, in which the supply of and demand for money determine the price level. The Keynesian result stems from the behavioral assumption that the demand for money is interest-sensitive plus the fact that the price level does not vary.

5. Changes in the money supply alter the level of interest rates in the Keynesian world. The impact on economic activity is then determined by the response of investment spending and the subsequent multiplier effects on GDP. The greater the impact of money supply changes on interest rates, and the larger the sensitivity of spending to interest rate changes, the larger the effect of monetary policy on GDP.

6. There are actually three transmission mechanisms linking monetary policy to GDP. The cost of capital channel through investment spending, the wealth channel through consumption, and the exchange rate channel through net exports.

7. All Keynesian analysis focuses on the aggregate demand for goods and services. It assumes that aggregate supply is sufficient to accommodate increased demand without raising prices. Any increases in aggregate demand at full employment will raise prices and cause inflation. Supply-side policies emphasize the need to generate increased real output at or near full employment.

KEY TERMS autonomous spending change

cost of capital effect

fiscal policy

disposable income

investment

consumption

exchange rate effect

Keynesian

consumption function

financial asset

liquidity preference

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The Keynesian Framework liquidity trap

multiplier

supply-side economics

marginal propensity to consume

saving function

transmission mechanisms of monetary policy

marginal propensity to save

speculative demand for money

wealth effect

QUESTIONS Questions with a red oval are in

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at www.myeconlab.com.

23.1

What happens, according to Keynes, when desired saving exceeds desired investment? Is this view different from classical economics?

23.2

Why does a change in investment spending produce a change in GDP by some multiple, according to Keynes?

23.3

Explain how the equilibrium rate of interest is determined by the supply of and demand for money, according to Keynesian analysis.

23.4

Show geometrically that if there is a so-called liquidity trap, monetary policy cannot lower interest rates.

23.5

Explain why the transactions demand for money falls as the rate of interest rises.

23.6

Is it correct to say that if a change in the money supply is fully anticipated, then there will be no impact on the interest rate at the time of the change?

23.7

What does Keynesian analysis assume about the shape of the aggregate supply schedule? How does this assumption produce different results from those of classical economics?

23.8

Discussion question: Put yourself into Keynes’s shoes and try to explain what it was about classical economics that forced you to change your outlook. Was it the quantity theory, Say’s law, or the shape of the aggregate supply curve?

The ISLM World

Why confuse things with a more complicated model of GDP determination? Is it worth the effort? Haven’t we said that a good model is like a good map—it tells you how to get from one place to another without detailing every curve in the road, every bump in the terrain? True enough. But sometimes a few complications make life more interesting. Versatility is the password. Being adaptable to more than one use is a desirable characteristic for a model. The more complex model of GDP determination is known as ISLM analysis. Among its many attractions, it shows how monetary and fiscal policy interact with each other; it shows what determines the relative multiplier effects of each; it provides a partial integration of the classical and Keynesian systems into one conceptual framework; and it demonstrates some of the fundamental features distinguishing the classical and Keynesian outlooks. As in the previous chapter, most of the analysis assumes a fixed price level, so that we still are concerned with the level of real GDP. In the next-to-last section we will analyze the implications of flexible wages and prices, and at the end we will show how the ISLM model collapses into an aggregate demand schedule.

LEARNING OBJECTIVES In this chapter you will learn to identify the shift and slope determinants of the LM curve identify the shift and slope determinants of the IS curve understand how combining the IS and LM curves determines an equilibrium level of real GDP and interest rate explain how ISLM analysis is connected to the aggregate demand curve

From Chapter 24 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

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The LM Curve The classical economists stressed the transactions demand for money. Keynes also discussed this transactions demand, although he did not himself seem to perceive all its ramifications. In particular, because transactions demand increases with income, the rate of interest rises as income rises. Thus not only does the interest rate help determine income; in addition, income helps determine the interest rate.1 Causation runs both ways—from the interest rate to income and from income to the interest rate. Fortunately, this is not an insurmountable problem. The economy winds up with a determinate level of each, but our model must be reformulated to take this into account. We begin, in Figure 1, with three alternative money-demand functions, each associated with a different level of income.2 The liquidity-preference function associated with Y1 is for a level of GDP that is less than Y2, which in turn is less than Y3. Each level of GDP has its own liquidity-preference function, because at higher income levels more money is demanded for transactions purposes (at every rate of interest). The horizontal distance between any two demand-for-money functions is equal to the difference in the demand for money at the two levels of GDP. If we use the classical formulation coming out of Cambridge, we can write: Demand for Money = kY or ¢Demand for Money = k¢Y The latter implies that the demand for money will change by k times the change in the level of GDP (where k equals, for example, 0.25). In terms of Figure 1, this means that the horizontal distance between any two liquiditypreference curves equals k¢Y. The demand for money is really a function of two variables—income and the interest rate. The equilibrium condition (amount of money demanded = money supply) no longer provides an interest rate: rather, it provides combinations of income (Y) and the interest rate (r), which satisfy the condition that money demand equals money supply when the money supply is fixed. In fact, according to Figure 1, a positive relationship between Y and r is needed to keep the amount of money demanded equal to the fixed money supply.

1The one exception is the liquidity trap, introduced in the last chapter, where the rate of interest is given and is independent of everything except public psychology. 2The

discussion in the remainder of this chapter will be based on geometric analysis. For those who prefer algebra, the appendix to the chapter presents the entire model, and its implications, in equation form.

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The ISLM World

Interest rate Supply of money

r3 r2

Liquidity preference at Y3

r1

Liquidity preference at Y2 Liquidity preference at Y1

Money supply and demand

FIGURE 1

How to derive the LM curve: At higher levels of income, the demand for money rises and so do interest rates.

A higher level of GDP (compare Y2 with Y1) is associated with a higher interest rate (r2 versus r1). This relationship between Y and r that satisfies the equilibrium condition in the money market is plotted in Figure 2, where the interest rate is still on the vertical axis but now we have income on the Interest rate LM

r3

r2

r1

Y1

Y2

Y3 Income

FIGURE 2

The LM curve.

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The ISLM World

horizontal axis. The line is labeled LM because it is the locus of combinations of Y and r that satisfy the liquidity-preference-equals-money-supply equilibrium condition. How should you “read” the LM curve? In either of two ways. For a series of alternative interest rates, it tells you what the resulting income would have to be to make the demand for money equal to the (fixed) supply of money. At higher interest rates, there is less money demanded, so income must be higher to increase the demand for transactions balances if the total demand for money is to remain equal to the (fixed) supply. Or, for a series of alternative income levels, Figure 2 tells you what the resulting interest rate would have to be to make the demand for money equal to the fixed supply. At higher income levels, more transactions money is desired, so the interest rate must be higher to shrink the demand for money balances if total demand is to remain equal to the fixed supply. Before you write to the folks back home and tell them that an increase in the interest rate raises GDP, or that an increase in GDP raises the interest rate, rest assured that nothing of the sort has been said—so far. In fact, we can’t even determine Y and r as yet, much less say anything about how each of these variables changes. All we have is one relationship (equation or equilibrium condition) and two variables, Y and r, and you remember enough high school algebra to know that you need at least two equations to determine the equilibrium values of two variables. We will produce another relationship between Y and r, based on the equilibrium condition in the market for goods and services (the C + I + G = Y or the I = S equilibrium condition). This great unification and solution, which will knock your socks off, is scheduled to take place in about ten pages. But before that cataclysmic experience, it will be helpful for subsequent policy discussions to elaborate on the factors determining the slope of the LM curve and shifts in its position. Both of these help determine the relative size of monetary and fiscal policy multipliers.

The Slope of the LM Curve The determinants of the slope of the LM curve are best illustrated by going over the reasons for its positive slope. Take point A in Figure 3. Assume that the amount of money demanded equals the fixed money supply at that point, hence combination Y1 and r1 lies on the LM curve. To see whether a second (Y, r) combination that also satisfies the equilibrium condition (money demand = money supply) lies above and to the right of A (like point B), or below and to the right (like point D), let us first pick a point C which differs from A only in the level of income. At point C, the rate of interest is still r1 but income is Y2 (above Y1). Since income is higher at point C than at point A, the transactions demand for money is greater at C. Nothing else is changed, so point C must have a larger demand for money than the (fixed) supply. To set matters right, the interest

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The ISLM World

Interest rate LM B

r2

r1

A

C D

Y1

Y2 Income

FIGURE 3

The slope of the LM curve.

rate must rise to reduce the demand for money and thereby restore the equality between demand and supply. The slope of line AB (the LM curve) in Figure 3 is determined by two factors. The first is the size of the gap between money demand and supply at point C. If the increment in the amount of money demanded per unit ¢Y is large, then the amount demanded will be a lot higher at C than at A, and the increase in r needed to restore equilibrium (to lower the amount demanded) will be large. In other words, if transactions demand is great, then the level of r needed to maintain demand-supply equality at Y2 will be great, point B will be higher than otherwise, and the slope of the LM curve will be steeper. The second factor influencing the slope of the LM curve is the interest-sensitivity of money demand. For a given excess of money demand over supply at point C in Figure 3, the greater the interest-sensitivity of liquidity preference, the smaller the necessary increase in the rate of interest to restore equilibrium. This is so because when liquidity preference is highly interest-sensitive, then even a small increase in r reduces the amount of money demanded by a lot. In other words, at Y2 the rise in r needed to ensure demand-supply equality will be smaller the greater is the sensitivity of demand to r; point B will be lower than otherwise, and the slope of the LM curve will be flatter. To summarize: The slope of the LM curve will be steeper the greater is the income-sensitivity of demand for money, and the less is the interest-sensitivity of demand for money; the LM curve will be flatter the less is the incomesensitivity of the demand for money, and the greater is the interest-sensitivity.

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The ISLM World

Monetary Policy and the LM Curve What causes the LM curve to shift position (in contrast to a change in its slope)? It does get boring in the same position, so the monetary authorities rush to the rescue. An increase in the supply of money moves the LM curve to the right, and a decrease in the money supply moves the LM curve to the left. By shifting the position of the LM curve, the Federal Reserve can increase or decrease the potential equilibrium level of GDP associated with a given interest rate. Let’s see why a change in the money supply shifts the LM curve. In Figure 4 we start with an initial supply and demand for money that generates an equilibrium interest rate, r1. Since all points on the LM curve satisfy the condition that the amount of money demanded equals the amount of money supplied (in this case, M1 ), the equilibrium in the money market corresponds with a single point on the LM curve with interest rate r1 and income Y1. Now, imagine that the Federal Reserve chooses to increase the money supply to M2 (perhaps by purchasing t-bills from the public). As shown in the money supply/money demand diagram, this will reduce the equilibrium interest rate to r2. Notice, only the quantity of money has changed so far—the economy continues to earn income of Y1 (after all, simply releasing money into the economy does not immediately change the quantity of goods and services produced). We now have a new combination of income and interest rates (Y1 and r2) that are obviously not on the original LM curve. This is represented by point B on Figure 4. Indeed, the increase of money shifts the LM curve to the right (or down). A similar argument shows that the LM curve must shift to the left (or up) if there is a decrease in the money supply. A second approach may help when thinking about shifting the LM curve. An increase in the money supply from M1 to M2 causes the supply of money to exceed the demand for money. One way for this surplus to be resolved would be for income to rise (which, as we learned in the previous chapter, increases the transactions demand for money). If income were to rise enough, then money demand would rise to equal money supply. We can say exactly how far to the right (or to the left) the new LM curve must be. If the supply of money increases by ¢M, the amount of money demanded must change by the same amount in order to restore equilibrium. But we know that the transactions demand for money changes by k times the change in income (k¢Y). So income must change until k¢Y equals ¢M (assuming nothing else changes, which is what we are doing by looking at the horizontal differences between two LM curves, with the interest rate held constant). The demand for money will increase to match the enlarged supply when k¢Y = ¢M, or when ¢Y = ¢M/k, which we can also write as ¢Y = 1/k * ¢M. In other words, the horizontal distance between two LM curves is equal to 1/k * ¢M (or the difference in Figure 4 between Y1 and Y2 is 1/k * ¢M).3 3When there is no interest-sensitivity of the demand for money, then 1/k equals velocity. Under those conditions, the horizontal distance (which holds the rate of interest constant) between the two LM curves equals ¢M times velocity. This will be important in the next chapter, unless you decide not to read it because things are complicated enough as is.

376

FIGURE 4

r2

r1

Interest rate

(a)

M1

Money supply

M2 Money supply and demand

r2

r1

Interest rate

An increase in the money supply shifts the LM curve to the right.

Money demand

B

(b)

Y1

A C

Income

LM(M2)

LM(M1)

The ISLM World

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The ISLM World

Unfortunately, we cannot as yet say exactly where the new increased money supply leads us. Will it all be absorbed by increases in GDP, or will it all be absorbed by declines in the interest rate? That question is a Big One. Expansion in M will lead to both a higher GDP and a lower interest rate. Hence, if we start out at point A in Figure 4, the new equilibrium of the economy lies somewhere between points B and C. The classical economists, however, said an increase in M will all be absorbed by transactions demand. We cannot yet answer the question because we don’t really know where we started from. In order to find out where the devil we are, we must introduce the goods sector of the economy—saving and investment.

The IS Curve Economic activity and interest rates are affected by behavior in the market for goods and services as well as in the money market. The counterpart to the money-demand-equals-money-supply equilibrium condition is the equilibrium between desired saving and investment (or total desired expenditure equals production). The equilibrium levels of GDP and interest rate must satisfy two equilibrium conditions: the condition that I = S as well as money demand = money supply—which is a good thing, because with two variables, Y and r, we need two equations if both variables are to be determined simultaneously. To describe the combinations of Y and r needed for equilibrium in the goods market, we must recall the investment function. Desired investment spending is negatively related to the rate of interest; a fall in the rate of interest raises the level of investment spending. A higher level of investment spending, in turn, implies a higher level of GDP. These relationships are best depicted graphically. We will then discuss them in more general terms. In Figure 5(a) the saving function is drawn together with three alternative levels of investment, each one associated with a different rate of interest. “Investment (r1)” assumes rate of interest r1, “investment (r2)” assumes rate of interest r2 (a higher rate than r1), and so on. Figure 5(b) depicts the same situation, but from the total expenditure point of view. The three total expenditure lines are associated with the three different levels of investment. The alternative levels of investment are derived from the investment function in Figure 6, where the rate of interest is measured on the vertical axis and the level of investment is on the horizontal axis. Interest rate r3 is the highest rate and is associated with the lowest level of investment I(r3); interest rate r1 is the lowest rate and is associated with the highest level of investment I(r1). The change in the amount of investment per unit change in the rate of interest (¢I/¢r) measures the sensitivity of investment spending to changes in the rate of interest.

378

The ISLM World

Saving and investment Saving

Investment (r1)

Investment (r2)

Investment (r3)

Y(r3)

Y(r2)

Y(r1) Income

(a) Expenditure E=Y E = C + I (r1) + G

E = C + I (r2) + G

E = C + I (r3) + G

Y(r3)

Y(r2)

Y(r1) Income

(b)

FIGURE 5

How to derive the IS curve: At lower rates of interest the level of investment is higher, and so is the level of income.

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The ISLM World

Interest rate

r3 Δr r2

ΔI

r1

Investment

I(r3)

I(r2)

I(r1) Investment

FIGURE 6

The investment-demand function.

It should be obvious from Figures 5(a) and (b) that there is a negative relationship between Y and r as far as the goods market is concerned. Lower interest rates are associated with higher income levels because lower interest rates induce more investment spending (as seen on Figure 6). This relationship between Y and r is summarized in Figure 7, with r measured on the vertical axis and Y on the horizontal axis. (At this point, we are having difficulty distinguishing the horizontal from the vertical and who’s on what—so keep your eyes open.) The locus of points satisfying the investment-equals-saving equilibrium condition is called the IS curve. How should you “read” the IS curve? As with the LM curve, in either of two ways. For a series of alternative interest rates, it tells you what income must be to make saving equal to investment. At higher interest rates, there is less investment, so income must be lower to shrink saving (which is a function of income) to the point where it equals the smaller volume of investment. Or, for a series of alternative income levels, it tells you what the interest rate must be to make saving equal to investment. At higher income levels, saving is larger, so the interest rate must be lower to expand investment to the point where it equals the larger volume of saving. Perhaps now you can appreciate our advice earlier in the chapter, with respect to the LM curve, suggesting that you not pass on that particular information about the relationship between Y and r. Now there are two relationships between Y and r. While more of a good thing is usually better, it can lead to embarrassing situations. In our case, however, it will rescue our model

380

The ISLM World

Interest rate

A

r3

B

r2

C

r1 IS

Y3

Y2

Y1 Income

FIGURE 7

The IS curve and its slope.

from indeterminacy. But before presenting the Missouri Compromise (named after those who refused to believe it was possible), let’s take a quick look at the factors that determine the slope and position of the IS curve; these are the things, along with the factors that determine the slope and position of the LM curve, that influence the relative magnitudes of the monetary and fiscal policy multipliers on GDP.

The Slope of the IS Curve To see why the IS curve looks the way it does, what makes it flatter or steeper, what moves it to the right or to the left, let us examine its negative slope in greater detail. Take point A in Figure 7 and assume that combination (r3, Y3) satisfies the condition that saving equals investment: Hence A lies on the IS curve. Now let us move to point B, which differs from A only in having a lower interest rate (r2 compared with r3). But a lower rate of interest implies a higher level of investment. Hence, if I = S at point A, then I must exceed S at point B. In order to restore equilibrium, saving must be brought up to equality with investment. There’s no better way to do it (in fact, no other way at all in our model) than for income to rise, say to Y2, which raises saving (by the marginal propensity to save times ¢Y ). At point C saving is once again equal to investment, and it, too, is admitted to that select group of points on the IS curve. The slope of the IS curve is determined by the size of the discrepancy between I and S at point B—that is, by the sensitivity of investment to a unit

381

The ISLM World

change in the interest rate—and by the responsiveness of saving to increases in income (the marginal propensity to save). For example, if investment is very sensitive to changes in r (in Figure 6, if the investment function were flatter, so that ¢I per unit ¢r were larger), then investment would exceed saving by a lot at point B in Figure 7. In order to increase saving by a lot, income would have to rise a lot; point C would be further to the right than it is, and the IS curve would be flatter. If the marginal propensity to save were very large, however, the increase in Y need not be very large to restore equilibrium, point C would be more to the left, and the IS curve would be steeper. All of this could be said in somewhat less formal terms. The fall in the rate of interest at point B compared with point A raises investment spending. This ¢I, in turn, raises the level of GDP by ¢I times the “simple” multiplier, 1/(1 - b), of the previous chapter. This increase in GDP is measured from point B to point C. (Note that this assumes quite explicitly that the rate of interest remains the same both before and after the increase in Y, and that is accomplished by drawing a horizontal line from B to C.) Hence, the more sensitive investment spending is to changes in the rate of interest, the flatter the slope of the IS curve will be and the larger the multiplier effect. This is perfectly consistent with the story just told in terms of the marginal propensity to save, because the larger the marginal propensity to save (= 1 - b), the smaller the multiplier of the simple Keynesian model. To summarize: A highly interest-sensitive investment function and a low marginal propensity to save imply a flat IS curve; a low interest-sensitivity of investment and a high marginal propensity to save imply a steep IS curve. The position of the IS curve (in contrast to its slope) is altered by any change in autonomous spending, such as government spending, private investment that is independent of the rate of interest, or private consumption spending that is independent of income (or, looked at from another standpoint, private saving that is independent of income, such as changes induced by government taxation). Such shifts in autonomous spending disturb the I = S (or E = Y) equilibrium condition. The equilibrium combinations of Y and r will, therefore, be altered. This can be seen by looking either at savingequals-investment equilibrium or income-equals-expenditure equilibrium. We will spare you the agony of doing it both ways ( just this once) and concentrate on the expenditure-equals-income approach. In Figure 8 let’s arbitrarily start with an interest rate r1 that generates investment spending of I(r1) which, when added with consumption and government spending, generates income of Y1. This particular income and interest rate are represented as point A on the IS curve. Now, assume government spending increases from G1 to G2. The increase in government spending raises the expenditure line and, through the simple multiplier process described in previous chapter, increases income to Y2. At this point, since only government spending changed, it is clear that we no longer are on the original IS curve. As a matter of fact, at the original interest rate of r1, an income of Y2

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The ISLM World

Expenditure E=Y E = C + I (r1) + G2 E = C + I (r1) + G1

Y1

Y2

(a)

Income

Interest rate

C A

r1

B

IS(G2)

IS(G1) Y1 (b)

FIGURE 8

Y2 Income

An increase in government spending shifts the IS curve to the right.

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The ISLM World

means that we are now at point B, clearly a point not on the original IS curve. An increase in government spending shifts the IS curve to the right (or up) to IS (G2).4 Similar shifts in the IS curve would be brought on by increases or decreases in investment spending that are independent of the rate of interest. How might that come about? If entrepreneurs suddenly expect higher future dollar returns on investment projects, the rate of return will increase and some investment spending will be undertaken that otherwise would not have been. Keynes thought such shifts would, in fact, occur quite often and in substantial magnitude. Entrepreneurs are a fickle group, very sensitive to anything (war and peace) and anyone (presidents and reporters) that might influence the future profitability of their investments. Their actions tend to shift the investment demand function (Figure 6) to the right or left, thereby shifting the IS curve to the right or left as well. We can also say exactly how much the IS curve shifts to the right or left because of a change in autonomous spending. A change in autonomous spending, ¢A, produces a change in GDP by the amount ¢A times the multiplier, 1/(1 - b), assuming no changes in other categories of spending (besides consumption via the change in income). In Figure 8, the horizontal distance between two IS curves—for example, point A to point B—measures the difference between two levels of income, assuming that some type of autonomous spending has increased but the rate of interest remains constant. That would equal ¢A times our old multiplier friend 1/(1 - b). Therefore, an increase in autonomous spending—such as a change in government spending—shifts the IS curve to the right by ¢A times 1/(1 - b), while a decrease in autonomous spending shifts the IS curve to the left by ¢A times 1/(1 - b). But there really is another possibility. The increase in autonomous spending need not raise GDP if some other category of spending simultaneously contracts. If, at the same time that government spending goes up, private investment spending is discouraged (because the rate of interest rises), it is conceivable that GDP could remain unchanged. This possibility is recognized explicitly in Figure 8 by point C, which is directly above A, implying no change at all in GDP. Instead, the rate of interest has risen sufficiently so that total spending remains the same: Income equals desired expenditure at point C as well as point B, saving equals investment at both points, and so both are on the new IS curve. Keynesians seem to agree that a change in government spending will raise GDP a lot, hence we will wind up near point B when G goes up. The classical economists, on the other hand, felt that the level of output would be unaffected by changes in any particular category of expenditure. An increase in G would be accompanied by a decrease in some other kind of spending, leaving income unchanged (we would move to point C). We can’t really tell what will

4An

increase in taxes, on the other hand, implies a lower level of consumption in Figure 5(b), hence each of the total expenditure lines is lower than before and the level of Y associated with each rate of interest is less. Result: The IS curve shifts to the left.

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The ISLM World

happen until we bring the IS curve together with the LM curve, derive equilibrium Y and r simultaneously, and then examine the way these variables respond to monetary and fiscal policy within that general equilibrium framework.

The Simultaneous Determination of Income and Interest: IS and LM Together The equilibrium levels of GDP and the interest rate must satisfy equilibrium in the money market (money demand = money supply or LP = M), and in the product market (I = S). In Figure 9 we have drawn an LM curve for a given money supply and an IS curve for a given level of government expenditure and taxation and a given investment function (relating I to r). The equilibrium Y and r must be at the intersection point of the IS and LM curves, point E, since only at that point does saving equal investment and liquidity preference (LP) equal the money supply. At any other point, one or both of these equilibrium conditions are violated, and dynamic forces will move income and the interest rate toward point E. Let’s see what happens if the economy is not at point E in Figure 9. Take point A on the IS curve. Saving equals investment, but money demand is less than money supply. (The latter is so because point A is directly above point B, which is on the LM curve. At point B we know LP = M. Since point A has a

Interest rate LM A

C

I = S, LP < M

LP = M, IS

I = S, LP > M

IS

YE Income

FIGURE 9

The simultaneous determination of income and interest (fantastic!).

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The ISLM World

higher rate of interest, the amount of money demanded is less, so with a given money supply we have LP less than M.) People want to hold less money than they have at point A. To get rid of the money they start to buy bonds, driving bond prices higher and the interest rate lower. As the interest rate falls, investment rises and so does income—and, believe it or not, we are sliding down the IS curve toward E. At point B, money supply equals money demand because we are on the LM curve, but investment exceeds saving (point B is directly below A; at A we know S = I; at B the interest rate is lower, hence I exceeds S). The excess of I over S leads to an increase in production as entrepreneurs try to replenish falling inventories. As income rises, the rate of interest is driven up because the money supply is fixed and people start to sell bonds in order to get additional transactions balances. We are now climbing up the LM curve toward E. At points to the right of E, dynamic forces would lead to a fall in the level of income. At C we have LP = M, but desired investment is less than desired saving (see if you know why—hint: compare with D). Entrepreneurs cut back their production in order to reduce inventory accumulation. As GDP falls there is a reduction in the need for transactions balances, people start buying bonds with the extra cash, bond prices rise, and interest rates decline—we return to E by sliding down the LM curve. Finally, at point D investment equals saving, but LP exceeds M. People try to sell bonds to get more cash, bond prices fall, interest rates rise; investment spending starts to fall and income falls along with it—we climb the IS curve until we get to E. Equilibrium point E has the nice property that if the economy is not there, dynamic forces will restore that particular combination of Y and r. It is a stable equilibrium. As long as the IS and LM curves remain in the same position, any deviation of income from YE will set forces in motion to restore that level of output; the same is true of interest rate rE. But there is nothing sacred about income YE. It may or may not be a full employment level of output. We have noted no tendency for the economy to ensure that YE is full employment, although we will suggest a few things later on. If YE happens to be full employment, all is well. But if it isn’t, and the army of unemployed becomes restless, Keynes suggested that the government should step in to produce full employment. As we noted in the previous chapter, it could use monetary policy or fiscal policy. We have all the tools to do a complete analysis of the impact of such policies on GDP.

Monetary and Fiscal Policy Monetary Policy We have now reached the point where we can put all of our slopes and shifts to good use. Figures 10, 11, and 12 summarize the way monetary policy influences economic activity, and the factors affecting the size of the multiplier effects on GDP within the ISLM framework.

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The ISLM World

Interest rate LM

LM'

r r'

IS

Y

Y' Income

FIGURE 10

An expansionary monetary policy.

Interest rate

LM LM'

ISflat

ISsteep Y

Ys

Yf Income

FIGURE 11

Monetary policy is more effective the flatter the IS curve.

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The ISLM World

Interest rate LMsteep

LM'steep LMflat LM'flat

IS

Y

Yf

Ys Income

FIGURE 12

Monetary policy is more effective the steeper the LM curve.

In Figure 10, if we start with LM and IS, the equilibrium level of income is Y and the interest rate is r. An increase in the money supply, for example, shifts the LM function to LM ¿, reducing the interest rate to r ¿ and increasing GDP to Y ¿.5 Figure 11 shows that an increase in money supply (LM shifts to LM ¿ ) raises GDP by more, the flatter is the IS curve. With the relatively steep IS curve, the increase in income is only to Ys, while with the flatter IS curve the increase is to Yf. The flatter IS curve can be due to a highly interest-sensitive investment function.6 Hence, the fall in r due to an increase in M raises the level of investment by a lot. The impact of monetary policy on GDP is more powerful under such conditions.

5All

the examples are in terms of increases in the money supply. A decrease would simply shift the LM curve to the left and all the changes would be just the reverse.

6The

wealth effect of interest rates on consumption also makes the IS curve flatter, thereby increasing the impact of a change in the money supply on GDP. The reasoning is as follows: A decline in the rate of interest not only increases investment spending directly but also increases wealth (by raising bond prices) and thereby induces consumers to spend more. For a given decline in the rate of interest, therefore, both investment and consumption go up, causing income to rise by a larger amount. Similarly, the exchange rate effect also makes the IS curve flatter. In particular, a decline in the rate of interest lowers the value of the dollar on the foreign exchange market, thereby encouraging net exports, causing GDP to increase more.

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The ISLM World

Interest rate LM

r' r IS'

IS

Y

Y'

Y" Income

FIGURE 13

An expansionary fiscal policy.

Figure 12 is somewhat more complicated. It illustrates that an increase in the money supply is more powerful the less the sensitivity of money demand to changes in the interest rate. If the demand for money is rather insensitive to changes in the rate of interest, the LM curve is steeper. An increase in money supply would shift LMsteep to LM¿ steep or LMflat to LM¿ flat.7 The former implies an increase in GDP from Y to Ys, while the latter implies a shift from Y to Yf. The explanation is as follows: The less the interest-sensitivity of the demand for money, the larger the decline in the rate of interest when money supply is increased (because the amount of money demanded increases only slightly when there is only a small fall in r); therefore, with a big drop in r (needed to increase money demand), the induced increases in investment spending and GDP are large.

Fiscal Policy The nature of the impact of fiscal policy on GDP is summarized in Figures 13, 14, and 15. An increase in government spending (or a decrease in taxes) shifts the IS curve to the right.8 In Figure 13 there is a shift from IS to IS ¿ . 7Notice that the horizontal distances between the curves in the two sets are identical because the income sensitivity of the demand for money is the same in both cases; hence the potential increase in GDP due to the increased money supply is the same (at the old equilibrium interest rate). 8A

decrease in government spending or an increase in taxes shifts the IS curve to the left, and all the impacts are the reverse of those in the text.

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The ISLM World

Interest rate LMsteep

LMflat

IS' IS

Y

Ys Yf Income

FIGURE 14

Fiscal policy is more effective the flatter the LM curve.

Interest rate

LM

IS'flat ISflat IS'steep ISsteep Y

Yf Ys Income

FIGURE 15

390

Fiscal policy is more effective the steeper the IS curve.

The ISLM World

Equilibrium GDP goes from Y to Y ¿ at the same time that the interest rate is driven up from r to r ¿ . The interest rate goes up because there is increased transactions demand for money associated with the rise in GDP; therefore, with a fixed money supply, r must rise to keep LP = M. Up to now this interest rate effect has been suppressed in evaluating the impact of ¢G (or any change in autonomous spending) on economic activity. It has significant consequences, however. It reduces the size of the autonomous expenditure multiplier, hence the power of fiscal policy, because the increase in the interest rate reduces investment spending at the same time that government expenditure is going up. If the rate of interest had remained unchanged, the increase in GDP would have been to Y –. The size of the horizontal shift in the IS curve is equal to ¢G times 1/(1 - b), and the increase from Y to Y – is equal to that. But the actual increase in GDP is less (only to Y ¿), because the interest rate goes up and investment spending is reduced somewhat (now you know why we called 1/(1 - b) the “simple” multiplier). In fact, this decrease in investment when government spending rises has come to be known as the crowding-out effect. The size of the government expenditure multiplier (and thus the effectiveness of fiscal policy) is greater, the smaller is the offsetting effect of rising interest rates on investment spending. In Figure 14 the rightward shift in the IS curve has a smaller impact on GDP with the steeper LM curve than with the flatter LM curve. When a steep LM curve is due to small interest-sensitivity of liquidity preference, for example, the increased transactions demand for money as GDP rises requires a large increase in the rate of interest to bring total money demand back into equality with money supply. The large rise in the rate of interest cuts off a large amount of private investment—there is a large “crowding-out” effect—hence the net impact on GDP is relatively small.9 Figure 15 is another rather complicated diagram. It indicates that the less the interest-sensitivity of investment, the larger is the government expenditure multiplier, and thus the more effective is fiscal policy. If investment spending is insensitive to changes in the rate of interest, the IS curve is steeper. An increase in government spending either shifts ISsteep to IS¿ steep raising GDP to Ys, or shifts ISflat to IS¿ flat, raising GDP to Yf. The increase in the rate of interest cuts off more investment the greater the sensitivity of investment to the rate of interest; hence the rise in income is smaller under such circ*mstances.10 As a reward for reading this far and still remaining conscious (check your pulse), Table 1 summarizes the factors influencing the relative effectiveness of monetary policy and fiscal policy. Start at the top of columns (1) 9The

steep LM curve can also be due to a large transactions demand for money. In this case, the increase in Y produces a large rise in the demand for money, forcing the rate of interest to rise by a lot in order to bring money demand back into equality with the fixed money supply.

10Notice that the horizontal distances between the IS curves in the two sets are identical. This is so because, if the rate of interest is held constant, the potential increase in GDP due to an increase in government spending is the same (because the marginal propensity to consume is assumed to be the same).

391

The ISLM World

TABLE 1

A Summary of Monetary and Fiscal Policy Effectiveness

Then

(1) If LP is very sensitive to r

(2) If l is very sensitive to r

(A) The LM curve is

flatter

—

(B) The IS curve is

—

flatter

(C) Monetary policy is

less effective

more effective

(D) Fiscal policy is

more effective

less effective

and (2), with the statement, for example, “If LP is very sensitive to r,” and then proceed to the extreme left-hand column for “Then (A), (B), (C), and (D).” The implications of each statement for ISLM analysis and monetary and fiscal policy are recorded in the table.

What About Velocity? Velocity, one of the cornerstones of the classical system, seems to have disappeared from our Keynesian framework. Where has velocity gone? It has disappeared behind the LM curve. Since a particular LM function is drawn for a given money supply, as one moves up along an LM function, the income velocity of money is necessarily going up. Income is rising but the money supply is constant, so Y/M (⫽ V ) has to rise. In Figure 16, three different IS curves

Interest rate

LM c

r3 b

r2 r1

a

IS3 IS1 Y1

Y2

IS2 Y3 Income

FIGURE 16

392

When the IS curve shifts, both income and velocity rise.

The ISLM World

Interest rate

LM

r3

r2 IS3 r1

IS2 IS1 Y Income

FIGURE 17

When the LM curve is vertical, shifts in the IS curve raise neither income nor velocity.

produce three different levels of GDP, as well as three different levels of velocity: V1 (= Y1/M) at a; V2 (= Y2/M) at b; and V3 (= Y3/M) at c.11 V3 is greater than V2, which is greater than V1. The rightward shifts in the IS curve in Figure 16, associated with (for example) increased levels of government spending, succeed in raising GDP by raising velocity. In fact, velocity goes up because the demand for money is sensitive to the rate of interest. The rise in the rate of interest induces the public to hold less speculative balances (or, more generally, to make more economical use of all money balances), permitting more cash to be used for carrying out transactions. If the demand for money were totally insensitive to the interest rate, then velocity would be constant and GDP would not be affected by shifts in autonomous spending. An interest-insensitive demand for money means that money demand depends only on income. For a given supply of money, there is only one level of income at which the equilibrium condition, LP = M, is satisfied. The LM curve is vertical at that level of GDP, as shown in Figure 17— implying that no matter how high government spending rises, the level of GDP cannot go up because then LP would exceed M.

11Velocity is properly defined as PY/M, but in our discussion prices are fixed so that movements in velocity are identified with Y.

393

The ISLM World

It is the fixed money supply that prevents GDP from rising under such circ*mstances. If autonomous spending goes up, illustrated by the rightward shifts in the IS curve in Figure 17, the result is an increase in the rate of interest, cutting off investment spending. The rate of interest rises until the drop in interest-sensitive investment spending is equal to the autonomous increase in spending, resulting in no increase in GDP. The “crowding-out” effect is complete. (We will return to the implications of a vertical LM curve in the next chapter.) Another feature of ISLM analysis is that it integrates the classical and Keynesian theories of interest rate determination. The simplified Keynesian view was that the interest rate was a purely monetary phenomenon, determined by the supply of and demand for money. The classical school, on the other hand, argued that the interest rate was a “real” phenomenon, determined exclusively by saving and investment.12 In our current treatment both monetary factors, embodied in the LM curve, and real factors, embodied in the IS curve, affect the interest rate. An increase in the money supply, by shifting the LM curve to the right, lowers the rate of interest, as Keynes suggested. An increase in autonomous investment, by shifting the IS curve to the right, raises the rate of interest, as the classics suggested. This partial rehabilitation of classical interest rate theory forces us back to the question we raised earlier: Why don’t variations in the rate of interest automatically bring about full employment in the Keynesian system, as the classical economists argued would happen? Having resurrected this much of classical theory, can we bring Say’s law back to life as well?

When Will Full Employment Prevail? The classical argument that the level of economic activity would tend toward full employment can be put into the Keynesian ISLM framework by allowing the price level to vary. Figure 18 shows an equilibrium level of income and interest rate associated with IS and LM. Let’s assume that the level of GDP that would generate full employment is YFE. Quite clearly, equilibrium economic activity at Y is too low to justify employing all those who want to work at the going wage rate. Unemployment is the result. The Keynesian apparatus makes it perfectly clear that the only way employment will increase is for aggregate economic activity to increase; only if desired spending increases will GDP increase beyond Y toward YFE. So far we have no reason to suspect that either the IS curve or the LM curve will shift to the right, hence no reason to suspect that output Y will not remain at that level unless there are increases in government spending or the money supply.

12Recall once again that this controversy refers to the real rate of interest. As long as inflationary expectations are zero, real rates equal nominal rates. Moreover, as long as inflationary expectations are unchanged, changes in nominal interest rates correspond to changes in real rates.

394

The ISLM World

Interest rate LM LM' (with a lower price level)

r

IS

Y

YFE Income

FIGURE 18

The classical position: Lower prices shift the LM curve to the right and automatically produce full employment.

But the classical economists said we needn’t wait for government intervention. With less than full employment, workers would lower their wage demands and prices would be lowered as entrepreneurs tried to sell the output they produced with the increased labor that they hired (more workers would presumably be hired at lower wage rates). However, if both prices and wages are falling, there is no reason to expect consumers to spend more— goods cost less but individuals receive less money for their work, so their real income hasn’t increased. Investment spending is also not likely to be affected directly. Entrepreneurs pay less for their inputs because of the decline in prices, but they must also expect to receive a smaller dollar return on outputs; the two are likely to cancel each other and expected profitability should be more or less unchanged. Indeed, all our behavioral relationships are in real terms; people see through falling prices accompanied by falling incomes, so consumption, investment, and money-holding decisions are unaffected by equal movements in dollar incomes and prices. Thus it seems that both the IS and LM curves in Figure 18 will remain unchanged, aggregate demand will remain at its old level (Y), workers just hired will be fired, and the level of employment will be back where it started. Nevertheless, the classical economists had an ace in the hole: One thing clearly affected by a fall in the price level is the real value of the supply of money. As we saw in previous chapters, if the money supply is fixed at $1,000 and the price level is one, its real value (in purchasing power) is the same as if the money supply were $2,000 and the price level were doubled. But if we start

395

The ISLM World

Going Out on a Limb ISLM Analysis Lives To paraphrase Mark Twain, reports of the death of ISLM are greatly exaggerated. The ISLM model was invented by Sir John Hicks in a famous 1937 article, “Mr. Keynes and the Classics.” It quickly became the standard exposition of the Keynesian viewpoint, although there have always been reservations about how faithfully ISLM analysis represented the views of Lord Keynes himself. Prominent objections to the ISLM approach include the following: (1) The analysis of income and expenditure (the IS curve) is a flow concept, while money and portfolio balance (the LM curve) is a stock concept, and there is no linkage between the flows and stocks; (2) monetary effects are collapsed into

a single parameter, the interest rate, with no role for such potentially important factors as bank portfolio composition and the structure of financial markets; (3) money is viewed as a direct substitute for other financial assets, but not for physical assets; (4) prices of goods are either fixed or flexible, rather than flexible in varying degrees. There is little doubt that each of these objections contains a strong element of truth, and each has spawned more sophisticated approaches to macro-monetary analysis. Nevertheless, ISLM has stood the test of time. Despite its shortcomings it has been with us for more than sixty years. Odds are that it will last at least another few.

out with a $2,000 money supply and the price level is cut in half—presto, the real money supply doubles (for example, from $2,000/2 to $2,000/1)! This increase in the real value of the money supply due to falling prices is the mechanism through which the economy would move itself from a position of less than full employment to full employment. Here’s how. In terms of Figure 18, falling prices shift the LM curve to the right for the same reason that an increase in money supply does: Falling prices increase the real value of the money supply and thereby create an excess of (real) money supply over the (real) demand for money. Falling prices continue as long as people are unemployed, so that the increased real value of the money supply continues to shift the LM curve to the right, lowering the interest rate and increasing desired investment. This process would continue until the LM curve in Figure 18 is shifted from LM to LM ¿ (the latter associated with a lower price level than at the original position), at which point economic activity is at full employment. The Keynesian attack on this classical mechanism was not confined to the argument that prices and wages are sticky and inflexible and not likely to fall very promptly. The classical school, in fact, stressed that unemployment was the result of such downward inflexibility in wages and prices. Keynes said, however, that there were at least two other circ*mstances that would stall the move toward full employment. The first is the case of a liquidity trap, in which an increase in the money supply would not lower the interest rate. As long as the liquidity-preference function is perfectly horizontal, and increase in the money supply, real or nominal, is associated with the same rate of interest.

396

The ISLM World

Interest rate

LM

IS YFE Income

FIGURE 19

An extreme Keynesian position: A liquidity trap.

The LM curve is horizontal under such conditions,13 and no matter how far the price level declines, the interest rate won’t fall, investment spending will remain unaltered, and so will aggregate output and employment. This situation is depicted in Figure 19. The second case in which falling prices fail to work is when investment is highly insensitive to the rate of interest. The IS curve is very steep. Under such conditions, declining prices and the induced reduction in the rate of interest will be unable to raise investment to a sufficiently high level to generate full employment spending, as in Figure 20. But classical economics wasn’t built on such a fragile link between the monetary sector and spending on goods and services. The classical argument that we have just presented based the automatic tendency toward full employment on the rightward shift in the LM curve due to increases in the real value of the money supply. This is a thoroughly “Keynesian” mechanism, in the sense that money affects the economy only through the interest rate. But falling prices not only lower the interest rate, they also make people’s real money balances worth more, and this might have a more direct impact on economic activity. People would be wealthier in addition to being more liquid. And if more liquidity wouldn’t help (because of, say, the liquidity trap), more wealth (in the form of real balances) certainly would. A cash balance of $10

13Recall

that the LM curve is flatter the greater the interest-sensitivity of money demand. In the liquidity trap, money demand is infinitely interest-elastic; hence the LM curve becomes totally flat.

397

The ISLM World

Interest rate LM

IS

LM' (with a lower price level)

YFE Income

FIGURE 20

Another extreme Keynesian position: Investment unresponsive to the interest rate.

may not mean you’re very rich if the price level is unity. But if the price level fell to 1/10 of what it was, you’d have $100 in purchasing power; a drop to 1/100 would make your $10 bill worth $1,000 (in purchasing power); and a decline in the price level to 1/100,000 of what it was would make you a millionaire! As we noted in our discussion of the consumption function in, an increase in wealth raises desired consumption at every level of income.14 In terms of Figures 19 and 20, the IS curve would now shift to the right until it intersected the LM curve at the full employment level of GDP. Prices would then stop falling, and all those who wanted jobs would be employed (with so many millionaires, perhaps the unemployment problem would be eliminated by the army of the wealthy pulling out of the labor force). Thus, in contrast to our initial impression, the complete classical argument has both Keynesian curves, the IS and LM, moving to the right as a result of falling prices. Changes in the real value of money balances affect the rate of interest and indirectly influence investment spending (the rightward

14The wealth effect just discussed is called the real balance effect, to distinguish it from the influence of interest rates on wealth. As we mentioned in footnote 6, the interest-rate-induced wealth effect merely changes the slope of the IS curve (it depends on the interest rate, and the interest rate is on the vertical axis). The real balance effect shifts the IS curve because it alters spending at every rate of interest.

398

The ISLM World

shift in LM), but they may also affect consumption spending directly (the rightward shift in IS). Keynes would say all this is fine, but by the time it comes about all those who wanted jobs will have passed through the Great Unemployment Window in the Sky. The classical “do it yourself” path to full employment is lengthy and arduous. Unemployment can last a very long time if the economy is left to its own devices, with no help from its friends. So the Keynesian prescription is fiscal policy. We use aggregate supply and demand analysis to describe these alternative viewpoints. It will be useful therefore to see how the ISLM model developed here meshes with that broader framework.

ISLM and Aggregate Demand The aggregate demand curve relates the price level to the demand for real output. The ISLM model is concerned with a different relationship: the interest rate and the demand for real output. That’s why price is on the vertical axis in the picture for the aggregate demand schedule (see Figure 11), while the interest rate is on the vertical axis in the ISLM picture. The two models emphasize different relationships because they focus on movements in different variables. But both the ISLM model and the aggregate demand schedule focus on the demand for real output. Here are the specifics on how they are related. It is relatively straightforward to generate a complete aggregate demand schedule from the ISLM model. Different price levels are associated with a family of LM curves, as in Figure 21(a). Given the curve IS in Figure 21 (a), we have a number of equilibrium real income or output levels (Y0, Y1, and Y2) associated with price levels P0, P1, and P2, where P1 is lower than P0, and P2 is lower than P1. Figure 21(b) plots the demand for real output as an explicit function of those prices. The result is D, which is exactly what we call the aggregate demand curve. It is also fairly easy to see the underlying factors causing the aggregate demand schedule to change position. Figure 21(a) shows that a rightward shift in the IS curve to IS ¿ generates higher levels of GDP for any given price level. Thus the aggregate demand curve shifts from D to D ¿ when any category of exogenous spending pushes the IS curve to the right. It follows that decreases in exogenous spending push the aggregate demand curve to the left. Less obvious but also true, an increase in the stock of money shifts aggregate demand to the right. The reasoning is as follows: An exogenous increase in the money supply causes each of the LM curves in Figure 21(a) to shift rightward (use your imagination); thus a higher level of demand for GDP is associated with any given price level, and that’s represented by a demand schedule like D ¿ compared with D in Figure 21(b). Similarly, decreases in the money supply will cause the aggregate demand curve to shift to the left.

399

The ISLM World

Interest rate

IS' IS LM (P0) LM (P1) LM (P2)

Y0

Y1

Y2

Y0⬘

Y1⬘

Y2⬘ Income

(a) Price level

D

D'

P0 P1 P2

Y0

Y1

Y2

Y0⬘

Y1⬘

Y2⬘ Income

(b)

FIGURE 21

400

Deriving aggregate demand from ISLM.

The ISLM World

It is possible to describe in greater detail how the IS and LM curves combine to determine the slope and the size of the shifts in the aggregate demand schedule. For our purposes, you are no doubt happy to know, it is more important simply to recognize the connection between the ISLM world and the aggregate demand/supply framework.

SUMMARY 1. The main advantage of ISLM analysis is that it shows the behavior of the money market and the product market in a single diagram. Keynes’s earlier treatment ignored some crucial interactions. An important mechanism is that the interest rate both influences GDP (through investment) and is affected by it (through the demand for money).

2. The simple Keynesian fiscal policy multiplier ignores the fact that an expansion in aggregate demand raises interest rates. Thus in the ISLM model the impact of fiscal policy on GDP is tempered by rising interest rates that crowd out private investment.

3. Monetary policy raises GDP by lowering the interest rate and encouraging investment. The impact on GDP will be reduced, therefore, when either the interest rate can’t be lowered much (because money demand is very interest-sensitive) or when investment spending is relatively insensitive to the interest rate.

4. Velocity, the cornerstone of classical economics, is hidden behind the LM curve of the Keynesian model. Fiscal policy raises GDP by increasing the velocity of the existing money supply.

5. Flexible wages and prices will push aggregate demand toward full employment equilibrium even in the Keynesian world. That process is tempered by a very interest-sensitive money demand and by very interest-insensitive investment. Nevertheless, given enough time, wage-price flexibility will generate full employment even according to ISLM analysis.

KEY TERMS crowding-out effect

ISLM analysis

LM curve

exchange rate effect

liquidity trap

wealth effect

IS curve

401

The ISLM World

QUESTIONS Questions with a red oval are in

402

at www.myeconlab.com.

24.1

Explain in words what the LM curve represents. Do the same for the IS curve.

24.2

Explain why the equilibrium level of GDP is at the intersection point of the IS and LM curves. Take a point on the IS curve above and to the left of the intersection point and explain why GDP will increase from that level.

24.3

Show geometrically that a flatter IS curve makes monetary policy more powerful, while a flatter LM curve makes fiscal policy more powerful.

24.4

What is meant by “crowding out” in the ISLM world? What makes it more or less of a problem?

24.5

Is it correct to say that the interest rate is determined by the supply of and demand for money, according to ISLM analysis?

24.6

How did Keynes argue that the slopes of the IS and/or LM curves could prevent falling wages and prices from producing full employment GDP? What did classical economists argue in response?

24.7

Explain the relationship between the IS and LM curves and the aggregate demand curve.

24.8

For each of the following, state the impact on the IS, LM, and aggregate demand curves: a. An increase in government expenditures b. An increase in the money supply c. The elimination of transaction fees when using ATM machines leading to a decrease in money demand d. Investment becomes more sensitive to changes in interest rates

APPENDIX

THE SIMPLE ALGEBRA OF INCOME DETERMINATION

For the algebraically inclined, much of ISLM analysis can be summarized succinctly in equation form. The economy is divided into two sectors: the goods or product market, comprising the demand for goods and services; and the monetary sector, comprising the demand for and supply of money.

The Model The product market can be described by four functional relationships (behavior equations) and one equilibrium condition (an identity). All the functional relationships are assumed to be linear, an assumption that simplifies exposition without doing excessive damage to real-world applications. The functional relationships: (1) C = a + b(Y - T) (2) I = d - nr (3) T = e + tY (4) G = G and the equilibrium condition: (5)

Consumption (C ) function Investment (I) function Tax (T ) function Government spending (G)

C + I + G = Y or S + T = I + G

where Y stands for GDP (income) and r for the interest rate. The symbols a, d, and e represent constant terms, t represents the slope of the tax function, b is the marginal propensity to consume (¢C/¢(Y - T)), and n is the interest-sensitivity of the investment function (¢I/¢R). Government spending is indicated –– by G and is exogenously fixed (imposed on the system from outside).

403

The ISLM World

The monetary sector of the economy consists of two functional relationships and one equilibrium condition: (6) (7) (8)

Liquidity preference (L) or demand-for-money function Money supply (M) Equilibrium condition

L = f - hr + kY M = M L = M

The IS and L M Functions By solving equations (1) through (5), we find the IS function: 192

Y =

a - be + G + d n r 1 - b + bt 1 - b + bt

By solving equations (6) through (8), we find the LM function: 1102

Y =

M - f h + r k k

or

r =

kY + f - M h

Equilibrium Income and Interest By solving (9) and (10) simultaneously, we obtain equilibrium income (Y) and interest rate (r): nf 1 nM (112 Y = aa - be + d + G + b nk h h 1 - b + bt + h

1122

1 r = [ka - kbe + kd + kG h11 - b + bt2 + nk + f11 - b + bt2 - M11 - b + t2]

Multiplier Effects on Income and the Interest Rate From equation (11) one can derive the multiplier effects on income, and from (12) one can derive the multiplier effects on the interest rate that follow from a change in government spending (¢G), an autonomous shift in the consumption or investment function ( ¢ a or ¢d), a shift in the tax function (¢e), a change in the money supply (¢M), or an autonomous shift in the demand for money (¢f ).

404

The ISLM World

The multiplier effects on income, from equation (11), are: (13)

¢Y 1 = ¢G or ¢a or ¢d 1 - b + bt +

nk h

¢Y b = ¢e 1 - b + bt +

(14)

nk h

¢Y n = ¢M(or - ¢f ) h(1 - b + bt) + nk

(15)

The multiplier effects on the interest rate, from equation (12), are: (16)

¢r k = ¢G or ¢a or ¢d h11 - b + bt2 + nk

(17)

kb ¢r = ¢e h11 - b + bt2 + nk

(18)

(1 - b + bt) ¢r = ¢M (or - ¢f) h(1 - b + bt) + nk

Policy Implications A number of policy implications are contained in the above multiplier formulas. Among the more important are the following: 1. As equation (13) indicates, in the complete Keynesian system the multiplier effect on income of a change in government spending is smaller than the simple 1/(1 - b) that is typically taught in beginning economics courses. It is smaller by the addition of bt + nk/h to the denominator. Here’s what it means: t represents tax rates (they cut back consumer spending); k is the transactions demand for money (as income rises, the amount of transactions money desired increases, raising interest rates); n is the interest-sensitivity of investment spending (as interest rates rise, they cut back investment spending); h is the interest-sensitivity of the demand for money (if liquidity preference is very responsive to interest rates, it will take only a small rise in rates to induce people to reduce their cash holdings enough to provide the additional money needed for transactions purposes). 2. Compare equations (13) and (14): As long as b is less than unity, an increase in government spending will increase income by more than an equal increase in taxes will lower income. The multiplier for a change in government spending is larger than the multiplier for a tax change. 2a. It follows from the above that a simultaneous and equal increase in both government spending and taxes—that is, a balanced budget change in government spending (financed entirely by higher taxes)—will not leave

405

The ISLM World

income unchanged but will increase it. Increasing government spending and taxes by the same amount is not neutral with respect to income. 3. Equation (15) indicates that monetary policy will be less powerful in affecting income the larger is h (the responsiveness of liquidity preference to interest rates) and the smaller is n (the responsiveness of investment spending to interest rates).1 3a. As a special case of the above, if h is infinite (Keynesian liquidity trap) or n is zero (investment completely insensitive to interest rates), then the multiplier for ¢M = 0 and monetary policy is useless. 3b. Under such circ*mstances (h = q or n = 0), it follows that fiscal policy is the only alternative. 4. Conversely, equation (15) also indicates that monetary policy will be more powerful in affecting income the smaller is h and the larger is n. 4a. As a special case of the above, if h is zero (liquidity preference completely insensitive to interest rates), then—from equation (13)—the multiplier for ¢G = 0 and fiscal policy is useless. 4b. On the other hand, under such circ*mstances (h = 0), monetary policy is both necessary and sufficient to control income. If h = 0, equation (15) indicates that the multiplier for ¢M = 1/k; so long as k is constant in the liquidity-preference function, a change in the money supply will always change income by the constant 1/k. That is, ¢M * 1/k = ¢Y, which is—surprise!—the same as the quantity theory of money (M * velocity = Y, with velocity constant and equal to 1/k).

QUESTIONS Questions with a red oval are in

at www.myeconlab.com.

24A.1 Assume an economy can be described by the following equations: (1) (2) (3) (4) (5) (6)

C = 400 + .9(Y - T) I = 200 - 10r T = 40 + .2Y G = 150 L = 1,000 - 10r + .1Y M = 1,000 a. Sketch the resulting IS and LM curves. b. What are the equilibrium levels of Y and r? c. Imagine that full employment occurred at Y = 2,500. Provide one fiscal policy and one monetary policy that will move this economy to that level. Be specific: How much of each variable needs to be changed to arrive at full employment?

1The effect of changes in h, n, or any of the other coefficients on the size of the multipliers can be verified by numerical examples (putting in actual numbers for each coefficient, calculating the multiplier, and then changing one of the coefficients and recalculating the multiplier), or by using calculus (take the derivative, for example, of ¢Y/¢M with respect to n, h, or k). Note also that the points made under 3a, 3b, 4a, and 4b are not discussed in this chapter. They correspond to points that will be made in the next chapter.

406

Money and Economic Stability in the ISLM World* Last chapter’s ISLM model integrated the classical and Keynesian outlooks on the determination of GDP and interest rates. We can now utilize this ISLM framework to articulate some of the controversies that have surrounded the debate between the Keynesians and the intellectual heirs of the classical wisdom, known at various times as monetarists or new classical macroeconomists. The first section of this chapter reviews the old debate concerning the relative effectiveness of monetary and fiscal policy. The next section turns to the ISLM framework to explain why monetarists and new classicists contend that economic activity is inherently stable while Keynesians emphasize the need for an active attempt at economic stabilization. In the last section we turn to an explicit consideration of price flexibility in the ISLM world.

LEARNING OBJECTIVES In this chapter you will learn to explain the circ*mstances under which fiscal or monetary policy is a more effective method of stabilizing GDP understand the importance of crowding out and possible liquidity traps define the role of prices and their impact on economic stability

Monetary Policy, Fiscal Policy, and Crowding Out The oldest controversy articulated within the ISLM framework is over the relative effectiveness of monetary and fiscal policy. In fact, near the end of the last chapter (see Figure 17) the monetarist “special case” in the Keynesian model *This

chapter uses analytical techniques developed in previous chapter. If you skipped previous chapter skip this one too. All this material is presented in next chapter in a somewhat different framework.

From Chapter 25 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

407

Money and Economic Stability in the ISLM World

Interest rate LM

LM'

ΔM ΔM

V or 1/k

IS Y

Y' Income

FIGURE 1

When the LM curve is vertical, an increase in the money supply increases income by ¢ M times velocity.

was set forth: a demand for money that is unresponsive to interest rates— depending on income only—and that produces a vertical LM function. In that world, things are very simple. Velocity is constant. With a fixed money supply, GDP can’t change and neither does velocity. The impact of a change in money supply on the level of income equals ¢ M multiplied by velocity (V). This can be seen in Figure 1. Start with LM and IS and equilibrium income Y. An increase in the money supply shifts the LM curve to the right by ¢ M × V. The new equilibrium level of income is Y ¿, and it is obvious that the change in income from Y to Y ¿ equals ¢ M × V in this case. Income continues to rise until all the increased money supply is absorbed into increased transactions demand. On the other hand, as Figure 2 shows, when the LM curve is not vertical but is positively sloped (as is the case when the demand for money that underlies it is somewhat responsive to the rate of interest), then the increase in income due to a change in the money supply will be less than in Figure 1. In Figure 2 we have superimposed a set of positively sloped LM curves (LM and LM ¿ ) on the monetarist case of Figure 1. While the horizontal distance between the two LM curves is the same as before, the increase in income is clearly less than before.1 Why? Because the increase in the supply of money

1The

horizontal distance between the two LM curves is the same as before, but now it is simply called ¢M * 1/k, because 1/k = V only when the interest-sensitivity of liquidity preference equals zero.

408

Money and Economic Stability in the ISLM World

Interest rate LM LM'

ΔM

1/k

IS Y

Y' Income

FIGURE 2

When the LM curve is not vertical, an increase in the money supply is less powerful in increasing income.

lowers the interest rate, and at lower interest rates people will hold some of the increased money supply in the form of “idle” balances rather than for transactions purposes. Thus the velocity or rate of turnover of the total money supply falls (some of it is now being held “idle”). But we are running a bit ahead of ourselves; let’s wait until we come to the Keynesian analysis of money to complete this part of our story. Let us reemphasize that the monetarists are playing the game under protest—they don’t like the rules of the Keynesian ISLM apparatus. It forces them into a situation where the change in money supply first lowers the interest rate, which increases investment, and thereby GDP. For monetarists, the channels through which money influences spending are not restricted to interest rates, as will be emphasized in the next chapter. Thus while the vertical LM curve does convey some of the monetarist flavor—that is, the stability of velocity—it still leaves a Keynesian taste. Moreover, the assumption of stability in velocity is replaced by predictability in modern versions of monetarism. The Keynesian reservations about the potency of monetary policy can be summarized in a number of “special cases” in the ISLM model. First, an increase in money supply would not affect anything if the LM curve were horizontal at the relevant level of GDP; that is, if the liquidity trap were a reality. Figure 3’s money-supply-and-demand functions form the basis for constructing Figure 4’s LM functions. If we increase the money supply from

409

Money and Economic Stability in the ISLM World

Interest rate

L(Y1)

L(Y2)

M

M'

req

Money supply and demand

FIGURE 3

With a liquidity trap, an increase in the money supply from M to M ¿ does not shift the LM curve (see Figure 4).

Interest rate

Yeq

LM and LM'

IS Income

FIGURE 4

410

With a liquidity trap, an increase in the money supply, because it does not shift the LM curve, does not change income.

Money and Economic Stability in the ISLM World

In the News Japan’s Liquidity Trap For the fifth time in the past 10 years, Japan’s economy is showing signs of revival. Growth in gross domestic product has picked up and the Nikkei has surged past 10,000. Some commentators have begun to call a turn. Their optimism may be misplaced. Japan is stuck in the mid to late stages of a massive boom-bust cycle that began in the mid-1980s. The main cause of the boom was a confluence of rising asset prices, overheated real economic activity, and unrealistic lending, each factor reinforcing the others. When the boom ended in the early 1990s, the same factors reversed themselves and fed a vicious circle of economic decline. A central bank can usually cut short-term interest rates to the point where banks replenish their capital, asset prices are revalued, and real economic activity recovers. But the difference between the boom and the bust became too large for the Bank of Japan to bridge. Five years ago its transmission mechanism broke, rendering conventional monetary policy useless. Short-term rate cuts to zero in February 1999 (and virtually zero since) have been ineffective because banks have warehoused

the excess reserves. Since then the monetary base and the money supply have continued to converge as medium-term bond yields have approached zero. Last month, long-term yen bond yields became lower than those of any country, ever. Nevertheless, banks have continued to buy bonds instead of extending loans. Bank lending has declined continuously since 1998. The BoJ needs to create moderate inflation (in excess of nominal interest rates)—a tricky feat. Adopting an inflation target will further compromise the BoJ’s credibility; creating ever more liquidity will fall foul of Japan’s liquidity trap. There is a way out however. The government can give money away. If it printed and distributed a moderate amount of yen to every citizen, it would have a huge psychological impact. Unlike a conventional tax rebate, this disbursem*nt would not entail any increase in the nation’s debt. The public, seeing the unlimited ability of the government to print and distribute money “as if dropped by a helicopter” (in Milton Friedman’s phrase), would be likely to increase spending and investing. Source: Nick Ricciardi, Financial Times, Aug. 25, 2003, p. 17.

M to M ¿ in Figure 3’s liquidity trap, then we get no shift in the LM function in Figure 4. The LM curve with M (namely, LM) is the same as with M ¿ (namely, LM ¿ ). As can be seen in Figure 4, when the IS curve intersects LM (or LM ¿ ), producing equilibrium income Yeq, an increase in the money supply from M to M ¿ does not lower the interest rate. All the increased money supply is held as idle balances. Equilibrium income is unchanged. More money and the same level of GDP imply a decrease in velocity—the hallmark of the Keynesian critique of monetary policy. A second category of pitfalls for monetary policy concerns the IS curve. Even if the liquidity-preference function is well behaved, so that an increase in the money supply succeeds in lowering the rate of interest, there may still be no impact on GDP if investment is completely unresponsive to the rate of interest.

411

Money and Economic Stability in the ISLM World

Interest rate IS

LM LM'

r

r'

Y Income

FIGURE 5

When the IS curve is vertical, monetary policy is ineffective.

We know that the IS curve is very steep if investment has little interest-sensitivity; with zero interest-sensitivity, the IS curve is vertical. Under such conditions, changes in the money supply do not affect income even though they may change the rate of interest. Figure 5 illustrates that situation. Start with IS and LM and equilibrium income Y. Then, an increase in the money supply causes a rightward shift in the LM curve to LM ¿ , which merely lowers the interest rate with no impact on GDP. Once again, the money supply has gone up but GDP hasn’t, with velocity falling as a result. To summarize the monetary policy discussion: Monetary stimulus works in the Keynesian world when both the IS curve and the LM curve are “normal.” Pathological cases of horizontal LMs and vertical ISs render monetary policy impotent. More generally, even when we are untroubled by horizontal LM curves and vertical IS curves, the impact of money on GDP is not the simple ¢ M times a fixed velocity. For example, an increase in M may very well produce falling interest rates, more investment, and higher GDP. But GDP is not likely to rise in direct proportion to the change in M, because as interest rates decline, the speculative demand for money increases along with the transactions demand. In other words, velocity is likely to decline. Turning to fiscal policy, the monetarist and Keynesian polar cases in ISLM analysis produce symmetrical results. In particular, fiscal policy has a zero impact with a vertical LM curve, while it is completely effective (with no offsetting

412

Money and Economic Stability in the ISLM World

Interest rate LM

b

r'

r

c LM'

a IS' IS Y

Y' Income

FIGURE 6

When the LM curve is vertical, fiscal policy is completely ineffective; when it is horizontal, it is totally effective.

crowding out due to interest rate effects on private investment) with a horizontal LM curve. Figure 6 illustrates these points. Let’s start at point a with income Y and interest rate r. An increase in government spending (or a reduction in taxes) shifts the IS curve from IS to IS ¿ . If the LM curve were LM, the new equilibrium would be at b, and the entire impact would be absorbed by a higher interest rate with no increase at all in GDP. In this case there is complete crowding out. But if the LM curve were LM ¿, the new equilibrium would be at c and the impact would be entirely on GDP, with no rise at all in the interest rate; in fact, since the rightward shift in the IS curve equals ΔG times 1/(1 - b), which also equals the change in GDP, the simple multiplier has returned in full bloom. The general case of the positively sloped LM curve produces results that lie between the extremes, as we saw in the last chapter. An increase in government expenditure raises GDP, but by less than the “full multiplier” of the simple Keynesian system. This is because the interest rate goes up, cutting off some private investment (there is partial but not total crowding out). The rise in the rate of interest does not lower investment by as much as government spending increases, because the higher rate of interest also reduces the demand for money, permitting once-idle speculative balances to be used for carrying out the increased transactions associated with higher levels of GDP. It would seem, therefore, that unless the economy is characterized by the

413

Money and Economic Stability in the ISLM World

extreme case of zero interest-sensitivity of the demand for money (producing a vertical LM curve), even monetarists would agree that fiscal policy could have some impact on GDP.

Is the Private Sector Inherently Stable? Most economists now believe that the LM curve is positively sloped, although they may disagree over whether it is very steep or somewhat flat. Such differences of opinion over the steepness of the LM curve are sufficient to demonstrate the stability or instability of economic activity in the face of exogenous shifts in private investment. Figure 7 shows two alternative LM curves: LMsteep and LMflat. There are two IS curves representing shifts in autonomous investment. As can be seen in the picture, with LMsteep the induced fluctuation in GDP due to the shifting IS curve is S to S ¿ . When the LM curve is LMflat, however, the fluctuation in GDP is much wider, between F and F ¿ . The key to the smaller fluctuation in GDP with LMsteep is that the level of interest rates fluctuates more than with LMflat. Thus when the IS curve shifts from IS ¿ to IS, the interest rate falls a lot, inducing a large amount of endogenous investment to offset a large part of the decline in autonomous investment. With a flatter LM curve, the fall in the rate of interest is smaller and induced investment is less. Thus a steeper LM curve

“In theory yes, Mrs. Wilkins. But also in theory, no.” © The New Yorker Collection 1976 Stan Hunt from cartoonbank.com. All Rights Reser ved.

414

Money and Economic Stability in the ISLM World

Interest rate LMsteep

LMflat

IS'

IS F

S

S'

F' Income

FIGURE 7

A flatter LM curve means wider fluctuations in GDP associated with exogenous shifts in investment.

stabilizes the level of economic activity associated with a particular stock of money, because the interest rate fluctuates more. When the economy operates near its full employment capacity, fluctuations in the price level help provide self-correcting stabilization. Figure 8 shows the intersection of IS and LM(P0) at YFE. We introduced YFE to represent full employment GDP. The LM curve is labeled with a particular price index, P0, since changes in the price level will affect the position of LM. Moreover, at full employment, we assume that prices rise in response to increases in aggregate demand. A shift in autonomous spending pushes IS to IS ¿ and raises aggregate demand. As a result, prices rise. With a fixed stock of money, this reduces the real supply of money, and the LM curve is pushed back toward the full employment line. This process stops once aggregate demand is back at full employment; in our picture this occurs at the intersection between IS ¿ and LM(P1). At the new equilibrium E ¿ we have both a higher price level and a higher rate of interest. The higher price level (caused by an exogenous increase in spending) has reduced the real supply of money, raised interest rates, and pushed back aggregate demand to the full employment level. Thus the fixed supply of money, together with flexible prices and interest rates, insulates full employment economic activity from exogenous changes in investment. The process would be reversed (lower prices and lower interest rates) if there were a decrease in exogenous investment (shifting IS to the left). Notice that Figure 8 has the elements of an inflation story, as we will see shortly.

415

Money and Economic Stability in the ISLM World

Interest rate LM (P1)

E'

2

LM (P0)

E 1 IS'

IS

YFE

Y Income

FIGURE 8

At full employment, fluctuations in the price level help stabilize economic activity.

Flexible Prices, the Natural Rate of Interest, and Real Crowding Out Price flexibility has even more startling effects on the impacts of monetary and fiscal policy. In the first instance, when the economy is operating at or near full employment, and prices are flexible, the Keynesian interest rate mechanism gives way completely to purely classical arguments. In particular, at full employment the rate of interest is independent of movements in the money stock. This can be seen in Figure 9, starting with IS and LM intersecting at YFE and rFE. The latter is the real rate of interest because, as usual, we are assuming the absence of any inflationary expectations. As always, an increase in money supply shifts LM to LM ¿ , apparently pushing down the interest rate from rFE to r ¿ and raising aggregate demand to Y ¿ . But the excess of aggregate demand over YFE causes prices to rise. This reduces the real supply of money, pushing LM ¿ back toward LM. After all is said and done, prices have risen until the LM curve is back where it started, since otherwise prices would keep on rising. And when LM ¿ is back at LM, the real rate of interest is restored to its original level. Thus, at full employment, increases in money supply cannot reduce the interest rate below rFE. Similar reasoning shows that decreases in the money stock will not raise interest rates above rFE if prices fall when aggregate demand is below full employment.

416

Money and Economic Stability in the ISLM World

Interest rate LM 1

LM⬘

2

rFE r'

IS

YFE

Y⬘ Income

FIGURE 9

An increase in money supply at full employment doesn’t lower the interest rate.

The interest rate rFE has a special name. It is called the natural rate of interest and is defined as that rate which equates saving and investment at full employment. It is determined by the intersection point between the IS curve and the YFE line. Shifts in the money stock can’t change rFE. Only shifts in the IS curve can, as we saw earlier in Figure 8. Thus at full employment only saving and investment (including government spending) determine the interest rate; money has nothing to do with it. At full employment, classical interest theory pops out of the Keynesian picture! The implications for the effect of expansionary monetary policy on interest rates at full employment are twofold: (1) the real rate of interest is unchanged by increases in money supply; (2) nominal rates (not shown in the figures) will rise if inflationary expectations are generated by the increased money stock. The latter is quite likely, especially in the long run. Borrowers and lenders recognize that excessive expansion in money stock means rising prices. This will no doubt lead them to agree upon an inflation premium attached to the real rate of interest. With the real rate fixed at rFE, the net result is an increase in nominal rates by the expected rate of inflation.2 The analysis of fiscal policy under flexible prices adds another dimension to the crowding-out mechanism. In particular, we see that at full employment an increase in government expenditure is crowded out in real terms, even if the 2In

the next chapter there is a more detailed discussion of real and nominal interest rate movements. Also, return to earlier chapter for a simple discussion.

417

Money and Economic Stability in the ISLM World

LM curve has a positive slope. Look again at Figure 8, which shows equilibrium at YFE with IS and LM(P0). The rightward shifts to IS ¿ now represent an increase in government spending at full employment. Initially there is an increase in aggregate demand to Y ¿, with investment demand declining (along the IS curve) to offset only part of the increase in government expenditure. A positively sloped LM curve permits such an expansion in aggregate demand. But that’s not the end of the story. With aggregate demand, Y ¿, exceeding full employment production, YFE, prices rise (from P0 to P1), pushing LM(P0) back toward LM(P1) and raising the interest rate still further. That process will continue until the new equilibrium, E ¿ , is reached. At that point the interest rate has increased by enough to cut off an amount of investment spending equal to the initial increase in government expenditure. How do we know? If that weren’t the case, aggregate demand would still be above YFE, prices would still be rising, and so would the interest rate. Two points are worth noting in this example. First, the interest rate at full employment is obviously affected by shifts in the real sector of the economy, represented by the IS curve (even though it is unaffected by shifts in the monetary sector). Second, notice that nominal GDP is higher at E ¿ compared with E. How do we know? Because real income is still at YFE, but prices are higher (P1 versus P0). Thus while there is real crowding out at full employment even with a positively sloped LM curve, there isn’t nominal crowding out as with the vertical LM curve. The story at full employment is decidedly classical, even when cloaked in a Keynesian framework. But that’s not really as devastating to Keynesian protagonists as it initially seems. After all, at full employment Keynes was as classical an economist as Milton Friedman and John Stuart Mill put together.

SUMMARY 1. The “special” (or extreme) monetarist and Keynesian slopes of the ISLM diagram help to highlight the polar positions on monetary and fiscal policy. In particular, a vertical IS curve and a horizontal LM curve make monetary policy impotent and fiscal policy supreme. A vertical LM curve, on the other hand, causes fiscal policy to lose its potency (complete crowding out) and raises monetary policy to its ultimate power (fixed velocity).

2. The demonstration that a steep LM curve insulates GDP from exogenous investment shocks highlights the stabilizing role of fluctuating interest rates on economic activity. Flexible prices add to that stabilizing mechanism.

3. Price flexibility at full employment restores the results of classical interest rate theory: The level of the real rate of interest is determined only by saving and investment. A change in the money supply cannot alter this “natural rate of interest”; it can only influence nominal interest rates by changing inflationary expectations. Price flexibility at full employment also causes fiscal policy’s impact on real GDP to be completely crowded out even with a positively sloped LM curve.

418

Money and Economic Stability in the ISLM World

KEY TERM natural rate of interest

QUESTIONS Questions with a red oval are in

at www.myeconlab.com.

25.1

Explain why monetarists would argue that the slope of the LM curve determines only part of the real crowding-out effect associated with fiscal policy.

25.2

Explain verbally or geometrically how the slope of the LM curve helps determine whether shifts in autonomous investment cause small or large fluctuations in GDP.

25.3

Define the natural rate of interest and show how price flexibility prevents changes in the money supply from influencing the natural rate.

25.4

In ISLM analysis, is there a tradeoff between the volatility of GDP and the volatility of interest rates? Could high amounts of interest rate volatility reduce future GDP growth? How?

25.5

Discussion question: Which do you think is the more powerful force in stabilizing the economy at or near full employment, flexible wages and prices or flexible interest rates?

419

APPENDIX

INTEREST RATES VERSUS THE MONEY SUPPLY UNDER UNCERTAINTY There are advantages and disadvantages to using the money supply versus the interest rate as a target of monetary policy. Monetarists generally prefer a money supply target, while Keynesians prefer an interest rate objective. At this point we can formalize the underlying analysis to demonstrate the pluses and minuses of each. The issue boils down to this: Is it always better for the Fed to specify a target for the money supply rather than the interest rate, or vice versa? The answer is—it depends. Consider the situation where the major source of instability in GDP comes from unanticipated movements in the IS curve. In Figure A.1 we have the IS curve shifting back and forth between IS and IS ¿. With a money supply target set by the Fed and a stable demand function for money, we have the upward-sloping money market equilibrium curve pictured in Figure A.1. The level of GDP varies between A and B. Compare this variability in GDP with what occurs when the Fed sets the interest rate as its policy target. Under such conditions we have the horizontal money market equilibrium curve in Figure A.1.1 GDP varies between X and Z. Clearly the money supply target is superior—it ensures a smaller variability in GDP when the major source of instability is in the IS curve (a victory for the monetarists). When the game is played in the Keynesian ballpark, things turn out just the reverse. Here the demand for money is highly unstable. If the money supply is fixed by the Fed and the demand for money shifts, then the LM curve moves between LM and LM ¿ in Figure A.2. With a fixed IS curve, GDP varies between

1The

LM curve is flat under such circ*mstances, because the Fed accompanies any increased demand for money with an increased supply. Hence higher levels of Y (which increase the demand for money) are associated with the same level of interest, r*. Notice that the definition of the LM curve is slightly different; it is the combination of Y and r with a given Federal Reserve policy and not a given money supply. That’s why we’ve called the LM curve by its generic name: the money market equilibrium curve.

420

Money and Economic Stability in the ISLM World

Interest rate LM money supply target

r*

LM interest rate target

IS

X

A

IS'

B

Z Income

FIGURE A.1

With an interest rate target, an unstable IS curve leads to wider variation in GDP than if the Fed had a money supply target.

Interest rate

Money supply target LMs LM

LM'

r*

LM interest rate target

IS

A

X

B Income

FIGURE A.2

With a money supply target, an unstable LM curve leads to wider variation in GDP than if the Fed had an interest rate target.

421

Money and Economic Stability in the ISLM World

A and B. But if the Fed uses an interest rate target, the relevant “LM curve” is again horizontal and there is no instability in GDP whatsoever. It stays put at X. Monetarists insist that the most stable relationship in the economy (if not the world) is the demand for money. The Keynesian consumption function is much less stable. The IS curve is therefore the major source of GDP instability. Figure A.1 tells the truth—a money supply target is best. Keynesians argue that if anything is unstable it is monetarists themselves. Not being psychiatrists, they’ll settle for an unstable demand function for money. The LM curve is therefore the major source of GDP variability. Figure A.2 tells the truth—an interest rate target is best. As in most monetarist-Keynesian disputes, the ultimate resolution lies in empirical evidence.

422

An Aggregate Supply and Demand Perspective on Money and Economic Stability At a conference of professional economists, Robert Solow, a prominent Keynesian from MIT, commented as follows on a paper presented by Milton Friedman: “Another difference between Milton and myself is that everything reminds Milton of the money supply; well, everything reminds me of sex, but I try to keep it out of my papers.” The intellectual traditions represented by these two Nobel Prize-winning economists surely extends well beyond the money supply. Robert Solow is a staunch supporter of Keynesian policy activism, while Milton Friedman has long trumpeted the virtues of classical laissez-faire macroeconomics. Nevertheless, there was a time when the importance of the money supply in explaining aggregate economic performance was the defining distinction among these two, as well as all other, macroeconomists. Thus the name monetarists came to represent the upholders of the broad classical traditions of nonintervention as well as the narrower notion that the money supply cannot be relegated to a sideshow, as the followers of Keynes had once suggested. Although the so-called new classical macroeconomists have refined monetarist thinking by focusing on rational expectations and the role of prices in clearing imbalances between supply and demand, we nevertheless use the term monetarists to represent the entire spectrum of modern classical thinking on money and economic stability.

From Chapter 26 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

423

An Aggregate Supply and Demand Perspective on Money and Economic Stability

As it turns out, the most important elements of the monetarist-Keynesian dialogue can be best articulated within the aggregate supply and demand framework. In the rest of this chapter we put the details of the classical and Keynesian models on the back burner and use the aggregate supply and demand graphs to explain the opposing positions on the stability of the economy, the relative effectiveness of monetary and fiscal policy, the causes of inflation, and the consequences for interest rates. Although these issues have been discussed in previous chapters, the unifying theme of aggregate supply and demand provides a powerful perspective. In the next chapter we will return to these issues from still another vantage point: rational expectations. By that time we should have a clear understanding of the monetarist and Keynesian outlooks on just about everything.

LEARNING OBJECTIVES In this chapter you will learn to analyze the debate centering on the stability of the economy around its full employment level define the role crowding out has in debates between Keynesians and monetarists explain the Phillips curve and its relevance for fiscal and monetary policies understand the importance of real versus nominal interest rates in the discussion of monetary policy

Is the Private Sector Inherently Stable? Monetarists tend to believe that aggregate demand will be relatively unaffected by autonomous shifts in investment spending. Keynesians argue that unless there is an active attempt at stabilization, the level of economic activity and unemployment will fluctuate considerably when buffeted by entrepreneurial “animal spirits,” as Keynes referred to unexpected gyrations in aggregate spending. Monetarists, reflecting their classical ancestry, argue that any exogenous decrease in investment spending would be countered automatically by either increased consumption or interest-sensitive investment spending. The mechanism could be attributed, somewhat mysteriously, to the fixed money stock, resulting in a relatively fixed level of aggregate demand based on the quantity theory; or, in keeping with classical interest theory, it could be attributed to a reduction in interest rates that would follow a downward shift in the investment function. The drop in interest rates would, in turn, stimulate investment spending,

424

An Aggregate Supply and Demand Perspective on Money and Economic Stability

reduce saving (thereby increasing consumption), and make up for the initial drop in investment. Keynesians are less impressed with the automatic offsets to gyrations in the investment spending. First, the mysterious quantity theory linkage between money and aggregate demand is simply not part of the picture. Moreover, they argue that the interest rate does not necessarily respond to a drop in investment. And even if the interest rate did decline, there’s no guarantee that it would induce much additional spending. Fluctuations in the price level are another source of stability, according to monetarists. If, for example, consumption and investment didn’t rise fast enough to offset the initial decline in investment spending, the resulting unemployment would drive down prices. A fixed money stock with lower prices means a larger real supply of money. This could stimulate spending directly via the quantity theory. Alternatively, the larger real supply of money would lower interest rates—in good Keynesian fashion—and investment spending would increase still further. The Keynesian response to such expected price effects is twofold: First, prices rarely decline; and second, the spending effects are too slow to restore full employment without causing significant economic suffering. These arguments can be put somewhat more elegantly in terms of aggregate demand and supply. Recall from our earlier discussions that the aggregate demand schedule, labeled D in Figure 1, shows how the quantity of

Price level S

? P

P' D D'

Y

YFE Income

FIGURE 1

Monetarist response to declines in exogenous investment: Income remains at the full employment level.

425

An Aggregate Supply and Demand Perspective on Money and Economic Stability

real income (or output) demanded varies with changes in the price level. In particular, decreases in prices increase the amount of goods and services demanded because real money balances increase when the price level falls.1 The aggregate supply schedule, labeled S, shows how quantity produced varies with price. In Figure 1, the supply curve is vertical, reflecting the classical assumption that quantity supplied is fixed at full employment. First let’s focus on aggregate demand. The quantity theory approach of monetarists assumes a direct and powerful impact of increased real money balances on the demand for output. When people have more real cash balances, they want to spend more—period. For Keynesians, on the other hand, there are many things that can intervene between real money balances and demand. In particular, interest rates may not fall very much when money balances increase, because people may simply hold the additional cash balances. In addition, desired spending may not be very responsive to decreases in interest rates. All of this implies that the slope of the aggregate demand schedule, measuring how much of an increase in amount demanded occurs when prices fall, is flatter for monetarists than for Keynesians. Of greater importance is the stability (or predictability) of the entire aggregate demand schedule—whether it stays put or jumps around a lot. According to monetarists, the major factor determining aggregate demand is the stock of money. Once that is fixed, the amount of real output demanded depends upon the price level—lower prices mean more goods and services demanded. Thus monetarists argue that, once the stock of money is fixed, there will be relatively little impact on the aggregate demand schedule from exogenous shifts in spending. For example, if investment spending falls, monetarists expect interest rates to decline, which reduces saving and increases consumption. For Keynesians, however, changes in investment do not necessarily generate offsetting movements in consumption expenditures. Thus the aggregate demand schedule will be pushed to the left if exogenous investment falls, because at every price level fewer goods are demanded. Now let’s put the economy through its paces. Our objective is to see whether GDP is stable at full employment. Obviously, this depends on the behavior of the aggregate demand schedule, but it also depends on the shape of aggregate supply. Thus Figure 1 has the monetarist vertical aggregate supply curve, while Figure 2 has the simple Keynesian horizontal supply curve (S) as well as a somewhat more realistic upward-sloping supply curve (S ¿).

1Recall

that a decrease in the price level does not increase people’s real income directly, because a falling price level means both goods prices and factor prices (wages) are falling. Thus falling prices do not directly expand aggregate demand via a simple Keynesian consumption function argument.

426

An Aggregate Supply and Demand Perspective on Money and Economic Stability

Price level S'

S

P P'

D D'

Y

Y'

YFE Income

FIGURE 2

Keynesian response to declines in exogenous investment: Income falls below the full employment level.

Start with aggregate demand curve D in each figure, so that GDP is at the full employment level. Now ask what happens if businesses suddenly decide to invest less than they have been. From the monetarist view of Figure 1, the demand schedule, D, may simply stay put, in which case aggregate economic activity remains at YFE . Some other form of spending will increase to take the place of the drop in investment. But if the aggregate demand curve does shift to D ¿ in Figure 1, and the level of aggregate demand falls to Y at the old price level P, the resulting unemployed labor and unused capacity cause wages and prices to fall toward P ¿. As prices fall, the real quantity of money expands and aggregate demand increases along the new demand curve D ¿. Prices fall until demand is brought back into equality with aggregate supply at YFE . In the Keynesian presentation of Figure 2, the leftward shift from D to D ¿ most certainly takes place as a result of the fall in exogenous investment. If that happens, the story can end right there, when it has hardly begun. If prices are rigid even in the face of unemployment and excess capacity, the supply curve is S and aggregate demand and GDP remain at the depressed level Y. The monetarist incentive to increase spending—falling prices—never appears. The more realistic Keynesian case occurs when prices fall somewhat when production is below full capacity, and wages also decline but at a slower pace.

427

An Aggregate Supply and Demand Perspective on Money and Economic Stability

This produces an aggregate supply curve that looks like S ¿ in Figure 2.2 With supply curve S ¿, aggregate real output is above Y (where it would be if prices didn’t fall) but is still below full employment income, YFE. The problem is that wages and prices do not fall far enough to stimulate sufficient new aggregate demand along D ¿ to offset the decrease in exogenous investment. Note that in both of the figures, if the demand curve were flatter, the fall in prices would not have to be that large to encourage more aggregate demand along the new demand curve D ¿. This would also reflect the monetarist point of view: Falling prices with a fixed stock of money will generate full employment because aggregate demand is very sensitive to increases in real money balances. An important point to remember is that the upward-sloping Keynesian aggregate supply curve S ¿ is only a short-run relationship. Even Keynesians recognize that with production below full employment there will be continued downward pressure on wages. As wages fall more, there will be an incentive for producers to move back to full employment production. Eventually, therefore, the vertical aggregate supply curve of Figure 1 comes into the picture, even for Keynesians. But the essential message is that the entire process takes time, and during that time the aggregate supply curve is not vertical. Thus, Keynesians argue, we should try to push up aggregate demand by monetary and fiscal policies. To summarize: Monetarists tend to think that the aggregate demand curve is stable, given a particular money supply, and that the aggregate supply schedule is vertical. These conditions imply that exogenous shifts in investment leave GDP unchanged. Keynesians argue that the aggregate demand curve is quite sensitive to exogenous changes in investment and that the aggregate supply schedule is not vertical. These circ*mstances imply that entrepreneurial animal spirits buffet the level of real income.

Monetary Policy, Fiscal Policy, and Crowding Out Suppose the Keynesians are right and aggregate demand shifts to D ¿ when business people are discouraged and cut back on their investment expenditures. Let’s also put the economy into Figure 2 with the upward-sloping supply schedule S ¿. Thus the reduction in aggregate demand reduces income

2Here’s

one way of looking at why the supply curve is positively sloped. When wages (W) and prices (P) fall at the same rate, business firms’ real wage expense (W/P) remains unchanged and they will hire the same number of workers as before. On the other hand, if wages fall less than prices, then firms will fire some workers and cut back their output of goods and services. That is precisely the implication of the positive slope in supply curve S ¿ : When prices fall, the supply of real output declines below the level that would fully employ all labor (and capital). We will return to this issue in our discussion of inflation later in this chapter.

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An Aggregate Supply and Demand Perspective on Money and Economic Stability

to Y ¿. If we don’t want to wait for further price adjustments to set matters right, then something must be done to push up aggregate demand. Monetary and fiscal policies are the two discretionary tools available to government policymakers for precisely such circ*mstances. According to the monetarists, if the central bank increases the money supply, the aggregate demand schedule shifts to the right, reflecting increased demand for goods and services.3 The transmission mechanism of an increase in money to spending is direct. It isn’t necessary for extra cash balances to first go into the bond market (as with Keynesians), where prices are forced up and interest rates pushed down. Rather, there can be direct substitution between money and real goods. For Keynesians, on the other hand, an increase in the money supply may very well shift the aggregate demand schedule rightward, but the impact is less certain than for monetarists. The problem is that the transmission mechanism between money and spending is not quite so direct. According to Keynesians, falling interest rates can generate increased spending in a number of ways. The so-called cost-of-capital effect is the traditional impact of lower borrowing costs on the demand for investment goods. The wealth effect focuses on the impact of interest rates on securities prices: Lower interest rates mean higher bond prices, and people respond to such capital gains by consuming more. The exchange rate effect implies that with flexible exchange rates, lower interest rates drive down the value of the dollar on foreign exchange markets, increasing our net exports. Finally, the credit availability effect asserts that lenders may simply increase the amount of funds offered to borrowers, thereby permitting them to expand their spending plans. When all these channels of money to spending are operative, then the impact of expanding the money supply on aggregate demand is quite potent. But in this very specific outlook, there’s many a possible slip ’twixt the cup and the lip. The Keynesian answer to the somewhat less certain effects of monetary policy is to focus on fiscal policy to stimulate aggregate demand. We started out with a reduction in autonomous investment expenditure that pushed the aggregate demand curve to the left. A simple solution is to offset that decrease by exogenously increasing government spending or raising consumer expenditure by a discretionary reduction in tax rates. A monetarist questions whether any exogenous shift in expenditure, whether generated by business firms or by the government, influences aggregate demand. We saw earlier that, according to monetarists, interest rates would fall to counteract the effects of decreased investment on aggregate demand. A symmetrical argument maintains that interest rates will rise when

3Do

not be confused on this point. Increases in real balances caused by falling prices are reflected in the slope of the aggregate demand curve, because prices are on the vertical axis; increases in real balances caused by an increase in the stock of money shift the aggregate demand curve, because at each price level (on the vertical axis) more goods and services will be demanded (measured on the horizontal axis).

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An Aggregate Supply and Demand Perspective on Money and Economic Stability

government spending goes up. Thus the government spends more, but others— business firms and consumers—are induced to spend less because interest rates rise. This process has often been called by a special name: crowding out. Because in the past it has received considerable attention as a central issue dividing monetarists and Keynesians, it is worth some further elaboration. We begin by noting that, initially, an increase in government spending raises aggregate demand directly, before anything else has happened. But the public’s need for day-to-day transactions money is likely to rise along with aggregate demand. If the supply of money does not increase simultaneously, the public will find itself short of cash, will presumably sell off some financial assets to try to get additional money, and will thereby drive up interest rates. This crowding-out effect may inhibit private investment spending, at least partly offsetting the expansionary impact of the government’s spending. In brief, both the execution and the net impact of fiscal policy appear to be inextricably bound up with monetary implications. Moreover, it is especially important to consider how the government finances the increased expenditure (or the reduction in taxes). The Keynesian position on these matters is that any fiscal action, no matter how it is financed, will have a significant effect on aggregate demand. Keynesians do not deny that interest rates are likely to rise unless new money is forthcoming to meet cash needs for day-to-day transactions. Thus they admit that a government deficit financed by money creation is more expansionary than one financed by borrowing from the public, and that both are more expansionary than increased government spending financed by taxation. But higher interest rates have dual effects. They may reduce private investment spending, but they may also lead people to economize on their cash balances, thereby supplying part of the need for new transactions money from formerly idle cash holdings. As the monetarists see it, a fiscal deficit financed by selling bonds to the public will not affect aggregate demand. True, the government will be spending more. But others will wind up spending less. Net result: No change in total spending. The rise in government spending will initially increase aggregate demand. However, this will increase the demand for cash for transactions purposes and drive up interest rates, and bond sales to finance the government’s expenditures will drive up rates still further. The public will be buying government bonds and financing the government, instead of buying corporate bonds and financing business firms. Business firms will be crowded out of financial markets by the government. The rise in interest rates will reduce private investment spending by as much as government spending is increased, and that will be the end of the story. Government fiscal policy, unaccompanied by changes in the supply of money, merely changes the proportion of government spending relative to private spending. It is useful to summarize the monetary and fiscal issues with a chronological flavor. The first leg of the debate focused on Keynesian skepticism over

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An Aggregate Supply and Demand Perspective on Money and Economic Stability

Going out on a limb Are Bank Loans Special? There has been a long-simmering debate between some monetarists and Keynesians over whether bank loans matter. Most Keynesians feel that bank loans are special because borrowers at banks often have few alternative sources of funds. Therefore, an expansion or contraction of money supply associated with movements in bank loans will have more powerful effects on spending compared with money supply movements based on bank purchases or sales of securities. Most monetarists, on the other hand, argue that money is money, no matter how it comes about. The security seller receiving cash is just as likely to spend as someone who has taken out a bank loan. Empirical evidence leaves little doubt that bank borrowing is the major source of funds for small and intermediate-size businesses. Thus tight money that restricts bank lending is likely to squeeze these spenders out of the marketplace; they cannot turn to the money or bond markets to raise funds, as the IBMs of the world can. On the other hand, large firms can and do extend credit, called trade credit, to smaller firms, thereby providing indirect access to the money and bond markets. In addition, large firms compete with small firms, so that if the latter do less business, the former will make it up.

So, the question remains, are bank loans special? The answer: probably, at least in the short run. Large firms cannot fully replace small firms without substantial time for adjustment. Moreover, small firms prefer bank loans to trade credit because bank loans are cheaper. Thus an expansion or contraction in money supply associated with movements in bank loans has a more powerful effect on spending than a monetary expansion or contraction based on bank purchases or sales of securities. Other factors besides monetary policy may affect this “loan channel.” For example, some evidence indicates that bank regulators may have overreacted during the 1990 to 1992 recession, fearing a repeat in the banking industry of the saving and loan industry debacle of the 1980s. Excessive regulator scrutiny of banking may have caused a credit crunch in bank lending by encouraging banks to contract the supply of credit to small and mid-size companies. The sub-prime mortgage crisis, which began in the fall of 2007, may also have a negative impact on the supply of credit. Subprime loan losses may cause banks to lend less to small and midsize business as banks attempt to contract their balance sheets.

whether changes in the money supply influenced aggregate demand. The next step was the monetarist counterattack on fiscal policy because of crowding out. And just as the respective positions on these items came under control, a third, as yet undiscussed, issue emerged as a focal point of concern: whether countercyclical policy has any impact on spending at all. The problem usually focuses on whether countercyclical movements in the money supply are anticipated and whether such anticipations lead to expected inflation and hence neutralize the money supply changes. To deal with this latest development properly, we first turn to issues of inflation and countercyclical policy. In the next chapter we extend the discussion to include rational expectations.

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An Aggregate Supply and Demand Perspective on Money and Economic Stability

Inflation, Money, and the Phillips Curve The first issue dividing monetarists and Keynesians is whether or not inflation is purely a monetary phenomenon. This issue turns on what influences the aggregate demand schedule. This is evident in Figure 3, which shows that if we start at full employment (where we always tend to be), with aggregate demand D and price level P, anything pushing demand to D ¿ and D – raises prices to P ¿ and P –. The dynamics of P rising to P ¿ and then P – is precisely what we mean by inflation: rising prices. Thus monetarists contend that since the aggregate demand schedule is likely to be stable at D unless the money supply changes, the main culprit behind shifts to D ¿ and D – is the Federal Reserve. Keynesians, on the other hand, are not so quick to blame the Fed when inflation gets out of control. Any group of suddenly overexuberant spenders— government, business, or consumers—can push up aggregate demand and generate increases in prices. Obviously, the Keynesian position permits the blame for inflation to be attributed to expanding government deficits when the economy is at full employment. Monetarists, on the other hand, cannot rail against deficits per se as causing inflation. Only if the deficit induces the Federal Reserve to expand the money supply will inflation follow. Shifts in the aggregate supply schedule can also be charged with generating inflation. In fact, the so-called cost-push variety of inflation forces up

Price level S

P"

P'

P

D" D' D YFE Income

FIGURE 3

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Anything shifting aggregate demand to the right causes inflation.

An Aggregate Supply and Demand Perspective on Money and Economic Stability

prices precisely because it shifts the supply schedule in Figure 3 to the left. Higher input costs (such as spikes in oil prices) restrict production, producing a period of rising prices. But monetarists stress that such a once-and-forall “supply shock” cannot account for persistent inflation; it is more of a one-shot deal. A second issue dividing monetarists and Keynesians on inflation concerns the possibility of a trade-off between inflation and unemployment. Keynesians have supported the notion of a trade-off, known as a Phillips curve after Professor A. W. Phillips, who popularized the relationship. The Phillips curve suggests that lower rates of unemployment could be obtained if only we were willing to tolerate a faster rate of increase in prices.4 Monetarists deny that there is a permanent trade-off between inflation and unemployment, arguing instead that once inflation was incorporated into people’s expectations, the unemployment rate would return to its “natural” level. Once again we can explain the underlying conflict in terms of our aggregate supply/demand framework, but this time the issue turns on the shape of the supply function. Figure 3 is the monetarist picture: a vertical supply curve showing no change in GDP when higher aggregate demand causes prices to increase, hence no Phillips curve trade-off between inflation and unemployment. Figure 4 is the Keynesian picture: a positively sloped supply curve showing that as prices rise because of shifts in aggregate demand, real output expands beyond YFE. This higher level of income is produced by reducing the unemployment rate below what is normally considered full employment. Or, more generally, more inflation means less unemployment, as in the Phillips curve.

4The

original article describing the relationship is “The Relation Between Unemployment and the Rate of Change in Money Wages in the United Kingdom, 1861–1957,” Economica (1958). The graph of a Phillips curve looks like this:

Inflation rate 12% 10% 8% 6% 4% 2% 2% 4% 6% 8% 10% Unemployment rate

The negatively sloped curve shows that lower rates of unemployment are associated with higher rates of inflation.

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An Aggregate Supply and Demand Perspective on Money and Economic Stability

Price level S

P"

P' P D" D' D YFE

Y'

Y" Income

FIGURE 4

Inflation causes higher income (and lower unemployment) with a positively sloped supply curve.

This situation, unfortunately, requires some explaining in terms of worker behavior, wage-price lags, and inflationary expectations. Rest assured, however, that we will expose you to only the bare minimum (we really don’t know very much more ourselves). The key to the debate focuses, once again, on whether the aggregate supply curve is vertical or positively sloped. A positive slope implies that real output varies positively with the price level. Our discussion back in footnote 2 showed that output varies positively with prices when wages change more slowly than prices. And that’s reasonable, according to Keynesians, because many wage rates are set contractually, and contracts are not adjusted continuously. What this means is that when the price level falls, declining wages lag behind falling goods prices, and the real value of labor’s compensation increases. That’s why fewer workers are employed and less is produced when the price level declines. The other side of the coin is that when the price level rises, wages increase more slowly than prices, labor’s real compensation falls, more workers are hired, and GDP goes up. And that’s why the Keynesian picture shows a trade-off between inflation and unemployment. Monetarists have emphasized, and economists of all persuasions now recognize, that a lower real wage cannot permanently induce workers to spend less time playing tennis and more time at the factory or behind the desk. Thus, after a while, labor will demand that wages be adjusted upward. Some workers may feel reluctant to do so right away because of a long-run contractual

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An Aggregate Supply and Demand Perspective on Money and Economic Stability

relationship with their employer, one that transcends what could be only a temporary erosion in the value of their paychecks. But as the inflation reality sinks in and workers come to expect a permanently higher rate of inflation, their wage demands become more vociferous. Wages will be pushed up by competitive pressure among employers. But once wages catch up to the higher rate of price increase, there is little incentive for business firms to produce more than they started with. Thus production eventually returns to YFE and unemployment goes back to what is normally considered a full employment rate. What we have just described is a slow but steady transition from the upward-sloping supply curve in Figure 4 to the vertical aggregate supply curve in Figure 3. Thus, after everything has adjusted, including inflationary expectations and labor-business contractual agreements, the aggregate supply curve must be vertical. In other words, the Phillips curve eventually must show no trade-off between inflation and unemployment. One of the main questions is, of course, how long can a temporary situation last? A more intriguing possibility is that if everyone knows that the trade-off is temporary, it may not even get started! In the next chapter we return to this discussion within the framework of rational expectations. For now let’s turn our attention to the consequences of inflation and inflationary expectations for the level of interest rates.

Inflation and Interest Rates Inflationary expectations are crucial to explaining how interest rates respond to changes in the money supply. In this area, however, we cannot appeal to the aggregate supply/demand framework for expositional help. English will have to suffice (sorry; we don’t like it any more than you do). Milton Friedman has argued that an expansionary monetary policy raises interest rates and a contractionary monetary policy lowers interest rates—just the reverse of standard Keynesian analysis. How does Milton do it? Here’s the point: An increase in the money supply may initially lower interest rates, if the increased liquidity is spent on financial assets. But that is only the beginning. Once aggregate demand responds to the increased money supply (as it must in the monetarist world), the transactions demand for money will increase, thereby driving interest rates upward. But this is hardly new. Mainstream Keynesians certainly wouldn’t disagree. The monetarists argue, however, that the “income effect” of the increased money supply will overwhelm the initial “liquidity effect,” so that the interest rate will snap back past its original level. If pressed on this last point, Keynesians might even acquiesce again. After a while interest rates could pass the original equilibrium, but it all depends on the speed and strength of the response in GDP to monetary expansion. Keynesians would focus their attention on the interim period—before GDP expands. And this interim period is sufficiently long to justify the statement: Expansionary

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An Aggregate Supply and Demand Perspective on Money and Economic Stability

monetary policy means lower interest rates, and contractionary policy means higher rates. But there’s more to the monetarist story, namely, inflationary expectations. In particular, if expectations of inflation are generated by an expansionary monetary policy, then this will cause a further increase in the level of nominal interest rates. The reason is as follows: Suppose that when the expected rate of inflation is zero, the equilibrium interest rate is 5 percent. If lenders expect prices to rise by 2 percent during the next 12 months and want to receive 5 percent in real terms, they will demand 7 percent from borrowers. As long as borrowers expect the same rate of inflation, they will go along with the higher nominal rate of interest. After all, if they were ready to pay 5 percent with no inflation, they should be equally eager to borrow money at 7 percent with 2 percent inflation—they will be paying off the loan in “cheaper” dollars.5 What might lead both borrowers and lenders to expect inflation and then arrive at a higher nominal rate of interest? You guessed it—an expansionary monetary policy. When such inflationary expectations are tacked onto the income effect, monetarists contend that it is virtually certain that these two will dominate the initial liquidity impact and expansionary monetary policy will lead to higher nominal interest rates. An analogous argument can be made for contractionary monetary policy lowering interest rates. Notice, by the way, that the distinction between real and nominal rates is crucial in these arguments. Increases in money lead to inflation via the quantity theory. The real interest rate is determined by savers and investors. They “pierce the veil” of money and refuse to let inflation interfere with their agreedupon real rate of interest. Thus when the “inflation premium” described by Irving Fisher is added to the real rate, we see that increases in money supply raise the nominal rate of interest. Therefore, Milton Friedman, with an assist from Irving Fisher, concludes that an expansionary monetary policy raises interest rates. The story just told, of nominal interest rates rising because of the inflationary expectations generated by expansionary monetary policy, can take on still another dimension. In particular, if policymakers are expected to increase the money supply in an effort to lower interest rates, there will, in fact, not even be any temporary liquidity effect on real interest rates, since such anticipated money stock movements will have already been incorporated in portfolio decisions. For example, the liquidity effect of the anticipated increase in money stock will have already raised bond demand to take advantage of anticipated capital gains; thus no further bond price increases occur when the

5Borrowers

would like to pay only 5 percent. But competition for funds forces them to pay what lenders demand, unless they are willing to pass up some investment projects. But inflation will increase the expected dollar returns on investments, so that if a project was worth undertaking before it would be just as worthwhile with inflation and the higher nominal interest rate.

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money stock actually increases. All that’s left is the quantity theory effect, which says that increases in money stock raise prices. Thus the anticipated rate of inflation generated by expansionary monetary policy pushes up nominal interest rates. There simply aren’t any intermediate steps.6 Although the expectations story sounds convincing, remember that Keynesians argue that the simple quantity theory operates only at or near full employment. At lower levels of economic activity, there is considerable slippage between money and prices. Even near what we designate as full employment there are wage and price rigidities because of contractual arrangements that interfere with any proportional relationship between money and prices. Most observers contend, therefore, that it takes time for the inflation premium to be fully reflected in nominal interest rates. In the short run, lenders may have to settle for lower real interest rates. Instead of the nominal rate rising by 2 percent in our example above, it may rise by less, and therefore the real rate would fall somewhat when expected inflation jumped by 2 percent. Eventually, as lenders adjust their cash balances and borrowers alter their investment plans, the real rate returns to its long-run equilibrium level and the nominal rate rises above the real rate by the full expected rate of inflation. How long is the long run? Ah, if we only knew the answer to that question, how simple life would be. We get closer to Irving Fisher’s result even in the short run—say, within six months—as the delay in borrower and lender reactions gets shorter. Furthermore, when expectations of inflation respond quickly to economic forces, the Fisher result is likely to occur still more quickly. On the other hand, when delays are long and expectations of inflation respond slowly, then it takes longer for nominal rates to rise by the full amount of the expected inflation. As a general rule, it is a good bet that an increase in nominal rates of interest will closely follow a jump in inflationary expectations, but nominal interest rates are unlikely to respond immediately by the full amount Fisher suggested. Can we really be this far into a book on money and not be sure which way interest rates respond to monetary ease or stringency? Yes and no—unequivocally. We can summarize the discussion as follows. An increase in the money supply will immediately reduce both the nominal rate and the real rate of interest because of a liquidity effect. As inflationary expectations respond to the monetary expansion, nominal rates are driven up but by less than the inflationary surge. Thus the nominal rate could very well be above the original level of nominal (and real) rates while the real rate can be below it. After borrowers and lenders have completed all their adjustments, the real rate of interest will be back where we started and the nominal rate will have

6This

discussion has applied the rational expectations argument to interest rates. More on this in the next chapter.

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An Aggregate Supply and Demand Perspective on Money and Economic Stability

increased by the expected rate of inflation.7 So now you can answer just about anything you want to the question of what happens to interest rates when the money supply expands, as long as you keep the real and nominal straightened out (don’t worry, not many people can do that). To really confuse matters you might try to explain how decreases in the money supply produce an opposite set of results.

Should a Robot Replace the Federal Reserve? We started this chapter with a discussion of whether the private sector is inherently stable. If the self-correcting mechanisms described above operate properly, there is little need for active monetary and fiscal policies to prevent economic fluctuations. In fact, these stabilizing mechanisms form the foundation for the monetarist argument against government attempts at fine-tuning the economy. It’s simply not needed. Keynesians claim that since the strength of these self-correcting forces is uncertain, we should use countercyclical monetary and fiscal policies to help ensure full employment production. They implicitly assume that attempts at leaning against the economic trends—expansionary policy in recessions and contractionary policy during inflations—can only help. The problem is that attempts at countercyclical policy can actually wind up causing greater instability than would have otherwise been the case. Milton Friedman was the first to point out the potentially destabilizing impacts of government countercyclical policy. To explain the argument we must recognize that the effects of changes in monetary policy or fiscal policy take time to work themselves out. In particular, there are lags in the impacts of monetary and fiscal policy on GDP. The empirical evidence on lags is presented later. For now it is sufficient to recognize that it takes time for changes in interest rates to alter business spending decisions and it takes time even for households to adjust their consumer expenditures to increased disposable income. In a moment we will see that putting this little addendum on lags together with our aggregate demand story, we are able to show the potential damage of stabilization efforts. An alternative philosophy—rules rather than discretion—is proposed by monetarists to mitigate the problem. Assume that the Federal Reserve forecasts a recession six months from now. If the forecast is correct, and if a current expansion in the money supply

7The

fact that expansionary monetary policy cannot reduce interest rates permanently explains why it is impossible for the central bank to make Congress happy by forcing down the cost of credit. It also explains why bondholders will not be forever wealthier because of increases in the money supply.

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GDP Tight money imposed

The business cycle as it does exist because of monetary policy

Impact of easy money

Easy money imposed

Impact of tight money

The business cycle as it would exist without monetary policy

Time

FIGURE 5

Friedman’s alleged perverse effects of countercyclical monetary policy.

would have an impact six months hence, well and good. But what if the Federal Reserve’s crystal ball is not clear, and it is more than a year before the main impact of today’s monetary policy is reflected in the economy? Then the effects of today’s expansionary monetary policy are likely to be felt after the economy has passed the trough and is already on its way up. As Figure 5 illustrates, the impact of today’s easy money may exacerbate tomorrow’s inflation. Tight money will have similarly delayed effects; it may be imposed with the best of intentions, to curtail a boom, but its real impact, being delayed, might accentuate a recession. Monetary policy is a destabilizer rather than a stabilizer! On these grounds—the precarious nature of economic forecasting and the alleged length, variability, and unpredictability of the time lags involved— monetarists have given up on orthodox monetary policy. Friedman argues that the economy has been and is now inherently stable and that it would automatically tend to stay on a fairly straight course, as Figure 5 indicates, if only it were not being almost continuously knocked off the track by erratic or unwise monetary policies. Conclusion: Quarantine the central bank. The best stabilization policy is no stabilization policy at all. Hasn’t it all been said before: They also serve who only stand and waite. John Milton

What monetarists propose instead is that the Federal Reserve be instructed by Congress to follow a fixed long-run rule: Increase the money supply at a steady and inflexible rate, month in and month out, year in and year out,

439

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Price level S

S' D'

D

S" D"

P

YFE

Y'FE

Y"FE Income

FIGURE 6

Aggregate demand and supply shifting together over time according to a fixed monetary rule.

regardless of current economic conditions. Set the money supply on automatic pilot and then leave it alone. The specific growth rate—3, 4, or 6 percent—is less important than the principle. Once a figure is decided upon, no tinkering is permitted. In point of fact, the actual money supply growth rate is intended to keep prices stable and employment high by allowing aggregate demand to grow at the same rate as the economy’s real productive capacity. This is illustrated in Figure 6 with our by now familiar aggregate supply and demand framework. But in this context, we allow the aggregate supply curve to shift rightward to reflect growth in productivity, capital, and the labor force. Stable prices and full employment will be achieved when growth in the money supply pushes the aggregate demand schedule to the right along with aggregate supply (as in Figure 6). The main advantage of a rule is that it would eliminate forecasting and lag problems and therefore remove what monetarists see as the major cause of instability in the economy—the capricious and unpredictable impact of discretionary countercyclical monetary policy. As long as the money supply grows at a constant rate each year, be it 3, 4, or 6 percent, any decline into recession will be temporary. The liquidity provided by a constantly growing money supply will cause aggregate demand to expand. Similarly, if the supply of money does not rise at a more than average rate, any inflationary increase in spending will burn itself out for lack of fuel. Discretionary deviations by the

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central bank would interfere with the natural course of the economy and only make matters worse. The U.S. Congress has been impressed enough to come part of the way toward a rule, in preference to allowing the Federal Reserve to rely entirely on its own judgment and discretion. In March 1975 both the House of Representatives and the Senate passed House Congressional Resolution 133, which instructed the Federal Reserve to “maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production.” In November 1977 this provision was incorporated into the Federal Reserve Act itself. Whether one believes in a fixed rule or not, such requirements have surely been beneficial. They have forced the Fed to assess its policies continuously in quantitative terms without shackling it with an inflexible formula. The objective is smoother monetary growth and the elimination of the extremely high (and extremely low) monetary growth rates that have often had harmful effects in the past. Some proponents of activist stabilization policies argue that as long as there are some immediate impacts of policy on GDP, past errors of timing can be corrected. Thus expansionary monetary policy that acts too slowly to forestall a recession can be prevented from exacerbating the next round of inflation by a still more restrictive monetary policy. This possibility argues against a rule that would tie the hands of the stabilization authorities. Of course, the problem here is that ever-larger doses of stimulus or restraint might be required to offset the detrimental lagged consequences of past policy. And that means that slight miscalculations might leave the system vulnerable to an explosion in either direction. It is instructive that in the final analysis the extremists from both camps, monetarist and Keynesian, have collectively ganged up on the Federal Reserve. The extreme monetarists want to shackle it, because their concern with time lags leads them to believe it is both mischievous and harmful, and the extreme Keynesians want to subordinate it to fiscal policy. In the middle, squabbling but making more common cause than they had thought possible, are the moderates: moderate monetarists, who believe that the forecasting-lag problem is not so great as to negate all the stabilizing effects of countercyclical monetary policy, and moderate Keynesians, who believe that monetary policy has a powerful impact on spending and should be used along with fiscal policy with considerable caution. It seems clear, after all is said and done, that central banking is still at least as much art as science. We simply do not know enough yet to legislate an eternal rule, or even a rule for the next six months, that the Federal Reserve must follow under any and all circ*mstances. Meanwhile, for better or worse, we appear to have no alternative but to rely on our best knowledge and judgment in the formulation of monetary policy. We can only try to make sure that the decision makers are able and qualified men and women with open minds and the capacity to learn from experience.

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SUMMARY 1. The monetarist argument that the private sector is inherently stable stems from the automatic tendency for falling interest rates and prices to raise aggregate demand whenever exogenous spending falls. Keynesians claim that in the short run wages are less flexible than prices and that therefore exogenous shifts in aggregate demand will produce variations in GDP.

2. Monetarists claim that the transmission mechanism between money and spending is direct. Additional cash balances are spent directly on real goods and services. According to Keynesians, however, the linkage between money and spending occurs through the interest rate, and in this case there is room for considerable slippage.

3. Keynesians contend that fiscal policy has a direct and powerful impact on spending. Monetarists claim that much of the expansionary impact of fiscal policy disappears because rising interest rates crowd out private investment.

4. Inflation is basically a monetary phenomenon, according to monetarists, because aggregate demand depends primarily on the money supply. Keynesians claim that fiscal policy or other exogenous spending can cause inflation as well.

5. The existence of a Phillips curve trade-off between inflation and unemployment depends upon the lags of wages and expectations behind changes in the price level. Even Keynesians would agree that in the long run there is no trade-off, but in the short run there is considerable disagreement.

6. Real interest rates initially fall after an increase in the money supply, but once inflationary expectations take hold, nominal rates rise. After a while the real rate will return to its original level, but as long as inflationary expectations remain, the nominal level of rates will be higher.

7. The monetarist case for a fixed rule to circ*mscribe stabilization policy stems from the possibility that the lagged effects of policy changes might cause greater instability in GDP. The key problem is accurately anticipating the timing of policy impacts on aggregate demand. Monetarists propose a fixed rule to prevent destabilizing effects. Keynesians believe the inflexibility imposed by a rule cannot be justified, given the present state of knowledge about the impact of policy on demand.

8. Many of these monetarist-Keynesian arguments can be traced to differing views of the aggregate supply and demand curves. Monetarists tend to believe aggregate demand is stable once money supply is fixed; Keynesians see no reason to assume such stability. Monetarists say the aggregate supply curve is usually vertical; Keynesians claim it is horizontal some of the time and upward sloping much of the time.

KEY TERMS countercyclical monetary and fiscal policy

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Phillips curve

An Aggregate Supply and Demand Perspective on Money and Economic Stability

QUESTIONS Questions with a red oval are in

at www.myeconlab.com.

26.1

How does the slope of the aggregate supply curve help determine whether GDP will be stable at full employment?

26.2

What is the Phillips curve, and how is it related to the aggregate supply curve?

26.3

Does an increase in money supply increase interest rates or decrease interest rates? (Hint: Be careful to identify real versus nominal interest rates.)

26.4

What is meant by crowding out? How many different types of crowding out can you identify?

26.5

Why should the money supply grow in the long run?

26.6

Discussion question: Do you believe we would be better off with a monetary policy that follows a fixed rule for money supply growth? Explain why we do not (and are not likely to) have one.

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Rational Expectations: Theory and Policy Implications

From Chapter 27 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

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Rational Expectations: Theory and Policy Implications Rational expectations, ice cream, and apple pie have at least one thing in common: It’s hard to be against them. But the similarity ends there, because the implications of rational expectations are far more controversial than either of the other two—even if you’re serious about counting calories. In a discussion of the monetarist and Keynesian viewpoints, expectations cannot be far from the surface. We see that inflationary expectations are crucial determinants of the nominal interest rate. We also see how inflationary expectations enter into wage agreements and thereby influence the shape of the aggregate supply curve and hence the Phillips curve trade-off between inflation and unemployment. Finally, we see that expectations of monetary policy actions can affect the timing of interest rate responses to changes in the money supply. In all these earlier discussions we never were very particular about how these expectations were formulated. Implicit in most discussions was the assumption that expectations of the future are based on the past: If price increases have been accelerating, for example, then inflation is expected to get worse. As it turns out, this seemingly innocuous formulation of expected inflation is not terribly rational, because it ignores other pieces of information that might be important to a proper estimate of future inflation. The first order of business, therefore, is to describe precisely what is meant by rational expectations. We then turn to the implications for monetary and fiscal policy, the ability to control inflation, and the consequences for interest rates.

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LEARNING OBJECTIVES In this chapter you will learn to differentiate between rational and adaptive expectations explain why monetary policy is ineffective under rational expectations realize the importance of central bank credibility under rational expectations define monetary policy’s influence on interest rates under different expectations regimes

When Are Expectations Rational? If people use all available information to formulate expectations (of prices, interest rates, money supply, or anything else), then their expectations are considered rational. If people ignore information, then expectations are not rational. People are likely to be rational in formulating their expectations, because ignoring something is usually costly. For example, ignoring the news report of a freeze in Florida in formulating your expectation of orange juice prices next month is likely to cost you money. A rational forecast would suggest stocking up on orange juice before prices go up. Ignoring the information and relying on recent price trends to guide your spending plans will lead to inferior results. Thus people have strong incentives to make rational forecasts and can be relied upon to act accordingly. If our models are to describe economic activity accurately, then the behavioral relationships must be based on rational expectations. Let’s examine in somewhat greater detail how inflationary expectations are formulated. Extrapolating recent price trends is often referred to as adaptive expectations. Thus if inflation has been on the rise, adaptive expectations suggest that people expect inflation to continue to go up. But if at the same time that inflation is increasing the Federal Reserve restricts the money supply, and people are aware of this policy, then on the basis of their knowledge of how the economy works, people would probably expect the inflation rate to go down rather than up. Such expectations would be considered rational because they include information—what is happening to the money supply— that is relevant for properly forecasting inflation. Moreover, people will utilize that information, because spending, investing, and business decisions depend upon inflation forecasts. If inflation is expected to go down, certain job opportunities become more or less attractive, some investments become more or less attractive, and so on. Notice that rational inflationary expectations include at least two items that were ignored by the less rigorous adaptive approach to forecasting: the behavior of the monetary authority and the structure of the economy. Since knowledge of what policymakers will do and what economic models suggest are the consequences of such actions is potentially important for the future course of prices, it is crucial that rational expectations incorporate that information.

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The reason is not that we say so but that people will find it optimal (and profitable) to behave according to rational expectations.

Anticipated Versus Unanticipated Monetary Policy Perhaps the most stunning implication of rational expectations is that when it is combined with the classical world’s assumption of completely flexible wages and prices, the result is that an anticipated monetary policy will have no impact on economic activity. The argument is complicated, so we will have to pay attention. It goes like this. Recall from the last chapter that the positively sloped aggregate supply curve implies that faster money supply growth leads to higher output and less unemployment as long as wages go up more slowly than prices. The argument is straightforward: If wages go up more slowly than prices it will pay business firms to hire more workers when prices of their products rise. The problem is that workers will permit their wages to rise more slowly than prices only as long as their inflationary expectations lag behind actual inflation. People will not work more if they expect a decline in their real wages (money wages adjusted for inflation to provide a measure of the goods and services the money wages can buy). But according to rational expectations, workers recognize the connection between inflation and money supply growth. Thus if we start with an anticipated increase in the money supply, then the subsequent inflation will also be anticipated. And in that case, inflationary expectations keep pace with actual inflation and, because wages and prices are completely flexible, workers make sure that wages move up simultaneously with prices. Under those circ*mstances there won’t be any

Off The Record Applying Rational Expectations to the Securities Markets It makes considerable sense to apply the principle of rational expectations to securities prices. Every scrap of information is likely to be exploited in formulating expected bond prices or stock prices, because there are direct, and often immediate, profit opportunities available in acting upon such information. This idea has an interesting implication for current securities prices: They will reflect all currently available information. For example, suppose a secret Federal Reserve document describing a surprise reduction in money supply growth was discovered in a Washington, D.C., trash can and was then published in the

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Wall Street Journal. Since a less expansionary monetary policy would lead to less inflation and lower nominal rates of interest, hence higher bond prices in the future, the demand for bonds would increase right now and bond prices would rise until there was no longer an opportunity to earn a profit. Thus the information about the Federal Reserve’s new policy would be incorporated in bond prices immediately upon its release. In other words, securities prices fully reflect all available information. Thus the application of rational expectations to securities markets produces what we called efficient capital markets.

Rational Expectations: Theory and Policy Implications

Price level

S(Pe2) S(Pe1)

2 P2

1

P1

D2

D1

YE Income

FIGURE 1

Anticipated monetary policy shifts aggregate supply along with aggregate demand, leaving GDP unchanged.

increase in output or reduction in unemployment as a result of the anticipated increase in the money supply. Note that if the money growth is not anticipated, the increased aggregate demand leads to higher prices that are not anticipated. Wages do, in fact, lag behind prices, and business firms hire more workers. The result: higher output and lower unemployment when money supply growth is not anticipated. It is possible to illustrate the entire story within the aggregate supply and demand model as long as we remember to label each aggregate supply curve with the appropriate expected price level. In Figure 1 start with aggregate demand curve D1 and aggregate supply curve S(P e1), where P e1 indicates that the expected price level is P1. The equilibrium price level given by the intersection point between D1 and S(P e1) is P1 and equilibrium income is YE. An increase in the money supply shifts D1 to D2 and would raise output above YE if the aggregate supply curve remained S(P e1). But if the change in money supply is anticipated, the aggregate supply curve no longer is S(P e1) because the increased money supply is expected to increase the price level above P1. The new aggregate supply curve under rational expectations is S(P e2), where the new equilibrium price level is equal to P2. Thus the end result of an anticipated change in the money supply is an unchanged level of economic activity and a higher price level.1 proof that the new aggregate supply curve must be exactly S(P e2) is fairly complicated. It is based on the notion that the expected price level P e2 must be consistent with the actual new equilibrium price level P2, and that neither has any tendency to change. This will occur where the level of output YE has no tendency to change as well; that is, YE is the full employment level of output.

1The

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Implications for Stabilization Policy The distinction between anticipated and unanticipated monetary policy takes on still greater significance once we recognize that stabilization policy usually falls under the category of anticipated policy. If unemployment begins to rise and the Federal Reserve is known to pursue countercyclical monetary policy, then everyone expects the Federal Reserve to expand the money supply. As long as wages and prices are flexible, however, the expansion in money supply will lead to higher prices. Because people are aware of these relationships, expected inflation occurs simultaneously with the expansion in money supply, wages move up in tandem with prices, and the impact of the expansionary monetary policy on real economic activity is neutralized. The cruel facts of rational expectations are that only random acts by the central bank—“erroneous” increases or decreases in the money supply—influence the level of economic activity. Systematic policies are useless. From this perspective, the discussions in the last chapter on rules versus discretion and whether the Federal Reserve should be a robot are irrelevant. No matter what systematic decision rule the Fed follows, it will not influence real economic activity—for better or worse. The outcome of the rational expectations world is decidedly classicalmonetarist rather than Keynesian. Although rational expectations do not necessarily support Milton Friedman’s contention that the attempt at economic stablization is destabilizing (since any systematic policy is neutralized), the close connection between money supply and inflation and the inherent stability of the economy at full employment are monetarist-classical propositions. Rational expectations theory is sometimes considered the main component of the new classical macroeconomics. But all is not lost for proponents of Keynesian thinking. Rational expectations combined with contractual rigidity in wages and prices modify the stark conclusions just described. In particular, even though inflationary expectations follow directly from expansionary monetary policy, and even though countercyclical policy will be anticipated, wages and prices are not determined by an auctioneer. Unlike prices of stocks and bonds, wages are frequently set by contractual agreement. If that’s the case, then wages may very well lag behind prices even if expectations of inflation are formed rationally. Somewhat more concretely, even when workers expect inflation to rise, they do not force up their wage demands instantaneously. Similarly, even if business firms expect a decrease in inflation, they do not reduce wages paid instantaneously. These sluggish adjustments are part of the implicit and explicit contractual arrangements in labor markets. Without instantaneous adjustments in wages to reflect expected inflation, the positively sloped aggregate supply curve does not shift to the left in Figure 1. Thus when D1 shifts to the right, the equilibrium level of output does, in fact, increase. From our new perspective these results occur not because expected inflation lags behind actual inflation—rational expectations do not permit that—but

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because contractual wages simply do not rise as fast as prices. Corporations hire more workers and output rises until the contractual arrangements run their course. The battlefield between monetarists and Keynesians over the effectiveness of stabilization policy has shifted once again. Instead of inflationary expectations, the area of contention now is labor contracts and rigid wages. For some reason, that has a familiar ring to it. And for good reason, because wage rigidity is exactly where Keynes and his classical mentors originally parted company.

Inflation, the Phillips Curve, and Credibility There is a controversy over the Phillips curve: Keynesians argued that a tradeoff existed between inflation and unemployment, while monetarists claimed that there was no long-run trade-off. The key was the shape of the aggregate supply curve and whether inflationary expectations lag behind actual inflation. According to the Keynesians, the aggregate supply curve is positively sloped because expectations of inflation adjust more slowly than actual inflation to changes in underlying economic activity. Under such circ*mstances, policymakers could increase the level of economic activity and reduce unemployment as long as they were ready to tolerate an increase in the rate of inflation. Monetarists argued that in the short run this might be so, but after expectations have adjusted, the aggregate supply curve is vertical and no permanent trade-off is possible. The rational expectations story pushes the monetarists’ long-run analysis into the short run by transforming a series of upward-sloping aggregate supply curves into a vertical one. We begin, once again, with a change in the money supply that is fully anticipated. The increased money supply shifts the aggregate demand curve to the right. But as we saw in Figure 1, if wages and prices are flexible, whenever the Federal Reserve embarks on an expansion in the money supply, the rightward shift in aggregate demand is met by a leftward shift in aggregate supply. In Figure 2, we illustrate these simultaneously shifting aggregate supply and demand curves that leave income and output at the “natural” full employment level YFE. The simultaneous shifts in aggregate supply and demand occur because the expansionary monetary policy that shifts D1 to D2 to D3 produces rational inflationary expectations that shift S(P e1) to S(P e2) to S(P e3). The equilibrium points in Figure 2 show an unchanged level of output at YFE combined with ever-increasing price levels. The result is that even though we have individual positively sloped aggregate supply curves, the outcome of a countercyclical monetary policy is a de facto vertical aggregate supply curve produced by simultaneous shifts in S and D. Thus policymakers are not confronted by a Phillips curve trade-off between inflation and unemployment, because the positively sloped aggregate supply curve does not stay put.

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Price level S(Pe3) P3

S(Pe2) S(Pe1)

P2 D3 P1

D2 D1

YFE Income

FIGURE 2

Anticipated monetary policy can affect only the price level.

Keynesians, of course, would respond that as long as wages and prices are set contractually, shifting aggregate supply curves would not eliminate the Phillips curve trade-off between inflation and unemployment. Even under rational expectations, the contractual rigidities remain and provide policymakers with an avenue for influencing real economic activity. For those of you with a soft spot for policy-making, do not think that a Phillips curve is necessary to provide a meaningful life. Although the absence of a trade-off between inflation and unemployment under rational expectations (with flexible wages and prices) deals a devastating blow to policymakers trying to reduce unemployment, it creates a pleasant surprise for the inflation fighters. In particular, reducing inflation is accomplished painlessly. Let the central bank embark on a contractionary monetary policy and make certain that everyone knows about it. As long as the Federal Reserve’s policy is credible, the leftward shift in the aggregate demand schedule produced by a reduction in the money supply is accompanied by a rightward shift in the aggregate supply curve. For example, if we start in Figure 2 with S(P e3) and D3 and price level P3, the reduction in money supply shifts D3 to D2. Since everyone now expects the lower price level P2, the aggregate supply curve also shifts to S(P e2). The economy moves from price level P3 to price level P2 painlessly—without any decrease in economic activity and without any increase in unemployment.

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In the News Laureate Phelps This week, the Royal Swedish Academy of Sciences announced the winner of the 2005 Nobel Prize in economic science: Edmund S. Phelps, of Columbia University. He earned the prize “for his analysis of intertemporal tradeoffs in macroeconomic policy.” That’s fancy language for two main contributions. The more important of the two was Mr. Phelps’s work on the tradeoff between unemployment and inflation. In the early 1960s, most economists believed that the tradeoff was stable. Government policy makers, according to this view, could pick a combination of inflation and unemployment as if they were ordering from a menu. But in the late 1960s, Mr. Phelps challenged this view by going back to basics— that is, by considering how individual employees and employers act. He assumed that employees would act based on their expectations of future inflation. If they expected, say, 3 percent inflation, they would build this into their wage bargains. But what if the Federal Reserve printed money at a rate that caused a 5 percent inflation rate?

Then with this higher inflation rate, wages offered would be higher than expected also. Unemployed workers looking for work would see wages that they would mistakenly think were higher in real terms and would, therefore, accept jobs at these wages sooner than otherwise. Millions of unemployed workers taking jobs just a few weeks earlier would result in a lower unemployment rate. But then workers’ expectations would adapt to reality. They would realize that the wages weren’t as high in real terms as they had thought, and some would quit and look for more lucrative work, thus slowly raising the unemployment rate. In other words, policy makers could temporarily reduce the unemployment rate by making inflation higher than people expected, but could not achieve a long-run reduction in unemployment with an increase in inflation. In the long-run, then, there is no tradeoff between inflation and unemployment. This striking finding is now mainstream economic wisdom. Source: David R. Henderson, Wall Street Journal (Eastern edition). Oct. 12, 2006, p. A.18. “Laureate Phelps” October 12, 2006. Reprinted from The Wall Street Journal © 2006 Dow Jones & Company.

The key to this happy result is credibility. If the public suspects that the Federal Reserve will not stick to its guns, perhaps because the Fed is afraid that unemployment will increase, then the expected price level will not fall to P e2, and the aggregate supply curve will stay where it is. The result will be costly: a reduction in output and increased unemployment. Only if the Fed announces its policy and the public is convinced that it will pursue it at all costs will the costs turn out to be negligible. How is this credibility accomplished? Rhetoric is usually not sufficient, especially in democratic societies where considerable political pressure can be brought to bear on policymakers. Concrete policy changes are necessary to alter ingrained inflationary expectations. This is especially so in the case of hyperinflation, where exorbitant rates of inflation have taken hold of an economy. Under such circ*mstances, changing the monetary unit, introducing a truly independent central bank, and invoking severe fiscal restraint to

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balance the budget have had the desired effect. The hyperinflations suffered by Germany, Austria, Poland, and Hungary in the aftermath of World War I were reversed with hardly any reduction in real output as a result of an overhaul in the monetary-fiscal regimes in each of those countries. Under more mundane circ*mstances, however, the search for a credible policy proceeds with much more caution. And that often dooms the experiment before it gets started. At this point our discussion of the trade-off between inflation and unemployment sounds more like topics in advanced psychology than anything resembling economic policy. In part, that is the message of rational expectations. Economic policy-making is far more complicated than the Keynesian revolution had anticipated.

Interest Rates and Anticipated Monetary Policy The rational expectations message for interest rates is not much brighter than for monetary policy in general. Recall our discussion in the last chapter on how a change in the money supply affects the level of interest rates. We identified the Keynesian liquidity effect, which links an increase in money supply with a decline in both real and nominal interest rates. The monetarists stress that this liquidity effect is only transitory, soon to be swamped by inflationary expectations that drive nominal rates above real rates. Keynesians have a short-run “liquidity” perspective when claiming that expansionary monetary policy lowers interest rates, while monetarists have a longer-run perspective when emphasizing that interest rates go up because of inflationary expectations. The rational expectations world is much simpler. An anticipated increase in the money supply leads to higher nominal interest rates immediately, while unanticipated increases in money supply produce lower nominal interest rates. The reasoning is straightforward. Anticipated increases in money supply produce inflationary expectations simultaneously with the expansion in money supply. Under such circ*mstances, lenders are reluctant to part with funds unless interest rates reflect the expected inflation and borrowers agree to pay higher rates because of the expected inflation. The liquidity effect never reduces interest rates, because inflationary expectations respond instantaneously. When the money supply jumps without warning, however, then the liquidity effect produces a drop in rates. In fact, if the expansion in money supply occurred without rhyme or reason, inflationary expectations might not get started until aggregate demand pushed up economic activity. And that might take sufficient time for the liquidity effect to remain for a while. The lesson of the rational expectations story is harder to avoid in financial markets than in labor markets. When it comes to stocks and bonds, prices are

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not set by contractual agreement. Thus the rational expectations distinctions between the impacts of anticipated and unanticipated monetary policy on interest rates are important lessons. Nevertheless, the story cannot end here. Empirical evidence is the only way to resolve the policy disputes between monetarists and Keynesians, with or without rational expectations. And for answers we must turn to the next chapter.

SUMMARY 1. Expectations are rational when people take account of all available information in forecasting economic variables. In forecasting inflation, for example, rational expectations reflect information on what is happening to the money supply and what economic models predict the consequences will be for prices.

2. When expectations are rational and when wages and prices are completely flexible, anticipated monetary policies have no effect on economic activity. The result for stabilization policy, which is usually anticipated, is decidedly monetarist-classical: There is no impact of countercyclical policy on the level of economic activity.

3. The Keynesian viewpoint is that even if expectations are rational, wages and prices are not completely flexible because of contractual arrangements in labor markets. Under such circ*mstances, even an anticipated countercyclical monetary policy will have an impact on economic activity.

4. The rational expectations perspective eliminates even a temporary trade-off between inflation and unemployment. This means policymakers cannot reduce unemployment below some natural level by increasing the rate of inflation. There is no short-run Phillips curve under rational expectations.

5. A contractionary monetary policy can reduce inflation without an increase in unemployment in the rational expectations world. As long as the anti-inflationary policy has credibility, the reduction in inflation will be painless.

6. Prices and yields in financial markets are sufficiently flexible to make the rational expectations world a reality. Under such circ*mstances, an anticipated monetary policy cannot influence real interest rates even in the short run. Anticipated monetary policy influences interest rates only through inflationary expectations.

KEY TERM rational expectations

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QUESTIONS Questions with a red oval are in

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at www.myeconlab.com.

27.1

Define rational expectations and explain why it is reasonable to assume people formulate expectations rationally.

27.2

Explain why an anticipated monetary policy will have no effect on the level of economic activity if people formulate price expectations rationally.

27.3

What behavioral assumption do Keynesians propose that revives the case for the effectiveness of countercyclical policy despite rational expectations? Explain.

27.4

How does credibility in fighting inflation reduce the likelihood that unemployment will accompany anti-inflationary monetary policies?

27.5

Discussion question: If everyone agrees that rational expectations make sense, why is it that our government still practices countercyclical monetary (and fiscal) policy?

Empirical Evidence on the Effectiveness of Monetary Policy Theory, like punishment, is said to be good for the soul. But even the most philosophical among us realize that humans—and yes, even students—also require rewards that are somewhat more concrete. Having poked into every nook and cranny of the monetaristKeynesian dialogue over the effectiveness of monetary and fiscal policy, the time has come to reveal the Truth (with a capital T). Since many people believe that numbers are Truth, here they are aplenty. What are the facts about the behavior of velocity? How powerful is the impact of monetary policy on economic activity? How are interest rates affected? What particular categories of spending are most influenced by money? After all, if monetary policy is to alter GDP, it cannot do it by mystic incantations; it has to do it by changing the consumer spending of households, the investment spending of business firms, or the expenditures of governments—federal, state, or local. In contrast to the theoretical discussion of previous chapters, we now turn to the empirical evidence.

LEARNING OBJECTIVES In this chapter you will learn to understand the historical volatility in velocity and money demand and the implications of that volatility for Keynesianism and monetarism explain the fiscal and monetary policy lags and the resulting difficulties in enacting these policies analyze the empirical evidence relating monetary and fiscal policies to GDP, investment, consumption, and interest rates

From Chapter 28 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

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Living with Velocity We have seen that part of the monetarist-Keynesian debate hinges on the behavior of velocity—monetarists contending that it is relatively stable and that any changes are highly predictable, and Keynesians arguing that either contention is an exaggeration. The facts are that velocity is neither perfectly stable nor fully predictable. The Federal Reserve, unfortunately, does not operate in a world designed for its own convenience. With a money supply of $500 billion, a miscalculation of only 0.1 in velocity means a $50 billion swing in GDP. And with a money supply of $1,000 billion, the GDP jump is twice as large. But all is not necessarily lost. While velocity is not fixed, neither do its movements appear to be obviously random or perverse. If the Federal Reserve could discover the underlying determinants of fluctuations in velocity, it might still be able to coexist with such a moving target. With that in mind, examining the past may provide a clue to developments in the future. Figure 1 plots the historical course of two measures of velocity, each one associated with a different money supply concept. The velocity figures for V1 are based on M1 and V2 on M2. Two broad generalizations emerge from the picture. First, while none of the velocity measures has been completely stable, the meanderings of V2 have been relatively tame. Of course, we just pointed out that even small miscalculations in velocity mean wide swings in GDP, especially for the more inclusive definition of money. This helps to explain why the Fed stopped announcing targets for M2 in 2000

Velocity 12 10 V1

8 6 4

V2 2

0 1960

FIGURE 1

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1965

1970

1975

1980

1985

1990

1995

Historical movements in M1 and M2 velocities.

2000

2005

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Empirical Evidence on the Effectiveness of Monetary Policy

despite the seemingly narrow range of movement in V2. The second glaring message of Figure 1 is that V1 looks highly unpredictable. Those who prefer the narrow definition of money have some explaining to do. First the facts. Velocity of M1 reached a peak of about 4 with the onset of the 1920s. It fell almost continuously during the Great Depression and World War II to an all-time low of about 2 in 1946. Since then, however, V1 has skyrocketed. It rose to 2.5 in 1950 and to 3.5 in 1960, passed its previous peak of 4 in 1965, pushed past 5 in the early seventies, bounced between 6 and 7 in the 1980s and exceeded 10 in 2006. Why has the velocity of M1 gone on its own trip, apparently giving monetarism a bad name and making life difficult for the Federal Reserve? If we have a reasonable explanation, we may be able to claim that V1’s behavior is predictable, and that’s enough for most reasonable people. The main reason for the post–World War II rise in velocity of M1 lies in the relatively narrow historical definition of M1—demand deposits plus currency— and the increasing attractiveness of other categories of financial assets— bonds as well as stocks, money market mutual funds and money market deposit accounts—as prudent and desirable outlets in which to invest excess cash. These assets are highly liquid, almost as liquid as money, and yet they offer much higher interest rates than demand deposits. Attractive yields on financial assets other than money have led more and more people to wonder why they should ever hold any idle cash aside from what they need for day-to-day transactions purposes. Traditional concepts about how much cash on hand is really necessary for doing business have also come under reexamination. If money for day-to-day transactions purposes can be pared down, then some of it can be lent to earn higher interest. The money then moves to borrowers who can use it for current purchases. As a result, a larger volume of current spending flows from the same stock of money. Corporate treasurers, in particular, have found that it pays dividends to scrutinize their cash holdings intensively. Could they manage to get along with somewhat less in the till than they had previously thought of as “normal” and invest a portion in high-yielding time deposits at commercial banks or in U.S. Treasury bills? Increasingly the answer has been yes, and imaginative new techniques of cash management have been developed to facilitate the process (as well as some not-so-imaginative old techniques, such as becoming “slow payers” when bills come due). This trend has not escaped the attention of consumers. They have learned to economize on money by substituting lines of credit at retail stores and financial institutions in place of cash reserves; in addition, the growing use of credit cards has drastically reduced household needs for day-to-day transactions money. What was formerly held in the form of demand deposits or currency, for emergency use or for current payments, now shifts to interest-bearing savings deposits or higher-yielding money market mutual funds and money market deposit accounts. In summary, there has been a pattern in the movements of M1 velocity since the end of World War II—a persistent long-run rise with minor short-run

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dips during recessions. Even though we may not be able to pinpoint all the specific determinants, we can still see broad cause-and-effect relationships. Higher interest rates lead to an increase in velocity by inducing business firms and households to economize on money. They hold less, lend out the excess, and others (the borrowers) can then spend it. Once learned, techniques of cash management are not easily forgotten, so that even in recessions, when interest rates fall, velocity does not drop back very far. When it comes to practical policy, however, the Federal Reserve may be able to live with such moving targets. By gaining further insight into what makes velocity move, the central bank might be able to establish a range of probabilities as to where velocity is likely to be tomorrow and the day after and to act on that basis. In other words, a morning line on velocity (not unlike the one your local bookie puts out on the races at Hialeah)—provided the odds were unemotionally calculated and continuously reassessed in the light of emerging evidence—might still enable the Federal Reserve to come out a winner.

The Demand for Money We have just suggested that the historical movement in the velocity of M1 stems from many factors, including movements in interest rates, technology, and innovations in financial markets. To focus more precisely on the relative importance of each of these requires that we disentangle their separate influences. Only a formal application of statistical techniques to historical data on the money stock, interest rates, income, and other variables will permit us to identify the individual relationships. Indeed, economists have spent considerable effort estimating statistical counterparts to the money demand equations discussed in earlier chapters. And the reasons for the effort are not difficult to understand—after all, the monetarist and Keynesian heritages have a large stake in the outcome of such studies. Just about every statistical study has shown that both the interest rate and the level of GDP influence money demand. In particular, higher interest rates significantly reduce the demand for cash balances. This result, by itself, contradicts extreme forms of monetarism, which assume zero interest-sensitivity of money demand. On the other hand, none of the empirical investigations has ever isolated the Keynesian liquidity trap. Thus the monetarist outlook gains support as well. The question of the interest-sensitivity of money demand has historically been an important issue dividing monetarists and Keynesians. But once the extreme positions—zero and infinite interest-elasticity—have been ruled out, the more sophisticated problem focuses on the stability of the money demand equation. After all, given the statistical results, the specific numbers are less important than their reliability in forecasting future money demand. As long as the historical estimates are reliable predictors of money demand, then the Federal Reserve can gauge the proper amount of money to add to or subtract from the economy in order to hit a particular target of economic activity.

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On the other hand, if the particular estimates change a lot, or if the demand for money jumps around for no apparent reason, then changes in the money supply will be useless predictors of economic activity. Monetarists would obviously be unhappy at such results, and so would ecumenical Keynesians, who view both monetary and fiscal policies as potentially important stabilization weapons. Most of the evidence suggests that the demand for money was quite stable until the mid-1970s; the predictive power of statistical money demand equations was quite good. Then, about the middle of 1974, the estimated demand equations for money went adrift. People were holding smaller money balances than the historical relationships suggested. The 1980s were also not helpful. In fact, the problem was just the opposite of the 1970s: too much money rather than too little. This is reflected in the decline in M1 velocity during the 1980s in Figure 1. The continued inability to explain movements in M1 demand is one of the reasons the Federal Reserve dropped M1 targeting in its execution of monetary policy.

Econometrics and Time Lags The empirical evidence just presented on velocity and money demand provides only modest comfort to those promoting the relationship between money and economic activity. Moreover, the simple velocity and money demand approaches, even with carefully calculated probabilities, leave much to be desired as a guideline for Federal Reserve policy-making. In particular, they ignore time lags between changes in monetary policy and the impact on economic activity. They also ignore the more sophisticated statistical methodology that can be used together with modern computer technology to simulate the impact of monetary policy on economic activity via a formal econometric model. Both lags and econometric models add flesh to the skeleton of our theoretical models. First we look at lags, and then we introduce the power of econometric modeling. By their own admission, Federal Reserve officials are not omniscient. If the economy starts to slip into a recession, it takes time before the experts realize what is happening so they can take steps to correct it. Similarly, if inflation begins to accelerate, it takes awhile before the evidence verifies the fact. Prompt recognition of what the economy is doing is not as easy as it sounds. For one thing, the available data are often inadequate and frequently mixed: New car orders will rise while retail department store sales are falling; farm prices may be dropping while employment in urban areas is rising. Furthermore, the economy rarely proceeds on a perfectly smooth course, either up or down. Every upsweep is interrupted from time to time by erratic dips; every decline into recession is punctuated irregularly by false signs of progress, which then evaporate. Is a change only a brief and temporary interruption of an already existing trend, or is it the start of a new trend in the opposite direction? No one is ever perfectly sure. This problem of getting an

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Going Out On A Limb Where Is All That Cash Hiding? In 1960, 20 percent of the U.S. money supply (M1) was in the form of currency (including coins). We had $29 billion of currency in circulation and $112 billion of checking accounts. The population of the United States at the time was 180 million people, so that the $29 billion of coin and bills amounted to an average of $160 for each man, woman, and child in the country. By contrast, in 2008 about 55 percent of the M1 money supply consisted of currency ($768 billion of currency in circulation and $602 billion of checking accounts). The population of the United States was then 303 million people, so that the $768 billion of coin and bills amounted to a startling average of $2,535 for each man, woman, and child in the country. Perhaps people are holding so much more cash today because prices are higher now than they were in 1960. In any event, the effect of higher prices should be at least partly offset by the increased use of credit cards,

enabling people to hold less cash than they used to carry. Also, a lot of U.S. currency is used abroad, in inflation-prone countries like Ecuador, Russia, and Brazil. But no doubt much of the reason for the increase in cash is activity in the covert “underground” economy—that part of the economic system that never uses checks as a means of payment. Cash only, please! Cash leaves no paper trail. The underground economy includes illegal transactions, such as gambling, prostitution, and drug dealing; home-repair types of activities, such as gardening and carpentry, where payment in cash is requested in order to evade taxes; and even the labor of an untold number of industrious and otherwise honest college students (and maybe some of their professors) who work “off the books” for tax evasion purposes. No one knows for sure how large the underground economy is, but we calculate that it could be as big as 10 to 15 percent of the officially reported gross domestic product.

accurate “fix” on what is happening in the economy, or what is likely to happen in the near future, is called the recognition lag in monetary policy. As soon as the recognition lag ends, the impact lag begins, spanning the time from when the central bank starts using one of its tools, such as open market operations, until an effect is evident on the ultimate objective—aggregate spending in the economy. It may take weeks before interest rates change significantly after a monetary action has begun. Changes in credit availability and money supply also take time. And a further delay is probable before actual spending decisions are affected. Once monetary policy does start to influence spending, however, it will most likely continue to have an impact on GDP for quite a while. All of this was swept under the rug in the theoretical models discussed in earlier chapters. But now it’s time to add some flesh to that bare-bones description of the real world. Regarding the recognition lag, rough impressionistic evidence suggests that the Federal Reserve generally starts to tighten only a few months after a business cycle has reached its trough, while its move toward easing after a peak in the cycle is somewhat more delayed. This evidence is less than definitive, and it is likely that under some circ*mstances the monetary authorities

462

Empirical Evidence on the Effectiveness of Monetary Policy

will sense what is going on and take action more promptly than under other circ*mstances. Nevertheless, the inference that the central bank is typically more concerned with preventing inflation than with avoiding recession probably contains a grain of truth. The impact lag is most conveniently discussed, along with the strength of monetary policy, in terms of the results that formal econometric models of the economy have produced. An econometric model is a mathematical-statistical representation that describes how the economy behaves. Such a model gives empirical content to theoretical propositions about how individuals and business firms, lenders and borrowers, savers and spenders react to economic stimuli. After such relationships are formalized in mathematical expressions, data on past experience in the real world are used to estimate the precise behavioral patterns of each sector. A model, therefore, is based on real-world observations jelled into a formal pattern by the grace of statistical techniques. Thrown into a computer, the model simulates the economy in action and grinds out predictions based on the formal interactions the model embodies. Our knowledge of how best to construct such a model is far from complete. The same data can produce different results, depending on the theoretical propositions used to construct the model. As one cynic put it, “If one tortures the data long enough, it will confess.” A Keynesian model, for instance, would incorporate behavioral assumptions different from those of a monetarist model and hence grind out a different set of predictions. Monetarist models frequently relate total GDP to money supply directly, on the basis of a predictable velocity assumption. Keynesian models, on the other hand, involve considerable efforts to explain the determinants of consumption spending, investment spending, and liquidity preference. With regard to monetary policy in particular, the Keynesians’ model tries to show explicitly the linkages between money supply, interest rates, and real spending decisions. And if something is left out, they have only themselves to blame. Since both monetarists and Keynesians are presumably interested in the truth, it is reasonable to assume that their models have been specified with that objective in mind. Let’s review the evidence to see if some consensus emerges.

The Impact of Monetary Policy on GDP The Federal Reserve board, working with economists at several universities, has developed an econometric model of the behavior of economic aggregates in the United States. Many other economists have done similar work at universities and financial institutions. But our discussion will be based primarily on the Federal Reserve model, which was prepared specifically to evaluate the impact of stabilization policies on economic activity. It is important to emphasize at the outset that these econometric models are evolutionary phenomena, constantly revised and altered to reflect new and

463

Empirical Evidence on the Effectiveness of Monetary Policy

different perspectives about economic reality. Moreover, the computer-generated numerical estimates of how the economy responds to a change in monetary policy (and fiscal policy as well) vary with the specific conditions of economic activity. Thus the numbers reported later provide a general flavor of how the models simulate economic and financial responses to policy, but they should be viewed as impressionistic. In fact, we should always stamp our computer output with the technician’s favorite warning: GIGO.1 The Federal Reserve’s model articulates rather carefully the impact of monetary policy on various categories of spending. Indeed, the channels of transmission are clearly set out in mathematical splendor. We will give some of the details later, but at this point it is best to concentrate on an overview of the model’s findings for monetary policy. Recent versions of the Fed’s model show that a 1 percent increase in the money supply raises real GDP by about 1/2 percent after one year. During the next two years, GDP continues to rise until it increases by the same 1 percent as the money supply after a total of three years. Earlier versions of the Fed model took longer for monetary policy to work its way through the economy. Back then monetarists were unhappy with such results and suspected that the architects of the Federal Reserve’s model unwittingly left something out of their complicated system of equations. As a result monetarist economists at the Federal Reserve Bank of St. Louis developed a simple model that related GDP directly to the money supply, without any intervening steps. And after all was said and done, this model also showed that a 1 percent change in money supply increased GDP by about 1 percent after a year. The surprising outcome is an apparent consensus that monetary policy has a significant impact on economic activity even within a year. The problem is that after this initial period the impact of the monetary expansion probably continues and this can cause difficulties for policymakers.

Fiscal Policy and Crowding Out The theoretical discussions in earlier chapters indicated a clear distinction between monetarist and Keynesian views on the effectiveness of fiscal policy. Monetarists contend that tax and expenditure policies merely displace private spending, leaving little net impact of fiscal policy on GDP. Keynesians, on the other hand, argue that the “crowding-out” effects of government policies are incomplete, implying that fiscal policy generates much of the traditional multiplier effect on GDP. It should be clear by now that this dispute can be resolved only by resort to empirical evidence. Experiments with the Federal Reserve model show that, holding the money supply constant, an increase in government spending by 1 percent of

1GIGO, of course, means Garbage In, Garbage Out. In our terms, if the economic assumptions underlying the model are bad, so are the simulations.

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GDP increases the level of real GDP by about 1 percent for at least two years. It takes more than three years for crowding out to reduce the impact on real GDP to zero. An alternative experiment shows that if the money supply varies so that the level of interest rates is held constant, then the multiplier effects on GDP are enormous: Even after four years GDP is 4 percent higher than without the expansion in government spending. These results suggest that according to the Federal Reserve’s model, fiscal policy has a multiplier of about one without any help from monetary policy, but that an accommodating monetary authority can make fiscal policy even more effective. The original version of the monetarist model developed at the Federal Reserve Bank of St. Louis was much more pessimistic about fiscal policy: It reported complete crowding out of fiscal effects within the first year after government spending was increased. One of the problems with this revolutionary result was that the St. Louis model was silent on the specific categories of private spending that were crowded out by the government’s expenditure. This agnosticism of the St. Louis model made its results highly suspect, according to most Keynesians. It seems that the empirical evidence on fiscal policy confirms the crowdingout effect, but only if the contractionary effects on private spending are given substantial time to work themselves out. This brings us to the question of the role of interest rates within the framework of our models. First let’s look at how changes in money supply influence the level of rates, and then we can turn to the specific categories of spending that are most sensitive to interest rate movements.

Interest Rates According to both monetarists and Keynesians, the initial liquidity impact of an expansionary monetary policy reduces the level of interest rates. Similarly, both monetarists and Keynesians recognize that inflationary expectations generated by excessively expansionary monetary policy will raise interest rates. The key difference of opinion focuses on how long it takes for inflationary expectations to counteract the initial liquidity effects. Figure 2 illustrates that the levels of short-term interest rates have been closely related to actual movements in the rate of inflation. Thus a broad sweep of the data clearly shows the impact of inflation on the rate of interest. But the chart also shows substantial intervals of independent movements in the level of interest rates. And to identify the separate role of monetary policy in this area, it is once again necessary to consult the statistical evidence. Most econometric models, including that of the Fed, report that interest rates decline and remain below their original levels for six months to a year after an expansionary monetary policy and that they are above their original levels for a similar period after a contractionary monetary policy. After a year, however, the initial liquidity effect is reversed, and interest rates move in the opposite direction. In contrast, there are some monetarist models that show

465

Empirical Evidence on the Effectiveness of Monetary Policy

Percent 18 3-month T-bill rate

16 14 12 10 8 6 4 2

Annual rate of inflation

0 1970

FIGURE 2

1975

1980

1985

1990

1995

2000

2005 Year

Interest rates move with the rate of inflation.

the Treasury bill rate snapping back to its original level and going above it within three months after an expansionary monetary policy. It should be emphasized that the response of inflationary expectations depends crucially on the initial state of the economy. At levels of economic activity that are very close to full employment, or when saver and investor concerns about inflation are especially strong, an upward jump in inflationary expectations due to expansionary monetary policy can be even quicker than we just indicated. Thus while the formal models show a relatively slow adjustment, their predictions are based on the average historical experience. Any particular historical event can show more sensitivity than the average if the specific conditions are ripe. At this point it seems useful to go one step further in examining the behavior of interest rates. Rising rates should cut off some spending and falling rates should be stimulative. Let us see which categories of spending are most sensitive to movements in interest rates. In this way we can isolate the channels through which monetary policy operates, as well as identify the categories of private spending that are likely to be crowded out by fiscal actions.

Business Investment One would expect interest rates and all types of investment spending to move in opposite directions: An increase in interest rates, for example, should lower business spending on plant and equipment. If the cost of borrowing rises, so

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Empirical Evidence on the Effectiveness of Monetary Policy

our theory said, business firms should presumably be less willing to incur new debt to build new factories or buy new machines. The simple historical record shows, however, that interest rates and business investment almost always move in the same direction. As in most cases where fact contradicts economic theory, one of them must give ground—and it is usually fact. In the historical record, many things are happening simultaneously, so separate strands of cause and effect are not sorted out. Investment spending on plant and equipment is influenced by a number of factors besides interest rates—sales expectations, changes in anticipated profitability, pressures from competitors, the degree of capacity currently being utilized, and expectations regarding inflation, to name only some. An increase in interest rates may inhibit investment, and yet investment may, in fact, rise if a number of these other elements shift sufficiently to offset its effect. Econometric methods, such as those used in constructing the Federal Reserve model, permit us to sort out the effects of individual variables. For our particular concern, we can examine the impact of interest rates on investment, holding all other influences constant. The Fed model shows, for example, that an increase of 1 percentage point (say from 8 to 9 percent) in the corporate bond rate lowers business spending on new plant and equipment by nearly 5 percent after three years, but almost all of that effect occurs in the last year. In this instance, the time delay of interest rate effects is clearly quite substantial. Most investment decisions are not made today and executed tomorrow. Decisions regarding installation of new machinery and construction of new plants are usually made far in advance. Thus an increase in interest rates does not promptly affect investment in plant and equipment. What it does affect is current decisions that will be implemented months or years in the future.

Residential Construction The impact of monetary policy is felt more promptly and more powerfully on residential construction expenditures. In particular, an increase of 1 percentage point in the interest rate lowers spending on housing by approximately 9 percent within a year. Part of this effect on residential construction occurs through credit rationing activities by financial institutions engaged in mortgage lending. In fact, credit availability is often emphasized by modern Keynesians as a significant channel through which monetary policy influences spending. But this specific case of mortgage credit rationing is less important now that financial institutions are less specialized. Construction expenditures by state and local governments also appear sensitive to the actions of the monetary authorities. Municipal bond flotations are often reduced, postponed, or canceled during periods of high and rising interest rates. Many municipal governments have self-imposed interest rate ceilings that eliminate them from the market when rates go up. In other instances, when interest costs become too large, local voters are reluctant to

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Empirical Evidence on the Effectiveness of Monetary Policy

approve bond issues for school construction and other projects, since the higher interest burden implies the immediate or eventual imposition of higher property or sales taxes.

Consumer Spending The last major item on the monetary policy hit list is consumer spending. In this case the Federal Reserve model includes the wealth effect of modern Keynesians to channel the impact of interest rates to spending. In particular, a lower interest rate raises the value of stocks and bonds, according to the model, and this increases the level of consumer spending. The importance of the wealth effect in the overall impact of monetary policy is quite substantial, according to the Federal Reserve’s formulation. About one-quarter of the impact of monetary policy on GDP after one year stems from the effects of changes in wealth on consumer spending. This is more than four times the response in plant and equipment expenditure and just about equal to the powerful effect of monetary policy on residential construction. Perhaps the most important message of the entire set of empirical results is that there are significant impacts of monetary policy on spending. While at first glance this seems to bolster the role of the Federal Reserve in the countercyclical efforts of the government, the potentially destabilizing impacts become even more threatening. The Federal Reserve model suggests that monetary policy is a force to be reckoned with but might be too powerful to harness for delicate fine-tuning of economic activity.

SUMMARY 1. The historical behavior of GDP relative to M1 rules out the simple notion that velocity is fixed and unchanging. Although M2 velocity is somewhat more stable historically, it is more important to concentrate on the predictability of velocity, rather than its stability.

2. Statistical investigations of money demand suggest that the demand for money is less stable than was once thought, although M2 has fewer problems than M1.

3. The impact of monetary policy on economic activity, as well as the associated time delays, is best illustrated by the results of econometric models. The main implication of the Federal Reserve’s model is a rather substantial impact of money on GDP.

4. Fiscal policy has an impact on GDP, according to the models, but there is also evidence of significant crowding out. In particular, if government spending increases when the money supply is held constant, the rising rates of interest will cut off substantial amounts of private spending.

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Empirical Evidence on the Effectiveness of Monetary Policy

5. Interest rates increase and decrease with the rate of inflation. The relationship is not close enough, however, to negate the fact that increased money supply growth will lower short-term interest rates for a while (perhaps six months) before inflationary expectations take over.

6. Tight monetary policy and rising rates of interest have significant contractionary effects on residential construction. Consumer spending is also discouraged through a wealth effect of higher interest rates on stock and bond values. Business plant and equipment spending responds to higher interest rates with a significant delay.

KEY TERMS credit rationing

impact lag

recognition lag

QUESTIONS Questions with a red oval are in

at www.myeconlab.com.

28.1

Why did the velocity associated with M1 increase from about 2 immediately after World War II to over 10 in 2008?

28.2

What is the evidence from computer simulations of econometric models regarding the time lags between a change in money supply and a response in GDP?

28.3

Do historical movements in the Treasury bill rate seem to reflect changes in the rate of inflation?

28.4

Which is more responsive to tight money, residential construction or business investment? Why do you think this is so?

28.5

Is the demand for money stable and predictable?

469

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Tying It All Together

The alarm rings and your eyelids open slowly. Last night is a vague memory. You stumble into the kitchen to get that all-important cup of coffee. Just a few peaceful moments alone with the morning paper—that’s all you ask. But there it is—front page—staring you right in the face. Another economic indicator! This time it’s the “purchasing managers’ index.” Bad news, too. The index fell from 46.8 percent to 44.2 percent. So how did the market react? Bonds up! Doesn’t seem to make sense. You read on and find that money managers feel that if the employment numbers scheduled for release on Friday are worse than expected, the bond market is going up even more. Is the world upside down? Bad news is good news? It’s too early for this! Early or not, this is the stuff of the morning’s business news. Nearly every day the Wall Street Journal discusses an economic indicator, perhaps one of those in Figure 1, that was released the previous business day. Often the headlines relate that indicator to movements in the stock and bond markets. But what are the linkages? We have waited until now to address this question because all bases had to be covered: markets and instruments, banks, central banking, and, of course, monetary theory. Now we can tie it all together. We begin by discussing some of the key economic indicators and then turn to explaining how these indicators influence securities prices.

LEARNING OBJECTIVES In this chapter you will learn to understand the role of economic indicators and their importance to financial markets realize the complexities of modern financial markets and their importance to the economy

From Chapter 29 of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

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Tying It All Together

Real GDP

Unemployment Rate

Industrial Production

Change from previous quarter at annual rate, seasonally adjusted

Seasonally adjusted

Change from previous month, seasonally adjusted

6%

3%

5.5%

2%

6% 4%

1%

5% 2% 0%

0%

4.5% 2005

2006

4%

2007

Source: Department of Commerce

–1% 2005

2006

2007

Source: Bureau of Labor Statistics

–2%

2005

2006

Source: Federal Reserve

Purchasing Managers’ Index

Retail Sales

Consumer Spending

Reading above 50 indicates expansion in manufacturing activity

In billions, seasonally adjusted

Personal consumption expenditures change from previous month, seasonally adjusted

70

$400

60

$375

1.0%

50

$350

.5%

40

$325

0%

30

$300

–.5%

2005

2006

2007

Source: Institute for Supply Mgmt.

1.5%

2005

2006

2007

Source: Department of Commerce

2005

2006

2007

Source: Department of Commerce

Consumer Confidence

Consumer Prices

Producer Prices

Index stood at 100 in 1985, its base year

Change from previous year, not seasonally adjusted

Change from previous year, not seasonally adjusted

140

5%

120

4%

100

3%

80

2%

60

1%

2005

2006

Source: Conference Board

2007

8% 6% 4% 2% 0% 2005

2006

–2%

2005

Existing-Home Sales

Annual rate, in millions of units, seasonally adjusted

Annual rate, in millions of units, seasonally adjusted

2.40

8.5

2.00

7.5

1.60

6.5

1.20

5.5 2005

2006

2007

4.5

2005

2006

2007

Source: Bureau of Labor Statistics

Housing Starts

.80

FIGURE 1

2007

Source: Bureau of Labor Statistics

Source: Department of Commerce

2006

2007

Source: National Association of Realtors

Selected economic indicators.

Source: online.wsj.com/documents/ecocharts.htm. Reprinted with permission of The Wall Street Journal, Copyright © 2008, Dow Jones & Company, Inc. All Rights Reserved Worldwide.

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2007

Tying It All Together

The Economic Indicators An economic indicator measures economic performance. Some indicators are obviously important, such as GDP growth, unemployment, and inflation. In fact, these economic aggregates embody the ultimate objectives or goals set by the Federal Reserve when it establishes a game plan for monetary policy. Other economic indicators are more focused but still measure how well the economy and its components are doing. Some of these indicators you may have heard of, such as new car sales and new home sales. Others you may not have heard of before, such as the purchasing managers’ index, housing starts/building permits, and the index of leading economic indicators. Table 1 lists the most important economic indicators, with the source of the data shown in column 2 and the frequency of the release dates in column 3. Column 4 records our “expected” response for the stock and bond markets, which we will come back to shortly. Every stock and bond trader knows exactly (to the minute in most cases) when these indicators will be released. They sit behind their computers with bated breath and the instant the data hit the screens they buy or sell, depending on the news. Thus it is not surprising that news gets impounded in stock and bond prices nearly instantaneously. To understand how the markets react to a particular indicator requires a two-step procedure. First we have to understand what the indicator is and then determine its connection to securities prices. We start with the details of a particular indicator—more specifically, who produces it, how accurate it is, and how often it is revised. And then, of course, we determine how the indicator behaves relative to changes in the economy. A detailed description of each of the indicators listed in Table 1 is beyond our scope, so we’ll focus on some of the most important of them.1

The Employment Report The monthly employment report is compiled by the Bureau of Labor Statistics (BLS) of the U.S. Department of Labor. It is usually released on the Friday of the first week of the month (showing data for the previous month). The report contains information on employment and average workweek and hourly earnings, with the unemployment rate and the level of payroll employment getting the most press coverage. In many ways the employment report can be viewed as the most important economic indicator of all. Unlike the GDP numbers, which are released quarterly, the employment statistics are released every month, so they offer a frequent update on the

1For further details, see R. Mark Rogers, Handbook of Key Economic Indicators (New York: McGraw-Hill, 1998).

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TABLE 1

Key Economic Indicators

Name

Source

Availability/ Release Date

GDP/GNP

Dept. of Commerce -BEA** Dept. of Labor -BLS Dept. of Commerce -BEA Auto Makers

Quarterly 4 weeks after quarter ends Monthly 1st–7th Monthly 22nd–31st Every 10 days

ISM

Monthly 1st bus. day Monthly 11th–14th Monthly 14th–17th Monthly 14th–17th Monthly 22nd–28th Monthly 28th–4th Monthly 16th–20th Monthly 1st bus. day (2 mo. lag) Monthly 13th–17th (2 mo. lag) Monthly 30th–6th (2 mo. lag) Monthly 18th–21st Monthly 15th–21st Monthly 9th–16th

Employment Personal inc. & consumption Car sales Purchasing managers’ index Retail sales Industrial production Capacity utilization Durable goods orders New home sales

Dept. of Commerce -BOC Federal Reserve Federal Reserve

Housg strts/ bldg permits Construction spending

Dept. of Commerce -BOC Dept. of Commerce -BOC Dept. of Commerce -BOC Dept. of Commerce -BOC

Business inventories & sales

Dept. of Commerce -BOC

Factory orders & mfg inventories

Dept. of Commerce -BOC

Index of leading econ. indicators Consumer price index

Conference Board

Producer price index

Dept. of Labor -BLS Dept. of Labor -BLS

Predicted Market Response to “Good” News* Bonds–dn Stocks–up Bonds–dn Stocks–up Bonds–dn Stocks–up Bonds–dn Stocks–up Bonds–dn Stocks–up Bonds–dn Stocks–up Bonds–dn Stocks–up Bonds–dn Stocks–up Bonds–dn Stocks–up Bonds–dn Stocks–up Bonds–dn Stocks–up Bonds–none Stocks–none Bonds–uncertain Stocks–none Bonds–dn Stocks–up Bonds–dn Stocks–up Bonds–up Stocks–up Bonds–up Stocks–up

*Market response is in terms of probable securities’ price reaction to good news about the indicator. Good news means news that is better than expected. Bond yield reaction is the opposite of bond price reaction. Bond price reaction is shown here. “dn” equals down. **BEA: Bureau of Economic Analysis of the U.S. Department of Commerce; BLS: Bureau of Labor Statistics of the U.S. Department of Labor; ISM: Institute for Supply Management; BOC: Bureau of the Census of the U.S. Department of Commerce.

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pulse of economic activity. Because the employment numbers indicate how many people are looking for jobs, they are the most politically sensitive of all the indicators. Washington pays attention when the employment data are released because the whole nation pays attention! The employment numbers show why it’s important to know the details behind each economic indicator before placing your bets on the market. The two key bits of information, the unemployment rate and the level of payroll employment, are actually based on two surveys: a household survey and an establishment survey (both conducted by the BLS). The household survey is based on a monthly sample of about 60,000 households. The BLS uses this survey to estimate the unemployment rate based on the answers to two questions: Are you employed? And, if you are not, are you looking for work? The unemployment rate is then calculated as the ratio of the number of people unemployed to the number of people in the labor force. To be counted in the labor force you must either have a job or be looking for one. The number reported for payroll employment, however, is not calculated from the household survey but from the establishment survey, which canvasses business establishments rather than households. One might expect both surveys to produce the same results, and often they do; but just as often, they do not. Some of the difference may be due to statistical “noise.” But there are other reasons as well. Self-employed and domestic workers are included in the household survey but not in the payroll survey. Also, if a person has more than one job, she will be counted only once in the household survey but may be counted several times in the establishment survey. There may also be bias in the household survey that is avoided in the establishment survey. For example, individuals responding to the household survey may be reluctant to admit that they are no longer looking for a job—possibly out of fear that they might lose their unemployment benefits or endanger their immigration status. Working in the other direction, some respondents to the household survey may have stopped looking for jobs because they view the effort as fruitless. The net effect of these relative strengths and weaknesses is that while both surveys are considered important, market participants place a little more weight on the payroll numbers compared with the unemployment rate because the measurement problems are probably less severe. Note also that because these data are released before most of the other key indicators, they tend to set the stage for the rest of the month. Of course, when interpreting economic developments it is important to remember that the employment numbers tend to be lagging indicators. That is, they follow behind changes in overall economic activity. Employment turns up after the economy turns up, and employment turns down after the economy has peaked.

Housing Starts and Building Permits The report on housing starts and building permits is important in part because it reflects activity in a very important sector of the economy. In particular,

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In the News Reading the Indicators: Is Employment Rising or Falling? In the June 2, 2003 edition of Barron’s, columnist Gene Epstein disagreed with a pessimistic assessment of the job market that had appeared in the Wall Street Journal on May 29. The Journal article by Jon Hilsenrath observed that “the U.S. is experiencing the most protracted jobmarket downturn since the Great Depression.” Epstein, on the other hand, called the Journal’s article a “front-page fantasy” and argued that employment had actually been increasing. What is the source of this disagreement? Who was right? And what did this mean for the market? As it turns out, both authors were correct. As Epstein pointed out, the Journal article looked at economic indicators from the establishment survey portion of the employment report rather than the household survey.

Epstein noted that the establishment and household indicators have been pointing in opposite directions since early 2002, as this chart below shows. For reasons discussed in this chapter (such as self-employed workers), the household survey and the establishment survey can give different information and under different circ*mstances either one may be more reliable. Based on past trends, Epstein argues that the establishment data will soon start to turn around and match the household data. Only time will tell if Epstein is right, but what is clear is that using and interpreting economic indicators can be difficult. Source: Bureau of Labor Statistics

Payroll employment (in thousands) 133,000

Persons employed (in thousands) 138,000 Household data

132,500

137,500

132,000 137,000

131,500 131,000

136,500

130,500 136,000

130,000 129,500 Jan. 2000

Establishment data July 2000

Jan. 2001

July 2001

Jan. 2002

July 2002

Jan. 2003

135,500

housing accounts for more than 25 percent of the investment component of GDP and more than 40 percent of household budget expenses. Housing is also important because expansion in housing construction leads economic upturns, making housing starts and building permits a leading indicator.

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When investment in housing increases, it has a ripple effect throughout the economy. So when analysts and forecasters see housing activity turn up— typically prompted by low interest rates that are associated with the trough of a recession—they are likely to predict good times ahead. As you may have guessed, the housing report has two components, housing starts and building permits. Data on housing starts are collected by the Bureau of the Census, a division of the Department of Commerce, and are released about mid-month. Housing starts are divided into two categories, single-family and multifamily. A 200-unit apartment building, for example, would be categorized as 200 multifamily “starts.” A housing start is recorded when excavation begins for a new house or apartment building. Most localities require building permits before excavation so that building permits precede housing starts (usually by about one month). Housing starts are about 10 percent greater than building permits because some localities do not require permits.

Purchasing Managers’ Index (PMI) The purchasing managers’ index is based on a survey conducted by the Institute for Supply Management (ISM). Purchasing executives from more than 400 industrial companies in 20 different industries are surveyed once a month. The survey consists of questions about production, orders, prices, inventories, vendor performance, and employment. Respondents are asked to characterize each activity as either up, down, or unchanged. A composite index is formed from the responses to each question so that an index above 50 represents an expanding manufacturing sector and below 50 implies contraction. The ISM index is viewed by analysts and investors as useful in tracking the overall economy even though it focuses only on manufacturing. It is a coincident indicator, which means that its movements occur simultaneously with economic activity.

Index of Leading Economic Indicators As we noted above, some economic indicators are called leading indicators because they precede changes in economic activity. Wouldn’t it be nice, then, if somebody compiled an index of the best leading indicators to predict recessions and economic upturns? Well somebody did, and it’s called, not surprisingly, the index of leading economic indicators (LEI), released each month by the Conference Board. Here are some details. The LEI has 10 components: 1. 2. 3. 4.

Average weekly hours worked—manufacturing Initial unemployment claims New orders for consumer goods Vendor performance

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5. 6. 7. 8. 9. 10.

Plant and equipment orders Building permits Slope of the term structure of interest rates Stock prices—500 common stocks Inflation-adjusted M2 Index of consumer expectations

As a general rule of thumb, the LEI turns down before a decline in GDP and turns up before GDP resumes its uptrend. Market participants view three consecutive monthly changes in one direction (for example, -0.4 percent, -1.0 percent, and -0.9 percent) as anticipating a change in economic activity, in this case, predicting a downturn.

Valuation, the Fed, and Market Reaction How do the stock and bond markets react to improvements in each of these economic indicators? The final column in Table 1 shows the “conventional wisdom” about how prices react to good news about an indicator. For example, a higher reading on the purchasing managers’ index probably triggers a decline in bond prices,2 while driving up the stock market. Similarly, good news about GDP growth, employment, housing starts and building permits, and the index of leading indicators will all make the bond market go down and the stock market go up. In general, as we will see shortly, good news about any of the indicators related to expenditure drives up stock prices and drives down bond prices. But that doesn’t necessarily mean that an announcement that GDP increased by 2 percent or that employment rose by 50,000 workers will necessarily be followed by a jump in the stock market and a decline in bond prices. To see why this is so, we must dig a little deeper into market psychology.

Good News Versus Bad News: The Role of Expectations If good news about GDP growth is good news for the stock market, then at first blush we should expect the stock market to go up if GDP goes up. But, as we’ve stressed in earlier discussions, investor expectations drive decision making so that what really matters is how the numbers that are released compare with what was expected. For example, a company that announces an

2Bond

traders think in terms of prices instead of interest rates, even though we know from Chapter 4 that one is just the mirror image of the other. So when reading in the business section of our favorite newspaper that bond markets have “fallen,” it probably means that prices have fallen and interest rates have risen.

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increase in earnings per share from $5.00 to $8.00 might easily suffer a decline in its stock price if everyone had expected an increase in earnings to $12.00 per share. Similarly, 2 percent growth in GDP could be bad news if investors had expected 21/2 percent growth. On the other hand, if they had expected 2 percent growth, then there would be little reaction because 2 percent growth had been anticipated—in the language of Wall Street, it would have been fully discounted by the market. Fully discounted simply means fully anticipated and therefore embedded in prices because investors have already bought or sold based on their expectations. Thus markets react only to unanticipated news, or somewhat redundantly, only to new news. The LEI, for example, is mostly old news because most of the component indicators that make up the LEI have been released earlier. Thus forecasters and investors have reasonably good estimates of what the LEI will show ahead of time, so there is less reaction on the day the LEI is released than seems justified for a leading index. By the same logic, housing starts have less of an impact on the market than building permits because this month’s housing starts can be partially predicted by last month’s building permits. One last tidbit. Some indicators are less reliable than others because they are subject to substantial future revision. “All other things being equal” (a phrase used by economists who don’t want to wager anything on their forecasts), an indicator that is less vulnerable to revision will be more powerful in moving the market. As it turns out, however, in many cases all other things are not equal. For example, the GDP and payroll employment numbers are powerful despite their vulnerability to large revisions.

Stock and Bond Valuation—A Refresher Now let’s turn to the heart of the issue—column 4 in Table 1, “Predicted Market Response to ‘Good’ News.” We’ve already explained that “good” news means unanticipated increases in an indicator of economic activity. We’ve also noted that “good” news drives up stock prices and drives down bond prices. To see how this works, we need to recall our earlier discussions about bond pricing and stock valuation. The entire process can be illustrated with some simple examples. To represent bonds we take a ten-year zero-coupon government bond, and to represent stocks we assume a company pays out all of its earnings in dividends and that these cash distributions will be the same forever. The price of the ten-year zero-coupon bond is given by the following formula, where F is the face value paid at maturity and r is the ten-year interest rate: Bond Price ⫽ F/(1 ⫹ r)10 The price of a stock comes from a slightly different formula, where D represents the future stream of dividend payments (they are all the same) and k is a

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In the News Wall Street Rebounds as Investors Go Bargain-hunting Wall Street rebounded Thursday after the previous session’s big drop, with investors eager to take advantage of bargains and cheered by a milder-than-expected drop in manufacturing activity in the Philadelphia region. The Dow Jones industrial average rose more than 250 points. A plunge in commodities prices also gave investors some hope that lower energy and food prices might boost consumers’ discretionary spending and ease inflation concerns. Crude oil fell on the New York Mercantile Exchange, while gold prices fell sharply. Stocks had wobbled in the early going Thursday after the Labor Department said the number of newly laid off workers filing for unemployment benefits rose last week by a

more-than-anticipated 22,000 to 378,000. That level is the highest in nearly two months. But Wall Street found reason to buy back into stocks when the Philadelphia Federal Reserve said manufacturing activity is dropping in March by less than it did in February, and by less than many economists anticipated. Investors appeared relieved about the Philadelphia Fed’s report, but economic jitters are far from alleviated. On top of the disappointing jobless claims report, the Conference Board said Thursday that its index of leading economic indicators fell, as expected, for the fifth straight month in February. Source: The Associated Press, The Salt Lake Tribune, Mar. 20, 2008.

discount factor consisting of the risk-free rate (such as on Treasury bills) plus an adjustment for the riskiness of the stock: Stock Price ⫽ D/k There are, of course, more complicated examples for each type of security but none of these would alter our general conclusions. Let’s take the bond first. The numerator in the formula, the face value of the bond, is a fixed obligation. Whether the economy is heating up, or whether it is slowing down, the U.S. Treasury still has to pay the same amount at the end. So bond prices will change only if the denominator, the ten-year interest rate, is affected by unanticipated readings on an economic indicator. Well, what affects this rate? In great part it is expectations about the future rate of inflation. Thus good news about the economy drives down bond prices primarily because as the economy heats up expectations are generated of more future inflation. In addition, good news about the economy also suggests that the Federal Reserve’s open market committee (FOMC) may tighten monetary policy to restrain inflationary pressures. This means that the Fed may very well drive up the federal funds rate which, via the term structure of interest rates pushes up the ten-year interest rate. Thus fears of emerging inflationary pressure plus concern that the Fed will respond by driving up the federal funds rate will decrease the value of our ten-year zero-coupon bond because the fixed future cash flow (F) will be discounted at a higher rate.

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What about stocks? Stocks are a more complicated matter because good news will likely affect both the numerator and the denominator of our formula. Good news about the economy means that companies will earn more, implying that they will pay higher dividends in the future. This will increase stock values because dividends are in the numerator in our stock valuation formula. However, the interest rate is also in the stock valuation formula. In fact, it is in the denominator as part of the discount factor applied to expected future dividends. Thus the denominator of the stock formula behaves just as it does in the bond formula; that is, unanticipated good news drives up the discount factor because of expectations of inflation and anticipated tightening by the Federal Reserve. Thus in the stock valuation formula there are two effects which work in opposite directions. Unanticipated good news increases the numerator (through dividends) and good news increases the denominator (through interest rates). Which effect dominates? Theoretically, it could be either depending on circ*mstances. In practice, conventional wisdom on Wall Street is that the effect on the numerator is usually stronger than the denominator, so that stock prices rise on good news. The effect of good news on stocks and bonds and the linkages just discussed are summarized in Figure 2. One notable departure from the pattern that stock and bond prices move in opposite directions when unanticipated news

Economic Indicators

Bad News

Good News

Expectation of Increased Inflation and Fed Tightening Expectation of Increased Earnings

Interest Rates

FIGURE 2

Expectation of Decreased Inflation and Fed Loosening Expectation of Decreased Earnings

Interest Rates

Bond Prices Down

Bond Prices Up

Stock Prices Up (net effect)

Stock Prices Down (net effect)

Economic indicators and market behavior.

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is released is the reaction to inflation. Unanticipated good news about inflation (that is, news that inflation is lower) has a positive effect on both the stock and bond markets. The reason is that favorable news about inflation drives down the level of interest rates and, as we’ve just seen, the interest rate is in the denominator of both the stock and bond formulas. Thus lower inflation drives up both stock prices and bond prices.

Putting It All Together Economic indicators are at the center of a feedback mechanism operating through economic activity, economic policy, and investor behavior. The indicators measure how the economy is currently performing and suggest how the economy will perform in the future. Investors, forecasters, and analysts all observe these indicators and make assessments about the future—more precisely about future dividends and interest rates. Because the Federal Reserve also monitors the economy through these economic indicators, favorable or unfavorable news triggers new monetary policy settings. Exactly how things work out is the result of a complicated set of interactions. Here is an example. Consider the case where unanticipated good news about economic activity is released today. This suggests that future inflation will rise, leading to higher interest rates, and also suggests that dividends will increase with faster economic activity. Moreover, investors now expect tighter monetary policy as the Fed moves to offset increased inflationary pressure. Investors and traders, however, are not going to wait until next year’s inflation numbers are out, nor even until the next FOMC meeting, to make their investment decisions. They will trade today based on updated estimates of Fed monetary policy, dividends, and inflation, including an estimate of how successful the Fed will be in countering emerging inflationary pressures. The net outcome of investor and trader assessments will be recorded in stock and bond markets much like voters casting their ballots in a referendum. Can we make money based on newly released economic indicators, that is, can we make a killing in the market by buying stocks and selling bonds on good news and vice versa on bad news? Unfortunately, it’s not so easy. Remember our discussion of the “newness” of news. By the time we read about an economic indicator in the paper (or hear about it on television), it is now old news. The people who are paid to manage the hundreds of millions of dollars of investment funds, such as the pension fund managers, mutual fund managers, insurance company investment managers, and activist Wall Street professional traders, get there first—probably seconds after they saw the news on their computer screens. Will we always see the stock and bond markets reacting according to Table 1 when reading the morning newspaper? Sometimes, but not always. Rarely is a single economic indicator the only event of the day. In our global

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marketplace, elections in Japan, labor strikes in France, and monetary policy in Germany can all affect the U.S. securities markets—not to mention the budget debates in Washington, D.C. The conventional wisdom reflected in Table 1, however, rests on the linkages between the institutions and markets that we’ve discussed. While you may not be able to outwit the stock and the bond markets, you now have a good sense of the forces at work that influence financial decision making. Our advice is to sit back, relax, and enjoy the next performance. Hopefully, you will now understand what is going on.

SUMMARY 1. Economic indicators are measures of how well the economy, or specific segments of the economy, are doing. There are leading, lagging, and coincident economic indicators. Leading economic indicators precede changes in overall economic activity, while lagging economic indicators follow changes in overall economic activity, and coincident economic indicators move with overall economic activity.

2. The index of leading economic indicators is comprised of 10 separate leading indicators. It performs better as a predictor of economic turning points than any of its component parts.

3. The stock and bond markets react to economic indicators in different ways. Bond market prices fall on good news about the economy because of inflationary expectations and anticipated Federal Reserve tightening while the stock market rises because expected increases in future dividends dominate.

4. The stock and bond markets will react only to unanticipated news. A fully anticipated economic release will not have any effect on the market because the news was already reflected in prices. The news must be “new.”

5. It is unlikely that individual investors can profit by trading on newly released economic indicators. Institutional investors respond instantaneously to news releases so that stock and bond prices are driven up or down within minutes of an announcement. By the time you read it in the newspaper it is too late.

KEY TERMS coincident indicator

lagging indicator

economic indicator

leading indicator

purchasing managers’ index

index of leading economic indicators

payroll employment

unemployment rate

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QUESTIONS Questions with a red oval are in

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at www.myeconlab.com.

29.1

Why do markets react to some economic indicators more than others?

29.2

Why do investors care so much about what the Federal Reserve is likely to do in the future?

29.3

Why is “good news” bad news for bond prices?

29.4

Why isn’t “good news” bad news for stock prices?

29.5

Discussion question: Many of the economic indicators are produced by government agencies. Should we invest more money in these agencies in order to get more precise estimates, or should we move in the opposite direction and rely more on the private sector for generating measures of economic performance?

G L O S S A RY accrued interest Interest accumulated on a bond since the last interest payment. actuarial probabilities Calculations of life expectancy based on past experience with respect to age, gender, and similar factors. adjustable rate mortgage A mortgage in which the interest rate and payments change periodically during the life of the loan. adverse selection A problem of asymmetric information that occurs, in the case of a debt contract, at the origination stage because lenders can not differentiate between high and low quality borrowers. aggregate demand (supply) The total amount of goods and services demanded (supplied) in the economy. allocational efficiency The tendency of market prices to reflect all information affecting the underlying value of securities. amortize To pay off the principal of an indebtedness, along with the interest, during the life of a loan. angel financing Financing provided by high net worth individuals (called “angels”) who invest in the equity of startup (new) companies. annual return Value of an investment and its proceeds at the end of one year, less the value at the beginning divided by value at the beginning. See also total return and yield to maturity. annuity A contract to pay an amount of funds in the future in a series of periodic payments. appreciate To increase in value, especially referring to foreign currency. arbitrageur One who engages in arbitrage, or buying something in one market and simultaneously selling it at a profit in another market. asked price The price a dealer charges when selling to the public.

asset (1) An item owned that has value; (2) an item on a balance sheet showing the value of property owned or receivable. assumption method A procedure, used in cases of bank failure, in which the failed bank is merged with a healthy one. asymmetric information A situation that occurs in any type of contracting when the seller has more information than the buyer. auction market A market where buyers and sellers bargain directly with each other. automated clearinghouse (ACH) An electronic system for making regular payments or receiving regular credits. automated teller machine (ATM) A cardoperated facility for making bank deposits and withdrawals. autonomous spending changes Changes in spending that are independent of GDP. balance of payments (national) A record of payments that one country makes to and receives from all other foreign countries. balance sheet A summary statement of an individual’s or a business’s financial condition on a given date. bank See commercial bank. bank examination An audit of the financial condition and overall safety and soundness of a bank by its regulators. bank failure Situation in which a bank goes out of business because it cannot meet its obligations. See also assumption method and payoff method. bank holding company A holding company that owns one or more banks and possibly other (nonbank) subsidiaries. banking-oriented system A financial system such as Germany or Japan in which the banking market is large relative to the stock and bond markets. Bank Insurance Fund (BIF) Fund, operated by the FDIC, that insures deposits at commercial banks and most savings banks.

From the Glossary of Principles of Money, Banking & Financial Markets, 12/e. Lawrence S. Ritter. William L. Siber. Gregory F. Udell. Copyright © 2010 by Pearson Prentice Hall. All rights reserved.

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Glossary bank (or depository institutions) reserve equation A formal statement of factors affecting bank reserves: Fed assets minus all Fed liabilities and capital accounts, other than those Fed liabilities that constitute bank reserves, plus Treasury currency in bank vaults. bank reserves See reserves. basis point One-hundredth of a percentage point (0.01 percent, or 0.0001). Yields change by one basis point when interest rates go from 9.00 percent to 9.01 percent. bear market A financial market in which prices are falling. bid price The price a dealer will pay when buying from the public. bid-asked spread The difference between the price a dealer is willing to pay for a security (bid price) and the price at which the dealer is willing to sell the security (asked or offer price). blue-chip stock Stock of a high-quality corporation with a good record of earnings and stability. Board of Governors of the Federal Reserve System Seven individuals appointed by the President to run the central bank. See also Federal Reserve System. bond A liability issued by a government (government bond) or a business (corporate bond) promising to pay the holder a fixed cash amount at a specified maturity date and (usually) to make regular interest payments in the interim. See also municipal bond and zero-coupon bond. bond-anticipation notes (BANs) Shortterm municipal securities issued to raise stopgap funds and paid off when long-term bonds are issued. bond equivalent yield See coupon equivalent yield. Bretton Woods The New Hampshire town where fixed exchange rates and the International Monetary Fund were established by international agreement in 1944. See also fixed exchange rates and International Monetary Fund.

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broker An institution (or individual) who arranges purchases and sales of securities for the account of others and receives a commission on each transaction. brokerage house A financial institution that acts as a broker, dealer, and underwriter of securities. See also broker, dealer, and underwriting. brokered market A market where a person (or institution) called a broker is employed to find the other side of the trade. bubble An event in which prices do not represent the intrinsic value of the underlying asset and typically rise rapidly and then suddenly crash. bull market A financial market in which prices are rising. callable See call provision. call option An option contract in which the option buyer has the right (but not the obligation) to buy a specified quantity of the underlying asset at a specified price until the expiration date of the option. call provision A stipulation in a bond that allows the bond issuer to pay off part or all of the bond before the scheduled maturity date. capital account The account that represents all transactions between domestic and foreign residents involving a change of asset ownership. A foreign investor acquiring a domestic asset represents a domestic capital account surplus. capital adequacy The sufficiency of a bank’s capital to protect the depositors (and the FDIC) against losses. capital gain The difference between the price paid for an asset and the higher price at which it is sold. If the selling price is lower than the purchase price, there is a capital loss. capital market The market for stocks and long-term debt instruments. captive finance companies A finance company that is owned by a parent company and whose principal activities are associated with financing the products sold by its parent company.

Glossary cash-balance approach A version of the quantity theory of money that focuses on the demand for money. See also demand-formoney equation. cash items in the process of collection Checks drawn on one bank and deposited in a second bank but not yet cleared. caveat emptor et venditor Buyer and seller beware. central bank A governmental “bank for banks,” generally responsible for national monetary policy. See also Federal Reserve System. certificates of deposit (CD) Deposits with specific maturities, also referred to as time deposits. checking (checkable) deposits Accounts at a financial institution (checking accounts) that permit the account holder to transfer funds to a third party via a check (an order to pay). classical economics A system of economic thought, founded by Adam Smith, that relies on the price system to allocate resources and argues that price flexibility will lead to full employment (Say’s law). clearing corporation Associated with a futures exchange to guarantee rights and obligations of market participants. clearinghouse A facility for settling transfers of funds between banks. Clearing House Interbank Payment System (CHIPS) A telecommunications system that transfers funds between banks internationally. closed-end investment company A mutual fund issuing a limited number of shares that are then traded in the stock market. collateral Assets such as equipment, accounts receivable, inventory or real estate pledged to a lender to secure a loan. collateralized mortgage obligation (CMO) A pool of mortgages placed in a trust with a division of claims designed to give investors a more predictable cash flow than individual mortgages.

commercial bank A financial institution that offers a wide variety of services, including checking accounts and business loans. commercial finance companies Nondeposit financial intermediaries that specialize in making business loans. commercial paper Short-term debt instruments issued by finance companies and large business firms. Commodities Futures Trading Commission (CFTC) The government agency that regulates futures trading in the United States. common stock Ownership interest in a company; such ownership provides a residual claim to the company’s earnings, paid in the form of dividends. compound interest Interest calculated on the sum of the principal and the interest already earned. comptroller of the currency The primary regulator of nationally chartered commercial banks. consols Perpetual bonds, which have no maturity date but pay a fixed cash flow (interest) forever. consumer finance companies Nondeposit financial intermediaries that specialize in making consumer loans. consumption The using up of goods or services by households; more generally, the purchase of goods for immediate use by households. consumption function The relationship of consumption spending to the level of income, in its simplest form expressed as C = a + bY. See also marginal propensity to consume. contemporaneous reserves The system of reserve requirements now in effect, which makes required reserves depend on the current level of deposits (but still leaves a small gap between the calculation and the holding of required reserves). conversion feature (of a bond) The right to convert a corporate bond into shares of the company’s stock at a predetermined price.

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Glossary convertible debt A debt instrument that can be converted into equity (at a predetermined price) if the investor chooses to do so. convertible preferred stock Preferred stock that can be converted into common stock at a predetermined price. corporate takeover The acquisition of one company by another company or by a group of investors. correspondent balances Funds kept by one bank in another (a correspondent bank) to facilitate check clearing and other business relationships. cost of capital effect Impact of a change in interest rates on GDP through investment spending. countercyclical monetary policy A policy of the central bank designed to stabilize economic activity, usually by increasing the rate of growth of the money supply (expansionary monetary policy) during recessions and decreasing the rate of growth of the money supply (contractionary monetary policy) in inflationary periods. counterparties Two parties to a swap agreement. coupon equivalent yield (bond equivalent yield) The difference between the face value and the purchase price of a Treasury bill, divided by the purchase price and annualized using 365 days to the year (366 in leap year). coupon rate The interest rate calculated by dividing the annual coupon payment on a bond by the face value of the bond. coupon securities (coupon-bearing securities) Bonds that make periodic interest payments prior to maturity. In some cases the bonds have actual coupons attached, which bondholders remove and send in at regular intervals to collect interest. credit risk The risk associated with the possibility that borrowers may default on their obligation. credit unions Depository institutions specializing in consumer loans that are organized around a common link

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among depositors—such as a common employer. crowding-out effect A decrease in spending (usually investment) resulting from a rise in interest rates caused by an increase in government spending. currency Coins and bills used as money. currency swaps A contractual agreement between two counterparties to exchange payments in different currencies during a future period. current account The account that represents all transactions between domestic and foreign residents involving transactions of goods or services. A foreigner purchasing a domestic good or service represents a domestic current account surplus. current coupon Most recently issued government security of a particular maturity. current yield The annual coupon payment on a bond divided by the current price of the bond. daily earnings at risk A measure of the amount of potential loss exposure to a financial intermediary over the next day due to trading risk. dealer An institution or individual acting as a market-maker by continuously quoting bids and offers on a security, with the objective of earning a profit on the bidasked spread. dealer market A market where a specialized trader called a dealer or market-maker continuously quotes bid and offer prices. default To fail to make a payment on schedule. default risk The chance that the issuer of a security will default. defensive open market operations. See open market operations. deferred credit items An entry on a bank’s balance sheet indicating that at a predetermined time it will receive an addition to its reserve account. deficit nation A nation that imports more than it exports, resulting in a deficit balance of trade.

Glossary defined benefit plans A pension plan where the benefits paid at retirement are specified. defined contribution plans A pension plan where the contributions of the employer and the employee are specified and the benefits depend on the performance of the assets in the plan. deflation Generally falling price levels. demand deposit Noninterest bearing checking accounts. demand deposit expansion multiplier The number that when multiplied by the level of reserves determines the maximum amount of demand deposits. In its simplest form, it equals the inverse of the required reserve ratio. demand-for-money equation An equation explaining how the demand for money varies with other economic variables, especially income and interest rates. depository institution An institution that accepts deposits and/or offers services such as checking accounts; includes commercial banks, savings and loan associations, savings banks, and credit unions. depository institutions reserve equation See bank reserve equation. deposit rate ceilings See Regulation Q. depreciate To decrease in value, especially referring to foreign currency. depression A time span marked by a severe drop in the level of economic activity and very high levels of unemployment. derivative financial instrument A financial instrument such as a swap or an option or futures contract that derives its value from some other, underlying, financial asset. devaluation A lowering of the agreed-upon value of a country’s money, in a system of fixed exchange rates. discount bond See zero-coupon bond. discount rate The interest rate financial institutions pay to the Federal Reserve to borrow reserves. discount window The facility that financial institutions are said to use when borrowing reserves from the Federal Reserve.

discretionary funds Bank liabilities and assets that are subject to short-term management control. dishoarding Decreased money holdings. disintermediation Removal of funds from financial institutions for direct investment in primary securities. disposable income Income minus taxes. dividends Earnings of a corporation that are distributed to stockholders. dividend yield The current annual dividend of a stock divided by its price. Dow Jones Industrial Average (DJIA) A measure of the level of stock prices, based on the stock prices of 30 blue-chip industrial companies. dual banking system The chartering and supervision of commercial banks by both state and federal governments. due diligence An assessment of a firm’s overall quality conducted when its securities are originated. duration A measure of the futurity of a bond’s payment stream that takes into account coupon size as well as time to maturity. It also measures the price sensitivity of the bond to a change in yield. dynamic open market operations See open market operations. economies of scale The condition under which the average unit cost of production goes down as the firm gets larger. economies of scope The condition under which the average unit cost of production goes down as the firm adds different products. Edge Act corporation An international banking subsidiary of a U.S. bank. efficient capital market A financial market in which securities prices reflect all available information. efficient portfolio A combination of assets that yields the greatest possible return for a given risk and that carries the lowest possible risk for a given return. electronic funds transfer system (EFTS) A system in which telecommunications

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Glossary replace checks as the means of transferring funds between banks. Employee Retirement Income Security Act (ERISA) Legislation enacted in 1974 to safeguard employee pension rights and establish the Pension Benefit Guaranty Corporation. entrepreneur An individual who as an owner starts, organizes, and manages the risk of a business venture. equation of exchange MV = PY, an expression showing that total spending (the supply of money times velocity) equals the value of what is bought (the price level times the level of real GDP). Sometimes used to relate the price level (P) or nominal GDP (PY) to the money supply. equilibrium A level or value from which there is no tendency to change. equilibrium interest rate The interest rate at which the quantity of funds lenders want to lend equals the quantity of funds borrowers want to borrow. At equilibrium, there is no tendency for the interest rate to change. equilibrium price The price at which the quantity demanded equals the amount supplied, so that there is no tendency for the price to change. equities See stocks. equity capital The difference between total assets and total liabilities on a balance sheet. euro Currency of the European Monetary Union introduced in January, 1999. Eurobonds Bonds sold outside a borrowing corporation’s home country. Eurodollars Deposits held in dollars in foreign banks. Euromarket The market for Eurodollars and Eurobonds. European Monetary System (EMS) A quasi-fixed exchange rate system among several European countries established in 1979. European Union The formal union of European countries to form a common market for goods and services. ex ante Planned or expected (contrast with ex post).

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excess reserves Bank reserves held in excess of what is required. See also reserves and required reserves. exchange rate effect Impact of a change in interest rates on GDP through net exports. exchange rates See foreign exchange rate, fixed exchange rates, and floating exchange rates. Exchange Traded Funds (ETF) Securities that track an index and represent a basket of stocks like an index mutual fund but trade like a stock on an exchange. exercise price The predetermined price in an option that the underlying asset can be bought at (call) or sold for (put). expectations hypothesis A theory of the term structure of interest rates stressing that long-term rates will be an average of the current short-term rate and expected future short-term rates. ex post Actual or realized (contrast with ex ante). face value The final amount of indebtedness (excluding interest) that must be repaid on a bond. See also principal. Fed Federal Reserve System. Federal Advisory Council A group of commercial bankers that makes recommendations to the Federal Reserve Board of Governors regarding monetary policy. Federal Deposit Insurance Corporation (FDIC) A federal agency that insures deposits at commercial banks, savings banks and savings and loan associations. It also examines and supervises state-chartered commercial banks that are not members of the Federal Reserve System. federal funds An unsecured loan between banks where the funds that are lent are transferred the same day the loan is made. federal funds market The market for unsecured loans between banks, called federal funds. federal funds rate The interest rate on federal funds. Federal Home Loan Banks Government sponsored banks from whom savings and loans associations can borrow money.

Glossary These banks are members of the Federal Home Loan Bank system. Federal Home Loan Mortgage Corporation (“Freddie Mac”) A subsidiary of the Federal Home Loan Bank that issues debt instruments that provide claims primarily to pools of conventional mortgages. Federal Housing Finance Board (FHFB) An agency that oversees the Federal Home Loan Banks. Federal Land Banks Part of the Federal Farm Credit System, these banks make loans to farmers. Federal National Mortgage Association (“Fannie Mae”) A private corporation with certain ties to the government that issues debt instruments that provide claims primarily to pools of governmentinsured mortgages. Federal Open Market Committee (FOMC) A policy-making group within the Federal Reserve System that directs the open market operations of the system. Federal Reserve System (“the Fed”) The central banking system and monetary authority of the United States, made up of regional Federal Reserve banks and the Federal Reserve Board of Governors, which supervises and examines statechartered member banks, regulates bank holding companies, and is responsible for the conduct of monetary policy. Federal Savings and Loan Insurance Corporation (FSLIC) Government agency that provided deposit insurance for savings and loan associations (replaced by the Federal Deposit Insurance Corporation). Fed Wire A telecommunications system, operated by the Federal Reserve, that transfers funds between banks. FHA-VA mortgage A mortgage insured either by the Federal Housing Authority (FHA) or by the Veterans Administration (VA). finance companies Nondeposit financial intermediaries that specialize in making consumer and business loans. financial assets See real assets.

financial disintermediation When funds flowing through the intermediated markets are shifted to flowing through the financial (securities) markets. financial futures Futures contracts whose underlying assets are securities or, in index futures, the cash value of a group of securities. financial holding company A holding company that can hold one or more bank or non-bank financial subsidiaries (such as an insurance company). financial institutions Institutions which engage in activities associated with either the financial markets or the intermediated markets. financial intermediaries Institutions with financial claims on both sides of the balance sheet that act as go-betweens in funneling funds from saver-lenders to borrowerspenders. financial intermediation The process of funneling funds from saver-lenders to borrower-spenders through a financial intermediary. financial markets Markets in which financial assets can be traded. fiscal policy Government policy concerning spending and taxation. fixed exchange rates An international financial system in which rates of exchange between the values of different countries’ currencies are maintained at agreed-upon levels. fixed-rate loan (mortgage, security) A loan (mortgage, security) that carries an unchanging interest rate throughout the life of the instrument. fixed-rate payer Party in an interest rate swap making fixed payments. float The total value of checks that have been credited by the Fed to the banks in which they have been deposited but have not yet been collected from the banks on which they are drawn. floating exchange rates An international financial system in which rates of exchange between the values of different countries’ currencies fluctuate according to supply and demand in the marketplace.

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Glossary floating interest rate A loan whose interest rate is adjusted periodically with changes in market rates. floating-rate (variable-rate) loan (mortgage, security) A loan that carries an interest rate that is adjusted periodically to reflect changes in market interest rates in general. floating-rate payer Party in an interest rate swap making variable payments. flower bonds Government bonds that can be used at par value to settle federal estate taxes. flow of funds accounting A record of payments and receipts among the different sectors of the economy. foreign exchange rate The value of a unit of one nation’s money in terms of another nation’s money. forward contract A nonstandardized agreement to exchange an asset in the future at a currently agreed upon price. funding (of pension benefits) Setting aside funds now to cover future pension liabilities. futures contract A standardized agreement, traded on an organized futures exchange, for delivery of a specific commodity or security on a specified future date and at a specified price. GAP ratio The one-year repricing GAP divided by total assets. See also one-year repricing GAP. general obligation bonds Municipal bonds backed by the overall taxing power of the state or local government. Glass-Steagall Act of 1933 Legislation that separated investment banking from commercial banking. GNMA (“Ginnie Mae”) pass-through securities Claims to a pool of FHA-VA mortgages insured by the Government National Mortgage Association (GNMA). gold export point Under an international gold standard, the limit to which a deficit nation’s currency can depreciate before it becomes cheaper to export gold than to purchase foreign currency. gold import point Under an international gold standard, the limit to which a surplus nation’s currency can appreciate before it

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becomes cheaper for other nations to pay their trade deficits to it in gold than to purchase its currency. gold standard A monetary system in which currency is redeemable in gold at a fixed price. Government National Mortgage Association (GNMA, “Ginnie Mae”) A division of the U.S. Department of Housing and Urban Development that insures pools of FHA and VA mortgages. Gramm-Leach-Bliley Act of 1999 Legislation that allowed cross-ownership of financial institutions and essentially repealed the Glass-Steagall Act. Gresham’s law “Bad money drives good money out of circulation.” gross domestic product (GDP) The total value of goods and services produced in the domestic economy in a given year. group insurance Insurance made available to members of a group, such as employees of a corporation, usually at favorable rates. Hausbank A German company’s principal bank. The company relies on it as the primary source of all forms of external finance, including both debt and equity. hedge fund An unregulated investment pool that is open only to institutions or wealthy individual investors. hedger One who tries to reduce the risk of loss resulting from a change in the price of a particular asset. In futures markets, it is someone who sells a futures contract while holding the underlying asset (short hedger) or purchases such a contract in anticipation of purchasing the underlying asset (long hedger). high-yield See junk bonds. historical cost accounting Accounting rule used for banks and savings and loan associations that values assets and liabilities at their purchase price. hoarding Increased money holdings. holding company A corporation set up to hold a controlling interest in one or more other corporations. A bank holding company owns one or more banks.

Glossary holding period yield The annual return on a bond when it is sold before maturity. Also see yield to maturity. hostile takeover The acquisition of one company, against its management’s will, by another company or by a group of investors usually associated with the removal of the acquired company’s management. hyperinflation A rapid increase in general price levels, e.g., above 100 percent per year. impact lag of monetary policy The time between the use of a monetary strategy and its effect on the economy. income statement A summary statement of an individual’s or a business’s current receipts and current expenditures during a period of time. index fund A mutual fund whose goal is to mimic the performance of one of the financial market indices, often the S&P 500. Individual Retirement Account (IRA) A tax-benefited pension plan for workers. inflation Generally rising price levels. initial public offering (IPO) An offering in which a company issues publicly traded stock for the first time. insider trading Illegal use of knowledge not available to the general public, to gain advantage in buying and selling securities. institutionalization Shift in flow of funds from investors directly purchasing traded securities to indirectly purchasing traded securities through financial intermediaries such as mutual funds. insurance company A financial institution providing protection against loss (of life or property) or costs (such as medical or legal costs) by accepting payments (premiums) in return for a guarantee of compensation. Inter-District Settlement Fund A facility for transferring funds among banks located in different Federal Reserve districts. interest A charge paid by a borrower to a lender for the use of the lender’s money. interest rate The cost of borrowing expressed as a percent of principal per annum. See also yield and yield to maturity.

interest rate risk The risk that a change in interest rates may affect the net worth of a financial intermediary because of a mismatch in the maturity of its assets and liabilities. interest rate swaps A contractual agreement between two counterparties to exchange interest payments during a future period. intermediated markets Markets in which funds flow from saver-lenders to borrowerspenders through financial intermediaries. internal rate of return See yield to maturity. International Banking Facility (IBF) A domestic branch bank established for international banking and treated for regulatory purposes as a foreign branch. International Monetary Fund (IMF) An international organization set up in 1944 to supervise exchange rates and to promote orderly international financial conditions. international reserves Reserves held by one country usually in the form of gold or in the money of another country. intrinsic value An option’s value at expiration (or if it is exercised). investment banks Financial institutions whose central activity is originating securities in the primary market but often also engage in securities market-making, brokering, trading and advisory services. investment grade Bonds rated in the top four categories by Moody’s or Standard and Poor’s. investment portfolio The collection of securities, such as stocks and bonds, held by an individual or a corporation. investment spending The purchase of plant, equipment, and inventories by a business. IOU See promissory note. IS curve Graph of points showing combinations of level of income and interest rate at which savings equals investment. ISLM analysis A model of the economy that shows the interaction of monetary policy and fiscal policy and partially integrates the classical and Keynesian systems.

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Glossary junk bonds Risky bonds rated below Baa. keiretsu A group of Japanese companies that are controlled through interlocking ownership (the companies own stock in each other). Keogh Plan A tax-benefited pension plan designed for self-employed individuals. Keynesian Derived from the theories of John Maynard Keynes, advocating government spending and taxation to maintain full employment and a stable economy. lagged reserves The former system of bank reserve requirements, which left a gap of two weeks between the calculation of required reserves and the time when the reserves had to be held. laissez-faire “Let (people) do (as they wish),” a policy of government nonintervention in the economy. league tables The rankings of investment banks by volume of underwriting in specific classes of securities. legal tender Money that the government requires a creditor to accept in discharge of debts. If it is not accepted, interest need not accrue thereafter. lender of last resort The Federal Reserve, which acts as the ultimate source of funds to banks and other financial institutions by providing reserves to prevent bank failures. lesser developed countries (LDCs) Refers to developing countries whose economies and financial systems are still considered immature. letter of credit A financial guarantee given by a bank to insure payment by one of its customers to a third party. leverage The degree to which financial intermediaries, or any company, is financed by debt versus equity—often measured in banking by the leverage ratio, which equals stockholders equity divided by total assets. leveraged buyout (LBO) The acquisition of a company where the acquisition is substantially financed by debt. liability A financial obligation. LIBOR London Interbank Offered Rate, the rate charged between banks for Eurodollar time deposits.

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life insurance company Companies that sell life insurance, annuities and other savings-oriented products. line of credit (L/C) A commitment by a bank or other institutional lender that provides a borrower with a capacity to borrow up to a specified limit. liquid asset An asset that can be converted quickly into a medium of exchange without suffering a loss. liquidity Ability to convert an asset into cash quickly with little loss in value. liquidity preference Keynes’s term for the demand for money, often used in connection with the rate of interest. liquidity premium The higher yield on longer-term securities compared with short-term securities, to compensate for the additional risk of long-term issues. Associated with the liquidity premium theory of the term structure of interest rates. liquidity risk The risk to a bank that unexpected deposit withdrawals or unexpected loan demand will leave it short of funds. liquidity trap In Keynesian theory, the point beyond which an increase in the money supply will no longer cause interest rates to drop. LM curve Graph of points showing combinations of level of GDP and interest rates at which liquidity preference equals the money supply. loanable funds Funds that lenders are willing to make available to borrowers. Can be used as a framework for determining the equilibrium level of interest rates. loan charge-offs The amount of the loan portfolio that had to be written down over the past year because some of the bank’s borrowers could not pay their loans back. loan/deposit ratio The ratio of a bank’s total loans to its total deposits, a measure of the bank’s liquidity. loaned up Said of a bank that has no excess reserves against which it can make loans. long The buyer of a financial asset, usually an options or futures contract, who is also said to “take a long position.”

Glossary M1 See money supply. M2 A definition of money supply that adds to M1 such assets as savings accounts, small-denomination time deposits, money market deposit accounts, and money market mutual fund shares. M3 A definition of money supply that adds to M1 and M2 such assets as largedenomination time deposits. macroeconomics The study of whole systems of the economy, such as total income and output, the price level and interest rates, and the interrelationships among them. magnetic ink character recognition (MICR) A technology that uses characters printed with magnetic ink to allow automated processing of checks. managed floating system The international financial system currently in use, in which major nations intervene to influence foreign exchange rates by buying and selling currencies. manager-stockholder conflict Conflict that arises because of asymmetric information and the difference between a manager’s personal objectives and the objective of maximizing stockholder wealth. margin (1) A minimum down payment required by law for the purchase of stock; (2) a deposit placed with a clearing corporation by both the buyer and the seller of a futures contract. marginal propensity to consume The amount that a person spends out of each dollar of incremental income. marginal propensity to save The amount that a person saves out of each dollar of incremental income. marked-to-market Accounting rule that changes the value of a security (or any asset or liability) any time its market value changes. marketability The ease of buying and selling an asset, associated with narrow bid-asked spreads. market-maker See dealer. market portfolio Portfolio consisting of all securities in the marketplace.

market risk (capital uncertainty) The risk of price fluctuations for a security. For bonds, it is associated with variations in the level of the interest rate. markets-oriented system A financial system such as the U.S. or the U.K. in which the stock and bond markets are large relative to the banking system. mark-to-market settlement Daily adjustments made in balances at a clearing corporation to reflect price changes in futures contracts. matched sale-purchase agreement Open market operation (sale), sometimes called a “reverse repo,” in which the Federal Reserve sells securities and agrees to buy them back in the near future. maturity date The due date for the final payment on a financial instrument such as a bond or a certificate of deposit. medium of exchange Something used to finalize payments for goods and services (M1, or currency and checking accounts). medium-term notes Debt instruments that are similar to commercial paper except their maturities range from 1–5 years instead of 270 days or less. merchant bank A bank that can use its own capital to take an ownership stake in a non-financial company with the eventual goal of reselling the ownership interest to make a profit. mezzanine debt funds A fund that invests in subordinated debt, or a combination of debt and equity. modern portfolio theory Analysis of portfolio decisions under uncertainty and the implications for the returns on risky securities. monetarism The position, based in classical economics, that an “invisible hand” pushes the economy toward a full employment level of production at which it is inherently stable and that government efforts to affect economic activity through countercyclical policies are unnecessary and potentially damaging. Also associated with the quantity theory of money.

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Glossary monetary authority An institution responsible for executing national monetary policy, such as the central bank. monetary base Total bank reserves plus currency held by the nonbank public. monetary policy Government policy concerning money and credit conditions, especially the rate of growth in the money supply and the level of interest rates. See also countercyclical monetary policy. monetizing the debt The government’s creation of money with which to buy back interest-bearing government securities. money Whatever is used as a medium of exchange, unit of account, and store of value. See also legal tender and money supply. money market The financial market for short-term securities. money market deposit accounts Deposits with limited checking account privileges that typically pay an interest rate comparable to Treasury bills or other money market instruments. money market mutual funds Mutual funds that invest in money market instruments. money multiplier See demand deposit expansion multiplier. money supply (M1) The total of currency outside banks and demand deposits. monitoring Producing and using information about a borrower or issuer after a financial contract’s origination. moral hazard A problem of asymmetric information occurring after a loan is made. In particular, the borrower may become riskier without being detected by the lender. mortgage A (usually long-term) loan for the purchase of a home or other building, where the home or building serves as collateral in case of default. mortgage pool A package of mortgages that is sold as a unit. multiplier The ratio of the change in GDP to a change in exogenous spending; some-

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times called expenditure multiplier to distinguish it from the money multiplier. municipal bond A bond issued by a state or local government, called a tax-exempt because the interest is exempt from federal income tax. mutual fund A fund that pools the investments of a large number of shareholders and purchases securities such as stocks or, in a money market mutual fund, money market instruments. mutual fund family A group of mutual funds owned and managed by the same management company. mutual savings banks Depository institutions that specialize in making consumer and mortgage loans. These thrift institutions are mostly located in the Northeast. National Association of Securities Dealers An association of securities dealers to whom the Securities and Exchange Commission has delegated oversight of the over the counter equities market. National Association of Securities Dealers Automated Quotation System (NASDAQ) A computerized system for displaying bid and asked prices for over-the-counter stocks. natural rate of interest The rate of interest at which savings equals investment at full employment. negotiable certificates of deposit (CDs) Certificates of deposit that can be traded in a secondary market. negotiable order of withdrawal (NOW) account An interest-bearing checking account. net asset value (NAV) The value of a share of a mutual fund, based on the market value of the assets owned by the fund and the number of shares outstanding. net interest income Interest income minus interest expense on a bank’s income statement. net interest margin (NIM) Net interest income expressed as a percent of total bank assets. net worth The difference between an individual’s or business’s assets and liabilities.

Glossary New York Stock Exchange Composite Index A measure of the level of stock prices, based on all the stocks listed on the New York Stock Exchange. no-load funds Mutual funds sold directly to the public with no sales commission. nominal GDP The gross domestic product measured in current prices. nominal interest rate Interest rate measured in money terms, as distinct from the real interest rate, which is corrected for changes in purchasing power. nonbank bank A bank that limits its commercial services (dropping either demand deposits or business loans) in order to bypass various legal restrictions. nondepository financial intermediaries A financial intermediary that does not issue deposits. nondiscretionary funds Bank liabilities and assets not subject to short-term management control. nonperforming loans Loans whose interest payments are delinquent 30 days or more. nonsystematic risk Risk that is independent of other securities and can be eliminated by portfolio diversification. nontraded financial contracts A financial claim or contract that cannot be traded in a secondary market but is instead held to maturity by its original investor or lender. notional principal amount Agreed-upon principal in a swap transaction. off-balance sheet Refers to activities that banks engage in that are not recorded as either assets or liabilities. offer price See asked price. offering memorandum A document used in the origination of private placements that contains information about the issuing firm and the purpose of the issue. offering (or preliminary) prospectus A public document filed with the registration statement that contains all relevant factual information about the firm and its financing. Office of Thrift Supervision (OTS) Department within the U.S. Treasury that

charters, regulates, examines, and supervises savings and loan associations. one-year repricing GAP The dollar difference between the amount of a bank’s assets that will be repriced in less than one year and the amount of the bank’s liabilities that will be repriced in less than one year. on the run See current coupon. open-end mutual fund A mutual fund that offers to the public shares that are redeemable at net asset value. open interest The number of open long (equal to short) positions for a given option or futures contract. open market operations The purchase and sale of government securities by the Federal Reserve in order to control levels of bank reserves. Those aimed at defending a target level of reserves from outside influences are defensive open market operations; those aimed at changing the level of reserves are dynamic open market operations. operating efficiency (of securities markets) The effectiveness with which markets bring together buyers and sellers. operating target One of two intermediate objectives of an open market operation, usually either the level of reserves or the federal funds rate. option contract See call option and put option. option premium The price paid by an option buyer to the option seller for the rights acquired. over-the-counter market (OTC) Trading in stocks, usually of smaller companies, that are not listed on one of the stock exchanges. Also refers to how government and corporate bonds are traded, that is, through dealers who quote bids and offers to buy and sell “over the counter.” passbook savings account Name used in the past to refer to bank accounts which carry a specific interest rate and from which funds can be withdrawn at any time. pass-through securities See GNMA passthrough securities.

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Glossary payments system The institutional arrangements for settling transactions in the economy. payoff method A procedure, used in cases of bank failure, in which the bank goes into receivership and the FDIC pays depositors directly. peg To hold to a fixed level, as in pegging the foreign exchange rate. Pension Benefit Guaranty Corporation (Penny Benny) An agency that insures pension benefits against company bankruptcy. pension (retirement) fund A fund that invests the contributions made by or for workers and makes payments to them when they retire. personally guaranteed A loan to a business that is also guaranteed by an individual, typically the business’ owner. petrodollars Revenue, in dollars, from OPEC sales of oil. Phillips curve The relationship between inflation and unemployment, suggesting that lower unemployment is usually accompanied by higher rates of inflation. Originally presented by Professor A. W. Phillips. point of sale (POS) terminal An electronic device that automatically debits a buyer’s checking account and credits the seller’s checking account at the time of sale. portfolio diversification Holding many different types of securities in a portfolio. preferred habitat theory The theory of the term structure of interest rates that combines supply and demand forces with expectations. preferred stock Ownership interest in a company that carries a fixed promised dividend payment. preliminary prospectus See offering prospectus. prepayment Payment of an obligation before the payment is due. present value Value of a future payment discounted by an interest rate to produce its present value (value today). price-earnings (P/E) ratio The price of a stock divided by its earnings per share.

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primary credit The Fed’s discount window borrowing facility for borrowers that meet creditworthiness conditions. primary securities Stocks and bonds issued by ultimate borrower-spenders. primary securities market The financial market for the purchase and sale of stocks or bonds when they are first issued. prime A reference to the most creditworthy borrowers, market, or institution. Contrast with subprime. prime rate The interest rate that banks charge their “biggest and best” customers, although frequently a bank’s very largest customers may pay rates below the prime rate. principal (of a bond) The amount borrowed, excluding interest. Frequently used interchangeably with the face value of a bond, although they are equal only for a coupon-bearing security that is sold at par. private pension funds Funds that invest and manage the contributions of individuals saving for retirement. private placements Nontraded corporate bonds that do not have to be registered with the SEC. promissory note A written promise to pay a specified sum of money at a specified time or on demand; sometimes called an IOU. prompt corrective action (PCA) A set of banking regulations that take much of the discretion away from regulators in their handling of failing banks. property and casualty insurance companies Financial intermediaries that offer insurance against casualties such as automobile accidents, fire, theft, negligence, and malpractice. put option An option contract in which the option buyer has the right (but not the obligation) to sell a specified quantity of the underlying asset at a specified price until the expiration date of the option. quantity theory of money The theory that a proportional increase in the supply of money leads to a proportional increase in the price level.

Glossary rational expectations Expectations of economic variables that reflect all currently available information. According to some, rational expectations may lead individuals to anticipate monetary policy and neutralize its effects. real assets Property such as land or equipment, as distinguished from financial assets, such as stocks and bonds. real GDP Gross domestic product, adjusted for the effects of inflation. real interest rate The interest rate in terms of goods and services; approximated by subtracting the rate of inflation from the nominal interest rate. recession A time span marked by a drop in the level of economic activity and increased unemployment. recognition lag of monetary policy The time between a change in economic conditions and the realization by policymakers that the change has occurred. redlining Discriminatory practices in mortgage lending. registration statement A public document that must be filed with the Securities Exchange Commission before a security can be sold to the public. Regulation Q The regulation that imposed ceilings on deposit interest rates. Regulation Q was effectively dismantled in the early 1980s. repricing maturity The length of time until a loan’s interest rate is reset or the loan matures. repurchase agreement (RP or “repo”) The sale of securities with a commitment to buy them back at a specified date and at a specified price. Repos are used by the Federal Reserve as a type of open market operation and by government securities dealers to finance their inventories of bonds. required reserve ratio The ratio of bank reserves to deposits that a bank must hold according to law. required reserves Funds that a bank must hold in the form of vault cash or deposits

at the Federal Reserve to meet its required reserve ratio. reserve requirements See required reserve ratio. reserves Funds that a bank holds in the form of vault cash or deposits at the Federal Reserve. Resolution Trust Corporation (RTC) An agency that administered the closing or merging of insolvent thrift institutions. restrictive covenants Contractual promises agreed to by a corporation when it obtains financing that typically restrict its activities. retained earnings Profits of a corporation that are not distributed as dividends to shareholders. return on assets (ROA) Net income after taxes divided by total assets. return on equity (ROE) Net income after taxes divided by stockholders’ equity. revenue bond A bond issued to finance a particular project, such as a toll road, the receipts from which are used to pay the interest and principal on the bond. reverse repo See matched-sale purchase agreement. revolving lines of credit A financing package from commercial banks that combines a line of credit with a term loan. risk aversion An investor characteristic requiring higher expected returns on risky securities compared with a riskless security. risk-based capital (RBC) requirements A regulatory requirement in banking that links minimum capital standards to bank risk. risk-based deposit insurance premiums Deposit insurance premiums that vary with the riskiness of the bank, as required under the FDIC Improvement Act of 1991. risk premium Extra return above the risk free rate for investing in a risky security. risk structure of interest rates The relationship between yields on different types of securities, especially those with different credit ratings. risky securities Securities with uncertain returns.

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Glossary round lot The unit in which securities are usually traded (100 shares of an equity, $1 million of face value in Treasury bills). saving function The relationship between saving and level of income, in its simplest form expressed as S = -a + (1 - b)Y. See also marginal propensity to save. savings accounts See savings deposits. savings and loan association (S&L) Depository institutions that are substantially restricted to investing in homerelated assets such as mortgages. Savings Association Insurance Fund (SAIF) Fund, operated by the FDIC, that insures deposits at savings and loan associations. savings bank A financial institution that traditionally was limited to accepting savings deposits and making home mortgage loans. savings deposits Nontransactions deposits that can be withdrawn at any time such as a money market deposit account. Say’s law “Supply creates its own demand,” hence total spending (demand) will always be sufficient to justify production at full employment (supply). secondary credit The Fed’s discount window borrowing facility for borrowers that do not meet creditworthiness conditions. secondary securities market A financial market in which previously issued securities are traded, such as the New York Stock Exchange. Section 20 affiliates Investment banking subsidiaries of bank holding companies that can engage in underwriting activities formerly prohibited under the GlassSteagall Act. secured lender A lender whose loans are secured by collateral. securities Financial instruments representing ownership or debt, such as stocks and bonds, that provide claims to future expected cash flows. Securities and Exchange Commission A federal agency that regulates securities brokers and dealers and securities markets. securities brokers Financial institutions (or individuals who work for these institu-

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tions) that operate in the secondary market by matching buyers and sellers of a particular security and earn a commission or fee for bringing the two together. securitization Pooling a group of loans into a trust and then selling securities issued against the trust, thus transforming nontraded loans into traded securities. serial maturity Scheduled retirement of a portion of a bond issue each year until the entire issue has matured. settlement by offset The cancellation of rights and obligations in the options and futures market through purchases and sales of identical contracts. share A unit of ownership in the capital stock of a corporation. shelf registration The process by which a firm registers a dollar capacity to issue securities with the Securities and Exchange Commission that it can use in increments, or in total, at any time during the life of the shelf. shell branch A banking facility set up abroad to avoid domestic regulation and taxation. short The seller of a financial asset who still has an outstanding obligation to buy back the asset, especially an options or futures contract. Also phrased as “take a short position.” simple interest Interest calculated by multiplying the principal by the interest rate and the time in years. See also compound interest. Society for Worldwide Interbank Financial Telecommunications (SWIFT) A telecommunications system that transfers funds between banks internationally. sources and uses of funds statement A financial statement integrating the income statement and balance sheet of a unit or a sector of the economy. specialist A dealer who makes a market in stocks traded on an organized exchange (such as the New York Stock Exchange) and who is also responsible for matching public buy and sell orders in an auction format.

Glossary speculative demand for money Keynes’ notion that people demand cash balances to speculate on future interest rates. speculators People who take on risk on financial transactions in anticipation of profit. spot market The market in which an asset is traded for immediate delivery, also called the cash market, as opposed to a market for forward or future delivery. Standard & Poor’s 500 Stock Index A measure of the level of stock prices based on the prices of 500 stocks selected by Standard & Poor’s Corporation. state and local government retirement funds Funds that invest and manage the contributions of state and local government employees saving for retirement. stock flotation The sale of a new stock issue to raise capital for a corporation. stockholder-lender conflict Conflict between stockholders and lenders that arises because of asymmetric information and the difference in the way risk affects each of them. stocks (equities) Shares of ownership in corporations. See also common stock. store of value The extent to which assets maintain their purchasing power over time. Money must be a good store of value to function well. strike price See exercise price. stripping Removing the interest coupons from bonds and reselling them as separate (zero-coupon) securities. subordinated debt A class of debt whose repayment priority in bankruptcy is behind, or junior to, other classes of debt. subprime A reference to market participants who have poor, non-existent, or insufficient credit history to qualify for conventional financing. A subprime mortgage may be made to individuals who cannot verify their income. supply-side economics The theory that reduction in tax rates increases production incentives and encourages expansion of economic activity, resulting ultimately in increased tax revenues.

syndicate A group of investment banks that is put together to share the risk associated with underwriting a security. systematic risk Risk that is common to all securities that cannot be eliminated by portfolio diversification. T-account A simple accounting statement that records only changes in balance sheet items from a starting point. tax and loan accounts Deposits of U.S. government funds, generated by tax receipts and bond sales, in commercial banks. tax-anticipation notes (TANs) Short-term municipal securities issued to raise stop-gap funds and paid off from tax receipts. tax-exempts See municipal bond. Taylor rule A monetary policy rule that uses a simple equation to determine the level of the federal funds rate given the values of the inflation rate and the gap between actual and potential real GDP. term life insurance Pure life insurance with no savings component included in the policy. term sheet A short document used in the origination of private placements that summarizes the key terms of the contract. term structure of interest rates The relationship between yields on different maturities of the same type of security. thin markets A market with low trading volume. thrift institutions (“thrifts”) Savings and loans associations, mutual savings banks, and credit unions are referred to as the thrift institutions. time deposits See certificates of deposit. total return A security’s capital gain plus coupon or dividend income divided by price. traded securities Financial claims or contracts that are traded in a secondary market such as stocks traded on the NYSE. trading risk The risk to a financial intermediary associated with trading a financial instrument. transactions costs Costs, such as commissions and the bid-asked spread, of buying and selling securities. See also marketability.

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Glossary transactions demand for money The demand for money associated with the level of economic activity. transactions deposits Deposits with unlimited checking privileges. transmission mechanisms of monetary policy The channels through which changes in money affect economic activity. Treasury bills A zero-coupon obligation of the U.S. government issued with a maturity of one year or less. Treasury bond A coupon-bearing obligation of the U.S. government issued with a maturity of over ten years. Treasury Inflation Protected Securities (TIPS) Bonds issued by the federal government that periodically adjust their principal and interest to account for varying rates of inflation. Treasury note A coupon-bearing obligation of the U.S. government issued with a maturity of one to ten years. underwriter A financial institution that is hired by a company to sell its securities to the public. underwriting The process by which a newly issued security is sold to the public. underwriting spread The fee earned by an investment bank or other financial institution for marketing a newly issued security. unit of account Something used to measure relative values of goods and services. Money is usually a unit of account. universal banking The combination of the traditional activities of a commercial bank and the underwriting activities of an investment bank and possibly other financial services under the same roof. universal life A life insurance policy that includes a savings component that pays a money market rate. unsecured loan A loan that is not secured by collateral. variable life A life insurance policy that includes a savings component that can be allocated among a menu of investment options.

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variable-rate loan See floating-rate loan. velocity The rate of turnover of the money supply; the average number of times per year each dollar is used to purchase goods and services (often measured as GDP divided by the money supply). venture capital funds A fund that invests in the equity of new “start-up” companies. vesting Rights in a pension fund that are not lost if the employee leaves the job before retirement. wealth The total value of the assets owned by an individual or business at a particular point in time. wealth effect Impact of a change in interest rates on GDP through the effect of wealth on consumption. whole life Life insurance policies with a constant premium and savings component. World Bank (International Bank for Reconstruction and Development) An organization funded by developed countries to lend money to developing countries. yield The effective rate of return for holding a debt instrument, as distinguished from its coupon rate of interest. See also current yield, yield to maturity and holding period yield. yield curve A graphic representation of the relationship between yield and maturity of securities. yield on a discount basis The difference between the face value and the purchase price of a Treasury bill, divided by the face value and annualized using 360 days to the year. yield to maturity (internal rate of return) The rate of discount (per annum) that makes the sum of the present values of all future payments of a security equal to its purchase price. zaibatsu Large Japanese financial-industrial combines that preceded the keirestu. zero-coupon bond A bond issued without interest-bearing coupons, at a discount below face value.

Index Page references followed by "f" indicate illustrated figures or photographs; followed by "t" indicates a table.

4 401(k) plans, 110

A Abilities, 341 Account executive, 147, 153 Accountability, 98 Accountants, 4, 212, 263-264 Accounting, 4, 8, 182, 212, 215, 226, 235, 292, 298, 315-316, 320, 338, 492, 495, 501 corporate governance, 315 finance and, 4 Accounting rules, 212, 316 accounts payable, 257 Accounts receivable, 198, 254-255, 257-258, 274, 487 accuracy, 43, 76 Acquisitions, 201, 220-221, 223-225, 246, 291, 313, 318 addresses, 288, 290 adjustments, 78, 290, 429, 437, 450, 495 Advanced economies, 299 Advances, 198 Advantages, 4, 8, 97, 155, 229, 253, 420 Adverse selection, 185, 187, 189, 205, 216, 254, 266, 268, 271, 273, 275, 300, 485 Advertising, 53 corporate, 53 Affect, 2, 20, 28, 47, 66, 93, 202, 214, 226, 281, 292, 314, 355, 394, 398-399, 409, 412, 415, 430-431, 446, 452, 467, 481, 483, 493, 495, 502 Africa, 169 Age, 192, 240, 242, 485 Agencies, 38, 43, 80, 96, 98, 118, 227, 277, 280, 291, 303-304, 312, 314, 316-317, 484 Agent, 90, 261-263, 265, 276 Agents, 206, 225, 247, 261-263, 265-266, 285, 311 bond, 206, 225, 262-263, 265 life insurance, 261-262 special, 262 Aggregate demand, 319, 328-330, 334-335, 340, 342, 351, 362, 366-369, 371, 395, 399-402, 415-416, 418, 424-433, 435, 438, 440, 442, 449, 451-452, 454, 485 components of, 362 Aggregate demand curve, 319, 371, 399, 402, 427-429, 449, 451 shifts in, 428, 451 Aggregate supply, 319, 328-330, 332, 334-335, 342, 366-370, 399, 423-443, 446, 448-453 Aggregate supply curve, 367, 370, 426, 428, 434-435, 440, 442-443, 446, 448-453 long-run, 434, 451, 453 short-run, 428 agreement, 103, 122-123, 141, 143, 146-147, 149, 159, 161-162, 179, 211, 236, 263, 450, 455, 486, 488, 492-493, 495, 499 Agreements, 13, 36, 44, 115, 122-124, 142-143, 146, 159, 163, 211, 219, 235, 435, 446 AIG, 232 Alabama, 241 American option, 153 announcements, 92 Annuity, 485 individual, 485 life, 485 anticipate, 66, 104, 141, 149, 161, 169, 499 appearance, 90, 132 Application, 72, 286, 448, 460 Applications, 403 Arbitrage, 151, 158, 485 Argentina, 167-170, 182

arguments, 158, 188, 200, 416, 425, 436, 442 ARM, 128 Art, 441 Asia, 168, 228, 253, 315 Assets, 1-2, 12-13, 20-22, 36-37, 39-44, 69, 75, 92, 99, 103-114, 125, 138-139, 151, 166, 181, 191-193, 196-197, 199-205, 208-224, 226, 228-229, 231-232, 234-236, 237-239, 241-242, 244-245, 247-249, 254-256, 258-259, 262, 267-269, 271, 282, 284, 287-291, 294, 306, 309-310, 323, 325, 356-358, 396, 430, 435, 459, 486-487, 489-497, 499-502 current, 20-22, 69, 75, 104-105, 138, 166, 216, 218, 241, 256, 262, 282, 288, 325, 459, 487, 489-490, 493, 497, 502 fixed, 12, 22, 36-37, 39, 44, 104, 106, 138, 181, 196, 202-203, 218, 234, 236, 259, 287, 290, 294, 356, 358, 396, 486-487, 489-492 return on assets, 215, 236, 268-269, 499 Asymmetric information, 186-187, 198, 201, 205-206, 212, 216, 253-254, 266-267, 273-274, 300-301, 312, 315-316, 485, 495-496, 501 attention, 4, 6-7, 11, 41, 73, 88, 125, 144, 152, 224, 321, 354, 430, 435, 448, 459, 475 Attorneys, 264 Attribute, 186, 223 Auditors, 9, 158, 315 Audits, 293 Austria, 178, 454 Authority, 15, 34, 257, 277, 280-281, 297, 447, 465, 491, 496 civil, 281 Auto insurance, 242 deductible, 242 availability, 222, 253, 272, 304, 429, 462, 467, 474 Available, 5, 13-14, 20, 30, 48, 51, 59, 100-102, 104, 110, 112, 131, 135, 186-187, 189, 216, 230, 240, 247, 258, 267, 272, 279, 281, 300, 302, 320, 322, 324, 329, 333, 352, 368, 429, 447-448, 455, 461, 489, 492-494, 499

B bad news, 193, 196, 202, 230, 267, 471, 478-479, 481-482, 484 Bahamas, 228-229 Bahrain, 169 Baht, 168, 181 Bait-and-switch, 270 Balance of payments, 165-166, 170, 179, 182, 485 Balance of trade, 488 Balance sheet, 21, 40, 80, 202-203, 208, 212, 215-217, 225-226, 234-236, 268-270, 356, 485, 488, 490-491, 497, 500-501 Balance sheets, 40, 161, 163, 196, 200, 203-205, 234, 270, 431 Balanced budget, 405 Bank deposits, 30, 39, 195, 285-286, 294, 485 Bank failures, 200, 284-285, 296, 494 Bank for International Settlements, 288, 298 Bank of England, 309 Bank of Japan, 308, 411 Bank runs, 284 Banking crisis, 286 Bankruptcy, 44, 126, 131, 158, 240, 248, 258, 269, 313, 498, 501 Banks, 1-9, 11-13, 15, 18, 20, 26-27, 32-33, 35, 37-39, 42-45, 49, 65, 74-75, 92, 116, 118, 122-124, 132, 134, 142, 152, 158, 160, 165, 182, 186, 191-201, 203-206, 207-236, 244, 246-250, 255-257, 259-264, 270, 273-275, 277-288, 290-297, 299-300, 302-303, 306-316, 333, 360, 411, 431, 459, 471, 485, 487, 489-494, 496-501 Barter, 16-17, 19, 27 Bartering, 17

Base year, 472 Basic form, 107 Behavior, 1-2, 15, 23, 47-70, 111, 113, 137, 174, 187, 189, 271, 286, 300, 304, 318, 329, 366, 378, 401, 403, 426, 434, 447, 457-459, 463, 466, 468, 481-482 Belgium, 178 Benefits, 4, 16, 43, 155-156, 185, 199, 239-242, 245, 249, 257, 278, 290, 293, 296-298, 475, 480, 489, 492, 498 extended, 199, 245, 296 life insurance, 43, 239, 242, 293, 296-297 payment of, 498 service, 240-241, 257, 297 biases, 196 Bid, 5-6, 54, 89, 91, 94-99, 101-102, 120-121, 124, 127, 130, 134, 142, 147, 219, 228, 247, 264, 281, 486, 488, 495-496, 501 board of directors, 302, 305-306 Boards of directors, 317 Bond market, 38, 54, 65, 70, 83, 85, 101, 115-116, 125, 127, 260, 262-265, 273, 275-276, 304, 307, 358, 361, 364, 429, 471, 478, 483 Bond prices, 50, 54-57, 59, 65, 68, 74, 76, 86, 126, 130, 148-149, 156, 158, 162, 358, 360-361, 364-365, 386, 388, 429, 448, 473, 478-484 economy and, 473 interest, 50, 54-57, 59, 65, 68, 74, 76, 86, 126, 130, 148, 158, 162, 358, 360-361, 364-365, 386, 388, 429, 448, 478-482 Bonds, 1-2, 5-8, 11-12, 18, 20, 22, 29-34, 36-38, 40-46, 47, 50-51, 53-59, 61-62, 65-66, 69, 71-73, 75-76, 79-85, 87-88, 89, 91-92, 94, 96-97, 101-102, 104, 110, 112, 115-118, 125-133, 137-138, 142-144, 145-150, 152, 155-156, 161-162, 164, 166, 175, 178, 186, 196-197, 203, 205, 219, 225-226, 229, 239, 241, 245-247, 258, 260, 264-265, 270, 275, 289, 304, 307-308, 314, 323, 325, 331, 338, 345, 356-365, 386, 411, 430, 448, 450, 454, 459, 468, 471, 474, 479, 481-482, 486-488, 490, 492-495, 497-502 appeal, 133, 142, 247 contract, 20, 36, 45, 69, 145-150, 152, 155-156, 161-162, 241, 258, 270, 275, 486, 492, 494-495, 497-498, 500-501 court, 126, 129, 131, 258 financial institution, 32, 145, 486-487, 493, 500, 502 payment, 12, 22, 36, 50-51, 53, 55-58, 73, 87, 104, 116, 127, 130, 132-133, 147, 161-162, 226, 331, 360, 487-488, 494-495, 498 performance, 1-2, 7, 41, 89, 91-92, 94, 96-97, 101-102, 112, 137, 147, 149, 186, 203, 239, 493 Bootstrap financing, 245 Borrowing, 8, 18, 32-34, 44, 59-61, 64, 68, 80, 105, 116, 122-123, 128-129, 141, 212, 217, 229, 256, 258, 312, 322, 343, 429-431, 466, 489-490, 493, 498, 500 Borrowing funds, 212, 322 brackets, 86 Brand, 116, 281 Brazil, 168, 462 Breakdown, 187 Britain, 179, 181, 229 British pound, 5, 172, 177 Broker, 90-91, 97, 101-102, 120, 130, 141, 247, 250, 486 Brokers, 38, 89, 91-92, 98, 101, 132, 134, 246-247, 280, 311, 500 Budget, 64-65, 67, 118, 142, 166, 240, 405, 454, 476, 483 defined, 240 Budget deficit, 65 Bureau of Economic Analysis, 474 Bureau of Labor Statistics, 472-474, 476

503

Bureau of the Census, 474, 477 Burglary, 44 Business cycle, 66, 68, 78, 439, 462 Business cycles, 140 Business risk, 274, 304 Buyers, 7, 32, 34-35, 50, 63, 68, 89-92, 94-95, 98-99, 101, 116, 118, 120, 125-127, 131-132, 147-148, 150, 152-155, 157, 162, 185-188, 239, 246, 261, 263, 266, 485, 497, 500 Product, 132, 497 Role, 91-92, 185-186

C Call option, 36, 45, 153-155, 157, 163, 486, 497 Canada, 168, 224 Cancellation, 500 Capabilities, 257, 262 Capacity, 21, 26, 81, 91, 127, 219, 255, 264, 315, 317, 368, 415, 427, 440-441, 467, 474, 494, 500 Capital, 4, 9, 31, 34, 37-39, 43, 45, 50, 52, 56, 64, 69, 74-76, 82, 91-93, 96, 100, 105, 110-112, 115-144, 145, 150, 166, 174, 183, 203-204, 210, 212, 215-216, 224, 226, 236, 237, 243-245, 247-250, 255-256, 272, 281, 287-291, 293, 296-298, 314, 320-322, 324, 333, 336, 342-343, 351, 356-357, 362, 365, 368-369, 411, 428-429, 436, 440, 448, 457, 486, 488-490, 495, 499-502 definition of, 281, 287, 495 fixed, 4, 9, 34, 37, 39, 45, 52, 56, 116, 122, 132, 138, 183, 203, 236, 287, 290, 342, 356, 428, 440, 486, 489-490 growth, 119, 136, 139-140, 226, 243, 247, 255, 272, 291, 314, 365, 411, 440, 448, 488 human, 132 requirements, 141, 174, 216, 226, 244, 287-288, 293, 297-298, 499 working, 43, 224, 243, 255-256, 281 Capital account, 166, 183, 486 Capital accounts, 166, 486 Capital equipment, 64, 322 Capital gains, 34, 56, 76, 245, 356, 429, 436 Capital investment projects, 321 Capitalism, 188, 267, 299, 315-317 capitalization, 290, 293, 313 Career, 3-4 Career opportunities, 4 Careers, 2-3, 239 Caribbean, 228-229 carrying costs, 152 Cash dividend, 135 Cash flow, 104, 133, 202, 217, 257, 480, 487 Cash flows, 34-35, 53, 58, 80, 104, 113, 132, 136, 202, 500 Cash management, 247, 459-460 definition of, 459 Casualty insurance, 42, 44-45, 204, 239, 250, 297, 498 cause and effect, 141, 467 Cause-and-effect relationships, 460 Caveat emptor, 101, 487 Cayman Islands, 228 Central banks, 1, 26, 132, 182, 300 Certainty, 74, 104-106 Ceteris paribus, 360 Channel, 367, 369, 431, 467-468 Channels, 30, 362, 409, 429, 464, 466, 502 Industrial, 502 Character, 495 Checkable deposits, 12-14, 27-28 Checking accounts, 12-15, 19-20, 26, 42-44, 201, 211, 223, 257, 273, 295, 327, 333, 356, 360, 462, 487, 489, 495 Chicago Board of Trade, 36, 146-147 Chicago Mercantile Exchange, 98, 146 Chief executive officer, 301 Chief financial officer, 160 Children, 323 Chile, 168 China, 168, 179 Chinese, 179 Claims, 30-31, 34-35, 40-41, 44-45, 113, 186, 202-203, 208, 230, 248, 477, 480, 487, 491-492, 500-501 record, 492 settlement, 500 Classical economics, 319-321, 332-335, 338, 341-342, 368-370, 397, 401, 487, 495 clauses, 241

504

Clearing, 120, 147-148, 154, 163, 309, 423, 487-488, 495 Collapse, 33, 91, 158, 181, 294, 333 Collateral, 8, 34, 44-45, 122-123, 131, 187, 198, 205, 212, 216, 235, 258-261, 265-266, 268, 271-275, 286, 303, 487, 496, 500, 502 Collision, 44 Colombia, 168 colons, 54 Columbia, 174, 453 Columns, 127, 169, 192-193, 310-311, 391 Commercial banks, 5-6, 11, 13, 18, 37-39, 42, 45, 74-75, 118, 123, 142, 192-193, 197, 200, 204, 207-210, 212-213, 218, 222-225, 229-230, 234-235, 244, 247, 249-250, 260-263, 277-278, 280-282, 285, 293-296, 306, 308-310, 333, 459, 485, 487, 489-490, 499, 501 Commitment, 100, 149, 226, 241, 256, 264, 494, 499 committees, 257 Commodities, 99, 110, 146, 278, 280, 298, 329, 480, 487 Common market, 490 Communication, 98 Communism, 299, 315-316 Communist countries, 317 Community development financial institutions, 224 Companies, 2, 6, 8, 18, 33, 37-45, 69, 75, 80, 82, 92, 102, 110, 112, 114, 116, 118, 126-129, 132, 134, 138, 142, 148-149, 152, 159, 170, 189, 192-193, 195, 198-199, 201, 203-206, 211-212, 220-221, 225, 229, 236, 237-239, 241, 243-250, 254-265, 271-273, 275-276, 278-279, 281, 292-295, 297-298, 300-303, 305-317, 431, 477, 481, 485-487, 489, 491, 494, 497-498, 500, 502 Company stock, 313 Comparative advantage, 201 Compensation, 93, 104, 106, 111-112, 114, 125, 153, 262, 279, 285, 303, 305, 313, 318, 358, 434, 493 Compete, 134, 196, 248-249, 315, 431 Competition, 60, 192-193, 200, 206, 214, 219-220, 225, 228, 249, 257, 264, 277, 309, 322, 436 Competitors, 61, 170, 214, 295, 467 complaints, 292 Compliance, 282, 314 Component parts, 483 compromise, 381, 411 Conditions, 6, 26, 34, 66, 81, 105, 110, 132, 140-141, 149, 170, 197, 229, 239, 249, 264, 290-291, 346, 360, 365, 376, 378, 385, 388, 397, 412, 420, 428, 440, 464, 466, 493, 496, 498-500 Conference Board, 472, 474, 477, 480 Confidence, 17, 233, 472 Conflict, 300-306, 310, 312-313, 316-317, 433, 495, 501 Conflict resolution, 302-303, 306, 310, 312 connotation, 109 Consideration, 11, 16, 153, 162, 315, 407 Consolidation, 201, 207, 219-222, 235, 303-304 Consortium, 229 Constraints, 309 UNIQUE, 309 Construction, 197, 261, 347, 467-469, 474, 476 Consumer credit, 31 Consumer goods, 64, 336, 338-339, 343, 477 Consumer Price Index, 6-7, 66, 354, 474 Consumer spending, 140, 343, 347, 351, 367, 369, 405, 457, 468-469, 472 income and, 369 Consumers, 1, 41, 47, 64, 66, 98, 187, 207, 211, 222, 238, 249, 273, 277, 283, 300, 329, 342-343, 355, 361, 388, 395, 430, 432, 459, 480 Consumption, 18, 105, 113, 321, 323-324, 335, 337-340, 344-353, 356, 361-362, 369, 382, 384, 388, 395, 398-399, 403-404, 422, 424-426, 457, 463, 472, 474, 487, 502 autonomous, 350-352, 362, 369, 382, 384, 404, 424 consumer, 335, 337-339, 347, 351, 361-362, 369, 457, 472, 474, 487 Consumption expenditures, 337, 339, 426, 472 Consumption function, 344-348, 350-351, 353, 362, 369, 398, 422, 426, 487 changes in, 347-348, 350-351, 369, 398, 426 Contacts, 3, 227 Content, 112, 343, 359, 463 Contract, 15, 20, 36, 45, 69, 145-156, 159, 161-163,

169, 206, 241, 253, 257-258, 261-262, 268, 270-273, 275, 431, 485-486, 489, 492, 494-498, 500-501 definition of, 495 contractions, 332 Contracts, 36, 44, 79, 124, 142, 145-155, 158-159, 161-162, 164, 189-191, 253-276, 279, 283, 303-304, 312, 317, 384, 434, 451, 491, 495, 497, 500-501 leasing, 271 Contractual agreements, 36, 44, 163, 435 Control, 15, 23, 26-28, 61, 158-159, 196, 237-238, 258, 269, 302, 304-306, 308, 311-312, 316, 327, 368, 406, 431-432, 446, 489, 497 Control mechanisms, 306 Controlling, 304, 317, 492 Conventions, 159, 206 Conversation, 323 conversion, 125, 142-143, 487 Cooperation, 8, 296 Copyright, 1, 11, 29, 47, 71, 89, 98, 103, 110, 115, 131, 145, 165, 174, 179, 185, 188, 207, 218, 231-233, 237, 241, 253, 277, 299, 319, 341, 371, 407, 423, 445, 457, 471-472, 485 licensing, 233 protecting, 277 Corporate bonds, 5, 8, 32-33, 37-38, 43-44, 59, 71, 79-80, 85, 91, 101, 104, 125-130, 133, 142, 161, 239, 304, 308, 357, 430, 497-498 Corporate governance, 158, 302, 306, 311, 315 corporation, 4, 9, 32-33, 43, 92-94, 125, 127-128, 131, 143, 147-149, 154, 158, 163, 197, 200, 211-212, 221, 227, 229, 241, 244, 246, 268-269, 278, 282, 285, 292-293, 298, 364, 486-487, 489-493, 495, 498-501 advantages of, 4 definition of, 495 Corporations, 5, 33, 36, 39, 41, 44, 78, 80, 92, 101, 118, 125-126, 128-129, 131, 134, 137, 165, 182, 197, 226-227, 237, 246, 309-312, 315-316, 451, 492, 501 domestic, 5, 125, 226-227, 309, 492 foreign, 5, 118, 165, 182, 226-227, 309, 311, 492 professional, 316 Corrective action, 288, 291, 297-298, 498 cost accounting, 212, 215, 235, 492 Cost of living, 24 Cost-benefit analysis, 315 Costs, 4, 16, 22, 40-41, 45, 54, 94, 96-97, 119, 147, 152, 155, 157, 160, 170, 186, 189, 191, 198, 205, 223, 234, 240-241, 245, 260, 262-263, 265-266, 292, 298, 317, 331, 364, 429, 433, 453, 467, 493, 501 distribution, 223, 262-263 Countries, 15-16, 31, 165-166, 178, 181-183, 198, 216, 226, 228, 277, 296, 299, 305-306, 310-312, 315-317, 340, 362, 454, 462, 485, 490-491, 494, 502 Coupons, 7-8, 32-33, 46, 53, 55, 87, 117, 345, 488, 501-502 courtesy, 132 Covenants, 8, 258-262, 264-266, 271, 275, 303, 499 Creativity, 110 credibility, 104, 411, 447, 451, 453, 455-456 Credit, 2, 8, 13, 15, 18-20, 31, 38-39, 42, 44-45, 59-64, 66, 68, 80, 112, 126-127, 147, 160, 187, 191-193, 200, 202-206, 207, 209, 212, 214-216, 225-226, 230, 232-236, 244, 246-247, 254-257, 259-263, 265-267, 271-276, 278, 283, 285, 292, 300, 304, 307-308, 310, 312, 317, 327, 364-365, 429, 431, 438, 441, 459, 462, 467, 469, 488-489, 491, 494, 496, 498-501 debt financing, 260, 262, 308 credit approval, 257 Credit cards, 233, 255, 259, 272, 327, 364-365, 459, 462 Credit crunch, 431 Credit insurance, 225 Credit line, 260 Credit unions, 13, 18, 39, 42, 44, 191-193, 203-204, 234, 278, 283, 285, 488-489, 501 Cross-border acquisitions, 221 Crowding out, 402, 407, 413, 416, 418, 424, 428, 430-431, 443, 464-465, 468 Currency, 9, 12-16, 19, 24, 26-28, 140, 159, 162-163, 165-166, 169-171, 174-175, 178-179, 181-182, 200, 210, 219, 278, 281-282, 297-298, 333, 356, 360, 459, 462, 485-490,

492, 495-496 European Union, 16, 298, 490 exchange of, 181 exchange rate system, 182, 490 fixed exchange rate system, 182, 490 government intervention, 333 payment methods, 26 risk, 9, 159, 162-163, 169, 174-175, 219, 297-298, 356, 488-490, 492, 495 Currency markets, 182 Currency swap, 163 Currency swaps, 159, 200, 488 Current account, 166-167, 183, 488 Current account deficit, 166-167, 183 Current account surplus, 167, 488 Curves, 60-64, 66, 72, 77, 79, 83-84, 90, 94-95, 167, 170, 335, 371-372, 376, 384-386, 389, 391-392, 395, 398-399, 401-402, 406, 408, 412, 414, 442, 451-452 slope of, 398 supply, 60-64, 66, 72, 79, 90, 94-95, 167, 170, 335, 372, 376, 385-386, 389, 391-392, 395, 399, 401-402, 406, 408, 412, 442, 451-452 Customers, 4, 6-8, 43, 90, 129, 134, 201-202, 206, 220, 227, 230, 249, 254, 257, 273-274, 276, 283, 303, 494, 498 Customs, 226

D Damage, 403, 438 data, 13-14, 25, 52, 65, 130, 218, 225, 233, 255, 282, 295, 354, 460-461, 463, 465, 473, 475-477 data processing, 225, 295 dates, 32, 79, 88, 104, 130, 154, 209, 473 Death, 43, 242, 396 Debit cards, 26 Debt, 8, 29, 33-35, 44, 61, 80-81, 83, 92, 115, 118, 127, 131, 142, 145, 160-161, 197, 199, 203-204, 215, 225, 233, 237, 240, 245, 247-250, 259-260, 262, 265-266, 268-273, 287, 291, 293, 295, 302, 305-306, 308, 313, 411, 467, 485-488, 491-492, 494-496, 500-502 defined, 199, 225, 240, 249-250, 287, 293 Debt financing, 260, 262, 306, 308 Debt markets, 8, 115, 308 deception, 101, 270, 281 Decision makers, 441 Decision making, 103, 105, 175, 355, 478, 483 Defined benefit pension plans, 241-242 Defined benefit plans, 239, 241-242, 249, 489 Defined contribution pension plans, 244, 249 Defined contribution plans, 199, 206, 239, 242, 249-250, 489 Deflation, 19, 21, 24, 27, 117, 489 Degree of risk, 106 Demand, 13, 22, 25, 27-28, 32, 42, 47, 59-70, 72-76, 78-79, 90, 94-95, 101, 103, 105, 111, 114, 138, 140, 147, 149, 154, 156, 162, 165-167, 170, 173, 175, 178-180, 182, 193, 209, 219, 243, 245, 259, 262, 282-283, 294, 319-322, 326-332, 334-336, 340, 342-343, 351, 355-370, 371-378, 380, 384-386, 389, 391, 393-397, 399-405, 408-410, 412-416, 418, 420, 422, 423-443, 448-449, 451-452, 454, 457, 459-461, 468-469, 485, 487, 489, 491, 494, 496-498, 500-502 aggregate, 28, 243, 319, 328-330, 332, 334-336, 340, 342, 351, 360, 362, 366-370, 371, 394-395, 397, 399-402, 415-416, 418, 423-443, 448-449, 451-452, 454, 485 change in, 22, 62-63, 65, 68, 74, 175, 179, 326, 351, 358-359, 361-363, 365, 367, 369-370, 372, 376, 378, 384, 391, 404-405, 408-409, 412-413, 418, 430, 433, 449, 451, 454, 469, 489, 496, 502 currency, 13, 27-28, 140, 162, 165-166, 170, 175, 178-179, 182, 219, 282, 356, 360, 459, 485, 487, 489, 496 derived, 351, 357, 378, 494 elastic, 397 excess, 60, 138, 170, 173, 175, 178-180, 321, 326, 328, 343, 358-360, 375, 386, 396, 416, 427, 459-460, 494 for money, 22, 140, 319, 327, 334-335, 342-343, 355, 357-360, 363-365, 369-370, 372-376, 389, 391, 393-394, 396, 401-402, 404-405, 408, 412-414, 420,

422, 435, 443, 460-461, 468-469, 487, 489, 494, 501-502 increases in, 25, 27, 65, 140, 326, 330, 334, 360, 366-367, 369, 378, 389, 394, 397, 415-416, 428-429, 432, 436-438, 454 prices and, 65, 73, 94, 140, 154, 245, 320, 369, 395-397, 415, 426, 440, 442 Demand conditions, 170 Demand curve, 62-63, 66, 68, 95, 170, 173, 319, 329-330, 371, 399, 402, 427-429, 449, 451 decreases in, 399 individual, 451 labor, 329, 427-428, 451 market, 95, 170, 329, 429 movement along, 62-63 negatively sloped, 329 shifts in, 62, 68, 170, 428, 451 Demand deposits, 13, 25, 28, 42, 140, 282, 294, 360, 459, 489, 496-497 Demand schedule, 329, 367-368, 371, 399, 401, 425-427, 429, 432, 440, 452 Denmark, 168 Department of Commerce, 354, 472, 474, 477 Department of Housing and Urban Development, 35, 492 Department of Labor, 473-474 Deposit accounts, 13, 25, 28, 211, 236, 249, 459, 495-496 Deposit insurance, 4, 9, 197, 200, 212, 224, 229, 278, 282, 284-287, 290, 292-293, 296-298, 299-300, 333, 490-491, 499 Deposits, 2, 12-15, 18, 20, 25, 27-28, 30, 39-40, 42-44, 123, 140, 143, 146, 160-161, 164, 165, 192-196, 202-204, 210-211, 214, 217-220, 227-228, 230, 234-235, 274, 282-286, 289-292, 294, 307, 333, 360, 459, 485, 487, 489-490, 494-497, 499-502 Depreciation, 173, 178, 181-182, 214 Depression, 19, 21, 24-25, 81-82, 194, 287, 333, 341-342, 459, 476, 489 Deregulation, 5, 196, 306 Derivatives, 36, 44, 124, 132, 145-164, 200, 218-219, 309 design, 191, 259, 271, 299-318, 342 principles of, 299 Detailed analysis, 203 Determinant, 109 Devaluation, 181-182, 489 Developed countries, 198, 494, 502 World Bank, 502 Developed country, 205 Developing countries, 494, 502 diagrams, 360-361 Diminishing returns, 322 Direct investment, 205, 489 Directive, 7 Discipline, 6, 65, 297 Discount rate, 278, 489 Discounts, 314, 345 Discretionary spending, 480 Discrimination, 242 Disintermediation, 194, 205, 228, 489, 491 Disposable income, 353, 369, 438, 489 Distance, 347, 372, 376, 384, 408 Distribution, 15, 107, 113, 132, 134, 196, 208-210, 223, 246, 262-263, 316 marketing and, 262 Diversifiable risk, 186 Diversification, 40-43, 45, 103, 106-114, 126, 186, 191, 205-206, 296-297, 497-498, 501 Dividends, 30, 33-34, 44, 105, 135-136, 138, 144, 212, 243, 259, 276, 291, 459, 479, 481-483, 487, 489, 499 documents, 472 Dollar, 6, 14-15, 17, 21, 23, 34, 37, 48, 50, 52-53, 56, 68, 79, 97, 104, 106, 116, 123, 128, 152, 157, 159, 161, 165-179, 182-183, 191, 195, 203, 208, 210, 227-229, 245, 263-264, 285, 289-290, 326, 328, 345, 347, 353-354, 362, 384, 388, 395, 429, 436, 495, 497, 500, 502 exchange rates, 165-168, 170, 174-176, 178-179, 182-183, 362, 429, 495 international monetary fund, 178-179, 183 Dollars, 17, 19, 28, 31-32, 37-38, 42, 53, 57, 66, 115, 118, 122, 132, 137, 150, 159, 166-167, 169-170, 174-175, 178-179, 181-182, 186, 192, 206, 208, 210, 213, 228-229, 240, 242-243, 250, 276, 282, 289, 315, 325, 331, 333, 346, 362, 364, 436, 482, 490, 498

Dominance, 224, 307 Dow Jones Industrial Average, 34, 137, 139, 143-144, 480, 489 Downsizing, 206 Due diligence, 261-263, 275, 489 Dumping, 182 Durable goods, 474 Dynamics, 432

E Earnings, 99, 125, 135-139, 142, 219, 235, 238, 241, 267, 292, 473, 479, 481, 486-489, 498-499 Eastern Europe, 253, 315-318 Econometric models, 461, 463, 465, 468-469 Economic analysis, 331, 474 Economic development, 18 Economic fluctuations, 342, 438 Economic forces, 437 Economic growth, 1, 18, 26, 41, 46, 179 rates, 26, 179 Economic models, 365, 447, 455 Economic policy, 286, 454, 482 Economic recovery, 126 Economic stability, 407-419, 421-422, 423-443 Economic uncertainty, 103 Economic variables, 455, 489, 499 Economics, 60, 62, 86, 98, 106, 139, 185, 187, 191, 198, 222-223, 255, 260, 265, 272-273, 319-321, 325, 328, 331-336, 338, 341-342, 366, 368-370, 397, 401, 405, 487, 495, 501 Economies of scale, 189, 222-223, 235, 489 Economy, 1-2, 12, 16-21, 27, 41, 66, 78, 81, 108, 114, 126, 132, 138, 164, 188, 193, 233, 245, 256, 277, 312-313, 315, 319-320, 324, 332-338, 342, 352, 354-356, 362, 364-368, 372, 376, 378, 385-386, 396-397, 399, 403-404, 406, 411, 413, 415-416, 418-419, 422, 424, 426, 428, 432, 438-441, 447, 450, 452-453, 460-464, 466, 471, 473, 475, 477, 480-483, 485, 492-495, 498, 500 trust and, 500 Ecuador, 168, 462 Effective interest rate, 238, 392 Efficiency, 89, 91, 94, 99-102, 206, 214, 221, 224, 235, 281, 301, 305, 485, 497 Efficiency gains, 305 Egypt, 169 Elections, 483 electronic funds transfer, 489 electronic media, 26 Emerging economies, 253, 315 emphasis, 5, 75, 283, 305, 307, 368 Employee Retirement Income Security Act, 241, 250, 293, 298, 490 ERISA, 241, 250, 293, 298, 490 Employees, 8, 44, 199, 214, 233-234, 240, 242-243, 249-250, 254-255, 267, 279, 316, 453, 492, 501 benefits for, 199, 240, 242 Employment, 1-2, 7, 21, 23, 25-27, 69, 279, 319-321, 324, 326, 328-330, 332-335, 341-343, 347, 352, 355, 367-369, 386, 394-399, 401-402, 406, 415-419, 424-428, 432-433, 435, 437-438, 440, 443, 449-451, 461, 466, 471, 473-479, 483, 487, 494-496, 500 family and, 477 full, 2, 26, 279, 320-321, 326, 328-330, 332-335, 341-343, 347, 352, 355, 367-369, 386, 394-399, 401-402, 406, 415-419, 424-428, 432-433, 435, 437-438, 440, 443, 449-451, 466, 487, 494-496, 500 EMS, 178, 183, 490 European monetary system, 178, 183, 490 England, 196, 221, 286, 309, 325 English, 309, 435 Enron, 158, 315 Entities, 189 Entrepreneur, 248, 255, 321-322, 490 Entrepreneurs, 255, 320-322, 324, 343, 345, 347, 355, 368, 384, 386, 395 Entrepreneurship, 336 Environment, 105, 174, 193, 211, 229, 238, 309, 316-318, 334 natural, 105 Environmental factors, 191 Equilibrium, 6, 60, 62-66, 69, 77, 82-84, 89-91, 94-97, 99-101, 104, 165, 170, 173, 178-181, 319, 322-324, 326-329, 331-332, 335-340, 342-344, 346-347, 349, 352-353, 357-360,

505

363-364, 367, 370, 371-376, 378, 380-382, 385-386, 388-389, 391, 393-394, 399, 401-404, 406, 408, 411-413, 415, 418, 420, 435-437, 449-451, 490, 494 long-run, 170, 437, 451 market, 6, 60, 65, 69, 82-83, 90-91, 94-97, 99-101, 165, 170, 178-179, 329, 338, 343, 358-359, 364, 373-374, 376, 378, 380, 385, 388, 401, 403, 420, 490 short-run, 342 Equilibrium exchange rate, 170, 179 Equilibrium output, 338, 346 Equilibrium price, 6, 90-91, 94-97, 99-101, 104, 170, 180, 328-329, 449, 490 Equity, 29, 33, 40, 97, 112, 115, 137, 156, 188, 197, 203-204, 210, 212, 215-217, 225-226, 236, 244-245, 247-248, 255, 260, 265, 267-273, 275, 279, 281, 286-287, 289-290, 293, 295, 299, 302, 304, 306, 308-311, 315-316, 356, 485, 488, 490, 492, 494-495, 499-500, 502 defined, 225, 244, 287, 293, 356 internal, 272, 502 issuing, 40, 203, 265, 272, 293 Equity capital, 210, 212, 215-216, 226, 490 Equity financing, 255 Equity investment, 204, 255 Equity markets, 115, 308, 315-316 Estate taxes, 492 EU, 362 Euro, 16, 146, 168, 171, 177-179, 183, 362, 490 international monetary fund, 178-179, 183 Eurobonds, 229, 490 Eurodollar, 123-124, 142-143, 146, 161, 195, 228-229, 235, 494 Eurodollars, 13, 115, 123-124, 142, 162, 228, 490 Europe, 165, 168, 228, 253, 314-318 European Monetary System, 178, 183, 490 European Monetary Union, 178, 183, 490 European Union, 16, 249, 277, 296, 298, 490 European monetary union, 490 structure of, 490 Evaluation, 189, 256-257, 259, 262 evidence, 24, 78, 102, 106, 108, 223-224, 256, 294, 297, 312, 368, 422, 431, 438, 455, 457-469 supporting, 294 exaggeration, 11, 458 Excess demand, 170, 173, 175, 178 Excess reserves, 20, 411, 490, 494 Excess supply, 170, 173, 178-180, 343, 360 Exchange, 5, 12, 16-17, 19, 26-28, 32-33, 36, 38, 54, 74, 90-92, 94, 97-99, 101-102, 118, 126, 133-134, 137, 142, 145-147, 149, 152, 154-155, 159-161, 163, 165-183, 186, 244-247, 250, 260, 263, 278-280, 296, 298, 299, 307-309, 324-327, 335, 351, 356, 362, 369, 388, 401, 429, 480, 486-500 Exchange rate, 5, 165-167, 169-171, 174-175, 178-179, 181-183, 308, 362, 369, 388, 401, 429, 490, 492, 498 appreciation, 178-179, 182, 362 depreciation, 178, 181-182 fixed, 165, 178-179, 181-183, 490, 492, 498 flexible, 362, 401, 429 Exchange rates, 165-168, 170, 174-176, 178-179, 181-183, 362, 429, 486, 489-491, 493, 495 Brazil, 168 International Monetary Fund, 178-179, 183, 486, 493 Exchanges, 16, 36, 91, 97, 99, 101, 134, 146-147, 152, 165, 169, 182, 247, 280, 307, 314, 360, 497 Expansion, 12, 22, 66, 68, 140, 207, 226, 267, 295, 330, 362, 378, 401, 417-418, 431, 435, 437-438, 450-451, 454, 464-465, 472, 476, 489, 496, 501 expect, 34, 50, 67, 69-70, 73-74, 76, 80, 91, 104, 112, 136, 150, 163, 217, 292, 311, 321, 331, 343, 356, 361, 363, 365, 384, 395, 426, 435-436, 447-448, 450, 466, 475, 478, 482 Expectations, 62, 64-68, 72-78, 82-84, 105, 107, 139, 175, 178, 333-335, 346, 365, 394, 416-418, 423-424, 431, 433-437, 442, 445-456, 465-467, 469, 478-481, 483, 490, 498-499 Expectations of inflation, 65, 67, 334, 436-437, 450-451, 481 Expected real interest rate, 58 Expected return, 104, 106, 108-109, 111, 113-114, 174, 269-270, 276, 297, 301, 322, 346, 356-357

506

Expenditures, 31, 126, 326-327, 336-337, 339-340, 352, 367, 369, 402, 426, 428, 430, 438, 457, 467, 472, 493 defined, 337 Expense ratio, 292 Expenses, 213-214, 240, 265, 476 Experience, 26, 83, 267, 284, 316, 374, 441, 463, 466, 485 expertise, 41, 197, 262 Explanations, 72, 79, 96, 139 Explosion, 145, 441 Exporting, 167, 226 foreign exchange and, 167 Exports, 166-167, 179, 340, 351, 362, 369, 388, 429, 488, 490 China, 179 External debt, 260

F Factors of production, 336 Failure, 130, 187-188, 202, 205, 212, 269-270, 285-287, 293, 300, 338, 485, 498 Fair price, 31 fairness, 281 Family, 34, 43, 206, 244, 253, 255, 274, 399, 477, 496 Fannie Mae, 491 FAST, 19, 69, 75, 139, 200, 207, 354, 425, 451 Feature, 38, 73, 90, 125, 143, 242, 258, 277, 290, 314, 354, 394, 487 Federal budget, 64-65, 67, 142 Federal Deposit Insurance Corporation, 4, 9, 200, 212, 278, 282, 292, 298, 490-491 Federal funds market, 20, 27, 122, 219, 490 Federal funds rate, 20, 122-123, 217, 235, 480, 490, 497, 501 Federal government, 8, 33, 38, 64-65, 80, 117, 197, 281, 502 Federal income tax, 129, 142, 496 Federal National Mortgage Association, 38, 45, 97, 491 Fannie Mae, 491 Federal Open Market Committee, 7, 491 Federal regulation, 282 Federal Reserve, 2, 4-5, 7, 9, 13-15, 19-23, 27-28, 37-38, 42, 65-66, 68, 78, 117-118, 128, 132, 138-139, 141, 145, 188, 192-195, 211, 218, 225, 227-229, 233, 254-255, 260, 278, 280, 282-283, 291, 294-298, 315, 326, 365, 376, 420, 432, 438-439, 441, 447-448, 450-453, 458-465, 467-468, 472-474, 480-484, 486-487, 489-491, 493-495, 497, 499 inflation and, 448, 450-453, 481 interest rates and, 141, 188, 194, 283, 467, 482 monetary policy and, 376, 452, 461, 465, 493, 499 money supply and, 14-15, 22-23, 450 open market operations of, 491 structure of, 5, 78, 145, 218, 447, 480, 490, 494, 499 Federal Reserve Bank, 20, 78, 464-465 Federal Reserve Banks, 15, 491 Federal Reserve Board, 254-255, 260, 463, 490-491 Federal Reserve System, 4, 15, 278, 282-283, 297, 486-487, 490-491 feedback, 187, 482 Fidelity Investments, 199, 244 Fields, 341 Finance, 2, 4, 26, 30-31, 35, 39, 41-43, 45-46, 64-65, 115, 123, 127-130, 132, 141-143, 186, 188, 190, 192-193, 201, 203-204, 219, 224, 226, 237, 240, 244-246, 248-250, 254-258, 265, 273, 275, 293, 302-303, 306-310, 314, 430, 486-487, 491-492, 499 Financial analysis, 315 Financial assets, 1-2, 21-22, 42, 92, 99, 103-114, 138, 202, 241, 310, 323, 325, 358, 396, 430, 435, 459, 491, 499 Financial centers, 221 Financial condition, 41, 262-263, 283, 485 Financial crises, 165, 181-182, 315 Financial crisis, 240 Financial institutions, 1-2, 4-5, 9, 11-13, 18-19, 32, 39, 42, 45, 47, 65, 122, 152, 154, 158, 160, 162-163, 201, 207-236, 237-251, 260, 267, 283, 308, 311-312, 459, 463, 467, 489, 491-494, 500 Financial instruments, 18, 29-46, 152, 186, 191, 205, 219, 253, 500 Financial intermediaries, 1-2, 18, 29-31, 39-42, 44-46, 92, 185-186, 189-191, 198-205, 215, 249,

253, 277, 293, 300, 303-304, 311-312, 314, 317, 487, 491, 493-494, 497-498 Financial markets, 1-9, 11, 18, 29-32, 35, 37, 40, 44, 46, 47, 50, 60-61, 71, 89, 100, 103, 115-116, 141, 145, 152, 165, 178, 185-186, 189-190, 192, 198-199, 205-206, 207, 220, 226, 237, 253, 255, 267, 272-273, 277-279, 283, 299, 306, 314-315, 319, 338-339, 341, 371, 396, 407, 423, 430, 445, 454-455, 457, 460, 471, 485, 491 Financial services, 196, 200-201, 206, 247, 277, 294, 309, 502 Financial services industry, 201, 277, 294 Financial Services Modernization Act, 201 Financial statement, 197, 214, 258, 500 Balance sheet, 500 Financial systems, 29, 299-300, 302, 304, 312-313, 316, 494 Financial Times, 411 Fines, 126 Finland, 178 Fire, 44, 188, 239, 297, 301-302, 304, 428, 498 risk of, 297 firewall, 298 Firm performance, 305, 313 Firms, 6, 15, 30-31, 38-39, 43-44, 61, 64, 66, 70, 80, 92, 118, 125-128, 134, 159, 169, 198, 203-204, 207, 211, 225-226, 233, 236, 238, 241, 246-249, 254-256, 258-259, 261, 263, 265, 267, 270-273, 275, 280, 295, 300-304, 306, 308, 311-318, 320, 324, 336-340, 342-343, 368, 428-431, 435, 448-450, 457, 460, 463, 467, 487 Fiscal policy, 355, 369, 371, 374, 381, 385-386, 389-392, 399, 401-402, 406, 407, 412-414, 416-419, 424, 428-431, 438, 441-442, 446, 457, 464-465, 468, 491, 493 expansionary, 389, 417, 430, 438, 441-442, 465 Keynesian, 355, 369, 371, 392, 399, 401, 406, 407, 412-413, 416-418, 424, 428-430, 441-442, 446, 464, 493 lags and, 457 role of, 407, 418, 465, 468 stabilization policies, 441 Fixed assets, 259 Fixed exchange rate system, 182, 490 Fixed exchange rates, 178, 181-183, 486, 489-491 Flexibility, 199, 206, 249, 271, 329, 334, 401, 407, 416, 418-419, 487 Flexible prices, 415-418 Floating exchange rates, 178, 490-491 Food, 207, 480 Forecasting, 366, 439-441, 447, 455, 460 Forecasts, 78, 232, 438, 447, 479 Foreclosures, 230, 233 Foreign bonds, 362 Foreign branch, 229, 493 Foreign competition, 228 Foreign exchange, 5, 165-183, 351, 362, 388, 429, 490, 492, 495, 498 Foreign exchange markets, 166, 174, 181, 429 Forward contract, 146, 163, 492 Forward contracts, 146, 162 Forward market, 169 Foundations, 319-335, 337-340 Fragmentation, 90 France, 16, 178, 229, 483 fraud, 17, 101-102, 126, 158, 315 Freddie Mac, 131, 143, 491 Free market, 341, 355 Freedom, 118, 142, 225, 295 Frequency, 139, 266, 327, 473 Full employment, 26, 320-321, 326, 328-330, 332-335, 341-343, 347, 352, 355, 367-369, 386, 394-399, 401-402, 406, 415-419, 424-428, 432-433, 435, 437-438, 440, 443, 449-451, 466, 487, 494-496, 500 Fund, 4, 6, 8, 13, 27, 40-43, 45, 69, 84, 112, 137, 149, 158, 162, 178-179, 182-183, 186, 191, 194-195, 197-199, 201, 203, 205-206, 228, 237, 239-241, 243-244, 247-250, 255, 272, 283, 285, 287, 292, 294, 296, 482, 485-487, 490, 492-493, 495-498, 500, 502 Fund liabilities, 294 Futures contract, 36, 45, 146-149, 151-153, 155-156, 163, 489, 492, 494-495, 497, 500 Futures contracts, 36, 44, 145-154, 162, 164, 491, 495

G

Gambling, 462 GDP, 21-23, 27-28, 44, 310-311, 319, 324-328, 333-336, 342, 344, 347-355, 360-367, 369-370, 371-374, 376, 378, 381-382, 384-386, 388-389, 391, 393-394, 398-399, 401-403, 407-409, 411-415, 418-422, 426-428, 433-435, 438-439, 441-443, 449, 457-458, 460, 462-465, 468-469, 472-474, 476, 478-479, 485, 488, 490, 492, 494, 496-497, 499, 501-502 GDP deflator, 354 Gender, 242, 485 Germany, 16, 24, 99, 178, 253, 299-300, 302, 305-317, 454, 483, 485 Globalization, 219, 226, 249 markets, 219, 226 summary, 249 GNP, 474 Goals, 245, 277, 280, 283, 286, 297, 473 definition of, 280 Gold, 11, 14, 19, 29, 36-37, 90, 94, 181, 240, 245, 480, 492-493 Gold prices, 480 Gold standard, 492 Goods, 17-19, 21-27, 57, 64, 66, 166-167, 170, 174, 316, 319-322, 324-331, 334, 336-340, 342-343, 351, 354, 356, 362-363, 366-369, 374, 376, 378, 380, 395-397, 403, 426, 428-429, 434, 442, 448, 474, 477, 485, 487-488, 490, 492, 495, 499, 502 basket of, 490 free, 174, 499 normal, 21, 329, 363 private, 26, 442 public, 21-22, 324, 326-328, 330, 356, 376, 485, 499, 502 substitute, 329, 396 Government, 6-9, 12, 15, 20, 26, 31-35, 37-40, 42-46, 50, 53-54, 59, 64-67, 71, 76, 79-83, 91, 98, 101, 104, 115-118, 122-123, 125-126, 128-131, 137-138, 142-143, 146, 148, 175, 178-179, 183, 188, 192-193, 196-197, 199, 206, 209, 214, 219, 224, 229, 233, 240, 246, 276, 277, 281, 286, 293, 308, 311, 316, 333, 339-340, 344, 351-355, 357, 367-369, 382-386, 389, 391, 393-395, 402-406, 411, 413, 417-418, 429-430, 432, 438, 453, 456, 464-465, 468, 479, 484, 486-488, 490-492, 494-497, 499, 501-502 intervention, 333, 395 loans from, 209 Government Accountability Office, 98 Government agencies, 38, 43, 484 Government insurance, 35 Government intervention, 333, 395 Government policies, 368, 464 Government regulation, 26, 229 Government regulations, 219 Government securities, 33, 37-38, 42, 59, 76, 79-80, 115-118, 122-123, 126, 138, 142, 148, 175, 209, 214, 219, 246, 496-497, 499 Government spending, 352, 354, 367, 382-384, 389, 391, 393-394, 403-406, 413, 417-418, 429-430, 464-465, 468, 488, 494 aggregate demand and, 367 GDP and, 352, 494 multiplier, 354, 367, 382, 384, 391, 404-406, 413, 464-465 Gramm-Leach-Bliley Act, 225, 249-250, 295-297, 310, 492 Graphs, 424 Great Britain, 229 Great Depression, 24, 81-82, 194, 287, 333, 342, 459, 476 Greece, 178 Gross domestic product, 21, 27, 319, 324, 333, 335-336, 411, 462, 492, 497, 499 growth in, 411 nominal, 319, 324, 335, 411, 497, 499 real, 21, 319, 324, 333, 335-336, 411, 462, 497, 499 Gross profit, 214 Group, 1, 8, 59, 61, 79, 90, 92, 98, 109, 128, 131, 146, 199, 225, 229, 234, 238, 242, 244, 246, 248, 273-274, 292, 305, 307, 309, 317, 332, 381, 384, 432, 488, 490-494, 496, 500-501 Group insurance, 238, 492 life, 238 marketing, 238

term life, 238 universal life, 238 groups, 44, 224, 286, 295, 308, 336, 338 development of, 286 Growth rate, 440

H headings, 150 headlines, 471 Health care, 240 Health insurance, 242 group, 242 Hedge funds, 132, 237, 247-248, 292 Hedgers, 148, 150-152, 156, 162-163 Hedging, 149-150, 156, 164, 218, 248 insurance, 156, 164, 218 Hedging strategies, 156 Highly compensated employees, 279 Holding company, 201, 220-222, 225, 235, 247, 250-251, 291, 295-296, 485, 491-492 Home country, 229, 490 Hong Kong, 168 Host country, 228 Housing market, 132, 233 Housing prices, 158 HTTP, 150 Hungary, 24, 168, 454 Hyperinflation, 19, 24, 27, 453, 493 hyphens, 33 hypothesis, 89, 326, 490

I Ice, 446 III, 45, 189-190, 198-199 illustration, 51, 53, 56, 179 Image, 478 IMF, 178, 183, 315, 493 Immigration, 335, 475 Implementation, 247, 286-287, 291 Importing, 167, 226 Imports, 166-167, 340, 351, 362, 488 Impression, 281, 398 Inc., 96-97, 108, 110, 149, 174, 179, 224, 231-233, 267, 292, 472, 474 Incentives, 149, 189, 243, 250, 271, 281, 287, 368, 447, 501 Income, 4, 7-9, 18, 22, 30-31, 33-34, 38, 52, 54, 71, 81-84, 105-106, 118, 129, 142, 149, 211-215, 217, 229-230, 236, 238, 241-243, 246, 248, 250, 258, 293, 298, 311, 320-321, 324-325, 328-330, 336-339, 342, 344-356, 363-364, 366-369, 372-377, 379-400, 403-406, 408-413, 415-418, 421, 425-428, 432-436, 438, 440, 449, 451-452, 460, 487, 489-490, 493, 495-496, 499-501 circular flow of, 336-337 decrease in, 351, 363-364, 376, 384, 389, 391, 411, 415, 426, 428, 452, 489 differences in, 31, 217, 293 disposable, 353, 369, 438, 489 increase in, 22, 211, 215, 230, 324, 330, 345, 351, 354, 363-364, 367, 369, 374-376, 382-384, 386, 388-389, 391, 394, 396, 398-399, 405, 408-413, 415-418, 426, 433, 435-436, 440, 449, 451-452, 460, 493 market, 7, 33-34, 38, 54, 82-83, 118, 129, 142, 149, 211-212, 215, 217, 229-230, 236, 238, 243, 246, 248, 311, 320-321, 325, 329, 338, 355, 364, 373-374, 376, 380, 385, 388, 403, 487, 489-490, 493, 495-496, 499-501 national, 7, 9, 38, 118, 229, 298, 311, 336, 487, 496 permanent, 433, 451 personal, 242, 258, 495 Income effect, 329, 435-436 Income statement, 212-215, 217, 356, 493, 496, 500 Income tax, 82, 84, 129, 142, 242, 496 India, 168 Individual retirement accounts, 243 IRAs, 243 Indonesia, 168, 286 Industry, 4, 98, 108, 110, 114, 131-132, 149, 188, 191, 193, 196-197, 199-201, 203, 205, 207, 209, 214, 216, 219-221, 223, 234, 238, 277, 281, 287, 292, 294-295, 297, 307, 431 Inefficiencies, 224 Inflation, 1-2, 12, 17, 19, 21, 23-28, 54, 57-58, 62,

65-68, 70, 116-117, 141-143, 170, 174, 182, 200, 328, 330-335, 354-355, 366-369, 411, 415, 417, 424, 428, 431-439, 441-442, 446-448, 450-456, 461-463, 465-467, 469, 473, 478, 480-482, 493, 498-499, 501-502 anticipated, 366, 431, 436-437, 448, 450-452, 454-456, 467, 480-481 expectations of, 65-67, 333-334, 436-437, 446, 450-451, 453, 481, 499 hyperinflation, 19, 24, 27, 453, 493 unanticipated, 448, 450, 454-455, 480-482 unemployment and, 433, 453 Inflation rate, 24, 57, 331, 433, 447, 453, 501 Information, 6-7, 17, 19, 31-32, 40-41, 45, 91-92, 96, 99-102, 127, 130, 186-187, 189, 191, 198, 201-202, 205-206, 212, 216, 253-255, 257, 260, 262-263, 266-267, 271-275, 279-281, 283, 297-298, 300-304, 306, 312, 314-318, 333, 380, 446-448, 455, 473, 475-476, 485, 489, 495-497, 499, 501 asymmetric, 186-187, 198, 201, 205-206, 212, 216, 253-254, 266-267, 273-274, 300-301, 312, 315-316, 485, 495-496, 501 imperfect, 31 Information systems, 127 Information technology, 198 Initial public offering, 247, 250, 255, 267, 493 IPO, 247, 250, 255, 267, 493 Innovation, 245, 363 Innovations, 133, 192, 198-199, 460 defined, 199 Input costs, 433 Insolvency, 197 Insurance, 2, 4-7, 9, 18, 30, 35, 37-39, 42-45, 75, 82, 92, 116, 118, 126-127, 134, 148, 152, 155-156, 162, 164, 188, 191-193, 197-198, 200-201, 203-206, 212, 218, 224-225, 229, 237-239, 242, 245, 247, 249-250, 256, 261-262, 264, 272-273, 275, 278-279, 282-287, 290, 292-298, 299-300, 303, 307, 311, 333, 482, 485, 490-494, 498-502 adverse selection and, 205, 275 availability, 272 brokers, 38, 92, 134, 247, 311, 500 commissioner, 238 contracts, 44, 148, 152, 155, 162, 164, 191, 256, 261-262, 264, 272-273, 275, 279, 283, 303, 491, 500-501 definition of, 287 excess, 30, 239, 490, 494 gap, 239, 492, 494, 501 option, 18, 37, 45, 155-156, 162, 164, 245, 282, 490, 493, 498 risk and, 205, 272, 297 types of, 2, 4, 7, 35, 116, 201, 205, 238, 275, 284, 293, 498-499 Insurance agents, 206 Integration, 371 Integrity, 287 Interbank market, 124 Interest, 2-5, 7-8, 13, 18, 20, 22, 25-26, 28, 30-35, 38-39, 41, 44-46, 47-70, 71-84, 86-88, 92, 94, 104-105, 110, 115-118, 122, 125-127, 129-133, 136, 138-139, 141-142, 144, 145-146, 148, 152, 154, 158-164, 166, 178, 187-188, 192-197, 199-200, 202-203, 205, 211-218, 226, 228-230, 234-236, 238-239, 241-243, 256-257, 262, 264, 266, 268, 270-271, 274, 276, 279, 283, 291, 301-302, 304, 315-318, 319, 321-324, 331-332, 334-336, 338, 341-343, 345-346, 351, 355-367, 369-370, 371-376, 378-406, 407-422, 424-426, 429-430, 435-438, 442-443, 446-448, 454-455, 457, 459-460, 462-463, 465-469, 477-482, 485-502 credit, 2, 8, 13, 18, 20, 31, 38-39, 44-45, 59-64, 66, 68, 80, 126-127, 160, 187, 192-193, 200, 202-203, 205, 212, 214-216, 226, 230, 234-236, 256-257, 262, 266, 271, 274, 276, 283, 304, 317, 364-365, 429, 438, 459, 462, 467, 469, 488-489, 491, 494, 496, 498-501 Interest expense, 213-214, 496 Interest rate, 5, 7, 20, 22, 35, 44, 47-70, 72, 78, 84, 104-105, 125, 129-130, 139, 145, 152, 159-160, 162-164, 178, 187, 193-194, 196, 200, 202-203, 205, 211-212, 214-218, 226, 230, 234-236, 238, 257, 262, 264, 266, 270, 274, 276, 279, 319, 321-324, 331, 334-335,

507

338, 343, 355-365, 367, 369-370, 371-376, 378, 380-383, 385-405, 408-422, 425, 435-436, 442, 446, 460, 465, 467-468, 479-482, 485, 488-493, 495-500 current, 20, 22, 50, 52, 55, 69, 104-105, 130, 164, 216, 218, 262, 322, 324, 394, 467, 488-490, 493, 497 guaranteed, 104, 218, 498 risk, 7, 44, 72, 78, 84, 104-105, 125, 129-130, 139, 145, 152, 159-160, 162-164, 187, 202-203, 205, 214-218, 230, 234-236, 264, 266, 270, 274, 276, 356-358, 480, 488-490, 492-493, 495, 497, 499 Interest rates, 3-5, 7-8, 22, 25-26, 28, 35, 38, 45, 47, 50, 55-57, 59, 61, 63-70, 71-84, 86-88, 92, 115, 118, 125-126, 131-132, 138-139, 141-142, 144, 148, 159, 161-164, 166, 188, 192, 194-197, 202-203, 205, 211, 214, 217-218, 234, 271, 283, 291, 319, 321, 331, 334, 341-342, 356-367, 369-370, 373-374, 376, 378, 380, 386, 388, 391, 394, 398, 401-402, 405-406, 407-409, 411-412, 414-420, 424-426, 429-430, 435-438, 442-443, 446-447, 454-455, 457, 459-460, 462-463, 465-469, 477-478, 480-482, 486, 488-490, 492-496, 498-499, 501-502 bond prices and, 55, 65 determination of, 342, 407 GDP and, 378, 407, 419, 478, 494 inflation and, 435-436, 442, 446, 454-455, 481, 498 investment and, 342, 365, 388 monetary policy and, 342, 362, 376, 391, 465, 469, 493, 499 money demand and, 401, 457 nominal, 57, 65-70, 319, 331, 334, 367, 394, 411, 417-418, 424, 436-438, 442-443, 446, 454, 490, 499 present value and, 47, 144 real, 22, 26, 45, 57, 65-66, 68-70, 72, 75, 118, 131-132, 142, 197, 202-203, 234, 319, 331, 334, 341-342, 356, 366-367, 369, 394, 398, 411, 415-419, 424-426, 429, 436-438, 442-443, 454-455, 462-463, 465, 490, 499, 501 Intermediaries, 1-2, 18, 29-31, 39-42, 44-46, 92, 185-186, 189-191, 193, 198-205, 215, 249, 253, 277, 293, 300, 303-304, 311-312, 314, 317, 487, 491, 493-494, 497-498 Internal rate of return, 53, 493, 502 Internal Revenue Service, 81 International Bank for Reconstruction and Development, 502 International Banking, 207, 226-227, 229, 235, 489, 493 commercial banks, 207, 229, 235, 489 investment banks, 493 International business, 5 International markets, 306 International Monetary Fund, 178-179, 183, 486, 493 International trade, 227, 309, 362 International transactions, 166-167, 228 Internet, 26, 132, 135, 150, 222 Interpersonal skills, 5, 8 Inventories, 64, 66, 99, 320, 338, 343, 386, 474, 477, 493, 499 Inventory, 6, 91-92, 95-96, 118, 134, 142-143, 148-150, 156, 164, 198, 202, 246, 254-255, 257-258, 274, 343, 386, 487 management of, 255 Investment, 4-8, 18, 20, 30-32, 35, 37, 40, 47, 50, 52-53, 59, 65, 80-81, 92-93, 100-102, 104-105, 107-108, 110, 125-126, 130, 132, 134, 143, 158, 174-175, 183, 188-189, 195, 198-199, 201, 204-205, 215, 218, 224-225, 229-230, 233-236, 239, 241, 243-250, 255, 261-265, 270, 277, 279, 281, 286, 292-297, 308-309, 311, 314-315, 319, 321-324, 331-332, 334, 336-340, 342-352, 355-356, 360-362, 364-365, 367-370, 378-382, 384-386, 388-389, 391, 394-398, 401-406, 409, 411-415, 417-419, 424-430, 436-437, 442, 457, 463, 466-467, 469, 476-477, 482, 485, 487-489, 492-494, 496, 500-502 finance and, 4, 31, 35 financial intermediaries and, 30, 92, 311 government, 6-8, 20, 31-32, 35, 37, 40, 50, 53, 59, 65, 80-81, 101, 104, 125-126, 130, 143, 175, 183, 188, 199, 224, 229, 233, 246, 277, 281, 286, 293, 308, 311, 339-340,

508

344, 351-352, 355, 367-369, 382, 384-386, 389, 391, 394-395, 402-406, 411, 413, 417-418, 429-430, 487-488, 492, 494, 496, 501-502 gross, 319, 324, 336, 411, 492 interest rates and, 50, 188, 361, 367, 442, 466-467, 482 net, 175, 215, 218, 234-236, 243, 250, 255, 292, 340, 351, 362, 369, 388, 391, 417, 429-430, 482, 485, 493, 496 present value and, 47, 53 private, 4-5, 80, 204, 225, 239, 241, 255, 261-265, 279, 352, 382, 384, 391, 401, 413-414, 424, 430, 442, 466, 501 saving and, 18, 319, 321-322, 331-332, 334, 336-340, 343, 346, 355, 378-379, 394, 417-418, 426, 500 stock market and, 311 Investment banker, 126 Investment banks, 5-7, 32, 92, 134, 201, 204, 230, 233, 236, 246-247, 249, 261-262, 264, 292, 309, 315, 493-494, 501 Investment decisions, 47, 183, 311, 467, 482 Investment pool, 492 Investment spending, 322, 338, 340, 343, 347-348, 350-351, 355-356, 360-362, 364, 367-370, 378, 380, 382, 384, 386, 388-389, 391, 394-395, 397-398, 401, 405-406, 418, 424-426, 430, 457, 463, 466-467, 488, 493 money market and, 401 Investments, 2, 4, 27, 31, 75, 103, 107-108, 118, 126, 161, 178, 182, 194-195, 197, 199, 213-214, 238, 244, 248, 315, 324, 384, 436, 447, 496 funds of, 118 life insurance, 2, 75, 126, 238 Investors, 1, 5-8, 41, 67, 72-76, 79-80, 82, 84, 91-92, 97, 99, 101-102, 103-108, 110-114, 116, 118, 126-133, 135, 139, 142, 144, 148, 152, 154, 158, 164, 174-175, 178, 182-183, 186, 188-189, 194-195, 199, 203, 205, 212, 218, 224, 229, 244-245, 247-248, 255, 260-267, 276, 277, 279-281, 293-294, 299, 304-305, 311, 314, 317, 331, 362, 436, 477, 479-480, 482-484, 487-488, 492-493 Invisible hand, 320, 332, 495 IRAs, 110, 243 Ireland, 178 Israel, 169 Italy, 178, 229

J Japan, 24, 99, 146, 168, 299-300, 302, 305-318, 362, 411, 483, 485 exports, 362 foreign exchange, 168, 362 Japanese yen, 5, 146, 162, 165, 172, 176, 181, 183, 362 job market, 476 Jobs, 2-5, 69, 223, 233, 301, 398-399, 453, 475 levels, 4, 399 Jordan, 169 Junk bonds, 112, 125-126, 143, 197, 245, 492, 494

K Keiretsu, 307-308, 317, 494 Keogh plans, 243 Keynesian fiscal policy, 401 Knowledge, 2, 7, 31, 138, 269-270, 333, 441-442, 447, 463, 493 Korea, 168, 315 Kuwait, 169

L Labeling, 312 Labor, 44, 198, 214, 233, 240, 270, 320, 322, 324, 329, 333, 335-336, 368, 395, 398, 427-428, 434-435, 440, 450-451, 454-455, 462, 472-476, 480, 483 government intervention, 333, 395 labor force, 320, 322, 324, 333, 335, 398, 440, 475 Lags, 434, 438-439, 441-442, 450, 457, 461, 469 Laissez-faire, 320, 335, 423, 494 Language, 8, 226, 287, 453, 479 Latin America, 227 Law of large numbers, 110-111 Lawsuits, 44, 99, 257 Leader, 28, 149 Learning, 2, 12, 29, 47, 71, 89, 103, 115, 145, 165,

185, 207, 237, 254, 278, 300, 319, 342, 371, 407, 424, 447, 457, 471 Leasing, 271, 295 Lebanon, 169 Legislation, 188, 196, 199, 210, 220-221, 229, 241-243, 279, 281, 285-286, 294-296, 298, 490, 492 regulation by, 295 Lehman Brothers, 127 Letter of credit, 226, 236, 494 Leverage, 215-216, 226, 234-236, 245, 287, 289-290, 494 Leverage ratio, 216, 287, 289-290, 494 Leveraged buyout, 244, 250, 305, 317, 494 Liabilities, 19-20, 39-42, 44, 75, 132, 196, 202-205, 207-208, 210, 212, 214, 217-218, 228-229, 235, 241-243, 258, 268-269, 287, 289-290, 293-294, 486, 489-490, 492-493, 496-497 Liability, 123, 188, 196, 202, 204, 208, 212, 226, 240-241, 249, 269-270, 283, 290, 300, 486, 494-495 business, 188, 202, 208, 226, 249, 270, 283, 300, 486 contingent, 226 law, 495 products, 283, 486, 494 LIBID, 124 London Interbank Bid Rate, 124 LIBOR, 124, 142-143, 159-162, 217-218, 236, 494 Licensing, 233 Life insurance, 2, 30, 37-38, 42-43, 45, 75, 82, 92, 126-127, 164, 191-193, 203-205, 237-239, 242, 250, 261-262, 264, 272-273, 275, 279, 293-294, 296-297, 303, 494, 501-502 actuaries, 238 balance sheet, 203, 501 buying, 30, 43, 45, 164, 191, 239, 262, 273, 501 group, 92, 238, 242, 273, 494, 501 investments, 2, 75, 126, 238 need for, 126 ordinary, 279 premiums, 43, 126, 164, 238-239, 242, 293, 297 private, 42-43, 45, 192-193, 203-204, 239, 261-262, 264, 272-273, 275, 279, 501 term, 37-38, 42-43, 45, 75, 82, 126, 203, 238-239, 250, 261-262, 272-273, 275, 494, 501 Line of credit, 255-256, 275, 494, 499 Liquidation, 291 Liquidity, 9, 12-13, 21-23, 27, 74-75, 77-79, 82-84, 94, 97, 99, 102, 126, 130, 145, 147, 154, 212, 215, 219, 234-236, 244, 262-263, 273, 314, 326, 342, 356-359, 361, 363, 369-370, 372-375, 385, 391, 396-397, 401, 404-406, 407-411, 435-437, 440, 454, 460, 463, 465, 494 Liquidity preference, 342, 357-358, 363, 369, 373, 375, 385, 391, 404-406, 408, 463, 494 Loans, 1-4, 8, 15, 20, 30, 35, 39-44, 47, 59, 92, 132, 140, 164, 187-189, 192-193, 197-199, 201-205, 208-209, 211-214, 216-219, 223, 227-228, 231-236, 244-247, 249-250, 256-262, 265-266, 268, 271, 274-276, 283-284, 288-289, 293, 300, 307, 310, 316, 411, 431, 487-488, 490-491, 494, 496-497, 500-501 Local government, 32-33, 37-38, 42-43, 129, 142, 192-193, 246, 492, 496, 501 London, 29, 90, 94, 99, 123-124, 142, 159, 161, 228, 239, 309, 494 London Interbank Bid Rate, 124 LIBID, 124 London Stock Exchange, 309 Long-run equilibrium, 437 Long-term debt, 260, 266, 271-273, 486 notes, 272, 486 Long-term financing, 249, 261 Loss, 6, 12, 21, 38, 57, 69, 126, 135, 137, 148, 155-156, 164, 197-198, 215, 226, 247, 264, 267, 270, 287, 356-357, 486, 488, 492-494 assessment, 287 expected, 126, 137, 270, 356-357 income, 38, 215, 356, 493 indirect, 198 known, 264, 270 of goods and services, 57, 492 ratio, 135, 226, 287, 492, 494 reserve, 21, 38, 486, 488, 493-494 settlement, 148, 493 underwriting, 226, 264, 486, 494

M Macroeconomic activity, 355 Macroeconomic policy, 453 Macroeconomics, 351, 368, 423, 450, 495 Malaysia, 168 Malta, 169 Management, 8-9, 40, 43, 80, 110, 112, 136, 145, 152, 195, 201-203, 207, 212, 219, 224, 234-235, 244-248, 255, 262, 287, 290-291, 301-302, 304-305, 309, 311, 313-314, 318, 459-460, 474, 477, 489, 493, 496-497 activities of, 152, 301 Management issues, 234 Managers, 47, 56, 73-74, 112, 137, 158, 182, 192, 202, 217, 243-245, 247-249, 255, 257, 259, 267, 290, 301-302, 305, 308, 311, 313, 315-318, 366, 471-474, 477-478, 482-483 Manufacturers, 179, 207, 221, 255 Manufacturing, 40, 43, 128, 202, 214, 268-270, 293, 472, 477, 480 Manufacturing firms, 128 Margin, 141, 143, 147, 163, 214, 217-218, 234-236, 280, 292, 495-496 Marginal propensity to consume, 345, 347, 349, 353, 370, 391, 403, 487, 495 Marginal propensity to save, 347, 370, 381-382, 495, 500 Marginal utility, 106 Market capitalization, 313 Market efficiency, 101 Market equilibrium, 420 Market failure, 187, 205 Market leader, 149 Market performance, 98, 112 Market position, 248 Market power, 61 Market share, 179 Market value, 37, 137, 197, 212, 215, 217, 243, 495-496 Marketing, 32, 199, 238, 247, 249, 261-262, 270, 272, 502 defined, 199, 249 value and, 502 Marketing plan, 247, 272 Marketplace, 1, 37, 90-92, 94-95, 101, 111-112, 122, 133-134, 150, 152, 182, 217, 219, 279, 314, 431, 483, 491, 495 Markets, 1-9, 11, 18, 29-46, 47, 50, 60-61, 71, 73-74, 79, 89-102, 103, 112, 115-144, 145, 147-148, 151-152, 158, 164, 165-166, 174, 178, 181-182, 185-186, 189-190, 192, 198-199, 205-206, 207, 219-220, 226, 235, 237, 245-246, 248, 253-255, 262, 267, 272-273, 275, 277-298, 299, 302-317, 319-320, 338-339, 341, 371, 396, 407, 423, 429-431, 445, 448, 450, 454-455, 457, 460, 471, 473, 478-479, 482-484, 485, 491-493, 495, 497, 500-501 development of, 286, 316 thin, 89, 98-99, 102, 501 virtues of, 423 Markups, 245 Massachusetts, 221 meaning, 39, 107, 169, 197, 225, 229, 248, 250, 323, 327, 360 Measurement, 47-70, 109, 293, 475 measurements, 12 mechanics, 47, 62 Media, 26, 89 Medicare, 240-241 medium, 12, 16-17, 19, 27-28, 89, 92, 254, 265-266, 272-273, 275, 327, 356, 411, 494-496 written, 494 Medium of exchange, 12, 16-17, 19, 27-28, 327, 356, 494-496 meetings, 267, 308-309 conducting, 267 formal, 308-309 Memory, 60, 187, 471 memos, 7 Merchant, 249-250, 295, 309, 495 Merchant banks, 309 Mergers, 126, 221, 223-224, 246, 313, 318 Mergers and acquisitions, 223, 246, 313, 318 message, 34, 78, 131, 174, 330, 428, 454, 459, 468 positive, 428 sales, 131, 468 Mexican pesos, 183

Mexico, 168, 183 Microeconomics, 322 Middle East, 169 Ministry of Finance, 308 Modernization, 201 Monetarists, 319, 332, 335, 407, 409, 414, 419-420, 422, 423-426, 428-436, 438-442, 451, 454-455, 458, 460-461, 463-465 Monetary policy, 5, 15, 20-23, 133, 138-139, 141-142, 277, 342, 351, 359-363, 365-366, 369-370, 376, 386-388, 391-392, 401-402, 406, 407, 409, 411-412, 417-418, 420, 424, 428-429, 431, 435-441, 443, 446-452, 454-456, 457-469, 473, 480, 482-483, 487-488, 490-491, 493, 496, 499, 501-502 contractionary, 435-436, 438, 452, 455, 465, 469, 488 expansionary, 387, 417, 435-439, 441, 448, 450-451, 454, 465-466, 488 Fed and, 420 interest rates and, 141-142, 359, 361, 435, 454, 466-467, 482 lags in, 438 Money, 1-9, 11-28, 29-34, 36-40, 42-45, 47-49, 52-53, 55, 57, 59, 63, 66, 68, 71, 78, 85, 89, 103-104, 108, 111-112, 115-144, 145, 148, 151, 158, 162, 165-167, 169, 174, 178-179, 181-182, 185-189, 191-199, 202, 204-206, 207-208, 211-212, 214-215, 218-220, 228-229, 234, 236, 237-241, 243-244, 246-247, 249-250, 253, 256-257, 259, 261, 265, 272-274, 276, 277, 282, 285, 290-292, 294, 299-300, 311, 319-320, 324-336, 338, 341-343, 345, 355-365, 367-370, 371-378, 385-386, 388-389, 391-399, 401-406, 407-422, 423-443, 445-455, 457-465, 468-469, 471, 482, 484, 485, 487-490, 492-498, 500-502 as medium of exchange, 28 commodity, 151, 329, 492 demand for, 22, 32, 59, 66, 68, 138, 162, 165-167, 178-179, 182, 193, 319, 326-331, 334-335, 342-343, 355, 357-365, 367, 369-370, 372-376, 389, 391, 393-394, 396, 399, 401-405, 408, 412-414, 420, 422, 426, 429-430, 435, 448, 460-461, 468-469, 487, 489, 494, 501-502 M1, 12-15, 20, 23-25, 27-28, 333, 376-377, 458-462, 468-469, 495-496 M2, 12-14, 24-25, 27-28, 376-377, 458, 468, 495 real value of, 325, 395-398, 434 velocity of, 23, 27, 325, 392, 401, 459-460 Money center banks, 215 Money demand, 327, 332, 372, 374-378, 385-386, 389, 391, 393, 397, 401-402, 457, 460-461, 468 GDP and, 378, 385 inflation and, 332 transaction, 402 Money market, 5-7, 13, 25, 27-28, 37-39, 42-45, 115, 118, 121, 123, 128, 130, 142, 191-198, 204-206, 211, 220, 229, 236, 238-239, 243-244, 247, 249, 265, 294, 343, 358, 373, 376, 378, 385, 401, 420, 459, 495-496, 500, 502 equilibrium in, 358, 376, 378, 385 Money market investments, 197 Money multiplier, 496 Money supply, 1, 12-15, 19-28, 138-141, 207, 326-327, 329-335, 355, 357, 359-365, 367-370, 372-374, 376-378, 385-386, 388-389, 391-392, 394-397, 399, 401-402, 404, 406, 408-412, 416-422, 423, 428-429, 431-432, 435-440, 442-443, 446-452, 454-455, 458, 461-465, 468-469, 488, 490, 494-496, 502 aggregate demand and, 367, 432, 440 changes in, 20-22, 141, 326, 329-330, 332, 335, 355, 359-361, 363, 365, 367-369, 378, 389, 391, 394, 402, 406, 412, 419, 428, 431, 435, 438, 442, 446, 451, 461-462, 465, 468-469, 495, 502 interest rates and, 141, 359, 361, 367, 435, 442, 454 Monopoly, 214, 240 Moral hazard, 185, 187-189, 205-206, 216, 254, 266, 268, 270-271, 273, 275, 286-288, 290, 292-293, 297-298, 300, 496 Mortgage, 5-9, 31, 34-35, 38, 43-45, 63, 96-97, 127,

131-133, 139, 142-144, 192, 196-197, 203, 207, 225, 230, 233, 235-236, 273-274, 295, 307, 431, 467, 485, 487, 491-492, 496, 499-501 investment in, 467 Mortgage loans, 35, 43-44, 203, 307, 496, 500 Motivation, 223, 294, 297, 318 Motorcycles, 170, 175 Multinational corporations, 182, 226 Multiplier effect, 382, 405, 464 Multipliers, 374, 381, 406 fiscal, 374, 381, 406 government spending, 406 money, 374, 406 using, 406 Mutual funds, 5, 13, 18, 25, 28, 37, 39, 41-43, 45, 92, 118, 128, 133, 191-193, 195, 197-199, 201, 203-205, 220, 225, 236, 238, 243-244, 247, 249-250, 264-265, 294, 311, 459, 493, 496-497

N NASDAQ, 34, 91, 96-97, 102, 134, 137, 143, 267, 496 National Association of Insurance Commissioners, 262 National Association of Securities Dealers Automated Quotation system, 91, 134, 143, 496 NASDAQ, 91, 134, 143, 496 National debt, 118 National income, 311, 336 Nations, 181, 229, 492, 495 Negative relationship, 357-358, 360, 380 Negligence, 44, 239, 498 Negotiation, 147, 154, 256 Process, 147, 256 nervousness, 245 Net exports, 340, 351, 362, 369, 388, 429, 490 Net income, 213, 215, 499 Net interest, 152, 213-214, 217-218, 234-236, 496 Net worth, 196-197, 202, 255, 260, 485, 493, 496 Netherlands, 178 Netting, 97 New products, 255 New York Stock Exchange, 32-33, 90-92, 97, 99, 101, 118, 126, 133-134, 137, 142, 152, 154, 246, 278, 280, 299, 308, 497, 500 New York Times, 12, 131, 240 New Zealand, 168 news releases, 483 Newspapers, 12, 50, 57, 130, 135, 150, 243, 354 Nominal GDP, 325-327, 335, 367, 418, 490, 497 Nominal interest rate, 57-58, 65, 69, 335, 417, 436, 446, 497, 499 Nominal interest rates, 57, 66-67, 70, 394, 411, 418, 424, 436-437, 443, 454 Nominal value, 325 Nonprofit organizations, 199 Nonsystematic risk, 103, 111, 113-114, 497 Norway, 169 NYSE, 134, 137, 501

O Objectives, 1-2, 4, 12, 29, 40, 47, 71, 89, 103, 115, 145, 165, 185, 207, 237, 254, 278, 300-301, 319, 342, 371, 407, 424, 447, 457, 471, 473, 495, 497 accounting, 4, 495 Obligation, 35-36, 129-131, 133, 142-143, 146-147, 153, 160-162, 225, 270, 276, 289, 480, 486-488, 492, 494, 498, 500, 502 Occurrence, 139, 150, 181 Offer, 4-6, 44, 69, 91, 94-96, 102, 104-105, 111-113, 125, 147, 166, 179, 195, 198, 206, 211, 219, 222, 225, 228-229, 239, 245, 247-250, 262, 268, 283, 307, 320, 459, 473, 486, 488, 497-498 Office of Thrift Supervision, 278, 283, 497 OTS, 497 Offset, 109, 113, 148-150, 163, 174, 197, 286, 288, 352, 355, 369, 414, 418, 425, 428-429, 441, 462, 467, 482, 500 Offsets, 156, 263, 301, 425 Oil, 100, 182, 199, 245, 433, 480, 498 One-to-one relationship, 359 OPEC, 498 Open market operations, 118, 462, 488-489, 491, 497 Operating expenses, 213-214 Operating income, 213-214 Operations, 101, 107, 115, 118, 223, 226-229, 326,

509

333, 462, 488-489, 491, 497 Opportunities, 4-5, 9, 18, 31, 123, 241, 276, 447-448 Opportunity cost, 358 Optimism, 411 Option contract, 486, 497-498 Organization, 90, 102, 221-222, 224-225, 227, 241, 262, 296, 307, 493, 502 Organizational structure, 91 Organizations, 127, 199, 201, 221-224, 243, 278, 295-296, 299, 309 Orientation, 255, 307, 326 future, 255 OTC market, 134 Over-the-counter market, 134 OTS, 497 Outlays, 64 Output, 21, 25-27, 207, 320, 324-326, 328-329, 332, 335-338, 340, 341, 343-344, 346, 354, 366-369, 384, 386, 394-395, 397, 399, 426, 428, 433-434, 448-451, 453-454, 464, 495 equilibrium, 324, 326, 328-329, 332, 335-338, 340, 343-344, 346, 367, 386, 394, 399, 449-451 interest rates and, 367, 454 potential, 27, 320, 368 taxes and, 354, 369 Over-the-counter market, 126, 133-134, 142, 152, 161, 497 OTC market, 134 Ownership, 33, 43-44, 135, 201, 212, 237, 243, 255, 276, 300, 302-304, 306-314, 317, 486-487, 492, 494-495, 498, 500-501

P PACE, 19, 88, 191, 218, 233, 354, 427, 448 Pacific exchange, 152 Packaging, 212 Pakistan, 168 Par value, 492 paragraphs, 269 Parameter, 396 parentheses, 86 paychecks, 435 payroll, 11, 201, 241, 257, 473, 475-476, 479, 483 Pension Benefit Guaranty Corporation, 241, 293, 490, 498 Pension obligations, 279 Perception, 197, 318 Performance, 1-2, 7, 41, 89-102, 112, 137, 147, 149, 154, 186, 188-189, 203, 215-216, 239, 242, 257, 266, 280, 301, 305, 312-313, 317, 354, 423, 473, 477, 483-484, 489, 493 firm performance, 305, 313 market performance, 98, 112 Permits, 18-19, 148, 264, 307, 418, 432, 473-479 Personal income, 242 Peru, 168 Philadelphia Stock Exchange, 152 Philippines, 168 Physical capital, 321 Place, 2, 14-16, 19, 21, 23, 25, 29, 31, 38, 62, 66, 90, 92, 94-95, 102, 117-118, 122, 126-127, 133-134, 142, 147-148, 153, 165, 179, 185, 187, 201, 207, 224, 226, 235, 256, 305, 319, 355, 364-365, 371, 374, 427, 459, 475 Plans, 30, 105, 110, 175, 199, 206, 239-244, 249-250, 279, 286, 293, 331, 342-343, 429, 437, 447, 489 business, 30, 249-250, 342, 429, 447 reasons for, 206 Pledges, 258, 271, 273 Poland, 169, 454 inflation, 454 Policies, 8-9, 68, 155, 188, 203-204, 238-239, 242, 280, 283, 287, 368-369, 386, 424, 428-429, 438-439, 441, 450, 455-456, 457, 461, 463-464, 495, 502 limited, 155, 188, 287 Pooling, 274, 500 Population, 64, 255, 323, 462 Portfolio, 4, 7-8, 20-22, 40-41, 56, 69, 73-74, 76, 78, 92, 103, 106, 108-114, 118, 126-127, 158, 186, 195, 206, 209, 214, 216, 218-219, 233, 243, 245, 248, 296, 326, 356-358, 366, 396, 436, 489, 493-495, 497-498, 501 Model, 356, 366, 396, 493 Portfolio analysis, 108, 113, 356 Portugal, 178 Potential output, 320

510

Power, 57, 61, 66, 80-81, 129-131, 141-142, 214, 225, 234, 241, 259, 280, 295-296, 301-302, 308, 320, 327, 391, 395, 398, 418, 461, 492, 497, 501 Premium, 36, 45, 74-75, 77, 82-84, 111, 113, 131, 138, 153-156, 158, 162-163, 238, 240, 263, 290, 293, 298, 331, 334, 417, 436-437, 494, 497, 499, 502 forward, 162-163 Premiums, 43-44, 78, 126, 153, 156-158, 163-164, 238-239, 242, 286, 290, 292-293, 297, 493, 499 bond, 44, 126, 156, 158, 239, 493, 499 earned, 292 gross, 499 life insurance, 43, 126, 164, 238-239, 242, 293, 297 pure, 238 tax, 238-239, 242, 493 Prepayments, 8, 35, 133 Present value, 47, 49-53, 55-56, 68-69, 86-87, 144, 206, 217, 498 interest rates and, 50 presentations, 265 Press release, 267 press releases, 291 Price, 1, 6-8, 12, 16-17, 19, 22, 28, 31-34, 36-38, 40, 42, 45, 50-61, 65-66, 68, 74, 76, 78-79, 82, 85-88, 90-102, 103-104, 115-116, 119-122, 125-127, 129, 133-136, 138-139, 142, 144, 146-158, 162-163, 165-167, 169-170, 173, 180-181, 208, 212, 215, 219, 224, 230-231, 239, 245-248, 263-264, 267, 273-274, 279-281, 301, 308, 324-332, 334-335, 341-345, 354-356, 359, 366-369, 371, 394-401, 407, 415-416, 418-419, 425-427, 429, 432, 434-437, 440, 442, 446-447, 449, 451-453, 456, 474, 479-480, 485-490, 492-493, 495, 497-499, 501-502 defined, 28, 51, 68, 86, 152, 239, 354, 356, 489 price changes, 91, 96, 99, 103, 155, 162, 219, 354, 495 Price changes, 91, 96, 99, 103, 155, 162, 219, 354, 495 Price effects, 425 Price level, 17, 19, 28, 324-332, 334-335, 341-342, 344, 354-355, 366-369, 371, 394-400, 415-416, 425-427, 429, 432, 434, 440, 442, 449, 452-453, 490, 495, 498 money demand and, 327 Prices, 1-2, 12, 14, 17, 19, 21-26, 28, 33-34, 36, 38, 47, 50, 54-57, 59, 62, 65, 68, 73-74, 76, 86, 89-92, 94-96, 98-102, 120, 125-126, 130, 132-134, 136-142, 144, 148-151, 154-156, 158, 162-163, 169-170, 174, 188, 209, 219, 230, 233, 235, 244-245, 247, 265, 270, 281, 314, 320, 324-335, 341, 343, 351, 354-355, 358, 360-361, 364-369, 371, 386, 388, 393, 395-399, 401-402, 407, 411, 415-419, 423, 425-429, 432-434, 436-437, 440, 442, 447-452, 454-455, 461-462, 471-473, 477-484, 485-486, 488-489, 496-497, 501 auction, 65, 89-91, 94-95, 101-102, 120, 148, 156, 485 custom, 162 demand and, 62, 68, 95, 170, 327-328, 366-367, 401, 425, 427, 432, 440 equilibrium, 62, 65, 89-91, 94-96, 99-101, 170, 324, 326-329, 331-332, 335, 343, 358, 360, 364, 367, 371, 386, 388, 393, 399, 401-402, 411, 415, 418, 436-437, 449-451 expectations of higher, 333 flexible, 320, 329, 371, 396, 401, 415-419, 429, 442, 448, 450-452, 455 full employment and, 26, 332, 343 inflation and, 12, 332, 368, 433-434, 436, 442, 448, 450-452, 454-455, 481 input, 433 maximum, 489 minimum, 2, 17, 96, 120, 126, 130, 141, 434 retail, 149, 461, 472 sticky, 343, 396 wages and, 320, 329, 371, 396, 401-402, 419, 427-428, 442, 448, 450-452, 455 Pricing, 1, 56, 91, 98, 101, 103-114, 133, 136, 149, 151, 158, 230, 262, 273-274, 293, 358, 479 objectives, 1, 103 payment, 56, 104, 133

strategy, 106, 108, 158, 262 value, 1, 56, 91, 103, 107, 136, 158, 230, 274, 479 Prime rate, 217, 236, 498 Principal, 1-2, 4, 32, 34-35, 48-49, 51, 80-81, 85-87, 104, 109, 117-118, 125, 130, 132-133, 142, 159-160, 163, 188-189, 206, 207, 220, 229, 234, 246, 268, 270, 278, 282, 284, 291, 316-317, 485-487, 490, 492-493, 497-500, 502 Principles, 1, 11, 29, 47, 55, 71, 89, 103-104, 107-108, 111-112, 115, 136, 145, 165, 167, 185, 207, 237, 253, 277, 299, 319, 341, 371, 407, 423, 445, 457, 471, 485 Private banks, 306 Private investors, 182, 305 Private ownership, 300 Private placement, 206, 260-265, 271-273, 275-276, 279 Private sector, 4, 118, 240, 352, 414, 424, 438, 442, 484 Privatization, 315-317 Probability, 8, 83, 107-109, 113, 181, 187, 238, 270, 274 insurance and, 238 Product development, 247 Product mix, 224 Product or service, 257 Production, 15, 17, 22-23, 25, 41, 45, 132, 186, 189, 191, 201, 205, 220, 223, 257, 262, 273, 303-304, 319-321, 323-325, 328, 332, 336, 338, 340, 343-344, 346-347, 355, 368-369, 378, 386, 418, 427-428, 433, 435, 438, 441, 472, 474, 477, 489, 495, 500-501 national, 15, 45, 220, 262, 336, 472 Production costs, 189 Production function, 320 productive capacity, 368, 440 Productivity, 170, 174, 179, 182, 322, 324, 440 labor, 322, 324, 440 Products, 43, 114, 132, 149, 166-167, 174, 201, 222-223, 238, 255, 257, 283, 293, 309, 351, 362, 448, 486, 489, 494 defined, 293, 489 levels of, 489 Professionals, 85 Profit, 4, 6, 36, 41, 54, 69, 75, 91, 100, 129, 132, 140, 148-150, 155, 157, 160-162, 164, 208, 214-215, 218, 243, 247, 249, 267, 281, 310, 329, 448, 483, 485, 488, 495, 501 definition of, 281, 495 Profits, 4, 6, 8, 33, 41, 64, 100-101, 151, 188, 196, 202, 215, 219, 247, 286, 315, 336, 499 Property, 42, 44-45, 192-193, 204, 239, 250, 386, 468, 485, 493, 498-499 removal, 493 Property and casualty insurance, 42, 44-45, 204, 239, 498 Property insurance, 250 proposals, 65, 188, 276 Prosperity, 22, 212 Protection, 156, 193, 244, 279-280, 293-294, 297, 493 Prototype, 272, 309 Psychology, 372, 454, 478 Public offering, 247, 250, 255, 267, 279, 493 Public policy, 281 Public relations, 227 Publicity, 267, 317-318 purchase order, 6, 98 Purchasing, 23, 30, 37, 57, 61, 66, 69, 93, 101, 187, 189, 206, 279, 320, 323, 327, 358, 376, 395, 398, 471-474, 477-478, 483, 488, 492-493, 497, 501 Purchasing power, 57, 66, 320, 327, 395, 398, 497, 501 purpose, 41, 43, 182, 229, 262, 273, 291, 308, 497 general, 43, 229, 308 specific, 308, 497 Put option, 36, 45, 153, 156, 497-498

Q Quality, 9, 31, 81, 94, 125, 128, 137, 142, 186-187, 197-199, 202, 205-206, 266-268, 283-284, 287, 317, 485-486, 489 Quantity demanded, 490 Quantity supplied, 94, 426 quotations, 54, 96-97, 127, 135, 150, 155, 168-169 quoting, 5, 124, 247, 488

R Race, 65, 191 Rate of return, 53, 58, 69, 104, 144, 241, 345-346, 351, 384, 493, 502 internal, 53, 493, 502 Rates, 3-5, 7-8, 17, 22, 24-26, 28, 31, 35, 38, 45, 47, 50, 55-57, 59, 61-70, 71-84, 86-88, 92, 115, 118, 123-126, 128, 131-132, 138-139, 141-142, 144, 148, 159-164, 165-168, 170, 174-176, 178-183, 188, 192-197, 202-203, 205, 211, 214, 217-218, 227, 230, 234, 238-239, 271, 274, 283, 291, 319, 321, 331, 334, 341-342, 345, 356-370, 373-374, 376, 378-380, 386, 388, 391, 394-395, 398, 401-402, 405-406, 407-409, 411-412, 414-420, 424-426, 429-430, 433-438, 441-443, 446-448, 453-455, 457, 459-460, 462-463, 465-469, 477-478, 480-482, 486, 488-496, 498-499, 501-502 definition of, 24-25, 28, 73, 86-87, 420, 459, 495 discriminatory, 499 excessive, 291, 417 gross, 214, 319, 411, 462, 492, 499 reasonable, 50, 75, 358, 434, 459, 463 regulation of, 283, 291 Rating, 80-81, 125-127, 132, 230, 262, 303-304, 312, 314, 316-317 Rating agencies, 80, 303-304, 312, 314, 316-317 Rational expectations, 333, 335, 365, 423-424, 431, 435, 437, 445-456, 499 Ratios, 17, 216, 288-289 Raw materials, 207 RBC, 216, 236, 499 Reach, 245 Real estate, 12, 34, 91, 131-132, 197-199, 203-204, 208-209, 230, 234-235, 239, 258, 268, 307, 487 Real GDP, 324-326, 328, 334-335, 342, 354, 367, 371, 418, 464-465, 472, 490, 499, 501 Real interest rate, 57-58, 68-69, 335, 436, 497, 499 Real interest rates, 57, 65, 70, 118, 142, 436-437, 442, 455 Real value, 325, 395-398, 434 Real wages, 448 Receivables, 198, 274, 310 Recession, 21-22, 24, 26, 66, 78, 114, 132, 209, 315, 341, 431, 438-441, 461, 463, 477, 499 Recessions, 19, 24, 66, 68, 209, 438, 460, 477, 488 reasons for, 460 Reciprocity, 221 recommendations, 311, 490 Records, 62, 90, 97, 242, 285, 304, 345, 473, 501 Redlining, 499 Referrals, 256 Reform, 287, 315 Registered bonds, 260 Registration statement, 263-264, 275, 279, 298, 497, 499 Regulation, 26, 100-101, 193-196, 201, 205-206, 211, 224, 227-229, 233, 238, 244, 277-298, 309, 489, 499-500 federal, 193-196, 201, 205, 211, 224, 227-229, 233, 278, 280-283, 285-288, 291-292, 294-298, 489, 499-500 methods, 26, 278, 290 RBC, 499 reasons for, 206, 277 state, 193, 224, 227, 229, 233, 238, 278, 281-283, 293-294, 297, 489 Regulation A, 100 Regulations, 5, 101, 192, 196, 219, 224, 227-229, 248, 277-278, 283, 288, 294, 308, 498 Regulatory environment, 309 Relationships, 73, 79, 81, 109, 201, 256-257, 270, 306-307, 315, 320, 336, 343, 378, 380, 395, 399, 403-404, 447, 450, 460-461, 463, 488 cause-and-effect relationships, 460 preferences, 109 Repetition, 141 reports, 8, 78, 101, 135, 150, 200, 238, 240, 257, 280, 396 online, 150 types of, 238 Required reserves, 487, 490, 494, 499 research, 7-9, 26, 144 primary, 7 Reserve ratio, 489, 499 Reserve requirements, 228-229, 278, 487, 494, 499

Reserves, 20-21, 27, 122, 179, 181-182, 227, 238, 287, 292, 411, 459, 486-487, 489-490, 493-494, 496-497, 499 case, 122, 292, 496 definition of, 27, 287, 459 initial, 493 loss, 21, 287, 486, 493-494 mean, 21 policy, 20-21, 179, 182, 238, 287, 411, 459, 487, 490, 493-494, 496, 499 regulation of, 287, 292 tax-deferred, 238 Resources, 18, 101, 314, 323, 487 Responsibility, 41, 189, 191, 193, 264, 280, 292, 295 Restricted, 225, 259, 290-291, 314, 409, 500 Restrictions, 201, 220, 225, 227, 236, 249, 278, 291, 293-295, 309, 497 Restrictive covenant, 275 Retail stores, 459 Retailers, 43, 149 Retained earnings, 499 Retirement, 38, 42-43, 84, 110, 126, 199, 201, 239-243, 250, 257, 293, 298, 489-490, 493, 498, 500-502 Retirement income, 241-242, 250, 293, 298, 490 monthly, 242 Retirement plans, 240 Return on assets, 215, 236, 268-269, 499 Return on equity, 215, 236, 499 ROE, 215, 236, 499 Revaluation, 179 Revenue, 81, 129-131, 142-143, 149, 200, 214, 225, 345, 355, 498-499 marginal, 345 Revenue bonds, 129-131, 142-143 Revenues, 142, 225, 292, 345, 501 revision, 267, 479 Rewards, 457 Risk, 2, 7-9, 36, 40-41, 44, 71-84, 86-88, 91-92, 96-97, 99, 103-114, 125-126, 128-130, 132, 138-139, 144, 145, 147-152, 155-164, 169, 174-175, 186-188, 198, 202-203, 205, 214-219, 230, 234-236, 242-243, 248, 255, 258-259, 264, 266, 269-274, 276, 283, 286-294, 296-298, 300-304, 316, 356-358, 480, 488-490, 492-495, 497, 499, 501 asset, 9, 36, 41, 44, 103, 108-111, 113, 139, 145, 148, 152, 155-158, 162-163, 198, 202-203, 205, 234, 242-243, 255, 266, 269, 271, 274, 287-291, 356, 489-490, 492, 494-495, 497, 501 business, 8, 44, 78, 96, 108, 114, 125, 132, 139, 149-150, 161, 169, 186-188, 198, 202-203, 218-219, 230, 236, 248, 255, 258-259, 270-271, 273-274, 276, 283, 287, 291, 296-297, 300-301, 304, 316, 356, 488, 490, 493, 497 commercial, 7-8, 40, 74-75, 92, 106, 125, 128-129, 148, 159-160, 186, 198, 203, 218, 230, 234-236, 255, 272-273, 287-289, 293-294, 296-298, 303-304, 489-490, 492, 495, 497, 499, 501 definition of, 73, 86-87, 104, 106, 113, 287, 495 diversifiable, 186 financial, 2, 7-9, 36, 40-41, 44, 71, 73, 80-81, 92, 99, 103-114, 126, 128, 130, 138, 145, 148-152, 155, 158, 160, 162-163, 186-188, 198, 202-203, 205, 214-219, 230, 234-236, 242-243, 248, 255, 258-259, 264, 266, 269-274, 276, 283, 292-294, 296-297, 300-304, 316, 356, 358, 488-489, 492-495, 497, 499, 501 fire, 44, 188, 297, 301-302, 304 insurance and, 296 interest rate, 7, 44, 72, 78, 84, 104-105, 125, 129-130, 139, 145, 152, 159-160, 162-164, 187, 202-203, 205, 214-218, 230, 234-236, 264, 266, 270, 274, 276, 356-358, 480, 488-490, 492-493, 495, 497, 499 market, 7, 44, 73-74, 78-79, 82-83, 91-92, 96-97, 99, 111-113, 125-126, 128-130, 132, 139, 144, 147-152, 161, 163, 169, 174-175, 186-188, 198, 205, 215, 217-219, 230, 235-236, 243, 248, 255, 264, 266, 270-273, 276, 288, 294, 297, 303-304, 316, 358, 480, 488-490, 492-493, 495, 497, 499, 501 objective, 41, 103-104, 161-162, 243, 288, 488,

495 operational, 149 personal, 242, 258-259, 270-272, 274, 301, 495 political, 139 property, 44, 493, 499 pure, 73, 75, 82-84, 501 speculative, 81, 139, 358, 501 subjective, 106 underwriting, 129, 230, 235, 264, 294, 296, 494, 501 Risk management, 9, 145, 152, 203, 235 commercial, 203, 235 financial, 9, 145, 152, 203, 235 objectives, 145 Risk managers, 158 Risk of loss, 492 Risk taking, 286, 294, 297 Risk-based capital, 216, 236, 287-289, 293, 297-298, 499 RBC, 216, 236, 499 regulation of, 287-289, 293, 297-298 standards, 288, 293, 499 Risks, 37, 112-113, 132, 158, 163, 188, 202-203, 207, 215, 218, 242, 249, 274, 278, 281, 286, 293 Risk-taking, 106 ROE, 215, 236, 499 Role, 1-2, 5, 11-28, 31, 39-40, 75, 79, 83, 87, 91-92, 142, 160, 175, 185-186, 189, 196, 202, 227, 244, 249, 275, 295-296, 309-310, 319, 324, 332, 342, 354, 364, 368-369, 396, 407, 418, 423-424, 465, 468, 471, 478 interpersonal, 5 managerial, 185, 202 Round lot, 97, 500 Russia, 169, 462

S S corporation, 292, 501 Salaries, 213-214, 259 Salary, 214, 235, 301, 364 Sales, 5-9, 66, 105, 118, 120, 131, 149-150, 181, 238, 243, 325, 336, 338, 343, 347, 351, 365, 430-431, 461, 467-468, 472-474, 486, 497-498, 500-501 Sales taxes, 131, 468 Salespeople, 5-8 Saudi Arabia, 169 Saving, 2, 18, 31, 104-105, 319, 321-324, 331-332, 334, 336-340, 342-347, 349-350, 353, 355-356, 370, 378-382, 384-386, 394, 417-418, 425-426, 431, 498, 500-501 increase in, 324, 331, 334, 345, 378, 382, 384, 386, 394, 417-418, 426, 498 investment and, 18, 340, 342, 347, 349, 382, 385 Savings and loan crisis, 195, 285 Scale economies, 223, 235 scope, 178, 223-224, 235, 278, 473, 489 Securities, 1, 4-8, 15-16, 20, 22, 29-35, 37-42, 44-45, 47, 50-51, 53-56, 59, 61, 68-69, 71-76, 78-80, 82, 89-102, 103-109, 111-113, 115-119, 122-123, 125-127, 129-134, 138, 142-143, 145-148, 150-152, 156, 160, 162, 166, 174-175, 183, 185-186, 189, 191, 198-199, 201-202, 204, 206, 208-209, 211-215, 217, 219, 225-227, 230, 233, 235, 239, 243-247, 249-250, 253, 260, 263, 265-268, 272, 274, 278-281, 289, 293-298, 299, 307-310, 314, 316-317, 356, 362, 429, 431, 448, 471, 473-474, 483, 485-486, 488-502 Securities and Exchange Commission, 38, 101-102, 145, 244, 260, 263, 278-279, 296, 298, 496, 500 Securities brokers, 246, 500 Securities Exchange Act of 1934, 279-280 Securities Exchange Commission, 499 Securities exchanges, 280 Securitization, 35, 45, 212, 236, 253, 273-275, 309, 314, 500 Security, 1, 5, 7-9, 22, 26, 32, 34, 45, 50-53, 56-57, 68-69, 71, 73-75, 78-79, 90-91, 93-95, 97, 99-100, 104, 106-109, 111-113, 116-117, 121, 130, 141, 143-144, 146, 151-152, 175, 186, 193, 206, 212, 215, 239, 241, 246, 250, 258, 262, 264, 279-280, 293, 298, 314, 431, 480, 486, 488, 490-492, 495, 498-502 investing in, 1, 74, 111, 113, 175, 499-500 Selection, 185, 187, 189, 205, 216, 254, 266, 268, 271, 273, 275, 300, 485

511

Sellers, 23, 36, 50, 89-91, 94-95, 98-99, 101, 127, 147-148, 150, 152-154, 157, 162, 185-187, 246, 266, 485, 497, 500 Sensitivity, 6, 8, 217, 369, 375-376, 378, 381-382, 389, 391, 397, 403, 405, 408, 412, 414, 460, 466, 489 sentences, 281 SEP, 176-177 service activities, 297, 307 Services, 17, 19, 21-23, 25-27, 41, 57, 64, 66, 90, 93, 129-130, 166-167, 196, 198, 200-201, 205-206, 220, 222, 225-226, 230, 235, 247-249, 257, 263, 273, 277, 291, 294, 307, 309, 319-331, 334, 336-340, 342-343, 354, 356, 362-363, 366-369, 374, 376, 378, 397, 403, 426, 428-429, 442, 448, 485, 487-490, 492-493, 495, 497, 499, 502 defined, 205-206, 225, 249, 337-338, 354, 356, 489 levels of, 330, 354, 378, 489, 497 Shareholder, 243, 269, 279, 301, 313, 317 Shareholders, 42, 133, 135, 202-203, 215, 251, 279, 308, 496, 499 shipping, 245 Shortage, 9 Short-term debt, 203, 260, 487 Short-term financing, 261, 265, 275 SIMPLE, 7-8, 21, 47-49, 68-69, 72, 85, 90, 100, 107, 109-110, 136, 186, 192, 208, 239, 256, 268, 277, 281, 287, 299, 325, 332, 343-345, 352-353, 365, 368, 382, 391, 401, 403, 405, 408, 412-413, 417, 426, 429, 437, 461, 464, 467-468, 479, 500-501 Singapore, 168 Single market, 73-74 SIR, 16, 396 Size, 26, 41-43, 56, 92, 97, 101-102, 170, 220, 223, 226, 235, 244, 254-255, 259-260, 262-263, 265-267, 272, 275, 287, 301-302, 308, 310-311, 320, 350, 358, 374-375, 381, 386, 391, 401, 406, 431, 489 Skills, 2, 4-5, 8 Slope, 71, 345, 350, 371, 374-376, 381-382, 398, 401, 403, 418-419, 426, 428-429, 434, 443, 478 Small business, 187-189, 198, 254-259, 268, 270-271, 275-276, 307-308, 314 Small Business Administration, 255 Small business owners, 276 Smoke, 126, 188 SOAP, 17 Social Security, 206, 239 Societies, 309, 453 Society, 500 software, 271 Solvency, 290 South Africa, 169 South Korea, 168 Soviet Union, 315 Spain, 178 Specialized services, 273 Speculation, 17, 26, 139, 141, 203, 248 Speculators, 36, 148, 150-152, 156, 162-163, 188, 501 Spot market, 501 Stabilization policies, 441, 463 Stakeholders, 316 Standard deviation, 107-109, 111-114 Standard of living, 239 Standardization, 147, 152, 154 State government, 240 statistics, 16, 43, 126, 140, 174, 200, 208-210, 213, 238, 316, 354, 472-474, 476 Status, 81, 258, 282, 293, 475 Status quo, 293 Sticker shock, 174 Stock, 23, 27, 32-34, 36-37, 42-45, 78, 90-92, 96-97, 99-101, 104, 112, 114, 115, 118, 125-126, 132-144, 145-146, 150, 152-155, 157-158, 162, 164, 166, 186, 192-193, 205-206, 212, 227, 237-239, 243-244, 246-249, 255, 265, 267, 273, 276, 278-281, 294, 299, 301-302, 304-317, 320, 322, 325-326, 329, 333, 338, 342, 365, 396, 399, 415-417, 424-426, 428-429, 436-437, 448, 459-460, 469, 471, 473, 478-484, 485-490, 493-495, 497-498, 500-501 Stock exchanges, 247, 307, 314, 497 Stock markets, 302, 310-311, 317 Stock of capital, 320 Stockholders, 33, 125, 135-136, 215, 237, 269,

512

279-280, 286-287, 290, 300-301, 304-305, 314, 318, 489, 494, 499, 501 Store of value, 12, 16-19, 27, 496, 501 Stories, 267, 315 Strategies, 7-8, 156, 158, 248, 259, 270, 286, 301 corporate, 8, 158, 301 Strategy, 80, 106, 108, 156, 158, 161, 202, 218, 225, 259, 261-262, 268-270, 276, 285, 301, 313, 493 combination, 108, 225 defined, 225 focus, 202, 270 global, 285 multinational, 218 push, 225 Stress, 78, 433, 454 Strike price, 36, 45, 153, 155-156, 163, 501 Students, 165, 457, 462 Subprime loans, 132, 209 Subprime mortgage crisis, 139, 207, 230 Subprime mortgages, 230, 233, 235 Subsidiaries, 201, 211, 225-227, 230, 295-296, 309, 485, 491, 500 Substitution, 78-79, 209, 329, 429 Success, 111, 130, 179, 188, 206, 212, 215-216, 234, 246, 267, 269-270, 286, 300, 307, 316 Supermarkets, 222, 251 Supply, 1-2, 12-15, 19-28, 44, 47, 59-70, 72-75, 78-79, 90, 94-95, 101, 103, 105, 122, 130-131, 138-141, 147, 156, 162, 165-167, 170, 173-175, 178-180, 182, 207, 209, 249, 294, 319-322, 324, 326-336, 342-343, 355, 357-370, 372-378, 385-386, 388-389, 391-397, 399, 401-404, 406, 408-412, 415-422, 423-443, 446-455, 458, 461-465, 468-469, 472, 474, 477, 485, 488, 490-491, 494-496, 498, 500-502 aggregate, 1, 28, 319, 328-330, 332, 334-336, 342, 360, 362, 366-370, 394-395, 397, 399, 401-402, 415-416, 418, 423-443, 446, 448-454, 462, 485 currency, 12-15, 19, 24, 26-28, 140, 162, 165-166, 170, 174-175, 178-179, 182, 333, 360, 462, 485, 488, 490, 495-496 excess, 1, 20, 60, 138, 170, 173, 175, 178-180, 321, 324, 326, 328, 343, 358-360, 375, 386, 396, 411, 416, 427, 490, 494 law of, 319, 322 long-run, 170, 174, 182, 434, 437, 439, 441, 451, 453 of capital, 174, 320, 324, 362, 369, 488 of labor, 329, 368, 434, 472, 474 of money, 1-2, 12-15, 19-28, 47, 103, 131, 165, 207, 294, 319, 324, 326-330, 332, 334-335, 357-360, 363-365, 367, 369, 372-376, 386, 389, 392-393, 395, 397, 399, 403, 406, 408-409, 412, 415-416, 423, 425-431, 436, 440, 458, 468, 485, 490, 495-496, 498 Supply and demand, 47, 59-61, 64-65, 69-70, 72-73, 75, 90, 94, 103, 147, 156, 170, 321, 332, 335, 342-343, 357, 363, 373, 376, 399, 410, 423-443, 449, 451, 491, 498 Supply curve, 62-63, 66, 68, 95, 170, 173, 179, 367, 370, 426-428, 433-435, 440, 442-443, 446, 448-453 aggregate, 367, 370, 426-428, 433-435, 440, 442-443, 446, 448-453 individual, 451, 453 labor, 427-428, 434-435, 440, 450-451 long-run, 170, 434, 451, 453 market, 95, 170, 179 movement along, 62-63 rightward shift, 63, 170, 173, 367, 451-452 short-run, 428 slope of, 426, 443 Supply-side economics, 366, 368, 370, 501 Support, 5, 20, 65, 139, 149, 450, 460 Surplus, 18, 38, 166-167, 170, 179, 182, 376, 486, 488, 492 consumer, 488 total, 492 surveys, 475 Sweden, 169 Swiss franc, 5, 178 Switzerland, 169, 175 system, 2, 4, 11, 15-16, 21, 27-28, 30-31, 39, 80, 91, 98, 130-131, 134, 143, 178, 181-183, 187-188, 205, 224, 236, 248, 253, 267, 275,

277-278, 280-283, 285, 287, 294, 296-298, 299-318, 319, 324, 333, 356, 365, 392, 394, 403, 405, 413, 441, 462, 464, 485-487, 489-492, 494-496, 498, 500 System design, 299-318 Systematic risk, 111, 113-114, 501

T Tables, 52, 191, 200-201, 208-210, 212, 228, 239, 246, 494 Taiwan, 168 Tax havens, 228-229 Tax rates, 82, 142, 368, 405, 429, 501 Tax revenues, 501 Taxation, 33, 129, 228-229, 352, 355, 369, 382, 385, 430, 491, 494, 500 Taxes, 33, 38, 65, 71, 81-83, 129, 131, 199, 213, 215, 228-229, 238, 242, 339-340, 352-355, 368-369, 384, 389, 405-406, 413, 430, 462, 468, 489, 492, 499 burden of, 81 consumption, 339-340, 352-353, 369, 384 corporate, 33, 38, 71, 83, 129, 430 employment, 352, 355, 368-369, 406 estate, 131, 199, 492 flat, 71, 82 income, 33, 38, 71, 81-83, 129, 213, 215, 229, 238, 242, 339, 352-355, 368-369, 384, 389, 405-406, 413, 489, 499 property, 468, 499 sales, 131, 238, 430, 468 teams, 9 Technology, 26, 99, 132, 198, 255, 320, 322, 324, 368, 460-461, 495 advances in, 198 information technology, 198 Telecommunications, 91, 99, 127, 487, 489, 491, 500 telephone, 91-92, 126-127, 134, 222, 256-257 Term bonds, 56-57, 76, 79, 85, 126, 130, 196, 203, 486 Term insurance, 238 Term loan, 255, 260, 272, 499 Terminology, 146, 181, 345, 356 Territory, 75 Thai baht, 181 Thailand, 168 The New Yorker, 117, 284, 334, 414 Theft, 44, 188, 239, 498 burglary, 44 Thin market, 98, 102 Time dimension, 356 Time value of money, 53, 136 Timing, 85, 292, 355, 441-442, 446 Tokyo Stock Exchange, 92, 308 Top managers, 308 Total assets, 21, 212-217, 219, 222-223, 226, 282, 287, 289, 291, 306, 490, 492, 494, 499 Total cost, 189 Tourism, 174 Trade, 6, 16-17, 36, 90-92, 96-101, 106, 130, 134, 142, 146-147, 165-166, 179, 215, 226-227, 244, 254-255, 257, 281, 309, 314, 362, 431, 433-435, 442, 446, 451-452, 454-455, 482, 486, 488, 490, 492 deficit, 142, 166, 179, 488, 492 domestic, 226-227, 309, 314, 362, 486, 488, 492 surplus, 166, 179, 486, 488, 492 Trade balance, 166 Trade credit, 254-255, 257, 431 Trade deficit, 166 Transactions, 1-2, 5, 16-17, 26, 40-41, 45, 90-91, 94-98, 101, 127, 134, 138, 147, 152, 159, 166-167, 178, 186, 191, 198, 205-206, 210-212, 219, 228-229, 235-236, 245, 265-266, 273, 280, 291, 295, 325, 327, 335, 338, 356, 363-364, 370, 372, 374-376, 378, 386, 391, 393, 405, 408-409, 412-413, 430, 435, 459, 462, 486, 488, 498, 501-502 consistent, 273 durable, 245 Transfers, 18-19, 148, 211, 228, 286, 300, 487, 491, 500 Transparency, 315 treasurer, 39, 175, 240, 364 Treasurers, 5, 182, 211, 459 Treasury bills, 33, 38-39, 43-45, 71-73, 116, 118-120, 123-124, 128-129, 142-143, 194-195, 211, 459, 480, 496, 500, 502 Treasury bonds, 36, 62, 97, 102, 116, 128, 146, 148,

152, 155-156, 162, 164 Treasury securities, 5, 73, 97, 101, 118, 122, 145, 156, 160, 175, 289 Trends, 34, 66-67, 99, 141, 188, 207-209, 219, 314, 438, 447, 476 Trust, 5, 7, 65, 86, 118, 129, 133, 137, 188, 201, 210, 220, 224, 240, 245, 257, 274, 306, 487, 499-500 Trust Fund, 137, 240 Trust Funds, 118 investments, 118 Trustee, 133 Trusts, 210, 230, 244, 249 Turkey, 169 currency, 169 Turnover, 22, 27, 324-325, 409, 502

U Underground economy, 462 Underwriter, 263-264, 275-276, 486, 502 Underwriting, 93, 102, 127, 129, 142, 201, 225-226, 229-230, 235, 246, 249, 262-265, 275, 294-296, 307-308, 486, 494, 500-502 cycle, 307 field, 226 line, 127, 249, 275, 494 losses, 235, 264, 296, 486 risk, 129, 230, 235, 264, 294, 296, 494, 501 Unemployed, 320, 386, 396, 427, 453, 475 Unemployment, 21, 27, 66, 233, 324, 333, 335, 342-343, 352, 354, 394, 396, 398-399, 424-425, 427, 433-435, 442, 446, 448-456, 472-473, 475, 477, 480, 483, 489, 498-499 cyclical, 66, 333 duration of, 333 inflation and, 433-435, 442, 446, 448, 450-455, 498 Unemployment rate, 354, 433, 453, 472-473, 475, 483 Uninsured, 224, 285 Unions, 13, 18, 39, 42, 44, 191-193, 203-204, 234, 278, 283, 285, 488-489, 501 Unit of account, 12, 16-17, 27, 496, 502 United Kingdom, 178, 299-300, 302, 305, 309-314, 317-318, 433 United States, 2, 9, 12, 14-15, 24, 27, 32, 92, 98, 120, 131-133, 153, 166, 170, 174, 185, 191-193, 198, 203, 207, 212, 216, 220-221, 223, 226-229, 237, 244, 249, 253, 278-281, 284-285, 288, 297-298, 299-300, 302, 305-306, 309-315, 317-318, 333, 336, 462-463, 487, 491 Universities, 463 Uruguay, 168 U.S, 15, 28, 32-33, 37-39, 45, 54, 62, 67, 76, 82, 99, 112, 115-118, 123, 125-126, 130, 132, 142, 150, 166-181, 183, 208-209, 219, 221, 224, 226-229, 231-233, 235, 238, 240, 242, 245-246, 248, 267, 276, 277, 279-283, 285, 287-289, 296, 299, 306-310, 312-315, 362, 441, 459, 462, 473-474, 476, 480, 483, 489, 492, 495, 497, 501-502 U.S., 15, 28, 32-33, 37-39, 45, 54, 62, 67, 76, 82, 99, 112, 115-118, 123, 125-126, 130, 132, 142, 150, 166-181, 183, 208-209, 219, 221, 224, 226-229, 231-233, 235, 238, 240, 242, 245-246, 248, 267, 276, 277, 279-283, 285, 287-289, 296, 299, 306-310, 312-315, 362, 441, 459, 462, 473-474, 476, 480, 483, 489, 492, 495, 497, 501-502 U.S. Department of Commerce, 474 U.S. Department of Labor, 473-474 U.S. dollar, 168-169, 171-172, 174-177, 179, 229 euro and, 179 U.S. economy, 132, 233, 245, 277, 315, 362 U.S. Treasury bills, 33, 38-39, 459 Utilities, 131 Utility, 106

V Validity, 112 Value, 1-2, 12, 14, 16-19, 21, 24, 27-28, 33-34, 36-38, 47, 49-56, 68-69, 86-87, 91, 96-97, 99, 102, 103, 107, 116, 119-123, 125, 127, 136-137, 139, 144, 145-148, 150, 152-158, 161, 163, 166, 169, 174, 178, 181-182, 196-197, 202, 206, 212, 215, 217, 230, 233, 235, 238, 243, 250, 258-259, 267, 269, 274, 285, 294, 301, 319, 325-329, 336-337, 345, 348, 356, 361-362, 388, 395-398, 429, 434-435, 468,

479-480, 485-486, 488-498, 500-502 building, 53, 479, 496 defined, 28, 51, 68, 86, 152, 206, 243, 250, 337, 356, 489 market value, 37, 137, 197, 212, 215, 217, 243, 495-496 Vanguard Group, 199, 244 Variability, 103, 112-113, 420, 422, 439 Variables, 140-141, 342, 365, 372, 374, 378, 385, 399, 455, 460, 467, 489, 499 Variance, 108, 149 Velocity of money, 23, 27, 325, 392 Venezuela, 168 Venture capital, 111, 203-204, 237, 247-250, 255, 272, 502 Venture capitalists, 247 Visualize, 31, 115, 145 Volume, 18, 23-24, 26, 37, 96-99, 127-128, 146-147, 150, 155, 227, 246, 295, 313, 327, 329, 380, 459, 494, 501 mergers and acquisitions, 246, 313 of international trade, 227 Voting rights, 306, 311

W Wages, 199, 213-214, 235, 320, 329, 336, 343, 371, 395-396, 401-402, 419, 426-428, 433-435, 442, 448-453, 455 efficiency, 214, 235 equilibrium, 329, 336, 343, 371, 401-402, 435, 449-451 full employment and, 343 minimum, 434 nominal, 396, 442, 448 prices and, 320, 395-396, 426, 442, 455 real, 199, 235, 329, 336, 343, 371, 395-396, 419, 426-428, 433-434, 442, 448, 450, 452-453, 455 sticky, 343, 396 Wall Street Journal, 12, 84, 93, 96, 110, 137, 141, 231-233, 448, 453, 471-472, 476 War, 24, 140, 165, 178, 181, 205, 237, 281, 308, 384, 454, 459, 469 Water, 13 Weaknesses, 256, 475 Wealth, 21, 130, 141, 258, 267, 271-272, 301, 356, 358, 361-362, 369-370, 388, 397-398, 401, 429, 468-469, 495, 502 Wealth effect, 362, 370, 388, 398, 401, 429, 468-469, 502 Weather conditions, 149 websites, 135 Women, 242, 441 Won, 17, 31, 37, 51, 98, 126, 134, 168, 233, 265, 270, 397, 448 Work, 4-6, 8-9, 16, 31, 49, 51, 94, 110, 135, 140, 145, 159, 162, 178, 192, 219, 222, 224, 301, 313, 319-320, 341, 352, 354, 368, 394-395, 397, 438, 448, 453, 462-465, 475, 481-483, 500 Workers, 17, 110, 240-241, 343, 395, 428, 434-435, 448-451, 453, 475-476, 478, 480, 493, 498 discouraged, 428 Working capital, 43, 255-256 World, 9, 24, 47, 66, 72, 75, 80, 89-90, 101, 105, 107, 112-113, 117, 124, 132, 165, 178-179, 181-182, 186, 188, 192-193, 205, 220, 233, 237, 255, 270, 299, 305, 308, 315, 362, 367, 369, 371-406, 407-419, 421-422, 431, 435, 448, 450, 454-455, 458-459, 462-463, 469, 471, 502 World Bank, 502 World War, 24, 165, 178, 181, 205, 308, 454, 459, 469 First, 459 Second, 459 WWW, 28, 46, 69, 83, 96, 102, 113, 119, 143, 163, 183, 206, 236, 250, 276, 298, 317, 335, 370, 402, 406, 419, 443, 456, 469, 484

Y Yen, 5, 146, 162, 165, 168, 170, 172, 176, 179, 181, 183, 362, 411 Yuan, 168, 179

513

514