I have continually strived to improve this textbook with each new edition, and the

Seventh Edition of The Economics of Money, Banking, and Financial Markets is no

exception. The text has undergone a major revision, but it retains the basic hallmarks

that have made it the best-selling textbook on money and banking in the past

six editions:

• A unifying, analytic framework that uses a few basic economic principles to

organize students’ thinking about the structure of financial markets, the foreign

exchange markets, financial institution management, and the role of monetary

policy in the economy

• A careful, step-by-step development of models (an approach found in the best

principles of economics textbooks), which makes it easier for students to learn

• The complete integration of an international perspective throughout the text

• A thoroughly up-to-date treatment of the latest developments in monetary theory

• Special features called “Following the Financial News” and “Reading the Wall

Street Journal” to encourage reading of a financial newspaper

• An applications-oriented perspective with numerous applications and specialtopic

boxes that increase students’ interest by showing them how to apply theory

to real-world examples

What’s New in the Seventh Edition

In addition to the expected updating of all data through the end of 2002 whenever

possible, there is major new material in every part of the text. Indeed, this revision

is one of the most substantial that I have ever done.

With the wide swings in the stock prices in recent years, students of money and

banking have become increasingly interested in what drives the stock market. As a

result, I have expanded the discussion of this market by describing simple valuation

methods for stocks and examining recent developments in the stock market

and the link between monetary policy and stock prices. I have combined this material

with the discussion of the theory of rational expectations and efficient capital

markets to create a new Chapter 7, “The Stock Market, the Theory of Rational

Expectations, and the Efficient Market Hypothesis.”

Expanded

Coverage of the

Stock Market

xxix

PREFACE

In light of continuing changes in financial markets and institutions, I have added

the following new material to keep the text current:

• Extensive discussion of recent corporate scandals and the collapse of Enron,

including their impact on the economy (Chapters 6, 7, 11, and 26)

• Discussion of the role of venture capitalists in the high-tech sector (Chapter 8)

• Examination of how information technology is influencing bank consolidation,

and analysis of whether clicks will dominate bricks in the banking industry

(Chapter 10)

• New material on the Basel Committee on Bank Supervision and where the Basel

Accord is heading (Chapter 11)

• Discussion of the spread of deposit insurance throughout the world (Chapter 11)

• Perspective on the growing concerns about Fannie Mae and Freddie Mac

(Chapter 12)

• A new type of special-interest box, the E-Finance box, which relates how

changes in technology have affected the conduct of business in banking and

financial markets. The placement of these boxes throughout the text helps to

demonstrate the impact of technology across a broad range of areas in finance.

The growing importance of the global economy has encouraged me to add more

new material with an international perspective:

• Extensive discussion of recent developments in Argentina (Chapters 1, 8, 11,

20, and 21)

• Analysis of how central banks set overnight interest rates in other countries

(Chapter 17)

• Discussion of how the euro has fared in its first four years (Chapter 19)

• Additional treatment of recent events in the Japanese economy (Chapters 11

and 26)

Drawing on my continuing involvement with central banks around the world, I

have added new material to keep the discussion of monetary theory and policy

current:

• New boxes on Fed watching and Federal Reserve transparency (Chapters 14

and 18)

• Discussion of the changes (implemented in 2003) in the way the Fed administers

the discount window (Chapter 17)

• An updated discussion of the market for reserves and how the channel/corridor

system for setting interest rates works (Chapter 17)

• Discussion of how the recent corporate scandals have hindered the recovery of

the economy from the 2001–2002 recession (Chapter 25)

The incredible advances in electronic (computer and telecommunications) technology

in recent years have had a major impact on the financial system. This Seventh

Edition reflects these developments by adding many new features with an electronic

focus.

Web Enhancement. The Seventh Edition embraces the exploding world of information

now available over the World Wide Web. There are few areas where the Internet

E-Focus

New Material on

Monetary Theory

and Policy

Increased

International

Perspective

New Material on

Financial

Institutions

xxx Preface

has been as valuable as in the realm of money, banking, and financial markets. Data

that were once difficult and tedious to collect are now readily available. To help students

appreciate what they can access online, I have added a number of new features:

1. Web Exercises. This edition adds all-new end-of-chapter Web Exercises.

These require that students collect information from online sources or use

online resources to enhance their learning experience. The Web Exercises are

relatively quick and easy to complete, while still accomplishing the goal of

familiarizing students with online sources of data.

2. Web Sources. Much of the data used to create the many tables and charts were

collected from online sources. Wherever a Web URL is available, it is exactly

reported as the source. The interested student or instructor can use this URL to

see what has happened since the chart or table was created.

3. Marginal Web References. In addition to listing the sources of data used to

create the charts and graphs, I have also included in the margin URLs to Web

sites that provide information or data that supplement the text. These references

include a brief description of what students will find at the site.

Interested students can use these sites to extend their study, and instructors can

draw from them to supplement their lecture notes. Because the URLs for Web

sources and references do sometimes change, the Mishkin Companion Web

Site at www.aw.com/mishkin will provide the new URLs when they are needed.

E-Finance Boxes. To illustrate how electronic technology has increasingly permeated

financial markets and institutions, I have included the all-new E-Finance

boxes, described earlier, to show the ongoing real-world impact of this remarkable

development.

As textbooks go into later editions, they often grow in length. Over the years, I have

resisted this tendency, and in this edition have made even greater efforts to streamline

the book. Despite the addition of a lot of new material, the book is substantially

shorter. Moreover, at the suggestion of reviewers, I have moved the discussion of

rational expectations and efficient markets earlier in the book, to Chapter 7. I have

also shifted the material on the foreign exchange market and the determination of

exchange rates to Chapter 19 so that it comes immediately before the chapter on

the international financial system, allowing this material to be taught together.

The Web site for this book, www.aw.com/mishkin, has allowed me to produce a

large amount of new material for the book without lengthening the text, because we

have placed this material in appendices on the Web site. The appendices include:

Chapter 2: Financial Market Instruments

Chapter 4: Measuring Interest-Rate Risk: Duration

Chapter 5: Models of Asset Pricing

Chapter 5: Applying the Asset Market Approach to a Commodity Market:

The Case of Gold

Chapter 9: Duration Gap Analysis

Chapter 9: Measuring Bank Performance

Chapter 11: Evaluating FDICIA and Other Proposed Reforms of the Bank

Regulatory System

Appendices on

the Web

Streamlined

Coverage and

Organization

Preface xxxi

Chapter 15: The Fed’s Balance Sheet and the Monetary Base

Chapter 16: The M2 Money Multiplier

Chapter 16: Explaining the Behavior of the Currency Ratio

Chapter 22: A Mathematical Treatment of the Baumol-Tobin and Tobin Mean

Variance Model

Chapter 22: Empirical Evidence on the Demand for Money

Chapter 24: Algebra of the ISLM Model

Chapter 25: Aggregate Supply and the Phillips Curve

Instructors can either use these appendices in class to supplement the material in

the textbook, or recommend them to students who want to expand their knowledge

of the money and banking field.

Flexibility

In using previous editions, adopters, reviewers, and survey respondents have continually

praised this text’s flexibility. There are as many ways to teach money, banking,

and financial markets as there are instructors. To satisfy the diverse needs of

instructors, the text achieves flexibility as follows:

• Core chapters provide the basic analysis used throughout the book, and other

chapters or sections of chapters can be used or omitted according to instructor

preferences. For example, Chapter 2 introduces the financial system and basic

concepts such as transaction costs, adverse selection, and moral hazard. After

covering Chapter 2, the instructor may decide to give more detailed coverage

of financial structure by assigning Chapter 8, or may choose to skip Chapter 8

and take any of a number of different paths through the book.

• The text also allows instructors to cover the most important issues in monetary

theory and policy without having to use the ISLM model in Chapters 23 and

24, while more complete treatments of monetary theory make use of the ISLM

chapters.

• The internationalization of the text through marked international sections within

chapters, as well as through complete separate chapters on the foreign exchange

market and the international monetary system, is comprehensive yet flexible.

Although many instructors will teach all the international material, others will

not. Instructors who want less emphasis on international topics can easily skip

Chapter 19 on the foreign exchange market and Chapter 20 on the international

financial system and monetary policy. The international sections within chapters

are self-contained and can be omitted with little loss of continuity.

To illustrate how this book can be used for courses with varying emphases, several

course outlines are suggested for a semester teaching schedule. More detailed

information about how the text can be used flexibly in your course is available in

the Instructor’s Manual.

• General Money and Banking Course: Chapters 1–5, 9–11, 14, 17, 18, 25, 27,

with a choice of 6 of the remaining 15 chapters.

• General Money and Banking Course with an International Emphasis: Chapters 1–5,

9–11, 14, 17–20, 25, 27 with a choice of 4 of the remaining 13 chapters.

xxxii Preface

• Financial Markets and Institutions Course: Chapters 1–13, with a choice of 6 of

the remaining 15 chapters.

• Monetary Theory and Policy Course: Chapters 1–5, 14, 15, 17, 18, 21, 25–28,

with a choice of 5 of the remaining 14 chapters.

Pedagogical Aids

In teaching theory or its applications, a textbook must be a solid motivational tool.

To this end, I have incorporated a wide variety of pedagogical features to make the

material easy to learn:

1. Previews at the beginning of each chapter tell students where the chapter is

heading, why specific topics are important, and how they relate to other topics

in the book.

2. Applications, numbering more than 50, demonstrate how the analysis in the

book can be used to explain many important real-world situations. A special set

of applications, called “Reading the Wall Street Journal,” shows students how to

read daily columns in this leading financial newspaper.

3. “Following the Financial News” boxes introduce students to relevant news

articles and data that are reported daily in the press, and explain how to read

them.

4. “Inside the Fed” boxes give students a feel for what is important in the operation

and structure of the Federal Reserve System.

5. Global boxes include interesting material with an international focus.

6. E-Finance boxes relate how changes in technology have affected financial markets

or institutions.

7. Special-interest boxes highlight dramatic historical episodes, interesting

ideas, and intriguing facts related to the subject matter.

8. Study Guides are highlighted statements scattered throughout the text that

provide hints to the student on how to think about or approach a topic.

9. Summary tables provide a useful study aid in reviewing material.

10. Key statements are important points set in boldface italic type so that students

can easily find them for later reference.

11. Graphs with captions, numbering more than 150, help students clearly

understand the interrelationship of the variables plotted and the principles of

analysis.

12. Summary at the end of each chapter lists the main points covered.

13. Key terms are important words or phrases, boldfaced when they are defined

for the first time and listed by page number at the end of the chapter.

14. End-of-chapter questions and problems, numbering more than 400, help

students learn the subject matter by applying economic concepts, including a

special class of problems that students find particularly relevant, under the

heading “Using Economic Analysis to Predict the Future.”

15. Web Exercises encourage students to collect information from online sources

or use online resources to enhance their learning experience.

16. Web sources report the Web URL source of the data used to create the many

tables and charts.

Preface xxxiii

17. Marginal Web references point the student to Web sites that provide information

or data that supplement the text material.

18. Glossary at the back of the book provides definitions of all the key terms.

19. Answers section at the back of the book provides solutions to half of the questions

and problems (marked by *).

An Easier Way to Teach Money, Banking, and Financial Markets

The demands for good teaching have increased dramatically in recent years. To

meet these demands, I have provided the instructor with supplementary materials,

unlike those available with any competing text, that should make teaching this

course substantially easier.

This book comes with not only full-color Microsoft PowerPoint electronic

transparencies of all the figures and tables but also full-color overhead transparencies.

Furthermore, the Instructor’s Manual contains transparency masters of the lecture

notes, perforated so that they can be easily detached for use in class.

The lecture notes are comprehensive and outline all the major points covered

in the text. They have been class-tested successfully—they are in fact the notes that

I use in class—and they should help other instructors prepare their lectures as they

have helped me. Some instructors might use these lecture notes as their own class

notes and prefer to teach with a blackboard. But for those who prefer to teach with

visual aids, the PowerPoint presentation and the full-color transparencies of the figures

and tables afford the flexibility to take this approach.

I am also aware that many instructors want to make variations in their lectures

that depart somewhat from material covered in the text. For their convenience, the

entire set of lecture notes has been put on the Instructor’s Resource CD-ROM using

Microsoft Word. Instructors can modify the lecture notes as they see fit for their own

use, for class handouts, or for transparencies to be used with an overhead projector.

The Instructor’s Resource CD-ROM also offers the entire contents of the

Instructor’s Manual, which includes chapter outlines, overviews, and teaching tips;

answers to the end-of-chapter problems that are not included in the text. Using this

handy feature, instructors can prepare student handouts such as solutions to problem

sets made up of end-of-chapter problems, the outline of the lecture that day, or

essay discussion questions for homework. I have used handouts of this type in my

teaching and have found them to be very effective. Instructors have my permission

and are encouraged to photocopy all of the materials on the CD-ROM and use them

as they see fit in class.

Supplements Program to Accompany the Seventh Edition

The Economics of Money, Banking, and Financial Markets, Seventh Edition, includes

the most comprehensive program of supplements of any money, banking, and

financial markets textbook. These items are available to qualified domestic adopters,

but in some cases may not be available to international adopters.

1. Instructor’s Resource Manual, a print supplement prepared by me and offering

conventional elements such as sample course outlines, chapter outlines, and

For the Professor

xxxiv Preface

answers to questions and problems in the text. In addition, the manual contains

my Lecture Notes, numbering more than 300, in transparency master format;

these notes comprehensively outline the major points covered in the textbook.

2. Instructor’s Resource CD-ROM, which conveniently holds the MS Word files

to the Instructor’s Manual, the Computerized Test Bank, and the MS PowerPoint

Lecture Presentation.

3. Full-Color Transparencies, numbering more than 150, for all of the figures,

tables, and summary tables.

4. PowerPoint Electronic Lecture Presentation, numbering more than 300

images, which include all the book’s figures and tables in full color, plus the lecture

notes. Available on the Instructor’s Resource CD-ROM.

5. Printed Test Bank by James Butkiewicz of the University of Delaware, comprising

more than 4,500 multiple-choice and essay test items, many with graphs.

6. Computerized Test Bank, allowing the instructor to produce exams efficiently.

This product consists of the multiple-choice and essay questions in the printed

Test Bank and offers editing capabilities. It is available in Macintosh and Windows

versions on the Instructor’s Resource CD-ROM.

1. Study Guide and Workbook, prepared by Erick Eschker of Humboldt State

University, John McArthur of Wofford College, and me, which includes chapter

synopses and completions, exercises, self-tests, and answers to the exercises

and self-tests.

2. Readings in Money, Banking, and Financial Markets, edited by James W.

Eaton of Bridgewater College and me, updated annually, with over half the articles

new each year to enable instructors to keep the content of their course current

throughout the life of an edition of the text. The readings are available

within MyEconLab (see next section).

Course Management with MyEconLab

Every student who buys a new textbook receives a prepaid subscription to

MyEconLab. New to the Seventh Edition of The Economics of Money, Banking, and

Financial Markets, MyEconLab delivers rich online content and innovative learning

tools to your classroom. Instructors who use MyEconLab gain access to powerful

communication and assessment tools, and their students receive access to the additional

learning resources described next.

MyEconLab delivers the content and tools your students need to succeed within

Addison-Wesley’s innovative CourseCompass system. Students whose instructors

use MyEconLab gain access to a variety of resources:

• The complete textbook online, in PDF format, with animated graphs that help

students master the key concepts

• MathXL for Economics—a powerful tutorial to refresh students on the basics

of creating and interpreting graphs; solving applied problems using graphs; calculating

ratios and percentages; performing calculations; calculating average,

median, and mode; and finding areas

• Research Navigator™—a one-stop research tool, with extensive help on the entire

research process, including evaluating sources, drafting, and documentation, as

Students and

MyEconLab

For the Student

Preface xxxv

well as access to a variety of scholarly journals and publications, a complete

year of search for full-text articles from the New York Times, and a “Best of the

Web” Link Library of peer-reviewed Web sites

• eThemes of the Times—thematically related articles from the New York Times,

accompanied by critical-thinking questions

• Readings on Money, Banking, and Financial Markets—edited by James W. Eaton

of Bridgewater College and me and updated annually, with a focus on articles

from Federal Reserve publications and economics and finance journals

• Additional study resources such as self-testing quizzes for each chapter, a

weekly current events feature, online glossary term flashcards, and additional

articles and supplemental materials

The Student Access Kit that arrives bundled with all new books walks students

step-by-step through the registration process.

With MyEconLab, instructors can customize existing content and add their own.

They can manage, create, and assign tests to students, choosing from our Test Bank,

or upload tests they’ve written themselves. MyEconLab also includes advanced

tracking features that record students’ usage and performance and a Gradebook feature

to see students’ test results. Please refer to the Instructor Quick Start Guide or

contact your Addison-Wesley sales representative to set up MyEconLab for your

course.

Acknowledgments

As always in so large a project, there are many people to thank. My gratitude goes

to Victoria Warneck, economics editor at Addison Wesley; Sylvia Mallory, Executive

Development Manager; and Jane Tufts, the best development editor in the business.

I also have been assisted by comments from my colleagues at Columbia and from

my students.

In addition, I have been guided by the thoughtful commentary of outside

reviewers and correspondents, especially Jim Eaton. Their feedback has made this

a better book. In particular, I thank the following:

Burton Abrams, University of Delaware

Francis W. Ahking, University of Connecticut

Mohammed Akacem, Metropolitan State College of Denver

Harjit K. Arora, Le Moyne College

Stacie Beck, University of Delaware

Gerry Bialka, University of North Florida

Daniel K. Biederman, University of North Dakota

John Bishop, East Carolina University

Daniel Blake, California State University, Northridge

Robert Boatler, Texas Christian University

Henning Bohn, University of California, Santa Barbara

Michael W. Brandl, University of Texas at Austin

Oscar T. Brookins, Northeastern University

William Walter Brown, California State University, Northridge

Instructors and

MyEconLab

xxxvi Preface

James L. Butkiewicz, University of Delaware

Colleen M. Callahan, Lehigh University

Ray Canterbery, Florida State University

Sergio Castello, University of Mobile

Jen-Chi Cheng, Wichita State University

Patrick Crowley, Middlebury College

Sarah E. Culver, University of Alabama, Birmingham

Maria Davis, San Antonio College

Ranjit S. Dighe, State University of New York, Oswego

Richard Douglas, Bowling Green University

Donald H. Dutkowsky, Syracuse University

Richard Eichhorn, Colorado State University

Paul Emberton, Southwest Texas State University

Erick Eschker, Humboldt State University

Robert Eyler, Sonoma State University

L. S. Fan, Colorado State University

Sasan Fayazmanesh, California State University, Fresno

Dennis Fixler, George Washington University

Gary Fleming, Roanoke College

Grant D. Forsyth, Eastern Washington University

James Gale, Michigan Technological University

Stuart M. Glosser, University of Wisconsin, Whitewater

Fred C. Graham, American University

Jo Anna Gray, University of Oregon

David Gulley, Bentley College

Daniel Haak, Stanford University

Larbi Hammami, McGill University

Bassan Harik, Western Michigan University

J. C. Hartline, Rutgers University

Scott E. Hein, Texas Tech University

Robert Stanley Herren, North Dakota State University

Jane Himarios, University of Texas, Arlington

Dar-Yeh Hwang, National Taiwan University

Jayvanth Ishwaran, Stephen F. Austin State University

Jonatan Jelen, Queens College and City College of CUNY

U Jin Jhun, State University of New York, Oswego

Frederick L. Joutz, George Washington University

Bryce Kanago, University of Northern Iowa

Magda Kandil, International Monetary Fund

George G. Kaufman, Loyola University Chicago

Richard H. Keehn, University of Wisconsin, Parkside

Elizabeth Sawyer Kelly, University of Wisconsin, Madison

Jim Lee, Fort Hays State University

Robert Leeson, University of Western Ontario

Tony Lima, California State University, Hayward

Bernard Malamud, University of Nevada, Las Vegas

Marvin Margolis, Millersville University

Stephen McCafferty, Ohio State University

James McCown, Ohio State University

Preface xxxvii

Cheryl McGaughey, Angelo State University

W. Douglas McMillin, Louisiana State University

William Merrill, Iowa State University

Carrie Meyer, George Mason University

Stephen M. Miller, University of Connecticut

Masoud Moghaddam, Saint Cloud State University

Thomas S. Mondschean, DePaul University

Clair Morris, U.S. Naval Academy

Jon Nadenichek, California State University, Northridge

John Nader, Grand Valley State University

Leonce Ndikumana, University of Massachusetts, Amherst

Ray Nelson, Brigham Young University

Inder P. Nijhawan, Fayetteville State University

Nick Noble, Miami University of Ohio

Dennis O’Toole, Virginia Commonwealth University

Mark J. Perry, University of Michigan, Flint

Chung Pham, University of New Mexico

Marvin M. Phaup, George Washington University

Ganga P. Ramdas, Lincoln University

Ronald A. Ratti, University of Missouri, Columbia

Hans Rau, Ball State University

Prosper Raynold, Miami University

Javier Reyes, Texas A&M University

Jack Russ, San Diego State University

Robert S. Rycroft, Mary Washington College

Lynn Schneider, Auburn University, Montgomery

Walter Schwarm, Colorado State University

Harinder Singh, Grand Valley State University

Larry Taylor, Lehigh University

Leigh Tesfatsion, Iowa State University

Frederick D. Thum, University of Texas, Austin

Robert Tokle, Idaho State University

C. Van Marrewijk, Erasmus University

Christopher J. Waller, Indiana University

Maurice Weinrobe, Clark University

James R. Wible, University of New Hampshire

Philip R. Wiest, George Mason University

William Wilkes, Athens State University

Thomas Williams, William Paterson University

Laura Wolff, Southern Illinois University, Edwardsville

Robert Wright, University of Virginia

Ben T. Yu, California State University, Northridge

Ky H. Yuhn, Florida Atlantic University

Jeffrey Zimmerman, Methodist College

Finally, I want to thank my wife, Sally; my son, Matthew; and my daughter,

Laura, who provide me with a warm and happy environment that enables me to do

my work, and my father, Sydney, now deceased, who a long time ago put me on the

path that led to this book.

Frederic S. Mishkin

xxxviii Preface

P a r t I

Introduction

PREVIEW On the evening news you have just heard that the Federal Reserve is raising the federal

funds rate by of a percentage point. What effect might this have on the interest

rate of an automobile loan when you finance your purchase of a sleek new sports car?

Does it mean that a house will be more or less affordable in the future? Will it make

it easier or harder for you to get a job next year?

This book provides answers to these and other questions by examining how

financial markets (such as those for bonds, stocks, and foreign exchange) and financial

institutions (banks, insurance companies, mutual funds, and other institutions)

work and by exploring the role of money in the economy. Financial markets and institutions

not only affect your everyday life but also involve huge flows of funds (trillions

of dollars) throughout our economy, which in turn affect business profits, the

production of goods and services, and even the economic well-being of countries

other than the United States. What happens to financial markets, financial institutions,

and money is of great concern to our politicians and can even have a major

impact on our elections. The study of money, banking, and financial markets will

reward you with an understanding of many exciting issues. In this chapter we provide

a road map of the book by outlining these issues and exploring why they are worth

studying.

Why Study Financial Markets?

Part II of this book focuses on financial markets, markets in which funds are transferred

from people who have an excess of available funds to people who have a shortage.

Financial markets such as bond and stock markets are crucial to promoting

greater economic efficiency by channeling funds from people who do not have a productive

use for them to those who do. Indeed, well-functioning financial markets are

a key factor in producing high economic growth, and poorly performing financial

markets are one reason that many countries in the world remain desperately poor.

Activities in financial markets also have direct effects on personal wealth, the behavior

of businesses and consumers, and the cyclical performance of the economy.

A security (also called a financial instrument) is a claim on the issuer’s future income

or assets (any financial claim or piece of property that is subject to ownership). A

bond is a debt security that promises to make payments periodically for a specified

The Bond Market

and Interest

Rates

12

3

Chap ter

Why Study Money, Banking,

and Financial Markets?

1

period of time.1 The bond market is especially important to economic activity because

it enables corporations or governments to borrow to finance their activities and

because it is where interest rates are determined. An interest rate is the cost of borrowing

or the price paid for the rental of funds (usually expressed as a percentage of

the rental of $100 per year). There are many interest rates in the economy—mortgage

interest rates, car loan rates, and interest rates on many different types of bonds.

Interest rates are important on a number of levels. On a personal level, high interest

rates could deter you from buying a house or a car because the cost of financing

it would be high. Conversely, high interest rates could encourage you to save because

you can earn more interest income by putting aside some of your earnings as savings.

On a more general level, interest rates have an impact on the overall health of the

economy because they affect not only consumers’ willingness to spend or save but

also businesses’ investment decisions. High interest rates, for example, might cause a

corporation to postpone building a new plant that would ensure more jobs.

Because changes in interest rates have important effects on individuals, financial

institutions, businesses, and the overall economy, it is important to explain fluctuations

in interest rates that have been substantial over the past twenty years. For example,

the interest rate on three-month Treasury bills peaked at over 16% in 1981. This

interest rate then fell to 3% in late 1992 and 1993, rose to above 5% in the mid to

late 1990s, and then fell to a low of below 2% in the early 2000s.

Because different interest rates have a tendency to move in unison, economists

frequently lump interest rates together and refer to “the” interest rate. As Figure 1

4 PA RT I Introduction

1The definition of bond used throughout this book is the broad one in common use by academics, which covers

short- as well as long-term debt instruments. However, some practitioners in financial markets use the word bond

to describe only specific long-term debt instruments such as corporate bonds or U.S. Treasury bonds.

FIGURE 1 Interest Rates on Selected Bonds, 1950–2002

Sources: Federal Reserve Bulletin; www.federalreserve.gov/releases/H15/data.htm.

0

5

10

15

20

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Interest Rate (%)

U.S. Government

Long-Term Bonds

Corporate Baa Bonds

Three-Month

Treasury Bills

www.federalreserve

.gov/releases/

Daily, weekly, monthly,

quarterly, and annual releases

and historical data for selected

interest rates, foreign exchange

rates, and so on.

shows, however, interest rates on several types of bonds can differ substantially. The

interest rate on three-month Treasury bills, for example, fluctuates more than the other

interest rates and is lower, on average. The interest rate on Baa (medium-quality) corporate

bonds is higher, on average, than the other interest rates, and the spread

between it and the other rates became larger in the 1970s.

In Chapter 2 we study the role of bond markets in the economy, and in Chapters

4 through 6 we examine what an interest rate is, how the common movements in

interest rates come about, and why the interest rates on different bonds vary.

A common stock (typically just called a stock) represents a share of ownership in a

corporation. It is a security that is a claim on the earnings and assets of the corporation.

Issuing stock and selling it to the public is a way for corporations to raise funds

to finance their activities. The stock market, in which claims on the earnings of corporations

(shares of stock) are traded, is the most widely followed financial market in

America (that’s why it is often called simply “the market”). A big swing in the prices

of shares in the stock market is always a big story on the evening news. People often

speculate on where the market is heading and get very excited when they can brag

about their latest “big killing,” but they become depressed when they suffer a big loss.

The attention the market receives can probably be best explained by one simple fact:

It is a place where people can get rich—or poor—quickly.

As Figure 2 indicates, stock prices have been extremely volatile. After the market

rose in the 1980s, on “Black Monday,” October 19, 1987, it experienced the worst

one-day drop in its entire history, with the Dow Jones Industrial Average (DJIA) falling

by 22%. From then until 2000, the stock market experienced one of the great bull

markets in its history, with the Dow climbing to a peak of over 11,000. With the collapse

of the high-tech bubble in 2000, the stock market fell sharply, dropping by over

30% by 2002. These considerable fluctuations in stock prices affect the size of people’s

wealth and as a result may affect their willingness to spend.

The stock market is also an important factor in business investment decisions,

because the price of shares affects the amount of funds that can be raised by selling

newly issued stock to finance investment spending. A higher price for a firm’s shares

means that it can raise a larger amount of funds, which can be used to buy production

facilities and equipment.

In Chapter 2 we examine the role that the stock market plays in the financial system,

and we return to the issue of how stock prices behave and respond to information

in the marketplace in Chapter 7.

For funds to be transferred from one country to another, they have to be converted

from the currency in the country of origin (say, dollars) into the currency of the country

they are going to (say, euros). The foreign exchange market is where this conversion

takes place, and so it is instrumental in moving funds between countries. It is

also important because it is where the foreign exchange rate, the price of one country’s

currency in terms of another’s, is determined.

Figure 3 shows the exchange rate for the U.S. dollar from 1970 to 2002 (measured

as the value of the American dollar in terms of a basket of major foreign currencies).

The fluctuations in prices in this market have also been substantial: The

dollar weakened considerably from 1971 to 1973, rose slightly in value until 1976,

and then reached a low point in the 1978–1980 period. From 1980 to early 1985, the

dollar appreciated dramatically in value, but since then it has fallen substantially.

The Foreign

Exchange Market

The Stock Market

C H A P T E R 1 Why Study Money, Banking, and Financial Markets? 5

http://stockcharts.com/charts

/historical/

Historical charts of various

stock indexes over differing

time periods.

What have these fluctuations in the exchange rate meant to the American public

and businesses? A change in the exchange rate has a direct effect on American consumers

because it affects the cost of imports. In 2001 when the euro was worth

around 85 cents, 100 euros of European goods (say, French wine) cost $85. When the

dollar subsequently weakened, raising the cost of a euro near $1, the same 100 euros

of wine now cost $100. Thus a weaker dollar leads to more expensive foreign goods,

makes vacationing abroad more expensive, and raises the cost of indulging your

desire for imported delicacies. When the value of the dollar drops, Americans will

decrease their purchases of foreign goods and increase their consumption of domestic

goods (such as travel in the United States or American-made wine).

Conversely, a strong dollar means that U.S. goods exported abroad will cost more

in foreign countries, and hence foreigners will buy fewer of them. Exports of steel, for

example, declined sharply when the dollar strengthened in the 1980–1985 and

6 PA RT I Introduction

FIGURE 2 Stock Prices as Measured by the Dow Jones Industrial Average, 1950–2002

Source: Dow Jones Indexes: http://finance.yahoo.com/?u.

0

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

2,000

4,000

6,000

8,000

10,000

12,000

Dow Jones

Industrial Average

1995–2001 periods. A strong dollar benefited American consumers by making foreign

goods cheaper but hurt American businesses and eliminated some jobs by cutting

both domestic and foreign sales of their products. The decline in the value of the

dollar from 1985 to 1995 and 2001 to 2002 had the opposite effect: It made foreign

goods more expensive, but made American businesses more competitive. Fluctuations

in the foreign exchange markets have major consequences for the American economy.

In Chapter 19 we study how exchange rates are determined in the foreign

exchange market in which dollars are bought and sold for foreign currencies.

Why Study Banking and Financial Institutions?

Part III of this book focuses on financial institutions and the business of banking.

Banks and other financial institutions are what make financial markets work. Without

them, financial markets would not be able to move funds from people who save to

people who have productive investment opportunities. They thus also have important

effects on the performance of the economy as a whole.

The financial system is complex, comprising many different types of private sector

financial institutions, including banks, insurance companies, mutual funds, finance

companies, and investment banks, all of which are heavily regulated by the government.

If an individual wanted to make a loan to IBM or General Motors, for example,

he or she would not go directly to the president of the company and offer a loan.

Instead, he or she would lend to such companies indirectly through financial intermediaries,

institutions that borrow funds from people who have saved and in turn

make loans to others.

Why are financial intermediaries so crucial to well-functioning financial markets?

Why do they extend credit to one party but not to another? Why do they usually write

Structure of

the Financial

System

C H A P T E R 1 Why Study Money, Banking, and Financial Markets? 7

FIGURE 3 Exchange Rate of the U.S. Dollar, 1970–2002

Source: Federal Reserve: www.federalreserve.gov/releases/H10/summary.

1970 1975 1980 1985 1990 1995 2000 2005

75

90

105

120

135

150

Index

(March 1973 = 100)

complicated legal documents when they extend loans? Why are they the most heavily

regulated businesses in the economy?

We answer these questions in Chapter 8 by developing a coherent framework for

analyzing financial structure in the United States and in the rest of the world.

Banks are financial institutions that accept deposits and make loans. Included under

the term banks are firms such as commercial banks, savings and loan associations,

mutual savings banks, and credit unions. Banks are the financial intermediaries that

the average person interacts with most frequently. A person who needs a loan to buy

a house or a car usually obtains it from a local bank. Most Americans keep a large proportion

of their financial wealth in banks in the form of checking accounts, savings

accounts, or other types of bank deposits. Because banks are the largest financial

intermediaries in our economy, they deserve the most careful study. However, banks

are not the only important financial institutions. Indeed, in recent years, other financial

institutions such as insurance companies, finance companies, pension funds,

mutual funds, and investment banks have been growing at the expense of banks, and

so we need to study them as well.

In Chapter 9, we examine how banks and other financial institutions manage

their assets and liabilities to make profits. In Chapter 10, we extend the economic

analysis in Chapter 8 to understand why bank regulation takes the form it does and

what can go wrong in the regulatory process. In Chapters 11 and 12, we look at the

banking industry and at nonbank financial institutions; we examine how the competitive

environment has changed in these industries and learn why some financial

institutions have been growing at the expense of others. Because the economic environment

for banks and other financial institutions has become increasingly risky,

these institutions must find ways to manage risk. How they manage risk with financial

derivatives is the topic of Chapter 13.

In the good old days, when you took cash out of the bank or wanted to check your

account balance, you got to say hello to the friendly human teller. Nowadays you are

more likely to interact with an automatic teller machine when withdrawing cash, and

you can get your account balance from your home computer. To see why these

options have been developed, in Chapter 10 we study why and how financial innovation

takes place, with particular emphasis on how the dramatic improvements in

information technology have led to new means of delivering financial services electronically,

in what has become known as e-finance. We also study financial innovation,

because it shows us how creative thinking on the part of financial institutions

can lead to higher profits. By seeing how and why financial institutions have been creative

in the past, we obtain a better grasp of how they may be creative in the future.

This knowledge provides us with useful clues about how the financial system may

change over time and will help keep our knowledge about banks and other financial

institutions from becoming obsolete.

Why Study Money and Monetary Policy?

Money, also referred to as the money supply, is defined as anything that is generally

accepted in payment for goods or services or in the repayment of debts. Money is linked

Financial

Innovation

Banks and Other

Financial

Institutions

8 PA RT I Introduction

to changes in economic variables that affect all of us and are important to the health of

the economy. The final two parts of the book examine the role of money in the economy.

In 1981–1982, total production of goods and services (called aggregate output) in

the U.S. economy fell and the unemployment rate (the percentage of the available

labor force unemployed) rose to over 10%. After 1982, the economy began to expand

rapidly, and by 1989 the unemployment rate had declined to 5%. In 1990, the eightyear

expansion came to an end, with the unemployment rate rising above 7%. The

economy bottomed out in 1991, and the subsequent recovery was the longest in U.S.

history, with the unemployment rate falling to around 4%. A mild economic downturn

then began in March 2001, with unemployment rising to 6%.

Why did the economy expand from 1982 to 1990, contract in 1990 to 1991,

boom again from 1991 to 2001, and then contract again in 2001? Evidence suggests

that money plays an important role in generating business cycles, the upward and

downward movement of aggregate output produced in the economy. Business cycles

affect all of us in immediate and important ways. When output is rising, for example,

it is easier to find a good job; when output is falling, finding a good job might be difficult.

Figure 4 shows the movements of the rate of money growth over the

1950–2002 period, with the shaded areas representing recessions, periods of declining

aggregate output. What we see is that the rate of money growth has declined

before every recession. Indeed, every recession since the beginning of the twentieth

century has been preceded by a decline in the rate of money growth, indicating that

Money and

Business Cycles

C H A P T E R 1 Why Study Money, Banking, and Financial Markets? 9

FIGURE 4 Money Growth (M2 Annual Rate) and the Business Cycle in the United States, 1950–2002

Note: Shaded areas represent recessions.

Source: Federal Reserve Bulletin, p. A4, Table 1.10; www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

15

10

5

0

Money

Growth Rate

(%)

Money Growth

Rate (M2)

2005

www.federalreserve.gov

General information, monetary

policy, banking system,

research, and economic data of

the Federal Reserve.

changes in money might also be a driving force behind business cycle fluctuations.

However, not every decline in the rate of money growth is followed by a recession.

We explore how money might affect aggregate output in Chapters 22 through 28,

where we study monetary theory, the theory that relates changes in the quantity of

money to changes in aggregate economic activity and the price level.

Thirty years ago, the movie you might have paid $9 to see last week would have set

you back only a dollar or two. In fact, for $9 you could probably have had dinner,

seen the movie, and bought yourself a big bucket of hot buttered popcorn. As shown

in Figure 5, which illustrates the movement of average prices in the U.S. economy

from 1950 to 2002, the prices of most items are quite a bit higher now than they were

then. The average price of goods and services in an economy is called the aggregate

price level, or, more simply, the price level (a more precise definition is found in the

appendix to this chapter). From 1950 to 2002, the price level has increased more than

sixfold. Inflation, a continual increase in the price level, affects individuals, businesses,

and the government. Inflation is generally regarded as an important problem

to be solved and has often been a primary concern of politicians and policymakers.

To solve the inflation problem, we need to know something about its causes.

Money and

Inflation

10 PA RT I Introduction

FIGURE 5 Aggregate Price Level and the Money Supply in the United States, 1950–2002

Sources: www.stls.frb.org/fred/data/gdp/gdpdef; www.federalreserve.gov/releases/h6/hist/h6hist10.txt.

0

25

50

75

100

125

150

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Aggregate Price Level

(GDP Deflator)

Money Supply

(M2)

175

200

225

Index (1987= 100)

www.newsengin.com

/neFreeTools.nsf/CPIcalc

?OpenView

Calculator lets you compute

how buying power has changed

since 1913.

What explains inflation? One clue to answering this question is found in Figure 5,

which plots the money supply and the price level. As we can see, the price level and

the money supply generally move closely together. These data seem to indicate that a

continuing increase in the money supply might be an important factor in causing the

continuing increase in the price level that we call inflation.

Further evidence that inflation may be tied to continuing increases in the money

supply is found in Figure 6. For a number of countries, it plots the average inflation

rate (the rate of change of the price level, usually measured as a percentage change per

year) over the ten-year period 1992–2002 against the average rate of money growth

over the same period. As you can see, there is a positive association between inflation

and the growth rate of the money supply: The countries with the highest inflation rates

are also the ones with the highest money growth rates. Belarus, Brazil, Romania, and

Russia, for example, experienced very high inflation during this period, and their rates

of money growth were high. By contrast, the United Kingdom and the United States

had very low inflation rates over the same period, and their rates of money growth have

been low. Such evidence led Milton Friedman, a Nobel laureate in economics, to make

the famous statement, “Inflation is always and everywhere a monetary phenomenon.”2

We look at money’s role in creating inflation by studying in detail the relationship

between changes in the quantity of money and changes in the price level in Chapter 27.

C H A P T E R 1 Why Study Money, Banking, and Financial Markets? 11

FIGURE 6 Average Inflation Rate Versus Average Rate of Money Growth for Selected Countries, 1992–2002

Source: International Financial Statistics.

20 40 60 80 100 120 140 160 180 200 220

20

40

60

80

100

120

140

160

180

200

220

Average

Inflation Rate (%)

Average Money Growth Rate (%)

0

United States

Uruguay

Peru

Argentina

Brazil

Belarus

Romania

United Kingdom

Venezuela

Mexico

Ecuador

Colombia

Chile

Russia

2Milton Friedman, Dollars and Deficits (Upper Saddle River, N.J.: Prentice Hall, 1968), p. 39.

In addition to other factors, money plays an important role in interest-rate fluctuations,

which are of great concern to businesses and consumers. Figure 7 shows the

changes in the interest rate on long-term Treasury bonds and the rate of money

growth. As the money growth rate rose in the 1960s and 1970s, the long-term bond

rate rose with it. However, the relationship between money growth and interest rates

has been less clear-cut since 1980. We analyze the relationship between money and

interest rates when we examine the behavior of interest rates in Chapter 5.

Because money can affect many economic variables that are important to the wellbeing

of our economy, politicians and policymakers throughout the world care about

the conduct of monetary policy, the management of money and interest rates. The

organization responsible for the conduct of a nation’s monetary policy is the central

bank. The United States’ central bank is the Federal Reserve System (also called

simply the Fed). In Chapters 14–18 and 21, we study how central banks like the

Federal Reserve System can affect the quantity of money in the economy and then

look at how monetary policy is actually conducted in the United States and elsewhere.

Fiscal policy involves decisions about government spending and taxation. A budget

deficit is the excess of government expenditures over tax revenues for a particular

time period, typically a year, while a budget surplus arises when tax revenues exceed

government expenditures. The government must finance any deficit by borrowing,

while a budget surplus leads to a lower government debt burden. As Figure 8 shows,

the budget deficit, relative to the size of our economy, peaked in 1983 at 6% of

national output (as calculated by the gross domestic product, or GDP, a measure of

Fiscal Policy and

Monetary Policy

Conduct of

Monetary Policy

Money and

Interest Rates

12 PA RT I Introduction

FIGURE 7 Money Growth (M2 Annual Rate) and Interest Rates (Long-Term U.S. Treasury Bonds), 1950–2002

Sources: Federal Reserve Bulletin, p. A4, Table 1.10; www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

0

2

4

6

8

10

12

14

16

1950 1955 1960 1965 1970 1975 1980 1985 1990

0

2

4

6

8

10

12

14

16

Money

Growth Rate

(% annual rate)

Interest

Rate (%)

Money Growth Rate (M2)

Interest Rate

1995 2000 2005

aggregate output described in the appendix to this chapter). Since then, the budget

deficit at first declined to less than 3% of GDP, rose again to over 5% by 1989, and

fell subsequently, leading to budget surpluses from 1999 to 2001. In the aftermath of

the terrorist attacks of September 11, 2001, the budget has swung back again into

deficit. What to do about budget deficits and surpluses has been the subject of legislation

and bitter battles between the president and Congress in recent years.

You may have heard statements in newspapers or on TV that budget surpluses are

a good thing while deficits are undesirable. We explore the accuracy of such claims in

Chapters 8 and 21 by seeing how budget deficits might lead to a financial crisis as

they did in Argentina in 2001. In Chapter 27, we examine why deficits might result

in a higher rate of money growth, a higher rate of inflation, and higher interest rates.

How We Will Study Money, Banking, and Financial Markets

This textbook stresses the economic way of thinking by developing a unifying framework

to study money, banking, and financial markets. This analytic framework uses

a few basic economic concepts to organize your thinking about the determination of

asset prices, the structure of financial markets, bank management, and the role of

money in the economy. It encompasses the following basic concepts:

• A simplified approach to the demand for assets

• The concept of equilibrium

• Basic supply and demand to explain behavior in financial markets

• The search for profits

C H A P T E R 1 Why Study Money, Banking, and Financial Markets? 13

FIGURE 8 Government Budget Surplus or Deficit as a Percentage of Gross Domestic Product, 1950–2002

Source: http://w3.access.gpo.gov/usbudget/fy2003/spreadsheets.html.

6

5

4

3

2

1

0

1

2

3

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Percent of GDP

Deficit

Surplus

www.kowaldesign

.com/budget/

This site reports the current

Federal budget deficit or

surplus and how it has changed

since the 1950s. It also reports

how the federal budget is spent.

www.brillig.com/debt_clock/

National Debt clock. This site

reports the exact national debt

at each point in time.

• An approach to financial structure based on transaction costs and asymmetric

information

• Aggregate supply and demand analysis

The unifying framework used in this book will keep your knowledge from

becoming obsolete and make the material more interesting. It will enable you to learn

what really matters without having to memorize a mass of dull facts that you will forget

soon after the final exam. This framework will also provide you with the tools to

understand trends in the financial marketplace and in variables such as interest rates,

exchange rates, inflation, and aggregate output.

To help you understand and apply the unifying analytic framework, simple models

are constructed in which the variables held constant are carefully delineated, each

step in the derivation of the model is clearly and carefully laid out, and the models

are then used to explain various phenomena by focusing on changes in one variable

at a time, holding all other variables constant.

To reinforce the models’ usefulness, this text uses case studies, applications, and

special-interest boxes to present evidence that supports or casts doubts on the theories

being discussed. This exposure to real-life events and data should dissuade you

from thinking that all economists make abstract assumptions and develop theories

that have little to do with actual behavior.

To function better in the real world outside the classroom, you must have the

tools to follow the financial news that appears in leading financial publications such

as the Wall Street Journal. To help and encourage you to read the financial section of

the newspaper, this book contains two special features. The first is a set of special

boxed inserts titled “Following the Financial News” that contain actual columns and

data from the Wall Street Journal that typically appear daily or periodically. These

boxes give you the detailed information and definitions you need to evaluate the data

being presented. The second feature is a set of special applications titled “Reading the

Wall Street Journal” that expand on the “Following the Financial News” boxes. These

applications show you how the analytic framework in the book can be used directly

to make sense of the daily columns in the United States’ leading financial newspaper.

In addition to these applications, this book also contains nearly 400 end-of-chapter

problems that ask you to apply the analytic concepts you have learned to other realworld

issues. Particularly relevant is a special class of problems headed “Predicting the

Future.” So that you can work on many of these problems on your own, answers to

half of them are found at the end of the book. These give you an opportunity to

review and apply many of the important financial concepts and tools presented

throughout the book.

The World Wide Web has become an extremely valuable and convenient resource for

financial research. We emphasize the importance of this tool in several ways. First,

wherever we utilize the Web to find information to build the charts and tables that

appear throughout the text, we include the source site’s URL. These sites often contain

additional information and are updated frequently. Second, in the margin of the

text, we have included the URLs of sites related to the material being discussed. Visit

these sites to further explore a topic you find of particular interest. Finally, we have

added Web exercises to the end of each chapter. These exercises prompt you to visit

sites related to the chapter and to work with real-time data and information.

Web site URLs are subject to frequent change. We have tried to select stable sites, but

we realize that even government URLs change. The publisher’s web site (www.aw.com

/mishkin) will maintain an updated list of current URLs for your reference.

Exploring the Web

14 PA RT I Introduction

A sample Web exercise has been included in this chapter. This is an especially

important example, since it demonstrates how to export data from a web site into

Microsoft® Excel for further analysis. We suggest you work through this problem on

your own so that you will be able to perform this activity when prompted in subsequent

Web exercises.

You have been hired by Risky Ventures, Inc., as a consultant to help them analyze interest rate

trends. They are initially interested in determining the historical relationship between longand

short-term interest rates. The biggest task you must immediately undertake is collecting

market interest-rate data. You know the best source of this information is the Web.

1. You decide that your best indicator of long-term interest rates is the 30-year U.S. Treasury

note. Your first task is to gather historical data. Go to www.federalreserve.gov/releases/ and

click “H.15 Selected Interest Rates, Historical data.” The site should look like Figure 9.

a. Click on “Historical data.” Scroll down to “U.S. Government securities/Treasury

constant maturities/30 year.” Scroll over to the right and click on “annual.”

C H A P T E R 1 Why Study Money, Banking, and Financial Markets? 15

Web Exercises

FIGURE 9 Federal Reserve Board Web Site

b. While you have located an accurate source of historical interest rate data, getting it

onto a spreadsheet will be very tedious. You recall that Excel will let you convert text

data into columns. Begin by highlighting the two columns of data (the year and rate).

Right-click on the mouse and choose COPY. Now open Excel and put the cursor in a

cell. Click PASTE. Now choose DATA from the tool bar and click on TEXT TO COLUMNS.

Follow the wizard (Figure 10), checking the fixed-width option. The list of interest

rates should now have the year in one column and the interest rate in the next column.

Label your columns.

Repeat the above steps to collect the 1-year interest rate series. Put it in the column

next to the 30-year series. Be sure to line up the years correctly and delete any years

that are not included in both series.

c. You now want to analyze the interest rates by graphing them. Again highlight the two

columns of data you just created in Excel. Click on the charts icon on the tool bar (or

INSERT/CHART). Select scatter diagram and choose any type of scatter diagram that

connects the dots. Let the Excel wizard take you through the steps of completing the

graph. (See Figure 11.)

16 PA RT I Introduction

FIGURE 10 Excel Spreadsheet with Interest Rate Data

Concluding Remarks

The topic of money, banking, and financial markets is an exciting field that directly

affects your life—interest rates influence earnings on your savings and the payments

on loans you may seek on a car or a house, and monetary policy may affect your job

prospects and the prices of goods in the future. Your study of money, banking, and

financial markets will introduce you to many of the controversies about the conduct

of economic policy that are currently the subject of hot debate in the political arena

and will help you gain a clearer understanding of economic phenomena you frequently

hear about in the news media. The knowledge you gain will stay with you

and benefit you long after the course is done.

C H A P T E R 1 Why Study Money, Banking, and Financial Markets? 17

Summary

1. Activities in financial markets have direct effects on

individuals’ wealth, the behavior of businesses, and the

efficiency of our economy. Three financial markets

deserve particular attention: the bond market (where

interest rates are determined), the stock market (which

has a major effect on people’s wealth and on firms’

investment decisions), and the foreign exchange market

(because fluctuations in the foreign exchange rate have

major consequences for the American economy).

FIGURE 11 Excel Graph of Interest Rate Data

18 PA RT I Introduction

Key Terms

aggregate income (appendix), p. 20

aggregate output, p. 9

aggregate price level, p. 10

asset, p. 3

banks, p. 8

bond, p. 3

budget deficit, p. 12

budget surplus, p. 12

business cycles, p. 9

central bank, p. 12

common stock, p. 5

e-finance, p. 8

Federal Reserve System (the Fed), p. 12

financial intermediaries, p. 7

financial markets, p. 3

fiscal policy, p. 12

foreign exchange market, p. 5

foreign exchange rate, p. 5

gross domestic product (appendix),

p. 12, 20

inflation, p. 10

inflation rate, p. 11

interest rate, p. 4

monetary policy, p. 12

monetary theory, p. 10

money (money supply), p. 8

recession, p. 9

security, p. 3

stock, p. 5

unemployment rate, p. 9

Questions and Problems

Questions marked with an asterisk are answered at the end

of the book in an appendix, “Answers to Selected Questions

and Problems.”

1. Has the inflation rate in the United States increased or

decreased in the past few years? What about interest

rates?

*2. If history repeats itself and we see a decline in the rate

of money growth, what might you expect to happen to:

a. real output

b. the inflation rate, and

c. interest rates?

3. When was the most recent recession?

*4. When interest rates fall, how might you change your

economic behavior?

5. Can you think of any financial innovation in the past

ten years that has affected you personally? Has it made

you better off or worse off? Why?

*6. Is everybody worse off when interest rates rise?

7. What is the basic activity of banks?

*8. Why are financial markets important to the health of

the economy?

9. What is the typical relationship between interest rates

on three-month Treasury bills, long-term Treasury

bonds, and Baa corporate bonds?

*10. What effect might a fall in stock prices have on business

investment?

11. What effect might a rise in stock prices have on consumers’

decisions to spend?

2. Banks and other financial institutions channel funds

from people who might not put them to productive use

to people who can do so and thus play a crucial role in

improving the efficiency of the economy.

3. Money appears to be a major influence on inflation,

business cycles, and interest rates. Because these

economic variables are so important to the health of the

economy, we need to understand how monetary policy

is and should be conducted. We also need to study

government fiscal policy because it can be an influential

factor in the conduct of monetary policy.

4. This textbook stresses the economic way of thinking by

developing a unifying analytic framework for the study

of money, banking, and financial markets using a

few basic economic principles. This textbook also

emphasizes the interaction of theoretical analysis and

empirical data.

QUIZ

C H A P T E R 1 Why Study Money, Banking, and Financial Markets? 19

*12. How does a fall in the value of the pound sterling

affect British consumers?

13. How does an increase in the value of the pound sterling

affect American businesses?

*14. Looking at Figure 3, in what years would you have

chosen to visit the Grand Canyon in Arizona rather

than the Tower of London?

15. When the dollar is worth more in relation to currencies

of other countries, are you more likely to buy

American-made or foreign-made jeans? Are U.S. companies

that manufacture jeans happier when the dollar

is strong or when it is weak? What about an American

company that is in the business of importing jeans

into the United States?

Web Exercises

1. In this exercise we are going to practice collecting data

from the Web and graphing it using Excel. Use the

example in the text as a guide. Go to www.forecasts.org

/data/index.htm, click on “stock indices” at the top of

the page then choose the U.S. Stock indices –

monthly option. Finally, choose the Dow Jones

Industrial Average option.

a. Using the method presented in this chapter, move

the data into an Excel spreadsheet.

b. Using the data from a, prepare a graph. Use the

graphing wizard to properly label your axes.

2. In Web Exercise 1 you collected and graphed the Dow

Jones Industrial Average. This same site reports forecast

values of the DJIA. Go to www.forecasts.org

/data/index.htm and click on “FFC Home” at the top

of the page. Click on the Dow Jones Industrial link

under Forecasts in the far left column.

a. What is the Dow forecast to be in 3 months?

b. What percentage increase is forecast for the next

three months?

20

Because these terms are used so frequently throughout the text, we need to have a

clear understanding of the definitions of aggregate output, income, the price level, and

the inflation rate.

Aggregate Output and Income

The most commonly reported measure of aggregate output, the gross domestic

product (GDP), is the market value of all final goods and services produced in a

country during the course of the year. This measure excludes two sets of items that at

first glance you might think would be included. Purchases of goods that have been

produced in the past, whether a Rembrandt painting or a house built 20 years ago,

are not counted as part of GDP, nor are purchases of stocks or bonds. None of these

enter into GDP because they are not goods and services produced during the course

of the year. Intermediate goods, which are used up in producing final goods and services,

such as the sugar in a candy bar or the energy used to produce steel, are also not

counted separately as part of GDP. Because the value of the final goods already

includes the value of the intermediate goods, to count them separately would be to

count them twice.

Aggregate income, the total income of factors of production (land, labor, and capital)

from producing goods and services in the economy during the course of the year,

is best thought of as being equal to aggregate output. Because the payments for final

goods and services must eventually flow back to the owners of the factors of production

as income, income payments must equal payments for final goods and services.

For example, if the economy has an aggregate output of $10 trillion, total income payments

in the economy (aggregate income) are also $10 trillion.

Real Versus Nominal Magnitudes

When the total value of final goods and services is calculated using current prices, the

resulting GDP measure is referred to as nominal GDP. The word nominal indicates that

values are measured using current prices. If all prices doubled but actual production

of goods and services remained the same, nominal GDP would double even though

appendix

to chapter

Defining Aggregate Output, Income,

the Price Level, and the Inflation Rate

1

people would not enjoy the benefits of twice as many goods and services. As a result,

nominal variables can be misleading measures of economic well-being.

A more reliable measure of economic well-being expresses values in terms of

prices for an arbitrary base year, currently 1996. GDP measured with constant prices

is referred to as real GDP, the word real indicating that values are measured in terms

of fixed prices. Real variables thus measure the quantities of goods and services and

do not change because prices have changed, but rather only if actual quantities have

changed.

A brief example will make the distinction clearer. Suppose that you have a nominal

income of $30,000 in 2004 and that your nominal income was $15,000 in 1996.

If all prices doubled between 1996 and 2004, are you better off? The answer is no:

Although your income has doubled, your $30,000 buys you only the same amount

of goods because prices have also doubled. A real income measure indicates that your

income in terms of the goods it can buy is the same. Measured in 1996 prices, the

$30,000 of nominal income in 2004 turns out to be only $15,000 of real income.

Because your real income is actually the same in the two years, you are no better or

worse off in 2004 than you were in 1996.

Because real variables measure quantities in terms of real goods and services, they

are typically of more interest than nominal variables. In this text, discussion of aggregate

output or aggregate income always refers to real measures (such as real GDP).

Aggregate Price Level

In this chapter, we defined the aggregate price level as a measure of average prices in

the economy. Three measures of the aggregate price level are commonly encountered

in economic data. The first is the GDP deflator, which is defined as nominal GDP

divided by real GDP. Thus if 2004 nominal GDP is $10 trillion but 2004 real GDP in

1996 prices is $9 trillion,

The GDP deflator equation indicates that, on average, prices have risen 11 percent

since 1996. Typically, measures of the price level are presented in the form of a

price index, which expresses the price level for the base year (in our example, 1996)

as 100. Thus the GDP deflator for 2004 would be 111.

Another popular measure of the aggregate price level (which officials in the Fed

frequently focus on) is the PCE deflator, which is similar to the GDP deflator and is

defined as nominal personal consumption expenditures (PCE) divided by real PCE.

The measure of the aggregate price level that is most frequently reported in the press

is the consumer price index (CPI). The CPI is measured by pricing a “basket” list of goods

and services bought by a typical urban household. If over the course of the year, the

cost of this basket of goods and services rises from $500 to $600, the CPI has risen by

20 percent. The CPI is also expressed as a price index with the base year equal to 100.

The CPI, the PCE deflator, and the GDP deflator measures of the price level can

be used to convert or deflate a nominal magnitude into a real magnitude. This is

accomplished by dividing the nominal magnitude by the price index. In our example,

GDP deflator

$10 trillion

$9 trillion

1.11

C H A P T E R 1 Why Study Money, Banking, and Financial Markets? 21

in which the GDP deflator for 2004 is 1.11 (expressed as an index value of 111), real

GDP for 2004 equals

which corresponds to the real GDP figure for 2004 mentioned earlier.

Growth Rates and the Inflation Rate

The media often talk about the economy’s growth rate, and particularly the growth

rate of real GDP. A growth rate is defined as the percentage change in a variable,1 i.e.,

where t indicates today and t 1 a year earlier.

For example, if real GDP grew from $9 trillion in 2004 to $9.5 trillion in 2005,

then the GDP growth rate for 2005 would be 5.6%:

The inflation rate is defined as the growth rate of the aggregate price level. Thus

if the GDP deflator rose from 111 in 2004 to 113 in 2005, the inflation rate using the

GDP deflator would be 1.8%:

inflation rate

113 111

111

100 1.8%

GDP growth rate

$9.5 trillion $9 trillion

$9 trillion

100 5.6%

growth rate

xt xt1

xt1

100

$10 trillion

1.11

$9 trillion in 1996 prices

22 PA RT I Introduction

1If the growth rate is for a period less than one year, it is usually reported on an annualized basis; that is, it is converted

to the growth rate over a year’s time, assuming that the growth rate remains constant. For GDP, which is

reported quarterly, the annualized growth rate would be approximately four times the percentage change in GDP

from the previous quarter. For example, if GDP rose % from the first quarter of 2004 to the second quarter of

2004, then the annualized GDP growth rate for the second quarter of 2004 would be reported as 2% ( 4 %).

(A more accurate calculation would be 2.02%, because a precise quarterly growth rate should be compounded

on a quarterly basis.)

12

1

2

PREVIEW Inez the Inventor has designed a low-cost robot that cleans house (even does windows),

washes the car, and mows the lawn, but she has no funds to put her wonderful

invention into production. Walter the Widower has plenty of savings, which he

and his wife accumulated over the years. If we could get Inez and Walter together so

that Walter could provide funds to Inez, Inez’s robot would see the light of day, and

the economy would be better off: We would have cleaner houses, shinier cars, and

more beautiful lawns.

Financial markets (bond and stock markets) and financial intermediaries (banks,

insurance companies, pension funds) have the basic function of getting people like

Inez and Walter together by moving funds from those who have a surplus of funds

(Walter) to those who have a shortage of funds (Inez). More realistically, when IBM

invents a better computer, it may need funds to bring it to market. Similarly, when a

local government needs to build a road or a school, it may need more funds than local

property taxes provide. Well-functioning financial markets and financial intermediaries

are crucial to economic health.

To study the effects of financial markets and financial intermediaries on the economy,

we need to acquire an understanding of their general structure and operation.

In this chapter, we learn about the major financial intermediaries and the instruments

that are traded in financial markets as well as how these markets are regulated.

This chapter presents an overview of the fascinating study of financial markets

and institutions. We return to a more detailed treatment of the regulation, structure,

and evolution of the financial system in Chapters 8 through 13.

Function of Financial Markets

Financial markets perform the essential economic function of channeling funds from

households, firms, and governments that have saved surplus funds by spending less

than their income to those that have a shortage of funds because they wish to spend

more than their income. This function is shown schematically in Figure 1. Those who

have saved and are lending funds, the lender-savers, are at the left, and those who

must borrow funds to finance their spending, the borrower-spenders, are at the right.

The principal lender-savers are households, but business enterprises and the government

(particularly state and local government), as well as foreigners and their governments,

sometimes also find themselves with excess funds and so lend them out.

23

Chap ter

An Overview of the

Financial System

2

The most important borrower-spenders are businesses and the government (particularly

the federal government), but households and foreigners also borrow to finance

their purchases of cars, furniture, and houses. The arrows show that funds flow from

lender-savers to borrower-spenders via two routes.

In direct finance (the route at the bottom of Figure 1), borrowers borrow funds

directly from lenders in financial markets by selling them securities (also called financial

instruments), which are claims on the borrower’s future income or assets.

Securities are assets for the person who buys them but liabilities (IOUs or debts) for

the individual or firm that sells (issues) them. For example, if General Motors needs

to borrow funds to pay for a new factory to manufacture electric cars, it might borrow

the funds from savers by selling them bonds, debt securities that promise to make

payments periodically for a specified period of time.

Why is this channeling of funds from savers to spenders so important to the economy?

The answer is that the people who save are frequently not the same people who

have profitable investment opportunities available to them, the entrepreneurs. Let’s

first think about this on a personal level. Suppose that you have saved $1,000 this

year, but no borrowing or lending is possible because there are no financial markets.

If you do not have an investment opportunity that will permit you to earn income

with your savings, you will just hold on to the $1,000 and will earn no interest.

However, Carl the Carpenter has a productive use for your $1,000: He can use it to

24 PA RT I Introduction

FIGURE 1 Interest Rates on Selected Bonds, 1950–2002

Sources: Federal Reserve Bulletin; www.frb.fed.us/releases/.

FIGURE 1 Flows of Funds Through the Financial System

INDIRECT FINANCE

Financial

Intermediaries

FUNDS

FUNDS FUNDS

Financial

Markets

Borrower-Spenders

1. Business firms

2. Government

3. Households

4. Foreigners

Lender-Savers

1. Households

2. Business firms

3. Government

4. Foreigners

DIRECT FINANCE

FUNDS FUNDS

purchase a new tool that will shorten the time it takes him to build a house, thereby

earning an extra $200 per year. If you could get in touch with Carl, you could lend

him the $1,000 at a rental fee (interest) of $100 per year, and both of you would be

better off. You would earn $100 per year on your $1,000, instead of the zero amount

that you would earn otherwise, while Carl would earn $100 more income per year

(the $200 extra earnings per year minus the $100 rental fee for the use of the funds).

In the absence of financial markets, you and Carl the Carpenter might never get

together. Without financial markets, it is hard to transfer funds from a person who has

no investment opportunities to one who has them; you would both be stuck with the

status quo, and both of you would be worse off. Financial markets are thus essential

to promoting economic efficiency.

The existence of financial markets is also beneficial even if someone borrows for

a purpose other than increasing production in a business. Say that you are recently

married, have a good job, and want to buy a house. You earn a good salary, but

because you have just started to work, you have not yet saved much. Over time, you

would have no problem saving enough to buy the house of your dreams, but by then

you would be too old to get full enjoyment from it. Without financial markets, you

are stuck; you cannot buy the house and must continue to live in your tiny apartment.

If a financial market were set up so that people who had built up savings could

lend you the funds to buy the house, you would be more than happy to pay them some

interest in order to own a home while you are still young enough to enjoy it. Then,

over time, you would pay back your loan. The overall outcome would be such that you

would be better off, as would the persons who made you the loan. They would now

earn some interest, whereas they would not if the financial market did not exist.

Now we can see why financial markets have such an important function in the

economy. They allow funds to move from people who lack productive investment

opportunities to people who have such opportunities. Thus financial markets are critical

for producing an efficient allocation of capital, which contributes to higher production

and efficiency for the overall economy. Indeed, as we will explore in Chapter

8, when financial markets break down during financial crises, as they have in Mexico,

East Asia, and Argentina in recent years, severe economic hardship results, which can

even lead to dangerous political instability.

Well-functioning financial markets also directly improve the well-being of consumers

by allowing them to time their purchases better. They provide funds to young

people to buy what they need and can eventually afford without forcing them to wait

until they have saved up the entire purchase price. Financial markets that are operating

efficiently improve the economic welfare of everyone in the society.

Structure of Financial Markets

Now that we understand the basic function of financial markets, let’s look at their

structure. The following descriptions of several categorizations of financial markets

illustrate essential features of these markets.

A firm or an individual can obtain funds in a financial market in two ways. The most

common method is to issue a debt instrument, such as a bond or a mortgage, which

is a contractual agreement by the borrower to pay the holder of the instrument fixed

Debt and Equity

Markets

C H A P T E R 2 An Overview of the Financial System 25

dollar amounts at regular intervals (interest and principal payments) until a specified

date (the maturity date), when a final payment is made. The maturity of a debt

instrument is the number of years (term) until that instrument’s expiration date. A

debt instrument is short-term if its maturity is less than a year and long-term if its

maturity is ten years or longer. Debt instruments with a maturity between one and ten

years are said to be intermediate-term.

The second method of raising funds is by issuing equities, such as common

stock, which are claims to share in the net income (income after expenses and taxes)

and the assets of a business. If you own one share of common stock in a company that

has issued one million shares, you are entitled to 1 one-millionth of the firm’s net

income and 1 one-millionth of the firm’s assets. Equities often make periodic payments

(dividends) to their holders and are considered long-term securities because

they have no maturity date. In addition, owning stock means that you own a portion

of the firm and thus have the right to vote on issues important to the firm and to elect

its directors.

The main disadvantage of owning a corporation’s equities rather than its debt is

that an equity holder is a residual claimant; that is, the corporation must pay all its

debt holders before it pays its equity holders. The advantage of holding equities is that

equity holders benefit directly from any increases in the corporation’s profitability or

asset value because equities confer ownership rights on the equity holders. Debt holders

do not share in this benefit, because their dollar payments are fixed. We examine

the pros and cons of debt versus equity instruments in more detail in Chapter 8,

which provides an economic analysis of financial structure.

The total value of equities in the United States has typically fluctuated between

$1 and $20 trillion since the early 1970s, depending on the prices of shares. Although

the average person is more aware of the stock market than any other financial market,

the size of the debt market is often larger than the size of the equities market: The

value of debt instruments was $20 trillion at the end of 2002 while the value of equities

was $11 trillion at the end of 2002.

A primary market is a financial market in which new issues of a security, such as a

bond or a stock, are sold to initial buyers by the corporation or government agency

borrowing the funds. A secondary market is a financial market in which securities

that have been previously issued (and are thus secondhand) can be resold.

The primary markets for securities are not well known to the public because the

selling of securities to initial buyers often takes place behind closed doors. An important

financial institution that assists in the initial sale of securities in the primary market

is the investment bank. It does this by underwriting securities: It guarantees a

price for a corporation’s securities and then sells them to the public.

The New York and American stock exchanges and NASDAQ, in which previously

issued stocks are traded, are the best-known examples of secondary markets, although

the bond markets, in which previously issued bonds of major corporations and the

U.S. government are bought and sold, actually have a larger trading volume. Other

examples of secondary markets are foreign exchange markets, futures markets, and

options markets. Securities brokers and dealers are crucial to a well-functioning secondary

market. Brokers are agents of investors who match buyers with sellers of securities;

dealers link buyers and sellers by buying and selling securities at stated prices.

When an individual buys a security in the secondary market, the person who has

sold the security receives money in exchange for the security, but the corporation that

Primary and

Secondary

Markets

26 PA RT I Introduction

www.nyse.com

New York Stock Exchange.

Find listed companies, quotes,

company historical data, realtime

market indices, and more.

http://stockcharts.com/def

/servlet/Favorites.CServlet

?obj=msummary&cmd=show

&disp=SXA

This site contains

historical stock market index

charts for many countries

around the world.

issued the security acquires no new funds. A corporation acquires new funds only

when its securities are first sold in the primary market. Nonetheless, secondary markets

serve two important functions. First, they make it easier and quicker to sell these

financial instruments to raise cash; that is, they make the financial instruments more

liquid. The increased liquidity of these instruments then makes them more desirable

and thus easier for the issuing firm to sell in the primary market. Second, they determine

the price of the security that the issuing firm sells in the primary market. The

investors that buy securities in the primary market will pay the issuing corporation

no more than the price they think the secondary market will set for this security. The

higher the security’s price in the secondary market, the higher will be the price that

the issuing firm will receive for a new security in the primary market, and hence the

greater the amount of financial capital it can raise. Conditions in the secondary market

are therefore the most relevant to corporations issuing securities. It is for this reason

that books like this one, that deal with financial markets, focus on the behavior

of secondary markets rather than primary markets.

Secondary markets can be organized in two ways. One is to organize exchanges,

where buyers and sellers of securities (or their agents or brokers) meet in one central

location to conduct trades. The New York and American stock exchanges for stocks

and the Chicago Board of Trade for commodities (wheat, corn, silver, and other raw

materials) are examples of organized exchanges.

The other method of organizing a secondary market is to have an over-thecounter

(OTC) market, in which dealers at different locations who have an inventory

of securities stand ready to buy and sell securities “over the counter” to anyone

who comes to them and is willing to accept their prices. Because over-the-counter

dealers are in computer contact and know the prices set by one another, the OTC

market is very competitive and not very different from a market with an organized

exchange.

Many common stocks are traded over-the-counter, although a majority of the

largest corporations have their shares traded at organized stock exchanges such as the

New York Stock Exchange. The U.S. government bond market, with a larger trading

volume than the New York Stock Exchange, is set up as an over-the-counter market.

Forty or so dealers establish a “market” in these securities by standing ready to buy

and sell U.S. government bonds. Other over-the-counter markets include those that

trade other types of financial instruments such as negotiable certificates of deposit,

federal funds, banker’s acceptances, and foreign exchange.

Another way of distinguishing between markets is on the basis of the maturity of the

securities traded in each market. The money market is a financial market in which

only short-term debt instruments (generally those with original maturity of less than

one year) are traded; the capital market is the market in which longer-term debt

(generally those with original maturity of one year or greater) and equity instruments

are traded. Money market securities are usually more widely traded than longer-term

securities and so tend to be more liquid. In addition, as we will see in Chapter 4,

short-term securities have smaller fluctuations in prices than long-term securities,

making them safer investments. As a result, corporations and banks actively use the

money market to earn interest on surplus funds that they expect to have only temporarily.

Capital market securities, such as stocks and long-term bonds, are often

Money and

Capital Markets

Exchanges and

Over-the-Counter

Markets

C H A P T E R 2 An Overview of the Financial System 27

www.nasdaq.com

Detailed market and security

information for the NASDAQ

OTC stock exchange.

held by financial intermediaries such as insurance companies and pension funds,

which have little uncertainty about the amount of funds they will have available in

the future.1

Internationalization of Financial Markets

The growing internationalization of financial markets has become an important trend.

Before the 1980s, U.S. financial markets were much larger than financial markets outside

the United States, but in recent years the dominance of U.S. markets has been

disappearing. The extraordinary growth of foreign financial markets has been the

result of both large increases in the pool of savings in foreign countries such as Japan

and the deregulation of foreign financial markets, which has enabled them to expand

their activities. American corporations and banks are now more likely to tap international

capital markets to raise needed funds, and American investors often seek

investment opportunities abroad. Similarly, foreign corporations and banks raise

funds from Americans, and foreigners have become important investors in the United

States. A look at international bond markets and world stock markets will give us a

picture of how this globalization of financial markets is taking place.

The traditional instruments in the international bond market are known as foreign

bonds. Foreign bonds are sold in a foreign country and are denominated in that

country’s currency. For example, if the German automaker Porsche sells a bond in the

United States denominated in U.S. dollars, it is classified as a foreign bond. Foreign

bonds have been an important instrument in the international capital market for centuries.

In fact, a large percentage of U.S. railroads built in the nineteenth century were

financed by sales of foreign bonds in Britain.

A more recent innovation in the international bond market is the Eurobond, a

bond denominated in a currency other than that of the country in which it is sold—

for example, a bond denominated in U.S. dollars sold in London. Currently, over 80

percent of the new issues in the international bond market are Eurobonds, and the

market for these securities has grown very rapidly. As a result, the Eurobond market

is now larger than the U.S. corporate bond market.

A variant of the Eurobond is Eurocurrencies, which are foreign currencies

deposited in banks outside the home country. The most important of the Eurocurrencies

are Eurodollars, which are U.S. dollars deposited in foreign banks outside

the United States or in foreign branches of U.S. banks. Because these short-term

deposits earn interest, they are similar to short-term Eurobonds. American banks borrow

Eurodollar deposits from other banks or from their own foreign branches, and

Eurodollars are now an important source of funds for American banks (over $190 billion

outstanding).

Note that the new currency, the euro, can create some confusion about the terms

Eurobond, Eurocurrencies, and Eurodollars. A bond denominated in euros is called a

International

Bond Market,

Eurobonds, and

Eurocurrencies

28 PA RT I Introduction

1If you would like more detail about the different types of money and capital market instruments, you can find

this information in an appendix to this chapter, which can be found on this book’s web site at www.aw.com/mishkin.

Eurobond only if it is sold outside the countries that have adopted the euro. In fact, most

Eurobonds are not denominated in euros but are instead denominated in U.S. dollars.

Similarly, Eurodollars have nothing to do with euros, but are instead U.S. dollars

deposited in banks outside the United States.

Until recently, the U.S. stock market was by far the largest in the world, but foreign

stock markets have been growing in importance. Now the United States is not always

number one: In the mid-1980s, the value of stocks traded in Japan at times exceeded

the value of stocks traded in the United States. The increased interest in foreign stocks

has prompted the development in the United States of mutual funds specializing in

trading in foreign stock markets. American investors now pay attention not only to

the Dow Jones Industrial Average but also to stock price indexes for foreign stock

markets such as the Nikkei 225 Average (Tokyo) and the Financial Times–Stock

Exchange 100-Share Index (London).

The internationalization of financial markets is having profound effects on the

United States. Foreigners, particularly the Japanese, are not only providing funds to

corporations in the United States, but are also helping finance the federal government.

Without these foreign funds, the U.S. economy would have grown far less rapidly in

the last twenty years. The internationalization of financial markets is also leading the

way to a more integrated world economy in which flows of goods and technology

between countries are more commonplace. In later chapters, we will encounter many

examples of the important roles that international factors play in our economy.

Function of Financial Intermediaries

As shown in Figure 1 (p. 24), funds can move from lenders to borrowers by a second

route, called indirect finance because it involves a financial intermediary that stands

between the lender-savers and the borrower-spenders and helps transfer funds from one

to the other. A financial intermediary does this by borrowing funds from the lendersavers

and then using these funds to make loans to borrower-spenders. For example, a

bank might acquire funds by issuing a liability to the public (an asset for the public) in

the form of savings deposits. It might then use the funds to acquire an asset by making

a loan to General Motors or by buying a GM bond in the financial market. The ultimate

result is that funds have been transferred from the public (the lender-savers) to GM (the

borrower-spender) with the help of the financial intermediary (the bank).

The process of indirect finance using financial intermediaries, called financial

intermediation, is the primary route for moving funds from lenders to borrowers.

Indeed, although the media focus much of their attention on securities markets, particularly

the stock market, financial intermediaries are a far more important source of

financing for corporations than securities markets are. This is true not only for the

United States but for other industrialized countries as well (see Box 1). Why are financial

intermediaries and indirect finance so important in financial markets? To answer

this question, we need to understand the role of transaction costs, risk sharing, and

information costs in financial markets.

Transaction costs, the time and money spent in carrying out financial transactions,

are a major problem for people who have excess funds to lend. As we have seen, Carl

the Carpenter needs $1,000 for his new tool, and you know that it is an excellent

Transaction Costs

World Stock

Markets

C H A P T E R 2 An Overview of the Financial System 29

http://quote.yahoo.com/m2?u

Major world stock indices, with

charts, news, and components.

investment opportunity. You have the cash and would like to lend him the money, but

to protect your investment, you have to hire a lawyer to write up the loan contract

that specifies how much interest Carl will pay you, when he will make these interest

payments, and when he will repay you the $1,000. Obtaining the contract will cost

you $500. When you figure in this transaction cost for making the loan, you realize

that you can’t earn enough from the deal (you spend $500 to make perhaps $100)

and reluctantly tell Carl that he will have to look elsewhere.

This example illustrates that small savers like you or potential borrowers like Carl

might be frozen out of financial markets and thus be unable to benefit from them. Can

anyone come to the rescue? Financial intermediaries can.

Financial intermediaries can substantially reduce transaction costs because they

have developed expertise in lowering them; because their large size allows them to

take advantage of economies of scale, the reduction in transaction costs per dollar of

transactions as the size (scale) of transactions increases. For example, a bank knows

30 PA RT I Introduction

Source: Wall Street Journal, Tuesday, January 21, 2003, p. C6.

Following the Financial News

Foreign stock market indexes are published

daily in the Wall Street Journal next

to the “World Markets” column, which

reports developments in foreign stock

markets.

The first column identifies the country

of the foreign stock exchange followed

by the market index; for example,

the circled entry is for the Nikkei 225

Average in Japan. The second column,

“CLOSE,” gives the closing value of the

index, which was 8558.82 for the Nikkei

225 Average on January 20, 2003. The

“NET CHG” column indicates the

change in the index from the previous

trading day, 131.43, and the “% CHG”

column indicates the percentage change

in the index, 1.51%. The “YTD NET

CHG” column indicates the change in

the index from the beginning of the year

(year to date), 20.13, and the “YTD %

CHG” column indicates the percentage

change in the index from the beginning

of the year, 0.23%.

Foreign Stock Market Indexes

International Stock Market Indexes

1/20/03 NET % YTD YTD

COUNTRY INDEX CLOSE CHG CHG NET CHG % CHG

Argentina Merval 575.74 1.46 0.25 50.79 9.68

Australia All Ordinaries 3028.20 3.50 0.12 52.70 1.77

Belgium Bel–20 1944.77 14.75 0.75 80.27 3.96

Brazil Sao Paulo Bovespa 11648.38 27.32 0.23 379.91 3.37

Canada Toronto 300 Composite 6740.37 15.55 0.23 125.83 1.90

Chile Santiago IPSA 1017.96 5.05 0.50 17.96 1.80

China Dow Jones China 88 127.54 0.09 0.07 9.33 7.89

China Dow Jones Shanghai 181.24 0.26 0.14 13.30 7.92

China Dow Jones Shenzhen 170.61 0.68 0.40 13.16 8.36

Europe DJ STOXX (Euro) 198.30 2.63 1.31 3.42 1.70

Europe DJ STOXX 50 2337.76 44.76 1.88 69.75 2.90

Euro Zone DJ Euro STOXX 205.29 2.39 1.15 0.65 0.32

Euro Zone DJ Euro STOXX 50 2352.81 37.55 1.57 33.60 1.41

France Paris CAC 40 3020.07 36.86 1.21 43.84 1.43

Germany Frankfurt Xetra DAX 2893.55 25.27 0.87 0.92 0.03

Hong Kong Hang Seng 9552.02 62.57 0.65 230.73 2.48

India Bombay Sensex 3341.89 28.50 0.85 35.39 1.05

Israel Tel Aviv 25 311.62 1.87 0.60 22.29 6.68

Italy Milan MIBtel 17339.00 199.00 1.13 146.00 0.84

Japan Tokyo Nikkei 225 8558.82 131.43 1.51 20.13 0.23

Japan Tokyo Nikkei 300 166.81 1.58 0.94 1.36 0.82

Japan Tokyo Topix Index 853.90 5.35 0.62 10.61 1.26

Mexico I.P.C. All-Share 6161.12 43.34 0.70 34.03 0.56

Netherlands Amsterdam AEX 313.04 5.55 1.74 9.69 3.00

Singapore Straits Times 1363.19 3.64 0.27 22.16 1.65

South Africa Johannesburg All Share 9485.48 2.94 0.03 208.26 2.24

South Korea KOSPI 634.50 1.96 0.31 6.95 1.11

Spain IBEX 35 6390.80 67.40 1.04 353.90 5.86

Sweden SX All Share 155.40 1.56 1.01 5.83 3.90

Switzerland Zurich Swiss Market 4679.70 73.90 1.55 48.90 1.06

Taiwan Weighted 4951.03 43.25 0.88 498.58 11.20

U.K. London FTSE 100-share 3778.60 42.00 1.10 161.80 4.11

U.K. London FTSE 250-share 4312.50 9.20 0.21 6.80 0.16

how to find a good lawyer to produce an airtight loan contract, and this contract can

be used over and over again in its loan transactions, thus lowering the legal cost per

transaction. Instead of a loan contract (which may not be all that well written) costing

$500, a bank can hire a topflight lawyer for $5,000 to draw up an airtight loan

contract that can be used for 2,000 loans at a cost of $2.50 per loan. At a cost of $2.50

per loan, it now becomes profitable for the financial intermediary to lend Carl the

$1,000.

Because financial intermediaries are able to reduce transaction costs substantially,

they make it possible for you to provide funds indirectly to people like Carl with productive

investment opportunities. In addition, a financial intermediary’s low transaction

costs mean that it can provide its customers with liquidity services, services that

make it easier for customers to conduct transactions. For example, banks provide

depositors with checking accounts that enable them to pay their bills easily. In addition,

depositors can earn interest on checking and savings accounts and yet still convert

them into goods and services whenever necessary.

Another benefit made possible by the low transaction costs of financial institutions is

that they can help reduce the exposure of investors to risk; that is, uncertainty about

the returns investors will earn on assets. Financial intermediaries do this through the

process known as risk sharing: they create and sell assets with risk characteristics

that people are comfortable with, and the intermediaries then use the funds they

acquire by selling these assets to purchase other assets that may have far more risk.

Risk Sharing

C H A P T E R 2 An Overview of the Financial System 31

Box 1: Global

The Importance of Financial Intermediaries to Securities Markets: An International Comparison

Patterns of financing corporations differ across countries,

but one key fact emerges. Studies of the major

developed countries, including the United States,

Canada, Great Britain, Japan, Italy, Germany, and

France, show that when businesses go looking for

funds to finance their activities, they usually obtain

them indirectly through financial intermediaries and

not directly from securities markets.* Even in the

United States and Canada, which have the most

developed securities markets in the world, loans from

financial intermediaries are far more important for

corporate finance than securities markets are. The

countries that have made the least use of securities

markets are Germany and Japan; in these two countries,

financing from financial intermediaries has been

almost ten times greater than that from securities

markets. However, with the deregulation of Japanese

securities markets in recent years, the share of corporate

financing by financial intermediaries has been

declining relative to the use of securities markets.

Although the dominance of financial intermediaries

over securities markets is clear in all countries,

the relative importance of bond versus stock markets

differs widely across countries. In the United States, the

bond market is far more important as a source of corporate

finance: On average, the amount of new financing

raised using bonds is ten times the amount using

stocks. By contrast, countries such as France and

Italy make use of equities markets more than the

bond market to raise capital.

*See, for example, Colin Mayer, “Financial Systems, Corporate Finance, and Economic Development,” in Asymmetric Information, Corporate Finance, and

Investment, ed. R. Glenn Hubbard (Chicago: University of Chicago Press, 1990), pp. 307–332.

Low transaction costs allow financial intermediaries to do risk sharing at low cost,

enabling them to earn a profit on the spread between the returns they earn on risky

assets and the payments they make on the assets they have sold. This process of risk

sharing is also sometimes referred to as asset transformation, because in a sense,

risky assets are turned into safer assets for investors.

Financial intermediaries also promote risk sharing by helping individuals to diversify

and thereby lower the amount of risk to which they are exposed. Diversification

entails investing in a collection (portfolio) of assets whose returns do not always move

together, with the result that overall risk is lower than for individual assets.

(Diversification is just another name for the old adage that “you shouldn’t put all your

eggs in one basket.”) Low transaction costs allow financial intermediaries to do this by

pooling a collection of assets into a new asset and then selling it to individuals.

The presence of transaction costs in financial markets explains, in part, why financial

intermediaries and indirect finance play such an important role in financial markets.

An additional reason is that in financial markets, one party often does not know

enough about the other party to make accurate decisions. This inequality is called

asymmetric information. For example, a borrower who takes out a loan usually has

better information about the potential returns and risk associated with the investment

projects for which the funds are earmarked than the lender does. Lack of information

creates problems in the financial system on two fronts: before the transaction is

entered into and after.2

Adverse selection is the problem created by asymmetric information before the

transaction occurs. Adverse selection in financial markets occurs when the potential

borrowers who are the most likely to produce an undesirable (adverse) outcome—the

bad credit risks—are the ones who most actively seek out a loan and are thus most

likely to be selected. Because adverse selection makes it more likely that loans might

be made to bad credit risks, lenders may decide not to make any loans even though

there are good credit risks in the marketplace.

To understand why adverse selection occurs, suppose that you have two aunts to

whom you might make a loan—Aunt Louise and Aunt Sheila. Aunt Louise is a conservative

type who borrows only when she has an investment she is quite sure will

pay off. Aunt Sheila, by contrast, is an inveterate gambler who has just come across a

get-rich-quick scheme that will make her a millionaire if she can just borrow $1,000

to invest in it. Unfortunately, as with most get-rich-quick schemes, there is a high

probability that the investment won’t pay off and that Aunt Sheila will lose the

$1,000.

Which of your aunts is more likely to call you to ask for a loan? Aunt Sheila, of

course, because she has so much to gain if the investment pays off. You, however,

would not want to make a loan to her because there is a high probability that her

investment will turn sour and she will be unable to pay you back.

If you knew both your aunts very well—that is, if your information were not

asymmetric—you wouldn’t have a problem, because you would know that Aunt

Sheila is a bad risk and so you would not lend to her. Suppose, though, that you don’t

Asymmetric

Information:

Adverse Selection

and Moral Hazard

32 PA RT I Introduction

2Asymmetric information and the adverse selection and moral hazard concepts are also crucial problems for the

insurance industry (see Chapter 12).

know your aunts well. You are more likely to lend to Aunt Sheila than to Aunt Louise

because Aunt Sheila would be hounding you for the loan. Because of the possibility

of adverse selection, you might decide not to lend to either of your aunts, even though

there are times when Aunt Louise, who is an excellent credit risk, might need a loan

for a worthwhile investment.

Moral hazard is the problem created by asymmetric information after the transaction

occurs. Moral hazard in financial markets is the risk (hazard) that the borrower

might engage in activities that are undesirable (immoral) from the lender’s point of

view, because they make it less likely that the loan will be paid back. Because moral

hazard lowers the probability that the loan will be repaid, lenders may decide that

they would rather not make a loan.

As an example of moral hazard, suppose that you made a $1,000 loan to another

relative, Uncle Melvin, who needs the money to purchase a word processor so he can

set up a business typing students’ term papers. Once you have made the loan, however,

Uncle Melvin is more likely to slip off to the track and play the horses. If he bets

on a 20-to-1 long shot and wins with your money, he is able to pay you back your

$1,000 and live high off the hog with the remaining $19,000. But if he loses, as is

likely, you don’t get paid back, and all he has lost is his reputation as a reliable,

upstanding uncle. Uncle Melvin therefore has an incentive to go to the track because

his gains ($19,000) if he bets correctly are much greater than the cost to him (his reputation)

if he bets incorrectly. If you knew what Uncle Melvin was up to, you would

prevent him from going to the track, and he would not be able to increase the moral

hazard. However, because it is hard for you to keep informed about his whereabouts—

that is, because information is asymmetric—there is a good chance that

Uncle Melvin will go to the track and you will not get paid back. The risk of moral

hazard might therefore discourage you from making the $1,000 loan to Uncle Melvin,

even if you were sure that you would be paid back if he used it to set up his business.

Study Guide Because the concepts of adverse selection and moral hazard are extremely useful in

understanding the behavior we examine in this and many of the later chapters (and

in life in general), you must understand them fully. One way to distinguish between

them is to remember that adverse selection is a problem of asymmetric information

before entering into a transaction, whereas moral hazard is a problem of asymmetric

information after the transaction has occurred. A helpful way to nail down these concepts

is to think of other examples, for financial or other types of transactions, in

which adverse selection or moral hazard plays a role. Several problems at the end of

the chapter provide additional examples of situations involving adverse selection and

moral hazard.

The problems created by adverse selection and moral hazard are an important

impediment to well-functioning financial markets. Again, financial intermediaries can

alleviate these problems.

With financial intermediaries in the economy, small savers can provide their funds

to the financial markets by lending these funds to a trustworthy intermediary—say, the

Honest John Bank—which in turn lends the funds out either by making loans or by

buying securities such as stocks or bonds. Successful financial intermediaries have

higher earnings on their investments than small savers, because they are better

C H A P T E R 2 An Overview of the Financial System 33

equipped than individuals to screen out bad credit risks from good ones, thereby

reducing losses due to adverse selection. In addition, financial intermediaries have high

earnings because they develop expertise in monitoring the parties they lend to, thus

reducing losses due to moral hazard. The result is that financial intermediaries can

afford to pay lender-savers interest or provide substantial services and still earn a profit.

As we have seen, financial intermediaries play an important role in the economy

because they provide liquidity services, promote risk sharing, and solve information

problems. The success of financial intermediaries in performing this role is evidenced

by the fact that most Americans invest their savings with them and obtain loans from

them. Financial intermediaries play a key role in improving economic efficiency

because they help financial markets channel funds from lender-savers to people with

productive investment opportunities. Without a well-functioning set of financial

intermediaries, it is very hard for an economy to reach its full potential. We will

explore further the role of financial intermediaries in the economy in Part III.

Financial Intermediaries

We have seen why financial intermediaries play such an important role in the economy.

Now we look at the principal financial intermediaries themselves and how they

perform the intermediation function. They fall into three categories: depository institutions

(banks), contractual savings institutions, and investment intermediaries. Table

1 provides a guide to the discussion of the financial intermediaries that fit into these

three categories by describing their primary liabilities (sources of funds) and assets

(uses of funds). The relative size of these intermediaries in the United States is indicated

in Table 2, which lists the amount of their assets at the end of 1970, 1980, 1990,

and 2002.

Depository institutions (for simplicity, we refer to these as banks throughout this text)

are financial intermediaries that accept deposits from individuals and institutions and

make loans. The study of money and banking focuses special attention on this group

of financial institutions, because they are involved in the creation of deposits, an

important component of the money supply. These institutions include commercial

banks and the so-called thrift institutions (thrifts): savings and loan associations,

mutual savings banks, and credit unions.

Commercial Banks. These financial intermediaries raise funds primarily by issuing

checkable deposits (deposits on which checks can be written), savings deposits

(deposits that are payable on demand but do not allow their owner to write checks),

and time deposits (deposits with fixed terms to maturity). They then use these funds

to make commercial, consumer, and mortgage loans and to buy U.S. government

securities and municipal bonds. There are slightly fewer than 8,000 commercial

banks in the United States, and as a group, they are the largest financial intermediary

and have the most diversified portfolios (collections) of assets.

Savings and Loan Associations (S&Ls) and Mutual Savings Banks. These depository institutions,

of which there are approximately 1,500, obtain funds primarily through savings

deposits (often called shares) and time and checkable deposits. In the past, these insti-

Depository

Institutions

34 PA RT I Introduction

tutions were constrained in their activities and mostly made mortgage loans for residential

housing. Over time, these restrictions have been loosened so that the distinction

between these depository institutions and commercial banks has blurred. These intermediaries

have become more alike and are now more competitive with each other.

Credit Unions. These financial institutions, numbering about 9,500, are very small

cooperative lending institutions organized around a particular group: union members,

employees of a particular firm, and so forth. They acquire funds from deposits

called shares and primarily make consumer loans.

Contractual savings institutions, such as insurance companies and pension funds, are

financial intermediaries that acquire funds at periodic intervals on a contractual basis.

Because they can predict with reasonable accuracy how much they will have to pay

Contractual

Savings

Institutions

C H A P T E R 2 An Overview of the Financial System 35

Primary Liabilities Primary Assets

Type of Intermediary (Sources of Funds) (Uses of Funds)

Depository institutions (banks)

Commercial banks Deposits Business and consumer

loans, mortgages, U.S.

government securities

and municipal bonds

Savings and loan associations Deposits Mortgages

Mutual savings banks Deposits Mortgages

Credit unions Deposits Consumer loans

Contractual savings institutions

Life insurance companies Premiums from policies Corporate bonds and

mortgages

Fire and casualty insurance Premiums from policies Municipal bonds,

companies corporate bonds and

stock, U.S. government

securities

Pension funds, government Employer and employee Corporate bonds and stock

retirement funds contributions

Investment intermediaries

Finance companies Commercial paper, Consumer and business

stocks, bonds loans

Mutual funds Shares Stocks, bonds

Money market mutual funds Shares Money market instruments

Table 1 Primary Assets and Liabilities of Financial Intermediaries

out in benefits in the coming years, they do not have to worry as much as depository

institutions about losing funds. As a result, the liquidity of assets is not as important

a consideration for them as it is for depository institutions, and they tend to invest

their funds primarily in long-term securities such as corporate bonds, stocks, and

mortgages.

Life Insurance Companies. Life insurance companies insure people against financial

hazards following a death and sell annuities (annual income payments upon retirement).

They acquire funds from the premiums that people pay to keep their policies

in force and use them mainly to buy corporate bonds and mortgages. They also purchase

stocks, but are restricted in the amount that they can hold. Currently, with $3.3

trillion in assets, they are among the largest of the contractual savings institutions.

Fire and Casualty Insurance Companies. These companies insure their policyholders

against loss from theft, fire, and accidents. They are very much like life insurance

companies, receiving funds through premiums for their policies, but they have a

greater possibility of loss of funds if major disasters occur. For this reason, they use

their funds to buy more liquid assets than life insurance companies do. Their largest

holding of assets is municipal bonds; they also hold corporate bonds and stocks and

U.S. government securities.

36 PA RT I Introduction

Value of Assets

($ billions, end of year)

Type of Intermediary 1970 1980 1990 2002

Depository institutions (banks)

Commercial banks 517 1,481 3,334 7,161

Savings and loan associations

and mutual savings banks 250 792 1,365 1,338

Credit unions 18 67 215 553

Contractual savings institutions

Life insurance companies 201 464 1,367 3,269

Fire and casualty insurance companies 50 182 533 894

Pension funds (private) 112 504 1,629 3,531

State and local government retirement funds 60 197 737 1,895

Investment intermediaries

Finance companies 64 205 610 1,165

Mutual funds 47 70 654 3,419

Money market mutual funds 0 76 498 2,106

Source: Federal Reserve Flow of Funds Accounts: www.federalreserve.gov/releases/Z1/LevelTables.

Table 2 Principal Financial Intermediaries and Value of Their Assets

Pension Funds and Government Retirement Funds. Private pension funds and state and

local retirement funds provide retirement income in the form of annuities to employees

who are covered by a pension plan. Funds are acquired by contributions from

employers or from employees, who either have a contribution automatically deducted

from their paychecks or contribute voluntarily. The largest asset holdings of pension

funds are corporate bonds and stocks. The establishment of pension funds has been

actively encouraged by the federal government, both through legislation requiring

pension plans and through tax incentives to encourage contributions.

This category of financial intermediaries includes finance companies, mutual funds,

and money market mutual funds.

Finance Companies. Finance companies raise funds by selling commercial paper (a

short-term debt instrument) and by issuing stocks and bonds. They lend these funds

to consumers, who make purchases of such items as furniture, automobiles, and

home improvements, and to small businesses. Some finance companies are organized

by a parent corporation to help sell its product. For example, Ford Motor Credit

Company makes loans to consumers who purchase Ford automobiles.

Mutual Funds. These financial intermediaries acquire funds by selling shares to many

individuals and use the proceeds to purchase diversified portfolios of stocks and

bonds. Mutual funds allow shareholders to pool their resources so that they can take

advantage of lower transaction costs when buying large blocks of stocks or bonds. In

addition, mutual funds allow shareholders to hold more diversified portfolios than

they otherwise would. Shareholders can sell (redeem) shares at any time, but the

value of these shares will be determined by the value of the mutual fund’s holdings of

securities. Because these fluctuate greatly, the value of mutual fund shares will too;

therefore, investments in mutual funds can be risky.

Money Market Mutual Funds. These relatively new financial institutions have the characteristics

of a mutual fund but also function to some extent as a depository institution

because they offer deposit-type accounts. Like most mutual funds, they sell shares to

acquire funds that are then used to buy money market instruments that are both safe

and very liquid. The interest on these assets is then paid out to the shareholders.

A key feature of these funds is that shareholders can write checks against the

value of their shareholdings. In effect, shares in a money market mutual fund function

like checking account deposits that pay interest. Money market mutual funds

have experienced extraordinary growth since 1971, when they first appeared. By

2002, their assets had climbed to nearly $2.1 trillion.

Regulation of the Financial System

The financial system is among the most heavily regulated sectors of the American

economy. The government regulates financial markets for two main reasons: to

increase the information available to investors and to ensure the soundness of the

financial system. We will examine how these two reasons have led to the present regulatory

environment. As a study aid, the principal regulatory agencies of the U.S.

financial system are listed in Table 3.

Investment

Intermediaries

C H A P T E R 2 An Overview of the Financial System 37

38 PA RT I Introduction

Table 3 Principal Regulatory Agencies of the U.S. Financial System

Regulatory Agency

Securities and Exchange

Commission (SEC)

Commodities Futures

Trading Commission

(CFTC)

Office of the Comptroller

of the Currency

National Credit Union

Administration (NCUA)

State banking and

insurance commissions

Federal Deposit Insurance

Corporation (FDIC)

Federal Reserve System

Office of Thrift Supervision

Subject of Regulation

Organized exchanges

and financial markets

Futures market

exchanges

Federally chartered

commercial banks

Federally chartered

credit unions

State-chartered

depository institutions

Commercial banks,

mutual savings banks,

savings and loan

associations

All depository institutions

Savings and loan associations

Nature of Regulations

Requires disclosure of

information, restricts insider

trading

Regulates procedures for trading

in futures markets

Charters and examines the

books of federally chartered

commercial banks and

imposes restrictions on assets

they can hold

Charters and examines the

books of federally chartered

credit unions and imposes

restrictions on assets they can

hold

Charters and examines the

books of state-chartered

banks and insurance

companies, imposes

restrictions on assets they can

hold, and imposes restrictions

on branching

Provides insurance of up to

$100,000 for each depositor

at a bank, examines the books

of insured banks, and

imposes restrictions on assets

they can hold

Examines the books of

commercial banks that are

members of the system, sets

reserve requirements for all

banks

Examines the books of savings

and loan associations,

imposes restrictions on assets

they can hold

Asymmetric information in financial markets means that investors may be subject to

adverse selection and moral hazard problems that may hinder the efficient operation

of financial markets. Risky firms or outright crooks may be the most eager to sell securities

to unwary investors, and the resulting adverse selection problem may keep

investors out of financial markets. Furthermore, once an investor has bought a security,

thereby lending money to a firm, the borrower may have incentives to engage in

risky activities or to commit outright fraud. The presence of this moral hazard problem

may also keep investors away from financial markets. Government regulation can

reduce adverse selection and moral hazard problems in financial markets and increase

their efficiency by increasing the amount of information available to investors.

As a result of the stock market crash in 1929 and revelations of widespread fraud

in the aftermath, political demands for regulation culminated in the Securities Act of

1933 and the establishment of the Securities and Exchange Commission (SEC). The

SEC requires corporations issuing securities to disclose certain information about their

sales, assets, and earnings to the public and restricts trading by the largest stockholders

(known as insiders) in the corporation. By requiring disclosure of this information and

by discouraging insider trading, which could be used to manipulate security prices, the

SEC hopes that investors will be better informed and be protected from some of the

abuses in financial markets that occurred before 1933. Indeed, in recent years, the SEC

has been particularly active in prosecuting people involved in insider trading.

Asymmetric information can also lead to widespread collapse of financial intermediaries,

referred to as a financial panic. Because providers of funds to financial intermediaries

may not be able to assess whether the institutions holding their funds are

sound, if they have doubts about the overall health of financial intermediaries, they

may want to pull their funds out of both sound and unsound institutions. The possible

outcome is a financial panic that produces large losses for the public and causes

serious damage to the economy. To protect the public and the economy from financial

panics, the government has implemented six types of regulations.

Restrictions on Entry. State banking and insurance commissions, as well as the Office

of the Comptroller of the Currency (an agency of the federal government), have created

very tight regulations governing who is allowed to set up a financial intermediary.

Individuals or groups that want to establish a financial intermediary, such as a

bank or an insurance company, must obtain a charter from the state or the federal

government. Only if they are upstanding citizens with impeccable credentials and a

large amount of initial funds will they be given a charter.

Disclosure. There are stringent reporting requirements for financial intermediaries.

Their bookkeeping must follow certain strict principles, their books are subject to

periodic inspection, and they must make certain information available to the public.

Restrictions on Assets and Activities. There are restrictions on what financial intermediaries

are allowed to do and what assets they can hold. Before you put your funds

into a bank or some other such institution, you would want to know that your funds

are safe and that the bank or other financial intermediary will be able to meet its obligations

to you. One way of doing this is to restrict the financial intermediary from

engaging in certain risky activities. Legislation passed in 1933 (repealed in 1999) separated

commercial banking from the securities industry so that banks could not

engage in risky ventures associated with this industry. Another way is to restrict financial

Ensuring the

Soundness of

Financial

Intermediaries

Increasing

Information

Available to

Investors

C H A P T E R 2 An Overview of the Financial System 39

www.sec.gov

The United States Securities and

Exchange Commission home

page. It contains vast SEC

resources, laws and regulations,

investor information, and

litigation.

intermediaries from holding certain risky assets, or at least from holding a greater

quantity of these risky assets than is prudent. For example, commercial banks and

other depository institutions are not allowed to hold common stock because stock

prices experience substantial fluctuations. Insurance companies are allowed to hold

common stock, but their holdings cannot exceed a certain fraction of their total assets.

Deposit Insurance. The government can insure people’s deposits so that they do not

suffer any financial loss if the financial intermediary that holds these deposits should

fail. The most important government agency that provides this type of insurance is

the Federal Deposit Insurance Corporation (FDIC), which insures each depositor at a

commercial bank or mutual savings bank up to a loss of $100,000 per account. All

commercial and mutual savings banks, with a few minor exceptions, are contributers

to the FDIC’s Bank Insurance Fund, which is used to pay off depositors in the case of

a bank’s failure. The FDIC was created in 1934 after the massive bank failures of

1930–1933, in which the savings of many depositors at commercial banks were

wiped out. Similar government agencies exist for other depository institutions: The

Savings Association Insurance Fund (part of the FDIC) provides deposit insurance for

savings and loan associations, and the National Credit Union Share Insurance Fund

(NCUSIF) does the same for credit unions.

Limits on Competition. Politicians have often declared that unbridled competition

among financial intermediaries promotes failures that will harm the public. Although

the evidence that competition does this is extremely weak, it has not stopped the state

and federal governments from imposing many restrictive regulations. First are the

restrictions on the opening of additional locations (branches). In the past, banks were

not allowed to open up branches in other states, and in some states, banks were

restricted from opening additional locations.

Restrictions on Interest Rates. Competition has also been inhibited by regulations

that impose restrictions on interest rates that can be paid on deposits. For decades

after 1933, banks were prohibited from paying interest on checking accounts. In

addition, until 1986, the Federal Reserve System had the power under Regulation Q

to set maximum interest rates that banks could pay on savings deposits. These regulations

were instituted because of the widespread belief that unrestricted interest-rate

competition helped encourage bank failures during the Great Depression. Later evidence

does not seem to support this view, and restrictions like Regulation Q have

been abolished.

In later chapters, we will look more closely at government regulation of financial

markets and will see whether it has improved the functioning of financial markets.

Not surprisingly, given the similarity of the economic system here and in Japan,

Canada, and the nations of Western Europe, financial regulation in these countries is

similar to financial regulation in the United States. The provision of information is

improved by requiring corporations issuing securities to report details about assets and

liabilities, earnings, and sales of stock, and by prohibiting insider trading. The soundness

of intermediaries is ensured by licensing, periodic inspection of financial intermediaries’

books, and the provision of deposit insurance (although its coverage is

smaller than in the United States and its existence is often intentionally not advertised).

The major differences between financial regulation in the United States and

abroad relate to bank regulation. In the past, the United States was the only industrialized

country to subject banks to restrictions on branching, which limited banks’ size

Financial

Regulation Abroad

40 PA RT I Introduction

and restricted them to certain geographic regions. (These restrictions were abolished

by legislation in 1994.) U.S. banks are also the most restricted in the range of assets

they may hold. Banks abroad frequently hold shares in commercial firms; in Japan

and Germany, those stakes can be sizable.

C H A P T E R 2 An Overview of the Financial System 41

Summary

1. The basic function of financial markets is to channel

funds from savers who have an excess of funds to

spenders who have a shortage of funds. Financial

markets can do this either through direct finance, in

which borrowers borrow funds directly from lenders by

selling them securities, or through indirect finance,

which involves a financial intermediary that stands

between the lender-savers and the borrower-spenders

and helps transfer funds from one to the other. This

channeling of funds improves the economic welfare of

everyone in the society, because it allows funds to move

from people who have no productive investment

opportunities to those who have such opportunities,

thereby contributing to increased efficiency in the

economy. In addition, channeling of funds directly

benefits consumers by allowing them to make

purchases when they need them most.

2. Financial markets can be classified as debt and equity

markets, primary and secondary markets, exchanges

and over-the-counter markets, and money and capital

markets.

3. An important trend in recent years is the growing

internationalization of financial markets. Eurobonds,

which are denominated in a currency other than that of

the country in which they are sold, are now the

dominant security in the international bond market and

have surpassed U.S. corporate bonds as a source of new

funds. Eurodollars, which are U.S. dollars deposited in

foreign banks, are an important source of funds for

American banks.

4. Financial intermediaries are financial institutions that

acquire funds by issuing liabilities and in turn use those

funds to acquire assets by purchasing securities or

making loans. Financial intermediaries play an

important role in the financial system, because they

reduce transaction costs, allow risk sharing, and solve

problems created by adverse selection and moral

hazard. As a result, financial intermediaries allow small

savers and borrowers to benefit from the existence of

financial markets, thereby increasing the efficiency of

the economy.

5. The principal financial intermediaries fall into three

categories: (a) banks—commercial banks, savings and

loan associations, mutual savings banks, and credit

unions; (b) contractual savings institutions—life

insurance companies, fire and casualty insurance

companies, and pension funds; and (c) investment

intermediaries—finance companies, mutual funds, and

money market mutual funds.

6. The government regulates financial markets and

financial intermediaries for two main reasons: to

increase the information available to investors and to

ensure the soundness of the financial system.

Regulations include requiring disclosure of information

to the public, restrictions on who can set up a financial

intermediary, restrictions on what assets financial

intermediaries can hold, the provision of deposit

insurance, reserve requirements, and the setting of

maximum interest rates that can be paid on checking

accounts and savings deposits.

Key Terms

asset transformation, p. 32

adverse selection, p. 32

asymmetric information, p. 32

brokers, p. 26

capital market, p. 27

dealers, p. 26

diversification, p. 32

dividends, p. 26

economies of scale, p. 30

42 PA RT I Introduction

equities, p. 26

Eurobond, p. 28

Eurocurrencies, p. 28

Eurodollars, p. 28

exchanges, p. 27

financial intermediation, p. 29

financial panic, p. 39

foreign bonds, p. 28

intermediate-term, p. 26

investment bank, p. 26

liabilities, p. 24

liquid, p. 27

liquidity services, p. 31

long-term, p. 26

maturity, p. 26

money market, p. 27

moral hazard, p. 33

over-the-counter (OTC) market, p. 27

portfolio, p. 32

primary market, p. 26

risk, p. 31

risk sharing, p. 31

secondary market, p. 26

short-term, p. 26

thrift institutions (thrifts), p. 34

transaction costs, p. 29

underwriting, p. 26

Questions and Problems

Questions marked with an asterisk are answered at the end

of the book in an appendix, “Answers to Selected Questions

and Problems.”

*1. Why is a share of IBM common stock an asset for its

owner and a liability for IBM?

2. If I can buy a car today for $5,000 and it is worth

$10,000 in extra income next year to me because it

enables me to get a job as a traveling anvil seller,

should I take out a loan from Larry the Loan Shark at

a 90% interest rate if no one else will give me a loan?

Will I be better or worse off as a result of taking out

this loan? Can you make a case for legalizing loansharking?

*3. Some economists suspect that one of the reasons that

economies in developing countries grow so slowly is

that they do not have well-developed financial markets.

Does this argument make sense?

4. The U.S. economy borrowed heavily from the British

in the nineteenth century to build a railroad system.

What was the principal debt instrument used? Why

did this make both countries better off?

*5. “Because corporations do not actually raise any funds

in secondary markets, they are less important to the

economy than primary markets.” Comment.

6. If you suspect that a company will go bankrupt next

year, which would you rather hold, bonds issued by

the company or equities issued by the company?

Why?

*7. How can the adverse selection problem explain why

you are more likely to make a loan to a family member

than to a stranger?

8. Think of one example in which you have had to deal

with the adverse selection problem.

*9. Why do loan sharks worry less about moral hazard in

connection with their borrowers than some other

lenders do?

10. If you are an employer, what kinds of moral hazard

problems might you worry about with your employees?

*11. If there were no asymmetry in the information that a

borrower and a lender had, could there still be a

moral hazard problem?

12. “In a world without information and transaction costs,

financial intermediaries would not exist.” Is this statement

true, false, or uncertain? Explain your answer.

*13. Why might you be willing to make a loan to your

neighbor by putting funds in a savings account earning

a 5% interest rate at the bank and having the bank

lend her the funds at a 10% interest rate rather than

lend her the funds yourself?

14. How does risk sharing benefit both financial intermediaries

and private investors?

*15. Discuss some of the manifestations of the globalization

of world capital markets.

QUIZ

1. One of the single best sources of information about

financial institutions is the U.S. Flow of Funds report

produced by the Federal Reserve. This document contains

data on most financial intermediaries. Go to

www.federalreserve.gov/releases/Z1/. Go to the most

current release. You may have to load Acrobat Reader

if your computer does not already have it. The site has

a link for a free patch. Go to the Level Tables and

answer the following.

a. What percent of assets do commercial banks hold

in loans? What percent of assets are held in mortgage

loans?

b. What percent of assets do Savings and Loans hold

in mortgage loans?

c. What percent of assets do credit unions hold in

mortgage loans and in consumer loans?

2. The most famous financial market in the world is the

New York Stock Exchange. Go to www.nyse.com.

a. What is the mission of the NYSE?

b. Firms must pay a fee to list their shares for sale on

the NYSE. What would be the fee for a firm with 5

million shares common outstanding?

C H A P T E R 2 An Overview of the Financial System 43

Web Exercises

Here we examine the securities (instruments) traded in financial markets. We first

focus on the instruments traded in the money market and then turn to those traded

in the capital market.

Because of their short terms to maturity, the debt instruments traded in the money

market undergo the least price fluctuations and so are the least risky investments. The

money market has undergone great changes in the past three decades, with the

amount of some financial instruments growing at a far more rapid rate than others.

The principal money market instruments are listed in Table 1 along with the

amount outstanding at the end of 1970, 1980, 1990, and 2002.

United States Treasury Bills. These short-term debt instruments of the U.S. government

are issued in 3-, 6-, and 12-month maturities to finance the federal government.

They pay a set amount at maturity and have no interest payments, but they effectively

pay interest by initially selling at a discount, that is, at a price lower than the set

amount paid at maturity. For instance, you might pay $9,000 in May 2004 for a oneyear

Treasury Bill that can be redeemed in May 2005 for $10,000.

U.S. Treasury bills are the most liquid of all the money market instruments,

because they are the most actively traded. They are also the safest of all money market

instruments, because there is almost no possibility of default, a situation in which

the party issuing the debt instrument (the federal government, in this case) is unable

to make interest payments or pay off the amount owed when the instrument matures.

The federal government is always able to meet its debt obligations, because it can raise

taxes or issue currency (paper money or coins) to pay off its debts. Treasury bills are

held mainly by banks, although small amounts are held by households, corporations,

and other financial intermediaries.

Negotiable Bank Certificates of Deposit. A certificate of deposit (CD) is a debt instrument,

sold by a bank to depositors, that pays annual interest of a given amount and at

maturity, pays back the original purchase price. Before 1961, CDs were nonnegotiable;

that is, they could not be sold to someone else and could not be redeemed from the

bank before maturity without paying a substantial penalty. In 1961, to make CDs more

liquid and more attractive to investors, Citibank introduced the first negotiable CD in

large denominations (over $100,000) that could be resold in a secondary market. This

instrument is now issued by almost all the major commercial banks and has been

extremely successful, with the amount outstanding currently around $1.2 trillion. CDs

Money Market

Instruments

1

Financial Market Instruments

appendix

to chapter 2

are an extremely important source of funds for commercial banks, from corporations,

money market mutual funds, charitable institutions, and government agencies.

Commercial Paper. Commercial paper is a short-term debt instrument issued by large

banks and well-known corporations, such as General Motors and AT&T. Before the

1960s, corporations usually borrowed their short-term funds from banks, but since

then they have come to rely more heavily on selling commercial paper to other financial

intermediaries and corporations for their immediate borrowing needs; in other

words, they engage in direct finance. Growth of the commercial paper market has

been substantial: The amount of commercial paper outstanding has increased by over

3,900% (from $33 billion to $1.3 trillion) in the period 1970–2002. We discuss why

the commercial paper market has had such tremendous growth in Chapter 10.

Banker’s Acceptances. These money market instruments are created in the course of

carrying out international trade and have been in use for hundreds of years. A banker’s

acceptance is a bank draft (a promise of payment similar to a check) issued by a firm,

payable at some future date, and guaranteed for a fee by the bank that stamps it

“accepted.” The firm issuing the instrument is required to deposit the required funds

into its account to cover the draft. If the firm fails to do so, the bank’s guarantee means

that it is obligated to make good on the draft. The advantage to the firm is that the

draft is more likely to be accepted when purchasing goods abroad, because the foreign

exporter knows that even if the company purchasing the goods goes bankrupt,

the bank draft will still be paid off. These “accepted” drafts are often resold in a secondary

market at a discount and are therefore similar in function to Treasury bills.

Typically, they are held by many of the same parties that hold Treasury bills, and the

amount outstanding has experienced limited growth, rising by 28% ($7 billion to $9

billion) from 1970 to 2002.

2 Appendix to Chapter 2

Amount Outstanding

($ billions, end of year)

Type of Instrument 1970 1980 1990 2002

U.S. Treasury bills 81 216 527 888

Negotiable bank certificates of

deposit (large denominations) 55 317 543 1,177

Commercial paper 33 122 557 1,321

Banker’s acceptances 7 42 52 9

Repurchase agreements 3 57 144 470

Federal funds* 16 18 61 29

Eurodollars 2 55 92 213

*Figures after 1970 are for large banks only.

Sources: Federal Reserve Flow of Funds Accounts; Federal Reserve Bulletin; Banking and Monetary Statistics, 1945–1970; Annual Statistical

Digest, 1971–1975; Economic Report of the President. www.federalreserve.gov/releases/z1

Table 1 Principal Money Market Instruments

Repurchase Agreements. Repurchase agreements, or repos, are effectively short-term

loans (usually with a maturity of less than two weeks) in which Treasury bills serve as

collateral, an asset that the lender receives if the borrower does not pay back the loan.

Repos are made as follows: A large corporation, such as General Motors, may have

some idle funds in its bank account, say $1 million, which it would like to lend for a

week. GM uses this excess $1 million to buy Treasury bills from a bank, which agrees

Financial Market Instruments 3

Source: Wall Street Journal, Wednesday, June 4, 2003, p. C14.

Following the Financial News

The Wall Street Journal publishes daily a listing of interest

rates on many different financial instruments in its

“Money Rates” column. (See “Today’s Contents” on

page 1 of the Journal for the location.)

The four interest rates in the “Money Rates” column

that are discussed most frequently in the media

are these:

• Prime rate: The base interest rate on corporate

bank loans, an indicator of the cost of business

borrowing from banks

• Federal funds rate: The interest rate charged on

overnight loans in the federal funds market, a sensitive

indicator of the cost to banks of borrowing

funds from other banks and the stance of monetary

policy

• Treasury bill rate: The interest rate on U.S. Treasury

bills, an indicator of general interest-rate movements

• Federal Home Loan Mortgage Corporation rates:

Interest rates on “Freddie Mac”–guaranteed mortgages,

an indicator of the cost of financing residential

housing purchases

Money Market Rates

Wednesday, June 3, 2003

The key U.S., and foreign annual interest rates below are a guide to general

levels but don’t always represent actual transactions.

PRIME RATE: 4.25% (effective 11/07/02).

DISCOUNT RATE: 2.25% (effective 01/09/03).

FEDERAL FUNDS: 1.250% high, 1.000% low, 1.125% near closing bid,

1.188% offered. Effective rate: 1.22%. Source: Prebon Yamane (USA) Inc.

Federal-funds target rate: 1.250% (effective 11/06/02).

CALL MONEY: 3.00% (effective 11/07/02).

COMMERCIAL PAPER: Placed directly by General Electric Capital Corp.:

1.05% 30 to 35 days; 1.24% 36 to 43 days; 1.23% 44 to 70 days; 1.21%

71 to 99 days; 1.19% 100 to 113 days; 1.05% 114 to 122 days; 1.19%

123 to 143 days; 1.17% 144 to 270 days.

EURO COMMERCIAL PAPER: Placed directly by General Electric Capital

Corp.: 2.25% 30 days; 2.20% two months; 2.19% three months; 2.15% four

months; 2.14% five months; 2.13% six months.

DEALER COMMERCIAL PAPER: High-grade unsecured notes sold through

dealers by major corporations: 1.21% 30 days; 1.20% 60 days; 1.19% 90

days.

CERTIFICATES OF DEPOSIT: 1.26% one month; 1.21% three months;

1.18% six months.

BANKERS ACCEPTANCE: 1.25% 30 days; 1.22% 60 days; 1.19% 90 days;

1.17% 120 days; 1.16% 150 days; 1.14% 180 days; Source: Prebon

Yamane (USA) Inc.

LONDON INTERBANK OFFERED RATES (LIBOR): 1.31875% one month;

1.2800% three months; 1.2300% six months; 1.2300% one year. Effective

rate for contracts entered into two days from date appearing at top of this

column.

EURO INTERBANK OFFERED RATES (EURIBOR): 2.319% one month; 2.235%

three months; 2.179% six months; 2.122% one year. Source: Reuters.

FOREIGN PRIME RATES: Canada 5.00%; European Central Bank 2.50%;

Japan 1.375%; Switzerland 2.25%; Britain 3.75%

TREASURY BILLS: Results of the Monday, June 2, 2003, auction of shortterm

U.S. government bills, sold at a discount from face value in units of

$1,000 to $1 million: 1.110% 13 weeks; 1.095% 26 weeks. Tuesday, June

3, 2003 auction: 1.140% 4 weeks.

OVERNIGHT REPURCHASE RATE: 1.22%. Source: Garban Intercapital

FREDDIE MAC: Posted yields on 30-year mortgage commitments. Delivery

within 30 days 4.68%, 60 days 4.80%, standard conventional fixed-rate

mortgages: 2.875%, 2% rate capped one-year adjustable rate mortgages.

FANNIE MAE: Posted yields on 30 year mortgage commitments (priced at

par) for delivery within 30 days 4.78%, 60 days 4.87% standard conventional

fixed-rate mortgages; 3.00% 6/2 rate capped one-year adjustable rate

mortgages. Constant Maturity Debt Index: 1.193% three months; 1.119% six

months; 1.187% one year

MERRILL LYNCH READY ASSETS TRUST: 0.78%.

CONSUMER PRICE INDEX: April 183.8, up 2.2% from a year ago. Bureau of

Labor Statistics.

MONEY RATES

to repurchase them the next week at a price slightly above GM’s purchase price. The

effect of this agreement is that GM makes a loan of $1 million to the bank and holds

$1 million of the bank’s Treasury bills until the bank repurchases the bills to pay off

the loan. Repurchase agreements are a fairly recent innovation in financial markets,

having been introduced in 1969. They are now an important source of bank funds

(over $400 billion). The most important lenders in this market are large corporations.

Federal (Fed) Funds. These are typically overnight loans between banks of their

deposits at the Federal Reserve. The federal funds designation is somewhat confusing,

because these loans are not made by the federal government or by the Federal

Reserve, but rather by banks to other banks. One reason why a bank might borrow

in the federal funds market is that it might find it does not have enough deposits at

the Fed to meet the amount required by regulators. It can then borrow these deposits

from another bank, which transfers them to the borrowing bank using the Fed’s wire

transfer system. This market is very sensitive to the credit needs of the banks, so the

interest rate on these loans, called the federal funds rate, is a closely watched barometer

of the tightness of credit market conditions in the banking system and the stance

of monetary policy; when it is high, it indicates that the banks are strapped for funds,

whereas when it is low, banks’ credit needs are low.

Capital market instruments are debt and equity instruments with maturities of greater

than one year. They have far wider price fluctuations than money market instruments

and are considered to be fairly risky investments. The principal capital market instruments

are listed in Table 2, which shows the amount outstanding at the end of 1970,

1980, 1990, and 2002.

Capital Market

Instruments

4 Appendix to Chapter 2

Amount Outstanding

($ billions, end of year)

Type of Instrument 1970 1980 1990 2002

Corporate stocks (market value) 906 1,601 4,146 11,734

Residential mortgages 355 1,106 2,886 6,930

Corporate bonds 167 366 1,008 2,699

U.S. government securities 160 407 1,653 2,169

(marketable long-term)

U.S. government agency securities 51 193 435 2,305

State and local government bonds 146 310 870 1,442

Bank commercial loans 152 459 818 1,345

Consumer loans 134 355 813 1,757

Commercial and farm mortgages 116 352 829 1,461

Sources: Federal Reserve Flow of Funds Accounts; Federal Reserve Bulletin; Banking and Monetary Statistics, 1941–1970. http://www.

federalreserve.gov/releases/z1

Table 2 Principal Capital Market Instruments

Stocks. Stocks are equity claims on the net income and assets of a corporation. Their

value of $11 trillion at the end of 2002 exceeds that of any other type of security in

the capital market. The amount of new stock issues in any given year is typically quite

small—less than 1% of the total value of shares outstanding. Individuals hold around

half of the value of stocks; the rest are held by pension funds, mutual funds, and

insurance companies.

Mortgages. Mortgages are loans to households or firms to purchase housing, land, or

other real structures, where the structure or land itself serves as collateral for the

loans. The mortgage market is the largest debt market in the United States, with the

amount of residential mortgages (used to purchase residential housing) outstanding

more than quadruple the amount of commercial and farm mortgages. Savings and

loan associations and mutual savings banks have been the primary lenders in the residential

mortgage market, although commercial banks have started to enter this market

more aggressively. The majority of commercial and farm mortgages are made by

commercial banks and life insurance companies. The federal government plays an

active role in the mortgage market via the three government agencies—the Federal

National Mortgage Association (FNMA, “Fannie Mae”), the Government National

Mortgage Association (GNMA, “Ginnie Mae”), and the Federal Home Loan Mortgage

Corporation (FHLMC, “Freddie Mac”)—that provide funds to the mortgage market

by selling bonds and using the proceeds to buy mortgages. An important development

in the residential mortgage market in recent years is the mortgage-backed security

(see Box 1).

Financial Market Instruments 5

Box 1

Mortgage-Backed Securities

A major change in the residential mortgage market in

recent years has been the creation of an active secondary

market for mortgages. Because mortgages

have different terms and interest rates, they were not

sufficiently liquid to trade as securities on secondary

markets. To stimulate mortgage lending, in 1970 the

Government National Mortgage Association (GNMA,

called “Ginnie Mae”) developed the concept of a passthrough

mortgage-backed security when it began a program

in which it guaranteed interest and principal

payments on bundles of standardized mortgages.

Under this program, private financial institutions

such as savings and loans and commercial banks were

now able to gather a group of GNMA-guaranteed

mortgages into a bundle of, say, $1 million and then

sell this bundle as a security to a third party (usually

a large institutional investor such as a pension fund).

When individuals make their mortgage payments on

the GNMA-guaranteed mortgage to the financial

institution, the financial institution passes the payments

through to the owner of the security by sending

a check for the total of all the payments. Because

GNMA guarantees the payments, these pass-through

securities have a very low default risk and are very

popular, with amounts outstanding exceeding $500

billion.

Mortgage-backed securities are issued not only by

the government agencies, but also by private financial

institutions. Indeed, mortgage-backed securities have

been so successful that they have completely transformed

the residential mortgage market. Throughout

the 1970s, over 80% of residential mortgages were

owned outright by savings and loans, mutual savings

banks, and commercial banks. Now only one-third

are owned outright by these institutions, with twothirds

held as mortgage-backed securities.

Corporate Bonds. These are long-term bonds issued by corporations with very strong

credit ratings. The typical corporate bond sends the holder an interest payment twice

a year and pays off the face value when the bond matures. Some corporate bonds,

called convertible bonds, have the additional feature of allowing the holder to convert

them into a specified number of shares of stock at any time up to the maturity date.

This feature makes these convertible bonds more desirable to prospective purchasers

than bonds without it, and allows the corporation to reduce its interest payments,

because these bonds can increase in value if the price of the stock appreciates sufficiently.

Because the outstanding amount of both convertible and nonconvertible

bonds for any given corporation is small, they are not nearly as liquid as other securities

such as U.S. government bonds.

Although the size of the corporate bond market is substantially smaller than that

of the stock market, with the amount of corporate bonds outstanding less than onefourth

that of stocks, the volume of new corporate bonds issued each year is substantially

greater than the volume of new stock issues. Thus the behavior of the

corporate bond market is probably far more important to a firm’s financing decisions

than the behavior of the stock market. The principal buyers of corporate bonds are

life insurance companies; pension funds and households are other large holders.

U.S. Government Securities. These long-term debt instruments are issued by the U.S.

Treasury to finance the deficits of the federal government. Because they are the most

widely traded bonds in the United States (the volume of transactions on average

exceeds $100 billion daily), they are the most liquid security traded in the capital

market. They are held by the Federal Reserve, banks, households, and foreigners.

U.S. Government Agency Securities. These are long-term bonds issued by various government

agencies such as Ginnie Mae, the Federal Farm Credit Bank, and the

Tennessee Valley Authority to finance such items as mortgages, farm loans, or powergenerating

equipment. Many of these securities are guaranteed by the federal government.

They function much like U.S. government bonds and are held by similar

parties.

State and Local Government Bonds. State and local bonds, also called municipal bonds,

are long-term debt instruments issued by state and local governments to finance

expenditures on schools, roads, and other large programs. An important feature of

these bonds is that their interest payments are exempt from federal income tax and

generally from state taxes in the issuing state. Commercial banks, with their high

income tax rate, are the biggest buyers of these securities, owning over half the total

amount outstanding. The next biggest group of holders consists of wealthy individuals

in high income brackets, followed by insurance companies.

Consumer and Bank Commercial Loans. These are loans to consumers and businesses

made principally by banks, but—in the case of consumer loans—also by finance companies.

There are often no secondary markets in these loans, which makes them the

least liquid of the capital market instruments listed in Table 2. However, secondary

markets have been rapidly developing.

6 Appendix to Chapter 2

44

PREVIEW If you had lived in America before the Revolutionary War, your money might have

consisted primarily of Spanish doubloons (silver coins that were also called pieces of

eight). Before the Civil War, the principal forms of money in the United States were

not only gold and silver coins but also paper notes, called banknotes, issued by private

banks. Today, you use not only coins and dollar bills issued by the government as

money, but also checks written on accounts held at banks. Money has been different

things at different times; however, it has always been important to people and to the

economy.

To understand the effects of money on the economy, we must understand exactly

what money is. In this chapter, we develop precise definitions by exploring the functions

of money, looking at why and how it promotes economic efficiency, tracing how

its forms have evolved over time, and examining how money is currently measured.

Meaning of Money

As the word money is used in everyday conversation, it can mean many things, but to

economists, it has a very specific meaning. To avoid confusion, we must clarify how

economists’ use of the word money differs from conventional usage.

Economists define money (also referred to as the money supply) as anything that is

generally accepted in payment for goods or services or in the repayment of debts.

Currency, consisting of dollar bills and coins, clearly fits this definition and is one type

of money. When most people talk about money, they’re talking about currency (paper

money and coins). If, for example, someone comes up to you and says, “Your money

or your life,” you should quickly hand over all your currency rather than ask, “What

exactly do you mean by ‘money’?”

To define money merely as currency is much too narrow for economists. Because

checks are also accepted as payment for purchases, checking account deposits are

considered money as well. An even broader definition of money is often needed,

because other items such as savings deposits can in effect function as money if they

can be quickly and easily converted into currency or checking account deposits. As

you can see, there is no single, precise definition of money or the money supply, even

for economists.

Chap ter

3 What Is Money?

To complicate matters further, the word money is frequently used synonymously

with wealth. When people say, “Joe is rich—he has an awful lot of money,” they probably

mean that Joe has not only a lot of currency and a high balance in his checking

account but has also stocks, bonds, four cars, three houses, and a yacht. Thus while

“currency” is too narrow a definition of money, this other popular usage is much too

broad. Economists make a distinction between money in the form of currency,

demand deposits, and other items that are used to make purchases and wealth, the

total collection of pieces of property that serve to store value. Wealth includes not

only money but also other assets such as bonds, common stock, art, land, furniture,

cars, and houses.

People also use the word money to describe what economists call income, as in the

sentence “Sheila would be a wonderful catch; she has a good job and earns a lot of

money.” Income is a flow of earnings per unit of time. Money, by contrast, is a stock:

It is a certain amount at a given point in time. If someone tells you that he has an

income of $1,000, you cannot tell whether he earned a lot or a little without knowing

whether this $1,000 is earned per year, per month, or even per day. But if someone

tells you that she has $1,000 in her pocket, you know exactly how much this is.

Keep in mind that the money discussed in this book refers to anything that is generally

accepted in payment for goods and services or in the repayment of debts and is

distinct from income and wealth.

Functions of Money

Whether money is shells or rocks or gold or paper, it has three primary functions in

any economy: as a medium of exchange, as a unit of account, and as a store of value.

Of the three functions, its function as a medium of exchange is what distinguishes

money from other assets such as stocks, bonds, and houses.

In almost all market transactions in our economy, money in the form of currency or

checks is a medium of exchange; it is used to pay for goods and services. The use of

money as a medium of exchange promotes economic efficiency by minimizing the

time spent in exchanging goods and services. To see why, let’s look at a barter economy,

one without money, in which goods and services are exchanged directly for other

goods and services.

Take the case of Ellen the Economics Professor, who can do just one thing well:

give brilliant economics lectures. In a barter economy, if Ellen wants to eat, she must

find a farmer who not only produces the food she likes but also wants to learn economics.

As you might expect, this search will be difficult and time-consuming, and

Ellen might spend more time looking for such an economics-hungry farmer than she

will teaching. It is even possible that she will have to quit lecturing and go into farming

herself. Even so, she may still starve to death.

The time spent trying to exchange goods or services is called a transaction cost. In

a barter economy, transaction costs are high because people have to satisfy a “double

coincidence of wants”—they have to find someone who has a good or service they

want and who also wants the good or service they have to offer.

Medium of

Exchange

C H A P T E R 3 What Is Money? 45

Let’s see what happens if we introduce money into Ellen the Economics

Professor’s world. Ellen can teach anyone who is willing to pay money to hear her lecture.

She can then go to any farmer (or his representative at the supermarket) and buy

the food she needs with the money she has been paid. The problem of the double

coincidence of wants is avoided, and Ellen saves a lot of time, which she may spend

doing what she does best: teaching.

As this example shows, money promotes economic efficiency by eliminating

much of the time spent exchanging goods and services. It also promotes efficiency by

allowing people to specialize in what they do best. Money is therefore essential in an

economy: It is a lubricant that allows the economy to run more smoothly by lowering

transaction costs, thereby encouraging specialization and the division of labor.

The need for money is so strong that almost every society beyond the most primitive

invents it. For a commodity to function effectively as money, it has to meet several

criteria: (1) It must be easily standardized, making it simple to ascertain its value;

(2) it must be widely accepted; (3) it must be divisible, so that it is easy to “make

change”; (4) it must be easy to carry; and (5) it must not deteriorate quickly. Forms

of money that have satisfied these criteria have taken many unusual forms throughout

human history, ranging from wampum (strings of beads) used by Native

Americans, to tobacco and whiskey, used by the early American colonists, to cigarettes,

used in prisoner-of-war camps during World War II.1 The diversity of forms of

money that have been developed over the years is as much a testament to the inventiveness

of the human race as the development of tools and language.

The second role of money is to provide a unit of account; that is, it is used to measure

value in the economy. We measure the value of goods and services in terms of money,

just as we measure weight in terms of pounds or distance in terms of miles. To see why

this function is important, let’s look again at a barter economy where money does not

perform this function. If the economy has only three goods—say, peaches, economics

lectures, and movies—then we need to know only three prices to tell us how to

exchange one for another: the price of peaches in terms of economics lectures (that is,

how many economics lectures you have to pay for a peach), the price of peaches in

terms of movies, and the price of economics lectures in terms of movies. If there were

ten goods, we would need to know 45 prices in order to exchange one good for another;

with 100 goods, we would need 4,950 prices; and with 1,000 goods, 499,500 prices.2

Imagine how hard it would be in a barter economy to shop at a supermarket with

1,000 different items on its shelves, having to decide whether chicken or fish is a better

buy if the price of a pound of chicken were quoted as 4 pounds of butter and the

price of a pound of fish as 8 pounds of tomatoes. To make it possible to compare

Unit of Account

46 PA RT I Introduction

1An extremely entertaining article on the development of money in a prisoner-of-war camp during

World War II is R. A. Radford, “The Economic Organization of a P.O.W. Camp,” Economica 12 (November

1945): 189–201.

2The formula for telling us the number of prices we need when we have N goods is the same formula that tells

us the number of pairs when there are N items. It is

In the case of ten goods, for example, we would need

10(10 1)

2

90

2

45

N(N 1)

2

prices, the tag on each item would have to list up to 999 different prices, and the time

spent reading them would result in very high transaction costs.

The solution to the problem is to introduce money into the economy and have all

prices quoted in terms of units of that money, enabling us to quote the price of economics

lectures, peaches, and movies in terms of, say, dollars. If there were only three

goods in the economy, this would not be a great advantage over the barter system,

because we would still need three prices to conduct transactions. But for ten goods

we now need only ten prices; for 100 goods, 100 prices; and so on. At the 1,000-good

supermarket, there are now only 1,000 prices to look at, not 499,500!

We can see that using money as a unit of account reduces transaction costs in an

economy by reducing the number of prices that need to be considered. The benefits

of this function of money grow as the economy becomes more complex.

Money also functions as a store of value; it is a repository of purchasing power over

time. A store of value is used to save purchasing power from the time income is

received until the time it is spent. This function of money is useful, because most of

us do not want to spend our income immediately upon receiving it, but rather prefer

to wait until we have the time or the desire to shop.

Money is not unique as a store of value; any asset—whether money, stocks,

bonds, land, houses, art, or jewelry—can be used to store wealth. Many such assets

have advantages over money as a store of value: They often pay the owner a higher

interest rate than money, experience price appreciation, and deliver services such as

providing a roof over one’s head. If these assets are a more desirable store of value than

money, why do people hold money at all?

The answer to this question relates to the important economic concept of

liquidity, the relative ease and speed with which an asset can be converted into a

medium of exchange. Liquidity is highly desirable. Money is the most liquid asset of

all because it is the medium of exchange; it does not have to be converted into anything

else in order to make purchases. Other assets involve transaction costs when

they are converted into money. When you sell your house, for example, you have to

pay a brokerage commission (usually 5% to 7% of the sales price), and if you need

cash immediately to pay some pressing bills, you might have to settle for a lower price

in order to sell the house quickly. Because money is the most liquid asset, people are

willing to hold it even if it is not the most attractive store of value.

How good a store of value money is depends on the price level, because its value

is fixed in terms of the price level. A doubling of all prices, for example, means that

the value of money has dropped by half; conversely, a halving of all prices means that

the value of money has doubled. During inflation, when the price level is increasing

rapidly, money loses value rapidly, and people will be more reluctant to hold their

wealth in this form. This is especially true during periods of extreme inflation, known

as hyperinflation, in which the inflation rate exceeds 50% per month.

Hyperinflation occurred in Germany after World War I, with inflation rates sometimes

exceeding 1,000% per month. By the end of the hyperinflation in 1923, the

price level had risen to more than 30 billion times what it had been just two years

before. The quantity of money needed to purchase even the most basic items became

excessive. There are stories, for example, that near the end of the hyperinflation, a

wheelbarrow of cash would be required to pay for a loaf of bread. Money was losing

its value so rapidly that workers were paid and given time off several times during the

day to spend their wages before the money became worthless. No one wanted to hold

Store of Value

C H A P T E R 3 What Is Money? 47

on to money, and so the use of money to carry out transactions declined and barter

became more and more dominant. Transaction costs skyrocketed, and as we would

expect, output in the economy fell sharply.

Evolution of the Payments System

We can obtain a better picture of the functions of money and the forms it has taken

over time by looking at the evolution of the payments system, the method of conducting

transactions in the economy. The payments system has been evolving over

centuries, and with it the form of money. At one point, precious metals such as gold

were used as the principal means of payment and were the main form of money. Later,

paper assets such as checks and currency began to be used in the payments system

and viewed as money. Where the payments system is heading has an important bearing

on how money will be defined in the future.

To obtain perspective on where the payments system is heading, it is worth exploring

how it has evolved. For any object to function as money, it must be universally acceptable;

everyone must be willing to take it in payment for goods and services. An object

that clearly has value to everyone is a likely candidate to serve as money, and a natural

choice is a precious metal such as gold or silver. Money made up of precious metals

or another valuable commodity is called commodity money, and from ancient

times until several hundred years ago, commodity money functioned as the medium

of exchange in all but the most primitive societies. The problem with a payments system

based exclusively on precious metals is that such a form of money is very heavy

and is hard to transport from one place to another. Imagine the holes you’d wear in

your pockets if you had to buy things only with coins! Indeed, for large purchases

such as a house, you’d have to rent a truck to transport the money payment.

The next development in the payments system was paper currency (pieces of paper

that function as a medium of exchange). Initially, paper currency carried a guarantee

that it was convertible into coins or into a quantity of precious metal. However, currency

has evolved into fiat money, paper currency decreed by governments as legal

tender (meaning that legally it must be accepted as payment for debts) but not convertible

into coins or precious metal. Paper currency has the advantage of being much

lighter than coins or precious metal, but it can be accepted as a medium of exchange

only if there is some trust in the authorities who issue it and if printing has reached a

sufficiently advanced stage that counterfeiting is extremely difficult. Because paper

currency has evolved into a legal arrangement, countries can change the currency that

they use at will. Indeed, this is currently a hot topic of debate in Europe, which has

adopted a unified currency (see Box 1).

Major drawbacks of paper currency and coins are that they are easily stolen and

can be expensive to transport in large amounts because of their bulk. To combat this

problem, another step in the evolution of the payments system occurred with the

development of modern banking: the invention of checks.

A check is an instruction from you to your bank to transfer money from your account

to someone else’s account when she deposits the check. Checks allow transactions to

Checks

Fiat Money

Commodity

Money

48 PA RT I Introduction

www.federalreserve

.gov/paymentsys.htm

This site reports on the Federal

Reserve’s policies regarding

payments systems.

take place without the need to carry around large amounts of currency. The introduction

of checks was a major innovation that improved the efficiency of the payments

system. Frequently, payments made back and forth cancel each other; without checks,

this would involve the movement of a lot of currency. With checks, payments that cancel

each other can be settled by canceling the checks, and no currency need be moved.

The use of checks thus reduces the transportation costs associated with the payments

system and improves economic efficiency. Another advantage of checks is that they can

be written for any amount up to the balance in the account, making transactions for

large amounts much easier. Checks are also advantageous in that loss from theft is

greatly reduced, and because they provide convenient receipts for purchases.

There are, however, two problems with a payments system based on checks. First,

it takes time to get checks from one place to another, a particularly serious problem

if you are paying someone in a different location who needs to be paid quickly. In

addition, if you have a checking account, you know that it usually takes several business

days before a bank will allow you to make use of the funds from a check you

have deposited. If your need for cash is urgent, this feature of paying by check can be

C H A P T E R 3 What Is Money? 49

Box 1: Global

Birth of the Euro: Will It Benefit Europe?

As part of the December 1991 Maastricht Treaty on

European Union, the European Economic Commission

outlined a plan to achieve the creation of a single

European currency starting in 1999. Despite concerns,

the new common currency—the euro—came

into existence right on schedule in January 1999,

with 11 of the 15 European Union countries participating

in the monetary union: Austria, Belgium,

Finland, France, Germany, Italy, Ireland, Luxembourg,

the Netherlands, Portugal, and Spain. Denmark,

Sweden, and the United Kingdom chose not to participate

initially, and Greece failed to meet the economic

criteria specified by the Maastricht Treaty

(such as having a budget deficit less than 3% of GDP

and total government debt less than 60% of GDP) but

was able to join later.

Starting January 1, 1999, the exchange rates of

countries entering the monetary union were fixed permanently

to the euro (which became a unit of account),

the European Central Bank took over monetary policy

from the individual national central banks, and the

governments of the member countries began to issue

debt in euros. In early 2002, euro notes and coins

began to circulate and by June 2002, the old national

currencies were phased out completely, so that only

euros could be used in the member countries.

Advocates of monetary union point out the advantages

that the single currency has in eliminating the

transaction costs incurred in exchanging one currency

for another. In addition, the use of a single currency

may promote further integration of the European

economies and enhance competition. Skeptics who

think that monetary union may be bad for Europe

suggest that because labor will not be very mobile

across national boundaries and because fiscal transfers

(i.e., tax income from one region being spent on

another) from better-performing regions to worseperforming

regions will not take place as occurs in the

United States, a single currency may lead to some

regions of Europe being depressed for substantial

periods of time while other regions are booming.

Whether the euro will be good for the economies

of Europe and increase their GDP is an open question.

However, the motive behind monetary union was

probably more political than economic. European

monetary union may encourage political union, producing

a unified Europe that can play a stronger economic

and political role on the world stage.

frustrating. Second, all the paper shuffling required to process checks is costly; it is

estimated that it currently costs over $10 billion per year to process all the checks

written in the United States.

The development of inexpensive computers and the spread of the Internet now make

it cheap to pay bills electronically. In the past, you had to pay your bills by mailing a

check, but now banks provide a web site in which you just log on, make a few clicks,

and thereby transmit your payment electronically. Not only do you save the cost of

the stamp, but paying bills becomes (almost) a pleasure, requiring little effort.

Electronic payment systems provided by banks now even spare you the step of logging

on to pay the bill. Instead, recurring bills can be automatically deducted from

your bank account. Estimated cost savings when a bill is paid electronically rather

than by a check exceed one dollar. Electronic payment is thus becoming far more

common in the United States, but Americans lag considerably behind Europeans, particularly

Scandinavians, in their use of electronic payments (see Box 2).

Electronic

Payment

50 PA RT I Introduction

Why Are Scandinavians So Far Ahead of Americans in Using Electronic Payments?

Americans are the biggest users of checks in the

world. Close to 100 billion checks are written every

year in the United States, and over three-quarters of

noncash transactions are conducted with paper. In

contrast, in most countries of Europe, more than

two-thirds of noncash transactions are electronic,

with Finland and Sweden having the greatest proportion

of online banking customers of any countries in

the world. Indeed, if you were Finnish or Swedish,

instead of writing a check, you would be far more

likely to pay your bills online, using a personal computer

or even a mobile phone. Why do Europeans

and especially Scandinavians so far outpace Americans

in the use of electronic payments?

First, Europeans got used to making payments

without checks even before the advent of the personal

computer. Europeans have long made use of so-called

giro payments, in which banks and post offices transfer

funds for customers to pay bills. Second,

Europeans—and particularly Scandinavians—are

much greater users of mobile phones and the Internet

than are Americans. Finland has the highest per capita

use of mobile phones in the world, and Finland and

Sweden lead the world in the percentage of the population

that accesses the Internet. Maybe these usage

patterns stem from the low population densities of

these countries and the cold and dark winters that

keep Scandinavians inside at their PCs. For their part,

Scandinavians would rather take the view that their

high-tech culture is the product of their good education

systems and the resulting high degree of computer

literacy, the presence of top technology

companies such as Finland’s Nokia and Sweden’s

Ericsson, and government policies promoting the

increased use of personal computers, such as Sweden’s

tax incentives for companies to provide their employees

with home computers. The wired populations of

Finland and Sweden are (percentage-wise) the biggest

users of online banking in the world.

Americans are clearly behind the curve in their use

of electronic payments, which has imposed a high

cost on the U.S. economy. Switching from checks to

electronic payments might save the U.S. economy

tens of billions of dollars per year, according to some

estimates. Indeed, the U.S. federal government is trying

to switch all its payments to electronic ones by

directly depositing them into bank accounts, in order

to reduce its expenses. Can Americans be weaned

from paper checks and fully embrace the world of

high-tech electronic payments?

Box 2: E-Finance

Electronic payments technology can not only substitute for checks, but can substitute

for cash, as well, in the form of electronic money (or e-money), money that exists

only in electronic form. The first form of e-money was the debit card. Debit cards,

which look like credit cards, enable consumers to purchase goods and services by

electronically transferring funds directly from their bank accounts to a merchant’s

account. Debit cards are used in many of the same places that accept credit cards and

are now often becoming faster to use than cash. At most supermarkets, for example,

you can swipe your debit card through the card reader at the checkout station, press

a button, and the amount of your purchases is deducted from your bank account.

Most banks and companies such as Visa and MasterCard issue debit cards, and your

ATM card typically can function as a debit card.

A more advanced form of e-money is the stored-value card. The simplest form of

stored-value card is purchased for a preset dollar amount that the consumer pays up

front, like a prepaid phone card. The more sophisticated stored-value card is known

as a smart card. It contains a computer chip that allows it to be loaded with digital

cash from the owner’s bank account whenever needed. Smart cards can be loaded

from ATM machines, personal computers with a smart card reader, or specially

equipped telephones.

A third form of electronic money is often referred to as e-cash, which is used on

the Internet to purchase goods or services. A consumer gets e-cash by setting up an

account with a bank that has links to the Internet and then has the e-cash transferred

to her PC. When she wants to buy something with e-cash, she surfs to a store on the

Web and clicks the “buy” option for a particular item, whereupon the e-cash is automatically

transferred from her computer to the merchant’s computer. The merchant

can then have the funds transferred from the consumer’s bank account to his before

the goods are shipped.

Given the convenience of e-money, you might think that we would move quickly

to the cashless society in which all payments were made electronically. However, this

hasn’t happened, as discussed in Box 3.

Measuring Money

The definition of money as anything that is generally accepted in payment for goods

and services tells us that money is defined by people’s behavior. What makes an asset

money is that people believe it will be accepted by others when making payment. As

we have seen, many different assets have performed this role over the centuries, ranging

from gold to paper currency to checking accounts. For that reason, this behavioral

definition does not tell us exactly what assets in our economy should be considered

money. To measure money, we need a precise definition that tells us exactly what

assets should be included.

The Federal Reserve System (the Fed), the central banking authority responsible for

monetary policy in the United States, has conducted many studies on how to measure

money. The problem of measuring money has recently become especially crucial

because extensive financial innovation has produced new types of assets that might

properly belong in a measure of money. Since 1980, the Fed has modified its measures

of money several times and has settled on the following measures of the money

The Federal

Reserve’s

Monetary

Aggregates

E-Money

C H A P T E R 3 What Is Money? 51

supply, which are also referred to as monetary aggregates (see Table 1 and the

Following the Financial News box).

The narrowest measure of money that the Fed reports is M1, which includes currency,

checking account deposits, and traveler’s checks. These assets are clearly

money, because they can be used directly as a medium of exchange. Until the mid-

1970s, only commercial banks were permitted to establish checking accounts, and

they were not allowed to pay interest on them. With the financial innovation that has

occurred (discussed more extensively in Chapter 9), regulations have changed so that

other types of banks, such as savings and loan associations, mutual savings banks,

and credit unions, can also offer checking accounts. In addition, banking institutions

can offer other checkable deposits, such as NOW (negotiated order of withdrawal)

accounts and ATS (automatic transfer from savings) accounts, that do pay interest on

their balances. Table 1 lists the assets included in the measures of the monetary aggregates;

both demand deposits (checking accounts that pay no interest) and these other

checkable deposits are included in the M1 measure.

The M2 monetary aggregate adds to M1 other assets that have check-writing features

(money market deposit accounts and money market mutual fund shares) and

other assets (savings deposits, small-denomination time deposits and repurchase

agreements) that are extremely liquid, because they can be turned into cash quickly

at very little cost.

52 PA RT I Introduction

Are We Headed for a Cashless Society?

Predictions of a cashless society have been around for

decades, but they have not come to fruition. For

example, Business Week predicted in 1975 that electronic

means of payment “would soon revolutionize

the very concept of money itself,” only to reverse

itself several years later. Pilot projects in recent years

with smart cards to convert consumers to the use of

e-money have not been a success. Mondex, one of the

widely touted, early stored-value cards that was

launched in Britain in 1995, is only used on a few

British university campuses. In Germany and

Belgium, millions of people carry bank cards with

computer chips embedded in them that enable them

to make use of e-money, but very few use them. Why

has the movement to a cashless society been so slow

in coming?

Although e-money might be more convenient and

may be more efficient than a payments system based

on paper, several factors work against the disappearance

of the paper system. First, it is very expensive to

set up the computer, card reader, and telecommunications

networks necessary to make electronic money

the dominant form of payment. Second, electronic

means of payment raise security and privacy concerns.

We often hear media reports that an unauthorized

hacker has been able to access a computer

database and to alter information stored there.

Because this is not an uncommon occurrence,

unscrupulous persons might be able to access bank

accounts in electronic payments systems and steal

funds by moving them from someone else’s accounts

into their own. The prevention of this type of fraud is

no easy task, and a whole new field of computer science

has developed to cope with security issues. A

further concern is that the use of electronic means of

payment leaves an electronic trail that contains a large

amount of personal data on buying habits. There are

worries that government, employers, and marketers

might be able to access these data, thereby encroaching

on our privacy.

The conclusion from this discussion is that

although the use of e-money will surely increase in

the future, to paraphrase Mark Twain, “the reports of

cash’s death are greatly exaggerated.”

Box 3: E-Finance

www.federalreserve

.gov/releases/h6/Current/

The Federal Reserve reports the

current levels of M1, M2, and

M3 on its web site.

The M3 monetary aggregate adds to M2 somewhat less liquid assets such as largedenomination

time deposits and repurchase agreements, Eurodollars, and institutional

money market mutual fund shares.

Because we cannot be sure which of the monetary aggregates is the true measure of

money, it is logical to wonder if their movements closely parallel one another. If they do,

then using one monetary aggregate to predict future economic performance and to conduct

policy will be the same as using another, and it does not matter much that we are

not sure of the appropriate definition of money for a given policy decision. However, if

the monetary aggregates do not move together, then what one monetary aggregate tells

us is happening to the money supply might be quite different from what another monetary

aggregate would tell us. The conflicting stories might present a confusing picture

that would make it hard for policymakers to decide on the right course of action.

Figure 1 plots the growth rates M1, M2, and M3 from 1960 to 2002. The growth

rates of these three monetary aggregates do tend to move together; the timing of their

rise and fall is roughly similar until the 1990s, and they all show a higher growth rate

on average in the 1970s than in the 1960s.

Yet some glaring discrepancies exist in the movements of these aggregates.

According to M1, the growth rate of money did not accelerate between 1968, when it

C H A P T E R 3 What Is Money? 53

Value as of December 2002

($billions)

M1 Currency 626.5

Traveler’s checks 7.7

Demand deposits 290.7

Other checkable deposits 281.2

Total M1 1,206.1

M2 M1

Small-denomination time deposits and repurchase agreements 1,332.3

Savings deposits and money market deposit accounts 2,340.4

Money market mutual fund shares (noninstitutional) 923.7

Total M2 5,802.5

M3 M2

Large-denomination time deposits and repurchase agreements 1,105.2

Money market mutual fund shares (institutional) 767.7

Repurchase agreements 511.7

Eurodollars 341.1

Total M3 8,528.2

Source: www.federalreserve.gov/releases/h6/hist.

Note: The Travelers checks item includes only traveler’s checks issued by non-banks, while traveler’s checks issued by banks are included

in the Demand deposits item, which also includes checkable deposits to businesses and which also do not pay interest.

Table 1 Measures of the Monetary Aggregates

54 PA RT I Introduction

Source: Wall Street Journal, Friday, January 3, 2003, p. C10.

F E D E R A L R E S E R V E DATA

MONETARY AGGREGATES

(daily average in billions)

1 Week Ended:

Dec. 23 Dec. 16

Money supply (M1) sa . . . 1227.1 1210.1

Money supply (M1) nsa . . . 1256.0 1214.9

Money supply (M2) sa . . . 5822.7 5811.3

Money supply (M2) nsa . . . 5834.5 5853.9

Money supply (M3) sa . . . 8542.8 8549.2

Money supply (M3) nsa . . . 8572.6 8623.0

4 Weeks Ended:

Dec. 23 Nov. 25

Money supply (M1) sa . . . 1218.3 1197.5

Money supply (M1) nsa . . . 1230.9 1195.9

Money supply (M2) sa . . . 5815.5 5795.8

Money supply (M2) nsa . . . 5835.7 5780.7

Money supply (M3) sa . . . 8543.4 8465.4

Money supply (M3) nsa . . . 8578.1 8440.5

Month

Nov. Oct.

Money supply (M1) sa . . . 1200.7 1199.6

Money supply (M2) sa . . . 5800.7 5753.8

Money supply (M3) sa . . . 8485.2 8348.4

nsa-Not seasonally adjusted

sa-Seasonally adjusted.

Following the Financial News

Data for the Federal Reserve’s monetary aggregates (M1,

M2, and M3) are published every Friday. In the Wall

Street Journal, the data are found in the “Federal Reserve

Data” column, an example of which is presented here.

The third entry indicates that the money supply

(M2) averaged $5,822.7 billion for the week ending

December 23, 2002. The notation “sa” for this entry

indicates that the data are seasonally adjusted; that is,

seasonal movements, such as those associated with

Christmas shopping, have been removed from the

data. The notation “nsa” indicates that the data have

not been seasonally adjusted.

The Monetary Aggregates

FIGURE 1 Growth Rates of the Three Money Aggregates, 1960–2002

Sources: Federal Reserve Bulletin, p. A4, Table 1.10, various issues; Citibase databank; www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

-5

0

-10

Annual

Growth Rate (%)

5

10

15

20

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

M3 M2 M1

was in the 6–7% range, and 1971, when it was at a similar level. In the same period,

the M2 and M3 measures tell a different story; they show a marked acceleration from

the 8–10% range to the 12–15% range. Similarly, while the growth rate of M1 actually

increased from 1989 to 1992, the growth rates of M2 and M3 in this same period

instead showed a downward trend. Furthermore, from 1992 to 1998, the growth rate

of M1 fell sharply while the growth rates of M2 and M3 rose substantially; from 1998

to 2002, M1 growth generally remained well below M2 and M3 growth. Thus, the different

measures of money tell a very different story about the course of monetary policy

in recent years.

From the data in Figure 1, you can see that obtaining a single precise, correct measure

of money does seem to matter and that it does make a difference which monetary

aggregate policymakers and economists choose as the true measure of money.

How Reliable Are the Money Data?

The difficulties of measuring money arise not only because it is hard to decide what

is the best definition of money, but also because the Fed frequently later revises earlier

estimates of the monetary aggregates by large amounts. There are two reasons why

the Fed revises its figures. First, because small depository institutions need to report

the amounts of their deposits only infrequently, the Fed has to estimate these amounts

until these institutions provide the actual figures at some future date. Second, the

adjustment of the data for seasonal variation is revised substantially as more data

become available. To see why this happens, let’s look at an example of the seasonal

variation of the money data around Christmas-time. The monetary aggregates always

rise around Christmas because of increased spending during the holiday season; the

rise is greater in some years than in others. This means that the factor that adjusts the

data for the seasonal variation due to Christmas must be estimated from several years

of data, and the estimates of this seasonal factor become more precise only as more

data become available. When the data on the monetary aggregates are revised, the seasonal

adjustments often change dramatically from the initial calculation.

Table 2 shows how severe a problem these data revisions can be. It provides the

rates of money growth from one-month periods calculated from initial estimates of

the M2 monetary aggregate, along with the rates of money growth calculated from a

major revision of the M2 numbers published in February 2003. As the table shows,

for one-month periods the initial versus the revised data can give a different picture

of what is happening to monetary policy. For January 2003, for example, the initial

data indicated that the growth rate of M2 at an annual rate was 2.2%, whereas the

revised data indicate a much higher growth rate of 5.4%.

A distinctive characteristic shown in Table 2 is that the differences between the

initial and revised M2 series tend to cancel out. You can see this by looking at the last

row of the table, which shows the average rate of M2 growth for the two series and

the average difference between them. The average M2 growth for the initial calculation

of M2 is 6.5%, and the revised number is 6.5%, a difference of 0.0%. The conclusion

we can draw is that the initial data on the monetary aggregates reported by

the Fed are not a reliable guide to what is happening to short-run movements in the

money supply, such as the one-month growth rates. However, the initial money data

are reasonably reliable for longer periods, such as a year. The moral is that we probably

should not pay much attention to short-run movements in the money supply

numbers, but should be concerned only with longer-run movements.

C H A P T E R 3 What Is Money? 55

56 PA RT I Introduction

Initial Revised Difference

Period Rate Rate (Revised Rate – Initial Rate)

January 2.2 5.4 3.2

February 6.8 8.7 1.9

March –1.4 0.2 1.6

April –4.0 –2.6 1.4

May 14.8 15.4 0.6

June 7.6 7.1 –0.5

July 13.6 11.0 –2.6

August 9.9 8.6 –1.3

September 5.1 5.7 0.6

October 10.9 8.3 –2.6

November 10.2 8.0 –2.2

December 2.8 2.8 0.0

Average 6.5 6.5 0.0

Source: Federal Reserve Statistical Release H.6: www.federalreserve.gov/releases/h6.

Table 2 Growth Rate of M2: Initial and Revised Series, 2002

(percent, compounded annual rate)

Summary

1. To economists, the word money has a different meaning

from income or wealth. Money is anything that is

generally accepted as payment for goods or services or

in the repayment of debts.

2. Money serves three primary functions: as a medium of

exchange, as a unit of account, and as a store of value.

Money as a medium of exchange avoids the problem of

double coincidence of wants that arises in a barter

economy by lowering transaction costs and

encouraging specialization and the division of labor.

Money as a unit of account reduces the number of

prices needed in the economy, which also reduces

transaction costs. Money also functions as a store of

value, but performs this role poorly if it is rapidly losing

value due to inflation.

3. The payments system has evolved over time. Until several

hundred years ago, the payments system in all but the

most primitive societies was based primarily on precious

metals. The introduction of paper currency lowered the

cost of transporting money. The next major advance was

the introduction of checks, which lowered transaction

costs still further. We are currently moving toward an

electronic payments system in which paper is eliminated

and all transactions are handled by computers. Despite

the potential efficiency of such a system, obstacles are

slowing the movement to the checkless society and the

development of new forms of electronic money.

4. The Federal Reserve System has defined three different

measures of the money supply—M1, M2, and M3.

These measures are not equivalent and do not always

move together, so they cannot be used interchangeably

by policymakers. Obtaining the precise, correct

measure of money does seem to matter and has

implications for the conduct of monetary policy.

5. Another problem in the measurement of money is that

the data are not always as accurate as we would like.

C H A P T E R 3 What Is Money? 57

Substantial revisions in the data do occur; they indicate

that initially released money data are not a reliable

guide to short-run (say, month-to-month) movements

in the money supply, although they are more reliable

over longer periods of time, such as a year.

Key Terms

commodity money, p. 48

currency, p. 44

e-cash, p. 51

electronic money (e-money), p. 51

fiat money, p. 48

hyperinflation, p. 47

income, p. 45

liquidity, p. 47

M1, p. 52

M2, p. 52

M3, p. 53

medium of exchange, p. 45

monetary aggregates, p. 52

payments system, p. 48

smart card, p. 51

store of value, p. 47

unit of account, p. 46

wealth, p. 45

Questions and Problems

Questions marked with an asterisk are answered at the end

of the book in an appendix, “Answers to Selected Questions

and Problems.”

1. Which of the following three expressions uses the

economists’ definition of money?

a. “How much money did you earn last week?”

b. “When I go to the store, I always make sure that I

have enough money.”

c. “The love of money is the root of all evil.”

*2. There are three goods produced in an economy by

three individuals:

Good Producer

Apples Orchard owner

Bananas Banana grower

Chocolate Chocolatier

If the orchard owner likes only bananas, the banana

grower likes only chocolate, and the chocolatier likes

only apples, will any trade between these three persons

take place in a barter economy? How will introducing

money into the economy benefit these three

producers?

3. Why did cavemen not need money?

*4. Why were people in the United States in the nineteenth

century sometimes willing to be paid by check

rather than with gold, even though they knew that

there was a possibility that the check might bounce?

5. In ancient Greece, why was gold a more likely candidate

for use as money than wine was?

*6. Was money a better store of value in the United States

in the 1950s than it was in the 1970s? Why or why

not? In which period would you have been more willing

to hold money?

7. Would you be willing to give up your checkbook and

instead use an electronic means of payment if it were

made available? Why or why not?

8. Rank the following assets from most liquid to least liquid:

a. Checking account deposits

b. Houses

c. Currency

d. Washing machines

e. Savings deposits

f. Common stock

*9. Why have some economists described money during a

hyperinflation as a “hot potato” that is quickly passed

from one person to another?

10. In Brazil, a country that was undergoing a rapid inflation

before 1994, many transactions were conducted

in dollars rather than in reals, the domestic currency.

Why?

QUIZ

*11. Suppose that a researcher discovers that a measure of

the total amount of debt in the U.S. economy over the

past 20 years was a better predictor of inflation and

the business cycle than M1, M2, or M3. Does this discovery

mean that we should define money as equal to

the total amount of debt in the economy?

12. Look up the M1, M2, and M3 numbers in the Federal

Reserve Bulletin for the most recent one-year period.

Have their growth rates been similar? What implications

do their growth rates have for the conduct of

monetary policy?

*13. Which of the Federal Reserve’s measures of the monetary

aggregates, M1, M2, or M3, is composed of the

most liquid assets? Which is the largest measure?

14. For each of the following assets, indicate which of the

monetary aggregates (M1, M2, M3) includes them:

a. Currency

b. Money market mutual funds

c. Eurodollars

d. Small-denomination time deposits

e. Large-denomination repurchase agreements

f. Checkable deposits

*15. Why are revisions of monetary aggregates less of a

problem for measuring long-run movements of the

money supply than they are for measuring short-run

movements?

58 PA RT I Introduction

Web Exercises

1. Go to www.federalreserve.gov/releases/h6/Current/.

a. What has been the growth rate in M1, M2, and M3

over the last 12 months?

b. From what you know about the state of the economy,

does this seem expansionary or restrictive?

2. Go to www.federalreserve.gov/paymentsys.htm and

select one topic on which the Federal Reserve has a

written policy. Write a one-paragraph summary of this

policy.

P a r t I I

Financial

Markets

PREVIEW Interest rates are among the most closely watched variables in the economy. Their

movements are reported almost daily by the news media, because they directly affect

our everyday lives and have important consequences for the health of the economy.

They affect personal decisions such as whether to consume or save, whether to buy a

house, and whether to purchase bonds or put funds into a savings account. Interest

rates also affect the economic decisions of businesses and households, such as

whether to use their funds to invest in new equipment for factories or to save their

money in a bank.

Before we can go on with the study of money, banking, and financial markets, we

must understand exactly what the phrase interest rates means. In this chapter, we see

that a concept known as the yield to maturity is the most accurate measure of interest

rates; the yield to maturity is what economists mean when they use the term interest

rate. We discuss how the yield to maturity is measured and examine alternative (but

less accurate) ways in which interest rates are quoted. We’ll also see that a bond’s

interest rate does not necessarily indicate how good an investment the bond is

because what it earns (its rate of return) does not necessarily equal its interest rate.

Finally, we explore the distinction between real interest rates, which are adjusted for

inflation, and nominal interest rates, which are not.

Although learning definitions is not always the most exciting of pursuits, it is

important to read carefully and understand the concepts presented in this chapter.

Not only are they continually used throughout the remainder of this text, but a firm

grasp of these terms will give you a clearer understanding of the role that interest rates

play in your life as well as in the general economy.

Measuring Interest Rates

Different debt instruments have very different streams of payment with very different

timing. Thus we first need to understand how we can compare the value of one kind

of debt instrument with another before we see how interest rates are measured. To do

this, we make use of the concept of present value.

The concept of present value (or present discounted value) is based on the commonsense

notion that a dollar paid to you one year from now is less valuable to you than

a dollar paid to you today: This notion is true because you can deposit a dollar in a

Present Value

61

Chap ter

4 Understanding Interest Rates

www.bloomberg.com

/markets/

Under “Rates & Bonds,” you

can access information on key

interest rates, U.S. Treasuries,

Government bonds, and

municipal bonds.

savings account that earns interest and have more than a dollar in one year.

Economists use a more formal definition, as explained in this section.

Let’s look at the simplest kind of debt instrument, which we will call a simple

loan. In this loan, the lender provides the borrower with an amount of funds (called

the principal) that must be repaid to the lender at the maturity date, along with an

additional payment for the interest. For example, if you made your friend, Jane, a simple

loan of $100 for one year, you would require her to repay the principal of $100

in one year’s time along with an additional payment for interest; say, $10. In the case

of a simple loan like this one, the interest payment divided by the amount of the loan

is a natural and sensible way to measure the interest rate. This measure of the socalled

simple interest rate, i, is:

If you make this $100 loan, at the end of the year you would have $110, which

can be rewritten as:

$100 (1 0.10) $110

If you then lent out the $110, at the end of the second year you would have:

$110 (1 0.10) $121

or, equivalently,

$100 (1 0.10) (1 0.10) $100 (1 0.10)2 $121

Continuing with the loan again, you would have at the end of the third year:

$121 (1 0.10) $100 (1 0.10)3 $133

Generalizing, we can see that at the end of n years, your $100 would turn into:

$100 (1 i )n

The amounts you would have at the end of each year by making the $100 loan today

can be seen in the following timeline:

This timeline immediately tells you that you are just as happy having $100 today

as having $110 a year from now (of course, as long as you are sure that Jane will pay

you back). Or that you are just as happy having $100 today as having $121 two years

from now, or $133 three years from now or $100 (1 0.10)n, n years from now.

The timeline tells us that we can also work backward from future amounts to the present:

for example, $133 $100 (1 0.10)3 three years from now is worth $100

today, so that:

The process of calculating today’s value of dollars received in the future, as we have

done above, is called discounting the future. We can generalize this process by writing

$100

$133

(1 0.10)3

$100 (1 0.10)n

Year

Today

0

$100 $110

Year

1

$121

Year

2

$133

Year

3

i

$10

$100

0.10 10%

62 PA RT I I Financial Markets

today’s (present) value of $100 as PV, the future value of $133 as FV, and replacing

0.10 (the 10% interest rate) by i. This leads to the following formula:

(1)

Intuitively, what Equation 1 tells us is that if you are promised $1 for certain ten

years from now, this dollar would not be as valuable to you as $1 is today because if

you had the $1 today, you could invest it and end up with more than $1 in ten years.

The concept of present value is extremely useful, because it allows us to figure

out today’s value (price) of a credit market instrument at a given simple interest rate

i by just adding up the individual present values of all the future payments received.

This information allows us to compare the value of two instruments with very different

timing of their payments.

As an example of how the present value concept can be used, let’s assume that

you just hit the $20 million jackpot in the New York State Lottery, which promises

you a payment of $1 million for the next twenty years. You are clearly excited, but

have you really won $20 million? No, not in the present value sense. In today’s dollars,

that $20 million is worth a lot less. If we assume an interest rate of 10% as in the

earlier examples, the first payment of $1 million is clearly worth $1 million today, but

the next payment next year is only worth $1 million/(1 0.10) $909,090, a lot less

than $1 million. The following year the payment is worth $1 million/(1 0.10)2

$826,446 in today’s dollars, and so on. When you add all these up, they come to $9.4

million. You are still pretty excited (who wouldn’t be?), but because you understand

the concept of present value, you recognize that you are the victim of false advertising.

You didn’t really win $20 million, but instead won less than half as much.

In terms of the timing of their payments, there are four basic types of credit market

instruments.

1. A simple loan, which we have already discussed, in which the lender provides

the borrower with an amount of funds, which must be repaid to the lender at the

maturity date along with an additional payment for the interest. Many money market

instruments are of this type: for example, commercial loans to businesses.

2. A fixed-payment loan (which is also called a fully amortized loan) in which the

lender provides the borrower with an amount of funds, which must be repaid by making

the same payment every period (such as a month), consisting of part of the principal

and interest for a set number of years. For example, if you borrowed $1,000, a

fixed-payment loan might require you to pay $126 every year for 25 years. Installment

loans (such as auto loans) and mortgages are frequently of the fixed-payment type.

3. A coupon bond pays the owner of the bond a fixed interest payment (coupon

payment) every year until the maturity date, when a specified final amount (face

value or par value) is repaid. The coupon payment is so named because the bondholder

used to obtain payment by clipping a coupon off the bond and sending it to

the bond issuer, who then sent the payment to the holder. Nowadays, it is no longer

necessary to send in coupons to receive these payments. A coupon bond with $1,000

face value, for example, might pay you a coupon payment of $100 per year for ten

years, and at the maturity date repay you the face value amount of $1,000. (The face

value of a bond is usually in $1,000 increments.)

A coupon bond is identified by three pieces of information. First is the corporation

or government agency that issues the bond. Second is the maturity date of the

Four Types of

Credit Market

Instruments

PV

FV

(1 i )n

C H A P T E R 4 Understanding Interest Rates 63

bond. Third is the bond’s coupon rate, the dollar amount of the yearly coupon payment

expressed as a percentage of the face value of the bond. In our example, the

coupon bond has a yearly coupon payment of $100 and a face value of $1,000. The

coupon rate is then $100/$1,000 0.10, or 10%. Capital market instruments such

as U.S. Treasury bonds and notes and corporate bonds are examples of coupon bonds.

4. A discount bond (also called a zero-coupon bond) is bought at a price below

its face value (at a discount), and the face value is repaid at the maturity date. Unlike

a coupon bond, a discount bond does not make any interest payments; it just pays off

the face value. For example, a discount bond with a face value of $1,000 might be

bought for $900; in a year’s time the owner would be repaid the face value of $1,000.

U.S. Treasury bills, U.S. savings bonds, and long-term zero-coupon bonds are examples

of discount bonds.

These four types of instruments require payments at different times: Simple loans

and discount bonds make payment only at their maturity dates, whereas fixed-payment

loans and coupon bonds have payments periodically until maturity. How would you

decide which of these instruments provides you with more income? They all seem so

different because they make payments at different times. To solve this problem, we use

the concept of present value, explained earlier, to provide us with a procedure for

measuring interest rates on these different types of instruments.

Of the several common ways of calculating interest rates, the most important is the

yield to maturity, the interest rate that equates the present value of payments

received from a debt instrument with its value today.1 Because the concept behind the

calculation of the yield to maturity makes good economic sense, economists consider

it the most accurate measure of interest rates.

To understand the yield to maturity better, we now look at how it is calculated

for the four types of credit market instruments.

Simple Loan. Using the concept of present value, the yield to maturity on a simple

loan is easy to calculate. For the one-year loan we discussed, today’s value is $100,

and the payments in one year’s time would be $110 (the repayment of $100 plus the

interest payment of $10). We can use this information to solve for the yield to maturity

i by recognizing that the present value of the future payments must equal today’s

value of a loan. Making today’s value of the loan ($100) equal to the present value of

the $110 payment in a year (using Equation 1) gives us:

Solving for i,

This calculation of the yield to maturity should look familiar, because it equals

the interest payment of $10 divided by the loan amount of $100; that is, it equals the

simple interest rate on the loan. An important point to recognize is that for simple

loans, the simple interest rate equals the yield to maturity. Hence the same term i is used

to denote both the yield to maturity and the simple interest rate.

i

$110 $100

$100

$10

$100

0.10 10%

$100

$110

1 i

Yield to Maturity

64 PA RT I I Financial Markets

1In other contexts, it is also called the internal rate of return.

Study Guide The key to understanding the calculation of the yield to maturity is equating today’s

value of the debt instrument with the present value of all of its future payments. The

best way to learn this principle is to apply it to other specific examples of the four types

of credit market instruments in addition to those we discuss here. See if you can develop

the equations that would allow you to solve for the yield to maturity in each case.

Fixed-Payment Loan. Recall that this type of loan has the same payment every period

throughout the life of the loan. On a fixed-rate mortgage, for example, the borrower

makes the same payment to the bank every month until the maturity date, when the

loan will be completely paid off. To calculate the yield to maturity for a fixed-payment

loan, we follow the same strategy we used for the simple loan—we equate today’s

value of the loan with its present value. Because the fixed-payment loan involves more

than one payment, the present value of the fixed-payment loan is calculated as the

sum of the present values of all payments (using Equation 1).

In the case of our earlier example, the loan is $1,000 and the yearly payment is

$126 for the next 25 years. The present value is calculated as follows: At the end of

one year, there is a $126 payment with a PV of $126/(1 i); at the end of two years,

there is another $126 payment with a PV of $126/(1 i)2; and so on until at the end

of the twenty-fifth year, the last payment of $126 with a PV of $126/(1 i)25 is made.

Making today’s value of the loan ($1,000) equal to the sum of the present values of all

the yearly payments gives us:

More generally, for any fixed-payment loan,

(2)

where LV loan value

FP fixed yearly payment

n number of years until maturity

For a fixed-payment loan amount, the fixed yearly payment and the number of

years until maturity are known quantities, and only the yield to maturity is not. So we

can solve this equation for the yield to maturity i. Because this calculation is not easy,

many pocket calculators have programs that allow you to find i given the loan’s numbers

for LV, FP, and n. For example, in the case of the 25-year loan with yearly payments

of $126, the yield to maturity that solves Equation 2 is 12%. Real estate brokers always

have a pocket calculator that can solve such equations so that they can immediately tell

the prospective house buyer exactly what the yearly (or monthly) payments will be if

the house purchase is financed by taking out a mortgage.2

Coupon Bond. To calculate the yield to maturity for a coupon bond, follow the same

strategy used for the fixed-payment loan: Equate today’s value of the bond with its

present value. Because coupon bonds also have more than one payment, the present

LV

FP

1 i

FP

(1 i )2

FP

(1 i )3 . . .

FP

(1 i )n

$1,000

$126

1 i

$126

(1 i )2

$126

(1 i )3 . . .

$126

(1 i )25

C H A P T E R 4 Understanding Interest Rates 65

2The calculation with a pocket calculator programmed for this purpose requires simply that you enter

the value of the loan LV, the number of years to maturity n, and the interest rate i and then run the program.

value of the bond is calculated as the sum of the present values of all the coupon payments

plus the present value of the final payment of the face value of the bond.

The present value of a $1,000-face-value bond with ten years to maturity and

yearly coupon payments of $100 (a 10% coupon rate) can be calculated as follows:

At the end of one year, there is a $100 coupon payment with a PV of $100/(1 i );

at the end of the second year, there is another $100 coupon payment with a PV of

$100/(1 i )2; and so on until at maturity, there is a $100 coupon payment with a

PV of $100/(1 i )10 plus the repayment of the $1,000 face value with a PV of

$1,000/(1 i )10. Setting today’s value of the bond (its current price, denoted by P)

equal to the sum of the present values of all the payments for this bond gives:

More generally, for any coupon bond,3

(3)

where P price of coupon bond

C yearly coupon payment

F face value of the bond

n years to maturity date

In Equation 3, the coupon payment, the face value, the years to maturity, and the

price of the bond are known quantities, and only the yield to maturity is not. Hence

we can solve this equation for the yield to maturity i. Just as in the case of the fixedpayment

loan, this calculation is not easy, so business-oriented pocket calculators

have built-in programs that solve this equation for you.4

Let’s look at some examples of the solution for the yield to maturity on our 10%-

coupon-rate bond that matures in ten years. If the purchase price of the bond is

$1,000, then either using a pocket calculator with the built-in program or looking at

a bond table, we will find that the yield to maturity is 10 percent. If the price is $900,

we find that the yield to maturity is 11.75%. Table 1 shows the yields to maturity calculated

for several bond prices.

P

C

1 i

C

(1 i )2

C

(1 i )3 . . .

C

(1 i )n

F

(1 i )n

P

$100

1 i

$100

(1 i )2

$100

(1 i )3 . . .

$100

(1 i )10

$1,000

(1 i )10

66 PA RT I I Financial Markets

3Most coupon bonds actually make coupon payments on a semiannual basis rather than once a year as assumed

here. The effect on the calculations is only very slight and will be ignored here.

4The calculation of a bond’s yield to maturity with the programmed pocket calculator requires simply that you

enter the amount of the yearly coupon payment C, the face value F, the number of years to maturity n, and the

price of the bond P and then run the program.

Price of Bond ($) Yield to Maturity (%)

1,200 7.13

1,100 8.48

1,000 10.00

900 11.75

800 13.81

Table 1 Yields to Maturity on a 10%-Coupon-Rate Bond Maturing in Ten

Years (Face Value = $1,000)

Three interesting facts are illustrated by Table 1:

1. When the coupon bond is priced at its face value, the yield to maturity equals the

coupon rate.

2. The price of a coupon bond and the yield to maturity are negatively related; that

is, as the yield to maturity rises, the price of the bond falls. As the yield to maturity

falls, the price of the bond rises.

3. The yield to maturity is greater than the coupon rate when the bond price is

below its face value.

These three facts are true for any coupon bond and are really not surprising if you

think about the reasoning behind the calculation of the yield to maturity. When you

put $1,000 in a bank account with an interest rate of 10%, you can take out $100 every

year and you will be left with the $1,000 at the end of ten years. This is similar to buying

the $1,000 bond with a 10% coupon rate analyzed in Table 1, which pays a $100

coupon payment every year and then repays $1,000 at the end of ten years. If the bond

is purchased at the par value of $1,000, its yield to maturity must equal 10%, which

is also equal to the coupon rate of 10%. The same reasoning applied to any coupon

bond demonstrates that if the coupon bond is purchased at its par value, the yield to

maturity and the coupon rate must be equal.

It is straightforward to show that the bond price and the yield to maturity are negatively

related. As i, the yield to maturity, rises, all denominators in the bond price formula

must necessarily rise. Hence a rise in the interest rate as measured by the yield

to maturity means that the price of the bond must fall. Another way to explain why

the bond price falls when the interest rises is that a higher interest rate implies that

the future coupon payments and final payment are worth less when discounted back

to the present; hence the price of the bond must be lower.

There is one special case of a coupon bond that is worth discussing because its

yield to maturity is particularly easy to calculate. This bond is called a consol or a perpetuity;

it is a perpetual bond with no maturity date and no repayment of principal

that makes fixed coupon payments of $C forever. Consols were first sold by the

British Treasury during the Napoleonic Wars and are still traded today; they are quite

rare, however, in American capital markets. The formula in Equation 3 for the price

of the consol P simplifies to the following:5

P (4)

C

C H A P T E R 4 Understanding Interest Rates 67

5The bond price formula for a consol is:

which can be written as:

in which x 1/(1 i). The formula for an infinite sum is:

and so:

which by suitable algebraic manipulation becomes:

P C 1 i

i

C

P C 1

1 x

1 C c 1

1 1(1 i )

1 d

1 x x 2 x 3 . . .

1

1 x

for x 1

P C (x x 2 x 3 . . . )

P

C

1 i

C

(1 i )2

C

(1 i )3 . . .

where P = price of the consol

C = yearly payment

One nice feature of consols is that you can immediately see that as i goes up, the

price of the bond falls. For example, if a consol pays $100 per year forever and the

interest rate is 10%, its price will be $1,000 $100/0.10. If the interest rate rises to

20%, its price will fall to $500 $100/0.20. We can also rewrite this formula as

(5)

We see then that it is also easy to calculate the yield to maturity for the consol

(despite the fact that it never matures). For example, with a consol that pays $100

yearly and has a price of $2,000, the yield to maturity is easily calculated to be 5%

( $100/$2,000).

Discount Bond. The yield-to-maturity calculation for a discount bond is similar to

that for the simple loan. Let us consider a discount bond such as a one-year U.S.

Treasury bill, which pays off a face value of $1,000 in one year’s time. If the current

purchase price of this bill is $900, then equating this price to the present value of the

$1,000 received in one year, using Equation 1, gives:

and solving for i,

More generally, for any one-year discount bond, the yield to maturity can be written

as:

(6)

where F face value of the discount bond

P current price of the discount bond

In other words, the yield to maturity equals the increase in price over the year

F – P divided by the initial price P. In normal circumstances, investors earn positive

returns from holding these securities and so they sell at a discount, meaning that the

current price of the bond is below the face value. Therefore, F – P should be positive,

and the yield to maturity should be positive as well. However, this is not always the

case, as recent extraordinary events in Japan indicate (see Box 1).

An important feature of this equation is that it indicates that for a discount bond,

the yield to maturity is negatively related to the current bond price. This is the same

conclusion that we reached for a coupon bond. For example, Equation 6 shows that

a rise in the bond price from $900 to $950 means that the bond will have a smaller

i

F P

P

i

$1,000 $900

$900

0.111 11.1%

$900i $1,000 $900

$900 $900i $1,000

(1 i ) $900 $1,000

$900

$1,000

1 i

i

C

P

68 PA RT I I Financial Markets

increase in its price at maturity, and the yield to maturity falls from 11.1 to 5.3%.

Similarly, a fall in the yield to maturity means that the price of the discount bond has

risen.

Summary. The concept of present value tells you that a dollar in the future is not as

valuable to you as a dollar today because you can earn interest on this dollar.

Specifically, a dollar received n years from now is worth only $1/(1 i )n today. The

present value of a set of future payments on a debt instrument equals the sum of the

present values of each of the future payments. The yield to maturity for an instrument

is the interest rate that equates the present value of the future payments on that instrument

to its value today. Because the procedure for calculating the yield to maturity is

based on sound economic principles, this is the measure that economists think most

accurately describes the interest rate.

Our calculations of the yield to maturity for a variety of bonds reveal the important

fact that current bond prices and interest rates are negatively related: When the

interest rate rises, the price of the bond falls, and vice versa.

Other Measures of Interest Rates

The yield to maturity is the most accurate measure of interest rates; this is what economists

mean when they use the term interest rate. Unless otherwise specified, the

terms interest rate and yield to maturity are used synonymously in this book. However,

because the yield to maturity is sometimes difficult to calculate, other, less accurate

C H A P T E R 4 Understanding Interest Rates 69

Box 1: Global

Negative T-Bill Rates? Japan Shows the Way

We normally assume that interest rates must always

be positive. Negative interest rates would imply that

you are willing to pay more for a bond today than

you will receive for it in the future (as our formula for

yield to maturity on a discount bond demonstrates).

Negative interest rates therefore seem like an impossibility

because you would do better by holding cash

that has the same value in the future as it does today.

The Japanese have demonstrated that this reasoning

is not quite correct. In November 1998, interest rates

on Japanese six-month Treasury bills became negative,

yielding an interest rate of –0.004%, with investors

paying more for the bills than their face value. This is

an extremely unusual event—no other country in the

world has seen negative interest rates during the last

fifty years. How could this happen?

As we will see in Chapter 5, the weakness of the

Japanese economy and a negative inflation rate drove

Japanese interest rates to low levels, but these two

factors can’t explain the negative rates. The answer is

that large investors found it more convenient to hold

these six-month bills as a store of value rather than

holding cash because the bills are denominated in

larger amounts and can be stored electronically. For

that reason, some investors were willing to hold

them, despite their negative rates, even though in

monetary terms the investors would be better off

holding cash. Clearly, the convenience of T-bills goes

only so far, and thus their interest rates can go only a

little bit below zero.

www.teachmefinance.com

A review of the key

financial concepts: time value

of money, annuities,

perpetuities, and so on.

measures of interest rates have come into common use in bond markets. You will frequently

encounter two of these measures—the current yield and the yield on a discount

basis—when reading the newspaper, and it is important for you to understand what

they mean and how they differ from the more accurate measure of interest rates, the

yield to maturity.

The current yield is an approximation of the yield to maturity on coupon bonds that is

often reported, because in contrast to the yield to maturity, it is easily calculated. It is

defined as the yearly coupon payment divided by the price of the security,

(7)

where ic current yield

P price of the coupon bond

C yearly coupon payment

This formula is identical to the formula in Equation 5, which describes the calculation

of the yield to maturity for a consol. Hence, for a consol, the current yield is

an exact measure of the yield to maturity. When a coupon bond has a long term to

maturity (say, 20 years or more), it is very much like a consol, which pays coupon payments

forever. Thus you would expect the current yield to be a rather close approximation

of the yield to maturity for a long-term coupon bond, and you can safely use

the current-yield calculation instead of calculating the yield to maturity with a financial

calculator. However, as the time to maturity of the coupon bond shortens (say, it

becomes less than five years), it behaves less and less like a consol and so the approximation

afforded by the current yield becomes worse and worse.

We have also seen that when the bond price equals the par value of the bond, the

yield to maturity is equal to the coupon rate (the coupon payment divided by the par

value of the bond). Because the current yield equals the coupon payment divided by the

bond price, the current yield is also equal to the coupon rate when the bond price is at

par. This logic leads us to the conclusion that when the bond price is at par, the current

yield equals the yield to maturity. This means that the closer the bond price is to the

bond’s par value, the better the current yield will approximate the yield to maturity.

The current yield is negatively related to the price of the bond. In the case

of our 10%-coupon-rate bond, when the price rises from $1,000 to $1,100, the current

yield falls from 10% ( $100/$1,000) to 9.09% ( $100/$1,100). As Table 1

indicates, the yield to maturity is also negatively related to the price of the bond; when

the price rises from $1,000 to $1,100, the yield to maturity falls from 10 to 8.48%.

In this we see an important fact: The current yield and the yield to maturity always

move together; a rise in the current yield always signals that the yield to maturity has

also risen.

The general characteristics of the current yield (the yearly coupon payment

divided by the bond price) can be summarized as follows: The current yield better

approximates the yield to maturity when the bond’s price is nearer to the bond’s par

value and the maturity of the bond is longer. It becomes a worse approximation when

the bond’s price is further from the bond’s par value and the bond’s maturity is shorter.

Regardless of whether the current yield is a good approximation of the yield to maturity,

a change in the current yield always signals a change in the same direction of the

yield to maturity.

ic

C

P

Current Yield

70 PA RT I I Financial Markets

Before the advent of calculators and computers, dealers in U.S. Treasury bills found it

difficult to calculate interest rates as a yield to maturity. Instead, they quoted the interest

rate on bills as a yield on a discount basis (or discount yield), and they still do

so today. Formally, the yield on a discount basis is defined by the following formula:

(8)

where idb yield on a discount basis

F face value of the discount bond

P purchase price of the discount bond

This method for calculating interest rates has two peculiarities. First, it uses the

percentage gain on the face value of the bill (F P)/F rather than the percentage gain

on the purchase price of the bill (F P)/P used in calculating the yield to maturity.

Second, it puts the yield on an annual basis by considering the year to be 360 days

long rather than 365 days.

Because of these peculiarities, the discount yield understates the interest rate on

bills as measured by the yield to maturity. On our one-year bill, which is selling for

$900 and has a face value of $1,000, the yield on a discount basis would be as follows:

whereas the yield to maturity for this bill, which we calculated before, is 11.1%. The

discount yield understates the yield to maturity by a factor of over 10%. A little more

than 1% ([365 360]/360 0.014 1.4%) can be attributed to the understatement

of the length of the year: When the bill has one year to maturity, the second term on

the right-hand side of the formula is 360/365 0.986 rather than 1.0, as it should be.

The more serious source of the understatement, however, is the use of the percentage

gain on the face value rather than on the purchase price. Because, by definition,

the purchase price of a discount bond is always less than the face value, the

percentage gain on the face value is necessarily smaller than the percentage gain on

the purchase price. The greater the difference between the purchase price and the face

value of the discount bond, the more the discount yield understates the yield to maturity.

Because the difference between the purchase price and the face value gets larger

as maturity gets longer, we can draw the following conclusion about the relationship

of the yield on a discount basis to the yield to maturity: The yield on a discount basis

always understates the yield to maturity, and this understatement becomes more

severe the longer the maturity of the discount bond.

Another important feature of the discount yield is that, like the yield to maturity,

it is negatively related to the price of the bond. For example, when the price of

the bond rises from $900 to $950, the formula indicates that the yield on a discount

basis declines from 9.9 to 4.9%. At the same time, the yield to maturity declines from

11.1 to 5.3%. Here we see another important factor about the relationship of yield

on a discount basis to yield to maturity: They always move together. That is, a rise in

the discount yield always means that the yield to maturity has risen, and a decline in the

discount yield means that the yield to maturity has declined as well.

The characteristics of the yield on a discount basis can be summarized as follows:

Yield on a discount basis understates the more accurate measure of the interest rate,

the yield to maturity; and the longer the maturity of the discount bond, the greater

idb

$1,000 $900

$1,000

360

365

0.099 9.9%

idb

F P

F

360

days to maturity

Yield on a

Discount Basis

C H A P T E R 4 Understanding Interest Rates 71

this understatement becomes. Even though the discount yield is a somewhat misleading

measure of the interest rates, a change in the discount yield always indicates

a change in the same direction for the yield to maturity.

72 PA RT I I Financial Markets

Application Reading the Wall Street Journal: The Bond Page

Now that we understand the different interest-rate definitions, let’s apply our

knowledge and take a look at what kind of information appears on the bond

page of a typical newspaper, in this case the Wall Street Journal. The

“Following the Financial News” box contains the Journal’s listing for three

different types of bonds on Wednesday, January 23, 2003. Panel (a) contains

the information on U.S. Treasury bonds and notes. Both are coupon bonds,

the only difference being their time to maturity from when they were originally

issued: Notes have a time to maturity of less than ten years; bonds have

a time to maturity of more than ten years.

The information found in the “Rate” and “Maturity” columns identifies

the bond by coupon rate and maturity date. For example, T-bond 1 has a

coupon rate of 4.75%, indicating that it pays out $47.50 per year on a

$1,000-face-value bond and matures in January 2003. In bond market parlance,

it is referred to as the Treasury’s 4 s of 2003. The next three columns

tell us about the bond’s price. By convention, all prices in the bond market

are quoted per $100 of face value. Furthermore, the numbers after the colon

represent thirty-seconds (x/32, or 32nds). In the case of T-bond 1, the first

price of 100:02 represents 100 100.0625, or an actual price of $1000.62

for a $1,000-face-value bond. The bid price tells you what price you will

receive if you sell the bond, and the asked price tells you what you must pay

for the bond. (You might want to think of the bid price as the “wholesale”

price and the asked price as the “retail” price.) The “Chg.” column indicates

how much the bid price has changed in 32nds (in this case, no change) from

the previous trading day.

Notice that for all the bonds and notes, the asked price is more than the bid

price. Can you guess why this is so? The difference between the two (the spread )

provides the bond dealer who trades these securities with a profit. For T-bond 1,

the dealer who buys it at 100 , and sells it for 100 , makes a profit of . This

profit is what enables the dealer to make a living and provide the service of

allowing you to buy and sell bonds at will.

The “Ask Yld.” column provides the yield to maturity, which is 0.43% for

T-bond 1. It is calculated with the method described earlier in this chapter

using the asked price as the price of the bond. The asked price is used in the

calculation because the yield to maturity is most relevant to a person who is

going to buy and hold the security and thus earn the yield. The person selling

the security is not going to be holding it and hence is less concerned with

the yield.

The figure for the current yield is not usually included in the newspaper’s

quotations for Treasury securities, but it has been added in panel (a) to give

you some real-world examples of how well the current yield approximates

1

32

3

32

2

32

2

32

3

4

C H A P T E R 4 Understanding Interest Rates 73

Following the Financial News

Bond prices and interest rates are published daily. In

the Wall Street Journal, they can be found in the

“NYSE/AMEX Bonds” and “Treasury/Agency Issues”

section of the paper. Three basic formats for quoting

bond prices and yields are illustrated here.

Bond Prices and Interest Rates

TREASURY BILLS

GOVT. BONDS & NOTES

Maturity Ask

Rate Mo/Yr Bid Asked Chg. Yld.

4.750 Jan 03n 100:02 100:03 . . . 0.43

5.500 Jan 03n 100:02 100:03 —1 0.46

5.750 Aug 03n 102:17 102:18 . . . 0.16

11.125 Aug 03 105:16 105:17 —1 1.22

5.250 Feb 29 103:17 103:18 23 5.00

3.875 Apr 29i 122:03 122:04 2 2.69

6.125 Aug 29 116:10 116:11 24 5.00

5.375 Feb 31 107:27 107:28 24 4.86

T-bond 1

T-bond 2

T-bond 3

T-bond 4

Current Yield 4.75%

Current Yield 10.55%

Current Yield 5.07%

Current Yield 4.98%

(a) Treasury bonds

and notes

(b) Treasury bills

Source: Wall Street Journal, Thursday, January 23, 2003, p. C11.

Days

to Ask

Maturity Mat. Bid Asked Chg. Yld.

May 01 03 98 1.14 1.13 –0.02 1.15

May 08 03 105 1.14 1.13 –0.03 1.15

May 15 03 112 1.15 1.14 –0.02 1.16

May 22 03 119 1.15 1.14 –0.02 1.16

May 29 03 126 1.15 1.14 –0.01 1.16

Jun 05 03 133 1.15 1.14 –0.02 1.16

Jun 12 03 140 1.16 1.15 –0.01 1.17

Jun 19 03 147 1.15 1.14 –0.02 1.16

Jun 26 03 154 1.15 1.14 –0.01 1.16

Jul 03 03 161 1.15 1.14 –0.02 1.16

Jul 10 03 168 1.16 1.15 –0.02 1.17

Jul 17 03 175 1.16 1.15 –0.03 1.17

Jul 24 03 182 1.17 1.16 . . . 1.18

Representative Over-the-Counter quotation based on transactions of $1

million or more.

Treasury bond, note and bill quotes are as of mid-afternoon. Colons

in bid-and-asked quotes represent 32nds; 101:01 means 101 1/32. Net

changes in 32nds. n-Treasury note. i-Inflation-Indexed issue. Treasury bill

quotes in hundredths, quoted on terms of a rate of discount. Days to

maturity calculated from settlement date. All yields are to maturity and

based on the asked quote. Latest 13-week and 26-week bills are boldfaced.

For bonds callable prior to maturity, yields are computed to the

earliest call date for issues quoted above par and to the maturity date

for issues below par. *When issued.

Source: eSpeed/Cantor Fitzgerald

U.S. Treasury strips as of 3 p.m. Eastern time, also based on

transactions of $1 million or more. Colons in bid and asked quotes represent

32nds; 99:01 means 99 1/32. Net changes in 32nds. Yields

calculated on the asked quotation. ci-stripped coupon interest. bp-

Treasury bond, stripped principal. np-Treasury note, stripped principal.

For bonds callable prior to maturity, yields are computed to the earliest

call date for issues quoted above par and to the maturity date for

issues below par.

Source: Bear, Stearns & Co. via Street Software Technology, Inc.

Days

to Ask

Maturity Mat. Bid Asked Chg. Yld.

Jan 30 03 7 1.15 1.14 –0.01 1.16

Feb 06 03 14 1.14 1.13 –0.01 1.15

Feb 13 03 21 1.14 1.13 –0.01 1.15

Feb 20 03 28 1.14 1.13 . . . 1.15

Feb 27 03 35 1.13 1.12 –0.01 1.14

Mar 06 03 42 1.13 1.12 . . . 1.14

Mar 13 03 49 1.13 1.12 –0.01 1.14

Mar 20 03 56 1.12 1.11 –0.01 1.13

Mar 27 03 63 1.13 1.12 –0.01 1.14

Apr 03 03 70 1.13 1.12 –0.01 1.14

Apr 10 03 77 1.12 1.11 –0.03 1.13

Apr 17 03 84 1.14 1.13 –0.01 1.15

Apr 24 03 91 1.15 1.14 . . . 1.16

(c) New York Stock

Exchange bonds

NEW YORK BONDS

CORPORATION BONDS

Cur Net

Bonds Yld Vol Close Chg.

AT&T 55/804 5.5 238 101.63 . . .

AT&T 63/804 6.2 60 102.63 –0.13

AT&T 71/204 7.2 101 103.63 –0.13

AT&T 81/824 8.0 109 101 0.38

ATT 8.35s25 8.3 60 101 0.50

AT&T 61/229 7.5 190 87.25 0.13

AT&T 85/831 8.4 138 102.75 0.88

Bond 1

Bond 2

Yield to Maturity 3.68%

Yield to Maturity 8.40%

TREASURY BONDS, NOTES AND BILLS

January 22, 2003

74 PA RT I I Financial Markets

the yield to maturity. Our previous discussion provided us with some rules

for deciding when the current yield is likely to be a good approximation and

when it is not.

T-bonds 3 and 4 mature in around 30 years, meaning that their characteristics

are like those of a consol. The current yields should then be a good

approximation of the yields to maturity, and they are: The current yields are

within two-tenths of a percentage point of the values for the yields to maturity.

This approximation is reasonable even for T-bond 4, which has a price

about 7% above its face value.

Now let’s take a look at T-bonds 1 and 2, which have a much shorter

time to maturity. The price of T-bond 1 differs by less than 1% from the par

value, and look how poor an approximation the current yield is for the

yield to maturity; it overstates the yield to maturity by more than 4 percentage

points. The approximation for T-bond 2 is even worse, with the

overstatement over 9 percentage points. This bears out what we learned

earlier about the current yield: It can be a very misleading guide to the

value of the yield to maturity for a short-term bond if the bond price is not

extremely close to par.

Two other categories of bonds are reported much like the Treasury

bonds and notes in the newspaper. Government agency and miscellaneous

securities include securities issued by U.S. government agencies such as the

Government National Mortgage Association, which makes loans to savings

and loan institutions, and international agencies such as the World Bank.

Tax-exempt bonds are the other category reported in a manner similar to

panel (a), except that yield-to-maturity calculations are not usually provided.

Tax-exempt bonds include bonds issued by local government and public

authorities whose interest payments are exempt from federal income taxes.

Panel (b) quotes yields on U.S. Treasury bills, which, as we have seen,

are discount bonds. Since there is no coupon, these securities are identified

solely by their maturity dates, which you can see in the first column. The

next column, “Days to Mat.,” provides the number of days to maturity of the

bill. Dealers in these markets always refer to prices by quoting the yield on a

discount basis. The “Bid” column gives the discount yield for people selling

the bills to dealers, and the “Asked” column gives the discount yield for people

buying the bills from dealers. As with bonds and notes, the dealers’ profits

are made by the asked price being higher than the bid price, leading to the

asked discount yield being lower than the bid discount yield.

The “Chg.” column indicates how much the asked discount yield

changed from the previous day. When financial analysts talk about changes

in the yield, they frequently describe the changes in terms of basis points,

which are hundredths of a percentage point. For example, a financial analyst

would describe the 0.01 change in the asked discount yield for the

February 13, 2003, T-bill by saying that it had fallen by 1 basis point.

As we learned earlier, the yield on a discount basis understates the

yield to maturity, which is reported in the column of panel (b) headed “Ask

Yld.” This is evident from a comparison of the “Ask Yld.” and “Asked”

columns. As we would also expect from our discussion of the calculation of

yields on a discount basis, the understatement grows as the maturity of the

bill lengthens.

The Distinction Between

Interest Rates and Returns

Many people think that the interest rate on a bond tells them all they need to know

about how well off they are as a result of owning it. If Irving the Investor thinks he is

better off when he owns a long-term bond yielding a 10% interest rate and the interest

rate rises to 20%, he will have a rude awakening: As we will shortly see, if he has

to sell the bond, Irving has lost his shirt! How well a person does by holding a bond

or any other security over a particular time period is accurately measured by the

return, or, in more precise terminology, the rate of return. For any security, the rate

of return is defined as the payments to the owner plus the change in its value,

expressed as a fraction of its purchase price. To make this definition clearer, let us see

what the return would look like for a $1,000-face-value coupon bond with a coupon

rate of 10% that is bought for $1,000, held for one year, and then sold for $1,200. The

payments to the owner are the yearly coupon payments of $100, and the change in its

value is $1,200 $1,000 $200. Adding these together and expressing them as a

fraction of the purchase price of $1,000 gives us the one-year holding-period return

for this bond:

You may have noticed something quite surprising about the return that we have

just calculated: It equals 30%, yet as Table 1 indicates, initially the yield to maturity

was only 10 percent. This demonstrates that the return on a bond will not necessarily

equal the interest rate on that bond. We now see that the distinction between

interest rate and return can be important, although for many securities the two may

be closely related.

$100 $200

$1,000

$300

$1,000

0.30 30%

C H A P T E R 4 Understanding Interest Rates 75

Panel (c) has quotations for corporate bonds traded on the New York

Stock Exchange. Corporate bonds traded on the American Stock Exchange

are reported in like manner. The first column identifies the bond by indicating

the corporation that issued it. The bonds we are looking at have all been

issued by American Telephone and Telegraph (AT&T). The next column tells

the coupon rate and the maturity date (5 and 2004 for Bond 1). The “Cur.

Yld.” column reports the current yield (5.5), and “Vol.” gives the volume of

trading in that bond (238 bonds of $1,000 face value traded that day). The

“Close” price is the last traded price that day per $100 of face value. The price

of 101.63 represents $1016.30 for a $1,000-face-value bond. The “Net Chg.”

is the change in the closing price from the previous trading day.

The yield to maturity is also given for two bonds. This information is

not usually provided in the newspaper, but it is included here because it

shows how misleading the current yield can be for a bond with a short maturity

such as the 5 s, of 2004. The current yield of 5.5% is a misleading measure

of the interest rate because the yield to maturity is actually 3.68 percent.

By contrast, for the 8 s, of 2031, with nearly 30 years to maturity, the current

yield and the yield to maturity are exactly equal.

58

58

5

8

Study Guide The concept of return discussed here is extremely important because it is used continually

throughout the book. Make sure that you understand how a return is calculated

and why it can differ from the interest rate. This understanding will make the

material presented later in the book easier to follow.

More generally, the return on a bond held from time t to time t 1 can be written

as:

(9)

where RET return from holding the bond from time t to time t 1

Pt price of the bond at time t

Pt1 price of the bond at time t 1

C coupon payment

A convenient way to rewrite the return formula in Equation 9 is to recognize that

it can be split into two separate terms:

The first term is the current yield ic (the coupon payment over the purchase price):

The second term is the rate of capital gain, or the change in the bond’s price relative

to the initial purchase price:

where g rate of capital gain. Equation 9 can then be rewritten as:

(10)

which shows that the return on a bond is the current yield ic plus the rate of capital

gain g. This rewritten formula illustrates the point we just discovered. Even for a bond

for which the current yield ic is an accurate measure of the yield to maturity, the return

can differ substantially from the interest rate. Returns will differ from the interest rate,

especially if there are sizable fluctuations in the price of the bond that produce substantial

capital gains or losses.

To explore this point even further, let’s look at what happens to the returns on

bonds of different maturities when interest rates rise. Table 2 calculates the one-year

return on several 10%-coupon-rate bonds all purchased at par when interest rates on

RET ic g

Pt1 Pt

Pt

g

C

Pt

ic

RET

C

Pt

Pt1 Pt

Pt

RET

C Pt1 Pt

Pt

76 PA RT I I Financial Markets

all these bonds rise from 10 to 20%. Several key findings in this table are generally

true of all bonds:

• The only bond whose return equals the initial yield to maturity is one whose time

to maturity is the same as the holding period (see the last bond in Table 2).

• A rise in interest rates is associated with a fall in bond prices, resulting in capital

losses on bonds whose terms to maturity are longer than the holding period.

• The more distant a bond’s maturity, the greater the size of the percentage price

change associated with an interest-rate change.

• The more distant a bond’s maturity, the lower the rate of return that occurs as a

result of the increase in the interest rate.

• Even though a bond has a substantial initial interest rate, its return can turn out

to be negative if interest rates rise.

At first it frequently puzzles students (as it puzzles poor Irving the Investor) that

a rise in interest rates can mean that a bond has been a poor investment. The trick to

understanding this is to recognize that a rise in the interest rate means that the price

of a bond has fallen. A rise in interest rates therefore means that a capital loss has

occurred, and if this loss is large enough, the bond can be a poor investment indeed.

For example, we see in Table 2 that the bond that has 30 years to maturity when purchased

has a capital loss of 49.7% when the interest rate rises from 10 to 20%. This

loss is so large that it exceeds the current yield of 10%, resulting in a negative return

(loss) of 39.7%. If Irving does not sell the bond, his capital loss is often referred to

as a “paper loss.” This is a loss nonetheless because if he had not bought this bond

and had instead put his money in the bank, he would now be able to buy more bonds

at their lower price than he presently owns.

C H A P T E R 4 Understanding Interest Rates 77

(1)

Years to (2) (4) (5) (6)

Maturity Initial (3) Price Rate of Rate of

When Current Initial Next Capital Return

Bond Is Yield Price Year* Gain (2 + 5)

Purchased (%) ($) ($) (%) (%)

30 10 1,000 503 49.7 39.7

20 10 1,000 516 48.4 38.4

10 10 1,000 597 40.3 30.3

5 10 1,000 741 25.9 15.9

2 10 1,000 917 8.3 1.7

1 10 1,000 1,000 0.0 10.0

*Calculated using Equation 3.

Table 2 One-Year Returns on Different-Maturity 10%-Coupon-Rate

Bonds When Interest Rates Rise from 10% to 20%

The finding that the prices of longer-maturity bonds respond more dramatically to

changes in interest rates helps explain an important fact about the behavior of bond markets:

Prices and returns for long-term bonds are more volatile than those for shorterterm

bonds. Price changes of 20% and 20% within a year, with corresponding

variations in returns, are common for bonds more than 20 years away from maturity.

We now see that changes in interest rates make investments in long-term bonds

quite risky. Indeed, the riskiness of an asset’s return that results from interest-rate

changes is so important that it has been given a special name, interest-rate risk.6

Dealing with interest-rate risk is a major concern of managers of financial institutions

and investors, as we will see in later chapters (see also Box 2).

Although long-term debt instruments have substantial interest-rate risk, shortterm

debt instruments do not. Indeed, bonds with a maturity that is as short as the

holding period have no interest-rate risk.7We see this for the coupon bond at the bottom

of Table 2, which has no uncertainty about the rate of return because it equals

the yield to maturity, which is known at the time the bond is purchased. The key to

understanding why there is no interest-rate risk for any bond whose time to maturity

matches the holding period is to recognize that (in this case) the price at the end of

the holding period is already fixed at the face value. The change in interest rates can

then have no effect on the price at the end of the holding period for these bonds, and

the return will therefore be equal to the yield to maturity known at the time the bond

is purchased.8

Maturity and the

Volatility of Bond

Returns: Interest-

Rate Risk

78 PA RT I I Financial Markets

6Interest-rate risk can be quantitatively measured using the concept of duration. This concept and how it is

calculated is discussed in an appendix to this chapter, which can be found on this book’s web site at

www.aw.com/mishkin.

7The statement that there is no interest-rate risk for any bond whose time to maturity matches the holding period

is literally true only for discount bonds and zero-coupon bonds that make no intermediate cash payments before

the holding period is over. A coupon bond that makes an intermediate cash payment before the holding period

is over requires that this payment be reinvested. Because the interest rate at which this payment can be reinvested

is uncertain, there is some uncertainty about the return on this coupon bond even when the time to maturity

equals the holding period. However, the riskiness of the return on a coupon bond from reinvesting the coupon

payments is typically quite small, and so the basic point that a coupon bond with a time to maturity equaling the

holding period has very little risk still holds true.

8In the text, we are assuming that all holding periods are short and equal to the maturity on short-term bonds and

are thus not subject to interest-rate risk. However, if an investor’s holding period is longer than the term to maturity

of the bond, the investor is exposed to a type of interest-rate risk called reinvestment risk. Reinvestment risk occurs

because the proceeds from the short-term bond need to be reinvested at a future interest rate that is uncertain.

To understand reinvestment risk, suppose that Irving the Investor has a holding period of two years and

decides to purchase a $1,000 one-year bond at face value and will then purchase another one at the end of the

first year. If the initial interest rate is 10%, Irving will have $1,100 at the end of the year. If the interest rate rises

to 20%, as in Table 2, Irving will find that buying $1,100 worth of another one-year bond will leave him at the

end of the second year with $1,100 (1 0.20) $1,320. Thus Irving’s two-year return will be

($1,320 $1,000)/1,000 0.32 32%, which equals 14.9% at an annual rate. In this case, Irving has earned

more by buying the one-year bonds than if he had initially purchased the two-year bond with an interest rate of

10%. Thus when Irving has a holding period that is longer than the term to maturity of the bonds he purchases,

he benefits from a rise in interest rates. Conversely, if interest rates fall to 5%, Irving will have only $1,155 at the

end of two years: $1,100 (1 0.05). Thus his two-year return will be ($1,155 $1,000)/1,000 0.155

15.5%, which is 7.2 percent at an annual rate. With a holding period greater than the term to maturity of the

bond, Irving now loses from a fall in interest rates.

We have thus seen that when the holding period is longer than the term to maturity of a bond, the return is

uncertain because the future interest rate when reinvestment occurs is also uncertain—in short, there is reinvestment

risk. We also see that if the holding period is longer than the term to maturity of the bond, the investor

benefits from a rise in interest rates and is hurt by a fall in interest rates.

The return on a bond, which tells you how good an investment it has been over the

holding period, is equal to the yield to maturity in only one special case: when the

holding period and the maturity of the bond are identical. Bonds whose term to

maturity is longer than the holding period are subject to interest-rate risk: Changes

in interest rates lead to capital gains and losses that produce substantial differences

between the return and the yield to maturity known at the time the bond is purchased.

Interest-rate risk is especially important for long-term bonds, where the capital

gains and losses can be substantial. This is why long-term bonds are not

considered to be safe assets with a sure return over short holding periods.

The Distinction Between Real and

Nominal Interest Rates

So far in our discussion of interest rates, we have ignored the effects of inflation on the

cost of borrowing. What we have up to now been calling the interest rate makes no

allowance for inflation, and it is more precisely referred to as the nominal interest rate,

which is distinguished from the real interest rate, the interest rate that is adjusted by

subtracting expected changes in the price level (inflation) so that it more accurately

reflects the true cost of borrowing.9 The real interest rate is more accurately defined by

the Fisher equation, named for Irving Fisher, one of the great monetary economists of the

Summary

C H A P T E R 4 Understanding Interest Rates 79

Box 2

Helping Investors to Select Desired Interest-Rate Risk

Because many investors want to know how much

interest-rate risk they are exposed to, some mutual

fund companies try to educate investors about the perils

of interest-rate risk, as well as to offer investment

alternatives that match their investors’ preferences.

Vanguard Group, for example, offers eight separate

high-grade bond mutual funds. In its prospectus,

Vanguard separates the funds by the average maturity

of the bonds they hold and demonstrates the effect of

interest-rate changes by computing the percentage

change in bond value resulting from a 1% increase

and decrease in interest rates. Three of the bond funds

invest in bonds with average maturities of one to three

years, which Vanguard rates as having the lowest

interest-rate risk. Three other funds hold bonds with

average maturities of five to ten years, which Vanguard

rates as having medium interest-rate risk. Two funds

hold long-term bonds with maturities of 15 to 30

years, which Vanguard rates as having high interestrate

risk.

By providing this information, Vanguard hopes to

increase its market share in the sales of bond funds.

Not surprisingly, Vanguard is one of the most successful

mutual fund companies in the business.

9The real interest rate defined in the text is more precisely referred to as the ex ante real interest rate because it is

adjusted for expected changes in the price level. This is the real interest rate that is most important to economic

decisions, and typically it is what economists mean when they make reference to the “real” interest rate. The interest

rate that is adjusted for actual changes in the price level is called the ex post real interest rate. It describes how

well a lender has done in real terms after the fact.

www.martincapital.com

/charts.htm

Go to charts of real versus

nominal rates to view 30 years of

nominal interest rates compared

to real rates for the 30-year

T-bond and 90-day T-bill.

twentieth century. The Fisher equation states that the nominal interest rate i equals

the real interest rate ir plus the expected rate of inflation e:10

(11)

Rearranging terms, we find that the real interest rate equals the nominal interest rate

minus the expected inflation rate:

(12)

To see why this definition makes sense, let us first consider a situation in which

you have made a one-year simple loan with a 5% interest rate (i 5%) and you

expect the price level to rise by 3% over the course of the year (e 3%). As a result

of making the loan, at the end of the year you will have 2% more in real terms, that

is, in terms of real goods and services you can buy. In this case, the interest rate you

have earned in terms of real goods and services is 2%; that is,

as indicated by the Fisher definition.

Now what if the interest rate rises to 8%, but you expect the inflation rate to be

10% over the course of the year? Although you will have 8% more dollars at the end

of the year, you will be paying 10% more for goods; the result is that you will be able

to buy 2% fewer goods at the end of the year and you are 2% worse off in real terms.

This is also exactly what the Fisher definition tells us, because:

ir 8% 10% 2%

As a lender, you are clearly less eager to make a loan in this case, because in

terms of real goods and services you have actually earned a negative interest rate of

2%. By contrast, as the borrower, you fare quite well because at the end of the year,

the amounts you will have to pay back will be worth 2% less in terms of goods and

services—you as the borrower will be ahead by 2% in real terms. When the real interest

rate is low, there are greater incentives to borrow and fewer incentives to lend.

A similar distinction can be made between nominal returns and real returns.

Nominal returns, which do not allow for inflation, are what we have been referring to

as simply “returns.” When inflation is subtracted from a nominal return, we have the

real return, which indicates the amount of extra goods and services that can be purchased

as a result of holding the security.

The distinction between real and nominal interest rates is important because the

real interest rate, which reflects the real cost of borrowing, is likely to be a better indicator

of the incentives to borrow and lend. It appears to be a better guide to how peoir

5% 3% 2%

ir i e

i ir e

80 PA RT I I Financial Markets

10A more precise formulation of the Fisher equation is:

because:

and subtracting 1 from both sides gives us the first equation. For small values of ir and e, the term

ir e is so small that we ignore it, as in the text.

1 i (1 ir )(1 e ) 1 ir e (ir e )

i ir e (ir e )

ple will be affected by what is happening in credit markets. Figure 1, which presents

estimates from 1953 to 2002 of the real and nominal interest rates on three-month

U.S. Treasury bills, shows us that nominal and real rates often do not move together.

(This is also true for nominal and real interest rates in the rest of the world.) In particular,

when nominal rates in the United States were high in the 1970s, real rates

were actually extremely low—often negative. By the standard of nominal interest

rates, you would have thought that credit market conditions were tight in this period,

because it was expensive to borrow. However, the estimates of the real rates indicate

that you would have been mistaken. In real terms, the cost of borrowing was actually

quite low.11

C H A P T E R 4 Understanding Interest Rates 81

F I G U R E 1 Real and Nominal Interest Rates (Three-Month Treasury Bill), 1953–2002

Sources: Nominal rates from www.federalreserve.gov/releases/H15. The real rate is constructed using the procedure outlined in Frederic S. Mishkin, “The Real

Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151–200. This procedure involves estimating expected

inflation as a function of past interest rates, inflation, and time trends and then subtracting the expected inflation measure from the nominal interest rate.

16

12

8

4

0

–4

1955 1960 1970 1990 2000

Interest Rate (%)

1965 1975 1980 1985 1995

Estimated Real Rate

Nominal Rate

11Because most interest income in the United States is subject to federal income taxes, the true earnings in real

terms from holding a debt instrument are not reflected by the real interest rate defined by the Fisher equation but

rather by the after-tax real interest rate, which equals the nominal interest rate after income tax payments have been

subtracted, minus the expected inflation rate. For a person facing a 30% tax rate, the after-tax interest rate earned

on a bond yielding 10% is only 7% because 30% of the interest income must be paid to the Internal Revenue

Service. Thus the after-tax real interest rate on this bond when expected inflation is 5% equals 2% ( 7% 5%).

More generally, the after-tax real interest rate can be expressed as:

where the income tax rate.

This formula for the after-tax real interest rate also provides a better measure of the effective cost of borrowing

for many corporations and homeowners in the United States because in calculating income taxes, they can deduct

i (1 ) e

Until recently, real interest rates in the United States were not observable; only

nominal rates were reported. This all changed when, in January 1997, the U.S.

Treasury began to issue indexed bonds, whose interest and principal payments are

adjusted for changes in the price level (see Box 3).

82 PA RT I I Financial Markets

Box 3

With TIPS, Real Interest Rates Have Become Observable in the United States

When the U.S. Treasury decided to issue TIPS

(Treasury Inflation Protection Securities), in January

1997, a version of indexed Treasury coupon bonds,

it was somewhat late in the game. Other countries

such as the United Kingdom, Canada, Australia, and

Sweden had already beaten the United States to the

punch. (In September 1998, the U.S. Treasury also

began issuing the Series I savings bond, which provides

inflation protection for small investors.)

These indexed securities have successfully

acquired a niche in the bond market, enabling governments

to raise more funds. In addition, because

their interest and principal payments are adjusted for

changes in the price level, the interest rate on these

bonds provides a direct measure of a real interest rate.

These indexed bonds are very useful to policymakers,

especially monetary policymakers, because by subtracting

their interest rate from a nominal interest rate

on a nonindexed bond, they generate more insight

into expected inflation, a valuable piece of information.

For example, on January 22, 2003, the interest

rate on the ten-year Treasury bond was 3.84%, while

that on the ten-year TIPS was 2.19%. Thus, the

implied expected inflation rate for the next ten years,

derived from the difference between these two rates,

was 1.65%. The private sector finds the information

provided by TIPS very useful: Many commercial and

investment banks routinely publish the expected U.S.

inflation rates derived from these bonds.

Summary

1. The yield to maturity, which is the measure that most

accurately reflects the interest rate, is the interest rate

that equates the present value of future payments of a

debt instrument with its value today. Application of this

principle reveals that bond prices and interest rates are

negatively related: When the interest rate rises, the

price of the bond must fall, and vice versa.

2. Two less accurate measures of interest rates are

commonly used to quote interest rates on coupon and

discount bonds. The current yield, which equals the

coupon payment divided by the price of a coupon

bond, is a less accurate measure of the yield to maturity

the shorter the maturity of the bond and the greater the

gap between the price and the par value. The yield on a

discount basis (also called the discount yield) understates

the yield to maturity on a discount bond, and the

understatement worsens with the distance from

maturity of the discount security. Even though these

interest payments on loans from their income. Thus if you face a 30% tax rate and take out a mortgage loan with

a 10% interest rate, you are able to deduct the 10% interest payment and thus lower your taxes by 30% of this

amount. Your after-tax nominal cost of borrowing is then 7% (10% minus 30% of the 10% interest payment), and

when the expected inflation rate is 5%, the effective cost of borrowing in real terms is again 2% ( 7% 5%).

As the example (and the formula) indicates, after-tax real interest rates are always below the real interest rate

defined by the Fisher equation. For a further discussion of measures of after-tax real interest rates, see Frederic

S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference Series on Public

Policy 15 (1981): 151–200.

C H A P T E R 4 Understanding Interest Rates 83

measures are misleading guides to the size of the

interest rate, a change in them always signals a change

in the same direction for the yield to maturity.

3. The return on a security, which tells you how well you

have done by holding this security over a stated period

of time, can differ substantially from the interest rate as

measured by the yield to maturity. Long-term bond

prices have substantial fluctuations when interest rates

change and thus bear interest-rate risk. The resulting

capital gains and losses can be large, which is why longterm

bonds are not considered to be safe assets with a

sure return.

4. The real interest rate is defined as the nominal interest

rate minus the expected rate of inflation. It is a better

measure of the incentives to borrow and lend than the

nominal interest rate, and it is a more accurate indicator

of the tightness of credit market conditions than the

nominal interest rate.

Key Terms

basis point, p. 74

consol or perpetuity, p. 67

coupon bond, p. 63

coupon rate, p. 64

current yield, p. 70

discount bond (zero-coupon bond),

p. 64

face value (par value), p. 63

fixed-payment loan (fully amortized

loan), p. 63

indexed bond, p. 82

interest-rate risk, p. 78

nominal interest rate, p. 79

present discounted value, p. 61

present value, p. 61

rate of capital gain, p. 76

real interest rate, p. 79

real terms, p. 80

return (rate of return), p. 75

simple loan, p. 62

yield on a discount basis (discount

yield), p. 71

yield to maturity, p. 64

Questions and Problems

Questions marked with an asterisk are answered at the end

of the book in an appendix, “Answers to Selected Questions

and Problems.”

*1. Would a dollar tomorrow be worth more to you today

when the interest rate is 20% or when it is 10%?

2. You have just won $20 million in the state lottery,

which promises to pay you $1 million (tax free) every

year for the next 20 years. Have you really won $20

million?

*3. If the interest rate is 10%, what is the present value of

a security that pays you $1,100 next year, $1,210 the

year after, and $1,331 the year after that?

4. If the security in Problem 3 sold for $3,500, is the

yield to maturity greater or less than 10%? Why?

*5. Write down the formula that is used to calculate the

yield to maturity on a 20-year 10% coupon bond with

$1,000 face value that sells for $2,000.

6. What is the yield to maturity on a $1,000-face-value

discount bond maturing in one year that sells for

$800?

*7. What is the yield to maturity on a simple loan for $1

million that requires a repayment of $2 million in five

years’ time?

8. To pay for college, you have just taken out a $1,000

government loan that makes you pay $126 per year

for 25 years. However, you don’t have to start making

these payments until you graduate from college two

years from now. Why is the yield to maturity necessarily

less than 12%, the yield to maturity on a normal

$1,000 fixed-payment loan in which you pay $126

per year for 25 years?

*9. Which $1,000 bond has the higher yield to maturity, a

20-year bond selling for $800 with a current yield of

15% or a one-year bond selling for $800 with a current

yield of 5%?

QUIZ

84 PA RT I I Financial Markets

10. Pick five U.S. Treasury bonds from the bond page of

the newspaper, and calculate the current yield. Note

when the current yield is a good approximation of the

yield to maturity.

*11. You are offered two bonds, a one-year U.S. Treasury

bond with a yield to maturity of 9% and a one-year

U.S. Treasury bill with a yield on a discount basis of

8.9%. Which would you rather own?

12. If there is a decline in interest rates, which would you

rather be holding, long-term bonds or short-term

bonds? Why? Which type of bond has the greater

interest-rate risk?

*13. Francine the Financial Adviser has just given you the

following advice: “Long-term bonds are a great investment

because their interest rate is over 20%.” Is

Francine necessarily right?

14. If mortgage rates rise from 5% to 10% but the

expected rate of increase in housing prices rises from

2% to 9%, are people more or less likely to buy

houses?

*15. Interest rates were lower in the mid-1980s than they

were in the late 1970s, yet many economists have

commented that real interest rates were actually much

higher in the mid-1980s than in the late 1970s. Does

this make sense? Do you think that these economists

are right?

Web Exercises

1. Investigate the data available from the Federal Reserve

at www.federalreserve.gov/releases/. Answer the following

questions:

a. What is the difference in the interest rates on commercial

paper for financial firms when compared to

nonfinancial firms?

b. What was the interest rate on the one-month

Eurodollar at the end of 2002?

c. What is the most recent interest rate report for the

30-year Treasury note?

2. Figure 1 in the text shows the estimated real and

nominal rates for three-month treasury bills. Go to

www.martincapital.com/charts.htm and click on

“interest rates and yields,” then on “real interest rates.”

a. Compare the three-month real rate to the longterm

real rate. Which is greater?

b. Compare the short-term nominal rate to the longterm

nominal rate. Which appears most volatile?

3. In this chapter we have discussed long-term bonds as

if there were only one type, coupon bonds. In fact

there are also long-term discount bonds. A discount

bond is sold at a low price and the whole return

comes in the form of a price appreciation. You can easily

compute the current price of a discount bond using

the financial calculator at http://app.ny.frb.org/sbr/.

To compute the redemption values for savings

bonds, fill in the information at the site and click on

the Compute Values button. A maximum of five years

of data will be displayed for each computation.

In our discussion of interest-rate risk, we saw that when interest rates change, a bond

with a longer term to maturity has a larger change in its price and hence more interestrate

risk than a bond with a shorter term to maturity. Although this is a useful general

fact, in order to measure interest-rate risk, the manager of a financial institution

needs more precise information on the actual capital gain or loss that occurs when the

interest rate changes by a certain amount. To do this, the manager needs to make use

of the concept of duration, the average lifetime of a debt security’s stream of payments.

The fact that two bonds have the same term to maturity does not mean that they

have the same interest-rate risk. A long-term discount bond with ten years to maturity,

a so-called zero-coupon bond, makes all of its payments at the end of the ten years,

whereas a 10% coupon bond with ten years to maturity makes substantial cash payments

before the maturity date. Since the coupon bond makes payments earlier than

the zero-coupon bond, we might intuitively guess that the coupon bond’s effective

maturity, the term to maturity that accurately measures interest-rate risk, is shorter

than it is for the zero-coupon discount bond.

Indeed, this is exactly what we find in example 1.

EXAMPLE 1: Rate of Capital Gain

Calculate the rate of capital gain or loss on a ten-year zero-coupon bond for which the

interest rate has increased from 10% to 20%. The bond has a face value of $1,000.

Solution

The rate of capital gain or loss is 49.7%.

g

where

Pt1 price of the bond one year from now $193.81

Pt price of the bond today $385.54

$1,000

(1 0.10)10

$1,000

(1 0.20)9

Pt1 Pt

Pt

Measuring Interest-Rate

Risk: Duration

appendix

to chapter 4

1

Thus:

g

g 0.497 49.7%

But as we have already calculated in Table 2 in Chapter 4, the capital gain on the

10% ten-year coupon bond is 40.3%. We see that interest-rate risk for the ten-year

coupon bond is less than for the ten-year zero-coupon bond, so the effective maturity

on the coupon bond (which measures interest-rate risk) is, as expected, shorter than

the effective maturity on the zero-coupon bond.

To calculate the duration or effective maturity on any debt security, Frederick

Macaulay, a researcher at the National Bureau of Economic Research, invented the

concept of duration more than half a century ago. Because a zero-coupon bond makes

no cash payments before the bond matures, it makes sense to define its effective maturity

as equal to its actual term to maturity. Macaulay then realized that he could measure

the effective maturity of a coupon bond by recognizing that a coupon bond is

equivalent to a set of zero-coupon discount bonds. A ten-year 10% coupon bond with

a face value of $1,000 has cash payments identical to the following set of zero-coupon

bonds: a $100 one-year zero-coupon bond (which pays the equivalent of the $100

coupon payment made by the $1,000 ten-year 10% coupon bond at the end of one

year), a $100 two-year zero-coupon bond (which pays the equivalent of the $100

coupon payment at the end of two years), … , a $100 ten-year zero-coupon bond

(which pays the equivalent of the $100 coupon payment at the end of ten years), and

a $1,000 ten-year zero-coupon bond (which pays back the equivalent of the coupon

bond’s $1,000 face value). This set of coupon bonds is shown in the following time

line:

This same set of coupon bonds is listed in column (2) of Table 1, which calculates the

duration on the ten-year coupon bond when its interest rate is 10%.

To get the effective maturity of this set of zero-coupon bonds, we would want to

sum up the effective maturity of each zero-coupon bond, weighting it by the percentage

of the total value of all the bonds that it represents. In other words, the duration

of this set of zero-coupon bonds is the weighted average of the effective

maturities of the individual zero-coupon bonds, with the weights equaling the proportion

of the total value represented by each zero-coupon bond. We do this in several

steps in Table 1. First we calculate the present value of each of the zero-coupon

bonds when the interest rate is 10% in column (3). Then in column (4) we divide

each of these present values by $1,000, the total present value of the set of zerocoupon

bonds, to get the percentage of the total value of all the bonds that each bond

represents. Note that the sum of the weights in column (4) must total 100%, as shown

at the bottom of the column.

0 1 2 3 4 5 6 7 8 9 10

Year When Paid

Amount

$100 $100 $100 $100 $100 $100 $100 $100 $100 $100

$1,000

Calculating

Duration

$193.81 $385.54

$385.54

2 Appendix to Chapter 4

To get the effective maturity of the set of zero-coupon bonds, we add up the

weighted maturities in column (5) and obtain the figure of 6.76 years. This figure for

the effective maturity of the set of zero-coupon bonds is the duration of the 10% tenyear

coupon bond because the bond is equivalent to this set of zero-coupon bonds.

In short, we see that duration is a weighted average of the maturities of the cash

payments.

The duration calculation done in Table 1 can be written as follows:

(1)

where DUR duration

t years until cash payment is made

CPt cash payment (interest plus principal) at time t

i interest rate

n years to maturity of the security

This formula is not as intuitive as the calculation done in Table 1, but it does have the

advantage that it can easily be programmed into a calculator or computer, making

duration calculations very easy.

If we calculate the duration for an 11-year 10% coupon bond when the interest

rate is again 10%, we find that it equals 7.14 years, which is greater than the 6.76

years for the ten-year bond. Thus we have reached the expected conclusion: All else

being equal, the longer the term to maturity of a bond, the longer its duration.

DUR n

t1

CPt

(1 i )t n

t1

CPt

(1 i )t

Measuring Interest-Rate Risk: Duration

(1) (2) (3) (4) (5)

Present

Cash Payments Value (PV) Weights Weighted

(Zero-Coupon of Cash Payments (% of total Maturity

Bonds) (i 10%) PV PV/$1,000) (1 4)/100

Year ($) ($) (%) (years)

1 100 90.91 9.091 0.09091

2 100 82.64 8.264 0.16528

3 100 75.13 7.513 0.22539

4 100 68.30 6.830 0.27320

5 100 62.09 6.209 0.31045

6 100 56.44 5.644 0.33864

7 100 51.32 5.132 0.35924

8 100 46.65 4.665 0.37320

9 100 42.41 4.241 0.38169

10 100 38.55 3.855 0.38550

10 1,000 385.54 38.554 3.85500

Total 1,000.00 100.000 6.75850

Table 1 Calculating Duration on a $1,000 Ten-Year 10% Coupon Bond When Its Interest Rate Is 10%

3

You might think that knowing the maturity of a coupon bond is enough to tell

you what its duration is. However, that is not the case. To see this and to give you

more practice in calculating duration, in Table 2 we again calculate the duration for

the ten-year 10% coupon bond, but when the current interest rate is 20%, rather than

10% as in Table 1. The calculation in Table 2 reveals that the duration of the coupon

bond at this higher interest rate has fallen from 6.76 years to 5.72 years. The explanation

is fairly straightforward. When the interest rate is higher, the cash payments in

the future are discounted more heavily and become less important in present-value

terms relative to the total present value of all the payments. The relative weight for

these cash payments drops as we see in Table 2, and so the effective maturity of the

bond falls. We have come to an important conclusion: All else being equal, when

interest rates rise, the duration of a coupon bond falls.

The duration of a coupon bond is also affected by its coupon rate. For example,

consider a ten-year 20% coupon bond when the interest rate is 10%. Using the same

procedure, we find that its duration at the higher 20% coupon rate is 5.98 years versus

6.76 years when the coupon rate is 10%. The explanation is that a higher coupon

rate means that a relatively greater amount of the cash payments are made earlier in

the life of the bond, and so the effective maturity of the bond must fall. We have thus

established a third fact about duration: All else being equal, the higher the coupon

rate on the bond, the shorter the bond’s duration.

Appendix to Chapter 4

(1) (2) (3) (4) (5)

Present

Cash Payments Value (PV) Weights Weighted

(Zero-Coupon of Cash Payments (% of total Maturity

Bonds) (i 20%) PV PV/$580.76) (1 4)/100

Year ($) ($) (%) (years)

1 100 83.33 14.348 0.14348

2 100 69.44 11.957 0.23914

3 100 57.87 9.965 0.29895

4 100 48.23 8.305 0.33220

5 100 40.19 6.920 0.34600

6 100 33.49 5.767 0.34602

7 100 27.91 4.806 0.33642

8 100 23.26 4.005 0.32040

9 100 19.38 3.337 0.30033

10 100 16.15 2.781 0.27810

10 $1,000 161.51 27.808 2.78100

Total 580.76 100.000 5.72204

Table 2 Calculating Duration on a $1,000 Ten-Year 10% Coupon Bond When Its Interest Rate Is 20%

4

Study Guide To make certain that you understand how to calculate duration, practice doing the

calculations in Tables 1 and 2. Try to produce the tables for calculating duration in

the case of an 11-year 10% coupon bond and also for the 10-year 20% coupon bond

mentioned in the text when the current interest rate is 10%. Make sure your calculations

produce the same results found in this appendix.

One additional fact about duration makes this concept useful when applied to a

portfolio of securities. Our examples have shown that duration is equal to the

weighted average of the durations of the cash payments (the effective maturities of the

corresponding zero-coupon bonds). So if we calculate the duration for two different

securities, it should be easy to see that the duration of a portfolio of the two securities

is just the weighted average of the durations of the two securities, with the

weights reflecting the proportion of the portfolio invested in each.

EXAMPLE 2: Duration

A manager of a financial institution is holding 25% of a portfolio in a bond with a fiveyear

duration and 75% in a bond with a ten-year duration. What is the duration of the

portfolio?

Solution

The duration of the portfolio is 8.75 years.

(0.25 5) (0.75 10) 1.25 7.5 8.75 years

We now see that the duration of a portfolio of securities is the weighted average

of the durations of the individual securities, with the weights reflecting the proportion

of the portfolio invested in each. This fact about duration is often referred to as

the additive property of duration, and it is extremely useful, because it means that the

duration of a portfolio of securities is easy to calculate from the durations of the individual

securities.

To summarize, our calculations of duration for coupon bonds have revealed

four facts:

1. The longer the term to maturity of a bond, everything else being equal, the

greater its duration.

2. When interest rates rise, everything else being equal, the duration of a coupon

bond falls.

3. The higher the coupon rate on the bond, everything else being equal, the shorter

the bond’s duration.

4. Duration is additive: The duration of a portfolio of securities is the weighted average

of the durations of the individual securities, with the weights reflecting the

proportion of the portfolio invested in each.

Measuring Interest-Rate Risk: Duration 5

Now that we understand how duration is calculated, we want to see how it can be

used by the practicing financial institution manager to measure interest-rate risk.

Duration is a particularly useful concept, because it provides a good approximation,

particularly when interest-rate changes are small, for how much the security price

changes for a given change in interest rates, as the following formula indicates:

(2)

where %P (Pt1 Pt)/Pt percent change in the price of the security

from t to t 1 rate of capital gain

DUR duration

i interest rate

EXAMPLE 3: Duration and Interest-Rate Risk

A pension fund manager is holding a ten-year 10% coupon bond in the fund’s portfolio

and the interest rate is currently 10%. What loss would the fund be exposed to if the

interest rate rises to 11% tomorrow?

Solution

The approximate percentage change in the price of the bond is 6.15%.

As the calculation in Table 1 shows, the duration of a ten-year 10% coupon bond

is 6.76 years.

where

DUR duration 6.76

i change in interest rate 0.11 0.10 0.01

i current interest rate 0.10

Thus:

%P 6.76

%P 0.0615 6.15%

EXAMPLE 4: Duration and Interest-Rate Risk

Now the pension manager has the option to hold a ten-year coupon bond with a coupon

rate of 20% instead of 10%. As mentioned earlier, the duration for this 20% coupon

bond is 5.98 years when the interest rate is 10%. Find the approximate change in the

bond price when the interest rate increases from 10% to 11%.

Solution

This time the approximate change in bond price is 5.4%. This change in bond price

is much smaller than for the higher-duration coupon bond:

%P DUR

i

1 i

0.01

1 0.10

%P DUR

i

1 i

%P DUR

i

1 i

Duration and

Interest-Rate Risk

6 Appendix to Chapter 4

where

DUR duration 5.98

i change in interest rate 0.11 0.10 0.01

i current interest rate 0.10

Thus:

%P 5.98

%P 0.054 5.4%

The pension fund manager realizes that the interest-rate risk on the 20% coupon

bond is less than on the 10% coupon, so he switches the fund out of the 10%

coupon bond and into the 20% coupon bond.

Examples 3 and 4 have led the pension fund manager to an important conclusion

about the relationship of duration and interest-rate risk: The greater the duration of

a security, the greater the percentage change in the market value of the security for

a given change in interest rates. Therefore, the greater the duration of a security,

the greater its interest-rate risk.

This reasoning applies equally to a portfolio of securities. So by calculating the

duration of the fund’s portfolio of securities using the methods outlined here, a pension

fund manager can easily ascertain the amount of interest-rate risk the entire fund

is exposed to. As we will see in Chapter 9, duration is a highly useful concept for the

management of interest-rate risk that is widely used by managers of banks and other

financial institutions.

0.01

1 0.10

Measuring Interest-Rate Risk: Duration 7

PREVIEW In the early 1950s, nominal interest rates on three-month Treasury bills were about

1% at an annual rate; by 1981, they had reached over 15%, then fell to 3% in 1993,

rose to above 5% by the mid-1990s, and fell below 2% in the early 2000s. What

explains these substantial fluctuations in interest rates? One reason why we study

money, banking, and financial markets is to provide some answers to this question.

In this chapter, we examine how the overall level of nominal interest rates (which

we refer to as simply “interest rates”) is determined and which factors influence their

behavior. We learned in Chapter 4 that interest rates are negatively related to the price

of bonds, so if we can explain why bond prices change, we can also explain why interest

rates fluctuate. To do this, we make use of supply and demand analysis for bond

markets and money markets to examine how interest rates change.

In order to derive a demand curve for assets like money or bonds, the first step

in our analysis, we must first understand what determines the demand for these

assets. We do this by examining an economic theory known as the theory of asset

demand, which outlines criteria that are important when deciding how much of an

asset to buy. Armed with this theory, we can then go on to derive the demand curve

for bonds or money. After deriving supply curves for these assets, we develop the

concept of market equilibrium, the point at which the quantity supplied equals the

quantity demanded. Then we use this model to explain changes in equilibrium interest

rates.

Because interest rates on different securities tend to move together, in this chapter

we will proceed as if there were only one type of security and a single interest rate

in the entire economy. In the following chapter, we expand our analysis to look at why

interest rates on different types of securities differ.

Determinants of Asset Demand

Before going on to our supply and demand analysis of the bond market and the market

for money, we must first understand what determines the quantity demanded of

an asset. Recall that an asset is a piece of property that is a store of value. Items such

as money, bonds, stocks, art, land, houses, farm equipment, and manufacturing

machinery are all assets. Facing the question of whether to buy and hold an asset or

85

Chap ter

5 The Behavior of Interest Rates

whether to buy one asset rather than another, an individual must consider the following

factors:

1. Wealth, the total resources owned by the individual, including all assets

2. Expected return (the return expected over the next period) on one asset relative

to alternative assets

3. Risk (the degree of uncertainty associated with the return) on one asset relative

to alternative assets

4. Liquidity (the ease and speed with which an asset can be turned into cash) relative

to alternative assets

Study Guide As we discuss each factor that influences asset demand, remember that we are always

holding all the other factors constant. Also, think of additional examples of how

changes in each factor would influence your decision to purchase a particular asset:

say, a house or a share of common stock. This intuitive approach will help you understand

how the theory works in practice.

When we find that our wealth has increased, we have more resources available with

which to purchase assets, and so, not surprisingly, the quantity of assets we demand

increases. Therefore, the effect of changes in wealth on the quantity demanded of an

asset can be summarized as follows: Holding everything else constant, an increase in

wealth raises the quantity demanded of an asset.

In Chapter 4, we saw that the return on an asset (such as a bond) measures how much

we gain from holding that asset. When we make a decision to buy an asset, we are

influenced by what we expect the return on that asset to be. If a Mobil Oil

Corporation bond, for example, has a return of 15% half the time and 5% the other

half of the time, its expected return (which you can think of as the average return) is

10% ( 0.5 15% 0.5 5%).1 If the expected return on the Mobil Oil bond rises

relative to expected returns on alternative assets, holding everything else constant,

then it becomes more desirable to purchase it, and the quantity demanded increases.

This can occur in either of two ways: (1) when the expected return on the Mobil Oil

bond rises while the return on an alternative asset—say, stock in IBM—remains

unchanged or (2) when the return on the alternative asset, the IBM stock, falls while

the return on the Mobil Oil bond remains unchanged. To summarize, an increase in

an asset’s expected return relative to that of an alternative asset, holding everything

else unchanged, raises the quantity demanded of the asset.

Expected Returns

Wealth

86 PA RT I I Financial Markets

1If you are interested in finding out more information on how to calculate expected returns, as well as standard

deviations of returns that measure risk, you can look at an appendix to this chapter describing models of asset

pricing that is on this book’s web site at www.aw.com/mishkin. This appendix also describes how diversification

lowers the overall risk of a portfolio and has a discussion of systematic risk and basic asset pricing models such

as the capital asset pricing model and arbitrage pricing theory.

The degree of risk or uncertainty of an asset’s returns also affects the demand for the

asset. Consider two assets, stock in Fly-by-Night Airlines and stock in Feet-on-the-

Ground Bus Company. Suppose that Fly-by-Night stock has a return of 15% half the

time and 5% the other half of the time, making its expected return 10%, while stock

in Feet-on-the-Ground has a fixed return of 10%. Fly-by-Night stock has uncertainty

associated with its returns and so has greater risk than stock in Feet-on-the-Ground,

whose return is a sure thing.

A risk-averse person prefers stock in Feet-on-the-Ground (the sure thing) to Flyby-

Night stock (the riskier asset), even though the stocks have the same expected

return, 10%. By contrast, a person who prefers risk is a risk preferrer or risk lover. Most

people are risk-averse, especially in their financial decisions: Everything else being

equal, they prefer to hold the less risky asset. Hence, holding everything else constant,

if an asset’s risk rises relative to that of alternative assets, its quantity

demanded will fall.

Another factor that affects the demand for an asset is how quickly it can be converted

into cash at low costs—its liquidity. An asset is liquid if the market in which it is traded

has depth and breadth; that is, if the market has many buyers and sellers. A house is

not a very liquid asset, because it may be hard to find a buyer quickly; if a house must

be sold to pay off bills, it might have to be sold for a much lower price. And the transaction

costs in selling a house (broker’s commissions, lawyer’s fees, and so on) are substantial.

A U.S. Treasury bill, by contrast, is a highly liquid asset. It can be sold in a

well-organized market where there are many buyers, so it can be sold quickly at low

cost. The more liquid an asset is relative to alternative assets, holding everything

else unchanged, the more desirable it is, and the greater will be the quantity

demanded.

All the determining factors we have just discussed can be assembled into the theory

of asset demand, which states that, holding all of the other factors constant:

1. The quantity demanded of an asset is positively related to wealth.

2. The quantity demanded of an asset is positively related to its expected return relative

to alternative assets.

3. The quantity demanded of an asset is negatively related to the risk of its returns

relative to alternative assets.

4. The quantity demanded of an asset is positively related to its liquidity relative to

alternative assets.

These results are summarized in Table 1.

Supply and Demand in the Bond Market

Our first approach to the analysis of interest-rate determination looks at supply and

demand in the bond market. The first step in the analysis is to obtain a bond demand

curve, which shows the relationship between the quantity demanded and the price

when all other economic variables are held constant (that is, values of other variables

are taken as given). You may recall from previous economics courses that the

Theory of

Asset Demand

Liquidity

Risk

C H A P T E R 5 The Behavior of Interest Rates 87

assumption that all other economic variables are held constant is called ceteris paribus,

which means “other things being equal” in Latin.

To clarify our analysis, let us consider the demand for one-year discount bonds,

which make no coupon payments but pay the owner the $1,000 face value in a year.

If the holding period is one year, then as we have seen in Chapter 4, the return on the

bonds is known absolutely and is equal to the interest rate as measured by the yield

to maturity. This means that the expected return on this bond is equal to the interest

rate i, which, using Equation 6 in Chapter 4, is:

where i interest rate yield to maturity

expected return

F face value of the discount bond

P initial purchase price of the discount bond

This formula shows that a particular value of the interest rate corresponds to each

bond price. If the bond sells for $950, the interest rate and expected return is:

At this 5.3% interest rate and expected return corresponding to a bond price of

$950, let us assume that the quantity of bonds demanded is $100 billion, which is

plotted as point A in Figure 1. To display both the bond price and the corresponding

interest rate, Figure 1 has two vertical axes. The left vertical axis shows the bond price,

with the price of bonds increasing from $750 near the bottom of the axis toward $1,000

at the top. The right vertical axis shows the interest rate, which increases in the opposite

direction from 0% at the top of the axis to 33% near the bottom. The right and left

vertical axes run in opposite directions because, as we learned in Chapter 4, bond

$1,000 $950

$950

0.053 5.3%

RET e

i RETe

F P

P

Demand Curve

88 PA RT I I Financial Markets

Table 1 Response of the Quantity of an Asset Demanded to Changes in Wealth,

Expected Returns, Risk, and Liquidity

S U M M A R Y

Change in

Variable Change in Variable Quantity Demanded

Wealth ↑ ↑

Expected return relative to other assets ↑ ↑

Risk relative to other assets ↑ ↓

Liquidity relative to other assets ↑ ↑

Note: Only increases in the variables are shown. The effect of decreases in the variables on the change in demand would be the opposite

of those indicated in the rightmost column.

price and interest rate are always negatively related: As the price of the bond rises, the

interest rate on the bond necessarily falls.

At a price of $900, the interest rate and expected return equals:

Because the expected return on these bonds is higher, with all other economic variables

(such as income, expected returns on other assets, risk, and liquidity) held constant,

the quantity demanded of bonds will be higher as predicted by the theory of asset

demand. Point B in Figure 1 shows that the quantity of bonds demanded at the price of

$900 has risen to $200 billion. Continuing with this reasoning, if the bond price is $850

(interest rate and expected return 17.6%), the quantity of bonds demanded (point C)

will be greater than at point B. Similarly, at the lower prices of $800 (interest rate

25%) and $750 (interest rate 33.3%), the quantity of bonds demanded will be even

higher (pointsDand E). The curve Bd, which connects these points, is the demand curve

for bonds. It has the usual downward slope, indicating that at lower prices of the bond

(everything else being equal), the quantity demanded is higher.2

$1,000 $900

$900

0.111 11.1%

C H A P T E R 5 The Behavior of Interest Rates 89

2Note that although our analysis indicates that the demand curve is downward-sloping, it does not imply that the curve

is a straight line. For ease of exposition, however, we will draw demand curves and supply curves as straight lines.

100 200 300 400 500

750

800

P* = 850

900

950

1,000

33.0

25.0

17.6 = i *

11.1

5.3

0.0

Quantity of Bonds, B

($ billions)

A

B

C

D

F E

G

H

I

Bs

Bd

Interest Rate, i (%)

(i increases )↑

Price of Bonds, P ($)

(P increases ↑ )

FIGURE 1 Supply and

Demand for Bonds

Equilibrium in the bond market

occurs at point C, the intersection

of the demand curve Bd and

the bond supply curve Bs. The

equilibrium price is P* $850,

and the equilibrium interest rate

is i * 17.6%. (Note: P and i

increase in opposite directions. P

on the left vertical axis increases

as we go up the axis from $750

near the bottom to $1,000 at the

top, while i on the right vertical

axis increases as we go down the

axis from 0% at the top to 33%

near the bottom.)

An important assumption behind the demand curve for bonds in Figure 1 is that all

other economic variables besides the bond’s price and interest rate are held constant.

We use the same assumption in deriving a supply curve, which shows the relationship

between the quantity supplied and the price when all other economic variables

are held constant.

When the price of the bonds is $750 (interest rate 33.3%), point F shows that

the quantity of bonds supplied is $100 billion for the example we are considering. If

the price is $800, the interest rate is the lower rate of 25%. Because at this interest

rate it is now less costly to borrow by issuing bonds, firms will be willing to borrow

more through bond issues, and the quantity of bonds supplied is at the higher level

of $200 billion (point G). An even higher price of $850, corresponding to a lower

interest rate of 17.6%, results in a larger quantity of bonds supplied of $300 billion

(point C). Higher prices of $900 and $950 result in even greater quantities of bonds

supplied (points H and I). The Bs curve, which connects these points, is the supply

curve for bonds. It has the usual upward slope found in supply curves, indicating that

as the price increases (everything else being equal), the quantity supplied increases.

In economics, market equilibrium occurs when the amount that people are willing

to buy (demand) equals the amount that people are willing to sell (supply) at a given

price. In the bond market, this is achieved when the quantity of bonds demanded

equals the quantity of bonds supplied:

Bd Bs (1)

In Figure 1, equilibrium occurs at point C, where the demand and supply curves

intersect at a bond price of $850 (interest rate of 17.6%) and a quantity of bonds of

$300 billion. The price of P* 850, where the quantity demanded equals the quantity

supplied, is called the equilibrium or market-clearing price. Similarly, the interest

rate of i * 17.6% that corresponds to this price is called the equilibrium or marketclearing

interest rate.

The concepts of market equilibrium and equilibrium price or interest rate are

useful, because there is a tendency for the market to head toward them. We can see

that it does in Figure 1 by first looking at what happens when we have a bond price

that is above the equilibrium price. When the price of bonds is set too high, at, say,

$950, the quantity of bonds supplied at point I is greater than the quantity of bonds

demanded at point A. A situation like this, in which the quantity of bonds supplied

exceeds the quantity of bonds demanded, is called a condition of excess supply.

Because people want to sell more bonds than others want to buy, the price of the

bonds will fall, and this is why the downward arrow is drawn in the figure at the bond

price of $950. As long as the bond price remains above the equilibrium price, there

will continue to be an excess supply of bonds, and the price will continue to fall. This

will stop only when the price has reached the equilibrium price of $850, where the

excess supply of bonds has been eliminated.

Now let’s look at what happens when the price of bonds is below the equilibrium

price. If the price of the bonds is set too low, at, say, $750, the quantity demanded at

point E is greater than the quantity supplied at point F. This is called a condition of

excess demand. People now want to buy more bonds than others are willing to sell,

and so the price of bonds will be driven up. This is illustrated by the upward arrow

drawn in the figure at the bond price of $750. Only when the excess demand for

Market

Equilibrium

Supply Curve

90 PA RT I I Financial Markets

bonds is eliminated by the price rising to the equilibrium level of $850 is there no further

tendency for the price to rise.

We can see that the concept of equilibrium price is a useful one because it indicates

where the market will settle. Because each price on the left vertical axis of Figure 1 corresponds

to a value of the interest rate on the right vertical axis, the same diagram also

shows that the interest rate will head toward the equilibrium interest rate of 17.6%.

When the interest rate is below the equilibrium interest rate, as it is when it is at 5.3%,

the price of the bond is above the equilibrium price, and there will be an excess supply

of bonds. The price of the bond then falls, leading to a rise in the interest rate toward

the equilibrium level. Similarly, when the interest rate is above the equilibrium level, as

it is when it is at 33.3%, there is excess demand for bonds, and the bond price will rise,

driving the interest rate back down to the equilibrium level of 17.6%.

Our Figure 1 is a conventional supply and demand diagram with price on the left vertical

axis and quantity on the horizontal axis. Because the interest rate that corresponds

to each bond price is also marked on the right vertical axis, this diagram

allows us to read the equilibrium interest rate, giving us a model that describes the

determination of interest rates. It is important to recognize that a supply and demand

diagram like Figure 1 can be drawn for any type of bond because the interest rate and

price of a bond are always negatively related for any type of bond, whether a discount

bond or a coupon bond.

Throughout this book we will use diagrams like Figure 1 and analyze interest rate

behavior in terms of the supply and demand for bonds. However, the analysis of the

bond market that we have developed here has another interpretation with a different

terminology. Here we discuss this other terminology, which is couched in terms of the

supply and demand for loanable funds used by some economists. We include this discussion

in case you come across this other terminology, but you will not need to make

use of it to understand how interest rates are determined.

One disadvantage of the diagram in Figure 1 is that interest rates run in an

unusual direction on the right vertical axis: As we go up the right axis, interest rates

fall. Because economists are typically more concerned with the value of interest rates

than with the price of bonds, we could plot the supply of and demand for bonds on

a diagram that has only a left vertical axis that provides the values of the interest rates

running in the usual direction, rising as we go up the axis. Figure 2 is such a diagram,

in which points A through I match the corresponding points in Figure 1.

However, making interest rates run in the “usual” direction on the vertical axis

presents us with a problem. Our demand curve for bonds, points A through E, now

looks peculiar because it has an upward slope. This upward slope is, however, completely

consistent with our usual demand analysis, which produces a negative relationship

between price and quantity. The inverse relationship between bond prices

and interest rates means that in moving from point A to point B to point C, bond

prices are falling and, consistent with usual demand analysis, the quantity demanded

is rising. Similarly, our supply curve for bonds, points F through I, has an unusuallooking

downward slope but is completely consistent with the usual view that price

and the quantity supplied are positively related.

One way to give the demand curve the usual downward slope and the supply

curve the usual upward slope is to rename the horizontal axis and the demand and

Loanable Funds

Framework

Supply and

Demand Analysis

C H A P T E R 5 The Behavior of Interest Rates 91

supply curves. Because a firm supplying bonds is in fact taking out a loan from a person

buying a bond, “supplying a bond” is equivalent to “demanding a loan.” Thus the

supply curve for bonds can be reinterpreted as indicating the quantity of loans

demanded for each value of the interest rate. If we rename the horizontal axis loanable

funds, defined as the quantity of loans, the supply of bonds can be reinterpreted as

the demand for loanable funds. Similarly, the demand curve for bonds can be reidentified

as the supply of loanable funds because buying (demanding) a bond is equivalent

to supplying a loan. Figure 2 relabels the curves and the horizontal axis using the

loanable funds terminology in parentheses, and now the renamed loanable funds

demand curve has the usual downward slope and the renamed loanable funds supply

curve the usual upward slope.

Because supply and demand diagrams that explain how interest rates are determined

in the bond market often use the loanable funds terminology, this analysis is

frequently referred to as the loanable funds framework. However, because in later

chapters describing the conduct of monetary policy we focus on how the demand for

and supply of bonds is affected, we will continue to conduct supply and demand

analysis in terms of bonds, as in Figure 1, rather than loanable funds. Whether the

analysis is done in terms of loanable funds or in terms of the demand for and supply

92 PA RT I I Financial Markets

33.0

100 200 300 400 500 600

25.0

i * = 17.6

11.1

5.3

0.0

Quantity of Bonds, B

(Loanable Funds, L)

($ billions)

C

Supply of Bonds, Bs

(Demand for Loanable Funds, Ld )

Demand for Bonds, Bd

(Supply of Loanable Funds, Ls )

Interest Rate, i (%)

(i increases ↑ )

F

G

H

A I

B

D

E

FIGURE 2 A Comparison of Terminology: Loanable Funds and Supply and Demand for Bonds

The demand for bonds is equivalent to the supply of loanable funds, and the supply of bonds is equivalent to the demand for loanable

funds. (Note: i increases as we go up the vertical axis, in contrast to Figure 1, in which the opposite occurs.)

of bonds, the results are the same: The two ways of analyzing the determination of

interest rates are equivalent.

An important feature of the analysis here is that supply and demand are always

in terms of stocks (amounts at a given point in time) of assets, not in terms of flows.

This approach is somewhat different from certain loanable funds analyses, which are

conducted in terms of flows (loans per year). The asset market approach for understanding

behavior in financial markets—which emphasizes stocks of assets rather

than flows in determining asset prices—is now the dominant methodology used by

economists, because correctly conducting analyses in terms of flows is very tricky,

especially when we encounter inflation.3

Changes in Equilibrium Interest Rates

We will now use the supply and demand framework for bonds to analyze why interest

rates change. To avoid confusion, it is important to make the distinction between

movements along a demand (or supply) curve and shifts in a demand (or supply) curve.

When quantity demanded (or supplied) changes as a result of a change in the price

of the bond (or, equivalently, a change in the interest rate), we have a movement along

the demand (or supply) curve. The change in the quantity demanded when we move

from point A to B to C in Figure 1, for example, is a movement along a demand curve.

A shift in the demand (or supply) curve, by contrast, occurs when the quantity

demanded (or supplied) changes at each given price (or interest rate) of the bond in

response to a change in some other factor besides the bond’s price or interest rate.

When one of these factors changes, causing a shift in the demand or supply curve,

there will be a new equilibrium value for the interest rate.

In the following pages, we will look at how the supply and demand curves shift

in response to changes in variables, such as expected inflation and wealth, and what

effects these changes have on the equilibrium value of interest rates.

The theory of asset demand demonstrated at the beginning of the chapter provides a

framework for deciding what factors cause the demand curve for bonds to shift. These

factors include changes in four parameters:

1. Wealth

2. Expected returns on bonds relative to alternative assets

3. Risk of bonds relative to alternative assets

4. Liquidity of bonds relative to alternative assets

To see how a change in each of these factors (holding all other factors constant) can

shift the demand curve, let us look at some examples. (As a study aid, Table 2 summarizes

the effects of changes in these factors on the bond demand curve.)

Shifts in the

Demand for

Bonds

C H A P T E R 5 The Behavior of Interest Rates 93

3The asset market approach developed in the text is useful in understanding not only how interest rates behave

but also how any asset price is determined. A second appendix to this chapter, which is on this book’s web site

at www.aw.com/mishkin, shows how the asset market approach can be applied to understanding the behavior of

commodity markets; in particular, the gold market.

94 PA RT I I Financial Markets

S U M M A R Y Table 2 Factors That Shift the Demand Curve for Bonds

Change in

Change in Quantity Shift in

Variable Variable Demanded Demand Curve

Wealth ↑ ↑

Expected interest rate ↑ ↓

Expected inflation ↑ ↓

Riskiness of bonds ↑ ↓

relative to other assets

Liquidity of bonds ↑ ↑

relative to other assets

Note: P and i increase in opposite directions: P on the left vertical axis increases as we go up the axis, while i on the right vertical axis increases

as we go down the axis. Only increases in the variables are shown. The effect of decreases in the variables on the change in demand would

be the opposite of those indicated in the remaining columns.

B d1B d2

←

(increases )↑

(increases )↑

(increases )↑

(increases )↑

(increases ↑)

P

(increases ↑)

P

(increases ↑)

P

(increases ↑)

P

B

B

B

B

B d1

B d2

←

B d1

B d2

←

B d1

B d2

←

(increases )↑

(increases ↑)

P

B

B d1

B d2

←

Wealth. When the economy is growing rapidly in a business cycle expansion and

wealth is increasing, the quantity of bonds demanded at each bond price (or interest

rate) increases as shown in Figure 3. To see how this works, consider point B on the

initial demand curve for bonds Bd

1. It tells us that at a bond price of $900 and an interest

rate of 11.1%, the quantity of bonds demanded is $200 billion. With higher

wealth, the quantity of bonds demanded at the same interest rate must rise, say, to

$400 billion (point B). Similarly, the higher wealth causes the quantity demanded at

a bond price of $800 and an interest rate of 25% to rise from $400 billion to $600

billion (point D to D). Continuing with this reasoning for every point on the initial

demand curve Bd

1, we can see that the demand curve shifts to the right from Bd

1 to Bd

2

as is indicated by the arrows.

The conclusion we have reached is that in a business cycle expansion with growing

wealth, the demand for bonds rises and the demand curve for bonds shifts to the

right. Using the same reasoning, in a recession, when income and wealth are falling,

the demand for bonds falls, and the demand curve shifts to the left.

Another factor that affects wealth is the public’s propensity to save. If households

save more, wealth increases and, as we have seen, the demand for bonds rises and the

demand curve for bonds shifts to the right. Conversely, if people save less, wealth and

the demand for bonds will fall and the demand curve shifts to the left.

Expected Returns. For a one-year discount bond and a one-year holding period, the

expected return and the interest rate are identical, so nothing besides today’s interest

rate affects the expected return.

C H A P T E R 5 The Behavior of Interest Rates 95

FIGURE 3 Shift in the

Demand Curve for Bonds

When the demand for bonds

increases, the demand curve

shifts to the right as shown.

(Note: P and i increase in opposite

directions. P on the left

vertical axis increases as we go

up the axis, while i on the right

vertical axis increases as we go

down the axis.)

A

B

C

D

E

A

B

C

D

E

750

800

850

900

950

1,000

100 200 300 400 500 600 700

Quantity of Bonds, B

($ billions)

0.0

5.3

11.1

17.6

25.0

33.0

Bd

1

Bd

2

Price of Bonds, P

(P increases )

Interest Rate, i (%)

(i increases )↑ ↑

For bonds with maturities of greater than one year, the expected return may differ

from the interest rate. For example, we saw in Chapter 4, Table 2, that a rise in the

interest rate on a long-term bond from 10 to 20% would lead to a sharp decline in

price and a very negative return. Hence if people begin to think that interest rates will

be higher next year than they had originally anticipated, the expected return today on

long-term bonds would fall, and the quantity demanded would fall at each interest

rate. Higher expected interest rates in the future lower the expected return for longterm

bonds, decrease the demand, and shift the demand curve to the left.

By contrast, a revision downward of expectations of future interest rates would

mean that long-term bond prices would be expected to rise more than originally

anticipated, and the resulting higher expected return today would raise the quantity

demanded at each bond price and interest rate. Lower expected interest rates in the

future increase the demand for long-term bonds and shift the demand curve to the

right (as in Figure 3).

Changes in expected returns on other assets can also shift the demand curve for

bonds. If people suddenly became more optimistic about the stock market and began

to expect higher stock prices in the future, both expected capital gains and expected

returns on stocks would rise. With the expected return on bonds held constant, the

expected return on bonds today relative to stocks would fall, lowering the demand for

bonds and shifting the demand curve to the left.

A change in expected inflation is likely to alter expected returns on physical assets

(also called real assets) such as automobiles and houses, which affect the demand for

bonds. An increase in expected inflation, say, from 5 to 10%, will lead to higher prices

on cars and houses in the future and hence higher nominal capital gains. The resulting

rise in the expected returns today on these real assets will lead to a fall in the

expected return on bonds relative to the expected return on real assets today and thus

cause the demand for bonds to fall. Alternatively, we can think of the rise in expected

inflation as lowering the real interest rate on bonds, and the resulting decline in the

relative expected return on bonds causes the demand for bonds to fall. An increase

in the expected rate of inflation lowers the expected return for bonds, causing their

demand to decline and the demand curve to shift to the left.

Risk. If prices in the bond market become more volatile, the risk associated with

bonds increases, and bonds become a less attractive asset. An increase in the riskiness

of bonds causes the demand for bonds to fall and the demand curve to shift to

the left.

Conversely, an increase in the volatility of prices in another asset market, such as

the stock market, would make bonds more attractive. An increase in the riskiness of

alternative assets causes the demand for bonds to rise and the demand curve to shift

to the right (as in Figure 3).

Liquidity. If more people started trading in the bond market, and as a result it became

easier to sell bonds quickly, the increase in their liquidity would cause the quantity of

bonds demanded at each interest rate to rise. Increased liquidity of bonds results in

an increased demand for bonds, and the demand curve shifts to the right (see Figure

3). Similarly, increased liquidity of alternative assets lowers the demand for bonds

and shifts the demand curve to the left. The reduction of brokerage commissions for

trading common stocks that occurred when the fixed-rate commission structure was

96 PA RT I I Financial Markets

abolished in 1975, for example, increased the liquidity of stocks relative to bonds,

and the resulting lower demand for bonds shifted the demand curve to the left.

Certain factors can cause the supply curve for bonds to shift, among them these:

1. Expected profitability of investment opportunities

2. Expected inflation

3. Government activities

We will look at how the supply curve shifts when each of these factors changes (all

others remaining constant). (As a study aid, Table 3 summarizes the effects of changes

in these factors on the bond supply curve.)

Shifts in the

Supply of Bonds

C H A P T E R 5 The Behavior of Interest Rates 97

S U M M A R Y Table 3 Factors That Shift the Supply of Bonds

Change in

Change in Quantity Shift in

Variable Variable Supplied Supply Curve

Profitability of ↑ ↑

investments

Expected inflation ↑ ↑

Government deficit ↑ ↑

Note: P and i increase in opposite directions: P on the left vertical axis increases as we go up the axis, while i on the right vertical axis increases

as we go down the axis. Only increases in the variables are shown. The effect of decreases in the variables on the change in supply would

be the opposite of those indicated in the remaining columns.

B s2

B s1

B

←

(increases ↑)

P

(increases )↑

B s2

B s1

B

←

(increases ↑)

P

(increases )↑

B s2

B s1

B

←

(increases ↑)

P

(increases )↑

Expected Profitability of Investment Opportunities. The more profitable plant and

equipment investments that a firm expects it can make, the more willing it will be to

borrow in order to finance these investments. When the economy is growing rapidly,

as in a business cycle expansion, investment opportunities that are expected to be

profitable abound, and the quantity of bonds supplied at any given bond price and

interest rate will increase (see Figure 4). Therefore, in a business cycle expansion, the

supply of bonds increases, and the supply curve shifts to the right. Likewise, in a

recession, when there are far fewer expected profitable investment opportunities,

the supply of bonds falls, and the supply curve shifts to the left.

Expected Inflation. As we saw in Chapter 4, the real cost of borrowing is more accurately

measured by the real interest rate, which equals the (nominal) interest rate

minus the expected inflation rate. For a given interest rate, when expected inflation

increases, the real cost of borrowing falls; hence the quantity of bonds supplied

increases at any given bond price and interest rate. An increase in expected inflation

causes the supply of bonds to increase and the supply curve to shift to the right (see

Figure 4).

Government Activities. The activities of the government can influence the supply of

bonds in several ways. The U.S. Treasury issues bonds to finance government deficits,

the gap between the government’s expenditures and its revenues. When these deficits

are large, the Treasury sells more bonds, and the quantity of bonds supplied at each

bond price and interest rate increases. Higher government deficits increase the supply

of bonds and shift the supply curve to the right (see Figure 4). On the other hand,

98 PA RT I I Financial Markets

FIGURE 4 Shift in the

Supply Curve for Bonds

When the supply of bonds

increases, the supply curve shifts

to the right. (Note: P and i

increase in opposite directions. P

on the left vertical axis increases

as we go up the axis, while i on

the right vertical axis increases

as we go down the axis.)

F

750

800

850

900

950

1,000

100 200 300 400 500 600 700

Quantity of Bonds, B

($ billions)

0.0

5.3

11.1

17.6

25.0

33.0

Price of Bonds, P ($)

(P increases )

Interest Rate, i (%)

(i increases )↑ ↑

I

H

C

G

F

I

H

C

G

Bs1

Bs2

ftp://ftp.bls.gov/pub/special

.requests/cpi/cpiai.txt

Contains historical information

about inflation.

government surpluses, as occurred in the late 1990s, decrease the supply of bonds

and shift the supply curve to the left.

State and local governments and other government agencies also issue bonds to

finance their expenditures, and this can also affect the supply of bonds. We will see

in later chapters that the conduct of monetary policy involves the purchase and sale

of bonds, which in turn influences the supply of bonds.

C H A P T E R 5 The Behavior of Interest Rates 99

Changes in the Equilibrium Interest Rate Due to Expected Inflation

or Business Cycle Expansions

Application

We now can use our knowledge of how supply and demand curves shift to

analyze how the equilibrium interest rate can change. The best way to do this

is to pursue several applications that are particularly relevant to our understanding

of how monetary policy affects interest rates.

Study Guide Supply and demand analysis for the bond market is best learned by practicing

applications. When there is an application in the text and we look at how

the interest rate changes because some economic variable increases, see if you

can draw the appropriate shifts in the supply and demand curves when this

same economic variable decreases. While you are practicing applications,

keep two things in mind:

1. When you examine the effect of a variable change, remember that we are

assuming that all other variables are unchanged; that is, we are making

use of the ceteris paribus assumption.

2. Remember that the interest rate is negatively related to the bond price,

so when the equilibrium bond price rises, the equilibrium interest rate

falls. Conversely, if the equilibrium bond price moves downward, the

equilibrium interest rate rises.

We have already done most of the work to evaluate how a change in expected

inflation affects the nominal interest rate, in that we have already analyzed

how a change in expected inflation shifts the supply and demand curves.

Figure 5 shows the effect on the equilibrium interest rate of an increase in

expected inflation.

Suppose that expected inflation is initially 5% and the initial supply and

demand curves Bs

1 and Bd

1 intersect at point 1, where the equilibrium bond

price is P1 and the equilibrium interest rate is i1. If expected inflation rises to

10%, the expected return on bonds relative to real assets falls for any given

bond price and interest rate. As a result, the demand for bonds falls, and the

demand curve shifts to the left from Bd

1 to Bd

2. The rise in expected inflation

also shifts the supply curve. At any given bond price and interest rate, the

real cost of borrowing has declined, causing the quantity of bonds supplied

to increase, and the supply curve shifts to the right, from Bs

1 to B s

2.

When the demand and supply curves shift in response to the change in

expected inflation, the equilibrium moves from point 1 to point 2, the intersection

Changes in

Expected Inflation:

The Fisher Effect

100 PA RT I I Financial Markets

FIGURE 5 Response to a

Change in Expected Inflation

When expected inflation rises,

the supply curve shifts from Bs

1

to Bs2

, and the demand curve

shifts from Bd

1 to Bd

2 . The equilibrium

moves from point 1 to

point 2, with the result that the

equilibrium bond price (left

axis) falls from P1 to P2 and the

equilibrium interest rate (right

axis) rises from i1 to i2. (Note: P

and i increase in opposite

directions. P on the left vertical

axis increases as we go up the

axis, while i on the right vertical

axis increases as we go

down the axis.)

1

2

Bd

1

Bd

2

i1

i2

P1

P2

Price of Bonds, P

(P increases )

Interest Rate, i

(i increases )

Quantity of Bonds, B

↑ ↑

Bs

1

Bs

2

of Bd

2 and Bs

2. The equilibrium bond price has fallen from P1 to P2, and

because the bond price is negatively related to the interest rate (as is indicated

by the interest rate rising as we go down the right vertical axis), this means

that the interest rate has risen from i1 to i2. Note that Figure 5 has been drawn

so that the equilibrium quantity of bonds remains the same for both point 1

and point 2. However, depending on the size of the shifts in the supply and

demand curves, the equilibrium quantity of bonds could either rise or fall

when expected inflation rises.

Our supply and demand analysis has led us to an important observation:

When expected inflation rises, interest rates will rise. This result has been

named the Fisher effect, after Irving Fisher, the economist who first pointed

out the relationship of expected inflation to interest rates. The accuracy of

this prediction is shown in Figure 6. The interest rate on three-month

Treasury bills has usually moved along with the expected inflation rate.

Consequently, it is understandable that many economists recommend that

inflation must be kept low if we want to keep interest rates low.

Figure 7 analyzes the effects of a business cycle expansion on interest rates.

In a business cycle expansion, the amounts of goods and services being produced

in the economy rise, so national income increases. When this occurs,

businesses will be more willing to borrow, because they are likely to have

many profitable investment opportunities for which they need financing.

Hence at a given bond price and interest rate, the quantity of bonds that firms

want to sell (that is, the supply of bonds) will increase. This means that in a

business cycle expansion, the supply curve for bonds shifts to the right (see

Figure 7) from Bs

1 to Bs

2.

Business Cycle

Expansion

C H A P T E R 5 The Behavior of Interest Rates 101

FIGURE 6 Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2002

Source: Expected inflation calculated using procedures outlined in Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference

Series on Public Policy 15 (1981): 151–200. These procedures involve estimating expected inflation as a function of past interest rates, inflation, and time trends.

1955

20

16

12

8

4

0

1960 1970 1980 1990 2000

Annual Rate (%)

1965 1975 1985 1995

Interest Rate

Expected Inflation

FIGURE 7 Response to a

Business Cycle Expansion

In a business cycle expansion,

when income and wealth are

rising, the demand curve shifts

rightward from Bd

1 to Bd

2, and

the supply curve shifts rightward

from Bs1

to Bs

2. If the supply

curve shifts to the right

more than the demand curve, as

in this figure, the equilibrium

bond price (left axis) moves down

from P1 to P2, and the equilibrium

interest rate (right axis) rises

from i1 to i2. (Note: P and i

increase in opposite directions.

P on the left vertical axis

increases as we go up the axis,

while i on the right vertical axis

increases as we go down the

axis.)

Price of Bonds, P

(P increases )

Interest Rate, i

(i increases )

Quantity of Bonds, B

↑ ↑

1

2

Bd

1

Bd

2

i 1

i 2

P1

P2

Bs1

Bs2

102 PA RT I I Financial Markets

Expansion in the economy will also affect the demand for bonds. As the

business cycle expands, wealth is likely to increase, and then the theory of

asset demand tells us that the demand for bonds will rise as well. We see this

in Figure 7, where the demand curve has shifted to the right, from Bd

1 to Bd

2.

Given that both the supply and demand curves have shifted to the right,

we know that the new equilibrium reached at the intersection of Bd

2 and Bs

2

must also move to the right. However, depending on whether the supply

curve shifts more than the demand curve or vice versa, the new equilibrium

interest rate can either rise or fall.

The supply and demand analysis used here gives us an ambiguous

answer to the question of what will happen to interest rates in a business

cycle expansion. The figure has been drawn so that the shift in the supply

curve is greater than the shift in the demand curve, causing the equilibrium

bond price to fall to P2, leading to a rise in the equilibrium interest rate to i2.

The reason the figure has been drawn so that a business cycle expansion and

a rise in income lead to a higher interest rate is that this is the outcome we

actually see in the data. Figure 8 plots the movement of the interest rate on

three-month U.S. Treasury bills from 1951 to 2002 and indicates when the

business cycle is undergoing recessions (shaded areas). As you can see, the

interest rate rises during business cycle expansions and falls during recessions,

which is what the supply and demand diagram indicates.

FIGURE 8 Business Cycle and Interest Rates (Three-Month Treasury Bills), 1951–2002

Shaded areas indicate periods of recession. The figure shows that interest rates rise during business cycle expansions and fall during contractions,

which is what Figure 7 suggests would happen.

Source: Federal Reserve: www.federalreserve.gov/releases/H15/data.htm.

16

14

18

12

10

8

6

4

2

0

1950 1960 1970 1980 1990

Interest Rate

(%)

1955 1965 1975 1985 1995 2000

Interest Rate

C H A P T E R 5 The Behavior of Interest Rates 103

Application Explaining Low Japanese Interest Rates

In the 1990s and early 2000s, Japanese interest rates became the lowest in

the world. Indeed, in November 1998, an extraordinary event occurred:

Interest rates on Japanese six-month Treasury bills turned slightly negative

(see Chapter 4). Why did Japanese rates drop to such low levels?

In the late 1990s and early 2000s, Japan experienced a prolonged recession,

which was accompanied by deflation, a negative inflation rate. Using

these facts, analysis similar to that used in the preceding application explains

the low Japanese interest rates.

Negative inflation caused the demand for bonds to rise because the

expected return on real assets fell, thereby raising the relative expected return

on bonds and in turn causing the demand curve to shift to the right. The negative

inflation also raised the real interest rate and therefore the real cost of

borrowing for any given nominal rate, thereby causing the supply of bonds

to contract and the supply curve to shift to the left. The outcome was then

exactly the opposite of that graphed in Figure 5: The rightward shift of the

demand curve and leftward shift of the supply curve led to a rise in the bond

price and a fall in interest rates.

The business cycle contraction and the resulting lack of investment

opportunities in Japan also led to lower interest rates, by decreasing the supply

of bonds and shifting the supply curve to the left. Although the demand

curve also would shift to the left because wealth decreased during the business

cycle contraction, we have seen in the preceding application that the

demand curve would shift less than the supply curve. Thus, the bond price

rose and interest rates fell (the opposite outcome to that in Figure 7).

Usually, we think that low interest rates are a good thing, because they

make it cheap to borrow. But the Japanese example shows that just as there

is a fallacy in the adage, “You can never be too rich or too thin”: (maybe you

can’t be too rich, but you can certainly be too thin and do damage to your

health), there is a fallacy in always thinking that lower interest rates are better.

In Japan, the low and even negative interest rates were a sign that the

Japanese economy was in real trouble, with falling prices and a contracting

economy. Only when the Japanese economy returns to health will interest

rates rise back to more normal levels.

Application Reading the Wall Street Journal “Credit Markets” Column

Now that we have an understanding of how supply and demand determine

prices and interest rates in the bond market, we can use our analysis to

understand discussions about bond prices and interest rates appearing in the

financial press. Every day, the Wall Street Journal reports on developments in

the bond market on the previous business day in its “Credit Markets” column,

an example of which is found in the “Following the Financial News”

box. Let’s see how statements in the “Credit Markets” column can be

explained using our supply and demand framework.

104 PA RT I I Financial Markets

The column describes how the coming announcement of the Bush stimulus

package, which was larger than expected, has led to a decline in the prices

of Treasury bonds. This is exactly what our supply and demand analysis predicts

would happen.

The larger than expected stimulus package has raised concerns about rising

future issuance of government bonds, as is mentioned in the second paragraph.

The increased supply of bonds in the future will thus shift the supply

curve to the right, thereby lowering the price of these bonds in the future by

more than expected. The resulting decline in the expected return on these

bonds because of their higher future price will lead to an immediate rightward

shift in the demand for these bonds today. The outcome is thus a fall in their

equilibrium price and a rise in their interest rates.

Our analysis thus demonstrates why, even though the Bush plan has not

increased the supply of bonds today, the price of these bonds falls immediately.

BY MICHAEL MACKENZIE

Dow Jones Newswires

NEW YORK—Already buckling amid signs

of improvement in the economy and a departure

of investors seeking better returns in corporate

bonds and equities, Treasurys face

another bearish element when President Bush

outlines his fiscal-stimulus package today.

Reports that the package could total

about $600 billion over 10 years, much

larger than expected by bond investors, contributed

to a further selloff yesterday amid

concerns about rising future issuance of government

bonds.

After closing 2002 around 2.73% and

3.81%, respectively, five-year and 10-year

Treasury yields have risen sharply in the new

year. Yesterday, five-year and 10-year yields

ended at 3.04% and 4.06%, respectively, up

from 2.98% and 4.03% Friday.

The benchmark 10-year note’s price,

which moves inversely to its yield, at 4 p.m.

was down 11/32 point, or $3.44 per $1,000

face value, at 99 15/32.

The 30-year bond’s price was down 14/32

point at 105 27/32 to yield 4.984%, up from

4.949% Friday.

The selloff was concentrated in shortermaturity

Treasurys, as investors sold those

issues while buying long-dated Treasurys in

so-called curve-flattening trades. Later, hedging

related to nongovernment bond issues

helped lift prices from lows but failed to

spark any real rally.

Although uncertainty about geopolitical

issues continued to lend some support to

Treasurys, the proposed Bush stimulus package

“is front and center for the Treasurys

market at the moment,” said Michael

Kastner, head of taxable fixed income for

Deutsche Private Banking, New York.

“Details are leaking out, and Treasurys are

selling off.”

The prospect of rising government spending

means more Treasury issuance, concentrated

in the five-and 10-year areas, analysts

said. Lehman Brothers forecast “net supply”

of Treasurys would increase about $300 billion

this year.

“The Treasury market already reflects the

assumption that a large stimulus package

will be unveiled,” said Joseph Shatz, government-

securities strategist at Merrill Lynch.

However, he noted that key questions for the

market are “what elements of stimulus will

be passed, and the time frame of stimulus

objectives.”

Indeed, there are some factors that mitigate

the package’s short-term impact on the

economy and the market, some added.

Analysts at Wrightson ICAP in Jersey City,

N.J., said roughly half of a $500 billion to

$600 billion stimulus package “will be

longer-term supply-side tax reform measures

spread evenly over the period, while the

other half would be more quick-focused fixes

for the business cycle.”

The proposal to eliminate taxes individuals

pay on dividends would boost stocks,

likely at the expense of bonds, analysts said.

They also noted that the Bush proposals

have to muster congressional support, which

could take some time.

Yet, most added, there is no escaping the

sense that the stars are aligned against the

Treasury market this year, with a hefty stimulus

package another bleak factor clouding

the outlook for government bonds.

“Treasury yields are currently too low,” said

Deutsche’s Mr. Kastner. “Uncertainty over Iraq

is maintaining some support for Treasurys,

but we are starting to sense that the mood of

the market is one of selling the rallies.”

Treasurys Drop Ahead of Bush Stimulus Package

Selloff Is Fueled by Reports Of More Extensive Plan Than Investors Expected

CREDIT MARKETS

Source: Wall Street Journal, Tuesday, January 7, 2003, p. C14.

Following the Financial News

The “Credit Markets” column appears daily in

the Wall Street Journal; an example is presented here.

It is found in the third section, “Money and Investing.”

The “Credit Markets” Column

Supply and Demand in the Market for Money:

The Liquidity Preference Framework

Whereas the loanable funds framework determines the equilibrium interest rate using

the supply of and demand for bonds, an alternative model developed by John

Maynard Keynes, known as the liquidity preference framework, determines the

equilibrium interest rate in terms of the supply of and demand for money. Although

the two frameworks look different, the liquidity preference analysis of the market for

money is closely related to the loanable funds framework of the bond market.4

The starting point of Keynes’s analysis is his assumption that there are two main

categories of assets that people use to store their wealth: money and bonds. Therefore,

total wealth in the economy must equal the total quantity of bonds plus money in the

economy, which equals the quantity of bonds supplied (Bs) plus the quantity of

money supplied (Ms). The quantity of bonds (Bd) and money (Md) that people want

to hold and thus demand must also equal the total amount of wealth, because people

cannot purchase more assets than their available resources allow. The conclusion is

that the quantity of bonds and money supplied must equal the quantity of bonds and

money demanded:

Bs Ms Bd Md (2)

Collecting the bond terms on one side of the equation and the money terms on

the other, this equation can be rewritten as:

Bs Bd Md Ms (3)

The rewritten equation tells us that if the market for money is in equilibrium (Ms

Md ), the right-hand side of Equation 3 equals zero, implying that Bs Bd, meaning

that the bond market is also in equilibrium.

Thus it is the same to think about determining the equilibrium interest rate by

equating the supply and demand for bonds or by equating the supply and demand

for money. In this sense, the liquidity preference framework, which analyzes the market

for money, is equivalent to the loanable funds framework, which analyzes the

bond market. In practice, the approaches differ, because by assuming that there are

only two kinds of assets, money and bonds, the liquidity preference approach implicitly

ignores any effects on interest rates that arise from changes in the expected returns

on real assets such as automobiles and houses. In most instances, however, both

frameworks yield the same predictions.

The reason that we approach the determination of interest rates with both frameworks

is that the loanable funds framework is easier to use when analyzing the effects

from changes in expected inflation, whereas the liquidity preference framework provides

a simpler analysis of the effects from changes in income, the price level, and the

supply of money.

Because the definition of money that Keynes used includes currency (which earns

no interest) and checking account deposits (which in his time typically earned little

C H A P T E R 5 The Behavior of Interest Rates 105

4Note that the term market for money refers to the market for the medium of exchange, money. This market differs

from the money market referred to by finance practitioners, which is the financial market in which short-term

debt instruments are traded.

or no interest), he assumed that money has a zero rate of return. Bonds, the only alternative

asset to money in Keynes’s framework, have an expected return equal to the

interest rate i.5 As this interest rate rises (holding everything else unchanged), the

expected return on money falls relative to the expected return on bonds, and as the

theory of asset demand tells us, this causes the demand for money to fall.

We can also see that the demand for money and the interest rate should be negatively

related by using the concept of opportunity cost, the amount of interest

(expected return) sacrificed by not holding the alternative asset—in this case, a bond.

As the interest rate on bonds, i, rises, the opportunity cost of holding money rises,

and so money is less desirable and the quantity of money demanded must fall.

Figure 9 shows the quantity of money demanded at a number of interest rates,

with all other economic variables, such as income and the price level, held constant.

At an interest rate of 25%, point A shows that the quantity of money demanded is $100

billion. If the interest rate is at the lower rate of 20%, the opportunity cost of money is

lower, and the quantity of money demanded rises to $200 billion, as indicated by the

move from point A to point B. If the interest rate is even lower, the quantity of money

demanded is even higher, as is indicated by points C, D, and E. The curve Md connecting

these points is the demand curve for money, and it slopes downward.

At this point in our analysis, we will assume that a central bank controls the

amount of money supplied at a fixed quantity of $300 billion, so the supply curve for

106 PA RT I I Financial Markets

FIGURE 9 Equilibrium in the

Market for Money

5

10

20

25

30

0 200 300 400 500 600

i * = 15

Quantity of Money, M

($ billions)

Ms

Md

100

Interest Rate, i

(%)

A

B

C

D

E

5Keynes did not actually assume that the expected returns on bonds equaled the interest rate but rather argued

that they were closely related (see Chapter 24). This distinction makes no appreciable difference in our analysis.

money Ms in the figure is a vertical line at $300 billion. The equilibrium where the

quantity of money demanded equals the quantity of money supplied occurs at the

intersection of the supply and demand curves at point C, where

Md Ms (4)

The resulting equilibrium interest rate is at i * 15%.

We can again see that there is a tendency to approach this equilibrium by first

looking at the relationship of money demand and supply when the interest rate is

above the equilibrium interest rate. When the interest rate is 25%, the quantity of

money demanded at point A is $100 billion, yet the quantity of money supplied is

$300 billion. The excess supply of money means that people are holding more money

than they desire, so they will try to get rid of their excess money balances by trying

to buy bonds. Accordingly, they will bid up the price of bonds, and as the bond price

rises, the interest rate will fall toward the equilibrium interest rate of 15%. This tendency

is shown by the downward arrow drawn at the interest rate of 25%.

Likewise, if the interest rate is 5%, the quantity of money demanded at point E is

$500 billion, but the quantity of money supplied is only $300 billion. There is now

an excess demand for money because people want to hold more money than they currently

have. To try to obtain more money, they will sell their only other asset—

bonds—and the price will fall. As the price of bonds falls, the interest rate will rise

toward the equilibrium rate of 15%. Only when the interest rate is at its equilibrium

value will there be no tendency for it to move further, and the interest rate will settle

to its equilibrium value.

Changes in Equilibrium Interest Rates in the

Liquidity Preference Framework

Analyzing how the equilibrium interest rate changes using the liquidity preference

framework requires that we understand what causes the demand and supply curves

for money to shift.

Study Guide Learning the liquidity preference framework also requires practicing applications.

When there is an application in the text to examine how the interest rate changes

because some economic variable increases, see if you can draw the appropriate shifts

in the supply and demand curves when this same economic variable decreases. And

remember to use the ceteris paribus assumption: When examining the effect of a

change in one variable, hold all other variables constant.

In Keynes’s liquidity preference analysis, two factors cause the demand curve for

money to shift: income and the price level.

Income Effect. In Keynes’s view, there were two reasons why income would affect the

demand for money. First, as an economy expands and income rises, wealth increases

and people will want to hold more money as a store of value. Second, as the economy

Shifts in the

Demand for

Money

C H A P T E R 5 The Behavior of Interest Rates 107

expands and income rises, people will want to carry out more transactions using

money, with the result that they will also want to hold more money. The conclusion

is that a higher level of income causes the demand for money to increase and the

demand curve to shift to the right.

Price-Level Effect. Keynes took the view that people care about the amount of money

they hold in real terms; that is, in terms of the goods and services that it can buy.

When the price level rises, the same nominal quantity of money is no longer as valuable;

it cannot be used to purchase as many real goods or services. To restore their

holdings of money in real terms to its former level, people will want to hold a greater

nominal quantity of money, so a rise in the price level causes the demand for money

to increase and the demand curve to shift to the right.

We will assume that the supply of money is completely controlled by the central bank,

which in the United States is the Federal Reserve. (Actually, the process that determines

the money supply is substantially more complicated, involving banks, depositors,

and borrowers from banks. We will study it in more detail later in the book.) For

now, all we need to know is that an increase in the money supply engineered by the

Federal Reserve will shift the supply curve for money to the right.

Shifts in the

Supply of Money

108 PA RT I I Financial Markets

Changes in the Equilibrium Interest Rate Due to Changes in

Income, the Price Level, or the Money Supply

Application

To see how the liquidity preference framework can be used to analyze the movement

of interest rates, we will again look at several applications that will be useful

in evaluating the effect of monetary policy on interest rates. (As a study aid,

Table 4 summarizes the shifts in the demand and supply curves for money.)

When income is rising during a business cycle expansion, we have seen that

the demand for money will rise, shown in Figure 10 by the shift rightward in

the demand curve from Md

1 to Md

2. The new equilibrium is reached at point

2 at the intersection of the Md

2 curve with the money supply curve Ms. As you

can see, the equilibrium interest rate rises from i1 to i2. The liquidity preference

framework thus generates the conclusion that when income is rising

during a business cycle expansion (holding other economic variables constant),

interest rates will rise. This conclusion is unambiguous when contrasted

to the conclusion reached about the effects of a change in income on

interest rates using the loanable funds framework.

When the price level rises, the value of money in terms of what it can purchase

is lower. To restore their purchasing power in real terms to its former

level, people will want to hold a greater nominal quantity of money. A higher

price level shifts the demand curve for money to the right from Md

1 to Md

2

(see Figure 10). The equilibrium moves from point 1 to point 2, where the

equilibrium interest rate has risen from i1 to i2, illustrating that when the

price level increases, with the supply of money and other economic variables

held constant, interest rates will rise.

Changes in the

Price Level

Changes in Income

C H A P T E R 5 The Behavior of Interest Rates 109

An increase in the money supply due to expansionary monetary policy by the

Federal Reserve implies that the supply curve for money shifts to the right.

As is shown in Figure 11 by the movement of the supply curve from Ms

1 to

Ms

2, the equilibrium moves from point 1 down to point 2, where the Ms

2 supply

curve intersects with the demand curve Md and the equilibrium interest

rate has fallen from i1 to i2. When the money supply increases (everything

else remaining equal), interest rates will decline.6

Changes in the

Money Supply

S U M M A R Y Table 4 Factors That Shift the Demand for and Supply of Money

Change in Money

Change in Demand (Md) Change in

Variable Variable or Supply (Ms) Interest Rate

Income ↑ Md ↑ ↑

Price level ↑ Md ↑ ↑

Money supply ↑ Ms ↑ ↓

Note: Only increases in the variables are shown. The effect of decreases in the variables on the change in demand would be the opposite

of those indicated in the remaining columns.

M

Ms

i2

i1

M d1

M d2

←

M

i1

i2

M s1

M s2

←

Md

M

i2

i1

M d1

M d2

←

Ms

6This same result can be generated using the loanable funds framework. As we will see in Chapters 15 and 16,

the primary way that a central bank produces an increase in the money supply is by buying bonds and thereby

decreasing the supply of bonds to the public. The resulting shift to the left of the supply curve for bonds will lead

to a decline in the equilibrium interest rate.

www.federalreserve.gov

/releases/H6/Current

The Federal Reserve reports

money supply data at

4:30 p.m. every Thursday.

110 PA RT I I Financial Markets

FIGURE 10 Response to a

Change in Income or the Price Level

In a business cycle expansion,

when income is rising, or when

the price level rises, the demand

curve shifts from Md

1 to Md

2. The

supply curve is fixed at Ms .

The equilibrium interest rate rises

from i1 to i2.

M

FIGURE 11 Response to a

Change in the Money Supply

When the money supply increases,

the supply curve shifts from Ms1

Ms2

, and the equilibrium interest

rate falls from i1 to i2.

Md

1

Md

2

2

1

i2

i1

M

Interest Rate, i

Quantity of Money, M

Ms

Quantity of Money, M

Ms Ms

2

1

i2

i1

Interest Rate, i

Md

1 2

C H A P T E R 5 The Behavior of Interest Rates 111

Following the Financial News

Forecasting interest rates is a time-honored profession.

Economists are hired (sometimes at very high

salaries) to forecast interest rates, because businesses

need to know what the rates will be in order to plan

their future spending, and banks and investors

require interest-rate forecasts in order to decide

which assets to buy. Interest-rate forecasters predict

what will happen to the factors that affect the supply

and demand for bonds and for money—factors such

as the strength of the economy, the profitability of

investment opportunities, the expected inflation rate,

and the size of government budget deficits and borrowing.

They then use the supply and demand analysis

we have outlined in this chapter to come up with

their interest-rate forecasts.

The Wall Street Journal reports interest-rate forecasts

by leading prognosticators twice a year (early January

and July) in its “Economy” column or in its “Credit

Markets” column, which surveys developments in the

bond market daily. Forecasting interest rates is a perilous

business. To their embarrassment, even the top

experts are frequently far off in their forecasts.

Forecasting Interest Rates

The Wall Street Journal Forecasting Survey for 2003

In percent except for dollar vs. yen and dollar vs. euro

JULY 2002 SURVEY NEW FORECASTS FOR 2003

3-MO. 10-YR. GDP-b CPI-c $U.S. UNEMPL. 3-MO. 10-YR. GDP-b CPI-c $U.S. $U.S. UNEMPL.

TREASURY vs. TREASURY vs. vs.

BILL-a NOTE Q1–Q3 YEN BILLS-a NOTE Q1 Q2 Q3 Q4 YEN EURO

Dec. Dec. 2002 Nov. Dec. Nov. June June 2003 2003 2003 2003 May June June May

Susan M. Sterne, Economic Analysis 2.50 5.30 2.9 2.1 125 5.8 2.25 5.50 4.6 4.0 4.2 4.3 2.5 115 1.10 5.6

Gail Fosler, The Conference Board 2.30 5.35 2.2 2.7 132 6.1 1.50 5.10 4.2 3.1 4.1 5.2 2.5 131 0.87 5.9

Stephen Gallagher, Societe Generale 2.15 5.60 2.4 2.7 120 5.9 1.25 4.50 4.0 3.0 3.5 3.5 2.3 125 1.00 5.7

Ian Shepherdson, High Frequency Economics 2.00 5.25 3.3 N.A. 135 6.5 1.25 4.75 4.0 4.0 5.0 5.0 2.2 N.A. N.A. 6.5

James F. Smith, University of North Carolina 2.45 4.30 4.8 1.8 143 5.2 1.48 4.00 3.8 4.3 3.2 2.8 1.5 137 0.89 5.6

Lawrence Kudlow, Kudlow & Co. LLC 1.90 5.30 3.7 2.2 130 5.8 1.50 5.00 3.6 4.5 4.5 5.0 2.1 130 1.00 5.8

D. Malpass/J. Ryding, Bear Stearns 2.00 5.10 1.6 1.9 132 6.1 1.60 4.80 3.6 3.9 4.1 4.1 1.8 130 0.95 5.9

Michael K. Evans, Evans Carroll & Assoc. 1.75 5.00 1.0 2.1 130 6.1 1.30 4.30 3.5 2.0 3.5 2.5 3.0 135 1.00 6.2

Tracy Herrick, Jefferies & Company Inc. 2.60 5.40 2.3 1.8 118 5.4 1.20 4.00 3.5 3.0 3.5 4.0 2.7 125 1.05 5.7

David L. Littman, Comerica Bank 2.42 5.50 3.4 1.2 117 6.0 1.60 4.80 3.5 4.0 4.0 4.0 2.2 130 0.97 5.7

Paul McCulley, PIMCO 1.70 5.20 2.3 1.5 130 6.0 1.20 4.15 3.5 2.5 3.0 2.5 2.3 125 1.03 5.8

Henry Willmore, Barclays Capital 2.40 5.60 4.2 2.3 135 6.2 1.40 4.40 3.5 4.5 4.5 2.0 2.3 135 0.92 5.9

J. Meil/A. Raha, Eaton Corp. 2.80 5.40 N.A. 2.8 130 5.6 1.50 4.30 3.3 3.5 3.4 3.4 2.2 123 1.00 6.0

A. Hodge/W. Mak, Global Insight 2.30 5.60 1.2 2.0 125 6.0 1.30 5.60 3.2 3.3 3.9 4.5 2.2 123 0.98 6.1

Kurt Karl, Swiss Re 2.70 5.40 0.4 2.5 120 6.0 1.60 5.00 3.2 3.6 4.2 3.9 1.9 128 1.00 5.8

Richard D. Rippe, Prudential Securities 2.25 5.20 3.3 2.4 115 6.0 1.30 4.50 3.2 3.5 3.9 4.3 2.3 120 1.05 6.1

Daniel Laufenberg, American Express 2.30 5.15 3.1 2.5 125 5.6 1.50 4.50 3.1 3.0 4.1 3.8 2.0 120 1.04 5.7

John D. Mueller, LBMC LLC 2.50 5.60 4.7 1.6 115 5.5 1.50 4.90 3.1 5.5 6.7 6.0 0.9 118 0.96 5.6

Diane C. Swonk, Bank One, NA 3.00 5.10 2.5 2.0 123 5.7 1.44 4.00 3.1 2.9 3.3 3.3 2.9 123 0.98 6.1

David Wyss, Standard and Poor’s 1.80 4.90 2.1 2.4 115 5.7 1.20 4.30 3.1 3.1 4.5 3.8 2.2 130 1.02 6.4

James W. Coons, Huntington National Bank 1.85 5.00 1.5 2.5 120 5.7 1.50 4.35 3.0 3.5 3.5 3.5 2.4 130 1.00 5.8

Richard DeKaser, National City Corporation 2.69 5.05 2.5 2.3 135 5.7 1.27 4.53 3.0 3.2 4.3 4.4 2.4 118 1.04 5.8

Neal Soss, CSFB 1.70 4.25 2.0 2.6 122 5.5 1.25 3.40 3.0 2.7 2.9 2.7 2.4 112 1.07 6.1

Brian S.Wesbury, Griffin Kubik Steph. & Thomp. 2.32 5.80 1.8 2.1 126 5.4 1.25 4.50 3.0 3.0 4.8 5.2 2.6 125 1.05 5.8

Stuart Hoffman, PNC Financial Services Group 2.00 5.30 1.3 2.3 125 5.7 1.25 4.05 2.8 3.0 3.5 3.5 2.4 125 1.02 5.8

John Lonski, Moody’s Investors Service 2.30 5.40 2.4 1.8 125 5.5 1.53 4.40 2.8 2.9 3.5 3.7 2.3 122 1.04 5.7

R. T. McGee/T.W. Synnott, US Trust Co. 2.00 5.40 1.8 2.2 125 5.7 1.20 4.30 2.8 2.9 3.5 3.8 2.2 125 1.05 5.8

David Lereah, National Association of Realtors N.A. N.A. N.A. N.A. N.A. N.A. 1.80 4.40 2.7 3.0 3.6 3.2 2.4 125 0.98 5.7

Maria Fiorini Ramirez, MFR Inc. 2.00 5.00 1.7 1.7 123 5.9 1.25 4.00 2.6 2.0 2.5 2.7 2.1 128 1.05 6.2

J. Prakken/C. Varvares, Macroeconomic Adv. N.A. N.A. N.A. N.A. N.A. N.A. 1.20 4.32 2.6 3.4 3.7 3.7 2.0 121 1.01 5.7

David W. Berson, Fannie Mae 2.00 5.20 2.2 2.6 121 5.5 1.30 4.40 2.5 3.5 3.7 3.6 2.0 135 1.05 5.8

(continued)

N.A. Not Available; a Treasury bill rates are on a bond-equivalent basis; b Real gross domestic product, average annualized rate for first three quarters, based on January and July surveys;

c Year-to-year change in the consumer price index; d David Rosenberg replaces Bruce Steinberg at Merrill Lynch; e Averages are for analysts polled at time of survey

Source: Wall Street Journal, Thursday, January 2, 2003, p. A2.

112 PA RT I I Financial Markets

Application Money and Interest Rates

The liquidity preference analysis in Figure 11 seems to lead to the conclusion

that an increase in the money supply will lower interest rates. This conclusion

has important policy implications because it has frequently caused

politicians to call for a more rapid growth of the money supply in order to

drive down interest rates.

But is this conclusion that money and interest rates should be negatively

related correct? Might there be other important factors left out of the liquidity

preference analysis in Figure 11 that would reverse this conclusion? We

will provide answers to these questions by applying the supply and demand

analysis we have used in this chapter to obtain a deeper understanding of the

relationship between money and interest rates.

An important criticism of the conclusion that a rise in the money supply

lowers interest rates has been raised by Milton Friedman, a Nobel laureate in

economics. He acknowledges that the liquidity preference analysis is correct

and calls the result—that an increase in the money supply (everything else

Following the Financial News

The Wall Street Journal Forecasting Survey for 2003 (continued)

In percent except for dollar vs. yen and dollar vs. euro

JULY 2002 SURVEY NEW FORECASTS FOR 2003

3-MO. 10-YR. GDP-b CPI-c $U.S. UNEMPL. 3-MO. 10-YR. GDP-b CPI-c $U.S. $U.S. UNEMPL.

TREASURY vs. TREASURY vs. vs.

BILL-a NOTE Q1–Q3 YEN BILLS-a NOTE Q1 Q2 Q3 Q4 YEN EURO

Dec. Dec. 2002 Nov. Dec. Nov. June June 2003 2003 2003 2003 May June June May

Maury Harris, UBS Warburg 2.00 5.00 1.7 2.0 120 5.9 1.60 4.60 2.5 4.5 3.5 3.5 2.3 115 1.05 5.7

William B. Hummer,Wayne Hummer Invest. 2.21 5.05 2.2 2.4 119 5.5 1.31 4.14 2.5 3.1 3.6 3.8 2.1 125 1.05 5.8

R. Shrouds/R. Fry, DuPont Co. 1.80 5.00 2.9 2.1 110 5.8 1.30 4.50 2.5 3.0 3.5 3.5 1.9 128 1.05 6.0

Allen Sinai, Decision Economics Inc. 1.82 4.94 0.8 1.9 123 6.0 1.27 4.17 2.5 2.2 2.9 3.2 2.2 135 1.06 6.5

Sung Won Sohn,Wells Fargo & Co. 2.05 5.20 1.8 3.0 115 5.7 1.30 4.40 2.5 3.7 3.8 3.8 1.5 125 0.99 5.8

Gary Thayer, A.G. Edwards 2.20 5.60 2.0 1.8 120 5.5 1.40 4.50 2.5 3.5 3.0 4.5 2.1 119 1.06 5.7

Mark Zandi, Economy.com 2.20 5.25 1.1 2.2 125 6.0 1.70 4.50 2.4 2.7 3.2 3.8 2.2 125 1.00 6.3

R. Berner/D. Greenlaw, Morgan Stanley 2.00 5.30 1.9 2.6 124 5.8 1.50 4.50 2.3 3.8 3.9 3.5 1.9 120 1.05 5.9

David Resler, Nomura Securities International 1.90 5.10 3.2 2.4 120 5.9 1.25 4.25 2.3 3.0 3.5 3.8 1.8 125 1.04 6.0

Edward Leamer, UCLA Anderson Forecast N.A. N.A. N.A. N.A. N.A. N.A. 2.03 4.00 2.2 2.3 2.7 3.2 2.4 N.A. 1.10 6.1

David Rosenberg, Merrill Lynch[d] 2.25 5.25 2.3 2.0 125 5.8 1.20 4.00 2.2 3.3 3.0 3.5 2.4 125 1.07 6.5

Saul Hymans, RSQE, University of Michigan 2.30 5.30 1.9 2.7 122 5.6 1.72 4.03 2.1 4.3 4.2 4.2 2.4 N.A. N.A. 6.1

Nicholas S. Perna, Perna Associates 2.62 5.53 1.3 2.1 122 5.7 1.47 4.53 2.1 3.0 2.9 3.1 2.3 114 1.03 5.5

Richard Yamarone, Argus Research 3.00 5.65 3.1 2.8 128 4.7 1.70 4.60 2.1 2.5 3.0 2.5 3.3 128 1.00 5.6

Ram Bhagavatula, The Royal Bank of Scotland 2.45 5.35 3.8 2.4 121 5.4 1.10 3.75 2.0 2.8 4.1 4.3 21 127 1.06 6.1

J. Dewey Daane, Vanderbilt University 2.00 5.00 0.8 2.0 121 6.0 1.60 4.50 2.0 2.2 2.4 2.6 2.0 118 1.00 5.9

Peter Hooper, Deutsche Bank Securities 2.25 5.40 2.7 2.3 130 5.7 1.75 4.50 2.0 4.0 4.0 3.9 1.4 130 1.05 6.1

William T.Wilson, Ernst & Young 2.50 6.25 2.0 2.5 115 5.5 1.60 5.40 2.0 5.0 4.0 4.1 1.4 120 1.00 5.6

Robert DiClemente, Citibank SSB 1.90 5.30 2.6 1.9 125 5.8 1.30 4.60 1.8 2.7 3.3 4.1 1.9 132 0.93 5.9

Mike Cosgrove, Econoclast 2.00 5.30 2.1 2.3 130 6.0 1.30 4.30 1.6 2.9 3.5 4.0 2.4 125 1.00 6.0

William C. Dudley, Goldman Sachs 2.00 5.00 1.5 2.4 132 6.0 1.00 4.20 1.5 2.5 3.0 3.5 2.1 120 1.08 6.4

Ethan S. Harris, Lehman Brothers N.A. 4.85 N.A. 2.2 116 6.1 1.20 4.20 1.5 3.0 3.5 4.0 2.3 124 1.07 6.2

Donald H. Straszheim, Straszheim Global Adv. 2.25 5.15 N.A. 1.9 114 5.9 1.40 4.40 1.0 2.0 4.0 4.0 2.0 127 1.04 6.1

A. Gary Shilling, A. Gary Shilling & Co. 1.50 4.00 –1.1 0.5 130 6.4 0.75 3.50 –2.0 –2.0 2.0 3.0 1.2 130 0.94 7.3

AVERAGE [e] 2.20 5.20 2.3 2.2 122 5.8 1.41 4.42 2.7 3.2 3.7 3.7 2.2 125 1.02 6.0

ACTUAL NUMBERS as of Dec. 31, 2002 1.21 3.82 3.4 2.2 119 6.0

N.A. Not Available; a Treasury bill rates are on a bond-equivalent basis; b Real gross domestic product, average annualized rate for first three quarters, based on January and July surveys;

c Year-to-year change in the consumer price index; d David Rosenberg replaces Bruce Steinberg at Merrill Lynch; e Averages are for analysts polled at time of survey

Source: Wall Street Journal, Thursday, January 2, 2003, p. A2.

C H A P T E R 5 The Behavior of Interest Rates 113

remaining equal) lowers interest rates—the liquidity effect. However, he views

the liquidity effect as merely part of the story: An increase in the money supply

might not leave “everything else equal” and will have other effects on the

economy that may make interest rates rise. If these effects are substantial, it is

entirely possible that when the money supply rises, interest rates too may rise.

We have already laid the groundwork to discuss these other effects

because we have shown how changes in income, the price level, and

expected inflation affect the equilibrium interest rate.

Study Guide To get further practice with the loanable funds and liquidity preference

frameworks, show how the effects discussed here work by drawing the supply

and demand diagrams that explain each effect. This exercise will also

improve your understanding of the effect of money on interest rates.

1. Income Effect. Because an increasing money supply is an expansionary

influence on the economy, it should raise national income and wealth.

Both the liquidity preference and loanable funds frameworks indicate that

interest rates will then rise (see Figures 7 and 10). Thus the income effect of

an increase in the money supply is a rise in interest rates in response to the

higher level of income.

2. Price-Level Effect. An increase in the money supply can also cause the

overall price level in the economy to rise. The liquidity preference framework

predicts that this will lead to a rise in interest rates. So the price-level effect

from an increase in the money supply is a rise in interest rates in response

to the rise in the price level.

3. Expected-Inflation Effect. The higher inflation rate that results from an

increase in the money supply also affects interest rates by affecting the

expected inflation rate. Specifically, an increase in the money supply may lead

people to expect a higher price level in the future—hence the expected inflation

rate will be higher. The loanable funds framework has shown us that this

increase in expected inflation will lead to a higher level of interest rates.

Therefore, the expected-inflation effect of an increase in the money supply is

a rise in interest rates in response to the rise in the expected inflation rate.

At first glance it might appear that the price-level effect and the

expected-inflation effect are the same thing. They both indicate that increases

in the price level induced by an increase in the money supply will raise interest

rates. However, there is a subtle difference between the two, and this is

why they are discussed as two separate effects.

Suppose that there is a onetime increase in the money supply today that

leads to a rise in prices to a permanently higher level by next year. As the

price level rises over the course of this year, the interest rate will rise via the

price-level effect. Only at the end of the year, when the price level has risen

to its peak, will the price-level effect be at a maximum.

The rising price level will also raise interest rates via the expectedinflation

effect, because people will expect that inflation will be higher over

the course of the year. However, when the price level stops rising next year,

inflation and the expected inflation rate will return to zero. Any rise in interest

rates as a result of the earlier rise in expected inflation will then be

114 PA RT I I Financial Markets

reversed. We thus see that in contrast to the price-level effect, which reaches

its greatest impact next year, the expected-inflation effect will have its smallest

impact (zero impact) next year. The basic difference between the two

effects, then, is that the price-level effect remains even after prices have

stopped rising, whereas the expected-inflation effect disappears.

An important point is that the expected-inflation effect will persist only

as long as the price level continues to rise. As we will see in our discussion

of monetary theory in subsequent chapters, a onetime increase in the money

supply will not produce a continually rising price level; only a higher rate of

money supply growth will. Thus a higher rate of money supply growth is

needed if the expected-inflation effect is to persist.

We can now put together all the effects we have discussed to help us decide

whether our analysis supports the politicians who advocate a greater rate of

growth of the money supply when they feel that interest rates are too high.

Of all the effects, only the liquidity effect indicates that a higher rate of money

growth will cause a decline in interest rates. In contrast, the income, pricelevel,

and expected-inflation effects indicate that interest rates will rise when

money growth is higher. Which of these effects are largest, and how quickly

do they take effect? The answers are critical in determining whether interest

rates will rise or fall when money supply growth is increased.

Generally, the liquidity effect from the greater money growth takes effect

immediately, because the rising money supply leads to an immediate decline in

the equilibrium interest rate. The income and price-level effects take time to

work, because it takes time for the increasing money supply to raise the price

level and income, which in turn raise interest rates. The expected-inflation

effect, which also raises interest rates, can be slow or fast, depending on

whether people adjust their expectations of inflation slowly or quickly when

the money growth rate is increased.

Three possibilities are outlined in Figure 12; each shows how interest

rates respond over time to an increased rate of money supply growth starting

at time T. Panel (a) shows a case in which the liquidity effect dominates the

other effects so that the interest rate falls from i1 at time T to a final level of

i2. The liquidity effect operates quickly to lower the interest rate, but as time

goes by, the other effects start to reverse some of the decline. Because the liquidity

effect is larger than the others, however, the interest rate never rises

back to its initial level.

Panel (b) has a smaller liquidity effect than the other effects, with the

expected-inflation effect operating slowly because expectations of inflation are

slow to adjust upward. Initially, the liquidity effect drives down the interest

rate. Then the income, price-level, and expected-inflation effects begin to raise

it. Because these effects are dominant, the interest rate eventually rises above

its initial level to i2. In the short run, lower interest rates result from increased

money growth, but eventually they end up climbing above the initial level.

Panel (c) has the expected-inflation effect dominating as well as operating

rapidly because people quickly raise their expectations of inflation when the

rate of money growth increases. The expected-inflation effect begins immediately

to overpower the liquidity effect, and the interest rate immediately starts

Does a Higher Rate

of Growth of the

Money Supply Lower

Interest Rates?

C H A P T E R 5 The Behavior of Interest Rates 115

FIGURE 12 Response Over Time to an Increase in Money Supply Growth

Liquidity

Effect

Income, Price-Level,

and Expected-

Inflation Effects

( a ) Liquidity effect larger than

other effects

Time

i1

i2

T

Liquidity

Effect

Income, Price-Level,

and Expected-

Inflation Effects

(b) Liquidity effect smaller than

other effects and slow adjustment

of expected inflation

Time

i1

i2

T

Liquidity and

Expected-

Inflation Effects

Income and Price-

Level Effects

( c ) Liquidity effect smaller than

expected-inflation effect and fast

adjustment of expected inflation

Time

i1

i2

T

Interest Rate, i

Interest Rate, i

Interest Rate, i

116 PA RT I I Financial Markets

FIGURE 13 Money Growth (M2, Annual Rate) and Interest Rates (Three-Month Treasury Bills), 1950–2002

Sources: Federal Reserve: www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

0

2

4

6

8

10

12

14

16

18

22

20

Money Growth Rate (M2)

Interest Rate

Interest

Rate (%)

Money

Growth Rate

(% annual rate)

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

2

4

6

8

10

12

14

0

to climb. Over time, as the income and price-level effects start to take hold,

the interest rate rises even higher, and the eventual outcome is an interest rate

that is substantially above the initial interest rate. The result shows clearly that

increasing money supply growth is not the answer to reducing interest rates;

rather, money growth should be reduced in order to lower interest rates!

An important issue for economic policymakers is which of these three

scenarios is closest to reality. If a decline in interest rates is desired, then an

increase in money supply growth is called for when the liquidity effect dominates

the other effects, as in panel (a). A decrease in money growth is appropriate

if the other effects dominate the liquidity effect and expectations of

inflation adjust rapidly, as in panel (c). If the other effects dominate the liquidity

effect but expectations of inflation adjust only slowly, as in panel (b),

then whether you want to increase or decrease money growth depends on

whether you care more about what happens in the short run or the long run.

Which scenario is supported by the evidence? The relationship of interest

rates and money growth from 1950 to 2002 is plotted in Figure 13. When the

rate of money supply growth began to climb in the mid-1960s, interest rates

rose, indicating that the liquidity effect was dominated by the price-level,

income, and expected-inflation effects. By the 1970s, interest rates reached

C H A P T E R 5 The Behavior of Interest Rates 117

Summary

1. The theory of asset demand tells us that the quantity

demanded of an asset is (a) positively related to wealth,

(b ) positively related to the expected return on the

asset relative to alternative assets, (c) negatively related

to the riskiness of the asset relative to alternative assets,

and (d) positively related to the liquidity of the asset

relative to alternative assets.

2. The supply and demand analysis for bonds, frequently

referred to as the loanable funds framework, provides

one theory of how interest rates are determined. It

predicts that interest rates will change when there is a

change in demand because of changes in income (or

wealth), expected returns, risk, or liquidity or when

there is a change in supply because of changes in the

attractiveness of investment opportunities, the real cost

of borrowing, or government activities.

3. An alternative theory of how interest rates are

determined is provided by the liquidity preference

framework, which analyzes the supply of and demand

for money. It shows that interest rates will change when

there is a change in the demand for money because of

changes in income or the price level or when there is a

change in the supply of money.

4. There are four possible effects of an increase in the

money supply on interest rates: the liquidity effect, the

income effect, the price-level effect, and the expectedinflation

effect. The liquidity effect indicates that a rise

in money supply growth will lead to a decline in interest

rates; the other effects work in the opposite direction.

The evidence seems to indicate that the income, pricelevel,

and expected-inflation effects dominate the

liquidity effect such that an increase in money supply

growth leads to higher rather than lower interest rates.

levels unprecedented in the post-World War II period, as did the rate of

money supply growth.

The scenario depicted in panel (a) of Figure 12 seems doubtful, and the

case for lowering interest rates by raising the rate of money growth is much

weakened. Looking back at Figure 6, which shows the relationship between

interest rates and expected inflation, you should not find this too surprising.

The rise in the rate of money supply growth in the 1960s and 1970s is

matched by a large rise in expected inflation, which would lead us to predict

that the expected-inflation effect would be dominant. It is the most plausible

explanation for why interest rates rose in the face of higher money growth.

However, Figure 13 does not really tell us which one of the two scenarios,

panel (b) or panel (c) of Figure 12, is more accurate. It depends critically on

how fast people’s expectations about inflation adjust. However, recent

research using more sophisticated methods than just looking at a graph like

Figure 13 do indicate that increased money growth temporarily lowers shortterm

interest rates.7

7See Lawrence J. Christiano and Martin Eichenbaum, “Identification and the Liquidity Effect of a

Monetary Policy Shock,” in Business Cycles, Growth, and Political Economy, ed. Alex Cukierman, Zvi

Hercowitz, and Leonardo Leiderman (Cambridge, Mass.: MIT Press, 1992), pp. 335–370; Eric M.

Leeper and David B. Gordon, “In Search of the Liquidity Effect,” Journal of Monetary Economics 29

(1992): 341–370; Steven Strongin, “The Identification of Monetary Policy Disturbances: Explaining the

Liquidity Puzzle,” Journal of Monetary Economics 35 (1995): 463–497; Adrian Pagan and John C.

Robertson, “Resolving the Liquidity Effect,” Federal Reserve Bank of St. Louis Review 77 (May-June

1995): 33–54; and Ben S. Bernanke and Ilian Mihov, “Measuring Monetary Policy,” Quarterly Journal of

Economics 113, 3 (August 1998), pp. 869–902.

118 PA RT I I Financial Markets

Key Terms

asset market approach, p. 93

demand curve, p. 87

expected return, p. 86

excess demand, p. 90

excess supply, p. 90

Fisher effect, p. 100

liquidity, p. 86

liquidity preference framework,

p. 105

loanable funds, p. 92

loanable funds framework, p. 92

market equilibrium, p. 90

opportunity cost, p. 106

risk, p. 86

supply curve, p. 90

theory of asset demand, p. 87

wealth, p. 86

Questions and Problems

Questions marked with an asterisk are answered at the end

of the book in an appendix, “Answers to Selected Questions

and Problems.”

1. Explain why you would be more or less willing to buy

a share of Microsoft stock in the following situations:

a. Your wealth falls.

b. You expect the stock to appreciate in value.

c. The bond market becomes more liquid.

d. You expect gold to appreciate in value.

e. Prices in the bond market become more volatile.

*2. Explain why you would be more or less willing to buy

a house under the following circumstances:

a. You just inherited $100,000.

b. Real estate commissions fall from 6% of the sales

price to 5% of the sales price.

c. You expect Microsoft stock to double in value next

year.

d. Prices in the stock market become more volatile.

e. You expect housing prices to fall.

3. Explain why you would be more or less willing to buy

gold under the following circumstances:

a. Gold again becomes acceptable as a medium of

exchange.

b. Prices in the gold market become more volatile.

c. You expect inflation to rise, and gold prices tend to

move with the aggregate price level.

d. You expect interest rates to rise.

*4. Explain why you would be more or less willing to buy

long-term AT&T bonds under the following circumstances:

a. Trading in these bonds increases, making them easier

to sell.

b. You expect a bear market in stocks (stock prices

are expected to decline).

c. Brokerage commissions on stocks fall.

d. You expect interest rates to rise.

e. Brokerage commissions on bonds fall.

5. What would happen to the demand for Rembrandts if

the stock market undergoes a boom? Why?

Answer each question by drawing the appropriate supply

and demand diagrams.

*6. An important way in which the Federal Reserve

decreases the money supply is by selling bonds to the

public. Using a supply and demand analysis for

bonds, show what effect this action has on interest

rates. Is your answer consistent with what you would

expect to find with the liquidity preference framework?

7. Using both the liquidity preference framework and

supply and demand for bonds framework, show why

interest rates are procyclical (rising when the economy

is expanding and falling during recessions).

*8. Why should a rise in the price level (but not in

expected inflation) cause interest rates to rise when

the nominal money supply is fixed?

9. Find the “Credit Markets” column in the Wall Street

Journal. Underline the statements in the column that

explain bond price movements, and draw the appropriate

supply and demand diagrams that support these

statements.

10. What effect will a sudden increase in the volatility of

gold prices have on interest rates?

QUIZ

C H A P T E R 5 The Behavior of Interest Rates 119

*11. How might a sudden increase in people’s expectations

of future real estate prices affect interest rates?

12. Explain what effect a large federal deficit might have

on interest rates.

*13. Using both the supply and demand for bonds and liquidity

preference frameworks, show what the effect is

on interest rates when the riskiness of bonds rises. Are

the results the same in the two frameworks?

14. If the price level falls next year, remaining fixed thereafter,

and the money supply is fixed, what is likely to

happen to interest rates over the next two years? (Hint:

Take account of both the price-level effect and the

expected-inflation effect.)

*15. Will there be an effect on interest rates if brokerage

commissions on stocks fall? Explain your answer.

Using Economic Analysis to Predict the Future

16. The president of the United States announces in a

press conference that he will fight the higher inflation

rate with a new anti-inflation program. Predict what

will happen to interest rates if the public believes him.

*17. The chairman of the Fed announces that interest rates

will rise sharply next year, and the market believes

him. What will happen to today’s interest rate on

AT&T bonds, such as the 8 s of 2022?

18. Predict what will happen to interest rates if the public

suddenly expects a large increase in stock prices.

*19. Predict what will happen to interest rates if prices in

the bond market become more volatile.

20. If the next chair of the Federal Reserve Board has a

reputation for advocating an even slower rate of

money growth than the current chair, what will happen

to interest rates? Discuss the possible resulting

situations.

18

Web Exercises

1. One of the largest single influences on the level of

interest rates is inflation. There are a number of sites

that report inflation over time. Go to ftp://ftp.bls.gov

/pub/special.requests/cpi/cpiai.txt and review the data

available. Note that the last columns report various

averages. Move this data into a spreadsheet using the

method discussed in the Web exploration at the end

of Chapter 1. What has the average rate of inflation

been since 1950, 1960, 1970, 1980, and 1990? What

year had the lowest level of inflation? What year had

the highest level of inflation?

2. Increasing prices erodes the purchasing power of the

dollar. It is interesting to compute what goods would

have cost at some point in the past after adjusting for

inflation. Go to www.interest.com/hugh/calc/cpi.cgi.

What would a car that cost $22,000 today have cost

the year that you were born?

3. One of the points made in this chapter is that inflation

erodes investment returns. Go to www.src-net.com

/InvestmentMultiplier/iminflation.htm and review how

changes in inflation alter your real return. What happens

to the difference between the adjusted value of an

investment compared to its inflation-adjusted value as:

a. Inflation increases?

b. The investment horizon lengthens?

c. Expected returns increase?

In Chapter 4, we saw that the return on an asset (such as a bond) measures how

much we gain from holding that asset. When we make a decision to buy an asset, we

are influenced by what we expect the return on that asset to be and its risk. Here we

show how to calculate expected return and risk, which is measured by the standard

deviation.

Expected Return

If a Mobil Oil Corporation bond, for example, has a return of 15% half of the time

and 5% the other half of the time, its expected return (which you can think of as the

average return) is 10%. More formally, the expected return on an asset is the weighted

average of all possible returns, where the weights are the probabilities of occurrence

of that return:

Re p1R1 p2R2 . . . pnRn (1)

where Re expected return

n number of possible outcomes (states of nature)

Ri return in the ith state of nature

pi probability of occurrence of the return Ri

EXAMPLE 1: Expected Return

What is the expected return on the Mobil Oil bond if the return is 12% two-thirds of the

time and 8% one-third of the time?

Solution

The expected return is 10.68%:

Re p1R1 p2R2

where

p1 probability of occurrence of return 1 0.67

R1 return in state 1 12% 0.12

2

3

Models of Asset Pricing

appendix1

to chapter 5

1

p2 probability of occurrence return 2 .33

R2 return in state 2 8% 0.08

Thus:

Re (0.67)(0.12) (0.33)(0.08) 0.1068 10.68%

The degree of risk or uncertainty of an asset’s returns also affects the demand for the

asset. Consider two assets, stock in Fly-by-Night Airlines and stock in Feet-on-the-

Ground Bus Company. Suppose that Fly-by-Night stock has a return of 15% half of

the time and 5% the other half of the time, making its expected return 10%, while

stock in Feet-on-the-Ground has a fixed return of 10%. Fly-by-Night stock has uncertainty

associated with its returns and so has greater risk than stock in Feet-on-the-

Ground, whose return is a sure thing.

To see this more formally, we can use a measure of risk called the standard deviation.

The standard deviation of returns on an asset is calculated as follows. First calculate

the expected return, Re; then subtract the expected return from each return to

get a deviation; then square each deviation and multiply it by the probability of occurrence

of that outcome; finally, add up all these weighted squared deviations and take

the square root. The formula for the standard deviation, , is thus:

(2)

The higher the standard deviation, , the greater the risk of an asset.

EXAMPLE 2: Standard Deviation

What is the standard deviation of the returns on the Fly-by-Night Airlines stock and Feeton-

the-Ground Bus Company, with the same return outcomes and probabilities

described above? Of these two stocks, which is riskier?

Solution

Fly-by-Night Airlines has a standard deviation of returns of 5%.

Re p1R1 p2R2

where

p1 probability of occurrence of return 1 0.50

R1 return in state 1 15% 0.15

p2 probability of occurrence of return 2 0.50

R2 return in state 2 5% 0.05

Re expected return (0.50)(0.15) (0.50)(0.05) 0.10

1

2

1

2

p1(R1 Re )2 p2(R2 Re )2

p1(R1 Re )2 p2(R2 Re )2 . . . pn(Rn Re )2

Calculating

Standard Deviation

of Returns

1

3

Models of Asset Pricing 2

Thus:

0.05 5%

Feet-on-the-Ground Bus Company has a standard deviation of returns of 0%.

Re p1R1

where

p1 probability of occurrence of return 1 1.0

R1 return in state 1 10% 0.10

Re expected return (1.0)(0.10) 0.10

Thus:

Clearly, Fly-by-Night Airlines is a riskier stock, because its standard deviation of

returns of 5% is higher than the zero standard deviation of returns for Feet-on-the-

Ground Bus Company, which has a certain return.

Benefits of Diversification

Our discussion of the theory of asset demand indicates that most people like to avoid

risk; that is, they are risk-averse. Why, then, do many investors hold many risky assets

rather than just one? Doesn’t holding many risky assets expose the investor to more

risk?

The old warning about not putting all your eggs in one basket holds the key to

the answer: Because holding many risky assets (called diversification) reduces the overall

risk an investor faces, diversification is beneficial. To see why this is so, let’s look

at some specific examples of how an investor fares on his investments when he is

holding two risky securities.

Consider two assets: common stock of Frivolous Luxuries, Inc., and common

stock of Bad Times Products, Unlimited. When the economy is strong, which we’ll

assume is one-half of the time, Frivolous Luxuries has high sales and the return on

the stock is 15%; when the economy is weak, the other half of the time, sales are low

and the return on the stock is 5%. On the other hand, suppose that Bad Times

Products thrives when the economy is weak, so that its stock has a return of 15%, but

it earns less when the economy is strong and has a return on the stock of 5%. Since

both these stocks have an expected return of 15% half the time and 5% the other half

of the time, both have an expected return of 10%. However, both stocks carry a fair

amount of risk, because there is uncertainty about their actual returns.

Suppose, however, that instead of buying one stock or the other, Irving the

Investor puts half his savings in Frivolous Luxuries stock and the other half in Bad

0 0 0%

(1.0 )(0.10 0.10)2

p1(R1 Re )2

(0.50)(0.0025) (0.50)(0.0025) 0.0025

(0.50)(0.15 0.10)2 (0.50)(0.05 0.10)2

3 Appendix 1 to Chapter 5

Times Products stock. When the economy is strong, Frivolous Luxuries stock has a

return of 15%, while Bad Times Products has a return of 5%. The result is that Irving

earns a return of 10% (the average of 5% and 15%) on his holdings of the two stocks.

When the economy is weak, Frivolous Luxuries has a return of only 5% and Bad Times

Products has a return of 15%, so Irving still earns a return of 10% regardless of whether

the economy is strong or weak. Irving is better off from this strategy of diversification

because his expected return is 10%, the same as from holding either Frivolous

Luxuries or Bad Times Products alone, and yet he is not exposed to any risk.

Although the case we have described demonstrates the benefits of diversification,

it is somewhat unrealistic. It is quite hard to find two securities with the characteristic

that when the return of one is high, the return of the other is always low.1 In the real

world, we are more likely to find at best returns on securities that are independent of

each other; that is, when one is high, the other is just as likely to be high as to be low.

Suppose that both securities have an expected return of 10%, with a return of 5%

half the time and 15% the other half of the time. Sometimes both securities will earn

the higher return and sometimes both will earn the lower return. In this case if Irving

holds equal amounts of each security, he will on average earn the same return as if he

had just put all his savings into one of these securities. However, because the returns

on these two securities are independent, it is just as likely that when one earns the

high 15% return, the other earns the low 5% return and vice versa, giving Irving a

return of 10% (equal to the expected return). Because Irving is more likely to earn

what he expected to earn when he holds both securities instead of just one, we can

see that Irving has again reduced his risk through diversification.2

The one case in which Irving will not benefit from diversification occurs when the

returns on the two securities move perfectly together. In this case, when the first security

has a return of 15%, the other also has a return of 15% and holding both securities

results in a return of 15%. When the first security has a return of 5%, the other

has a return of 5% and holding both results in a return of 5%. The result of diversifying

by holding both securities is a return of 15% half of the time and 5% the other

half of the time, which is exactly the same set of returns that are earned by holding

only one of the securities. Consequently, diversification in this case does not lead to

any reduction of risk.

The examples we have just examined illustrate the following important points

about diversification:

1. Diversification is almost always beneficial to the risk-averse investor since it

reduces risk unless returns on securities move perfectly together (which is an

extremely rare occurrence).

2. The less the returns on two securities move together, the more benefit (risk reduction)

there is from diversification.

Models of Asset Pricing

1Such a case is described by saying that the returns on the two securities are perfectly negatively correlated.

2 We can also see that diversification in the example above leads to lower risk by examining the standard deviation

of returns when Irving diversifies and when he doesn’t. The standard deviation of returns if Irving holds

only one of the two securities is . When Irving holds

equal amounts of each security, there is a probability of 1/4 that he will earn 5% on both (for a total return of

5%), a probability of 1/4 that he will earn 15% on both (for a total return of 15%), and a probability of 1/2 that

he will earn 15% on one and 5% on the other (for a total return of 10%). The standard deviation of returns when

Irving diversifies is thus .

Since the standard deviation of returns when Irving diversifies is lower than when he holds only one security,

we can see that diversification has reduced risk.

0.25 (15% 10%)2 0.25 (5% 10%)2 0.5 (10% 10%)2 3.5%

0.5 (15% 10%)2 0.5 (5% 10%)2 5%

4

Diversification and Beta

In the previous section, we demonstrated the benefits of diversification. Here, we

examine diversification and the relationship between risk and returns in more detail.

As a result, we obtain an understanding of two basic theories of asset pricing: the capital

asset pricing model (CAPM) and arbitrage pricing theory (APT).

We start our analysis by considering a portfolio of n assets whose return is:

Rp x1R1 x2R2 … xnRn (3)

where Rp the return on the portfolio of n assets

Ri the return on asset i

xi the proportion of the portfolio held in asset i

The expected return on this portfolio, E(Rp), equals

E(Rp) E(x1R1) E(x2R2) … E(xnRn)

x1E(R1) x2E(R2) … xnE(Rn) (4)

An appropriate measure of the risk for this portfolio is the standard deviation of the

portfolio’s return (p) or its squared value, the variance of the portfolio’s return (p

2),

which can be written as:

p

2 E[Rp E(Rp)]2 E[{x1R1 … xnRn} {x1E(R1) … xnE(Rn)}]2

E[x1{R1 E(R1)} … xn{Rn E(Rn)}]2

This expression can be rewritten as:

p

2 E[{x1[R1 E(R1)] … xn[Rn E(Rn)]} {Rp E(Rp)}]

x1E[{R1 E(R1)} {Rp E(Rp)}] … xnE[{Rn E(Rn)} {Rp E(Rp)}]

This gives us the following expression for the variance for the portfolio’s return:

p

2 x11p x22p xnnp (5)

where

ip the covariance of the return on asset i

with the portfolio’s return E[{Ri E(Ri)} {Rp E(Rp)}]

Equation 5 tells us that the contribution to risk of asset i to the portfolio is xiip.

By dividing this contribution to risk by the total portfolio risk (p

2), we have the proportionate

contribution of asset i to the portfolio risk:

xiip/p

2

The ratio ip/p

2 tells us about the sensitivity of asset i’s return to the portfolio’s return.

The higher the ratio is, the more the value of the asset moves with changes in the

5 Appendix 1 to Chapter 5

value of the portfolio, and the more asset i contributes to portfolio risk. Our algebraic

manipulations have thus led to the following important conclusion: The marginal

contribution of an asset to the risk of a portfolio depends not on the risk of the asset

in isolation, but rather on the sensitivity of that asset’s return to changes in the

value of the portfolio.

If the total of all risky assets in the market is included in the portfolio, then it is

called the market portfolio. If we suppose that the portfolio, p, is the market portfolio,

m, then the ratio im/m

2 is called the asset i’s beta, that is:

i im /m

2 (6)

where

i the beta of asset i

An asset’s beta then is a measure of the asset’s marginal contribution to the risk of the

market portfolio. A higher beta means that an asset’s return is more sensitive to

changes in the value of the market portfolio and that the asset contributes more to the

risk of the portfolio.

Another way to understand beta is to recognize that the return on asset i can be

considered as being made up of two components—one that moves with the market’s

return (Rm) and the other a random factor with an expected value of zero that is

unique to the asset (i) and so is uncorrelated with the market return:

Ri     i iRm i (7)

The expected return of asset i can then be written as:

E(Ri)     i iE(Rm)

It is easy to show that i in the above expression is the beta of asset i we defined before

by calculating the covariance of asset i’s return with the market return using the two

equations above:

im E[{Ri E(Ri)} {Rm E(Rm)}] E[{i[Rm E(Rm)] i}

{Rm E(Rm)}]

However, since i is uncorrelated with Rm, E[{i} {Rm E(Rm)}] 0. Therefore,

im im

2

Dividing through by m

2 gives us the following expression for i:

i im /m

2

which is the same definition for beta we found in Equation 6.

The reason for demonstrating that the i in Equation 7 is the same as the one we

defined before is that Equation 7 provides better intuition about how an asset’s beta

measures its sensitivity to changes in the market return. Equation 7 tells us that when

Models of Asset Pricing 6

the beta of an asset is 1.0, it’s return on average increases by 1 percentage point when

the market return increases by 1 percentage point; when the beta is 2.0, the asset’s

return increases by 2 percentage points when the market return increases by 1 percentage

point; and when the beta is 0.5, the asset’s return only increases by 0.5 percentage

point on average when the market return increases by 1 percentage point.

Equation 7 also tells us that we can get estimates of beta by comparing the average

return on an asset with the average market return. For those of you who know a

little econometrics, this estimate of beta is just an ordinary least squares regression of

the asset’s return on the market return. Indeed, the formula for the ordinary least

squares estimate of i im/m

2 is exactly the same as the definition of i earlier.

Systematic and Nonsystematic Risk

We can derive another important idea about the riskiness of an asset using Equation

7. The variance of asset i’s return can be calculated from Equation 7 as:

i

2 E[Ri E(Ri)]2 E{i[Rm E(Rm)} i]2

and since i is uncorrelated with market return:

i

2 i

2 m

2

2

The total variance of the asset’s return can thus be broken up into a component that

is related to market risk, i

2 m

2 , and a component that is unique to the asset,

2. The

i

2 m

2 component related to market risk is referred to as systematic risk and the

2

component unique to the asset is called nonsystematic risk. We can thus write the total

risk of an asset as being made up of systematic risk and nonsystematic risk:

Total Asset Risk Systematic Risk Nonsystematic Risk (8)

Systematic and nonsystematic risk each have another feature that makes the distinction

between these two types of risk important. Systematic risk is the part of an

asset’s risk that cannot be eliminated by holding the asset as part of a diversified portfolio,

whereas nonsystematic risk is the part of an asset’s risk that can be eliminated

in a diversified portfolio. Understanding these features of systematic and nonsystematic

risk leads to the following important conclusion: The risk of a well-diversified

portfolio depends only on the systematic risk of the assets in the portfolio.

We can see that this conclusion is true by considering a portfolio of n assets, each

of which has the same weight on the portfolio of (1/n). Using Equation 7, the return

on this portfolio is:

which can be rewritten as:

Rp       Rm 1n)n

i1

i

Rp (1n)n

i1

    i (1n)n

i1

iRm (1n)n

i1

i

7 Appendix 1 to Chapter 5

where

the average of the     i’s

the average of the i’s

If the portfolio is well diversified so that the i’s are uncorrelated with each other, then

using this fact and the fact that all the i’s are uncorrelated with the market return, the

variance of the portfolio’s return is calculated as:

(average varience of i)

As n gets large the second term, (1/n)(average variance of i), becomes very small, so

that a well-diversified portfolio has a risk of , which is only related to systematic

risk. As the previous conclusion indicated, nonsystematic risk can be eliminated

in a well-diversified portfolio. This reasoning also tells us that the risk of a well-diversified

portfolio is greater than the risk of the market portfolio if the average beta of the assets

in the portfolio is greater than one; however, the portfolio’s risk is less than the market

portfolio if the average beta of the assets is less than one.

The Capital Asset Pricing Model (CAPM)

We can now use the ideas we developed about systematic and nonsystematic risk and

betas to derive one of the most widely used models of asset pricing—the capital asset

pricing model (CAPM) developed by William Sharpe, John Litner, and Jack Treynor.

Each cross in Figure 1 shows the standard deviation and expected return for each

risky asset. By putting different proportions of these assets into portfolios, we can generate

a standard deviation and expected return for each of the portfolios using

Equations 4 and 5. The shaded area in the figure shows these combinations of standard

deviation and expected return for these portfolios. Since risk-averse investors

always prefer to have higher expected return and lower standard deviation of the

return, the most attractive standard deviation-expected return combinations are the

ones that lie along the heavy line, which is called the efficient portfolio frontier. These

are the standard deviation-expected return combinations risk-averse investors would

always prefer.

The capital asset pricing model assumes that investors can borrow and lend as

much as they want at a risk-free rate of interest, Rf. By lending at the risk-free rate, the

investor earns an expected return of Rf and his investment has a zero standard deviation

because it is risk-free. The standard deviation-expected return combination for

this risk-free investment is marked as point A in Figure 1. Suppose an investor decides

to put half of his total wealth in the risk-free loan and the other half in the portfolio on

the efficient portfolio frontier with a standard deviation-expected return combination

marked as point M in the figure. Using Equation 4, you should be able to verify that

the expected return on this new portfolio is halfway between Rf and E(Rm); that is,

[Rf E(Rm)]/2. Similarly, because the covariance between the risk-free return and the

return on portfolio M must necessarily be zero, since there is no uncertainty about the

22

2p

22

m (1n)

(1n)n

i1

    i

(1n)n

i1

Models of Asset Pricing 8

return on the risk-free loan, you should also be able to verify, using Equation 5, that

the standard deviation of the return on the new portfolio is halfway between zero and

m, that is, (1/2)m. The standard deviation-expected return combination for this new

portfolio is marked as point B in the figure, and as you can see it lies on the line

between point A and point M. Similarly, if an investor borrows the total amount of her

wealth at the risk-free rate Rf and invests the proceeds plus her wealth (that is, twice

her wealth) in portfolio M, then the standard deviation of this new portfolio will be

twice the standard deviation of return on portfolio M, 2m. On the other hand, using

Equation 4, the expected return on this new portfolio is E(Rm) plus E(Rm) Rf, which

equals 2E(Rm) Rf. This standard deviation-expected return combination is plotted

as point C in the figure.

You should now be able to see that both point B and point C are on the line connecting

point A and point M. Indeed, by choosing different amounts of borrowing

and lending, an investor can form a portfolio with a standard deviation-expected

return combination that lies anywhere on the line connecting points A and M. You

may have noticed that point M has been chosen so that the line connecting points A

and M is tangent to the efficient portfolio frontier. The reason for choosing point M

in this way is that it leads to standard deviation-expected return combinations along

the line that are the most desirable for a risk-averse investor. This line can be thought

of as the opportunity locus, which shows the best combinations of standard deviations

and expected returns available to the investor.

The capital asset pricing model makes another assumption: All investors have the

same assessment of the expected returns and standard deviations of all assets. In this

case, portfolio M is the same for all investors. Thus when all investors’ holdings of

portfolio M are added together, they must equal all of the risky assets in the market,

Appendix 1 to Chapter 5

FIGURE 1 Risk Expected

Return Trade-off

The crosses show the combination

of standard deviation and expected

return for each risky asset. The

efficient portfolio frontier indicates

the most preferable standard

deviation-expected return combinations

that can be achieved by

putting risky assets into portfolios.

By borrowing and lending at the

risk-free rate and investing in portfolio

M, the investor can obtain

standard deviation-expected return

combinations that lie along the

line connecting A, B, M, and C.

This line, the opportunity locus,

contains the best combinations of

standard deviations and expected

returns available to the investor;

hence the opportunity locus shows

the trade-off between expected

returns and risk for the investor.

Expected

Return

E(R)

2E(Rm) — Rf

E(Rm)

Rf + E(Rm)

2

Rf

Efficient

Portfolio

Frontier

Opportunity

Locus

1/2m m 2m

A

B

M

C

Standard Deviation of Retuns

+ +

+ +

+ +

+

+ +

+

+ +

+

+ +

9

which is just the market portfolio. The assumption that all investors have the same

assessment of risk and return for all assets thus means that portfolio M is the market

portfolio.Therefore, the Rm and m in Figure 1 are identical to the market return, Rm,

and the standard deviation of this return, m, referred to earlier in this appendix.

The conclusion that the market portfolio and portfolio M are one and the same

means that the opportunity locus in Figure 1 can be thought of as showing the tradeoff

between expected returns and increased risk for the investor. This trade-off is

given by the slope of the opportunity locus, E(Rm) Rf, and it tells us that when an

investor is willing to increase the risk of his portfolio by m, then he can earn an additional

expected return of E(Rm) Rf. The market price of a unit of market risk, m,

is E(Rm) Rf. E(Rm) Rf is therefore referred to as the market price of risk.

We now know that market price of risk is E(Rm) Rf and we also have learned

that an asset’s beta tells us about systematic risk, because it is the marginal contribution

of that asset to a portfolio’s risk. Therefore the amount an asset’s expected return

exceeds the risk-free rate, E(Ri) Rf, should equal the market price of risk times the

marginal contribution of that asset to portfolio risk, [E(Rm) Rf]i. This reasoning

yields the CAPM asset pricing relationship:

E(Ri) Rf i[E(Rm) Rf] (9)

This CAPM asset pricing equation is represented by the upward sloping line in Figure 2,

which is called the security market line. It tells us the expected return that the market

sets for a security given its beta. For example, it tells us that if a security has a beta of

1.0 so that its marginal contribution to a portfolio’s risk is the same as the market

portfolio, then it should be priced to have the same expected return as the market

portfolio, E(Rm).

Models of Asset Pricing

FIGURE 2 Security Market Line

The security market line derived

from the capital asset pricing

model describes the relationship

between an asset’s beta and its

expected return.

S

T

Expected

Return

E(R)

Security

Market

Line

E(Rm)

Rf

0.5 1.0 Beta

10

To see that securities should be priced so that their expected return-beta combination

should lie on the security market line, consider a security like S in Figure 2,

which is below the security market line. If an investor makes an investment in which

half is put into the market portfolio and half into a risk-free loan, then the beta of this

investment will be 0.5, the same as security S. However, this investment will have an

expected return on the security market line, which is greater than that for security S.

Hence investors will not want to hold security S and its current price will fall, thus

raising its expected return until it equals the amount indicated on the security market

line. On the other hand, suppose there is a security like T which has a beta of 0.5

but whose expected return is above the security market line. By including this security

in a well-diversified portfolio with other assets with a beta of 0.5, none of which

can have an expected return less than that indicated by the security line (as we have

shown), investors can obtain a portfolio with a higher expected return than that

obtained by putting half into a risk-free loan and half into the market portfolio. This

would mean that all investors would want to hold more of security T, and so its price

would rise, thus lowering its expected return until it equaled the amount indicated on

the security market line.

The capital asset pricing model formalizes the following important idea: An asset

should be priced so that is has a higher expected return not when it has a greater

risk in isolation, but rather when its systematic risk is greater.

Arbitrage Pricing Theory

Although the capital asset pricing model has proved to be very useful in practice,

deriving it does require the adoption of some unrealistic assumptions; for example,

the assumption that investors can borrow and lend freely at the risk-free rate, or the

assumption that all investors have the same assessment of expected returns and standard

deviations of returns for all assets. An important alternative to the capital asset

pricing model is the arbitrage pricing theory (APT) developed by Stephen Ross of

M.I.T.

In contrast to CAPM, which has only one source of systematic risk, the market

return, APT takes the view that there can be several sources of systematic risk in the

economy that cannot be eliminated through diversification. These sources of risk can

be thought of as factors that may be related to such items as inflation, aggregate output,

default risk premiums, and/or the term structure of interest rates. The return on

an asset i can thus be written as being made up of components that move with these

factors and a random component that is unique to the asset (i):

Ri i

1 (factor 1) i

2 (factor 2) … i

k (factor k) i (10)

Since there are k factors, this model is called a k-factor model. The i

1 ,…, i

k describe

the sensitivity of the asset i’s return to each of these factors.

Just as in the capital asset pricing model, these systematic sources of risk should

be priced. The market price for each factor j can be thought of as E(Rfactor j ) Rf, and

hence the expected return on a security can be written as:

E(Ri) Rf i

1 [E(Rfactor 1) Rf] … i

k [E(Rfactor k) Rf] (11)

11 Appendix 1 to Chapter 5

This asset pricing equation indicates that all the securities should have the same market

price for the risk contributed by each factor. If the expected return for a security

were above the amount indicated by the APT pricing equation, then it would provide

a higher expected return than a portfolio of other securities with the same average

sensitivity to each factor. Hence investors would want to hold more of this security

and its price would rise until the expected return fell to the value indicated by the

APT pricing equation. On the other hand, if the security’s expected return were less

than the amount indicated by the APT pricing equation, then no one would want to

hold this security, because a higher expected return could be obtained with a portfolio

of securities with the same average sensitivity to each factor. As a result, the price

of the security would fall until its expected return rose to the value indicated by the

APT equation.

As this brief outline of arbitrage pricing theory indicates, the theory supports a

basic conclusion from the capital asset pricing model: An asset should be priced so

that it has a higher expected return not when it has a greater risk in isolation, but

rather when its systematic risk is greater. There is still substantial controversy about

whether a variant of the capital asset pricing model or the arbitrage pricing theory is

a better description of reality. At the present time, both frameworks are considered

valuable tools for understanding how risk affects the prices of assets.

Models of Asset Pricing 12

Both models of interest-rate determination in Chapter 4 make use of an asset market

approach in which supply and demand are always considered in terms of stocks of assets

(amounts at a given point in time). The asset market approach is useful in understanding

not only why interest rates fluctuate but also how any asset’s price is determined.

One asset that has fascinated people for thousands of years is gold. It has been a

driving force in history: The conquest of the Americas by Europeans was to a great

extent the result of the quest for gold, to cite just one example. The fascination with

gold continues to the present day, and developments in the gold market are followed

closely by financial analysts and the media. This appendix shows how the asset market

approach can be applied to understanding the behavior of commodity markets, in

particular the gold market. (The analysis in this appendix can also be used to understand

behavior in many other asset markets.)

Supply and Demand in the Gold Market

The analysis of a commodity market, such as the gold market, proceeds in a similar

fashion to the analysis of the bond market by examining the supply of and demand

for the commodity. We again use our analysis of the determinants of asset demand to

obtain a demand curve for gold, which shows the relationship between the quantity

of gold demanded and the price when all other economic variables are held constant.

To derive the relationship between the quantity of gold demanded and its price, we

again recognize that an important determinant of the quantity demanded is its

expected return:

where Re expected return

Pt price of gold today

Pet

1 expected price of gold next year

ge expected capital gain

In deriving the demand curve, we hold all other variables constant, particularly

the expected price of gold next year Pe

t1. With a given value of the expected price of

gold next year Pe

t1, a lower price of gold today Pt means that there will be a greater

Re

Pet

1 Pt

Pt

ge

Demand Curve

Applying the Asset Market

Approach to a Commodity

Market: The Case of Gold

appendix 2

to chapter 5

1

appreciation in the price of gold over the coming year. The result is that a lower price

of gold today implies a higher expected capital gain over the coming year and hence

a higher expected return: Re (Pe

t1 Pt)/Pt. Thus because the price of gold today

(which for simplicity we will denote as P) is lower, the expected return on gold is

higher, and the quantity demanded is higher. Consequently, the demand curve Gd

1

slopes downward in Figure 1.

To derive the supply curve, expressing the relationship between the quantity supplied

and the price, we again assume that all other economic variables are held constant. A

higher price of gold will induce producers to mine for extra gold and also possibly

induce governments to sell some of their gold stocks to the public, thus increasing the

quantity supplied. Hence the supply curve Gs

1 in Figure 1 slopes upward. Notice that

the supply curve in the figure is drawn to be very steep. The reason for this is that the

actual amount of gold produced in any year is only a tiny fraction of the outstanding

stock of gold that has been accumulated over hundreds of years. Thus the increase in

the quantity of the gold supplied in response to a higher price is only a small fraction

of the stock of gold, resulting in a very steep supply curve.

Market equilibrium in the gold market occurs when the quantity of gold demanded

equals the quantity of gold supplied:

Gd Gs

With the initial demand and supply curves of Gd

1 and Gs

1, equilibrium occurs

at point 1, where these curves intersect at a gold price of P1. At a price above this

Market

Equilibrium

Supply Curve

Applying the Asset Market Approach to a Commodity Market: The Case of Gold

FIGURE 1 A Change in the

Equilibrium Price of Gold

When the demand curve shifts rightward

from G1

d to G2 d —say, because

expected inflation rises—equilibrium

moves from point 1 to point 2, and

the equilibrium price of gold rises

from P1 to P2.

1

P2

P1

Price of Gold P

G d1

G d2

G s1

Quantity of Gold G

2

2

equilibrium, the amount of gold supplied exceeds the amount demanded, and this

condition of excess supply leads to a decline in the gold price until it reaches P1, the

equilibrium price. Similarly, if the price is below P1, there is excess demand for gold,

which drives the price upward until it settles at the equilibrium price P1.

Changes in the Equilibrium Price of Gold

Changes in the equilibrium price of gold occur when there is a shift in either the supply

curve or the demand curve; that is, when the quantity demanded or supplied

changes at each given price of gold in response to a change in some factor other than

today’s gold price.

Our analysis of the determinants of asset demand in the chapter provides the factors

that shift the demand curve for gold: wealth, expected return on gold relative to alternative

assets, riskiness of gold relative to alternative assets, and liquidity of gold relative

to alternative assets. The analysis of how changes in each of these factors shift the

demand curve for gold is the same as that found in the chapter.

When wealth rises, at a given price of gold, the quantity demanded increases, and

the demand curve shifts to the right, as in Figure 1. When the expected return on gold

relative to other assets rises—either because speculators think that the future price of

gold will be higher or because the expected return on other assets declines—gold

becomes more desirable; the quantity demanded therefore increases at any given price

of gold, and the demand curve shifts to the right, as in Figure 1. When the relative

riskiness of gold declines, either because gold prices become less volatile or because

returns on other assets become more volatile, gold becomes more desirable, the quantity

demanded at every given price rises, and the demand curve again shifts to the

right. When the gold market becomes relatively more liquid and gold therefore

becomes more desirable, the quantity demanded at any given price rises, and the

demand curve also shifts to the right, as in Figure 1.

The supply curve for gold shifts when there are changes in technology that make gold

mining more efficient or when governments at any given price of gold decide to

increase sales of their holdings of gold. In these cases, the quantity of gold supplied

at any given price increases, and the supply curve shifts to the right.

Study Guide To give yourself practice with supply and demand analysis in the gold market, see if

you can analyze what happens to the price of gold for the following situations,

remembering that all other things are held constant: 1) Interest rates rise, 2) the gold

market becomes more liquid, 3) the volatility of gold prices increases, 4) the stock

market is expected to turn bullish in the near future, 5) investors suddenly become

fearful that there will be a collapse in real estate prices, and 6) Russia sells a lot of gold

in the open market to raise hard currency to finance expenditures.

Shifts in the

Supply Curve for

Gold

Shift in the

Demand Curve

for Gold

3 Appendix 2 to Chapter 5

Applying the Asset Market Approach to a Commodity Market: The Case of Gold

Changes in the Equilibrium Price of Gold Due to a Rise in

Expected Inflation

Application

To illustrate how changes in the equilibrium price of gold occur when supply

and demand curves shift, let’s look at what happens when there is a

change in expected inflation.

Suppose that expected inflation is 5% and the initial supply and demand

curves are at Gs1

and Gd1

so that the equilibrium price of gold is at P1 in Figure

1. If expected inflation now rises to 10%, prices of goods and commodities

next year will be expected to be higher than they otherwise would have been,

and the price of gold next year Pe

t1 will also be expected to be higher than

otherwise. Now at any given price of gold today, gold is expected to have a

greater rate of appreciation over the coming year and hence a higher expected

capital gain and return. The greater expected return means that the quantity

of gold demanded increases at any given price, thus shifting the demand

curve from Gd

1 to Gd

2. Equilibrium therefore moves from point 1 to point 2,

and the price of gold rises from P1 to P2.

By using a supply and demand diagram like that in Figure 1, you should

be able to see that if the expected rate of inflation falls, the price of gold today

will also fall. We thus reach the following conclusion: The price of gold

should be positively related to the expected inflation rate.

Because the gold market responds immediately to any changes in

expected inflation, it is considered a good barometer of the trend of inflation

in the future. Indeed, Alan Greenspan, the chairman of the Board of

Governors of the Federal Reserve System, at one point advocated using the

price of gold as an indicator of inflationary pressures in the economy. Not

surprisingly, then, the gold market is followed closely by financial analysts

and monetary policymakers.

4

120

PREVIEW In our supply and demand analysis of interest-rate behavior in Chapter 5, we examined

the determination of just one interest rate. Yet we saw earlier that there are enormous

numbers of bonds on which the interest rates can and do differ. In this chapter,

we complete the interest-rate picture by examining the relationship of the various

interest rates to one another. Understanding why they differ from bond to bond can

help businesses, banks, insurance companies, and private investors decide which

bonds to purchase as investments and which ones to sell.

We first look at why bonds with the same term to maturity have different interest

rates. The relationship among these interest rates is called the risk structure of

interest rates, although risk, liquidity, and income tax rules all play a role in determining

the risk structure. A bond’s term to maturity also affects its interest rate, and

the relationship among interest rates on bonds with different terms to maturity is

called the term structure of interest rates. In this chapter, we examine the sources

and causes of fluctuations in interest rates relative to one another and look at a number

of theories that explain these fluctuations.

Risk Structure of Interest Rates

Figure 1 shows the yields to maturity for several categories of long-term bonds from

1919 to 2002. It shows us two important features of interest-rate behavior for bonds

of the same maturity: Interest rates on different categories of bonds differ from one

another in any given year, and the spread (or difference) between the interest rates

varies over time. The interest rates on municipal bonds, for example, are above those

on U.S. government (Treasury) bonds in the late 1930s but lower thereafter. In addition,

the spread between the interest rates on Baa corporate bonds (riskier than Aaa

corporate bonds) and U.S. government bonds is very large during the Great

Depression years 1930–1933, is smaller during the 1940s–1960s, and then widens

again afterwards. What factors are responsible for these phenomena?

One attribute of a bond that influences its interest rate is its risk of default, which

occurs when the issuer of the bond is unable or unwilling to make interest payments

when promised or pay off the face value when the bond matures. A corporation suffering

big losses, such as Chrysler Corporation did in the 1970s, might be more likely

Default Risk

Chap ter

The Risk and Term Structure

of Interest Rates

6

to suspend interest payments on its bonds.1 The default risk on its bonds would

therefore be quite high. By contrast, U.S. Treasury bonds have usually been considered

to have no default risk because the federal government can always increase taxes

to pay off its obligations. Bonds like these with no default risk are called default-free

bonds. (However, during the budget negotiations in Congress in 1995 and 1996, the

Republicans threatened to let Treasury bonds default, and this had an impact on the

bond market, as one application following this section indicates.) The spread between

the interest rates on bonds with default risk and default-free bonds, called the risk

premium, indicates how much additional interest people must earn in order to be

willing to hold that risky bond. Our supply and demand analysis of the bond market

in Chapter 5 can be used to explain why a bond with default risk always has a positive

risk premium and why the higher the default risk is, the larger the risk premium

will be.

To examine the effect of default risk on interest rates, let us look at the supply and

demand diagrams for the default-free (U.S. Treasury) and corporate long-term bond

markets in Figure 2. To make the diagrams somewhat easier to read, let’s assume that

initially corporate bonds have the same default risk as U.S. Treasury bonds. In this

case, these two bonds have the same attributes (identical risk and maturity); their

equilibrium prices and interest rates will initially be equal (P c

1 P T

1 and i c

1 i T

1 ),

and the risk premium on corporate bonds (i c

1 i T

1 ) will be zero.

C H A P T E R 6 The Risk and Term Structure of Interest Rates 121

FIGURE 1 Long-Term Bond Yields, 1919–2002

Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal Reserve: www.federalreserve.gov/releases/h15/data/.

16

14

12

10

8

6

4

2

0

1950 1960 1970 1980 1990 2000

State and Local Government

(Municipal)

U.S. Government

Long-Term Bonds

Corporate Baa Bonds

Annual Yield (%)

Corporate Aaa Bonds

1920 1930 1940

1Chrysler did not default on its loans in this period, but it would have were it not for a government bailout plan

intended to preserve jobs, which in effect provided Chrysler with funds that were used to pay off creditors.

www.federalreserve.gov

/Releases/h15/update/

The Federal Reserve reports the

returns on different quality

bonds. Look at the bottom of

the listing of interest rates for

AAA and BBB rated bonds.

Study Guide Two exercises will help you gain a better understanding of the risk structure:

1. Put yourself in the shoes of an investor—see how your purchase decision would

be affected by changes in risk and liquidity.

2. Practice drawing the appropriate shifts in the supply and demand curves when

risk and liquidity change. For example, see if you can draw the appropriate shifts

in the supply and demand curves when, in contrast to the examples in the text,

a corporate bond has a decline in default risk or an improvement in its liquidity.

If the possibility of a default increases because a corporation begins to suffer large

losses, the default risk on corporate bonds will increase, and the expected return on

these bonds will decrease. In addition, the corporate bond’s return will be more

uncertain as well. The theory of asset demand predicts that because the expected

return on the corporate bond falls relative to the expected return on the default-free

Treasury bond while its relative riskiness rises, the corporate bond is less desirable

(holding everything else equal), and demand for it will fall. The demand curve for

corporate bonds in panel (a) of Figure 2 then shifts to the left, from Dc

1 to Dc

2.

At the same time, the expected return on default-free Treasury bonds increases

relative to the expected return on corporate bonds, while their relative riskiness

122 PA RT I I Financial Markets

FIGURE 2 Response to an Increase in Default Risk on Corporate Bonds

An increase in default risk on corporate bonds shifts the demand curve from Dc

1 to Dc

2. Simultaneously, it shifts the demand curve for

Treasury bonds from DT

1 to DT

2. The equilibrium price for corporate bonds (left axis) falls from P c

1 to P c

2, and the equilibrium interest rate

on corporate bonds (right axis) rises from i c

1 to i c

2. In the Treasury market, the equilibrium bond price rises from P T

1 to P T

2, and the equilibrium

interest rate falls from i T

1 to i T

2. The brace indicates the difference between i c

2 and i T

2, the risk premium on corporate bonds. (Note: P

and i increase in opposite directions. P on the left vertical axis increases as we go up the axis, while i on the right vertical axis increases as

we go down the axis.)

Quantity of Corporate Bonds Quantity of Treasury Bonds

Price of Bonds, P

(P increases ↑)

Interest Rate, i

(i increases )↑

Interest Rate, i