P2 banking and financial market

245 0 0

It also does not look as though community banks will disappear. When New York
State liberalized branching laws in 1962, there were fears that community banks
upstate would be driven from the market by the big New York City banks. Not only
did this not happen, but some of the big boys found that the small banks were able
to run rings around them in the local markets. Similarly, California, which has had
unrestricted statewide branching for a long time, continues to have a thriving number
of community banks.
Economists see some important benefits of bank consolidation and nationwide
banking. The elimination of geographic restrictions on banking will increase competition
and drive inefficient banks out of business, thus raising the efficiency of the
banking sector. The move to larger banking organizations also means that there will
be some increase in efficiency because they can take advantage of economies of scale
and scope. The increased diversification of banks’ loan portfolios may lower the probability
of a banking crisis in the future. In the 1980s and early 1990s, bank failures
were often concentrated in states with weak economies. For example, after the decline
in oil prices in 1986, all the major commercial banks in Texas, which had been very
profitable, now found themselves in trouble. At that time, banks in New England were
doing fine. However, when the 1990–1991 recession hit New England hard, New
England banks started failing. With nationwide banking, a bank could make loans in
both New England and Texas and would thus be less likely to fail, because when loans
go sour in one location, they would likely be doing well in the other. Thus nationwide
banking is seen as a major step toward creating a banking system that is less
prone to banking crises.
Two concerns remain about the effects of bank consolidation—that it may lead to
a reduction in lending to small businesses and that banks rushing to expand into new
geographic markets may take increased risks leading to bank failures. The jury is still
out on these concerns, but most economists see the benefits of bank consolidation
and nationwide banking as outweighing the costs.
Separation of the Banking and Other Financial Service Industries
Another important feature of the structure of the banking industry in the United
States until recently was the separation of the banking and other financial services
industries—such as securities, insurance, and real estate—mandated by the Glass-
Steagall Act of 1933. As pointed out earlier in the chapter, Glass-Steagall allowed
commercial banks to sell new offerings of government securities but prohibited them
from underwriting corporate securities or from engaging in brokerage activities. It
also prevented banks from engaging in insurance and real estate activities. In turn, it
prevented investment banks and insurance companies from engaging in commercial
banking activities and thus protected banks from competition.
Despite the Glass-Steagall prohibitions, the pursuit of profits and financial innovation
stimulated both banks and other financial institutions to bypass the intent of the
Glass-Steagall Act and encroach on each other’s traditional territory. Brokerage firms
engaged in the traditional banking business of issuing deposit instruments with the
development of money market mutual funds and cash management accounts. After
the Federal Reserve used a loophole in Section 20 of the Glass-Steagall Act in 1987 to
Erosion of
Glass-Steagall
250 PART I I I Financial Institutions
allow bank holding companies to underwrite previously prohibited classes of securities,
banks began to enter this business. The loophole allowed affiliates of approved
commercial banks to engage in underwriting activities as long as the revenue didn’t
exceed a specified amount, which started at 10% but was raised to 25% of the affiliates’
total revenue. After the U.S. Supreme Court validated the Fed’s action in July
1988, the Federal Reserve allowed J.P. Morgan, a commercial bank holding company,
to underwrite corporate debt securities (in January 1989) and to underwrite stocks
(in September 1990), with the privilege extended to other bank holding companies.
The regulatory agencies later allowed banks to engage in some real estate and some
insurance activities.
Because restrictions on commercial banks’ securities and insurance activities put
American banks at a competitive disadvantage relative to foreign banks, bills to overturn
Glass-Steagall appeared in almost every session of Congress in the 1990s. With
the merger in 1998 of Citicorp, the second-largest bank in the United States, and
Travelers Group, an insurance company that also owned the third-largest securities
firm in the country (Salomon Smith Barney), the pressure to abolish Glass-Steagall
became overwhelming. Legislation to eliminate Glass-Steagall finally came to fruition
in 1999. This legislation, the Gramm-Leach-Bliley Financial Services Modernization
Act of 1999, allows securities firms and insurance companies to purchase banks, and
allows banks to underwrite insurance and securities and engage in real estate activities.
Under this legislation, states retain regulatory authority over insurance activities,
while the Securities and Exchange Commission continues to have oversight of securities
activities. The Office of the Comptroller of the Currency has the authority to regulate
bank subsidiaries engaged in securities underwriting, but the Federal Reserve
continues to have the authority to oversee bank holding companies under which all
real estate and insurance activities and large securities operations will be housed.
As we have seen, the Riegle-Neal Interstate Banking and Branching Efficiency Act of
1994 has stimulated consolidation of the banking industry. The financial consolidation
process will be further hastened by the Gramm-Leach-Bliley Act of 1999, because
the way is now open to consolidation in terms not only of the number of banking
institutions, but also across financial service activities. Given that information technology
is increasing economies of scope, mergers of banks with other financial service
firms like that of Citicorp and Travelers should become increasingly common, and
more mega-mergers are likely to be on the way. Banking institutions are becoming not
only larger, but also increasingly complex, organizations, engaging in the full gamut
of financial service activities.
Not many other countries in the aftermath of the Great Depression followed the lead
of the United States in separating the banking and other financial services industries.
In fact, in the past this separation was the most prominent difference between banking
regulation in the United States and in other countries. Around the world, there
are three basic frameworks for the banking and securities industries.
The first framework is universal banking, which exists in Germany, the Netherlands,
and Switzerland. It provides no separation at all between the banking and securities
industries. In a universal banking system, commercial banks provide a full range
of banking, securities, real estate, and insurance services, all within a single legal
Separation of
Banking
and Other
Financial Services
Industries
Throughout the
World
Implications
for Financial
Consolidation
The Gramm-
Leach-Bliley
Financial Services
Modernization Act
of 1999: Repeal
of Glass-Steagall
C H A P T E R 1 0 Banking Industry: Structure and Competition 251
entity. Banks are allowed to own sizable equity shares in commercial firms, and often
they do.
The British-style universal banking system, the second framework, is found in the
United Kingdom and countries with close ties to it, such as Canada and Australia, and
now the United States. The British-style universal bank engages in securities underwriting,
but it differs from the German-style universal bank in three ways: Separate
legal subsidiaries are more common, bank equity holdings of commercial firms are
less common, and combinations of banking and insurance firms are less common.
The third framework features some legal separation of the banking and other
financial services industries, as in Japan. A major difference between the U.S. and
Japanese banking systems is that Japanese banks are allowed to hold substantial
equity stakes in commercial firms, whereas American banks cannot. In addition, most
American banks use a bank-holding-company structure, but bank holding companies
are illegal in Japan. Although the banking and securities industries are legally separated
in Japan under Section 65 of the Japanese Securities Act, commercial banks are
increasingly being allowed to engage in securities activities and like U.S. banks are
thus becoming more like British-style universal banks.
Thrift Industry: Regulation and Structure
Not surprisingly, the regulation and structure of the thrift industry (savings and loan
associations, mutual savings banks, and credit unions) closely parallels the regulation
and structure of the commercial banking industry.
Just as there is a dual banking system for commercial banks, savings and loan associations
(S&Ls) can be chartered either by the federal government or by the states. Most
S&Ls, whether state or federally chartered, are members of the Federal Home Loan
Bank System (FHLBS). Established in 1932, the FHLBS was styled after the Federal
Reserve System. It has 12 district Federal Home Loan banks, which are supervised by
the Office of Thrift Supervision.
Federal deposit insurance (up to $100,000 per account) for S&Ls is provided by
the Savings Association Insurance Fund, a subsidiary of the FDIC. The Office of Thrift
Supervision regulates federally insured S&Ls by setting minimum capital requirements,
requiring periodic reports, and examining the S&Ls. It is also the chartering
agency for federally chartered S&Ls, and for these S&Ls it approves mergers and sets
the rules for branching.
The branching regulations for S&Ls were more liberal than for commercial
banks: In the past, almost all states permitted branching of S&Ls, and since 1980,
federally chartered S&Ls were allowed to branch statewide in all states. Since 1981,
mergers of financially troubled S&Ls were allowed across state lines, and nationwide
branching of S&Ls is now a reality.
The FHLBS, like the Fed, makes loans to the members of the system (obtaining
funds for this purpose by issuing bonds). However, in contrast to the Fed’s discount
loans, which are expected to be repaid quickly, the loans from the FHLBS often need
not be repaid for long periods of time. In addition, the rates charged to S&Ls for these
loans are often below the rates that the S&Ls must pay when they borrow in the open
market. In this way, the FHLBS loan program provides a subsidy to the savings and
Savings and Loan
Associations
252 PART I I I Financial Institutions
loan industry (and implicitly to the housing industry, since most of the S&L loans are
for residential mortgages).
As we will see in the next chapter, the savings and loans experienced serious difficulties
in the 1980s. Because savings and loans now engage in many of the same
activities as commercial banks, many experts view having a separate charter and regulatory
apparatus for S&Ls an anachronism that no longer makes sense.
Of the 400 or so mutual savings banks, approximately half are chartered by states.
Although the mutual savings banks are primarily regulated by the states in which they
are located, the majority have their deposits insured by the FDIC up to the limit of
$100,000 per account; these banks are also subject to many of the FDIC’s regulations
for state-chartered banks. As a rule, the mutual savings banks whose deposits are not
insured by the FDIC have their deposits insured by state insurance funds.
The branching regulations for mutual savings banks are determined by the states
in which they operate. Because these regulations are not too restrictive, there are few
mutual savings banks with assets of less than $25 million.
Credit unions are small cooperative lending institutions organized around a particular
group of individuals with a common bond (union members or employees of a particular
firm). They are the only financial institutions that are tax-exempt and can be
chartered either by the states or by the federal government; over half are federally
chartered. The National Credit Union Administration (NCUA) issues federal charters
and regulates federally chartered credit unions by setting minimum capital requirements,
requiring periodic reports, and examining the credit unions. Federal deposit
insurance (up to the $100,000-per-account limit) is provided to both federallychartered
and state-chartered credit unions by a subsidiary of the NCUA, the National
Credit Union Share Insurance Fund (NCUSIF). Since the majority of credit union
lending is for consumer loans with fairly short terms to maturity, they did not suffer
the financial difficulties of the S&Ls and mutual savings banks.
Because their members share a common bond, credit unions are typically quite
small; most hold less than $10 million of assets. In addition, their ties to a particular
industry or company make them more likely to fail when large numbers of workers
in that industry or company are laid off and have trouble making loan payments.
Recent regulatory changes allow individual credit unions to cater to a more diverse
group of people by interpreting the common bond requirement less strictly, and this
has encouraged an expansion in the size of credit unions that may help reduce credit
union failures in the future.
Often a credit union’s shareholders are dispersed over many states, and sometimes
even worldwide, so branching across state lines and into other countries is permitted
for federally chartered credit unions. The Navy Federal Credit Union, for
example, whose shareholders are members of the U.S. Navy and Marine Corps, has
branches throughout the world.
International Banking
In 1960, only eight U.S. banks operated branches in foreign countries, and their total
assets were less than $4 billion. Currently, around 100 American banks have branches
Credit Unions
Mutual Savings
Banks
C H A P T E R 1 0 Banking Industry: Structure and Competition 253
abroad, with assets totaling over $500 billion. The spectacular growth in international
banking can be explained by three factors.
First is the rapid growth in international trade and multinational (worldwide)
corporations that has occurred since 1960. When American firms operate abroad,
they need banking services in foreign countries to help finance international trade.
For example, they might need a loan in a foreign currency to operate a factory abroad.
And when they sell goods abroad, they need to have a bank exchange the foreign currency
they have received for their goods into dollars. Although these firms could use
foreign banks to provide them with these international banking services, many of
them prefer to do business with the U.S. banks with which they have established
long-term relationships and which understand American business customs and practices.
As international trade has grown, international banking has grown with it.
Second, American banks have been able to earn substantial profits by being very
active in global investment banking, in which they underwrite foreign securities. They
also sell insurance abroad, and they derive substantial profits from these investment
banking and insurance activities.
Third, American banks have wanted to tap into the large pool of dollar-denominated
deposits in foreign countries known as Eurodollars. To understand the structure of
U.S. banking overseas, let us first look at the Eurodollar market, an important source
of growth for international banking.
Eurodollars are created when deposits in accounts in the United States are transferred
to a bank outside the country and are kept in the form of dollars. (For a discussion of
the birth of the Eurodollar, see Box 4.) For example, if Rolls-Royce PLC deposits a $1
million check, written on an account at an American bank, in its bank in London—
specifying that the deposit is payable in dollars—$1 million in Eurodollars is created.3
Over 90% of Eurodollar deposits are time deposits, more than half of them certificates
of deposit with maturities of 30 days or more. The total amount of Eurodollars outstanding
is on the order of $4.4 trillion, making the Eurodollar market one of the
most important financial markets in the world economy.
Why would companies like Rolls-Royce want to hold dollar deposits outside the
United States? First, the dollar is the most widely used currency in international trade,
so Rolls-Royce might want to hold deposits in dollars to conduct its international
transactions. Second, Eurodollars are “offshore” deposits—they are held in countries
that will not subject them to regulations such as reserve requirements or restrictions
(called capital controls) on taking the deposits outside the country.4
The main center of the Eurodollar market is London, a major international financial
center for hundreds of years. Eurodollars are also held outside Europe in locations
that provide offshore status to these deposits—for example, Singapore, the Bahamas,
and the Cayman Islands.
Eurodollar Market
254 PART I I I Financial Institutions
3Note that the London bank keeps the $1 million on deposit at the American bank, so the creation of Eurodollars
has not caused a reduction in the amount of bank deposits in the United States.
4Although most offshore deposits are denominated in dollars, some are also denominated in other currencies.
Collectively, these offshore deposits are referred to as Eurocurrencies. A Japanese yen-denominated deposit held
in London, for example, is called a Euroyen.
The minimum transaction in the Eurodollar market is typically $1 million, and
approximately 75% of Eurodollar deposits are held by banks. Plainly, you and I are
unlikely to come into direct contact with Eurodollars. The Eurodollar market is, however,
an important source of funds to U.S. banks, whose borrowing of these deposits
is over $100 billion. Rather than using an intermediary and borrowing all the deposits
from foreign banks, American banks decided that they could earn higher profits by
opening their own branches abroad to attract these deposits. Consequently, the
Eurodollar market has been an important stimulus to U.S. banking overseas.
U.S. banks have most of their foreign branches in Latin America, the Far East, the
Caribbean, and London. The largest volume of assets is held by branches in London,
because it is a major international financial center and the central location for the
Eurodollar market. Latin America and the Far East have many branches because of
the importance of U.S. trade with these regions. Parts of the Caribbean (especially the
Bahamas and the Cayman Islands) have become important as tax havens, with minimal
taxation and few restrictive regulations. In actuality, the bank branches in the
Bahamas and the Cayman Islands are “shell operations” because they function primarily
as bookkeeping centers and do not provide normal banking services.
An alternative corporate structure for U.S. banks that operate overseas is the Edge
Act corporation, a special subsidiary engaged primarily in international banking.
U.S. banks (through their holding companies) can also own a controlling interest in
foreign banks and in foreign companies that provide financial services, such as
finance companies. The international activities of U.S. banking organizations are governed
primarily by the Federal Reserve’s Regulation K.
In late 1981, the Federal Reserve approved the creation of international banking
facilities (IBFs) within the United States that can accept time deposits from foreigners
but are not subject to either reserve requirements or restrictions on interest
payments. IBFs are also allowed to make loans to foreigners, but they are not allowed
to make loans to domestic residents. States have encouraged the establishment of IBFs
by exempting them from state and local taxes. In essence, IBFs are treated like foreign
Structure of U.S.
Banking Overseas
C H A P T E R 1 0 Banking Industry: Structure and Competition 255
Box 4: Global
Ironic Birth of the Eurodollar Market
One of capitalism’s great ironies is that the Eurodollar
market, one of the most important financial markets
used by capitalists, was fathered by the Soviet Union.
In the early 1950s, during the height of the Cold War,
the Soviets had accumulated a substantial amount of
dollar balances held by banks in the United States.
Because the Russians feared that the U.S. government
might freeze these assets in the United States, they
wanted to move the deposits to Europe, where they
would be safe from expropriation. (This fear was not
unjustified—consider the U.S. freeze on Iranian
assets in 1979 and Iraqi assets in 1990.) However,
they also wanted to keep the deposits in dollars so
that they could be used in their international transactions.
The solution to the problem was to transfer the
deposits to European banks but to keep the deposits
denominated in dollars. When the Soviets did this,
the Eurodollar was born.
branches of U.S. banks and are not subject to domestic regulations and taxes. The
purpose of establishing IBFs is to encourage American and foreign banks to do more
banking business in the United States rather than abroad. From this point of view,
IBFs were a success: Their assets climbed to nearly $200 billion in the first two years,
but have currently fallen to below $100 billion.
The growth in international trade has not only encouraged U.S. banks to open offices
overseas, but has also encouraged foreign banks to establish offices in the United
States. Foreign banks have been extremely successful in the United States. Currently,
they hold more than 10% of total U.S. bank assets and do a large portion of all U.S.
bank lending, with nearly a 19% market share for lending to U.S. corporations.
Foreign banks engage in banking activities in the United States by operating an
agency office of the foreign bank, a subsidiary U.S. bank, or a branch of the foreign
bank. An agency office can lend and transfer funds in the United States, but it cannot
accept deposits from domestic residents. Agency offices have the advantage of not
being subject to regulations that apply to full-service banking offices (such as requirements
for FDIC insurance). A subsidiary U.S. bank is just like any other U.S. bank (it
may even have an American-sounding name) and is subject to the same regulations,
but it is owned by the foreign bank. A branch of a foreign bank bears the foreign
bank’s name and is usually a full-service office. Foreign banks may also form Edge Act
corporations and IBFs.
Before 1978, foreign banks were not subject to many regulations that applied to
domestic banks: They could open branches across state lines and were not expected
to meet reserve requirements, for example. The passage of the International Banking
Act of 1978, however, put foreign and domestic banks on a more equal footing. Now
foreign banks may open new full-service branches only in the state they designate as
their home state or in states that allow the entry of out-of-state banks. Limited-service
branches and agency offices in any other state are permitted, however, and foreign
banks are allowed to retain any full-service branches opened before ratification of the
International Banking Act of 1978.
The internationalization of banking, both by U.S. banks going abroad and by foreign
banks entering the United States, has meant that financial markets throughout
the world have become more integrated. As a result, there is a growing trend toward
international coordination of bank regulation, one example of which is the 1988 Basel
agreement to standardize minimum capital requirements in industrialized countries,
discussed in Chapter 11. Financial market integration has also encouraged bank consolidation
abroad, culminating in the creation of the first trillion-dollar bank with the
proposed merger of the Industrial Bank of Japan, Dai-Ichi Kangyo Bank, and Fuji
Bank, announced in August 1999, but which took place in 2002. Another development
has been the importance of foreign banks in international banking. As is shown
in Table 3, in 2002, eight of the ten largest banks in the world were foreign. The
implications of this financial market integration for the operation of our economy is
examined further in Chapter 20 when we discuss the international financial system in
more detail.
Foreign Banks in
the United States
256 PART I I I Financial Institutions
C H A P T E R 1 0 Banking Industry: Structure and Competition 257
Bank Assets (U.S. $ millions)
1. Mizuho Holdings, Japan 1,281,389
2. Citigroup, U.S. 1,057,657
3. Mitsubishi Tokyo Financial Group, Japan 854,749
4. Deutsche Bank, Germany 815,126
5. Allianz, Germany 805,433
6. UBS, Switzerland 753,833
7. BNP, France 734,833
8. HSBC Holdings, U.K. 694,590
9. J.P. Morgan & Chase Company, U.S. 712,508
10. Bayerische Hypo-Und Vereinsbanken, Germany 638,544
Source: American Banker, 167 (132): 17, July 12, 2002.
Table 3 Ten Largest Banks in the World, 2002
Summary
1. The history of banking in the United States has left us
with a dual banking system, with commercial banks
chartered by the states and the federal government.
Multiple agencies regulate commercial banks: the Office
of the Comptroller, the Federal Reserve, the FDIC, and
the state banking authorities.
2. A change in the economic environment will stimulate
financial institutions to search for financial innovations.
Changes in demand conditions, especially the rise in
interest-rate risk; changes in supply conditions,
especially improvements in information technology;
and the desire to avoid costly regulations have been
major driving forces behind financial innovation.
Financial innovation has caused banks to suffer declines
in cost advantages in acquiring funds and in income
advantages on their assets. The resulting squeeze has
hurt profitability in banks’ traditional lines of business
and has led to a decline in traditional banking.
3. Restrictive state branching regulations and the
McFadden Act, which prohibited branching across state
lines, led to a large number of small commercial banks.
The large number of commercial banks in the United
States reflected the past lack of competition, not the
presence of vigorous competition. Bank holding
companies and ATMs were important responses to
branching restrictions that weakened the restrictions’
anticompetitive effect.
4. Since the mid-1980s, bank consolidation has been
occurring at a rapid pace. The first phase of bank
consolidation was the result of bank failures and the
reduced effectiveness of branching restrictions. The
second phase has been stimulated by information
technology and the Riegle-Neal Interstate Banking and
Branching Efficiency Act of 1994, which establishes the
basis for a nationwide banking system. Once banking
consolidation has settled down, we are likely to be left
with a banking system with several thousand banks.
Most economists believe that the benefits of bank
consolidation and nationwide banking will outweigh
the costs.
5. The Glass-Steagall Act separated commercial banking
from the securities industry. Legislation in 1999,
258 PART I I I Financial Institutions
Key Terms
automated banking machine (ABM),
p. 235
automated teller machine (ATM),
p. 235
bank holding companies, p. 232
branches, p. 244
central bank, p. 230
deposit rate ceilings, p. 238
disintermediation, p. 238
dual banking system, p. 231
economies of scope, p. 248
Edge Act corporation, p. 255
financial derivatives, p. 233
financial engineering, p. 232
futures contracts, p. 233
hedge, p. 233
international banking facilities (IBFs),
p. 255
large, complex, banking organizations
(LCBOs), p. 248
national banks, p. 231
securitization, p. 237
state banks, p. 231
superregional banks, p. 247
sweep account, p. 239
virtual bank, p. 235
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 was the United States one of the last of the major
industrialized countries to have a central bank?
*2. Which regulatory agency has the primary responsibility
for supervising the following categories of commercial
banks?
a. National banks
b. Bank holding companies
c. Non–Federal Reserve state banks
d. Federal Reserve member state banks
3. “The commercial banking industry in Canada is less
competitive than the commercial banking industry in
the United States because in Canada only a few large
banks dominate the industry, while in the United
States there are around 8,000 commercial banks.” Is
this statement true, false, or uncertain? Explain your
answer.
*4. Why did new technology make it harder to enforce
limitations on bank branching?
5. Why has there been such a dramatic increase in bank
holding companies?
*6. Why is there a higher percentage of banks with under
$25 million of assets among commercial banks than
among savings and loans and mutual savings banks?
however, repealed the Glass-Steagall Act, removing the
separation of these industries.
6. The regulation and structure of the thrift industry
(savings and loan associations, mutual savings banks,
and credit unions) parallel closely the regulation and
structure of the commercial banking industry. Savings
and loans are primarily regulated by the Office of
Thrift Supervision, and deposit insurance is
administered by the FDIC. Mutual savings banks are
regulated by the states, and federal deposit insurance is
provided by the FDIC. Credit unions are regulated by
the National Credit Union Administration, and deposit
insurance is provided by the National Credit Union
Share Insurance Fund.
7. With the rapid growth of world trade since 1960,
international banking has grown dramatically. United
States banks engage in international banking activities
by opening branches abroad, owning controlling
interests in foreign banks, forming Edge Act
corporations, and operating international banking
facilities (IBFs) located in the United States. Foreign
banks operate in the United States by owning a
subsidiary American bank or by operating branches or
agency offices in the United States.
QUIZ
7. Unlike commercial banks, savings and loans, and
mutual savings banks, credit unions did not have
restrictions on locating branches in other states. Why,
then, are credit unions typically smaller than the other
depository institutions?
*8. What incentives have regulatory agencies created to
encourage international banking? Why have they done
this?
9. How could the approval of international banking facilities
(IBFs) by the Fed in 1981 have reduced employment
in the banking industry in Europe?
*10. If the bank at which you keep your checking account
is owned by Saudi Arabians, should you worry that
your deposits are less safe than if the bank were
owned by Americans?
11. If reserve requirements were eliminated in the future,
as some economists advocate, what effects would this
have on the size of money market mutual funds?
*12. Why have banks been losing cost advantages in
acquiring funds in recent years?
13. “If inflation had not risen in the 1960s and 1970s, the
banking industry might be healthier today.” Is this
statement true, false, or uncertain? Explain your
answer.
*14. Why have banks been losing income advantages on
their assets in recent years?
15. “The invention of the computer is the major factor
behind the decline of the banking industry.” Is this
statement true, false, or uncertain? Explain your
answer.
C H A P T E R 1 0 Banking Industry: Structure and Competition 259
Web Exercises
1. Go to www.fdic.gov/bank/statistical/statistics
/index.html. Select “Highlights and Trends.” Choose
“Number of FDIC-Insured Commercial Banks and
Trust Companies.” Looking at the trend in bank
branches, does the public appear to have more or less
access to banking facilities? How many banks were
there in 1934 and how many are there now? Does the
graph indicate that the trend toward consolidation is
continuing?
2. Despite the regulations that protect banks from failure,
some do fail. Go to www2.fdic.gov/hsob/. Select
the tab labeled “Bank and Thrift Failures.” How many
bank failures occurred in the U.S. during the most
recent complete calendar year? What were the total
assets held by the banks that failed? How many banks
failed in 1937?
260
PREVIEW As we have seen in the previous chapters, the financial system is among the most
heavily regulated sectors of the economy, and banks are among the most heavily regulated
of financial institutions. In this chapter, we develop an economic analysis of
why regulation of banking takes the form it does.
Unfortunately, the regulatory process may not always work very well, as evidenced
by recent crises in the banking systems, not only in the United States but in
many countries throughout the world. Here we also use our economic analysis of
banking regulation to explain the worldwide crises in banking and how the regulatory
system can be reformed to prevent future disasters.
Asymmetric Information and Banking Regulation
In earlier chapters, we have seen how asymmetric information, the fact that different
parties in a financial contract do not have the same information, leads to adverse selection
and moral hazard problems that have an important impact on our financial system.
The concepts of asymmetric information, adverse selection, and moral hazard are especially
useful in understanding why government has chosen the form of banking regulation
we see in the United States and in other countries. There are eight basic categories
of banking regulation: the government safety net, restrictions on bank asset holdings,
capital requirements, chartering and bank examination, assessment of risk management,
disclosure requirements, consumer protection, and restrictions on competition.
As we saw in Chapter 8, banks are particularly well suited to solving adverse selection
and moral hazard problems because they make private loans that help avoid the
free-rider problem. However, this solution to the free-rider problem creates another
asymmetric information problem, because depositors lack information about the
quality of these private loans. This asymmetric information problem leads to two reasons
why the banking system might not function well.
First, before the FDIC started operations in 1934, a bank failure (in which a
bank is unable to meet its obligations to pay its depositors and other creditors and so
must go out of business) meant that depositors would have to wait to get their deposit
funds until the bank was liquidated (until its assets had been turned into cash); at that
time, they would be paid only a fraction of the value of their deposits. Unable to learn
Government
Safety Net:
Deposit Insurance
and the FDIC
Chap ter
11 Economic Analysis of Banking Regulation
www.ny.frb.org/Pihome
/regs.html
View bank regulation
information.
if bank managers were taking on too much risk or were outright crooks, depositors
would be reluctant to put money in the bank, thus making banking institutions less
viable. Second is that depositors’ lack of information about the quality of bank assets
can lead to bank panics, which, as we saw in Chapter 8, can have serious harmful
consequences for the economy. To see this, consider the following situation. There is
no deposit insurance, and an adverse shock hits the economy. As a result of the shock,
5% of the banks have such large losses on loans that they become insolvent (have a
negative net worth and so are bankrupt). Because of asymmetric information, depositors
are unable to tell whether their bank is a good bank or one of the 5% that are
insolvent. Depositors at bad and good banks recognize that they may not get back 100
cents on the dollar for their deposits and will want to withdraw them. Indeed, because
banks operate on a “sequential service constraint” (a first-come, first-served basis),
depositors have a very strong incentive to show up at the bank first, because if they
are last in line, the bank may run out of funds and they will get nothing. Uncertainty
about the health of the banking system in general can lead to runs on banks both
good and bad, and the failure of one bank can hasten the failure of others (referred to
as the contagion effect). If nothing is done to restore the public’s confidence, a bank
panic can ensue.
Indeed, bank panics were a fact of American life in the nineteenth and early twentieth
centuries, with major ones occurring every 20 years or so in 1819, 1837, 1857,
1873, 1884, 1893, 1907, and 1930–1933. Bank failures were a serious problem even
during the boom years of the 1920s, when the number of bank failures averaged
around 600 per year.
A government safety net for depositors can short-circuit runs on banks and bank
panics, and by providing protection for the depositor, it can overcome reluctance to
put funds in the banking system. One form of the safety net is deposit insurance, a
guarantee such as that provided by the Federal Deposit Insurance Corporation (FDIC)
in the United States in which depositors are paid off in full on the first $100,000 they
have deposited in the bank no matter what happens to the bank. With fully insured
deposits, depositors don’t need to run to the bank to make withdrawals—even if they
are worried about the bank’s health—because their deposits will be worth 100 cents
on the dollar no matter what. From 1930 to 1933, the years immediately preceding
the creation of the FDIC, the number of bank failures averaged over 2,000 per year.
After the establishment of the FDIC in 1934, bank failures averaged fewer than 15 per
year until 1981.
The FDIC uses two primary methods to handle a failed bank. In the first, called
the payoff method, the FDIC allows the bank to fail and pays off deposits up to the
$100,000 insurance limit (with funds acquired from the insurance premiums paid by
the banks who have bought FDIC insurance). After the bank has been liquidated, the
FDIC lines up with other creditors of the bank and is paid its share of the proceeds
from the liquidated assets. Typically, when the payoff method is used, account holders
with deposits in excess of the $100,000 limit get back more than 90 cents on the
dollar, although the process can take several years to complete.
In the second method, called the purchase and assumption method, the FDIC reorganizes
the bank, typically by finding a willing merger partner who assumes (takes
over) all of the failed bank’s deposits so that no depositor loses a penny. The FDIC
may help the merger partner by providing it with subsidized loans or by buying some
of the failed bank’s weaker loans. The net effect of the purchase and assumption
method is that the FDIC has guaranteed all deposits, not just those under the
C H A P T E R 1 1 Economic Analysis of Banking Regulation 261
$100,000 limit. The purchase and assumption method was the FDIC’s most common
procedure for dealing with a failed bank before new banking legislation in 1991.
Deposit insurance is not the only way in which governments provide a safety net
for depositors. In other countries, governments have often stood ready to provide
support to domestic banks when they face runs even in the absence of explicit deposit
insurance. This support is sometimes provided by lending from the central bank to
troubled institutions and is often referred to as the “lender of last resort” role of the
central bank. In other cases, funds are provided directly by the government to troubled
institutions, or these institutions are taken over by the government and the government
then guarantees that depositors will receive their money in full. However, in
recent years, government deposit insurance has been growing in popularity and has
spread to many countries throughtout the world. Whether this trend is desirable is
discussed in Box 1.
Moral Hazard and the Government Safety Net. Although a government safety net has
been successful at protecting depositors and preventing bank panics, it is a mixed
blessing. The most serious drawback of the government safety net stems from moral
hazard, the incentives of one party to a transaction to engage in activities detrimental
to the other party. Moral hazard is an important concern in insurance arrangements
in general because the existence of insurance provides increased incentives for taking
262 PART I I I Financial Institutions
Box 1: Global
The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing?
For the first 30 years after federal deposit insurance
was established in the United States, only 6 countries
emulated the United States and adopted deposit
insurance. However, this began to change in the late
1960s, with the trend accelerating in the 1990s, when
the number of countries adopting deposit insurance
doubled to over 70. Government deposit insurance
has taken off throughout the world because of growing
concern about the health of banking systems, particularly
after the increasing number of banking crises
in recent years (documented at the end of this chapter).
Has this spread of deposit insurance been a good
thing? Has it helped improve the performance of the
financial system and prevent banking crises?
The answer seems to be no under many circumstances.
Research at the World Bank has found that
on average, the adoption of explicit government
deposit insurance is associated with less banking sector
stability and a higher incidence of banking
crises.* Furthermore, on average it seems to retard
financial development. However, the negative effects
of deposit insurance appear only in countries with
weak institutional environments: an absence of rule
of law, ineffective regulation and supervision of the
financial sector, and high corruption. This is exactly
what might be expected because, as we will see later
in this chapter, a strong institutional environment is
needed to limit the incentives for banks to engage in
the excessively risky behavior encouraged by deposit
insurance. The problem is that developing a strong
institutional environment may be very difficult to
achieve in many emerging market countries. This
leaves us with the following conclusion: Adoption of
deposit insurance may be exactly the wrong medicine
for promoting stability and efficiency of banking systems
in emerging market countries.
*See World Bank, Finance for Growth: Policy Choices in a Volatile World (Oxford: World Bank and Oxford University Press, 2001).
risks that might result in an insurance payoff. For example, some drivers with automobile
collision insurance that has a low deductible might be more likely to drive
recklessly, because if they get into an accident, the insurance company pays most of
the costs for damage and repairs.
Moral hazard is a prominent concern in government arrangements to provide a
safety net. Because with a safety net depositors know that they will not suffer losses if
a bank fails, they do not impose the discipline of the marketplace on banks by withdrawing
deposits when they suspect that the bank is taking on too much risk.
Consequently, banks with a government safety net have an incentive to take on greater
risks than they otherwise would.
Adverse Selection and the Government Safety Net. A further problem with a government
safety net like deposit insurance arises because of adverse selection, the fact that
the people who are most likely to produce the adverse outcome insured against (bank
failure) are those who most want to take advantage of the insurance. For example, bad
drivers are more likely than good drivers to take out automobile collision insurance
with a low deductible. Because depositors protected by a government safety net have
little reason to impose discipline on the bank, risk-loving entrepreneurs might find
the banking industry a particularly attractive one to enter—they know that they will
be able to engage in highly risky activities. Even worse, because protected depositors
have so little reason to monitor the bank’s activities, without government intervention
outright crooks might also find banking an attractive industry for their activities
because it is easy for them to get away with fraud and embezzlement.
“Too Big to Fail.” The moral hazard created by a government safety net and the desire
to prevent bank failures have presented bank regulators with a particular quandary.
Because the failure of a very large bank makes it more likely that a major financial disruption
will occur, bank regulators are naturally reluctant to allow a big bank to fail
and cause losses to its depositors. Indeed, consider Continental Illinois, one of the ten
largest banks in the United States when it became insolvent in May 1984. Not only
did the FDIC guarantee depositors up to the $100,000 insurance limit, but it also
guaranteed accounts exceeding $100,000 and even prevented losses for Continental
Illinois bondholders. Shortly thereafter, the Comptroller of the Currency (the regulator
of national banks) testified to Congress that the FDIC’s policy was to regard the 11
largest banks as “too big to fail”—in other words, the FDIC would bail them out so
that no depositor or creditor would suffer a loss. The FDIC would do this by using
the purchase and assumption method, giving the insolvent bank a large infusion of
capital and then finding a willing merger partner to take over the bank and its
deposits. The too-big-to-fail policy was extended to big banks that were not even
among the 11 largest. (Note that “too big to fail” is somewhat misleading because
when a bank is closed or merged into another bank, the managers are usually fired
and the stockholders in the bank lose their investment.)
One problem with the too-big-to-fail policy is that it increases the moral hazard
incentives for big banks. If the FDIC were willing to close a bank using the alternative
payoff method, paying depositors only up to the $100,000 limit, large depositors with
more than $100,000 would suffer losses if the bank failed. Thus they would have an
incentive to monitor the bank by examining the bank’s activities closely and pulling
their money out if the bank was taking on too much risk. To prevent such a loss of
deposits, the bank would be more likely to engage in less risky activities. However,
once large depositors know that a bank is too big to fail, they have no incentive to
C H A P T E R 1 1 Economic Analysis of Banking Regulation 263
monitor the bank and pull out their deposits when it takes on too much risk: No matter
what the bank does, large depositors will not suffer any losses. The result of the
too-big-to-fail policy is that big banks might take on even greater risks, thereby making
bank failures more likely.1
Financial Consolidation and the Government Safety Net. With financial innovation and
the passage of the Riegle-Neal Interstate Banking and Branching and Efficiency Act of
1994 and the Gramm-Leach-Bliley Financial Services Modernization Act in 1999,
financial consolidation has been proceeding at a rapid pace, leading to both larger and
more complex banking organizations. Financial consolidation poses two challenges to
banking regulation because of the existence of the government safety net. First, the
increased size of banks as a result of financial consolidation increases the too-big-tofail
problem, because there will now be more large institutions whose failure exposes
the financial system to systemic (system-wide) risk. Thus more banking institutions
are likely to be treated as too big to fail, and the increased moral hazard incentives for
these large institutions to take on greater risk can then increase the fragility of the
financial system. Second, financial consolidation of banks with other financial services
firms means that the government safety net may be extended to new activities
such as securities underwriting, insurance, or real estate activities, thereby increasing
incentives for greater risk taking in these activities that can also weaken the fabric of
the financial system. Limiting the moral hazard incentives for the larger, more complex
financial organizations that are resulting from recent changes in legislation will
be one of the key issues facing banking regulators in the future.
As we have seen, the moral hazard associated with a government safety net encourages
too much risk taking on the part of banks. Bank regulations that restrict asset
holdings and bank capital requirements are directed at minimizing this moral hazard,
which can cost the taxpayers dearly.
Even in the absence of a government safety net, banks still have the incentive to
take on too much risk. Risky assets may provide the bank with higher earnings when
they pay off; but if they do not pay off and the bank fails, depositors are left holding
the bag. If depositors were able to monitor the bank easily by acquiring information
on its risk-taking activities, they would immediately withdraw their deposits if the
bank was taking on too much risk. To prevent such a loss of deposits, the bank would
be more likely to reduce its risk-taking activities. Unfortunately, acquiring information
on a bank’s activities to learn how much risk the bank is taking can be a difficult
task. Hence most depositors are incapable of imposing discipline that might prevent
banks from engaging in risky activities. A strong rationale for government regulation
to reduce risk taking on the part of banks therefore existed even before the establishment
of federal deposit insurance.
Bank regulations that restrict banks from holding risky assets such as common
stock are a direct means of making banks avoid too much risk. Bank regulations also
promote diversification, which reduces risk by limiting the amount of loans in particular
categories or to individual borrowers. Requirements that banks have sufficient
Restrictions on
Asset Holdings
and Bank Capital
Requirements
264 PART I I I Financial Institutions
1Evidence reveals, as our analysis predicts, that large banks took on riskier loans than smaller banks and that this
led to higher loan losses for big banks; see John Boyd and Mark Gertler, “U.S. Commercial Banking: Trends,
Cycles and Policy,” NBER Macroeconomics Annual, 1993, pp. 319–368.
bank capital are another way to change the bank’s incentives to take on less risk.
When a bank is forced to hold a large amount of equity capital, the bank has more to
lose if it fails and is thus more likely to pursue less risky activities.
Bank capital requirements take two forms. The first type is based on the so-called
leverage ratio, the amount of capital divided by the bank’s total assets. To be classified
as well capitalized, a bank’s leverage ratio must exceed 5%; a lower leverage ratio,
especially one below 3%, triggers increased regulatory restrictions on the bank.
Through most of the 1980s, minimum bank capital in the United States was set solely
by specifying a minimum leverage ratio.
In the wake of the Continental Illinois and savings and loans bailouts, regulators
in the United States and the rest of the world have become increasingly worried about
banks’ holdings of risky assets and about the increase in banks’ off-balance-sheet
activities, activities that involve trading financial instruments and generating income
from fees, which do not appear on bank balance sheets but nevertheless expose banks
to risk. An agreement among banking officials from industrialized nations set up the
Basel Committee on Banking Supervision (because it meets under the auspices of
the Bank for International Settlements in Basel, Switzerland), which has implemented
the so-called Basel Accord on a second type of capital requirements, risk-based capital
requirements. The Basel Accord, which required that banks hold as capital at least
8% of their risk-weighted assets, has been adopted by more than 100 countries,
including the United States. Assets and off-balance-sheet activities were allocated into
four categories, each with a different weight to reflect the degree of credit risk. The
first category carries a zero weight and includes items that have little default risk, such
as reserves and government securities in the OECD, Organization for Economic
Cooperation and Development, (industrialized) countries. The second category has a
20% weight and includes claims on banks in OECD countries. The third category has
a weight of 50% and includes municipal bonds and residential mortgages. The fourth
category has the maximum weight of 100% and includes loans to consumers and corporations.
Off-balance-sheet activities are treated in a similar manner by assigning a
credit-equivalent percentage that converts them to on-balance-sheet items to which
the appropriate risk weight applies. The 1996 Market Risk Amendment to the Accord
set minimum capital requirements for risks in banks’ trading accounts.
Over time, limitations of the Accord have become apparent, because the regulatory
measure of bank risk as stipulated by the risk weights can differ substantially
from the actual risk the bank faces. This has resulted in what is known as regulatory
arbitrage, in which banks keep on their books assets that have the same risk-based
capital requirement but are relatively risky, such as a loan to a company with a very
low credit rating, while taking off their books low-risk assets, such as a loan to a company
with a very high credit rating. The Basel Accord could thus lead to increased risk
taking, the opposite of its intent. To address these limitations, the Basel Committee on
Bank Supervision has released proposals for a new capital accord, often referred to as
Basel 2, but it is not clear if it is workable or if it will be implemented (see Box 2).
The Basel Committee’s work on bank capital requirements is never-ending. As the
banking industry changes, the regulation of bank capital must change with it to
ensure the safety and soundness of the banking institutions.
Overseeing who operates banks and how they are operated, referred to as bank
supervision or more generally as prudential supervision, is an important method
for reducing adverse selection and moral hazard in the banking business. Because
Bank Supervision:
Chartering and
Examination
C H A P T E R 1 1 Economic Analysis of Banking Regulation 265
banks can be used by crooks or overambitious entrepreneurs to engage in highly speculative
activities, such undesirable people would be eager to run a bank. Chartering
banks is one method for preventing this adverse selection problem; through chartering,
proposals for new banks are screened to prevent undesirable people from controlling
them.
Regular on-site bank examinations, which allow regulators to monitor whether
the bank is complying with capital requirements and restrictions on asset holdings,
also function to limit moral hazard. Bank examiners give banks a so-called CAMELS
rating (the acronym is based on the six areas assessed: capital adequacy, asset quality,
management, earnings, liquidity, and sensitivity to market risk). With this information
about a bank’s activities, regulators can enforce regulations by taking such formal
actions as cease and desist orders to alter the bank’s behavior or even close a bank if its
CAMELS rating is sufficiently low. Actions taken to reduce moral hazard by restricting
banks from taking on too much risk help reduce the adverse selection problem
further, because with less opportunity for risk taking, risk-loving entrepreneurs will
be less likely to be attracted to the banking industry. Note that the methods regulators
use to cope with adverse selection and moral hazard have their counterparts in
private financial markets (see Chapters 8 and 9). Chartering is similar to the screening
of potential borrowers, regulations restricting risky asset holdings are similar to
restrictive covenants that prevent borrowing firms from engaging in risky investment
activities, bank capital requirements act like restrictive covenants that require
266 PART I I I Financial Institutions
Box 2: Global
Basel 2: Is It Spinning Out of Control?
Starting in June 1999, the Basel Committee on
Banking Supervision released several proposals to
reform the original 1988 Basel Accord. These efforts
have culminated in what bank supervisors refer to as
Basel 2, which is based on three pillars. Pillar 1 intends
to link capital requirements more closely to actual risk.
It does so by specifying many more categories of risk
with different weights in its so-called standardized
approach. Alternatively, it allows sophisticated banks
to pursue instead an internal ratings–based approach
that permits banks to use their own models of credit
risk. Pillar 2 focuses on strengthening the supervisory
process, particularly in assessing the quality of risk
management in banking institutions and in evaluating
whether these institutions have adequate procedures
to determine how much capital they need. Pillar 3
focuses on improving market discipline through
increased disclosure of details about the bank’s credit
exposures, its amount of reserves and capital, the officials
who control the bank, and the effectiveness of its
internal ratings system.
Although Basel 2 makes great strides toward limiting
excessive risk taking by banking institutions, it has
come at a cost of greatly increasing the complexity of
the Accord. The document describing the original
Basel Accord was twenty-six pages, while the second
draft of Basel 2 issued in January 2001 exceeds 500
pages. The original timetable called for the completion
of the final round of consultation by the end of
May 2001, with the new rules taking effect by 2004.
However, criticism from banks, trade associations,
and national regulators has led to several postponements,
with the final draft now scheduled to be published
in the last quarter of 2003 and the Accord to be
implemented in 2006. Will the increasing complexity
of the Basel Accord lead to further postponements?
Will Basel 2 eventually be put into operation? As of
this writing, these questions remain unanswered.
www.federalreserve.gov
/Regulations/default.htm
Access regulatory publications
of the Federal Reserve Board.
minimum amounts of net worth for borrowing firms, and regular bank examinations
are similar to the monitoring of borrowers by lending institutions.
A commercial bank obtains a charter either from the Comptroller of the Currency
(in the case of a national bank) or from a state banking authority (in the case of a state
bank). To obtain a charter, the people planning to organize the bank must submit an
application that shows how they plan to operate the bank. In evaluating the application,
the regulatory authority looks at whether the bank is likely to be sound by examining
the quality of the bank’s intended management, the likely earnings of the bank,
and the amount of the bank’s initial capital. Before 1980, the chartering agency typically
explored the issue of whether the community needed a new bank. Often a new
bank charter would not be granted if existing banks in a community would be hurt
by its presence. Today this anticompetitive stance (justified by the desire to prevent
bank failures of existing banks) is no longer as strong in the chartering agencies.
Once a bank has been chartered, it is required to file periodic (usually quarterly)
call reports that reveal the bank’s assets and liabilities, income and dividends, ownership,
foreign exchange operations, and other details. The bank is also subject to examination
by the bank regulatory agencies to ascertain its financial condition at least
once a year. To avoid duplication of effort, the three federal agencies work together
and usually accept each other’s examinations. This means that, typically, national
banks are examined by the Office of the Comptroller of the Currency, the state banks
that are members of the Federal Reserve System are examined by the Fed, and insured
nonmember state banks are examined by the FDIC.
Bank examinations are conducted by bank examiners, who sometimes make
unannounced visits to the bank (so that nothing can be “swept under the rug” in
anticipation of their examination). The examiners study a bank’s books to see whether
it is complying with the rules and regulations that apply to its holdings of assets. If a
bank is holding securities or loans that are too risky, the bank examiner can force the
bank to get rid of them. If a bank examiner decides that a loan is unlikely to be repaid,
the examiner can force the bank to declare the loan worthless (to write off the loan).
If, after examining the bank, the examiner feels that it does not have sufficient capital
or has engaged in dishonest practices, the bank can be declared a “problem bank”
and will be subject to more frequent examinations.
Traditionally, on-site bank examinations have focused primarily on assessment of the
quality of the bank’s balance sheet at a point in time and whether it complies with
capital requirements and restrictions on asset holdings. Although the traditional focus
is important for reducing excessive risk taking by banks, it is no longer felt to be adequate
in today’s world, in which financial innovation has produced new markets and
instruments that make it easy for banks and their employees to make huge bets easily
and quickly. In this new financial environment, a bank that is quite healthy at a
particular point in time can be driven into insolvency extremely rapidly from trading
losses, as forcefully demonstrated by the failure of Barings in 1995 (discussed in
Chapter 9). Thus an examination that focuses only on a bank’s position at a point in
time may not be effective in indicating whether a bank will in fact be taking on excessive
risk in the near future.
This change in the financial environment for banking institutions has resulted in
a major shift in thinking about the bank supervisory process throughout the world.
Bank examiners are now placing far greater emphasis on evaluating the soundness of
a bank’s management processes with regard to controlling risk. This shift in thinking
Assessment of
Risk Management
C H A P T E R 1 1 Economic Analysis of Banking Regulation 267
was reflected in a new focus on risk management in the Federal Reserve System’s 1993
guidelines to examiners on trading and derivatives activities. The focus was expanded
and formalized in the Trading Activities Manual issued early in 1994, which provided
bank examiners with tools to evaluate risk management systems. In late 1995, the
Federal Reserve and the Comptroller of the Currency announced that they would be
assessing risk management processes at the banks they supervise. Now bank examiners
give a separate risk management rating from 1 to 5 that feeds into the overall management
rating as part of the CAMELS system. Four elements of sound risk
management are assessed to come up with the risk management rating: (1) The quality
of oversight provided by the board of directors and senior management, (2) the
adequacy of policies and limits for all activities that present significant risks, (3) the
quality of the risk measurement and monitoring systems, and (4) the adequacy of
internal controls to prevent fraud or unauthorized activities on the part of employees.
This shift toward focusing on management processes is also reflected in recent
guidelines adopted by the U.S. bank regulatory authorities to deal with interest-rate
risk. At one point, U.S. regulators were contemplating requiring banks to use a standard
model to calculate the amount of capital a bank would need to have to allow for
the interest-rate risk it bears. Because coming up with a one-size-fits-all model that
would work for all banks has proved difficult, the regulatory agencies have instead
decided to adopt guidelines for the management of interest-rate risk, although bank
examiners will continue to consider interest-rate risk in deciding on the bank’s capital
requirements. These guidelines require the bank’s board of directors to establish
interest-rate risk limits, appoint officials of the bank to manage this risk, and monitor
the bank’s risk exposure. The guidelines also require that senior management of a
bank develop formal risk management policies and procedures to ensure that the
board of director’s risk limits are not violated and to implement internal controls to
monitor interest-rate risk and compliance with the board’s directives.
The free-rider problem described in Chapter 8 indicates that individual depositors
and other bank creditors will not have enough incentive to produce private information
about the quality of a bank’s assets. To ensure that there is better information for
depositors and the marketplace, regulators can require that banks adhere to certain
standard accounting principles and disclose a wide range of information that helps
the market assess the quality of a bank’s portfolio and the amount of the bank’s exposure
to risk. More public information about the risks incurred by banks and the quality
of their portfolio can better enable stockholders, creditors, and depositors to
evaluate and monitor banks and so act as a deterrent to excessive risk taking. This
view is consistent with a position paper issued by the Eurocurrency Standing
Committee of the G-10 Central Banks, which recommends that estimates of financial
risk generated by firms’ own internal risk management systems be adapted for public
disclosure purposes.2 Such information would supplement disclosures based on tra-
Disclosure
Requirements
268 PART I I I Financial Institutions
2See Eurocurrency Standing Committee of Central Banks of Group of Ten Countries (Fisher Group), “Discussion
Paper on Public Disclosure of Markets and Credit Risks by Financial Intermediaries,” September 1994, and a
companion piece to this report, Federal Reserve Bank of New York, “A Discussion Paper on Public Disclosure of
Risks Related to Market Activity,” September 1994.
ditional accounting conventions by providing information about risk exposure and
risk management that is not normally included in conventional balance sheet and
income statement reports.
The existence of asymmetric information also suggests that consumers may not have
enough information to protect themselves fully. Consumer protection regulation has
taken several forms. First is “truth in lending,” mandated under the Consumer
Protection Act of 1969, which requires all lenders, not just banks, to provide information
to consumers about the cost of borrowing including a standardized interest
rate (called the annual percentage rate, or APR) and the total finance charges on the
loan. The Fair Credit Billing Act of 1974 requires creditors, especially credit card
issuers, to provide information on the method of assessing finance charges and
requires that billing complaints be handled quickly. Both of these acts are administered
by the Federal Reserve System under Regulation Z.
Congress has also passed legislation to reduce discrimination in credit markets.
The Equal Credit Opportunity Act of 1974 and its extension in 1976 forbid discrimination
by lenders based on race, gender, marital status, age, or national origin. It is
administered by the Federal Reserve under Regulation B. The Community Reinvestment
Act (CRA) of 1977 was enacted to prevent “redlining,” a lender’s refusal to lend in a
particular area (marked off by a hypothetical red line on a map). The Community
Reinvestment Act requires that banks show that they lend in all areas in which they
take deposits, and if banks are found to be in noncompliance with the act, regulators
can reject their applications for mergers, branching, or other new activities.
Increased competition can also increase moral hazard incentives for banks to take on
more risk. Declining profitability as a result of increased competition could tip the
incentives of bankers toward assuming greater risk in an effort to maintain former
profit levels. Thus governments in many countries have instituted regulations to protect
banks from competition. These regulations have taken two forms in the United
States in the past. First were restrictions on branching, such as those described in
Chapter 10, which reduced competition between banks. The second form involved
preventing nonbank institutions from competing with banks by engaging in banking
business, as embodied in the Glass-Steagall Act, which was repealed in 1999.
Although restricting competition propped up the health of banks, restrictions on
competition also had serious disadvantages: They led to higher charges to consumers
and decreased the efficiency of banking institutions, which did not have to compete
as hard. Thus, although the existence of asymmetric information provided a rationale
for anticompetitive regulations, it did not mean that they would be beneficial. Indeed,
in recent years, the impulse of governments in industrialized countries to restrict
competition has been waning. Electronic banking has raised a new set of concerns for
regulators to deal with. See Box 3 for a discussion of this challenge.
Study Guide Because so many laws regulating banking have been passed in the United States, it is
hard to keep track of them all. As a study aid, Table 1 lists the major banking legislation
in the twentieth century and its key provisions.
Restrictions on
Competition
Consumer
Protection
C H A P T E R 1 1 Economic Analysis of Banking Regulation 269
www.fdic.gov/regulations/laws
/important/index.html
Describes the most important
laws that have affected banking
industry in the U.S.
270 PART I I I Financial Institutions
Electronic Banking: New Challenges for Bank Regulation
The advent of electronic banking has raised new concerns
for banking regulation, specifically about security
and privacy.
Worries about the security of electronic banking
and e-money are an important barrier to their
increased use. With electronic banking, you might
worry that criminals might access your bank account
and steal your money by moving your balances to
someone else’s account. Indeed, a notorious case of
this happened in 1995, when a Russian computer
programmer got access to Citibank’s computers and
moved funds electronically into his and his conspirators’
accounts. Private solutions to deal with this problem
have arisen with the development of more secure
encryption technologies to prevent this kind of fraud.
However, because bank customers are not knowledgeable
about computer security issues, there is a
role for the government to regulate electronic banking
to make sure that encryption procedures are adequate.
Similar encryption issues apply to e-money, so
requirements that banks make it difficult for criminals
to engage in digital counterfeiting make sense. To
meet these challenges, bank examiners in the United
States assess how a bank deals with the special security
issues raised by electronic banking and also oversee
third-party providers of electronic banking
platforms. Also, because consumers want to know
that electronic banking transactions are executed correctly,
bank examiners also assess the technical skills
of banks in setting up electronic banking services and
the bank’s capabilities for dealing with problems.
Another security issue of concern to bank customers
is the validity of digital signatures. The Electronic
Signatures in Global and National Commerce Act of
2000 makes electronic signatures as legally binding as
written signatures in most circumstances.
Electronic banking also raises serious privacy
concerns. Because electronic transactions can be
stored on databases, banks are able to collect a huge
amount of information about their customers—their
assets, creditworthiness, what they purchase, and so
on—that can be sold to other financial institutions
and businesses. This potential invasion of our privacy
rightfully makes us very nervous. To protect
customers’ privacy, the Gramm-Leach-Bliley Act of
1999 has limited the distribution of these data, but
it does not go as far as the European Data Protection
Directive, which prohibits the transfer of information
about online transactions. How to protect consumers’
privacy in our electronic age is one of the great challenges
our society faces, so privacy regulations for
electronic banking are likely to evolve over time.
Box 3: E-Finance
Federal Reserve Act (1913)
Created the Federal Reserve System
McFadden Act of 1927
Effectively prohibited banks from branching across state lines
Put national and state banks on equal footing regarding branching
Banking Act of 1933 (Glass-Steagall) and 1935
Created the FDIC
Separated commercial banking from the securities industry
Prohibited interest on checkable deposits and restricted such deposits to commercial banks
Put interest-rate ceilings on other deposits
Table 1 Major Banking Legislation in the United States in the Twentieth Century
(continues)
C H A P T E R 1 1 Economic Analysis of Banking Regulation 271
Bank Holding Company Act and Douglas Amendment (1956)
Clarified the status of bank holding companies (BHCs)
Gave the Federal Reserve regulatory responsibility for BHCs
Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980
Gave thrift institutions wider latitude in activities
Approved NOW and sweep accounts nationwide
Phased out interest rate ceilings on deposits
Imposed uniform reserve requirements on depository institutions
Eliminated usury ceilings on loans
Increased deposit insurance to $100,000 per account
Depository Institutions Act of 1982 (Garn–St. Germain)
Gave the FDIC and the FSLIC emergency powers to merge banks and thrifts across state lines
Allowed depository institutions to offer money market deposit accounts (MMDAs)
Granted thrifts wider latitude in commercial and consumer lending
Competitive Equality in Banking Act (CEBA) of 1987
Provided $10.8 billion to the FSLIC
Made provisions for regulatory forbearance in depressed areas
Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989
Provided funds to resolve S&L failures
Eliminated the FSLIC and the Federal Home Loan Bank Board
Created the Office of Thrift Supervision to regulate thrifts
Created the Resolution Trust Corporation to resolve insolvent thrifts
Raised deposit insurance premiums
Reimposed restrictions on S&L activities
Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991
Recapitalized the FDIC
Limited brokered deposits and the too-big-to-fail policy
Set provisions for prompt corrective action
Instructed the FDIC to establish risk-based premiums
Increased examinations, capital requirements, and reporting requirements
Included the Foreign Bank Supervision Enhancement Act (FBSEA), which strengthened the Fed’s
Authority to supervise foreign banks
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
Overturned prohibition of interstate banking
Allowed branching across state lines
Gramm-Leach-Bliley Financial Services Modernization Act of 1999
Repealed Glass-Steagall and removed the separation of banking and securities industries
Table 1 Major Banking Legislation in the United States in the Twentieth Century (continued)
International Banking Regulation
Because asymmetric information problems in the banking industry are a fact of life
throughout the world, bank regulation in other countries is similar to that in the
United States. Banks are chartered and supervised by government regulators, just as
they are in the United States. Deposit insurance is also a feature of the regulatory systems
in most other developed countries, although its coverage is often smaller than in
the United States and is intentionally not advertised. We have also seen that bank capital
requirements are in the process of being standardized across countries with agreements
like the Basel Accord.
Particular problems in bank regulation occur when banks are engaged in international
banking and thus can readily shift their business from one country to another. Bank
regulators closely examine the domestic operations of banks in their country, but they
often do not have the knowledge or ability to keep a close watch on bank operations
in other countries, either by domestic banks’ foreign affiliates or by foreign banks with
domestic branches. In addition, when a bank operates in many countries, it is not
always clear which national regulatory authority should have primary responsibility
for keeping the bank from engaging in overly risky activities. The difficulties inherent
in regulating international banking were highlighted by the collapse of the Bank of
Credit and Commerce International (BCCI). BCCI, which was operating in more than
70 countries, including the United States and the United Kingdom, was supervised
by Luxembourg, a tiny country unlikely to be up to the task. When massive fraud was
discovered, the Bank of England closed BCCI down, but not before depositors and
stockholders were exposed to huge losses. Cooperation among regulators in different
countries and standardization of regulatory requirements provide potential solutions
to the problems of regulating international banking. The world has been moving in
this direction through agreements like the Basel Accords and oversight procedures
announced by the Basel Committee in July 1992, which require a bank’s worldwide
operations to be under the scrutiny of a single home-country regulator with enhanced
powers to acquire information on the bank’s activities. Also, the Basel Committee
ruled that regulators in other countries can restrict the operations of a foreign bank if
they feel that it lacks effective oversight. Whether agreements of this type will solve
the problem of regulating international banking in the future is an open question.
Asymmetric information analysis explains what types of banking regulations are
needed to reduce moral hazard and adverse selection problems in the banking system.
However, understanding the theory behind regulation does not mean that regulation
and supervision of the banking system are easy in practice. Getting bank
regulators and supervisors to do their job properly is difficult for several reasons.
First, as we learned in the discussion of financial innovation in Chapter 10, in their
search for profits, financial institutions have strong incentives to avoid existing regulations
by loophole mining. Thus regulation applies to a moving target: Regulators are
continually playing cat-and-mouse with financial institutions—financial institutions
think up clever ways to avoid regulations, which then causes regulators to modify
their regulation activities. Regulators continually face new challenges in a dynamically
changing financial system, and unless they can respond rapidly to change, they may
not be able to keep financial institutions from taking on excessive risk. This problem
can be exacerbated if regulators and supervisors do not have the resources or expert-
Summary
Problems in
Regulating
International
Banking
272 PART I I I Financial Institutions
ise to keep up with clever people in financial institutions who think up ways to hide
what they are doing or to get around the existing regulations.
Bank regulation and supervision are difficult for two other reasons. In the regulation
and supervision game, the devil is in the details. Subtle differences in the details
may have unintended consequences; unless regulators get the regulation and supervision
just right, they may be unable to prevent excessive risk taking. In addition, regulators
and supervisors may be subject to political pressure to not do their jobs
properly. For all these reasons, there is no guarantee that bank regulators and supervisors
will be successful in promoting a healthy financial system. Indeed, as we will
see, bank regulation and supervision have not always worked well, leading to banking
crises in the United States and throughout the world.
The 1980s U.S. Banking Crisis: Why?
Before the 1980s, federal deposit insurance seemed to work exceedingly well. In contrast
to the pre-1934 period, when bank failures were common and depositors frequently
suffered losses, the period from 1934 to 1980 was one in which bank failures
were a rarity, averaging 15 a year for commercial banks and fewer than 5 a year for
savings and loans. After 1981, this rosy picture changed dramatically. Failures in both
commercial banks and savings and loans climbed to levels more than ten times greater
than in earlier years, as can be seen in Figure 1. Why did this happen? How did a
C H A P T E R 1 1 Economic Analysis of Banking Regulation 273
FIGURE 1 Bank Failures in the United States, 1934–2002
Source: www2.fdic.gov/qbp/2002sep/cbl.html.
1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
0
50
25
75
100
150
200
Number of Bank
Failures
125
175
225
deposit insurance system that seemed to be working well for half a century find itself
in so much trouble?
The story starts with the burst of financial innovation in the 1960s, 1970s, and early
1980s. As we saw in the previous chapter, financial innovation decreased the profitability
of certain traditional business for commercial banks. Banks now faced
increased competition for their sources of funds from new financial institutions such
as money market mutual funds while they were losing commercial lending business
to the commercial paper market and securitization.
With the decreasing profitability of their traditional business, by the mid-1980s,
commercial banks were forced to seek out new and potentially risky business to keep
their profits up, by placing a greater percentage of their total loans in real estate and
in credit extended to assist corporate takeovers and leveraged buyouts (called highly
leveraged transaction loans).
The existence of deposit insurance increased moral hazard for banks because
insured depositors had little incentive to keep the banks from taking on too much
risk. Regardless of how much risk banks were taking, deposit insurance guaranteed
that depositors would not suffer any losses.
Adding fuel to the fire, financial innovation produced new financial instruments
that widened the scope for risk taking. New markets in financial futures, junk bonds,
swaps, and other instruments made it easier for banks to take on extra risk—making
the moral hazard problem more severe. New legislation that deregulated the banking
industry in the early 1980s, the Depository Institutions Deregulation and Monetary
Control Act (DIDMCA) of 1980 and the Depository Institutions (Garn–St. Germain)
Act of 1982, gave expanded powers to the S&Ls and mutual savings banks to engage
in new risky activities. These thrift institutions, which had been restricted almost
entirely to making loans for home mortgages, now were allowed to have up to 40%
of their assets in commercial real estate loans, up to 30% in consumer lending, and
up to 10% in commercial loans and leases. In the wake of this legislation, S&L regulators
allowed up to 10% of assets to be in junk bonds or in direct investments (common
stocks, real estate, service corporations, and operating subsidiaries).
In addition, DIDMCA increased the mandated amount of federal deposit insurance
from $40,000 per account to $100,000 and phased out Regulation Q depositrate
ceilings. Banks and S&Ls that wanted to pursue rapid growth and take on risky
projects could now attract the necessary funds by issuing larger-denomination
insured certificates of deposit with interest rates much higher than those being offered
by their competitors. Without deposit insurance, high interest rates would not have
induced depositors to provide the high-rolling banks with funds because of the realistic
expectation that they might not get the funds back. But with deposit insurance,
the government was guaranteeing that the deposits were safe, so depositors were more
than happy to make deposits in banks with the highest interest rates.
Financial innovation and deregulation in the permissive atmosphere of the
Reagan years led to expanded powers for the S&L industry that in turn led to several
problems. First, many S&L managers did not have the required expertise to
manage risk appropriately in these new lines of business. Second, the new
expanded powers meant that there was a rapid growth in new lending, particularly
to the real estate sector. Even if the required expertise was available initially, rapid
credit growth may outstrip the available information resources of the banking institution,
resulting in excessive risk taking. Third, these new powers of the S&Ls and
Early Stages of
the Crisis
274 PART I I I Financial Institutions
www2.fdic.gov/hsob/SelectRpt
.asp?EntryTyp=30
Search for data on bank
failures in any year.
the lending boom meant that their activities were expanding in scope and were
becoming more complicated, requiring an expansion of regulatory resources to
monitor these activities appropriately. Unfortunately, regulators of the S&Ls at the
Federal Savings and Loan Insurance Corporation (FSLIC) had neither the expertise
nor the resources that would have enabled them to monitor these new activities sufficiently.
Given the lack of expertise in both the S&L industry and the FSLIC, the
weakening of the regulatory apparatus, and the moral hazard incentives provided
by deposit insurance, it is no surprise that S&Ls took on excessive risks, which led
to huge losses on bad loans.
In addition, the incentives of moral hazard were increased dramatically by a historical
accident: the combination of sharp increases in interest rates from late 1979
until 1981 and a severe recession in 1981–1982, both of which were engineered by
the Federal Reserve to bring down inflation. The sharp rises in interest rates produced
rapidly rising costs of funds for the savings and loans that were not matched by higher
earnings on the S&Ls’ principal asset, long-term residential mortgages (whose rates
had been fixed at a time when interest rates were far lower). The 1981–1982 recession
and a collapse in the prices of energy and farm products hit the economies of certain
parts of the country, such as Texas, very hard. As a result, there were defaults on
many S&L loans. Losses for savings and loan institutions mounted to $10 billion in
1981–1982, and by some estimates over half of the S&Ls in the United States had a
negative net worth and were thus insolvent by the end of 1982.
At this point, a logical step might have been for the S&L regulators—the Federal
Home Loan Bank Board and its deposit insurance subsidiary, the Federal Savings and
Loan Insurance Fund (FSLIC), both now abolished—to close the insolvent S&Ls.
Instead, these regulators adopted a stance of regulatory forbearance: They refrained
from exercising their regulatory right to put the insolvent S&Ls out of business. To
sidestep their responsibility to close ailing S&Ls, they adopted irregular regulatory
accounting principles that in effect substantially lowered capital requirements. For
example, they allowed S&Ls to include in their capital calculations a high value for
intangible capital, called goodwill (an accounting entry to reflect value to the firm of
its having special expertise or a particularly profitable business line).
There were three main reasons why the Federal Home Loan Bank Board and
FSLIC opted for regulatory forbearance. First, the FSLIC did not have sufficient
funds in its insurance fund to close the insolvent S&Ls and pay off their deposits.
Second, the Federal Home Loan Bank Board was established to encourage the
growth of the savings and loan industry, so the regulators were probably too close to
the people they were supposed to be regulating. Third, because bureaucrats do not
like to admit that their own agency is in trouble, the Federal Home Loan Bank Board
and the FSLIC preferred to sweep their problems under the rug in the hope that they
would go away.
Regulatory forbearance increases moral hazard dramatically because an operating
but insolvent S&L (nicknamed a “zombie S&L” by economist Edward Kane because
it is the “living dead”) has almost nothing to lose by taking on great risk and “betting
the bank”: If it gets lucky and its risky investments pay off, it gets out of insolvency.
Unfortunately, if, as is likely, the risky investments don’t pay off, the zombie S&L’s
losses will mount, and the deposit insurance agency will be left holding the bag.
This strategy is similar to the “long bomb” strategy in football. When a football
team is almost hopelessly behind and time is running out, it often resorts to a high-risk
Later Stages of
the Crisis:
Regulatory
Forbearance
C H A P T E R 1 1 Economic Analysis of Banking Regulation 275
play: the throwing of a long pass to try to score a touchdown. Of course, the long
bomb is unlikely to be successful, but there is always a small chance that it will work.
If it doesn’t, the team has lost nothing, since it would have lost the game anyway.
Given the sequence of events we have discussed here, it should be no surprise
that savings and loans began to take huge risks: They built shopping centers in the
desert, bought manufacturing plants to convert manure to methane, and purchased
billions of dollars of high-risk, high-yield junk bonds. The S&L industry was no
longer the staid industry that once operated on the so-called 3-6-3 rule: You took in
money at 3%, lent it at 6%, and played golf at 3 P.M. Although many savings and loans
were making money, losses at other S&Ls were colossal.
Another outcome of regulatory forbearance was that with little to lose, zombie
S&Ls attracted deposits away from healthy S&Ls by offering higher interest rates.
Because there were so many zombie S&Ls in Texas pursuing this strategy, abovemarket
interest rates on deposits at Texas S&Ls were said to have a “Texas premium.”
Potentially healthy S&Ls now found that to compete for deposits, they had to pay
higher interest rates, which made their operations less profitable and frequently
pushed them into the zombie category. Similarly, zombie S&Ls in pursuit of asset
growth made loans at below-market interest rates, thereby lowering loan interest rates
for healthy S&Ls, and again made them less profitable. The zombie S&Ls had actually
taken on attributes of vampires—their willingness to pay above-market rates for
deposits and take below-market interest rates on loans was sucking the lifeblood
(profits) out of healthy S&Ls.
Toward the end of 1986, the growing losses in the savings and loan industry were
bankrupting the insurance fund of the FSLIC. The Reagan administration sought $15
billion in funds for the FSLIC, a completely inadequate sum considering that many
times this amount was needed to close down insolvent S&Ls. The legislation passed
by Congress, the Competitive Equality in Banking Act (CEBA) of 1987, did not even
meet the administration’s requests. It allowed the FSLIC to borrow only $10.8 billion
through a subsidiary corporation called Financing Corporation (FICO) and, what was
worse, included provisions that directed the Federal Home Loan Bank Board to continue
to pursue regulatory forbearance (allow insolvent institutions to keep operating),
particularly in economically depressed areas such as Texas.
The failure of Congress to deal with the savings and loan crisis was not going to
make the problem go away. Consistent with our analysis, the situation deteriorated
rapidly. Losses in the savings and loan industry surpassed $10 billion in 1988 and
approached $20 billion in 1989. The crisis was reaching epidemic proportions. The
collapse of the real estate market in the late 1980s led to additional huge loan losses
that greatly exacerbated the problem.
Political Economy of the Savings and Loan Crisis
Although we now have a grasp of the regulatory and economic forces that created the
S&L crisis, we still need to understand the political forces that produced the regulatory
structure and activities that led to it. The key to understanding the political economy
of the S&L crisis is to recognize that the relationship between voter-taxpayers
and the regulators and politicians creates a particular type of moral hazard problem,
Competitive
Equality in
Banking Act of
1987
276 PART I I I Financial Institutions
discussed in Chapter 8: the principal–agent problem, which occurs when representatives
(agents) such as managers have incentives that differ from those of their
employer (the principal) and so act in their own interest rather than in the interest of
the employer.
Regulators and politicians are ultimately agents for voter-taxpayers (principals),
because in the final analysis, taxpayers bear the cost of any losses by the deposit insurance
agency. The principal–agent problem occurs because the agent (a politician or
regulator) does not have the same incentives to minimize costs to the economy as the
principal (the taxpayer).
To act in the taxpayers’ interest and lower costs to the deposit insurance agency,
regulators have several tasks, as we have seen. They must set tight restrictions on
holding assets that are too risky, must impose high capital requirements, and must
not adopt a stance of regulatory forbearance, which allows insolvent institutions to
continue to operate. However, because of the principal–agent problem, regulators
have incentives to do the opposite. Indeed, as our sad saga of the S&L debacle indicates,
they have at times loosened capital requirements and restrictions on risky asset
holdings and pursued regulatory forbearance. One important incentive for regulators
that explains this phenomenon is their desire to escape blame for poor performance
by their agency. By loosening capital requirements and pursuing regulatory forbearance,
regulators can hide the problem of an insolvent bank and hope that the situation
will improve. Edward Kane characterizes such behavior on the part of regulators
as “bureaucratic gambling.”
Another important incentive for regulators is that they want to protect their
careers by acceding to pressures from the people who most influence their careers.
These people are not the taxpayers but the politicians who try to keep regulators
from imposing tough regulations on institutions that are major campaign contributors.
Members of Congress have often lobbied regulators to ease up on a particular
S&L that contributed large sums to their campaigns. Regulatory agencies that
have little independence from the political process are more vulnerable to these
pressures.
In addition, both Congress and the presidential administration promoted banking
legislation in 1980 and 1982 that made it easier for savings and loans to engage
in risk-taking activities. After the legislation passed, the need for monitoring the S&L
industry increased because of the expansion of permissible activities. The S&L regulatory
agencies needed more resources to carry out their monitoring activities properly,
but Congress (successfully lobbied by the S&L industry) was unwilling to
allocate the necessary funds. As a result, the S&L regulatory agencies became so
short-staffed that they actually had to cut back on their on-site examinations just
when these were needed most. In the period from January 1984 to July 1986, for
example, several hundred S&Ls were not examined even once. Even worse, spurred
on by the intense lobbying efforts of the S&L industry, Congress passed the
Competitive Equality in Banking Act of 1987, which, as we have seen, provided inadequate
funding to close down the insolvent S&Ls and also hampered the S&L regulators
from doing their job properly by including provisions encouraging regulatory
forbearance.
As these examples indicate, the structure of our political system has created a serious
principal–agent problem; politicians have strong incentives to act in their own
interests rather than in the interests of taxpayers. Because of the high cost of running
The Principal–
Agent Problem for
Regulators and
Politicians
C H A P T E R 1 1 Economic Analysis of Banking Regulation 277
campaigns, American politicians must raise substantial contributions. This situation
may provide lobbyists and other campaign contributors with the opportunity to influence
politicians to act against the public interest.
Savings and Loan Bailout: The Financial Institutions Reform,
Recovery, and Enforcement Act of 1989
Immediately after taking office, the first Bush administration proposed new legislation
to provide adequate funding to close down the insolvent S&Ls. The resulting legislation,
the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), was
signed into law on August 9, 1989. It was the most significant legislation to affect the
thrift industry since the 1930s. FIRREA’s major provisions were as follows: The regulatory
apparatus was significantly restructured, eliminating the Federal Home Loan
Bank Board and the FSLIC, both of which had failed in their regulatory tasks. The regulatory
role of the Federal Home Loan Bank Board was relegated to the Office of Thrift
Supervision (OTS), a bureau within the U.S. Treasury Department whose responsibilities
are similar to those that the Office of the Comptroller of the Currency has over
the national banks. The regulatory responsibilities of the FSLIC were given to the
FDIC, and the FDIC became the sole administrator of the federal deposit insurance
system with two separate insurance funds: the Bank Insurance Fund (BIF) and the
Savings Association Insurance Fund (SAIF). Another new agency, the Resolution Trust
Corporation (RTC), was established to manage and resolve insolvent thrifts placed in
conservatorship or receivership. It was made responsible for selling more than $450
billion of real estate owned by failed institutions. After seizing the assets of about 750
insolvent S&Ls, over 25% of the industry, the RTC sold over 95% of them, with a
recovery rate of over 85%. After this success, the RTC went out of business on
December 31, 1995.
The cost of the bailout ended up on the order of $150 billion. The funding for
the bailout came partly from capital in the Federal Home Loan Banks (owned by the
S&L industry) but mostly from the sale of government debt by both the Treasury and
the Resolution Funding Corporation (RefCorp).
FIRREA also imposed new restrictions on thrift activities that in essence reregulated
the S&L industry to the asset choices it had before 1982. It increased the corecapital
leverage requirement from 3% to 8% and imposed the same risk-based capital
standards imposed on commercial banks. FIRREA also enhanced the enforcement
powers of thrift regulators by making it easier for them to remove managers, issue
cease and desist orders, and impose civil money penalties.
FIRREA was a serious attempt to deal with some of the problems created by the
S&L crisis in that it provided substantial funds to close insolvent thrifts. However, the
losses that continued to mount for the FDIC in 1990 and 1991 would have depleted
its Bank Insurance Fund by 1992, requiring that this fund be recapitalized. In addition,
FIRREA did not focus on the underlying adverse selection and moral hazard
problems created by deposit insurance. FIRREA did, however, mandate that the U.S.
Treasury produce a comprehensive study and plan for reform of the federal deposit
insurance system. After this study appeared in 1991, Congress passed the Federal
Deposit Insurance Corporation Improvement Act (FDICIA), which engendered major
reforms in the bank regulatory system.
278 PART I I I Financial Institutions
Federal Deposit Insurance Corporation Improvement Act of 1991
FDICIA’s provisions were designed to serve two purposes: to recapitalize the Bank
Insurance Fund of the FDIC and to reform the deposit insurance and regulatory system
so that taxpayer losses would be minimized.
FDICIA recapitalized the Bank Insurance Fund by increasing the FDIC’s ability to
borrow from the Treasury and also mandated that the FDIC assess higher deposit
insurance premiums until it could pay back its loans and achieve a level of reserves
in its insurance funds that would equal 1.25 percent of insured deposits.
The bill reduced the scope of deposit insurance in several ways, but the most
important one is that the too-big-to-fail doctrine has been substantially limited. The
FDIC must now close failed banks using the least-costly method, thus making it far
more likely that uninsured depositors will suffer losses. An exception to this provision,
whereby a bank would be declared too big to fail so that all depositors, both
insured and uninsured, would be fully protected, would be allowed only if not doing
so would “have serious adverse effects on economic conditions or financial stability.”
Furthermore, to invoke the too-big-to-fail policy, a two-thirds majority of both the
Board of Governors of the Federal Reserve System and the directors of the FDIC, as
well as the approval of the Secretary of the Treasury, are required. Furthermore, FDICIA
requires that the Fed share the FDIC’s losses if long-term Fed lending to a bank that
fails increases the FDIC’s losses.
Probably the most important feature of FDICIA is its prompt corrective action provisions,
which require the FDIC to intervene earlier and more vigorously when a bank
gets into trouble. Banks are now classified into five groups based on bank capital.
Group 1, classified as “well capitalized,” are banks that significantly exceed minimum
capital requirements and are allowed privileges such as the ability to do some securities
underwriting. Banks in group 2, classified as “adequately capitalized,” meet minimum
capital requirements and are not subject to corrective actions but are not allowed
the privileges of the well-capitalized banks. Banks in group 3, “undercapitalized,” fail
to meet capital requirements. Banks in groups 4 and 5 are “significantly undercapitalized”
and “critically undercapitalized,” respectively, and are not allowed to pay interest
on their deposits at rates that are higher than average. In addition, for group 3 banks,
the FDIC is required to take prompt corrective actions such as requiring them to submit
a capital restoration plan, restrict their asset growth, and seek regulatory approval
to open new branches or develop new lines of business. Banks that are so undercapitalized
as to have equity capital less than 2% of assets fall into group 5, and the FDIC
must take steps to close them down.
FDICIA also instructed the FDIC to come up with risk-based insurance premiums.
The system that the FDIC has put in place, however, has not worked very well,
because it resulted in more than 90% of the banks with over 95% of the deposits paying
the same premium. Other provisions of FDICIA are listed in Table 1 on page 271.
FDICIA is an important step in the right direction, because it increases the incentives
for banks to hold capital and decreases their incentives to take on excessive risk.
However, concerns that it has not adequately addressed risk-based premiums or the
too-big-to-fail problem have led economists to continue to search for further reforms
that might help promote the safety and soundness of the banking system.3
C H A P T E R 1 1 Economic Analysis of Banking Regulation 279
3A further discussion of how well FDICIA has worked and other proposed reforms of the banking regulatory
system appears in an appendix to this chapter that can be found on this book’s web site at www.aw.com/mishkin.
Banking Crises Throughout the World
Because misery loves company, it may make you feel better to know that the United
States has by no means been alone in suffering a banking crisis. Indeed, as Table 2 and
Figure 2 illustrate, banking crises have struck a large number of countries throughout
the world, and many of them have been substantially worse than ours. We will examine
what took place in several of these other countries and see that the same forces that
produced a banking crisis in the United States have been at work elsewhere too.
As in the United States, an important factor in the banking crises in Norway, Sweden,
and Finland was the financial liberalization that occurred in the 1980s. Before the
1980s, banks in these Scandinavian countries were highly regulated and subject to
restrictions on the interest rates they could pay to depositors and on the interest rates
they could earn on loans. In this noncompetitive environment, and with artificially
low rates on both deposits and loans, these banks lent only to the best credit risks,
and both banks and their regulators had little need to develop expertise in screening
and monitoring borrowers. With the deregulated environment, a lending boom
ensued, particularly in the real estate sector. Given the lack of expertise in both the
banking industry and its regulatory authorities in keeping risk taking in check, banks
Scandinavia
280 PART I I I Financial Institutions
Date Country Cost as a % of GDP
1980–1982 Argentina 55
1997–ongoing Indonesia 50
1981–1983 Chile 41
1997–ongoing Thailand 33
1997–ongoing South Korea 27
1997–ongoing Malaysia 16
1994–1997 Venezuela 22
1995 Mexico 19
1990–ongoing Japan 20
1989–1991 Czech Republic 12
1991–1994 Finland 11
1991–1995 Hungary 10
1994–1996 Brazil 13
1987–1993 Norway 8
1998 Russia 5–7
1991–1994 Sweden 4
1984–1991 United States 3
Source: Daniela Klingebiel and Luc Laewen, eds., Managing the Real and Fiscal Effects of Banking Crises,
World Bank Discussion Paper No. 428 (Washington: World Bank, 2002).
Table 2 The Cost of Rescuing Banks in Several Countries
engaged in risky lending. When real estate prices collapsed in the late 1980s, massive
loan losses resulted. The outcome of this process was similar to what happened in the
savings and loan industry in the United States. The government was forced to bail out
almost the entire banking industry in these countries in the late 1980s and early 1990s
on a scale that was even larger relative to GDP than in the United States (see Table 2).
The Latin American banking crises typically show a pattern similar to those in the
United States and in Scandinavia. Before the 1980s, banks in many Latin American
countries were owned by the government and were subject to interest-rate restrictions
as in Scandinavia. Their lending was restricted to the government and other low-risk
borrowers. With the deregulation trend that was occurring world-wide, many of these
countries liberalized their credit markets and privatized their banks. We then see the
same pattern we saw in the United States and Scandinavia, a lending boom in the face
of inadequate expertise on the part of both bankers and regulators. The result was
again massive loan losses and the inevitable government bailout. The Argentine banking
crisis of 2001, which is ongoing, differed from those typically seen in Latin
America. Argentina’s banks were well supervised and in relatively good shape before
Latin America
C H A P T E R 1 1 Economic Analysis of Banking Regulation 281
FIGURE 2 Banking Crises Throughout the World Since 1970
Source: Gerard Caprio and Daniela Klingebiel, “Episodes of Systemic and Borderline Financial Crises” mimeo., World Bank, October 1999.
Systemic
banking crises
Episodes of
nonsystemic
banking crises
No crises
Insufficient
information
the government coerced them into purchasing large amounts of Argentine government
debt in order to help solve the government’s fiscal problem. However, when
market confidence in the government plummeted, spreads between Argentine government
debt and U.S. Treasuries soared to more than 2,500 basis points (25 percentage
points), leading to a sharp fall in the price of these securities. The losses on
their holdings of government debt and rising bad loans because of the ongoing severe
recession increased doubts about the solvency of the banking system.
A banking panic erupted in October and November 2001, with the Argentine
public rushing to withdraw their deposits. On December 1, after losing more than $8
billion of deposits, the government imposed a $1,000 monthly limit on deposit withdrawals.
Then with the collapse of the peso and the requirement that the banks must
pay back their dollar deposits at a higher exchange value than they would be paid
back on their dollar loans, banks’ balance sheets went even further in the hole. The
cost of the recent Argentine banking crisis is not yet clear, but it could very well be as
large as the previous banking crisis in Argentina in the 1980–1982 period listed in
Table 2 and could exceed 50% of GDP.
What is particularly striking about the Latin American experience is that the cost
of the bailouts relative to GDP dwarfs that in the United States. The cost to the taxpayer
of the government bailouts in Latin America has been anywhere from around
20% to more than 50% of GDP, in contrast to the 3% figure for the United States.
Before the end of the Cold War, in the communist countries of Eastern Europe and
the Soviet Union, banks were owned by the state. When the downfall of communism
occurred, banks in these countries had little expertise in screening and monitoring
loans. Furthermore, bank regulatory and supervisory apparatus that could rein in the
banks and keep them from taking on excessive risk barely existed. Given the lack of
expertise on the part of regulators and banks, not surprisingly, substantial loan losses
ensued, resulting in the failure or government bailout of many banks. For example,
in the second half of 1993, eight banks in Hungary with 25% of the financial system’s
assets were insolvent, and in Bulgaria, an estimated 75% of all loans in the banking
system were estimated to be substandard in 1995.
On August 24, 1995, a bank panic requiring government intervention occurred
in Russia when the interbank loan market seized up and stopped functioning because
of concern about the solvency of many new banks. This was not the end of troubles
in the Russian banking system. On August 17, 1998, the Russian government
announced that Russia would impose a moratorium on the repayment of foreign debt
because of insolvencies in the banking system. In November, the Russian central bank
announced that nearly half of the country’s 1,500 commercial banks might go under
and the cost of the bailout is expected to be on the order of $15 billion.
Japan was a latecomer to the banking crisis game. Before 1990, the vaunted Japanese
economy looked unstoppable. Unfortunately, it has recently experienced many of the
same pathologies that we have seen in other countries. Before the 1980s, Japan’s
financial markets were among the most heavily regulated in the world, with very strict
restrictions on the issuing of securities and interest rates. Financial deregulation and
innovation produced a more competitive environment that set off a lending boom,
with banks lending aggressively in the real estate sector. As in the other countries we
have examined here, financial disclosure and monitoring by regulators did not keep
Japan
Russia and
Eastern Europe
282 PART I I I Financial Institutions
pace with the new financial environment. The result was that banks could and did
take on excessive risks. When property values collapsed in the early 1990s, the banks
were left holding massive amounts of bad loans. For example, Japanese banks decided
to get into the mortgage lending market by setting up the so-called jusen, home mortgage
lending companies that raised funds by borrowing from banks and then lent
these funds out to households. Seven of these jusen became insolvent, leaving banks
with $60 billion or so of bad loans.
As a result the Japanese have experienced their first bank failures since World
War II. In July 1995, Tokyo-based Cosmo Credit Corporation, Japan’s fifth-largest
credit union, failed and on August 30, the Osaka authorities announced the imminent
closing of Kizu Credit Cooperative, Japan’s second-largest credit union. (Kizu’s story
is remarkably similar to that of many U.S. savings and loans. Kizu, like many
American S&Ls, began offering high rates on large time deposits and grew at a blistering
pace, with deposits rising from $2.2 billion in 1988 to $12 billion by 1995 and
real estate loans growing by a similar amount. When the property market collapsed,
so did Kizu.) On the same day, the Ministry of Finance announced that it was liquidating
Hyogo Bank, a midsize Kobe bank that was the first commercial bank to fail.
Larger banks now began to follow the same path. In late 1996, the Hanwa Bank, a
large regional bank, was liquidated, followed in 1997 by a government-assisted
restructuring of the Nippon Credit Bank, Japan’s seventeenth-largest bank. In
November 1997, Hokkaido Takushoku Bank was forced to go out of business, making
it the first city bank (a large commercial bank) to be closed during the crisis.
The Japanese have been going through a cycle of forbearance similar to the one
that occurred in the United States in the 1980s. The Japanese regulators in the Ministry
of Finance enabled banks to meet capital standards and to keep operating by allowing
them to artificially inflate the value of their assets. For example, they were allowed to
value their large holdings of equities at historical value, rather than market value,
which was much lower. Inadequate amounts were allocated for recapitalization of the
banking system, and the extent of the problem was grossly underestimated by government
officials. Furthermore, until the closing of the Hokkaido Takushoku Bank, the
bank regulators in the Ministry of Finance were unwilling to close down city banks and
impose any losses on stockholders or any uninsured creditors.
By the middle of 1998, the Japanese government began to take some steps to
attack these problems. In June, supervisory authority over financial institutions was
taken away from the Ministry of Finance and transferred to the Financial Supervisory
Agency (FSA), which reports directly to the prime minister. This was the first instance
in half a century in which the all-powerful Ministry of Finance was stripped of some
of its authority. In October, the parliament passed a bailout package of $500 billion
(60 trillion yen). However, disbursement of the funds depended on the voluntary
cooperation of the banks: the law did not require insolvent banks to close or to accept
the funds. Indeed, acceptance of the funds required the bailed-out bank to open its
books and reveal its true losses, and thus many banks remain very undercapitalized.
The banking sector in Japan thus remains in very poor shape: It is burdened with bad
loans and poor profitability. Indeed, many private sector analysts estimate that bad
loans have reached a level of more than $1 trillion.
There has been some progress in cleaning up the banking mess: immediately after
the 1998 banking law was passed, one of the ailing city banks, Long-Term Credit
Bank of Japan, was taken over by the government and declared insolvent, and in
December 1998, the Nippon Credit Bank was finally put out of its misery and closed
C H A P T E R 1 1 Economic Analysis of Banking Regulation 283
down by the government. Since then, the clean-up process has stalled and the economy
has remained weak, with a growth rate from 1991–2002 averaging an anemic
1%. A new, reform-oriented prime minister, Junichiro Koizumi, who pledged to clean
up the banking system, came into office in 2001; yet he has been unable to come to
grips with the Japanese banking problem. This situation does not bode well for the
Japanese economy.
We discussed the banking and financial crisis in the East Asian countries (Thailand,
Malaysia, Indonesia, the Philippines, and South Korea) in Chapter 8. Due to inadequate
supervision of the banking system, the lending booms that arose in the aftermath
of financial liberalization led to substantial loan losses, which became huge after
the currency collapses that occurred in the summer of 1997. An estimated 15% to
35% of all bank loans have turned sour in Thailand, Indonesia, Malaysia, and South
Korea, and the cost of the bailout for the banking system is estimated at more than
20% of GDP in these countries and over 50% of GDP in Indonesia. The Philippines
is expected to fare somewhat better, with the cost below 10% of GDP.
What we see in banking crises in these different countries is that history has kept on
repeating itself. The parallels between the banking crisis episodes in all these countries
are remarkably similar, leaving us with a feeling of déjà vu. Although financial
liberalization is generally a good thing because it promotes competition and can make
a financial system more efficient, as we have seen in the countries examined here, it
can lead to an increase in moral hazard, with more risk taking on the part of banks if
there is lax regulation and supervision; the result can then be banking crises.
However, these episodes do differ in that deposit insurance has not played an important
role in many of the countries experiencing banking crises. For example, the size
of the Japanese equivalent of the FDIC, the Deposit Insurance Corporation, was so
tiny relative to the FDIC that it did not play a prominent role in the banking system
and exhausted its resources almost immediately with the first bank failures. This
means that deposit insurance is not to blame for some of these banking crises.
However, what is common to all the countries discussed here is the existence of a government
safety net, in which the government stands ready to bail out banks whether
deposit insurance is an important feature of the regulatory environment or not. It is
the existence of a government safety net, and not deposit insurance per se, that
increases moral hazard incentives for excessive risk taking on the part of banks.
“Déjà Vu All
Over Again”
East Asia
284 PART I I I Financial Institutions
Summary
1. The concepts of asymmetric information, adverse selection,
and moral hazard help explain the eight types of banking
regulation that we see in the United States and other
countries: the government safety net, restrictions on bank
asset holdings, capital requirements, bank supervision,
assessment of risk mangement, disclosure requirements,
consumer protection, and restrictions on competition.
2. Because asymmetric information problems in the
banking industry are a fact of life throughout the world,
bank regulation in other countries is similar to that in
the United States. It is particularly problematic to
regulate banks engaged in international banking,
because they can readily shift their business from one
country to another.
3. Because of financial innovation, deregulation, and a set
of historical accidents, adverse selection and moral
hazard problems increased in the 1980s and resulted in
huge losses for the U.S. savings and loan industry and
for taxpayers.
4. Regulators and politicians are subject to the
principal–agent problem, meaning that they may not
have sufficient incentives to minimize the costs of
deposit insurance to taxpayers. As a result, regulators
and politicians relaxed capital standards, removed
restrictions on holdings of risky assets, and relied on
regulatory forbearance, thereby increasing the costs of
the S&L bailout.
5. The Financial Institutions Reform, Recovery, and
Enforcement Act (FIRREA) of 1989 provided funds for
the S&L bailout; created the Resolution Trust
Corporation to manage the resolution of insolvent thrifts;
eliminated the Federal Home Loan Bank Board and gave
its regulatory role to the Office of Thrift Supervision;
eliminated the FSLIC, whose insurance role and
regulatory responsibilities were taken over by the FDIC;
imposed restrictions on thrift activities similar to those in
effect before 1982; increased the capital requirements to
those adhered to by commercial banks; and increased the
enforcement powers of thrift regulators.
6. The Federal Deposit Insurance Corporation Improvement
Act (FDICIA) of 1991 recapitalized the Bank
Insurance Fund of the FDIC and included reforms for
the deposit insurance and regulatory system so that
taxpayer losses would be minimized. This legislation
limited brokered deposits and the use of the too-bigto-
fail policy, mandated prompt corrective action to
deal with troubled banks, and instituted risk-based
deposit insurance premiums. These provisions have
helped reduce the incentives of banks to take on
excessive risk and so should help reduce taxpayer
exposure in the future.
7. The parallels between the banking crisis episodes that
have occurred in countries throughout the world are
striking, indicating that similar forces are at work.
C H A P T E R 1 1 Economic Analysis of Banking Regulation 285
Key Terms
bank failure, p. 260
bank supervision (prudential
supervision), p. 265
Basel Accord, p. 265
Basel Committee on Banking
Supervision, p. 265
goodwill, p. 275
leverage ratio, p. 265
off-balance-sheet activities, p. 265
regulatory arbitrage, p. 265
regulatory forbearance, p. 275
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. Give one example each of moral hazard and adverse
selection in private insurance arrangements.
*2. If casualty insurance companies provided fire insurance
without any restrictions, what kind of adverse
selection and moral hazard problems might result?
3. What bank regulation is designed to reduce adverse
selection problems for deposit insurance? Will it
always work?
*4. What bank regulations are designed to reduce moral
hazard problems created by deposit insurance? Will
they completely eliminate the moral hazard problem?
5. What are the costs and benefits of a too-big-to-fail
policy?
*6. Why did the S&L crisis not occur until the 1980s?
7. Why is regulatory forbearance a dangerous strategy for
a deposit insurance agency?
*8. The FIRREA legislation of 1989 is the most comprehensive
banking legislation since the 1930s. Describe
its major features.
QUIZ
9. What steps were taken in the FDICIA legislation of
1991 to improve the functioning of federal deposit
insurance?
*10. Some advocates of campaign reform believe that government
funding of political campaigns and restrictions
on campaign spending might reduce the
principal–agent problem in our political system. Do
you agree? Explain your answer.
11. How can the S&L crisis be blamed on the
principal–agent problem?
*12. Do you think that eliminating or limiting the amount
of deposit insurance would be a good idea? Explain
your answer.
13. Do you think that removing the impediments to a
nationwide banking system will be beneficial to the
economy? Explain your answer.
*14. How could higher deposit insurance premiums for
banks with riskier assets benefit the economy?
15. How has too-big-too-fail been limited in the FDICIA
legislation? How might limiting too-big-too-fail help
reduce the risk of a future banking crisis?
286 PART I I I Financial Institutions
Web Exercises
1. Go to www.fdic.gov/regulations/laws/important
/index.html. This site reports on the most significant
pieces of legislation affecting banks since the 1800s.
Summarize the most recently enacted bank regulation
listed on this site.
2. The Office of the Comptroller of the Currency is
responsible for many of the regulations affecting bank
operations. Go to www.occ.treas.gov/. Click on
“Regulatory Information.” Now click on the 12 CFR
Parts 1 to 199. What does Part 1 cover? How many
parts are there in 12 CRF? Open Part 18. What topic
does it cover? Summarize its purpose.
FDICIA is a major step in reforming the banking regulatory system. How well will it
work to solve the adverse selection and moral hazard problems of the bank regulatory
system? Let’s use the analysis in the chapter to evaluate the most important provisions
of this legislation to answer this question.
Study Guide Before looking at the evaluation for each set of provisions and proposals in this application,
try to reason out how well they will solve the current problems with banking
regulation. This exercise will help you develop a deeper understanding of the material
in this chapter.
FDICIA’s reduction of the scope of deposit insurance by limiting insurance on brokered
deposits and restricting the use of the too-big-to-fail policy might have
increased the incentives for uninsured depositors to monitor banks and to withdraw
funds if the bank is taking on too much risk. Because banks might now fear the loss
of deposits when they engage in risky activities, they might have less incentive to take
on too much risk. Limitations on the use of the too-big-to-fail policy starting in 1992
have resulted in increased losses to uninsured depositors at failed banks as planned.
Although the cited elements of FDICIA strengthen the incentive of depositors to
monitor banks, some critics of FDICIA would take these limitations on the scope of
deposit insurance even further. Some suggest that deposit insurance should be eliminated
entirely or should be reduced in amount from the current $100,000 limit to,
say, $50,000 or $20,000. Another proposed reform would institute a system of coinsurance
in which only a percentage of a deposit—say, 90%—would be covered by
insurance. In this system, the insured depositor would suffer a percentage of the
losses along with the deposit insurance agency. Because depositors facing a lower limit
on deposit insurance or coinsurance would suffer losses if the bank goes broke, they
will have an incentive to monitor the bank’s activities. Other critics believe that FDICIA
provides too much support for the too-big-to-fail policy. Because under FDICIA the
Fed, the Treasury, and the FDIC can still agree to implement too-big-to-fail and thus
bail out uninsured as well as insured depositors, big banks will not be subjected to
enough discipline by uninsured depositors. These critics advocate eliminating the
too-big-to-fail policy entirely, thereby decreasing the incentives of big banks to take
on too much risk.
Limits on the
Scope of Deposit
Insurance
Evaluating FDICIA and Other
Proposed Reforms of the
Banking Regulatory System
appendix
to chapter 11
1
However, other experts do not believe that depositors are capable of monitoring
banks and imposing discipline on them. The basic problem with reducing the scope
of deposit insurance even further as proposed is that banks would be subject to runs,
sudden withdrawals by nervous depositors. Such runs could by themselves lead to
bank failures. In addition to protecting individual depositors, the purpose of deposit
insurance is to prevent a large number of bank failures, which would lead to an unstable
banking system and an unstable economy as occurred periodically before the
establishment of federal deposit insurance in 1934. From this perspective, federal
deposit insurance has been a resounding success. Bank panics, in which there are
simultaneous failures of many banks and consequent disruption of the financial system,
have not occurred since federal deposit insurance was established.
On the one hand, evidence that the largest banks benefiting from the de facto toobig-
to-fail policy before 1991 were also the ones that took on the most risk suggests
that limiting its application, as FDICIA does, may substantially reduce risk taking. On
the other hand, eliminating the too-big-to-fail policy altogether would also cause some
of the same problems that would occur if deposit insurance were eliminated or
reduced: The probability of bank panics would increase. If a big bank were allowed to
fail, the repercussions in the financial system might be immense. Other banks with a
correspondent relationship with the failed bank (those that have deposits at the bank
in exchange for a variety of services) would suffer large losses and might fail in turn,
leading to a full-scale panic. In addition, the problem of liquidating the big bank’s loan
portfolio might create a major disruption in the financial market.
The prompt corrective action provisions of FDICIA should also substantially reduce
incentives for bank risk taking and reduce taxpayer losses. FDICIA uses a carrot-andstick
approach to get banks to hold more capital. If they are well capitalized, they
receive valuable privileges; if their capital ratio falls, they are subject to more and
more onerous regulation. Increased bank capital reduces moral hazard incentives for
the bank, because the bank now has more to lose if it fails and so is less likely to take
on too much risk.
In addition, encouraging banks to hold more capital reduces potential losses for
the FDIC, because increased bank capital is a cushion that makes bank failure less
likely. Furthermore, forcing the FDIC to close banks once their net worth is less than
2% (group 5) rather than waiting until net worth has fallen to zero makes it more
likely that when a bank is closed, it will still have a positive net worth, thus limiting
FDIC losses.
Prompt corrective action, which requires regulators to intervene early when bank
capital begins to fall, is a serious attempt to reduce the principal–agent problem for
politicians and regulators. With prompt corrective action provisions, regulators no
longer have the option of regulatory forbearance, which, as we have seen, can greatly
increase moral hazard incentives for banks.
Some critics of FDICIA feel that there are too many loopholes in the bill
that still allow regulators too much discretion, thus leaving open the possibility of
regulatory forbearance. However, an often overlooked part of the bill increases the
accountability of regulators. FDICIA requires a mandatory review of any bank failure
that imposes costs on the FDIC. The resulting report must be made available to any
member of Congress and to the general public upon request, and the General
Accounting Office must do an annual review of these reports. Opening up the actions
of the regulators to public scrutiny will make regulatory forbearance less attractive to
Prompt
Corrective
Action
Evaluating FDICIA and Other Proposed Reforms of the Banking Regulatory System 2
them, thereby reducing the principal–agent problem. It will also reduce the incentives
of politicians to lean on regulators to relax their regulatory supervision of banks.
Under FDICIA, banks deemed to be taking on greater risk, in the form of lower capital
or riskier assets, will be subjected to higher insurance premiums. Risk-based
insurance premiums will consequently reduce the moral hazard incentives for banks
to take on higher risk. In addition, the fact that risk-based premiums drop as the
bank’s capital increases encourages the bank to hold more capital, which has the benefits
already mentioned.
One problem with risk-based premiums is that the scheme for determining the
amount of risk the bank is taking may not be very accurate. For example, it might
be hard for regulators to determine when a bank’s loans are risky. Some critics have
also pointed out that the classification of banks by such measures as the Basel riskbased
capital standard solely reflects credit risk and does not take sufficient account
of interest-rate risk. The regulatory authorities, however, are encouraged by FDICIA
to modify existing risk-based standards to include interest-rate risk and, as we have
seen earlier in the chapter, have proposed guidelines to encourage banks to manage
interest-rate risk.
FDICIA’s requirements that regulators perform bank examinations at least once a year
are necessary for monitoring banks’ compliance with bank capital requirements and
asset restrictions. As the S&L debacle illustrates, frequent supervisory examinations
of banks are necessary to keep them from taking on too much risk or committing
fraud. Similarly, beefing up the ability of the Federal Reserve to monitor foreign banks
might help dissuade international banks from engaging in these undesirable activities.
The stricter and more burdensome reporting requirements for banks have the
advantage of providing more information to regulators to help them monitor bank
activities. However, these reporting requirements have been criticized by banks,
which claim that the requirements make it harder to lend to small businesses.
Regulatory Consolidation. The current bank regulatory system in the United States
has banking institutions supervised by four federal agencies: the FDIC, the Office of
the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal
Reserve. Critics of this system of multiple regulatory agencies with overlapping jurisdictions
believe it creates a system that is too complex and too costly because it is rife
with duplication. The Clinton administration proposed a consolidation in which the
duties of the four regulatory agencies would be given to a new Federal Banking
Commission governed by a five-member board with one member from the Treasury,
one from the Federal Reserve, and three independent members appointed by the
president and confirmed by the Senate. The Federal Reserve strongly opposed this
proposal because it believed that it needed to have hands-on supervision of the largest
banks through their bank holding companies (as is the case currently) in order to
have the information that would enable the Fed to respond sufficiently quickly in a
crisis. The Fed also pointed out that a monolithic regulator might be less effective
than two or more regulators in providing checks and balances for regulatory supervision.
The Clinton administration’s proposal was not passed by Congress, but the issue
of regulatory consolidation is sure to come up again.
Other Proposed
Changes in
Banking
Regulations
Other FDICIA
Provisions
Risk-Based
Insurance
Premiums
3 Appendix to Chapter 11
Market-Value Accounting for Capital Requirements. We have seen that the requirement
that a bank have substantial equity capital makes the bank less likely to fail. The
requirement is also advantageous, because a bank with high equity capital has more
to lose if it takes on risky investments and so will have less incentive to hold risky
assets. Unfortunately, capital requirements, including new risk-based measures, are
calculated on a historical-cost (book value) basis in which the value of an asset is set
at its initial purchase price. The problem with historical-cost accounting is that
changes in the value of assets and liabilities because of changes in interest rates or
default risk are not reflected in the calculation of the firm’s equity capital. Yet changes
in the market value of assets and liabilities and hence changes in the market value of
equity capital are what indicate if a firm is truly insolvent. Furthermore, it is the market
value of capital that determines the incentives for a bank to hold risky assets.
Market-value accounting when calculating capital requirements is another reform
that receives substantial support. All assets and liabilities could be updated to market
value periodically—say, every three months—to determine if a bank’s capital is sufficient
to meet the minimum requirements. This market-value accounting information
would let the deposit insurance agency know quickly when a bank was falling below
its capital requirement. The bank could then be closed down before its net worth fell
below zero, thus preventing a loss to the deposit insurance agency. The market-valuebased
capital requirement would also ensure that banks would not be operating with
negative capital, thereby preventing the bet-the-bank strategy of taking on excessive
risk.
Objections to market-value-based capital requirements center on the difficulty of
making accurate and straightforward market-value estimates of capital. Historical-cost
accounting has an important advantage in that accounting rules are easier to define
and standardize when the value of an asset is simply set at its purchase price. Marketvalue
accounting, by contrast, requires estimates and approximations that are harder
to standardize. For example, it might be hard to assess the market value of your friend
Joe’s car loan, whereas it would be quite easy to value a government bond. In addition,
conducting market-value accounting would prove costly to banks because estimation
of market values requires the collection of more information about the
characteristics of assets and liabilities. Nevertheless, proponents of market-value
accounting for capital requirements point out that although market-value accounting
involves some estimates and approximations, it would still provide regulators with
more accurate assessment of bank equity capital than historical-cost accounting does.
FDICIA appears to be an important step in the right direction, because it increases the
incentives for banks to hold capital and decreases their incentives to take on excessive
risk. However, more could be done to improve the incentives for banks to limit
their risk taking. Yet eliminating deposit insurance and the too-big-to-fail policy altogether
may be going too far, because these proposals might make the banking system
too prone to a banking panic.
Overall Evaluation
Evaluating FDICIA and Other Proposed Reforms of the Banking Regulatory System 4
PREVIEW Banking is not the only type of financial intermediation you are likely to experience.
You might decide to purchase insurance, take out an installment loan from a finance
company, or buy a share of stock. In each of these transactions you will be engaged
in nonbank finance and will deal with nonbank financial institutions. In our economy,
nonbank finance also plays an important role in channeling funds from lender-savers
to borrower-spenders. Furthermore, the process of financial innovation we discussed
in Chapter 10 has increased the importance of nonbank finance and is blurring the
distinction between different financial institutons. This chapter examines in more
detail how institutions engaged in nonbank finance operate, how they are regulated,
and recent trends in nonbank finance.
Insurance
Every day we face the possibility of the occurrence of certain catastrophic events that
could lead to large financial losses. A spouse’s earnings might disappear due to death
or illness; a car accident might result in costly repair bills or payments to an injured
party. Because financial losses from crises could be large relative to our financial
resources, we protect ourselves against them by purchasing insurance coverage that
will pay a sum of money if catastrophic events occur. Life insurance companies sell
policies that provide income if a person dies, is incapacitated by illness, or retires.
Property and casualty companies specialize in policies that pay for losses incurred as
a result of accidents, fire, or theft.
The first life insurance company in the United States (Presbyterian Ministers’ Fund in
Philadelphia) was established in 1759 and is still in existence. There are currently
about 1,400 life insurance companies, which are organized in two forms: as stock
companies or as mutuals. Stock companies are owned by stockholders; mutuals are
technically owned by the policyholders. Although over 90% of life insurance companies
are organized as stock companies, some of the largest ones are organized as
mutuals.
Unlike commercial banks and other depository institutions, life insurance companies
have never experienced widespread failures, so the federal government has not
seen the need to regulate the industry. Instead, regulation is left to the states in which
a company operates. State regulation is directed at sales practices, the provision of
Life Insurance
287
Chap ter
12 Nonbank Finance
www.iii.org
The Insurance Information
Institute publishes facts and
statistics about the
insurance industry.
adequate liquid assets to cover losses, and restrictions on the amount of risky assets
(such as common stock) that the companies can hold. The regulatory authority is typically
a state insurance commissioner.
Because death rates for the population as a whole are predictable with a high
degree of certainty, life insurance companies can accurately predict what their payouts
to policyholders will be in the future. Consequently, they hold long-term assets that
are not particularly liquid—corporate bonds and commercial mortgages as well as
some corporate stock.
There are two principal forms of life insurance policies: permanent life insurance
(such as whole, universal, and variable life) and temporary insurance (such as term).
Permanent life insurance policies have a constant premium throughout the life of the
policy. In the early years of the policy, the size of this premium exceeds the amount
needed to insure against death because the probability of death is low. Thus the policy
builds up a cash value in its early years, but in later years the cash value declines
because the constant premium falls below the amount needed to insure against death,
the probability of which is now higher. The policyholder can borrow against the cash
value of the permanent life policy or can claim it by canceling the policy.
Term insurance, by contrast, has a premium that is matched every year to the
amount needed to insure against death during the period of the term (such as one
year or five years). As a result, term policies have premiums that rise over time as the
probability of death rises (or level premiums with a decline in the amount of death
benefits). Term policies have no cash value and thus, in contrast to permanent life
policies, provide insurance only, with no savings aspect.
Weak investment returns on permanent life insurance in the 1960s and 1970s led
to slow growth of demand for life insurance products. The result was a shrinkage in
the size of the life insurance industry relative to other financial intermediaries, with
their share of total financial intermediary assets falling from 19.6% at the end of 1960
to 11.5% at the end of 1980. (See Table 1, which shows the relative shares of financial
intermediary assets for each of the financial intermediaries discussed in this chapter.)
Beginning in the mid-1970s, life insurance companies began to restructure their
business to become managers of assets for pension funds. An important factor behind
this restructuring was 1974 legislation that encouraged pension funds to turn fund
management over to life insurance companies. Now more than half of the assets managed
by life insurance companies are for pension funds and not for life insurance.
Insurance companies have also begun to sell investment vehicles for retirement such
as annuities, arrangements whereby the customer pays an annual premium in
exchange for a future stream of annual payments beginning at a set age, say 65, and
continuing until death. The result of this new business has been that the market share
of life insurance companies as a percentage of total financial intermediary assets has
held steady since 1980.
There are on the order of 3,000 property and casualty insurance companies in the
United States, the two largest of which are State Farm and Allstate. Property and casualty
companies are organized as both stock and mutual companies and are regulated
by the states in which they operate.
Although property and casualty insurance companies had a slight increase in
their share of total financial intermediary assets from 1960 to 1990 (see Table 1), in
recent years they have not fared well, and insurance premiums have skyrocketed.
With the high interest rates in the 1970s and 1980s, insurance companies had high
Property and
Casualty
Insurance
288 PART I I I Financial Institutions
www.federalreserve.gov
/releases/Z1/
The Flow of Funds Accounts of
the United States reports details
about the current state of the
insurance industry. Scroll down
through the table of contents to
find the location of data on
insurance companies.
investment income that enabled them to keep insurance rates low. Since then, however,
investment income has fallen with the decline in interest rates, while the growth
in lawsuits involving property and casualty insurance and the explosion in amounts
awarded in such cases have produced substantial losses for companies.
To return to profitability, insurance companies have raised their rates dramatically—
sometimes doubling or even tripling premiums—and have refused to provide
coverage for some people. They have also campaigned actively for limits on insurance
payouts, particularly for medical malpractice. In the search for profits, insurance companies
are also branching out into uncharted territory by insuring the payment of
interest on municipal and corporate bonds and on mortgage-backed securities. One
worry is that the insurance companies may be taking on excessive risk in order to
boost their profits. One result of the concern about the health of the property and
casualty insurance industry is that insurance regulators have proposed new rules that
would impose risk-based capital requirements on these companies based on the riskiness
of their assets and operations.
The investment policies of these companies are affected by two basic facts. First,
because they are subject to federal income taxes, the largest share of their assets is held
in tax-exempt municipal bonds. Second, because property losses are more uncertain
than the death rate in a population, these insurers are less able to predict how much
they will have to pay policyholders than life insurance companies are. Natural or
C H A P T E R 1 2 Nonbank Finance 289
1960 1970 1980 1990 2002
Insurance Companies
Life insurance 19.6 15.3 11.5 12.5 13.6
Property and casualty 4.4 3.8 4.5 4.9 3.7
Pension Funds
Private 6.4 8.4 12.5 14.9 14.7
Public (state and local government) 3.3 4.6 4.9 6.7 7.9
Finance Companies 4.7 4.9 5.1 5.6 3.2
Mutual Funds
Stock and bond 2.9 3.6 1.7 5.9 10.6
Money market 0.0 0.0 1.9 4.6 8.8
Depository Institutions (Banks)
Commercial banks 38.6 38.5 36.7 30.4 29.8
S&L and mutual savings banks 19.0 19.4 19.6 12.5 5.6
Credit unions 1.1 1.4 1.6 2.0 2.3
Total 100.0 100.0 100.0 100.0 100.0
Source: Federal Reserve Flow of Funds Accounts.
Table 1 Relative Shares of Total Financial Intermediary Assets, 1960–2002 (percent)
unnatural disasters such as the Los Angeles earthquake in 1994 and Hurricane Floyd
in 1999, which devastated parts of the East Coast, and the September 11, 2001
destruction of the World Trade Center, exposed the property and casualty insurance
companies to billions of dollars of losses. Therefore, property and casualty insurance
companies hold more liquid assets than life insurance companies; municipal bonds
and U.S. government securities amount to over half their assets, and most of the
remainder is held in corporate bonds and corporate stock.
Property and casualty insurance companies will insure against losses from almost
any type of event, including fire, theft, negligence, malpractice, earthquakes, and
automobile accidents. If a possible loss being insured is too large for any one firm,
several firms may join together to write a policy in order to share the risk. Insurance
companies may also reduce their risk exposure by obtaining reinsurance. Reinsurance
allocates a portion of the risk to another company in exchange for a portion of the
premium and is particularly important for small insurance companies. You can think
of reinsurance as insurance for the insurance company. The most famous risk-sharing
operation is Lloyd’s of London, an association in which different insurance companies
can underwrite a fraction of an insurance policy. Lloyd’s of London has claimed that
it will insure against any contingency—for a price.
Until recently, banks have been restricted in their ability to sell life insurance products.
This has been changing rapidly, however. Over two-thirds of the states allow
banks to sell life insurance in one form or another. In recent years, the bank regulatory
authorities, particularly the Office of the Comptroller of the Currency (OCC),
have also encouraged banks to enter the insurance field because getting into insurance
would help diversify banks’ business, thereby improving their economic health
and making bank failures less likely. For example, in 1990, the OCC ruled that selling
annuities was a form of investment that was incidental to the banking business
and so was a permissible banking activity. As a result, the banks’ share of the annuities
market has surpassed 20%. Currently, more than 40% of banks sell insurance
products, and the number is expected to grow in the future.
Insurance companies and their agents reacted to this competitive threat with both
lawsuits and lobbying actions to block banks from entering the insurance business.
Their efforts were set back by several Supreme Court rulings that favored the banks.
Particularly important was a ruling in favor of Barnett Bank in March 1996, which held
that state laws to prevent banks from selling insurance can be superseded by federal
rulings from banking regulators that allow banks to sell insurance. The decision gave
banks a green light to further their insurance activities, and with the passage of the
Gramm-Leach-Bliley Act of 1999, banking institutions will further engage in the insurance
business, thus blurring the distinction between insurance companies and banks.
The Competitive
Threat from the
Banking Industry
290 PART I I I Financial Institutions
Application Insurance Management
Insurance, like banking, is in the financial intermediation business of transforming
one type of asset into another for the public. Insurance providers
use the premiums paid on policies to invest in assets such as bonds, stocks,
mortgages, and other loans; the earnings from these assets are then used to
pay out claims on the policies. In effect, insurers transform assets such as
C H A P T E R 1 2 Nonbank Finance 291
bonds, stocks, and loans into insurance policies that provide a set of services
(for example, claim adjustments, savings plans, friendly insurance
agents). If the insurer’s production process of asset transformation efficiently
provides its customers with adequate insurance services at low cost and if it
can earn high returns on its investments, it will make profits; if not, it will
suffer losses.
In Chapter 9 the economic concepts of adverse selection and moral hazard
allowed us to understand principles of bank management related to managing
credit risk; many of these same principles also apply to the lending
activities of insurers. Here again we apply the adverse selection and moral hazard
concepts to explain many management practices specific to insurance.
In the case of an insurance policy, moral hazard arises when the existence
of insurance encourages the insured party to take risks that increase the likelihood
of an insurance payoff. For example, a person covered by burglary
insurance might not take as many precautions to prevent a burglary because
the insurance company will reimburse most of the losses if a theft occurs.
Adverse selection holds that the people most likely to receive large insurance
payoffs are the ones who will want to purchase insurance the most. For
example, a person suffering from a terminal disease would want to take out
the biggest life and medical insurance policies possible, thereby exposing the
insurance company to potentially large losses. Both adverse selection and
moral hazard can result in large losses to insurance companies, because they
lead to higher payouts on insurance claims. Lowering adverse selection and
moral hazard to reduce these payouts is therefore an extremely important
goal for insurance companies, and this goal explains the insurance practices
we will discuss here.
To reduce adverse selection, insurance providers try to screen out good insurance
risks from poor ones. Effective information collection procedures are
therefore an important principle of insurance management.
When you apply for auto insurance, the first thing your insurance agent
does is ask you questions about your driving record (number of speeding
tickets and accidents), the type of car you are insuring, and certain personal
matters (age, marital status). If you are applying for life insurance, you go
through a similar grilling, but you are asked even more personal questions
about such things as your health, smoking habits, and drug and alcohol use.
The life insurer even orders a medical evaluation (usually done by an independent
company) that involves taking blood and urine samples. Just as a
bank calculates a credit score to evaluate a potential borrower, the insurers
use the information you provide to allocate you to a risk class—a statistical
estimate of how likely you are to have an insurance claim. Based on this
information, the insurer can decide whether to accept you for the insurance
or to turn you down because you pose too high a risk and thus would be an
unprofitable customer.
Charging insurance premiums on the basis of how much risk a policyholder
poses for the insurance provider is a time-honored principle of insurance
management. Adverse selection explains why this principle is so important
to insurance company profitability.
Risk-Based
Premiums
Screening
292 PART I I I Financial Institutions
To understand why an insurance provider finds it necessary to have riskbased
premiums, let’s examine an example of risk-based insurance premiums
that at first glance seems unfair. Harry and Sally, both college students with no
accidents or speeding tickets, apply for auto insurance. Normally, Harry will
be charged a much higher premium than Sally. Insurance providers do this
because young males have a much higher accident rate than young females.
Suppose, though, that one insurer did not base its premiums on a risk classification
but rather just charged a premium based on the average combined
risk for males and females. Then Sally would be charged too much and Harry
too little. Sally could go to another insurer and get a lower rate, while Harry
would sign up for the insurance. Because Harry’s premium isn’t high enough
to cover the accidents he is likely to have, on average the insurer would lose
money on Harry. Only with a premium based on a risk classification, so that
Harry is charged more, can the insurance provider make a profit.1
Restrictive provisions in policies are an insurance management tool for
reducing moral hazard. Such provisions discourage policyholders from
engaging in risky activities that make an insurance claim more likely. For
example, life insurers have provisions in their policies that eliminate death
benefits if the insured person commits suicide within the first two years that
the policy is in effect. Restrictive provisions may also require certain behavior
on the part of the insured. A company renting motor scooters may be
required to provide helmets for renters in order to be covered for any liability
associated with the rental. The role of restrictive provisions is not unlike
that of restrictive covenants on debt contracts described in Chapter 8: Both
serve to reduce moral hazard by ruling out undesirable behavior.
Insurance providers also face moral hazard because an insured person has an
incentive to lie to the insurer and seek a claim even if the claim is not valid.
For example, a person who has not complied with the restrictive provisions
of an insurance contract may still submit a claim. Even worse, a person may
file claims for events that did not actually occur. Thus an important management
principle for insurance providers is conducting investigations to prevent
fraud so that only policyholders with valid claims receive compensation.
Being prepared to cancel policies is another insurance management tool.
Insurers can discourage moral hazard by threatening to cancel a policy when
the insured person engages in activities that make a claim more likely. If your
auto insurance company makes it clear that coverage will be canceled if a
driver gets too many speeding tickets, you will be less likely to speed.
The deductible is the fixed amount by which the insured’s loss is reduced
when a claim is paid off. A $250 deductible on an auto policy, for example,
Deductibles
Cancellation of
Insurance
Prevention of Fraud
Restrictive
Provisions
1Note that the example here is in fact the lemons problem described in Chapter 8.
C H A P T E R 1 2 Nonbank Finance 293
means that if you suffer a loss of $1,000 because of an accident, the insurer
will pay you only $750. Deductibles are an additional management tool that
helps insurance providers reduce moral hazard. With a deductible, you experience
a loss along with the insurer when you make a claim. Because you also
stand to lose when you have an accident, you have an incentive to drive more
carefully. A deductible thus makes a policyholder act more in line with what
is profitable for the insurer; moral hazard has been reduced. And because
moral hazard has been reduced, the insurance provider can lower the premium
by more than enough to compensate the policyholder for the existence
of the deductible. Another function of the deductible is to eliminate the
administrative costs of handling small claims by forcing the insured to bear
these losses.
When a policyholder shares a percentage of the losses along with the insurer,
their arrangement is called coinsurance. For example, some medical insurance
plans provide coverage for 80% of medical bills, and the insured person
pays 20% after a certain deductible has been met. Coinsurance works to
reduce moral hazard in exactly the same way that a deductible does. A policyholder
who suffers a loss along with the insurer has less incentive to take
actions, such as going to the doctor unnecessarily, that involve higher claims.
Coinsurance is thus another useful management tool for insurance providers.
Another important principle of insurance management is that there should
be limits on the amount of insurance provided, even though a customer is
willing to pay for more coverage. The higher the insurance coverage, the
more the insured person can gain from risky activities that make an insurance
payoff more likely and hence the greater the moral hazard. For example,
if Zelda’s car were insured for more than its true value, she might not
take proper precautions to prevent its theft, such as making sure that the
key is always removed or putting in an alarm system. If it were stolen, she
comes out ahead because the excessive insurance payment would allow her
to buy an even better car. By contrast, when the insurance payments are
lower than the value of her car, she will suffer a loss if it is stolen and will
thus take precautions to prevent this from happening. Insurance providers
must always make sure that their coverage is not so high that moral hazard
leads to large losses.
Effective insurance management requires several practices: information collection
and screening of potential policyholders, risk-based premiums, restrictive
provisions, prevention of fraud, cancellation of insurance, deductibles,
coinsurance, and limits on the amount of insurance. All of these practices
reduce moral hazard and adverse selection by making it harder for policyholders
to benefit from engaging in activities that increase the amount and
likelihood of claims. With smaller benefits available, the poor insurance risks
(those who are more likely to engage in the activities in the first place) see
less benefit from the insurance and are thus less likely to seek it out.
Summary
Limits on the
Amount of
Insurance
Coinsurance
Pension Funds
In performing the financial intermediation function of asset transformation, pension
funds provide the public with another kind of protection: income payments on
retirement. Employers, unions, or private individuals can set up pension plans,
which acquire funds through contributions paid in by the plan’s participants. As we
can see in Table 1, pension plans both public and private have grown in importance,
with their share of total financial intermediary assets rising from 10% at the end of
1960 to 22.6% at the end of 2002. Federal tax policy has been a major factor behind
the rapid growth of pension funds because employer contributions to employee pension
plans are tax-deductible. Furthermore, tax policy has also encouraged employee
contributions to pension funds by making them tax-deductible as well and enabling
self-employed individuals to open up their own tax-sheltered pension plans, Keogh
plans, and individual retirement accounts (IRAs).
Because the benefits paid out of the pension fund each year are highly predictable,
pension funds invest in long-term securities, with the bulk of their asset
holdings in bonds, stocks, and long-term mortgages. The key management issues for
pension funds revolve around asset management: Pension fund managers try to hold
assets with high expected returns and lower risk through diversification. They also
use techniques we discussed in Chapter 9 to manage credit and interest-rate risk.
The investment strategies of pension plans have changed radically over time. In the
aftermath of World War II, most pension fund assets were held in government
bonds, with less than 1% held in stock. However, the strong performance of stocks
in the 1950s and 1960s afforded pension plans higher returns, causing them to shift
their portfolios into stocks, currently on the order of two-thirds of their assets. As a
result, pension plans now have a much stronger presence in the stock market: In the
early 1950s, they held on the order of 1% of corporate stock outstanding; currently
they hold on the order of 25%. Pension funds are now the dominant players in the
stock market.
Although the purpose of all pension plans is the same, they can differ in a number
of attributes. First is the method by which payments are made: If the benefits are
determined by the contributions into the plan and their earnings, the pension is a
defined-contribution plan; if future income payments (benefits) are set in advance,
the pension is a defined-benefit plan. In the case of a defined-benefit plan, a further
attribute is related to how the plan is funded. A defined-benefit plan is fully funded
if the contributions into the plan and their earnings over the years are sufficient to pay
out the defined benefits when they come due. If the contributions and earnings are
not sufficient, the plan is underfunded. For example, if Jane Brown contributes $100
per year into her pension plan and the interest rate is 10%, after ten years the contributions
and their earnings would be worth $1,753.2 If the defined benefit on her
294 PART I I I Financial Institutions
2The $100 contributed in year 1 would become worth $100 (1 0.10)10 $259.37 at the end of ten years;
the $100 contributed in year 2 would become worth $100 (1 0.10)9 $235.79; and so on until the $100
contributed in year 10 would become worth $100 (1 0.10) $110. Adding these together, we get the total
value of these contributions and their earnings at the end of ten years:
$259.37 $235.79 $214.36 $194.87 $177.16
$161.05 $146.41 $133.10 $121.00 $110.00 $1,753.11
pension plan pays her $1,753 or less after ten years, the plan is fully funded because
her contributions and earnings will fully pay for this payment. But if the defined
benefit is $2,000, the plan is underfunded, because her contributions and earnings
do not cover this amount.
A second characteristic of pension plans is their vesting, the length of time that a
person must be enrolled in the pension plan (by being a member of a union or an
employee of a company) before being entitled to receive benefits. Typically, firms require
that an employee work five years for the company before being vested and qualifying to
receive pension benefits; if the employee leaves the firm before the five years are up,
either by quitting or being fired, all rights to benefits are lost.
Private pension plans are administered by a bank, a life insurance company, or a pension
fund manager. In employer-sponsored pension plans, contributions are usually
shared between employer and employee. Many companies’ pension plans are underfunded
because they plan to meet their pension obligations out of current earnings
when the benefits come due. As long as companies have sufficient earnings, underfunding
creates no problems, but if not, they may not be able to meet their pension
obligations. Because of potential problems caused by corporate underfunding, mismanagement,
fraudulent practices, and other abuses of private pension funds
(Teamsters pension funds are notorious in this regard), Congress enacted the Employee
Retirement Income Security Act (ERISA) in 1974. This act established minimum standards
for the reporting and disclosure of information, set rules for vesting and the
degree of underfunding, placed restrictions on investment practices, and assigned the
responsibility of regulatory oversight to the Department of Labor.
ERISA also created the Pension Benefit Guarantee Corporation (called “Penny
Benny”), which performs a role similar to that of the FDIC. It insures pension benefits
up to a limit (currently over $40,000 per year per person) if a company with an
underfunded pension plan goes bankrupt or is unable to meet its pension obligations
for other reasons. Penny Benny charges pension plans premiums to pay for this insurance,
and it can also borrow funds up to $100 million from the U.S. Treasury.
Unfortunately, the problem of pension plan underfunding has been growing worse in
recent years. In 1993, the secretary of labor indicated that underfunding had reached
levels in excess of $45 billion, with one company’s pension plan alone, that of General
Motors, underfunded to the tune of $11.8 billion. As a result, Penny Benny, which
insures the pensions of one of every three workers, may have to foot the bill if companies
with large underfunded pensions go broke.
The most important public pension plan is Social Security (Old Age and Survivors’
Insurance Fund), which covers virtually all individuals employed in the private sector.
Funds are obtained from workers through Federal Insurance Contribution Act (FICA)
deductions from their paychecks and from employers through payroll taxes. Social
Security benefits include retirement income, Medicare payments, and aid to the disabled.
When Social Security was established in 1935, the federal government intended to
operate it like a private pension fund. However, unlike a private pension plan, benefits
are typically paid out from current contributions, not tied closely to a participant’s
past contributions. This “pay as you go” system at one point led to a massive underfunding,
estimated at over $1 trillion.
The problems of the Social Security system could become worse in the future
because of the growth in the number of retired people relative to the working
Public Pension
Plans
Private Pension
Plans
C H A P T E R 1 2 Nonbank Finance 295
www.ssa.gov/
The web site for the Social
Security Administration
contains information on your
benefits available from social
security.
www.pbgc.gov/
The web site for the Pension
Benefit Guarantee Corporation
contains information about
pensions and the insurance that
it provides.
population. Congress has been grappling with the problems of the Social Security system
for years, but the prospect of a huge bulge in new retirees when the 77 billion
baby boomers born between 1946 and 1964 start to retire in 2011 has resulted in
calls for radical surgery on Social Security (see Box 1).
State and local governments and the federal government, like private employers,
have also set up pension plans for their employees. These plans are almost identical in
operation to private pension plans and hold similar assets. Underfunding of the plans is
also prevalent, and some investors in municipal bonds worry that it may lead to future
difficulties in the ability of state and local governments to meet their debt obligations.
Finance Companies
Finance companies acquire funds by issuing commercial paper or stocks and bonds
or borrowing from banks, and they use the proceeds to make loans (often for small
amounts) that are particularly well suited to consumer and business needs. The finan-
296 PART I I I Financial Institutions
Box 1
Should Social Security Be Privatized?
In recent years, public confidence in the Social
Security system has reached a new low. Some surveys
suggest that young people have more confidence in
the existence of flying saucers than they do in the government’s
promise to pay them their Social Security
benefits. Without some overhaul of the system, Social
Security will not be able to meet its future obligations.
The government has set up advisory commissions and
has been holding hearings to address this problem.
Currently, the assets of the Social Security system,
which reside in a trust fund, are all invested in U.S.
Treasury securities. Because stocks and corporate
bonds have higher returns than Treasury securities,
many proposals to save the Social Security system
suggest investing part of the trust fund in corporate
securities and thus partially privatizing the system.
Suggestions for privatization take three basic forms:
1. Government investment of trust fund assets in corporate
securities. This plan has the advantage of possibly
improving the trust fund’s overall return, while
minimizing transactions costs because it exploits the
economies of scale of the trust fund. Critics warn
that government ownership of private assets could
lead to increased government intervention in the private
sector.
2. Shift of trust fund assets to individual accounts that
can be invested in private assets. This option has the
advantage of possibly increasing the return on investments
and does not involve the government in the
ownership of private assets. However, critics warn
that it might expose individuals to greater risk and to
transaction costs on individual accounts that might
be very high because of the small size of many of
these accounts.
3. Individual accounts in addition to those in the trust
fund. This option has advantages and disadvantages
similar to those of option 2 and may provide more
funds to individuals at retirement. However, some
increase in taxes would be required to fund these
accounts.
Whether some privatization of the Social Security
system occurs is an open question. In the short
term, Social Security reform is likely to involve an
increase in taxes, a reduction in benefits, or both.
For example, the age at which benefits begin is
already scheduled to increase from 65 to 67, and
might be increased further to 70. It is also likely that
the cap on wages subject to the Social Security tax
will be raised further, thereby increasing taxes paid
into the system.
cial intermediation process of finance companies can be described by saying that they
borrow in large amounts but often lend in small amounts—a process quite different
from that of banking institutions, which collect deposits in small amounts and then
often make large loans.
A key feature of finance companies is that although they lend to many of the same
customers that borrow from banks, they are virtually unregulated compared to commercial
banks and thrift institutions. States regulate the maximum amount they can
loan to individual consumers and the terms of the debt contract, but there are no
restrictions on branching, the assets they hold, or how they raise their funds. The lack
of restrictions enables finance companies to tailor their loans to customer needs better
than banking institutions can.
There are three types of finance companies: sales, consumer, and business.
1. Sales finance companies are owned by a particular retailing or manufacturing
company and make loans to consumers to purchase items from that company. Sears,
Roebuck Acceptance Corporation, for example, finances consumer purchases of all
goods and services at Sears stores, and General Motors Acceptance Corporation
finances purchases of GM cars. Sales finance companies compete directly with banks
for consumer loans and are used by consumers because loans can frequently be
obtained faster and more conveniently at the location where an item is purchased.
2. Consumer finance companies make loans to consumers to buy particular items
such as furniture or home appliances, to make home improvements, or to help refinance
small debts. Consumer finance companies are separate corporations (like
Household Finance Corporation) or are owned by banks (Citigroup owns Person-to-
Person Finance Company, which operates offices nationwide). Typically, these companies
make loans to consumers who cannot obtain credit from other sources and
charge higher interest rates.
3. Business finance companies provide specialized forms of credit to businesses by
making loans and purchasing accounts receivable (bills owed to the firm) at a discount;
this provision of credit is called factoring. For example, a dressmaking firm
might have outstanding bills (accounts receivable) of $100,000 owed by the retail
stores that have bought its dresses. If this firm needs cash to buy 100 new sewing
machines, it can sell its accounts receivable for, say, $90,000 to a finance company,
which is now entitled to collect the $100,000 owed to the firm. Besides factoring,
business finance companies also specialize in leasing equipment (such as railroad
cars, jet planes, and computers), which they purchase and then lease to businesses for
a set number of years.
Mutual Funds
Mutual funds are financial intermediaries that pool the resources of many small
investors by selling them shares and using the proceeds to buy securities. Through the
asset transformation process of issuing shares in small denominations and buying large
blocks of securities, mutual funds can take advantage of volume discounts on brokerage
commissions and purchase diversified holdings (portfolios) of securities. Mutual
funds allow the small investor to obtain the benefits of lower transaction costs in purchasing
securities and to take advantage of the reduction of risk by diversifying the
portfolio of securities held. Many mutual funds are run by brokerage firms, but others
are run by banks or independent investment advisers such as Fidelity or Vanguard.
C H A P T E R 1 2 Nonbank Finance 297
www.federalreserve.gov
/Releases/G20/current
/default.htm
Federal reserve information
about financial companies.
www.ici.org/facts_figures
/factbook_toc.html
The Mutual Fund Fact Book
published by Investment
Company Institute includes
information about the mutual
funds industry’s history,
regulation, taxation, and
shareholders.
Mutual funds have seen a large increase in their market share since 1980 (see
Table 1), due primarily to the then-booming stock market. Another source of growth
has been mutual funds that specialize in debt instruments, which first appeared in the
1970s. Before 1970, mutual funds invested almost solely in common stocks. Funds
that purchase common stocks may specialize even further and invest solely in foreign
securities or in specialized industries, such as energy or high technology. Funds that
purchase debt instruments may specialize further in corporate, U.S. government, or
tax-exempt municipal bonds or in long-term or short-term securities.
Mutual funds are primarily held by households (around 80%) with the rest held
by other financial institutions and nonfinancial businesses. Mutual funds have
become increasingly important in household savings. In 1980, only 6% of households
held mutual fund shares; this number has risen to around 50% in recent years. The
age group with the greatest participation in mutual fund ownership includes individuals
between 50 and 70, which makes sense because they are the most interested in
saving for retirement. Interestingly, Generation X (18–30) is the second most active
age group in mutual fund ownership, suggesting that they have a greater tolerance for
investment risk than those who are somewhat older. Generation X is also leading the
way in Internet access to mutual funds (see Box 2).
The growing importance of investors in mutual funds and pension funds, socalled
institutional investors, has resulted in their controlling over 50% of the outstanding
stock in the United States. Thus, institutional investors are the predominant
players in the stock markets, with over 70% of the total daily volume in the stock
market due to their trading. Increased ownership of stocks has also meant that institutional
investors have more clout with corporate boards, often forcing changes in
leadership or in corporate policies.
Mutual funds are structured in two ways. The more common structure is an
open-end fund, from which shares can be redeemed at any time at a price that is tied
298 PART I I I Financial Institutions
Mutual Funds and the Internet
The Investment Company Institute estimates that as
of 2000, 68% of households owning mutual funds
use the Internet, and nearly half of those online
shareholders visit fund-related web sites. The
Internet increases the attractiveness of mutual funds
because it enables shareholders to review performance
information and share prices and personal
account information.
Of all U.S. households that conducted mutual
funds transactions between April 1999 and March
2000, 18% bought or sold fund shares online. The
median number of funds transactions conducted over
the Internet during the 12-month period was four,
while the average number was eight, indicating that a
high volume of online transactions were conducted
by a small number of shareholders.
Online shareholders were typically younger, had
greater household income, and were better educated
than those not using the Internet. The median online
shareholder was 42 years old, had a household
income of $100,900, and was college-educated. The
median shareholder not using the Internet was 51
years old, had a household income of $41,000, and
did not have a college degree.
The use of the Internet to track and trade mutual
funds is rapidly increasing. The number of shareholders
who visited web sites offering fund shares
nearly doubled between April 1999 and March 2000.
Box 2: E-Finance
to the asset value of the fund. Mutual funds also can be structured as a closed-end
fund, in which a fixed number of nonredeemable shares are sold at an initial offering
and are then traded like a common stock. The market price of these shares fluctuates
with the value of the assets held by the fund. In contrast to the open-end fund, however,
the price of the shares may be above or below the value of the assets held by the
fund, depending on factors such as the liquidity of the shares or the quality of the
management. The greater popularity of the open-end funds is explained by the greater
liquidity of their redeemable shares relative to the nonredeemable shares of closedend
funds.
Originally, shares of most open-end mutual funds were sold by salespeople (usually
brokers) who were paid a commission. Since this commission is paid at the time
of purchase and is immediately subtracted from the redemption value of the shares,
these funds are called load funds. Most mutual funds are currently no-load funds;
they are sold directly to the public with no sales commissions. In both types of funds,
the managers earn their living from management fees paid by the shareholders. These
fees amount to approximately 0.5% of the asset value of the fund per year.
Mutual funds are regulated by the Securities and Exchange Commission, which
was given the ability to exercise almost complete control over investment companies
in the Investment Company Act of 1940. Regulations require periodic disclosure of
information on these funds to the public and restrictions on the methods of soliciting
business.
An important addition to the family of mutual funds resulting from the financial innovation
process described in earlier chapters is the money market mutual fund. Recall
that this type of mutual fund invests in short-term debt (money market) instruments
of very high quality, such as Treasury bills, commercial paper, and bank certificates of
deposit. There is some fluctuation in the market value of these securities, but because
their maturity is typically less than six months, the change in the market value is small
enough that these funds allow their shares to be redeemed at a fixed value. (Changes
in the market value of the securities are figured into the interest paid out by the fund.)
Because these shares can be redeemed at a fixed value, the funds allow shareholders
to redeem shares by writing checks on the fund’s account at a commercial bank. In
this way, shares in money market mutual funds effectively function as checkable
deposits that earn market interest rates on short-term debt securities.
In 1977, the assets in money market mutual funds were less than $4 billion; by
1980, they had climbed to over $50 billion and now stand at $2.1 trillion, with a
share of financial intermediary assets that has grown to nearly 9% (see Table 1).
Currently, money market mutual funds account for around one-quarter of the asset
value of all mutual funds.
Hedge funds are a special type of mutual fund, with estimated assets of more than
$500 billion. Hedge funds have received considerable attention recently due to the
shock to the financial system resulting from the near collapse of Long-Term Capital
Management, once one of the most important hedge funds (Box 3). Well-known
hedge funds include Moore Capital Management and the Quantum group of funds
associated with George Soros. Like mutual funds, hedge funds accumulate money
from many people and invest on their behalf, but several features distinguish them
from traditional mutual funds. Hedge funds have a minimum investment requirement
Hedge Funds
Money Market
Mutual Funds
C H A P T E R 1 2 Nonbank Finance 299
between $100,000 and $20 million, with the typical minimum investment being $1
million. Long-Term Capital Management required a $10 million minimum investment.
Federal law limits hedge funds to have no more than 99 investors (limited partners)
who must have steady annual incomes of $200,000 or more or a net worth of
$1 million, excluding their homes. These restrictions are aimed at allowing hedge
funds to be largely unregulated, on the theory that the rich can look out for themselves.
Many of the 4,000 hedge funds are located offshore to escape regulatory
restrictions.
Hedge funds also differ from traditional mutual funds in that they usually require
that investors commit their money for long periods of time, often several years. The
purpose of this requirement is to give managers breathing room to pursue long-run
300 PART I I I Financial Institutions
Box 3
The Long-Term Capital Management Debacle
Long-Term Capital Management was a hedge fund
with a star cast of managers, including 25 PhDs, two
Nobel Prize winners in economics (Myron Scholes
and Robert Merton), a former vice-chairman of the
Federal Reserve System (David Mullins), and one of
Wall Street’s most successful bond traders (John
Meriwether). It made headlines in September 1998
because its near collapse roiled markets and required
a private rescue plan organized by the Federal
Reserve Bank of New York.
The experience of Long-Term Capital demonstrates
that hedge funds are far from risk-free,
despite their use of market-neutral strategies. Long-
Term Capital got into difficulties when it thought
that the spread between prices on long-term
Treasury bonds and long-term corporate bonds was
too high, and bet that this “anomaly” would disappear
and the spread would narrow. In the wake of
the collapse of the Russian financial system in
August 1998, investors increased their assessment of
the riskiness of corporate securities and as we saw in
Chapter 6, the spread between corporates and
Treasuries rose rather than narrowed as Long-Term
Capital had predicted. The result was that Long-
Term Capital took big losses on its positions, eating
up much of its equity position.
By mid-September, Long-Term Capital was unable
to raise sufficient funds to meet the demands of its
creditors. With Long-Term Capital facing the potential
need to liquidate its portfolio of $80 billion in
securities and more than $1 trillion of notional value
in derivatives (discussed in Chapter 13), the Federal
Reserve Bank of New York stepped in on September
23 and organized a rescue plan with its creditors. The
Fed’s rationale for stepping in was that a sudden liquidation
of Long-Term Capital’s portfolio would create
unacceptable systemic risk. Tens of billions of
dollars of illiquid securities would be dumped on an
already jittery market, causing potentially huge losses
to numerous lenders and other institutions. The rescue
plan required creditors, banks and investment
banks, to supply an additional $3.6 billion of funds
to Long-Term Capital in exchange for much tighter
management control of funds and a 90% reduction in
the managers’ equity stake. In the middle of 1999,
John Meriwether began to wind down the funds
operations.
Even though no public funds were expended, the
Fed’s involvement in organizing the rescue of Long-
Term Capital was highly controversial. Some critics
argue that the Fed intervention increased moral hazard
by weakening discipline imposed by the market
on fund managers because future Fed interventions of
this type would be expected. Others think that the
Fed’s action was necessary to prevent a major shock to
the financial system that could have provoked a financial
crisis. The debate on whether the Fed should have
intervened is likely to go on for some time.
strategies. Hedge funds also typically charge large fees to investors. The typical fund
charges a 1% annual fee on the assets it manages plus 20% of profits, and some charge
significantly more. Long-Term Capital, for example, charged investors a 2% asset
management fee and took 25% of the profits.
The term hedge fund is highly misleading, because the word “hedge” typically
indicates strategies to avoid risk. As the near failure of Long-Term Capital illustrates,
despite their name, these funds can and do take big risks. Many hedge funds engage
in what are called “market-neutral” strategies where they buy a security, such as a
bond, that seems cheap and sell an equivalent amount of a similar security that
appears to be overvalued. If interest rates as a whole go up or down, the fund is
hedged, because the decline in value of one security is matched by the rise in value
of the other. However, the fund is speculating on whether the spread between the
price on the two securities moves in the direction predicted by the fund managers. If
the fund bets wrong, it can lose a lot of money, particularly if it has leveraged up its
positions; that is, has borrowed heavily against these positions so that its equity stake
is small relative to the size of its portfolio. When Long-Term Capital was rescued, it
had a leverage ratio of 50 to 1; that is, its assets were fifty times larger than its equity,
and even before it got into trouble, it was leveraged 20 to 1.
In the wake of the near collapse of Long-Term Capital, many U.S. politicians have
called for regulation of these funds. However, because many of these funds operate
offshore in places like the Cayman Islands and are outside of U.S. jurisdiction, they
would be extremely hard to regulate. What U.S. regulators can do is ensure that U.S.
banks and investment banks have clear guidelines on the amount of lending they can
provide to hedge funds and require that these institutions get the appropriate amount
of disclosure from hedge funds as to the riskiness of their positions.
Government Financial Intermediation
The government has become involved in financial intermediation in two basic ways:
first, by setting up federal credit agencies that directly engage in financial intermediation
and, second, by supplying government guarantees for private loans.
To promote residential housing, the government has created three government agencies
that provide funds to the mortgage market by selling bonds and using the proceeds
to buy mortgages: the Government National Mortgage Association (GNMA, or
“Ginnie Mae”), the Federal National Mortgage Association (FNMA, or “Fannie Mae”),
and the Federal Home Loan Mortgage Corporation (FHLMC, or “Freddie Mac”).
Except for Ginnie Mae, which is a federal agency and is thus an entity of the U.S. government,
the other agencies are federally sponsored agencies (FSEs) that function as
private corporations with close ties to the government. As a result, the debt of sponsored
agencies is not explicitly backed by the U.S. government, as is the case for
Treasury bonds. As a practical matter, however, it is unlikely that the federal government
would allow a default on the debt of these sponsored agencies.
Agriculture is another area in which financial intermediation by government
agencies plays an important role. The Farm Credit System (composed of Banks for
Cooperatives, Farm Credit banks, and various farm credit associations) issues securities
and then uses the proceeds to make loans to farmers.
Federal Credit
Agencies
C H A P T E R 1 2 Nonbank Finance 301
In recent years, government financial intermediaries experienced financial difficulties.
The Farm Credit System is one example. The rising tide of farm bankruptcies
meant losses in the billions of dollars for the Farm Credit System, and as a result
it required a bailout from the federal government in 1987. The agency was authorized
to borrow up to $4 billion to be repaid over a 15-year period and received over
$1 billion in assistance. There is growing concern in Washington about the health of
the federal credit agencies. To head off government bailouts like that for the Farm
Credit System, the Federal Credit Reform Act of 1990 set new rules that require such
agencies to increase their capital to provide a greater cushion to offset any potential
losses. However, there have been growing concerns about Fannie Mae and Freddie
Mac (Box 4).
Securities Market Operations
The smooth functioning of securities markets, in which bonds and stocks are traded,
involves several financial institutions, including securities brokers and dealers, investment
banks, and organized exchanges. None of these institutions were included in our
list of financial intermediaries in Chapter 2, because they do not perform the intermediation
function of acquiring funds by issuing liabilities and then using the funds to
acquire financial assets. Nonetheless, they are important in the process of channeling
funds from savers to spenders and can be thought of as “financial facilitators.”
First, however, we must recall the distinction between primary and secondary
securities markets discussed in Chapter 2. In a primary market, new issues of a security
are sold to buyers by the corporation or government agency borrowing the funds.
A secondary market then trades the securities that have been sold in the primary mar-
302 PART I I I Financial Institutions
Box 4
Are Fannie Mae and Freddie Mac Getting Too Big for Their Britches?
With the growth of Fannie Mae and Freddie Mac to
immense proportions, there are rising concerns that
these federally sponsored agencies could threaten the
health of the financial system. Fannie Mae and
Freddie Mac either own or insure the risk on close to
half of U.S. residential mortgages (amounting to $2
trillion). In fact, their publicly issued debt is well over
half that issued by the federal government. A failure
of either of these institutions would therefore pose a
grave shock to the financial system. Although the federal
government would be unlikely to stand by and
let them fail, in such a case, the taxpayer would face
substantial costs, as in the S&L crisis.
Concerns about the safety and soundness of these
institutions arise because they have much smaller
capital-to-asset ratios than banks. Critics also charge
that Fannie Mae and Freddie Mac have become so
large that they wield too much political influence. In
addition, these federally sponsored agencies have
conflicts of interest, because they have to serve two
masters: as publicly traded corporations, they are
supposed to maximize profits for the shareholders,
but as government agencies, they are supposed to
work in the interests of the public. These concerns
have led to calls for reform of these agencies, with
many advocating full privatization as was done voluntarily
by the Student Loan Market Association
(“Sallie Mae”) in the mid-1990s.
ket (and so are secondhand). Investment banks assist in the initial sale of securities in
the primary market; securities brokers and dealers assist in the trading of securities in
the secondary markets, some of which are organized into exchanges.
When a corporation wishes to borrow (raise) funds, it normally hires the services of an
investment banker to help sell its securities. (Despite its name, an investment banker
is not a banker in the ordinary sense; that is, it is not engaged in financial intermediation
that takes in deposits and then lends them out.) Some of the well-known U.S.
investment banking firms are Merrill Lynch, Salomon Smith Barney, Morgan Stanley
Dean Witter, Goldman Sachs, Lehman Brothers, and Credit Suisse First Boston, which
have been very successful not only in the United States but outside it as well.
Investment bankers assist in the sale of securities as follows. First, they advise the
corporation on whether it should issue bonds or stock. If they suggest that the corporation
issue bonds, investment bankers give advice on what the maturity and interest
payments on the bonds should be. If they suggest that the corporation should sell
stock, they give advice on what the price should be. This is fairly easy to do if the firm
has prior issues currently selling in the market, called seasoned issues. However,
when a firm issues stock for the first time in what is called an initial public offering
(IPO), it is more difficult to determine what the correct price should be. All the skills
and expertise of the investment banking firm then need to be brought to bear to determine
the most appropriate price. IPOs have become very important in the U.S. economy,
because they are a major source of financing for Internet companies, which
became all the rage on Wall Street in the late 1990s. Not only have IPOs helped these
companies to acquire capital to substantially expand their operations, but they have
also made the original owners of these firms very rich. Many a nerdy 20- to 30-yearold
became an instant millionaire when his stake in his Internet company was given
a high valuation after the initial public offering of shares in the company. However,
with the bursting of the tech bubble in 2000, many of them lost much of their wealth
when the value of their shares came down to earth.
When the corporation decides which kind of financial instrument it will issue, it
offers them to underwriters—investment bankers that guarantee the corporation a
price on the securities and then sell them to the public. If the issue is small, only one
investment banking firm underwrites it (usually the original investment banking firm
hired to provide advice on the issue). If the issue is large, several investment banking
firms form a syndicate to underwrite the issue jointly, thus limiting the risk that any
one investment bank must take. The underwriters sell the securities to the general
public by contacting potential buyers, such as banks and insurance companies,
directly and by placing advertisements in newspapers like the Wall Street Journal (see
the “Following the Financial News” box).
The activities of investment bankers and the operation of primary markets are
heavily regulated by the Securities and Exchange Commission (SEC), which was created
by the Securities and Exchange Acts of 1933 and 1934 to ensure that adequate
information reaches prospective investors. Issuers of new securities to the general
public (for amounts greater than $1.5 million in a year with a maturity longer than
270 days) must file a registration statement with the SEC and must provide to potential
investors a prospectus containing all relevant information on the securities. The
issuer must then wait 20 days after the registration statement is filed with the SEC
before it can sell any of the securities. If the SEC does not object during the 20-day
waiting period, the securities can be sold.
Investment
Banking
C H A P T E R 1 2 Nonbank Finance 303
www.ipo.com
The site reports initial
public offering news and
information and includes
advanced search tools for IPO
offerings, venture capital
research reports, and so on.
Securities brokers and dealers conduct trading in secondary markets. Brokers act as
agents for investors in the purchase or sale of securities. Their function is to match
buyers with sellers, a function for which they are paid brokerage commissions. In
contrast to brokers, dealers link buyers and sellers by standing ready to buy and sell
securities at given prices. Therefore, dealers hold inventories of securities and make
their living by selling these securities for a slightly higher price than they paid for
them—that is, on the “spread” between the asked price and the bid price. This can be
a high-risk business because dealers hold securities that can rise or fall in price; in
recent years, several firms specializing in bonds have collapsed. Brokers, by contrast,
are not as exposed to risk because they do not own the securities involved in their
business dealings.
Brokerage firms engage in all three securities market activities, acting as brokers,
dealers, and investment bankers. The largest in the United States is Merrill Lynch;
other well-known ones are PaineWebber, Morgan Stanley Dean Witter, and Salomon
Smith Barney. The SEC not only regulates the investment banking operation of the
firms but also restricts brokers and dealers from misrepresenting securities and from
Securities
Brokers and
Dealers
304 PART I I I Financial Institutions
Following the Financial News
Information about new securities being issued is presented
in distinctive advertisements published in the
Wall Street Journal and other newspapers. These
advertisements, called “tombstones” because of their
appearance, are typically found in the “Money and
Investing” section of the Wall Street Journal.
The tombstone indicates the number of shares of
stock being issued (5.7 million shares for Cinergy)
and the investment bank involved in selling them.
Source: Wall Street Journal, Wednesday, February 12, 2003, p. C5.
New Securities Issues
www.sec.gov
The Securities and Exchange
Commission web site contains
regulatory actions, concept
releases, interpretive releases,
and more.
This announcement is under no circumstances to be construed as an
offer to sell or as a solicitation of an offer to buy any of these securities.
The offering is made only by the Prospectus Supplement
and the Prospectus to which it relates.
New Issue January 31, 2003
5,700,000 Shares
Common Stock
Price $31.10 Per Share
Copies of the Prospectus Supplement and the Prospectus to which it relates may be
obtained in any State or jurisdiction in which this announcement is circulated from the
undersigned or other dealers or brokers as may lawfully offer these securities in such
State or jurisdiction.
Merrill Lynch & Co.
trading on insider information, nonpublic information known only to the management
of a corporation.
The forces of competition led to an important development: Brokerage firms
started to engage in activities traditionally conducted by commercial banks. In 1977,
Merrill Lynch developed the cash management account (CMA), which provides a
package of financial services that includes credit cards, immediate loans, checkwriting
privileges, automatic investment of proceeds from the sale of securities into a
money market mutual fund, and unified record keeping. CMAs were adopted by
other brokerage firms and spread rapidly. The result is that the distinction between
banking activities and the activities of nonbank financial institutions has become
blurred (see Box 5). Another development is the growing importance of the Internet
in securities markets (Box 6).
As discussed in Chapter 2, secondary markets can be organized either as over-thecounter
markets, in which trades are conducted using dealers, or as organized
exchanges, in which trades are conducted in one central location. The New York
Stock Exchange (NYSE), trading thousands of securities, is the largest organized
exchange in the world, and the American Stock Exchange (AMEX) is a distant second.
A number of smaller regional exchanges, which trade only a small number of securities
(under 100), exist in places such as Boston and Los Angeles.
Organized stock exchanges actually function as a hybrid of an auction market
(in which buyers and sellers trade with each other in a central location) and a dealer
Organized
Exchanges
C H A P T E R 1 2 Nonbank Finance 305
Box 5
The Return of the Financial Supermarket?
In the 1980s, companies dreamed of creating “financial
supermarkets” in which there would be one-stop
shopping for financial services. Consumers would be
able to make deposits into their checking accounts,
buy mutual funds, get a mortgage or a student loan,
get a car or life insurance policy, obtain a credit card,
or buy real estate. In the early 1980s, Sears, which
already owned Allstate Insurance and a consumer
finance subsidiary, bought Coldwell Banker Real
Estate and Dean Witter, a brokerage firm. It also
acquired a $6 billion California-based savings bank
and introduced its Discover Card. Unfortunately, the
concept of the financial supermarket never worked at
Sears. (Indeed, the concept was derided as “stocks ’n’
socks.”) Sears’s financial service firms lost money and
Sears began to sell off these businesses in the late
1980s and early 1990s.
Sears is not the only firm to find it difficult to
make a go of the financial supermarket concept. In
the 1980s, American Express bought Shearson, Loeb
Rhodes, a brokerage and securities firm, only to find
it unprofitable. Similarly, Bank of America’s purchase
of Charles Schwab, the discount broker, also proved
to be unprofitable.
Citicorp and Travelers Group, which merged in
October 1998 with the view that Congress would
remove all barriers to combining banking and nonbanking
businesses in a financial service firm (which
the Congress subsequently did in 1999), bet that the
financial supermarket is an idea whose time has come.
Citigroup hopes that the time is right to take advantage
of economies of scope. With Citicorp’s success at
retail banking and the credit card business—it is the
largest credit card issuer, with over 60 million outstanding—
and Travelers’ success in the insurance and
securities business, the merged company, Citigroup,
hopes to generate huge profits by providing convenient
financial shopping for the consumer.
www.nyse.com
At the New York Stock
Exchange home page, you
will find listed companies,
member information, real-time
market indices, and current
stock quotes.
market (in which dealers make the market by buying and selling securities at given
prices). Securities are traded on the floor of the exchange with the help of a special
kind of dealer-broker called a specialist. A specialist matches buy and sell orders
submitted at the same price and so performs a brokerage function. However, if buy
and sell orders do not match up, the specialist buys stocks or sells from a personal
inventory of securities, in this manner performing a dealer function. By assuming
both functions, the specialist maintains orderly trading of the securities for which he
or she is responsible.
Organized exchanges in which securities are traded are also regulated by the SEC.
Not only does the SEC have the authority to impose regulations that govern the behavior
of brokers and dealers involved with exchanges, but it also has the authority to alter
the rules set by exchanges. In 1975, for example, the SEC disallowed rules that set minimum
brokerage commission rates. The result was a sharp drop in brokerage commission
rates, especially for institutional investors (mutual funds and pension funds), which
purchase large blocks of stock. The Securities Amendments Act of 1975 confirmed the
SEC’s action by outlawing the setting of minimum brokerage commissions.
Furthermore, the Securities Amendments Act directed the SEC to facilitate a
national market system that consolidates trading of all securities listed on the national
and regional exchanges as well as those traded in the over-the-counter market using
the National Association of Securities Dealers’ automated quotation system (NASDAQ).
Computers and advanced telecommunications, which reduce the costs of linking
these markets, have encouraged the expansion of a national market system. We thus
see that legislation and modern computer technology are leading the way to a more
competitive securities industry.
The growing internationalization of capital markets has encouraged another trend
in securities trading. Increasingly, foreign companies are being listed on U.S. stock
exchanges, and the markets are moving toward trading stocks internationally, 24
hours a day.
306 PART I I I Financial Institutions
The Internet Comes to Wall Street
An important development in recent years is the
growing importance of the Internet in securities markets.
Initial public offerings of stock are now being
sold on the Internet, and many brokerage firms allow
clients to conduct securities trades online or to transmit
buy and sell orders via e-mail. In June of 1999,
Wall Street was rocked by the announcement that its
largest full-service brokerage firm, Merrill Lynch,
would begin offering online trading for as little as
$29.95 a trade to its five million customers. Now
online trading is ubiquitous. The brokerage business
will never be the same.
Box 6: E-Finance
Summary
1. Insurance providers, which are regulated by the states,
acquire funds by selling policies that pay out benefits if
catastrophic events occur. Property and casualty
insurance companies hold more liquid assets than life
insurance companies because of greater uncertainty
regarding the benefits they will have to pay out. All
insurers face moral hazard and adverse selection
problems that explain the use of insurance management
C H A P T E R 1 2 Nonbank Finance 307
tools, such as information collection and screening of
potential policyholders, risk-based premiums,
restrictive provisions, prevention of fraud, cancellation
of insurance, deductibles, coinsurance, and limits on
the amount of insurance.
2. Pension plans provide income payments to people
when they retire after contributing to the plans for
many years. Pension funds have experienced very rapid
growth as a result of encouragement by federal tax
policy and now play an important role in the stock
market. Many pension plans are underfunded, which
means that in future years they will have to pay out
higher benefits than the value of their contributions and
earnings. The problem of underfunding is especially
acute for public pension plans such as Social Security.
To prevent abuses, Congress enacted the Employee
Retirement Income Security Act (ERISA), which
established minimum standards for reporting, vesting,
and degree of underfunding of private pension plans.
This act also created the Pension Benefit Guarantee
Corporation, which insures pension benefits.
3. Finance companies raise funds by issuing commercial
paper and stocks and bonds and use the proceeds to
make loans that are particularly suited to consumer and
business needs. Virtually unregulated in comparison to
commercial banks and thrift institutions, finance
companies have been able to tailor their loans to
customer needs very quickly and have grown rapidly.
4. Mutual funds sell shares and use the proceeds to buy
securities. Open-end funds issue shares that can be
redeemed at any time at a price tied to the asset value
of the firm. Closed-end funds issue nonredeemable
shares, which are traded like common stock. They are
less popular than open-end funds because their shares
are not as liquid. Money market mutual funds hold
only short-term, high-quality securities, allowing
shares to be redeemed at a fixed value using checks.
Shares in these funds effectively function as checkable
deposits that earn market interest rates. All mutual
funds are regulated by the Securities and Exchange
Commission (SEC).
5. Investment bankers assist in the initial sale of securities
in primary markets, whereas securities brokers and
dealers assist in the trading of securities in the
secondary markets, some of which are organized into
exchanges. The SEC regulates the financial institutions
in the securities markets and ensures that adequate
information reaches prospective investors.
Key Terms
annuities, p. 288
brokerage firms, p. 304
closed-end fund, p. 299
coinsurance, p. 293
deductible, p. 292
defined-benefit plan, p. 294
defined-contribution plan, p. 294
fully funded, p. 294
hedge fund, p. 299
initial public offering (IPO), p. 303
load funds, p. 299
no-load funds, p. 299
open-end fund, p. 298
reinsurance, p. 290
seasoned issue, p. 303
specialist, p. 306
underfunded, p. 294
underwriters, p. 303
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. If death rates were to become less predictable than
they are, how would life insurance companies change
the types of assets they hold?
2. Why do property and casualty insurance companies
have large holdings of municipal bonds but life insurance
companies do not?
*3. Why are all defined contribution pension plans fully
funded?
4. How can favorable tax treatment of pension plans
encourage saving?
QUIZ
*5. “In contrast to private pension plans, government
pension plans are rarely underfunded.” Is this statement
true, false, or uncertain? Explain your answer.
6. What explains the widespread use of deductibles in
insurance policies?
*7. Why might insurance companies restrict the amount
of insurance a policyholder can buy?
8. Why are restrictive provisions a necessary part of
insurance policies?
*9. If you needed to take out a loan, why might you first
go to your local bank rather than to a finance company?
10. Explain why shares in closed-end mutual funds typically
sell for less than the market value of the stocks
they hold.
*11. Why might you buy a no-load mutual fund instead of
a load fund?
12. Why can a money market mutual fund allow its
shareholders to redeem shares at a fixed price but
other mutual funds cannot?
*13. Why might government loan guarantees be a highcost
way for the government to subsidize certain
activities?
14. If you like to take risks, would you rather be a dealer,
a broker, or a specialist? Why?
*15. Is investment banking a good career for someone who
is afraid of taking risks? Why or why not?
308 PART I I I Financial Institutions
Web Exercises
1. Initial public offerings (IPOs) are where securities are
sold to the public for the very first time. Go to
http://ipo.com. This site lists various statistics regarding
the IPO market.
a. What is the largest IPO year to date ranked by
amount raised?
b. What is the next IPO to be offered to the public?
c. How many IPOs were priced this year?
2. The Federal Reserve maintains extensive data on finance
companies. Go to www.federalreserve.gov/releases and
scroll down until you find G.20 Finance Companies.
Click on “Releases” and find the current release.
a. Review the terms of credit for new car loans. What
is the most recent average interest rate and what is
the term to maturity? How much is the average
new car loan offered by finance companies?
b. Do finance companies make more consumer loans,
real estate loans, or business loans?
c. Which type of loan has grown most rapidly over
the last 5 years?
PREVIEW Starting in the 1970s and increasingly in the 1980s and 1990s, the world became a
riskier place for the financial institutions described in this part of the book. Swings in
interest rates widened, and the bond and stock markets went through some episodes
of increased volatility. As a result of these developments, managers of financial institutions
became more concerned with reducing the risk their institutions faced. Given
the greater demand for risk reduction, the process of financial innovation described
in Chapter 9 came to the rescue by producing new financial instruments that help
financial institution managers manage risk better. These instruments, called financial
derivatives, have payoffs that are linked to previously issued securities and are
extremely useful risk reduction tools.
In this chapter, we look at the most important financial derivatives that managers
of financial institutions use to reduce risk: forward contracts, financial futures,
options, and swaps. We examine not only how markets for each of these financial
derivatives work but also how they can be used by financial institutions to manage
risk. We also study financial derivatives because they have become an important
source of profits for financial institutions, particularly larger banks, which, as we saw
in Chapter 10, have found their traditional business declining.
Hedging
Financial derivatives are so effective in reducing risk because they enable financial
institutions to hedge; that is, engage in a financial transaction that reduces or eliminates
risk. When a financial institution has bought an asset, it is said to have taken a
long position, and this exposes the institution to risk if the returns on the asset are
uncertain. On the other hand, if it has sold an asset that it has agreed to deliver to
another party at a future date, it is said to have taken a short position, and this can
also expose the institution to risk. Financial derivatives can be used to reduce risk by
invoking the following basic principle of hedging: Hedging risk involves engaging in
a financial transaction that offsets a long position by taking an additional short
position, or offsets a short position by taking an additional long position. In other
words, if a financial institution has bought a security and has therefore taken a long
position, it conducts a hedge by contracting to sell that security (take a short position)
at some future date. Alternatively, if it has taken a short position by selling a security
that it needs to deliver at a future date, then it conducts a hedge by contracting to buy
309
Chap ter
13 Financial Derivatives
that security (take a long position) at a future date. We look at how this principle can
be applied using forward and futures contracts.
Interest-Rate Forward Contracts
Forward contracts are agreements by two parties to engage in a financial transaction
at a future (forward) point in time. Here we focus on forward contracts that are linked
to debt instruments, called interest-rate forward contracts; later in the chapter, we
discuss forward contracts for foreign currencies.
Interest-rate forward contracts involve the future sale of a debt instrument and
have several dimensions: (1) specification of the actual debt instrument that will be
delivered at a future date, (2) amount of the debt instrument to be delivered, (3) price
(interest rate) on the debt instrument when it is delivered, and (4) date on which
delivery will take place. An example of an interest-rate forward contract might be an
agreement for the First National Bank to sell to the Rock Solid Insurance Company,
one year from today, $5 million face value of the 8s of 2023 Treasury bonds (that is,
coupon bonds with an 8% coupon rate that mature in 2023) at a price that yields the
same interest rate on these bonds as today’s, say 8%. Because Rock Solid will buy the
securities at a future date, it is said to have taken a long position, while the First
National Bank, which will sell the securities, has taken a short position.
310 PART I I I Financial Institutions
Application Hedging with Interest-Rate Forward Contracts
Why would the First National Bank want to enter into this forward contract
with Rock Solid Insurance Company in the first place?
To understand, suppose that you are the manager of the First National
Bank and have bought $5 million of the 8s of 2023 Treasury bonds. The
bonds are currently selling at par value, so their yield to maturity is 8%.
Because these are long-term bonds, you recognize that you are exposed to
substantial interest-rate risk: If interest rates rise in the future, the price of
these bonds will fall and result in a substantial capital loss that may cost you
your job. How do you hedge this risk?
Knowing the basic principle of hedging, you see that your long position
in these bonds can be offset by a short position with a forward contract. That
is, you need to contract to sell these bonds at a future date at the current par
value price. As a result, you agree with another party—in this case, Rock
Solid Insurance Company—to sell them the $5 million of the 8s of 2023
Treasury bonds at par one year from today. By entering into this forward contract,
you have successfully hedged against interest-rate risk. By locking in
the future price of the bonds, you have eliminated the price risk you face
from interest-rate changes.
Why would Rock Solid Insurance Company want to enter into the futures
contract with the First National Bank? Rock Solid expects to receive premiums
of $5 million in one year’s time that it will want to invest in the 8s of 2023,
but worries that interest rates on these bonds will decline between now and
next year. By using the forward contract, it is able to lock in the 8% interest
rate on the Treasury bonds that will be sold to it by the First National Bank.
The advantage of forward contracts is that they can be as flexible as the parties
involved want them to be. This means that an institution like the First National Bank
may be able to hedge completely the interest-rate risk for the exact security it is holding
in its portfolio, just as it has in our example.
However, forward contracts suffer from two problems that severely limit their
usefulness. The first is that it may be very hard for an institution like the First National
Bank to find another party (called a counterparty) to make the contract with. There
are brokers to facilitate the matching up of parties like the First National Bank with
the Rock Solid Insurance Company, but there may be few institutions that want to
engage in a forward contract specifically for the 8s of 2023. This means that it may
prove impossible to find a counterparty when a financial institution like the First
National Bank wants to make a specific type of forward contract. Furthermore, even
if the First National Bank finds a counterparty, it may not get as high a price as it
wants because there may not be anyone else to make the deal with. A serious problem
for the market in interest-rate forward contracts, then, is that it may be difficult
to make the financial transaction or that it will have to be made at a disadvantageous
price; in the parlance of financial economists, this market suffers from a lack of liquidity.
(Note that this use of the term liquidity when it is applied to a market is somewhat
broader than its use when it is applied to an asset. For an asset, liquidity refers to the
ease with which the asset can be turned into cash; whereas for a market, liquidity
refers to the ease of carrying out financial transactions.)
The second problem with forward contracts is that they are subject to default risk.
Suppose that in one year’s time, interest rates rise so that the price of the 8s of 2023
falls. The Rock Solid Insurance Company might then decide that it would like to
default on the forward contract with the First National Bank, because it can now buy
the bonds at a price lower than the agreed price in the forward contract. Or perhaps
Rock Solid may not have been rock solid after all, and may have gone bust during
the year, and no longer be available to complete the terms of the forward contract.
Because there is no outside organization guaranteeing the contract, the only recourse
is for the First National Bank to go to the courts to sue Rock Solid, but this process
will be costly. Furthermore, if Rock Solid is already bankrupt, the First National Bank
will suffer a loss; the bank can no longer sell the 8s of 2023 at the price it had agreed
on with Rock Solid, but instead will have to sell at a price well below that, because
the price of these bonds has fallen.
The presence of default risk in forward contracts means that parties to these contracts
must check each other out to be sure that the counterparty is both financially
sound and likely to be honest and live up to its contractual obligations. Because this
type of investigation is costly and because all the adverse selection and moral hazard
problems discussed in earlier chapters apply, default risk is a major barrier to the use
of interest-rate forward contracts. When the default risk problem is combined with a
lack of liquidity, we see that these contracts may be of limited usefulness to financial
institutions. Although there is a market for interest-rate forward contracts, particularly
in Treasury and mortgage-backed securities, it is not nearly as large as the financial
futures market, to which we turn next.
Financial Futures Contracts and Markets
Given the default risk and liquidity problems in the interest-rate forward market, another
solution to hedging interest-rate risk was needed. This solution was provided by the development
of financial futures contracts by the Chicago Board of Trade starting in 1975.
Pros and Cons
of Forward
Contracts
C H A P T E R 1 3 Financial Derivatives 311
A financial futures contract is similar to an interest-rate forward contract, in that
it specifies that a financial instrument must be delivered by one party to another on a
stated future date. However, it differs from an interest-rate forward contract in several
ways that overcome some of the liquidity and default problems of forward markets.
To understand what financial futures contracts are all about, let’s look at one of
the most widely traded futures contracts—that for Treasury bonds, which are traded
on the Chicago Board of Trade. (An illustration of how prices on these contracts are
quoted can be found in the “Following the Financial News” box.) The contract value
is for $100,000 face value of bonds. Prices are quoted in points, with each point equal
to $1,000, and the smallest change in price is one thirty-second of a point ($31.25).
This contract specifies that the bonds to be delivered must have at least 15 years to
maturity at the delivery date (and must also not be callable—that is, redeemable by
the Treasury at its option—in less than 15 years). If the Treasury bonds delivered to
settle the futures contract have a coupon rate different from the 8% specified in the
futures contract, the amount of bonds to be delivered is adjusted to reflect the difference
in value between the delivered bonds and the 8% coupon bond. In line with the
terminology used for forward contracts, parties who have bought a futures contract
312 PART I I I Financial Institutions
Following the Financial News
The prices for financial futures contracts for debt
instruments are published daily. In the Wall Street
Journal, these prices are found in the “Commodities”
section under the “Interest Rate” heading of the
“Future Prices” columns. An excerpt is reproduced
here.
Information for each contract is presented in
columns, as follows. (The Chicago Board of Trade’s
contract for delivery of long-term Treasury bonds in
March 2000 is used as an example.)
Open: Opening price; each point corresponds to
$1,000 of face value—111 8/32 is $111,250 for
the March contract
High: Highest traded price that day—111 30/32 is
$111,938 for the March contract
Low: Lowest traded price that day—110 24/32 is
$110,750 for the March contract
Settle: Settlement price, the closing price that day—
111 23/32 is $111,719 for the March contract
Chg: Change in the settlement price from the previous
trading day—21/32 is $656.25 for the March contract
Lifetime High: Highest price ever—113 28/32 is
$113,875 for the March contract
Lifetime Low: Lowest price ever—100 5/32 is
$100,156 for the March contract
Open Interest: Number of contracts outstanding—
393,546 for the March contract, with a face value
of $39 billion (393,546 $100,000)
Financial Futures
Source: Wall Street Journal, January 31, 2003, p. B6.
INTEREST RATE
TREASURY BONDS (CBT)-$100,000; pts. 32nds of 100%
Lifetime Open
Open High Low Settle Chg. High Low Int.
Mar 111-08 111-30 110-24 111-23 21 113-28 100-05 393,546
June 109-26 110-13 109-15 110-12 21 112-15 105-00 37,713
Est vol 179,387; vol Wed 159,069; open int 431,381, +368.
http://home.teleport.com
/~rpotts/fincontr.html
Find information about
financial futures contract
specifications.
and thereby agreed to buy (take delivery of ) the bonds are said to have taken a long
position, and parties who have sold a futures contract and thereby agreed to sell
(deliver) the bonds have taken a short position.
To make our understanding of this contract more concrete, let’s consider what
happens when you buy or sell a Treasury bond futures contract. Let’s say that on
February 1, you sell one $100,000 June contract at a price of 115 (that is, $115,000).
By selling this contract, you agree to deliver $100,000 face value of the long-term
Treasury bonds to the contract’s counterparty at the end of June for $115,000. By buying
the contract at a price of 115, the buyer has agreed to pay $115,000 for the
$100,000 face value of bonds when you deliver them at the end of June. If interest
rates on long-term bonds rise, so that when the contract matures at the end of June,
the price of these bonds has fallen to 110 ($110,000 per $100,000 of face value), the
buyer of the contract will have lost $5,000, because he or she paid $115,000 for the
bonds but can sell them only for the market price of $110,000. But you, the seller of
the contract, will have gained $5,000, because you can now sell the bonds to the
buyer for $115,000 but have to pay only $110,000 for them in the market.
It is even easier to describe what happens to the parties who have purchased
futures contracts and those who have sold futures contracts if we recognize the following
fact: At the expiration date of a futures contract, the price of the contract is
the same as the price of the underlying asset to be delivered. To see why this is the
case, consider what happens on the expiration date of the June contract at the end of
June when the price of the underlying $100,000 face value Treasury bond is 110
($110,000). If the futures contract is selling below 110—say at 109—a trader can buy
the contract for $109,000, take delivery of the bond, and immediately sell it for
$110,000, thereby earning a quick profit of $1,000. Because earning this profit
involves no risk, it is a great deal that everyone would like to get in on. That means
that everyone will try to buy the contract, and as a result, its price will rise. Only when
the price rises to 110 will the profit opportunity cease to exist and the buying pressure
disappear. Conversely, if the price of the futures contract is above 110—say at
111—everyone will want to sell the contract. Now the sellers get $111,000 from selling
the futures contract but have to pay only $110,000 for the Treasury bonds that
they must deliver to the buyer of the contract, and the $1,000 difference is their
profit. Because this profit involves no risk, traders will continue to sell the futures
contract until its price falls back down to 110, at which price there are no longer any
profits to be made. The elimination of riskless profit opportunities in the futures market
is referred to as arbitrage, and it guarantees that the price of a futures contract at
expiration equals the price of the underlying asset to be delivered.1
Armed with the fact that a futures contract at expiration equals the price of the
underlying asset makes it even easier to see who profits and who loses from such a
contract when interest rates change. When interest rates have risen so that the price
of the Treasury bond is 110 on the expiration day at the end of June, the June Treasury
bond futures contract will also have a price of 110. Thus if you bought the contract
for 115 in February, you have a loss of 5 points, or $5,000 (5% of $100,000). But if
you sold the futures contract at 115 in February, the decline in price to 110 means
that you have a profit of 5 points, or $5,000.
C H A P T E R 1 3 Financial Derivatives 313
1In actuality, futures contracts sometimes set conditions for delivery of the underlying assets that cause the price
of the contract at expiration to differ slightly from the price of the underlying assets. Because the difference in
price is extremely small, we ignore it in this chapter.
314 PART I I I Financial Institutions
Application Hedging with Financial Futures
First National Bank can also use financial futures contracts to hedge the interest
rate risk on its holdings of $5 million of the 8s of 2023. To see how, suppose
that in March 2004, the 8s of 2023 are the long-term bonds that would
be delivered in the Chicago Board of Trade’s T-bond futures contract expiring
one year in the future, in March 2005. Also suppose that the interest rate on
these bonds is expected to remain at 8% over the next year, so that both the
8s of 2023 and the futures contract are selling at par (i.e., the $5 million of
bonds is selling for $5 million and the $100,000 futures contract is selling
for $100,000). The basic principle of hedging indicates that you need to offset
the long position in these bonds with a short position, and so you have
to sell the futures contract. But how many contracts should you sell? The
number of contracts required to hedge the interest-rate risk is found by
dividing the amount of the asset to be hedged by the dollar value of each contract,
as is shown in Equation (1):
NC VA/VC (1)
where NC number of contracts for the hedge
VA value of the asset
VC value of each contract
Given that the 8s of 2023 are the long-term bonds that would be delivered
in the CBT T-bond futures contract expiring one year in the future and that
the interest rate on these bonds is expected to remain at 8% over the next
year, so that both the 8s of 2023 and the futures contract are selling at par,
how many contracts must First National sell to remove its interest-rate exposure
from its $5 million holdings of the 8s of 2023?2 Since VA $5 million
and VC $100,000:
NC $5 million/$100,000 50
You therefore hedge the interest-rate risk by selling 50 of the Treasury Bond
futures contracts.
Now suppose that over the next year, interest rates increase to 10% due
to an increased threat of inflation. The value of the 8s of 2023 that the First
National Bank is holding will then fall to $4,163,508 in March 2005.3 Thus
the loss from the long position in these bonds is $836,492:
Value on March 2005 @ 10% interest rate $ 4,163,508
Value on March 2004 @ 8% interest rate $ 5,000,000
Loss $ 836,492
2In the real world, designing a hedge is somewhat more complicated than the example here, because the bond
that is most likely to be delivered might not be an 8s of 2023.
3The value of the bonds can be calculated using a financial calculator as follows: FV $5,000,000,
PMT $500,000, I 10%, N 19, PV $4,163,508.
Financial futures contracts are traded in the United States on organized exchanges
such as the Chicago Board of Trade, the Chicago Mercantile Exchange, the New York
Futures Exchange, the MidAmerica Commodity Exchange, and the Kansas City Board
of Trade. These exchanges are highly competitive with one another, and each organization
tries to design contracts and set rules that will increase the amount of futures
trading on its exchange.
The futures exchanges and all trades in financial futures in the United States are
regulated by the Commodity Futures Trading Commission (CFTC), which was created
in 1974 to take over the regulatory responsibilities for futures markets from the
Department of Agriculture. The CFTC oversees futures trading and the futures
exchanges to ensure that prices in the market are not being manipulated, and it also
registers and audits the brokers, traders, and exchanges to prevent fraud and to
ensure the financial soundness of the exchanges. In addition, the CFTC approves proposed
futures contracts to make sure that they serve the public interest. The most
widely traded financial futures contracts listed in the Wall Street Journal and the
exchanges where they are traded (along with the number of contracts outstanding,
called open interest, on January 30, 2003) are listed in Table 1.
Given the globalization of other financial markets in recent years, it is not surprising
that increased competition from abroad has been occurring in financial futures
markets as well.
Organization
of Trading in
Financial Futures
Markets
C H A P T E R 1 3 Financial Derivatives 315
However, the short position in the 50 futures contracts that obligate you to
deliver $5 million of the 8s of 2023 on March 2004 have a value equal to
$4,163,568, the value of the $5 million of bonds after the interest rate has
risen to 10%, as we have seen before. Yet when you sold the futures contract,
the buyer was obligated to pay you $5 million on the maturity date. Thus the
gain from the short position on these contracts is also $836,492:
Amount paid to you on March 2005,
agreed upon in March 2004 $5,000,000
Value of bonds delivered on March 2005
@ 10% interest rate – $4,163,508
Gain $ 836,492
Therefore the net gain for the First National Bank is zero, indicating that the
hedge has been conducted successfully.
The hedge just described is called a micro hedge because the financial
institution is hedging the interest-rate risk for a specific asset it is holding. A
second type of hedge that financial institutions engage in is called a macro
hedge, in which the hedge is for the institution’s entire portfolio. For example,
if a bank has more rate-sensitive liabilities than assets, we have seen in
Chapter 9 that a rise in interest rates will cause the value of the bank to
decline. By selling interest-rate future contracts that will yield a profit when
interest rates rise, the bank can offset the losses on its overall portfolio from
an interest-rate rise and thereby hedge its interest-rate risk.
www.rmahq.org
The web site of the Risk
Management Association
reports useful information such
as annual statement studies, online
publications, and so on.
www.usafutures.com
/stockindexfutures.htm
Detailed information about
stock index futures.
316 PART I I I Financial Institutions
Open Interest
January 30, 2003
Type of Contract Contract Size Exchange* Reflects March 2003 Futures
Treasury Rate Contracts
Treasury bonds $100,000 CBT 393,546
Treasury notes $100,000 CBT 746,015
Five-year Treasury notes $100,000 CBT 683,499
Two-year Treasury notes $200,000 CBT 106,184
Thirty-day Fed levels $5 million CBT 49,069
Treasury bills $1 million CME 292
One-month LIBOR $3 million CME 6,389
Municipal Bond Index $1,000 CBT 2,683
Eurodollar $4 million CME 747,691
Euroyen $100 million CME 10,765
Sterling £500,000 LIFFE 159,800
Long Gilt £100,000 LIFFE 90,093
Three-month Euribor € 1 million LIFFE 497,688
Euroswiss franc SF 1 million LIFFE 85,366
Ten-year Euronational bonds € 100,000 EUREX 812,029
Canadian banker’s acceptance C$1 million ME 64,333
Stock Index Contracts
Standard & Poor’s 500 Index $250 index CME 577,661
Standard & Poor’s MIDCAP 400 $500 index CME 13,652
NASDAQ 100 $100 index CME 71,233
Nikkei 225 Stock Average $5 index CME 16,193
Financial Times–Stock Exchange
100-Share Index £10 per index point LIFFE 460,997
Currency Contracts
Yen 12,500,000 yen CME 90,508
Euro 125,000 euros CME 102,536
Canadian dollar 100,000 Canadian $ CME 89,651
British pound 100,000 pounds CME 102,536
Swiss franc 125,000 francs CME 55,402
Mexican peso 500,000 new pesos CME 29,774
*Exchange abbreviations: CBT, Chicago Board of Trade; CME, Chicago Mercantile Exchange; LIFFE, London International Financial
Futures Exchange; EUREX, European Exchange; ME, Montreal Exchange.
Source: Wall Street Journal, January 31, 2003, p. C21.
Table 1 Widely Traded Financial Futures Contracts
Because American futures exchanges were the first to develop financial futures, they
dominated the trading of financial futures in the early 1980s. For example, in 1985,
all of the top ten futures contracts were traded on exchanges in the United States.
With the rapid growth of financial futures markets and the resulting high profits made
by the American exchanges, foreign exchanges saw a profit opportunity and began to
enter this business. By the 1990s, Eurodollar contracts traded on the London
International Financial Futures Exchange, Japanese government bond contracts and
Euroyen contracts traded on the Tokyo Stock Exchange, French government bond
contracts traded on the Marché à Terme International de France, and Nikkei 225 contracts
traded on the Osaka Securities Exchange all became among the most widely
traded futures contracts in the world.
Foreign competition has also spurred knockoffs of the most popular financial
futures contracts initially developed in the United States. These contracts traded on
foreign exchanges are virtually identical to those traded in the United States and
have the advantage that they can be traded when the American exchanges are
closed. The movement to 24-hour-a-day trading in financial futures has been further
stimulated by the development of the Globex electronic trading system, which
allows traders throughout the world to trade futures even when the exchanges are
not officially open. Financial futures trading has thus become completely internationalized,
and competition between U.S. and foreign exchanges will be intense in
the future.
The tremendous success of the financial futures market in Treasury bonds is evident
from the fact that the total open interest of Treasury bond contracts was over 393,000
on January 30, 2003, for a total value of over $39 billion (393,000 $100,000).
There are several differences between financial futures and forward contracts and in
the organization of their markets that help explain why financial futures markets like
those for Treasury bonds have been so successful.
Several features of futures contracts were designed to overcome the liquidity
problem inherent in forward contracts. The first feature is that, in contrast to forward
contracts, the quantities delivered and the delivery dates of futures contracts are
standardized, making it more likely that different parties can be matched up in the
futures market, thereby increasing the liquidity of the market. In the case of the
Treasury bond contract, the quantity delivered is $100,000 face value of bonds, and
the delivery dates are set to be the last business day of March, June, September, and
December. The second feature is that after the futures contract has been bought or
sold, it can be traded (bought or sold) again at any time until the delivery date. In
contrast, once a forward contract is agreed on, it typically cannot be traded. The
third feature is that in a futures contract, not just one specific type of Treasury bond
is deliverable on the delivery date, as in a forward contract. Instead, any Treasury
bond that matures in more than 15 years and is not callable for 15 years is eligible
for delivery. Allowing continuous trading also increases the liquidity of the futures
market, as does the ability to deliver a range of Treasury bonds rather than one specific
bond.
Another reason why futures contracts specify that more than one bond is eligible
for delivery is to limit the possibility that someone might corner the market and
“squeeze” traders who have sold contracts. To corner the market, someone buys up
all the deliverable securities so that investors with a short position cannot obtain from
anyone else the securities that they contractually must deliver on the delivery date. As
Explaining the
Success of
Futures Markets
The Globalization
of Financial
Futures Markets
C H A P T E R 1 3 Financial Derivatives 317
a result, the person who has cornered the market can set exorbitant prices for the
securities that investors with a short position must buy to fulfill their obligations
under the futures contract. The person who has cornered the market makes a fortune,
but investors with a short position take a terrific loss. Clearly, the possibility that corners
might occur in the market will discourage people from taking a short position
and might therefore decrease the size of the market. By allowing many different securities
to be delivered, the futures contract makes it harder for anyone to corner the
market, because a much larger amount of securities would have to be purchased to
establish the corner. Corners are a concern to both regulators and the organized
exchanges that design futures contracts.
Trading in the futures market has been organized differently from trading in
forward markets to overcome the default risk problems arising in forward contracts.
In both types, for every contract, there must be a buyer who is taking a long position
and a seller who is taking a short position. However, the buyer and seller of a
futures contract make their contract not with each other but with the clearinghouse
associated with the futures exchange. This setup means that the buyer of the futures
contract does not need to worry about the financial health or trustworthiness of the
seller, or vice versa, as in the forward market. As long as the clearinghouse is financially
solid, buyers and sellers of futures contracts do not have to worry about
default risk.
To make sure that the clearinghouse is financially sound and does not run into
financial difficulties that might jeopardize its contracts, buyers or sellers of futures
contracts must put an initial deposit, called a margin requirement, of perhaps
$2,000 per Treasury bond contract into a margin account kept at their brokerage firm.
Futures contracts are then marked to market every day. What this means is that at
the end of every trading day, the change in the value of the futures contract is added
to or subtracted from the margin account. Suppose that after you buy the Treasury
bond contract at a price of 115 on Wednesday morning, its closing price at the end
of the day, the settlement price, falls to 114. You now have a loss of 1 point, or $1,000,
on the contract, and the seller who sold you the contract has a gain of 1 point, or
$1,000. The $1,000 gain is added to the seller’s margin account, making a total of
$3,000 in that account, and the $1,000 loss is subtracted from your account, so you
now only have $1,000 in your account. If the amount in this margin account falls
below the maintenance margin requirement (which can be the same as the initial
requirement but is usually a little less), the trader is required to add money to the
account. For example, if the maintenance margin requirement is also $2,000, you
would have to add $1,000 to your account to bring it up to $2,000. Margin requirements
and marking to market make it far less likely that a trader will default on a contract,
thus protecting the futures exchange from losses.
A final advantage that futures markets have over forward markets is that most
futures contracts do not result in delivery of the underlying asset on the expiration
date, whereas forward contracts do. A trader who sold a futures contract is allowed to
avoid delivery on the expiration date by making an offsetting purchase of a futures
contract. Because the simultaneous holding of the long and short positions means that
the trader would in effect be delivering the bonds to itself, under the exchange rules
the trader is allowed to cancel both contracts. Allowing traders to cancel their contracts
in this way lowers the cost of conducting trades in the futures market relative
to the forward market in that a futures trader can avoid the costs of physical delivery,
which is not so easy with forward contracts.
318 PART I I I Financial Institutions
C H A P T E R 1 3 Financial Derivatives 319
Application Hedging Foreign Exchange Risk
As we discussed in Chapter 1, foreign exchange rates have been highly
volatile in recent years. The large fluctuations in exchange rates subject
financial institutions and other businesses to significant foreign exchange
risk because they generate substantial gains and losses. Luckily for financial
institution managers, the financial derivatives discussed in this chapter—
forward and financial futures contracts—can be used to hedge foreign
exchange risk.
To understand how financial institution managers manage foreign
exchange risk, let’s suppose that in January, the First National Bank’s customer
Frivolous Luxuries, Inc. is due a payment of 10 million euros in two
months for $10 million worth of goods it has just sold in Germany. Frivolous
Luxuries is concerned that if the value of the euro falls substantially from its
current value of $1, the company might suffer a large loss because the 10 million
euro payment will no longer be worth $10 million. So Sam, the CEO of
Frivolous Luxuries, calls up his friend Mona, the manager of the First
National Bank, and asks her to hedge this foreign exchange risk for his company.
Let’s see how the bank manager does this using forward and financial
futures contracts.
Forward markets in foreign exchange have been highly developed by commercial
banks and investment banking operations that engage in extensive
foreign exchange trading and so are widely used to hedge foreign exchange
risk. Mona knows that she can use this market to hedge the foreign exchange
risk for Frivolous Luxuries. Such a hedge is quite straightforward for her to
execute. Because the payment of euros in two months means that at that time
Sam would hold a long position in euros, Mona knows that the basic principle
of hedging indicates that she should offset this long position by a short
position. Thus, she just enters a forward contract that obligates her to sell 10
million euros two months from now in exchange for dollars at the current
forward rate of $1 per euro.4
In two months, when her customer receives the 10 million euros, the forward
contract ensures that it is exchanged for dollars at an exchange rate of
$1 per euro, thus yielding $10 million. No matter what happens to future
exchange rates, Frivolous Luxuries will be guaranteed $10 million for the
goods it sold in Germany. Mona calls up her friend Sam to let him know that
his company is now protected from any foreign exchange movements, and he
thanks her for her help.
Hedging Foreign
Exchange Risk with
Forward Contracts
4The forward exchange rate will probably differ slightly from the current spot rate of $1 per euro because the
interest rates in Germany and the United States may not be equal. In that case, as we will see in Equation 2 in
Chapter 19, the future expected exchange rate will not equal the current spot rate and neither will the forward
rate. However, since interest differentials have typically been less than 6% at an annual rate (1% bimonthly), the
expected appreciation or depreciation of the euro over a two-month period has always been less than 1%. Thus
the forward rate is always close to the current spot rate, and so our assumption in the example that the forward
rate and the spot rate are the same is a reasonable one.
Options
Another vehicle for hedging interest-rate and stock market risk involves the use of
options on financial instruments. Options are contracts that give the purchaser the
option, or right, to buy or sell the underlying financial instrument at a specified price,
called the exercise price or strike price, within a specific period of time (the term to
expiration) . The seller (sometimes called the writer) of the option is obligated to buy
or sell the financial instrument to the purchaser if the owner of the option exercises
the right to sell or buy. These option contract features are important enough to be
emphasized: The owner or buyer of an option does not have to exercise the option; he
or she can let the option expire without using it. Hence the owner of an option is not
obligated to take any action, but rather has the right to exercise the contract if he or
she so chooses. The seller of an option, by contrast, has no choice in the matter; he
or she must buy or sell the financial instrument if the owner exercises the option.
Because the right to buy or sell a financial instrument at a specified price has
value, the owner of an option is willing to pay an amount for it called a premium.
There are two types of option contracts: American options can be exercised at any
time up to the expiration date of the contract, and European options can be exercised
only on the expiration date.
Option contracts are written on a number of financial instruments (an example
of which is shown in the “Following the Financial News” box). Options on individ-
320 PART I I I Financial Institutions
As an alternative, Mona could have used the currency futures market to hedge
the foreign exchange risk. In this case, she would see that the Chicago
Mercantile Exchange has a euro contract with a contract amount of 125,000
euros and a price of $1 per euro. To do the hedge, Mona must sell euros as
with the forward contract, to the tune of 10 million euros of the March
futures. How many of the Chicago Mercantile Exchange March euro contracts
must Mona sell in order to hedge the 10 million euro payment due in March?
Using Equation 1 with VA 10 million euros and VC 125,000 euros:
NC 10 million/125,000 40
Thus Mona does the hedge by selling 40 of the CME euro contracts. Given
the $1-per-euro price, the sale of the contract yields 40 125, 000 euros
$10 million. The futures hedge thus again enables her to lock in the exchange
rate for Frivolous Luxuries so that it gets its payment of $10 million.
One advantage of using the futures market is that the contract size of
125,000 euros, worth $125,000, is quite a bit smaller than the minimum size
of a forward contract, which is usually $1 million or more. However, in this
case, the bank manager is making a large enough transaction that she can use
either the forward or the futures market. Her choice depends on whether the
transaction costs are lower in one market than in the other. If the First
National Bank is active in the forward market, that market would probably
have the lower transaction costs, but if First National rarely deals in foreign
exchange forward contracts, the bank manager may do better by sticking
with the futures market.
Hedging Foreign
Exchange Risk with
Futures Contracts
ual stocks are called stock options, and such options have existed for a long time.
Option contracts on financial futures called financial futures options or, more commonly,
futures options, were developed in 1982 and have become the most widely
traded option contracts.
You might wonder why option contracts are more likely to be written on financial
futures than on underlying debt instruments such as bonds or certificates of
deposit. As you saw earlier in the chapter, at the expiration date, the price of the
futures contract and of the deliverable debt instrument will be the same because of
arbitrage. So it would seem that investors should be indifferent about having the
option written on the debt instrument or on the futures contract. However, financial
futures contracts have been so well designed that their markets are often more liquid
than the markets in the underlying debt instruments. So investors would rather have
the option contract written on the more liquid instrument, in this case the futures
contract. That explains why the most popular futures options are written on many of
the same futures contracts listed in Table 1.
The regulation of option markets is split between the Securities and Exchange
Commission (SEC), which regulates stock options, and the Commodity Futures
Trading Commission (CFTC), which regulates futures options. Regulation focuses on
ensuring that writers of options have enough capital to make good on their contractual
obligations and on overseeing traders and exchanges to prevent fraud and ensure
that the market is not being manipulated.
C H A P T E R 1 3 Financial Derivatives 321
Following the Financial News
The prices for financial futures options are published
daily. In the Wall Street Journal, they are found in the
section “Futures Options Prices” under the “Interest
Rate” heading. An excerpt from this listing is reproduced
here.
Information for each contract is reported in
columns, as follows. (The Chicago Board of Trade’s
option on its Treasury bonds futures contract is used
as an example.)
Strike Price: Strike (exercise) price of each contract,
which runs from 111 to 116
Calls-Settle: Premium (price) at settlement for call
options on the Treasury bond futures expiring in
the month listed, with each full point representing
$1,000 and 64ths of a point listed to the right of
the hyphen; at a strike price of 112, the March call
option’s premium is 1 45/64, or $1,703.10 per
contract
Puts-Settle: Premium (price) at settlement for put
options on the Treasury bond futures expiring in
the month listed, with each full point representing
$1,000 and 64ths of a point listed to the right of
the hyphen; at a strike price of 112, the March put
option’s premium is 19/64, or $296.90 per contract
Futures Options
Source: Wall Street Journal, February 14, 2003, p. C10.
INTEREST RATE
T-BONDS (CBT)
$100,000; points and 64ths of 100%
Strike Calls-Settle Puts-Settle
Price Mar Apr May Mar Apr May
111 2-34 2-21 2-62 0-08 1-15 1-57
112 1-45 1-50 2-28 0-19 1-43 2-22
113 1-01 1-20 1-61 0-39 2-14 ...
114 0-34 0-59 1-36 1-08 2-52 ...
115 0-16 0-41 1-14 1-54 ... ...
116 0-07 0-28 0-60 2-45 ... ...
Est vol 78,455;
Wd vol 51,578 calls 17,896 puts
Op int Wed 252,705 calls 282,711 puts
A call option is a contract that gives the owner the right to buy a financial instrument
at the exercise price within a specific period of time. A put option is a contract that
gives the owner the right to sell a financial instrument at the exercise price within a
specific period of time.
Study Guide Remembering which is a call option and which is a put option is not always easy. To
keep them straight, just remember that having a call option to buy a financial instrument
is the same as having the option to call in the instrument for delivery at a specified
price. Having a put option to sell a financial instrument is the same as having the
option to put up an instrument for the other party to buy.
To understand option contracts more fully, let’s first examine the option on the same
June Treasury bond futures contract that we looked at earlier in the chapter. Recall
that if you buy this futures contract at a price of 115 (that is, $115,000), you have
agreed to pay $115,000 for $100,000 face value of long-term Treasury bonds when
they are delivered to you at the end of June. If you sold this futures contract at a price
of 115, you agreed, in exchange for $115,000, to deliver $100,000 face value of the
long-term Treasury bonds at the end of June. An option contract on the Treasury bond
futures contract has several key features: (1) It has the same expiration date as the
underlying futures contract, (2) it is an American option and so can be exercised at
any time before the expiration date, and (3) the premium (price) of the option is
quoted in points that are the same as in the futures contract, so each point corresponds
to $1,000. If, for a premium of $2,000, you buy one call option contract on
the June Treasury bond contract with an exercise price of 115, you have purchased
the right to buy (call in) the June Treasury bond futures contract for a price of 115
($115,000 per contract) at any time through the expiration date of this contract at the
end of June. Similarly, when for $2,000 you buy a put option on the June Treasury
bond contract with an exercise price of 115, you have the right to sell (put up) the
June Treasury bond futures contract for a price of 115 ($115,000 per contract) at any
time until the end of June.
Futures option contracts are somewhat complicated, so to explore how they work
and how they can be used to hedge risk, let’s first examine how profits and losses on
the call option on the June Treasury bond futures contract occur. In February, our old
friend Irving the Investor buys, for a $2,000 premium, a call option on the $100,000
June Treasury bond futures contract with a strike price of 115. (We assume that if
Irving exercises the option, it is on the expiration date at the end of June and not
before.) On the expiration date at the end of June, suppose that the underlying
Treasury bond for the futures contract has a price of 110. Recall that on the expiration
date, arbitrage forces the price of the futures contract to be the same as the price
of the underlying bond, so it too has a price of 110 on the expiration date at the end
of June. If Irving exercises the call option and buys the futures contract at an exercise
price of 115, he will lose money by buying at 115 and selling at the lower market
price of 110. Because Irving is smart, he will not exercise the option, but he will be
out the $2,000 premium he paid. In such a situation, in which the price of the underlying
financial instrument is below the exercise price, a call option is said to be “out
of the money.” At the price of 110 (less than the exercise price), Irving thus suffers a
Profits and
Losses on Option
and Futures
Contracts
Option Contracts
322 PART I I I Financial Institutions
loss on the option contract of the $2,000 premium he paid. This loss is plotted as
point A in panel (a) of Figure 1.
On the expiration date, if the price of the futures contract is 115, the call option
is “at the money,” and Irving is indifferent whether he exercises his option to buy the
futures contract or not, since exercising the option at 115 when the market price is
also at 115 produces no gain or loss. Because he has paid the $2,000 premium, at the
price of 115 his contract again has a net loss of $2,000, plotted as point B.
If the futures contract instead has a price of 120 on the expiration day, the option
is “in the money,” and Irving benefits from exercising the option: He would buy the
futures contract at the exercise price of 115 and then sell it for 120, thereby earning
a 5-point gain ($5,000 profit) on the $100,000 Treasury bond contract. Because
Irving paid a $2,000 premium for the option contract, however, his net profit is
C H A P T E R 1 3 Financial Derivatives 323
FIGURE 1 Profits and Losses on Options Versus Futures Contracts
The futures contract is the $100,000 June Treasury bond contract, and the option contracts are written on this futures contract with an exercise
price of 115. Panel (a) shows the profits and losses for the buyer of the call option and the buyer of the futures contract, and panel (b)
shows the profits and losses for the buyer of the put option and the seller of the futures contract.
Buyer of
Futures
Buyer of
Call Option
Price of
Futures
Contract
at Expiration
($)
Profit ($)
Loss ($) Loss ($)
(a) Profit or loss for
buyer of call option
and buyer of futures
A
A
B
B
C
C
D
D
110 120 125
0
2,000
4,000
6,000
8,000
12,000
Profit ($)
12,000
10,000
– 2,000
– 4,000
– 6,000
– 8,000
–12,000 –12,000
– 10,000
Seller of
Futures
Buyer of
Put Option
Price of Futures
Contract at
Expiration ($)
(b) Profit or loss for
buyer of put option
and seller of futures
A
A
B
B
C
C
D
D
110 120 125
0
2,000
4,000
6,000
8,000
10,000
– 2,000
– 4,000
– 6,000
– 8,000
– 10,000
115 115
$3,000 ($5,000 $2,000). The $3,000 profit at a price of 120 is plotted as point C.
Similarly, if the price of the futures contract rose to 125, the option contract would
yield a net profit of $8,000 ($10,000 from exercising the option minus the $2,000
premium), plotted as point D. Plotting these points, we get the kinked profit curve
for the call option that we see in panel (a).
Suppose that instead of purchasing the futures option contract in February, Irving
decides instead to buy the $100,000 June Treasury bond futures contract at the price
of 115. If the price of the bond on the expiration day at the end of June declines to
110, meaning that the price of the futures contract also falls to 110, Irving suffers a
loss of 5 points, or $5,000. The loss of $5,000 on the futures contract at a price of
110 is plotted as point A in panel (a). At a price of 115 on the expiration date, Irving
would have a zero profit on the futures contract, plotted as point B. At a price of 120,
Irving would have a profit on the contract of 5 points, or $5,000 (point C), and at a
price of 125, the profit would be 10 percentage points, or $10,000 (point D).
Plotting these points, we get the linear (straight-line) profit curve for the futures contract
that appears in panel (a).
Now we can see the major difference between a futures contract and an option
contract. As the profit curve for the futures contract in panel (a) indicates, the futures
contract has a linear profit function: Profits grow by an equal dollar amount for every
point increase in the price of the underlying financial instrument. By contrast, the
kinked profit curve for the option contract is nonlinear, meaning that profits do not
always grow by the same amount for a given change in the price of the underlying
financial instrument. The reason for this nonlinearity is that the call option protects
Irving from having losses that are greater than the amount of the $2,000 premium. In
contrast, Irving’s loss on the futures contract is $5,000 if the price on the expiration
day falls to 110, and if the price falls even further, Irving’s loss will be even greater. This
insurance-like feature of option contracts explains why their purchase price is referred
to as a premium. Once the underlying financial instrument’s price rises above the exercise
price, however, Irving’s profits grow linearly. Irving has given up something by
buying an option rather than a futures contract. As we see in panel (a), when the price
of the underlying financial instrument rises above the exercise price, Irving’s profits are
always less than that on the futures contract by exactly the $2,000 premium he paid.
Panel (b) plots the results of the same profit calculations if Irving buys not a call
but a put option (an option to sell) with an exercise price of 115 for a premium of
$2,000 and if he sells the futures contract rather than buying one. In this case, if on
the expiration date the Treasury bond futures have a price above the 115 exercise price,
the put option is “out of the money.” Irving would not want to exercise the put option
and then have to sell the futures contract he owns as a result at a price below the market
price and lose money. He would not exercise his option, and he would be out only
the $2,000 premium he paid. Once the price of the futures contract falls below the 115
exercise price, Irving benefits from exercising the put option because he can sell the
futures contract at a price of 115 but can buy it at a price below this. In such a situation,
in which the price of the underlying instrument is below the exercise price, the
put option is “in the money,” and profits rise linearly as the price of the futures contract
falls. The profit function for the put option illustrated in panel (b) of Figure 1 is
kinked, indicating that Irving is protected from losses greater than the amount of the
premium he paid. The profit curve for the sale of the futures contract is just the negative
of the profit for the futures contract in panel (a) and is therefore linear.
Panel (b) of Figure 1 confirms the conclusion from panel (a) that profits on
option contracts are nonlinear but profits on futures contracts are linear.
324 PART I I I Financial Institutions
Study Guide To make sure you understand how profits and losses on option and futures contracts
are generated, calculate the net profits on the put option and the short position in the
futures contract at prices on the expiration day of 110, 115, 120, and 125. Then verify
that your calculations correspond to the points plotted in panel (b) of Figure 1.
Two other differences between futures and option contracts must be mentioned.
The first is that the initial investment on the contracts differs. As we saw earlier in the
chapter, when a futures contract is purchased, the investor must put up a fixed
amount, the margin requirement, in a margin account. But when an option contract is
purchased, the initial investment is the premium that must be paid for the contract.
The second important difference between the contracts is that the futures contract
requires money to change hands daily when the contract is marked to market, whereas
the option contract requires money to change hands only when it is exercised.
C H A P T E R 1 3 Financial Derivatives 325
Application Hedging with Futures Options
Earlier in the chapter, we saw how the First National Bank could hedge the
interest-rate risk on its $5 million holdings of 8s of 2023 by selling $5 million
of T-bond futures. A rise in interest rates and the resulting fall in bond
prices and bond futures contracts would lead to profits on the bank’s sale of
the futures contracts that would exactly offset the losses on the 8s of 2023
the bank is holding.
As panel (b) of Figure 1 suggests, an alternative way for the manager to
protect against a rise in interest rates and hence a decline in bond prices is to
buy $5 million of put options written on the same Treasury bond futures. As
long as the exercise price is not too far from the current price as in panel (b),
the rise in interest rates and decline in bond prices will lead to profits on the
futures and the futures put options, profits that will offset any losses on the
$5 million of Treasury bonds.
The one problem with using options rather than futures is that the First
National Bank will have to pay premiums on the options contracts, thereby
lowering the bank’s profits in order to hedge the interest-rate risk. Why might
the bank manager be willing to use options rather than futures to conduct the
hedge? The answer is that the option contract, unlike the futures contract,
allows the First National Bank to gain if interest rates decline and bond prices
rise. With the hedge using futures contracts, the First National Bank does not
gain from increases in bond prices because the profits on the bonds it is holding
are offset by the losses from the futures contracts it has sold. However, as
panel (b) of Figure 1 indicates, the situation when the hedge is conducted
with put options is quite different: Once bond prices rise above the exercise
price, the bank does not suffer additional losses on the option contracts. At
the same time, the value of the Treasury bonds the bank is holding will
increase, thereby leading to a profit for the bank. Thus using options rather
than futures to conduct the micro hedge allows the bank to protect itself from
rises in interest rates but still allows the bank to benefit from interest-rate
declines (although the profit is reduced by the amount of the premium).
326 PART I I I Financial Institutions
Similar reasoning indicates that the bank manager might prefer to use
options to conduct the macro hedge to immunize the entire bank portfolio
from interest-rate risk. Again, the strategy of using options rather than futures
has the disadvantage that the First National Bank has to pay the premiums on
these contracts up front. By contrast, using options allows the bank to keep the
gains from a decline in interest rates (which will raise the value of the bank’s
assets relative to its liabilities), because these gains will not be offset by large
losses on the option contracts.
In the case of a macro hedge, there is another reason why the bank might
prefer option contracts to futures contracts. Profits and losses on futures contracts
can cause accounting problems for banks because such profits and
losses are not allowed to be offset by unrealized changes in the value of the
rest of the bank’s portfolio. Consider what happens when interest rates fall.
If First National sells futures contracts to conduct the macro hedge, then
when interest rates fall and the prices of the Treasury bond futures contracts
rise, it will have large losses on these contracts. Of course, these losses are offset
by unrealized profits in the rest of the bank’s portfolio, but the bank is not
allowed to offset these losses in its accounting statements. So even though the
macro hedge is serving its intended purpose of immunizing the bank’s portfolio
from interest-rate risk, the bank would experience large accounting
losses when interest rates fall. Indeed, bank managers have lost their jobs
when perfectly sound hedges with interest-rate futures have led to large
accounting losses. Not surprisingly, bank managers might shrink from using
financial futures to conduct macro hedges for this reason.
Futures options, however, can come to the rescue of the managers of
banks and other financial institutions. Suppose that First National conducted
the macro hedge by buying put options instead of selling Treasury bond
futures. Now if interest rates fall and bond prices rise well above the exercise
price, the bank will not have large losses on the option contracts, because it
will just decide not to exercise its options. The bank will not suffer the
accounting problems produced by hedging with financial futures. Because of
the accounting advantages of using futures options to conduct macro hedges,
option contracts have become important to financial institution managers as
tools for hedging interest-rate risk.
If we again look closely at the Wall Street Journal entry for Treasury bond futures
options in the “Following the Financial News” box on page 321, we learn several
interesting facts about how the premiums on option contracts are priced. The first
thing you may have noticed is that when the strike (exercise) price for a contract is
set at a higher level, the premium for the call option is lower and the premium for the
put option is higher. For example, in going from a contract with a strike price of 112
to one with 115, the premium for the March call option falls from 1 45/64 to 16/64,
and the premium for the March put option rises from 19/64 to 1 54/64.
Our understanding of the profit function for option contracts illustrated in Figure
1 helps explain this fact. As we saw in panel (a), a higher price for the underlying
financial instrument (in this case a Treasury bond futures contract) relative to the
option’s exercise price results in higher profits on the call (buy) option. Thus the lower
the strike price, the higher the profits on the call option contract and the greater the
Factors Affecting
the Prices of
Option Premiums
premium that investors like Irving are willing to pay. Similarly, we saw in panel (b)
that a higher price for the underlying financial instrument relative to the exercise price
lowers profits on the put (sell) option, so that a higher strike price increases profits
and thus causes the premium to increase.
The second thing you may have noticed in the Wall Street Journal entry is that as
the period of time over which the option can be exercised (the term to expiration) gets
longer, the premiums for both call and put options rise. For example, at a strike price
of 112, the premium on the call option increases from 1 45/64 in March to 1 50/64
in April and to 2 28/64 in May. Similarly, the premium on the put option increases
from 19/64 in March to 1 43/64 in April and to 2 22/64 in May. The fact that premiums
increase with the term to expiration is also explained by the nonlinear profit
function for option contracts. As the term to expiration lengthens, there is a greater
chance that the price of the underlying financial instrument will be very high or very
low by the expiration date. If the price becomes very high and goes well above the
exercise price, the call (buy) option will yield a high profit, but if the price becomes
very low and goes well below the exercise price, the losses will be small because the
owner of the call option will simply decide not to exercise the option. The possibility
of greater variability of the underlying financial instrument as the term to expiration
lengthens raises profits on average for the call option.
Similar reasoning tells us that the put (sell) option will become more valuable as
the term to expiration increases, because the possibility of greater price variability of
the underlying financial instrument increases as the term to expiration increases. The
greater chance of a low price increases the chance that profits on the put option will
be very high. But the greater chance of a high price does not produce substantial losses
for the put option, because the owner will again just decide not to exercise the option.
Another way of thinking about this reasoning is to recognize that option contracts
have an element of “heads, I win; tails, I don’t lose too badly.” The greater variability
of where the prices might be by the expiration date increases the value of both kinds
of options. Since a longer term to the expiration date leads to greater variability of
where the prices might be by the expiration date, a longer term to expiration raises
the value of the option contract.
The reasoning that we have just developed also explains another important fact
about option premiums. When the volatility of the price of the underlying instrument
is great, the premiums for both call and put options will be higher. Higher volatility
of prices means that for a given expiration date, there will again be greater variability
of where the prices might be by the expiration date. The “heads, I win; tails, I don’t
lose too badly” property of options then means that the greater variability of possible
prices by the expiration date increases average profits for the option and thus
increases the premium that investors are willing to pay.
Our analysis of how profits on options are affected by price movements for the underlying
financial instrument leads to the following conclusions about the factors that
determine the premium on an option contract:
1. The higher the strike price, everything else being equal, the lower the premium
on call (buy) options and the higher the premium on put (sell) options.
2. The greater the term to expiration, everything else being equal, the higher the
premiums for both call and put options.
3. The greater the volatility of prices of the underlying financial instrument, everything
else being equal, the higher the premiums for both call and put options.
Summary
C H A P T E R 1 3 Financial Derivatives 327
The results we have derived here appear in more formal models, such as the
Black-Scholes model, which analyze how the premiums on options are priced. You
might study such models in finance courses.
Interest-Rate Swaps
In addition to forwards, futures, and options, financial institutions use one other
important financial derivative to manage risk. Swaps are financial contracts that obligate
each party to the contract to exchange (swap) a set of payments (not assets) it
owns for another set of payments owned by another party. There are two basic kinds
of swaps: Currency swaps involve the exchange of a set of payments in one currency
for a set of payments in another currency. Interest-rate swaps involve the exchange
of one set of interest payments for another set of interest payments, all denominated
in the same currency.
Interest-rate swaps are an important tool for managing interest-rate risk, and they first
appeared in the United States in 1982, when, as we have seen, there was an increase
in the demand for financial instruments that could be used to reduce interest-rate risk.
The most common type of interest-rate swap (called the plain vanilla swap) specifies
(1) the interest rate on the payments that are being exchanged; (2) the type of interest
payments (variable or fixed-rate); (3) the amount of notional principal, which is the
amount on which the interest is being paid; and (4) the time period over which the
exchanges continue to be made. There are many other more complicated versions of
swaps, including forward swaps and swap options (called swaptions), but here we will
look only at the plain vanilla swap. Figure 2 illustrates an interest-rate swap between
the Midwest Savings Bank and the Friendly Finance Company. Midwest Savings agrees
to pay Friendly Finance a fixed rate of 7% on $1 million of notional principal for the
next ten years, and Friendly Finance agrees to pay Midwest Savings the one-year
Treasury bill rate plus 1% on $1 million of notional principal for the same period.
Thus, as shown in Figure 2, every year the Midwest Savings Bank would be paying the
Friendly Finance Company 7% on $1 million, while Friendly Finance would be paying
Midwest Savings the one-year T-bill rate plus 1% on $1 million.
Interest-Rate
Swap Contracts
328 PART I I I Financial Institutions
FIGURE 2 Interest-Rate Swap
Payments
In this swap arrangement with a
notional principal of $1 million and
a term of ten years, the Midwest
Savings Bank pays a fixed rate of
7% $1 million to the Friendly
Finance Company, which in turn
agrees to pay the one-year Treasury
bill rate plus 1% $1 million to
the Midwest Savings Bank.
Midwest
Savings
Bank
Fixed rate
over
ten-year period
7% $1 million
Variable rate
over
ten-year period
(T-bill + 1%) $1 million
Pays
Receives
Friendly
Finance
Company
Receives
Pays
To eliminate interest-rate risk, both the Midwest Savings Bank and the Friendly
Finance Company could have rearranged their balance sheets by converting fixed-rate
assets into rate-sensitive assets, and vice versa, instead of engaging in an interest-rate
swap. However, this strategy would have been costly for both financial institutions for
several reasons. The first is that financial institutions incur substantial transaction
costs when they rearrange their balance sheets. Second, different financial institutions
have informational advantages in making loans to certain customers who may prefer
certain maturities. Thus, adjusting the balance sheet to eliminate interest-rate risk
might result in a loss of these informational advantages, which the financial institution
is unwilling to give up. Interest-rate swaps solve these problems for financial
institutions, because in effect, they allow the institutions to convert fixed-rate assets
Advantages of
Interest-Rate
Swaps
C H A P T E R 1 3 Financial Derivatives 329
Application Hedging with Interest-Rate Swaps
You might wonder why these two parties find it advantageous to enter into
this swap agreement. The answer is that it may help both of them hedge
interest-rate risk.
Suppose that the Midwest Savings Bank, which tends to borrow shortterm
and then lend long-term in the mortgage market, has $1 million less of
rate-sensitive assets than it has of rate-sensitive liabilities. As we learned in
Chapter 9, this situation means that as interest rates rise, the rise in the cost
of funds (liabilities) is greater than the rise in interest payments it receives on
its assets, many of which are fixed-rate. The result of rising interest rates is
thus a shrinking of Midwest Savings’ net interest margin and a decline in its
profitability. As we saw in Chapter 9, to avoid this interest-rate risk, Midwest
Savings would like to convert $1 million of its fixed-rate assets into $1 million
of rate-sensitive assets, in effect making rate-sensitive assets equal ratesensitive
liabilities, thereby eliminating the gap. This is exactly what happens
when it engages in the interest-rate swap. By taking $1 million of its fixedrate
income and exchanging it for $1 million of rate-sensitive Treasury bill
income, it has converted income on $1 million of fixed-rate assets into
income on $1 million of rate-sensitive assets. Now when interest rates
increase, the rise in rate-sensitive income on its assets exactly matches the
rise in the rate-sensitive cost of funds on its liabilities, leaving the net interest
margin and bank profitability unchanged.
The Friendly Finance Company, which issues long-term bonds to raise
funds and uses them to make short-term loans, finds that it is in exactly the
opposite situation to Midwest Savings: It has $1 million more of rate-sensitive
assets than of rate-sensitive liabilities. It is therefore concerned that a fall in
interest rates, which will result in a larger drop in income from its assets than
the decline in the cost of funds on its liabilities, will cause a decline in profits.
By doing the interest-rate swap, it eliminates this interest-rate risk
because it has converted $1 million of rate-sensitive income into $1 million
of fixed-rate income. Now the Friendly Finance Company finds that when
interest rates fall, the decline in rate-sensitive income is smaller and so is
matched by the decline in the rate-sensitive cost of funds on its liabilities,
leaving its profitability unchanged.
into rate-sensitive assets without affecting the balance sheet. Large transaction costs
are avoided, and the financial institutions can continue to make loans where they
have an informational advantage.
We have seen that financial institutions can also hedge interest-rate risk with
other financial derivatives such as futures contracts and futures options. Interest-rate
swaps have one big advantage over hedging with these other derivatives: They can be
written for very long horizons, sometimes as long as 20 years, whereas financial
futures and futures options typically have much shorter horizons, not much more
than a year. If a financial institution needs to hedge interest-rate risk for a long horizon,
financial futures and option markets may not do it much good. Instead it can
turn to the swap market.
Although interest-rate swaps have important advantages that make them very popular
with financial institutions, they also have disadvantages that limit their usefulness.
Swap markets, like forward markets, can suffer from a lack of liquidity. Let’s return to
looking at the swap between the Midwest Savings Bank and the Friendly Finance
Company. As with a forward contract, it might be difficult for the Midwest Savings
Bank to link up with the Friendly Finance Company to arrange the swap. In addition,
even if the Midwest Savings Bank could find a counterparty like the Friendly Finance
Company, it might not be able to negotiate a good deal because it couldn’t find any
other institution with which to negotiate.
Swap contracts also are subject to the same default risk that we encountered for
forward contracts. If interest rates rise, the Friendly Finance Company would love to
get out of the swap contract, because the fixed-rate interest payments it receives are
less than it could get in the open market. It might then default on the contract, exposing
Midwest Savings to a loss. Alternatively, the Friendly Finance Company could go
bust, meaning that the terms of the swap contract would not be fulfilled.
As we have just seen, financial institutions do have to be aware of the possibility of losses
from a default on swaps. As with a forward contract, each party to a swap must have a
lot of information about the other party to make sure that the contract is likely to be fulfilled.
The need for information about counterparties and the liquidity problems in swap
markets could limit the usefulness of these markets. However, as we saw in Chapter 8,
when informational and liquidity problems crop up in a market, financial intermediaries
come to the rescue. That is exactly what happens in swap markets. Intermediaries such
as investment banks and especially large commercial banks have the ability to acquire
information cheaply about the creditworthiness and reliability of parties to swap contracts
and are also able to match up parties to a swap. Hence large commercial banks
and investment banks have set up swap markets in which they act as intermediaries.
Financial
Intermediaries in
Interest-Rate
Swaps
Disadvantages of
Interest-Rate
Swaps
330 PART I I I Financial Institutions
Summary
1. Interest-rate forward contracts, which are agreements to
sell a debt instrument at a future (forward) point in
time, can be used to hedge interest-rate risk. The
advantage of forward contracts is that they are flexible,
but the disadvantages are that they are subject to
default risk and their market is illiquid.
2. A financial futures contract is similar to an interest-rate
forward contract, in that it specifies that a debt
instrument must be delivered by one party to another
on a stated future date. However, it has advantages over
a forward contract in that it is not subject to default risk
and is more liquid. Forward and futures contracts can
C H A P T E R 1 3 Financial Derivatives 331
be used by financial institutions to hedge (protect)
against interest-rate risk.
3. An option contract gives the purchaser the right to buy
(call option) or sell (put option) a security at the
exercise (strike) price within a specific period of time.
The profit function for options is nonlinear—profits do
not always grow by the same amount for a given change
in the price of the underlying financial instrument. The
nonlinear profit function for options explains why their
value (as reflected by the premium paid for them) is
negatively related to the exercise price for call options,
positively related to the exercise price for put options,
positively related to the term to expiration for both call
and put options, and positively related to the volatility
of the prices of the underlying financial instrument for
both call and put options. Financial institutions use
futures options to hedge interest-rate risk in a similar
fashion to the way they use financial futures and
forward contracts. Futures options may be preferred for
macro hedges because they suffer from fewer
accounting problems than financial futures.
4. Interest-rate swaps involve the exchange of one set of
interest payments for another set of interest payments
and have default risk and liquidity problems similar to
those of forward contracts. As a result, interest-rate
swaps often involve intermediaries such as large
commercial banks and investment banks that make a
market in swaps. Financial institutions find that
interest-rate swaps are useful ways to hedge interestrate
risk. Interest-rate swaps have one big advantage
over financial futures and options: They can be written
for very long horizons.
Key Terms
American option, p. 320
arbitrage, p. 313
call option, p. 322
currency swap, p. 328
European option, p. 320
exercise price (strike price), p. 320
financial derivatives, p. 309
financial futures contract, p. 312
financial futures option (futures
option), p. 321
forward contract, p. 310
hedge, p. 309
interest-rate forward contract, p. 310
interest-rate swap, p. 328
long position, p. 309
macro hedge, p. 315
margin requirement, p. 318
marked to market, p. 318
micro hedge, p. 315
notional principal, p. 328
open interest, p. 315
option, p. 320
premium, p. 320
put option, p. 322
short position, p. 309
stock option, p. 321
swap, p. 328
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. If the pension fund you manage expects to have an
inflow of $120 million six months from now, what
forward contract would you seek to enter into to lock
in current interest rates?
*2. If the portfolio you manage is holding $25 million of
8s of 2023 Treasury bonds with a price of 110, what
forward contract would you enter into to hedge the
interest-rate risk on these bonds over the coming year?
3. If at the expiration date, the deliverable Treasury bond
is selling for 101 but the Treasury bond futures contract
is selling for 102, what will happen to the futures
price? Explain your answer.
*4. If you buy a $100,000 June Treasury bond contract
for 108 and the price of the deliverable Treasury bond
at the expiration date is 102, what is your profit or
loss on the contract?
5. Suppose that the pension you are managing is expecting
an inflow of funds of $100 million next year and
you want to make sure that you will earn the current
QUIZ
interest rate of 8% when you invest the incoming
funds in long-term bonds. How would you use the
futures market to do this?
*6. How would you use the options market to accomplish
the same thing as in Problem 5? What are the advantages
and disadvantages of using an options contract
rather than a futures contract?
7. If you buy a put option on a $100,000 Treasury bond
futures contract with an exercise price of 95 and the
price of the Treasury bond is 120 at expiration, is the
contract in the money, out of the money, or at the
money? What is your profit or loss on the contract if
the premium was $4,000?
*8. Suppose that you buy a call option on a $100,000
Treasury bond futures contract with an exercise price
of 110 for a premium of $1,500. If on expiration the
futures contract has a price of 111, what is your profit
or loss on the contract?
9. Explain why greater volatility or a longer term to
maturity leads to a higher premium on both call and
put options.
*10. Why does a lower strike price imply that a call option
will have a higher premium and a put option a lower
premium?
11. If the finance company you manage has a gap of $5
million (rate-sensitive assets greater than rate-sensitive
liabilities by $5 million), describe an interest-rate swap
that would eliminate the company’s income gap.
*12. If the savings and loan you manage has a gap of $42
million, describe an interest-rate swap that would eliminate
the S&L’s income risk from changes in interest rates.
13. If your company has a payment of 200 million euros
due one year from now, how would you hedge the foreign
exchange risk in this payment with 125,000 euro
futures contracts?
*14. If your company has to make a 10 million euro payment
to a German company in June, three months from
now, how would you hedge the foreign exchange risk in
this payment with a 125,000 euro futures contract?
15. Suppose that your company will be receiving 30 million
euros six months from now and the euro is currently
selling for 1 euro per dollar. If you want to
hedge the foreign exchange risk in this payment, what
kind of forward contract would you want to enter
into?
332 PART I I I Financial Institutions
Web Exercises
1. We have discussed the various stock markets in detail
throughout this text. Another market that is less well
known is the New York Mercantile Exchange. Here
contracts on a wide variety of commodities are traded
on a daily basis. Go to www.nymex.com/welcome
/info_01.htm and read the discussion explaining the
origin and purpose of the mercantile exchange. Write
a one-page summary discussing this material.
2. The following site can be used to demonstrate how
the features of an option affect the option’s prices. Go
to www.intrepid.com/~robertl/option-pricer4.html.
What happens to the price of an option under each of
the following situations?
a. The strike price increases
b. Interest rates increase
c. Volatility increases
d. The time until the option matures increases
P a r t I V
Central Banking
and the Conduct
of Monetary
Policy

PREVIEW Among the most important players in financial markets throughout the world are central
banks, the government authorities in charge of monetary policy. Central banks’
actions affect interest rates, the amount of credit, and the money supply, all of which
have direct impacts not only on financial markets, but also on aggregate output and
inflation. To understand the role that central banks play in financial markets and the
overall economy, we need to understand how these organizations work. Who controls
central banks and determines their actions? What motivates their behavior? Who
holds the reins of power?
In this chapter, we look at the institutional structure of major central banks, and
focus particularly on the Federal Reserve System, the most important central bank in
the world. We start by focusing on the formal institutional structure of the Fed and
then examine the more relevant informal structure that determines where the true
power within the Federal Reserve System lies. By understanding who makes the decisions,
we will have a better idea of how they are made. We then look at several other
major central banks and see how they are organized. With this information, we will
be more able to comprehend the actual conduct of monetary policy described in the
following chapters.
Origins of the Federal Reserve System
Of all the central banks in the world, the Federal Reserve System probably has the
most unusual structure. To understand why this structure arose, we must go back to
before 1913, when the Federal Reserve System was created.
Before the twentieth century, a major characteristic of American politics was the
fear of centralized power, as seen in the checks and balances of the Constitution and
the preservation of states’ rights. This fear of centralized power was one source of the
American resistance to the establishment of a central bank (see Chapter 10). Another
source was the traditional American distrust of moneyed interests, the most prominent
symbol of which was a central bank. The open hostility of the American public
to the existence of a central bank resulted in the demise of the first two experiments
in central banking, whose function was to police the banking system: The First Bank
of the United States was disbanded in 1811, and the national charter of the Second
335
Chap ter
Structure of Central Banks and the
Federal Reserve System
14
Bank of the United States expired in 1836 after its renewal was vetoed in 1832 by
President Andrew Jackson.
The termination of the Second Bank’s national charter in 1836 created a severe problem
for American financial markets, because there was no lender of last resort who could
provide reserves to the banking system to avert a bank panic. Hence in the nineteenth
and early twentieth centuries, nationwide bank panics became a regular event, occurring
every twenty years or so, culminating in the panic of 1907. The 1907 panic resulted in
such widespread bank failures and such substantial losses to depositors that the public
was finally convinced that a central bank was needed to prevent future panics.
The hostility of the American public to banks and centralized authority created
great opposition to the establishment of a single central bank like the Bank of
England. Fear was rampant that the moneyed interests on Wall Street (including the
largest corporations and banks) would be able to manipulate such an institution to
gain control over the economy and that federal operation of the central bank might
result in too much government intervention in the affairs of private banks. Serious
disagreements existed over whether the central bank should be a private bank or a
government institution. Because of the heated debates on these issues, a compromise
was struck. In the great American tradition, Congress wrote an elaborate system of
checks and balances into the Federal Reserve Act of 1913, which created the Federal
Reserve System with its 12 regional Federal Reserve banks (see Box 1).
Formal Structure of the Federal Reserve System
The formal structure of the Federal Reserve System was intended by writers of the
Federal Reserve Act to diffuse power along regional lines, between the private sector
and the government, and among bankers, businesspeople, and the public. This initial
diffusion of power has resulted in the evolution of the Federal Reserve System to
336 PA RT I V Central Banking and the Conduct of Monetary Policy
The history of the United States has been one of public
hostility to banks and especially to a central bank.
How were the politicians who founded the Federal
Reserve able to design a system that has become one
of the most prestigious institutions in the United
States?
The answer is that the founders recognized that if
power was too concentrated in either Washington or
New York, cities that Americans often love to hate, an
American central bank might not have enough public
support to operate effectively. They thus decided
to set up a decentralized system with 12 Federal
Reserve banks spread throughout the country to
make sure that all regions of the country were represented
in monetary policy deliberations. In addition,
they made the Federal Reserve banks quasi-private
institutions overseen by directors from the private
sector living in that district who represent views from
that region and are in close contact with the president
of the Federal Reserve bank. The unusual
structure of the Federal Reserve System has promoted
a concern in the Fed with regional issues as is evident
in Federal Reserve bank publications. Without this
unusual structure, the Federal Reserve System
might have been far less popular with the public,
making the institution far less effective.
The Political Genius of the Founders of the Federal Reserve System
Box 1: Inside the Fed
include the following entities: the Federal Reserve banks, the Board of Governors
of the Federal Reserve System, the Federal Open Market Committee (FOMC),
the Federal Advisory Council, and around 4,800 member commercial banks. Figure 1
outlines the relationships of these entities to one another and to the three policy tools
of the Fed (open market operations, the discount rate, and reserve requirements) discussed
in Chapters 15 to 17.
Each of the 12 Federal Reserve districts has one main Federal Reserve bank, which
may have branches in other cities in the district. The locations of these districts, the
Federal Reserve banks, and their branches are shown in Figure 2. The three largest
Federal Reserve
Banks
C H A P T E R 1 4 Structure of Central Banks and the Federal Reserve System 337
FIGURE 1 Formal Structure and Allocation of Policy Tools in the Federal Reserve
Twelve Federal Reserve
Banks (FRBs)
Each with nine directors
who appoint president
and other officers of
the FRB
Open market
operations
Board of Governors
Seven members appointed
by the president of
the United States and
confirmed by the Senate
Policy Tools
Federal
Reserve System
Reviews and
determines
Appoints three
directors to
each FRB
Elect six
directors to
each FRB
Federal Advisory Council
Twelve members (bankers)
Discount
rate
Reserve
requirements
Select
Sets (within
limits)
Directs
Establish
Federal Open Market
Committee (FOMC)
Seven members of Board
of Governors plus
presidents of FRB of New
York and four other FRBs
Around 4,800
member
commercial
banks
www.federalreserve.gov/pubs
/frseries/frseri.htm
Information on the structure of
the Federal Reserve System.
Federal Reserve banks in terms of assets are those of New York, Chicago, and San
Francisco—combined they hold over 50% of the assets (discount loans, securities, and
other holdings) of the Federal Reserve System. The New York bank, with around onequarter
of the assets, is the most important of the Federal Reserve banks (see Box 2).
Each of the Federal Reserve banks is a quasi-public (part private, part government)
institution owned by the private commercial banks in the district that are
members of the Federal Reserve System. These member banks have purchased stock
in their district Federal Reserve bank (a requirement of membership), and the dividends
paid by that stock are limited by law to 6% annually. The member banks elect
six directors for each district bank; three more are appointed by the Board of
Governors. Together, these nine directors appoint the president of the bank (subject
to the approval of the Board of Governors).
The directors of a district bank are classified into three categories, A, B, and C:
The three A directors (elected by the member banks) are professional bankers, and
the three B directors (also elected by the member banks) are prominent leaders from
industry, labor, agriculture, or the consumer sector. The three C directors, who are
appointed by the Board of Governors to represent the public interest, are not allowed
to be officers, employees, or stockholders of banks. This design for choosing directors
was intended by the framers of the Federal Reserve Act to ensure that the directors of
each Federal Reserve bank would reflect all constituencies of the American public.
338 PA RT I V Central Banking and the Conduct of Monetary Policy
FIGURE 2 Federal Reserve System
Source: Federal Reserve Bulletin.
Miami
12
4
10
9
11
6
5
3
1
2
7
8
Board of Governors of the Federal
Reserve System
Federal Reserve bank cities
Boundaries of Federal Reserve districts
(Alaska and Hawaii are in District 12)
Federal Reserve branch cities
1 Federal Reserve districts
Seattle
Portland Helena
Dallas
Omaha
Kansas City
Jacksonville
Atlanta
New York
Boston
Buffalo
Detroit
Salt Lake
City
Los Angeles
El Paso
Oklahoma City
Minneapolis
Chicago
St. Louis
Memphis
Little Rock
Houston
New Orleans
Nashville
Louisville
Richmond
WASHINGTON
Baltimore
Philadelphia
Denver
San Francisco
San Antonio
Charlotte
Culpeper
Pittsburgh
Cleveland
Cincinnati
Birmingham
www.federalreserve.gov
/otherfrb.htm
Addresses and phone numbers
of Federal Reserve banks,
branches, and RCPCs and links
to the main pages of the 12
reserve banks and Board of
Governors.
The 12 Federal Reserve banks perform the following functions:
• Clear checks
• Issue new currency
• Withdraw damaged currency from circulation
• Administer and make discount loans to banks in their districts
• Evaluate proposed mergers and applications for banks to expand their activities
• Act as liaisons between the business community and the Federal Reserve System
• Examine bank holding companies and state-chartered member banks
• Collect data on local business conditions
• Use their staffs of professional economists to research topics related to the conduct
of monetary policy
C H A P T E R 1 4 Structure of Central Banks and the Federal Reserve System 339
The Federal Reserve Bank of New York plays a special
role in the Federal Reserve System for several reasons.
First, its district contains many of the largest
commercial banks in the United States, the safety and
soundness of which are paramount to the health of
the U.S. financial system. The Federal Reserve Bank
of New York conducts examinations of bank holding
companies and state-chartered banks in its district,
making it the supervisor of some of the most important
financial institutions in our financial system. Not
surprisingly, given this responsibility, the bank supervision
group is one of the largest units of the New
York Fed and is by far the largest bank supervision
group in the Federal Reserve System.
The second reason for the New York Fed’s special
role is its active involvement in the bond and foreign
exchange markets. The New York Fed houses
the open market desk, which conducts open market
operations—the purchase and sale of bonds—that
determine the amount of reserves in the banking
system. Because of this involvement in the Treasury
securities market, as well as its walking-distance
location near the New York and American Stock
Exchanges, the officials at the Federal Reserve Bank
of New York are in constant contact with the major
domestic financial markets in the United States. In
addition, the Federal Reserve Bank of New York also
houses the foreign exchange desk, which conducts
foreign exchange interventions on behalf of the
Federal Reserve System and the U.S. Treasury. Its
involvement in these financial markets means that
the New York Fed is an important source of information
on what is happening in domestic and foreign
financial markets, particularly during crisis
periods, as well as a liaison between officials in the
Federal Reserve System and private participants in
the markets.
The third reason for the Federal Reserve Bank of
New York’s prominence is that it is the only Federal
Reserve bank to be a member of the Bank for
International Settlements (BIS). Thus the president of
the New York Fed, along with the chairman of the
Board of Governors, represents the Federal Reserve
System in its regular monthly meetings with other
major central bankers at the BIS. This close contact
with foreign central bankers and interaction with foreign
exchange markets means that the New York Fed
has a special role in international relations, both with
other central bankers and with private market participants.
Adding to its prominence in international circles
is that the New York Fed is the repository for over
$100 billion of the world’s gold, an amount greater
than the gold at Fort Knox.
Finally, the president of the Federal Reserve Bank
of New York is the only permanent member of the
FOMC among the Federal Reserve bank presidents,
serving as the vice-chairman of the committee. Thus
he and the chairman and vice-chairman of the Board
of Governors are the three most important officials in
the Federal Reserve System.
The Special Role of the Federal Reserve Bank of New York
Box 2: Inside the Fed
The 12 Federal Reserve banks are involved in monetary policy in several ways:
1. Their directors “establish” the discount rate (although the discount rate in each
district is reviewed and determined by the Board of Governors).
2. They decide which banks, member and nonmember alike, can obtain discount
loans from the Federal Reserve bank.
3. Their directors select one commercial banker from each bank’s district to serve on
the Federal Advisory Council, which consults with the Board of Governors and
provides information that helps in the conduct of monetary policy.
4. Five of the 12 bank presidents each have a vote in the Federal Open Market
Committee, which directs open market operations (the purchase and sale of
government securities that affect both interest rates and the amount of reserves in
the banking system). As explained in Box 2, the president of the New York Fed
always has a vote in the FOMC, making it the most important of the banks; the
other four votes allocated to the district banks rotate annually among the remaining
11 presidents.
All national banks (commercial banks chartered by the Office of the Comptroller of the
Currency) are required to be members of the Federal Reserve System. Commercial
banks chartered by the states are not required to be members, but they can choose to
join. Currently, around one-third of the commercial banks in the United States are
members of the Federal Reserve System, having declined from a peak figure of 49%
in 1947.
Before 1980, only member banks were required to keep reserves as deposits at
the Federal Reserve banks. Nonmember banks were subject to reserve requirements
determined by their states, which typically allowed them to hold much of their
reserves in interest-bearing securities. Because no interest is paid on reserves
deposited at the Federal Reserve banks, it was costly to be a member of the system,
and as interest rates rose, the relative cost of membership rose, and more and more
banks left the system.
This decline in Fed membership was a major concern of the Board of Governors
(one reason was that it lessened the Fed’s control over the money supply, making it
more difficult for the Fed to conduct monetary policy). The chairman of the Board of
Governors repeatedly called for new legislation requiring all commercial banks to be
members of the Federal Reserve System. One result of the Fed’s pressure on Congress
was a provision in the Depository Institutions Deregulation and Monetary Control Act
of 1980: All depository institutions became subject (by 1987) to the same requirements
to keep deposits at the Fed, so member and nonmember banks would be on
an equal footing in terms of reserve requirements. In addition, all depository institutions
were given access to the Federal Reserve facilities, such as the discount window
(discussed in Chapter 17) and Fed check clearing, on an equal basis. These provisions
ended the decline in Fed membership and reduced the distinction between member
and nonmember banks.
At the head of the Federal Reserve System is the seven-member Board of Governors,
headquartered in Washington, D.C. Each governor is appointed by the president of
the United States and confirmed by the Senate. To limit the president’s control over
the Fed and insulate the Fed from other political pressures, the governors serve one
Board of
Governors of the
Federal Reserve
System
Member Banks
340 PA RT I V Central Banking and the Conduct of Monetary Policy
nonrenewable 14-year term, with one governor’s term expiring every other January.1
The governors (many are professional economists) are required to come from different
Federal Reserve districts to prevent the interests of one region of the country from
being overrepresented. The chairman of the Board of Governors is chosen from
among the seven governors and serves a four-year term. It is expected that once a new
chairman is chosen, the old chairman resigns from the Board of Governors, even if
there are many years left to his or her term as a governor.
The Board of Governors is actively involved in decisions concerning the conduct
of monetary policy. All seven governors are members of the FOMC and vote on the
conduct of open market operations. Because there are only 12 voting members on this
committee (seven governors and five presidents of the district banks), the Board has
the majority of the votes. The Board also sets reserve requirements (within limits
imposed by legislation) and effectively controls the discount rate by the “review and
determination” process, whereby it approves or disapproves the discount rate “established”
by the Federal Reserve banks. The chairman of the Board advises the president
of the United States on economic policy, testifies in Congress, and speaks for the
Federal Reserve System to the media. The chairman and other governors may also
represent the United States in negotiations with foreign governments on economic
matters. The Board has a staff of professional economists (larger than those of individual
Federal Reserve banks), which provides economic analysis that the board uses
in making its decisions. (Box 3 discusses the role of the research staff.)
Through legislation, the Board of Governors has often been given duties not
directly related to the conduct of monetary policy. In the past, for example, the Board
set the maximum interest rates payable on certain types of deposits under Regulation
Q. (After 1986, ceilings on time deposits were eliminated, but there is still a restriction
on paying any interest on business demand deposits.) Under the Credit Control
Act of 1969 (which expired in 1982), the Board had the ability to regulate and control
credit once the president of the United States approved. The Board of Governors
also sets margin requirements, the fraction of the purchase price of securities that has
to be paid for with cash rather than borrowed funds. It also sets the salary of the president
and all officers of each Federal Reserve bank and reviews each bank’s budget.
Finally, the Board has substantial bank regulatory functions: It approves bank mergers
and applications for new activities, specifies the permissible activities of bank
holding companies, and supervises the activities of foreign banks in the United States.
The FOMC usually meets eight times a year (about every six weeks) and makes decisions
regarding the conduct of open market operations, which influence the monetary
base. Indeed, the FOMC is often referred to as the “Fed” in the press: for example,
when the media say that the Fed is meeting, they actually mean that the FOMC is
meeting. The committee consists of the seven members of the Board of Governors, the
president of the Federal Reserve Bank of New York, and the presidents of four other
Federal Reserve banks. The chairman of the Board of Governors also presides as the
chairman of the FOMC. Even though only the presidents of five of the Federal Reserve
Federal Open
Market
Committee
(FOMC)
C H A P T E R 1 4 Structure of Central Banks and the Federal Reserve System 341
1Although technically the governor’s term is nonrenewable, a governor can resign just before the term expires
and then be reappointed by the president. This explains how one governor, William McChesney Martin Jr.,
served for 28 years. Since Martin, the chairman from 1951 to 1970, retired from the board in 1970, the practice
of extending a governor’s term beyond 14 years has become a rarity.
www.federalreserve.gov/bios
/1199member.pdf
Lists all the members of the
Board of Governors of the
Federal Reserve since its
inception.
banks are voting members of the FOMC, the other seven presidents of the district
banks attend FOMC meetings and participate in discussions. Hence they have some
input into the committee’s decisions.
Because open market operations are the most important policy tool that the Fed
has for controlling the money supply, the FOMC is necessarily the focal point for policymaking
in the Federal Reserve System. Although reserve requirements and the discount
rate are not actually set by the FOMC, decisions in regard to these policy tools
342 PA RT I V Central Banking and the Conduct of Monetary Policy
The Federal Reserve System is the largest employer of
economists not just in the United States, but in the
world. The system’s research staff has around 1,000
people, about half of whom are economists. Of these
500 economists, 250 are at the Board of Governors,
100 are at the Federal Reserve Bank of New York, and
the remainder are at the other Federal Reserve banks.
What do all these economists do?
The most important task of the Fed’s economists is
to follow the incoming data from government agencies
and private sector organizations on the economy
and provide guidance to the policymakers on where
the economy may be heading and what the impact of
monetary policy actions on the economy might be.
Before each FOMC meeting, the research staff at each
Federal Reserve bank briefs its president and the senior
management of the bank on its forecast for the
U.S. economy and the issues that are likely to be discussed
at the meeting. The research staff also provides
briefing materials or a formal briefing on the economic
outlook for the bank’s region, something that
each president discusses at the FOMC meeting.
Meanwhile, at the Board of Governors, economists
maintain a large econometric model (a model whose
equations are estimated with statistical procedures)
that helps them produce their forecasts of the
national economy, and they too brief the governors
on the national economic outlook.
The research staffers at the banks and the board
also provide support for the bank supervisory staff,
tracking developments in the banking sector and
other financial markets and institutions and providing
bank examiners with technical advice that they
might need in the course of their examinations.
Because the Board of Governors has to decide on
whether to approve bank mergers, the research staff
at both the board and the bank in whose district the
merger is to take place prepare information on what
effect the proposed merger might have on the competitive
environment. To assure compliance with the
Community Reinvestment Act, economists also analyze
a bank’s performance in its lending activities in
different communities.
Because of the increased influence of developments
in foreign countries on the U.S. economy, the
members of the research staff, particularly at the New
York Fed and the Board, produce reports on the
major foreign economies. They also conduct research
on developments in the foreign exchange market
because of its growing importance in the monetary
policy process and to support the activities of the foreign
exchange desk. Economists also help support
the operation of the open market desk by projecting
reserve growth and the growth of the monetary
aggregates.
Staff economists also engage in basic research on
the effects of monetary policy on output and inflation,
developments in the labor markets, international
trade, international capital markets, banking
and other financial institutions, financial markets,
and the regional economy, among other topics. This
research is published widely in academic journals
and in Reserve bank publications. (Federal Reserve
bank reviews are a good source of supplemental
material for money and banking students.)
Another important activity of the research staff primarily
at the Reserve banks is in the public education
area. Staff economists are called on frequently to make
presentations to the board of directors at their banks
or to make speeches to the public in their district.
The Role of the Research Staff
Box 3: Inside the Fed
www.federalreserve.gov/fomc
Find general information on the
FOMC, its schedule of meetings,
statements, minutes, and
transcripts; information on its
members, and the “beige book.”
are effectively made there. The FOMC does not actually carry out securities purchases
or sales. Rather it issues directives to the trading desk at the Federal Reserve Bank of
New York, where the manager for domestic open market operations supervises a
roomful of people who execute the purchases and sales of the government or agency
securities. The manager communicates daily with the FOMC members and their staffs
concerning the activities of the trading desk.
The FOMC meeting takes place in the boardroom on the second floor of the main
building of the Board of Governors in Washington. The seven governors and the 12
Reserve Bank presidents, along with the secretary of the FOMC, the Board’s director
of the Research and Statistics Division and his deputy, and the directors of the
Monetary Affairs and International Finance Divisions, sit around a massive conference
table. Although only five of the Reserve Bank presidents have voting rights on the
FOMC at any given time, all actively participate in the deliberations. Seated around
the sides of the room are the directors of research at each of the Reserve banks and
other senior board and Reserve Bank officials, who, by tradition, do not speak at the
meeting.
Except for the meetings prior to the February and July testimony by the chairman
of the Board of Governors before Congress, the meeting starts on Tuesday at 9:00 A.M.
sharp with a quick approval of the minutes of the previous meeting of the FOMC. The
first substantive agenda item is the report by the manager of system open market
operations on foreign currency and domestic open market operations and other issues
related to these topics. After the governors and Reserve Bank presidents finish asking
questions and discussing these reports, a vote is taken to ratify them.
The next stage in the meeting is a presentation of the Board staff’s national economic
forecast, referred to as the “green book” forecast (see Box 4), by the director of
the Research and Statistics Division at the board. After the governors and Reserve
Bank presidents have queried the division director about the forecast, the so-called goround
occurs: Each bank president presents an overview of economic conditions in his
or her district and the bank’s assessment of the national outlook, and each governor,
except for the chairman, gives a view of the national outlook. By tradition, remarks
avoid the topic of monetary policy at this time.
After a coffee break, everyone returns to the boardroom and the agenda turns to
current monetary policy and the domestic policy directive. The Board’s director of the
Monetary Affairs Division then leads off the discussion by outlining the different scenarios
for monetary policy actions outlined in the blue book (see Box 4) and may
describe an issue relating to how monetary policy should be conducted. After a questionand-
answer period, the chairman (currently Alan Greenspan) sets the stage for the following
discussion by presenting his views on the state of the economy and then
typically makes a recommendation for what monetary policy action should be taken.
Then each of the FOMC members as well as the nonvoting bank presidents expresses
his or her views on monetary policy, and the chairman summarizes the discussion and
proposes specific wording for the directive on the federal funds rate target transmitted
to the open market desk. The secretary of the FOMC formally reads the proposed
statement, and the members of the FOMC vote.2
The FOMC
Meeting
C H A P T E R 1 4 Structure of Central Banks and the Federal Reserve System 343
2The decisions expressed in the directive may not be unanimous, and the dissenting views are made public.
However, except in rare cases, the chairman’s vote is always on the winning side.
Then there is an informal buffet lunch, and while eating, the participants hear a
presentation on the latest developments in Congress on banking legislation and other
legislation relevant to the Federal Reserve. Around 2:15 P.M., the meeting breaks up
and a public announcement is made about the outcome of the meeting: whether the
target federal funds rate and discount rate have been raised, lowered, or left
unchanged, and an assessment of the “balance of risks” in the future, whether toward
higher inflation or toward a weaker economy.3 The postmeeting announcement is an
innovation initiated in 1994. Before then, no such announcement was made, and the
markets had to guess what policy action was taken. The decision to announce this
information was a step in the direction of greater openness by the Fed.
Informal Structure of the Federal Reserve System
The Federal Reserve Act and other legislation give us some idea of the formal structure
of the Federal Reserve System and who makes decisions at the Fed. What is written
in black and white, however, does not necessarily reflect the reality of the power
and decision-making structure.
As envisioned in 1913, the Federal Reserve System was to be a highly decentralized
system designed to function as 12 separate, cooperating central banks. In the
original plan, the Fed was not responsible for the health of the economy through its
control of the money supply and its ability to affect interest rates. Over time, it has
344 PA RT I V Central Banking and the Conduct of Monetary Policy
3The meetings before the February and July chairman’s testimony before Congress, in which the Monetary Report
to Congress is presented, have a somewhat different format. Rather than start Tuesday morning at 9:00 A.M. like
the other meetings, they start in the afternoon on Tuesday and go over to Wednesday, with the usual announcement
around 2:15 P.M. These longer meetings consider the longer-term economic outlook as well as the current
conduct of open market operations.
What Do These Colors Mean at the Fed? Three
research documents play an important role in the
monetary policy process and at Federal Open Market
Committee meetings. The national forecast for the
next two years, generated by the Federal Reserve
Board of Governors’ Research and Statistics Division,
is placed between green covers and is thus known as
the “green book.” It is provided to all who attend the
FOMC meeting. The “blue book,” in blue covers, also
provided to all participants at the FOMC meeting,
contains the projections for the monetary aggregates
prepared by the Monetary Affairs Division at the
Board of Governors and typically also presents three
alternative scenarios for the stance of monetary policy
(labeled A, B, and C). The “beige book,” with
beige covers, is produced by the Reserve banks and
details evidence gleaned either from surveys or
from talks with key businesses and financial institutions
on the state of the economy in each of the
Federal Reserve districts. This is the only one of the
three books that is distributed publicly, and it often
receives a lot of attention in the press.
Green, Blue, and Beige
Box 4: Inside the Fed
acquired the responsibility for promoting a stable economy, and this responsibility has
caused the Federal Reserve System to evolve slowly into a more unified central bank.
The framers of the Federal Reserve Act of 1913 intended the Fed to have only one
basic tool of monetary policy: the control of discount loans to member banks. The use
of open market operations as a tool for monetary control was not yet well understood,
and reserve requirements were fixed by the Federal Reserve Act. The discount tool
was to be controlled by the joint decision of the Federal Reserve banks and the
Federal Reserve Board (which later became the Board of Governors), so that both
would share equally in the determination of monetary policy. However, the Board’s
ability to “review and determine” the discount rate effectively allowed it to dominate
the district banks in setting this policy.
Banking legislation during the Great Depression years centralized power within
the newly created Board of Governors by giving it effective control over the remaining
two tools of monetary policy, open market operations and changes in reserve
requirements. The Banking Act of 1933 granted the FOMC authority to determine
open market operations, and the Banking Act of 1935 gave the Board the majority of
votes in the FOMC. The Banking Act of 1935 also gave the Board authority to change
reserve requirements.
Since the 1930s, then, the Board of Governors has acquired the reins of control
over the tools for conducting monetary policy. In recent years, the power of the Board
has become even greater. Although the directors of a Federal Reserve bank choose its
president with the approval of the Board, the Board sometimes suggests a choice
(often a professional economist) for president of a Federal Reserve bank to the directors
of the bank, who then often follow the Board’s suggestions. Since the Board sets
the salary of the bank’s president and reviews the budget of each Federal Reserve
bank, it has further influence over the district banks’ activities.
If the Board of Governors has so much power, what power do the Federal
Advisory Council and the “owners” of the Federal Reserve banks—the member
banks—actually have within the Federal Reserve System? The answer is almost none.
Although member banks own stock in the Federal Reserve banks, they have none of
the usual benefits of ownership. First, they have no claim on the earnings of the Fed
and get paid only a 6% annual dividend, regardless of how much the Fed earns.
Second, they have no say over how their property is used by the Federal Reserve
System, in contrast to stockholders of private corporations. Third, usually only a single
candidate for each of the six A and B directorships is “elected” by the member
banks, and this candidate is frequently suggested by the president of the Federal
Reserve bank (who, in turn, is approved by the Board of Governors). The net result
is that member banks are essentially frozen out of the political process at the Fed and
have little effective power. Fourth, as its name implies, the Federal Advisory Council
has only an advisory capacity and has no authority over Federal Reserve policymaking.
Although the member bank “owners” do not have the usual power associated
with being a stockholder, they do play an important, but subtle, role in the Federal
Reserve System (see Box 5).
A fair characterization of the Federal Reserve System as it has evolved is that it
functions as a central bank, headquartered in Washington, D.C., with branches in 12
cities. Because all aspects of the Federal Reserve System are essentially controlled by
the Board of Governors, who controls the Board? Although the chairman of the Board
of Governors does not have legal authority to exercise control over this body, he effectively
does so through his ability to act as spokesperson for the Fed and negotiate with
C H A P T E R 1 4 Structure of Central Banks and the Federal Reserve System 345
Congress and the president of the United States. He also exercises control by setting
the agenda of Board and FOMC meetings. For example, the fact that the agenda at the
FOMC has the chairman speak first about monetary policy enables him to have
greater influence over what the policy action will be. The chairman also influences the
Board through the force of stature and personality. Chairmen of the Board of
Governors (including Marriner S. Eccles, William McChesney Martin Jr., Arthur
Burns, Paul A. Volcker, and Alan Greenspan) have typically had strong personalities
and have wielded great power.
The chairman also exercises power by supervising the Board’s staff of professional
economists and advisers. Because the staff gathers information for the Board and conducts
the analyses that the Board uses in its decisions, it also has some influence over
monetary policy. In addition, in the past, several appointments to the Board itself have
come from within the ranks of its professional staff, making the chairman’s influence
even farther-reaching and longer-lasting than a four-year term.
The informal power structure of the Fed, in which power is centralized in the
chairman of the Board of Governors, is summarized in Figure 3.
How Independent Is the Fed?
When we look, in the next four chapters, at how the Federal Reserve conducts monetary
policy, we will want to know why it decides to take certain policy actions but
not others. To understand its actions, we must understand the incentives that motivate
the Fed’s behavior. How free is the Fed from presidential and congressional pressures?
Do economic, bureaucratic, or political considerations guide it? Is the Fed truly
independent of outside pressures?
346 PA RT I V Central Banking and the Conduct of Monetary Policy
Although the member bank stockholders in each
Federal Reserve bank have little direct power in the
Federal Reserve System, they do play an important
role. Their six representatives on the board of directors
of each bank have a major oversight function.
Along with the three public interest directors, they
oversee the audit process for the Federal Reserve
bank, making sure it is being run properly, and also
share their management expertise with the senior
management of the bank. Because they vote on recommendations
by each bank to raise, lower, or maintain
the discount rate at its current level, they engage
in discussions about monetary policy and transmit
their private sector views to the president and senior
management of the bank. They also get to understand
the inner workings of the Federal Reserve banks and
the system so that they can help explain the position
of the Federal Reserve to their contacts in the private
and political sectors. Advisory councils like the
Federal Advisory Council and others that are often set
up by the district banks—for example, the Small
Business and Agriculture Advisory Council and the
Thrift Advisory Council at the New York Fed—are a
conduit for the private sector to express views on both
the economy and the state of the banking system.
So even though the owners of the Reserve banks
do not have the usual voting rights, they are important
to the Federal Reserve System, because they
make sure it does not get out of touch with the needs
and opinions of the private sector.
The Role of Member Banks in the Federal Reserve System
Box 5: Inside the Fed
Stanley Fischer, who was a professor at MIT and then the Deputy Managing
Director of the International Monetary Fund, has defined two different types of independence
of central banks: instrument independence, the ability of the central bank
to set monetary policy instruments, and goal independence, the ability of the central
bank to set the goals of monetary policy. The Federal Reserve has both types of independence
and is remarkably free of the political pressures that influence other government
agencies. Not only are the members of the Board of Governors appointed for
a 14-year term (and so cannot be ousted from office), but also the term is technically
not renewable, eliminating some of the incentive for the governors to curry favor with
the president and Congress.
Probably even more important to its independence from the whims of Congress is
the Fed’s independent and substantial source of revenue from its holdings of securities
C H A P T E R 1 4 Structure of Central Banks and the Federal Reserve System 347
FIGURE 3 Informal Power Structure of the Federal Reserve System
Six other
members of
the Board
of Governors
Discount
rate
Reserve
requirements
Board
staff
Federal Open
Market
Committee
(FOMC)
Advises
Advises
CHAIRMAN OF THE BOARD OF GOVERNORS
Advises Five Federal
Reserve bank
presidents
Vote
Vote
Sets agenda Supervises Votes and
sets agenda
Set (within limits ) Set
Directs
Open market
operations
and, to a lesser extent, from its loans to banks. In recent years, for example, the Fed
has had net earnings after expenses of around $28 billion per year—not a bad living
if you can find it! Because it returns the bulk of these earnings to the Treasury, it does
not get rich from its activities, but this income gives the Fed an important advantage
over other government agencies: It is not subject to the appropriations process usually
controlled by Congress. Indeed, the General Accounting Office, the auditing
agency of the federal government, cannot audit the monetary policy or foreign
exchange market functions of the Federal Reserve. Because the power to control the
purse strings is usually synonymous with the power of overall control, this feature of the
Federal Reserve System contributes to its independence more than any other factor.
Yet the Federal Reserve is still subject to the influence of Congress, because the legislation
that structures it is written by Congress and is subject to change at any time.
When legislators are upset with the Fed’s conduct of monetary policy, they frequently
threaten to take control of the Fed’s finances and force it to submit a budget request
like other government agencies. A recent example was the call by Senators Dorgan and
Reid in 1996 for Congress to have budgetary authority over the nonmonetary activities
of the Federal Reserve. This is a powerful club to wield, and it certainly has some
effect in keeping the Fed from straying too far from congressional wishes.
Congress has also passed legislation to make the Federal Reserve more accountable
for its actions. In 1975, Congress passed House Concurrent Resolution 133,
which requires the Fed to announce its objectives for the growth rates of the monetary
aggregates. In the Full Employment and Balanced Growth Act of 1978 (the
Humphrey-Hawkins Act), the Fed is required to explain how these objectives are consistent
with the economic plans of the president of the United States.
The president can also influence the Federal Reserve. Because congressional legislation
can affect the Fed directly or affect its ability to conduct monetary policy, the
president can be a powerful ally through his influence on Congress. Second, although
ostensibly a president might be able to appoint only one or two members to the Board
of Governors during each presidential term, in actual practice the president appoints
members far more often. One reason is that most governors do not serve out a full
14-year term. (Governors’ salaries are substantially below what they can earn in the
private sector, thus providing an incentive for them to take private sector jobs before
their term expires.) In addition, the president is able to appoint a new chairman of
the Board of Governors every four years, and a chairman who is not reappointed is
expected to resign from the board so that a new member can be appointed.
The power that the president enjoys through his appointments to the Board of
Governors is limited, however. Because the term of the chairman is not necessarily
concurrent with that of the president, a president may have to deal with a chairman
of the Board of Governors appointed by a previous administration. Alan Greenspan,
for example, was appointed chairman in 1987 by President Ronald Reagan and was
reappointed to another term by another Republican president, George Bush. When
Bill Clinton, a Democrat, became president in 1993, Greenspan had several years left
to his term. Clinton was put under tremendous pressure to reappoint Greenspan
when his term expired and did so in 1996 and again in 2000, even though Greenspan
is a Republican.4
348 PA RT I V Central Banking and the Conduct of Monetary Policy
4Similarly, William McChesney Martin, Jr., the chairman from 1951 to 1970, was appointed by President Truman
(Dem.) but was reappointed by Presidents Eisenhower (Rep.), Kennedy (Dem.), Johnson (Dem.), and Nixon
(Rep.). Also Paul Volcker, the chairman from 1979 to 1987, was appointed by President Carter (Dem.) but was
reappointed by President Reagan (Rep.).
You can see that the Federal Reserve has extraordinary independence for a government
agency and is one of the most independent central banks in the world.
Nonetheless, the Fed is not free from political pressures. Indeed, to understand the
Fed’s behavior, we must recognize that public support for the actions of the Federal
Reserve plays a very important role.5
Structure and Independence of Foreign Central Banks
In contrast to the Federal Reserve System, which is decentralized into 12 privately
owned district banks, central banks in other industrialized countries consist of one
centralized unit that is owned by the government. Here we examine the structure and
degree of independence of four of the most important foreign central banks: the Bank
of Canada, the Bank of England, the Bank of Japan, and the European Central Bank.
Canada was late in establishing a central bank: The Bank of Canada was founded in
1934. Its directors are appointed by the government to three-year terms, and they
appoint the governor, who has a seven-year term. A governing council, consisting of
the four deputy governors and the governor, is the policymaking body comparable to
the FOMC that makes decisions about monetary policy.
The Bank Act was amended in 1967 to give the ultimate responsibility for monetary
policy to the government. So on paper, the Bank of Canada is not as instrumentindependent
as the Federal Reserve. In practice, however, the Bank of Canada does
essentially control monetary policy. In the event of a disagreement between the bank
and the government, the minister of finance can issue a directive that the bank must
follow. However, because the directive must be in writing and specific and applicable
for a specified period, it is unlikely that such a directive would be issued, and none
has been to date. The goal for monetary policy, a target for inflation, is set jointly by
the Bank of Canada and the government, so the Bank of Canada has less goal independence
than the Fed.
Founded in 1694, the Bank of England is one of the oldest central banks. The Bank
Act of 1946 gave the government statutory authority over the Bank of England. The
Court (equivalent to a board of directors) of the Bank of England is made up of the
governor and two deputy governors, who are appointed for five-year terms, and 16
non-executive directors, who are appointed for three-year terms.
Until 1997, the Bank of England was the least independent of the central banks
examined in this chapter because the decision to raise or lower interest rates resided
not within the Bank of England but with the chancellor of the Exchequer (the equivalent
of the U.S. secretary of the Treasury). All of this changed when the new Labour
government came to power in May 1997. At this time, the new chancellor of the
Exchequer, Gordon Brown, made a surprise announcement that the Bank of England
would henceforth have the power to set interest rates. However, the Bank was not
granted total instrument independence: The government can overrule the Bank and
Bank of England
Bank of Canada
C H A P T E R 1 4 Structure of Central Banks and the Federal Reserve System 349
5An inside view of how the Fed interacts with the public and the politicians can be found in Bob Woodward,
Maestro: Greenspan’s Fed and the American Boom (New York: Simon and Schuster, 2000).
www.bank-banque-canada.ca/
The website for the Bank of
Canada.
www.bankofengland.co.uk
Links/setframe.html
The website for the Bank of
England.
set rates “in extreme economic circumstances” and “for a limited period.” Nonetheless,
as in Canada, because overruling the Bank would be so public and is supposed
to occur only in highly unusual circumstances and for a limited time, it likely to be a
rare occurrence.
The decision to set interest rates resides in the Monetary Policy Committee, made
up of the governor, two deputy governors, two members appointed by the governor
after consultation with the chancellor (normally central bank officials), plus four outside
economic experts appointed by the chancellor. (Surprisingly, two of the four outside
experts initially appointed to this committee were not British citizens—one was
Dutch and the other American, although both were residents of the United Kingdom.)
The inflation target for the Bank of England is set by the Chancellor of the Exchequer,
so the Bank of England is also less goal-independent than the Fed.
The Bank of Japan (Nippon Ginko) was founded in 1882 during the Meiji Restoration.
Monetary policy is determined by the Policy Board, which is composed of the
governor; two vice governors; and six outside members appointed by the cabinet and
approved by the parliament, all of whom serve for five-year terms.
Until recently, the Bank of Japan was not formally independent of the government,
with the ultimate power residing with the Ministry of Finance. However, the
new Bank of Japan Law, which took effect in April 1998 and was the first major
change in the powers of the Bank of Japan in 55 years, has changed this. In addition
to stipulating that the objective of monetary policy is to attain price stability, the law
granted greater instrument and goal independence to the Bank of Japan. Before this,
the government had two voting members on the Policy Board, one from the Ministry
of Finance and the other from the Economic Planning Agency. Now the government
may send two representatives from these agencies to board meetings, but they no
longer have voting rights, although they do have the ability to request delays in monetary
policy decisions. In addition, the Ministry of Finance lost its authority to oversee
many of the operations of the Bank of Japan, particularly the right to dismiss
senior officials. However, the Ministry of Finance continues to have control over the
part of the Bank’s budget that is unrelated to monetary policy, which might limit its
independence to some extent.
The Maastricht Treaty established the European Central Bank (ECB) and the European
System of Central Banks (ESCB), which began operation in January 1999. The structure
of the central bank is patterned after the U.S. Federal Reserve System in that central
banks for each country have a role similar to that of the Federal Reserve banks.
The executive board of the ECB is made up of the president, a vice president, and four
other members, who are appointed for eight-year terms. The monetary policymaking
body of the bank includes the six members of the executive board and the centralbank
governors from each of the euro countries, all of whom must have five-year
terms at a minimum.
The European Central Bank will be the most independent in the world—even
more independent than the German central bank, the Bundesbank, which, before
the establishment of the ECB, was considered the world’s most independent central
bank, along with the Swiss National Bank. The ECB is both instrument- and goalindependent
of both the European Union and the national governments and has complete
control over monetary policy. In addition, the ECB’s mandated mission is the
European Central
Bank
Bank of Japan
350 PA RT I V Central Banking and the Conduct of Monetary Policy
www.boj.or.jp/en/index.htm
The website for the Bank of
Japan.
www.ecb.int
The website for the European
Central Bank
pursuit of price stability. The ECB is far more independent than any other central
bank in the world because its charter cannot be changed by legislation: It can be
changed only by revision of the Maastricht Treaty, a difficult process, because all signatories
to the treaty would have to agree.
As our survey of the structure and independence of the major central banks indicates,
in recent years we have been seeing a remarkable trend toward increasing independence.
It used to be that the Federal Reserve was substantially more independent than
almost all other central banks, with the exception of those in Germany and
Switzerland. Now the newly established European Central Bank is far more independent
than the Fed, and greater independence has been granted to central banks
like the Bank of England and the Bank of Japan, putting them more on a par with the
Fed, as well as to central banks in such diverse countries as New Zealand, Sweden,
and the euro nations. Both theory and experience suggest that more independent central
banks produce better monetary policy, thus providing an impetus for this trend.
Explaining Central Bank Behavior
One view of government bureaucratic behavior is that bureaucracies serve the public
interest (this is the public interest view) . Yet some economists have developed a theory
of bureaucratic behavior that suggests other factors that influence how bureaucracies
operate. The theory of bureaucratic behavior suggests that the objective of a bureaucracy
is to maximize its own welfare, just as a consumer’s behavior is motivated by the maximization
of personal welfare and a firm’s behavior is motivated by the maximization
of profits. The welfare of a bureaucracy is related to its power and prestige. Thus this
theory suggests that an important factor affecting a central bank’s behavior is its
attempt to increase its power and prestige.
What predictions does this view of a central bank like the Fed suggest? One is
that the Federal Reserve will fight vigorously to preserve its autonomy, a prediction
verified time and time again as the Fed has continually counterattacked congressional
attempts to control its budget. In fact, it is extraordinary how effectively the Fed has
been able to mobilize a lobby of bankers and businesspeople to preserve its independence
when threatened.
Another prediction is that the Federal Reserve will try to avoid conflict with powerful
groups that might threaten to curtail its power and reduce its autonomy. The
Fed’s behavior may take several forms. One possible factor explaining why the Fed is
sometimes slow to increase interest rates and so smooths out their fluctuations is that
it wishes to avoid a conflict with the president and Congress over increases in interest
rates. The desire to avoid conflict with Congress and the president may also
explain why in the past the Fed was not at all transparent about its actions and is still
not fully transparent (see Box 6).
The desire of the Fed to hold as much power as possible also explains why it vigorously
pursued a campaign to gain control over more banks. The campaign culminated
in legislation that expanded jurisdiction of the Fed’s reserve requirements to all
banks (not just the member commercial banks) by 1987.
The theory of bureaucratic behavior seems applicable to the Federal Reserve’s
actions, but we must recognize that this view of the Fed as being solely concerned
The Trend Toward
Greater
Independence
C H A P T E R 1 4 Structure of Central Banks and the Federal Reserve System 351
with its own self-interest is too extreme. Maximizing one’s welfare does not rule out
altruism. (You might give generously to a charity because it makes you feel good
about yourself, but in the process you are helping a worthy cause.) The Fed is surely
concerned that it conduct monetary policy in the public interest. However, much
uncertainty and disagreement exist over what monetary policy should be.6 When it is
unclear what is in the public interest, other motives may influence the Fed’s behavior.
In these situations, the theory of bureaucratic behavior may be a useful guide to predicting
what motivates the Fed.
Should the Fed Be Independent?
As we have seen, the Federal Reserve is probably the most independent government
agency in the United States. Every few years, the question arises in Congress whether
the independence of the Fed should be curtailed. Politicians who strongly oppose a
Fed policy often want to bring it under their supervision in order to impose a policy
more to their liking. Should the Fed be independent, or would we be better off with
a central bank under the control of the president or Congress?
The strongest argument for an independent Federal Reserve rests on the view that
subjecting the Fed to more political pressures would impart an inflationary bias to
monetary policy. In the view of many observers, politicians in a democratic society are
The Case for
Independence
352 PA RT I V Central Banking and the Conduct of Monetary Policy
As the theory of bureaucratic behavior predicts, the
Fed has incentives to hide its actions from the public
and from politicians to avoid conflicts with them.
In the past, this motivation led to a penchant for
secrecy in the Fed, about which one former Fed official
remarked that “a lot of staffers would concede
that [secrecy] is designed to shield the Fed from
political oversight.”* For example, the Fed pursued
an active defense of delaying its release of FOMC
directives to Congress and the public. However, as
we have seen, in 1994, it began to reveal the FOMC
directive immediately after each FOMC meeting. In
1999, it also began to immediately announce the
“bias” toward which direction monetary policy was
likely to go, later expressed as the balance of risks in
the economy. In 2002, the Fed started to report the
roll call vote on the federal funds rate target taken at
the FOMC meeting. Thus the Fed has increased its
transparency in recent years. Yet even today, the Fed
is not fully transparent: it still does not release the
minutes of the FOMC meetings until six weeks after
a meeting has taken place, and it does not publish its
forecasts of the economy as some other central
banks do.
Federal Reserve Transparency
Box 6: Inside the Fed
*Quoted in “Monetary Zeal: How the Federal Reserve Under Volcker Finally Slowed Down Inflation,” Wall Street Journal, December 7, 1984, p. 23.
6One example of the uncertainty over how best to conduct monetary policy was discussed in Chapter 3:
Economists are not sure how to measure money. So even if economists agreed that controlling the quantity of
money is the appropriate way to conduct monetary policy (a controversial position, as we will see in later chapters),
the Fed cannot be sure which monetary aggregate it should control.
shortsighted because they are driven by the need to win their next election. With this
as the primary goal, they are unlikely to focus on long-run objectives, such as promoting
a stable price level. Instead, they will seek short-run solutions to problems,
like high unemployment and high interest rates, even if the short-run solutions have
undesirable long-run consequences. For example, we saw in Chapter 5 that high
money growth might lead initially to a drop in interest rates but might cause an
increase later as inflation heats up. Would a Federal Reserve under the control of
Congress or the president be more likely to pursue a policy of excessive money
growth when interest rates are high, even though it would eventually lead to inflation
and even higher interest rates in the future? The advocates of an independent Federal
Reserve say yes. They believe that a politically insulated Fed is more likely to be concerned
with long-run objectives and thus be a defender of a sound dollar and a stable
price level.
A variation on the preceding argument is that the political process in America
leads to the so-called political business cycle, in which just before an election,
expansionary policies are pursued to lower unemployment and interest rates. After
the election, the bad effects of these policies—high inflation and high interest rates—
come home to roost, requiring contractionary policies that politicians hope the public
will forget before the next election. There is some evidence that such a political
business cycle exists in the United States, and a Federal Reserve under the control of
Congress or the president might make the cycle even more pronounced.
Putting the Fed under the control of the president (making it more subject to
influence by the Treasury) is also considered dangerous because the Fed can be used
to facilitate Treasury financing of large budget deficits by its purchases of Treasury
bonds.7 Treasury pressure on the Fed to “help out” might lead to a more inflationary
bias in the economy. An independent Fed is better able to resist this pressure from the
Treasury.
Another argument for Fed independence is that control of monetary policy is too
important to leave to politicians, a group that has repeatedly demonstrated a lack of
expertise at making hard decisions on issues of great economic importance, such as
reducing the budget deficit or reforming the banking system. Another way to state this
argument is in terms of the principal–agent problem discussed in Chapters 8 and 11.
Both the Federal Reserve and politicians are agents of the public (the principals), and
as we have seen, both politicians and the Fed have incentives to act in their own interest
rather than in the interest of the public. The argument supporting Federal Reserve
independence is that the principal–agent problem is worse for politicians than for the
Fed because politicians have fewer incentives to act in the public interest.
Indeed, some politicians may prefer to have an independent Fed, which can be
used as a public “whipping boy” to take some of the heat off their backs. It is possible
that a politician who in private opposes an inflationary monetary policy will be forced
to support such a policy in public for fear of not being reelected. An independent Fed
can pursue policies that are politically unpopular yet in the public interest.
C H A P T E R 1 4 Structure of Central Banks and the Federal Reserve System 353
7The Federal Reserve Act prohibited the Fed from buying Treasury bonds directly from the Treasury (except to
roll over maturing securities); instead the Fed buys Treasury bonds on the open market. One possible reason for
this prohibition is consistent with the foregoing argument: The Fed would find it harder to facilitate Treasury
financing of large budget deficits.
Proponents of a Fed under the control of the president or Congress argue that it is
undemocratic to have monetary policy (which affects almost everyone in the economy)
controlled by an elite group responsible to no one. The current lack of accountability
of the Federal Reserve has serious consequences: If the Fed performs badly,
there is no provision for replacing members (as there is with politicians). True, the
Fed needs to pursue long-run objectives, but elected officials of Congress vote on
long-run issues also (foreign policy, for example). If we push the argument further
that policy is always performed better by elite groups like the Fed, we end up with
such conclusions as the Joint Chiefs of Staff should determine military budgets or the
IRS should set tax policies with no oversight from the president or Congress. Would
you advocate this degree of independence for the Joint Chiefs or the IRS?
The public holds the president and Congress responsible for the economic wellbeing
of the country, yet they lack control over the government agency that may well
be the most important factor in determining the health of the economy. In addition, to
achieve a cohesive program that will promote economic stability, monetary policy must
be coordinated with fiscal policy (management of government spending and taxation).
Only by placing monetary policy under the control of the politicians who also control
fiscal policy can these two policies be prevented from working at cross-purposes.
Another argument against Federal Reserve independence is that an independent
Fed has not always used its freedom successfully. The Fed failed miserably in its stated
role as lender of last resort during the Great Depression, and its independence certainly
didn’t prevent it from pursuing an overly expansionary monetary policy in the
1960s and 1970s that contributed to rapid inflation in this period.
Our earlier discussion also suggests that the Federal Reserve is not immune from
political pressures.8 Its independence may encourage it to pursue a course of narrow
self-interest rather than the public interest.
There is yet no consensus on whether Federal Reserve independence is a good
thing, although public support for independence of the central bank seems to have
been growing in both the United States and abroad. As you might expect, people who
like the Fed’s policies are more likely to support its independence, while those who
dislike its policies advocate a less independent Fed.
We have seen that advocates of an independent central bank believe that macroeconomic
performance will be improved by making the central bank more independent.
Recent research seems to support this conjecture: When central banks are ranked
from least independent to most independent, inflation performance is found to be the
best for countries with the most independent central banks.9 Although a more independent
central bank appears to lead to a lower inflation rate, this is not achieved at
the expense of poorer real economic performance. Countries with independent central
banks are no more likely to have high unemployment or greater output fluctuations
than countries with less independent central banks.
Central Bank
Independence and
Macroeconomic
Performance
Throughout The
World
The Case Against
Independence
354 PA RT I V Central Banking and the Conduct of Monetary Policy
8For evidence on this issue, see Robert E. Weintraub, “Congressional Supervision of Monetary Policy,” Journal of
Monetary Economics 4 (1978): 341–362. Some economists suggest that lessening the independence of the Fed
might even reduce the incentive for politically motivated monetary policy; see Milton Friedman, “Monetary
Policy: Theory and Practice,” Journal of Money, Credit and Banking 14 (1982): 98–118.
9Alberto Alesina and Lawrence H. Summers, “Central Bank Independence and Macroeconomic Performance:
Some Comparative Evidence,” Journal of Money, Credit and Banking 25 (1993): 151–162. However, Adam Posen,
“Central Bank Independence and Disinflationary Credibility: A Missing Link,” Federal Reserve Bank of New York
Staff Report No. 1, May 1995, has cast some doubt on whether the causality runs from central bank independence
to improved inflation performance.
C H A P T E R 1 4 Structure of Central Banks and the Federal Reserve System 355
Summary
1. The Federal Reserve System was created in 1913 to
lessen the frequency of bank panics. Because of public
hostility to central banks and the centralization of
power, the Federal Reserve System was created with
many checks and balances to diffuse power.
2. The formal structure of the Federal Reserve System
consists of 12 regional Federal Reserve banks, around
4,800 member commercial banks, the Board of
Governors of the Federal Reserve System, the Federal
Open Market Committee, and the Federal Advisory
Council.
3. Although on paper the Federal Reserve System appears
to be decentralized, in practice it has come to function
as a unified central bank controlled by the Board of
Governors, especially the board’s chairman.
4. The Federal Reserve is more independent than most
agencies of the U.S. government, but it is still subject to
political pressures because the legislation that structures
the Fed is written by Congress and can be changed at
any time. The theory of bureaucratic behavior suggests
that one factor driving the Fed’s behavior might be its
attempt to increase its power and prestige. This view
explains many of the Fed’s actions, although the agency
may also try to act in the public interest.
5. The case for an independent Federal Reserve rests on
the view that curtailing the Fed’s independence and
subjecting it to more political pressures would impart
an inflationary bias to monetary policy. An independent
Fed can afford to take the long view and not respond to
short-run problems that will result in expansionary
monetary policy and a political business cycle. The case
against an independent Fed holds that it is undemocratic
to have monetary policy (so important to the public)
controlled by an elite that is not accountable to the
public. An independent Fed also makes the
coordination of monetary and fiscal policy difficult.
Key Terms
Board of Governors of the Federal
Reserve System, p. 337
Federal Open Market Committee
(FOMC), p. 337
Federal Reserve banks, p. 337
goal independence, p. 347
instrument independence, p. 347
open market operations, p. 340
political business cycle, p. 353
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 was the Federal Reserve System set up with 12
regional Federal Reserve banks rather than one central
bank, as in other countries?
2. What political realities might explain why the Federal
Reserve Act of 1913 placed two Federal Reserve banks
in Missouri?
*3. “The Federal Reserve System resembles the U.S.
Constitution in that it was designed with many checks
and balances.” Discuss.
4. In what ways can the regional Federal Reserve banks
influence the conduct of monetary policy?
*5. Which entities in the Federal Reserve System control
the discount rate? Reserve requirements? Open market
operations?
6. Do you think that the 14-year nonrenewable terms for
governors effectively insulate the Board of Governors
from political pressure?
*7. Over time, which entities have gained power in the
Federal Reserve System and which have lost power?
Why do you think this has happened?
QUIZ
356 PA RT I V Central Banking and the Conduct of Monetary Policy
Web Exercises
1. Go to www.federalreserve.gov/general.htm and click
on the link to general information. Choose “Structure
of the Federal Reserve.” According to the Federal
Reserve, what is the most important responsibility of
the Board of Governors?
2. Go to the above site and click on “Monetary Policy” to
find the beige book. According to the summary of the
most recently published book, is the economy weakening
or recovering?
8. The Fed is the most independent of all U.S. government
agencies. What is the main difference between it
and other government agencies that explains its
greater independence?
*9. What is the primary tool that Congress uses to exercise
some control over the Fed?
10. In the 1960s and 1970s, the Federal Reserve System
lost member banks at a rapid rate. How can the theory
of bureaucratic behavior explain the Fed’s campaign
for legislation to require all commercial banks
to become members? Was the Fed successful in this
campaign?
*11. “The theory of bureaucratic behavior indicates that the
Fed never operates in the public interest.” Is this statement
true, false, or uncertain? Explain your answer.
12. Why might eliminating the Fed’s independence lead
to a more pronounced political business cycle?
*13. “The independence of the Fed leaves it completely
unaccountable for its actions.” Is this statement true,
false, or uncertain? Explain your answer.
14. “The independence of the Fed has meant that it takes
the long view and not the short view.” Is this statement
true, false, or uncertain? Explain your answer.
*15. The Fed promotes secrecy by not releasing the minutes
of the FOMC meetings to Congress or the public
immediately. Discuss the pros and cons of this policy.
PREVIEW As we saw in Chapter 5 and will see in later chapters on monetary theory, movements
in the money supply affect interest rates and the overall health of the economy and
thus affect us all. Because of its far-reaching effects on economic activity, it is important
to understand how the money supply is determined. Who controls it? What
causes it to change? How might control of it be improved? In this and subsequent
chapters, we answer these questions by providing a detailed description of the money
supply process, the mechanism that determines the level of the money supply.
Because deposits at banks are by far the largest component of the money supply,
understanding how these deposits are created is the first step in understanding the
money supply process. This chapter provides an overview of how the banking system
creates deposits, and describes the basic principles of the money supply, needed to
understand later chapters.
Four Players in the Money Supply Process
The “cast of characters” in the money supply story is as follows:
1. The central bank—the government agency that oversees the banking system and
is responsible for the conduct of monetary policy; in the United States, it is called
the Federal Reserve System
2. Banks (depository institutions)—the financial intermediaries that accept deposits
from individuals and institutions and make loans: commercial banks, savings and
loan associations, mutual savings banks, and credit unions
3. Depositors—individuals and institutions that hold deposits in banks
4. Borrowers from banks—individuals and institutions that borrow from the depository
institutions and institutions that issue bonds that are purchased by the
depository institutions
Of the four players, the central bank—the Federal Reserve System—is the most
important. The Fed’s conduct of monetary policy involves actions that affect its balance
sheet (holdings of assets and liabilities), to which we turn now.
357
Chap ter
Multiple Deposit Creation and the
Money Supply Process
15
The Fed’s Balance Sheet
The operation of the Fed and its monetary policy involve actions that affect its balance
sheet, its holdings of assets and liabilities. Here we discuss a simplified balance
sheet that includes just four items that are essential to our understanding of the
money supply process.1
The two liabilities on the balance sheet, currency in circulation and reserves, are often
referred to as the monetary liabilities of the Fed. They are an important part of the
money supply story, because increases in either or both will lead to an increase in the
money supply (everything else being constant). The sum of the Fed’s monetary liabilities
(currency in circulation and reserves) and the U.S. Treasury’s monetary liabilities
(Treasury currency in circulation, primarily coins) is called the monetary base. When
discussing the monetary base, we will focus only on the monetary liabilities of the Fed
because the monetary liabilities of the Treasury account for less then 10% of the base.2
1. Currency in circulation. The Fed issues currency (those green-and-gray pieces
of paper in your wallet that say “Federal Reserve Note” at the top). Currency in circulation
is the amount of currency in the hands of the public. (Currency held by depository
institutions is also a liability of the Fed, but is counted as part of the reserves.)
Federal Reserve notes are IOUs from the Fed to the bearer and are also liabilities,
but unlike most, they promise to pay back the bearer solely with Federal Reserve
notes; that is, they pay off IOUs with other IOUs. Accordingly, if you bring a $100 bill
to the Federal Reserve and demand payment, you will receive two $50s, five $20s, ten
$10s, or one hundred $1 bills.
People are more willing to accept IOUs from the Fed than from you or me
because Federal Reserve notes are a recognized medium of exchange; that is, they are
accepted as a means of payment and so function as money. Unfortunately, neither you
nor I can convince people that our IOUs are worth anything more than the paper they
are written on.3
Liabilities
358 PA RT I V Central Banking and the Conduct of Monetary Policy
FEDERAL RESERVE SYSTEM
Assets Liabilities
Government securities Currency in circulation
Discount loans Reserves
1A detailed discussion of the Fed’s balance sheet and the factors that affect the monetary base can be found in the
appendix to this chapter, which you can find on this book’s web site at www.aw.com/mishkin.
2It is also safe to ignore the Treasury’s monetary liabilities when discussing the monetary base because the
Treasury cannot actively supply its monetary liabilities to the economy due to legal restrictions.
3The currency item on our balance sheet refers only to currency in circulation; that is, the amount in the hands of
the public. Currency that has been printed by the U.S. Bureau of Engraving and Printing is not automatically a liability
of the Fed. For example, consider the importance of having $1 million of your own IOUs printed up. You
give out $100 worth to other people and keep the other $999,900 in your pocket. The $999,900 of IOUs does
not make you richer or poorer and does not affect your indebtedness. You care only about the $100 of liabilities
from the $100 of circulated IOUs. The same reasoning applies for the Fed in regard to its Federal Reserve notes.
For similar reasons, the currency component of the money supply, no matter how it is defined, includes only
currency in circulation. It does not include any additional currency that is not yet in the hands of the public. The
fact that currency has been printed but is not circulating means that it is not anyone’s asset or liability and thus
cannot affect anyone’s behavior. Therefore, it makes sense not to include it in the money supply.
www.rich.frb.org/research
/econed/museum/
A virtual tour of the Federal
Reserve’s money museum.
www.federalreserve.gov
/boarddocs/rptcongress
/annual01/default.htm
See the most recent Federal
Reserve financial statement.
2. Reserves. All banks have an account at the Fed in which they hold deposits.
Reserves consist of deposits at the Fed plus currency that is physically held by banks
(called vault cash because it is stored in bank vaults). Reserves are assets for the banks
but liabilities for the Fed, because the banks can demand payment on them at any
time and the Fed is required to satisfy its obligation by paying Federal Reserve notes.
As you will see, an increase in reserves leads to an increase in the level of deposits and
hence in the money supply.
Total reserves can be divided into two categories: reserves that the Fed requires
banks to hold (required reserves) and any additional reserves the banks choose to
hold (excess reserves). For example, the Fed might require that for every dollar of
deposits at a depository institution, a certain fraction (say, 10 cents) must be held as
reserves. This fraction (10%) is called the required reserve ratio. Currently, the Fed
pays no interest on reserves.
The two assets on the Fed’s balance sheet are important for two reasons. First, changes
in the asset items lead to changes in reserves and consequently to changes in the
money supply. Second, because these assets (government securities and discount
loans) earn interest while the liabilities (currency in circulation and reserves) do not,
the Fed makes billions of dollars every year—its assets earn income, and its liabilities
cost nothing. Although it returns most of its earnings to the federal government, the
Fed does spend some of it on “worthy causes,” such as supporting economic research.
1. Government securities. This category of assets covers the Fed’s holdings of
securities issued by the U.S. Treasury. As you will see, the Fed provides reserves to the
banking system by purchasing securities, thereby increasing its holdings of these
assets. An increase in government securities held by the Fed leads to an increase in
the money supply.
2. Discount loans. The Fed can provide reserves to the banking system by making
discount loans to banks. An increase in discount loans can also be the source of
an increase in the money supply. The interest rate charged banks for these loans is
called the discount rate.
Control of the Monetary Base
The monetary base (also called high-powered money) equals currency in circulation
C plus the total reserves in banking system R.4 The monetary base MB can be
expressed as
MB C R
The Federal Reserve exercises control over the monetary base through its purchases
or sale of government securities in the open market, called open market operations,
and through its extension of discount loans to banks.
The primary way in which the Fed causes changes in the monetary base is through its
open market operations. A purchase of bonds by the Fed is called an open market
purchase, and a sale of bonds by the Fed is called an open market sale.
Federal Reserve
Open Market
Operations
Assets
C H A P T E R 1 5 Multiple Deposit Creation and the Money Supply Process 359
4Here currency in circulation includes both Federal Reserve currency (Federal Reserve notes) and Treasury currency
(primarily coins).
Open Market Purchase from a Bank. Suppose that the Fed purchases $100 of bonds
from a bank and pays for them with a $100 check. The bank will either deposit the
check in its account with the Fed or cash it in for currency, which will be counted as
vault cash. To understand what occurs as a result of this transaction, we look at
T-accounts, which list only the changes that occur in balance sheet items starting from
the initial balance sheet position. Either action means that the bank will find itself
with $100 more reserves and a reduction in its holdings of securities of $100. The
T-account for the banking system, then, is:
The Fed meanwhile finds that its liabilities have increased by the additional $100 of
reserves, while its assets have increased by the $100 of additional securities that it
now holds. Its T-account is:
The net result of this open market purchase is that reserves have increased by $100,
the amount of the open market purchase. Because there has been no change of currency
in circulation, the monetary base has also risen by $100.
Open Market Purchase from the Nonbank Public. To understand what happens when
there is an open market purchase from the nonbank public, we must look at two
cases. First, let’s assume that the person or corporation that sells the $100 of bonds to
the Fed deposits the Fed’s check in the local bank. The nonbank public’s T-account
after this transaction is:
When the bank receives the check, it credits the depositor’s account with the $100
and then deposits the check in its account with the Fed, thereby adding to its reserves.
The banking system’s T-account becomes:
360 PA RT I V Central Banking and the Conduct of Monetary Policy
BANKING SYSTEM
Assets Liabilities
Securities $100
Reserves $100
FEDERAL RESERVE SYSTEM
Assets Liabilities
Securities $100 Reserves $100
NONBANK PUBLIC
Assets Liabilities
Securities $100
Checkable deposits $100
The effect on the Fed’s balance sheet is that it has gained $100 of securities in its
assets column, while it has an increase of $100 of reserves in its liabilities column:
As you can see in the above T-account, when the Fed’s check is deposited in a
bank, the net result of the Fed’s open market purchase from the nonbank public is
identical to the effect of its open market purchase from a bank: Reserves increase by
the amount of the open market purchase, and the monetary base increases by the
same amount.
If, however, the person or corporation selling the bonds to the Fed cashes the
Fed’s check either at a local bank or at a Federal Reserve bank for currency, the effect
on reserves is different.5 This seller will receive currency of $100 while reducing holdings
of securities by $100. The bond seller’s T-account will be:
The Fed now finds that it has exchanged $100 of currency for $100 of securities, so
its T-account is:
C H A P T E R 1 5 Multiple Deposit Creation and the Money Supply Process 361
BANKING SYSTEM
Assets Liabilities
Reserves $100 Checkable deposits $100
FEDERAL RESERVE SYSTEM
Assets Liabilities
Securities $100 Reserves $100
NONBANK PUBLIC
Assets Liabilities
Securities $100
Currency $100
5If the bond seller cashes the check at the local bank, its balance sheet will be unaffected, because the $100 of
vault cash that it pays out will be exactly matched by the deposit of the $100 check at the Fed. Thus its reserves
will remain the same, and there will be no effect on its T-account. That is why a T-account for the banking system
does not appear here.
FEDERAL RESERVE SYSTEM
Assets Liabilities
Securities $100 Currency in circulation $100
The net effect of the open market purchase in this case is that reserves are unchanged,
while currency in circulation increases by the $100 of the open market purchase.
Thus the monetary base increases by the $100 amount of the open market purchase,
while reserves do not. This contrasts with the case in which the seller of the bonds
deposits the Fed’s check in a bank; in that case, reserves increase by $100, and so does
the monetary base.
The analysis reveals that the effect of an open market purchase on reserves
depends on whether the seller of the bonds keeps the proceeds from the sale in currency
or in deposits. If the proceeds are kept in currency, the open market purchase
has no effect on reserves; if the proceeds are kept as deposits, reserves increase by the
amount of the open market purchase.
The effect of an open market purchase on the monetary base, however, is always
the same (the monetary base increases by the amount of the purchase) whether the
seller of the bonds keeps the proceeds in deposits or in currency. The impact of an
open market purchase on reserves is much more uncertain than its impact on the
monetary base.
Open Market Sale. If the Fed sells $100 of bonds to a bank or the nonbank public,
the monetary base will decline by $100. For example, if the Fed sells the bonds to an
individual who pays for them with currency, the buyer exchanges $100 of currency
for $100 of bonds, and the resulting T-account is:
The Fed, for its part, has reduced its holdings of securities by $100 and has also lowered
its monetary liability by accepting the currency as payment for its bonds, thereby
reducing the amount of currency in circulation by $100:
The effect of the open market sale of $100 of bonds is to reduce the monetary base
by an equal amount, although reserves remain unchanged. Manipulations of Taccounts
in cases in which the buyer of the bonds is a bank or the buyer pays for the
bonds with a check written on a checkable deposit account at a local bank lead to the
same $100 reduction in the monetary base, although the reduction occurs because
the level of reserves has fallen by $100.
362 PA RT I V Central Banking and the Conduct of Monetary Policy
NONBANK PUBLIC
Assets Liabilities
Securities $100
Currency $100
FEDERAL RESERVE SYSTEM
Assets Liabilities
Securities $100 Currency in circulation $100
Study Guide The best way to learn how open market operations affect the monetary base is to use
T-accounts. Using T-accounts, try to verify that an open market sale of $100 of bonds
to a bank or to a person who pays with a check written on a bank account leads to a
$100 reduction in the monetary base.
The following conclusion can now be drawn from our analysis of open market purchases
and sales: The effect of open market operations on the monetary base is much
more certain than the effect on reserves. Therefore, the Fed can control the monetary
base with open market operations more effectively than it can control reserves.
Open market operations can also be done in other assets besides government
bonds and have the same effects on the monetary base we have described here. One
example of this is a foreign exchange intervention by the Fed (see Box 1).
Even if the Fed does not conduct open market operations, a shift from deposits to currency
will affect the reserves in the banking system. However, such a shift will have
no effect on the monetary base, another reason why the Fed has more control over
the monetary base than over reserves.
Let’s suppose that Jane Brown (who opened a $100 checking account at the First
National Bank in Chapter 9) decides that tellers are so abusive in all banks that she
closes her account by withdrawing the $100 balance in cash and vows never to deposit
it in a bank again. The effect on the T-account of the nonbank public is:
Shifts from
Deposits into
Currency
C H A P T E R 1 5 Multiple Deposit Creation and the Money Supply Process 363
NONBANK PUBLIC
Assets Liabilities
Checkable deposits $100
Currency $100
Box 1: Global
Foreign Exchange Rate Intervention and the Monetary Base
It is common to read in the newspaper about a Federal
Reserve intervention to buy or sell dollars in the foreign
exchange market. (Note that this intervention occurs at
the request of the U.S. Treasury.) Can this intervention
also be a factor that affects the monetary base? The
answer is yes, because a Federal Reserve intervention in
the foreign exchange market involves a purchase or sale
of assets denominated in a foreign currency.
Suppose that the Fed purchases $100 of deposits
denominated in euros in exchange for $100 of deposits
at the Fed (a sale of dollars for euros). A Federal
Reserve purchase of any asset, whether it is a U.S. government
bond or a deposit denominated in a foreign
currency, is still just an open market purchase and so
leads to an equal rise in the monetary base. Similarly, a
sale of foreign currency deposits is just an open market
sale and leads to a decline in the monetary base.
Federal Reserve interventions in the foreign exchange
market are thus an important influence on the monetary
base, a topic that we discuss further in Chapter 20.
The banking system loses $100 of deposits and hence $100 of reserves:
For the Fed, Jane Brown’s action means that there is $100 of additional currency
circulating in the hands of the public, while reserves in the banking system have fallen
by $100. The Fed’s T-account is:
The net effect on the monetary liabilities of the Fed is a wash; the monetary base is
unaffected by Jane Brown’s disgust at the banking system. But reserves are affected.
Random fluctuations of reserves can occur as a result of random shifts into currency
and out of deposits, and vice versa. The same is not true for the monetary base, making
it a more stable variable.
In this chapter so far we have seen changes in the monetary base solely as a result of
open market operations. However, the monetary base is also affected when the Fed
makes a discount loan to a bank. When the Fed makes a $100 discount loan to the
First National Bank, the bank is credited with $100 of reserves from the proceeds of
the loan. The effects on the balance sheets of the banking system and the Fed are illustrated
by the following T-accounts:
The monetary liabilities of the Fed have now increased by $100, and the monetary
base, too, has increased by this amount. However, if a bank pays off a loan from
the Fed, thereby reducing its borrowings from the Fed by $100, the T-accounts of the
banking system and the Fed are as follows:
Discount Loans
364 PA RT I V Central Banking and the Conduct of Monetary Policy
BANKING SYSTEM FEDERAL RESERVE SYSTEM
Assets Liabilities Assets Liabilities
Reserves $100 Discount $100 Discount $100 Reserves $100
loans loans
BANKING SYSTEM
Assets Liabilities
Reserves $100 Checkable deposits $100
FEDERAL RESERVE SYSTEM
Assets Liabilities
Currency in circulation $100
Reserves $100
The net effect on the monetary liabilities of the Fed, and hence on the monetary
base, is then a reduction of $100. We see that the monetary base changes one-for-one
with the change in the borrowings from the Fed.
So far in this chapter, it seems as though the Fed has complete control of the monetary
base through its open market operations and discount loans. However, the world
is a little bit more complicated for the Fed. Two important items that are not controlled
by the Fed but affect the monetary base are float and Treasury deposits at the
Fed. When the Fed clears checks for banks, it often credits the amount of the check
to a bank that has deposited it (increases the bank’s reserves) but only later debits
(decreases the reserves of) the bank on which the check is drawn. The resulting temporary
net increase in the total amount of reserves in the banking system (and hence
in the monetary base) occurring from the Fed’s check-clearing process is called float.
When the U.S. Treasury moves deposits from commercial banks to its account at the
Fed, leading to a rise in Treasury deposits at the Fed, it causes a deposit outflow at these
banks like that shown in Chapter 9 and thus causes reserves in the banking system
and the monetary base to fall. Thus float (affected by random events such as the
weather, which affects how quickly checks are presented for payment) and Treasury
deposits at the Fed (determined by the U.S. Treasury’s actions) both affect the monetary
base but are not fully controlled by the Fed. Decisions by the U.S. Treasury to have
the Fed intervene in the foreign exchange market also affect the monetary base, as can
be seen in Box 1.
The factor that most affects the monetary base is the Fed’s holdings of securities,
which are completely controlled by the Fed through its open market operations.
Factors not controlled by the Fed (for example, float and Treasury deposits with the
Fed) undergo substantial short-run variations and can be important sources of fluctuations
in the monetary base over time periods as short as a week. However, these
fluctuations are usually quite predictable and so can be offset through open market
operations. Although float and Treasury deposits with the Fed undergo substantial
short-run fluctuations, which complicate control of the monetary base, they do not
prevent the Fed from accurately controlling it.
Multiple Deposit Creation: A Simple Model
With our understanding of how the Federal Reserve controls the monetary base and
how banks operate (Chapter 9), we now have the tools necessary to explain how
deposits are created. When the Fed supplies the banking system with $1 of additional
Overview of the
Fed’s Ability to
Control the
Monetary Base
Other Factors
That Affect the
Monetary Base
C H A P T E R 1 5 Multiple Deposit Creation and the Money Supply Process 365
BANKING SYSTEM FEDERAL RESERVE SYSTEM
Assets Liabilities Assets Liabilities
Reserves $100 Discount $100 Discount $100 Reserves $100
loans loans
reserves, deposits increase by a multiple of this amount—a process called multiple
deposit creation.
Suppose that the $100 open market purchase described earlier was conducted with
the First National Bank. After the Fed has bought the $100 bond from the First
National Bank, the bank finds that it has an increase in reserves of $100. To analyze
what the bank will do with these additional reserves, assume that the bank does not
want to hold excess reserves because it earns no interest on them. We begin the analysis
with the following T-account:
Because the bank has no increase in its checkable deposits, required reserves
remain the same, and the bank finds that its additional $100 of reserves means that
its excess reserves have increased by $100. Let’s say that the bank decides to make a
loan equal in amount to the $100 increase in excess reserves. When the bank makes
the loan, it sets up a checking account for the borrower and puts the proceeds of the
loan into this account. In this way, the bank alters its balance sheet by increasing its
liabilities with $100 of checkable deposits and at the same time increasing its assets
with the $100 loan. The resulting T-account looks like this:
The bank has created checkable deposits by its act of lending. Because checkable
deposits are part of the money supply, the bank’s act of lending has in fact created money.
In its current balance sheet position, the First National Bank still has excess
reserves and so might want to make additional loans. However, these reserves will not
stay at the bank for very long. The borrower took out a loan not to leave $100 idle at
the First National Bank but to purchase goods and services from other individuals and
corporations. When the borrower makes these purchases by writing checks, they will
be deposited at other banks, and the $100 of reserves will leave the First National
Bank. A bank cannot safely make loans for an amount greater than the excess
reserves it has before it makes the loan.
Deposit Creation:
The Single Bank
366 PA RT I V Central Banking and the Conduct of Monetary Policy
FIRST NATIONAL BANK
Assets Liabilities
Securities $100
Reserves $100
FIRST NATIONAL BANK
Assets Liabilities
Securities $100 Checkable deposits $100
Reserves $100
Loans $100
The final T-account of the First National Bank is:
The increase in reserves of $100 has been converted into additional loans of $100 at
the First National Bank, plus an additional $100 of deposits that have made their way
to other banks. (All the checks written on accounts at the First National Bank are
deposited in banks rather than converted into cash, because we are assuming that the
public does not want to hold any additional currency.) Now let’s see what happens to
these deposits at the other banks.
To simplify the analysis, let us assume that the $100 of deposits created by First
National Bank’s loan is deposited at Bank A and that this bank and all other banks
hold no excess reserves. Bank A’s T-account becomes:
If the required reserve ratio is 10%, this bank will now find itself with a $10 increase
in required reserves, leaving it $90 of excess reserves. Because Bank A (like the First
National Bank) does not want to hold on to excess reserves, it will make loans for the
entire amount. Its loans and checkable deposits will then increase by $90, but when
the borrower spends the $90 of checkable deposits, they and the reserves at Bank A
will fall back down by this same amount. The net result is that Bank A’s T-account will
look like this:
Deposit Creation:
The Banking
System
C H A P T E R 1 5 Multiple Deposit Creation and the Money Supply Process 367
FIRST NATIONAL BANK
Assets Liabilities
Securities $100
Loans $100
BANK A
Assets Liabilities
Reserves $100 Checkable deposits $100
BANK A
Assets Liabilities
Reserves $10 Checkable deposits $100
Loans $90
If the money spent by the borrower to whom Bank A lent the $90 is deposited in
another bank, such as Bank B, the T-account for Bank B will be:
The checkable deposits in the banking system have increased by another $90, for
a total increase of $190 ($100 at Bank A plus $90 at Bank B). In fact, the distinction
between Bank A and Bank B is not necessary to obtain the same result on the overall
expansion of deposits. If the borrower from Bank A writes checks to someone who
deposits them at Bank A, the same change in deposits would occur. The T-accounts
for Bank B would just apply to Bank A, and its checkable deposits would increase by
the total amount of $190.
Bank B will want to modify its balance sheet further. It must keep 10% of $90
($9) as required reserves and has 90% of $90 ($81) in excess reserves and so can
make loans of this amount. Bank B will make an $81 loan to a borrower, who spends
the proceeds from the loan. Bank B’s T-account will be:
The $81 spent by the borrower from Bank B will be deposited in another bank (Bank
C). Consequently, from the initial $100 increase of reserves in the banking system, the
total increase of checkable deposits in the system so far is $271 ( $100 $90
$81).
Following the same reasoning, if all banks make loans for the full amount of their
excess reserves, further increments in checkable deposits will continue (at Banks C,
D, E, and so on), as depicted in Table 1. Therefore, the total increase in deposits from
the initial $100 increase in reserves will be $1,000: The increase is tenfold, the reciprocal
of the 0.10 reserve requirement.
If the banks choose to invest their excess reserves in securities, the result is the
same. If Bank A had taken its excess reserves and purchased securities instead of making
loans, its T-account would have looked like this:
368 PA RT I V Central Banking and the Conduct of Monetary Policy
BANK B
Assets Liabilities
Reserves $90 Checkable deposits $90
BANK B
Assets Liabilities
Reserves $ 9 Checkable deposits $90
Loans $81
BANK A
Assets Liabilities
Reserves $10 Checkable deposits $100
Securities $90
When the bank buys $90 of securities, it writes a $90 check to the seller of the
securities, who in turn deposits the $90 at a bank such as Bank B. Bank B’s checkable
deposits rise by $90, and the deposit expansion process is the same as before.
Whether a bank chooses to use its excess reserves to make loans or to purchase
securities, the effect on deposit expansion is the same.
You can now see the difference in deposit creation for the single bank versus the
banking system as a whole. Because a single bank can create deposits equal only to the
amount of its excess reserves, it cannot by itself generate multiple deposit expansion. A
single bank cannot make loans greater in amount than its excess reserves, because the
bank will lose these reserves as the deposits created by the loan find their way to other
banks. However, the banking system as a whole can generate a multiple expansion of
deposits, because when a bank loses its excess reserves, these reserves do not leave the
banking system even though they are lost to the individual bank. So as each bank makes
a loan and creates deposits, the reserves find their way to another bank, which uses them
to make additional loans and create additional deposits. As you have seen, this process
continues until the initial increase in reserves results in a multiple increase in deposits.
The multiple increase in deposits generated from an increase in the banking system’s
reserves is called the simple deposit multiplier.6 In our example with a 10%
required reserve ratio, the simple deposit multiplier is 10. More generally, the simple
deposit multiplier equals the reciprocal of the required reserve ratio, expressed as a
fraction (10 1/0.10), so the formula for the multiple expansion of deposits can be
written as:
D (1)
1
r
R
C H A P T E R 1 5 Multiple Deposit Creation and the Money Supply Process 369
Increase in Increase in Increase in
Bank Deposits ($) Loans ($) Reserves ($)
First National 0.00 100.00 0.00
A 100.00 90.00 10.00
B 90.00 81.00 9.00
C 81.00 72.90 8.10
D 72.90 65.61 7.29
E 65.61 59.05 6.56
F 59.05 53.14 5.91
. . . .
. . . .
. . . .
Total for all banks 1,000.00 1,000.00 100.00
Table 1 Creation of Deposits (assuming 10% reserve requirement and a
$100 increase in reserves)
6This multiplier should not be confused with the Keynesian multiplier, which is derived through a similar stepby-
step analysis. That multiplier relates an increase in income to an increase in investment, whereas the simple
deposit multiplier relates an increase in deposits to an increase in reserves.
where D change in total checkable deposits in the banking system
r required reserve ratio (0.10 in the example)
R change in reserves for the banking system ($100 in the example)7
The formula for the multiple creation of deposits can also be derived directly using
algebra. We obtain the same answer for the relationship between a change in deposits
and a change in reserves, but more quickly.
Our assumption that banks do not hold on to any excess reserves means that the
total amount of required reserves for the banking system RR will equal the total
reserves in the banking system R:
RR R
The total amount of required reserves equals the required reserve ratio r times the
total amount of checkable deposits D:
RR r D
Substituting r D for RR in the first equation:
r D R
and dividing both sides of the preceding equation by r gives us:
Taking the change in both sides of this equation and using delta to indicate a change:
which is the same formula for deposit creation found in Equation 1.
This derivation provides us with another way of looking at the multiple creation
of deposits, because it forces us to look directly at the banking system as a whole rather
than one bank at a time. For the banking system as a whole, deposit creation (or contraction)
will stop only when all excess reserves in the banking system are gone; that
is, the banking system will be in equilibrium when the total amount of required
reserves equals the total amount of reserves, as seen in the equation RR R. When
r D is substituted for RR, the resulting equation R r D tells us how high checkable
deposits will have to be in order for required reserves to equal total reserves.
Accordingly, a given level of reserves in the banking system determines the level of
checkable deposits when the banking system is in equilibrium (when ER 0); put
another way, the given level of reserves supports a given level of checkable deposits.
D
1
r
R
D
1
r
R
Deriving the
Formula for
Multiple Deposit
Creation
370 PA RT I V Central Banking and the Conduct of Monetary Policy
7A formal derivation of this formula follows. Using the reasoning in the text, the change in checkable deposits
is $100 ( R 1) plus $90 [ R (1 r)] plus $81 [ R (1 r)2 and so on, which can be rewritten
as:
D R [1 (1 r) (1 r)2 (1 r)3 . . .]
Using the formula for the sum of an infinite series found in footnote 5 in Chapter 4, this can be rewritten as:
D R
1
1 (1 r )

1
r
R
In our example, the required reserve ratio is 10%. If reserves increase by $100,
checkable deposits must rise to $1,000 in order for total required reserves also to
increase by $100. If the increase in checkable deposits is less than this, say $900, then
the increase in required reserves of $90 remains below the $100 increase in reserves,
so there are still excess reserves somewhere in the banking system. The banks with
the excess reserves will now make additional loans, creating new deposits, and this
process will continue until all reserves in the system are used up. This occurs when
checkable deposits have risen to $1,000.
We can also see this by looking at the T-account of the banking system as a whole
(including the First National Bank) that results from this process:
The procedure of eliminating excess reserves by loaning them out means that the
banking system (First National Bank and Banks A, B, C, D, and so on) continues to
make loans up to the $1,000 amount until deposits have reached the $1,000 level. In
this way, $100 of reserves supports $1,000 (ten times the quantity) of deposits.
Our model of multiple deposit creation seems to indicate that the Federal Reserve is
able to exercise complete control over the level of checkable deposits by setting the
required reserve ratio and the level of reserves. The actual creation of deposits is much
less mechanical than the simple model indicates. If proceeds from Bank A’s $90 loan
are not deposited but are kept in cash, nothing is deposited in Bank B, and the deposit
creation process stops dead in its tracks. The total increase in checkable deposits is
only $100—considerably less than the $1,000 we calculated. So if some proceeds
from loans are used to raise the holdings of currency, checkable deposits will not
increase by as much as our streamlined model of multiple deposit creation tells us.
Another situation ignored in our model is one in which banks do not make loans
or buy securities in the full amount of their excess reserves. If Bank A decides to hold
on to all $90 of its excess reserves, no deposits would be made in Bank B, and this
would also stop the deposit creation process. The total increase in deposits would
again be only $100 and not the $1,000 increase in our example. Hence if banks
choose to hold all or some of their excess reserves, the full expansion of deposits predicted
by the simple model of multiple deposit creation does not occur.
Our examples rightly indicate that the Fed is not the only player whose behavior
influences the level of deposits and therefore the money supply. Banks’ decisions
regarding the amount of excess reserves they wish to hold, depositors’ decisions
regarding how much currency to hold, and borrowers’ decisions on how much to borrow
from banks can cause the money supply to change. In the next chapter, we stress
the behavior and interactions of the four players in constructing a more realistic
model of the money supply process.
Critique of the
Simple Model
C H A P T E R 1 5 Multiple Deposit Creation and the Money Supply Process 371
BANKING SYSTEM
Assets Liabilities
Securities $ 100 Checkable deposits $1,000
Reserves $ 100
Loans $1,000
372 PA RT I V Central Banking and the Conduct of Monetary Policy
Summary
1. There are four players in the money supply process: the
central bank, banks (depository institutions), depositors,
and borrowers from banks.
2. Four items in the Fed’s balance sheet are essential to our
understanding of the money supply process: the two
liability items, currency in circulation and reserves,
which together make up the monetary base, and the two
asset items, government securities and discount loans.
3. The Federal Reserve controls the monetary base
through open market operations and extension of
discount loans to banks and has better control over the
monetary base than over reserves. Although float and
Treasury deposits with the Fed undergo substantial
short-run fluctuations, which complicate control of the
monetary base, they do not prevent the Fed from
accurately controlling it.
4. A single bank can make loans up to the amount of its
excess reserves, thereby creating an equal amount of
deposits. The banking system can create a multiple
expansion of deposits, because as each bank makes a
loan and creates deposits, the reserves find their way to
another bank, which uses them to make loans and
create additional deposits. In the simple model of
multiple deposit creation in which banks do not hold
on to excess reserves and the public holds no currency,
the multiple increase in checkable deposits (simple
deposit multiplier) equals the reciprocal of the required
reserve ratio.
5. The simple model of multiple deposit creation has
serious deficiencies. Decisions by depositors to increase
their holdings of currency or of banks to hold excess
reserves will result in a smaller expansion of deposits
than the simple model predicts. All four players—the
Fed, banks, depositors, and borrowers from banks—are
important in the determination of the money supply.
Key Terms
discount rate, p. 359
excess reserves, p. 359
float, p. 365
high-powered money, p. 359
monetary base, p. 358
multiple deposit creation, p. 366
open market operations, p. 359
open market purchase, p. 359
open market sale, p. 359
required reserve ratio, p. 359
required reserves, p. 359
reserves, p. 359
simple deposit multiplier, p. 369
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. If the Fed sells $2 million of bonds to the First
National Bank, what happens to reserves and the monetary
base? Use T-accounts to explain your answer.
*2. If the Fed sells $2 million of bonds to Irving the
Investor, who pays for the bonds with a briefcase filled
with currency, what happens to reserves and the monetary
base? Use T-accounts to explain your answer.
*3. If the Fed lends five banks an additional total of $100
million but depositors withdraw $50 million and hold
it as currency, what happens to reserves and the monetary
base? Use T-accounts to explain your answer.
4. The First National Bank receives an extra $100 of
reserves but decides not to lend any of these reserves
QUIZ
C H A P T E R 1 5 Multiple Deposit Creation and the Money Supply Process 373
out. How much deposit creation takes place for the
entire banking system?
Unless otherwise noted, the following assumptions are made in all
the remaining problems: The required reserve ratio on checkable
deposits is 10%, banks do not hold any excess reserves, and the
public’s holdings of currency do not change.
*5. Using T-accounts, show what happens to checkable
deposits in the banking system when the Fed lends an
additional $1 million to the First National Bank.
6. Using T-accounts, show what happens to checkable
deposits in the banking system when the Fed sells $2
million of bonds to the First National Bank.
*7. Suppose that the Fed buys $1 million of bonds from
the First National Bank. If the First National Bank and
all other banks use the resulting increase in reserves to
purchase securities only and not to make loans, what
will happen to checkable deposits?
8. If the Fed buys $1 million of bonds from the First
National Bank, but an additional 10% of any deposit is
held as excess reserves, what is the total increase in
checkable deposits? (Hint: Use T-accounts to show what
happens at each step of the multiple expansion process.)
*9. If a bank depositor withdraws $1,000 of currency
from an account, what happens to reserves and checkable
deposits?
10. If reserves in the banking system increase by $1 billion
as a result of discount loans of $1 billion and
checkable deposits increase by $9 billion, why isn’t
the banking system in equilibrium? What will continue
to happen in the banking system until equilibrium
is reached? Show the T-account for the banking
system in equilibrium.
*11. If the Fed reduces reserves by selling $5 million worth
of bonds to the banks, what will the T-account of the
banking system look like when the banking system is
in equilibrium? What will have happened to the level
of checkable deposits?
12. If the required reserve ratio on checkable deposits
increases to 20%, how much multiple deposit creation
will take place when reserves are increased by $100?
*13. If a bank decides that it wants to hold $1 million of
excess reserves, what effect will this have on checkable
deposits in the banking system?
14. If a bank sells $10 million of bonds back to the Fed in
order to pay back $10 million on the discount loan it
owes, what will be the effect on the level of checkable
deposits?
*15. If you decide to hold $100 less cash than usual and
therefore deposit $100 in cash in the bank, what effect
will this have on checkable deposits in the banking
system if the rest of the public keeps its holdings of
currency constant?
Web Exercises
1. Go to www.federalreserve.gov/boarddocs/rptcongress/
and find the most recent annual report of the Federal
Reserve. Read the first section of the annual report
that summarizes Monetary Policy and the Economic
Outlook. Write a one-page summary of this section of
the report.
2. Go to www.federalreserve.gov/releases/h6/hist/ and
find the historical report of M1, M2, and M3.
Compute the growth rate in each aggregate over each
of the last 3 years (it will be easier to do if you move
the data into Excel as demonstrated in Chapter 1).
Does it appear that the Fed has been increasing or
decreasing the rate of growth of the money supply? Is
this consistent with what you understand the economy
needs? Why?
Just as any other bank has a balance sheet that lists its assets and liabilities, so does
the Fed. We examine each of its categories of assets and liabilities because changes in
them are an important way the Fed manipulates the money supply.
1. Securities. These are the Fed’s holdings of securities, which consist primarily
of Treasury securities but in the past have also included banker’s acceptances. The
total amount of securities is controlled by open market operations (the Fed’s purchase
and sale of these securities). As shown in Table 1, “Securities” is by far the largest category
of assets in the Fed’s balance sheet.
2. Discount loans. These are loans the Fed makes to banks. The amount is
affected by the Fed’s setting the discount rate, the interest rate that the Fed charges
banks for these loans.
These first two Fed assets are important because they earn interest. Because the
liabilities of the Fed do not pay interest, the Fed makes billions of dollars every year—
its assets earn income, and its liabilities cost nothing. Although it returns most of its
earnings to the federal government, the Fed does spend some of it on “worthy
causes,” such as supporting economic research.
Assets
The Fed’s Balance Sheet and
the Monetary Base
appendix
to chapter 15
Assets Liabilities
Securities: U.S. government 668.9 Federal Reserve notes 654.3
and agency securities and outstanding
banker’s acceptances Bank deposits (Reserves) 22.5
Discount loans 10.3 U.S. Treasury deposits 4.4
Gold and SDR certificate accounts 13.2 Foreign and other deposits 0.1
Coin 0.9 Deferred-availability cash items 9.4
Cash items in process of collection 10.2 Other Federal Reserve liabilities
Other Federal Reserve assets 28.5 and capital accounts 41.3
Total 732.0 Total 732.0
Source: Federal Reserve Bulletin.
Table 1 Consolidated Balance Sheet of the Federal Reserve System ($ billions, end of 2002)
1
3. Gold and SDR certificate accounts. Special drawing rights (SDRs) are issued to
governments by the International Monetary Fund (IMF) to settle international debts
and have replaced gold in international financial transactions. When the Treasury
acquires gold or SDRs, it issues certificates to the Fed that are claims on the gold or
SDRs and is in turn credited with deposit balances at the Fed. The gold and SDR
accounts are made up of these certificates issued by the Treasury.
4. Coin. This is the smallest item in the balance sheet, consisting of Treasury currency
(mostly coins) held by the Fed.
5. Cash items in process of collection. These arise from the Fed’s check-clearing
process. When a check is given to the Fed for clearing, the Fed will present it to the
bank on which it is written and will collect funds by deducting the amount of the
check from the bank’s deposits (reserves) with the Fed. Before these funds are collected,
the check is a cash item in process of collection and is a Fed asset.
6. Other Federal Reserve assets. These include deposits and bonds denominated
in foreign currencies as well as physical goods such as computers, office equipment,
and buildings owned by the Federal Reserve.
1. Federal Reserve notes (currency) outstanding. The Fed issues currency (those
green-and-gray pieces of paper in your wallet that say “Federal Reserve note” at the
top). The Federal Reserve notes outstanding are the amount of this currency that is in
the hands of the public. (Currency held by depository institutions is also a liability of
the Fed but is counted as part of the reserves liability.)
Federal Reserve notes are IOUs from the Fed to the bearer and are also liabilities,
but unlike most liabilities, they promise to pay back the bearer solely with Federal
Reserve notes; that is, they pay off IOUs with other IOUs. Accordingly, if you bring a
$100 bill to the Federal Reserve and demand payment, you will receive two $50s, five
$20s, ten $10s, or one hundred $1 bills.
People are more willing to accept IOUs from the Fed than from you or me because
Federal Reserve notes are a recognized medium of exchange; that is, they are accepted as
a means of payment and so function as money. Unfortunately, neither you nor I can convince
people that our IOUs are worth anything more than the paper they are written on.1
2. Reserves. All banks have an account at the Fed in which they hold deposits.
Reserves consist of deposits at the Fed plus currency that is physically held by banks
(called vault cash because it is stored in bank vaults). Reserves are assets for the banks
but liabilities for the Fed, because the banks can demand payment on them at any
time and the Fed is required to satisfy its obligation by paying Federal Reserve notes.
As shown in the chapter, an increase in reserves leads to an increase in the level of
deposits and hence in the money supply.
Liabilities
The Fed’s Balance Sheet and the Monetary Base
1The “Federal Reserve notes outstanding” item on the Fed’s balance sheet refers only to currency in circulation,
the amount in the hands of the public. Currency that has been printed by the U.S. Bureau of Engraving and
Printing is not automatically a liability of the Fed. For example, consider the importance of having $1 million of
your own IOUs printed up. You give out $100 worth to other people and keep the other $999,900 in your
pocket. The $999,900 of IOUs does not make you richer or poorer and does not affect your indebtedness. You
care only about the $100 of liabilities from the $100 of circulated IOUs. The same reasoning applies for the Fed
in regard to its Federal Reserve notes.
For similar reasons, the currency component of the money supply, no matter how it is defined, includes only
currency in circulation. It does not include any additional currency that is not yet in the hands of the public.
The fact that currency has been printed but is not circulating means that it is not anyone’s asset or liability and
thus cannot affect anyone’s behavior. Therefore, it makes sense not to include it in the money supply.
2
Total reserves can be divided into two categories: reserves that the Fed requires
banks to hold (required reserves) and any additional reserves the banks choose to hold
(excess reserves). For example, the Fed might require that for every dollar of deposits
at a depository institution, a certain fraction (say, 10 cents) must be held as reserves.
This fraction (10%) is called the required reserve ratio. Currently, the Fed pays no interest
on reserves.
3. U.S. Treasury deposits. The Treasury keeps deposits at the Fed, against which
it writes all its checks.
4. Foreign and other deposits. These include the deposits with the Fed owned by
foreign governments, foreign central banks, international agencies (such as the World
Bank and the United Nations), and U.S. government agencies (such as the FDIC and
Federal Home Loan banks).
5. Deferred-availability cash items. Like cash items in process of collection, these
also arise from the Fed’s check-clearing process. When a check is submitted for clearing,
the Fed does not immediately credit the bank that submitted the check. Instead,
it promises to credit the bank within a certain prearranged time limit, which never
exceeds two days. These promises are the deferred-availability items and are a liability
of the Fed.
6. Other Federal Reserve liabilities and capital accounts. This item includes all the
remaining Federal Reserve liabilities not included elsewhere on the balance sheet. For
example, stock in the Federal Reserve System purchased by member banks is
included here.
The first two liabilities on the balance sheet, Federal Reserve notes (currency) outstanding
and reserves, are often referred to as the monetary liabilities of the Fed. When
we add to these liabilities the U.S. Treasury’s monetary liabilities (Treasury currency
in circulation, primarily coins), we get a construct called the monetary base. The monetary
base is an important part of the money supply, because increases in it will lead
to a multiple increase in the money supply (everything else being constant). This is
why the monetary base is also called high-powered money. Recognizing that Treasury
currency and Federal Reserve currency can be lumped together into the category currency
in circulation, denoted by C, the monetary base equals the sum of currency in
circulation plus reserves R. The monetary base MB is expressed as2:
MB (Federal Reserve notes Treasury currency coin) reserves
C R
The items on the right-hand side of this equation indicate how the base is used
and are called the uses of the base. Unfortunately, this equation does not tell us the factors
that determine the base (the sources of the base), but the Federal Reserve balance
sheet in Table 1 comes to the rescue, because like all balance sheets, it has the property
that the total assets on the left-hand side must equal the total liabilities on the
right-hand side. Because the “Federal Reserve notes” and “reserves” items in the uses
of the base are Federal Reserve liabilities, the “assets equals liabilities” property of the
Fed balance sheet enables us to solve for these items in terms of the Fed balance sheet
Monetary Base
Appendix to Chapter 15
2In the member bank reserves data that the Fed publishes every week, Treasury currency outstanding is defined
to include Treasury currency that is held at the Treasury (called “Treasury cash holdings”). What we have defined
as “Treasury currency” is actually equal to “Treasury currency outstanding” minus “Treasury cash holdings.”
3
items that are included in the sources of the base: Specifically, Federal Reserve notes
and reserves equal the sum of all the Fed assets minus all the other Fed liabilities:
Federal Reserve notes reserves Securities discount loans gold and SDRs
coin cash items in process of collection other Federal Reserve assets
Treasury deposits foreign and other deposits deferred-availability cash items
other Federal Reserve liabilities and capital
The two balance sheet items related to check clearing can be collected into one
term called float, defined as “Cash items in process of collection” minus “Deferredavailability
cash items.” Substituting all the right-hand-side items in the equation for
“Federal Reserve notes reserves” in the uses-of-the-base equation, we obtain the following
expression describing the sources of the monetary base:
MB Securities discount loans gold and SDRs float other
Federal Reserve assets Treasury currency Treasury deposits (1)
foreign and other deposits other Federal Reserve liabilities and capital
Accounting logic has led us to a useful equation that clearly identifies the nine
factors affecting the monetary base listed in Table 2. As Equation 1 and Table 2 depict,
increases in the first six factors increase the monetary base, and increases in the last
three reduce the monetary base.
The Fed’s Balance Sheet and The Monetary Base
S U M M A R Y Table 2 Factors Affecting the Monetary Base
Value
($ billions, Change Change in
Factor end of 2002) in Factor Monetary Base
Factors That Increase the Monetary Base
1. Securities: U.S. government and agency 668.9 ↑ ↑
securities and banker’s acceptances
2. Discount loans 10.3 ↑ ↑
3. Gold and SDR certificate accounts 13.2 ↑ ↑
4. Float 10.2 ↑ ↑
5. Other Federal Reserve assets 28.5 ↑ ↑
6. Treasury currency 25.5 ↑ ↑
Subtotal 1 756.6
Factors That Decrease the Monetary Base
7. Treasury deposits with the Fed 4.4 ↑ ↓
8. Foreign and other deposits with the Fed 22.6 ↑ ↓
9. Other Federal Reserve liabilities and 41.3 ↑ ↓
capital accounts
Subtotal 2 68.3
Monetary Base
Subtotal 1 Subtotal 2 688.3
Source: Federal Reserve Bulletin.
4
374
PREVIEW In Chapter 15, we developed a simple model of multiple deposit creation that showed
how the Fed can control the level of checkable deposits by setting the required reserve
ratio and the level of reserves. Unfortunately for the Fed, life isn’t that simple; control
of the money supply is far more complicated. Our critique of this model indicated
that decisions by depositors about their holdings of currency and by banks about
their holdings of excess reserves also affect the money supply. To deal with this critique,
in this chapter we develop a money supply model in which depositors and
banks assume their important roles. The resulting framework provides an in-depth
description of the money supply process to help you understand the complexity of
the Fed’s role.
To simplify the analysis, we separate the development of our model into several
steps. First, because the Fed can exert more precise control over the monetary base
(currency in circulation plus total reserves in the banking system) than it can over
total reserves alone, our model links changes in the money supply to changes in the
monetary base. This link is achieved by deriving a money multiplier (a ratio that
relates the change in the money supply to a given change in the monetary base).
Finally, we examine the determinants of the money multiplier.
Study Guide One reason for breaking the money supply model into its component parts is to help
you answer questions using intuitive step-by-step logic rather than memorizing how
changes in the behavior of the Fed, depositors, or banks will affect the money supply.
In deriving a model of the money supply process, we focus here on a simple definition
of money (currency plus checkable deposits), which corresponds to M1.
Although broader definitions of money—particularly, M2—are frequently used in
policymaking, we conduct the analysis with an M1 definition because it is less complicated
and yet provides a basic understanding of the money supply process.
Furthermore, all analyses and results using the M1 definition apply equally well to the
M2 definition. A somewhat more complicated money supply model for the M2 definition
is developed in an appendix to this chapter, which can be viewed online at
www.aw.com/mishkin.
Chap ter
16 Determinants of the Money Supply
The Money Supply Model and the Money Multiplier
Because, as we saw in Chapter 15, the Fed can control the monetary base better than
it can control reserves, it makes sense to link the money supply M to the monetary
base MB through a relationship such as the following:
M m MB (1)
The variable m is the money multiplier, which tells us how much the money supply
changes for a given change in the monetary base MB. This multiplier tells us what
multiple of the monetary base is transformed into the money supply. Because the
money multiplier is larger than 1, the alternative name for the monetary base, highpowered
money, is logical; a $1 change in the monetary base leads to more than a $1
change in the money supply.
The money multiplier reflects the effect on the money supply of other factors
besides the monetary base, and the following model will explain the factors that determine
the size of the money multiplier. Depositors’ decisions about their holdings of
currency and checkable deposits are one set of factors affecting the money multiplier.
Another involves the reserve requirements imposed by the Fed on the banking system.
Banks’ decisions about excess reserves also affect the money multiplier.
In our model of multiple deposit creation in Chapter 15, we ignored the effects on
deposit creation of changes in the public’s holdings of currency and banks’ holdings
of excess reserves. Now we incorporate these changes into our model of the money
supply process by assuming that the desired level of currency C and excess reserves
ER grows proportionally with checkable deposits D; in other words, we assume that
the ratios of these items to checkable deposits are constants in equilibrium, as the
braces in the following expressions indicate:
c {C/D} currency ratio
e {ER/D} excess reserves ratio
We will now derive a formula that describes how the currency ratio desired by
depositors, the excess reserves ratio desired by banks, and the required reserve ratio
set by the Fed affect the multiplier m. We begin the derivation of the model of the
money supply with the equation:
R RR ER
which states that the total amount of reserves in the banking system R equals the sum
of required reserves RR and excess reserves ER. (Note that this equation corresponds
to the equilibrium condition RR R in Chapter 15, where excess reserves were
assumed to be zero.)
The total amount of required reserves equals the required reserve ratio r times the
amount of checkable deposits D:
RR r D
Deriving the
Money Multiplier
C H A P T E R 1 6 Determinants of the Money Supply 375
Substituting r D for RR in the first equation yields an equation that links reserves
in the banking system to the amount of checkable deposits and excess reserves they
can support:
R (r D) ER
A key point here is that the Fed sets the required reserve ratio r to less than 1. Thus
$1 of reserves can support more than $1 of deposits, and the multiple expansion of
deposits can occur.
Let’s see how this works in practice. If excess reserves are held at zero (ER 0),
the required reserve ratio is set at r 0.10, and the level of checkable deposits in the
banking system is $800 billion, the amount of reserves needed to support these
deposits is $80 billion ( 0.10 $800 billion). The $80 billion of reserves can support
ten times this amount in checkable deposits, just as in Chapter 15, because multiple
deposit creation will occur.
Because the monetary base MB equals currency C plus reserves R, we can generate
an equation that links the amount of monetary base to the levels of checkable
deposits and currency by adding currency to both sides of the equation:
MB R C (r D) ER C
Another way of thinking about this equation is to recognize that it reveals the amount
of the monetary base needed to support the existing amounts of checkable deposits,
currency, and excess reserves.
An important feature of this equation is that an additional dollar of MB that arises
from an additional dollar of currency does not support any additional deposits. This
occurs because such an increase leads to an identical increase in the right-hand side
of the equation with no change occurring in D. The currency component of MB does
not lead to multiple deposit creation as the reserves component does. Put another
way, an increase in the monetary base that goes into currency is not multiplied,
whereas an increase that goes into supporting deposits is multiplied.
Another important feature of this equation is that an additional dollar of MB that
goes into excess reserves ER does not support any additional deposits or currency. The
reason for this is that when a bank decides to hold excess reserves, it does not make
additional loans, so these excess reserves do not lead to the creation of deposits.
Therefore, if the Fed injects reserves into the banking system and they are held as
excess reserves, there will be no effect on deposits or currency and hence no effect on
the money supply. In other words, you can think of excess reserves as an idle component
of reserves that are not being used to support any deposits (although they are
important for bank liquidity management, as we saw in Chapter 9). This means that
for a given level of reserves, a higher amount of excess reserves implies that the banking
system in effect has fewer reserves to support deposits.
To derive the money multiplier formula in terms of the currency ratio c {C/D}
and the excess reserves ratio e {ER/D}, we rewrite the last equation, specifying C as
c D and ER as e D:
MB (r D) (e D) (c D) (r e c) D
We next divide both sides of the equation by the term inside the parentheses to get
an expression linking checkable deposits D to the monetary base MB:
D (2)
1
r e c
MB
376 PA RT I V Central Banking and the Conduct of Monetary Policy
Using the definition of the money supply as currency plus checkable deposits (M
D C) and again specifying C as c D,
M D (c D) (1 c) D
Substituting in this equation the expression for D from Equation 2, we have:
(3)
Finally, we have achieved our objective of deriving an expression in the form of our earlier
Equation 1. As you can see, the ratio that multiplies MB is the money multiplier
that tells how much the money supply changes in response to a given change in the
monetary base (high-powered money). The money multiplier m is thus:
(4)
and it is a function of the currency ratio set by depositors c, the excess reserves ratio
set by banks e, and the required reserve ratio set by the Fed r.
Although the algebraic derivation we have just completed shows you how the
money multiplier is constructed, you need to understand the basic intuition behind it
to understand and apply the money multiplier concept without having to memorize it.
In order to get a feel for what the money multiplier means, let us again construct a
numerical example with realistic numbers for the following variables:
r required reserve ratio 0.10
C currency in circulation $400 billion
D checkable deposits $800 billion
ER excess reserves $0.8 billion
M money supply (M1) C D $1,200 billion
From these numbers we can calculate the values for the currency ratio c and the
excess reserves ratio e:
The resulting value of the money multiplier is:
The money multiplier of 2.5 tells us that, given the required reserve ratio of 10% on
checkable deposits and the behavior of depositors as represented by c 0.5 and
banks as represented by e 0.001, a $1 increase in the monetary base leads to a
$2.50 increase in the money supply (M1).
An important characteristic of the money multiplier is that it is less than the simple
deposit multiplier of 10 found in Chapter 15. The key to understanding this result
m
1 0.5
0.1 0.001 0.5

1.5
0.601
2.5
e
$0.8 billion
$800 billion
0.001
c
$400 billion
$800 billion
0.5
Intuition Behind
the Money
Multiplier
m
1 c
r e c
M
1 c
r e c
MB
C H A P T E R 1 6 Determinants of the Money Supply 377
of our money supply model is to realize that although there is multiple expansion of
deposits, there is no such expansion for currency. Thus if some portion of the
increase in high-powered money finds its way into currency, this portion does not
undergo multiple deposit expansion. In our analysis in Chapter 15, we did not allow
for this possibility, and so the increase in reserves led to the maximum amount of multiple
deposit creation. However, in our current model of the money multiplier, the
level of currency does increase when the monetary base MB and checkable deposits
D increase because c is greater than zero. As previously stated, any increase in MB that
goes into an increase in currency is not multiplied, so only part of the increase in MB
is available to support checkable deposits that undergo multiple expansion. The overall
level of multiple deposit expansion must be lower, meaning that the increase in M,
given an increase in MB, is smaller than the simple model in Chapter 15 indicated.1
Factors That Determine the Money Multiplier
To develop our intuition of the money multiplier even further, let us look at how this
multiplier changes in response to changes in the variables in our model: c, e, and r.
The “game” we are playing is a familiar one in economics: We ask what happens when
one of these variables changes, leaving all other variables the same (ceteris paribus).
If the required reserve ratio on checkable deposits increases while all the other variables
stay the same, the same level of reserves cannot support as large an amount of
checkable deposits; more reserves are needed because required reserves for these
checkable deposits have risen. The resulting deficiency in reserves then means that
banks must contract their loans, causing a decline in deposits and hence in the
money supply. The reduced money supply relative to the level of MB, which has
remained unchanged, indicates that the money multiplier has declined as well.
Another way to see this is to realize that when r is higher, less multiple expansion of
checkable deposits occurs. With less multiple deposit expansion, the money multiplier
must fall.2
We can verify that the foregoing analysis is correct by seeing what happens to the
value of the money multiplier in our numerical example when r increases from 10%
to 15% (leaving all the other variables unchanged). The money multiplier becomes:
which, as we would expect, is less than 2.5.
m
1 0.5
0.15 0.001 0.5

1.5
0.651
2.3
Changes in the
Required Reserve
Ratio r
378 PA RT I V Central Banking and the Conduct of Monetary Policy
1Another reason the money multiplier is smaller is that e is a constant fraction greater than zero, indicating that
an increase in MB and D leads to higher excess reserves. The resulting higher amount of excess reserves means
that the amount of reserves used to support checkable deposits will not increase as much as it otherwise would.
Hence the increase in checkable deposits and the money supply will be lower, and the money multiplier will be
smaller. However, because e is currently so tiny—around 0.001—the impact of this ratio on the money multiplier
is now quite small. But there have been periods when e has been much larger and so has had a more important
role in lowering the money multiplier.
2This result can be demonstrated from the Equation 4 formula as follows: When r rises, the denominator of the
money multiplier rises, and therefore the money multiplier must fall.
The analysis just conducted can also be applied to the case in which the required
reserve ratio falls. In this case, there will be more multiple expansion for checkable
deposits because the same level of reserves can now support more checkable deposits,
and the money multiplier will rise. For example, if r falls from 10% to 5%, plugging
this value into our money multiplier formula (leaving all the other variables
unchanged) yields a money multiplier of:
which is above the initial value of 2.5.
We can now state the following result: The money multiplier and the money supply
are negatively related to the required reserve ratio r.
Next, what happens to the money multiplier when depositor behavior causes c to
increase with all other variables unchanged? An increase in c means that depositors
are converting some of their checkable deposits into currency. As shown before,
checkable deposits undergo multiple expansion while currency does not. Hence when
checkable deposits are being converted into currency, there is a switch from a component
of the money supply that undergoes multiple expansion to one that does not.
The overall level of multiple expansion declines, and so must the multiplier.3
This reasoning is confirmed by our numerical example, where c rises from 0.50
to 0.75. The money multiplier then falls from 2.5 to:
We have now demonstrated another result: The money multiplier and the money
supply are negatively related to the currency ratio c.
When banks increase their holdings of excess reserves relative to checkable deposits,
the banking system in effect has fewer reserves to support checkable deposits. This
means that given the same level of MB, banks will contract their loans, causing a
decline in the level of checkable deposits and a decline in the money supply, and the
money multiplier will fall.4
This reasoning is supported in our numerical example when e rises from 0.001
to 0.005. The money multiplier declines from 2.5 to:
Note that although the excess reserves ratio has risen fivefold, there has been only a
small decline in the money multiplier. This decline is small, because in recent years e
m
1 0.5
0.1 0.005 0.5

1.5
0.605
2.48
Changes in the
Excess Reserves
Ratio e
m
1 0.75
0.1 0.001 0.75

1.75
0.851
2.06
Changes in the
Currency Ratio c
m
1 0.5
0.05 0.001 0.5

1.5
0.551
2.72
C H A P T E R 1 6 Determinants of the Money Supply 379
3As long as r e is less than 1 (as is the case using the realistic numbers we have used), an increase in c raises
the denominator of the money multiplier proportionally by more than it raises the numerator. The increase in c
causes the multiplier to fall. If you would like to know more about what explains movements in the currency
ratio c, take a look at an appendix to this chapter on this topic, which can be found on this book’s web site at
www.aw.com/mishkin. Another appendix to this chapter, also found on the web site, discusses how the money
multiplier for M2 is determined.
4This result can be demonstrated from the Equation 4 formula as follows: When e rises, the denominator of the
money multiplier rises, and so the money multiplier must fall.
has been extremely small, so changes in it have only a small impact on the money
multiplier. However, there have been times, particularly during the Great Depression,
when this ratio was far higher, and its movements had a substantial effect on the
money supply and the money multiplier. Thus our final result is still an important
one: The money multiplier and the money supply are negatively related to the excess
reserves ratio e.
To understand the factors that determine the level of e in the banking system, we
must look at the costs and benefits to banks of holding excess reserves. When the
costs of holding excess reserves rise, we would expect the level of excess reserves and
hence e to fall; when the benefits of holding excess reserves rise, we would expect the
level of excess reserves and e to rise. Two primary factors affect these costs and benefits
and hence affect the excess reserves ratio: market interest rates and expected
deposit outflows.
Market Interest Rates. As you may recall from our analysis of bank management in
Chapter 9, the cost to a bank of holding excess reserves is its opportunity cost, the
interest that could have been earned on loans or securities if they had been held
instead of excess reserves. For the sake of simplicity, we assume that loans and securities
earn the same interest rate i, which we call the market interest rate. If i increases,
the opportunity cost of holding excess reserves rises, and the desired ratio of excess
reserves to deposits falls. A decrease in i, conversely, will reduce the opportunity cost
of excess reserves, and e will rise. The banking system’s excess reserves ratio e is negatively
related to the market interest rate i.
Another way of understanding the negative effect of market interest rates on e is
to return to the theory of asset demand, which states that if the expected returns on
alternative assets rise relative to the expected returns on a given asset, the demand for
that asset will decrease. As the market interest rate increases, the expected return on
loans and securities rises relative to the zero return on excess reserves, and the excess
reserves ratio falls.
Figure 1 shows us (as the theory of asset demand predicts) that there is a negative
relationship between the excess reserves ratio and a representative market interest
rate, the federal funds rate. The period 1960–1981 saw an upward trend in the
federal funds rate and a declining trend in e, whereas in the period 1981–2002, a
decline in the federal funds rate is associated with a rise in e. The empirical evidence
thus supports our analysis that the excess reserves ratio is negatively related to market
interest rates.
Expected Deposit Outflows. Our analysis of bank management in Chapter 9 also indicated
that the primary benefit to a bank of holding excess reserves is that they provide
insurance against losses due to deposit outflows; that is, they enable the bank
experiencing deposit outflows to escape the costs of calling in loans, selling securities,
borrowing from the Fed or other corporations, or bank failure. If banks fear that
deposit outflows are likely to increase (that is, if expected deposit outflows increase),
they will want more insurance against this possibility and will increase the excess
reserves ratio. Another way to put it is this: If expected deposit outflows rise, the
expected benefits, and hence the expected returns for holding excess reserves,
increase. As the theory of asset demand predicts, excess reserves will then rise.
Conversely, a decline in expected deposit outflows will reduce the insurance benefit
380 PA RT I V Central Banking and the Conduct of Monetary Policy
of excess reserves, and their level should fall. We have the following result: The excess
reserves ratio e is positively related to expected deposit outflows.
Additional Factors That Determine the Money Supply
So far we have been assuming that the Fed has accurate control over the monetary
base. However, whereas the amount of open market purchases or sales is completely
controlled by the Fed’s placing orders with dealers in bond markets, the central bank
cannot unilaterally determine, and therefore cannot perfectly predict, the amount of
borrowing by banks from the Fed. The Federal Reserve sets the discount rate (interest
rate on discount loans), and then banks make decisions about whether to borrow.
The amount of discount loans, though influenced by the Fed’s setting of the discount
rate, is not completely controlled by the Fed; banks’ decisions play a role, too.
Therefore, we might want to split the monetary base into two components: one
that the Fed can control completely and another that is less tightly controlled. The less
tightly controlled component is the amount of the base that is created by discount
loans from the Fed. The remainder of the base (called the nonborrowed monetary
C H A P T E R 1 6 Determinants of the Money Supply 381
FIGURE 1 The Excess Reserves Ratio e and the Interest Rate (Federal Funds Rate)
Source: Federal Reserve: www.federalreserve.gov/releases/h3/hist/h3hist2.txt.
0.0
0.001
0.002
0.003
0.004
0.005
0.006
0.007
5
10
15
20
Interest Rate
Excess Reserves Ratio
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
0
Excess
Reserves Ratio,
e
Interest
Rate (%)
0.008
0.009
0.010
base) is under the Fed’s control, because it results primarily from open market operations.
5 The nonborrowed monetary base is formally defined as the monetary base
minus discount loans from the Fed:
MBn MB DL
where MBn nonborrowed monetary base
MB monetary base
DL discount loans from the Fed
The reason for distinguishing the nonborrowed monetary base MBn from the
monetary base MB is that the nonborrowed monetary base, which is tied to open market
operations, is directly under the control of the Fed, whereas the monetary base,
which is also influenced by discount loans from the Fed, is not.
To complete the money supply model, we use MB MBn DL and rewrite the
money supply model as:
M m (MBn DL) (5)
where the money multiplier m is defined as in Equation 4. Thus in addition to the
effects on the money supply of the required reserve ratio, currency ratio, and excess
reserves ratio, the expanded model stipulates that the money supply is also affected
by changes in MBn and DL. Because the money multiplier is positive, Equation 5
immediately tells us that the money supply is positively related to both the nonborrowed
monetary base and discount loans. However, it is still worth developing the
intuition for these results.
As shown in Chapter 15, the Fed’s open market purchases increase the nonborrowed
monetary base, and its open market sales decrease it. Holding all other variables constant,
an increase in MBn arising from an open market purchase increases the amount
of the monetary base that is available to support currency and deposits, so the money
supply will increase. Similarly, an open market sale that decreases MBn shrinks the
amount of the monetary base available to support currency and deposits, thereby
causing the money supply to decrease.
We have the following result: The money supply is positively related to the nonborrowed
monetary base MBn.
With the nonborrowed monetary base MBn unchanged, more discount loans from the
Fed provide additional reserves (and hence higher MB) to the banking system, and
these are used to support more currency and deposits. As a result, the increase in DL
will lead to a rise in the money supply. If banks reduce the level of their discount
loans, with all other variables held constant, the amount of MB available to support
currency and deposits will decline, causing the money supply to decline.
Changes in
Discount
Loans DL
from the Fed
Changes in the
Nonborrowed
Monetary Base
MBn
382 PA RT I V Central Banking and the Conduct of Monetary Policy
5Actually, there are other items on the Fed’s balance sheet (discussed in the appendix on the web site) that affect
the magnitude of the nonborrowed monetary base. Since their effects on the nonborrowed base relative to open
market operations are both small and predictable, these other items do not present the Fed with difficulties in
controlling the nonborrowed base.
The result is this: The money supply is positively related to the level of discount
loans DL from the Fed. However, because the Federal Reserve now (since January
2003) keeps the interest rate on discount loans (the discount rate) above market interest
rates at which banks can borrow from each other, banks usually have little incentive
to take out discount loans. Discount lending, DL, is thus very small except under
exceptional circumstances that will be discussed in the next chapter.
Overview of the Money Supply Process
We now have a model of the money supply process in which all four of the players—
the Federal Reserve System, depositors, banks, and borrowers from banks—directly
influence the money supply. As a study aid, Table 1 charts the money supply (M1)
response to the six variables discussed and gives a brief synopsis of the reasoning
behind each result.
Study Guide To improve your understanding of the money supply process, slowly work through
the logic behind the results in Table 1 rather than just memorizing the results. Then
see if you can construct your own table in which all the variables decrease rather than
increase.
C H A P T E R 1 6 Determinants of the Money Supply 383
S U M M A R Y Table 1 Money Supply (M1) Response
Change in Money Supply
Player Variable Variable Response Reason
Federal Reserve r ↑ ↓ Less multiple deposit
System expansion
MBn ↑ ↑ More MB to support
D and C
DL ↑ ↑ More MB to support
D and C
Depositors c ↑ ↓ Less multiple deposit
expansion
Depositors Expected ↑ ↓ e ↑ so fewer reserves
and banks deposit outflows to support D
Borrowers from i ↑ ↑ e ↓ so more reserves
banks and the to support D
other three players
Note: Only increases ( ↑) in the variables are shown. The effects of decreases on the money supply would be the opposite of those
indicated in the “Money Supply Response” column.
The variables are grouped by the player or players who either influence the variable
or are most influenced by it. The Federal Reserve, for example, influences the
money supply by controlling the first three variables—r, MBn, and DL, also known as
the tools of the Fed. (How these tools are used is discussed in subsequent chapters.)
Depositors influence the money supply through their decisions about the currency
ratio c, while banks influence the money supply by their decisions about e, which are
affected by their expectations about deposit outflows. Because depositors’ behavior
also influences bankers’ expectations about deposit outflows, this variable also reflects
the role of both depositors and bankers in the money supply process. Market interest
rates, as represented by i, affect the money supply through the excess reserves ratio e.
As shown in Chapter 5, the demand for loans by borrowers influences market interest
rates, as does the supply of money. Therefore, all four players are important in the
determination of i.
384 PA RT I V Central Banking and the Conduct of Monetary Policy
Application Explaining Movements in the Money Supply, 1980–2002
To make the theoretical analysis of this chapter more concrete, we need to see
whether the model of the money supply process developed here helps us
understand recent movements of the money supply. We look at money supply
movements from 1980 to 2002—a particularly interesting period, because
the growth rate of the money supply displayed unusually high variability.
Figure 2 shows the movements of the money supply (M1) from 1980 to
2002, with the percentage next to each bracket representing the annual growth
rate for the bracketed period: From January 1980 to October 1984, for example,
the money supply grew at a 7.2% annual rate. The variability of money
growth in the 1980–2002 period is quite apparent, swinging from 7.2% to
13.1%, down to 3.3%, then up to 11.1% and finally back down to 2.3%.
What explains these sharp swings in the growth rate of the money supply?
Our money supply model, as represented by Equation 5, suggests that the
movements in the money supply that we see in Figure 2 are explained by either
changes in MBn DL (the nonborrowed monetary base plus discount loans)
or by changes in m (the money multiplier). Figure 3 plots these variables and
shows their growth rates for the same bracketed periods as in Figure 2.
Over the whole period, the average growth rate of the money supply
(5.3%) is reasonably well explained by the average growth rate of the nonborrowed
monetary base MBn (7.4%). In addition, we see that DL is rarely an
important source of fluctuations in the money supply since MBn DL is
closely tied to MBn except for the unusual period in 1984 and September 2001
when discount loans increased dramatically. (Both of these episodes involved
emergency lending by the Fed and are discussed in the following chapter.)
The conclusion drawn from our analysis is this: Over long periods, the
primary determinant of movements in the money supply is the nonborrowed
monetary base MBn , which is controlled by Federal Reserve open market
operations.
For shorter time periods, the link between the growth rates of the nonborrowed
monetary base and the money supply is not always close, primarily
because the money multiplier m experiences substantial short-run swings
www.federalreserve.gov
/Releases/h3/
The Federal Reserve web site
reports data about aggregate
reserves and the monetary
base. This site also reports on
the volume of discount
window lending.
www.federalreserve.gov
/Releases/h6/
This site reports current and
historical levels of M1, M2, and
M3, and other data on the
money supply.
C H A P T E R 1 6 Determinants of the Money Supply 385
that have a major impact on the growth rate of the money supply. The currency
ratio c, which is also plotted in Figure 3, explains most of these movements
in the money multiplier.
From January 1980 until October 1984, c is relatively constant.
Unsurprisingly, there is almost no trend in the money multiplier m, so the
growth rates of the money supply and the nonborrowed monetary base have
similar magnitudes. The upward movement in the money multiplier from
October 1984 to January 1987 is explained by the downward trend in the
currency ratio. The decline in c meant that there was a shift from one component
of the money supply with less multiple expansion (currency) to one
with more (checkable deposits), so the money multiplier rose. In the period
from January 1987 to April 1991, c underwent a substantial rise. As our
money supply model predicts, the rise in c led to a fall in the money multiplier,
because there was a shift from checkable deposits, with more multiple
expansion, to currency, which had less. From April 1991 to December 1993,
c fell somewhat. The decline in c led to a rise in the money multiplier,
because there was again a shift from the currency component of the money
supply with less multiple expansion to the checkable deposits component
FIGURE 2 Money Supply (M1), 1980–2002
Percentage for each bracket indicates the annual growth rate of the money supply over the bracketed period.
Source: Federal Reserve: www.federalreserve.gov/releases.
1200
1000
400
500
600
800
700
900
1100
300
0
M1 Money
Supply
($ billions)
M1
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2005
11.1%
3.3%
2.3%
13.1%
7.2%
386 PA RT I V Central Banking and the Conduct of Monetary Policy
FIGURE 3 Determinants of the Money Supply, 1980–2002
Percentage for each bracket indicates the annual growth rate of the series over the bracketed period.
Source: Federal Reserve: www.federalreserve.gov/releases.
m
500
600
700
400
300
200
100
3.0
2.6
0.30
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990
2.0%
–4.9%
4.4% – 3.6%
0.1%
9.1%
7.0%
10.0%
6.6%
7.1%
8.7%
6.9%
9.1%
6.6%
6.3%
MBn + DL
MBn
c
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2005
2.4
2.2
2.0
1.8
2.8
3.2
0.40
0.50
0.60
0.70
0.80
0.90
1.00
1.10
C H A P T E R 1 6 Determinants of the Money Supply 387
with more. Finally, the sharp rise in c from December 1993 to December
2002 should have led to a decline in the money multiplier, because the shift
into currency produces less multiple deposit expansion. As our money supply
model predicts, the money multiplier did indeed fall sharply in this
period, and there was a dramatic deceleration of money growth.
Although our examination of the 1980–2002 period indicates that factors
such as changes in c can have a major impact on the money supply over
short periods, we must not forget that over the entire period, the growth rate
of the money supply is closely linked to the growth rate of the nonborrowed
monetary base MBn. Indeed, empirical evidence suggests that more than
three-fourths of the fluctuations in the money supply can be attributed to
Federal Reserve open market operations, which determine MBn.
Application The Great Depression Bank Panics, 1930–1933
We can also use our money supply model to help us understand major movements
in the money supply that have occurred in the past. In this application,
we use the model to explain the monetary contraction that occurred during
the Great Depression, the worst economic downturn in U.S. history. In
Chapter 8, we discussed bank panics and saw that they could harm the economy
by making asymmetric information problems more severe in credit markets,
as they did during the Great Depression. Here we can see that another
consequence of bank panics is that they can cause a substantial reduction in
the money supply. As we will see in the chapters on monetary theory later in
the book, such reductions can also cause severe damage to the economy.
Figure 4 traces the bank crisis during the Great Depression by showing
the volume of deposits at failed commercial banks from 1929 to 1933. In
their classic book A Monetary History of the United States, 1867–1960, Milton
Friedman and Anna Schwartz describe the onset of the first banking crisis in
late 1930 as follows:
Before October 1930, deposits of suspended [failed] commercial banks had
been somewhat higher than during most of 1929 but not out of line with
experience during the preceding decade. In November 1930, they were more
than double the highest value recorded since the start of monthly data in
1921. A crop of bank failures, particularly in Missouri, Indiana, Illinois, Iowa,
Arkansas, and North Carolina, led to widespread attempts to convert checkable
and time deposits into currency, and also, to a much lesser extent, into
postal savings deposits. A contagion of fear spread among depositors, starting
from the agricultural areas, which had experienced the heaviest impact of bank
failures in the twenties. But failure of 256 banks with $180 million of deposits
in November 1930 was followed by the failure of 532 with over $370 million
of deposits in December (all figures seasonally unadjusted), the most dramatic
being the failure on December 11 of the Bank of United States with over
388 PA RT I V Central Banking and the Conduct of Monetary Policy
$200 million of deposits. That failure was especially important. The Bank of
United States was the largest commercial bank, as measured by volume of
deposits, ever to have failed up to that time in U.S. history. Moreover, though
it was just an ordinary commercial bank, the Bank of United States’s name had
led many at home and abroad to regard it somehow as an official bank, hence
its failure constituted more of a blow to confidence than would have been
administered by the fall of a bank with a less distinctive name.6
The first bank panic, from October 1930 to January 1931, is clearly visible
in Figure 4 at the end of 1930, when there is a rise in the amount of
deposits at failed banks. Because there was no deposit insurance at the time
(the FDIC wasn’t established until 1934), when a bank failed, depositors
would receive only partial repayment of their deposits. Therefore, when
banks were failing during a bank panic, depositors knew that they would be
likely to suffer substantial losses on deposits and thus the expected return on
deposits would be negative. The theory of asset demand predicts that with
the onset of the first bank crisis, depositors would shift their holdings from
checkable deposits to currency by withdrawing currency from their bank
FIGURE 4 Deposits of Failed
Commercial Banks, 1929–1933
Source: Milton Friedman and Anna
Jacobson Schwartz, A Monetary History
of the United States, 1867–1960
(Princeton, N.J.: Princeton University
Press, 1963), p. 309.
10
0
20
30
40
50
100
200
400
500
300
1929 1930 1931 1932 1933
Start of First
Banking
Crisis
End of Final
Banking
Crisis
Deposits
($ millions)
6Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton,
N.J.: Princeton University Press, 1963), pp. 308–311.
C H A P T E R 1 6 Determinants of the Money Supply 389
accounts, and c would rise. Our earlier analysis of the excess reserves ratio
suggests that the resulting surge in deposit outflows would cause the banks
to protect themselves by substantially increasing their excess reserves ratio e.
Both of these predictions are borne out by the data in Figure 5. During the
first bank panic (October 1930–January 1931) c began to climb. Even more
striking is the behavior of e, which more than doubled from November 1930
to January 1931.
The money supply model predicts that when e and c increase, the
money supply will fall. The rise in c results in a decline in the overall level of
multiple deposit expansion, leading to a smaller money multiplier and a
decline in the money supply, while the rise in e reduces the amount of
reserves available to support deposits and also causes the money supply to
fall. Thus our model predicts that the rise in e and c after the onset of the first
bank crisis would result in a decline in the money supply—a prediction
borne out by the evidence in Figure 6. The money supply declined sharply
in December 1930 and January 1931 during the first bank panic.
Banking crises continued to occur from 1931 to 1933, and the pattern
predicted by our model persisted: c continued to rise, and so did e. By the
FIGURE 5 Excess Reserves Ratio and Currency Ratio, 1929–1933
Sources: Federal Reserve Bulletin; Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, N.J.: Princeton
University Press, 1963), p. 333.
1929 1930 1931 1932 1933
0.40
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.05
0.10
0.15
0.20
0.25
0.30
0.35
Start of
First Banking
Crisis
End of
Final Banking
Crisis
Excess Reserves
Ratio, e
Currency Ratio,
c
0.0
c
e
0.0
end of the crises in March 1933, the money supply (M1) had declined by
over 25%—by far the largest decline in all of American history—and it coincided
with the nation’s worst economic contraction (see Chapter 8). Even
more remarkable is that this decline occurred despite a 20% rise in the level
of the monetary base—which illustrates how important the changes in c and
e during bank panics can be in the determination of the money supply. It also
illustrates that the Fed’s job of conducting monetary policy can be complicated
by depositor and bank behavior.
390 PA RT I V Central Banking and the Conduct of Monetary Policy
FIGURE 6 M1 and the Monetary Base, 1929–1933
Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, N.J.: Princeton University Press, 1963), p. 333.
1929 1930 1931 1932 1933
0 6
7
8
9
19
20
21
22
23
24
25
26
27
28
29
Money Supply
($ billions)
End of
Final Banking
Crisis
M1
Monetary Base
Start of
First Banking
Crisis
Summary
1. We developed a model to describe how the money
supply is determined. First, we linked the monetary base
to the money supply using the concept of the money
multiplier, which tells us how much the money supply
changes when there is a change in the monetary base.
2. The money supply is negatively related to the required
reserve ratio r, the currency ratio c, and the excess
reserves ratio e. It is positively related to the level of
discount loans DL from the Fed and the nonborrowed
base MBn, which is determined by Fed open market
C H A P T E R 1 6 Determinants of the Money Supply 391
operations. The money supply model therefore allows
for the behavior of all four players in the money supply
process: the Fed through its setting of the required
reserve ratio, the discount rate, and open market
operations; depositors through their decisions about the
currency ratio; the banks through their decisions about
the excess reserves ratio and discount loans from the
Fed; and borrowers from banks indirectly through their
effect on market interest rates, which affect bank
decisions regarding the excess reserves ratio and
borrowings from the Fed.
Key Terms
money multiplier, p. 374 nonborrowed monetary base, p. 381
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. “The money multiplier is necessarily greater than 1.” Is
this statement true, false, or uncertain? Explain your
answer.
2. “If reserve requirements on checkable deposits were
set at zero, the amount of multiple deposit expansion
would go on indefinitely.” Is this statement true, false,
or uncertain? Explain.
*3. During the Great Depression years 1930–1933, the
currency ratio c rose dramatically. What do you think
happened to the money supply? Why?
4. During the Great Depression, the excess reserves ratio
e rose dramatically. What do you think happened to
the money supply? Why?
*5. Traveler’s checks have no reserve requirements and are
included in the M1 measure of the money supply.
When people travel during the summer and convert
some of their checking account deposits into traveler’s
checks, what happens to the money supply? Why?
6. If Jane Brown closes her account at the First National
Bank and uses the money instead to open a money
market mutual fund account, what happens to M1?
Why?
*7. Some experts have suggested that reserve requirements
on checkable deposits and time deposits should
be set equal because this would improve control of
M2. Does this argument make sense? (Hint: Look at
the second appendix to this chapter and think about
what happens when checkable deposits are converted
into time deposits or vice versa.)
8. Why might the procyclical behavior of interest rates
(rising during business cycle expansions and falling
during recessions) lead to procyclical movements in
the money supply?
Using Economic Analysis to Predict the Future
*9. The Fed buys $100 million of bonds from the public
and also lowers r. What will happen to the money
supply?
10. The Fed has been discussing the possibility of paying
interest on excess reserves. If this occurred, what
would happen to the level of e?
*11. If the Fed sells $1 million of bonds and banks reduce
their discount loans by $1 million, predict what will
happen to the money supply.
12. Predict what will happen to the money supply if there
is a sharp rise in the currency ratio.
*13. What do you predict would happen to the money
supply if expected inflation suddenly increased?
14. If the economy starts to boom and loan demand picks
up, what do you predict will happen to the money
supply?
*15. Milton Friedman once suggested that Federal Reserve
discount lending should be abolished. Predict what
would happen to the money supply if Friedman’s suggestion
were put into practice.
QUIZ
392 PA RT I V Central Banking and the Conduct of Monetary Policy
Web Exercises
1. An important aspect of the supply of money is reserve
balances. Go to www.federalreserve.gov/Releases/h41/
and locate the most recent release. This site reports
changes in factors that affect depository reserve balances.
a. What is the current reserve balance?
b. What is the change in reserve balances since a
year ago?
c. Based on Questions a and b, does it appear that the
money supply should be increasing or decreasing?
2. Refer to Figure 3: Determinants of the Money Supply,
1980–2002. Go to www.federalreserve.gov/Releases
/h3/Current/ where the monetary base (MB) and borrowings
(DL) are reported. Compute the growth rate
in MB DL since the end of 2002. How does this
compare to previous periods reported on the graph?
The derivation of a money multiplier for the M2 definition of money requires only
slight modifications to the analysis in the chapter. The definition of M2 is:
M2 C D T MMF
where C currency in circulation
D checkable deposits
T time and savings deposits
MMF primarily money market mutual fund shares and money market
deposit accounts, plus overnight repurchase agreements and
overnight Eurodollars
We again assume that all desired quantities of these variables rise proportionally
with checkable deposits so that the equilibrium ratios c, t {T/D}, and mm
{MMF/D} set by depositors are treated as constants. Replacing C by c D, T by t
D, and MMF by mm D in the definition of M2 just given, we get:
M2 D (c D) (t D) (mm D)
(1 c t mm) D
Substituting in the expression for D from Equation 2 in the chapter,1 we have
(1)
To see what this formula implies about the M2 money multiplier, we continue with
the same numerical example in the chapter, with the additional information that T
$2,400 billion and MMF $400 billion so that t 3 and mm 0.5. The resulting
value of the multiplier for M2 is:
m2
1 0.5 3 0.5
0.10 0.001 0.5

5.0
0.601
8.32
M2
1 c t mm
r e c
MB
The M2 Money Multiplier
appendix1
to chapter 16
1From the derivation here it is clear that the quantity of checkable deposits D is unaffected by the depositor ratios
t and mm even though time deposits and money market mutual fund shares are included in M2. This is just a
consequence of the absence of reserve requirements on time deposits and money market mutual fund shares, so
T and MMF do not appear in any of the equations in the derivation of D in the chapter.
1
An important feature of the M2 multiplier is that it is substantially above the M1
multiplier of 2.5 that we found in the chapter. The crucial concept in understanding
this difference is that a lower required reserve ratio for time deposits or money market
mutual fund shares means that they undergo more multiple expansion because
fewer reserves are needed to support the same amount of them. Time deposits and
MMFs have a lower required reserve ratio than checkable deposits—zero—and they
will therefore have more multiple expansion than checkable deposits will. Thus the
overall multiple expansion for the sum of these deposits will be greater than for
checkable deposits alone, and so the M2 money multiplier will be greater than the M1
money multiplier.
Factors That Determine the M2 Money Multiplier
The economic reasoning analyzing the effect of changes in the required reserve ratio
and the currency ratio on the M2 money multiplier is identical to that used for the M1
multiplier in the chapter. An increase in the required reserve ratio r will decrease the
amount of multiple deposit expansion, thus lowering the M2 money multiplier. An
increase in c means that depositors have shifted out of checkable deposits into currency,
and since currency has no multiple deposit expansion, the overall level of multiple
deposit expansion for M2 must also fall, lowering the M2 multiplier. An increase
in the excess reserves ratio e means that banks use fewer reserves to support deposits,
so deposits and the M2 money multiplier fall.
We thus have the same results we found for the M1 multiplier: The M2 money
multiplier and M2 money supply are negatively related to the required reserve ratio
r, the currency ratio c, and the excess reserves ratio e.
An increase in either t or mm leads to an increase in the M2 multiplier, because the
required reserve ratios on time deposits and money market mutual fund shares are
zero and hence are lower than the required reserve ratio on checkable deposits.
Both time deposits and money market mutual fund shares undergo more multiple
expansion than checkable deposits. Thus a shift out of checkable deposits into
time deposits or money market mutual funds, increasing t or mm, implies that the
overall level of multiple expansion will increase, raising the M2 money multiplier.
A decline in t or mm will result in less overall multiple expansion, and the M2
money multiplier will decrease, leading to the following conclusion: The M2 money
multiplier and M2 money supply are positively related to both the time deposit ratio
t and the money market fund ratio mm.
The response of the M2 money supply to all the depositor and required reserve
ratios is summarized in Table 1.
Response to
Changes in t
and mm
Changes in r,
c, and e
The M2 Money Multiplier 2
Appendix 1 to Chapter 16
S U M M A R Y Table 1 Response of the M2 Money Supply to Changes in MBn, DL, r, e, c, t, and mm
Change in M2 Money
Variable Variable Supply Response Reason
MBn ↑ ↑ More MB to support C and D
DL ↑ ↑ More MB to support C and D
r ↑ ↓ Less multiple deposit expansion
e ↑ ↓ Fewer reserves to support C and D
c ↑ ↓ Less overall deposit expansion
t ↑ ↑ More multiple deposit expansion
mm ↑ ↑ More multiple deposit expansion
Note: Only increases ( ↑) in the variables are shown; the effects of decreases in the variables on the money multiplier would be the
opposite of those indicated in the “Response” column.
3
The general outline of the movements of the currency ratio c since 1892 is shown in
Figure 1. As you can see, several episodes stand out:
1. The declining trend in the ratio from 1892 until 1917, when the United States
entered World War I
2. The sharp increase in the ratio during World War I and the decline thereafter
3. The steepest increase in the ratio that we see in the figure, which occurs during
the Great Depression years from 1930 to 1933
4. The increase in the ratio during World War II
5. The reversal in the early 1960s of the downward trend in the ratio and the rise
thereafter
6. The halt in the upward trend from 1980 to 1993
7. The upward trend from 1994 to 2002
Expanding Behavior of
the Currency Ratio
appendix 2
to chapter 16
FIGURE 1 Currency-Checkable Deposits Ratio: 1892–2002
Sources: Federal Reserve Bulletin and Banking and Monetary Statistics. www.federalreserve.gov/releases/h6/hist/h6hist1.txt
0.25
1892 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
0.50
WWI WWII
Great
Depression
Currency
Ratio c
1
To be worthwhile, our analysis of c must be able to explain these movements.
These movements, however, will help us develop the analysis because they provide
clues to the factors that influence c.
A natural way to approach the analysis of the relative amount of assets (currency
and checkable deposits) people want to hold, hence the currency-checkable deposits
ratio, is to use the theory of asset demand developed in Chapter 5. Recall the theory
states that four categories of factors influence the demand for an asset such as currency
or checkable deposits: (1) the total resources available to individuals, that is,
wealth; (2) the expected return on one asset relative to the expected return on alternative
assets; (3) the degree of uncertainty or risk associated with the return from this
asset relative to the alternative assets; and (4) the liquidity of one asset relative to alternative
assets. Because risk and liquidity factors have not changed independently of
wealth and expected returns and lead to similar conclusions on the historical movements
of c, we will focus only on how factors affecting wealth and expected returns
influence c.
What is the relative response of currency to checkable deposits when an individual’s
resources change? Currency is a necessity because it is used extensively by people
with low incomes and little wealth, which means that the demand for currency grows
proportionately less with accumulation of wealth. In contrast, checkable deposits are
held by people with greater wealth, so checkable deposits are less of a necessity. Put
another way, as wealth grows, the holdings of checkable deposits relative to the holdings
of currency increase, and the amount of currency relative to checkable deposits
falls, causing the currency ratio c to decline. A decrease in income will lead to an
increase in the amount of currency relative to checkable deposits, causing c to
increase. The currency ratio is negatively related to income or wealth.
The second factor that influences the decision to hold currency versus checkable
deposits involves the expected returns on the checkable deposits relative to currency
and other assets. Four primary factors influence expected returns (and hence the currency
ratio): interest rates on checkable deposits, the cost of acquiring currency, bank
panics, and illegal activity.1
Interest Rates on Checkable Deposits. By its very nature, currency cannot pay interest.
Yet banks can and do pay interest on checkable deposits. One measure of the
expected return on checkable deposits relative to currency is the interest rate on
checkable deposits. As this interest rate increases, the theory of asset demand tells us
that people will want to hold less currency relative to checkable deposits, and c will
fall. Conversely, a decline in this interest rate will cause c to rise. The currency ratio
is negatively related to the interest rate paid on checkable deposits.
Between 1933 and 1980, regulations prevented banks from paying interest on
most checkable deposits,2 and before 1933, these interest rates were low and did not
Effect of Changes
in Expected
Returns
Effect of Changes
in Wealth
Appendix 2 to Chapter 16
1Changes in interest rates on other alternative assets (such as U.S. Treasury bills) could have a differential effect
on the demand for currency versus the checkable deposits, resulting in some effect on c. However, the evidence
for this effect is weak.
2Although banks could not pay interest on checkable deposits, they provided services to their checking account customers
that can be thought of as implicit interest payments. Because these services changed only slowly over time,
these implicit interest payments were not a major factor causing the demand for checkable deposits to fluctuate.
2
undergo substantial fluctuations. However, since 1980, banks have been allowed to
pay any interest rate they choose on checkable deposits, suggesting that fluctuations
in these rates can now be an important factor influencing c movements.
Cost of Acquiring Currency. If currency is made easier to acquire, thereby lowering the
cost of using it, then in effect its expected return rises relative to deposits and the currency
ratio c should rise. Lowering the cost of acquiring currency leads to a rise in
the currency ratio. The explosion of ATMs in recent years has indeed made it easier
for depositors at banks to get their hands on currency and should thus have increased
its use, raising c.
Bank Panics. Our discussion of interest-rate effects suggests that they did not have
a substantial impact on c before 1980. You might conclude that expected returns
have had little importance in determining this ratio for most of its history. Figure 1
provides us with a clue that we are overlooking an important factor when measuring
expected returns solely by the interest rates on assets. The steepest rise in c
occurred during the Great Depression years 1930–1933, when the banking system
nearly collapsed. Legend has it that during this period, people stuffed their mattresses
with cash rather than keep it in banks, because they had lost confidence in
them as a safe haven for their hard-earned savings. Can the theory of asset demand
explain this phenomenon?
A bank failure occurs when the bank is no longer able to pay back its depositors.
Before creation of the FDIC in 1933, if you had an account at a bank that failed, you
would suffer a substantial loss—you could not withdraw your savings and might
receive only a small fraction of the value of your deposits sometime in the future. The
simultaneous failure of many banks is called a bank panic, and the Great Depression
years 1930–1933 witnessed the worst set of bank panics in U.S. history. From the end
of 1930 to the bank holiday in March 1933, more than one-third of the banks in the
United States failed.
Bank panics can have a devastating effect on the expected returns from holding
deposits. When a bank is likely to fail during a bank panic, depositors know that if
they have deposits in this bank, they are likely to suffer substantial losses, and the
expected return on deposits can be negative. The theory of asset demand predicts that
depositors will shift their holdings from checkable deposits to currency by withdrawing
currency from their bank accounts, and c will rise. This is exactly what we see in
Figure 1 during the bank panics of the Great Depression period 1930–1933 and to a
lesser extent 1893 and 1907, when smaller-scale bank panics occurred. The conclusion
is that bank panics lead to a sharp increase in the currency ratio. Bank panics have
been an important source of fluctuations in this ratio in the past and could be important
in the future.
Illegal Activity. Expected returns on checkable deposits relative to currency can also
be affected by the amount of illegal activity conducted in an economy. U.S. law allows
government prosecutors access to bank records when conducting a criminal investigation.
So if you were engaged in some illegal activity, you would not conduct your
transactions with checks, because they are traceable and therefore a potentially powerful
piece of evidence against you. Currency, however, is much harder to trace. The
expected return on currency relative to checkable deposits is higher when you are
engaged in illegal transactions. Hence when illegal activity in a society increases, there
Expanding Behavior of the Currency Ratio 3
is an increase in the use of currency relative to checkable deposits, and c rises. There
is a positive association between illegal activity and the currency ratio.3
Looking at Figure 1, what types of increases in illegal activity would lead to an
increase in c? Beginning in the 1960s, c began to climb—just when the illegal drug trade
began to experience phenomenal growth. Because illegal drug transactions are always
carried out with currency, it is likely that the rise in drug trade is related to the rise in c.
Supporting evidence is the current huge flow of currency into southern Florida, the
major center for illegal drug importing in the United States.4 Other illegal activities—
prostitution, black markets, gambling, loan sharking, fencing of stolen goods, the
employment of illegal aliens—could also be sources of a higher currency ratio.
Another interesting set of movements in c are the two increases during both world
wars, which are associated with large increases in income taxes. Income taxes were
raised substantially in 1917 to help finance America’s entry into World War I. Although
income tax rates were reduced after the war, they were again raised substantially during
World War II to finance that conflict—never to return to prewar levels.
Increases in c when income tax rates rise can be explained in the following manner:
Higher tax rates promote the evasion of taxes. When income tax rates rise, the
incentive is high to evade taxes by conducting transactions in cash. If you receive an
unreported cash payment for some service (for example, as a cab driver, waiter, or
doctor), it is less likely that the Internal Revenue Service can prove that you are
understating your income. If you are paid with a check or credit card, you would be
wise to declare the income. The conclusion is clear: Higher tax rates will lead to a
rise in c.
Not only does income tax evasion explain the rise in c during the two world wars,
but it also helps explain the rise in the 1960s and 1970s. This may seem surprising
because the income tax rate schedule was not raised during this period. However, the
burden of income taxes was increasing because the American income tax system is
progressive (as income increases, the tax rate rises). A rising price level in the 1960s
and 1970s raised the nominal income and pushed more individuals into higher tax
brackets (a phenomenon called bracket creep). This meant that the effective tax rate
increased even though the tax schedule was unchanged. As a result, incentives
increased to evade paying taxes by not declaring income, and people would avoid the
use of checkable deposits. In other words, the expected return on checkable deposits
fell, so c rose.
Increased tax evasion and other illegal activities not only reflect an increase in the
currency ratio but also imply that more income will go unreported to the government.
The result is an understatement of statistics on economic activity such as gross domestic
product (GDP), which measures the total production of goods and services in the
economy.
Appendix 2 to Chapter 16
3 One exception to this is an increase in street crime. Checkable deposits have the advantage over currency that
if you are mugged, the loss from carrying checks is likely to be far less than the loss from carrying currency. So
if muggings are on the rise, the expected return on currency will fall relative to the expected return on checkable
deposits, and you would hold less currency relative to checkable deposits. The resulting negative association
of the illegal activity of street crime and c is ignored in the text because it is not an important source of
fluctuations in c.
4 The Drug Enforcement Agency has estimated that the retail value of the illegal drug trade exceeds $100 billion,
making it one of the largest businesses in the United States. Evidence that the drug trade has affected c is
found in Ralph C. Kimball, “Trends in the Use of Currency,” New England Economic Review, September–October
1981, pp. 43–53.
4
This unreported economic activity has been labeled the underground economy.
Evidence of its scope is the fact that the amount of currency for every man, woman,
and child in the United States (as measured by currency in circulation in 2002
divided by the population) is around $1,000. Very few people hold this amount of
currency; the likelihood is that much is used to conduct transactions in the underground
economy. Calculations of the size of the underground economy indicate that
it may exceed 10% of total economic activity. If this is true, and unreported income
could be taxed, America would solve its budget deficit problems overnight!
Expanding Behavior of The Currency Ratio
Application Explaining the Historical Record of c
The interaction of historical data with the theory of asset demand has helped
us identify the factors that influence the currency ratio. We have seen that the
theory of asset demand developed in Chapter 5 can help us understand how
these different factors influence c.
To put our analysis in perspective, let us proceed to explain the major
movements of c in Figure 1 by time periods.
Study Guide An excellent way to test your understanding of the factors influencing c is to
explain the movements in Figure 1 before reading this section of the text.
This exercise will give you practice in using the ideas developed in the preceding
discussion and should help make the abstract analysis clearer.
1892–1917. The general decline in c reflected in this period is explained by
the increase in wealth. Because checkable deposits have a higher wealth elasticity
than currency, the general trend of rising wealth over this span implies
that the holdings of currency will grow more slowly than the holdings of
checkable deposits, thus lowering c.
The upward blips in the ratio seen in 1893 and 1907 were due to bank
panics, which temporarily reduced the expected return on checkable deposits
and increased the risk—these factors led to a temporary increase in the holdings
of currency relative to checkable deposits, temporarily increasing c.
1917–1919. The upward surge in c when America entered World War I is
explained by the use of the income tax to help finance the war. The resulting
attempts at tax evasion encouraged people to avoid the use of checks, which
would make their income visible to the IRS; put another way, the increased
desire to avoid taxes lowered the expected return on checkable deposits,
resulting in a lower demand for them. The resulting increase in the use of
currency relative to checkable deposits raised c.
1919–1921. When income taxes were reduced after the war, the demand for
currency relative to checkable deposits began to fall back toward its old level,
and the rise in c that occurred during the war was reversed. However, a severe
recession in 1920–1921 led to a decline in wealth along with an increased
number of bank failures, both of which might have caused a rise in c at that
time. The decline in wealth led to a decline in the demand for both currency
and checkable deposits, but the higher wealth elasticity of checkable deposits
5
Appendix 2 to Chapter 16
meant that they declined more than currency, raising the currency ratio. The
increased number of bank failures also made checkable deposits less desirable
because it lowered their expected return, also leading to a rise in c.
1921–1929. During the prosperous period of the Roaring Twenties, we
would expect to see the downward trend in c reasserting itself. The rise in
wealth would lead to a fall in c because the holdings of currency would grow
more slowly than the holdings of checkable deposits.
1929–1933. The decline in income during the Great Depression was one
factor in the rise in c, but far more important were the bank panics that began
in late 1930 and ended in March 1933. The consequent sharp rise in c from
1930 to 1933 was a major factor in the financial and economic collapse.
These panics (the most severe in all of U.S. history) lowered the expected
return on deposits, thereby raising the demand for currency relative to
checkable deposits.
1933–1941. With the end of the bank panics and some restoration of the
confidence in banks (helped by establishment of the FDIC), c fell. This decline
was strengthened by a rise in wealth. However, c did not return to pre-
Depression levels, primarily because a loss of confidence in the U.S. banking
system lingered in the public mind. As a result, expected returns on deposits
did not return to their pre-Depression levels, leaving a high level of c.
1941–1945. When income tax rates were raised to unprecedented levels to
finance combat in World War II, c underwent a substantial rise. The incentive
to evade taxes was especially strong; hence the expected return on checkable
deposits fell. Price controls imposed during the war may also have
contributed to the rise in c because they stimulated black market activity,
whose transactions could be hidden using currency.
1945–Early 1960s. After the war, income tax rates were reduced slightly, but
not to anywhere near their prewar levels. Income taxes remained at permanently
higher levels because of the revenue needed to support an expanded
role for the U.S. military as the “world’s police force” and enlarged social programs
such as welfare, unemployment insurance, housing and urban development,
and Social Security. Although some decline in c occurred after the
war due to a reduction in tax rates, permanently higher income tax rates left
strong incentives for tax evasion, and c remained high. The steady rise in
wealth after the war promoted the return to a declining trend in c, but its
effect was not sufficiently strong to reduce the ratio below prewar levels.
Early 1960s–1980. The declining trend beginning at the end of World War
II began to reverse in the early 1960s for a number of reasons. Most important
was the growth of the underground economy, both because of the spectacular
rise in illegal drug trade and because of the increased desirability of
evading taxes due to bracket creep, which raised the effective tax rates. The
increase in illegal activity lowered the expected return on checkable deposits,
leading to an increased use of currency in relation to checkable deposits,
thereby raising c.
1980–1993. A halt in the upward trend in c can be attributed to the deregulation
of the banking system that allowed banks to pay interest on check-
6
Expanding Behavior of The Currency Ratio
able deposits. This raised the expected return on checkable deposits relative
to currency, and the resulting reduced demand for currency helped lower c.
1994–2002. The upward trend in c can be explained by the explosion in the
number of ATMs starting in the 1990s, which has been discussed in Chapter
10. The increase in the number of ATMs has dramatically lowered the cost of
acquiring currency and this has, in effect, raised the expected return on currency
relative to deposits, thereby raising c.
Application Predicting the Future of c
A good economic model not only explains the past but also helps predict the
response of economic variables to new events. The analysis of factors that
influence the currency ratio outlined here has this capability. Let us consider
two possible changes in the economic environment of the future and ask
what our analysis would predict will happen to the currency ratio as a result.
These predictions could be of interest to policymakers, who would want to
know how the money supply might be affected in each of these cases.
Study Guide Try to provide the reasoning for the predictions here without having to refer
to the text. This will give you excellent practice with the economic analysis
of c that we have developed in this chapter. You can get additional practice
by answering problems at the end of the chapter, which also ask you to predict
future movements in c.
Much talk is circulating about balancing the budget by increasing taxes.
What would happen to the currency ratio if income taxes were raised?
Higher tax rates would increase the incentives to evade taxes. The
expected return on checkable deposits would then effectively decline. The
use of currency would increase relative to checkable deposits (if other factors
are held constant), and we would predict a rise in c.
There have always been swings back and forth from deregulation to increased
regulation. What if the present tide of deregulation is reversed and regulations
were imposed that returned us to the situation when banks were not
allowed to pay interest on checkable deposits? What would happen to the
currency ratio in this case?
This policy would mean that the expected return on checkable deposits
would fall below its current level, and the expected return on checkable
deposits relative to currency would also fall. The resulting decreased attractiveness
of checkable deposits relative to currency would mean that holdings
of currency relative to checkable deposits would increase, raising c.
The usefulness of the foregoing analysis is not restricted to the predictions
of the response of c to the events discussed here. With this framework,
many other possible changes in our economic environment that would have
an impact on c can be analyzed (a few are discussed in the problems at the
end of the chapter).
Abolishment of
Interest Payments
on Checking
Accounts
Rise in Income Tax
Rates to Balance
the Budget
7
PREVIEW In the chapters describing the structure of the Federal Reserve System and the money
supply process, we mentioned three policy tools that the Fed can use to manipulate
the money supply and interest rates: open market operations, which affect the quantity
of reserves and the monetary base; changes in discount lending, which affect the
monetary base; and changes in reserve requirements, which affect the money multiplier.
Because the Fed’s use of these policy tools has such an important impact on
interest rates and economic activity, it is important to understand how the Fed wields
them in practice and how relatively useful each tool is.
In recent years, the Federal Reserve has increased its focus on the federal funds
rate (the interest rate on overnight loans of reserves from one bank to another) as the
primary indicator of the stance of monetary policy. Since February 1994, the Fed
announces a federal funds rate target at each FOMC meeting, an announcement that
is watched closely by market participants because it affects interest rates throughout
the economy. Thus, to fully understand how the Fed’s tools are used in the conduct
of monetary policy, we must understand not only their effect on the money supply,
but their direct effects on the federal funds rate as well. The chapter thus begins with
a supply-and-demand analysis of the market for reserves to explain how the Fed’s settings
for the three tools of monetary policy determine the federal funds rate. We then
go on to look in more detail at each of the three tools—open market operations, discount
rate policy, and reserve requirements—to see how they are used in practice and
to ask whether the use of these tools could be modified to improve the conduct of
monetary policy.
The Market for Reserves and the Federal Funds Rate
In Chapter 15, we saw how open market operations and discount lending affect the
balance sheet of the Fed and the amount of reserves. The market for reserves is where
the federal funds rate is determined, and this is why we turn to a supply-and-demand
analysis of this market to analyze how all three tools of monetary policy affect the federal
funds rate.
393
Chap ter
17 Tools of Monetary Policy
The analysis of the market for reserves proceeds in a similar fashion to the analysis of
the bond market we conducted in Chapter 5. We derive a demand and supply curve
for reserves. Then the market equilibrium in which the quantity of reserves
demanded equals the quantity of reserves supplied determines the federal funds rate,
the interest rate charged on the loans of these reserves.
Demand Curve. To derive the demand curve for reserves, we need to ask what happens
to the quantity of reserves demanded, holding everything else constant, as the
federal funds rate changes. Recall from Chapter 16 that the amount of reserves can be
split up into two components: (1) required reserves, which equal the required reserve
ratio times the amount of deposits on which reserves are required, and (2) excess
reserves, the additional reserves banks choose to hold. Therefore, the quantity of
reserves demanded equals required reserves plus the quantity of excess reserves
demanded. Excess reserves are insurance against deposit outflows, and the cost of
holding these excess reserves is their opportunity cost, the interest rate that could
have been earned on lending these reserves out, which is equivalent to the federal
funds rate. Thus as the federal funds rate decreases, the opportunity cost of holding
excess reserves falls and, holding everything else constant, including the quantity of
required reserves, the quantity of reserves demanded rises. Consequently, the demand
curve for reserves, Rd, slopes downward in Figure 1.
Supply Curve. The supply of reserves, Rs, can be broken up into two components: the
amount of reserves that are supplied by the Fed’s open market operations, called nonborrowed
reserves (Rn), and the amount of reserves borrowed from the Fed, called
discount loans (DL). The primary cost of borrowing discount loans from the Fed is
Supply and
Demand in the
Market for
Reserves
394 PA RT I V Central Banking and the Conduct of Monetary Policy
FIGURE 1 Equilibrium in the
Market for Reserves
Equilibrium occurs at the intersection
of the supply curve Rs and
the demand curve Rd at point 1
and an interest rate of i*ff .
Quantity of
Reserves, R
Rn
id
i ff 1
i ff
i ff
Federal
Funds Rate
Rd
Rs
2
*
1
the interest rate the Fed charges on these loans, the discount rate (id). Because borrowing
federal funds is a substitute for taking out discount loans from the Fed, if the
federal funds rate iff is below the discount rate id, then banks will not borrow from the
Fed and discount loans will be zero because borrowing in the federal funds market is
cheaper. Thus, as long as iff remains below id, the supply of reserves will just equal the
amount of nonborrowed reserves supplied by the Fed, Rn, and so the supply curve will
be vertical as shown in Figure 1. However, as the federal funds rate begins to rise above
the discount rate, banks would want to keep borrowing more and more at id and then
lending out the proceeds in the federal funds market at the higher rate, iff. The result
is that the supply curve becomes flat (infinitely elastic) at id, as shown in Figure 1.
Market Equilibrium. Market equilibrium occurs where the quantity of reserves
demanded equals the quantity supplied, Rs Rd. Equilibrium therefore occurs at the
intersection of the demand curve Rd and the supply curve Rs at point 1, with an equilibrium
federal funds rate of i*ff . When the federal funds rate is above the equilibrium
rate at i2
ff , there are more reserves supplied than demanded (excess supply) and so the
federal funds rate falls to i*ff as shown by the downward arrow. On the other hand,
when the federal funds rate is below the equilibrium rate at i1
ff , there are more reserves
demanded than supplied (excess demand) and so the federal funds rate rises as shown
by the upward arrow. (Note that Figure 1 is drawn so that id is above i*ff because the
Federal Reserve now keeps the discount rate substantially above the target for the federal
funds rate.)
Now that we understand how the federal funds rate is determined, we can examine
how changes in the three tools of monetary policy—open market operations, discount
lending, and reserve requirements—affect the market for reserves and the equilibrium
federal funds rate.
Open Market Operations. We have already seen that an open market purchase leads
to a greater quantity of reserves supplied; this is true at any given federal funds rate
because of the higher amount of nonborrowed reserves, which rises from R1
n to R2
n. An
open market purchase therefore shifts the supply curve to the right from Rs1
to Rs2
and
moves the equilibrium from point 1 to point 2, lowering the federal funds rate from
i1
ff to i2
ff (see Figure 2).1 The same reasoning implies that an open market sale decreases
the quantity of reserves supplied, shifts the supply curve to the left and causes the federal
funds rate to rise.
The result is that an open market purchase causes the federal funds rate to fall,
whereas an open market sale causes the federal funds rate to rise.
Discount Lending. The effect of a discount rate change depends on whether the
demand curve intersects the supply curve in its vertical section versus its flat section.
Panel a of Figure 3 shows what happens if the intersection occurs at the vertical section
of the supply curve so there is no discount lending. In this case, when the discount rate
How Changes
in the Tools of
Monetary Policy
Affect the Federal
Funds Rate
C H A P T E R 1 7 Tools of Monetary Policy 395
1We come to the same conclusion using the money supply framework in Chapter 16, along with the liquidity
preference framework in Chapter 5. An open market purchase raises reserves and the money supply, and then
the liquidity preference framework shows that interest rates fall.
www.federalreserve.gov
/fomc/fundsrate.htm
This site lists historical federal
funds rates and also discusses
Federal Reserve targets.
396 PA RT I V Central Banking and the Conduct of Monetary Policy
FIGURE 2 Response to an
Open Market Operation
An open market purchase increases
nonborrowed reserves and hence
the reserves supplied, and shifts
the supply curve from Rs1
to Rs2
.
The equilibrium moves from
point 1 to point 2, lowering the
federal funds rate from i 1
ff to i 2
ff .
Quantity of
Reserves, R
Rn Rn
id
1
2
i ff
i ff
Federal
Funds Rate
R1
R1 R2
1
2
s s
1 2
d
FIGURE 3 Response to a Change in the Discount Rate
In panel a when the discount rate is lowered by the Fed from i1d
to i2d
, the vertical section of the supply curve just shortens, as in Rs2
, so that the
equilibrium federal funds rate remains unchanged at i 1
ff. In panel b when the discount rate is lowered by the Fed from i1d
to i2d
, the horizontal
section of the supply curve Rs2
falls, and the equilibrium federal funds rate falls from i 1
ff to i 2
ff .
Quantity of
Reserves, R
Rn
Federal
Funds Rate
R2
(a) No discount lending
Quantity of
Reserves, R
Rn
i ff = i d
1
i 2 ff = i d
Federal
Funds Rate
(b) Some discount lending
i d
1
i ff
1
i d
2
R1 d
1
R1
s
s
R1
s
R2
s
R1 d
1 1
2 2
is lowered by the Fed from i1d
to i2d
, the vertical section of the supply curve where
there is no discount lending just shortens, as in Rs
2, while the intersection of the supply
and demand curve remains at the same point. Thus, in this case there is no
change in the equilibrium federal funds rate, which remains at i1
ff. Because this is the
typical situation—since the Fed now usually keeps the discount rate above its target
for the federal funds rate—the conclusion is that most changes in the discount rate
have no effect on the federal funds rate.
However, if the demand curve intersects the supply curve on its flat section, so
there is some discount lending, as in panel b of Figure 3, changes in the discount rate
do affect the federal funds rate. In this case, initially discount lending is positive and
the equilibrium federal funds rate equals the discount rate, i1
ff i1
d. When the discount
rate is lowered by the Fed from i1d
to i2d
, the horizontal section of the supply curve Rs2
falls, moving the equilibrium from point 1 to point 2, and the equilibrium federal
funds rate falls from i1
ff to i2
ff ( i2d
) in panel b.
Reserve Requirements. When the required reserve ratio increases, required reserves
increase and hence the quantity of reserves demanded increases for any given interest
rate. Thus a rise in the required reserve ratio shifts the demand curve to the right
from Rd1
to Rd
2 in Figure 4, moves the equilibrium from point 1 to point 2, and in turn
raises the federal funds rate from i 1
ff to i 2
ff .
The result is that when the Fed raises reserve requirements, the federal funds
rate rises.2
C H A P T E R 1 7 Tools of Monetary Policy 397
FIGURE 4 Response to a
Change in Required Reserves
When the Fed raises reserve
requirements, required reserves
increase, which increases the
demand for reserves. The demand
curve shifts from Rd1
to Rd
2, the
equilibrium moves from point 1
to point 2, and the federal fund
rate rises from i 1
ff to i 2
ff .
Quantity of
Reserves, R
Rn
id
1
2
i ff
Federal
Funds Rate
R1
s
R2
d
R1 d
i ff
1
2
2Because an increase in the required reserve ratio means that the same amount of reserves is able to support a
smaller amount of deposits, a rise in the required reserve ratio leads to a decline in the money supply. Using the
liquidity preference framework, the fall in the money supply results in a rise in interest rates, yielding the same
conclusion in the text that raising reserve requirements leads to higher interest rates.
www.frbdiscountwindow.org/
Information on the operation of
the discount window and data
on current and historical
interest rates.
www.federalreserve.gov
/monetarypolicy
/reservereq.htm
Historical data and discussion
about reserve requirements.
Similarly, a decline in the required reserve ratio lowers the quantity of reserves
demanded, shifts the demand curve to the left, and causes the federal funds rate to
fall. When the Fed decreases reserve requirements, it leads to a fall in the federal
funds rate.
Now that we understand how the three tools of monetary policy—open market
operations, discount lending, and reserve requirements—can be used by the Fed to
manipulate the money supply and interest rates, we will look at each of them in turn
to see how the Fed wields them in practice and how relatively useful each tool is.
Open Market Operations
Open market operations are the most important monetary policy tool, because they
are the primary determinants of changes in interest rates and the monetary base, the
main source of fluctuations in the money supply. Open market purchases expand
reserves and the monetary base, thereby raising the money supply and lowering
short-term interest rates. Open market sales shrink reserves and the monetary base,
lowering the money supply and raising short-term interest rates. Now that we understand
from Chapter 15 the factors that influence the reserves and monetary base, we
can examine how the Federal Reserve conducts open market operations with the
object of controlling short-term interest rates and the money supply.
There are two types of open market operations: Dynamic open market operations
are intended to change the level of reserves and the monetary base, and defensive
open market operations are intended to offset movements in other factors that
affect reserves and the monetary base, such as changes in Treasury deposits with the
Fed or float. The Fed conducts open market operations in U.S. Treasury and government
agency securities, especially U.S. Treasury bills.3 The Fed conducts most of its
open market operations in Treasury securities because the market for these securities
is the most liquid and has the largest trading volume. It has the capacity to absorb the
Fed’s substantial volume of transactions without experiencing excessive price fluctuations
that would disrupt the market.
As we saw in Chapter 14, the decision-making authority for open market operations
is the Federal Open Market Committee (FOMC), which sets a target for the federal
funds rate. The actual execution of these operations, however, is conducted by the
trading desk at the Federal Reserve Bank of New York. The best way to see how these
transactions are executed is to look at a typical day at the trading desk, located in a
newly built trading room on the ninth floor of the Federal Reserve Bank of New York.
The manager of domestic open market operations supervises the analysts and traders
who execute the purchases and sales of securities in order to hit the federal funds rate
target. To get a grip on what might happen in the federal funds market that day, her
workday and that of her staff begins with a review of developments in the federal
funds market the previous day and with an update on the actual amount of reserves
A Day at the
Trading Desk
398 PA RT I V Central Banking and the Conduct of Monetary Policy
3To avoid conflicts of interest, the Fed does not conduct open market operations in privately issued securities.
(For example, think of the conflict if the Federal Reserve purchased bonds issued by a company owned by the
chairman’s brother-in-law.)
www.federalreserve.gov/fomc
A discussion about the federal
open market committee, list of
current members, meeting
dates, and other current
information.
in the banking system the day before. Later in the morning, her staff issues updated
reports that contain detailed forecasts of what will be happening to some of the shortterm
factors affecting the supply and demand of reserves (discussed in Chapter 15).
For example, if float is predicted to decrease because good weather throughout the
country is speeding up check delivery, the manager of domestic open market operations
knows that she will have to conduct a defensive open market operation (in this
case, a purchase of securities) to offset the expected decline in reserves and the monetary
base from the decreased float. However, if Treasury deposits with the Fed are
predicted to fall, a defensive open market sale would be needed to offset the expected
increase in reserves. The report also predicts the change in the public’s holding of currency.
If currency holdings are expected to rise, then, as we have seen in Chapters 15
and 16, reserves fall, and an open market purchase is needed to raise reserves back
up again.
This information will help the manager of domestic open market operations and
her staff decide how large a change in reserves is needed to obtain the federal funds
rate target. If the amount of reserves in the banking system is too large, many banks
will have excess reserves to lend that other banks may have little desire to hold, and
the federal funds rate will fall. If the level of reserves is too low, banks seeking to borrow
reserves from the few banks that have excess reserves to lend may push the funds
rate higher than the desired level. Also during the morning, the staff will monitor the
behavior of the federal funds rate and contact some of the major participants in the
funds market, which may provide independent information about whether a change
in reserves is needed to achieve the desired level of the federal funds rate. Early in the
morning, members of the manager’s staff contact several representatives of the socalled
primary dealers, government securities dealers (who operate out of private
firms or commercial banks) that the open market desk trades with. Her staff finds out
how the dealers view market conditions to get a feel for what may happen to the
prices of the securities they trade in over the course of the day. They also call the
Treasury to get updated information on the expected level of Treasury balances at the
Fed in order to refine their estimates of the supply of reserves.
Afterward, members of the Monetary Affairs Division at the Board of Governors
are contacted, and the New York Fed’s forecasts of reserve supply and demand are
compared with the Board’s. On the basis of these projections and the observed behavior
of the federal funds market, the desk will formulate and propose a course of action
to be taken that day, which may involve plans to add reserves to or drain reserves from
the banking system through open market operations. If an operation is contemplated,
the type, size, and maturity will be discussed.
The whole process is currently completed by midmorning, at which time a daily
conference call is arranged linking the desk with the Office of the Director of
Monetary Affairs at the Board and with one of the four voting Reserve Bank presidents
outside of New York. During the call, a member of the open market operations unit
will outline the desk’s proposed reserve management strategy for the day. After the
plan is approved, the desk is instructed to execute immediately any temporary open
market operations that were planned for that day. (Outright operations, to be
described shortly, may be conducted at other times of the day.)
The desk is linked electronically with its domestic open market trading counterparties
by a computer system called TRAPS (Trading Room Automated Processing
System), and all open market operations are now performed over this system. A message
will be electronically transmitted simultaneously to all the primary dealers over
TRAPS indicating the type and maturity of the operation being arranged. The dealers
C H A P T E R 1 7 Tools of Monetary Policy 399
are given several minutes to respond via TRAPS with their propositions to buy or sell
government securities. The propositions are then assembled and displayed on a computer
screen for evaluation. The desk will select all propositions, beginning with the
most attractively priced, up to the point where the desired amount is purchased or
sold, and it will then notify each dealer via TRAPS which of its propositions have been
chosen. The entire selection process is typically completed in a matter of minutes.
These temporary transactions are of two basic types. In a repurchase agreement
(often called a repo), the Fed purchases securities with an agreement that the seller
will repurchase them in a short period of time, anywhere from 1 to 15 days from the
original date of purchase. Because the effects on reserves of a repo are reversed on the
day the agreement matures, a repo is actually a temporary open market purchase and
is an especially desirable way of conducting a defensive open market purchase that
will be reversed shortly. When the Fed wants to conduct a temporary open market
sale, it engages in a matched sale–purchase transaction (sometimes called a reverse
repo) in which the Fed sells securities and the buyer agrees to sell them back to the
Fed in the near future.
At times, the desk may see the need to address a persistent reserve shortage or surplus
and wish to arrange an operation that will have a permanent impact on the supply
of reserves. Outright transactions, which involve a purchase or sale of securities
that is not self-reversing, are also conducted over TRAPS. These operations are traditionally
executed at times of day when temporary operations are not being conducted.
Open market operations have several advantages over the other tools of monetary policy.
1. Open market operations occur at the initiative of the Fed, which has complete
control over their volume. This control is not found, for example, in discount operations,
in which the Fed can encourage or discourage banks to take out discount loans
by altering the discount rate but cannot directly control the volume of discount loans.
2. Open market operations are flexible and precise; they can be used to any
extent. No matter how small a change in reserves or the monetary base is desired,
open market operations can achieve it with a small purchase or sale of securities.
Conversely, if the desired change in reserves or the base is very large, the open market
operations tool is strong enough to do the job through a very large purchase or
sale of securities.
3. Open market operations are easily reversed. If a mistake is made in conducting
an open market operation, the Fed can immediately reverse it. If the Fed decides
that the federal funds rate is too low because it has made too many open market purchases,
it can immediately make a correction by conducting open market sales.
4. Open market operations can be implemented quickly; they involve no administrative
delays. When the Fed decides that it wants to change the monetary base or
reserves, it just places orders with securities dealers, and the trades are executed
immediately.
Discount Policy
The Federal Reserve facility at which discount loans are made to banks is called the
discount window. The easiest way to understand how the Fed affects the volume of
discount loans is by looking at how the discount window operates.
Advantages of
Open Market
Operations
400 PA RT I V Central Banking and the Conduct of Monetary Policy
The Fed’s discount loans to banks are of three types: primary credit, secondary credit,
and seasonal credit.4 Primary credit is the discount lending that plays the most important
role in monetary policy. Healthy banks are allowed to borrow all they want from
the primary credit facility, and it is therefore referred to as a standing lending facility.
The interest rate on these loans is the discount rate, and as we mentioned before, it is
set higher than the federal funds rate target, usually by 100 basis points (one percentage
point), and thus in most circumstances the amount of discount lending under
the primary credit facility is very small. Then why does the Fed have this facility?
The answer is that the facility is intended to be a backup source of liquidity for
sound banks so that the federal funds rate never rises too far above the federal funds
target. To see how the primary credit facility works, let’s see what happens if there is
a large increase in the demand for reserves, say because deposits have surged unexpectedly
and have led to an increase in required reserves. This situation is analyzed
in Figure 5. Suppose that initially, the demand and supply curve for reserves intersect
at point 1 so that the federal funds rate is at its target level, iT
ff. Now the increase in
required reserves shifts the demand curve to Rd2
and the equilibrium moves to point
2. The result is that discount lending increases from zero to DL2 and the federal funds
rate rises to id and can rise no further. The primary credit facility has thus put a ceiling
on the federal funds rate of id.
Operation of the
Discount Window
C H A P T E R 1 7 Tools of Monetary Policy 401
4The procedures for administering the discount window were changed in January 2003. The primary credit facility
replaced an adjustment credit facility whose discount rate was typically set below market interest rates, so
banks were restricted in their access to this credit. In contrast, now healthy banks can borrow all they want from
the primary credit facility. The secondary credit facility replaced the extended credit facility which focused somewhat
more on longer-term credit extensions. The seasonal credit facility remains basically unchanged.
FIGURE 5 How the Primary
Credit Facility Puts a Ceiling on the
Federal Funds Rate
The rightward shift of the demand
curve to reserves from Rd1
to Rd
2
moves the equilibrium from point
1 to point 2 where i 2
ff id and
discount lending rises from zero
to DL2.
Quantity of
Reserves, R
Rn DL2
1
i 2 ff = id
i ff
Federal
Funds Rate
Rs
2
T
R1
d
R2
d
Secondary credit is given to banks that are in financial trouble and are experiencing
severe liquidity problems. The interest rate on secondary credit is set at 50 basis
points (0.5 percentage points) above the discount rate. This interest rate on these
loans is set at a higher, penalty rate to reflect the less-sound condition of these borrowers.
Seasonal credit is given to meet the needs of a limited number of small banks
in vacation and agricultural areas that have a seasonal pattern of deposits. The interest
rate charged on seasonal credit is tied to the average of the federal funds rate and
certificate of deposit rates. The Federal Reserve has questioned the need for the seasonal
credit facility because of improvements in credit markets and is thus contemplating
eliminating it in the future.
In addition to its use as a tool to influence reserves, the monetary base, and the money
supply, discounting is important in preventing financial panics. When the Federal
Reserve System was created, its most important role was intended to be as the lender
of last resort; to prevent bank failures from spinning out of control, it was to provide
reserves to banks when no one else would, thereby preventing bank and financial
panics. Discounting is a particularly effective way to provide reserves to the banking
system during a banking crisis because reserves are immediately channeled to the
banks that need them most.
Using the discount tool to avoid financial panics by performing the role of lender
of last resort is an extremely important requirement of successful monetary policymaking.
As we demonstrated with our money supply analysis in Chapter 16, the bank
panics in the 1930–1933 period were the cause of the sharpest decline in the money
supply in U.S. history, which many economists see as the driving force behind the collapse
of the economy during the Great Depression. Financial panics can also severely
damage the economy because they interfere with the ability of financial intermediaries
and markets to move funds to people with productive investment opportunities (see
Chapter 8).
Unfortunately, the discount tool has not always been used by the Fed to prevent
financial panics, as the massive failures during the Great Depression attest. The Fed
learned from its mistakes of that period and has performed admirably in its role of
lender of last resort in the post–World War II period. The Fed has used its discount
lending weapon several times to avoid bank panics by extending loans to troubled
banking institutions, thereby preventing further bank failures. The largest of these
occurred in 1984, when the Fed lent Continental Illinois, at that time one of the ten
largest banks in the United States, more than $5 billion.
At first glance, it might seem that the presence of the FDIC, which insures depositors
up to a limit of $100,000 per account from losses due to a bank’s failure, would
make the lender-of-last-resort function of the Fed superfluous. (The FDIC is described
in detail in Chapter 11.) There are two reasons why this is not the case. First, it is
important to recognize that the FDIC’s insurance fund amounts to around 1% of the
amount of these deposits outstanding. If a large number of bank failures occurred, the
FDIC would not be able to cover all the depositors’ losses. Indeed, the large number
of bank failures in the 1980s and early 1990s, described in Chapter 11, led to large
losses and a shrinkage in the FDIC’s insurance fund, which reduced the FDIC’s ability
to cover depositors’ losses. This fact has not weakened the confidence of small
depositors in the banking system because the Fed has been ready to stand behind the
banks to provide whatever reserves are needed to prevent bank panics. Second, the
nearly $1 trillion of large-denomination deposits in the banking system are not
Lender of Last
Resort
402 PA RT I V Central Banking and the Conduct of Monetary Policy
guaranteed by the FDIC, because they exceed the $100,000 limit. A loss of confidence
in the banking system could still lead to runs on banks from the large-denomination
depositors, and bank panics could still occur despite the existence of the FDIC. The
importance of the Federal Reserve’s role as lender of last resort is, if anything, more
important today because of the high number of bank failures experienced in the
1980s and early 1990s.
Not only can the Fed be a lender of last resort to banks, but it can also play the
same role for the financial system as a whole. The existence of the Fed’s discount window
can help prevent financial panics that are not triggered by bank failures, as was
the case during the Black Monday stock market crash of 1987 and the terrorist
destruction of the World Trade Center in September 2001 (see Box 1).
Although the Fed’s role as the lender of last resort has the benefit of preventing
bank and financial panics, it does have a cost. If a bank expects that the Fed will provide
it with discount loans when it gets into trouble, as occurred with Continental
Illinois, it will be willing to take on more risk knowing that the Fed will come to the
rescue. The Fed’s lender-of-last-resort role has thus created a moral hazard problem
similar to the one created by deposit insurance (discussed in Chapter 11): Banks take
on more risk, thus exposing the deposit insurance agency, and hence taxpayers, to
greater losses. The moral hazard problem is most severe for large banks, which may
believe that the Fed and the FDIC view them as “too big to fail”; that is, they will
always receive Fed loans when they are in trouble because their failure would be likely
to precipitate a bank panic.
Similarly, Federal Reserve actions to prevent financial panic, as occurred after the
October 1987 stock market crash and the September 11, 2001 terrorist attacks, may
encourage financial institutions other than banks to take on greater risk. They, too,
expect the Fed to ensure that they could get loans if a financial panic seemed imminent.
When the Fed considers using the discount weapon to prevent panics, it therefore
needs to consider the trade-off between the moral hazard cost of its role as lender
of last resort and the benefit of preventing financial panics. This trade-off explains why
the Fed must be careful not to perform its role as lender of last resort too frequently.
The most important advantage of discount policy is that the Fed can use it to perform
its role of lender of last resort. Experiences with Continental Illinois, the Black Monday
crash, and September 11, 2001 indicate that this role has become more important in
the past couple of decades. In the past, discount policy was used as a tool of monetary
policy, with the discount rate changed in order to affect interest rates and the monetary
market. However, because the decisions to take out discount loans are made by banks
and are therefore not completely controlled by the Fed, while open market operations
are completely controlled by the Fed, the use of discount policy to conduct monetary
policy has little to recommend it. This is why the Fed moved in January 2003 to the
current system in which the discount facility is not used to set the federal funds rate,
but is only a backup facility to prevent the federal funds rate from rising too far above
its target.
Reserve Requirements
As we saw in Chapter 16, changes in reserve requirements affect the money supply by
causing the money supply multiplier to change. A rise in reserve requirements reduces
Advantages and
Disadvantages of
Discount Policy
C H A P T E R 1 7 Tools of Monetary Policy 403
404 PA RT I V Central Banking and the Conduct of Monetary Policy
The Black Monday Stock Market Crash of 1987
and the Terrorist Destruction of the World Trade
Center in September 2001. Although October 19,
1987, dubbed “Black Monday,” will go down in the
history books as the largest one-day percentage
decline in stock prices to date (the Dow Jones
Industrial Average declined by more than 20%), it
was on Tuesday, October 20, 1987, that financial
markets almost stopped functioning. Felix Rohatyn,
one of the most prominent men on Wall Street, stated
flatly: “Tuesday was the most dangerous day we had
in 50 years.”* Much of the credit for prevention of a
market meltdown after Black Monday must be given
to the Federal Reserve System and the chairman of
the Board of Governors, Alan Greenspan.
The stress of keeping markets functioning during
the sharp decline in stock prices on Monday, October
19, meant that many brokerage houses and specialists
(dealer-brokers who maintain orderly trading on the
stock exchanges) were severely in need of additional
funds to finance their activities. However, understandably
enough, New York banks, as well as foreign
and regional U.S. banks, growing very nervous about
the financial health of securities firms, began to cut
back credit to the securities industry at the very time
when it was most needed. Panic was in the air. One
chairman of a large specialist firm commented that on
Monday, “from 2 P.M. on, there was total despair. The
entire investment community fled the market. We
were left alone on the field.” It was time for the Fed,
like the cavalry, to come to the rescue.
Upon learning of the plight of the securities industry,
Alan Greenspan and E. Gerald Corrigan, then
president of the Federal Reserve Bank of New York
and the Fed official most closely in touch with Wall
Street, became fearful of a spreading collapse of securities
firms. To prevent this from occurring, Greenspan
announced before the market opened on Tuesday,
October 20, the Federal Reserve System’s “readiness
to serve as a source of liquidity to support the economic
and financial system.” In addition to this
extraordinary announcement, the Fed made it clear
that it would provide discount loans to any bank that
would make loans to the securities industry, although
this did not prove to be necessary. As one New York
banker said, the Fed’s message was, “We’re here.
Whatever you need, we’ll give you.”
The outcome of the Fed’s timely action was that a
financial panic was averted. The markets kept functioning
on Tuesday, and a market rally ensued that
day, with the Dow Jones Industrial Average climbing
over 100 points.
A similar lender-of-last-resort operation was carried
out in the aftermath of the destruction of the World
Trade Center in New York City on Tuesday, September
11, 2001—the worst terrorist incident in U.S. history.
Because of the disruption to the most important financial
center in the world, the liquidity needs of the
financial system skyrocketed. To satisfy these needs
and to keep the financial system from seizing up,
within a few hours of the incident, the Fed made an
announcement similar to that made after the crash of
1987: “The Federal Reserve System is open and operating.
The discount window is available to meet liquidity
needs.”** The Fed thenproceeded to provide
$45 billion to banks through the discount window, a
200-fold increase over the previous week. As a result
of this action, along with the injection of as much as
$80 billion of reserves into the banking system
through open market operations, the financial system
kept functioning. When the stock market reopened on
Monday, September 17, trading was orderly, although
the Dow Jones average did decline 7%.
The terrorists were able to bring down the twin
towers of the World Trade Center, with nearly 3,000
dead. However, they were unable to bring down the
U.S. financial system because of the timely actions of
the Federal Reserve.
*“Terrible Tuesday: How the Stock Market Almost Disintegrated a Day After the Crash,” Wall Street Journal, November 20, 1987, p. 1. This article provides a fascinating
and more detailed view of the events described here and is the source of all the quotations cited.
**“Economic Front: How Policy Makers Regrouped to Defend the Financial System,” Wall Street Journal, Tuesday, September 18, 2001, p. A1, provides more detail
on this episode.
Discounting to Prevent a Financial Panic
Box 1: Inside the Fed
the amount of deposits that can be supported by a given level of the monetary base
and will lead to a contraction of the money supply. A rise in reserve requirements
also increases the demand for reserves and raises the federal funds rate. Conversely,
a decline in reserve requirements leads to an expansion of the money supply and a
fall in the federal funds rate. The Fed has had the authority to vary reserve requirements
since the 1930s; this is a powerful way of affecting the money supply and
interest rates. Indeed, changes in reserve requirements have such large effects on the
money supply and interest rates that the Fed rarely resorts to using this tool to control
them.
The Depository Institutions Deregulation and Monetary Control Act of 1980 provided
a simpler scheme for setting reserve requirements. All depository institutions,
including commercial banks, savings and loan associations, mutual savings banks,
and credit unions, are subject to the same reserve requirements, as follows: Required
reserves on all checkable deposits—including non-interest-bearing checking
accounts, NOW accounts, super-NOW accounts, and ATS (automatic transfer savings)
accounts—are equal to 3% of the bank’s first $42.1 million of checkable
deposits5 and 10% of the checkable deposits over $42.1 million, and the percentage
set initially at 10% can be varied between 8 and 14%, at the Fed’s discretion. In
extraordinary circumstances, the percentage can be raised as high as 18%.
The main advantage of using reserve requirements to control the money supply and
interest rates is that they affect all banks equally and have a powerful effect on the
money supply. The fact that changing reserve requirements is a powerful tool, however,
is probably more of a curse than a blessing, because small changes in the money
supply and interest rates are hard to engineer by varying reserve requirements. With
checkable deposits currently around the $600 billion level, a -percentage-point
increase in the reserve requirement on these deposits would reduce excess reserves by
$30 billion. Because this decline in excess reserves would result in multiple deposit
contraction, the decline in the money supply would be even greater. It is true that
small changes in the money supply could be obtained by extremely small changes in
reserve requirements (say, by 0.001 percentage point), but because it is so expensive
to administer changes in reserve requirements, such a strategy is not practical. Using
reserve requirements to fine-tune the money supply is like trying to use a jackhammer
to cut a diamond.
Another disadvantage of using reserve requirements to control the money supply
and interest rates is that raising the requirements can cause immediate liquidity problems
for banks with low excess reserves. When the Fed has raised these requirements
in the past, it has usually softened the blow by conducting open market purchases or
by making the discount window more available, thus providing reserves to banks that
needed them. Continually fluctuating reserve requirements would also create more
uncertainty for banks and make their liquidity management more difficult.
The policy tool of changing reserve requirements does not have much to
recommend it, and it is rarely used.
12
Advantages and
Disadvantages
of Reserve
Requirement
Changes
C H A P T E R 1 7 Tools of Monetary Policy 405
5The $42.1 million figure is as of the end of 2002. Each year, the figure is adjusted upward by 80% of the percentage
increase in checkable deposits in the United States.
406 PA RT I V Central Banking and the Conduct of Monetary Policy
Application Why Have Reserve Requirements Been Declining Worldwide?
In recent years, central banks in many countries in the world have been reducing
or eliminating their reserve requirements. In the United States, the Federal
Reserve eliminated reserve requirements on time deposits in December 1990
and lowered reserve requirements on checkable deposits from 12% to 10% in
April 1992. As a result, the majority of U.S. depository institutions—but not
the largest ones with the bulk of deposits—find that reserve requirements are
not binding: In order to service their depositors, many depository institutions
need to keep sufficient vault cash on hand (which counts toward meeting
reserve requirements) that they more than meet reserve requirements voluntarily.
Canada has gone a step further: Financial market legislation taking effect
in June 1992 eliminated all reserve requirements over a two-year period. The
central banks of Switzerland, New Zealand, and Australia have also eliminated
reserve requirements entirely. What explains the downward trend for reserve
requirements in most countries?
You may recall from Chapter 9 that reserve requirements act as a tax on
banks. Because central banks typically do not pay interest on reserves, the
bank earns nothing on them and loses the interest that could have been
earned if the bank held loans instead. The cost imposed on banks from
reserve requirements means that banks, in effect, have a higher cost of funds
than intermediaries not subject to reserve requirements, making them less
competitive. We have already seen in Chapter 10 that additional market
forces have been making banks less competitive, weakening the health of
banking systems throughout the world. Central banks have thus been reducing
reserve requirements to make banks more competitive and stronger.6 The
Federal Reserve was explicit about this rationale for its April 1992 reduction
when it announced it on February 18, 1992, stating in its press release that
the reduction “will reduce funding costs for depositories and strengthen their
balance sheets. Over time, it is expected that most of these cost savings will
be passed on to depositors and borrowers.”
6Many economists believe that the Fed should pay market interest rates on reserves, another suggestion for dealing
with this problem.
7See Benjamin Friedman, “The Future of Monetary Policy: The Central Bank as an Army with Only a Signal
Corps?” International Finance 2 (1999), pp. 321–338, and the rest of the symposium on this topic in the same
journal.
Application The Channel/Corridor System for Setting Interest Rates in Other Countries
The fall in reserve requirements has elicited the concern that if the demand
for reserves falls to zero, then a central bank may not be able to exercise control
over interest rates.7 However, the so-called channel or corridor system
for conducting monetary policy—which has been adopted by Canada,
C H A P T E R 1 7 Tools of Monetary Policy 407
Australia, and New Zealand, all of which have eliminated reserve requirements—
shows that central banks can continue to effectively set overnight,
interbank interest rates like the federal funds rate. How the channel/corridor
system works is illustrated by Figure 6, which describes the market for
reserves along the lines discussed at the beginning of this chapter.
In the channel/corridor system, the central bank sets up a standing lending
facility, like the one currently in place in the United States and in most
industrialized countries, in which the central bank stands ready to lend
overnight any amount banks ask for at a fixed interest rate, il. This standing
lending facility is commonly called a lombard facility and the interest rate
charged on these loans is often called a lombard rate. (This name comes from
Lombardy, a region in northern Italy that was an important center of banking
in the middle ages.) As we saw at the beginning of the chapter, with a
standing lending facility, the central bank does not limit the amount of borrowing
by banks, but always stands ready to supply any amount the banks
want at the lending rate il. Thus the quantity of reserves supplied is flat (infinitely
elastic) at il as shown in Figure 6, because if the overnight interest rate,
denoted by iff, begins to rise above il, banks would just keep borrowing discount
loans indefinitely.
In the channel/corridor system the central bank sets up another standing
facility that pays banks a fixed interest rate ir on any reserves (deposits) they
would like to keep at the central bank. The quantity of reserves supplied is
also flat at ir, because if the overnight rate begins to fall below this rate, banks
would not lend in the overnight market. Instead they would keep increasing
the amount of their deposits in the central bank (effectively lending to the
central bank), and would thereby keep lowering the quantity of reserves the
central bank is supplying. In between ir and il, the quantity of reserves supplied
equals nonborrowed reserves Rn, which are determined by open market
operations. Nonborrowed reserves are set to zero if the demand for
reserves is also expected to be zero. The supply curve for reserves Rs is thus
the step function depicted in Figure 6.
The demand curve for reserves Rd has the usual downward slope. As we
can see in Figure 6, when the demand curve shifts to the left to Rd
1 the
overnight interest rate never falls below ir, while if the demand curve shifts
to the right to Rd
2, the overnight rate never rises above il. Thus the channel/
corridor system enables the central bank to keep the overnight interest rate
in between the narrow channel/corridor with an upper limit of il and lower
limit of ir. In Canada, Australia, and New Zealand the lending rate il is set 25
basis points (0.25 percentage points) above the announced target rate, while
the interest rate paid on reserves kept at the central bank is set at 25 basis
points below the target. More in-depth analysis shows that banks will set the
demand for reserves so that the demand curve is expected to intersect the
supply curve at the announced target overnight rate of i*ff, with the result that
deviations from the announced target are fairly small.8
8See Michael Woodford, “Monetary Policy in the Information Economy,” in Symposium on Economic Policy for the
Information Economy (Federal Reserve Bank of Kansas City: 2001), pp. 297–370.
408 PA RT I V Central Banking and the Conduct of Monetary Policy
FIGURE 6 The Channel/
Corridor System for Setting Interest
Rates
In the channel/corridor system
standing facilities result in a step
function supply curve, Rs. Then if
the demand curve shifts between
Rd1
and Rd2
, the overnight interest
rate iff always remains between ir
and il.
Quantity of
Reserves, R
Rn
i l
i r
Overnight Interest
Rate, i ff
Rd
Rs
i ff*
R1 d
R2 d
Summary
1. A supply and demand analysis of the market for
reserves yields the following results. When the Fed
makes an open market purchase or lowers reserve
requirements, the federal funds rate declines. When the
Fed makes an open market sale or raises reserve
requirements, the federal funds rate rises. Changes in
the discount rate may also affect the federal funds rate.
2. The amount of an open market operation conducted on
any given day by the trading desk of the Federal
Reserve Bank of New York is determined by the amount
of the dynamic open market operation intended to
change reserves and the monetary base and by the
amount of the defensive open market operation used to
offset other factors that affect reserves and the monetary
base. Open market operations are the primary tool used
by the Fed to control the money supply because they
occur at the initiative of the Fed, are flexible, are easily
reversed, and can be implemented quickly.
3. The volume of discount loans is affected by the
discount rate. Besides its effect on the monetary base
and the money supply, discounting allows the Fed to
perform its role as the lender of last resort. However,
because the decisions by banks to take out discount
loans are not controlled by the Fed, the use of discount
policy to conduct monetary policy has little to
recommend it.
4. Changing reserve requirements is too blunt a tool to use
for controlling the money supply, and hence it is rarely
used.
The important point of this analysis is that the channel/corridor approach
enables the central bank to set the overnight policy rate, whatever the demand
for reserves, including zero demand. Thus in the future, continuing declines
in the demand for reserves may eventually lead central banks to follow in the
footsteps of the central banks of Canada, Australia, and New Zealand, and to
adopt the channel/corridor system for conducting monetary policy.
C H A P T E R 1 7 Tools of Monetary Policy 409
Key Terms
defensive open market operations,
p. 398
discount window, p. 400
dynamic open market operations,
p. 398
federal funds rate, p. 393
lender of last resort, p. 402
matched sale–purchase transaction
(reverse repo), p. 400
primary dealers, p. 399
repurchase agreement (repo), p. 400
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. If the manager of the open market desk hears that a
snowstorm is about to strike New York City, making it
difficult to present checks for payment there and so
raising the float, what defensive open market operations
will the manager undertake?
2. During Christmastime, when the public’s holdings of
currency increase, what defensive open market operations
typically occur? Why?
*3. If the Treasury has just paid for a supercomputer and
as a result its deposits with the Fed fall, what defensive
open market operations will the manager of the
open market desk undertake?
4. If float decreases below its normal level, why might
the manager of domestic operations consider it more
desirable to use repurchase agreements to affect the
monetary base rather than an outright purchase of
bonds?
*5. Most open market operations are currently repurchase
agreements. What does this tell us about the likely
volume of defensive open market operations relative
to dynamic open market operations?
6. “The only way that the Fed can affect the level of discount
loans is by adjusting the discount rate.” Is this
statement true, false, or uncertain? Explain your answer.
*7. Using the supply and demand analysis of the market
for reserves, show what happens to the federal funds
rate, holding everything else constant, if the economy
is surprisingly strong, leading to a rise in the amount
of checkable deposits.
8. If there is a switch from deposits into currency, what
happens to the federal funds rate? Use the supply and
demand analysis of the market for reserves to explain
your answer.
*9. “Discounting is no longer needed because the presence
of the FDIC eliminates the possibility of bank
panics.” Discuss.
10. The benefits of using Fed discount operations to prevent
bank panics are straightforward. What are the
costs?
*11. You often read in the newspaper that the Fed has just
lowered the discount rate. Does this signal that the
Fed is moving to a more expansionary monetary policy?
Why or why not?
12. How can the procyclical movement of interest rates
(rising during business cycle expansions and falling
during business cycle contractions) lead to a procyclical
movement in the money supply as a result of Fed
discounting? Why might this movement of the money
supply be undesirable?
*13. “If reserve requirements were eliminated, it would
be harder to control interest rates.” True, false, or
uncertain?
14. “Considering that raising reserve requirements to
100% makes complete control of the money supply
possible, Congress should authorize the Fed to raise
reserve requirements to this level.” Discuss.
*15. Compare the use of open market operations, discounting,
and changes in reserve requirements to
control the money supply on the following criteria:
flexibility, reversibility, effectiveness, and speed of
implementation.
QUIZ
410 PA RT I V Central Banking and the Conduct of Monetary Policy
Web Exercises
1. Go to www.federalreserve.gov/fomc/. This site reports
activity by the open market committee. Scroll down to
Calendar and click on the statement released after the
last meeting. Summarize this statement in one paragraph.
Be sure to note whether the committee has
decided to increase or decrease the rate of growth of
reserves. Now review the statements of the last two
meetings. Has the stance of the committee changed?
2. Go to www.federalreserve.gov/releases/h15/update/.
What is the current Federal Funds Rate (define this
rate as well)? What is the current Federal Reserve
Discount rate (define this rate as well)? Is the difference
between these rates similar to what is usually
observed, based on Figure 4? Have short-term rates
increased or declined since the end of 2002?
PREVIEW Now that we understand the tools that central banks like the Federal Reserve use to
conduct monetary policy, we can proceed to how monetary policy is actually conducted.
Understanding the conduct of monetary policy is important, because it not
only affects the money supply and interest rates but also has a major influence on the
level of economic activity and hence on our well-being.
To explore this subject, we look at the goals that the Fed establishes for monetary
policy and its strategies for attaining them. After examining the goals and strategies,
we can evaluate the Fed’s conduct of monetary policy in the past, with the hope that
it will give us some clues to where monetary policy may head in the future.
Goals of Monetary Policy
Six basic goals are continually mentioned by personnel at the Federal Reserve and
other central banks when they discuss the objectives of monetary policy: (1) high
employment, (2) economic growth, (3) price stability, (4) interest-rate stability, (5)
stability of financial markets, and (6) stability in foreign exchange markets.
The Employment Act of 1946 and the Full Employment and Balanced Growth Act of
1978 (more commonly called the Humphrey-Hawkins Act) commit the U.S. government
to promoting high employment consistent with a stable price level. High
employment is a worthy goal for two main reasons: (1) the alternative situation—high
unemployment—causes much human misery, with families suffering financial distress,
loss of personal self-respect, and increase in crime (though this last conclusion
is highly controversial), and (2) when unemployment is high, the economy has not
only idle workers but also idle resources (closed factories and unused equipment),
resulting in a loss of output (lower GDP).
Although it is clear that high employment is desirable, how high should it be? At
what point can we say that the economy is at full employment? At first, it might seem
that full employment is the point at which no worker is out of a job; that is, when
unemployment is zero. But this definition ignores the fact that some unemployment,
called frictional unemployment, which involves searches by workers and firms to find
suitable matchups, is beneficial to the economy. For example, a worker who decides
High Employment
411
Chap ter
Conduct of Monetary Policy:
Goals and Targets
18
www.federalreserve.gov/pf
/pf.htm
Review what the Federal
Reserve reports as its primary
purposes and functions.
to look for a better job might be unemployed for a while during the job search.
Workers often decide to leave work temporarily to pursue other activities (raising a
family, travel, returning to school), and when they decide to reenter the job market,
it may take some time for them to find the right job. The benefit of having some
unemployment is similar to the benefit of having a nonzero vacancy rate in the market
for rental apartments. As many of you who have looked for an apartment have discovered,
when the vacancy rate in the rental market is too low, you will have a difficult
time finding the right apartment.
Another reason that unemployment is not zero when the economy is at full
employment is due to what is called structural unemployment, a mismatch between job
requirements and the skills or availability of local workers. Clearly, this kind of unemployment
is undesirable. Nonetheless, it is something that monetary policy can do little
about.
The goal for high employment should therefore not seek an unemployment level
of zero but rather a level above zero consistent with full employment at which the
demand for labor equals the supply of labor. This level is called the natural rate of
unemployment.
Although this definition sounds neat and authoritative, it leaves a troublesome
question unanswered: What unemployment rate is consistent with full employment?
On the one hand, in some cases, it is obvious that the unemployment rate is too high:
The unemployment rate in excess of 20% during the Great Depression, for example,
was clearly far too high. In the early 1960s, on the other hand, policymakers thought
that a reasonable goal was 4%, a level that was probably too low, because it led to
accelerating inflation. Current estimates of the natural rate of unemployment place it
between 4 and 6%, but even this estimate is subject to a great deal of uncertainty and
disagreement. In addition, it is possible that appropriate government policy, such as
the provision of better information about job vacancies or job training programs,
might decrease the natural rate of unemployment.
The goal of steady economic growth is closely related to the high-employment goal
because businesses are more likely to invest in capital equipment to increase productivity
and economic growth when unemployment is low. Conversely, if unemployment
is high and factories are idle, it does not pay for a firm to invest in additional
plants and equipment. Although the two goals are closely related, policies can be
specifically aimed at promoting economic growth by directly encouraging firms to
invest or by encouraging people to save, which provides more funds for firms to
invest. In fact, this is the stated purpose of so-called supply-side economics policies,
which are intended to spur economic growth by providing tax incentives for businesses
to invest in facilities and equipment and for taxpayers to save more. There is
also an active debate over what role monetary policy can play in boosting growth.
Over the past few decades, policymakers in the United States have become increasingly
aware of the social and economic costs of inflation and more concerned with a
stable price level as a goal of economic policy. Indeed, price stability is increasingly
viewed as the most important goal for monetary policy. (This view is also evident in
Europe—see Box 1.) Price stability is desirable because a rising price level (inflation)
creates uncertainty in the economy, and that uncertainty might hamper economic
growth. For example, when the overall level of prices is changing, the information
conveyed by the prices of goods and services is harder to interpret, which complicates
Price Stability
Economic Growth
12
412 PA RT I V Central Banking and the Conduct of Monetary Policy
www.economagic.com/
A comprehensive listing of
sites that offer a wide variety
of economic summary data
and graphs.
www.bls.gov/cpi/
View current data on the
consumer price index.
decision making for consumers, businesses, and government. Not only do public
opinion surveys indicate that the public is very hostile to inflation, but a growing
body of evidence suggests that inflation leads to lower economic growth.1 The most
extreme example of unstable prices is hyperinflation, such as Argentina, Brazil, and
Russia have experienced in the recent past. Many economists attribute the slower
growth that these countries have experienced to their problems with hyperinflation.
Inflation also makes it hard to plan for the future. For example, it is more difficult
to decide how much funds should be put aside to provide for a child’s college
education in an inflationary environment. Further, inflation can strain a country’s
social fabric: Conflict might result, because each group in the society may compete
with other groups to make sure that its income keeps up with the rising level of
prices.
Interest-rate stability is desirable because fluctuations in interest rates can create
uncertainty in the economy and make it harder to plan for the future. Fluctuations in
interest rates that affect consumers’ willingness to buy houses, for example, make it
more difficult for consumers to decide when to purchase a house and for construction
firms to plan how many houses to build. A central bank may also want to reduce
upward movements in interest rates for the reasons we discussed in Chapter 14:
Upward movements in interest rates generate hostility toward central banks like the
Fed and lead to demands that their power be curtailed.
As our analysis in Chapter 8 showed, financial crises can interfere with the ability of
financial markets to channel funds to people with productive investment opportunities,
thereby leading to a sharp contraction in economic activity. The promotion of a
more stable financial system in which financial crises are avoided is thus an important
goal for a central bank. Indeed, as discussed in Chapter 14, the Federal Reserve System
was created in response to the bank panic of 1907 to promote financial stability.
Stability of
Financial Markets
Interest-Rate
Stability
C H A P T E R 1 8 Conduct of Monetary Policy: Goals and Targets 413
1For example, see Stanley Fischer, “The Role of Macroeconomic Factors in Growth,” Journal of Monetary
Economics 32 (1993): 485–512.
Box 1: Global
The Growing European Commitment to Price Stability
Not surprisingly, given Germany’s experience with
hyperinflation in the 1920s, Germans have had the
strongest commitment to price stability as the primary
goal for monetary policy. Other Europeans have
been coming around to the view that the primary
objective for a central bank should be price stability.
The increased importance of this goal was reflected in
the December 1991 Treaty of European Union,
known as the Maastricht Treaty. This treaty created
the European System of Central Banks, which functions
very much like the Federal Reserve System. The
statute of the European System of Central Banks sets
price stability as the primary objective of this system
and indicates that the general economic policies
of the European Union are to be supported only if
they are not in conflict with price stability.
The stability of financial markets is also fostered by interest-rate stability, because
fluctuations in interest rates create great uncertainty for financial institutions. An
increase in interest rates produces large capital losses on long-term bonds and mortgages,
losses that can cause the failure of the financial institutions holding them. In
recent years, more pronounced interest-rate fluctuations have been a particularly
severe problem for savings and loan associations and mutual savings banks, many of
which got into serious financial trouble in the 1980s and early 1990s (as we have seen
in Chapter 11).
With the increasing importance of international trade to the U.S. economy, the value
of the dollar relative to other currencies has become a major consideration for the
Fed. A rise in the value of the dollar makes American industries less competitive with
those abroad, and declines in the value of the dollar stimulate inflation in the United
States. In addition, preventing large changes in the value of the dollar makes it easier
for firms and individuals purchasing or selling goods abroad to plan ahead. Stabilizing
extreme movements in the value of the dollar in foreign exchange markets is thus
viewed as a worthy goal of monetary policy. In other countries, which are even more
dependent on foreign trade, stability in foreign exchange markets takes on even
greater importance.
Although many of the goals mentioned are consistent with each other—high employment
with economic growth, interest-rate stability with financial market stability—
this is not always the case. The goal of price stability often conflicts with the goals of
interest-rate stability and high employment in the short run (but probably not in the
long run). For example, when the economy is expanding and unemployment is
falling, both inflation and interest rates may start to rise. If the central bank tries to
prevent a rise in interest rates, this might cause the economy to overheat and stimulate
inflation. But if a central bank raises interest rates to prevent inflation, in the short
run unemployment could rise. The conflict among goals may thus present central
banks like the Federal Reserve with some hard choices. We return to the issue of how
central banks should choose conflicting goals in later chapters when we examine how
monetary policy affects the economy.
Central Bank Strategy: Use of Targets
The central bank’s problem is that it wishes to achieve certain goals, such as price stability
with high employment, but it does not directly influence the goals. It has a set
of tools to employ (open market operations, changes in the discount rate, and changes
in reserve requirements) that can affect the goals indirectly after a period of time (typically
more than a year). If the central bank waits to see what the price level and
employment will be one year later, it will be too late to make any corrections to its
policy—mistakes will be irreversible.
All central banks consequently pursue a different strategy for conducting monetary
policy by aiming at variables that lie between its tools and the achievement of its
goals. The strategy is as follows: After deciding on its goals for employment and the
price level, the central bank chooses a set of variables to aim for, called intermediate
targets, such as the monetary aggregates (M1, M2, or M3) or interest rates (short- or
Conflict Among
Goals
Stability in
Foreign Exchange
Markets
414 PA RT I V Central Banking and the Conduct of Monetary Policy
long-term), which have a direct effect on employment and the price level. However,
even these intermediate targets are not directly affected by the central bank’s policy
tools. Therefore, it chooses another set of variables to aim for, called operating targets,
or alternatively instrument targets, such as reserve aggregates (reserves, nonborrowed
reserves, monetary base, or nonborrowed base) or interest rates (federal
funds rate or Treasury bill rate), which are more responsive to its policy tools. (Recall
that nonborrowed reserves are total reserves minus borrowed reserves, which are the
amount of discount loans; the nonborrowed base is the monetary base minus borrowed
reserves; and the federal funds rate is the interest rate on funds loaned
overnight between banks.)2
The central bank pursues this strategy because it is easier to hit a goal by aiming
at targets than by aiming at the goal directly. Specifically, by using intermediate and
operating targets, it can more quickly judge whether its policies are on the right track,
rather than waiting until it sees the final outcome of its policies on employment and
the price level.3 By analogy, NASA employs the strategy of using targets when it is trying
to send a spaceship to the moon. It will check to see whether the spaceship is
positioned correctly as it leaves the atmosphere (we can think of this as NASA’s “operating
target”). If the spaceship is off course at this stage, NASA engineers will adjust
its thrust (a policy tool) to get it back on target. NASA may check the position of the
spaceship again when it is halfway to the moon (NASA’s “intermediate target”) and can
make further midcourse corrections if necessary.
The central bank’s strategy works in a similar way. Suppose that the central bank’s
employment and price-level goals are consistent with a nominal GDP growth rate of
5%. If the central bank feels that the 5% nominal GDP growth rate will be achieved
by a 4%growth rate for M2 (its intermediate target), which will in turn be achieved by
a growth rate of 31 2% for the monetary base (its operating target), it will carry out open
market operations (its tool) to achieve the 31 2% growth in the monetary base. After
implementing this policy, the central bank may find that the monetary base is growing
too slowly, say at a 2% rate; then it can correct this too slow growth by increasing the
amount of its open market purchases. Somewhat later, the central bank will begin to
see how its policy is affecting the growth rate of the money supply. If M2 is growing
too fast, say at a 7% rate, the central bank may decide to reduce its open market purchases
or make open market sales to reduce the M2 growth rate.
One way of thinking about this strategy (illustrated in Figure 1) is that the central
bank is using its operating and intermediate targets to direct monetary policy (the
space shuttle) toward the achievement of its goals. After the initial setting of the policy
tools (the liftoff), an operating target such as the monetary base, which the central bank
can control fairly directly, is used to reset the tools so that monetary policy is channeled
toward achieving the intermediate target of a certain rate of money supply growth.
Midcourse corrections in the policy tools can be made again when the central bank
C H A P T E R 1 8 Conduct of Monetary Policy: Goals and Targets 415
2There is some ambiguity as to whether to call a particular variable an operating target or an intermediate target.
The monetary base and the Treasury bill rate are often viewed as possible intermediate targets, even though they
may function as operating targets as well. In addition, if the Fed wants to pursue a goal of interest-rate stability,
an interest rate can be both a goal and a target.
3This reasoning for the use of monetary targets has come under attack, because information on employment and
the price level can be useful in evaluating policy. See Benjamin M. Friedman, “The Inefficiency of Short-Run
Monetary Targets for Monetary Policy,” Brookings Papers on Economic Activity 2 (1977): 292–346.
sees what is happening to its intermediate target, thus directing monetary policy so
that it will achieve its goals of high employment and price stability (the space shuttle
launches the satellite in the appropriate orbit).
Choosing the Targets
As we see in Figure 1, there are two different types of target variables: interest rates
and aggregates (monetary aggregates and reserve aggregates). In our example, the central
bank chose a 4% growth rate for M2 to achieve a 5% rate of growth for nominal
GDP. It could have chosen to lower the interest rate on the three-month Treasury bills
to, say, 3% to achieve the same goal. Can the central bank choose to pursue both of
these targets at the same time? The answer is no. The application of the supply and
demand analysis of the money market that we covered in Chapter 5 explains why a
central bank must choose one or the other.
Let’s first see why a monetary aggregate target involves losing control of the interest
rate. Figure 2 contains a supply and demand diagram for the money market.
Although the central bank expects the demand curve for money to be at Md*, it fluctuates
between Md and Md because of unexpected increases or decreases in output
or changes in the price level. The money demand curve might also shift unexpectedly
because the public’s preferences about holding bonds versus money could change. If
the central bank’s monetary aggregate target of a 4% growth rate in M2 results in a
money supply of M*, it expects that the interest rate will be i*. However, as the figure
indicates, the fluctuations in the money demand curve between Md and Md will
result in an interest rate fluctuating between i and i. Pursuing a monetary aggregate
target implies that interest rates will fluctuate.
The supply and demand diagram in Figure 3 shows the consequences of an interestrate
target set at i*. Again, the central bank expects the money demand curve to be at
Md*, but it fluctuates between Md and Md due to unexpected changes in output, the
416 PA RT I V Central Banking and the Conduct of Monetary Policy
FIGURE 1 Central Bank Strategy
Tools of the Central Bank
Open market operations
Discount policy
Reserve requirements
Operating (Instrument) Targets
Reserve aggregates
(reserves, nonborrowed
reserves, monetary base,
nonborrowed base)
Interest rates (short-term
such as federal funds rate)
Intermediate Targets
Monetary aggregates
(M1, M2, M3)
Interest rates (shortand
long-term)
Goals
High employment,
price stability,
financial market
stability, and so on.
price level, or the public’s preferences toward holding money. If the demand curve
falls to Md, the interest rate will begin to fall below i*, and the price of bonds will
rise. With an interest-rate target, the central bank will prevent the interest rate from
falling by selling bonds to drive their price back down and the interest rate back up
C H A P T E R 1 8 Conduct of Monetary Policy: Goals and Targets 417
FIGURE 2 Result of Targeting
on the Money Supply
Targeting on the money supply at
M* will lead to fluctuations in the
interest rate between i and i
because of fluctuations in the
money demand curve between Md
and Md.
i*
i
i
Interest Rate, i
Md
Md*
Md
Quantity of Money, M
M*
Ms *
FIGURE 3 Result of Targeting
on the Interest Rate
Targeting the interest rate at M*
will lead to fluctuations of the
money supply between M and M
because of fluctuations in the
money demand curve between Md
and Md .
i*
i
i
Interest Rate, i Ms *
Md
Md *
Md
Quantity of Money, M
Ms Ms
M M* M
Interest Rate
Target, i *
to its former level. The central bank will make open market sales until the money supply
declines to Ms, at which point the equilibrium interest rate is again i*. Conversely,
if the demand curve rises to Md and drives up the interest rate, the central bank
would keep interest rates from rising by buying bonds to keep their prices from
falling. The central bank will make open market purchases until the money supply
rises to Ms and the equilibrium interest rate is i*. The central bank’s adherence to the
interest-rate target thus leads to a fluctuating money supply as well as fluctuations in
reserve aggregates such as the monetary base.
The conclusion from the supply and demand analysis is that interest-rate and
monetary aggregate targets are incompatible: A central bank can hit one or the other
but not both. Because a choice between them has to be made, we need to examine
what criteria should be used to decide on the target variable.
The rationale behind a central bank’s strategy of using targets suggests three criteria
for choosing an intermediate target: It must be measurable, it must be controllable by
the central bank, and it must have a predictable effect on the goal.
Measurability. Quick and accurate measurement of an intermediate-target variable is
necessary, because the intermediate target will be useful only if it signals rapidly when
policy is off track. What good does it do for the central bank to plan to hit a 4%
growth rate for M2 if it has no way of quickly and accurately measuring M2? Data on
the monetary aggregates are obtained after a two-week delay, and interest-rate data are
available almost immediately. Data on a variable like GDP that serves as a goal, by
contrast, are compiled quarterly and are made available with a month’s delay. In addition,
the GDP data are less accurate than data on the monetary aggregates or interest
rates. On these grounds alone, focusing on interest rates and monetary aggregates as
intermediate targets rather than on a goal like GDP can provide clearer signals about
the status of the central bank’s policy.
At first glance, interest rates seem to be more measurable than monetary aggregates
and hence more useful as intermediate targets. Not only are the data on interest
rates available more quickly than on monetary aggregates, but they are also measured
more precisely and are rarely revised, in contrast to the monetary aggregates, which
are subject to a fair amount of revision (as we saw in Chapter 3). However, as we
learned in Chapter 4, the interest rate that is quickly and accurately measured, the
nominal interest rate, is typically a poor measure of the real cost of borrowing, which
indicates with more certainty what will happen to GDP. This real cost of borrowing is
more accurately measured by the real interest rate—the interest rate adjusted for
expected inflation (ir i e). Unfortunately, the real interest rate is extremely hard
to measure, because we have no direct way to measure expected inflation. Since both
interest rate and monetary aggregates have measurability problems, it is not clear
whether one should be preferred to the other as an intermediate target.
Controllability. A central bank must be able to exercise effective control over a variable
if it is to function as a useful target. If the central bank cannot control an intermediate
target, knowing that it is off track does little good, because the central bank
has no way of getting the target back on track. Some economists have suggested that
nominal GDP should be used as an intermediate target, but since the central bank has
little direct control over nominal GDP, it will not provide much guidance on how the
Fed should set its policy tools. A central bank does, however, have a good deal of control
over the monetary aggregates and interest rates.
Criteria for
Choosing
Intermediate
Targets
418 PA RT I V Central Banking and the Conduct of Monetary Policy
Our discussion of the money supply process and the central bank’s policy tools
indicates that a central bank does have the ability to exercise a powerful effect on the
money supply, although its control is not perfect. We have also seen that open market
operations can be used to set interest rates by directly affecting the price of bonds.
Because a central bank can set interest rates directly, whereas it cannot completely
control the money supply, it might appear that interest rates dominate the monetary
aggregates on the controllability criterion. However, a central bank cannot set real
interest rates, because it does not have control over expectations of inflation. So again,
a clear-cut case cannot be made that interest rates are preferable to monetary aggregates
as an intermediate target or vice versa.
Predictable Effect on Goals. The most important characteristic a variable must have to
be useful as an intermediate target is that it must have a predictable impact on a goal.
If a central bank can accurately and quickly measure the price of tea in China and can
completely control its price, what good will it do? The central bank cannot use the
price of tea in China to affect unemployment or the price level in its country. Because
the ability to affect goals is so critical to the usefulness of an intermediate-target variable,
the linkage of the money supply and interest rates with the goals—output,
employment, and the price level—is a matter of much debate. The evidence on
whether these goals have a closer (more predictable) link with the money supply than
with interest rates is discussed in Chapter 26.
The choice of an operating target can be based on the same criteria used to evaluate
intermediate targets. Both the federal funds rate and reserve aggregates are measured
accurately and are available daily with almost no delay; both are easily controllable
using the policy tools that we discussed in Chapter 17. When we look at the third criterion,
however, we can think of the intermediate target as the goal for the operating
target. An operating target that has a more predictable impact on the most desirable
intermediate target is preferred. If the desired intermediate target is an interest rate,
the preferred operating target will be an interest-rate variable like the federal funds
rate because interest rates are closely tied to each other (as we saw in Chapter 6).
However, if the desired intermediate target is a monetary aggregate, our money supply
model in Chapters 15 and 16 shows that a reserve aggregate operating target such
as the monetary base will be preferred. Because there does not seem to be much reason
to choose an interest rate over a reserve aggregate on the basis of measurability or
controllability, the choice of which operating target is better rests on the choice of the
intermediate target (the goal of the operating target).
Fed Policy Procedures: Historical Perspective
The well-known adage “The road to hell is paved with good intentions” applies as
much to the Federal Reserve as it does to human beings. Understanding a central
bank’s goals and the strategies it can use to pursue them cannot tell us how monetary
policy is actually conducted. To understand the practical results of the theoretical
underpinnings, we have to look at how central banks have actually conducted policy
in the past. First we will look at the Federal Reserve’s past policy procedures: its
choice of goals, policy tools, operating targets, and intermediate targets. This historical
perspective will not only show us how our central bank carries out its duties but
Criteria for
Choosing
Operating Targets
C H A P T E R 1 8 Conduct of Monetary Policy: Goals and Targets 419
will also help us interpret the Fed’s activities and see where U.S. monetary policy may
be heading in the future. Once we are done studying the Fed, we will then examine
central banks’ experiences in other countries.
Study Guide The following discussion of the Fed’s policy procedures and their effect on the money
supply provides a review of the money supply process and how the Fed’s policy tools
work. If you have trouble understanding how the particular policies described affect
the money supply, it might be helpful to review the material in Chapters 15 and 16.
When the Fed was created, changing the discount rate was the primary tool of monetary
policy—the Fed had not yet discovered that open market operations were a
more powerful tool for influencing the money supply, and the Federal Reserve Act
made no provisions for changes in reserve requirements. The guiding principle for the
conduct of monetary policy was that as long as loans were being made for “productive”
purposes—that is, to support the production of goods and services—providing
reserves to the banking system to make these loans would not be inflationary.4 This
theory, now thoroughly discredited, became known as the real bills doctrine. In
practice, it meant that the Fed would make loans to member commercial banks when
they showed up at the discount window with eligible paper, loans to facilitate the production
and sale of goods and services. (Note that since the 1920s, the Fed has not
conducted discount operations in this way.) The Fed’s act of making loans to member
banks was initially called rediscounting, because the original bank loans to businesses
were made by discounting (loaning less than) the face value of the loan, and the Fed
would be discounting them again. (Over time, when the Fed’s emphasis on eligible
paper diminished, the Fed’s loans to banks became known as discounts, and the interest
rate on these loans the discount rate, which is the terminology we use today.)
By the end of World War I, the Fed’s policy of rediscounting eligible paper and
keeping interest rates low to help the Treasury finance the war had led to a raging
inflation; in 1919 and 1920, the inflation rate averaged 14%. The Fed decided that it
could no longer follow the passive policy prescribed by the real bills doctrine because
it was inconsistent with the goal of price stability, and for the first time the Fed
accepted the responsibility of playing an active role in influencing the economy. In
January 1920, the Fed raised the discount rate from 4 % to 6%, the largest jump in
its history, and eventually raised it further, to 7% in June 1920, where it remained for
nearly a year. The result of this policy was a sharp decline in the money supply and
an especially sharp recession in 1920–1921. Although the blame for this severe recession
can clearly be laid at the Fed’s doorstep, in one sense the Fed’s policy was very
successful: After an initial decline in the price level, the inflation rate went to zero,
paving the way for the prosperous Roaring Twenties.
In the early 1920s, a particularly important event occurred: The Fed accidentally discovered
open market operations. When the Fed was created, its revenue came exclusively
from the interest it received on the discount loans it made to member banks.
After the 1920–1921 recession, the volume of discount loans shrank dramatically, and
Discovery of Open
Market
Operations
34
The Early
Years: Discount
Policy as the
Primary Tool
420 PA RT I V Central Banking and the Conduct of Monetary Policy
4Another guiding principle was the maintenance of the gold standard, which we will discuss in Chapter 20.
the Fed was pressed for income. It solved this problem by purchasing income-earning
securities. In doing so, the Fed noticed that reserves in the banking system grew and
there was a multiple expansion of bank loans and deposits. This result is obvious to
us now (we studied the multiple deposit creation process in Chapter 15), but to the
Fed at that time it was a revelation. A new monetary policy tool was born, and by the
end of the 1920s, it was the most important weapon in the Fed’s arsenal.
The stock market boom in 1928 and 1929 created a dilemma for the Fed. It wanted
to temper the boom by raising the discount rate, but it was reluctant to do so, because
that would mean raising interest rates to businesses and individuals who had legitimate
needs for credit. Finally, in August 1929, the Fed raised the discount rate, but
by then it was too late; the speculative excesses of the market boom had already
occurred, and the Fed’s action only hastened the stock market crash and pushed the
economy into recession.
The weakness of the economy, particularly in the agricultural sector, led to what
Milton Friedman and Anna Schwartz labeled a “contagion of fear” that triggered substantial
withdrawals from banks, building to a full-fledged panic in November and
December 1930. For the next two years, the Fed sat idly by while one bank panic after
another occurred, culminating in the final panic in March 1933, at which point the
new president, Franklin Delano Roosevelt, declared a bank holiday. (Why the Fed
failed to engage in its lender-of-last-resort role during this period is discussed in Box 2.)
The Great
Depression
C H A P T E R 1 8 Conduct of Monetary Policy: Goals and Targets 421
The Federal Reserve System was totally passive during
the bank panics of the Great Depression period
and did not perform its intended role of lender of last
resort to prevent them. In retrospect, the Fed’s behavior
seems quite extraordinary, but hindsight is always
clearer than foresight.
The primary reason for the Fed’s inaction was that
Federal Reserve officials did not understand the negative
impact that bank failures could have on the
money supply and economic activity. Friedman and
Schwartz report that the Federal Reserve officials
“tended to regard bank failures as regrettable consequences
of bank management or bad banking practices,
or as inevitable reactions to prior speculative
excesses, or as a consequence but hardly a cause of
the financial and economic collapse in process.” In
addition, bank failures in the early stages of the bank
panics “were concentrated among smaller banks and,
since the most influential figures in the system were
big-city bankers who deplored the existence of
smaller banks, their disappearance may have been
viewed with complacency.”*
Friedman and Schwartz also point out that political
infighting may have played an important role in
the passivity of the Fed during this period. The
Federal Reserve Bank of New York, which until 1928
was the dominant force in the Federal Reserve
System, strongly advocated an active program of
open market purchases to provide reserves to the
banking system during the bank panics. However,
other powerful figures in the Federal Reserve System
opposed the New York bank’s position, and the bank
was outvoted. (Friedman and Schwartz’s discussion
of the politics of the Federal Reserve System during
this period makes for fascinating reading, and you
might enjoy their highly readable book.)
Bank Panics of 1930–1933: Why Did the Fed Let Them Happen?
Box 2: Inside the Fed
*Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, N.J.: Princeton University Press, 1963), p. 358.
The spate of bank panics from 1930 to 1933 were the most severe in U.S. history, and
Roosevelt aptly summed up the problem in his statement “The only thing we have to
fear is fear itself.” By the time the panics were over in March 1933, more than onethird
of the commercial banks in the United States had failed.
In Chapter 16, we examined how the bank panics of this period led to a decline
in the money supply by over 25%. The resulting unprecedented decline in the money
supply during this period is thought by many economists, particularly monetarists, to
have been the major contributing factor to the severity of the depression, never
equaled before or since.
The Thomas Amendment to the Agricultural Adjustment Act of 1933 provided the
Federal Reserve’s Board of Governors with emergency power to alter reserve requirements
with the approval of the president of the United States. In the Banking Act of
1935, this emergency power was expanded to allow the Fed to alter reserve requirements
without the president’s approval.
The first use of reserve requirements as a tool of monetary control proved that the
Federal Reserve was capable of adding to the blunders that it had made during the
bank panics of the early 1930s. By the end of 1935, banks had increased their holdings
of excess reserves to unprecedented levels, a sensible strategy, considering their
discovery during the 1930–1933 period that the Fed would not always perform its
intended role as lender of last resort. Bankers now understood that they would have
to protect themselves against a bank run by holding substantial amounts of excess
reserves. The Fed viewed these excess reserves as a nuisance that made it harder to
exercise monetary control. Specifically, the Fed worried that these excess reserves
might be lent out and would produce “an uncontrollable expansion of credit in the
future.”5
To improve monetary control, the Fed raised reserve requirements in three steps:
August 1936, January 1937, and May 1937. The result of this action was, as we would
expect from our money supply model, a slowdown of money growth toward the end
of 1936 and an actual decline in 1937. The recession of 1937–1938, which commenced
in May 1937, was a severe one and was especially upsetting to the American
public because even at its outset unemployment was intolerably high. So not only
does it appear that the Fed was at fault for the severity of the Great Depression contraction
in 1929–1933, but to add insult to injury, it appears that it was also responsible
for aborting the subsequent recovery. The Fed’s disastrous experience with
varying its reserve requirements made it far more cautious in the use of this policy
tool in the future.
With the entrance of the United States into World War II in late 1941, government
spending skyrocketed, and to finance it, the Treasury issued huge amounts of bonds.
The Fed agreed to help the Treasury finance the war cheaply by pegging interest rates
at the low levels that had prevailed before the war: % on Treasury bills and 2 % on
long-term Treasury bonds. Whenever interest rates rose above these levels and the
price of bonds began to fall, the Fed would make open market purchases, thereby
bidding up bond prices and driving interest rates down again. The result was a rapid
12
3
8
War Finance and
the Pegging of
Interest Rates:
1942–1951
Reserve
Requirements
as a Policy Tool
422 PA RT I V Central Banking and the Conduct of Monetary Policy
5Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton,
N.J.: Princeton University Press, 1963), p. 524.
growth in the monetary base and the money supply. The Fed had thus in effect relinquished
its control of monetary policy to meet the financing needs of the government.
When the war ended, the Fed continued to peg interest rates, and because there
was little pressure on them to rise, this policy did not result in an explosive growth
in the money supply. When the Korean War broke out in 1950, however, interest rates
began to climb, and the Fed found that it was again forced to expand the monetary
base at a rapid rate. Because inflation began to heat up (the consumer price index rose
8% between 1950 and 1951), the Fed decided that it was time to reassert its control
over monetary policy by abandoning the interest-rate peg. An often bitter debate
ensued between the Fed and the Treasury, which wanted to keep its interest costs
down and so favored a continued pegging of interest rates at low levels. In March
1951, the Fed and the Treasury came to an agreement known as the Accord, in which
pegging was abandoned but the Fed promised that it would not allow interest rates
to rise precipitously. After Eisenhower’s election as president in 1952, the Fed was
given complete freedom to pursue its monetary policy objectives.
With its freedom restored, the Federal Reserve, then under the chairmanship of
William McChesney Martin Jr., took the view that monetary policy should be
grounded in intuitive judgment based on a feel for the money market. The policy procedure
that resulted can be described as one in which the Fed targeted on money market
conditions, and particularly on interest rates.
An important characteristic of this policy procedure was that it led to more rapid
growth in the money supply when the economy was expanding and a slowing of
money growth when the economy was in recession. The so-called procyclical monetary
policy (a positive association of money supply growth with the business cycle) is
explained by the following step-by-step reasoning. As we learned in Chapter 5, a rise
in national income (Y↑) leads to a rise in market interest rates (i↑). With the rise in
interest rates, the Fed would purchase bonds to bid their price up and lower interest
rates to their target level. The resulting increase in the monetary base caused the
money supply to rise and the business cycle expansion to be accompanied by a faster
rate of money growth. In summary:
Y↑ ⇒i↑ ⇒MB↑ ⇒M↑
In a recession, the opposite sequence of events would occur, and the decline in
income would be accompanied by a slower rate of growth in the money supply
(Y↓ ⇒ M↓).
A further problem with using interest rates as the primary operating target is that
they may encourage an inflationary spiral to get out of control. As we saw in Chapter
5, when inflation and hence expected inflation rises, nominal interest rates rise via the
Fisher effect. If the Fed attempted to prevent this increase by purchasing bonds, this
would also lead to a rise in the monetary base and the money supply:
↑ ⇒e↑ ⇒i↑ ⇒MB↑ ⇒M↑
Higher inflation could thus lead to an increase in the money supply, which would
increase inflationary pressures further.
By the late 1960s, the rising chorus of criticism of procyclical monetary policy by
such prominent monetarist economists such as Milton Friedman, Karl Brunner, and
Targeting Money
Market Conditions:
The 1950s and
1960s
C H A P T E R 1 8 Conduct of Monetary Policy: Goals and Targets 423
Allan Meltzer and concerns about inflation finally led the Fed to abandon its focus on
money market conditions.
In 1970, Arthur Burns was appointed chairman of the Board of Governors, and soon
thereafter the Fed stated that it was committing itself to the use of monetary aggregates
as intermediate targets. Did monetary policy cease to be procyclical? A glance at
Figure 4 in Chapter 1 indicates that monetary policy was as procyclical in the 1970s
as in the 1950s and 1960s. What went wrong? Why did the conduct of monetary policy
not improve? The answers to these questions lie in the Fed’s operating procedures
during the period, which suggest that its commitment to targeting monetary aggregates
was not very strong.
Every six weeks, the Federal Open Market Committee would set target ranges for
the growth rates of various monetary aggregates and would determine what federal
funds rate (the interest rate on funds loaned overnight between banks) it thought consistent
with these aims. The target ranges for the growth in monetary aggregates were
fairly broad—a typical range for M1 growth might be 3% to 6%; for M2, 4% to 7%—
while the range for the federal funds rate was a narrow band, say from 7 % to 8 %.
The trading desk at the Federal Reserve Bank of New York was then instructed to
meet both sets of targets, but as we saw earlier, interest-rate targets and monetary
aggregate targets might not be compatible. If the two targets were incompatible—say,
the federal funds rate began to climb higher than the top of its target band when M1
was growing too rapidly—the trading desk was instructed to give precedence to the
federal funds rate target. In the situation just described, this would mean that
although M1 growth was too high, the trading desk would make open market purchases
to keep the federal funds rate within its target range.
The Fed was actually using the federal funds rate as its operating target. During
the six-week period between FOMC meetings, an unexpected rise in output (which
would cause the federal funds rate to hit the top of its target band) would then induce
open market purchases and a too rapid growth of the money supply. When the FOMC
met again, it would try to bring money supply growth back on track by raising the
target range on the federal funds rate. However, if income continued to rise unexpectedly,
money growth would overshoot again. This is exactly what occurred from
June 1972 to June 1973, when the economy boomed unexpectedly: M1 growth
greatly exceeded its target, increasing at approximately an 8% rate, while the federal
funds rate climbed from 4 % to 8 %. The economy soon became overheated, and
inflationary pressures began to mount.
The opposite chain of events occurred at the end of 1974, when the economic
contraction was far more severe than anyone had predicted. The federal funds rate fell
dramatically, from over 12% to 5%, and persistently bumped against the bottom of its
target range. The trading desk conducted open market sales to keep the federal funds
rate from falling, and money growth dropped precipitously, actually turning negative
by the beginning of 1975. Clearly, this sharp drop in money growth when the United
States was experiencing one of the worst economic contractions of the postwar era
was a serious mistake.
Using the federal funds rate as an operating target promoted a procyclical monetary
policy despite the Fed’s lip service to monetary aggregate targets. If the Federal
Reserve really intended to pursue monetary aggregate targets, it seems peculiar that it
would have chosen an interest rate for an operating target rather than a reserve aggregate.
The explanation for the Fed’s choice of an interest rate as an operating target is
12
1
2
1
4
1
2
Targeting
Monetary
Aggregates:
The 1970s
424 PA RT I V Central Banking and the Conduct of Monetary Policy
that it was still very concerned with achieving interest-rate stability and was reluctant
to relinquish control over interest-rate movements. The incompatibility of the Fed’s
policy procedure with its stated intent of targeting on the monetary aggregates had
become very clear by October 1979, when the Fed’s policy procedures underwent
drastic revision.
In October 1979, two months after Paul Volcker became chairman of the Board of
Governors, the Fed finally deemphasized the federal funds rate as an operating target
by widening its target range more than fivefold: A typical range might be from 10%
to 15%. The primary operating target became nonborrowed reserves, which the Fed
would set after estimating the volume of discount loans the banks would borrow. Not
surprisingly, the federal funds rate underwent much greater fluctuations after it was
deemphasized as an operating target. What is surprising, however, is that the deemphasis
of the federal funds target did not result in improved monetary control: After
October 1979, the fluctuations in the rate of money supply growth increased rather
than decreased as would have been expected. In addition, the Fed missed its M1
growth target ranges in all three years of the 1979–1982 period.6 What went wrong?
There are several possible answers to this question. The first is that the economy
was exposed to several shocks during this period that made monetary control more
difficult: the acceleration of financial innovation and deregulation, which added new
categories of deposits such as NOW accounts to the measures of monetary aggregates;
the imposition by the Fed of credit controls from March to July 1980, which restricted
the growth of consumer and business loans; and the back-to-back recessions of 1980
and 1981–1982.7
A more persuasive explanation for poor monetary control, however, is that controlling
the money supply was never really the intent of Volcker’s policy shift. Despite
Volcker’s statements about the need to target monetary aggregates, he was not committed
to these targets. Rather, he was far more concerned with using interest-rate
movements to wring inflation out of the economy. Volcker’s primary reason for changing
the Fed’s operating procedure was to free his hand to manipulate interest rates in
order to fight inflation. It was necessary to abandon interest-rate targets if Volcker
were to be able to raise interest rates sharply when a slowdown in the economy was
required to dampen inflation. This view of Volcker’s strategy suggests that the Fed’s
announced attachment to monetary aggregate targets may have been a smokescreen
to keep the Fed from being blamed for the high interest rates that would result from
the new policy.
New Fed
Operating
Procedures:
October 1979–
October 1982
C H A P T E R 1 8 Conduct of Monetary Policy: Goals and Targets 425
6The M1 target ranges and actual growth rates for 1980–1982 were as follows:
Year Target Range (%) Actual (%)
1980 4.5–7.0 7.5
1981 6.0–8.5 5.1
1982 2.5–5.5 8.8
Source: Board of Governors of the Federal Reserve System, Monetary Policy Objectives, 1981–1983.
7Another explanation focuses on the technical difficulties of monetary control when using a nonborrowed
reserves operating target under a system of lagged reserve requirements, in which required reserves for a given
week are calculated on the basis of the level of deposits two weeks earlier. See David Lindsey, “Nonborrowed
Reserve Targeting and Monetary Control,” in Improving Money Stock Control, ed. Laurence Meyer (Boston: Kluwer-
Nijhoff, 1983), pp. 3–41.
Interest-rate movements during this period support this interpretation of Fed
strategy. After the October 1979 announcement, short-term interest rates were driven
up by nearly 5%, until in March 1980 they exceeded 15%. With the imposition of
credit controls in March 1980 and the rapid decline in real GDP in the second quarter
of 1980, the Fed eased up on its policy and allowed interest rates to decline
sharply. When recovery began in July 1980, inflation remained persistent, still
exceeding 10%. Because the inflation fight was not yet won, the Fed tightened the
screws again, sending short-term rates above the 15% level for a second time. The
1981–1982 recession and its large decline in output and high unemployment began
to bring inflation down. With inflationary psychology apparently broken, interest
rates were allowed to fall.
The Fed’s anti-inflation strategy during the October 1979–October 1982 period
was neither intended nor likely to produce smooth growth in the monetary aggregates.
Indeed, the large fluctuations in interest rates and the business cycle, along with
financial innovation, helped generate volatile money growth.
In October 1982, with inflation in check, the Fed returned, in effect, to a policy of
smoothing interest rates. It did this by placing less emphasis on monetary aggregate
targets and shifting to borrowed reserves (discount loan borrowings) as an operating
target. To see how a borrowed reserves target produces interest-rate smoothing, let’s
consider what happens when the economy expands (Y↑) so that interest rates are
driven up. The rise in interest rates (i↑) increases the incentives for banks to borrow
more from the Fed, so borrowed reserves rise (DL↑). To prevent the resulting rise in
borrowed reserves from exceeding the target level, the Fed must lower interest rates
by bidding up the price of bonds through open market purchases. The outcome of
targeting on borrowed reserves, then, is that the Fed prevents a rise in interest rates.
In doing so, however, the Fed’s open market purchases increase the monetary base
(MB↑) and lead to a rise in the money supply (M↑), which produces a positive association
of money and national income (Y↑ ⇒M↑). Schematically,
Y↑ ⇒i↑ ⇒DL↑ ⇒MB↑ ⇒M↑
A recession causes the opposite chain of events: The borrowed reserves target prevents
interest rates from falling and results in a drop in the monetary base, leading to
a fall in the money supply (Y↓ ⇒ M↓).
The de-emphasis of monetary aggregates and the change to a borrowed reserves target
led to much smaller fluctuations in the federal funds rate after October 1982 but
continued to have large fluctuations in money supply growth. Finally, in February 1987,
the Fed announced that it would no longer even set M1 targets. The abandonment of
M1 targets was defended on two grounds. The first was that the rapid pace of financial
innovation and deregulation had made the definition and measurement of money very
difficult. The second is that there had been a breakdown in the stable relationship
between M1 and economic activity (discussed in Chapter 22). These two arguments
suggested that a monetary aggregate such as M1 might no longer be a reliable guide for
monetary policy. As a result, the Fed switched its focus to the broader monetary aggregate
M2, which it felt had a more stable relationship with economic activity. However,
in the early 1990s, this relationship also broke down, and in July 1993, Board of
Governors Chairman Alan Greenspan testified in Congress that the Fed would no longer
use any monetary targets, including M2, as a guide for conducting monetary policy.
De-emphasis of
Monetary
Aggregates:
October 1982–
Early 1990s
426 PA RT I V Central Banking and the Conduct of Monetary Policy
www.federalreserve.gov
/releases/H3
Historic and current data on
the aggregate reserves of
depository institutions and the
monetary base.
Finally, legislation in 2000 amending the Federal Reserve Act dropped the requirement
that the Fed report target ranges for monetary aggregates to Congress.
Having abandoned monetary aggregates as a guide for monetary policy, the Federal
Reserve returned to using a federal funds target in the early 1990s. Indeed, from late
1992 until February 1994, a period of a year and a half, the Fed kept the federal funds
rate targeted at the constant rate of 3%, a low level last seen in the 1960s. The explanation
for this unusual period of keeping the federal funds rate pegged so low for
such a long period of time was fear on the part of the Federal Reserve that the credit
crunch mentioned in Chapter 9 was putting a drag on the economy (the “headwinds”
referred to by Greenspan) that was producing a sluggish recovery from the
1990–1991 recession. Starting in February 1994, after the economy returned to rapid
growth, the Fed began a preemptive strike to head off any future inflationary pressures
by raising the federal funds rate in steps to 6% by early 1995. The Fed not only
has engaged in preemptive strikes against a rise in inflation, but it has acted preemptively
against negative shocks to demand. It lowered the federal funds rate in early
1996 to deal with a possible slowing in the economy and took the dramatic step of
reducing the federal funds rate by of a percentage point when the collapse of Long
Term Capital Management in the fall of 1998 (discussed in Chapter 12) led to concerns
about the health of the financial system. With the strong growth of the economy
in 1999 and heightened concerns about inflation, the Fed reversed course and
began to raise the federal funds rate again. The Fed’s timely actions kept the economy
on track, helping to produce the longest business cycle expansion in U.S. history.
With a weakening economy, in January 2001 (just before the start of the recession in
March 2001) the Fed reversed course again and began to reduce sharply the federal
funds rate from its height of 6.5% to near 1% eventually.
In February 1994, with the first change in the federal funds rate in a year and a
half, the Fed adopted a new policy procedure. Instead of keeping the federal funds
target secret, as it had done previously, the Fed now announced any federal funds rate
target change. As mentioned in Chapter 14, around 2:15 P.M., after every FOMC meeting,
the Fed now announces whether the federal funds rate target has been raised,
lowered, or kept the same. This move to greater transparency of Fed policy was followed
by another such move, when in February 1999 the Fed indicated that in the
future it would announce the direction of bias to where the federal funds rate will
head in the future. However, dissatisfaction with the confusion that the bias
announcement created for market participants led the Fed to revise its policy, and
starting in February 2000, the Fed switched to an announcement of a statement outlining
the “balance of risks” in the future, whether toward higher inflation or toward
a weaker economy. As a result of these announcements, the outcome of the FOMC
meeting is now big news, and the media devote much more attention to FOMC meeting,
because announced changes in the federal funds rate feeds into changes in other
interest rates that affect consumers and businesses.
The increasing importance of international trade to the American economy has brought
international considerations to the forefront of Federal Reserve policymaking in recent
years. By 1985, the strength of the dollar had contributed to a deterioration in American
competitiveness with foreign businesses. In public pronouncements, Chairman Volcker
and other Fed officials made it clear that the dollar was at too high a value and needed
to come down. Because, as we will see in Chapter 19, expansionary monetary policy is
International
Considerations
34
Federal Funds
Targeting Again:
Early 1990s and
Beyond
C H A P T E R 1 8 Conduct of Monetary Policy: Goals and Targets 427
one way to lower the value of the dollar, it is no surprise that the Fed engineered an
acceleration in the growth rates of the monetary aggregates in 1985 and 1986 and that
the value of the dollar declined. By 1987, policymakers at the Fed agreed that the dollar
had fallen sufficiently, and sure enough, monetary growth in the United States
slowed. These monetary policy actions by the Fed were encouraged by the process of
international policy coordination (agreements among countries to enact policies
cooperatively) that led to the Plaza Agreement in 1985 and the Louvre Accord in 1987
(see Box 3).
International considerations also played a role in the Fed’s decision to lower the
federal funds rate by of a percentage point in the fall of 1998. Concerns about the
potential for a worldwide financial crisis in the wake of the collapse of the Russian
financial system at that time and weakness in economies abroad, particularly in Asia,
stimulated the Fed to take a dramatic step to calm down markets. International considerations,
although not the primary focus of the Federal Reserve, are likely to be a
major factor in the conduct of American monetary policy in the future.
The Taylor Rule, NAIRU, and the Phillips Curve
As we have seen, the Federal Reserve currently conducts monetary policy by setting
a target for the federal funds rate. But how should this target be chosen?
John Taylor of Stanford University has come up with an answer, his so-called
Taylor rule. The Taylor rule indicates that the federal (fed) funds rate should be set
equal to the inflation rate plus an “equilibrium” real fed funds rate (the real fed funds
34
428 PA RT I V Central Banking and the Conduct of Monetary Policy
Box 3: Global
International Policy Coordination
The Plaza Agreement and the Louvre Accord. By
1985, the decrease in the competitiveness of American
corporations as a result of the strong dollar was raising
strong sentiment in Congress for restricting
imports. This protectionist threat to the international
trading system stimulated finance ministers and the
heads of central banks from the Group of Five (G-5)
industrial countries—the United States, the United
Kingdom, France, West Germany, and Japan—to
reach an agreement at New York’s Plaza Hotel in
September 1985 to bring down the value of the dollar.
From September 1985 until the beginning of
1987, the value of the dollar did indeed undergo a
substantial decline, falling by 35 percent on average
relative to foreign currencies. At this point, there was
growing controversy over the decline in the dollar,
and another meeting of policymakers from the G-5
countries plus Canada took place in February 1987 at
the Louvre Museum in Paris. There the policymakers
agreed that exchange rates should be stabilized
around the levels currently prevailing. Although the
value of the dollar did continue to fluctuate relative to
foreign currencies after the Louvre Accord, its downward
trend had been checked as intended.
Because subsequent exchange rate movements
were pretty much in line with the Plaza Agreement
and the Louvre Accord, these attempts at international
policy coordination have been considered successful.
However, other aspects of the agreements
were not adhered to by all signatories. For example,
West German and Japanese policymakers agreed that
their countries should pursue more expansionary policies
by increasing government spending and cutting
taxes, and the United States agreed to try to bring
down its budget deficit. At that time, the United States
was not particularly successful in lowering its deficit,
and the Germans were reluctant to pursue expansionary
policies because of their concerns about inflation.
www.federalreserve.gov
/centralbanks.htm
The Federal Reserve provides
links to other central bank
web pages.
rate that is consistent with full employment in the long run) plus a weighted average
of two gaps: (1) an inflation gap, current inflation minus a target rate, and (2) an output
gap, the percentage deviation of real GDP from an estimate of its potential full
employment level.8 This rule can be written as follows:
Federal funds rate target inflation rate equilibrium real fed funds rate
1/2 (inflation gap) 1/2 (output gap)
Taylor has assumed that the equilibrium real fed funds rate is 2% and that an appropriate
target for inflation would also be 2%, with equal weights of 1/2 on the inflation
and output gaps. For an example of the Taylor rule in practice suppose that the inflation
rate were at 3%, leading to a positive inflation gap of 1% ( 3% 2%), and real
GDP was 1% above its potential, resulting in a positive output gap of 1%. Then the
Taylor rule suggests that the federal funds rate should be set at 6% [ 3% inflation
2% equilibrium real fed funds rate 1/2 (1% inflation gap) 1/2 (1% output gap)].
The presence of both an inflation gap and an output gap in the Taylor rule might
indicate that the Fed should care not only about keeping inflation under control, but
also about minimizing business cycle fluctuations of output around its potential.
Caring about both inflation and output fluctuations is consistent with many statements
by Federal Reserve officials that controlling inflation and stabilizing real output
are important concerns of the Fed.
An alternative interpretation of the presence of the output gap in the Taylor rule is
that the output gap is an indicator of future inflation as stipulated in Phillips curve
theory. Phillips curve theory indicates that changes in inflation are influenced by the
state of the economy relative to its productive capacity, as well as to other factors. This
productive capacity can be measured by potential GDP, which is a function of the natural
rate of unemployment, the rate of unemployment consistent with full employment.
A related concept is the NAIRU, the nonaccelerating inflation rate of
unemployment, the rate of unemployment at which there is no tendency for inflation
to change.9 Simply put, the theory states that when the unemployment rate is above
NAIRU with output below potential, inflation will come down, but if it is below
NAIRU with output above potential, inflation will rise. Prior to 1995, the NAIRU was
thought to reside around 6%. However, with the decline in unemployment to around
the 4% level in the late 1990s, with no increase in inflation and even a slight decrease,
some critics have questioned the value of Phillips curve theory. Either they claim that
it just doesn’t work any more or alternatively believe that there is great uncertainty
about the value of NAIRU, which may have fallen to below 5% for reasons that are not
absolutely clear. Phillips curve theory is now highly controversial, and many economists
believe that it should not be used as a guide for the conduct of monetary policy.
As Figure 4 shows, the Taylor rule does a pretty good job of describing the Fed’s
setting of the federal funds rate under Chairman Greenspan. It also provides a perspective
on the Fed’s conduct of monetary policy under Chairmen Burns and Volcker.
During the Burns period, from 1970 to 1979, the federal funds rate was consistently
C H A P T E R 1 8 Conduct of Monetary Policy: Goals and Targets 429
8John B. Taylor, “Discretion Versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy
39 (1993): 195–214. A more intuitive discussion with a historical perspective can be found in John B. Taylor, “A
Historical Analysis of Monetary Policy Rules,” in Monetary Policy Rules, ed. John B. Taylor (Chicago: University
of Chicago Press, 1999), pp. 319–341.
9There are however subtle differences between the two concepts as is discussed in Arturo Estrella and Frederic
S. Mishkin, “The Role of NAIRU in Monetary Policy: Implications of Uncertainty and Model Selection,” in
Monetary Policy Rules, ed. John Taylor (Chicago: University of Chicago Press, 1999): 405–430.
lower than that indicated by the Taylor rule. This fact helps explain why inflation rose
during this period. During the Volcker period, when the Fed was trying to bring inflation
down quickly, the funds rate was generally higher than that recommended by the
Taylor rule. The closer correspondence between the actual funds rate and the Taylor
rule recommendation during the Greenspan era may help explain why the Fed’s performance
has been so successful in recent years.
430 PA RT I V Central Banking and the Conduct of Monetary Policy
F I G U R E 4 The Taylor Rule for the Federal Funds Rate, 1970–2002
Source: Federal Reserve: www.federalreserve.gov/releases and author’s calculations.
Federal Funds
Rate (%)
Taylor Rule
Federal Funds Rate
0
5
10
15
20
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Box 4
Fed Watching
As we have seen, the most important player in the
determination of the U.S. money supply and interest
rates is the Federal Reserve. When the Fed wants to
inject reserves into the system, it conducts open market
purchases of bonds, which cause bond prices to
increase and their interest rates to fall, at least in the
short term. If the Fed withdraws reserves from the
system, it sells bonds, thereby depressing their price
and raising their interest rates. From a longer-run
perspective, if the Fed pursues an expansionary monetary
policy with high money growth, inflation will
rise and, as we saw in Chapter 5, interest rates will
rise as well. Contractionary monetary policy is likely
to lower inflation in the long run and lead to lower
interest rates.
Knowing what actions the Fed might be taking can
thus help investors and financial institutions to predict
the future course of interest rates with greater
accuracy. Because, as we have seen, changes in interest
rates have a major impact on investors and financial
institutions’ profits, they are particularly interested
in scrutinizing the Fed’s behavior. To assist in this task,
financial institutions hire so-called Fed watchers, experts
on Federal Reserve behavior who may have worked in
the Federal Reserve System and so have an insider’s
view of Federal Reserve operations. A Fed watcher
who can accurately predict the course of monetary policy
is a very valuable commodity, and successful Fed
watchers therefore often earn very high salaries, well
into the six-figure range and sometimes even higher.
C H A P T E R 1 8 Conduct of Monetary Policy: Goals and Targets 431
Summary
1. The six basic goals of monetary policy are high
employment, economic growth, price stability, interestrate
stability, stability of financial markets, and stability
in foreign exchange markets.
2. By using intermediate and operating targets, a central
bank like the Fed can more quickly judge whether its
policies are on the right track and make midcourse
corrections, rather than waiting to see the final outcome
of its policies on such goals as employment and the
price level. The Fed’s policy tools directly affect its
operating targets, which in turn affect the intermediate
targets, which in turn affect the goals.
3. Because interest-rate and monetary aggregate targets are
incompatible, a central bank must choose between them
on the basis of three criteria: measurability, controllability,
and the ability to affect goal variables predictably.
Unfortunately, these criteria do not establish an
overwhelming case for one set of targets over another.
4. The historical record of the Fed’s conduct of monetary
policy reveals that the Fed has switched its operating
targets many times, returning to a federal funds rate
target in recent years.
5. The Taylor rule indicates that the federal funds rate
should be set equal to the inflation rate plus an
“equilibrium” real funds rate plus a weighted average of
two gaps: (1) an inflation gap, current inflation minus a
target rate, and (2) an output gap, the percentage
deviation of real GDP from an estimate of its potential
full employment level. The output gap in the Taylor
rule could represent an indicator of future inflation as
stipulated in Phillips curve theory. However, this theory
is controversial, because high output relative to
potential as measured by low unemployment has not
seemed to produce higher inflation in recent years.
Key Terms
instrument target, p. 415
intermediate targets, p. 414
international policy coordination,
p. 428
natural rate of unemployment, p. 412
nonaccelerating inflation rate of
unemployment (NAIRU), p. 429
operating target, p. 415
Phillips curve theory, p. 429
real bills doctrine, p. 420
Taylor rule, p. 428
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. “Unemployment is a bad thing, and the government
should make every effort to eliminate it.” Do you agree
or disagree? Explain your answer.
2. Classify each of the following as either an operating
target or an intermediate target, and explain why.
a. The three-month Treasury bill rate
b. The monetary base
c. M2
*3. “If the demand for money did not fluctuate, the Fed
could pursue both a money supply target and an
interest-rate target at the same time.” Is this statement
true, false, or uncertain? Explain your answer.
4. If the Fed has an interest-rate target, why will an
increase in money demand lead to a rise in the money
supply?
*5. What procedures can the Fed use to control the threemonth
Treasury bill rate? Why does control of this
interest rate imply that the Fed will lose control of the
money supply?
QUIZ
6. Compare the monetary base to M2 on the grounds of
controllability and measurability. Which do you prefer
as an intermediate target? Why?
*7. “Interest rates can be measured more accurately and
more quickly than the money supply. Hence an interest
rate is preferred over the money supply as an intermediate
target.” Do you agree or disagree? Explain
your answer.
8. Explain why the rise in the discount rate in 1920 led
to a sharp decline in the money supply.
*9. How did the Fed’s failure to perform its role as the
lender of last resort contribute to the decline of the
money supply in the 1930–1933 period?
10. Excess reserves are frequently called idle reserves, suggesting
that they are not useful. Does the episode of
the rise in reserve requirements in 1936–1937 bear
out this view?
*11. “When the economy enters a recession, an interestrate
target will lead to a slower rate of growth for the
money supply.” Explain why this statement is true.
What does it say about the use of interest rates as
targets?
12. “The failure of the Fed to control the money supply in
the 1970s and 1980s suggests that the Fed is not able
to control the money supply.” Do you agree or disagree?
Explain your answer.
*13. Which is more likely to produce smaller fluctuations
in the federal funds rate, a nonborrowed reserves target
or a borrowed reserves target? Why?
14. How can bank behavior and the Fed’s behavior cause
money supply growth to be procyclical (rising in
booms and falling in recessions)?
*15. Why might the Fed say that it wants to control the
money supply but in reality not be serious about
doing so?
432 PA RT I V Central Banking and the Conduct of Monetary Policy
Web Exercises
1. The Federal Open Market Committee (FOMC) meets
about every six weeks to assess the state of the economy
and to decide what actions the central bank
should take. The minutes of this meeting are
released after the next scheduled meeting; however,
a brief press release is made available immediately.
Find the schedule of minutes and press releases at
www.federalreserve.gov/fomc/.
a. When was the last scheduled meeting of the
FOMC? When is the next meeting?
b. Review the press release from the last meeting.
What did the committee decide to do about shortterm
interest rates?
c. Review the most recently published meeting minutes.
What areas of the economy seemed to be of
most concern to the committee members?
2. It is possible to access other central bank web sites to
learn about their structure. One example is the
European Central bank. Go to www.ecb.int/index.html.
On the ECB home page, locate the link to the current
exchange rate between the euro and the dollar. It was
initially set at 1 to 1. What is it now?
P a r t V
International
Finance and
Monetary
Policy

PREVIEW In the mid-1980s, American businesses became less competitive with their foreign
counterparts; subsequently, in the 1990s and 2000s, their competitiveness increased.
Did this swing in competitiveness occur primarily because American management fell
down on the job in the 1980s and then got its act together afterwards? Not really.
American business became less competitive in the 1980s because American dollars
become worth more in terms of foreign currencies, making American goods more
expensive relative to foreign goods. By the 1990s and 2000s, the value of the U.S. dollar
had fallen appreciably from its highs in the mid-1980s, making American goods
cheaper and American businesses more competitive.
The price of one currency in terms of another is called the exchange rate. It affects
the economy and our daily lives, because when the U.S. dollar becomes more valuable
relative to foreign currencies, foreign goods become cheaper for Americans and
American goods become more expensive for foreigners. When the U.S. dollar falls in
value, foreign goods become more expensive for Americans and American goods
become cheaper for foreigners. We begin our study of international finance by examining
the foreign exchange market, the financial market where exchange rates are
determined.
As you can see in Figure 1, exchange rates are highly volatile. What factors
explain the rise and fall of exchange rates? Why are exchange rates so volatile from
day to day?
To answer these questions, we develop a modern view of exchange rate determination
that explains recent behavior in the foreign exchange market.
Foreign Exchange Market
Most countries of the world have their own currencies: The United States has its dollar;
the European Monetary Union, the euro; Brazil, its real; and India, its rupee. Trade
between countries involves the mutual exchange of different currencies (or, more usually,
bank deposits denominated in different currencies). When an American firm
buys foreign goods, services, or financial assets, for example, U.S. dollars (typically,
bank deposits denominated in U.S. dollars) must be exchanged for foreign currency
(bank deposits denominated in the foreign currency).
The trading of currency and bank deposits denominated in particular currencies
takes place in the foreign exchange market. Transactions conducted in the foreign
435
Chap ter
19 The Foreign Exchange Market
www.ny.frb.org/Pihome
/addpub/usfxm
Get detailed information about
the foreign exchange market in
the United States.
exchange market determine the rates at which currencies are exchanged, which in
turn determine the cost of purchasing foreign goods and financial assets.
There are two kinds of exchange rate transactions. The predominant ones, called spot
transactions, involve the immediate (two-day) exchange of bank deposits. Forward
transactions involve the exchange of bank deposits at some specified future date. The
spot exchange rate is the exchange rate for the spot transaction, and the forward
exchange rate is the exchange rate for the forward transaction.
When a currency increases in value, it experiences appreciation; when it falls in
value and is worth fewer U.S. dollars, it undergoes depreciation. At the beginning of
1999, for example, the euro was valued at 1.18 dollars, and as indicated in the
“Following the Financial News” box, on February 5, 2003, it was valued at 1.08 dollars.
The euro depreciated by 8%: (1.08 1.18)/1.18 0.08 8%. Equivalently, we
could say that the U.S. dollar, which went from a value of 0.85 euros per dollar at the
What Are Foreign
Exchange Rates?
436 PA RT V International Finance and Monetary Policy
FIGURE 1 Exchange Rates, 1990–2002
Dollar prices of selected currencies. Note that a rise in these plots indicates a strengthening of the currency (weakening of the dollar).
Source: Federal Reserve: www.federalreserve.gov/releases/h10/hist.
Canadian dollar
British pound
Japanese yen Euro
1990
0.50
0.60
0.70
0.80
0.90
1.00
0.006
0.007
0.008
0.009
0.010
0.011
0.012
1.00
1.20
1.40
1.60
1.80
2.00
0.60
0.70
0.80
0.90
1.00
1.10
1.20
1990 2000
1990 1990 2000
$ $
$ $
2000
2000
http://quotes.ino.com/chart/
Go to this web site and click on
“Foreign Exchange” to get
market rates and time charts for
the exchange rate of the U.S.
dollar to major world
currencies.
C H A P T E R 1 9 The Foreign Exchange Market 437
Following the Financial News
Foreign exchange rates are published daily and
appear in the “Currency Trading” column of the Wall
Street Journal. The entries from one such column,
shown here, are explained in the text.
The first entry for the euro lists the exchange rate
for the spot transaction (the spot exchange rate) on
February 5, 2003, and is quoted in two ways: $1.0795
per euro and 0.9264 euros per dollar. Americans generally
regard the exchange rate with the euro as
$1.0795 per euro, while Europeans think of it as
0.9264 euros per dollar. The three entries immediately
below the spot exchange rates for some currencies
give the rates for forward transactions (the
forward exchange rates) that will take place one
month, three months, and six months in the future.
Foreign Exchange Rates
Wednesday, February 5, 2003
EXCHANGE RATES
The foreign exchange mid-range rates below apply to trading among banks in
amounts of $1 million and more, as quoted at 4 p.m. Eastern time by Reuters
and other sources. Retail transactions provide fewer units of foreign currency
per dollar.
Currency
U.S. $ Equivalent per U.S. $
Country Wed Tue Wed Tue
Argentina (Peso)-y . . . . . .3160 .3160 3.1646 3.1646
Australia (Dollar) . . . . . . .5901 .5915 1.6946 1.6906
Bahrain (Dinar) . . . . . . . . 2.6522 2.6523 .3770 .3770
Brazil (Real) . . . . . . . . . . .2784 .2798 3.5920 3.5740
Canada (Dollar) . . . . . . . .6574 .6602 1.5211 1.5147
1-month forward . . . . . .6566 .6595 1.5230 1.5163
3-months forward . . . . .6548 .6576 1.5272 1.5207
6-months forward . . . . .6517 .6544 1.5344 1.5281
Chile (Peso) . . . . . . . . . . .001348 .001346 741.84 742.94
China (Renminbi) . . . . . . .1208 .1208 8.2781 8.2781
Colombia (Peso) . . . . . . . .0003372 .0003378 2965.60 2960.33
Czech. Rep. (Koruna)
Commercial rate . . . . . .03398 .03438 29.429 29.087
Denmark (Krone) . . . . . . .1453 .1463 6.8823 6.8353
Ecuador (US Dollar) . . . . 1.0000 1.0000 1.0000 1.0000
Hong Kong (Dollar) . . . . . .1282 .1282 7.8003 7.8003
Hungary (Forint) . . . . . . . .004406 .004454 226.96 224.52
India (Rupee) . . . . . . . . . .02099 .02094 47.642 47.756
Indonesia (Rupiah) . . . . . .0001128 .0001127 8865 8873
Israel (Shekel) . . . . . . . . .2050 .2049 4.8780 4.8804
Japan (Yen) . . . . . . . . . . .008336 .008353 119.96 119.72
1-month forward . . . . . .008344 .008362 119.85 119.59
3-months forward . . . . .008363 .008381 119.57 119.32
6-months forward . . . . .008391 .008408 119.18 118.93
Jordan (Dinar) . . . . . . . . . 1.4094 1.4085 .7095 .7100
Kuwait (Dinar) . . . . . . . . 3.3479 3.3523 .2987 .2983
Lebanon (Pound) . . . . . . . .0006634 .0006634 1507.39 1507.39
Malaysia (Ringgit)-b . . . . .2632 .2632 3.7994 3.7994
Malta (Lira) . . . . . . . . . . 2.5690 2.5861 .3893 .3867
Mexico (Peso)
Floating rate . . . . . . . . .0920 .0913 10.8648 10.9481
New Zealand (Dollar) . . . .5494 .5496 1.8202 1.8195
Norway (Krone) . . . . . . . . .1434 .1448 6.9735 6.9061
Currency
U.S. $ Equivalent per U.S. $
Country Wed Tue Wed Tue
Pakistan (Rupee) . . . . . . .01719 .01723 58.173 58.038
Peru (new Sol) . . . . . . . . .2866 .2863 3.4892 3.4928
Philippines (Peso) . . . . . . .01852 .01853 53.996 53.967
Poland (Zloty) . . . . . . . . . .2606 .2622 3.8373 3.8139
Russia (Ruble)-a . . . . . . . 0.3142 0.3142 31.827 31.827
Saudi Arabia . . . . . . . . . . .2667 .2667 3.7495 3.7495
Singapore (Dollar) . . . . . . .5742 .5755 1.7416 1.7376
Slovak Rep. (Koruna) . . . .02579 .02607 38.775 38.358
South Africa (Rand) . . . . .1192 .1202 8.3893 8.3195
South Korea (Won) . . . . . .0008516 .0008529 1174.26 1172.47
Sweden (Krona) . . . . . . . .1169 .1177 8.5543 8.4962
Switzerland (Franc) . . . . . .7358 .7424 1.3591 1.3470
1-month forward . . . . . .7362 .7428 1.3583 1.3463
3-months forward . . . . .7371 .7437 1.3567 1.3446
6-months forward . . . . .7386 .7451 1.3539 1.3421
Taiwan (Dollar) . . . . . . . . .02881 .02881 34.710 34.710
Thailand (Baht) . . . . . . . . .02338 .02342 42.772 42.699
Turkey (Lira) . . . . . . . . . . .00000061 .00000061 1639344 1639344
U.K. (Pound) . . . . . . . . . . 1.6423 1.6485 .6089 .6066
1-month forward . . . . . 1.6391 1.6452 .6101 .6078
3-months forward . . . . 1.6322 1.6382 .6127 .6104
6-months forward . . . . 1.6221 1.6283 .6165 .6141
United Arab (Dirham) . . . .2723 .2723 3.6724 3.6724
Uruguay (Peso)
Financial . . . . . . . . . . . .03500 .03550 28.571 28.169
Venezuela (Bolivar) . . . . . .000520 .000520 1923.08 1923.08
SDR . . . . . . . . . . . . . . . . 1.3741 1.3697 .7277 .7301
Euro . . . . . . . . . . . . . . . 1.0795 1.0883 .9264 .9189
Special Drawing Rights (SDR) are based on exchange rates for the U.S.,
British, and Japanese currencies. Source: International Monetary Fund.
a-Russian Central Bank rate. b-Government rate. y-Floating rate.
Source: Wall Street Journal, Thursday, February 6, 2003, p. C12.
CURRENCY TRADING
beginning of 1999 to a value of 0.93 euros per dollar on February 5, 2003, appreciated
by 9%: (0.93 0.85)/0.85 0.09 9%.
Exchange rates are important because they affect the relative price of domestic and
foreign goods. The dollar price of French goods to an American is determined by the
interaction of two factors: the price of French goods in euros and the euro/dollar
exchange rate.
Suppose that Wanda the Winetaster, an American, decides to buy a bottle of 1961
(a very good year) Château Lafite Rothschild to complete her wine cellar. If the price
of the wine in France is 1,000 euros and the exchange rate is $1.08 to the euro, the
wine will cost Wanda $1,080 ( 1,000 euros $1.08/euro). Now suppose that
Wanda delays her purchase by two months, at which time the euro has appreciated
to $1.20 per euro. If the domestic price of the bottle of Lafite Rothschild remains
1,000 euros, its dollar cost will have risen from $1,080 to $1,200.
The same currency appreciation, however, makes the price of foreign goods in
that country less expensive. At an exchange rate of $1.08 per euro, a Compaq computer
priced at $2,000 costs Pierre the Programmer 1,852 euros; if the exchange rate
increases to $1.20 per euro, the computer will cost only 1,667 euros.
A depreciation of the euro lowers the cost of French goods in America but raises
the cost of American goods in France. If the euro drops in value to $0.90, Wanda’s
bottle of Lafite Rothschild will cost her only $900 instead of $1,080, and the Compaq
computer will cost Pierre 2,222 euros rather than 1,852.
Such reasoning leads to the following conclusion: When a country’s currency
appreciates (rises in value relative to other currencies), the country’s goods abroad
become more expensive and foreign goods in that country become cheaper (holding
domestic prices constant in the two countries). Conversely, when a country’s currency
depreciates, its goods abroad become cheaper and foreign goods in that country
become more expensive.
Appreciation of a currency can make it harder for domestic manufacturers to sell
their goods abroad and can increase competition at home from foreign goods, because
they cost less. From 1980 to early 1985, the appreciating dollar hurt U.S. industries.
For instance, the U.S. steel industry was hurt not just because sales abroad of the
more expensive American steel declined, but also because sales of relatively cheap foreign
steel in the United States increased. Although appreciation of the U.S. dollar hurt
some domestic businesses, American consumers benefited because foreign goods
were less expensive. Japanese videocassette recorders and cameras and the cost of
vacationing in Europe fell in price as a result of the strong dollar.
You cannot go to a centralized location to watch exchange rates being determined;
currencies are not traded on exchanges such as the New York Stock Exchange.
Instead, the foreign exchange market is organized as an over-the-counter market in
which several hundred dealers (mostly banks) stand ready to buy and sell deposits
denominated in foreign currencies. Because these dealers are in constant telephone
and computer contact, the market is very competitive; in effect, it functions no differently
from a centralized market.
An important point to note is that while banks, companies, and governments talk
about buying and selling currencies in foreign exchange markets, they do not take a
fistful of dollar bills and sell them for British pound notes. Rather, most trades involve
the buying and selling of bank deposits denominated in different currencies. So when
How Is Foreign
Exchange Traded?
Why Are Exchange
Rates Important?
438 PA RT V International Finance and Monetary Policy
we say that a bank is buying dollars in the foreign exchange market, what we actually
mean is that the bank is buying deposits denominated in dollars. The volume in this
market is colossal, exceeding $1 trillion per day.
Trades in the foreign exchange market consist of transactions in excess of
$1 million. The market that determines the exchange rates in the “Following the
Financial News” box is not where one would buy foreign currency for a trip abroad.
Instead, we buy foreign currency in the retail market from dealers such as American
Express or from banks. Because retail prices are higher than wholesale, when we buy
foreign exchange, we obtain fewer units of foreign currency per dollar than exchange
rates in the box indicate.
Exchange Rates in the Long Run
Like the price of any good or asset in a free market, exchange rates are determined by
the interaction of supply and demand. To simplify our analysis of exchange rates in a
free market, we divide it into two parts. First, we examine how exchange rates are
determined in the long run; then we use our knowledge of the long-run determinants
of the exchange rate to help us understand how they are determined in the short run.
The starting point for understanding how exchange rates are determined is a simple
idea called the law of one price: If two countries produce an identical good, and
transportation costs and trade barriers are very low, the price of the good should be
the same throughout the world no matter which country produces it. Suppose that
American steel costs $100 per ton and identical Japanese steel costs 10,000 yen per
ton. For the law of one price to hold, the exchange rate between the yen and the dollar
must be 100 yen per dollar ($0.01 per yen) so that one ton of American steel sells
for 10,000 yen in Japan (the price of Japanese steel) and one ton of Japanese steel sells
for $100 in the United States (the price of U.S. steel). If the exchange rate were 200
yen to the dollar, Japanese steel would sell for $50 per ton in the United States or half
the price of American steel, and American steel would sell for 20,000 yen per ton in
Japan, twice the price of Japanese steel. Because American steel would be more expensive
than Japanese steel in both countries and is identical to Japanese steel, the
demand for American steel would go to zero. Given a fixed dollar price for American
steel, the resulting excess supply of American steel will be eliminated only if the
exchange rate falls to 100 yen per dollar, making the price of American steel and
Japanese steel the same in both countries.
One of the most prominent theories of how exchange rates are determined is the theory
of purchasing power parity (PPP). It states that exchange rates between any two
currencies will adjust to reflect changes in the price levels of the two countries. The
theory of PPP is simply an application of the law of one price to national price levels
rather than to individual prices. Suppose that the yen price of Japanese steel rises 10%
(to 11,000 yen) relative to the dollar price of American steel (unchanged at $100). For
the law of one price to hold, the exchange rate must rise to 110 yen to the dollar, a
10% appreciation of the dollar. Applying the law of one price to the price levels in the
two countries produces the theory of purchasing power parity, which maintains that
if the Japanese price level rises 10% relative to the U.S. price level, the dollar will
appreciate by 10%.
Theory of
Purchasing
Power Parity
Law of
One Price
C H A P T E R 1 9 The Foreign Exchange Market 439
www.oecd.org/EN/home
/0,,EN-home-513-15-no-no-no
-0,00.html
The purchasing power parities
home page includes the PPP
program overview, statistics,
research, publications, and
OECD meetings on PPP.
As our U.S./Japanese example demonstrates, the theory of PPP suggests that if
one country’s price level rises relative to another’s, its currency should depreciate (the
other country’s currency should appreciate). As you can see in Figure 2, this prediction
is borne out in the long run. From 1973 to the end of 2002, the British price level
rose 99% relative to the U.S. price level, and as the theory of PPP predicts, the dollar
appreciated against the pound; though by 73%, an amount smaller than the 99%
increase predicted by PPP.
Yet, as the same figure indicates, PPP theory often has little predictive power in
the short run. From early 1985 to the end of 1987, for example, the British price level
rose relative to that of the United States. Instead of appreciating, as PPP theory predicts,
the U.S. dollar actually depreciated by 40% against the pound. So even though
PPP theory provides some guidance to the long-run movement of exchange rates, it
is not perfect and in the short run is a particularly poor predictor. What explains PPP
theory’s failure to predict well?
The PPP conclusion that exchange rates are determined solely by changes in relative
price levels rests on the assumption that all goods are identical in both countries and
that transportation costs and trade barriers are very low. When this assumption is
true, the law of one price states that the relative prices of all these goods (that is, the
relative price level between the two countries) will determine the exchange rate. The
assumption that goods are identical may not be too unreasonable for American and
Japanese steel, but is it a reasonable assumption for American and Japanese cars? Is a
Toyota the equivalent of a Chevrolet?
Because Toyotas and Chevys are obviously not identical, their prices do not have
to be equal. Toyotas can be more expensive relative to Chevys and both Americans
and Japanese will still purchase Toyotas. Because the law of one price does not hold
for all goods, a rise in the price of Toyotas relative to Chevys will not necessarily mean
Why the Theory of
Purchasing Power
Parity Cannot
Fully Explain
Exchange Rates
440 PA RT V International Finance and Monetary Policy
FIGURE 2 Purchasing Power
Parity, United States/United
Kingdom, 1973–2002
(Index: March 1973 = 100.)
Source: www.statistics.gov.uk/statbase
/tsdataset2.asp.
1973
200
100
150
1983 1993 2003
Levels (CPIUK/CPIUS)
Exchange Rate (£/$)
250
Index
Relative Price
that the yen must depreciate by the amount of the relative price increase of Toyotas
over Chevys.
PPP theory furthermore does not take into account that many goods and services
(whose prices are included in a measure of a country’s price level) are not traded
across borders. Housing, land, and services such as restaurant meals, haircuts, and
golf lessons are not traded goods. So even though the prices of these items might rise
and lead to a higher price level relative to another country’s, there would be little
direct effect on the exchange rate.
Our analysis indicates that in the long run, four major factors affect the exchange rate:
relative price levels, tariffs and quotas, preferences for domestic versus foreign goods,
and productivity. We examine how each of these factors affects the exchange rate
while holding the others constant.
The basic reasoning proceeds along the following lines: Anything that increases the
demand for domestic goods relative to foreign goods tends to appreciate the domestic
currency because domestic goods will continue to sell well even when the value of the
domestic currency is higher. Similarly, anything that increases the demand for foreign
goods relative to domestic goods tends to depreciate the domestic currency because
domestic goods will continue to sell well only if the value of the domestic currency is
lower.
Relative Price Levels. In line with PPP theory, when prices of American goods rise
(holding prices of foreign goods constant), the demand for American goods falls and
the dollar tends to depreciate so that American goods can still sell well. By contrast,
if prices of Japanese goods rise so that the relative prices of American goods fall, the
demand for American goods increases, and the dollar tends to appreciate, because
American goods will continue to sell well even with a higher value of the domestic
currency. In the long run, a rise in a country’s price level (relative to the foreign price
level) causes its currency to depreciate, and a fall in the country’s relative price level
causes its currency to appreciate.
Trade Barriers. Barriers to free trade such as tariffs (taxes on imported goods) and
quotas (restrictions on the quantity of foreign goods that can be imported) can affect
the exchange rate. Suppose that the United States increases its tariff or puts a lower
quota on Japanese steel. These increases in trade barriers increase the demand for
American steel, and the dollar tends to appreciate because American steel will still sell
well even with a higher value of the dollar. Increasing trade barriers cause a country’s
currency to appreciate in the long run.
Preferences for Domestic Versus Foreign Goods. If the Japanese develop an appetite for
American goods—say, for Florida oranges and American movies—the increased
demand for American goods (exports) tends to appreciate the dollar, because the
American goods will continue to sell well even at a higher value for the dollar.
Likewise, if Americans decide that they prefer Japanese cars to American cars, the
increased demand for Japanese goods (imports) tends to depreciate the dollar.
Increased demand for a country’s exports causes its currency to appreciate in the
long run; conversely, increased demand for imports causes the domestic currency to
depreciate.
Factors That
Affect Exchange
Rates in the
Long Run
C H A P T E R 1 9 The Foreign Exchange Market 441
Productivity. If one country becomes more productive than other countries, businesses
in that country can lower the prices of domestic goods relative to foreign goods
and still earn a profit. As a result, the demand for domestic goods rises, and the
domestic currency tends to appreciate. If, however, its productivity lags behind that
of other countries, its goods become relatively more expensive, and the currency
tends to depreciate. In the long run, as a country becomes more productive relative
to other countries, its currency appreciates.1
Study Guide The trick to figuring out what long-run effect a factor has on the exchange rate is to
remember the following: If a factor increases the demand for domestic goods relative
to foreign goods, the domestic currency will appreciate, and if a factor decreases
the relative demand for domestic goods, the domestic currency will depreciate. See
how this works by explaining what happens to the exchange rate when any of the factors
in Table 1 decreases rather than increases.
Our long-run theory of exchange rate behavior is summarized in Table 1. We use
the convention that the exchange rate E is quoted so that an appreciation of the currency
corresponds to a rise in the exchange rate. In the case of the United States, this
means that we are quoting the exchange rate as units of foreign currency per dollar
(say, yen per dollar).2
442 PA RT V International Finance and Monetary Policy
1A country might be so small that a change in productivity or the preferences for domestic or foreign goods
would have no effect on prices of these goods relative to foreign goods. In this case, changes in productivity or
changes in preferences for domestic or foreign goods affect the country’s income but will not necessarily affect
the value of the currency. In our analysis, we are assuming that these factors can affect relative prices and consequently
the exchange rate.
2Exchange rates can be quoted either as units of foreign currency per domestic currency or alternatively as units
of domestic currency per foreign currency. In professional writing, many economists quote exchange rates as
units of domestic currency per foreign currency so that an appreciation of the domestic currency is portrayed as
a fall in the exchange rate. The opposite convention is used in the text here, because it is more intuitive to think
of an appreciation of the domestic currency as a rise in the exchange rate.
S U M M A R Y Table 1 Factors That Affect Exchange Rates in the Long Run
Change in Response of the
Factor Factor Exchange Rate, E*
Domestic price level† ↑ ↓
Trade barriers† ↑ ↑
Import demand ↑ ↓
Export demand ↑ ↑
Productivity† ↑ ↑
*Units of foreign currency per dollar: ↑ indicates domestic currency appreciation; ↓ , depreciation.
†Relative to other countries.
Note: Only increases ( ↑) in the factors are shown; the effects of decreases in the variables on the
exchange rate are the opposite of those indicated in the “Response” column.
Exchange Rates in the Short Run
We have developed a theory of the long-run behavior of exchange rates. However, if
we are to understand why exchange rates exhibit such large changes (sometimes several
percent) from day to day, we must develop a theory of how current exchange rates
(spot exchange rates) are determined in the short run.
The key to understanding the short-run behavior of exchange rates is to recognize
that an exchange rate is the price of domestic bank deposits (those denominated in the
domestic currency) in terms of foreign bank deposits (those denominated in the foreign
currency). Because the exchange rate is the price of one asset in terms of another, the
natural way to investigate the short-run determination of exchange rates is through an
asset market approach that relies heavily on the theory of asset demand developed in
Chapter 5. As you will see, however, the long-run determinants of the exchange rate we
have just outlined also play an important role in the short-run asset market approach.3
Earlier approaches to exchange rate determination emphasized the role of import
and export demand. The more modern asset market approach used here does not
emphasize the flows of purchases of exports and imports over short periods, because
these transactions are quite small relative to the amount of domestic and foreign bank
deposits at any given time. For example, foreign exchange transactions in the United
States each year are well over 25 times greater than the amount of U.S. exports and
imports. Thus over short periods such as a year, decisions to hold domestic or foreign
assets play a much greater role in exchange rate determination than the demand for
exports and imports does.
In this analysis, we treat the United States as the home country, so as an example,
domestic bank deposits are denominated in dollars. For simplicity, we use euros to
stand for any foreign country’s currency, so foreign bank deposits are denominated in
euros. The theory of asset demand suggests that the most important factor affecting
the demand for domestic (dollar) deposits and foreign (euro) deposits is the expected
return on these assets relative to each other. When Americans or foreigners expect the
return on dollar deposits to be high relative to the return on foreign deposits, there is
a higher demand for dollar deposits and a correspondingly lower demand for euro
deposits. To understand how the demands for dollar and foreign deposits change, we
need to compare the expected returns on dollar deposits and foreign deposits.
To illustrate further, suppose that dollar deposits have an interest rate (expected
return payable in dollars) of iD, and foreign bank deposits have an interest rate
(expected return payable in the foreign currency, euros) of i F. To compare the
expected returns on dollar deposits and foreign deposits, investors must convert the
returns into the currency unit they use.
First let us examine how François the Foreigner compares the returns on dollar
deposits and foreign deposits denominated in his currency, the euro. When he considers
the expected return on dollar deposits in terms of euros, he recognizes that it
does not equal iD; instead, the expected return must be adjusted for any expected
appreciation or depreciation of the dollar. If the dollar were expected to appreciate by
7%, for example, the expected return on dollar deposits in terms of euros would be
Comparing
Expected Returns
on Domestic and
Foreign Deposits
C H A P T E R 1 9 The Foreign Exchange Market 443
3For a further description of the modern asset market approach to exchange rate determination that we use here,
see Paul Krugman and Maurice Obstfeld, International Economics, 6th ed. (Reading, Mass.: Addison Wesley
Longman, 2003).
www.federalreserve.gov
/releases/
The Federal Reserve reports
current and historical exchange
rates for many countries.
7% higher because the dollar has become worth 7% more in terms of euros. Thus if
the interest rate on dollar deposits is 10%, with an expected appreciation of the dollar
of 7%, the expected return on dollar deposits in terms of euros is 17%: the 10%
interest rate plus the 7% expected appreciation of the dollar. Conversely, if the dollar
were expected to depreciate by 7% over the year, the expected return on dollar
deposits in terms of euros would be only 3%: the 10% interest rate minus the 7%
expected depreciation of the dollar.
Writing the currency exchange rate (the spot exchange rate) as Et and the
expected exchange rate for the next period as Ee t1, we can write the expected rate of
appreciation of the dollar as (Ee t1 Et )/Et. Our reasoning indicates that the expected
return on dollar deposits RD in terms of foreign currency can be written as the sum of
the interest rate on dollar deposits plus the expected appreciation of the dollar:4
However, François’s expected return on foreign deposits RF in terms of euros is
just i F. Thus in terms of euros, the relative expected return on dollar deposits (that is, the
difference between the expected return on dollar deposits and euro deposits) is calculated
by subtracting i F from the expression just given to yield
(1)
As the relative expected return on dollar deposits increases, foreigners will want to
hold more dollar deposits and fewer foreign deposits.
Next let us look at the decision to hold dollar deposits versus euro deposits from
Al the American’s point of view. Following the same reasoning we used to evaluate the
decision for François, we know that the expected return on foreign deposits RF in
terms of dollars is the interest rate on foreign deposits i F plus the expected appreciation
of the foreign currency, equal to minus the expected appreciation of the dollar,
(Ee t1 Et )/Et, that is:
R F in terms of dollars i F
E e
t1 Et
Et
Relative R D iD i F
E e
t1 Et
Et
R D in terms of euros iD
E e
t1 Et
Et
444 PA RT V International Finance and Monetary Policy
4This expression is actually an approximation of the expected return in terms of euros, which can be more precisely
calculated by thinking how a foreigner invests in the dollar deposit. Suppose that François decides to put
one euro into dollar deposits. First he buys 1/E t of U.S. dollar deposits (recall that E t, the exchange rate between
dollar and euro deposits, is quoted in euros per dollar), and at the end of the period he is paid (1 iD)(1/Et )
in dollars. To convert this amount into the number of euros he expects to receive at the end of the period, he
multiplies this quantity by E e
t1. François’s expected return on his initial investment of one euro can thus be
written as (1 iD)(E e
t1/Et ) minus his initial investment of one euro:
which can be rewritten as
which is approximately equal to the expression in the text because E e
t1/Et is typically close to 1.
i DE e
t1
Et
E e
t1 E t
E t
(1 i D)E e
t1
Et 1
If the interest rate on euro deposits is 5%, for example, and the dollar is expected
to appreciate by 4%, then the expected return on euro deposits in terms of dollars is
1%. Al earns the 5% interest rate, but he expects to lose 4% because he expects the
euro to be worth 4% less in terms of dollars as a result of the dollar’s appreciation.
Al’s expected return on the dollar deposits RD in terms of dollars is just iD. Hence
in terms of dollars, the relative expected return on dollar deposits is calculated by
subtracting the expression just given from iD to obtain:
This equation is the same as the one describing François’s relative expected return
on dollar deposits (calculated in terms of euros). The key point here is that the relative
expected return on dollar deposits is the same whether it is calculated by François
in terms of euros or by Al in terms of dollars. Thus as the relative expected return on
dollar deposits increases, both foreigners and domestic residents respond in exactly
the same way—both will want to hold more dollar deposits and fewer foreign
deposits.
We currently live in a world in which there is capital mobility: Foreigners can easily
purchase American assets such as dollar deposits, and Americans can easily purchase
foreign assets such as euro deposits. Because foreign bank deposits and American
bank deposits have similar risk and liquidity and because there are few impediments
to capital mobility, it is reasonable to assume that the deposits are perfect substitutes
(that is, equally desirable). When capital is mobile and when bank deposits are perfect
substitutes, if the expected return on dollar deposits is above that on foreign
deposits, both foreigners and Americans will want to hold only dollar deposits and
will be unwilling to hold foreign deposits. Conversely, if the expected return on foreign
deposits is higher than on dollar deposits, both foreigners and Americans will not
want to hold any dollar deposits and will want to hold only foreign deposits. For
existing supplies of both dollar deposits and foreign deposits to be held, it must therefore
be true that there is no difference in their expected returns; that is, the relative
expected return in Equation 1 must equal zero. This condition can be rewritten as:
(2)
This equation is called the interest parity condition, and it states that the
domestic interest rate equals the foreign interest rate minus the expected appreciation
of the domestic currency. Equivalently, this condition can be stated in a more intuitive
way: The domestic interest rate equals the foreign interest rate plus the expected
appreciation of the foreign currency. If the domestic interest rate is above the foreign
interest rate, this means that there is a positive expected appreciation of the foreign
currency, which compensates for the lower foreign interest rate. A domestic interest
rate of 15% versus a foreign interest rate of 10% means that the expected appreciation
of the foreign currency must be 5% (or, equivalently, that the expected depreciation
of the dollar must be 5%).
There are several ways to look at the interest parity condition. First, we should
recognize that interest parity means simply that the expected returns are the same on
both dollar deposits and foreign deposits. To see this, note that the left side of the
interest parity condition (Equation 2) is the expected return on dollar deposits, while
iD i F
E e
t1 Et
Et
Interest Parity
Condition
Relative R D i D i F
E e
t1 Et
Et iD i F
E e
t1 Et
Et
C H A P T E R 1 9 The Foreign Exchange Market 445
the right side is the expected return on foreign deposits, both calculated in terms of
a single currency, the U.S. dollar. Given our assumption that domestic and foreign
bank deposits are perfect substitutes (equally desirable), the interest parity condition
is an equilibrium condition for the foreign exchange market. Only when the exchange
rate is such that expected returns on domestic and foreign deposits are equal—that
is, when interest parity holds—will the outstanding domestic and foreign deposits be
willingly held.
To see how the interest parity equilibrium condition works in determining the
exchange rate, our first step is to examine how the expected returns on euro and dollar
deposits change as the current exchange rate changes.
Expected Return on Euro Deposits. As we demonstrated earlier, the expected return in
terms of dollars on foreign deposits RF is the foreign interest rate minus the expected
appreciation of the domestic currency: i F (Ee t1 Et )/Et. Suppose that the foreign
interest rate i F is 10% and that the expected exchange rate next period Ee t1 is 1 euro
per dollar. When the current exchange rate Et is 0.95 euros per dollar, the expected
appreciation of the dollar is (1.00 0.95)/0.95 0.052 5.2%, so the expected
return on euro deposits RF in terms of dollars is 4.8% (equal to the 10% foreign interest
rate minus the 5.2% dollar appreciation). This expected return when Et 0.95
euros per dollar is plotted as point A in Figure 3. At a higher current exchange rate of
Et 1 euro per dollar, the expected appreciation of the dollar is zero because Ee t1
also equals 1 euro per dollar. Hence RF, the expected dollar return on euro deposits,
is now just i F 10%. This expected return on euro deposits when Et 1 euro per
dollar is plotted as point B. At an even higher exchange rate of Et 1.05 euros per
Equilibrium in
the Foreign
Exchange Market
446 PA RT V International Finance and Monetary Policy
FIGURE 3 Equilibrium in the
Foreign Exchange Market
Equilibrium in the foreign
exchange market occurs at the
intersection of the schedules for
the expected return on euro
deposits RF and the expected
return on dollar deposits RD at
point B. The equilibrium
exchange rate is E* 1 euro per
dollar.
RD Exchange Rate, Et
(euros/$)
1.05
Expected Return (in $ terms)
E * = 1.00
5% 10% 15%
RF
0.95
E
C
D
B
A
dollar, the expected change in the value of the dollar is now 4.8% [ (1.00 –
1.05)/1.05 0.048], so the expected dollar return on foreign deposits RF has now
risen to 14.8% [ 10% (4.8%)]. This combination of exchange rate and expected
return on euro deposits is plotted as point C.
The curve connecting these points is the schedule for the expected return on euro
deposits in Figure 3, labeled RF, and as you can see, it slopes upward; that is, as the
exchange rate Et rises, the expected return on euro deposits rises. The intuition for
this upward slope is that because the expected next-period exchange rate is held constant
as the current exchange rate rises, there is less expected appreciation of the dollar.
Hence a higher current exchange rate means a greater expected appreciation of the
foreign currency in the future, which increases the expected return on foreign
deposits in terms of dollars.
Expected Return on Dollar Deposits. The expected return on dollar deposits in terms of
dollars RD is always the interest rate on dollar deposits i D no matter what the exchange
rate is. Suppose that the interest rate on dollar deposits is 10%. The expected return
on dollar deposits, whether at an exchange rate of 0.95, 1.00, or 1.05 euros per dollar,
is always 10% (points D, B, and E) since no foreign-exchange transaction is needed to
convert the interest payments into dollars. The line connecting these points is the
schedule for the expected return on dollar deposits, labeled RD in Figure 3.
Equilibrium. The intersection of the schedules for the expected return on dollar
deposits RD and the expected return on euro deposits RF is where equilibrium occurs
in the foreign exchange market; in other words,
RD RF
At the equilibrium point B where the exchange rate E* is 1 euro per dollar, the
interest parity condition is satisfied because the expected returns on dollar deposits
and on euro deposits are equal.
To see that the exchange rate actually heads toward the equilibrium exchange rate
E*, let’s see what happens if the exchange rate is 1.05 euros per dollar, a value above
the equilibrium exchange rate. As we can see in Figure 3, the expected return on euro
deposits at point C is greater than the expected return on dollar deposits at point E.
Since dollar and euro deposits are perfect substitutes, people will not want to hold
any dollar deposits, and holders of dollar deposits will try to sell them for euro
deposits in the foreign exchange market (which is referred to as “selling dollars” and
“buying euros”). However, because the expected return on these dollar deposits is
below that on euro deposits, no one holding euros will be willing to exchange them
for dollar deposits. The resulting excess supply of dollar deposits means that the price
of the dollar deposits relative to euro deposits must fall; that is, the exchange rate
(amount of euros per dollar) falls as is illustrated by the downward arrow drawn in
the figure at the exchange rate of 1.05 euros per dollar. The decline in the exchange
rate will continue until point B is reached at the equilibrium exchange rate of 1 euro
per dollar, where the expected return on dollar and euro deposits is now equalized.
Now let us look at what happens when the exchange rate is 0.95 euros per dollar,
a value below the equilibrium level. Here the expected return on dollar deposits
is greater than that on euro deposits. No one will want to hold euro deposits, and
everyone will try to sell them to buy dollar deposits (“sell euros” and “buy dollars”),
thus driving up the exchange rate as illustrated by the upward arrow. As the exchange
C H A P T E R 1 9 The Foreign Exchange Market 447
rate rises, there is a higher expected depreciation of the dollar and so a higher
expected appreciation of the euro, thereby increasing the expected return on euro
deposits. Finally, when the exchange rate has risen to E* 1 euro per dollar, the
expected return on euro deposits has risen enough so that it again equals the expected
return on dollar deposits.
Explaining Changes in Exchange Rates
To explain how an exchange rate changes over time, we have to understand the factors
that shift the expected-return schedules for domestic (dollar) deposits and foreign
(euro) deposits.
As we have seen, the expected return on foreign (euro) deposits depends on the foreign
interest rate i F minus the expected appreciation of the dollar (Ee t1 Et )/Et .
Because a change in the current exchange rate Et results in a movement along the
expected-return schedule for euro deposits, factors that shift this schedule must work
through the foreign interest rate i F and the expected future exchange rate Ee t1. We
examine the effect of changes in these factors on the expected-return schedule for
euro deposits RF, holding everything else constant.
Study Guide To grasp how the expected-return schedule for euro deposits shifts, just think of yourself
as an investor who is considering putting funds into foreign deposits. When a
variable changes (i F, for example), decide whether at a given level of the current
exchange rate, holding all other variables constant, you would earn a higher or lower
expected return on euro deposits.
Changes in the Foreign Interest Rate. If the interest rate on foreign deposits i F
increases, holding everything else constant, the expected return on these deposits
must also increase. Hence at a given exchange rate, the increase in i F leads to a rightward
shift in the expected-return schedule for euro deposits from RF
1 to RF
2 in Figure 4.
As you can see in the figure, the outcome is a depreciation of the dollar from E1 to E2.
An alternative way to see this is to recognize that the increase in the expected return
on euro deposits at the original equilibrium exchange rate resulting from the rise in
i F means that people will want to buy euros and sell dollars, so the value of the dollar
must fall. Our analysis thus generates the following conclusion: An increase in the
foreign interest rate i F shifts the RF schedule to the right and causes the domestic
currency to depreciate (E↓).
Conversely, if i F falls, the expected return on euro deposits falls, the RF schedule
shifts to the left, and the exchange rate rises. This yields the following conclusion: A
decrease in i F shifts the RF schedule to the left and causes the domestic currency to
appreciate (E↑).
Changes in the Expected Future Exchange Rate. Any factor that causes the expected
future exchange rate Ee t1 to fall decreases the expected appreciation of the dollar and
hence raises the expected appreciation of the euro. The result is a higher expected return
Shifts in the
Expected-Return
Schedule
for Foreign
Deposits
448 PA RT V International Finance and Monetary Policy
on euro deposits, which shifts the schedule for the expected return on euro deposits
to the right and leads to a decline in the exchange rate as in Figure 4. Conversely, a
rise in Ee t1 raises the expected appreciation of the dollar, lowers the expected return
on foreign deposits, shifts the RF schedule to the left, and raises the exchange rate. To
summarize, a rise in the expected future exchange rate shifts the RF schedule to the
left and causes an appreciation of the domestic currency; a fall in the expected
future exchange rate shifts the RF schedule to the right and causes a depreciation of
the domestic currency.
Summary. Our analysis of the long-run determinants of the exchange rate indicates
the factors that influence the expected future exchange rate: the relative price level,
relative tariffs and quotas, import demand, export demand, and relative productivity
(refer to Table 1). The theory of purchasing power parity suggests that if a higher
American price level relative to the foreign price level is expected to persist, the dollar
will depreciate in the long run. A higher expected relative American price level
should thus have a tendency to lower Ee t1, raise the expected return on euro
deposits, shift the RF schedule to the right, and lower the current exchange rate.
Similarly, the other long-run determinants of the exchange rate we discussed earlier
can also influence the expected return on euro deposits and the current exchange
rate. Briefly, the following changes will lower Ee t1, increase the expected return on
euro deposits, shift the RF schedule to the right, and cause a depreciation of the domestic
currency, the dollar: (1) expectations of a rise in the American price level relative
to the foreign price level, (2) expectations of lower American trade barriers relative to
foreign trade barriers, (3) expectations of higher American import demand, (4) expectations
of lower foreign demand for American exports, and (5) expectations of lower
American productivity relative to foreign productivity.
C H A P T E R 1 9 The Foreign Exchange Market 449
FIGURE 4 Shifts in the
Schedule for the Expected Return on
Foreign Deposits RF
An increase in the expected
return on foreign deposits, which
occurs when either the foreign
interest rate rises or the expected
future exchange rate falls, shifts
the schedule for the expected
return on foreign deposits from
RF
1 to RF
2, and the exchange rate
falls from E1 to E2.
Exchange Rate, Et
(euros/$)
Expected Return (in $ terms)
R F
1
E1 1
2 E2
R F
2
i D
RD
Since the expected return on domestic (dollar) deposits is just the interest rate on
these deposits i D, this interest rate is the only factor that shifts the schedule for the
expected return on dollar deposits.
Changes in the Domestic Interest Rate. A rise in i D raises the expected return on dollar
deposits, shifts the RD schedule to the right, and leads to a rise in the exchange
rate, as is shown in Figure 5. Another way of seeing this is to recognize that a rise in
i D, which raises the expected return on dollar deposits, creates an excess demand for
dollar deposits at the original equilibrium exchange rate, and the resulting purchases
of dollar deposits cause an appreciation of the dollar. A rise in the domestic interest
rate i D shifts the RD schedule to the right and causes an appreciation of the domestic
currency; a fall in i D shifts the RD schedule to the left and causes a depreciation
of the domestic currency.
Study Guide As a study aid, the factors that shift the RF and RD schedules and lead to changes in
the current exchange rate Et are listed in Table 2. The table shows what happens to
the exchange rate when there is an increase in each of these variables, holding everything
else constant. To give yourself practice, see if you can work out what happens
to the RF and RD schedules and to the exchange rate if each of these factors falls rather
than rises. Check your answers by seeing if you get the opposite change in the
exchange rate to those indicated in Table 2.
Shifts in the
Expected-Return
Schedule for
Domestic
Deposits
450 PA RT V International Finance and Monetary Policy
FIGURE 5 Shifts in the
Schedule for the Expected Return on
Domestic Deposits RD
An increase in the expected return
on dollar deposits i D shifts the
expected return on domestic (dollar)
deposits from RD1
to RD
2 and
the exchange rate from E1 to E2.
Exchange Rate, Et
(euros/$)
Expected Return (in $ terms)
R F
1
E2
E1 1
iD2
iD1
RD
1 RD
2
2
C H A P T E R 1 9 The Foreign Exchange Market 451
S U M M A R Y Table 2 Factors That Shift the RF and RD Schedules and Affect the Exchange Rate
Change Response of
Factor in Factor Exchange Rate Et
Domestic interest rate i D ↑ ↑
Foreign interest rate i F ↑ ↓
Expected domestic price level* ↑ ↓
Expected trade barriers* ↑ ↑
Expected import demand ↑ ↓
Expected export demand ↑ ↑
Expected productivity* ↑ ↑
*Relative to other countries.
Note: Only increases ( ↑) in the factors are shown; the effects of decreases in the variables on the exchange rate are the opposite of those
indicated in the “Response” column.
RD
RD
RD
RD
RD
E1
E2
RF ←
E2
E1 RF2
RF1

E1
E2 RF1
RF2

E2
E1 RF2
RF1

E2
E1 RF2
RF1

E1
E2 RF1
RF2

E1
E2 RF1
RF2

RD
RD1
RD2
Et
Et
Et
Et
Et
Et
R in $
R in $
R in $
R in $
R in $
R in $
Et
R in $
452 PA RT V International Finance and Monetary Policy
Application Changes in the Equilibrium Exchange Rate: Two Examples
Our analysis has revealed the factors that affect the value of the equilibrium
exchange rate. Now we use this analysis to take a close look at the response
of the exchange rate to changes in interest rates and money growth.
Changes in domestic interest rates i D are often cited as a major factor affecting
exchange rates. For example, we see headlines in the financial press like
this one: “Dollar Recovers As Interest Rates Edge Upward.” But is the view
presented in this headline always correct?
Not necessarily, because to analyze the effects of interest rate changes, we
must carefully distinguish the sources of the changes. The Fisher equation
(Chapter 4) states that a (nominal) interest rate equals the real interest rate
plus expected inflation: i i r e. The Fisher equation indicates that an
interest rate i can change for two reasons: Either the real interest rate i r
changes or the expected inflation rate e changes. The effect on the exchange
rate is quite different, depending on which of these two factors is the source
of the change in the nominal interest rate.
Suppose that the domestic real interest rate increases so that the nominal
interest rate i D rises while expected inflation remains unchanged. In this
case, it is reasonable to assume that the expected appreciation of the dollar
will be unchanged because expected inflation is unchanged, and so the
expected return on foreign deposits will remain unchanged for any given
exchange rate. The result is that the RF schedule stays put and the RD schedule
shifts to the right, and we end up with the situation depicted in Figure 5,
which analyzes an increase in i D, holding everything else constant. Our
model of the foreign exchange market produces the following result: When
domestic real interest rates rise, the domestic currency appreciates.
When the nominal interest rate rises because of an increase in expected
inflation, we get a different result from the one shown in Figure 5. The rise in
expected domestic inflation leads to a decline in the expected appreciation of
the dollar (a higher appreciation of the euro), which is typically thought to be
larger than the increase in the domestic interest rate i D.5 As a result, at any
given exchange rate, the expected return on foreign deposits rises more than
the expected return on dollar deposits. Thus, as we see in Figure 6, the RF
schedule shifts to the right more than the RD schedule, and the exchange rate
falls. Our analysis leads to this conclusion: When domestic interest rates rise
due to an expected increase in inflation, the domestic currency depreciates.
Because this conclusion is completely different from the one reached
when the rise in the domestic interest rate is associated with a higher real
Changes in
Interest Rates
5This conclusion is standard in asset market models of exchange rate determination; see Rudiger Dornbusch,
“Expectations and Exchange Rate Dynamics,” Journal of Political Economy 84 (1976): 1061–1076. It is also consistent
with empirical evidence that suggests that nominal interest rates do not rise one-for-one with increases in
expected inflation. See Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-
Rochester Conference Series on Public Policy 15 (1981): 151–200; and Lawrence Summers, “The Nonadjustment
of Nominal Interest Rates: A Study of the Fisher Effect,” in Macroeconomics, Prices and Quantities, ed. James Tobin
(Washington, D.C.: Brookings Institution, 1983), pp. 201–240.
C H A P T E R 1 9 The Foreign Exchange Market 453
interest rate, we must always distinguish between real and nominal measures
when analyzing the effects of interest rates on exchange rates.
Suppose that the Federal Reserve decides to increase the level of the money
supply in order to reduce unemployment, which it believes to be excessive.
The higher money supply will lead to a higher American price level in the
long run (as we will see in Chapter 25) and hence to a lower expected future
exchange rate. The resulting decline in the expected appreciation of the dollar
increases the expected return on foreign deposits at any given current
exchange rate and so shifts the RF schedule rightward from RF
1 to RF
2 in Figure
7. In addition, the higher money supply will lead to a higher real money supply
M/P because the price level does not immediately increase in the short
run. As suggested in Chapter 5, the resulting rise in the real money supply
causes the domestic interest rate to fall from iD1
to iD2
, which lowers the
expected return on domestic (dollar) deposits, shifting the RD schedule leftward
from RD
1 to RD
2. As we can see in Figure 7, the result is a decline in the
exchange rate from E1 to E2. The conclusion is this: A higher domestic money
supply causes the domestic currency to depreciate.
Our analysis of the effect of an increase in the money supply on the exchange
rate is not yet over—we still need to look at what happens to the exchange
rate in the long run. A basic proposition in monetary theory, called monetary
neutrality, states that in the long run, a one-time percentage rise in the
money supply is matched by the same one-time percentage rise in the price
level, leaving unchanged the real money supply and all other economic variables
such as interest rates. An intuitive way to understand this proposition
Exchange Rate
Overshooting
Changes in the
Money Supply
FIGURE 6 Effect of a Rise in
the Domestic Nominal Interest Rate
as a Result of an Increase in
Expected Inflation
Because a rise in domestic
expected inflation leads to a
decline in expected dollar appreciation
that is larger than the
resulting increase in the domestic
interest rate, the expected return
on foreign deposits rises by more
than the expected return on
domestic (dollar) deposits. RF
shifts to the right more than RD,
and the equilibrium exchange rate
falls from E1 to E2.
iD1
iD2
RD
2 RD
1
Exchange Rate, Et
(euros/$)
Expected Return (in $ terms)
RF
1
E1 1
E2 2
RF
2
454 PA RT V International Finance and Monetary Policy
FIGURE 7 Effect of a Rise in
the Money Supply
A rise in the money supply leads
to a higher domestic price level in
the long run, which in turn leads
to a lower expected future
exchange rate. The resulting
decline in the expected appreciation
of the dollar raises the
expected return on foreign
deposits, shifting the RF schedule
rightward from RF
1 to RF
2. In the
short run, the domestic interest
rate iD falls, shifting RD from RD
1
to RD2
. The short-run outcome is
that the exchange rate falls from
E1 to E2. In the long run, however,
the interest rate returns to iD1 and RD returns to RD1
. The
exchange rate thus rises from E2
to E3 in the long run.
Exchange Rate, Et
(euros/$)
Expected Return (in $ terms)
RD
1
RF
1
E1 1
2
E3
RD
2
RF
2
E2
3
iD1
iD2
is to think of what would happen if our government announced overnight
that an old dollar would now be worth 100 new dollars. The money supply
in new dollars would be 100 times its old value and the price level would
also be 100 times higher, but nothing in the economy would really have
changed; real and nominal interest rates and the real money supply would
remain the same. Monetary neutrality tells us that in the long run, the rise in
the money supply would not lead to a change in the domestic interest rate
and so it would return to i D
1 in the long run, and the schedule for the
expected return on domestic deposits would return to RD
1. As we can see in
Figure 7, this means that the exchange rate would rise from E2 to E3 in the
long run.
The phenomenon we have described here in which the exchange rate
falls by more in the short run than it does in the long run when the money
supply increases is called exchange rate overshooting. It is important
because, as we will see in the following application, it can help explain why
exchange rates exhibit so much volatility.
Another way of thinking about why exchange rate overshooting occurs
is to recognize that when the domestic interest rate falls in the short run,
equilibrium in the foreign exchange market means that the expected return
on foreign deposits must be lower. With the foreign interest rate given, this
lower expected return on foreign deposits means that there must be an
expected appreciation of the dollar (depreciation of the euro) in order for the
expected return on foreign deposits to decline when the domestic interest
rate falls. This can occur only if the current exchange rate falls below its longrun
value.
C H A P T E R 1 9 The Foreign Exchange Market 455
Application Why Are Exchange Rates So Volatile?
The high volatility of foreign exchange rates surprises many people. Thirty or
so years ago, economists generally believed that allowing exchange rates to be
determined in the free market would not lead to large fluctuations in their values.
Recent experience has proved them wrong. If we return to Figure 1, we
see that exchange rates over the 1980–2002 period have been very volatile.
The asset market approach to exchange rate determination that we have
outlined in this chapter gives a straightforward explanation of volatile
exchange rates. Because expected appreciation of the domestic currency
affects the expected return on foreign deposits, expectations about the price
level, inflation, trade barriers, productivity, import demand, export demand,
and the money supply play important roles in determining the exchange rate.
When expectations about any of these variables change, our model indicates
that there will be an immediate effect on the expected return on foreign
deposits and therefore on the exchange rate. Since expectations on all these
variables change with just about every bit of news that appears, it is not surprising
that the exchange rate is volatile. In addition, we have seen that our
exchange rate analysis produces exchange rate overshooting when the money
supply increases. Exchange rate overshooting is an additional reason for the
high volatility of exchange rates.
Because earlier models of exchange rate behavior focused on goods markets
rather than asset markets, they did not emphasize changing expectations
as a source of exchange rate movements, and so these earlier models could
not predict substantial fluctuations in exchange rates. The failure of earlier
models to explain volatility is one reason why they are no longer so popular.
The more modern approach developed here emphasizes that the foreign
exchange market is like any other asset market in which expectations of the
future matter. The foreign exchange market, like other asset markets such as
the stock market, displays substantial price volatility, and foreign exchange
rates are notoriously hard to forecast.
Application The Dollar and Interest Rates, 1973–2002
In the chapter preview, we mentioned that the dollar was weak in the late
1970s, rose substantially from 1980 to 1985, and declined thereafter. We can
use our analysis of the foreign exchange market to understand exchange rate
movements and help explain the dollar’s rise and fall in the 1980s.
Some important information for tracing the dollar’s changing value is
presented in Figure 8, which plots measures of real and nominal interest rates
and the value of the dollar in terms of a basket of foreign currencies (called
an effective exchange rate index). We can see that the value of the dollar
and the measure of real interest rates tend to rise and fall together. In the late
1970s, real interest rates were at low levels, and so was the value of the dollar.
Beginning in 1980, however, real interest rates in the United States began
456 PA RT V International Finance and Monetary Policy
to climb sharply, and at the same time so did the dollar. After 1984, the real
interest rate declined substantially, as did the dollar.
Our model of exchange rate determination helps explain the rise and fall
in the dollar in the 1980s. As Figure 5 indicates, a rise in the U.S. real interest
rate raises the expected return on dollar deposits while leaving the
expected return on foreign deposits unchanged. The resulting increased
demand for dollar deposits then leads to purchases of dollar deposits (and
sales of foreign deposits), which raise the exchange rate. This is exactly what
occurred in the 1980–1984 period. The subsequent fall in U.S. real interest
rates then lowered the expected return on dollar deposits relative to foreign
deposits, and the resulting sales of dollar deposits (and purchases of foreign
deposits) lowered the exchange rate.
The plot of nominal interest rates in Figure 8 also demonstrates that the
correspondence between nominal interest rates and exchange rate movements
is not nearly as close as that between real interest rates and exchange
rate movements. This is also exactly what our analysis predicts. The rise in
nominal interest rates in the late 1970s was not reflected in a corresponding
rise in the value of the dollar; indeed, the dollar actually fell in the late 1970s.
FIGURE 8 Value of the Dollar and Interest Rates, 1973–2002
Sources: Federal Reserve: www.federalreserve.gov/releases/h10/summary/indexn_m.txt; real interest rate from Figure 1 in Chapter 4.
Effective Exchange Rate
15
20
10
5
0
–5
1974 1978 1982 1986 1990 1994 1998 2002
Interest Rate (%)
175
150
125
100
Effective
Exchange Rate
(Index: March
1973 = 100)
Real
Interest
Rate
Nominal
Interest Rate
C H A P T E R 1 9 The Foreign Exchange Market 457
Figure 8 explains why the rise in nominal rates in the late 1970s did not produce
a rise in the dollar. As a comparison of the real and nominal interest
rates in the late 1970s indicates, the rise in nominal interest rates reflected an
increase in expected inflation and not an increase in real interest rates. As our
analysis in Figure 6 demonstrates, the rise in nominal interest rates stemming
from a rise in expected inflation should lead to a decline in the dollar, and
that is exactly what happened.
If there is a moral to the story, it is that a failure to distinguish between
real and nominal interest rates can lead to poor predictions of exchange rate
movements: The weakness of the dollar in the late 1970s and the strength of
the dollar in the early 1980s can be explained by movements in real interest
rates but not by movements in nominal interest rates.
Application The Euro’s First Four Years
With much fanfare, the euro debuted on January 1, 1999, at an exchange rate
of 1.18 dollars per euro. Despite initial hopes that the euro would be a strong
currency, it has proved to be weak, declining 30% to a low of 83 cents per
euro in October 2000, only to recover to 1.05 dollars per euro by the beginning
of 2003. What explains the weakness of the euro in its first two years,
and its recovery in its third and fourth year?
The previous application has shown that changes in real interest rates are
an important factor determining the exchange rate. When the domestic real
interest rate falls relative to the foreign real interest rate, the domestic currency
declines in value. Indeed, this is exactly what has happened to the
euro. While the euro was coming into existence, European economies were
experiencing only slow recoveries from recession, thus causing both real and
nominal interest rates to fall. In contrast, in 1999 and 2000, the United States
experienced very rapid growth, substantially above their European counterparts.
As in the analysis of the previous application, low real interest rates in
Europe relative to those in the United States drove down the value of the
euro.
With the slowing of the U.S. economy, which entered into recession in
the spring of 2001, the process reversed. The U.S. growth rate fell slightly
behind Europe’s, so that U.S. relative real and nominal interest rates fell, setting
the stage for a recovery in the euro.
Application Reading the Wall Street Journal: The “Currency Trading” Column
Now that we have an understanding of how exchange rates are determined,
we can use our analysis to understand discussions about developments in the
foreign exchange market reported in the financial press.
Every day, the Wall Street Journal reports on developments in the foreign
exchange market on the previous business day in its “Currency
458 PA RT V International Finance and Monetary Policy
Trading” column, an example of which is presented in the “Following the
Financial News” box.
The column indicates that concerns about a possible war against Iraq
and weak economic data have put downward pressure on the U.S. dollar.
Our analysis of the foreign exchange market explains why these developments
have led to a weak dollar.
Following the Financial News
Concerns About War Put Pressure on the Dollar
Source: Wall Street Journal, Monday, January 13, 2003, p. C16.
CURRENCY TRADING
BY GRAINNE MCCARTHY
Dow Jones Newswires
NEW YORK—Having fallen swiftly on the
back of some surprisingly weak U.S.
employment data, the dollar is set to
remain under pressure this week, increasingly
vulnerable to the drumbeat of war
surrounding Iraq and nuclear saber-rattling
in North Korea.
“People are positioned for Armageddon
on the dollar. In that scenario, you can get
wacky moves,” says Paul Podolsky, chief
strategist at Fleet Global Markets in Boston.
Investors unsure of the dollar’s vulnerability
to the U.S. economic data got a resounding
wake-up call Friday, with the currency
tumbling swiftly after the government
reported a dismal December payrolls report
that fueled concerns about the lingering soft
spot dogging the world’s largest economy.
The dollar hit a fresh three-year trough
against the euro, while sliding to its weakest
point against the Swiss franc in four years.
In late New York trading Friday, the euro
was at $1.0579, up steeply from $1.0488
late Thursday. Against the Swiss franc, the
dollar was at 1.3799 francs, down sharply
from 1.3912 francs, while sterling was at
$1.6084, modestly up from $1.6064. The
dollar was at 119.16 yen, modestly lower
than 119.30 yen Thursday.
Even as Canada reported another
remarkably strong month of employment
growth, job losses in the U.S. soared to
101,000, far from consensus forecasts for a
modest increase of 20,000.
There were clearly some seasonal explanations
for the leap, but the report still
underscored a view that the sluggish U.S.
economic recovery isn’t creating jobs. That
potentially bodes ill for the dollar at a time
when it is already being undermined by
war concerns.
“Until Iraq goes away and the outlook
for consumer confidence and business
spending improves, the dollar is going to
remain under pressure,” said Jay Bryson,
global economist at Wachovia Securities in
Charlotte, N.C.
There will certainly be plenty of economic
data this week for dollar investors to
sink their teeth into, with the focus most
likely on somewhat stronger economic
activity and benign inflation. Retail sales
for December, to be reported tomorrow, are
expected to come in very firm, mostly
because of the 18% jump in auto sales
already reported. But excluding autos,
economists anticipate just a 0.3% increase.
The U.S. will also get December’s producer-
price and consumer-price indexes
on Wednesday and Thursday, respectively.
The focus for Friday will be squarely on the
initial University of Michigan consumersentiment
report for January, which should
provide a glimpse of how confidence is
holding up amid growing war jitters.
But aside from the clear significance of
much of these data, many analysts expect
the dollar to look more to the Pentagon,
State Department and, ultimately, the
White House for signposts for near-term
direction.
As the central emblem in financial markets
of the world’s only superpower, the
dollar is beset by multiple threats to global
stability that are breaking out on several
fronts. As well as the situations in North
Korea and Iraq, the continuing battle
against terrorist network al Qaeda is high
on the list of issues facing the Bush administration.
The U.S., given its position of
global hegemony, has almost by default
become the first line of defense in tackling
these challenges.
“Connect the dots, and what emerges is
hardly encouraging for the dollar in particular
and the financial markets in general,”
said Joseph Quinlan, global economist at
Johns Hopkins University.
He argues that investors in U.S. assets,
while certainly cognizant of a war risk, may
have priced in an overly rosy scenario
under which the war on terrorism has
already been won, the war against Iraq has
already been priced in, and a war on the
Korean peninsula is too remote a possibility
to take seriously.
An upset to this more optimistic picture
could weigh more heavily on global capital
flows, ultimately depressing the dollar,
given the U.S.’s status as a creditor nation
dependent on capital inflows to finance the
current account.
The “Currency Trading” column appears daily in
the Wall Street Journal; an example is presented
here. It is usually found in the third section, “Money
and Investing.”
The “Currency Trading” Column
The column starts by pointing out that surprisingly weak U.S. employment
data has led to a falling dollar. The weakness in the U.S. economy suggests
that real interest rates in the United States are likely to fall in the future.
As a result, in the future we have the opposite scenario to Figure 5 occurring,
the RD curve shifts to the left, lowering the value of the dollar. The future
decline in the dollar then means that the foreign currency is expected to
appreciate, thus raising the expected return on foreign deposits today and
shifting the RF curve to the right. Thus as we see in Figure 4 the dollar
declines today.
Concerns about a war with Iraq also have a similar impact. The possibility
that the war in Iraq might not go well and could lead to increased terrorist incidents
suggests that the U.S. economy might suffer negative consequences. This
provides an additional reason for a possible weakening of the economy and we
then get the identical analysis to that in the paragraph above, which shows that
the U.S. dollar would fall in response to these war fears.
C H A P T E R 1 9 The Foreign Exchange Market 459
Summary
1. Foreign exchange rates (the price of one country’s currency
in terms of another’s) are important because they
affect the price of domestically produced goods sold
abroad and the cost of foreign goods bought domestically.
2. The theory of purchasing power parity suggests that
long-run changes in the exchange rate between two
countries are determined by changes in the relative
price levels in the two countries. Other factors that
affect exchange rates in the long run are tariffs and quotas,
import demand, export demand, and productivity.
3. Exchange rates are determined in the short run by the
interest parity condition, which states that the
expected return on domestic deposits is equal to the
expected return on foreign deposits.
4. Any factor that changes the expected returns on
domestic or foreign deposits will lead to changes in
the exchange rate. Such factors include changes in
the interest rates on domestic and foreign deposits as
well as changes in any of the factors that affect the
long-run exchange rate and hence the expected
future exchange rate. Changes in the money supply
lead to exchange rate overshooting, causing the
exchange rate to change by more in the short run
than in the long run.
5. The asset market approach to exchange rate determination
can explain both the volatility of exchange rates
and the rise of the dollar in the 1980–1984 period
and its subsequent fall.
Key Terms
appreciation, p. 436
capital mobility, p. 445
depreciation, p. 436
effective exchange rate index, p. 455
exchange rate, p. 435
exchange rate overshooting, p. 454
foreign exchange market, p. 435
forward exchange rate, p. 436
forward transaction, p. 436
interest parity condition, p. 445
law of one price, p. 439
monetary neutrality, p. 453
460 PA RT V International Finance and Monetary Policy
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. When the euro appreciates, are you more likely to
drink California or French wine?
*2. “A country is always worse off when its currency is
weak (falls in value).” Is this statement true, false, or
uncertain? Explain your answer.
3. In a newspaper, check the exchange rates for the foreign
currencies listed in the “Following the Financial
News” box on page 437. Which of these currencies
have appreciated and which have depreciated since
February 5, 2003?
*4. If the Japanese price level rises by 5% relative to the
price level in the United States, what does the theory
of purchasing power parity predict will happen to the
value of the Japanese yen in terms of dollars?
5. If the demand for a country’s exports falls at the same
time that tariffs on imports are raised, will the country’s
currency tend to appreciate or depreciate in the
long run?
*6. In the mid- to late 1970s, the yen appreciated relative
to the dollar even though Japan’s inflation rate was
higher than America’s. How can this be explained by
an improvement in the productivity of Japanese industry
relative to American industry?
Using Economic Analysis to Predict the Future
Answer the remaining questions by drawing the appropriate
exchange market diagrams.
7. The president of the United States announces that he
will reduce inflation with a new anti-inflation program.
If the public believes him, predict what will
happen to the U.S. exchange rate.
*8. If the British central bank prints money to reduce
unemployment, what will happen to the value of the
pound in the short run and the long run?
9. If the Canadian government unexpectedly announces
that it will be imposing higher tariffs on foreign goods
one year from now, what will happen to the value of
the Canadian dollar today?
*10. If nominal interest rates in America rise but real interest
rates fall, predict what will happen to the U.S.
exchange rate.
11. If American auto companies make a breakthrough in
automobile technology and are able to produce a car
that gets 60 miles to the gallon, what will happen to
the U.S. exchange rate?
*12. If Americans go on a spending spree and buy twice as
much French perfume, Japanese TVs, English
sweaters, Swiss watches, and Italian wine, what will
happen to the value of the U.S. dollar?
13. If expected inflation drops in Europe so that interest
rates fall there, predict what will happen to the U.S.
exchange rate.
*14. If the European central bank decides to contract the
money supply in order to fight inflation, what will
happen to the value of the U.S. dollar?
15. If there is a strike in France, making it harder to buy
French goods, what will happen to the value of the
euro?
quotas, p. 441
spot exchange rate, p. 436
spot transaction, p. 436
tariffs, p. 441
theory of purchasing power parity
(PPP), p. 439
QUIZ
C H A P T E R 1 9 The Foreign Exchange Market 461
Web Exercises
1. The Federal Reserve maintains a web site that lists the
exchange rate between the U.S. dollar and many other
currencies. Go to www.federalreserve.gov/releases
/H10/hist/. Go to the historical data from 1999 and
later and find the Euro.
a. What has the percentage change in the Euro-dollar
exchange rate been between introduction and now?
b. What has been the annual percentage change in the
Euro-dollar exchange rate for each year since the
Euro’s introduction?
2. International travelers and business people frequently
need to accurately convert from one currency to
another. It is often easy to find the rate needed to
convert the U.S. dollar into another currency. It can
be more difficult to find cross-conversion rates. Go to
www.oanda.com/convert/classic. This site lets you
convert from any currency into any other currency.
How many Lithuanian Litas can you currently buy
with one Chilean Peso?
462
PREVIEW Thanks to the growing interdependence between the U.S. economy and the economies
of the rest of the world, a country’s monetary policy can no longer be conducted
without taking international considerations into account. In this chapter, we examine
how international financial transactions and the structure of the international financial
system affect monetary policy. We also examine the evolution of the international
financial system during the past half century and consider where it may be heading
in the future.
Intervention in the Foreign Exchange Market
In Chapter 19, we analyzed the foreign exchange market as if it were a completely free
market that responds to all market pressures. Like many other markets, however, the
foreign exchange market is not free of government intervention; central banks regularly
engage in international financial transactions called foreign exchange interventions
in order to influence exchange rates. In our current international financial
arrangement, called a managed float regime (or a dirty float), exchange rates fluctuate
from day to day, but central banks attempt to influence their countries’ exchange
rates by buying and selling currencies. The exchange rate analysis we developed in
Chapter 19 is used here to explain the impact that central bank intervention has on
the foreign exchange market.
The first step in understanding how central bank intervention in the foreign exchange
market affects exchange rates is to see the impact on the monetary base from a central
bank sale in the foreign exchange market of some of its holdings of assets denominated
in a foreign currency (called international reserves). Suppose that the Fed
decides to sell $1 billion of its foreign assets in exchange for $1 billion of U.S. currency.
(This transaction is conducted at the foreign exchange desk at the Federal
Reserve Bank of New York—see Box 1.) The Fed’s purchase of dollars has two effects.
First, it reduces the Fed’s holding of international reserves by $1 billion. Second,
because its purchase of currency removes it from the hands of the public, currency in
Foreign Exchange
Intervention and
the Money Supply
Chap ter
20 The International Financial System
circulation falls by $1 billion. We can see this in the following T-account for the
Federal Reserve:
Because the monetary base is made up of currency in circulation plus reserves, this
decline in currency implies that the monetary base has fallen by $1 billion.
If instead of paying for the foreign assets sold by the Fed with currency, the persons
buying the foreign assets pay for them by checks written on accounts at domestic banks,
C H A P T E R 2 0 The International Financial System 463
Although the U.S. Treasury is primarily responsible
for foreign exchange policy, decisions to intervene in
the foreign exchange market are made jointly by the
U.S. Treasury and the Federal Reserve as represented
by the FOMC (Federal Open Market Committee).
The actual conduct of foreign exchange intervention
is the responsibility of the foreign exchange desk at
the Federal Reserve Bank of New York, which is right
next to the open market desk.
The manager of foreign exchange operations at the
New York Fed supervises the traders and analysts
who follow developments in the foreign exchange
market. Every morning at 7:30, a trader on his staff
who has arrived at the New York Fed in the predawn
hours speaks on the telephone with counterparts at
the U.S. Treasury and provides an update on
overnight activity in overseas financial and foreign
exchange markets. Later in the morning, at 9:30, the
manager and his staff hold a conference call with senior
staff at the Board of Governors of the Federal
Reserve in Washington. In the afternoon, at 2:30,
they have a second conference call, which is a joint
briefing of officials at the board and the Treasury.
Although by statute the Treasury has the lead role in
setting foreign exchange policy, it strives to reach a
consensus among all three parties—the Treasury, the
Board of Governors, and the Federal Reserve Bank of
New York. If they decide that a foreign exchange
intervention is necessary that day—an unusual
occurrence, as a year may go by without a U.S. foreign
exchange intervention—the manager instructs
his traders to carry out the agreed-on purchase or
sale of foreign currencies. Because funds for exchange
rate intervention are held separately by the Treasury
(in its Exchange Stabilization Fund) and the Federal
Reserve, the manager and his staff are not trading the
funds of the Federal Reserve Bank of New York;
rather they act as an agent for the Treasury and the
FOMC in conducting these transactions.
As part of their duties, before every FOMC meeting,
the staff help prepare a lengthy document full of
data for the FOMC members, other Reserve bank
presidents, and Treasury officials. It describes developments
in the domestic and foreign markets over
the previous five or six weeks, a task that keeps them
especially busy right before the FOMC meeting.
A Day at the Federal Reserve Bank of New York’s Foreign Exchange Desk
Box 1: Inside the Fed
FEDERAL RESERVE SYSTEM
Assets Liabilities
Foreign assets (inter- Currency in
national reserves) $1 billion circulation $1 billion
then the Fed deducts the $1 billion from the deposit accounts these banks have with
the Fed. The result is that deposits with the Fed (reserves) decline by $1 billion, as
shown in the following T-account:
In this case, the outcome of the Fed sale of foreign assets and the purchase of dollar
deposits is a $1 billion decline in reserves and a $1 billion decline in the monetary
base because reserves are also a component of the monetary base.
We now see that the outcome for the monetary base is exactly the same when a
central bank sells foreign assets to purchase domestic bank deposits or domestic currency.
This is why when we say that a central bank has purchased its domestic currency,
we do not have to distinguish whether it actually purchased currency or bank
deposits denominated in the domestic currency. We have thus reached an important
conclusion: A central bank’s purchase of domestic currency and corresponding sale
of foreign assets in the foreign exchange market leads to an equal decline in its
international reserves and the monetary base.
We could have reached the same conclusion by a more direct route. A central
bank sale of a foreign asset is no different from an open market sale of a government
bond. We learned in our exploration of the money supply process that an open market
sale leads to an equal decline in the monetary base; therefore, a sale of foreign
assets also leads to an equal decline in the monetary base. By similar reasoning, a central
bank purchase of foreign assets paid for by selling domestic currency, like an open
market purchase, leads to an equal rise in the monetary base. Thus we reach the following
conclusion: A central bank’s sale of domestic currency to purchase foreign
assets in the foreign exchange market results in an equal rise in its international
reserves and the monetary base.
The intervention we have just described, in which a central bank allows the purchase
or sale of domestic currency to have an effect on the monetary base, is called an
unsterilized foreign exchange intervention. But what if the central bank does not
want the purchase or sale of domestic currency to affect the monetary base? All it has
to do is to counter the effect of the foreign exchange intervention by conducting an
offsetting open market operation in the government bond market. For example, in the
case of a $1 billion purchase of dollars by the Fed and a corresponding $1 billion sale
of foreign assets, which, as we have seen, would decrease the monetary base by $1
billion, the Fed can conduct an open market purchase of $1 billion of government
bonds, which would increase the monetary base by $1 billion. The resulting T-account
for the foreign exchange intervention and the offsetting open market operation leaves
the monetary base unchanged:
464 PA RT V International Finance and Monetary Policy
FEDERAL RESERVE SYSTEM
Assets Liabilities
Foreign assets (inter- Deposits with
national reserves) $1 billion the Fed (reserves) $1 billion
A foreign exchange intervention with an offsetting open market operation that leaves
the monetary base unchanged is called a sterilized foreign exchange intervention.
Now that we understand that there are two types of foreign exchange interventions—
unsterilized and sterilized—let’s look at how each affects the exchange rate.
Your intuition might lead you to suspect that if a central bank wants to lower the value
of the domestic currency, it should sell its currency in the foreign exchange market
and purchase foreign assets. Indeed, this intuition is correct for the case of an unsterilized
intervention.
Recall that in an unsterilized intervention, if the Federal Reserve decides to sell
dollars in order to buy foreign assets in the foreign exchange market, this works just
like an open market purchase of bonds to increase the monetary base. Hence the sale
of dollars leads to an increase in the money supply, and we find ourselves analyzing
exactly the situation already described in Figure 7 of Chapter 19, which is reproduced
here as Figure 1. The higher money supply leads to a higher U.S. price level in the
long run and so to a lower expected future exchange rate. The resulting decline in the
expected appreciation of the dollar increases the expected return on foreign deposits
and shifts the RF schedule to the right. In addition, the increase in the money supply
will lead to a higher real money supply in the short run, which causes the interest rate
on dollar deposits to fall. The resulting lower expected return on dollar deposits translates
as a leftward shift in the RD schedule. The fall in the expected return on dollar
deposits and the increase in the expected return on foreign deposits means that foreign
assets have a higher expected return than dollar deposits at the old equilibrium
exchange rate. Hence people will try to sell their dollar deposits, and the exchange
rate will fall. Indeed, as we saw in the previous chapter, the increase in the money
supply will lead to exchange rate overshooting, whereby the exchange rate falls by
more in the short run than it does in the long run.
Our analysis leads us to the following conclusion about unsterilized interventions
in the foreign exchange market: An unsterilized intervention in which domestic currency
is sold to purchase foreign assets leads to a gain in international reserves, an
increase in the money supply, and a depreciation of the domestic currency.
The reverse result is found for an unsterilized intervention in which domestic
currency is purchased by selling foreign assets. The purchase of domestic currency by
selling foreign assets (reducing international reserves) works like an open market sale
to reduce the monetary base and the money supply. The decrease in the money supply
raises the interest rate on dollar deposits and shifts RD rightward, while causing
Unsterilized
Intervention
C H A P T E R 2 0 The International Financial System 465
FEDERAL RESERVE SYSTEM
Assets Liabilities
Foreign assets (inter- Monetary base
national reserves) $1 billion (reserves) 0
Government bonds $1 billion
RF to shift leftward, because it leads to a lower U.S. price level in the long run and
thus to a higher expected appreciation of the dollar, and hence a lower expected
return on foreign deposits. The increase in the expected return on dollar deposits relative
to foreign deposits will mean that people will want to buy more dollar deposits,
and the exchange rate will rise. An unsterilized intervention in which domestic currency
is purchased by selling foreign assets leads to a drop in international reserves,
a decrease in the money supply, and an appreciation of the domestic currency.
The key point to remember about a sterilized intervention is that the central bank
engages in offsetting open market operations, so that there is no impact on the monetary
base and the money supply. In the context of the model of exchange rate determination
we have developed here, it is straightforward to show that a sterilized
intervention has no effect on the exchange rate. Remember that in our model, foreign
and domestic deposits are perfect substitutes, so equilibrium in the foreign exchange
market occurs when the expected returns on foreign and domestic deposits are equal.
A sterilized intervention leaves the money supply unchanged and so has no way of
directly affecting interest rates or the expected future exchange rate.1 Because the
Sterilized
Intervention
466 PA RT V International Finance and Monetary Policy
FIGURE 1 Effect of a Sale of
Dollars and a Purchase of Foreign
Assets
A sale of dollars and the consequent
open market purchase of foreign
assets increase the monetary
base. The resulting rise in the
money supply leads to a higher
domestic price level in the long
run, which leads to a lower
expected future exchange rate. The
resulting decline in the expected
appreciation of the dollar raises
the expected return on foreign
deposits, shifting the RF schedule
rightward from RF
1 to RF
2. In the
short run, the domestic interest
rate iD falls, shifting RD from RD1
to
RD2
. The short-run outcome is that
the exchange rate falls from E1 to
E2. In the long run, however, the
interest rate returns to iD1
, and RD
returns to RD
1. The exchange rate
therefore rises from E2 to E3 in
the long run.
Exchange Rate, Et
(euros/$)
Expected Return
(in $ terms)
RD1
i D
1
RF
1
E1 1
2
E3
RD2
i D2
RF
2
E2
3
1Note that a sterilized intervention could indicate what central banks want to happen to the future exchange rate
and so might provide a signal about the course of future monetary policy. In this way, a sterilized intervention
could lead to shifts in the RF schedule, but in reality it is the future change in monetary policy, not the sterilized
intervention, that is the ultimate source of exchange rate effects. For a discussion of the signaling effect, see
Maurice Obstfeld, “The Effectiveness of Foreign Exchange Intervention: Recent Experience, 1985–1988,” in
International Policy Coordination and Exchange Rate Fluctuations, ed. William H. Branson, Jacob A. Frenkel, and
Morris Goldstein (Chicago: University of Chicago Press, 1990), pp. 197–237.
expected returns on dollar and foreign deposits are unaffected, the expected return
schedules remain at RD1
and RF
1 in Figure 1, and the exchange rate remains unchanged
at E1.
At first it might seem puzzling that a central bank purchase or sale of domestic
currency that is sterilized does not lead to a change in the exchange rate. A central
bank purchase of domestic currency cannot raise the exchange rate, because with no
effect on the domestic money supply or interest rates, any resulting rise in the
exchange rate would mean that the expected return on foreign deposits would be
greater than the expected return on domestic deposits. Given our assumption that foreign
and domestic deposits are perfect substitutes (equally desirable), this would
mean that no one would want to hold domestic deposits.2 So the exchange rate would
have to fall back to its previous level, where the expected returns on domestic and foreign
deposits were equal.
Balance of Payments
Because international financial transactions such as foreign exchange interventions
have considerable effects on monetary policy, it is worth knowing how these transactions
are measured. The balance of payments is a bookkeeping system for recording
all receipts and payments that have a direct bearing on the movement of funds
between a nation (private sector and government) and foreign countries.
Here we examine the key items in the balance of payments that you often hear
about in the media.
The current account shows international transactions that involve currently produced
goods and services. The difference between merchandise exports and imports,
the net receipts from trade, is called the trade balance. When merchandise imports
are greater than exports (by $427 billion), we have a trade deficit; if exports are
greater than imports, we have a trade surplus.
Three additional items included in the current account are the net receipts that
arise from investment income, the purchase and sale of services, and unilateral transfers
(gifts, pensions, and foreign aid). In 2001, for example, net investment income
was negative $19 billion for the United States because Americans received less investment
income from abroad than they paid out. Americans bought less in services from
foreigners than foreigners bought from Americans, so net services generated $79 billion
in receipts. Since Americans made more unilateral transfers to foreign countries
(especially foreign aid) than foreigners made to the United States, net unilateral transfers
were negative $50 billion. The sum of the previous three items plus the trade balance
is the current account balance, which in 2001 showed a deficit of $417 billion
( $427 $19 $79 $50 $417 billion).
Another important item in the balance of payments is the capital account, the net
receipts from capital transactions. In 2001 the capital account was $416 billion,
C H A P T E R 2 0 The International Financial System 467
2If domestic and foreign deposits are not perfect substitutes, a sterilized intervention can affect the exchange rate.
However, most studies find little evidence to support the position that sterilized intervention has a significant
impact on foreign exchange rates. For a further discussion of the effects of sterilized versus unsterilized intervention,
see Paul Krugman and Maurice Obstfeld, International Economics, 5th ed. (Reading, Mass.: Addison
Wesley Longman, 2000).
http://research.stlouisfed.org
/fred/data/exchange.html
This web site contains exchange
rates, balance of payments, and
trade data.
indicating that $416 billion more capital came into the United States than went out.
Another way of saying this is that the United States had a net capital inflow of $416 billion.
3 The sum of the current account and the capital account equals the official reserve
transactions balance, which was negative $1 billion in 2001 ($417 $416 $1
billion). When economists refer to a surplus or deficit in the balance of payments, they
actually mean a surplus or deficit in the official reserve transactions balance.
Because the balance of payments must balance, the official reserve transactions
balance, which equals the current account plus the capital account, tells us the net
amount of international reserves that must move between governments (as represented
by their central banks) to finance international transactions: i.e.,
Current account capital account
net change in government international reserves
This equation shows us why the current account receives so much attention from
economists and the media. The current account balance tells us whether the United
States (private sector and government combined) is increasing or decreasing its claims
on foreign wealth. A surplus indicates that America is increasing its claims on foreign
wealth, and a deficit, as in 2001, indicates that the country is reducing its claims on
foreign wealth.4
Financial analysts follow the current account balance closely because they believe
that it can provide information on the future movement of exchange rates. The current
account balance provides some indication of what is happening to the demand
for imports and exports, which, as we saw in the previous chapter, can affect the
exchange rate. In addition, the current account balance provides information about
what will be happening to U.S. claims on foreign wealth in the long run. Because a
movement of foreign wealth to American residents can affect the demand for dollar
assets, changes in U.S. claims on foreign wealth, reflected in the current account balance,
can affect the exchange rate over time.5
Evolution of the International Financial System
Before examining the impact of international financial transactions on monetary policy,
we need to understand the past and current structure of the international financial
system.
468 PA RT V International Finance and Monetary Policy
3Note that the capital account balance number reported above includes a statistical discrepancy item that represents
errors due to unrecorded transactions involving smuggling and other capital flows ($39 billion in 2001).
Many experts believe that the statistical discrepancy item, which keeps the balance of payments in balance, is primarily
the result of large hidden capital flows, and this is why it is included in the capital account balance
reported above.
4The current account balance can also be viewed as showing the amount by which total saving exceeds private
sector and government investment in the United States. We can see this by noting that total U.S. saving equals
the increase in total wealth held by the U.S. private sector and government. Total investment equals the increase
in the U.S. capital stock (wealth physically in the United States). The difference between them is the increase in
U.S. claims on foreign wealth.
5If American residents have a greater preference for dollar assets than foreigners do, a movement of foreign wealth
to American residents when there is a balance-of-payments surplus will increase the demand for dollar assets over
time and will cause the dollar to appreciate.
Before World War I, the world economy operated under the gold standard, meaning
that the currency of most countries was convertible directly into gold. American dollar
bills, for example, could be turned in to the U.S. Treasury and exchanged for
approximately ounce of gold. Likewise, the British Treasury would exchange
ounce of gold for £1 sterling. Because an American could convert $20 into 1 ounce
of gold, which could be used to buy £4, the exchange rate between the pound and
the dollar was effectively fixed at $5 to the pound. Tying currencies to gold resulted
in an international financial system with fixed exchange rates between currencies. The
fixed exchange rates under the gold standard had the important advantage of encouraging
world trade by eliminating the uncertainty that occurs when exchange rates
fluctuate.
To see how the gold standard operated in practice, let us see what occurs if, under
the gold standard, the British pound begins to appreciate above the $5 par value. If
an American importer of £100 of English tweed tries to pay for the tweed with dollars,
it costs more than the $500 it cost before. Nevertheless, the importer has another
option involving the purchase of gold that can reduce the cost of the tweed. Instead
of using dollars to pay for the tweed, the American importer can exchange the $500
for gold, ship the gold to Britain, and convert it into £100. The shipment of gold to
Britain is cheaper as long as the British pound is above the $5 par value (plus a small
amount to pay for the cost of shipping the gold).
Under the gold standard, the appreciation of the pound leads to a British gain of
international reserves (gold) and an equal U.S. loss. Because a change in a country’s
holdings of international reserves (gold) leads to an equal change in its monetary
base, the movement of gold from the United States to Britain causes the British monetary
base to rise and the American monetary base to fall. The resulting rise in the
British money supply raises the British price level, while the fall in the U.S. money
supply lowers the U.S. price level. The resulting increase in the British price level relative
to the United States then causes the pound to depreciate. This process will continue
until the value of the pound falls back down to its $5 par value.
A depreciation of the pound below the $5 par value, on the contrary, stimulates
gold shipments from Britain to the United States. These shipments raise the American
money supply and lower the British money supply, causing the pound to appreciate
back toward the $5 par value. We thus see that under the gold standard, a rise or fall
in the exchange rate sets in motion forces that return it to the par value.
As long as countries abided by the rules under the gold standard and kept their
currencies backed by and convertible into gold, exchange rates remained fixed.
However, adherence to the gold standard meant that a country had no control over
its monetary policy, because its money supply was determined by gold flows between
countries. Furthermore, monetary policy throughout the world was greatly influenced
by the production of gold and gold discoveries. When gold production was low in the
1870s and 1880s, the money supply throughout the world grew slowly and did not
keep pace with the growth of the world economy. The result was deflation (falling
price levels). Gold discoveries in Alaska and South Africa in the 1890s then greatly
expanded gold production, causing money supplies to increase rapidly and price levels
to rise (inflation) until World War I.
World War I caused massive trade disruptions. Countries could no longer convert their
currencies into gold, and the gold standard collapsed. Despite attempts to revive it in
the interwar period, the worldwide depression, beginning in 1929, led to its permanent
Bretton Woods
System
14
1
20
Gold Standard
C H A P T E R 2 0 The International Financial System 469
demise. As the Allied victory in World War II was becoming certain in 1944, the Allies
met in Bretton Woods, New Hampshire, to develop a new international monetary system
to promote world trade and prosperity after the war. In the agreement worked out
among the Allies, central banks bought and sold their own currencies to keep their
exchange rates fixed at a certain level (called a fixed exchange rate regime). The
agreement lasted from 1945 to 1971 and was known as the Bretton Woods system.
The Bretton Woods agreement created the International Monetary Fund (IMF),
headquartered in Washington, D.C., which had 30 original member countries in 1945
and currently has over 180. The IMF was given the task of promoting the growth of
world trade by setting rules for the maintenance of fixed exchange rates and by making
loans to countries that were experiencing balance-of-payments difficulties. As part
of its role of monitoring the compliance of member countries with its rules, the IMF
also took on the job of collecting and standardizing international economic data.
The Bretton Woods agreement also set up the International Bank for Reconstruction
and Development, commonly referred to as the World Bank, also headquartered in
Washington, D.C., which provides long-term loans to help developing countries build
dams, roads, and other physical capital that would contribute to their economic
development. The funds for these loans are obtained primarily by issuing World Bank
bonds, which are sold in the capital markets of the developed countries.6
Because the United States emerged from World War II as the world’s largest economic
power, with over half of the world’s manufacturing capacity and the greater
part of the world’s gold, the Bretton Woods system of fixed exchange rates was based
on the convertibility of U.S. dollars into gold (for foreign governments and central
banks only) at $35 per ounce. The fixed exchange rates were to be maintained by
intervention in the foreign exchange market by central banks in countries besides the
United States who bought and sold dollar assets, which they held as international
reserves. The U.S. dollar, which was used by other countries to denominate the assets
that they held as international reserves, was called the reserve currency. Thus an
important feature of the Bretton Woods system was the establishment of the United
States as the reserve currency country. Even after the breakup of the Bretton Woods
system, the U.S. dollar has kept its position as the reserve currency in which most
international financial transactions are conducted. However, with the creation of the
euro in 1999, the supremacy of the U.S. dollar may be subject to a serious challenge
(see Box 2).
How a Fixed Exchange Rate Regime Works. The most important feature of the Bretton
Woods system was that it set up a fixed exchange rate regime. Figure 2 shows how a
fixed exchange rate regime works in practice using the model of exchange rate determination
we learned in the previous chapter. Panel (a) describes a situation in which
the domestic currency is initially overvalued: The schedule for the expected return on
foreign deposits RF
1 intersects the schedule for the expected return on domestic
deposits RD1
at exchange rate E1, which is lower than the par (fixed) value of the
exchange rate Epar. To keep the exchange rate at Epar, the central bank must intervene
in the foreign exchange market to purchase domestic currency by selling foreign
assets, and this action, like an open market sale, means that the monetary base and
470 PA RT V International Finance and Monetary Policy
6In 1960, the World Bank established an affiliate, the International Development Association (IDA), which provides
particularly attractive loans to third-world countries (with 50-year maturities and zero interest rates, for
example). Funds for these loans are obtained by direct contributions of member countries.
the money supply decline. Because the exchange rate will continue to be fixed at Epar,
the expected future exchange rate remains unchanged, and so the schedule for the
expected return on foreign deposits remains at RF
1. However, the purchase of domestic
C H A P T E R 2 0 The International Financial System 471
FIGURE 2 Intervention in the Foreign Exchange Market Under a Fixed Exchange Rate Regime
In panel (a), the exchange rate at Epar is overvalued. To keep the exchange rate at Epar (point 2), the central bank must purchase domestic currency
to shift the schedule for the expected return on domestic deposits to RD2
. In panel (b), the exchange rate at Epar is undervalued, so a central
bank sale of domestic currency is needed to shift RD to RD2
to keep the exchange rate at Epar (point 2).
2
1
RD
1
RF
1
R2
Exchange rate, Et
(foreign currency/
domestic currency)
i D
1 i D
2
Expected Return
( in domestic currency terms )
Epar
E1
2
RF
1
RD
2
Exchange rate, Et
( foreign currency/
domestic currency )
i D
2
Expected Return
( in domestic currency terms )
Epar
E1 1
RD
1
i D
1
(a) Intervention in the
case of an overvalued
exchange rate
(b) Intervention in the
case of an undervalued
exchange rate
Box 2: Global
The Euro’s Challenge to the Dollar
With the creation of the European Monetary System
and the euro in 1999, the U.S. dollar may face a challenge
to its position as the key reserve currency in
international financial transactions. Adoption of the
euro increases integration of Europe’s financial markets,
which could help them rival those in the United
States. The resulting increase in the use of euros in
financial markets will make it more likely that international
transactions are carried out in the euro. The
economic clout of the European Union rivals that of
the United States: Both have a similar share of world
GDP (around 20%) and world exports (around 15%).
If the European Central Bank can make sure that
inflation remains low so that the euro becomes a
sound currency, this should bode well for the euro.
However, for the euro to eat into the dollar’s position
as a reserve currency, the European Union must
function as a cohesive political entity that is able to
exert its influence on the world stage. There are serious
doubts on this score, and most analysts think it
will be a long time before the euro beats out the dollar
in international financial transactions.
currency, which leads to a fall in the money supply, also causes the interest rate on
domestic deposits i D to rise. This increase in turn shifts the expected return on
domestic deposits RD to the right. The central bank will continue purchasing domestic
currency and selling foreign assets until the RD curve reaches RD2
and the equilibrium
exchange rate is at Epar at point 2 in panel (a).
We have thus come to the conclusion that when the domestic currency is overvalued,
the central bank must purchase domestic currency to keep the exchange rate
fixed, but as a result it loses international reserves.
Panel (b) in Figure 2 shows how a central bank intervention keeps the exchange
rate fixed at Epar when the exchange rate is initially undervalued; that is, when RF
1 and
the initial RD1
intersect at exchange rate E 1, which is above Epar. Here the central bank
must sell domestic currency and purchase foreign assets, and this works like an open
market purchase to raise the money supply and lower the interest rate on domestic
deposits i D. The central bank keeps selling domestic currency and lowers i D until RD
shifts all the way to RD2
, where the equilibrium exchange rate is at Epar—point 2 in
panel (b). Our analysis thus leads us to the following result: When the domestic currency
is undervalued, the central bank must sell domestic currency to keep the
exchange rate fixed, but as a result, it gains international reserves.
As we have seen, if a country’s currency has an overvalued exchange rate, its central
bank’s attempts to keep the currency from depreciating will result in a loss of
international reserves. If the country’s central bank eventually runs out of international
reserves, it cannot keep its currency from depreciating, and then a devaluation
must occur, meaning that the par exchange rate is reset at a lower level.
If, by contrast, a country’s currency has an undervalued exchange rate, its central
bank’s intervention to keep the currency from appreciating leads to a gain of international
reserves. Because, as we will see shortly, the central bank might not want to
acquire these international reserves, it might want to reset the par value of its
exchange rate at a higher level (a revaluation) .
Note that if domestic and foreign deposits are perfect substitutes, as is assumed
in the model of exchange rate determination used here, a sterilized exchange rate
intervention would not be able to keep the exchange rate at Epar because, as we have
seen earlier in the chapter, neither RF nor RD will shift. For example, if the exchange
rate is overvalued, a sterilized purchase of domestic currency will still leave the
expected return on domestic deposits below the expected return on foreign deposits
at the par exchange rate—so pressure for a depreciation of the domestic currency is
not removed. If the central bank keeps on purchasing its domestic currency but continues
to sterilize, it will just keep on losing international reserves until it finally runs
out of them and is forced to let the value of the currency seek a lower level.
One implication of the foregoing analysis is that a country that ties its exchange
rate to a larger country’s currency loses control of its monetary policy. If the larger
country pursues a more contractionary monetary policy and decreases its money supply,
this would lead to lower expected inflation in the larger country, thus causing an
appreciation of the larger country’s currency and a depreciation of the smaller country’s
currency. The smaller country, having locked in its exchange rate, will now find
its currency overvalued and will therefore have to sell the larger country’s currency
and buy its own to keep its currency from depreciating. The result of this foreign
exchange intervention will then be a decline in the smaller country’s international
reserves, a contraction of the monetary base, and thus a decline in its money supply.
Sterilization of this foreign exchange intervention is not an option because this would
472 PA RT V International Finance and Monetary Policy
just lead to a continuing loss of international reserves until the smaller country was
forced to devalue. The smaller country no longer controls its monetary policy, because
movements in its money supply are completely determined by movements in the
larger country’s money supply.
Another way to see that when a country fixes its exchange rate to a larger country’s
currency it loses control of its monetary policy is through the interest parity condition
discussed in the previous chapter. There we saw that when there is capital
mobility, the domestic interest rate equals the foreign interest rate minus the expected
appreciation of the domestic currency. With a fixed exchange rate, expected appreciation
of the domestic currency is zero, so that the domestic interest rate equals the
foreign interest rate. Therefore changes in the monetary policy in the large country
that affect its interest rate are directly transmitted to interest rates in the small country.
Furthermore, because the monetary authorities in the small country cannot make
their interest rate deviate from that of the larger country, they have no way to use
monetary policy to affect their economy.
Bretton Woods System of Fixed Exchange Rates. Under the Bretton Woods system,
exchange rates were supposed to change only when a country was experiencing a
“fundamental disequilibrium”; that is, large persistent deficits or surpluses in its balance
of payments. To maintain fixed exchange rates when countries had balance-ofpayments
deficits and were losing international reserves, the IMF would loan deficit
countries international reserves contributed by other members. As a result of its
power to dictate loan terms to borrowing countries, the IMF could encourage deficit
countries to pursue contractionary monetary policies that would strengthen their currency
or eliminate their balance-of-payments deficits. If the IMF loans were not sufficient
to prevent depreciation of a currency, the country was allowed to devalue its
currency by setting a new, lower exchange rate.
A notable weakness of the Bretton Woods system was that although deficit countries
losing international reserves could be pressured into devaluing their currency or
pursuing contractionary policies, the IMF had no way to force surplus countries to
revise their exchange rates upward or pursue more expansionary policies. Particularly
troublesome in this regard was the fact that the reserve currency country, the United
States, could not devalue its currency under the Bretton Woods system even if the dollar
was overvalued. When the United States attempted to reduce domestic unemployment
in the 1960s by pursuing an inflationary monetary policy, a fundamental
disequilibrium of an overvalued dollar developed. Because surplus countries were not
willing to revise their exchange rates upward, adjustment in the Bretton Woods system
did not take place, and the system collapsed in 1971. Attempts to patch up the
Bretton Woods system with the Smithsonian Agreement in December 1971 proved
unsuccessful, and by 1973, America and its trading partners had agreed to allow
exchange rates to float.
Although exchange rates are currently allowed to change daily in response to market
forces, central banks have not been willing to give up their option of intervening in
the foreign exchange market. Preventing large changes in exchange rates makes it easier
for firms and individuals purchasing or selling goods abroad to plan into the
future. Furthermore, countries with surpluses in their balance of payments frequently
do not want to see their currencies appreciate, because it makes their goods more
expensive abroad and foreign goods cheaper in their country. Because an appreciation
Managed Float
C H A P T E R 2 0 The International Financial System 473
might hurt sales for domestic businesses and increase unemployment, surplus countries
have often sold their currency in the foreign exchange market and acquired international
reserves.
Countries with balance-of-payments deficits do not want to see their currency
lose value, because it makes foreign goods more expensive for domestic consumers
and can stimulate inflation. To keep the value of the domestic currency high, deficit
countries have often bought their own currency in the foreign exchange market and
given up international reserves.
The current international financial system is a hybrid of a fixed and a flexible
exchange rate system. Rates fluctuate in response to market forces but are not determined
solely by them. Furthermore, many countries continue to keep the value of
their currency fixed against other currencies, as was the case in the European Monetary
System (to be described shortly).
Another important feature of the current system is the continuing de-emphasis of
gold in international financial transactions. Not only has the United States suspended
convertibility of dollars into gold for foreign central banks, but since 1970 the IMF
has been issuing a paper substitute for gold, called special drawing rights (SDRs).
Like gold in the Bretton Woods system, SDRs function as international reserves.
Unlike gold, whose quantity is determined by gold discoveries and the rate of production,
SDRs can be created by the IMF whenever it decides that there is a need for
additional international reserves to promote world trade and economic growth.
The use of gold in international transactions was further de-emphasized by the
IMF’s elimination of the official gold price in 1975 and by the sale of gold by the U.S.
Treasury and the IMF to private interests in order to demonetize it. Currently, the
price of gold is determined in a free market. Investors who want to speculate in it are
able to purchase and sell at will, as are jewelers and dentists who use gold in their
businesses.
In March 1979, eight members of the European Economic Community (Germany,
France, Italy, the Netherlands, Belgium, Luxembourg, Denmark, and Ireland) set up
the European Monetary System (EMS), in which they agreed to fix their exchange
rates vis-à-vis one another and to float jointly against the U.S. dollar. Spain joined the
EMS in June 1989, the United Kingdom in October 1990, and Portugal in April 1992.
The EMS created a new monetary unit, the European currency unit (ECU), whose value
was tied to a basket of specified amounts of European currencies. Each member of the
EMS was required to contribute 20% of its holdings of gold and dollars to the
European Monetary Cooperation Fund and in return received an equivalent amount
of ECUs.
The exchange rate mechanism (ERM) of the European Monetary System worked
as follows. The exchange rate between every pair of currencies of the participating
countries was not allowed to fluctuate outside narrow limits around a fixed exchange
rate. (The limits were typically 2.25% but were raised to 15% in August 1993.)
When the exchange rate between two countries’ currencies moved outside these limits,
the central banks of both countries were supposed to intervene in the foreign
exchange market. If, for example, the French franc depreciated below its lower limit
against the German mark, the Bank of France was required to buy francs and sell
marks, thereby giving up international reserves. Similarly, the German central bank
was also required to intervene to sell marks and buy francs and consequently increase
its international reserves. The EMS thus required that intervention be symmetric
European
Monetary System
(EMS)
474 PA RT V International Finance and Monetary Policy
www.imf.org/external/np/exr
/facts/sdr.htm
Find information about special
drawing rights, allocation,
valuation, and SDR users’
guide.
when a currency fell outside the limits, with the central bank with the weak currency
giving up international reserves and the one with the strong currency gaining them.
Central bank intervention was also very common even when the exchange rate was
within the limits, but in this case, if one central bank intervened, no others were
required to intervene as well.
A serious shortcoming of fixed exchange rate systems such as the Bretton Woods
system or the European Monetary System is that they can lead to foreign exchange
crises involving a “speculative attack” on a currency—massive sales of a weak currency
or purchases of a strong currency to cause a sharp change in the exchange rate.
In the following application, we use our model of exchange rate determination to
understand how the September 1992 exchange rate crisis that rocked the European
Monetary System came about.
C H A P T E R 2 0 The International Financial System 475
Application The Foreign Exchange Crisis of September 1992
In the aftermath of German reunification in October 1990, the German central
bank, the Bundesbank, faced rising inflationary pressures, with inflation
having accelerated from below 3% in 1990 to near 5% by 1992. To get monetary
growth under control and to dampen inflation, the Bundesbank raised
German interest rates to near double-digit levels. Figure 3 shows the consequences
of these actions by the Bundesbank in the foreign exchange market
for sterling. Note that in the diagram, the pound sterling is the domestic currency
and RD is the expected return on sterling deposits, whereas the foreign
currency is the German mark (deutsche mark, DM), so RF is the expected
return on mark deposits.
The increase in German interest rates i F shifted the RF schedule rightward
to RF
2 in Figure 3, so that the intersection of the RD
1 and the RF
2 schedules
at point 1 was below the lower exchange rate limit (2.778 marks per
pound, denoted Epar ) under the exchange rate mechanism. To lower the
value of the mark relative to the pound and restore the pound/mark
exchange rate to within the ERM limits, either the Bank of England had to
pursue a contractionary monetary policy, thereby raising British interest rates
to iD2
and shifting the RD
1 schedule to the right to point 2, or the Bundesbank
could pursue an expansionary monetary policy, thereby lowering German
interest rates, which would shift the RF schedule to the left to move back to
point 1. (The shift in RD to point 2 is not shown in the figure.)
The catch was that the Bundesbank, whose primary goal was fighting
inflation, was unwilling to pursue an expansionary monetary policy, and the
British, who were facing their worst recession in the postwar period, were
unwilling to pursue a contractionary monetary policy to prop up the pound.
This impasse became clear when in response to great pressure from other
members of the EMS, the Bundesbank was willing to lower its lending rates
by only a token amount on September 14 after a speculative attack was
mounted on the currencies of the Scandinavian countries. So at some point
in the near future, the value of the pound would have to decline to point 1.
Speculators now knew that the appreciation of the mark was imminent and
476 PA RT V International Finance and Monetary Policy
hence that the value of foreign (mark) deposits would rise in value relative
to the pound. As a result, the expected return on mark deposits increased
sharply, shifting the RF schedule to RF
3 in Figure 3.
The huge potential losses on pound deposits and potential gains on mark
deposits caused a massive sell-off of pounds (and purchases of marks) by
speculators. The need for the British central bank to intervene to raise the
value of the pound now became much greater and required a huge rise in
British interest rates, all the way to i D
3. After a major intervention effort on the
part of the Bank of England, which included a rise in its lending rate from
10% to 15%, which still wasn’t enough, the British were finally forced to give
up on September 16: They pulled out of the ERM indefinitely, allowing the
pound to depreciate by 10% against the mark.
Speculative attacks on other currencies forced devaluation of the Spanish
peseta by 5% and the Italian lira by 15%. To defend its currency, the Swedish
central bank was forced to raise its daily lending rate to the astronomical level
of 500%! By the time the crisis was over, the British, French, Italian, Spanish,
and Swedish central banks had intervened to the tune of $100 billion; the
Bundesbank alone had laid out $50 billion for foreign exchange intervention.
Because foreign exchange crises lead to large changes in central banks’ holdings
of international reserves and thus affect the official reserve asset items
in the balance of payments, these crises are also referred to as balance-ofpayments
crises.
The attempt to prop up the European Monetary System was not cheap for
these central banks. It is estimated that they lost $4 to $6 billion as a result of
FIGURE 3 Foreign Exchange
Market for British Pounds in 1992
The realization by speculators that
the United Kingdom would soon
devalue the pound increased the
expected return on foreign
(German mark, DM) deposits and
shifted RF
2 rightward to RF
3. The
result was the need for a much
greater purchase of pounds by the
British central bank to raise the
interest rate to i D
3 to keep the
exchange rate at 2.778 German
marks per pound.
Expected Return ( in £ terms )
RF
2
RD
1
Epar = 2.778
Exchange Rate, Et
1 2
1
3
RF
1
iD1
iD2
iD3
(DM/£ )
RF
3
C H A P T E R 2 0 The International Financial System 477
exchange rate intervention during the crisis. What the central banks lost, the
speculators gained. A speculative fund run by George Soros ran up $1 billion of
profits during the crisis, and Citibank traders are reported to have made $200
million. When an exchange rate crisis comes, life can certainly be sweet for
exchange rate speculators.
Recent Foreign Exchange Crises in Emerging Market Countries:
Mexico 1994, East Asia 1997, Brazil 1999, and Argentina 2002
Application
Major currency crises in emerging market countries have been a common
occurrence in recent years. We can use Figure 3 to understand the sequence
of events during the currency crises in Mexico in 1994, East Asia in 1997,
Brazil in 1999, and Argentina in 2002. To do so, we just need to recognize
that dollars are the foreign currency, so that RF is the expected return on dollar
deposits, while RD is the expected return on deposits denominated in the
domestic currency, whether it was pesos, baht, or reals. (Note that the
exchange rate label on the vertical axis would be in terms of dollars/domestic
currency and that the label on the horizontal axis would be expected
return in the domestic currency—say, pesos.)
In Mexico in March 1994, political instability (the assassination of the
ruling party’s presidential candidate) sparked investors’ concerns that the
peso might be devalued. The result was that the expected return on dollar
deposits rose, thus moving the RF schedule from RF
1 to RF
2 in Figure 3. In the
case of Thailand in May 1997, the large current account deficit and the weakness
of the Thai financial system raised similar concerns about the devaluation
of the domestic currency, with the same effect on the RF schedule. In
Brazil in late 1998 and Argentina in 2001, concerns about fiscal situations
that could lead to the printing of money to finance the deficit, and thereby
raise inflation, also meant that a devaluation was more likely to occur. The
concerns thus raised the expected return on dollar deposits and shifted the
RF schedule from RF
1 to RF
2. In all of these cases, the result was that the intersection
of the RD1
and RF
2 curves was below the pegged value of the domestic
currency at Epar.
To keep their domestic currencies from falling below Epar, these countries’
central banks needed to buy the domestic currency and sell dollars to raise
interest rates to iD2
and shift the RD curve to the right, in the process losing
international reserves. At first, the central banks were successful in containing
this speculative attack. However, when more bad news broke, speculators
became even more confident that these countries could not defend their
currencies. (The bad news was everywhere: in Mexico, with an uprising in
Chiappas and revelations about problems in the banking system; in Thailand,
there was a major failure of a financial institution; in Brazil, a worsening fiscal
situation was reported, along with a threat by a governor to default on his
state’s debt; and in Argentina, a full-scale bank panic and an actual default on
the government debt occurred.) As a result, the expected returns on dollar
deposits shot up further, and RF moved much farther to the right, to RF
3; and
Capital Controls
Because capital flows have been an important element in the currency crises in Mexico
and East Asia, politicians and some economists have advocated that capital mobility
in emerging market countries should be restricted with capital controls in order to
avoid financial instability. Are capital controls a good idea?
Capital outflows can promote financial instability in emerging market countries,
because when domestic residents and foreigners pull their capital out of a country, the
resulting capital outflow forces a country to devalue its currency. This is why some
politicians in emerging market countries have recently found capital controls particularly
attractive. For example, Prime Minister Mahathir of Malaysia instituted capital
controls in 1998 to restrict outflows in the aftermath of the East Asian crisis.
Although these controls sound like a good idea, they suffer from several disadvantages.
First, empirical evidence indicates that controls on capital outflows are seldom
effective during a crisis because the private sector finds ingenious ways to evade
them and has little difficulty moving funds out of the country.7 Second, the evidence
Controls on
Capital Outflows
478 PA RT V International Finance and Monetary Policy
the central banks lost even more international reserves. Given the stress on the
economy from rising interest rates and the loss of reserves, eventually the
monetary authorities could no longer continue to defend the currency and
were forced to give up and let their currencies depreciate. This scenario happened
in Mexico in December 1994, in Thailand in July 1997, in Brazil in
January 1999, and in Argentina in January 2002.
Concerns about similar problems in other countries then triggered speculative
attacks against them as well. This contagion occurred in the aftermath
of the Mexican crisis (jauntily referred to as the “Tequila effect”) with speculative
attacks on other Latin American currencies, but there were no further
currency collapses. In the East Asian crisis, however, fears of devaluation
spread throughout the region, leading to a scenario akin to that depicted in
Figure 3. Consequently, one by one, Indonesia, Malaysia, South Korea, and
the Philippines were forced to devalue sharply. Even Hong Kong, Singapore,
and Taiwan were subjected to speculative attacks, but because these countries
had healthy financial systems, the attacks were successfully averted.
As we saw in Chapter 8, the sharp depreciations in Mexico, East Asia,
and Argentina led to full-scale financial crises that severely damaged these
countries’ economies. The foreign exchange crisis that shocked the European
Monetary System in September 1992 cost central banks a lot of money, but
the public in European countries were not seriously affected. By contrast, the
public in Mexico, Argentina, and the crisis countries of East Asia were not so
lucky: The collapse of these currencies triggered by speculative attacks led to
the financial crises described in Chapter 8, producing severe depressions that
caused hardship and political unrest.
7See Sebastian Edwards, “How Effective are Capital Controls?” Journal of Economic Perspectives, Winter 2000; vol.
13, no. 4, pp. 65–84.
suggests that capital flight may even increase after controls are put into place, because
confidence in the government is weakened. Third, controls on capital outflows often
lead to corruption, as government officials get paid off to look the other way when
domestic residents are trying to move funds abroad. Fourth, controls on capital outflows
may lull governments into thinking they do not have to take the steps to reform
their financial systems to deal with the crisis, with the result that opportunities are
lost to improve the functioning of the economy.
Although most economists find the arguments against controls on capital outflows
persuasive, controls on capital inflows receive more support. Supporters reason that
if speculative capital cannot come in, then it cannot go out suddenly and create a crisis.
Our analysis of the financial crises in East Asia in Chapter 8 provides support for
this view by suggesting that capital inflows can lead to a lending boom and excessive
risk taking on the part of banks, which then helps trigger a financial crisis.
However, controls on capital inflows have the undesirable feature that they may
block from entering a country funds that would be used for productive investment
opportunities. Although such controls may limit the fuel supplied to lending booms
through capital flows, over time they produce substantial distortions and misallocation
of resources as households and businesses try to get around them. Indeed, just
as with controls on capital outflows, controls on capital inflows can lead to corruption.
There are serious doubts whether capital controls can be effective in today’s environment,
in which trade is open and where there are many financial instruments that
make it easier to get around these controls.
On the other hand, there is a strong case for improving bank regulation and
supervision so that capital inflows are less likely to produce a lending boom and
encourage excessive risk taking by banking institutions. For example, restricting
banks in how fast their borrowing could grow might have the impact of substantially
limiting capital inflows. Supervisory controls of this type, focusing on the sources of
financial fragility rather than the symptoms, can enhance the efficiency of the financial
system rather than hampering it.
The Role of the IMF
The International Monetary Fund was originally set up under the Bretton Woods system
to help countries deal with balance-of-payments problems and stay with the fixed
exchange rate by lending to deficit countries. With the collapse of the Bretton Woods
system of fixed exchange rates in 1971, the IMF has taken on new roles.
The IMF continues to function as a data collector and provide technical assistance
to its member countries. Although the IMF no longer attempts to encourage fixed
exchange rates, its role as an international lender has become more important
recently. This role first came to the fore in the 1980s during the third-world debt crisis,
in which the IMF assisted developing countries in repaying their loans. The financial
crises in Mexico in 1994–1995 and in East Asia in 1997–1998 led to huge loans
by the IMF to these and other affected countries to help them recover from their
financial crises and to prevent the spread of these crises to other countries. This role,
in which the IMF acts like an international lender of last resort to cope with financial
instability, is indeed highly controversial.
Controls on
Capital Inflows
C H A P T E R 2 0 The International Financial System 479
As we saw in Chapter 17, in industrialized countries when a financial crisis occurs and
the financial system threatens to seize up, domestic central banks can address matters
with a lender-of-last-resort operation to limit the degree of instability in the banking
system. In emerging market countries, however, where the credibility of the central
bank as an inflation-fighter may be in doubt and debt contracts are typically short-term
and denominated in foreign currencies, a lender-of-last-resort operation becomes a
two-edged sword—as likely to exacerbate the financial crisis as to alleviate it. For
example, when the U.S. Federal Reserve engaged in a lender-of-last-resort operation
during the 1987 stock market crash (Chapter 17), there was almost no sentiment in
the markets that there would be substantially higher inflation. However, for a central
bank having less inflation-fighting credibility than the Fed, central bank lending to the
financial system in the wake of a financial crisis—even under the lender-of-last-resort
rhetoric—may well arouse fears of inflation spiraling out of control, causing an even
greater currency depreciation and still greater deterioration of balance sheets. The
resulting increase in moral hazard and adverse selection problems in financial markets,
along the lines discussed in Chapter 8, would only worsen the financial crisis.
Central banks in emerging market countries therefore have only a very limited
ability to successfully engage in a lender-of-last-resort operation. However, liquidity
provided by an international lender of last resort does not have these undesirable consequences,
and in helping to stabilize the value of the domestic currency, it strengthens
domestic balance sheets. Moreover, an international lender of last resort may be
able to prevent contagion, the situation in which a successful speculative attack on
one emerging market currency leads to attacks on other emerging market currencies,
spreading financial and economic disruption as it goes. Since a lender of last resort
for emerging market countries is needed at times, and since it cannot be provided
domestically, there is a strong rationale for an international institution to fill this role.
Indeed, since Mexico’s financial crisis in 1994, the International Monetary Fund and
other international agencies have stepped into the lender-of-last-resort role and provided
emergency lending to countries threatened by financial instability.
However, support from an international lender of last resort brings risks of its
own, especially the risk that the perception it is standing ready to bail out irresponsible
financial institutions may lead to excessive risk taking of the sort that makes financial
crises more likely. In the Mexican and East Asian crises, governments in the crisis
countries used IMF support to protect depositors and other creditors of banking institutions
from losses. This safety net creates a well-known moral hazard problem
because the depositors and other creditors have less incentive to monitor these banking
institutions and withdraw their deposits if the institutions are taking on too much
risk. The result is that these institutions are encouraged to take on excessive risks.
Indeed, critics of the IMF—most prominently, the Congressional Commission headed
by Professor Alan Meltzer of Carnegie-Mellon University—contend that IMF lending
in the Mexican crisis, which was used to bail out foreign lenders, set the stage for the
East Asian crisis, because these lenders expected to be bailed out if things went
wrong, and thus provided funds that were used to fuel excessive risk taking.8
An international lender of last resort must find ways to limit this moral hazard
problem, or it can actually make the situation worse. The international lender of last
resort can make it clear that it will extend liquidity only to governments that put the
Should the IMF Be
an International
Lender of Last
Resort?
480 PA RT V International Finance and Monetary Policy
8See International Financial Institution Advisory Commission, Report (IFIAC: Washington, D.C., 2000).
proper measures in place to prevent excessive risk taking. In addition, it can reduce
the incentives for risk taking by restricting the ability of governments to bail out
stockholders and large uninsured creditors of domestic financial institutions. Some
critics of the IMF believe that the IMF has not put enough pressure on the governments
to which it lends to contain the moral hazard problem.
One problem that arises for international organizations like the IMF engaged in
lender-of-last-resort operations is that they know that if they don’t come to the rescue,
the emerging market country will suffer extreme hardship and possible political
instability. Politicians in the crisis country may exploit these concerns and engage in
a game of chicken with the international lender of last resort: They resist necessary
reforms, hoping that the IMF will cave in. Elements of this game were present in the
Mexican crisis of 1995 and were also a particularly important feature of the negotiations
between the IMF and Indonesia during the Asian crisis.
The IMF would produce better outcomes if it made clear that it will not play this
game. Just as giving in to ill-behaved children may be the easy way out in the short
run, but supports a pattern of poor behavior in the long run, some critics worry that
the IMF may not be tough enough when confronted by short-run humanitarian concerns.
For example, these critics have been particularly critical of the IMF’s lending to
the Russian government, which resisted adopting appropriate reforms to stabilize its
financial system.
The IMF has also been criticized for imposing on the East Asian countries socalled
austerity programs that focus on tight macroeconomic policies rather than on
microeconomic policies to fix the crisis-causing problems in the financial sector. Such
programs are likely to increase resistance to IMF recommendations, particularly in
emerging market countries. Austerity programs allow these politicians to label institutions
such as the IMF as being anti-growth, rhetoric that helps the politicians mobilize
the public against the IMF and avoid doing what they really need to do to reform
the financial system in their country. IMF programs focused instead on microeconomic
policies related to the financial sector would increase the likelihood that the
IMF will be seen as a helping hand in the creation of a more efficient financial system.
An important historical feature of successful lender-of-last-resort operations is
that the faster the lending is done, the lower is the amount that actually has to be lent.
An excellent example occurred in the aftermath of the stock market crash on October
19, 1987 (Chapter 17). At the end of that day, in order to service their customers’
accounts, securities firms needed to borrow several billion dollars to maintain orderly
trading. However, given the unprecedented developments, banks were very nervous
about extending further loans to these firms. Upon learning this, the Federal Reserve
engaged in an immediate lender-of-last-resort operation, with the Fed making it clear
that it would provide liquidity to banks making loans to the securities industry.
Indeed, what is striking about this episode is that the extremely quick intervention of
the Fed not only resulted in a negligible impact of the stock market crash on the economy,
but also meant that the amount of liquidity that the Fed needed to supply to the
economy was not very large.
The ability of the Fed to engage in a lender-of-last-resort operation within a day
of a substantial shock to the financial system is in sharp contrast to the amount of time
it has taken the IMF to supply liquidity during the recent crises in emerging market
countries. Because IMF lending facilities were originally designed to provide funds
after a country was experiencing a balance-of-payments crisis and because the conditions
for the loan had to be negotiated, it took several months before the IMF made
C H A P T E R 2 0 The International Financial System 481
funds available. By this time, the crises had gotten much worse—and much larger
sums of funds were needed to cope with the crisis, often stretching the resources of
the IMF. One reason central banks can lend so much more quickly than the IMF is
that they have set up procedures in advance to provide loans, with the terms and conditions
for this lending agreed upon beforehand. The need for quick provision of liquidity,
to keep the loan amount manageable, argues for similar credit facilities at the
international lender of last resort, so that funds can be provided quickly, as long as
the borrower meets conditions such as properly supervising its banks or keeping
budget deficits low. A step in this direction was made in 1999 when the IMF set up a
new lending facility, the Contingent Credit Line, so that it can provide liquidity faster
during a crisis.
The debate on whether the world will be better off with the IMF operating as an
international lender of last resort is currently a hot one. Much attention is being
focused on making the IMF more effective in performing this role, and redesign of the
IMF is at the center of proposals for a new international financial architecture to help
reduce international financial instability.
International Considerations and Monetary Policy
Our analysis in this chapter so far has suggested several ways in which monetary policy
can be affected by international matters. Awareness of these effects can have significant
implications for the way monetary policy is conducted.
When central banks intervene in the foreign exchange market, they acquire or sell off
international reserves, and their monetary base is affected. When a central bank intervenes
in the foreign exchange market, it gives up some control of its money supply.
For example, in the early 1970s, the German central bank faced a dilemma. In
attempting to keep the German mark from appreciating too much against the U.S.
dollar, the Germans acquired huge quantities of international reserves, leading to a
rate of money growth that the German central bank considered inflationary.
The Bundesbank could have tried to halt the growth of the money supply by
stopping its intervention in the foreign exchange market and reasserting control over
its own money supply. Such a strategy has a major drawback when the central bank
is under pressure not to allow its currency to appreciate: The lower price of imports
and higher price of exports as a result of an appreciation in its currency will hurt
domestic producers and increase unemployment.
Because the U.S. dollar has been a reserve currency, the U.S. monetary base and
money supply have been less affected by developments in the foreign exchange market.
As long as foreign central banks, rather than the Fed, intervene to keep the value
of the dollar from changing, American holdings of international reserves are unaffected.
The ability to conduct monetary policy is typically easier when a country’s currency
is a reserve currency.9
Direct Effects
of the Foreign
Exchange Market
on the Money
Supply
482 PA RT V International Finance and Monetary Policy
9However, the central bank of a reserve currency country must worry about a shift away from the use of its currency
for international reserves.
Under the Bretton Woods system, balance-of-payments considerations were more
important than they are under the current managed float regime. When a nonreserve
currency country is running balance-of-payments deficits, it necessarily
gives up international reserves. To keep from running out of these reserves, under
the Bretton Woods system it had to implement contractionary monetary policy to
strengthen its currency—exactly what occurred in the United Kingdom before its
devaluation of the pound in 1967. When policy became expansionary, the balance
of payments deteriorated, and the British were forced to “slam on the brakes” by
implementing a contractionary policy. Once the balance of payments improved,
policy became more expansionary until the deteriorating balance of payments again
forced the British to pursue a contractionary policy. Such on-again, off-again actions
became known as a “stop-go” policy, and the domestic instability it created was criticized
severely.
Because the United States is a major reserve currency country, it can run large balanceof-
payments deficits without losing huge amounts of international reserves. This does
not mean, however, that the Federal Reserve is never influenced by developments in
the U.S. balance of payments. Current account deficits in the United States suggest
that American businesses may be losing some of their ability to compete because the
value of the dollar is too high. In addition, large U.S. balance-of-payments deficits
lead to balance-of-payments surpluses in other countries, which can in turn lead to
large increases in their holdings of international reserves (this was especially true
under the Bretton Woods system). Because such increases put a strain on the international
financial system and may stimulate world inflation, the Fed worries about
U.S. balance-of-payments and current account deficits. To help shrink these deficits,
the Fed might pursue a more contractionary monetary policy.
Unlike balance-of-payments considerations, which have become less important
under the current managed float system, exchange rate considerations now play a
greater role in the conduct of monetary policy. If a central bank does not want to see
its currency fall in value, it may pursue a more contractionary monetary policy of
reducing the money supply to raise the domestic interest rate, thereby strengthening
its currency. Similarly, if a country experiences an appreciation in its currency,
domestic industry may suffer from increased foreign competition and may pressure
the central bank to pursue a higher rate of money growth in order to lower the
exchange rate.
The pressure to manipulate exchange rates seems to be greater for central banks
in countries other than the United States, but even the Federal Reserve is not completely
immune. The growing tide of protectionism stemming from the inability of
American firms to compete with foreign firms because of the strengthening dollar
from 1980 to early 1985 stimulated congressional critics of the Fed to call for a more
expansionary monetary policy to lower the value of the dollar. As we saw in Chapter
18, the Fed then did let money growth surge to very high levels. A policy to bring the
dollar down was confirmed in the Plaza Agreement of September 1985, in which the
finance ministers from the five most important industrial nations in the free world
(the United States, Japan, West Germany, the United Kingdom, and France) agreed to
intervene in foreign exchange markets to achieve a decline in the dollar. The dollar
continued to fall rapidly after the Plaza Agreement, and the Fed played an important
role in this decline by continuing to expand the money supply at a rapid rate.
Exchange Rate
Considerations
Balance-of-
Payments
Considerations
C H A P T E R 2 0 The International Financial System 483
484 PA RT V International Finance and Monetary Policy
Summary
1. An unsterilized central bank intervention in which the
domestic currency is sold to purchase foreign assets
leads to a gain in international reserves, an increase in
the money supply, and a depreciation of the domestic
currency. Available evidence suggests, however, that
sterilized central bank interventions have little longterm
effect on the exchange rate.
2. The balance of payments is a bookkeeping system for
recording all payments between a country and foreign
countries that have a direct bearing on the movement of
funds between them. The official reserve transactions
balance is the sum of the current account balance plus
the items in the capital account. It indicates the amount
of international reserves that must be moved between
countries to finance international transactions.
3. Before World War I, the gold standard was
predominant. Currencies were convertible into gold,
thus fixing exchange rates between countries. After
World War II, the Bretton Woods system and the IMF
were established to promote a fixed exchange rate
system in which the U.S. dollar was convertible into
gold. The Bretton Woods system collapsed in 1971. We
now have an international financial system that has
elements of a managed float and a fixed exchange rate
system. Some exchange rates fluctuate from day to day,
although central banks intervene in the foreign
exchange market, while other exchange rates are fixed.
4. Controls on capital outflows receive support because
they may prevent domestic residents and foreigners
from pulling capital out of a country during a crisis and
make devaluation less likely. Controls on capital inflows
make sense under the theory that if speculative capital
cannot flow in, then it cannot go out suddenly and
create a crisis. However, capital controls suffer from
several disadvantages: they are seldom effective, they
lead to corruption, and they may allow governments to
avoid taking the steps needed to reform their financial
systems to deal with the crisis.
5. The IMF has recently taken on the role of an
international lender of last resort. Because central banks
in emerging market countries are unlikely to be able to
perform a lender-of-last-resort operation successfully,
an international lender of last resort like the IMF is
needed to prevent financial instability. However, the
IMF’s role as an international lender of last resort
creates a serious moral hazard problem that can
encourage excessive risk taking and make a financial
crisis more likely, but avoiding the problem may be
politically hard to do. In addition, it needs to be able to
provide liquidity quickly during a crisis in order to
keep manageable the amount of funds lent.
6. Three international considerations affect the conduct of
monetary policy: direct effects of the foreign exchange
market on the money supply, balance-of-payments
considerations, and exchange rate considerations.
Inasmuch as the United States has been a reserve
currency country in the post–World War II period, U.S.
monetary policy has been less affected by developments
in the foreign exchange market and its balance of
payments than is true for other countries. However, in
recent years, exchange rate considerations have been
playing a more prominent role in influencing U.S.
monetary policy.
Key Terms
balance of payments, p. 467
balance-of-payments crisis, p. 476
Bretton Woods system, p. 470
capital account, p. 467
current account, p. 467
devaluation, p. 472
fixed exchange rate regime, p. 470
foreign exchange intervention, p. 462
gold standard, p. 469
International Monetary Fund (IMF),
p. 470
international reserves, p. 462
managed float regime (dirty float),
p. 462
official reserve transactions balance,
p. 468
reserve currency, p. 470
revaluation, p. 472
C H A P T E R 2 0 The International Financial System 485
special drawing rights (SDRs), p. 474
sterilized foreign exchange
intervention, p. 465
trade balance, p. 467
unsterilized foreign exchange intervention,
p. 464
World Bank, p. 470
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. If the Federal Reserve buys dollars in the foreign
exchange market but conducts an offsetting open market
operation to sterilize the intervention, what will be
the impact on international reserves, the money supply,
and the exchange rate?
*2. If the Federal Reserve buys dollars in the foreign
exchange market but does not sterilize the intervention,
what will be the impact on international reserves,
the money supply, and the exchange rate?
3. For each of the following, identify in which part of the
balance-of-payments account it appears (current
account, capital account, or method of financing) and
whether it is a receipt or a payment.
a. A British subject’s purchase of a share of Johnson &
Johnson stock
b. An American’s purchase of an airline ticket from
Air France
c. The Swiss government’s purchase of U.S. Treasury
bills
d. A Japanese’s purchase of California oranges
e. $50 million of foreign aid to Honduras
f. A loan by an American bank to Mexico
g. An American bank’s borrowing of Eurodollars
*4. Why does a balance-of-payments deficit for the United
States have a different effect on its international
reserves than a balance-of-payments deficit for the
Netherlands?
5. Under the gold standard, if Britain became more productive
relative to the United States, what would happen
to the money supply in the two countries? Why
would the changes in the money supply help preserve
a fixed exchange rate between the United States and
Britain?
*6. What is the exchange rate between dollars and Swiss
francs if one dollar is convertible into ounce of
gold and one franc is convertible into ounce of
gold?
7. If a country’s par exchange rate was undervalued
during the Bretton Woods fixed exchange rate
regime, what kind of intervention would that country’s
central bank be forced to undertake, and what
effect would it have on its international reserves and
the money supply?
*8. How can a large balance-of-payments surplus contribute
to the country’s inflation rate?
9. “If a country wants to keep its exchange rate from
changing, it must give up some control over its money
supply.” Is this statement true, false, or uncertain?
Explain your answer.
*10. Why can balance-of-payments deficits force some
countries to implement a contractionary monetary
policy?
11. “Balance-of-payments deficits always cause a country
to lose international reserves.” Is this statement true,
false, or uncertain? Explain your answer.
*12. How can persistent U.S. balance-of-payments deficits
stimulate world inflation?
13. “Inflation is not possible under the gold standard.” Is
this statement true, false, or uncertain? Explain your
answer.
*14. Why is it that in a pure flexible exchange rate system,
the foreign exchange market has no direct effects on
the money supply? Does this mean that the foreign
exchange market has no effect on monetary policy?
15. “The abandonment of fixed exchange rates after 1973
has meant that countries have pursued more independent
monetary policies.” Is this statement true,
false, or uncertain? Explain your answer.
1
40
1
20
QUIZ
486 PA RT V International Finance and Monetary Policy
Web Exercises
1. The Federal Reserve publishes information online that
explains the workings of the foreign exchange market.
One such publication can be found at www.ny.frb
.org/pihome/addpub/usfxm/. Review the table of contents
and open Chapter 10, the evolution of the international
monetary system. Read this chapter and write
a one-page summary that discusses why each monetary
standard was dropped in favor of the succeeding one.
2. The International Monetary Fund stands ready to help
nations facing monetary crises. Go to www.imf.org.
Click on the tab labeled “About IMF.” What is the
stated purpose of the IMF? How many nations participate
and when was it established?
PREVIEW Getting monetary policy right is crucial to the health of the economy. Overly expansionary
monetary policy leads to high inflation, which decreases the efficiency of the
economy and hampers economic growth. The United States has not been exempt
from inflationary episodes, but more extreme cases of inflation, in which the inflation
rate climbs to over 100% per year, have been prevalent in some regions of the world
such as Latin America, and have been very harmful to the economy. Monetary policy
that is too tight can produce serious recessions in which output falls and unemployment
rises. It can also lead to deflation, a fall in the price level, as occurred in the
United States during the Great Depression and in Japan more recently. As we have
seen in Chapter 8, deflation can be especially damaging to the economy, because it
promotes financial instability and can even help trigger financial crises.
In Chapter 18 our discussion of the conduct of monetary policy focused primarily
on the United States. However, the United States is not the source of all wisdom
about how to do monetary policy well. In thinking about what strategies for the conduct
of monetary policy might be best, we need to examine monetary policy experiences
in other countries.
A central feature of monetary policy strategies in all countries is the use of a nominal
anchor (a nominal variable that monetary policymakers use to tie down the price
level such as the inflation rate, an exchange rate, or the money supply) as an intermediate
target to achieve an ultimate goal such as price stability. We begin the chapter
by examining the role a nominal anchor plays in promoting price stability. Then
we examine three basic types of monetary policy strategy—exchange-rate targeting,
monetary targeting, and inflation targeting—and compare them to the Federal
Reserve’s current monetary policy strategy, which features an implicit (not an explicit)
nominal anchor. We will see that despite the recent excellent performance of monetary
policy in the United States, there is much to learn from the foreign experience.
The Role of a Nominal Anchor
Adherence to a nominal anchor forces a nation’s monetary authority to conduct monetary
policy so that the nominal anchor variable such as the inflation rate or the
money supply stays within a narrow range. A nominal anchor thus keeps the price
level from growing or falling too fast and thereby preserves the value of a country’s
487
Chap ter
Monetary Policy Strategy:
The International Experience
21
www.federalreserve.gov
/centralbanks.htm
Features links to home pages
for central banks around the
world.
money. Thus, a nominal anchor of some sort is a necessary element in successful monetary
policy strategies.
One reason a nominal anchor is necessary for monetary policy is that it can help
promote price stability, which most countries now view as the most important goal
for monetary policy. A nominal anchor promotes price stability by tying inflation
expectations to low levels directly through its constraint on the value of domestic
money. A more subtle reason for a nominal anchor’s importance is that it can limit the
time-consistency problem, in which monetary policy conducted on a discretionary,
day-by-day basis leads to poor long-run outcomes.1
The time-consistency problem of discretionary policy arises because economic behavior
is influenced by what firms and people expect the monetary authorities to do in
the future. With firms’ and people’s expectations assumed to remain unchanged, policymakers
think they can boost economic output (or lower unemployment) by pursuing
discretionary monetary policy that is more expansionary than expected, and so
they have incentives to pursue this policy. This situation is described by saying that
discretionary monetary policy is time-consistent; that is, the policy is what policymakers
are likely to want to pursue at any given point in time. The problem with timeconsistent,
discretionary policy is that it leads to bad outcomes. Because decisions
about wages and prices reflect expectations about policy, workers and firms will raise
their expectations not only of inflation but also of wages and prices. On average, output
will not be higher under such an expansionary strategy, but inflation will be. (We
examine this more formally in Chapter 28.)
Clearly, a central bank will do better if it does not try to boost output by surprising
people with an unexpectedly expansionary policy, but instead keeps inflation
under control. However, even if a central bank recognizes that discretionary policy
will lead to a poor outcome—high inflation with no gains on the output front—it may
still fall into the time-consistency trap, because politicians are likely to apply pressure
on the central bank to try to boost output with overly expansionary monetary policy.
Although the analysis sounds somewhat complicated, the time-consistency problem
is actually something we encounter in everyday life. For example, at any given
point in time, it seems to make sense for a parent to give in to a child to keep the child
from acting up. The more the parent gives in, however, the more the demanding the
child is likely to become. Thus, the discretionary time-consistent actions by the parent
lead to a bad outcome—a very spoiled child—because the child’s expectations are
affected by what the parent does. How-to books on parenting suggest a solution to
the time-consistency problem (although they don’t call it that) by telling parents that
they should set rules for their children and stick to them.
A nominal anchor is like a behavior rule. Just as rules help to prevent the timeconsistency
problem in parenting, a nominal anchor can help to prevent the time-
The Time-
Consistency
Problem
488 PA RT V International Finance and Monetary Policy
1The time-consistency problem is also called the time-inconsistency problem because monetary policy that leads
to a good outcome by controlling inflation is not sustainable (and is thus time-inconsistent). When the central
bank pursues such a policy, it has incentives to deviate from it to try to boost output by engaging in discretionary,
time-consistent policy. The time-consistency problem was first outlined in Finn Kydland and Edward Prescott,
“Rules Rather Than Discretion: The Inconsistency of Optimal Plans,” Journal of Political Economy 85 (1977):
473–491; Guillermo Calvo, “On the Time Consistency of Optimal Policy in the Monetary Economy,” Econometrica
46 (November 1978): 1411–1428; and Robert J. Barro and David Gordon, “A Positive Theory of Monetary Policy
in a Natural Rate Model,” Journal of Political Economy 91 (August 1983).
consistency problem in monetary policy by providing an expected constraint on discretionary
policy. In the following sections, we examine three monetary policy strategies—
exchange-rate targeting, monetary targeting, and inflation targeting—that use a
nominal anchor.
Exchange-Rate Targeting
Targeting the exchange rate is a monetary policy strategy with a long history. It can
take the form of fixing the value of the domestic currency to a commodity such as
gold, the key feature of the gold standard described in Chapter 20. More recently,
fixed exchange-rate regimes have involved fixing the value of the domestic currency
to that of a large, low-inflation country like the United States or Germany (called the
anchor country). Another alternative is to adopt a crawling target or peg, in which a
currency is allowed to depreciate at a steady rate so that the inflation rate in the pegging
country can be higher than that of the anchor country.
Exchange-rate targeting has several advantages. First, the nominal anchor of an
exchange-rate target directly contributes to keeping inflation under control by tying
the inflation rate for internationally traded goods to that found in the anchor country.
It does this because the foreign price of internationally traded goods is set by the
world market, while the domestic price of these goods is fixed by the exchange-rate
target. For example, until 2002 in Argentina the exchange rate for the Argentine peso
was exactly one to the dollar, so that a bushel of wheat traded internationally at five
dollars had its price set at five pesos. If the exchange-rate target is credible (i.e.,
expected to be adhered to), the exchange-rate target has the added benefit of anchoring
inflation expectations to the inflation rate in the anchor country.
Second, an exchange-rate target provides an automatic rule for the conduct of
monetary policy that helps mitigate the time-consistency problem. As we saw in
Chapter 20, an exchange-rate target forces a tightening of monetary policy when there
is a tendency for the domestic currency to depreciate or a loosening of policy when
there is a tendency for the domestic currency to appreciate, so that discretionary,
time-consistent monetary policy is less of an option.
Third, an exchange-rate target has the advantage of simplicity and clarity,
which makes it easily understood by the public. A “sound currency” is an easy-tounderstand
rallying cry for monetary policy. In the past, this aspect was important in
France, where an appeal to the “franc fort” (strong franc) was often used to justify
tight monetary policy.
Given its advantages, it is not surprising that exchange-rate targeting has been
used successfully to control inflation in industrialized countries. Both France and the
United Kingdom, for example, successfully used exchange-rate targeting to lower inflation
by tying the value of their currencies to the German mark. In 1987, when France
first pegged its exchange rate to the mark, its inflation rate was 3%, two percentage
points above the German inflation rate. By 1992, its inflation rate had fallen to 2%, a
level that can be argued is consistent with price stability, and was even below that in
Germany. By 1996, the French and German inflation rates had converged, to a number
slightly below 2%. Similarly, after pegging to the German mark in 1990, the United
Kingdom was able to lower its inflation rate from 10% to 3% by 1992, when it was
forced to abandon the exchange rate mechanism (ERM, discussed in Chapter 20).
Advantages of
Exchange-Rate
Targeting
C H A P T E R 2 1 Monetary Policy Strategy: The International Experience 489
Exchange-rate targeting has also been an effective means of reducing inflation
quickly in emerging market countries. For example, before the devaluation in Mexico
in 1994, its exchange-rate target enabled it to bring inflation down from levels above
100% in 1988 to below 10% in 1994.
Despite the inherent advantages of exchange-rate targeting, there are several serious
criticisms of this strategy. The problem (as we saw in Chapter 20) is that with capital
mobility the targeting country no longer can pursue its own independent monetary
policy and so loses its ability to use monetary policy to respond to domestic shocks
that are independent of those hitting the anchor country. Furthermore, an exchangerate
target means that shocks to the anchor country are directly transmitted to the targeting
country, because changes in interest rates in the anchor country lead to a
corresponding change in interest rates in the targeting country.
A striking example of these problems occurred when Germany reunified in 1990.
In response to concerns about inflationary pressures arising from reunification and
the massive fiscal expansion required to rebuild East Germany, long-term German
interest rates rose until February 1991 and short-term rates rose until December
1991. This shock to the anchor country in the exchange rate mechanism (ERM) was
transmitted directly to the other countries in the ERM whose currencies were pegged
to the mark, and their interest rates rose in tandem with those in Germany.
Continuing adherence to the exchange-rate target slowed economic growth and
increased unemployment in countries such as France that remained in the ERM and
adhered to the exchange-rate peg.
A second problem with exchange-rate targets is that they leave countries open to
speculative attacks on their currencies. Indeed, one aftermath of German reunification
was the foreign exchange crisis of September 1992. As we saw in Chapter 20, the tight
monetary policy in Germany following reunification meant that the countries in the
ERM were subjected to a negative demand shock that led to a decline in economic
growth and a rise in unemployment. It was certainly feasible for the governments of
these countries to keep their exchange rates fixed relative to the mark in these circumstances,
but speculators began to question whether these countries’ commitment
to the exchange-rate peg would weaken. Speculators reasoned that these countries
would not tolerate the rise in unemployment resulting from keeping interest rates
high enough to fend off attacks on their currencies.
At this stage, speculators were, in effect, presented with a one-way bet, because
the currencies of countries like France, Spain, Sweden, Italy, and the United Kingdom
could go only in one direction and depreciate against the mark. Selling these currencies
before the likely depreciation occurred gave speculators an attractive profit
opportunity with potentially high expected returns. The result was the speculative
attack in September 1992 discussed in Chapter 20. Only in France was the commitment
to the fixed exchange rate strong enough so that France did not devalue. The
governments in the other countries were unwilling to defend their currencies at all
costs and eventually allowed their currencies to fall in value.
The different response of France and the United Kingdom after the September
1992 exchange-rate crisis illustrates the potential cost of an exchange-rate target.
France, which continued to peg to the mark and was thus unable to use monetary
policy to respond to domestic conditions, found that economic growth remained slow
after 1992 and unemployment increased. The United Kingdom, on the other hand,
Disadvantages of
Exchange-Rate
Targeting
490 PA RT V International Finance and Monetary Policy
which dropped out of the ERM exchange-rate peg and adopted inflation targeting
(discussed later in this chapter), had much better economic performance: economic
growth was higher, the unemployment rate fell, and yet its inflation was not much
worse than France’s.
In contrast to industrialized countries, emerging market countries (including the
so-called transition countries of Eastern Europe) may not lose much by giving up an
independent monetary policy when they target exchange rates. Because many emerging
market countries have not developed the political or monetary institutions that
allow the successful use of discretionary monetary policy, they may have little to gain
from an independent monetary policy, but a lot to lose. Thus, they would be better
off by, in effect, adopting the monetary policy of a country like the United States
through targeting exchange rates than by pursuing their own independent policy. This
is one of the reasons that so many emerging market countries have adopted exchangerate
targeting.
Nonetheless, exchange-rate targeting is highly dangerous for these countries,
because it leaves them open to speculative attacks that can have far more serious consequences
for their economies than for the economies of industrialized countries.
Indeed, as we saw in Chapters 8 and 20, the successful speculative attacks in Mexico
in 1994, East Asia in 1997, and Argentina in 2002 plunged their economies into fullscale
financial crises that devastated their economies.
An additional disadvantage of an exchange-rate target is that it can weaken the
accountability of policymakers, particularly in emerging market countries. Because
exchange-rate targeting fixes the exchange rate, it eliminates an important signal that
can help constrain monetary policy from becoming too expansionary. In industrialized
countries, particularly in the United States, the bond market provides an important
signal about the stance of monetary policy. Overly expansionary monetary policy
or strong political pressure to engage in overly expansionary monetary policy produces
an inflation scare in which inflation expectations surge, interest rates rise
because of the Fisher effect (described in Chapter 5), and there is a sharp decline in
long-term bond prices. Because both central banks and the politicians want to avoid
this kind of scenario, overly expansionary, time-consistent monetary policy will be
less likely.
In many countries, particularly emerging market countries, the long-term bond
market is essentially nonexistent. Under a flexible exchange-rate regime, however, if
monetary policy is too expansionary, the exchange rate will depreciate. In these countries
the daily fluctuations of the exchange rate can, like the bond market in United
States, provide an early warning signal that monetary policy is too expansionary. Just as
the fear of a visible inflation scare in the bond market constrains central bankers from
pursuing overly expansionary monetary policy and also constrains politicians from putting
pressure on the central bank to engage in overly expansionary monetary policy, fear
of exchange-rate depreciations can make overly expansionary, time-consistent monetary
policy less likely.
The need for signals from the foreign exchange market may be even more acute
for emerging market countries, because the balance sheets and actions of the central
banks are not as transparent as they are in industrialized countries. Targeting the
exchange rate can make it even harder to ascertain the central bank’s policy actions,
as was true in Thailand before the July 1997 currency crisis. The public is less able to
keep a watch on the central banks and the politicians pressuring it, which makes it
easier for monetary policy to become too expansionary.
C H A P T E R 2 1 Monetary Policy Strategy: The International Experience 491
Given the above disadvantages with exchange-rate targeting, when might it make
sense?
In industrialized countries, the biggest cost to exchange-rate targeting is the loss
of an independent monetary policy to deal with domestic considerations. If an independent,
domestic monetary policy can be conducted responsibly, this can be a serious
cost indeed, as the comparison between the post-1992 experience of France and
the United Kingdom indicates. However, not all industrialized countries have found
that they are capable of conducting their own monetary policy successfully, either
because of the lack of independence of the central bank or because political pressures
on the central bank lead to an inflation bias in monetary policy. In these cases, giving
up independent control of domestic monetary policy may not be a great loss, while
the gain of having monetary policy determined by a better-performing central bank
in the anchor country can be substantial.
Italy provides an example: It was not a coincidence that the Italian public was the
most favorable of all those in Europe to the European Monetary Union. The past
record of Italian monetary policy was not good, and the Italian public recognized that
having monetary policy controlled by more responsible outsiders had benefits that far
outweighed the costs of losing the ability to focus monetary policy on domestic considerations.
A second reason why industrialized countries might find targeting exchange rates
useful is that it encourages integration of the domestic economy with its neighbors.
Clearly this was the rationale for long-standing pegging of the exchange rate to the
deutsche mark by countries such as Austria and the Netherlands, and the more recent
exchange-rate pegs that preceded the European Monetary Union.
To sum up, exchange-rate targeting for industrialized countries is probably not
the best monetary policy strategy to control the overall economy unless (1) domestic
monetary and political institutions are not conducive to good monetary policymaking
or (2) there are other important benefits of an exchange-rate target that have nothing
to do with monetary policy.
In countries whose political and monetary institutions are particularly weak and who
therefore have been experiencing continued bouts of hyperinflation, a characterization
that applies to many emerging market (including transition) countries, exchangerate
targeting may be the only way to break inflationary psychology and stabilize the
economy. In this situation, exchange-rate targeting is the stabilization policy of last
resort. However, if the exchange-rate targeting regimes in emerging market countries
are not always transparent, they are more likely to break down, often resulting in disastrous
financial crises.
Are there exchange-rate strategies that make it less likely that the exchange-rate
regime will break down in emerging market countries? Two such strategies that have
received increasing attention in recent years are currency boards and dollarization.
One solution to the problem of lack of transparency and commitment to the exchangerate
target is the adoption of a currency board, in which the domestic currency is
backed 100% by a foreign currency (say, dollars) and in which the note-issuing authority,
whether the central bank or the government, establishes a fixed exchange rate to
this foreign currency and stands ready to exchange domestic currency for the foreign
currency at this rate whenever the public requests it. A currency board is just a variant
of a fixed exchange-rate target in which the commitment to the fixed exchange
Currency Boards
When Is
Exchange-Rate
Targeting
Desirable for
Emerging Market
Countries?
When Is
Exchange-Rate
Targeting
Desirable for
Industrialized
Countries?
492 PA RT V International Finance and Monetary Policy
http://users.erols.com
/kurrency/intro.htm
A detailed discussion of the
history, purpose, and function
of currency boards.
rate is especially strong because the conduct of monetary policy is in effect put on
autopilot, taken completely out of the hands of the central bank and the government.
In contrast, the typical fixed or pegged exchange-rate regime does allow the monetary
authorities some discretion in their conduct of monetary policy because they can still
adjust interest rates or print money.
A currency board arrangement thus has important advantages over a monetary
policy strategy that just uses an exchange-rate target. First, the money supply can
expand only when foreign currency is exchanged for domestic currency at the central
bank. Thus the increased amount of domestic currency is matched by an equal
increase in foreign exchange reserves. The central bank no longer has the ability to
print money and thereby cause inflation. Second, the currency board involves a
stronger commitment by the central bank to the fixed exchange rate and may therefore
be effective in bringing down inflation quickly and in decreasing the likelihood
of a successful speculative attack against the currency.
Although they solve the transparency and commitment problems inherent in an
exchange-rate target regime, currency boards suffer from some of the same shortcomings:
the loss of an independent monetary policy and increased exposure of the economy
to shocks from the anchor country, and the loss of the central bank’s ability to
create money and act as a lender of last resort. Other means must therefore be used to
cope with potential banking crises. Also, if there is a speculative attack on a currency
board, the exchange of the domestic currency for foreign currency leads to a sharp contraction
of the money supply, which can be highly damaging to the economy.
Currency boards have been established recently in countries such as Hong Kong
(1983), Argentina (1991), Estonia (1992), Lithuania (1994), Bulgaria (1997), and
Bosnia (1998). Argentina’s currency board, which operated from 1991 to 2002 and
required the central bank to exchange U.S. dollars for new pesos at a fixed exchange
rate of 1 to 1, is one of the most interesting. Box 1 describes Argentina’s experience
with its currency board.
Another solution to the problems created by a lack of transparency and commitment
to the exchange-rate target is dollarization, the adoption of a sound currency, like the
U.S. dollar, as a country’s money. Indeed, dollarization is just another variant of a
fixed exchange-rate target with an even stronger commitment mechanism than a currency
board provides. A currency board can be abandoned, allowing a change in the
value of the currency, but a change of value is impossible with dollarization: a dollar
bill is always worth one dollar whether it is held in the United States or outside of it.
Dollarization has been advocated as a monetary policy strategy for emerging market
countries: It has been discussed actively by Argentine officials in the aftermath of
the devaluation of the Brazilian real in January 1999 and was adopted by Ecuador in
March 2000. Dollarization’s key advantage is that it completely avoids the possibility
of a speculative attack on the domestic currency (because there is none). (Such an
attack is still a danger even under a currency board arrangement.)
Dollarization is subject to the usual disadvantages of an exchange-rate target (the
loss of an independent monetary policy, increased exposure of the economy to shocks
from the anchor country, and the inability of the central bank to create money and act
as a lender of last resort). Dollarization has one additional disadvantage not characteristic
of currency boards or other exchange-rate target regimes. Because a country
adopting dollarization no longer has its own currency it loses the revenue that a government
receives by issuing money, which is called seignorage. Because governments
Dollarization
C H A P T E R 2 1 Monetary Policy Strategy: The International Experience 493
(or their central banks) do not have to pay interest on their currency, they earn revenue
(seignorage) by using this currency to purchase income-earning assets such as
bonds. In the case of the Federal Reserve in the United States, this revenue is on the
order of $30 billion per year. If an emerging market country dollarizes and gives up
its currency, it needs to make up this loss of revenue somewhere, which is not always
easy for a poor country.
Study Guide As a study aid, the advantages and disadvantages of exchange-rate targeting and the
other monetary policy strategies are listed in Table 1.
494 PA RT V International Finance and Monetary Policy
Box 1: Global
Argentina’s Currency Board
Argentina has had a long history of monetary instability,
with inflation rates fluctuating dramatically and
sometimes surging to beyond 1,000% a year. To end
this cycle of inflationary surges, Argentina decided to
adopt a currency board in April 1991. The Argentine
currency board worked as follows. Under Argentina’s
convertibility law, the peso/dollar exchange rate was
fixed at one to one, and a member of the public can
go to the Argentine central bank and exchange a peso
for a dollar, or vice versa, at any time.
The early years of Argentina’s currency board
looked stunningly successful. Inflation, which had
been running at an 800% annual rate in 1990, fell to
less than 5% by the end of 1994, and economic
growth was rapid, averaging almost 8% at an annual
rate from 1991 to 1994. In the aftermath of the
Mexican peso crisis, however, concern about the
health of the Argentine economy resulted in the public
pulling money out of the banks (deposits fell by
18%) and exchanging pesos for dollars, thus causing
a contraction of the Argentine money supply. The
result was a sharp drop in Argentine economic activity,
with real GDP shrinking by more than 5% in 1995
and the unemployment rate jumping above 15%.
Only in 1996 did the economy begin to recover.
Because the central bank of Argentina had no control
over monetary policy under the currency board
system, it was relatively helpless to counteract the contractionary
monetary policy stemming from the public’s
behavior. Furthermore, because the currency
board did not allow the central bank to create pesos
and lend them to the banks, it had very little capability
to act as a lender of last resort. With help from international
agencies, such as the IMF, the World Bank, and
the Interamerican Development Bank, which
lent Argentina over $5 billion in 1995 to help shore up
its banking system, the currency board survived.
However, in 1998 Argentina entered another recession,
which was both severe and very long lasting. By
the end of 2001, unemployment reached nearly 20%,
a level comparable to that experienced in the United
States during the Great Depression of the 1930s. The
result has been civil unrest and the fall of the elected
government, as well as a major banking crisis and a
default on nearly $150 billion of government debt.
Because the Central Bank of Argentina had no control
over monetary policy under the currency board system,
it was unable to use monetary policy to expand
the economy and get out of its recession. Furthermore,
because the currency board did not allow the central
bank to create pesos and lend them to banks, it had
very little capability to act as a lender of last resort. In
January 2002, the currency board finally collapsed
and the peso depreciated by more than 70%. The
result was the full-scale financial crisis described in
Chapter 8, with inflation shooting up and an extremely
severe depression. Clearly, the Argentine public is not
as enamored of its currency board as it once was.
C H A P T E R 2 1 Monetary Policy Strategy: The International Experience 495
S U M M A R Y Table 1 Advantages and Disadvantages of Different Monetary Policy Strategies
Exchange-Rate Monetary Inflation Implicit Nominal
Targeting Targeting Targeting Anchor
Advantages
Directly ties down
inflation of internationally
traded goods
Automatic rule for conduct
of monetary policy
Simplicity and clarity Simplicity and clarity
of target of target
Independent monetary Independent monetary Independent monetary
policy can focus on policy can focus on policy can focus on
domestic considerations domestic considerations domestic considerations
Immediate signal on
achievement of target
Does not rely on stable Does not rely on stable
money–inflation relationship money–inflation relationship
Increased accountability of
central bank
Reduced effects of
inflationary shocks
Demonstrated success in U.S.
Disadvantages
Loss of independent
monetary policy
Open to speculative attacks
(less for currency board
and not a problem for
dollarization)
Loss of exchangerate
signal
Relies on stable money–
inflation relationship
Delayed signal about
achievement of target
Could impose rigid rule
(though not in practice)
Larger output fluctuations
if sole focus on inflation
(though not in practice)
Lack of transparency
Success depends on
individuals
Low accountability
Monetary Targeting
In many countries, exchange-rate targeting is not an option, because either the country
(or bloc of countries) is too large or because there is no country whose currency
is an obvious choice to serve as the nominal anchor. Exchange-rate targeting is therefore
clearly not an option for the United States, Japan, or the European Monetary
Union. These countries must look to other strategies for the conduct of monetary policy,
one of which is monetary targeting.
In the 1970s, monetary targeting was adopted by several countries, notably Germany,
Switzerland, Canada, the United Kingdom, and Japan, as well as in the United States
(already discussed in Chapter 18). This strategy involves using monetary aggregates
as an intermediate target of the type described in Chapter 18 to achieve an ultimate
goal such as price stability. Monetary targeting as practiced was quite different from
Milton Friedman’s suggestion that the chosen monetary aggregate be targeted to grow
at a constant rate. Indeed, in all these countries the central banks never adhered to
strict, ironclad rules for monetary growth and in some of these countries monetary
targeting was not pursued very seriously.
Canada and the United Kingdom. In a move similar to that made by the United States,
the Bank of Canada responded to a rise in inflation in the early 1970s by introducing
a program of monetary targeting referred to as “monetary gradualism.” Under this policy,
which began in 1975, M1 growth would be controlled within a gradually falling
target range. The British introduced monetary targeting in late 1973, also in response
to mounting concerns about inflation. The Bank of England targeted M3, a broader
monetary target than the Bank of Canada or the Fed used.
By 1978, only three years after monetary targeting had begun, the Bank of
Canada began to distance itself from this strategy out of concern for the exchange rate.
Because of the conflict with exchange-rate goals, as well as the uncertainty about M1
as a reliable guide to monetary policy, the M1 targets were abandoned in November
1982. Gerald Bouey, then governor of the Bank of Canada, described the situation by
saying, “We didn’t abandon monetary aggregates, they abandoned us.”
In the United Kingdom, after monetary aggregates overshot their targets and
inflation accelerated in the late 1970s, Prime Minister Margaret Thatcher in 1980
introduced the Medium-Term Financial Strategy, which proposed a gradual deceleration
of M3 growth. Unfortunately, the M3 targets ran into problems similar to those
of the M1 targets in the United States: They were not reliable indicators of the tightness
of monetary policy. After 1983, arguing that financial innovation was wreaking
havoc with the relationship between M3 and national income, the Bank of England
began to de-emphasize M3 in favor of a narrower monetary aggregate, M0 (the monetary
base). The target for M3 was temporarily suspended in October 1985 and was
completely dropped in 1987.
A feature of monetary targeting in Canada and especially in the United Kingdom
was that there was substantial game playing: Their central banks targeted multiple
aggregates, allowed base drift (by applying target growth rates to a new base at which
the target ended up every period), did not announce targets on a regular schedule,
used artificial means to bring down the growth of a targeted aggregate, often overshot
their targets without reversing the overshoot later, and often obscured why deviations
from the monetary targets occurred.
Monetary
Targeting in
Canada, the
United Kingdom,
Japan, Germany,
and Switzerland
496 PA RT V International Finance and Monetary Policy
Japan. The increase in oil prices in late 1973 was a major shock for Japan, which
experienced a huge jump in the inflation rate, to greater than 20% in 1974—a surge
facilitated by money growth in 1973 in excess of 20%. The Bank of Japan, like the
other central banks discussed here, began to pay more attention to money growth
rates. In 1978, the Bank of Japan began to announce “forecasts” at the beginning of
each quarter for M2 CDs. Although the Bank of Japan was not officially committed
to monetary targeting, monetary policy appeared to be more money-focused after
1978. For example, after the second oil price shock in 1979, the Bank of Japan
quickly reduced M2 CDs growth, rather than allowing it to shoot up as occurred
after the first oil shock. The Bank of Japan conducted monetary policy with operating
procedures that were similar in many ways to those that the Federal Reserve has used
in the United States. The Bank of Japan uses the interest rate in the Japanese interbank
market (which has a function similar to that of the federal funds market in the
United States) as its daily operating target, just as the Fed has done.
The Bank of Japan’s monetary policy performance during the 1978–1987 period
was much better than the Fed’s. Money growth in Japan slowed gradually, beginning
in the mid-1970s, and was much less variable than in the United States. The outcome
was a more rapid braking of inflation and a lower average inflation rate. In addition,
these excellent results on inflation were achieved with lower variability in real output
in Japan than in the United States.
In parallel with the United States, financial innovation and deregulation in Japan
began to reduce the usefulness of the M2 CDs monetary aggregate as an indicator
of monetary policy. Because of concerns about the appreciation of the yen, the Bank
of Japan significantly increased the rate of money growth from 1987 to 1989. Many
observers blame speculation in Japanese land and stock prices (the so-called bubble
economy) on the increase in money growth. To reduce this speculation, in 1989 the
Bank of Japan switched to a tighter monetary policy aimed at slower money growth.
The aftermath was a substantial decline in land and stock prices and the collapse of
the bubble economy.
The 1990s and afterwards has not been a happy period for the Japanese economy.
The collapse of land and stock prices helped provoke a severe banking crisis, discussed
in Chapter 11, that has continued to be a severe drag on the economy. The
resulting weakness of the economy has even led to bouts of deflation, promoting further
financial instability. The outcome has been an economy that has been stagnating
for over a decade. Many critics believe that the Bank of Japan has pursued overly tight
monetary policy and needs to substantially increase money growth in order to lift the
economy out of its stagnation.
Germany and Switzerland. The two countries that officially engaged in monetary targeting
for over 20 years starting at the end of 1974 were Germany and Switzerland,
and this is why we will devote more attention to them. The success of monetary policy
in these two countries in controlling inflation is the reason that monetary targeting
still has strong advocates and is an element of the official policy regime for the
European Central Bank (see Box 2).
The monetary aggregate chosen by the Germans was a narrow one they called
central bank money, the sum of currency in circulation and bank deposits weighted by
the 1974 required reserve ratios. In 1988, the Bundesbank switched targets from central
bank money to M3. The Swiss began targeting the M1 monetary aggregate, but in
1980 switched to the narrower monetary aggregate, M0, the monetary base.
C H A P T E R 2 1 Monetary Policy Strategy: The International Experience 497
The key fact about monetary targeting regimes in Germany and Switzerland is
that the targeting regimes were very far from a Friedman-type monetary targeting rule
in which a monetary aggregate is kept on a constant-growth-rate path and is the primary
focus of monetary policy. As Otmar Issing, at the time the chief economist of the
Bundesbank has noted, “One of the secrets of success of the German policy of moneygrowth
targeting was that ... it often did not feel bound by monetarist orthodoxy as
far as its more technical details were concerned.”2 The Bundesbank allowed growth
outside of its target ranges for periods of two to three years, and overshoots of its targets
were subsequently reversed. Monetary targeting in Germany and Switzerland was
instead primarily a method of communicating the strategy of monetary policy focused
on long-run considerations and the control of inflation.
The calculation of monetary target ranges put great stress on making policy transparent
(clear, simple, and understandable) and on regular communication with the
public. First and foremost, a numerical inflation goal was prominently featured in the
setting of target ranges. Second, monetary targeting, far from being a rigid policy rule,
was quite flexible in practice. The target ranges for money growth were missed on the
order of 50% of the time in Germany, often because of the Bundesbank’s concern
about other objectives, including output and exchange rates. Furthermore, the
Bundesbank demonstrated its flexibility by allowing its inflation goal to vary over
time and to converge gradually to the long-run inflation goal.
498 PA RT V International Finance and Monetary Policy
2Otmar Issing, “Is Monetary Targeting in Germany Still Adequate?” In Monetary Policy in an Integrated World
Economy: Symposium 1995, ed. Horst Siebert (Tübingen: Mohr, 1996), p. 120.
Box 2: Global
The European Central Bank’s Monetary Policy Strategy
The European Central Bank (ECB) has adopted a
hybrid monetary policy strategy that has much in
common with the monetary targeting strategy previously
used by the Bundesbank but also has some elements
of inflation targeting. The ECB’s strategy has
two key “pillars.” First is a prominent role for monetary
aggregates with a “reference value” for the growth
rate of a monetary aggregate (M3). Second is a
broadly based assessment of the outlook for future
price developments with a goal of price stability
defined as a year-on-year increase in the consumer
price index below 2%. After critics pointed out that a
deflationary situation with negative inflation would
satisfy the stated price stability criteria, the ECB provided
a clarification that inflation meant positive
inflation only, so that the price stability goal should
be interpreted as a range for inflation of 0–2%.
The ECB’s strategy is somewhat unclear and has
been subjected to criticism for this reason. Although
the 0–2% range for the goal of price stability sounds
like an inflation target, the ECB has not been willing
to live with this interpretation—it has repeatedly
stated that it does not have an inflation target. On the
other hand, the ECB has downgraded the importance
of monetary aggregates in its strategy by using the
term “reference value” rather than “target” in describing
its strategy and has indicated that it will also
monitor broadly based developments on the price
level. The ECB seems to have decided to try to have
its cake and eat it too by not committing too strongly
to either a monetary or an inflation-targeting strategy.
The resulting difficulty of assessing what the ECB’s
strategy is likely to be has the potential to reduce the
accountability of this new institution.
When the Bundesbank first set its monetary targets at the end of 1974, it
announced a medium-term inflation goal of 4%, well above what it considered to be
an appropriate long-run goal. It clarified that this medium-term inflation goal differed
from the long-run goal by labeling it the “unavoidable rate of price increase.” Its gradualist
approach to reducing inflation led to a period of nine years before the mediumterm
inflation goal was considered to be consistent with price stability. When this
occurred at the end of 1984, the medium-term inflation goal was renamed the “normative
rate of price increase” and was set at 2%. It continued at this level until 1997,
when it was changed to 1.5 to 2%. The Bundesbank also responded to negative supply
shocks, restrictions in the supply of energy or raw materials that raise the price
level, by raising its medium-term inflation goal: specifically, it raised the unavoidable
rate of price increase from 3.5% to 4% in the aftermath of the second oil price shock
in 1980.
The monetary targeting regimes in Germany and Switzerland demonstrated a
strong commitment to clear communication of the strategy to the general public. The
money growth targets were continually used as a framework to explain the monetary
policy strategy, and both the Bundesbank and the Swiss National Bank expended
tremendous effort in their publications and in frequent speeches by central bank officials
to communicate to the public what the central bank was trying to achieve. Given
that both central banks frequently missed their money growth targets by significant
amounts, their monetary targeting frameworks are best viewed as a mechanism for
transparently communicating how monetary policy is being directed to achieve inflation
goals and as a means for increasing the accountability of the central bank.
The success of Germany’s monetary targeting regime in producing low inflation
has been envied by many other countries, explaining why it was chosen as the anchor
country for the exchange rate mechanism. One clear indication of Germany’s success
occurred in the aftermath of German reunification in 1990. Despite a temporary surge
in inflation stemming from the terms of reunification, high wage demands, and the
fiscal expansion, the Bundesbank was able to keep these temporary effects from
becoming embedded in the inflation process, and by 1995, inflation fell back down
below the Bundesbank’s normative inflation goal of 2%.
Monetary targeting in Switzerland has been more problematic than in Germany,
suggesting the difficulties of targeting monetary aggregates in a small open economy
that also underwent substantial changes in the institutional structure of its money
markets. In the face of a 40% trade-weighted appreciation of the Swiss franc from the
fall of 1977 to the fall of 1978, the Swiss National Bank decided that the country
could not tolerate this high a level of the exchange rate. Thus, in the fall of 1978, the
monetary targeting regime was abandoned temporarily, with a shift from a monetary
target to an exchange-rate target until the spring of 1979, when monetary targeting
was reintroduced (although not announced).
The period from 1989 to 1992 was also not a happy one for Swiss monetary targeting,
because the Swiss National Bank failed to maintain price stability after it successfully
reduced inflation. The substantial overshoot of inflation from 1989 to 1992,
reaching levels above 5%, was due to two factors. The first was that the strength of
the Swiss franc from 1985 to 1987 caused the Swiss National Bank to allow the monetary
base to grow at a rate greater than the 2% target in 1987 and then caused it to
raise the money growth target to 3% for 1988. The second arose from the introduction
of a new interbank payment system, Swiss Interbank Clearing (SIC), and a wideranging
revision of the commercial banks’ liquidity requirements in 1988. The result
C H A P T E R 2 1 Monetary Policy Strategy: The International Experience 499
of the shocks to the exchange rate and the shift in the demand for monetary base arising
from the above institutional changes created a serious problem for its targeted
aggregate. As the 1988 year unfolded, it became clear that the Swiss National Bank
had guessed wrong in predicting the effects of these shocks, so that monetary policy
was too easy, even though the monetary target was undershot. The result was a subsequent
rise in inflation to above the 5% level.
As a result of these problems with monetary targeting Switzerland substantially
loosened its monetary targeting regime (and ultimately, adopted inflation targeting in
2000). The Swiss National Bank recognized that its money growth targets were of
diminished utility as a means of signaling the direction of monetary policy. Thus, its
announcement at the end of 1990 of the medium-term growth path did not specify a
horizon for the target or the starting point of the growth path. At the end of 1992, the
bank specified the starting point for the expansion path, and at the end of 1994, it
announced a new medium-term path for money base growth for the period 1995 to
1999. By setting this path, the bank revealed retroactively that the horizon of the first
path was also five years (1990–1995). Clearly, the Swiss National Bank moved to a
much more flexible framework in which hitting one-year targets for money base
growth has been abandoned. Nevertheless, Swiss monetary policy continued to be
successful in controlling inflation, with inflation rates falling back down below the 1%
level after the temporary bulge in inflation from 1989 to 1992.
There are two key lessons to be learned from our discussion of German and Swiss
monetary targeting. First, a monetary targeting regime can restrain inflation in the
longer run, even when the regime permits substantial target misses. Thus adherence
to a rigid policy rule has not been found to be necessary to obtain good inflation outcomes.
Second, the key reason why monetary targeting has been reasonably successful
in these two countries, despite frequent target misses, is that the objectives of
monetary policy are clearly stated and both the central banks actively engaged in
communicating the strategy of monetary policy to the public, thereby enhancing the
transparency of monetary policy and the accountability of the central bank.
As we will see in the next section, these key elements of a successful targeting
regime—flexibility, transparency, and accountability—are also important elements in
inflation-targeting regimes. German and Swiss monetary policy was actually closer in
practice to inflation targeting than it was to Friedman-like monetary targeting, and
thus might best be thought of as “hybrid” inflation targeting.
A major advantage of monetary targeting over exchange-rate targeting is that it
enables a central bank to adjust its monetary policy to cope with domestic considerations.
It enables the central bank to choose goals for inflation that may differ
from those of other countries and allows some response to output fluctuations. Also,
as with an exchange-rate target, information on whether the central bank is achieving
its target is known almost immediately—figures for monetary aggregates are
typically reported within a couple of weeks. Thus, monetary targets can send almost
immediate signals to the public and markets about the stance of monetary policy and
the intentions of the policymakers to keep inflation in check. In turn, these signals
help fix inflation expectations and produce less inflation. Monetary targets also
allow almost immediate accountability for monetary policy to keep inflation low,
thus helping to constrain the monetary policymaker from falling into the timeconsistency
trap.
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All of the above advantages of monetary aggregate targeting depend on a big if: There
must be a strong and reliable relationship between the goal variable (inflation or nominal
income) and the targeted aggregate. If the relationship between the monetary
aggregate and the goal variable is weak, monetary aggregate targeting will not work;
this seems to have been a serious problem in Canada, the United Kingdom, and
Switzerland, as well as in the United States. The weak relationship implies that hitting
the target will not produce the desired outcome on the goal variable and thus the
monetary aggregate will no longer provide an adequate signal about the stance of
monetary policy. As a result, monetary targeting will not help fix inflation expectations
and be a good guide for assessing the accountability of the central bank. In addition,
an unreliable relationship between monetary aggregates and goal variables
makes it difficult for monetary targeting to serve as a communications device that
increases the transparency of monetary policy and makes the central bank accountable
to the public.
Inflation Targeting
Given the breakdown of the relationship between monetary aggregates and goal variables
such as inflation, many countries that want to maintain an independent monetary
policy have recently adopted inflation targeting as their monetary policy regime.
New Zealand was the first country to formally adopt inflation targeting in 1990, followed
by Canada in 1991, the United Kingdom in 1992, Sweden and Finland in
1993, and Australia and Spain in 1994. Israel, Chile, and Brazil, among others, have
also adopted a form of inflation targeting.
Inflation targeting involves several elements: (1) public announcement of
medium-term numerical targets for inflation; (2) an institutional commitment to price
stability as the primary, long-run goal of monetary policy and a commitment to
achieve the inflation goal; (3) an information-inclusive strategy in which many variables
and not just monetary aggregates are used in making decisions about monetary
policy; (4) increased transparency of the monetary policy strategy through communication
with the public and the markets about the plans and objectives of monetary
policymakers; and (5) increased accountability of the central bank for attaining its
inflation objectives.
We begin our look at inflation targeting with New Zealand, because it was the first
country to adopt it. We then go on to look at the experiences in Canada and the
United Kingdom, which were next to adopt this strategy.3
New Zealand. As part of a general reform of the government’s role in the economy,
the New Zealand parliament passed a new Reserve Bank of New Zealand Act in 1989,
Inflation Targeting
in New Zealand,
Canada, and the
United Kingdom
Disadvantages
of Monetary
Targeting
C H A P T E R 2 1 Monetary Policy Strategy: The International Experience 501
3For further discussion of experiences with inflation targeting, particularly in other countries, see Leonardo
Leiderman and Lars E. O. Svensson, Inflation Targeting (London: Centre for Economic Policy Research, 1995);
Frederic S. Mishkin and Adam Posen, “Inflation Targeting: Lessons from Four Countries,” Federal Reserve Bank
of New York, Economic Policy Review 3 (August 1997), pp. 9–110; and Ben S. Bernanke, Thomas Laubach,
Frederic S. Mishkin, and Adam S. Posen, Inflation Targeting: Lessons from the International Experience (Princeton:
Princeton University Press, 1999).
www.ny.frb.org/rmaghome
/econ_pol/897fmis.htm
Research on inflation targeting
published by the Federal
Reserve and coauthored by the
author of this text.
which became effective on February 1, 1990. Besides increasing the independence of
the central bank, moving it from being one of the least independent to one of the most
independent among the developed countries, the act also committed the Reserve
Bank to a sole objective of price stability. The act stipulated that the minister of
finance and the governor of the Reserve Bank should negotiate and make public a
Policy Targets Agreement, a statement that sets out the targets by which monetary policy
performance will be evaluated, specifying numerical target ranges for inflation and
the dates by which they are to be reached. An unusual feature of the New Zealand legislation
is that the governor of the Reserve Bank is held highly accountable for the success
of monetary policy. If the goals set forth in the Policy Targets Agreement are not
satisfied, the governor is subject to dismissal.
The first Policy Targets Agreement, signed by the minister of finance and the governor
of the Reserve Bank on March 2, 1990, directed the Reserve Bank to achieve an
annual inflation rate within a 3–5% range. Subsequent agreements lowered the range
to 0–2% until the end of 1996, when the range was changed to 0–3%. As a result of
tight monetary policy, the inflation rate was brought down from above 5% to below
2% by the end of 1992 (see Figure 1, panel a), but at the cost of a deep recession and
a sharp rise in unemployment. Since then, inflation has typically remained within the
targeted range, with the exception of a brief period in 1995 when it exceeded the
range by a few tenths of a percentage point. (Under the Reserve Bank Act, the governor,
Donald Brash, could have been dismissed, but after parliamentary debate he was
retained in his job.) Since 1992, New Zealand’s growth rate has generally been high,
with some years exceeding 5%, and unemployment has come down significantly.
Canada. On February 26, 1991, a joint announcement by the minister of finance and
the governor of the Bank of Canada established formal inflation targets. The target
ranges were 2–4% by the end of 1992, 1.5–3.5% by June 1994, and 1–3% by
December 1996. After the new government took office in late 1993, the target range
was set at 1–3% from December 1995 until December 1998 and has been kept at this
level. Canadian inflation has also fallen dramatically since the adoption of inflation
targets, from above 5% in 1991, to a 0% rate in 1995, and to between 1 and 2% in
the late 1990s (see Figure 1, panel b). As was the case in New Zealand, however, this
decline was not without cost: unemployment soared to above 10% from 1991 until
1994, but then declined substantially.
United Kingdom. Once the U.K. left the European Monetary System after the speculative
attack on the pound in September 1992 (discussed in Chapter 20), the British
decided to turn to inflation targets instead of the exchange rate as their nominal
anchor. As you may recall from Chapter 14, the central bank in the U.K., the Bank of
England, did not have statutory authority over monetary policy until 1997; it could
only make recommendations about monetary policy. Thus it was the chancellor of the
Exchequer (the equivalent of the U.S. Treasury secretary) who announced an inflation
target for the U.K. on October 8, 1992. Three weeks later he “invited” the governor
of the Bank of England to begin producing an Inflation Report, a quarterly report on
the progress being made in achieving the target—an invitation the governor accepted.
The inflation target range was set at 1–4% until the next election, spring 1997 at the
latest, with the intent that the inflation rate should settle down to the lower half of the
range (below 2.5%). In May 1997, after the new Labour government came into
power, it adopted a point target of 2.5% for inflation and gave the Bank of England
the power to set interest rates henceforth, granting it a more independent role in monetary
policy.
502 PA RT V International Finance and Monetary Policy
C H A P T E R 2 1 Monetary Policy Strategy: The International Experience 503
F I G U R E 1 Inflation Rates and Inflation Targets for New Zealand, Canada, and the United Kingdom, 1980–2002
(a) New Zealand; (b) Canada; (c) United Kingdom
Source: Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Poson, Inflation Targeting: Lessons from the International Experience (Princeton:
Princeton University Press, 1999), updates from the same sources, and www.rbnz.govt.nz/statistics/econind/a3/ha3.xls.
(c) United Kingdom
Inflation
(%)
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
0
5
10
15
20
25
(a) New Zealand
0
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
2001 2002 2003
2001 2002 2003
5
10
15
20
Inflation
(%)
Inflation
targeting
begins
Inflation
targeting
begins
Inflation
targeting
begins
(b) Canada
Inflation
(%)
-2
0
5
10
15
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Target range
Target midpoint
Target range
Target midpoint
Target range
Target midpoint
Before the adoption of inflation targets, inflation had already been falling in the
U.K. from a peak of 9% at the beginning of 1991 to 4% at the time of adoption (see
Figure 1, panel c). After a small upward movement in early 1993, inflation continued
to fall until by the third quarter of 1994, it was at 2.2%, within the intended range
articulated by the chancellor. Subsequently inflation rose, climbing slightly above the
2.5% level by 1996, but has remained around the 2.5% target since then. Meanwhile,
growth of the U.K. economy has been strong, causing a substantial reduction in the
unemployment rate.
Inflation targeting has several advantages over exchange-rate and monetary targeting
as a strategy for the conduct of monetary policy. In contrast to exchange-rate targeting,
but like monetary targeting, inflation targeting enables monetary policy to focus
on domestic considerations and to respond to shocks to the domestic economy.
Inflation targeting also has the advantage that stability in the relationship between
money and inflation is not critical to its success, because it does not rely on this relationship.
An inflation target allows the monetary authorities to use all available information,
not just one variable, to determine the best settings for monetary policy.
Inflation targeting, like exchange-rate targeting, also has the key advantage that it
is readily understood by the public and is thus highly transparent. Monetary targets,
in contrast, are less likely to be easily understood by the public than inflation targets,
and if the relationship between monetary aggregates and the inflation goal variable is
subject to unpredictable shifts, as has occurred in many countries, monetary targets
lose their transparency because they are no longer able to accurately signal the stance
of monetary policy.
Because an explicit numerical inflation target increases the accountability of the
central bank, inflation targeting also has the potential to reduce the likelihood that the
central bank will fall into the time-consistency trap, trying to expand output and
employment by pursuing overly expansionary monetary policy. A key advantage of
inflation targeting is that it can help focus the political debate on what a central bank
can do in the long run—that is, control inflation, rather than what it cannot do, which
is permanently increase economic growth and the number of jobs through expansionary
monetary policy. Thus, inflation targeting has the potential to reduce political
pressures on the central bank to pursue inflationary monetary policy and thereby to
reduce the likelihood of time-consistent policymaking.
Inflation-targeting regimes also put great stress on making policy transparent and
on regular communication with the public. Inflation-targeting central banks have frequent
communications with the government, some mandated by law and some in
response to informal inquiries, and their officials take every opportunity to make public
speeches on their monetary policy strategy. While these techniques are also commonly
used in countries that have not adopted inflation targeting (such as Germany
before EMU and the United States), inflation-targeting central banks have taken public
outreach a step further: not only do they engage in extended public information
campaigns, including the distribution of glossy brochures, but they publish documents
like the Bank of England’s Inflation Report. The publication of these documents
is particularly noteworthy, because they depart from the usual dull-looking, formal
reports of central banks and use fancy graphics, boxes, and other eye-catching design
elements to engage the public’s interest.
The above channels of communication are used by central banks in inflationtargeting
countries to explain the following concepts to the general public, financial
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market participants, and the politicians: (1) the goals and limitations of monetary policy,
including the rationale for inflation targets; (2) the numerical values of the inflation
targets and how they were determined, (3) how the inflation targets are to be
achieved, given current economic conditions; and (4) reasons for any deviations from
targets. These communications have improved private sector planning by reducing
uncertainty about monetary policy, interest rates, and inflation; they have promoted
public debate of monetary policy, in part by educating the public about what a central
bank can and cannot achieve; and they have helped clarify the responsibilities of
the central bank and of politicians in the conduct of monetary policy.
Another key feature of inflation-targeting regimes is the tendency toward
increased accountability of the central bank. Indeed, transparency and communication
go hand in hand with increased accountability. The strongest case of accountability
of a central bank in an inflation-targeting regime is in New Zealand, where the
government has the right to dismiss the Reserve Bank’s governor if the inflation targets
are breached, even for one quarter. In other inflation-targeting countries, the central
bank’s accountability is less formalized. Nevertheless, the transparency of policy
associated with inflation targeting has tended to make the central bank highly
accountable to the public and the government. Sustained success in the conduct of
monetary policy as measured against a pre-announced and well-defined inflation target
can be instrumental in building public support for a central bank’s independence
and for its policies. This building of public support and accountability occurs even in
the absence of a rigidly defined and legalistic standard of performance evaluation and
punishment.
Two remarkable examples illustrate the benefits of transparency and accountability
in the inflation-targeting framework. The first occurred in Canada in 1996, when
the president of the Canadian Economic Association made a speech criticizing the
Bank of Canada for pursuing monetary policy that he claimed was too contractionary.
His speech sparked a widespread public debate. In countries not pursuing inflation
targeting, such debates often degenerate into calls for the immediate expansion of
monetary policy with little reference to the long-run consequences of such a policy
change. In this case, however, the very existence of inflation targeting channeled the
debate into a discussion over what should be the appropriate target for inflation, with
both the bank and its critics obliged to make explicit their assumptions and estimates
of the costs and benefits of different levels of inflation. Indeed, the debate and the
Bank of Canada’s record and responsiveness increased support for the Bank of
Canada, with the result that criticism of the bank and its conduct of monetary policy
was not a major issue in the 1997 elections as it had been before the 1993 elections.
The second example occurred upon the granting of operational independence to
the Bank of England on May 6, 1997. Prior to that date, the government, as represented
by the chancellor of the Exchequer, controlled the decision to set monetary policy
instruments, while the Bank of England was relegated to acting as the government’s
counterinflationary conscience. On May 6, the new chancellor of the Exchequer,
Gordon Brown, announced that the Bank of England would henceforth have the
responsibility for setting interest rates and for engaging in short-term exchange-rate
interventions. Two factors were cited by Chancellor Brown that justified the government’s
decision: first was the bank’s successful performance over time as measured
against an announced clear target; second was the increased accountability that an
independent central bank is exposed to under an inflation-targeting framework, making
the bank more responsive to political oversight. The granting of operational independence
C H A P T E R 2 1 Monetary Policy Strategy: The International Experience 505
to the Bank of England occurred because it would operate under a monetary policy
regime to ensure that monetary policy goals cannot diverge from the interests of society
for extended periods of time. Nonetheless, monetary policy was to be insulated
from short-run political considerations. An inflation-targeting regime makes it more
palatable to have an independent central bank that focuses on long-run objectives but
is consistent with a democratic society because it is accountable.
The performance of inflation-targeting regimes has been quite good. Inflationtargeting
countries seem to have significantly reduced both the rate of inflation and
inflation expectations beyond what would likely have occurred in the absence of inflation
targets. Furthermore, once down, inflation in these countries has stayed down;
following disinflations, the inflation rate in targeting countries has not bounced back
up during subsequent cyclical expansions of the economy.
Inflation targeting also seems to ameliorate the effects of inflationary shocks. For
example, shortly after adopting inflation targets in February 1991, the Bank of
Canada was faced with a new goods and services tax (GST), an indirect tax similar to
a value-added tax—an adverse supply shock that in earlier periods might have led to
a ratcheting up in inflation. Instead the tax increase led to only a one-time increase in
the price level; it did not generate second- and third-round increases in wages and
prices that would have led to a persistent rise in the inflation rate. Another example
is the experience of the United Kingdom and Sweden following their departures from
the ERM exchange-rate pegs in 1992. In both cases, devaluation would normally have
stimulated inflation because of the direct effects on higher export and import prices
from devaluation and the subsequent effects on wage demands and price-setting
behavior. Again, it seems reasonable to attribute the lack of inflationary response in
these episodes to adoption of inflation targeting, which short-circuited the secondand
later-round effects and helped to focus public attention on the temporary nature
of the inflation shocks. Indeed, one reason why inflation targets were adopted in both
countries was to achieve exactly this result.
Critics of inflation targeting cite four disadvantages/criticisms of this monetary policy
strategy: delayed signaling, too much rigidity, the potential for increased output fluctuations,
and low economic growth. We look at each in turn and examine the validity
of these criticisms.
Delayed Signaling. In contrast to exchange rates and monetary aggregates, inflation is
not easily controlled by the monetary authorities. Furthermore, because of the long
lags in the effects of monetary policy, inflation outcomes are revealed only after a substantial
lag. Thus, an inflation target is unable to send immediate signals to both the
public and markets about the stance of monetary policy. However, we have seen that
the signals provided by monetary aggregates may not be very strong and that an
exchange-rate peg may obscure the ability of the foreign exchange market to signal
overly expansionary policies. Hence, it is not at all clear that these other strategies are
superior to inflation targeting on these grounds.
Too Much Rigidity. Some economists have criticized inflation targeting because they
believe it imposes a rigid rule on monetary policymakers, limiting their discretion to
respond to unforeseen circumstances. For example, policymakers in countries that
adopted monetary targeting did not foresee the breakdown of the relationship
between monetary aggregates and goal variables such as nominal spending or infla-
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tion. With rigid adherence to a monetary rule, the breakdown in their relationship
could have been disastrous. However, the traditional distinction between rules and
discretion can be highly misleading. Useful policy strategies exist that are “rule-like,”
in that they involve forward-looking behavior that limits policymakers from systematically
engaging in policies with undesirable long-run consequences. Such policies
avoid the time-consistency problem and would best be described as “constrained
discretion.”
Indeed, inflation targeting can be described exactly in this way. Inflation targeting,
as actually practiced, is far from rigid. First, inflation targeting does not prescribe
simple and mechanical instructions on how the central bank should conduct monetary
policy. Rather, it requires the central bank to use all available information to
determine what policy actions are appropriate to achieve the inflation target. Unlike
simple policy rules, inflation targeting never requires the central bank to focus solely
on one key variable. Second, inflation targeting as practiced contains a substantial
degree of policy discretion. Inflation targets have been modified depending on economic
circumstances, as we have seen. Moreover, central banks under inflation-targeting
regimes have left themselves considerable scope to respond to output growth and
fluctuations through several devices.
Potential for Increased Output Fluctuations. An important criticism of inflation targeting
is that a sole focus on inflation may lead to monetary policy that is too tight when
inflation is above target and thus may lead to larger output fluctuations. Inflation targeting
does not, however, require a sole focus on inflation—in fact, experience has
shown that inflation targeters do display substantial concern about output fluctuations.
All the inflation targeters have set their inflation targets above zero.4 For example,
currently New Zealand has the lowest midpoint for an inflation target, 1.5%,
while Canada and Sweden set the midpoint of their inflation target at 2%; and the
United Kingdom and Australia currently have their midpoints at 2.5%.
The decision by inflation targeters to choose inflation targets above zero reflects
the concern of monetary policymakers that particularly low inflation can have substantial
negative effects on real economic activity. Deflation (negative inflation in
which the price level actually falls) is especially to be feared because of the possibility
that it may promote financial instability and precipitate a severe economic contraction
(Chapter 8). The deflation in Japan in recent years has been an important
factor in the weakening of the Japanese financial system and economy. Targeting inflation
rates of above zero makes periods of deflation less likely. This is one reason why
some economists both within and outside of Japan have been calling on the Bank of
Japan to adopt an inflation target at levels of 2% or higher.
Inflation targeting also does not ignore traditional stabilization goals. Central
bankers in inflation-targeting countries continue to express their concern about fluctuations
in output and employment, and the ability to accommodate short-run stabilization
goals to some degree is built into all inflation-targeting regimes. All
inflation-targeting countries have been willing to minimize output declines by gradually
lowering medium-term inflation targets toward the long-run goal.
C H A P T E R 2 1 Monetary Policy Strategy: The International Experience 507
4CPI indices have been found to have an upward bias in the measurement of true inflation, and so it is not surprising
that inflation targets would be chosen to exceed zero. However, the actual targets have been set to exceed
the estimates of this measurement bias, indicating that inflation targeters have decided to have targets for inflation
that exceed zero even after measurement bias is accounted for.
In addition, many inflation targeters, particularly the Bank of Canada, have
emphasized that the floor of the target range should be emphasized every bit as much
as the ceiling, thus helping to stabilize the real economy when there are negative
shocks to demand. Inflation targets can increase the central bank’s flexibility in
responding to declines in aggregate spending. Declines in aggregate demand that
cause the inflation rate to fall below the floor of the target range will automatically
stimulate the central bank to loosen monetary policy without fearing that its action
will trigger a rise in inflation expectations.
Another element of flexibility in inflation-targeting regimes is that deviations from
inflation targets are routinely allowed in response to supply shocks, such as restrictions
in the supply of energy or raw materials that could have substantial negative
effects on output. First, the price index on which the official inflation targets are based
is often defined to exclude or moderate the effects of “supply shocks”; for example,
the officially targeted price index may exclude some combination of food and energy
prices. Second, following (or in anticipation of) a supply shock, such as a rise in a
value-added tax (similar to a sales tax), the central bank would first deviate from its
planned policies as needed and then explain to the public the reasons for its action.
Low Economic Growth. Another common concern about inflation targeting is that it
will lead to low growth in output and employment. Although inflation reduction has
been associated with below-normal output during disinflationary phases in inflationtargeting
regimes, once low inflation levels were achieved, output and employment
returned to levels at least as high as they were before. A conservative conclusion is
that once low inflation is achieved, inflation targeting is not harmful to the real economy.
Given the strong economic growth after disinflation in many countries (such as
New Zealand) that have adopted inflation targets, a case can be made that inflation
targeting promotes real economic growth, in addition to controlling inflation.
The concern that a sole focus on inflation may lead to larger output fluctuations has
led some economists to propose a variation on inflation targeting in which central
banks would target the growth rate of nominal GDP (real GDP times the price level)
rather than inflation. Relative to inflation, nominal GDP growth has the advantage that
it does put some weight on output as well as prices in the policymaking process. With
a nominal GDP target, a decline in projected real output growth would automatically
imply an increase in the central bank’s inflation target. This increase would tend to be
stabilizing, because it would automatically lead to an easier monetary policy.
Nominal GDP targeting is close in spirit to inflation targeting, and although it has
the advantages mentioned in the previous paragraph, it has disadvantages as well.
First, a nominal GDP target forces the central bank or the government to announce a
number for potential (long-term) GDP growth. Such an announcement is highly
problematic, because estimates of potential GDP growth are far from precise and
change over time. Announcing a specific number for potential GDP growth may thus
imply a certainty that policymakers do not have and may also cause the public to mistakenly
believe that this estimate is actually a fixed target for potential GDP growth.
Announcing a potential GDP growth number is likely to be political dynamite,
because it opens policymakers to the criticism that they are willing to settle for longterm
growth rates that the public may consider too low. Indeed, a nominal GDP target
may lead to an accusation that the central bank or the targeting regime is
anti-growth, when the opposite is true, because a low inflation rate is a means to pro-
Nominal GDP
Targeting
508 PA RT V International Finance and Monetary Policy
mote a healthy economy with high growth. In addition, if the estimate for potential
GDP growth is higher than the true potential for long-term growth and becomes
embedded in the public mind as a target, it can lead to a positive inflation bias.
Second, information on prices is more timely and more frequently reported than
data on nominal GDP (and could be made even more so)—a practical consideration
that offsets some of the theoretical appeal of nominal GDP as a target. Although collecting
data on nominal GDP could be improved, measuring nominal GDP requires
data on current quantities and current prices, and the need to collect two pieces of
information is perhaps intrinsically more difficult to accomplish in a timely manner.
Third, the concept of inflation in consumer prices is much better understood by
the public than the concept of nominal GDP, which can easily be confused with real
GDP. Consequently, it seems likely that communication with the public and accountability
would be better served by using an inflation rather than a nominal GDP growth
target. While a significant number of central banks have adopted inflation targeting,
none has adopted a nominal GDP target.
Finally, as argued earlier, inflation targeting, as it is actually practiced, allows considerable
flexibility for policy in the short run, and elements of monetary policy tactics
based on nominal GDP targeting could easily be built into an inflation-targeting
regime. Thus it is doubtful that, in practice, nominal GDP targeting would be more
effective than inflation targeting in achieving short-run stabilization.
When all is said and done, inflation targeting has almost all the benefits of nominal
GDP targeting, but without the problems that arise from potential confusion
about what nominal GDP is or the political complications that arise because nominal
GDP requires announcement of a potential GDP growth path.
Monetary Policy with an Implicit Nominal Anchor
In recent years, the United States has achieved excellent macroeconomic performance
(including low and stable inflation) without using an explicit nominal anchor such as
an exchange rate, a monetary aggregate, or an inflation target. Although the Federal
Reserve has not articulated an explicit strategy, a coherent strategy for the conduct of
monetary policy exists nonetheless. This strategy involves an implicit but not an
explicit nominal anchor in the form of an overriding concern by the Federal Reserve
to control inflation in the long run. In addition, it involves forward-looking behavior
in which there is careful monitoring for signs of future inflation using a wide range of
information, coupled with periodic “pre-emptive strikes” by monetary policy against
the threat of inflation.
As emphasized by Milton Friedman, monetary policy effects have long lags. In
industrialized countries with a history of low inflation, the inflation process seems to have
tremendous inertia: Estimates from large macroeconometric models of the U.S. economy,
for example, suggest that monetary policy takes over a year to affect output and over two
years to have a significant impact on inflation. For countries whose economies respond
more quickly to exchange-rate changes or that have experienced highly variable inflation,
and therefore have more flexible prices, the lags may be shorter.
The presence of long lags means that monetary policy cannot wait to respond
until inflation has already reared its ugly head. If the central bank waited until overt
signs of inflation appeared, it would already be too late to maintain stable prices, at
least not without a severe tightening of policy: inflation expectations would already
C H A P T E R 2 1 Monetary Policy Strategy: The International Experience 509
be embedded in the wage- and price-setting process, creating an inflation momentum
that would be hard to halt. Inflation becomes much harder to control once it has been
allowed to gather momentum, because higher inflation expectations become ingrained
in various types of long-term contracts and pricing agreements.
To prevent inflation from getting started, therefore, monetary policy needs to be
forward-looking and pre-emptive: that is, depending on the lags from monetary policy
to inflation, monetary policy needs to act long before inflationary pressures appear
in the economy. For example, suppose it takes roughly two years for monetary policy
to have a significant impact on inflation. In this case, even if inflation is currently low
but policymakers believe inflation will rise over the next two years with an unchanged
stance of monetary policy, they must now tighten monetary policy to prevent the inflationary
surge.
Under Alan Greenspan, the Federal Reserve has been successful in pursuing a preemptive
monetary policy. For example, the Fed raised interest rates from 1994 to 1995
before a rise in inflation got a toehold. As a result, inflation not only did not rise, but
fell slightly. This pre-emptive monetary policy strategy is clearly also a feature of inflationtargeting
regimes, because monetary policy instruments are adjusted to take account
of the long lags in their effects in order to hit future inflation targets. However, the Fed’s
policy regime, which has no nominal anchor and so might best be described as a “just
do it” policy, differs from inflation targeting in that it does not officially have a nominal
anchor and is much less transparent in its monetary policy strategy.
The Fed’s “just do it” approach, which has some of the key elements of inflation targeting,
has many of the same advantages. It also enables monetary policy to focus on
domestic considerations and does not rely on a stable money–inflation relationship.
As with inflation targeting, the central bank uses many sources of information to
determine the best settings for monetary policy. The Fed’s forward-looking behavior
and stress on price stability also help to discourage overly expansionary monetary
policy, thereby ameliorating the time-consistency problem.
Another key argument for the “just do it” strategy is its demonstrated success. The
Federal Reserve has been able to bring down inflation in the United States from doubledigit
levels in 1980 to around the 3% level by the end of 1991. Since then, inflation
has dropped to around the 2% level, which is arguably consistent with the price stability
goal. The Fed conducted a successful pre-emptive strike against inflation from
February 1994 until early 1995, when in several steps it raised the federal funds rate
from 3% to 6% even though inflation was not increasing during this period. The subsequent
lengthy business-cycle expansion, the longest in U.S. history, brought unemployment
down to around 4%, a level not seen since the 1960s, while CPI inflation
fell to a level near 2%. In addition, the overall U.S. growth rate was very strong
throughout the 1990s. Indeed, the performance of the U.S. economy became the envy
of the industrialized world in the 1990s.
Given the success of the “just do it” strategy in the United States, why should the
United States consider other monetary policy strategies? (If it ain’t broke, why fix it?)
The answer is that the “just do it” strategy has some disadvantages that may cause it
to work less well in the future.
One disadvantage of the strategy is a lack of transparency. The Fed’s closemouthed
approach about its intentions gives rise to a constant guessing game about
what it is going to do. This high level of uncertainty leads to unnecessary volatility in
Disadvantages
of the Fed’s
Approach
Advantages of the
Fed’s Approach
510 PA RT V International Finance and Monetary Policy
financial markets and creates doubt among producers and the general public about
the future course of inflation and output. Furthermore, the opacity of its policymaking
makes it hard to hold the Federal Reserve accountable to Congress and the general
public: The Fed can’t be held accountable if there are no predetermined criteria
for judging its performance. Low accountability may make the central bank more susceptible
to the time-consistency problem, whereby it may pursue short-term objectives
at the expense of long-term ones.
Probably the most serious problem with the “just do it” approach is strong
dependence on the preferences, skills, and trustworthiness of the individuals in
charge of the central bank. In recent years in the United States, Federal Reserve
Chairman Alan Greenspan and other Federal Reserve officials have emphasized forwardlooking
policies and inflation control, with great success. The Fed’s prestige and
credibility with the public have risen accordingly. But the Fed’s leadership will eventually
change, and there is no guarantee that the new team will be committed to the
same approach. Nor is there any guarantee that the relatively good working relationship
that has existed between the Fed and the executive branch will continue. In
a different economic or political environment, the Fed might face strong pressure to
engage in over-expansionary policies, raising the possibility that time consistency
may become a more serious problem. In the past, after a successful period of low
inflation, the Federal Reserve has reverted to inflationary monetary policy—the
1970s are one example—and without an explicit nominal anchor, this could certainly
happen again.
Another disadvantage of the “just do it” approach is that it has some inconsistencies
with democratic principles. As described in Chapter 14, there are good reasons—
notably, insulation from short-term political pressures—for the central bank to have
some degree of independence, as the Federal Reserve currently does, and the evidence
does generally support central bank independence. Yet the practical economic arguments
for central bank independence coexist uneasily with the presumption that government
policies should be made democratically, rather than by an elite group.
In contrast, inflation targeting can make the institutional framework for the conduct
of monetary policy more consistent with democratic principles and avoid some
of the above problems. The inflation-targeting framework promotes the accountability
of the central bank to elected officials, who are given some responsibility for setting
the goals for monetary policy and then monitoring the economic outcomes.
However, under inflation targeting as it has generally been practiced, the central bank
has complete control over operational decisions, so that it can be held accountable for
achieving its assigned objectives.
Inflation targeting thus can help to promote operational independence of the central
bank. The example of the granting of independence to the Bank of England in
1997 indicates how inflation targeting can reduce the tensions between central bank
independence and democratic principles and promote central bank independence.
When operational independence was granted to the Bank of England in May 1997,
the chancellor of the Exchequer made it clear that this action had been made possible
by the adoption of an inflation-targeting regime, which had increased the transparency
of policy and the accountability of the bank for achieving policy objectives
set by the government.
The Fed’s monetary policy strategy may move more toward inflation targeting in the
future. Inflation targeting is not too far from the Fed’s current policymaking philosophy,
which has stressed the importance of price stability as the overriding, long-run goal of
C H A P T E R 2 1 Monetary Policy Strategy: The International Experience 511
monetary policy. Also, a move to inflation targeting is consistent with recent steps by the
Fed to increase the transparency of monetary policy, such as shortening the time before
the minutes of the FOMC meeting are released, the practice of announcing the FOMC’s
decision about whether to change the target for the federal funds rates immediately after
the conclusion of the FOMC meeting, and the announcement of the “balance of risks”
in the future, whether toward higher inflation or toward a weaker economy.
512 PA RT V International Finance and Monetary Policy
Summary
1. A nominal anchor is a key element in monetary policy
strategies. It helps promote price stability by tying
down inflation expectations and limiting the timeconsistency
problem, in which monetary policymakers
conduct monetary policy in a discretionary way that
produces poor long-run outcomes.
2. Exchange-rate targeting has the following advantages:
(1) it directly keeps inflation under control by tying the
inflation rate for internationally traded goods to that
found in the anchor country to whom its currency is
pegged; (2) it provides an automatic rule for the
conduct of monetary policy that helps mitigate the
time-consistency problem; and (3) it has the advantage
of simplicity and clarity. Exchange-rate targeting also
has serious disadvantages: (1) it results in a loss of
independent monetary policy and increases the
exposure of the economy to shocks from the anchor
country; (2) it leaves the currency open to speculative
attacks; and (3) it can weaken the accountability of
policymakers because the exchange-rate signal is lost.
Two strategies that make it less likely that the exchangerate
regime will break down are currency boards, in
which the central bank stands ready to automatically
exchange domestic for foreign currency at a fixed rate,
and dollarization, in which a sound currency like the
U.S. dollar is adopted as the country’s money.
3. Monetary targeting has two main advantages: It enables
a central bank to adjust its monetary policy to cope
with domestic considerations, and information on
whether the central bank is achieving its target is
known almost immediately. On the other hand,
monetary targeting suffers from the disadvantage that it
works well only if there is a reliable relationship
between the monetary aggregate and the goal variable,
inflation, a relationship that has often not held in
different countries.
4. Inflation targeting has several advantages: (1) it enables
monetary policy to focus on domestic considerations;
(2) stability in the relationship between money and
inflation is not critical to its success; (3) it is readily
understood by the public and is highly transparent;
(4) it increases accountability of the central bank; and
(5) it appears to ameliorate the effects of inflationary
shocks. It does have some disadvantages, however:
(1) inflation is not easily controlled by the monetary
authorities, so that an inflation target is unable to send
immediate signals to both the public and markets; (2) it
might impose a rigid rule on policymakers, although
this has not been the case in practice; and (3) a sole
focus on inflation may lead to larger output
fluctuations, although this has also not been the case in
practice. The concern that a sole focus on inflation may
lead to larger output fluctuations has led some
economists to propose a variant of inflation targeting,
nominal GDP targeting, in which central banks target
the growth in nominal GDP rather than inflation.
5. The Federal Reserve has a strategy of having an
implicit, not an explicit, nominal anchor. This strategy
has the following advantages: (1) it enables monetary
policy to focus on domestic considerations; (2) it does
not rely on a stable money–inflation relationship; and
(3) it has had a demonstrated success, producing low
inflation with the longest business cycle expansion in
U.S. history. However, it does have some disadvantages:
(1) it has a lack of transparency; (2) it is strongly
dependent on the preferences, skills, and
trustworthiness of individuals in the central bank and
the government; and (3) it has some inconsistencies
with democratic principles, because the central bank is
not highly accountable.
C H A P T E R 2 1 Monetary Policy Strategy: The International Experience 513
Key Terms
currency board, p. 492
dollarization, p. 493
nominal anchor, p. 487
seignorage, p. 493
time-consistency problem, p. 488
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. What are the benefits of using a nominal anchor for
the conduct of monetary policy?
2. Give an example of the time-consistency problem that
you experience in your everyday life.
3. What incentives arise for a central bank to engage in
time-consistent behavior?
*4. What are the key advantages of exchange-rate targeting
as a monetary policy strategy?
5. Why did the exchange-rate peg lead to difficulties for
the countries in the ERM when German reunification
occurred?
*6. How can exchange-rate targets lead to a speculative
attack on a currency?
7. Why may the disadvantage of exchange-rate targeting
of not having an independent monetary policy be less
of an issue for emerging market countries than for
industrialized countries?
*8. How can the long-term bond market help reduce the
time-consistency problem for monetary policy? Can
the foreign exchange market also perform this role?
9. When is exchange-rate targeting likely to be a sensible
strategy for industrialized countries? When is
exchange-rate targeting likely to be a sensible strategy
for emerging market countries?
*10. What are the advantages and disadvantages of a currency
board over a monetary policy that just uses an
exchange-rate target?
11. What are the key advantages and disadvantages of dollarization
over other forms of exchange-rate targeting?
*12. What are the advantages of monetary targeting as a
strategy for the conduct of monetary policy?
13. What is the big if necessary for the success of monetary
targeting? Does the experience with monetary targeting
suggest that the big if is a problem?
*14. What methods have inflation-targeting central banks
used to increase communication with the public and
increase the transparency of monetary policymaking?
15. Why might inflation targeting increase support for the
independence of the central bank to conduct monetary
policy?
*16. “Because the public can see whether a central bank
hits its monetary targets almost immediately, whereas
it takes time before the public can see whether an
inflation target is achieved, monetary targeting makes
central banks more accountable than inflation targeting
does.” True, false, or uncertain? Explain.
17. “Because inflation targeting focuses on achieving the
inflation target, it will lead to excessive output fluctuations.”
True, false, or uncertain? Explain.
*18. What are the most important advantages and disadvantages
of nominal GDP targeting over inflation targeting?
19. What are the key advantages and disadvantages of the
monetary strategy used in the United States under
Alan Greenspan in which the nominal anchor is only
implicit?
*20. What is the advantage that monetary targeting, inflation
targeting, and a monetary strategy with an
implicit, but not an explicit, nominal anchor have in
common?
QUIZ
514 PA RT V International Finance and Monetary Policy
Web Exercises
1. Many countries have central banks that are
responsible for their nation’s monetary policy. Go to
www.federalreserve.gov/centralbanks.htm and select
one of the central banks (for example, Norway).
Review that bank’s web site to determine its policies
regarding application of monetary policy. How does
this bank’s policies compare to those of the U.S. central
bank?
2. The web provides a rich source of information about
international issues. The topic of dollarization has
many references. Go to www.imf.org/external/pubs
/ft/fandd/2000/03/berg.htm. Summarize this report
sponsored by the International Monetary Fund about
the value of dollarization.
P a r t V I
Monetary
Theory

PREVIEW In earlier chapters, we spent a lot of time and effort learning what the money supply
is, how it is determined, and what role the Federal Reserve System plays in it. Now
we are ready to explore the role of the money supply in determining the price level
and total production of goods and services (aggregate output) in the economy. The
study of the effect of money on the economy is called monetary theory, and we
examine this branch of economics in the chapters of Part VI.
When economists mention supply, the word demand is sure to follow, and the discussion
of money is no exception. The supply of money is an essential building block
in understanding how monetary policy affects the economy, because it suggests the
factors that influence the quantity of money in the economy. Not surprisingly, another
essential part of monetary theory is the demand for money.
This chapter describes how the theories of the demand for money have evolved.
We begin with the classical theories refined at the start of the twentieth century by
economists such as Irving Fisher, Alfred Marshall, and A. C. Pigou; then we move on
to the Keynesian theories of the demand for money. We end with Milton Friedman’s
modern quantity theory.
A central question in monetary theory is whether or to what extent the quantity
of money demanded is affected by changes in interest rates. Because this issue is crucial
to how we view money’s effects on aggregate economic activity, we focus on the
role of interest rates in the demand for money.1
Quantity Theory of Money
Developed by the classical economists in the nineteenth and early twentieth centuries,
the quantity theory of money is a theory of how the nominal value of aggregate
income is determined. Because it also tells us how much money is held for a given
amount of aggregate income, it is also a theory of the demand for money. The most
important feature of this theory is that it suggests that interest rates have no effect on
the demand for money.
517
Chap ter
22 The Demand for Money
1In Chapter 24, we will see that the responsiveness of the quantity of money demanded to changes in interest
rates has important implications for the relative effectiveness of monetary policy and fiscal policy in influencing
aggregate economic activity.
The clearest exposition of the classical quantity theory approach is found in the work of
the American economist Irving Fisher, in his influential book The Purchasing Power of
Money, published in 1911. Fisher wanted to examine the link between the total quantity
of money M (the money supply) and the total amount of spending on final goods and
services produced in the economy P Y, where P is the price level and Y is aggregate
output (income). (Total spending P Y is also thought of as aggregate nominal income
for the economy or as nominal GDP.) The concept that provides the link between M and
P Y is called the velocity of money (often reduced to velocity), the rate of turnover of
money; that is, the average number of times per year that a dollar is spent in buying the
total amount of goods and services produced in the economy. Velocity V is defined more
precisely as total spending P Y divided by the quantity of money M:
(1)
If, for example, nominal GDP (P Y ) in a year is $5 trillion and the quantity of
money is $1 trillion, velocity is 5, meaning that the average dollar bill is spent five
times in purchasing final goods and services in the economy.
By multiplying both sides of this definition by M, we obtain the equation of
exchange, which relates nominal income to the quantity of money and velocity:
M V P Y (2)
The equation of exchange thus states that the quantity of money multiplied by the
number of times that this money is spent in a given year must be equal to nominal
income (the total nominal amount spent on goods and services in that year).2
As it stands, Equation 2 is nothing more than an identity—a relationship that is true
by definition. It does not tell us, for instance, that when the money supply M changes,
nominal income (P Y ) changes in the same direction; a rise in M, for example, could
be offset by a fall in V that leaves M V (and therefore P Y ) unchanged. To convert
the equation of exchange (an identity) into a theory of how nominal income is determined
requires an understanding of the factors that determine velocity.
Irving Fisher reasoned that velocity is determined by the institutions in an economy
that affect the way individuals conduct transactions. If people use charge accounts
and credit cards to conduct their transactions and consequently use money less often
when making purchases, less money is required to conduct the transactions generated
by nominal income (M↓ relative to P Y ) , and velocity (P Y )/M will increase.
Conversely, if it is more convenient for purchases to be paid for with cash or checks
(both of which are money), more money is used to conduct the transactions generated
by the same level of nominal income, and velocity will fall. Fisher took the view that
V
P Y
M
Velocity of Money
and Equation of
Exchange
518 PA RT V I Monetary Theory
2Fisher actually first formulated the equation of exchange in terms of the nominal value of transactions in the
economy PT:
MVT PT
where P average price per transaction
T number of transactions conducted in a year
VT PT/M transactions velocity of money
Because the nominal value of transactions T is difficult to measure, the quantity theory has been formulated
in terms of aggregate output Y as follows: T is assumed to be proportional to Y so that T vY, where v is a
constant of proportionality. Substituting vY for T in Fisher’s equation of exchange yields MVT vPY, which can
be written as Equation 2 in the text, in which V VT /v.
http://cepa.newschool.edu/het
/profiles/fisher.htm
A brief biography and summary
of the writings of Irving Fisher.
the institutional and technological features of the economy would affect velocity only
slowly over time, so velocity would normally be reasonably constant in the short run.
Fisher’s view that velocity is fairly constant in the short run transforms the equation
of exchange into the quantity theory of money, which states that nominal income is
determined solely by movements in the quantity of money: When the quantity of
money M doubles, M V doubles and so must P Y, the value of nominal income.
To see how this works, let’s assume that velocity is 5, nominal income (GDP) is initially
$5 trillion, and the money supply is $1 trillion. If the money supply doubles to
$2 trillion, the quantity theory of money tells us that nominal income will double to
$10 trillion ( 5 $2 trillion).
Because the classical economists (including Fisher) thought that wages and prices
were completely flexible, they believed that the level of aggregate output Y produced
in the economy during normal times would remain at the full-employment level, so
Y in the equation of exchange could also be treated as reasonably constant in the short
run. The quantity theory of money then implies that if M doubles, P must also double
in the short run, because V and Y are constant. In our example, if aggregate output
is $5 trillion, the velocity of 5 and a money supply of $1 trillion indicate that the
price level equals 1 because 1 times $5 trillion equals the nominal income of $5 trillion.
When the money supply doubles to $2 trillion, the price level must also double
to 2 because 2 times $5 trillion equals the nominal income of $10 trillion.
For the classical economists, the quantity theory of money provided an explanation
of movements in the price level: Movements in the price level result solely from
changes in the quantity of money.
Because the quantity theory of money tells us how much money is held for a given
amount of aggregate income, it is in fact a theory of the demand for money. We can
see this by dividing both sides of the equation of exchange by V, thus rewriting it as:
where nominal income P Y is written as PY. When the money market is in equilibrium,
the quantity of money M that people hold equals the quantity of money
demanded Md, so we can replace M in the equation by Md. Using k to represent the
quantity 1/V (a constant, because V is a constant), we can rewrite the equation as:
Md k PY (3)
Equation 3 tells us that because k is a constant, the level of transactions generated by a
fixed level of nominal income PY determines the quantity of money Md that people
demand. Therefore, Fisher’s quantity theory of money suggests that the demand for money
is purely a function of income, and interest rates have no effect on the demand for money.3
Fisher came to this conclusion because he believed that people hold money only to
conduct transactions and have no freedom of action in terms of the amount they want
to hold. The demand for money is determined (1) by the level of transactions generated
M
1
V
PY
Quantity Theory of
Money Demand
Quantity Theory
C H A P T E R 2 2 The Demand for Money 519
3While Fisher was developing his quantity theory approach to the demand for money, a group of classical economists
in Cambridge, England, came to similar conclusions, although with slightly different reasoning. They
derived Equation 3 by recognizing that two properties of money motivate people to hold it: its utility as a medium
of exchange and as a store of wealth.
by the level of nominal income PY and (2) by the institutions in the economy that affect
the way people conduct transactions and thus determine velocity and hence k.
Is Velocity a Constant?
The classical economists’ conclusion that nominal income is determined by movements
in the money supply rested on their belief that velocity PY/M could be treated as reasonably
constant.4 Is it reasonable to assume that velocity is constant? To answer this, let’s
look at Figure 1, which shows the year-to-year changes in velocity from 1915 to 2002
(nominal income is represented by nominal GDP and the money supply by M1 and M2).
What we see in Figure 1 is that even in the short run, velocity fluctuates too much
to be viewed as a constant. Prior to 1950, velocity exhibited large swings up and
down. This may reflect the substantial instability of the economy in this period, which
included two world wars and the Great Depression. (Velocity actually falls, or at least
its rate of growth declines, in years when recessions are taking place.) After 1950,
velocity appears to have more moderate fluctuations, yet there are large differences in
520 PA RT V I Monetary Theory
4Actually, the classical conclusion still holds if velocity grows at some uniform rate over time that reflects changes
in transaction technology. Hence the concept of a constant velocity should more accurately be thought of here as
a lack of upward and downward fluctuations in velocity.
FIGURE 1 Change in the Velocity of M1 and M2 from Year to Year, 1915–2002
Shaded areas indicate recessions. Velocities are calculated using nominal GNP before 1959 and nominal GDP thereafter.
Sources: Economic Report of the President; Banking and Monetary Statistics; www.federalreserve.gov/releases/h6/.
-20
-15
-10
-5
0
5
10
15
20
Change in
Velocity
(%)
1950 1960 1970 1980 1990
0
1915 1920 1930 1940
M1
M2
2000 2005
www.usagold.com
/gildedopinion/puplava
/20020614.html
A summary of how various
factors affect the velocity of
money.
the growth rate of velocity from year to year. The percentage change in M1 velocity
(GDP/M1) from 1981 to 1982, for example, was 2.5%, whereas from 1980 to 1981
velocity grew at a rate of 4.2%. This difference of 6.7% means that nominal GDP was
6.7% lower than it would have been if velocity had kept growing at the same rate as
in 1980–1981.5 The drop is enough to account for the severe recession that took
place in 1981–1982. After 1982, M1 velocity appears to have become even more
volatile, a fact that has puzzled researchers when they examine the empirical evidence
on the demand for money (discussed later in this chapter). M2 velocity remained
more stable than M1 velocity after 1982, with the result that the Federal Reserve
dropped its M1 targets in 1987 and began to focus more on M2 targets. However,
instability of M2 velocity in the early 1990s resulted in the Fed’s announcement in
July 1993 that it no longer felt that any of the monetary aggregates, including M2, was
a reliable guide for monetary policy.
Until the Great Depression, economists did not recognize that velocity declines
sharply during severe economic contractions. Why did the classical economists not
recognize this fact when it is easy to see in the pre-Depression period in Figure 1?
Unfortunately, accurate data on GDP and the money supply did not exist before
World War II. (Only after the war did the government start to collect these data.)
Economists had no way of knowing that their view of velocity as a constant was
demonstrably false. The decline in velocity during the Great Depression years was so
great, however, that even the crude data available to economists at that time suggested
that velocity was not constant. This explains why, after the Great Depression, economists
began to search for other factors influencing the demand for money that might
help explain the large fluctuations in velocity.
Let us now examine the theories of money demand that arose from this search for
a better explanation of the behavior of velocity.
Keynes’s Liquidity Preference Theory
In his famous 1936 book The General Theory of Employment, Interest, and Money, John
Maynard Keynes abandoned the classical view that velocity was a constant and developed
a theory of money demand that emphasized the importance of interest rates. His theory
of the demand for money, which he called the liquidity preference theory, asked the
question: Why do individuals hold money? He postulated that there are three motives
behind the demand for money: the transactions motive, the precautionary motive, and
the speculative motive.
In the classical approach, individuals are assumed to hold money because it is a medium
of exchange that can be used to carry out everyday transactions. Following the classical
tradition, Keynes emphasized that this component of the demand for money is determined
primarily by the level of people’s transactions. Because he believed that these
transactions were proportional to income, like the classical economists, he took the
transactions component of the demand for money to be proportional to income.
Transactions
Motive
C H A P T E R 2 2 The Demand for Money 521
5We reach a similar conclusion if we use M2 velocity. The percentage change in M2 velocity (GDP/M2) from 1981
to 1982 was 5.0%, whereas from 1980 to 1981 it was 2.3%. This difference of 7.3% means that nominal
GDP was 7.3% lower than it would have been if M2 velocity had kept growing at the same rate as in 1980–1981.
http://www-gap.dcs
.st-and.ac.uk/~history
/Mathematicians/Keynes.html
A brief history of
John Maynard Keynes.
Keynes went beyond the classical analysis by recognizing that in addition to holding
money to carry out current transactions, people hold money as a cushion against an
unexpected need. Suppose that you’ve been thinking about buying a fancy stereo; you
walk by a store that is having a 50%-off sale on the one you want. If you are holding
money as a precaution for just such an occurrence, you can purchase the stereo right
away; if you are not holding precautionary money balances, you cannot take advantage
of the sale. Precautionary money balances also come in handy if you are hit with
an unexpected bill, say for car repair or hospitalization.
Keynes believed that the amount of precautionary money balances people want
to hold is determined primarily by the level of transactions that they expect to make
in the future and that these transactions are proportional to income. Therefore, he
postulated, the demand for precautionary money balances is proportional to income.
If Keynes had ended his theory with the transactions and precautionary motives,
income would be the only important determinant of the demand for money, and he
would not have added much to the classical approach. However, Keynes took the
view that money is a store of wealth and called this reason for holding money the speculative
motive. Since he believed that wealth is tied closely to income, the speculative
component of money demand would be related to income. However, Keynes looked
more carefully at the factors that influence the decisions regarding how much money
to hold as a store of wealth, especially interest rates.
Keynes divided the assets that can be used to store wealth into two categories:
money and bonds. He then asked the following question: Why would individuals
decide to hold their wealth in the form of money rather than bonds?
Thinking back to the discussion of the theory of asset demand (Chapter 5), you
would want to hold money if its expected return was greater than the expected return
from holding bonds. Keynes assumed that the expected return on money was zero
because in his time, unlike today, most checkable deposits did not earn interest. For
bonds, there are two components of the expected return: the interest payment and the
expected rate of capital gains.
You learned in Chapter 4 that when interest rates rise, the price of a bond falls. If
you expect interest rates to rise, you expect the price of the bond to fall and therefore
suffer a negative capital gain—that is, a capital loss. If you expect the rise in interest
rates to be substantial enough, the capital loss might outweigh the interest payment,
and your expected return on the bond would be negative. In this case, you would want
to store your wealth as money because its expected return is higher; its zero return
exceeds the negative return on the bond.
Keynes assumed that individuals believe that interest rates gravitate to some normal
value (an assumption less plausible in today’s world). If interest rates are below this
normal value, individuals expect the interest rate on bonds to rise in the future and so
expect to suffer capital losses on them. As a result, individuals will be more likely to
hold their wealth as money rather than bonds, and the demand for money will be high.
What would you expect to happen to the demand for money when interest rates
are above the normal value? In general, people will expect interest rates to fall, bond
prices to rise, and capital gains to be realized. At higher interest rates, they are more
likely to expect the return from holding a bond to be positive, thus exceeding the
expected return from holding money. They will be more likely to hold bonds than
money, and the demand for money will be quite low. From Keynes’s reasoning, we can
conclude that as interest rates rise, the demand for money falls, and therefore money
demand is negatively related to the level of interest rates.
Speculative
Motive
Precautionary
Motive
522 PA RT V I Monetary Theory
In putting the three motives for holding money balances together into a demand for
money equation, Keynes was careful to distinguish between nominal quantities and
real quantities. Money is valued in terms of what it can buy. If, for example, all prices
in the economy double (the price level doubles), the same nominal quantity of money
will be able to buy only half as many goods. Keynes thus reasoned that people want
to hold a certain amount of real money balances (the quantity of money in real
terms)—an amount that his three motives indicated would be related to real income
Y and to interest rates i. Keynes wrote down the following demand for money equation,
known as the liquidity preference function, which says that the demand for real
money balances Md/P is a function of (related to) i and Y:6
(4)
The minus sign below i in the liquidity preference function means that the demand
for real money balances is negatively related to the interest rate i, and the plus sign
below Y means that the demand for real money balances and real income Y are positively
related. This money demand function is the same one that was used in our
analysis of money demand discussed in Chapter 5. Keynes’s conclusion that the
demand for money is related not only to income but also to interest rates is a major
departure from Fisher’s view of money demand, in which interest rates can have no
effect on the demand for money.
By deriving the liquidity preference function for velocity PY/M, we can see that
Keynes’s theory of the demand for money implies that velocity is not constant, but
instead fluctuates with movements in interest rates. The liquidity preference equation
can be rewritten as:
Multiplying both sides of this equation by Y and recognizing that Md can be replaced
by M because they must be equal in money market equilibrium, we solve for velocity:
(5)
We know that the demand for money is negatively related to interest rates; when i
goes up, f (i, Y ) declines, and therefore velocity rises. In other words, a rise in interest
rates encourages people to hold lower real money balances for a given level of
income; therefore, the rate of turnover of money (velocity) must be higher. This reasoning
implies that because interest rates have substantial fluctuations, the liquidity
preference theory of the demand for money indicates that velocity has substantial
fluctuations as well.
An interesting feature of Equation 5 is that it explains some of the velocity movements
in Figure 1, in which we noted that when recessions occur, velocity falls or its
rate of growth declines. What fact regarding the cyclical behavior of interest rates (discussed
in Chapter 5) might help us explain this phenomenon? You might recall that
V
PY
M

Y
f (i, Y )
P
Md
1
f (i, Y )
Md
P
f ( i, Y )

Putting the Three
Motives Together
C H A P T E R 2 2 The Demand for Money 523
6The classical economists’ money demand equation can also be written in terms of real money balances by dividing
both sides of Equation 3 by the price level P to obtain:
Md
P
k Y
interest rates are procyclical, rising in expansions and falling in recessions. The liquidity
preference theory indicates that a rise in interest rates will cause velocity to rise
also. The procyclical movements of interest rates should induce procyclical movements
in velocity, and that is exactly what we see in Figure 1.
Keynes’s model of the speculative demand for money provides another reason why
velocity might show substantial fluctuations. What would happen to the demand for
money if the view of the normal level of interest rates changes? For example, what if
people expect the future normal interest rate to be higher than the current normal interest
rate? Because interest rates are then expected to be higher in the future, more people
will expect the prices of bonds to fall and will anticipate capital losses. The expected
returns from holding bonds will decline, and money will become more attractive relative
to bonds. As a result, the demand for money will increase. This means that f (i, Y )
will increase and so velocity will fall. Velocity will change as expectations about future
normal levels of interest rates change, and unstable expectations about future movements
in normal interest rates can lead to instability of velocity. This is one more reason
why Keynes rejected the view that velocity could be treated as a constant.
Study Guide Keynes’s explanation of how interest rates affect the demand for money will be easier
to understand if you think of yourself as an investor who is trying to decide whether
to invest in bonds or to hold money. Ask yourself what you would do if you expected
the normal interest rate to be lower in the future than it is currently. Would you rather
be holding bonds or money?
To sum up, Keynes’s liquidity preference theory postulated three motives for
holding money: the transactions motive, the precautionary motive, and the speculative
motive. Although Keynes took the transactions and precautionary components of
the demand for money to be proportional to income, he reasoned that the speculative
motive would be negatively related to the level of interest rates.
Keynes’s model of the demand for money has the important implication that
velocity is not constant, but instead is positively related to interest rates, which fluctuate
substantially. His theory also rejected the constancy of velocity, because changes
in people’s expectations about the normal level of interest rates would cause shifts in
the demand for money that would cause velocity to shift as well. Thus Keynes’s liquidity
preference theory casts doubt on the classical quantity theory that nominal
income is determined primarily by movements in the quantity of money.
Further Developments in the Keynesian Approach
After World War II, economists began to take the Keynesian approach to the demand
for money even further by developing more precise theories to explain the three
Keynesian motives for holding money. Because interest rates were viewed as a crucial
element in monetary theory, a key focus of this research was to understand better the
role of interest rates in the demand for money.
William Baumol and James Tobin independently developed similar demand for
money models, which demonstrated that even money balances held for transactions
Transactions
Demand
524 PA RT V I Monetary Theory
purposes are sensitive to the level of interest rates.7 In developing their models, they
considered a hypothetical individual who receives a payment once a period and
spends it over the course of this period. In their model, money, which earns zero
interest, is held only because it can be used to carry out transactions.
To refine this analysis, let’s say that Grant Smith receives $1,000 at the beginning
of the month and spends it on transactions that occur at a constant rate during the
course of the month. If Grant keeps the $1,000 in cash in order to carry out his transactions,
his money balances follow the sawtooth pattern displayed in panel (a) of
Figure 2. At the beginning of the month he has $1,000, and by the end of the month
he has no cash left because he has spent it all. Over the course of the month, his holdings
of money will on average be $500 (his holdings at the beginning of the month,
$1,000, plus his holdings at the end of the month, $0, divided by 2).
At the beginning of the next month, Grant receives another $1,000 payment,
which he holds as cash, and the same decline in money balances begins again. This
process repeats monthly, and his average money balance during the course of the year
is $500. Since his yearly nominal income is $12,000 and his holdings of money average
$500, the velocity of money (V PY/M) is $12,000/$500 24.
Suppose that as a result of taking a money and banking course, Grant realizes that
he can improve his situation by not always holding cash. In January, then, he decides
to hold part of his $1,000 in cash and puts part of it into an income-earning security
such as bonds. At the beginning of each month, Grant keeps $500 in cash and uses
the other $500 to buy a Treasury bond. As you can see in panel (b), he starts out each
C H A P T E R 2 2 The Demand for Money 525
7William J. Baumol, “The Transactions Demand for Cash: An Inventory Theoretic Approach,” Quarterly Journal
of Economics 66 (1952): 545–556; James Tobin, “The Interest Elasticity of the Transactions Demand for Cash,”
Review of Economics and Statistics 38 (1956): 241–247.
FIGURE 2 Cash Balances in the Baumol-Tobin Model
In panel (a), the $1,000 payment at the beginning of the month is held entirely in cash and is spent at a constant rate until it is exhausted by
the end of the month. In panel (b), half of the monthly payment is put into cash and the other half into bonds. At the middle of the month,
cash balances reach zero and bonds must be sold to bring balances up to $500. By the end of the month, cash balances again dwindle to zero.
Cash
balances
($)
1,000
500
0 1 2
Months
(a)
Cash
balances
($)
1,000
500
0 1 1 2
Months
(b)
12
12
month with $500 of cash, and by the middle of the month, his cash balance has run
down to zero. Because bonds cannot be used directly to carry out transactions, Grant
must sell them and turn them into cash so that he can carry out the rest of the month’s
transactions. At the middle of the month, then, Grant’s cash balance rises back up to
$500. By the end of the month, the cash is gone. When he again receives his next
$1,000 monthly payment, he again divides it into $500 of cash and $500 of bonds,
and the process continues. The net result of this process is that the average cash balance
held during the month is $500/2 $250—just half of what it was before.
Velocity has doubled to $12,000/$250 48.
What has Grant Smith gained from his new strategy? He has earned interest on
$500 of bonds that he held for half the month. If the interest rate is 1% per month,
he has earned an additional $2.50 ( 1/2 $500 1%) per month.
Sounds like a pretty good deal, doesn’t it? In fact, if he had kept $333.33 in cash
at the beginning of the month, he would have been able to hold $666.67 in bonds for
the first third of the month. Then he could have sold $333.33 of bonds and held on
to $333.34 of bonds for the next third of the month. Finally, two-thirds of the way
through the month, he would have had to sell the remaining bonds to raise cash. The
net result of this is that Grant would have earned $3.33 per month [ (1/3 $666.67
1%) (1/3 $333.34 1%)]. This is an even better deal. His average cash holdings
in this case would be $333.33/2 $166.67. Clearly, the lower his average cash
balance, the more interest he will earn.
As you might expect, there is a catch to all this. In buying bonds, Grant incurs transaction
costs of two types. First, he must pay a straight brokerage fee for the buying and
selling of the bonds. These fees increase when average cash balances are lower because
Grant will be buying and selling bonds more often. Second, by holding less cash, he will
have to make more trips to the bank to get the cash, once he has sold some of his bonds.
Because time is money, this must also be counted as part of the transaction costs.
Grant faces a trade-off. If he holds very little cash, he can earn a lot of interest on
bonds, but he will incur greater transaction costs. If the interest rate is high, the benefits
of holding bonds will be high relative to the transaction costs, and he will hold
more bonds and less cash. Conversely, if interest rates are low, the transaction costs
involved in holding a lot of bonds may outweigh the interest payments, and Grant
would then be better off holding more cash and fewer bonds.
The conclusion of the Baumol-Tobin analysis may be stated as follows: As interest
rates increase, the amount of cash held for transactions purposes will decline,
which in turn means that velocity will increase as interest rates increase.8 Put another
way, the transactions component of the demand for money is negatively related to
the level of interest rates.
The basic idea in the Baumol-Tobin analysis is that there is an opportunity cost
of holding money—the interest that can be earned on other assets. There is also a benefit
to holding money—the avoidance of transaction costs. When interest rates
increase, people will try to economize on their holdings of money for transactions
purposes, because the opportunity cost of holding money has increased. By using
526 PA RT V I Monetary Theory
8Similar reasoning leads to the conclusion that as brokerage fees increase, the demand for transactions money
balances increases as well. When these fees rise, the benefits from holding transactions money balances increase
because by holding these balances, an individual will not have to sell bonds as often, thereby avoiding these
higher brokerage costs. The greater benefits to holding money balances relative to the opportunity cost of interest
forgone, then, lead to a higher demand for transactions balances.
simple models, Baumol and Tobin revealed something that we might not otherwise
have seen: that the transactions demand for money, and not just the speculative
demand, will be sensitive to interest rates. The Baumol-Tobin analysis presents a nice
demonstration of the value of economic modeling.9
Study Guide The idea that as interest rates increase, the opportunity cost of holding money
increases so that the demand for money falls, can be stated equivalently with the terminology
of expected returns used earlier. As interest rates increase, the expected
return on the other asset, bonds, increases, causing the relative expected return on
money to fall, thereby lowering the demand for money. These two explanations are in
fact identical, because as we saw in Chapter 5, changes in the opportunity cost of an
asset are just a description of what is happening to the relative expected return. The
opportunity cost terminology was used by Baumol and Tobin in their work on the
transactions demand for money, and that is why we used this terminology in the text.
To make sure you understand the equivalence of the two terminologies, try to translate
the reasoning in the precautionary demand discussion from opportunity cost terminology
to expected returns terminology.
Models that explore the precautionary motive of the demand for money have been
developed along lines similar to the Baumol-Tobin framework, so we will not go into
great detail about them here. We have already discussed the benefits of holding precautionary
money balances, but weighed against these benefits must be the opportunity
cost of the interest forgone by holding money. We therefore have a trade-off
similar to the one for transactions balances. As interest rates rise, the opportunity cost
of holding precautionary balances rises, and so the holdings of these money balances
fall. We then have a result similar to the one found for the Baumol-Tobin analysis.10
The precautionary demand for money is negatively related to interest rates.
Keynes’s analysis of the speculative demand for money was open to several serious
criticisms. It indicated that an individual holds only money as a store of wealth when
the expected return on bonds is less than the expected return on money and holds
only bonds when the expected return on bonds is greater than the expected return on
money. Only when people have expected returns on bonds and money that are
exactly equal (a rare instance) would they hold both. Keynes’s analysis therefore
implies that practically no one holds a diversified portfolio of bonds and money
simultaneously as a store of wealth. Since diversification is apparently a sensible strategy
for choosing which assets to hold, the fact that it rarely occurs in Keynes’s analysis
is a serious shortcoming of his theory of the speculative demand for money.
Tobin developed a model of the speculative demand for money that attempted to
avoid this criticism of Keynes’s analysis.11 His basic idea was that not only do people
Speculative
Demand
Precautionary
Demand
C H A P T E R 2 2 The Demand for Money 527
9The mathematics behind the Baumol-Tobin model can be found in an appendix to this chapter on this book’s
web site at www.aw.com/mishkin.
10These models of the precautionary demand for money also reveal that as uncertainty about the level of future transactions
grows, the precautionary demand for money increases. This is so because greater uncertainty means that individuals
are more likely to incur transaction costs if they are not holding precautionary balances. The benefit of holding
such balances then increases relative to the opportunity cost of forgone interest, and so the demand for them rises.
11James Tobin, “Liquidity Preference as Behavior Towards Risk,” Review of Economic Studies 25 (1958): 65–86.
care about the expected return on one asset versus another when they decide what to
hold in their portfolio, but they also care about the riskiness of the returns from each
asset. Specifically, Tobin assumed that most people are risk-averse—that they would
be willing to hold an asset with a lower expected return if it is less risky. An important
characteristic of money is that its return is certain; Tobin assumed it to be zero.
Bonds, by contrast, can have substantial fluctuations in price, and their returns can
be quite risky and sometimes negative. So even if the expected returns on bonds
exceed the expected return on money, people might still want to hold money as a
store of wealth because it has less risk associated with its return than bonds do.
The Tobin analysis also shows that people can reduce the total amount of risk in a
portfolio by diversifying; that is, by holding both bonds and money. The model suggests
that individuals will hold bonds and money simultaneously as stores of wealth. Since
this is probably a more realistic description of people’s behavior than Keynes’s, Tobin’s
rationale for the speculative demand for money seems to rest on more solid ground.
Tobin’s attempt to improve on Keynes’s rationale for the speculative demand for
money was only partly successful, however. It is still not clear that the speculative
demand even exists. What if there are assets that have no risk—like money—but earn
a higher return? Will there be any speculative demand for money? No, because an
individual will always be better off holding such an asset rather than money. The
resulting portfolio will enjoy a higher expected return yet has no higher risk. Do such
assets exist in the American economy? The answer is yes. U.S. Treasury bills and other
assets that have no default risk provide certain returns that are greater than those
available on money. Therefore, why would anyone want to hold money balances as a
store of wealth (ignoring for the moment transactions and precautionary reasons)?
Although Tobin’s analysis did not explain why money is held as a store of wealth,
it was an important development in our understanding of how people should choose
among assets. Indeed, his analysis was an important step in the development of the
academic field of finance, which examines asset pricing and portfolio choice (the decision
to buy one asset over another).
To sum up, further developments of the Keynesian approach have attempted to
give a more precise explanation for the transactions, precautionary, and speculative
demand for money. The attempt to improve Keynes’s rationale for the speculative
demand for money has been only partly successful; it is still not clear that this demand
even exists. However, the models of the transactions and precautionary demand for
money indicate that these components of money demand are negatively related to
interest rates. Hence Keynes’s proposition that the demand for money is sensitive to
interest rates—suggesting that velocity is not constant and that nominal income might
be affected by factors other than the quantity of money—is still supported.
Friedman’s Modern Quantity Theory of Money
In 1956, Milton Friedman developed a theory of the demand for money in a famous
article, “The Quantity Theory of Money: A Restatement.”12 Although Friedman frequently
refers to Irving Fisher and the quantity theory, his analysis of the demand for
money is actually closer to that of Keynes than it is to Fisher’s.
528 PA RT V I Monetary Theory
12Milton Friedman, “The Quantity Theory of Money: A Restatement,” in Studies in the Quantity Theory of Money,
ed. Milton Friedman (Chicago: University of Chicago Press, 1956), pp. 3–21.
Like his predecessors, Friedman pursued the question of why people choose to
hold money. Instead of analyzing the specific motives for holding money, as Keynes
did, Friedman simply stated that the demand for money must be influenced by the
same factors that influence the demand for any asset. Friedman then applied the theory
of asset demand to money.
The theory of asset demand (Chapter 5) indicates that the demand for money
should be a function of the resources available to individuals (their wealth) and the
expected returns on other assets relative to the expected return on money. Like
Keynes, Friedman recognized that people want to hold a certain amount of real
money balances (the quantity of money in real terms). From this reasoning, Friedman
expressed his formulation of the demand for money as follows:
(6)
where Md/P demand for real money balances
Yp Friedman’s measure of wealth, known as permanent income (technically,
the present discounted value of all expected future income, but
more easily described as expected average long-run income)
rm expected return on money
rb expected return on bonds
re expected return on equity (common stocks)
e expected inflation rate
and the signs underneath the equation indicate whether the demand for money is
positively () related or negatively () related to the terms that are immediately
above them.13
Let us look in more detail at the variables in Friedman’s money demand function
and what they imply for the demand for money.
Because the demand for an asset is positively related to wealth, money demand is
positively related to Friedman’s wealth concept, permanent income (indicated by the
plus sign beneath it). Unlike our usual concept of income, permanent income (which
can be thought of as expected average long-run income) has much smaller short-run
fluctuations, because many movements of income are transitory (short-lived). For
example, in a business cycle expansion, income increases rapidly, but because some
of this increase is temporary, average long-run income does not change very much.
Hence in a boom, permanent income rises much less than income. During a recession,
much of the income decline is transitory, and average long-run income (hence
permanent income) falls less than income. One implication of Friedman’s use of the
concept of permanent income as a determinant of the demand for money is that the
demand for money will not fluctuate much with business cycle movements.
Md
P
f (Yp , rb rm, re rm, e rm)

C H A P T E R 2 2 The Demand for Money 529
13Friedman also added to his formulation a term h that represented the ratio of human to nonhuman wealth. He
reasoned that if people had more permanent income coming from labor income and thus from their human capital,
they would be less liquid than if they were receiving income from financial assets. In this case, they might
want to hold more money because it is a more liquid asset than the alternatives. The term h plays no essential
role in Friedman’s theory and has no important implications for monetary theory. That is why we ignore it in the
money demand function.
An individual can hold wealth in several forms besides money; Friedman categorized
them into three types of assets: bonds, equity (common stocks), and goods. The
incentives for holding these assets rather than money are represented by the expected
return on each of these assets relative to the expected return on money, the last three
terms in the money demand function. The minus sign beneath each indicates that as
each term rises, the demand for money will fall.
The expected return on money rm, which appears in all three terms, is influenced
by two factors:
1. The services provided by banks on deposits included in the money supply, such as
provision of receipts in the form of canceled checks or the automatic paying of bills.
When these services are increased, the expected return from holding money rises.
2. The interest payments on money balances. NOW accounts and other deposits
that are included in the money supply currently pay interest. As these interest
payments rise, the expected return on money rises.
The terms rb rm and re rm represent the expected return on bonds and equity
relative to money; as they rise, the relative expected return on money falls, and the
demand for money falls. The final term, e rm, represents the expected return on
goods relative to money. The expected return from holding goods is the expected rate of
capital gains that occurs when their prices rise and hence is equal to the expected inflation
rate e. If the expected inflation rate is 10%, for example, then goods’ prices are
expected to rise at a 10% rate, and their expected return is 10%. When e rm rises,
the expected return on goods relative to money rises, and the demand for money falls.
Distinguishing Between the Friedman and Keynesian Theories
There are several differences between Friedman’s theory of the demand for money and
the Keynesian theories. One is that by including many assets as alternatives to money,
Friedman recognized that more than one interest rate is important to the operation of
the aggregate economy. Keynes, for his part, lumped financial assets other than money
into one big category—bonds—because he felt that their returns generally move
together. If this is so, the expected return on bonds will be a good indicator of the
expected return on other financial assets, and there will be no need to include them
separately in the money demand function.
Also in contrast to Keynes, Friedman viewed money and goods as substitutes; that
is, people choose between them when deciding how much money to hold. That is why
Friedman included the expected return on goods relative to money as a term in his
money demand function. The assumption that money and goods are substitutes indicates
that changes in the quantity of money may have a direct effect on aggregate spending.
In addition, Friedman stressed two issues in discussing his demand for money
function that distinguish it from Keynes’s liquidity preference theory. First, Friedman
did not take the expected return on money to be a constant, as Keynes did. When
interest rates rise in the economy, banks make more profits on their loans, and they
want to attract more deposits to increase the volume of their now more profitable
loans. If there are no restrictions on interest payments on deposits, banks attract
deposits by paying higher interest rates on them. Because the industry is competitive,
the expected return on money held as bank deposits then rises with the higher interest
rates on bonds and loans. The banks compete to get deposits until there are no
530 PA RT V I Monetary Theory
excess profits, and in doing so they close the gap between interest earned on loans
and interest paid on deposits. The net result of this competition in the banking industry
is that rb rm stays relatively constant when the interest rate i rises.14
What if there are restrictions on the amount of interest that banks can pay on their
deposits? Will the expected return on money be a constant? As interest rates rise, will
rb rm rise as well? Friedman thought not. He argued that although banks might be
restricted from making pecuniary payments on their deposits, they can still compete
on the quality dimension. For example, they can provide more services to depositors
by hiring more tellers, paying bills automatically, or making more cash machines available
at more accessible locations. The result of these improvements in money services
is that the expected return from holding deposits will rise. So despite the restrictions
on pecuniary interest payments, we might still find that a rise in market interest rates
will raise the expected return on money sufficiently so that rb rm will remain relatively
constant.15 Unlike Keynes’s theory, which indicates that interest rates are an
important determinant of the demand for money, Friedman’s theory suggests that
changes in interest rates should have little effect on the demand for money.
Therefore, Friedman’s money demand function is essentially one in which permanent
income is the primary determinant of money demand, and his money
demand equation can be approximated by:
f(Yp) (7)
In Friedman’s view, the demand for money is insensitive to interest rates—not because
he viewed the demand for money as insensitive to changes in the incentives for holding
other assets relative to money, but rather because changes in interest rates should
have little effect on these incentive terms in the money demand function. The incentive
terms remain relatively constant, because any rise in the expected returns on
other assets as a result of the rise in interest rates would be matched by a rise in the
expected return on money.
The second issue Friedman stressed is the stability of the demand for money
function. In contrast to Keynes, Friedman suggested that random fluctuations in the
demand for money are small and that the demand for money can be predicted accurately
by the money demand function. When combined with his view that the
demand for money is insensitive to changes in interest rates, this means that velocity
is highly predictable. We can see this by writing down the velocity that is implied by
the money demand equation (Equation 7):
(8)
Because the relationship between Y and Yp is usually quite predictable, a stable money
demand function (one that does not undergo pronounced shifts, so that it predicts the
V
Y
f (Yp )
Md
P
C H A P T E R 2 2 The Demand for Money 531
14Friedman does suggest that there is some increase in rb rm when i rises because part of the money supply (especially
currency) is held in forms that cannot pay interest in a pecuniary or nonpecuniary form. See, for example,
Milton Friedman, “Why a Surge of Inflation Is Likely Next Year,” Wall Street Journal, September 1, 1983, p. 24.
15Competing on the quality of services is characteristic of many industries that are restricted from competing on
price. For example, in the 1960s and early 1970s, when airfares were set high by the Civil Aeronautics Board,
airlines were not allowed to lower their fares to attract customers. Instead, they improved the quality of their service
by providing free wine, fancier food, piano bars, movies, and wider seats.
demand for money accurately) implies that velocity is predictable as well. If we can
predict what velocity will be in the next period, a change in the quantity of money
will produce a predictable change in aggregate spending. Even though velocity is no
longer assumed to be constant, the money supply continues to be the primary determinant
of nominal income as in the quantity theory of money. Therefore, Friedman’s
theory of money demand is indeed a restatement of the quantity theory, because it
leads to the same conclusion about the importance of money to aggregate spending.
You may recall that we said that the Keynesian liquidity preference function (in
which interest rates are an important determinant of the demand for money) is able to
explain the procyclical movements of velocity that we find in the data. Can Friedman’s
money demand formulation explain this procyclical velocity phenomenon as well?
The key clue to answering this question is the presence of permanent income
rather than measured income in the money demand function. What happens to permanent
income in a business cycle expansion? Because much of the increase in
income will be transitory, permanent income rises much less than income. Friedman’s
money demand function then indicates that the demand for money rises only a small
amount relative to the rise in measured income, and as Equation 8 indicates, velocity
rises. Similarly, in a recession, the demand for money falls less than income, because
the decline in permanent income is small relative to income, and velocity falls. In this
way, we have the procyclical movement in velocity.
To summarize, Friedman’s theory of the demand for money used a similar approach
to that of Keynes but did not go into detail about the motives for holding money.
Instead, Friedman made use of the theory of asset demand to indicate that the demand
for money will be a function of permanent income and the expected returns on alternative
assets relative to the expected return on money. There are two major differences
between Friedman’s theory and Keynes’s. Friedman believed that changes in interest
rates have little effect on the expected returns on other assets relative to money. Thus,
in contrast to Keynes, he viewed the demand for money as insensitive to interest rates.
In addition, he differed from Keynes in stressing that the money demand function does
not undergo substantial shifts and is therefore stable. These two differences also indicate
that velocity is predictable, yielding a quantity theory conclusion that money is the primary
determinant of aggregate spending.
Empirical Evidence on the Demand for Money
As we have seen, the alternative theories of the demand for money can have very different
implications for our view of the role of money in the economy. Which of these theories
is an accurate description of the real world is an important question, and it is the
reason why evidence on the demand for money has been at the center of many debates
on the effects of monetary policy on aggregate economic activity. Here we examine the
empirical evidence on the two primary issues that distinguish the different theories of
money demand and affect their conclusions about whether the quantity of money is the
primary determinant of aggregate spending: Is the demand for money sensitive to
changes in interest rates, and is the demand for money function stable over time?16
532 PA RT V I Monetary Theory
16If you are interested in a more detailed discussion of the empirical research on the demand for money, you can
find it in an appendix to this chapter on this book’s web site at www.aw.com/mishkin.
Earlier in the chapter, we saw that if interest rates do not affect the demand for money,
velocity is more likely to be a constant—or at least predictable—so that the quantity
theory view that aggregate spending is determined by the quantity of money is more
likely to be true. However, the more sensitive the demand for money is to interest
rates, the more unpredictable velocity will be, and the less clear the link between the
money supply and aggregate spending will be. Indeed, there is an extreme case of
ultrasensitivity of the demand for money to interest rates, called the liquidity trap, in
which monetary policy has no effect on aggregate spending, because a change in the
money supply has no effect on interest rates. (If the demand for money is ultrasensitive
to interest rates, a tiny change in interest rates produces a very large change in the
quantity of money demanded. Hence in this case, the demand for money is completely
flat in the supply and demand diagrams of Chapter 5. Therefore, a change in
the money supply that shifts the money supply curve to the right or left results in it
intersecting the flat money demand curve at the same unchanged interest rate.)
The evidence on the interest sensitivity of the demand for money found by different
researchers is remarkably consistent. Neither extreme case is supported by the
data: The demand for money is sensitive to interest rates, but there is little evidence
that a liquidity trap has ever existed.
If the money demand function, like Equation 4 or 6, is unstable and undergoes substantial
unpredictable shifts, as Keynes thought, then velocity is unpredictable, and
the quantity of money may not be tightly linked to aggregate spending, as it is in the
modern quantity theory. The stability of the money demand function is also crucial to
whether the Federal Reserve should target interest rates or the money supply (see
Chapter 18 and 24). Thus it is important to look at the question of whether the
money demand function is stable, because it has important implications for how
monetary policy should be conducted.
By the early 1970s, evidence strongly supported the stability of the money
demand function. However, after 1973, the rapid pace of financial innovation, which
changed what items could be counted as money, led to substantial instability in estimated
money demand functions. The recent instability of the money demand function
calls into question whether our theories and empirical analyses are adequate. It
also has important implications for the way monetary policy should be conducted,
because it casts doubt on the usefulness of the money demand function as a tool to
provide guidance to policymakers. In particular, because the money demand function
has become unstable, velocity is now harder to predict, and as discussed in Chapter
21, setting rigid money supply targets in order to control aggregate spending in the
economy may not be an effective way to conduct monetary policy.
Stability of Money
Demand
Interest Rates
and Money
Demand
C H A P T E R 2 2 The Demand for Money 533
Summary
1. Irving Fisher developed a transactions-based theory of
the demand for money in which the demand for real
balances is proportional to real income and is
insensitive to interest-rate movements. An implication
of his theory is that velocity, the rate of turnover of
money, is constant. This generates the quantity theory
of money, which implies that aggregate spending is
determined solely by movements in the quantity of
money.
2. The classical view that velocity can be effectively treated
as a constant is not supported by the data. The
nonconstancy of velocity became especially clear to the
534 PA RT V I Monetary Theory
economics profession after the sharp drop in velocity
during the years of the Great Depression.
3. John Maynard Keynes suggested three motives for
holding money: the transactions motive, the
precautionary motive, and the speculative motive. His
resulting liquidity preference theory views the
transactions and precautionary components of money
demand as proportional to income. However, the
speculative component of money demand is viewed as
sensitive to interest rates as well as to expectations
about the future movements of interest rates. This
theory, then, implies that velocity is unstable and
cannot be treated as a constant.
4. Further developments in the Keynesian approach
provided a better rationale for the three Keynesian
motives for holding money. Interest rates were found to
be important to the transactions and precautionary
components of money demand as well as to the
speculative component.
5. Milton Friedman’s theory of money demand used a
similar approach to that of Keynes. Treating money like
any other asset, Friedman used the theory of asset
demand to derive a demand for money that is a
function of the expected returns on other assets relative
to the expected return on money and permanent
income. In contrast to Keynes, Friedman believed that
the demand for money is stable and insensitive to
interest-rate movements. His belief that velocity is
predictable (though not constant) in turn leads to the
quantity theory conclusion that money is the primary
determinant of aggregate spending.
6. There are two main conclusions from the research on
the demand for money: The demand for money is
sensitive to interest rates, but there is little evidence that
the liquidity trap has ever existed; and since 1973,
money demand has been found to be unstable, with the
most likely source of the instability being the rapid pace
of financial innovation.
Key Terms
equation of exchange, p. 518
liquidity preference theory, p. 521
monetary theory, p. 517
quantity theory of money, p. 519
real money balances, p. 523
velocity of money, p. 518
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. The money supply M has been growing at 10% per
year, and nominal GDP PY has been growing at 20%
per year. The data are as follows (in billions of dollars):
2001 2002 2003
M 100 110 121
PY 1,000 1,200 1,440
Calculate the velocity in each year. At what rate is
velocity growing?
2. Calculate what happens to nominal GDP if velocity
remains constant at 5 and the money supply increases
from $200 billion to $300 billion.
*3. What happens to nominal GDP if the money supply
grows by 20% but velocity declines by 30%?
4. If credit cards were made illegal by congressional legislation,
what would happen to velocity? Explain your
answer.
*5. If velocity and aggregate output are reasonably constant
(as the classical economists believed), what happens
to the price level when the money supply
increases from $1 trillion to $4 trillion?
6. If velocity and aggregate output remain constant at 5
and 1,000, respectively, what happens to the price
level if the money supply declines from $400 billion
to $300 billion?
*7. Looking at Figure 1 in the chapter, when were the two
largest falls in velocity? What do declines like this sug-
QUIZ
C H A P T E R 2 2 The Demand for Money 535
gest about how velocity moves with the business
cycle? Given the data in Figure 1, is it reasonable to
assume, as the classical economists did, that declines
in aggregate spending are caused by declines in the
quantity of money?
8. Using data from the Economic Report of the President,
calculate velocity for the M2 definition of the money
supply in the past five years. Does velocity appear to
be constant?
*9. In Keynes’s analysis of the speculative demand for
money, what will happen to money demand if people
suddenly decide that the normal level of the interest
rate has declined? Why?
10. Why is Keynes’s analysis of the speculative demand for
money important to his view that velocity will
undergo substantial fluctuations and thus cannot be
treated as constant?
*11. If interest rates on bonds go to zero, what does the
Baumol-Tobin analysis suggest Grant Smith’s average
holdings of money balances should be?
12. If brokerage fees go to zero, what does the Baumol-
Tobin analysis suggest Grant Smith’s average holdings
of money should be?
*13. “In Tobin’s analysis of the speculative demand for
money, people will hold both money and bonds, even
if bonds are expected to earn a positive return.” Is this
statement true, false, or uncertain? Explain your
answer.
14. Both Keynes’s and Friedman’s theories of the demand
for money suggest that as the relative expected return
on money falls, demand for it will fall. Why does
Friedman think that money demand is unaffected by
changes in interest rates, but Keynes thought that it is
affected?
*15. Why does Friedman’s view of the demand for money
suggest that velocity is predictable, whereas Keynes’s
view suggests the opposite?
Web Exercises
1. Refer to Figure 1. The formula for computing the
velocity of money is GDP/M1. Go to www.research
.stlouisfed.org/fred/data/gdp.html and look up the GDP.
Next go to www.federalreserve.gov/Releases/h6/Current/
and find M1. Compute the most recent year’s velocity of
money and compare it to its level in 2002. Has it risen
or fallen? Suggest reasons for its change since that time.
2. John Maynard Keynes is among the most well known
economic theorists. Go to www-gap.dcsn.st-and
.ac.uk/~history/Mathematicians/Keynes.html and write
a one-page summary of his life and contributions.
Baumol-Tobin Model of Transactions Demand for Money
The basic idea behind the Baumol-Tobin model was laid out in the chapter. Here we
explore the mathematics that underlie the model. The assumptions of the model are
as follows:
1. An individual receives income of T0 at the beginning of every period.
2. An individual spends this income at a constant rate, so at the end of the period,
all income T0 has been spent.
3. There are only two assets—cash and bonds. Cash earns a nominal return of zero,
and bonds earn an interest rate i.
4. Every time an individual buys or sells bonds to raise cash, a fixed brokerage fee
of b is incurred.
Let us denote the amount of cash that the individual raises for each purchase or
sale of bonds as C, and n the number of times the individual conducts a transaction
in bonds. As we saw in Figure 3 in the chapter, where T0 1,000, C 500, and
n 2:
Because the brokerage cost of each bond transaction is b, the total brokerage costs for
a period are:
Not only are there brokerage costs, but there is also an opportunity cost to holding
cash rather than bonds. This opportunity cost is the bond interest rate i times average
cash balances held during the period, which, from the discussion in the chapter,
we know is equal to C/2. The opportunity cost is then:
Combining these two costs, we have the total costs for an individual equal to:
COSTS
bT0
C

iC
2
iC
2
nb
bT0
C
n
T0
C
A Mathematical Treatment of
the Baumol-Tobin and Tobin
Mean-Variance Models
appendix 1
to chapter 22
1
The individual wants to minimize costs by choosing the appropriate level of C.
This is accomplished by taking the derivative of costs with respect to C and setting it
to zero.1 That is:
Solving for C yields the optimal level of C:
Because money demand Md is the average desired holding of cash balances C/2,
(1)
This is the famous square root rule.2 It has these implications for the demand for
money:
1. The transactions demand for money is negatively related to the interest rate i.
2. The transactions demand for money is positively related to income, but there are
economies of scale in money holdings—that is, the demand for money rises less
than proportionally with income. For example, if T0 quadruples in Equation 1,
the demand for money only doubles.
3. A lowering of the brokerage costs due to technological improvements would
decrease the demand for money.
4. There is no money illusion in the demand for money. If the price level doubles,
T0 and b will double. Equation 1 then indicates that M will double as well. Thus
the demand for real money balances remains unchanged, which makes sense
because neither the interest rate nor real income has changed.
Md
1
22bT0
i
bT0
2i
C 2bT0
i
d COSTS
dC

bT0
C2
i
2
0
A Mathematical Treatment of the Baumol-Tobin and Tobin Mean-Variance Models
1To minimize costs, the second derivative must be greater than zero. We find that it is, because:
2An alternative way to get Equation 1 is to have the individual maximize profits, which equal the interest on
bonds minus the brokerage costs. The average holding of bonds over a period is just:
Thus profits are:
Then:
This equation yields the same square root rule as Equation 1.
d PROFITS
dC

i
2

bT0
C2 0
PROFITS
i
2
(T0 C)
bT0
C
T0
2

C
2
d2COSTS
dC2
2
C3 (bT0 )
2bT0
C3
 0
2
Tobin Mean-Variance Model
Tobin’s mean-variance analysis of money demand is just an application of the basic
ideas in the theory of portfolio choice. Tobin assumes that the utility that people
derive from their assets is positively related to the expected return on their portfolio
of assets and is negatively related to the riskiness of this portfolio as represented by
the variance (or standard deviation) of its returns. This framework implies that an
individual has indifference curves that can be drawn as in Figure 1. Notice that these
indifference curves slope upward because an individual is willing to accept more risk
if offered a higher expected return. In addition, as we go to higher indifference curves,
utility is higher, because for the same level of risk, the expected return is higher.
Tobin looks at the choice of holding money, which earns a certain zero return, or
bonds, whose return can be stated as:
RB i g
where i interest rate on the bond
g capital gain
Tobin also assumes that the expected capital gain is zero3 and its variance is g
2. That is,
E(g) 0 and so E(RB) i 0 i
Var(g) E[g E(g)]2 E(g2) g
2
Appendix 1 to Chapter 22
FIGURE 1 Indifference Curves
in a Mean-Variace Model
The indifference curves are
upward-sloping, and higher indifference
curves indicate that utility
is higher. In other words,
U3
 U2
 U1.
Expected Return
Higher
Utility
Standard Deviation of Returns
U3
U2
U1
3 This assumption is not critical to the results. If E(g) ≠ 0, it can be added to the interest term i, and the analysis
proceeds as indicated.
3
where E expectation of the variable inside the parentheses
Var variance of the variable inside the parentheses
If A is the fraction of the portfolio put into bonds (0 ≤ A ≤ 1) and 1 A is the
fraction of the portfolio held as money, the return R on the portfolio can be written
as:
R ARB (1 A)(0) ARB A(i g)
Then the mean and variance of the return on the portfolio, denoted respectively as
and 2, can be calculated as follows:
E(R) E(ARB) AE(RB) Ai
2 E(R )2 E[A(i g) Ai]2 E(Ag)2 A2E(g2) A2g
2
Taking the square root of both sides of the equation directly above and solving for A
yields:
(2)
Substituting for A in the equation Ai using the preceding equation gives us:
(3)
Equation 3 is known as the opportunity locus because it tells us the combinations
of and that are feasible for the individual. This equation is written in a form in
which the variable corresponds to the Y axis and the variable to the X axis. The
opportunity locus is a straight line going through the origin with a slope of i/g. It is
drawn in the top half of Figure 2 along with the indifference curves from Figure 1.
The highest indifference curve is reached at point B, the tangency of the indifference
curve and the opportunity locus. This point determines the optimal level of risk
* in the figure. As Equation 2 indicates, the optimal level of A, A*, is:
This equation is solved in the bottom half of Figure 2. Equation 2 for A is a straight
line through the origin with a slope of 1/g. Given *, the value of A read off this line
is the optimal value A*. Notice that the bottom part of the figure is drawn so that as
we move down, A is increasing.
Now let’s ask ourselves what happens when the interest rate increases from i1 to
i2. This situation is shown in Figure 3. Because g is unchanged, the Equation 2 line
in the bottom half of the figure does not change. However, the slope of the opportunity
locus does increase as i increases. Thus the opportunity locus rotates up and we
move to point C at the tangency of the new opportunity locus and the indifference
curve. As you can see, the optimal level of risk increases from *
1 and *
2 the optimal
fraction of the portfolio in bonds rises from A*
1 to A*
2. The result is that as the interest
A

g

i
g

A
1
g

A Mathematical Treatment of The Baumol-Tobin and Tobin Mean-Variance Models
* *
4
rate on bonds rises, the demand for money falls; that is, 1 A, the fraction of the
portfolio held as money, declines.4
Tobin’s model then yields the same result as Keynes’s analysis of the speculative
demand for money: It is negatively related to the level of interest rates. This model,
however, makes two important points that Keynes’s model does not:
1. Individuals diversify their portfolios and hold money and bonds at the same time.
2. Even if the expected return on bonds is greater than the expected return on
money, individuals will still hold money as a store of wealth because its return is
more certain.
Appendix 1 to Chapter 22
FIGURE 2 Optimal Choice of
the Fraction of the Portfolio in Bonds
The highest indifference curve is
reached at a point B, the tangency
of the indifference curve with the
opportunity locus. This point
determines the optimal risk *,
and using Equation 2 in the bottom
half of the figure, we solve for
the optimal fraction of the portfolio
in bonds A*.


*
A*
A
B
Slope = i/g
Slope = 1/g
Eq. 3
Opportunity
Locus
Eq. 2
4The indifference curves have been drawn so that the usual result is obtained that as i goes up, A* goes up as
well. However, there is a subtle issue of income versus substitution effects. If, as people get wealthier, they are
willing to bear less risk, and if this income effect is larger than the substitution effect, then it is possible to get
the opposite result that as i increases, A* declines. This set of conditions is unlikely, which is why the figure is
drawn so that the usual result is obtained. For a discussion of income versus substitution effects, see David
Laidler, The Demand for Money: Theories and Evidence, 4th ed. (New York: HarperCollins, 1993).
5
A Mathematical Treatment of The Baumol-Tobin and Tobin Mean-Variance Models
FIGURE 3 Optimal Choice of
the Fraction of the Portfolio in Bonds
as the Interest Rate Rises
The interest rate on bonds rises
from i1 to i2, rotating the opportunity
locus upward. The highest
indifference curve is now at point
C, where it is tangent to the new
opportunity locus. The optimal
level of risk rises from 1
* to 2
*,
and then Equation 2, in the bottom
haf of the figure, shows that
the optimal fraction of the portfolio
in bonds rises from A1
* to A2
*.


*
A*
A
B
C
Slope = i2/g
Slope = 1/g
Slope = i1/g
1 *2
1
A*2
6
Here we examine the empirical evidence on the two primary issues that distinguish
the different theories of money demand and affect their conclusions about whether
the quantity of money is the primary determinant of aggregate spending: Is the
demand for money sensitive to changes in interest rates, and is the demand for money
function stable over time?
James Tobin conducted one of the earliest studies on the link between interest rates
and money demand using U.S. data.1 Tobin separated out transactions balances from
other money balances, which he called “idle balances,” assuming that transactions
balances were proportional to income only, and idle balances were related to interest
rates only. He then looked at whether his measure of idle balances was inversely
related to interest rates in the period 1922–1941 by plotting the average level of idle
balances each year against the average interest rate on commercial paper that year.
When he found a clear-cut inverse relationship between interest rates and idle balances,
Tobin concluded that the demand for money is sensitive to interest rates.2
Additional empirical evidence on the demand for money strongly confirms
Tobin’s finding.3 Does this sensitivity ever become so high that we approach the case
of the liquidity trap in which monetary policy is ineffective? The answer is almost certainly
no. Keynes suggested in The General Theory that a liquidity trap might occur
when interest rates are extremely low. (However, he did state that he had never yet
seen an occurrence of a liquidity trap.)
Typical of the evidence demonstrating that the liquidity trap has never occurred
is that of David Laidler, Karl Brunner, and Allan Meltzer, who looked at whether the
interest sensitivity of money demand increased in periods when interest rates were
Interest Rates
and Money
Demand
Empirical Evidence on
the Demand for Money
appendix 2
to chapter 22
1James Tobin, “Liquidity Preference and Monetary Policy,” Review of Economics and Statistics 29 (1947): 124–131.
2A problem with Tobin’s procedure is that idle balances are not really distinguishable from transactions balances.
As the Baumol-Tobin model of transactions demand for money makes clear, transactions balances will be related
to both income and interest rates, just like idle balances.
3See David E. W. Laidler, The Demand for Money: Theories and Evidence, 4th ed. (New York: HarperCollins, 1993).
Only one major study has found that the demand for money is insensitive to interest rates: Milton Friedman,
“The Demand for Money: Some Theoretical and Empirical Results,” Journal of Political Economy 67 (1959):
327–351. He concluded that the demand for money is not sensitive to interest-rate movements, but as later work
by David Laidler (using the same data as Friedman) demonstrated, Friedman used a faulty statistical procedure
that biased his results: David E. W. Laidler, “The Rate of Interest and the Demand for Money: Some Empirical
Evidence,” Journal of Political Economy 74 (1966): 545–555. When Laidler employed the correct statistical procedure,
he found the usual result that the demand for money is sensitive to interest rates. In later work, Friedman
has also concluded that the demand for money is sensitive to interest rates.
1
very low.4 Laidler and Meltzer looked at this question by seeing whether the interest
sensitivity of money demand differed across periods, especially in periods such as the
1930s when interest rates were particularly low.5 They found that there was no tendency
for interest sensitivity to increase as interest rates fell—in fact, interest sensitivity
did not change from period to period. Brunner and Meltzer explored this
question by recognizing that higher interest sensitivity in the 1930s as a result of a liquidity
trap implies that a money demand function estimated for this period should
not predict well in more normal periods. What Brunner and Meltzer found was that
a money demand function, estimated mostly with data from the 1930s, accurately
predicted the demand for money in the 1950s. This result provided little evidence in
favor of the existence of a liquidity trap during the Great Depression period.
The evidence on the interest sensitivity of the demand for money found by different
researchers is remarkably consistent. Neither extreme case is supported by the
data: The demand for money is sensitive to interest rates, but there is little evidence
that a liquidity trap has ever existed.
If the money demand function, like Equation 4 or 6 in Chapter 22, is unstable and
undergoes substantial unpredictable shifts, as Keynes thought, then velocity is unpredictable,
and the quantity of money may not be tightly linked to aggregate spending,
as it is in the modern quantity theory. The stability of the money demand function is
also crucial to whether the Federal Reserve should target interest rates or the money
supply (see Chapter 24). Thus it is important to look at the question of whether the
money demand function is stable, because it has important implications for how
monetary policy should be conducted.
As our discussion of the Brunner and Meltzer article indicates, evidence on the
stability of the demand for money function is related to the evidence on the existence
of a liquidity trap. Brunner and Meltzer’s finding that a money demand function estimated
using data mostly from the 1930s predicted the demand for money well in the
postwar period not only suggests that a liquidity trap did not exist in the 1930s, but
also indicates that the money demand function has been stable over long periods of
time. The evidence that the interest sensitivity of the demand for money did not
change from period to period also suggests that the money demand function is stable,
since a changing interest sensitivity would mean that the demand for money function
estimated in one period would not be able to predict well in another period.
By the early 1970s, the evidence using quarterly data from the postwar period
strongly supported the stability of the money demand function when M1 was used as
the definition of the money supply. For example, a well-known study by Stephen
Goldfeld published in 1973 found not only that the interest sensitivity of M1 money
demand did not undergo changes in the postwar period, but also that the M1 money
demand function predicted extremely well throughout the postwar period.6 As a
Stability of Money
Demand
Empirical Evidence on the Demand for Money
4David E. W. Laidler, “Some Evidence on the Demand for Money,” Journal of Political Economy 74 (1966): 55–68;
Allan H. Meltzer, “The