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This International Student Edition is for use outside of the U.S.

SIXTH EDI TIO N

Money, Banking,
and Financial Markets
Stephen G. Cecchetti Kermit L . Schoenholtz
Money, Banking, and Financial Markets
Sixth Edition

Stephen G. Cecchetti
Brandeis International Business School

Kermit L. Schoenholtz
New York University
Leonard N. Stern School of Business
MONEY, BANKING, AND FINANCIAL MARKETS

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright ©2021 by McGraw-
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Dedication

To my father, Giovanni Cecchetti, who argued tirelessly that financial markets are not
efficient; and to my grandfather, Albert Schwabacher, who patiently explained why
inflation is destructive.
Stephen G. Cecchetti

To my wife, Elvira Pratsch, who continues to teach me what is true, good, and
beautiful.
Kermit L. Schoenholtz
About the Authors
Stephen G. Cecchetti is
Rosen Family Chair in In-
ternational Finance at the
Brandeis International
Business School (http://
people.brandeis.edu/~
cecchett/). He previously
taught at Brandeis from
2003 to 2008. Before re-
joining Brandeis in 2014,
­Cecchetti completed a five-
year term as Economic Ad-
viser and Head of the Monetary and Economic
Department at the Bank for International Settlements in
Basel, Switzerland. During his time at the Bank for In-
ternational Settlements, ­Cecchetti was involved in nu-
merous postcrisis global regulatory reform initiatives,
including the work of the Basel Committee on Banking
Supervision and the ­Financial Stability Board.
He has also taught at the New York University
­Leonard N. Stern School of Business and at The Ohio
State University. In addition to his other appointments,
­Cecchetti served as Executive Vice President and Direc-
tor of Research, Federal Reserve Bank of New York
(1997–1999); Editor, Journal of Money, Credit, and
Banking (1992–2001); Research Associate, National
Bureau of Economic Research (1989–2011); and
­Research ­Fellow, Centre for Economic Policy Research
(2008–present), among others.
Cecchetti’s research interests include inflation and
price measurement, monetary policy, macroeconomic
theory, economics of the Great Depression, and the eco-
nomics of financial regulation.
Cecchetti received an SB in Economics from the
Massachusetts Institute of Technology in 1977 and a
PhD in Economics from the University of California
at Berkeley in 1982. In 2016, he received an Honor-
ary Doctorate in Economics from the University of
Basel.
iv
Kermit L. Schoenholtz
is the Henry Kaufman
Professor of the History
of Financial Institutions
and Markets in the
Department of Eco-
­
nomics of New York
University’s Leonard N.
Stern School of Busi-
ness, where he teaches
courses on money and
banking (http://pages.
stern.nyu.edu/~kschoenh). He also directs NYU
Stern’s Center for Global Economy and Business
(www.stern.nyu.edu/cgeb). Schoenholtz was
­Citigroup’s global chief economist from 1997 until
2005.
Schoenholtz joined Salomon Brothers in 1986,
working in its New York, Tokyo, and London of-
fices. In 1997, he became chief economist at
­Salomon, after which he became chief economist at
Salomon Smith ­Barney and later at Citigroup.
Schoenholtz has published extensively for the
professional investment community about financial,
economic, and policy developments; more recently,
he has contributed to policy-focused scholarly re-
search in economics. He is a member of the Finan-
cial Research Advisory Committee of the U.S.
Treasury’s Office of Financial Research, a panel
member of the U.S. Monetary Policy Forum, and a
member of the Council on Foreign Relations.
He also has served as a member of the Executive
Committee of the London-based Centre for Eco-
nomic Policy Research.
From 1983 to 1985, Schoenholtz was a Visiting
Scholar at the Bank of Japan’s Institute for Monetary
and Economic Studies. He received an MPhil in eco-
nomics from Yale University in 1982 and an AB
from Brown University in 1977.
Preface
The world of money, banking, and financial markets
is constantly evolving. Every year, people explore
new ways to pay for purchases, save for the future,
and borrow to meet current needs.
New technology is an ongoing source of change.
Internet banking makes it easier than ever for indi-
viduals to take control of their finances. And smart-
phones not only allow American college students to
pay for their morning coffee but also are giving hun-
dreds of millions of people in poor countries their
first access to the financial system.
In some instances, crises provided the impetus for
change. For example, new regulations aimed at mak-
ing the financial system safer have pushed many banks
to take fewer risks than they did just a few years ago.
Financial markets also have become more resilient and
less likely to need public support. And monetary poli-
cymakers, especially in places where economic growth
has slowed and deflation is a risk, have adopted a slew
of policies never seen before. In much of Europe and
Japan, interest rates have fallen below zero—breaking
through what had long been seen as a permanent
­barrier—while new policies are in place to boost
bank lending and restore inflation and growth to pre-
crisis levels.
The same things that are reshaping the global fi-
nancial system also are transforming the study of
money and banking. Some old questions are surfac-
ing with new intensity: How can individuals use the
changing financial system to improve their lives?
How can governments ensure that the financial sys-
tem remains stable? How should we balance the need
for financial resilience with the goals of competition,
efficiency, and innovation? And how can monetary
policymakers keep inflation low, employment high,
and both of them stable?
Against this background, students who memorize
the operational details of today’s financial system are
investing in a short-lived asset. Our purpose in writ-
ing this book is to focus on the basic functions served
by the financial system while deemphasizing its cur-
rent structure and rules. Learning the economic ratio-
nale behind current financial tools, rules, and
structures is much more valuable than concentrating
on the tools, rules, and structures themselves. It is an
approach designed to give students the lifelong abil-
ity to understand and evaluate whatever financial in-
novations and developments they may one day
confront.
The Core Principles
Approach
Toward that end, the entire content of this book is
based on five core principles. Knowledge of these
principles is the basis for understanding what the
financial system does, how it is organized, how it is
linked to the real economy, and how it is changing. If
you understand these five principles, you will under-
stand the future:
1. Time has value.
2. Risk requires compensation.
3. Information is the basis for decisions.
4. Markets determine prices and allocate
resources.
5. Stability improves welfare.
These five core principles serve as a framework
through which to view the history, current status,
and future development of money and banking.
They are discussed in detail in Chapter 1; through-
out the rest of the text, marginal icons remind
students of the principles that underlie particular
discussions.
Focusing on core principles has created a book
that is both concise and logically organized. This ap-
proach does require some adjustments to the tradi-
tional methodology used to teach money and
banking, but for the most part they are changes in
emphasis only. That said, some of these changes have
greatly improved both the ease of teaching and the
value students draw from the course. Among them
are the emphasis on risk and on the lessons from the
financial crisis; use of the term financial instrument;
parallel presentation of the Federal Reserve and the
v
vi l Preface
European Central Bank; a streamlined, updated sec-
tion on monetary economics; and the adoption of an
integrated global perspective.
Innovations in This Text
In addition to the focus on core principles, this book
introduces a series of innovations designed to foster
coherence, relevance, and timeliness in the study of
money and banking.
The Money and Banking Blog
The global economy and financial system of the 21st
century is evolving quickly. Changes in technology,
in the structure of financial institutions and markets,
and in monetary and regulatory policy are occur-
ring at a pace that far outstrips the normal three-
or four-year cycle at which textbooks are revised.
We designed the Money and Banking blog to keep
examples and applications current. Available at
www.moneyandbanking.com, the blog provides timely
commentary on events in the news and on questions of
more lasting interest.
The blog is closely linked to this book. Like the
book, it aims to enhance students’ understanding of
the world around them. Based on the five core prin-
ciples of money and banking, each blog entry is as-
sociated with a specific chapter. Students following
the blog will learn how current events affect the vari-
ous parts of the financial system—money, financial
instruments, financial markets, financial institutions,
financial regulators, and central banks.
The material from the blog also is integrated into
the book in two ways. First, each chapter includes a
“Money and Banking Blog” boxed reading. These
are short versions of postings that have appeared on
www.moneyandbanking.com since the publication of
the previous edition of this text. These excerpts de-
scribe current issues that highlight the lessons in the
body of the chapter. Second, the website includes a
listing of the posts by chapter. This listing allows stu-
dents and instructors alike to find new, up-to-date
material that illustrates the lessons and core princi-
ples emphasized in each chapter.
To receive the latest commentary as it is posted
every week or so, subscribe to the blog at
www.moneyandbanking.com. You can also follow
the authors on Twitter (@MoneyBanking1).
Federal Reserve Economic
Data (FRED)
Money, Banking, and Financial Markets systemati-
cally integrates the use of economic and financial
data from FRED, the online database provided free
of charge to the public by the Federal Reserve Bank
of St. Louis. As of this writing, FRED offers nearly
600,000 data series from more than 85 sources,
including indicators for about 200 countries. Infor-
mation on using FRED appears in Appendix B to
Chapter 1.
Through frequent use of FRED, students will
gain up-to-date knowledge of the U.S. and other
economies and an understanding of the real-world
challenges of economic measurement; they will also
gain skills in analysis and data manipulation that
will serve them well for years to come. Many of the
graphs in this book were produced (and can be eas-
ily updated) using FRED. In addition, end-of-­
chapter Data Exploration problems call on students
to use FRED to analyze key economic and financial
indicators highlighted in that chapter. (For detailed
instructions for using FRED online to answer the
Data Exploration problems in Chapters 1 to 10, visit
www.mhhe.com/moneyandbanking6e and click on
Data Exploration Hints.) Students can even do some
assignments using the FRED app for their mobile
devices.
Impact of the Crises
The effects of the global financial crisis of 2007–
2009 and the euro-area crisis that began in 2010
transformed money, banking, and financial markets.
Accordingly, from beginning to end, the book inte-
grates the issues raised by these crises and by the
responses of policymakers.
The concept of a liquidity crisis surfaces in
­Chapter 2, and the risks associated with leverage and
the rise of shadow banking are introduced in Chapter 3.
Issues specific to the 2007–2009 crisis—including
securitization, rating agencies, subprime mort-
gages, over-the-counter trading, and complex financial
instruments like credit-default swaps—are included in
the appropriate intermediate chapters of the text.
­Chapter 16 explores the role of the European Central
Bank in managing the euro-area crisis. More broadly,
the sources of threats to the financial system as a whole
are identified throughout the book, and there is a

f­ocused discussion on regulatory initiatives to limit
such systemic threats. Finally, we present—in a logical
and organized manner—the unconventional monetary
policy tools, including the use of negative interest rates
and the concept of the effective lower bound, that have
become so prominent in postcrisis policy debates and
remain relevant today.
Early Introduction of Risk
It is impossible to appreciate how the financial sys-
tem works without understanding risk. In the mod-
ern financial world, virtually all transactions transfer
some degree of risk between two or more parties.
These risk trades can be extremely beneficial, as they
are in the case of insurance markets. But there is still
potential for disaster. In 2008, risk-trading activity at
some of the world’s largest financial firms threatened
the stability of the international financial system.
Even though risk is absolutely central to an under-
standing of the financial system, most money and
banking books give very little space to the topic. In
contrast, this book devotes an entire chapter to defin-
ing and measuring risk. Chapter 5 introduces the
concept of a risk premium as compensation for risk
and shows how diversification can reduce risk. Be-
cause risk is central to explaining the valuation of fi-
nancial instruments, the role of financial
intermediaries, and the job of central bankers, the
book returns to this concept throughout the chapters.
Emphasis on Financial Instruments
Financial instruments are introduced early in the
book, where they are defined based on their eco-
nomic function. This perspective leads naturally to
a discussion of the uses of various instruments and
the determinants of their value. Bonds, stocks, and
derivatives all fit neatly into this framework, so they
are all discussed together.
This approach solves one of the problems with
existing texts, use of the term f­ inancial market to re-
fer to bonds, interest rates, and foreign exchange. In
its conventional microeconomic sense, the term mar-
ket signifies a place where trade o­ ccurs, not the in-
struments that are traded. This book follows standard
usage of the term market to mean a place for trade. It
uses the term financial instruments to describe virtu-
ally all financial arrangements, including loans,
Preface l vii
bonds, stocks, futures, options, and insurance
­contracts. Doing so clears up the confusion that
can arise when students arrive in a money and bank-
ing class fresh from a course in the principles of
­economics.
Parallel Presentation of the
Federal Reserve and the
European Central Bank
To foster a deeper understanding of central banking
and monetary policy, the presentation of this material
begins with a discussion of the central bank’s role and
objectives. Descriptions of the Federal Reserve and
the European Central Bank follow. By starting on a
theoretical plane, students gain the tools they need to
understand how all central banks work. This avoids
focusing on institutional details that may quickly
become obsolete. Armed with a basic understand-
ing of what central banks do and how they do it, stu-
dents will be prepared to grasp the meaning of future
changes in institutional structure.
Another important innovation is the parallel dis-
cussion of the two most important central banks in
the world, the Federal Reserve and the European
Central Bank (ECB). Students of the 21st century are
ill-served by books that focus entirely on the U.S. fi-
nancial system. They need a global perspective on
central banking, the starting point for which is a de-
tailed knowledge of the ECB.
Modern Treatment of Monetary
Economics
The discussion of central banking is followed by a
simple framework for understanding the impact of
monetary policy on the real economy. Modern cen-
tral bankers think and talk about changing the inter-
est rate when inflation deviates from its target and
output deviates from its normal level. Yet traditional
treatments of monetary economics employ aggregate
demand and aggregate supply diagrams, which relate
output to the price level. Our approach is consistent
with that in the most recent editions of the leading
macroeconomics textbooks and directly links output
to inflation, simplifying the exposition and highlight-
ing the role of monetary policy. Because this book
also skips the IS-LM framework, its presentation
viii l Preface
of monetary economics is several chapters shorter.
Only those topics that are most important in a mon-
etary economics course are covered: long-run money
growth and inflation and short-run monetary policy
and business cycles. This streamlined treatment of
monetary theory is not only concise but more mod-
ern and more relevant than the traditional approach.
It helps students to see monetary policy changes as
part of a strategy rather than as one-off events, and
it gives them a complete understanding of business
cycle fluctuations.
Integrated Global Perspective
Technological advances have dramatically reduced
the importance of a bank’s physi­cal location, produc-
ing a truly global financial system. Twenty-five years
ago money and banking books could afford to focus
primarily on the U.S. financial system, relegating
international topics to a separate chapter that could be
considered optional. But in today’s financial world,
even a large country like the United States cannot be
treated in isolation. The global financial system is
truly an integrated one, rendering separate discussion
of a single country’s institutions, markets, or policies
impossible. This book incorporates the discussion of
international issues throughout the text, emphasizing
when national borders are important to bankers and
when they are not.
Organization
This book is organized to help students understand
both the financial system and its economic effects on
their lives. That means surveying a broad series of top-
ics, including what money is and how it is used; what
a financial instrument is and how it is valued; what a
financial market is and how it works; what a financial
institution is and why we need it; and what a central
bank is and how it operates. More important, it means
showing students how to apply the five core principles
of money and banking to the evolving financial and
economic arrangements that they inevitably will con-
front during their lifetimes.
Part I: Money and the Financial S
­ ystem.
Chapter 1 introduces the core principles of money
and banking, which serve as touchstones throughout
the book. It also presents FRED, the free online
d­ atabase of the Federal Reserve Bank of St. Louis.
The book often uses FRED data for figures and
tables, and every chapter calls on students to use
FRED to solve end-of-chapter problems. Chapter 2
examines money both in theory and in practice.
Chapter 3 follows with a bird’s-eye view of finan-
cial instruments, financial markets, and financial
institutions. (Instructors who prefer to discuss the
financial system first can cover Chapters 2 and 3 in
reverse order.)
Part II: Interest Rates, Financial Instru-
ments, and Financial Markets. ​Part II con-
tains a detailed description of financial instruments
and the financial theory required to understand
them. It begins with an explanation of present value
and risk, followed by specific discussions of bonds,
stocks, derivatives, and foreign exchange. Students
benefit from concrete examples of these concepts.
In Chapter 7 (The Risk and Term Structure of In-
terest Rates), for example, students learn how the
information contained in the risk and term struc-
ture of interest rates can be useful in forecasting. In
Chapter 8 (Stocks, Stock Markets, and Market Ef-
ficiency), they learn about stock bubbles and how
those anomalies influence the economy. And in
Chapter 10 (Foreign Exchange), they study the Big
Mac index and learn to understand the concepts of
purchasing power parity and interest rate parity.
Throughout this section, two ideas are emphasized:
that financial instruments transfer resources from
savers to investors, and that in doing so, they trans-
fer risk to those best equipped to bear it.
Part III: Financial Institutions. In Part III,
the focus shifts to financial institutions. Chapter 11
introduces the economic theory that is the basis for
our understanding of the role of financial intermedi-
aries. Through a series of examples, students see the
problems created by asymmetric information as well
as how financial intermediaries can mitigate those
problems. The remaining chapters in Part III put the-
ory into practice. Chapter 12 presents a detailed dis-
cussion of banking, the bank balance sheet, and the
risks that banks must manage. Chapter 13 provides a
brief overview of the financial industry’s structure,
and Chapter 14 explains financial regulation, includ-
ing a discussion of regulation to limit threats to the
financial system as a whole and of efforts to limit the
increased regulatory burden.

Part IV: Central Banks, Monetary Policy, transmission mechanism in some detail and ad-
and Financial S
­ tability. Chapters 15 through dresses key challenges facing central banks, such as
19 survey what central banks do and how they do it.
This part of the book begins with a discussion of the
role and objectives of central banks, which leads nat-
urally to the principles that guide central bank de-
sign. Chapter 16 applies those principles to the
Federal Reserve and the European Central Bank,
highlighting the strategic importance of their numeri-
cal inflation objectives and their communications.
Chapter 17 presents the central bank balance sheet,
the process of multiple deposit creation, and the
money supply. Chapters 18 and 19 cover operational
policy, based on control of both the interest rate and
the exchange rate. Chapter 18 also introduces the
monetary transmission mechanism and presents a va-
riety of unconventional monetary policy tools, in-
cluding negative interest rates and the concept of the
effective lower bound, that have become so promi-
nent in recent years. The goal of Part IV is to give
students the knowledge they will need to cope with
the inevitable changes that will occur in central bank
structure.
Part V: Modern Monetary Economics. The
last part of the book covers modern monetary eco-
nomics. While most books cover this topic in six or
more chapters, this one does it in four. This stream-
lined approach concentrates on what is important,
presenting only the essential lessons that students
truly need. Chapter 20 sets the stage by exploring
the relationship between inflation and money
growth. Starting with inflation keeps the presenta-
tion simple and powerful, and emphasizes the way
monetary policymakers think about what they do. A
discussion of aggregate demand, aggregate supply,
and the determinants of inflation and output follows.
Consistent with the presentation in recent editions of
leading macroeconomic textbooks, Chapter 21 pres-
ents a complete macroeconomic model with a dy-
namic aggregate demand curve that integrates
monetary policy directly into the presentation, along
with short- and long-run aggregate supply curves. In
Chapter 22 the model is used to help understand the
sources of business cycles, as well as a number of
important applications that face monetary policy-
makers in the world today. Each application stands
on its own, and the applications are ordered in in-
creasing difficulty to allow maximum flexibility in
their use. Finally, Chapter 23 explores the monetary
Preface l ix
asset price bubbles, the effective lower bound for
nominal rates, and the evolving structure of the fi-
nancial system.
For those instructors who have the time, we rec-
ommend closing the course with a rereading of the
first chapter and a review of the core principles.
What is the future likely to hold for the six parts of
the financial system: money, financial instruments,
financial markets, financial institutions, regulatory
agencies, and central banks? How do students envi-
sion each of these parts of the system 20 or even
50 years from now?
What’s New in the
Sixth Edition?
Many things have happened since the last edition. For
that reason, all of the figures and data have been updated
to reflect the most recent available information. In addi-
tion, the authors have made many changes to enhance
the sixth edition of Money, Banking, and Financial Mar-
kets. What follows is only a sample of these changes.
New Topics in the Integrated
Global Perspective
The sixth edition reflects the wide range of monetary
and regulatory developments that have taken place
since 2018. New topics introduced or discussed in
much greater detail include:
∙ The role of paper money and virtual currencies
∙ Mobile banking and financial inclusion
∙ Modernizing the payments system
∙ Bond market liquidity
∙ The distribution of wealth
∙ Replacing LIBOR
∙ Private versus public equity
∙ Intangible capital
∙ Fiscal sustainability
∙ Stress testing banks to ensure resilience
∙ Cyber risk
∙ Negative interest rates
∙ Chinese exchange rate policy
∙ The threat to Fed independence
x l Preface
∙ Measuring tail risk
∙ Big data and the macroeconomy
∙ Secular stagnation
∙ Balance of payments crises
The most extensive changes are in Chapter 12, which
includes a new section on cyber risk; in Chapter 14,
which includes a discussion of continued reforms to
financial regulation in the aftermath of the financial
crisis; and in Chapter 18, which includes a full treat-
ment of the Federal Reserve’s evolving operational
policy regime.
Changes at the Federal Reserve
and the ECB
The discussion of the Federal Reserve and the ECB
now considers their evolving communications strat-
egy (Chapter 16); the use of unconventional policy
tools, including negative interest rates and the dra-
matic growth in central bank balance sheets, aimed
at addressing first the financial crisis and then the
weak economic recoveries that followed (Chapter
18); the interactions between monetary policy and
financial stability (Chapter 18); and the impairment
of the monetary transmission process during the cri-
sis (Chapter 23). It also reflects the sharply increased
threat to Fed independence under President Trump
(Chapter 15).
Updated Coverage of
Current Events
Overall, nearly 30 of the 140 inserts in the previous edi-
tion have been replaced or altered substantially. These
changes capture new developments in the key areas of
technological change, the financial crisis, inequality,
regulatory reform, and monetary policy.
Here is a partial list of the new or revised features:
Money and Banking Blog
Virtual Frenzies: Bitcoin and Blockchain
­(Chapter 2)
Banking the Masses: 2018 Edition (Chapter 3)
Investing in College (Chapter 4)
On the Distribution of Wealth (Chapter 5)
Bond Market Liquidity: Should We Be Worried?
(Chapter 6)
The Cloudy Future of Peer-to-Peer Lending
(Chapter 12)
Fiscal Sustainability (Chapter 15)
Is 2 Percent Still the Right Inflation Target?
(Chapter 18)
Sudden Stops: Understanding Balance-of-
Payments Crises (Chapter 19)
The Phillips Curve (Chapter 21)
Secular Stagnation (Chapter 22)
GDP at Risk (Chapter 23)
Applying the Concept
Modernizing U.S. Payments: Faster, Cheaper and
More Secure (Chapter 2)
Raising Equity: Public versus Private (Chapter 8)
Financing Intangible Capital (Chapter 11)
Eclipsing LIBOR (Chapter 13)
Better Capitalized Banks Lend More and Lend
Better (Chapter 14)
The Threat to Fed Independence (Chapter 15)
Time Consistency (Chapter 15)
Central Bank Digital Currency (Chapter 16)
What Should the Fed Own? (Chapter 17)
GDP: One Size No Longer Fits All (Chapter 18)
China’s Changing Exchange Rate Regime
(Chapter 19)
GDP-Linked Bonds (Chapter 22)
Lessons from the Crisis
Central Counterparties and Systemic Risk
(Chapter 9)
The Three Phases of the Financial Crisis of
2007–2009 (Chapter 14)
Supplements for
Instructors
The following ancillaries are available for quick
download and convenient access via the Instructor
Resource material available through McGraw-Hill
Connect®.
Solutions Manual
Prepared by James Fackler (University of Kentucky)
and Roisin O’Sullivan (Smith College), this manual
contains detailed solutions to the end-of-chapter
questions—Conceptual and Analytical problems and
Data Exploration questions.

Test Bank
The revised test bank includes more than 2,500
multiple-choice and 600 short-answer and essay
questions. The test bank can be used both as a study
guide and as a source for exam questions. It has been
computerized to allow for both selective and random
­generation of test questions.
Test Builder
Available within Connect, Test Builder is a cloud-
based tool that enables instructors to format tests
that can be printed or administered within an LMS.
Test Builder offers a modern, streamlined interface
for easy content configuration that matches course
needs, without requiring a download.
Test Builder allows you to:
∙ access all test bank content from a particular
title.
∙ easily pinpoint the most relevant content
through robust filtering options.
∙ manipulate the order of questions or scramble
questions and/or answers.
∙ pin questions to a specific location within a test.
∙ determine your preferred treatment of algorith-
mic questions.
∙ choose the layout and spacing.
∙ add instructions and configure default settings.
Test Builder provides a secure interface for bet-
ter protection of content and allows for just-in-time
updates to flow directly into assessments.
PowerPoint Slides
Updated presentation slides outline the main points
in each ­chapter and reproduce major graphs and charts.
This handy, colorful supplement can be edited, printed,
or rearranged to fit the needs of your course.
Assurance of Learning
Ready
Many educational institutions today are focused on
the notion of assurance of learning, an important ele-
ment of some accreditation standards. Money, Bank-
ing, and Financial Markets­is designed specifically to
Preface l xi
support your assurance of learning initiatives with a
simple, yet powerful solution.
Instructors can use Connect to easily query for
learning outcomes/objectives that directly relate to the
learning objectives of your course. You can then use
the reporting features of Connect to aggregate student
results in similar fashion, making the collection and
presentation of assurance of learning data simple
and easy.
AACSB Statement
McGraw-Hill Global Education is a proud corporate
member of AACSB International. Understanding
the importance and value of AACSB accreditation,
Money, Banking, and Financial Markets has sought
to recognize the curricula guidelines detailed in the
AACSB standards for business accreditation by con-
necting questions in the text and test bank to the
general knowledge and skill guidelines found in the
AACSB standards.
The statements contained in ­Money, Banking, and
Financial Markets are provided only as a guide for
the users of this text. The AACSB leaves content cov-
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 Learning Tools Walkthrough

Learning Objectives Core Principle Icons

The learning objectives (LOs) introduced at the start of The entire text discussion is organized around the fol-

2
Chapter
each chapter highlight the material and concepts to be 78lowing
l Chapter 4five
Future core principles: Time has value; risk requires
Money and the Payments
Value, Present Value, and Interest Rates

mastered. Every end-of-chapter problem is denoted by compensation; information is the basis for decisions;
theSystem
is complicated because we need to add up the future values of forty $1,000 deposits,
LO to which it relates for reinforcement. markets seteach prices
made in aand allocate
different year, but doingresources;
so uses the concept and ­value.
of futures tability
The first
$1,000 is deposited for 40 years, so its future value is
improves welfare. Exploring these principles
$1,000(1.04) = $4,801.02 40
is the basis
for learningThewhat the financial system does,
second $1,000 is deposited for 39 years, so its future value is how it is
Learning Objectives ­organized, and how it is linked $1,000(1.04)to= the real economy.
$4,616.37 39

and so on. The practical implication of this calculation is that buying one less soda or
After reading this chapter, you should be able to: They are discussed candy bar per dayin isn’tdetail inyourChapter
just good for 1;it’sthroughout
physical health; good for your financialthe
health, too.
LO1 Define money and describe its functions.
rest of the text, marginal icons remind students of the
Present Value
LO2 Discuss the different methods of payment and the future of money.
principles that underlie particular discussions.
It’s easy to see why future value is important. We often want to know what savings and
LO3 Explain how the money supply is measured and how it is linked to economic
growth and inflation. investments will be worth in the future. But that isn’t the only thing we need to know.
There is another, somewhat different task that we face with some regularity. We need
to be able to figure out how much a payment promised in the future is worth today. Say
you agree to make a $225 loan, and the borrower offers to repay you either $100 a year
The makers of the board game Monopoly print on for three years or $125 a year for two years. Which offer should you take? Answering
average about $50 billion of Monopoly money this question means figuring out the current value of the promised payments on the
every year. Every new game has bills totaling dates when they will be made. To do that, we’ll use the concept of present value,
20,580 Monopoly dollars. At a cost of less than sometimes referred to as present discounted value.
24 l Chapter 2 Money and the Payments System
20 U.S. dollars per set, this “money” would be a
good deal if you could buy things other than The Definition In our discussion of future value, we used the term present value
to mean the initial amount invested or deposited. The way we used the term suggests
Boardwalk and Park Place with it. Unfortunately, its technical definition: Present value is the value today (in the present) of a payment
Debit Cards versusattempts Credit to Cards
pay for groceries, books, or rent with that is promised to be made in the future. Put another way, present value is the amount
this particular form of money have been unsuc- that must be invested today in order to realize a specific amount on a given future date.
YOUR FINANCIAL WORLD cessful. And that’s probably a good thing. Since Financial instruments promise future cash payments, so we need to know how to value
the mid-1930s, Parker Brothers has sold more those payments. Present value is an integral component of the computation of the price
than 250 million Monopoly games, containing of all financial instruments.
To understand the calculation of present value, go back to future value. Remember
When you go shopping, should you pay with a credit card more or thanA 4 trillion
credit Monopoly
card creates a deferreddollars,
payment. orThemoreissuer
that at a 5 percent interest rate, the future value one year from now of a $100 invest-
a debit card? To decide, you need to understand the agrees to make the payment for you, and you repay the debt
difference between the two. First make sure you knowthan
one of your cards is which. Usually an ATM card (the one
which twice
ofthat
later. U.S. official
That sounds good,currency
but there’s ain circulation
catch. If you’re lateas
2019.ing, there’s a late fee. And if you don’t pay the entire debt
pay-
Lessons from the Crisis ment today is $105. It follows that at this same 5 percent interest rate, the present value
of $105 one year from now is $100. All we did was invert the future value calculation.
you got from the bank when you opened your checking
When we pay for our purchases in the real
every month, you pay interest on the balance—at what is Reversing the calculation in general terms is just as easy. Start with the fact that the
These boxes explain concepts or issues that are both
account) is a debit card. But check to make sure. usually a very high interest rate. If you do pay your entire
What’s the real difference, from the shopper’s point world, we card
of credit have debtlots of choices:
every month, crisp
however, there is nonew
late fee
future value of a payment equals the current investment times one plus the interest
view? A debit card works just like a check, only faster.$20
When bills,
and no credit
interestcards, debityou
charge. Hence, cards,
get an checks,
interest-freeorloan rate: FV = PV × (1 + i) [equation (1)]. Divide both sides of this expression by (1 + i)
you write a paper check, it usually takes a day or two to go
through
ParkertheBrothers’s
system. A debit more
from the time you make the purchase to the time you pay the
complicated electronic methods. Regardless
card transaction goes through balance. If you can pay off your credit cards in full and on
bestselling
integral to the chapter and central to understanding how
to get an expression for how much we need to invest today to realize the future value
one year from today. The result is
right away. The electronic message gets to your bank of the choice
time, it’s towe
yourmake, weto use
arethem.
using money to
the financial crisis of 2007–2009 and the subsequent
on the advantage
board FV
day,game. PV = ______ (3)
same
buy ourThey
and your account is debited immediately. So, if
you want to use your debit card, your account balance has to
food and clothes and pay our bills. To
Credit cards have another advantage over debit cards.
help you build a credit history, which you’ll need when
(1 + i)
make
and sure wecomes
can do it, thousands ofBecause
peopledebit work
crisis in thePresent
eurovaluearea transformed thebyworld ofinterest
money,
Dave Donaldson/Alamy Stock Photo
be higher than the payment you want to make. During the time to buy a car or a house. cards = Future value of the payment divided (One plus the rate)
through
after every
the financial night,
crisis for inthe
that began payments
2007, debit card system
use arereally never ofsleeps.
just extensions And
your bank the volume
account, they don’t ofshow

banking, and financial markets. The topics range from

sharply outpaced credit card activity, as lenders and borrowers potential lenders that you are creditworthy. In fact, some In our example, we see that
payments is astounding. The Federal Reserve reports that in 2016 there were nearly 150
sought to slow the expansion (or even reduce the outstanding businesses, like car rental companies, require their custom-
billion noncash debt.payments made in the United ers States,
to use less
credit than 12this
percent
reason. of which were $105
FV = ______
______
level) of household cards for = $100
paper checks. That means something like 69 million paper checks and over 500 million
electronic payments were processed on an average business day. And, regardless of how
specific aspects of the crisis such as shadow banks and
(1 + i) (1.05)
so the present value of $105 one year from now, at a 5 percent interest rate, is
you choose to pay, the that
ensure pathresources
that thearepayment
allocatedfollows is pretty
to their best complicated.
uses. What matters are the relative prices central bank policy responses to broad concepts like
indeed $100.

Your Financial
that productWorld
of goods and services. When the
22price of one product is higher than the price of another,
is worth more to both producers and consumers. Using dollars makes these liquidity, leverage, sovereign default, and systemic risk.
comparisons easy. Imagine what would happen if we needed to compute relative prices Financial Instruments l 49
These boxes forshow students that the concepts taught in the
each pair of goods. With two goods, we would need only one price. With three goods,
we would need three prices. But with 100 goods, we would need 4,950 prices, and with cec26786_ch04_073-100.indd 78 01/10/19 2:10 PM

text are relevant to their50 million

would need nearly everyday lives.
prices. Using money asAmong
a yardstick andthe
1
quotingtopics
10,000 goods (substantially less than the 42,000 products in a typical supermarket), we
all prices
_ch02_022-043.indd 22 30/09/19 1:30 PM Leverage
covered are the importance of saving for retirement, the
in dollars certainly is easier.
LESSONS FROM THE CRISIS
risk in takingStore
on aofvariable-rate
Value mortgage, the desirability
For money to function as a means of payment, it has to be a store of value, too. That
of owning a diversified
is, if we are going to portfolio, and
use money to pay for goodstechniques
and services, then itfor
must retain its
Households and firms often borrow to make investments. Ob-
taining a mortgage for a new home or selling a corporate
When highly leveraged financial institutions experience a
loss, they usually try to reduce their leverage—that is, to
worth from day to day. Sellers are much less likely to accept things that are perishable,
getting the most out of theSo the financial
means of paymentnews.
bond to build a new plant are common examples. The use of deleverage—by selling assets and issuing securities that
like milk or lettuce. has to be durable and capable of trans- borrowing to finance part of an investment is called leverage.* raise their net worth (see accompanying figure). However,
ferring purchasing power from one day to the next. Paper currency does degrade with Leverage played a key role in the financial crisis of 2007– everyone in the financial system cannot deleverage at once.
2009, so it is worth understanding how leverage relates to When too many institutions try to sell assets simultaneously,
use ($1 bills have an estimated life span of 70 months in circulation), but regardless of risk and how it can make the financial system vulnerable. their efforts will almost surely prove counterproductive: fall-
its physical condition, it is usually accepted at face value in transactions. Modern economies rely heavily on borrowing to make ing prices will mean more losses, diminishing their net worth
Of course, money is not the only store of value. We hold our wealth in lots of other investments. They are all leveraged. Yet, the more leverage, further, raising leverage, and making the assets they hold
forms—stocks, bonds, houses, even cars. Many of these are actually preferable to the greater the risk that an adverse surprise will lead to seem riskier, thereby compelling further sales.
money as stores of value. Some, like bonds, pay higher interest rates than money. bankruptcy. If two households own houses of the same This “paradox of leverage” reinforces the destabilizing li-
value, the one that has borrowed more—the one that is more quidity spiral discussed in Chapter 2 (see Lessons from the
Others, like stocks, offer the potential for appreciation in nominal value, which money highly leveraged and has less net worth—is the more likely Crisis: Market Liquidity, Funding Liquidity, and Making Mar-
to default during a temporary slump in income. This example kets). Both spirals feed a vicious cycle of falling prices and
1
The general formula is that for n goods we need n(n − 1)/2 prices, so for 10,000 goods, the number would be could apply equally well to firms, financial institutions, or widespread deleveraging that was a hallmark of the financial
10,000(9,999)/2 = 49,995,000. even countries. crisis of 2007–2009. The financial system steadied only af-
Financial institutions are much more highly leveraged ter massive government interventions in response to the
than households or firms, typically owning assets of about plunge of many asset prices.
10 times their net worth. During the crisis, some important fi-
nancial firms leveraged more than 30 times their net worth.† *For a technical definition of leverage, see the Tools of the Trade
Such high leverage meant that these firms would be vulner- box in Chapter 5. For the evolution of U.S. commercial bank
able even to a minor decline in the value of their assets. For leverage, look at the FRED data series “EQTA.”
example, when a borrower is leveraged more than 30 times, †
A bank’s net worth—its assets minus liabilities—is commonly
cec26786_ch02_022-043.indd 24 30/09/19 a drop
1:30 PM as small as 3 percent in asset prices could eliminate known as bank capital. We will discuss this in more detail in
the cushion created by the net worth and lead to bankruptcy. Chapter 12.

Deleveraging Spiral

Bank
 34 l Chapter 2 Money and the Payments System

Virtual Frenzies: Bitcoin and Blockchain

MONEY AND BANKING BLOG

Bitcoin is the oldest and most prominent of more than Let’s have a closer look at Bitcoin itself. Some coun-
2,500 cryptocurrencies—sometimes called “virtual cur- tries classify Bitcoin as a commodity, subjecting it to capi-
rencies”—that have come into existence since 2008. Devo- tal gains taxation, or severely restricting its use. In no
tees hope these “tokens” will revolutionize many aspects country can Bitcoin be widely exchanged for goods and
of finance, including everyday payments. Cryptocurren- services. As a result, in early 2019 Bitcoin accounted for
cies like Bitcoin are a type of digital currency based on a less than 200 thousand daily transactions globally, com-
peer-to-peer network designed to allow for the verification pared with more than 500 million dollar transactions in the
of transfers without the need for a government authority or United States alone.
any trusted third party. The technology used to record Bitcoin’s value is extremely unstable: The dollar value of
ownership—blockchain—is an ever-growing, encrypted a single Bitcoin surged from just pennies in 2010 to nearly
public ledger of transactions spread over a network of $20,000 at the peak in December 2017, before plunging
computers. Promoters of this “distributed ledger technol- back below $3,200 a year later. Since 2014, the daily per- Measuring Money l 37
ogy” believe that it will have broad applications in sup- centage change in Bitcoin’s U.S. dollar value has ranged
Money
portingand Banking
payments Blog
in any currency. from –22 percent to +32 percent. Had Bitcoin been em-
The Consumer Price Index
Advocates claim that Bitcoin and other cryptocurren- ployed as a unit of account over this period, all other prices
One article per chapter is featured from the authors’ blog TOOLS OF THE TRADE
cies have two important advantages: (1) their value cannot would have been subject to enormous day-to-day swings.
at www.moneyandbanking.com. These readings show
be undermined by government fiat (because its value is Initially, Bitcoin’s anonymity made it popular with
howcreated
concepts introduced
and controlled byin
thethe chapter
network are applied
of users and a settoof money launderers,
Understanding how to measure inflation is central to under-

eye on measures like thetax evaders,

price index (CPI) to and
And for 2021, we get $165. Choosing 2020 as the base year,

drugCosttraffickers.
standing economics and finance. Most of us keep a close the index level in each year equals
consumer help of the basket in current year
contemporary issuesnot
in by
money and banking,
and (2)including
CPI = × 100 ___________________________

unchanging rules, government), users can Perhaps the powermost notorious users
gauge the value of our salary increases or the purchasing
of the money we hold. And adjusting offorBitcoin
interest rates were partici-
Cost of the basket in base year
The result of this computation is the fifth column of the table.

changes
remaininanonymous
technology, regulation, and the electronically
mechanisms ofpants in theThe CPIonline
inflation is critical for making investment decisions. (See
while making payments Chapter 4.) black market known
is designed to answer the following question:
as Silk Road,
Finally, we can use the index number to compute the in-
flation rate from the previous year. From 2020 to 2021, this

and efficiently.
monetary policy. which theHow U.S. government shut downmeans
much more would it cost for people to purchase today
the same basket of goods and services that they actually
in 2013. In
that

Inflation rate 2021 =

2016,
CPI in 2021 − CPI in 2020
× 100 _____________________

However, cryptocurrencies lack the three key charac- most Bitcoin currency the CPI, everytransactions wereUsing executed on2.2ex-
bought at some fixed time in the past? CPI in 2020
To calculate few years statisticians at the the numbers from Table to compute the inflation

teristics of money: They are not a commonly accepted changes in China,

bought. This probably
gives us the basket of to
goodsget
and ser-around government
Bureau of Labor Statistics (BLS) survey people to find out rate in 2021, we get that
what they 110 − 100 ________
vices bought by the typical consumer. Next, every month the × 100 = 10%
100
means of exchange, do not provide a reliable unit of ac- controls on
Applying Present Value l 85
moving
BLS collects information oncapital out
the prices of thousands ofof
goodsthe
and services—everything from breakfast cereal to gasoline to
and forcountry.
2022 the result is A year

count, and do not offer a stable store of value. As for later, thewashing theChinese government
surveys allows statisticians virtually banned these
machines to the cost of cable television. Combining 120 − 110 ________
× 100 = 9.1%
110
expenditure and price to com-
(These numbers are just for illustration. The U.S. inflation rate
blockchain,
How extensive
Much Is Ourexperimentation is underway to transactions.
pute the current cost of the basket. Finally, this current cost is
Distant Future Worth? compared to a benchmark to yield an index. And the percent-
age change in this index is a measure of inflation.
is closer to 2 percent.)
Inflation measured using the CPI tells us how much more
determine whether
APPLYING THEitCONCEPT
can beat out existing payments Other people
governments
To see how this works, let’salso have
look at an example. paid
Assume greater
spend 25 percent of their income on food, 50 per-
attention to
money we need to give people to restore the purchasing
power they had in the earlier period when the survey

mechanisms. activity incent

Many people worry about the challenges their descend-
ants will face. There are plenty of things to fret about, rang-
ing from the threat of rising sea levels in this century to the
long-range challenge of managing radioactive waste,
which can be toxic for many thousands of years. Physicist
Stephen Hawking has argued that human beings “won’t
survive another 1,000 years without escaping our fragile
planet.”
digital currencies in recent years.
on housing, and 25 percent on transportation. That’s
the survey information. Examples of the prices are in expenditure-weight inflation indexes like the CPI are known to
What discount rate should we use to value things in the
distant future? For questions like this, economists usually
look at market prices.
Various measures suggest that the appropriate rate is in
the range of 1 to 2½ percent. For example, in recent years
the long-term U.S. Treasury inflation-indexed bond yield has
averaged around 1 percent. At the upper end of the range,
research examining land leases with several hundred years
was
And, despite
done. But adjustments in wages based on fixed-
Table 2.2. Importantly, these are the prices of exactly the overcompensate people in an unintended way. This overstate-
same bundle of food, the same size and quality of housing, ment of inflation comes from what is known as substitution
bias. Because inflation is not uniform, the prices of some prod-
and the same transportation for each year.
ucts will increase by more than the prices of others. People can
Using the numbers in Table 2.2 we can compute the cost
escape some of the inflation by substituting goods and ser-
of the basket of goods in each year:
vices that have sustained less inflation for those that have sus-
Cost of the basket in 2020 tained more. By assuming that any substitution makes people
= 0.25 × Price of food + 0.5 × Price of housing worse off, the index overstates the impact of price changes. To
+ 0.25 × Price of transportation
address this problem, and take into account changes in spend-

them together, and invest them in short-term marketable debt issued by large corpora-
How much ought we be willing to spend now to avoid
damage 100 years from now that will cost $1 at that
of maturity points to a rate close to 2½ percent.
Policy disagreements among serious analysts of climate = 0.25 × $100 + 0.5 × $200 + 0.25 × $100
= $150
ing patterns, the Bureau of Labor Statistics in 2002 began
changing the weights every two years. Nevertheless, many
economists believe that the CPI still overstates inflation.
tions. Money-market mutual fund shares can be issued by nonbank financial interme-
time? The answer depends on many factors, including the change are closely related to their views on the appropriate
relative affluence of our descendants, the degree of uncer- discount rate. One well-known report applied a relatively low
tainty about the future, and the possibility of existential discount rate of 1.4 percent and called for a large tax on car-
threats.
diaries, such as brokerage firms. They do carry
To simplify the question, suppose that the only thing we
Table 2.2
bon emissions to limit future losses from climate change. A
check-writing privileges. M2 is the
Computing the Consumer Price Index
different analysis used a relatively high 4.3 percent discount

most commonly quoted monetary aggregate in the United States, because its move-
care about is the present value of the expected losses asso-
ciated with a preventable future disaster. In that case, the
rate and called for a carbon tax only about one-tenth the
level implied by the 1.4 percent rate analysis. Why? The low
Price of Price of Price of Cost of Consumer

ments are most closely related to interest rates and economic growth.
discount rate we use is critical for determining what we discount rate puts a great deal more weight on losses that
Year Food Housing Transportation the Basket Price Index
should do today. For example, for a disaster that is 100 years are predicted to occur hundreds of years in the future.
away, the value today of a $1 future loss at an annual dis- Of course, it’s not just about discount rates. It’s about the 2020 $100 $200 $100 $150 100
To clarify what the monetary aggregates mean, let’s compare their size to the size
count rate of 1 percent is $0.37. But at a discount rate of
2 percent, the present value drops to $0.14. And at 4 percent,
scale of future losses, too. If policy actions today can prevent a
calamity that threatens life on earth, then people might judge the
2021
2022
110
120
205
210
140
180
165
180
110
120
day would not make economic sense. of the economy. In the fourth quarter of 2018, nominal U.S. gross domestic product
it is less than $0.02. Spending more than these amounts to- appropriate discount rate to be quite low because they would
not weight the value of future lives any lower than their own.

Applying the Concept (GDP) was $20.501 trillion. Putting that number into the same units as those in
Table 2.1, that’s $20,501 billion. So GDP is nearly five and one-half times larger than
These sections
be 7.3 percent. showcase
Clearly, the three
M1history
payments are better
to do quite a bit of work to figure it out.
and
for you as the
and more
lender,examine
but we had
than 40 percent issues larger Tools
than M2.
of the Trade
relevant to the public policy debate to illustrate
Which one of the M’s should weThese how boxes
use to teach useful
understand inflation?skills, That’s
including
cec26786_ch02_022-043.indd 37
how to
a difficult
30/09/19 1:30 PM

Bonds: The Basics

ideas introduced in the question
One of the most common uses of the concept
chapter can
of present valuewhose
be applied
answer
is in the valuation of
to
hasthe
changedreadoverbond
time.and stock
Until the tables,
early 1980s, how toeconomists
read charts, and
and
world around us. Subjects
is issued as part of an arrangement to borrow.
include central
bonds. A bond is a promise to make a series of payments on specific future dates. It
policymakers
In essence, the borrower, looked bank digital
or seller, at M1. But withhow the
to dointroduction
some simple ofalgebraic
substitutes for standard
calculations. Some
currency, the replacement checkingofissue
LIBOR, accounts, andbonds
gives an IOU to the lender, or buyer, in return for some amount of money. Both gov-
ernments and corporations need to borrow, so both bonds. Because the
especially money-market
provide brief mutual
reviews fund of shares,
materialM1 frombecame less
the principles
heightened threat to Fed independence.
create obligations, they are best thought of as legal contracts that (1) require the
borrower to make payments to the lender and (2) specify what happens if the bor- of economics course, such as the relationship between
rower fails to do so.
Because there are many different kinds of bonds, to focus our discussion, we’ll look the current account and the capital account in the
at the most common type, a coupon bond. Say a borrower who needs $100 “issues” or
sells a $100 coupon bond to a lender. The bond issuer is required to make annual pay-
ments, called coupon payments. The annual amount of those payments (expressed as a
balance of payments.
percentage of the amount borrowed) is called the coupon rate. If the coupon rate is
5 percent, then the borrower/issuer pays the lender/bondholder $5 per year per $100
borrowed. The yearly coupon payment equals the coupon rate times the amount

cec26786_ch02_022-043.indd 34 30/09/19 1:30 PM

 interest rate that occurs. Someone who is making an economically important decision
will do so based on the expected real interest rate. Some time later, that person will look
back and compute the real interest rate actually paid or received. The first of these is
known as the ex ante real interest rate, meaning “before the fact.” The second, or real-
ized rate, is the ex post real interest rate, meaning “after the fact.” We can always com-
pute the ex post real interest rate, because we know the nominal interest rate and the
inflation rate there actually was. But it is the ex ante real interest rate that we really want

End-of-Chapter Features
to know.

Key Terms
basis point, 77 face value, 86 par value, 86
bond, 85 fixed-payment loan, 84 present value, 78
compound interest, 75 future value, 74 principal, 86
coupon bond, 85 internal rate of return, 83 real interest rate, 89
coupon payment, 85 maturity date, 86 rule of 72, 77
coupon rate, 85 nominal interest rate, 89 yield, 74

Using FRED: Codes for Data in This Chapter FRED Data Codes

www.moneyandbanking.com
The FRED table lists key economic and financial
Data Series FRED Data Code
1-year Treasury bill rate TB1YR
­indicators relevant to the chapter and the codes
3-month Treasury bill rate TB3MS by which they are accessed in FRED, the free
Consumer price index CPIAUCSL
1-year inflation expectations (Michigan survey) MICH online ­database provided by the Federal Reserve
Brazil Treasury bill rate
Brazil consumer price index
INTGSTBRM193N
BRACPIALLMINMEI
Bank of St. Louis. With the data codes, students
China discount rate INTDSRCNM193N can use FRED to analyze key economic patterns
China consumer price index
10-year Treasury constant maturity rate
CHNCPIALLMINMEI
GS10
and illuminate the ideas in the chapter. See
10-year Treasury inflation-indexed yield FII10 Appendix B to Chapter 1 for help using FRED
5-year Treasury constant maturity rate
5-year Treasury inflation-indexed yield
GS5
FII5
and refer to www.mhhe.com/moneyandbanking6e.
Data Exploration l 43

22. What are some of the main obstacles to a faster, more efficient U.S. payments
system and how might they be overcome? (LO2)
23. What are some advantages and disadvantages of a government continuing to
issue paper currency in the face of widespread financial innovation? (LO3)
cec26786_ch04_073-100.indd 93 01/10/19 2:11 PM

Data Exploration Data Exploration ®

Detailed end-of-chapter ­questions ask For detailed instructions on using Federal Reserve Economic Data (FRED) online to
Conceptual and Analytical Problems l the
41 following problems, visit www.mhhe.com/moneyandbanking6e
students to use FRED to analyze answer each of
and refer to the FRED Resources and Data Exploration Hints.
economic and financial data relevant to
c. For financial institutions, market liquidity is the ease with which they can sell a
1. Find the most recent level of M2 (FRED code: M2SL) and of the U.S. population
(FRED code: POP). Compute the quantity of money divided by the population.
the chapter. Appendix
security or loan B
for money. Funding
borrow to acquire a security or loan.
to Chapter
liquidity 1
is the ease with which they can (Note that M2 is measured in billions of dollars and population is in thousands of
individuals.) Do you think your answer is large? Why? (LO1)
provides
2. Money makes information
the payments systemon work.
using The FRED
payments system is the web of
2. Reproduce Figure 2.3 from 1960 to the present, showing the percent change from a
arrangements that allows people to exchange goods and services. There are three
andbroadsets the stage
categories forall its
of payments, useusethereafter.
of which money at some stage.
year ago of M1 (FRED code: M1SL) and M2 (FRED code: M2SL). Comment on
the pattern over the last five years. Would it matter which of the two monetary
a. Cash
Theb. Checks
Data Exploration questions have aggregates you looked at? (LO3)

www.moneyandbanking.com
c. Electronic payments 3. Which usually grows faster: M1 or M2? Produce a graph showing M2 divided by
now been
3. In the future, integrated
money will be usedinto Connect
less and less as a means of payment. M1. When this ratio rises, M2 outpaces M1 and vice versa. What is the long-run
pattern? Is the pattern stable? (LO3)
as4. assignable content
To understand the links to
between money help you
and inflation, we need to measure the quan-
tity of money in the economy. There are two basic measures of money: M1 and M2. 4. To complete payments, do you think people need more or less currency per dollar of
incorporate real-time data into your
M1, the narrowest measure, includes only the most liquid assets. M2, a broader transactions than they did 30 years ago? After stating your hypothesis, plot currency in
circulation as a percent of GDP from 1990 (FRED Codes: CURRENCY and GDP).
measure, includes assets not usable as a means of payment.
course!
a. Countries with high money growth have high inflation. Was your intuition consistent with the data? What might account for the trend you
b. In countries with low inflation, money growth is a poor forecaster of inflation. observe? (LO1)
5. Plot the annual inflation rate based on the percent change from a year ago of the

Conceptual and Analytical Problems ®

Conceptual and Analytical Problems
consumer price index (FRED code: CPIAUCSL). Comment on the average and
variability of inflation in the 1960s, the 1970s, and the most recent decade. (LO3)
www.moneyandbanking.com

1.
Describe four ways you could pay for your morning cup of coffee. What are the Each chapter contains at least 18 conceptual and
advantages and disadvantages of each? (LO2)
2. You are the owner of a small sandwich shop. A buyer may offer one of several ­analytical problems at varying levels of difficulty,
payment methods: cash, a check drawn on a bank, a credit card, or a debit
card. Which of these is the least costly for you? Explain why the others are more which reinforce the lessons in the chapter. All of the
expensive. (LO2)
3. Explain how money encourages specialization, and how specialization improves
problems are available as assignable ­content within
everyone’s standard of living. (LO3) Connect, McGraw-Hill’s ­homework ­management
4.* Could the dollar still function as the unit of account in a totally cashless
society? (LO2) platform, organized around ­learning objectives to
5. Give four examples of ACH transactions you might make. (LO2)
make it easier to plan, track, and ­analyze student
6. A subset of European Union countries have adopted the euro, while the
remaining member countries have retained their own currencies. What are the performance across different learning outcomes.
advantages of a common currency for someone who is traveling through
Europe? (LO1)
7. Why might each of the following commodities not serve well as money? (LO2)
a. Tomatoes
b. Bricks
c. Cattle
8. Despite the efforts of the U.S. Treasury and the Secret Service, someone discov-
ers a cheap way to counterfeit $100 bills. What will be the impact of this discov-
ery on the economy? (LO3) cec26786_ch02_022-043.indd 43 30/09/19 1:30 PM
9. What do you think accounts for the widespread adoption of mobile-based pay-
ment services in emerging economies? (LO2)
10. Over a nine-year period in the 16th century, King Henry VIII reduced the silver
content of the British pound to one-sixth its initial value. Why do you think he did
*
Indicates more difficult problems.
Acknowledgments
I owe thanks to many more people than I can ­possibly
list, including a large number of academics, central
bankers, and financial market participants around
the world. A few of these deserve special mention.
I would like to thank Robert M. Solow, who set
me on the path doing economics as a 20-year-old
undergraduate; George A. A ­ kerlof, whose inspiration
still guides me, even more than 35 years after he
signed my dissertation; William J. McDonough, who
gave me the opportunity to watch and ask questions
from inside the Federal Reserve; Peter R. Fisher, who
was my day-to-day guide to what I was seeing during
my time at the Fed; and Jaime Caruana and Hervé
­Hannoun, whose patience and understanding helped
me appreciate the global central bank community.
Of my numerous collaborators and colleagues
over the years, Nelson Mark (now at the University
of Notre Dame) is the most important. In addition,
­Michael Bryan has been a constant source of help
and encouragement, as have numerous friends
throughout the central banking world.
Among all of the professional colleagues who
took the time to read early versions of the manu-
script, I would like to single out Jim Fackler for his
insight and patience. This book is much better for the
time he generously devoted to correcting my logical
mistakes and helping ensure that the exercises would
reinforce the lessons in each chapter.
Without all the people at McGraw-Hill this book
would never have been written. Gary Burke and Paul
Shensa first convinced me that I could write this book,
and then taught me how. Erin Strathmann worked tire-
lessly (and daily) to improve the book. Betty Morgan
made my sentences and paragraphs readable. And all
of the people in production and design turned the
words and charts into a beautiful, readable book. Start-
ing with the third edition, Gregg Forte has made
notable contributions through his skilled editing of the
manuscript. And, for the last three editions, Christina
Kouvelis has done the hard work of ensuring everyone
maintained the high standard.
Without students, universities would not exist. And
without a class in money and banking to teach, I would
not have written this book. I owe a debt to every
student who has sat in a classroom with me. Several
deserve special mention for the time and effort they
put into helping with the manuscript: Margaret Mary
McConnell of the Federal Reserve Bank of New York,
Roisin O’Sullivan of Smith College, Stefan Krause for-
merly of the Banque de France, Lianfa Li of Peking
University, Craig Evers of Brevan Howard, and
Georgios Karras of the University of Illinois at Chicago.
And finally, there is my family; my wife, Ruth, and
our sons, Daniel and Ethan. For years they put up with
my daily routine of writing, rewriting, and rewriting
again and again. To them I owe the biggest thanks.
Stephen G. Cecchetti
Brandeis International Business School
There is not enough space here to thank the many
people who taught me about financial markets and
­institutions during my more than two decades of
work as a market economist, but a few deserve spe-
cial mention. Hugh Patrick was an inspiration in
graduate school and remains a friend and guide. In
the financial markets, I benefited especially from the
wisdom of Henry Kaufman and the economists he
gathered at S ­ alomon Brothers in the 1980s—Richard
Berner, Robert ­ D iClemente, John Lipsky, and
­Nicholas Sargen. The members of the economics
team that I was privileged to lead at Salomon (and
later at Citi) continued my education, including
(among many others) Lewis A ­ lexander, Robert
D iClemente, Don Hanna, Michael Saunders,
­
­Christopher ­Wiegand, and Jeffrey Young.
I also owe an extraordinary debt to my colleagues
at the New York University ­Leonard N. Stern School
of Business, who welcomed me, gave me the privi-
lege of teaching excellent students, and entrusted me
with the honor of directing Stern’s ­Center for Global
Economy and Business (www.stern.nyu.edu/cgeb).
For their sustained ­support and guidance, I thank for-
mer Deans Thomas Cooley and Peter Henry, current
Dean Rangarajan Sundaram, former Vice Dean Ingo
Walter, and the distinguished current and former
xv
xvi l Acknowledgments

chairs of the Department of Economics—the late
­David Backus, Luis Cabral, Paul Wachtel, Lawrence
White, and Stanley Zin. David Backus, Kim Ruhl,
and Michael Waugh gave me the tools to teach MBA
students. Jennifer Carpenter has been my partner as
Associate Director of the Center for Global Economy
and Business, while John Asker, Michael Dickstein,
Thomas Philippon, Kim Ruhl, Laura V ­ eldkamp,
Paul Wachtel, and Michael Waugh have all served as
Center research group co­ordinators and my advisors.
Jonathan ­ Robidoux keeps the Center operating
­efficiently and with a smile each day. Many o­ thers
deserve thanks for making Stern the thriving research
and teaching environment that it is today, but I am
especially grateful for the support of Viral Acharya,
Gian Luca C ­ lementi, Christopher Conlon, Robert
Engle, Mervyn King, Matthew Richardson, Maher
Said, Bruce Tuckman, Vaidyanathan Venkateswaran,
and Robert Whitelaw. Finally, many thanks to Corey
Feldman for his research assistance in the preparation
of this sixth edition.
Of course, my greatest debt is to my wife, Elvira
Pratsch. I also thank my sister and brother, Sharon
and Andy.
Kermit L. Schoenholtz
New York University Leonard N. Stern School of Business

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 Acknowledgments l xvii

Paul Emberton Chris Kauffman

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Texas Technical University University of Central Florida
xviii l Acknowledgments

Kyoko Mona Souren Soumbatiants

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Fort Lewis College
Brief Contents

Part I Money and the Financial System

chapter 1 An Introduction to Money and the Financial System 1
chapter 2 Money and the Payments System 22
chapter 3 Financial Instruments, Financial Markets, and Financial Institutions 44

Part II Interest Rates, Financial Instruments, and Financial Markets

chapter 4 Future Value, Present Value, and Interest Rates 73
chapter 5 Understanding Risk 101
chapter 6 Bonds, Bond Prices, and the Determination of Interest Rates 129
chapter 7 The Risk and Term Structure of Interest Rates 158
chapter 8 Stocks, Stock Markets, and Market Efficiency 184
chapter 9 Derivatives: Futures, Options, and Swaps 211
chapter 1 0 Foreign Exchange 238

Part III Financial Institutions

chapter 1 1 The Economics of Financial Intermediation 266
chapter 1 2 Depository Institutions: Banks and Bank Management 294
chapter 1 3 Financial Industry Structure 326
chapter 1 4 Regulating the Financial System 357

Part IV Central Banks, Monetary Policy, and Financial Stability

chapter 1 5 Central Banks in the World Today 393
chapter 1 6 The Structure of Central Banks: The Federal Reserve and the European Central Bank 421
chapter 1 7 The Central Bank Balance Sheet and the Money Supply Process 448
chapter 1 8 Monetary Policy: Stabilizing the Domestic Economy 479
chapter 1 9 Exchange Rate Policy and the Central Bank 521

Part V Modern Monetary Economics

chapter 20 Money Growth, Money Demand, and Modern Monetary Policy 553
chapter 2 1 Output, Inflation, and Monetary Policy 577
chapter 22 Understanding Business Cycle Fluctuations 615
chapter 23 Modern Monetary Policy and the Challenges Facing Central Bankers 647

xix
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Contents

About the Authors iv CHAPTER 2 MONEY AND THE PAYMENTS SYSTEM 22

Preface v Money and How We Use It 23
Learning Tools Walkthrough xii Means of Payment 23
Acknowledgments xv Unit of Account 23
Part I Money and the Financial System Store of Value 24
The Payments System 25
CHAPTER 1 AN INTRODUCTION TO MONEY
AND THE FINANCIAL SYSTEM 1
Commodity and Fiat Monies 25
The Six Parts of the Financial System 2 Checks 27
The Five Core Principles of Money and Banking 4 Electronic Payments 29
Core Principle 1: Time Has Value 4 The Future of Money 32
Core Principle 2: Risk Requires Measuring Money 32
Compensation 5 Key Terms 40
Core Principle 3: Information Is the Basis for Using FRED: Codes for Data in This Chapter 40
Decisions 5 Chapter Lessons 40
Core Principle 4: Markets Determine Prices Conceptual and Analytical Problems 41
and Allocate Resources 6
Data Exploration 43
Core Principle 5: Stability Improves Welfare 7
Special Features of This Book 8
CHAPTER 3 FINANCIAL INSTRUMENTS,
Your Financial World 8 FINANCIAL MARKETS, AND
Applying the Concept 9 FINANCIAL INSTITUTIONS 44

Lessons from the Crisis 9 Financial Instruments 46

Money and Banking Blog 10 Uses of Financial Instruments 47
Tools of the Trade 10 Characteristics of Financial Instruments:
Standardization and Information 48
End-of-Chapter Sections 12
Underlying versus Derivative
The Organization of This Book 12 Instruments 50
Key Terms 13 A Primer for Valuing Financial
Using FRED: Codes for Data in This Chapter 13 Instruments 50
Chapter Lessons 14 Examples of Financial Instruments 51
Conceptual and Analytical Problems 14 Financial Markets 53
Data Exploration 16 The Role of Financial Markets 54
Appendix A to Chapter 1: Measuring Economic The Structure of Financial Markets 55
Activity, Prices, and the Inflation Rate 17 Characteristics of a Well-Run Financial
Appendix B to Chapter 1: Using FRED 20 Market 62

xxiii
xxiv l Contents

Financial Institutions 63 Reducing Risk through Diversification 116

The Role of Financial Institutions 64 Hedging Risk 117
The Structure of the Financial Industry 64 Spreading Risk 118
Key Terms 68 Key Terms 122
Using FRED: Codes for Data in This Chapter 68 Using FRED: Codes for Data in This Chapter 122
Chapter Lessons 69 Chapter Lessons 122
Conceptual and Analytical Problems 70 Conceptual and Analytical Problems 123
Data Exploration 72 Data Exploration 126
Appendix to Chapter 5: The Mathematics of
Part II Interest Rates, Financial Diversification 127
Instruments, and Financial CHAPTER 6 BONDS, BOND PRICES, AND THE
Markets DETERMINATION OF INTEREST
RATES 129
CHAPTER 4 FUTURE VALUE, PRESENT VALUE, Bond Prices 130
AND INTEREST RATES 73
Zero-Coupon Bonds 130
Valuing Monetary Payments Now
and in the Future 74 Fixed-Payment Loans 131
Future Value and Compound Interest 74 Coupon Bonds 132
Present Value 78 Consols 132
Applying Present Value 82 Bond Yields 133
Internal Rate of Return 83 Yield to Maturity 133
Bonds: The Basics 85 Current Yield 134
Real and Nominal Interest Rates 89 Holding Period Returns 135
Key Terms 93 The Bond Market and the Determination
of Interest Rates 137
Using FRED: Codes for Data in This Chapter 93
Bond Supply, Bond Demand,
Chapter Lessons 94
and Equilibrium in the Bond Market 137
Conceptual and Analytical Problems 94
Factors That Shift Bond Supply 141
Data Exploration  97
Factors That Shift Bond Demand 142
Appendix to Chapter 4: The Algebra of
Understanding Changes in Equilibrium Bond
Present-Value Formulas 99
Prices and Interest Rates 145
CHAPTER 5 UNDERSTANDING RISK 101 Why Bonds Are Risky 146
Defining Risk 102 Default Risk 147
Measuring Risk 103 Inflation Risk 151
Possibilities, Probabilities, and Interest Rate Risk 152
Expected Value 103
Key Terms 153
Measures of Risk 106
Using FRED: Codes for Data in This Chapter 153
Risk Aversion, the Risk Premium,
and the Risk-Return Tradeoff 113 Chapter Lessons 154
Sources of Risk: Conceptual and Analytical Problems 154
Idiosyncratic and Systematic Risk 115 Data Exploration  157
 Contents l xxv

CHAPTER 7 THE RISK AND TERM STRUCTURE Key Terms 206

OF INTEREST RATES 158
Using FRED: Codes for Data in This Chapter 206
Ratings and the Risk Structure
of Interest Rates 159 Chapter Lessons 206
Bond Ratings 159 Conceptual and Analytical Problems 207
Commercial Paper Ratings 164 Data Exploration 209
The Impact of Ratings on Yields 164
CHAPTER 9 DERIVATIVES: FUTURES, OPTIONS,
Differences in Tax Status and AND SWAPS 211
Municipal Bonds 167
The Basics: Defining Derivatives 212
The Term Structure of Interest Rates 169
Forwards and Futures 213
The Expectations Hypothesis 170
Margin Accounts and Marking to Market 215
The Liquidity Premium Theory 173
Hedging and Speculating with Futures 216
The Information Content of Interest Rates 174
Arbitrage and the Determinants of
Information in the Risk Structure of Futures Prices 217
Interest Rates 174
Options 219
Information in the Term Structure of
Calls, Puts, and All That: Definitions 219
Interest Rates 175
Using Options 220
Key Terms 178
Pricing Options: Intrinsic Value and the
Using FRED: Codes for Data in This Chapter 179 Time Value of the Option 223
Chapter Lessons 179 The Value of Options: Some Examples 226
Conceptual and Analytical Problems 180 Swaps 227
Data Exploration 182 Interest Rate Swaps 228
Credit Default Swaps 232
CHAPTER 8 STOCKS, STOCK MARKETS,
AND MARKET EFFICIENCY 184 Key Terms 233
The Essential Characteristics Using FRED: Codes for Data in This Chapter 233
of Common Stock 185 Chapter Lessons 233
Measuring the Level of the Stock Market 188 Conceptual and Analytical Problems 235
The Dow Jones Industrial Average 189 Data Exploration 237
The Standard & Poor’s 500 Index 189
Other U.S. Stock Market Indexes 191 CHAPTER 10 FOREIGN EXCHANGE 238
World Stock Indexes 191 Foreign Exchange Basics 240
Valuing Stocks 193 The Nominal Exchange Rate 240
Fundamental Value and the The Real Exchange Rate 241
Dividend-Discount Model 193 Foreign Exchange Markets 244
Why Stocks Are Risky 195 Exchange Rates in the Long Run 245
Risk and the Value of Stocks 196 The Law of One Price 245
The Theory of Efficient Markets 199 Purchasing Power Parity 246
Investing in Stocks for the Long Run 200 Exchange Rates in the Short Run 250
The Stock Market’s Role in the Economy 203 The Supply of Dollars 250
xxvi l Contents

The Demand for Dollars 251 CHAPTER 12 DEPOSITORY INSTITUTIONS:

BANKS AND BANK MANAGEMENT 294
Equilibrium in the Market for Dollars 252
The Balance Sheet of Commercial Banks 295
Shifts in the Supply of and
Demand for Dollars 252 Assets: Uses of Funds 295
Explaining Exchange Rate Movements 253 Liabilities: Sources of Funds 298
Government Policy and Bank Capital and Profitability 300
Foreign Exchange Intervention 255 Off-Balance-Sheet Activities 305
Key Terms 257 Bank Risk: Where It Comes from and
Using FRED: Codes for Data in This Chapter 258 What to Do about It 306
Chapter Lessons 258 Liquidity Risk 307
Conceptual and Analytical Problems 259 Credit Risk 310
Data Exploration    262 Interest Rate Risk 311
Appendix to Chapter 10: Interest Rate Parity and Trading Risk 314
Short-Run Exchange Rate Determination 263 Cyber Risk and Other Operational Risks 316
Other Risks 317
Part III Financial Institutions Key Terms 319
CHAPTER 11 THE ECONOMICS OF Using FRED: Codes for Data in This Chapter 320
FINANCIAL INTERMEDIATION 266 Chapter Lessons 320
The Role of Financial Intermediaries 268 Conceptual and Analytical Problems 321
Pooling Savings 271 Data Exploration 325
Safekeeping, Payments System Access,
and Accounting 271
CHAPTER 13 FINANCIAL INDUSTRY STRUCTURE 326
Providing Liquidity 273
Banking Industry Structure 328
Diversifying Risk 274
A Short History of U.S. Banking 328
Collecting and Processing Information 274
Competition and Consolidation 330
Information Asymmetries and
Information Costs 275 The Globalization of Banking 333
Adverse Selection 276 The Future of Banks 336
Solving the Adverse Selection Problem 278 Nondepository Institutions 337
Moral Hazard: Problem and Solutions 281 Insurance Companies 338
Financial Intermediaries and Pension Funds 344
Information Costs 284 Securities Firms: Brokers, Mutual Funds, and
Screening and Certifying to Reduce Investment Banks 346
Adverse Selection 285 Finance Companies 347
Monitoring to Reduce Moral Hazard 286 Government-Sponsored Enterprises 348
Key Terms 288 Key Terms 351
Using FRED: Codes for Data in This Chapter 289 Using FRED: Codes for Data in This Chapter 352
Chapter Lessons 289 Chapter Lessons 352
Conceptual and Analytical Problems 290 Conceptual and Analytical Problems 353
Data Exploration 292 Data Exploration 355
 Contents l xxvii

CHAPTER 14 REGULATING THE FINANCIAL Low, Stable Inflation 400

SYSTEM 357
High, Stable Real Growth 401
The Sources and Consequences of Runs, Panics,
and Crises 359 Financial System Stability 402
The Government Safety Net 363 Interest Rate and Exchange Rate
Stability 403
The Unique Role of Banks and
Shadow Banks 364 Meeting the Challenge: Creating
a Successful Central Bank 404
The Government as Lender of Last Resort 365
The Need for Independence 406
Government Deposit Insurance 367
The Need for Accountability
Problems Created by the Government and Transparency 407
Safety Net 368
The Policy Framework, Policy Tradeoffs,
Regulation and Supervision of the and Credibility 409
Financial System 370
Decision Making by Committee 411
Restrictions on Competition 373
Fitting Everything Together:
Asset Holding Restrictions and Minimum Central Banks and Fiscal Policy 411
Capital Requirements 374
Key Terms 415
Disclosure Requirements 375
Using FRED: Codes for Data in This Chapter 416
Supervision and Examination 377
Chapter Lessons 416
Stress Tests 377
Conceptual and Analytical Problems 417
Evolving Challenges for Regulators
and Supervisors 381 Data Exploration 419
Micro-Prudential versus CHAPTER 16 THE STRUCTURE OF CENTRAL
Macro-Prudential Regulation 382 BANKS: THE FEDERAL RESERVE AND
Regulatory Reform: The THE EUROPEAN CENTRAL BANK 421
Dodd-Frank Act of 2010 385 The Structure of the Federal Reserve System 422
Key Terms 388 The Federal Reserve Banks 423
Using FRED: Codes for Data in This Chapter 388 The Board of Governors 425
Chapter Lessons 389 The Federal Open Market Committee 428
Conceptual and Analytical Problems 390 Assessing the Federal Reserve System’s
Data Exploration 391 Structure 431
Independence from Political Influence 432
Part IV Central Banks, Monetary Policy, Decision Making by Committee 432
and Financial Stability Accountability and Transparency 432
Policy Framework 434
CHAPTER 15 CENTRAL BANKS IN THE
The European Central Bank 434
WORLD TODAY 393
The Basics: How Central Banks Originated Organizational Structure 436
and Their Role Today 394 Accountability and Transparency 439
The Government’s Bank 394 The Price Stability Objective and
The Bankers’ Bank 396 Monetary Policy Strategy 439
Stability: The Primary Objective Key Terms 444
of All Central Banks 398 Using FRED: Codes for Data in This Chapter 444
xxviii l Contents

Chapter Lessons 444 Discount Lending, the Lender of Last Resort,

Conceptual and Analytical Problems 445 and Crisis Management 487
Data Exploration 447 Reserve Requirements 490
Operational Policy at the European
CHAPTER 17 THE CENTRAL BANK BALANCE SHEET Central Bank 490
AND THE MONEY SUPPLY PROCESS 448 The ECB’s Target Interest Rate and
The Central Bank’s Balance Sheet 450 Open Market Operations 491
Assets 451 The Marginal Lending Facility 491
Liabilities 451 The Deposit Facility 492
The Importance of Disclosure 453 Reserve Requirements 492
The Monetary Base 454 Linking Tools to Objectives: Making Choices 493
Changing the Size and Composition of Desirable Features of a Policy
the Balance Sheet 454 Instrument 494
Open Market Operations 455 Inflation Targeting 496
Foreign Exchange Intervention 456 A Guide to Central Bank Interest Rates:
Discount Loans 458 The Taylor Rule 497
Cash Withdrawal 458 Unconventional Policy Tools 501
The Deposit Expansion Multiplier 460 Forward Guidance 505
Deposit Creation in a Single Bank 460 Quantitative Easing 506
Deposit Expansion in a System Targeted Asset Purchases 508
of Banks 462 Making an Effective Exit 509
The Monetary Base and the Money
Concluding Remarks 513
Supply 465
Key Terms 513
Deposit Expansion with Excess Reserves
and Cash Withdrawals 465 Using FRED: Codes for Data in This Chapter 514
The Arithmetic of the Money Chapter Lessons 514
Multiplier 467
Conceptual and Analytical Problems 516
The Limits of the Central Bank’s Ability
Data Exploration 518
to Control the Quantity of Money 472
Key Terms 474 Appendix to Chapter 18: Monetary Policy
Operations and the Reverse Repo Rate 519
Using FRED: Codes for Data in This Chapter 474
Chapter Lessons 475 CHAPTER 19 EXCHANGE RATE POLICY
Conceptual and Analytical Problems 475 AND THE CENTRAL BANK 521
Data Exploration 477 Linking Exchange Rate Policy
with Domestic Monetary Policy 523
CHAPTER 18 MONETARY POLICY: STABILIZING THE Inflation and the Long-Run Implications
DOMESTIC ECONOMY 479 of Purchasing Power Parity 523
The Federal Reserve’s Conventional Interest Rates and the Short-Run Implications
Policy Toolbox 482 of Capital Market Arbitrage 524
The Target Federal Funds Rate and the Interest Capital Controls and the
on Excess Reserves 484 Policymakers’ Choice 526
 Contents l xxix

Mechanics of Exchange Rate Management 528 Targeting Money Growth:

The Central Bank’s Balance Sheet 528 The Fed and the ECB 569

Sterilized Intervention 531 Key Terms 573

Using FRED: Codes for Data in
The Costs, Benefits, and Risks of
This Chapter 573
Fixed Exchange Rates 532
Chapter Lessons 573
Assessing the Costs and Benefits 532
Conceptual and Analytical Problems 574
The Danger of Speculative Attacks 534
Data Exploration 576
Summarizing the Case for a
Fixed Exchange Rate 536
Fixed Exchange Rate Regimes 537 CHAPTER 21 OUTPUT, INFLATION,
AND MONETARY POLICY 577
Exchange Rate Pegs and the Bretton Output and Inflation in the Long Run 578
Woods System 537
Potential Output 578
Hard Pegs: Currency Boards
and Dollarization 539 Long-Run Inflation 579
Key Terms 545 Monetary Policy and the Dynamic
Aggregate Demand Curve 580
Using FRED: Codes for Data in
This Chapter 545 Aggregate Expenditure and the
Real Interest Rate 582
Chapter Lessons 546
Inflation, the Real Interest Rate, and
Conceptual and Analytical Problems 547 the Monetary Policy Reaction
Data Exploration 549 Curve 586
Appendix to Chapter 19: What You Really The Dynamic Aggregate Demand
Need to Know about the Balance of Curve 591
Payments 550 Aggregate Supply 595
Short-Run Aggregate Supply 595
Part V Modern Monetary Economics
Shifts in the Short-Run Aggregate
CHAPTER 20 MONEY GROWTH, MONEY DEMAND, Supply Curve 596
AND MODERN MONETARY POLICY 553 The Long-Run Aggregate Supply
Why We Care about Monetary Curve 597
Aggregates 554 Equilibrium and the Determination
The Quantity Theory and the of Output and Inflation 601
Velocity of Money 556 Short-Run Equilibrium 601
Velocity and the Equation of Exchange 557 Adjustment to Long-Run Equilibrium 601
The Quantity Theory of Money 558 The Sources of Fluctuations in Output
The Facts about Velocity 559 and Inflation 603
The Demand for Money 562 What Causes Recessions? 604
The Transactions Demand for Money 562 Key Terms 606
The Portfolio Demand for Money 564 Using FRED: Codes for Data in
Targeting Money Growth in a This Chapter 607
Low-Inflation Environment 566 Chapter Lessons 607
The Instability of U.S. Money Demand 566 Conceptual and Analytical Problems 608
xxx l Contents

Data Exploration 611 CHAPTER 23 MODERN MONETARY POLICY

AND THE CHALLENGES FACING
Appendix to Chapter 21: The Dynamic Aggregate
CENTRAL BANKERS 647
Demand–Aggregate Supply Model 612
The Monetary Policy
CHAPTER 22 UNDERSTANDING BUSINESS Transmission Mechanism 649
CYCLE FLUCTUATIONS 615 The Traditional Channels:
Sources of Fluctuations in Output Interest Rates and Exchange Rates 649
and Inflation 617 Bank-Lending and Balance-Sheet Channels 650
Shifts in the Dynamic Aggregate Asset-Price Channels: Wealth and
Demand Curve 617 Investment 655
Shifts in the Short-Run Aggregate Financial Crises and the Transmission of
Supply Curve 622 Monetary Policy 656
Using the Aggregate Demand–Aggregate The Challenges Modern Monetary
Supply Framework 623 Policymakers Face 658
How Do Policymakers Achieve Their Booms and Busts in Property
Stabilization Objectives? 623 and Equity Prices 659
What Accounts for the Great Deflation and the Effective Lower Interest
Moderation? 629 Rate Bound 662
What Happens When Potential Output The Evolving Structure
Changes? 632 of the Financial System 666
What Are the Implications of Globalization for Key Terms 668
Monetary Policy? 636
Using FRED: Codes for Data in This Chapter 669
Can Policymakers Stabilize Output and
Chapter Lessons 669
Inflation Simultaneously? 636
Conceptual and Analytical Problems 670
Key Terms 641
Data Exploration 672
Using FRED: Codes for Data in
This Chapter 642
Chapter Lessons 642 Glossary G-1
Conceptual and Analytical Problems 643 Notation Index N-1
Data Exploration 645 Index I-1
 Contents l xxxi

Learning Tools
Chapter 1 Applying the Concept:
Your Financial World: High Interest Rates, Low Interest Rates 92
Guard Your Identity 9 Chapter 5
Chapter 2 Applying the Concept:
Your Financial World: It’s Not Just Expected Return That Matters 104
Debit Cards versus Credit Cards 24 Tools of the Trade:
Your Financial World: The Impact of Leverage on Risk 110
Modernizing U.S. Payments: Faster, Cheaper, Lessons from the Crisis:
and More Secure 29 Systemic Risk 112
Lessons from the Crisis: Your Financial World:
Market Liquidity, Funding Liquidity, and Your Risk Tolerance 116
Making Markets 31 Applying the Concept:
Money and Banking Blog: Do U.S. Households Benefit When Growth
Virtual Frenzies: Bitcoin and Blockchain 34 Is Stable? 118
Tools of the Trade: Money and Banking Blog:
The Consumer Price Index 37 On the Distribution of Wealth 120
Applying the Concept: Chapter 6
Cash Is King, but $100 Bills Are Your Financial World:
for Crooks 38 Know Your Mortgage 132
Chapter 3 Tools of the Trade:
Lessons from the Crisis: Reading the Bond Page 138
Leverage 49 Applying the Concept:
Your Financial World: When Russia Defaulted 147
Disability Income Insurance 52 Applying the Concept:
Tools of the Trade: Securitization 148
Trading in Financial Markets 56 Your Financial World:
Applying the Concept: Bonds Indexed to Inflation 149
Basics of High-Frequency Trading 61 Money and Banking Blog:
Lessons from the Crisis: Bond Market Liquidity: Should
Shadow Banks 63 We Be Worried? 150
Money and Banking Blog: Chapter 7
Banking the Masses 66 Lessons from the Crisis:
Chapter 4 Subprime Mortgages 161
Your Financial World: Money and Banking Blog:
How Long Does Your Investment In Search of Better Credit Assessments 162
Take to Double? 77 Your Financial World:
Lessons from the Crisis: Your Credit Rating 166
Risk Taking and the Search for Yield 79 Lessons from the Crisis:
Tools of the Trade: Asset-Backed Commercial Paper 168
Computing Compound Annual Rates 82 Applying the Concept:
Applying the Concept: The Flight to Quality 175
How Much Is Our Distant Future Worth? 85 Chapter 8
Money and Banking Blog: Your Financial World:
Investing in College 86 A Home Is a Place to Live 187
Your Financial World: Tools of the Trade:
What Is Your Risk-Free Rate? 90 Reading Stock Indexes in the Business News 190
xxxii l Contents

Applying the Concept: Applying the Concept:

China’s Stock Market Boom and Bust 198 Financing Intangible Capital 286
Your Financial World: Chapter 12
Should You Own Stocks? 201 Tools of the Trade:
Money and Banking Blog: A Catalog of Depository Institutions 302
Should I Buy or Should I Sell? 202 Applying the Concept:
Applying the Concept: Shadow Banking in China 304
Raising Equity: Public versus Private Your Financial World:
Markets 205 The Cost of Payday Loans 306
Chapter 9 Lessons from the Crisis:
Lessons from the Crisis: Insufficient Bank Capital 312
Central Counterparties and Systemic Risk 217 Money and Banking Blog:
Your Financial World: The Cloudy Future of Peer-to-Peer Lending 315
Should You Believe Corporate Financial Applying the Concept:
Statements? 221 The Tri-Party Repo Market 318
Your Financial World: Chapter 13
Should You Accept Options as Applying the Concept:
Part of Your Pay? 225 Eclipsing LIBOR 335
Applying the Concept: Your Financial World:
What Was Long-Term Capital Why You Are Obliged to Buy
Management Doing? 228 Health Insurance 339
Money and Banking Blog: Your Financial World:
The VIX: The Thing to Fear Is the Lack How Much Life Insurance Do You Need? 341
of Fear Itself 231 Applying the Concept:
Chapter 10 Reinsurance and “Cat Bonds” 343
Tools of the Trade: Applying the Concept:
Following Exchange Rates in the News 242 Public Pensions and the Social
Applying the Concept: Security System 345
The Big Mac Index 249 Tools of the Trade:
Your Financial World: Hedge Funds 347
Yogi Berra and the Dollar 251 Money and Banking Blog:
Lessons from the Crisis: Still Riding the GSE Train 349
Currency Risk and Rollover Risk 254 Chapter 14
Money and Banking Blog: Lessons from the Crisis:
To RMB or Not to RMB? Lessons from The Three Phases of the Financial Crisis
Currency History 256 of 2007–2009 362
Chapter 11 Your Financial World:
Your Financial World: The Securities Investor Protection
Your First Credit Card 272 Corporation 366
Applying the Concept: Applying the Concept:
Truth or Consequences: Ponzi Schemes The Day the Bank of New York Borrowed
and Other Frauds 276 $23 Billion 367
Applying the Concept: Applying the Concept:
Deflation, Net Worth, and Better Capitalized Banks Lend More and
Information Costs 279 Lend Better 371
Lessons from the Crisis: Your Financial World:
Information Asymmetry and Securitization 280 Are Your Deposits Insured? 373
Money and Banking Blog: Tools of the Trade:
Conflicts of Interest in Finance 284 The Basel Accords: I, II, III, and Counting . . . 378
 Contents l xxxiii

Money and Banking Blog: Lessons from the Crisis:

Narrow Banks Won’t Stop Bank Runs 380 The Financial Stability–Monetary
Chapter 15 Policy Nexus 512
Applying the Concept: Chapter 19
Why Is Stable Money Such a Big Deal? 396 Your Financial World:
Applying the Concept: Is International Diversification Dead? 525
Time Consistency 399 Applying the Concept:
Applying the Concept: The Gold Standard: An Exchange Rate Regime
The Threat to Fed Independence 405 Whose Time Has Passed 535
Money and Banking Blog: Lessons from the Crisis:
Fiscal Sustainability 412 Oasis of Stability? 538
Chapter 16 Applying the Concept:
Applying the Concept: China’s Changing Exchange Rate Regime 540
Central Bank Digital Currency 427 Money and Banking Blog:
Tools of the Trade: Sudden Stops: Understanding
Decoding the FOMC Statement 431 Balance-of-Payments Crises 542
Applying the Concept: Chapter 20
The Evolution of Federal Reserve Applying the Concept:
Independence 433 Central Bank Money Without
Lessons from the Crisis: Inflation? 556
The Euro-Area Crisis and the ECB 440 Applying the Concept:
Money and Banking Blog: The ECB’s Reference Value for Money
The Importance of Being Europe 442 Growth 563
Chapter 17 Tools of the Trade:
Applying the Concept: Using Statistical Models in
The Fed’s Balance Sheet: Impact of Policy Evaluation 568
the Crisis 452 Money and Banking Blog:
Applying the Concept: We Are Still Overstating Inflation 570
What Should the Fed Own? 457 Chapter 21
Your Financial World: Your Financial World:
Has Paper Money Outlived Its Purpose? 466 Distinguishing Inflation, Deflation,
Applying the Concept: and Disinflation 579
Negative Nominal Interest Rates: Blast from Applying the Concept:
the Past? 469 Investment and the Business Cycle 588
Lessons from the Crisis: Money and Banking Blog:
The Impact on Money Supply 471 The Phillips Curve 598
Money and Banking Blog: Applying the Concept:
Monetary Policy: A Lesson Learned 473 Zero Matters 606
Chapter 18 Chapter 22
Applying the Concept: Tools of the Trade:
Alternative Monetary Policy Targets: Inflation, Defining a Recession: The NBER
Price Level, and Nominal GDP 494 Reference Cycle 624
Applying the Concept: Applying the Concept:
GDP: One Size No Longer Fits All 502 GDP-Linked Bonds 631
Tools of the Trade: Your Financial World:
Some Unconventional Policy Tools 504 The Problem with Measuring
Money and Banking Blog: Nominal GDP 637
Is 2 Percent Still the Right Money and Banking Blog:
Inflation Target? 510 A Guide to “Secular Stagnation” 640
xxxiv l Contents

Chapter 23 Applying the Concept:

Tools of the Trade: Debt, the Great Recession, and the Awful
Correlation Does Not Imply Causality 651 Recovery 658
Your Financial World: Money and Banking Blog:
Don’t Count on Inflation to Bail You Out 654 GDP at Risk 664
 1
Chapter

An Introduction to Money
and the Financial System

Learning Objectives
After reading this chapter, you should be able to:
LO1* List and explain the six parts of the financial system.

LO2 Identify the five core principles of money and banking.

LO3 Describe the special features and organization of the book.

This morning, a typical American college student bought coffee at the local café, pay-
ing for it with a debit card. Then she jumped into her insured car and drove to the
university, which she attends thanks to her student loan. She may have left her par-
ents’ home, which is mortgaged, a few minutes early to avoid construction work on a
new dormitory, financed by bonds issued by the university. Or perhaps she needed to
purchase this book online, using her credit card, before her first money and banking
class began.
Beneath the surface, the financial transactions embedded in this story—even the
seemingly simple ones—are quite complicated. If the café owner and the student
use different banks, paying for the coffee will require an interbank funds transfer. The
company that insures the student’s car has to invest the premiums she pays until they
are needed to pay off claims. The student’s parents almost surely obtained their home
mortgage through a mortgage broker, whose job was to find the cheapest mortgage
available. And the bonds the university issued to finance construction of the new dor-
mitory were created with the aid of an investment bank.
This brief example hints at the complex web of interdependent institutions and
­markets that is the foundation for our daily financial transactions. The system is so
efficient that most of us rarely take note of it. But a financial system is like air to an
economy: If it disappeared suddenly, everything would grind to a halt.
In the autumn of 2008, we came closer to such a financial meltdown than at any
time since the 1930s. In the earlier episode, the collapse of the banking system led to
the Great Depression. In the recent crisis, some of the world’s largest financial institu-
tions failed. Key markets stopped functioning. Credit dried up, even for sound borrow-
ers. As a result, vibrant companies that relied on short-term loans to pay their
employees and buy materials faced potential ruin. Even some fundamental ways that
we make payments for goods and services were threatened.

*LO, Learning Objective.

1
2 l Chapter 1  An Introduction to Money and the Financial System

Gasping for air in this financial crisis, the global economy during 2008 and 2009
sank into the deepest, broadest, and longest downturn since the 1930s. Around the
world, tens of millions of people lost their jobs. In the United States, millions lost their
homes and their life’s savings. Others became unable to borrow to buy a home or go to
college. And the weakness added to financial fragility elsewhere, especially in Europe,
where the viability of the euro, the world’s leading currency after the U.S. dollar, was
threatened. The chances are good that you know someone—in your neighborhood,
your school, or your family—whose life was changed for the worse by the crisis.
So, what happens in the financial system, whether for good or for bad, matters greatly
for all of us. To understand the system—both its strengths and its vulnerabilities—
­let’s take a closer look.

The Six Parts of the Financial System

The financial system1 has six parts, each of which plays a fundamental role in our
economy. Those parts are money, financial instruments, financial markets, financial
institutions, government regulatory agencies, and central banks.
We use the first part of the system, money, to pay for our purchases and to store our
wealth. We use the second part, financial instruments, to transfer resources from
savers to investors and to transfer risk to those who are best equipped to bear it. Stocks,
mortgages, and insurance policies are examples of financial instruments. The third
part of our financial system, financial markets, allows us to buy and sell financial
instruments quickly and cheaply. The New York Stock Exchange is an example of a
financial market. Financial institutions, the fourth part of the financial system, pro-
vide a myriad of services, including access to the financial markets and collection of
information about prospective borrowers to ensure they are creditworthy. Banks, secu-
rities firms, and insurance companies are examples of financial institutions. Govern-
ment r­ egulatory agencies form the fifth part of the financial system. They are
responsible for making sure that the elements of the financial system—including its
instruments, markets, and institutions—operate in a safe and reliable manner. Finally,
central banks, the sixth part of the system, monitor and stabilize the economy. The
Federal Reserve System is the central bank of the United States.
While the essential functions that define these six categories endure, their form is
constantly evolving. Money once consisted of gold and silver coins. These were even-
tually replaced by paper currency, which today is being eclipsed by electronic funds
transfers. Methods of accessing means of payment have changed dramatically as well.
As recently as 1970, people customarily obtained currency from bank tellers when
they cashed their paychecks or withdrew their savings from the local bank. Today, they
can get cash from practically any ATM anywhere in the world. To pay their bills, peo-
ple once wrote checks and put them in the mail, and then waited for their monthly bank
statements to make sure the transactions had been processed correctly. Today, pay-
ments can be made automatically, and account holders can check the transactions at
any time on their bank’s website or on their smartphone.
Financial instruments (or securities, as they are often called) have evolved just
as much as currency. In the last few centuries, investors could buy individual
stocks through stockbrokers, but the transactions were costly. Furthermore, putting
together a portfolio of even a small number of stocks and bonds was extremely
1
Throughout the book, terms in bold red are “key terms” listed at the end of each chapter and defined in the
glossary.
 The Six Parts of the Financial System l 3

time-consuming; just collecting the information necessary to evaluate a potential

investment was a daunting task. As a result, investing was an activity reserved for the
wealthy. Today, financial institutions offer people with as little as $1,000 to invest the
ability to purchase shares in mutual funds, which pool the savings of a large number of
investors. Because of their size, mutual funds can construct portfolios of hundreds or
even thousands of different stocks and/or bonds.
The markets where stocks and bonds are sold have undergone a similar
­transformation. Originally, financial markets were located in coffeehouses and taverns
where individuals met to exchange financial instruments. The next step was to create
organized markets, like the New York Stock Exchange—trading places specifically
dedicated to the buying and selling of stocks and bonds. Today, most of the activity
that once occurred at these big-city financial exchanges is handled by electronic net-
works. Buyers and sellers obtain price information and initiate transactions from their
desktop computers or from handheld devices. Because electronic networks have reduced
the cost of processing financial transactions, even small investors can afford to partici-
pate in them. Just as important, today’s financial markets offer a much broader array of
financial instruments than those available even 50 years ago.
Financial institutions have changed, as well. Banks began as vaults where people
could store their valuables. Gradually, they developed into institutions that accepted
deposits and made loans. For hundreds of years, in fact, that was what bankers did.
Today, a bank is more like a financial supermarket. Walk in and you will discover a
huge assortment of financial products and services for sale, from access to the
­financial markets to insurance policies, mortgages, consumer credit, and even invest-
ment advice.
The activities of government regulatory agencies and the design of regulation have
been evolving and have entered a period of more rapid change, too. In the aftermath of
the financial crisis of 1929–1933, when the failure of thousands of banks led to the
Great Depression, the U.S. government introduced regulatory agencies to provide
wide-ranging financial regulation—rules for the operation of financial institutions and
markets—and supervision—oversight through examination and enforcement. The U.S.
agencies established in the 1930s to issue and enforce these financial rules still operate.
Yet, the evolution of financial instruments, institutions, and markets has led to many
changes in the ways that regulatory agencies work. A bank examiner used to count the
money in the cash drawers and call borrowers to see if the loans on a bank’s books
were real. The examiner might even visit workplaces to see if the loans were used as
designed to buy equipment or build a factory. Today, banks engage in millions of
transactions, many of which are far more complex and difficult to understand than a
loan or a mortgage. So, a government examiner also looks at the systems that a bank
uses to manage its various risks. In doing so, regulators try to encourage best practices
throughout the financial industry.
However, the failure of regulators in the United States and elsewhere around the
world to anticipate or prevent the financial crisis of 2007–2009 has led many govern-
ments to undertake far-reaching changes to financial regulation and the regulatory
agencies. The Dodd-Frank Wall Street Reform and Consumer Protection Act, adopted
in 2010 and known as the Dodd-Frank Act, is the largest U.S. regulatory change since
the 1930s. Also in 2010, regulators of many nations agreed on a third, major update of
standards for internationally active banks—known as Basel III after the Swiss city
where the policymakers meet. Both reforms took years to implement, and have
prompted further changes to tailor the rules and limit the resulting regulatory burden.
Their influence will continue to shape the financial system for decades.
4 l Chapter 1  An Introduction to Money and the Financial System

Finally, central banks have changed a great deal. They began as large private
banks founded by monarchs to finance wars. For instance, King William of Orange
created the Bank of England in 1694 for the express purpose of raising taxes and
borrowing to finance a war between Austria, England, and the Netherlands on one
side and Louis XIV’s France on the other. Eventually, these government treasuries
grew into the modern central banks we know today. While only a few central banks
existed in 1900, now nearly every country in the world has one, and they have
become one of the most important institutions in government. Central banks control
the availability of money and credit to promote low inflation, high growth, and the
stability of the ­financial system. Because their current mission is to serve the public
at large rather than land-hungry monarchs, their operating methods have changed as
well. A central bank’s decisions used to be shrouded in mystery, but today’s policy-
makers strive for transparency in their operations. Officials at the European
­Central Bank (ECB) and the U.S. Federal Reserve—two of the most important
central banks in the world—go out of their way to explain the rationale for their
decisions.
Though the changing nature of our financial system is a fascinating topic, it poses
challenges for both students and instructors. How can we teach and learn about money
and banking in a way that will stand the test of time, so that the knowledge we gain
won’t become outmoded? The answer is that we must develop a way to understand and
adapt to the evolutionary structure of the financial system. That means discussing
money and banking within a framework of core principles that do not change over
time. The next section introduces the five core principles that will guide our studies
throughout this book.

The Five Core Principles of Money and Banking

Five core principles will inform our analysis of the financial system and its interaction
with the real economy. Once you have grasped these principles, you will have a better
understanding not only of what is happening in the financial world today but of
changes that will undoubtedly occur in the future. The five principles are based on
time, risk, information, markets, and stability.

Core Principle 1: Time Has Value

The first principle of money and banking is that time has value. At some very basic
level, everyone knows this. If you take a job at the local supermarket, you will almost
surely be paid by the hour. An hour’s worth of work equals a certain number of dollars.
Literally, your time has a price.
On a more sophisticated level, time affects the value of financial transactions. Most
loan contracts allow the borrower to spread out the payments over time. If you take out
an auto loan, for example, the lender will allow you to make a series of monthly pay-
ments over three, four, or even five years. If you add up the payments, you’ll discover
that the total exceeds the amount of the loan. At an interest rate of 4 percent, a four-
year, $10,000 car loan will require 48 monthly payments of $226 each. That means
you will repay a total of $10,848 (48 times $226). The reason your repayments total
more than the loan amount is that you are paying interest to compensate the lender for
the time during which you use the funds. That is, the resources you borrowed have an
opportunity cost to the lender so you have to pay rent on them.
 The Five Core Principles of Money and Banking l 5

Interest payments are fundamental to a market economy. In Chapter 4, we will

develop an understanding of interest rates and how to use them. Then, throughout the
remainder of Part II (Chapters 4 –10), we will apply the principle that time has value in
our discussion of the valuation of bonds, stocks, and other financial instruments involv-
ing future payments. How much should you be willing to pay for a particular stock or
bond? Figuring out what alternative investments are worth, and comparing them,
means valuing payments made on different future dates. The same principle applies to
the question of how much you must invest today to achieve a particular financial objec-
tive in the future. How much of your salary, for example, do you need to save each
month to meet your goal of buying a house? The length of time your savings will be
earning interest is a key to answering this question.

Core Principle 2: Risk Requires Compensation

The world is filled with uncertainty. More events, both good and bad, can happen than
will happen. Some of the possibilities, such as the likelihood of your home doubling in
value after you buy it, are welcome. Other possibilities, such as the chance that you
might lose your job and not be able to make your car payments, are distinctly unwel-
come. Dealing effectively with risk requires that you consider the full range of possi-
bilities in order to eliminate some risks, reduce others, pay someone to assume
particularly onerous risks, and just live with what’s left. Needless to say, no one will
assume your risks for free, which brings us to the second core principle of money and
banking: Risk requires compensation. In the financial world, compensation is made in
the form of explicit payments. That is, investors must be paid to assume risk; the
higher the risk, the bigger the required payment.
Car insurance is a common example of paying someone else to shoulder a risk you
don’t want to take. If your car is wrecked in an accident, you will want to be able to
repair it. But beyond that, auto insurance shelters drivers from the possibility of losing
all their wealth in the event that they cause an accident in which someone is seriously
injured. Although the chances of causing such an accident are quite small, the results
can be so serious that, even if the government didn’t require it, most of us would vol-
untarily purchase auto insurance. Driving without it just isn’t worth the risk. The insur-
ance company pools the premiums that policyholders pay and invests them. Even
though some of the premiums will be spent to settle claims when cars are stolen or
damaged by collisions, the chance to make a profit is good. So both the insurance com-
pany and the drivers who buy policies are ultimately better off.
Bearing in mind that time has value and risk requires compensation, we can begin
to see the rationale behind the valuation of a broad set of financial instruments. For
example, a lender will charge a higher interest rate on a loan if there is a chance that
the borrower will not repay. In Chapters 6 and 7, we will use this principle when we
examine the interest rates on bonds. As we will see, a company or a government that is
on the verge of being unable to pay its bills may still be able to issue bonds (called junk
bonds), but it will have to pay an extremely high interest rate to do so. The reason is
that the lender must be compensated for the substantial risk that the company will not
repay the loan. Risk requires compensation.

Core Principle 3: Information Is the Basis for Decisions

Most of us collect information before making decisions. The more important the deci-
sion, the more information we gather. Think of the difference between buying a $5
6 l Chapter 1  An Introduction to Money and the Financial System

sandwich and a $10,000 used car. You will surely spend more time comparing cars
than comparing sandwiches.
What’s true for sandwiches and cars is true for finance as well. That is, information
is the basis for decisions. In fact, the collection and processing of information is the
foundation of the financial system. In Chapter 11, we will learn how financial institu-
tions like banks funnel resources from savers to investors. Before a bank makes a loan,
a loan officer will investigate the financial condition of the individual or firm seeking
it. Banks want to provide loans only to the highest-quality borrowers. Thus, they spend
a great deal of time gathering the information needed to evaluate the creditworthiness
of loan applicants.
To understand the problem faced by the two parties to any financial transaction,
think about a home mortgage. Before making the loan, the mortgage broker exam-
ines the applicant’s finances and researches the home’s value to make sure the
applicant can afford the monthly payments and the property is more valuable than
the loan.
And before the broker transfers the funds to the seller, the new homeowner must
purchase fire insurance. All these requirements arise from the fact that the lender
doesn’t know much about the borrower and wants to make sure the loan will be repaid.
When lenders fail to assess creditworthiness properly, they end up with more
­borrowers who are unable to repay their loans in the future. Large mistakes like these
were a key factor in the wave of U.S. mortgage delinquencies and defaults that
preceded the financial crisis of 2007–2009. Even as recently as 2018, mortgages on
more than two million U.S. homes still exceeded the underlying property value.
Information plays a key role in other parts of the financial system as well. In Chapters
2 and 3, we’ll see that many types of transactions are arranged so that the buyer doesn’t
need to know anything about the seller. When merchants accept cash, they don’t need to
worry about the customer’s identity. When stocks change hands, the buyer doesn’t need
to know anything about the seller, or vice versa. Stock exchanges are organized to elimi-
nate the need for costly information gathering, facilitating the exchange of securities. In
one way or another, information is the key to the financial system.

Core Principle 4: Markets Determine Prices

and Allocate Resources
Markets are the core of the economic system. They are the place, physical or virtual,
where buyers and sellers meet, where firms go to issue stocks and bonds, and where
individuals go to trade assets. Financial markets are essential to the economy,
­channeling its resources and minimizing the cost of gathering information and making
transactions. In fact, well-developed financial markets are a necessary precondition for
healthy economic growth. For the most part, the better developed a country’s financial
markets, the faster the country will grow.
The reason for this connection between markets and growth is that markets deter-
mine prices and allocate resources. Financial markets gather information from a
large number of individual participants and aggregate it into a set of prices that sig-
nals what is valuable and what is not. Thus, markets are sources of information. By
attaching prices to different stocks or bonds, they provide a basis for the allocation
of capital.
To see how prices in the financial markets allocate capital, think about a large firm
wishing to finance the construction of a new factory costing several hundred million
 The Five Core Principles of Money and Banking l 7

dollars. To raise the funds, the firm can go directly into the financial markets and issue
stocks or bonds. The higher the price investors are willing to pay in the market, the
more appealing the idea will be, and the more likely it is that the firm will issue secu-
rities to raise the capital for the investment.
We will refer to the financial markets throughout much of this book. While our
primary focus in Part II (Chapters 4 –10) will be the nature of financial instruments,
we will also study the markets in which those instruments are traded. Chapters 6
through 10 describe the markets for bonds, stocks, derivatives, and foreign currencies.
Importantly, financial markets do not arise by themselves—at least, not the large,
well-oiled ones we see operating today. Markets like the New York Stock Exchange,
where billions of shares of stock change hands every day, require rules in order to work
properly, as well as authorities to police them. Otherwise, they will not function. For
people to be willing to participate in a market, they must perceive it as fair. As we will
see, this creates an important role for the government. Regulators and supervisors of
the financial system make and enforce the rules, punishing people who violate them.
When the government protects investors, financial markets work well and help pro-
mote economic growth; otherwise they don’t.
Finally, even well-developed markets can break down. When they do—as some did
during the financial crisis of 2007–2009—the financial system as a whole can be
at risk. So today, governments must also play a role in promoting the healthy operation
of markets.

Core Principle 5: Stability Improves Welfare

Most of us prefer stable to variable incomes. We like getting raises, but the prospect of
a salary cut is not a pleasant one. This brings us to the fifth core principle of money
and banking: Stability improves welfare. Stability is a desirable quality, not just in our
personal lives but in the financial system as a whole. As we saw at the start of this
chapter, financial instability in the autumn of 2008 brought us closer to a collapse of
the system than at any time since the 1930s, triggering the worst global downturn since
the Great Depression. And the banking and government debt crisis in the euro area
partly reversed Europe’s financial integration, a cornerstone of its successful economic
and political framework in recent decades.
If you are wondering whether this principle is related to Core Principle 2 (risk
requires compensation), you are right. Because volatility creates risk, reducing vol-
atility reduces risk. But while individuals can eliminate many risks on their own
(we’ll see how when we study financial instruments in Part II—Chapters 4 –10),
some risks can be reduced only by government policymakers. Business cycle fluctu-
ations are an example of the sort of instability individuals can’t eliminate on their
own. And though “automatic stabilizers” like unemployment insurance and the
income tax system reduce the burden of ­recessions on individuals, they cannot elim-
inate an economic slowdown. Monetary policymakers can moderate these down-
swings by carefully adjusting interest rates. Central banks also have powerful tools
to steady fragile financial systems and to repair or support dysfunctional markets. In
stabilizing the economy as a whole, they eliminate risks that individuals can’t,
improving everyone’s welfare in the process.
As we will learn in Part IV (Chapters 15–19) of this book, stabilizing the economy is
a primary function of central banks like the Federal Reserve and the European Central
Bank. Officials of these institutions are charged with controlling inflation and reducing
business cycle fluctuations. That is, they work to keep inflation low and stable and
8 l Chapter 1  An Introduction to Money and the Financial System

to keep growth high and stable. They also have key roles in securing financial stabil-
ity. When they are successful, they reduce both the risk that individuals will lose
their jobs and the uncertainty that firms face in making investment decisions. Not
surprisingly, a stable economy grows faster than an unstable economy. Stability
improves welfare.

Throughout the book you will notice icons like this in the margin in various
places. These will guide you to the core principle that provides the foundation for what
is being discussed at that point in the text.

Special Features of This Book

The very first special feature of every chapter in this book is its introduction—each
one presents a real-world example that leads to the big questions the chapter is
designed to answer, such as: What is money? What do banks do? How does the bond
market work? What does the Federal Reserve do to prevent or limit financial crises?
After that real-world setup, the text of each chapter presents the economic and
­financial theory you need to understand the topics covered. Learning objectives listed
at the beginning of the chapter outline the core concepts that are discussed and should
be mastered. Each chapter also contains a series of inserts that apply the theory. There
are five types of inserts: Your Financial World, Applying the Concept, Lessons from
the Crisis, Money and Banking Blog, and Tools of the Trade. Finally, the end of each
chapter is divided into four sections: Key Terms, Using FRED, Chapter Lessons, and
Problems. Here are some guidelines for using the inserts and end-of-chapter materials.

Your Financial World

When most people decide to make a major purchase, they begin by collecting informa-
tion. If they are considering buying a car, they will first try to decide which model is
best for them and then work hard to pay the lowest price possible. Even for smaller
purchases, like clothes or groceries, people first gather information and then buy.
Financial transactions should be no different from consumer purchases. Become
informed first, and then buy. If you’re thinking, “That’s easier said than done,” you’re
right. The problem is that most people have very little knowledge of the financial sys-
tem, so they don’t know how to start or what kind of information to collect.
That’s where Your Financial World comes in. These inserts provide basic guide-
lines for applying economic theory to the bread-and-butter financial decisions you
make nearly every day. Your Financial World answers questions about:
∙ Banking and Payments
∙ What’s the difference between credit and debit cards?
∙ Are your bank deposits insured?
∙ Investments
∙ Should you own stocks or bonds or gold?
∙ Should you invest in the company you work for?
∙ Credit, Loans, and Mortgages
∙ What do you need to know about your mortgage?
∙ What is your credit score and why is it important?
 Special Features of This Book l 9

Guard Your Identity

YOUR FINANCIAL WORLD

There is an old video advertisement in which a middle-aged
man is sitting in his living room drinking a beer. Out of the
man’s mouth comes the voice of a woman describing some
very expensive clothing she just bought. She didn’t care how
much the clothes cost because she wasn’t paying—she used
a credit card that was in the man’s name. The ad catches
viewers’ attention because it is funny. But its primary pur-
pose is to serve as a warning about identity theft, in which
one person takes on the identity of another to do things like
make credit card purchases.
Someone who has a few pieces of key information about
you can get a credit card in your name. To prevent this, you
need to protect personal information. Do your best never to
tell anyone your birth date and birthplace, your address, or
your mother’s maiden name. Most importantly, guard your
­Social Security number. Because it is unique, it is the key to
identity theft. Give out your Social Security number only when
absolutely necessary—on tax forms, for employment records,
and to open bank accounts. If a business requests it, ask if
there is an alternative number they can use. Importantly, be-
ware of phishing―fraudulent e-mails purporting to be from
reputable companies trying to get you to reveal passwords,
credit card information, or other personal information. Give
that information only to people you know to be legitimate.
Beyond protecting your personal information, you need
to monitor your financial statements closely, looking for
things that shouldn’t be there. Be on the lookout for unau-
thorized charges. This means maintaining careful records so
that you know what should be on your bank and credit card
statements.
The risks of identity theft have grown substantially in re-
cent years. In 2017, hackers gained unauthorized access to
more than 140 million records at Equifax, one of the three
large U.S. consumer credit reporting agencies. The personal
information obtained through the security breach included
names, addresses, birth dates, Social Security numbers, and
driver’s license numbers.
Unfortunately, even though it is a serious crime, Identity
theft occurs frequently. For more information about identity
theft, and how to avoid being a victim, see the U.S. Depart-
ment of Justice’s website: www.justice.gov/criminal-fraud/
identity-theft/identity-theft-and-identity-fraud.

∙ Insurance
∙ How much life insurance do you need?
∙ Why do we all need disability income insurance?

Applying the Concept

Applying the Concept inserts show how to put theory into practice. They provide real-
world examples of the ideas introduced in the chapter, drawn primarily from history or
from relevant public policy debates. Here are some of the questions examined in
Applying the Concept:
∙ Why do interest rates rise when inflation goes up?
∙ Under what conditions is a fixed exchange rate vulnerable?
∙ Why do large-scale frauds that damage investors occur repeatedly?
∙ Why is it important for central banks to be free of political influence?
∙ Can monetary policy be used to stabilize the economy?
∙ What determines inflation?
∙ How is China’s exchange rate policy evolving?

Lessons from the Crisis

These inserts cover episodes from the financial crisis of 2007–2009 and from the
­European banking and government debt crisis that began shortly thereafter. One goal
10 l Chapter 1  An Introduction to Money and the Financial System

is to give you a framework for understanding these crises and how they are transform-
ing the world of finance. Another goal is to highlight the relevance and power of the
ideas in the book more generally. Along the way, the various Lessons from the Crisis
offer you insight into the sources and effects of financial instability. They also address
the means that governments—including regulators and central bankers—use to coun-
ter financial instability. Most chapters contain one such insert.
The topics range from specific aspects of the crises to key issues that have wide
application. Here are some of the questions examined in Lessons from the Crisis:
∙ What factors led to the financial crisis of 2007–2009?
∙ What made financial institutions especially vulnerable in this period?
∙ Why do financial markets sometimes stop functioning?
∙ How do threats to the financial system differ from threats to specific financial
institutions?
∙ When a crisis erupts, what can central banks do to prevent another Great
­Depression?
∙ What factors link banks and governments in the euro-area crisis?

Money and Banking Blog

One of the primary purposes of this textbook is to help you understand the business
and financial news. Critically evaluating what you read, hear, and see means develop-
ing a clear understanding of how the financial system works, as well as reading the
news regularly. Like many other skills, critical reading of contemporary economic and
financial analysis takes practice. You can’t just turn to an economics blog, newspaper,
or magazine and skim through it quickly and efficiently; you need to learn how. Your
instructor will make suggestions about what you should read. See Table 1.1 for a list of
reliable sources of information on the economy and the financial system.
Given your need to become a skilled consumer of financial information, each chap-
ter in this book closes with an article drawn from our blog www.moneyandbanking.com
under the heading Money and Banking Blog. Each provides an example of how the
concepts introduced in the chapter are discussed in the real world.

Tools of the Trade

Many chapters in this book include an insert called Tools of the Trade that concen-
trates on practical knowledge relevant to the chapter. Some of these inserts cover basic
skills, including how to read bond and stock tables, how to read charts, and how to do
some simple algebraic calculations. Others provide brief reviews of material from
principles of economics classes, such as the relationship between the current account
and the capital account in the balance of payments. Still other Tools of the Trade
inserts address questions such as:
∙ What is leverage, and how does it affect risk?
∙ What are hedge funds?
∙ What tools did the Fed use to address the financial crisis?
∙ How is a recession defined?
Another random document with
no related content on Scribd:
359
As another instance of Dr. Bosanquet’s unintentional
unfairness to his opponents, I would note his positive injustice
to Theism as such. What many of us think of (however
imperfectly) and believe in as God is invariably to him “a
theistic Demiurge in his blankness and isolation.” I do not
believe in such an abstract Demiurge any more than I believe
in the separate, isolated self that he conjures up to his mind
when he thinks of personality. The problem of the twentieth
century may well be what Dr. Ward has signalised as the
relation of God to the “Absolute” of the Hegelian
metaphysicians, but this suggestion simply means to me the
discovery on the part of philosophers of terms and concepts
more adequate to the Supreme Being than either the Absolute,
or the external deity rejected by Dr. Bosanquet.
360
Stéphane Mallarmé, according to Nordau in Degeneration, p.
103.
361
And the general reader must remember that the “whole” is
always (with all due respect to his high dialectic ability and his
high temper of mind and his scholarship) a kind of ignis fatuus
in Dr. Bosanquet’s book, a kind of shadow thrown by the lamps
and the tools of his own choosing in his Quixotic search. The
“whole” is the “perfected individuality” of the individual who
sets out to find truth in this great world of ours with all its real
possibilities of gain and loss. It is the completion of the
“system” of truth to which the truth-seeker would fain reduce
the entire universe, that becomes for him (for the time being)
the mere “subject-matter” of his thought. It is, that is to say, in
both cases, a purely formal conception—an abstraction,
although to Dr. Bosanquet it is the reality implied in the very
existence and activity of the individual thinker. But the latter is
the case to him only because he looks upon man as existing to
think instead of as thinking to exist.
362
That is to say, for the scholar and the lover of Dante and
Dante’s world.
363
For he was not merely a “mind,” reflecting “Italy” and “minds”
and “experiences.”
364
And that, we might add, is still kept alive by some of our
humanists and educators of to-day as the ideal for both
primary and secondary education.
365
This is a thing that the beginner is taught in lectures
introductory to the study of the philosophy of Kant—in regard
to Kant’s relation to the barren, dogmatic formalism of Wolff—a
one-sided interpreter of the philosophy of Leibniz. I am quite
aware that Dr. Bosanquet does not merely use the Principle of
Non-Contradiction in the aggressive, or polemical, manner of
Mr. Bradley in Appearance and Reality. The principle of
positive coherence at which he aims, begins, to some extent,
where Mr. Bradley stopped. But it is still the idea of consistency
or inconsistency, with certain presuppositions of his own, that
rules his thinking; it determines, from the very outset of his
Lectures, what he accepts and what he rejects.
366
See p. 152 and p. 156, note 2.
367
I use this word “must” in a logical as well as in an ethical
sense, seeing that all judgment implies a belief in the reality of
a world of persons independent of the mere fact of “judgment”
as a piece of mental process.
368
See p. 145.
369
On p. 345 the words are: “When we consider the naïve or
elementary life of morality and religion”; and on p. 346: “The
naïve, or simple self of every-day morality and religion,” and
the marginal heading of the page upon which these words
occur is “The naïve good self compared to grasp of a
fundamental principle alone.” Could anything more clearly
indicate what the Kantians call a confusion of categories [in the
case in point the categories of “goodness” and the categories
of “truth”] or what Aristotle calls a μετάβασις εἰς ἄλλο γένος, the
unconscious treatment of one order of facts by the terms and
conceptions of another order of facts. To Dr. Bosanquet as the
Neo-Hellenist that he is in his professed creed, badness is
practically stupidity, and “lack of unification of life,” and “failure
of theoretical grasp.” This confusion between goodness and
wisdom is again indicated on p. 347 in the words: “A man is
good in so far as his being is ‘unified at’ all in any sphere of
wisdom or activity.” [This is simply not true, and its falsity is a
more unforgivable thing in the case of Dr. Bosanquet than it is
in the case of the pragmatists who also tend to make the
‘moral’ a kind of ‘unification’ or ‘effectiveness’ in ‘purpose.’] As
a proof of Dr. Bosanquet’s transformation of the facts of the
ethical life in the interest of logical theory, we can point to p.
334: “Our actions and ideas issue from our world as a
conclusion from its premises, or as a poem from its author’s
spirit,” or to p. 53, where it is definitely stated that the “self, as
it happens to be,” cannot, in any of its “three aspects,” “serve
as a test of reality.” To do the latter, it must, in his opinion,
follow the law of the “universal,” i.e. become a logical
conception. Now of course (1) it is not the self “as it happens to
be” that is chiefly dealt with in ethics, but rather the self as it
ought to be. And (2) the ethical self, or the “person,” does not
follow the “law of the universal” [a logical law] but the law of
right and wrong [an ethical law]. As a proof of the
subordination of the facts of conduct to the facts of aesthetics,
we may take the words on p. 348 where aesthetic excellence
is said to be “goodness in the wider or (‘shall we say’) in the
narrower sense.” Now the distinction between ethics and
aesthetics is not one of degree, but one of kind.
And as another illustration of his tendency to transform
ethical facts in the light of a metaphysical, or a logical, theory
[they are the same thing to him] we may quote the emphatic
declaration on p. 356: “Our effort has been to bring the
conception of moral and individual initiative nearer to the idea
of logical determination,” or the equally outspoken declaration
on p. 353: “But metaphysical theory, viewing the self in its
essential basis of moral solidarity with the natural and social
 world ... cannot admit that the independence of the self, though
a fact, is more than a partial fact.” Or the words at the top of
this same page: “The primary principle that should govern the
whole discussion is this, that the attitude of moral judgment
and responsibility for decisions is only one among other
attitudes and spheres of experience.” These last words alone
would prove definitely the non-ethical character of “Individuality
and Value.” The ethical life is to its author only a “quatenus
consideratur,” only a possible point of view, only an aspect of
reality, only an aspect, therefore, of a “logical system.” Now if
the ethical life of the world is to count for anything at all, it may
be said that the ethical life is no mere aspect of the life of the
self, and no mere aspect of the life of the world, seeing that
“nature” in the sense of mere “physical nature” does not come
into the sphere of morality at all. It is rather the activity of the
“whole self,” or the “normative” reflection of the self as a whole
upon all the merely partial or subordinate aspects of its activity,
upon bodily life, economic life, intellectual activity, and so on
that constitutes the world of morality.
370
See p. 147, and p. 244.
371
Good and evil to Dr. Bosanquet are two quasi-rational systems
in active antagonism as claiming to attach different “principles
and predicates” to identical data. The essence of their
antagonism to Dr. Bosanquet is not, however, that evil is
contemplated, as it must be sooner or later, in repentance for
example as wrong, but rather that the “evil” is an imperfect
“logical striving (p. 351) of the self after unity” which is in
“contradiction with a fuller and sounder striving” after the same.
The evil self is to him merely the vehicle of a logical
contradiction in the self.
372
This is seen in his admission (on p. 351) that the “bad will” no
less than the “good will” is a logical necessity, when taken
along with his doctrine about mind and body, his doctrine of the
“dependence” (p. 318) of the finite individual upon the external
mechanical world. Dr. Bosanquet, of course, thinks that even in
 this apparent Determinism he is justifiably supplementing the
ordinary ideas about the “self” as “creative” and “originative” (p.
354), by the wider recognition that I am more or less
completely doing the work of the “universe” as a “member” in a
“greater self.” And he adds in the same sentence the words
that “I am in a large measure continuous with the greater (p.
355) self,” and “dyed with its colours”—a further step in
Determinism, as it were, and a step which, with the preceding
one to which we have just referred, no critic can fail to connect
with the Determinism that we have already found to be
implicated in his doctrine of the “self,” and in his general
doctrine that the “external” must be frankly accepted as a
factor in the universe.
373
By the “spectator” fallacy we mean his tendency to talk and
think of the self as it is for a spectator or student, looking at
matters from the outside, and not as the self is for the man
himself.
374
Wollaston is the English ethical philosopher who, according to
Leslie Stephen’s account, thought, after thirty years of
meditation, that the only reason he had for not breaking his
wife’s head with a stick was, that this would be tantamount to a
denial that his wife was his wife.
375
See Idola Theatri by Henry Sturt (the editor of the well-known
“Personal Idealism” volume) of Oxford—a book that
enumerates and examines many of the fallacies of the Neo-
Hegelian school. Mr. Sturt’s first chapter is entitled the
“Passive Fallacy,” which he calls, with some degree of justice,
the prime mistake of the idealistic philosophy, meaning by this
the “ignoring” of the “kinetic” and the “dynamic” character of
our experience.
376
It is Natural Theology that is the subject proper of the Gifford
Lectures.
377
See p. 149 of Chapter VI.
378
With, we might almost say, the pragmatists and the humanists.
379
This is really their main distinguishing characteristic and merit.
380
See p. 162.
381
“Indeed, I do not conceal my belief that in the main the work
has been done.”—Preface.
382
I think that the confession is a praiseworthy one in view of the
fact of the prejudice of Rationalism, that philosophy has
nothing to do with convictions but only with knowledge.
383
By belief I have understood throughout this book simply man’s
working sense for reality, and I am inclined to think that this is
almost the best definition that could be given of it—our working
sense for reality. It is at least, despite its apparent
evasiveness, most in harmony with the pragmatist-humanist
inclusion of will elements and feeling elements in our
knowledge and in our apprehension of reality. It is also in
harmony with the conception of reality which may, in my
opinion, be extracted from both Pragmatism and Idealism—
that reality is what it proves itself to be in the daily
transformation of our experience. By the retention of the term
“working” in this attempted definition I express my agreement
with the idea that action, and the willingness to act, is an
essential element in belief. The outstanding positions in the
definitions of belief that are generally given in philosophical
dictionaries are, firstly, that belief is a conviction or subjective
apprehension of truth or reality in distinction from
demonstrable knowledge or direct evidence; and, secondly,
that feeling elements and action elements enter into it. I am
inclined to think that the sharp antithesis between belief and
knowledge, or the tendency of philosophical books to
emphasise the difference between belief and knowledge, is a
characteristic, or consequence, of our modern way of looking
at things, of our break with the unfortunate, medieval
conception of faith and of the higher reason. The study of the
 facts either of the history of religion or of the history of science,
will convince us, I think, that it is always belief, and that it still is
belief (as the working sense for reality), that is man’s measure
of reality, our knowledge about the universe being at all times
but a more or less perfect working out of our beliefs and of
their implications—of our sense of the different ways in which
the world affects us, and of the ways in which we are affected
towards it. Nor do I think, as I have indicated in different
places, that “reality” can be defined apart from belief, reality
being that in which we believe for all purposes, theoretical and
practical and emotional. In the conception of reality as a world
of intersubjective intercourse in which beings, or persons at
different stages of development, share in a common spiritual
life, we have attained so far (and only so far) to the truth that is
common to an idealism of the type of Dr. Bosanquet’s, and to
pragmatist-humanism when properly developed and
interpreted. There are, I find, upon thinking of the matter, any
number of philosophers and thinkers who interpret belief, in the
larger sense of the term, as our complete and final estimate of
reality, and as therefore not exclusive of, but inclusive of
knowledge in the ordinary sense of the term.
384
He even says in the Abstract of his first lecture upon the
“Central Experiences,” that Lord Gifford’s desire that his
lecturers should “try to communicate” a “grave experience” is
the demand that “introduces us to the double task of
philosophy. It [philosophy] needs the best of logic, but also the
best of life, and neither can be had in philosophy without the
other.”
385
Treatise upon Human Nature, sect. vii. (Green and Grose, i.
547).
386
I had originally the idea of calling this chapter by the more
modest title of a note upon “pragmatist elements” in the
teaching of Bergson. I have allowed myself to call it a chapter
partly for the sake of symmetry, and partly because the
footnotes and the criticism (of his Idealism) have carried it
 beyond the limits of a note. I find, too, (as I have partly
indicated in my preface) in the teaching of Bergson so many
things that make up almost the very body of truth and fact
upon which Pragmatism, and Humanism, and Idealism all
repose (or ought to repose) that I quote them directly in my
footnotes. They indicate to me the scope and the territory of
my entire subject. And they are a confirmation to me of much
that I had myself arrived at before I read a line of Bergson.
387
“Our intelligence, as it leaves the hands of nature, has for its
chief object the unorganised solid” (Creative Evolution, p. 162);
“of immobility alone does the intellect form a clear idea” (ibid.
164). “The aspect of life that is accessible to the intellect—as
indeed to our senses, of which our intellect is the extension—is
that which offers a hold to action” (ibid. 170). “We see that the
intellect, so skilful in dealing with the inert, is awkward the
moment it touches the living. Whether it wants to treat the life
of the body or the life of the mind, it proceeds with the rigour,
the stiffness, and the brutality of the instrument not designed
for such use. The history of hygiene or of pedagogy teaches us
much in this matter. When we think of the cardinal, urgent, and
constant need we have to preserve our bodies and to raise our
souls, of the special facilities given to each of us in this field to
experiment continually on ourselves and on others, of the
palpable injury by which the wrongness of a medical or a
pedagogical practice is made manifest and punished at once,
we are amazed at the stupidity and especially at the
persistence of errors. We may easily find their origin in the
natural obstinacy with which we treat the living like the lifeless,
and think all reality, however fluid, under the form of the
sharply-defined solid. We are at ease only in the
discontinuous, in the immobile, in the dead. The intellect is
characterised by a natural inability to comprehend life”
(Creative Evolution, p. 174). (Italics mine.)
388
“I look and I think I see, I listen and I think I hear, I examine
myself and I think I am reading the very depths of my heart.
But what I see and hear of the outer world is purely and simply
 a selection made by my senses to serve as a light to my
conduct; what I know of myself is what comes to the surface,
what participates in my actions. My senses and my
consciousness, therefore, give me no more than a practical
simplification of reality in the vision they furnish me of myself
and of things, the differences that are useless to man are
obliterated, the resemblances that are useful to him are
emphasised; ways are traced out for me in advance along
which my activity is to travel. These ways are the ways which
all mankind has trod before me. Things have been classified
with a view to the use I can derive from them” (Laughter, p.
151). “Life implies the acceptance of the utilitarian side of
things in order to respond to them by appropriate reactions; all
other impressions must be dimmed or else reach us vague and
blurred” (ibid. p. 131). These last words give us a glimpse of a
very important part of Bergson’s teaching—his idea, namely
(Voltaire has it in his Micromégas), that “matter” is greater than
our perceptions, that our perceptions reveal to us only those
aspects of the physical universe with which we are practically
concerned.
389
Some years ago psychologists began to distinguish a
“structural” from a “functional” psychology, meaning by the
former what is otherwise called Psycho-Physics or (to some
extent) Experimental Psychology.
390
Cf. “At first sight it may seem prudent to leave the
consideration of facts to positive science, to let physics and
chemistry busy themselves with matter, the biological and
psychological sciences with life. The task of the philosopher is
then clearly defined. He takes facts and laws from the
scientist’s hand, and whether he tries to go beyond them in
order to reach their deeper causes, or whether he thinks it
impossible to go further, and even proves it by the analysis of
scientific knowledge, in both cases he has for the facts and
relations, handed over by science, the sort of respect that is
due to a final verdict. To this knowledge he adds a critique of
the faculty of knowing, and also, if he thinks proper, a
 metaphysic; but the matter of knowledge he regards as the
affair of science, and not of philosophy” (Creative Evolution,
pp. 204–5). [All this represents only too faithfully what even
some of our Neo-Kantians have been saying, and teaching,
although there is an error in their whole procedure here.]
391
Schopenhauer’s phrase. See my book upon Schopenhauer’s
System.
392
It is chiefly in Matter and Memory (in which, by the way, there
are pages and pages of criticism of the rationalism of
philosophy that are as valuable as anything we have in
philosophy since the time of Descartes—Kant not excepted)
that we are to look for the detailed philosophy of sensation and
of perception, and the detailed philosophy of science upon
which this protest of Bergson’s against the excesses of
“conceptualism” rests. I indicate, too, at different places in this
chapter some of the other special considerations upon which it
rests. The gist of the whole is to be found, perhaps, in his
contention that our science and our philosophy of the past
centuries have both regarded “perception” as teaching us
(somehow) what things are independently of their effect upon
us, and of their place in the moving equilibrium of things—the
truth being on the contrary (with Pragmatism and Humanism)
that our knowledge has throughout a necessary relation to
ourselves and to our place in the universe, and to our liberation
from matter in the life of the spirit.
393
He expresses this idea in the following way in the Introduction
to Matter and Memory: “Psychology has for its object the study
of the human mind for practical utility,” whereas in
“metaphysics” we see “this same mind striving (the idea, as we
say elsewhere, is not free from difficulty) to transcend the
conditions of useful action and to come back to itself as to a
pure creative energy.” Or in the following sentences from his
Creative Evolution: “We must remember that philosophy, as we
define it, has not yet become completely conscious of itself.
Physics understands its role when it pushes matter into the
 direction of spatiality; but has metaphysics understood its role
when it has simply trodden the steps of physics, in the
chimerical hope of going farther in the same direction? Should
not its own task be, on the contrary, to remount the incline that
physics descends, to bring matters back to its origins, and to
build up progressively a cosmology which would be, so to
speak, a reversed psychology. All that which seems positive to
the physicist and to the geometrician would become, from this
new point of view, an interruption or inversion of the true
positivity which would have to be defined in psychological
terms” (pp. 219–20, italics mine).
394
As an indication of what the acceptance of the dynamic instead
of the static view of matter on the part of Bergson means, I cite
the phrase (or the conception) on p. 82 of Matter and Memory,
the effect that “matter is here as elsewhere the vehicle of an
action,” or the even more emphatic declaration on p. 261 of
Creative Evolution, “There are no things, there are only
actions.” It is impossible, of course, that these mere extracts
can convey to the mind of the casual reader the same
significance that they obtain in their setting in the pages of
Bergson, although it is surely almost a matter of common
knowledge about his teaching, that one of the first things it
does is to begin with the same activistic or “actionistic” view of
nature and matter that seems to be the stock in trade of the
physics of our time since the discoveries pertaining to radio-
activity, etc. Being only a layman in such matters, I may be
excused for quoting from a recent booklet (whose very
presence in the series in which it appears is to people like
myself a guarantee of its scientific reliability) in which I find this
same activistic view of matter that I find in Bergson. “What are
the processes by which the primary rock material is shifted?
There is the wind that, etc. etc.... There are the streams and
rivers that, etc.... There is the sea constantly wearing away,
etc.... Then there are ‘subtle’ physical and ‘chemical’ forces.
And the action of plants.... Hence by various mechanical,
organic, and chemical processes the materials originally
 scattered through the rocks of the earth’s crust, and floating in
the air or water, are collected into layers and form beds of
sand, clay, limestone, salt, and the various mineral fuels,
including peat and coal” (The Making of the Earth, by
Professor Gregory, F.R.S., of Glasgow University: Williams and
Norgate).
It is only right to state here, or to remind the reader in this
matter of a “dynamic” view of matter, that Bergson not only
dissipates matter into force or energy or activity (as do the
physicists of to-day), but also actually credits the world of
matter and life with a kind of consciousness (and why not be
courageous about it?) in which what I have already called the
“susceptibility of everything to everything else,” or the action of
everything upon everything else, becomes credible and
intelligible. “No doubt, also, the material universe itself, defined
as the totality of images, is a kind of consciousness in which
everything compensates and neutralises everything else, a
consciousness of which all the potential parts, balancing each
other by a reaction which is always equal to the action,
reciprocally hinder each from standing out” (Matter and
Memory, p. 313).
395
See Chapter III., and also the references to Mach, Ostwald,
Poincaré, and others, in the second chapter and elsewhere.
396
“There is no intelligence in which some traces of instinct are
not to be discovered, more, no instinct that is not surrounded
with a fringe of intelligence” (Creative Evolution, p. 143).
397
“We will not dwell here upon a point we have dealt with in
former works. Let us merely recall that a theory [the theory of
contemporary physiological psychology] such as that
according to which consciousness is attached to certain
neurons, and is thrown off from their work like a
phosphorescence, may be accepted by the scientist for the
detail of analysis; it is a convenient mode of expression. But it
is nothing else. In reality, a living being is a centre of action. It
 represents a certain sum of contingency entering into the
world, that is to say, a certain quantity of possible action—a
quantity variable with individuals and especially with species.
The nervous system of an animal marks out the flexible lines
on which its action will run (although the potential energy is
accumulated in the muscles rather than in the nervous system
itself); its nervous centres indicate, by their development and
their configuration, the more or less extended choice it will
have among more or less numerous and complicated actions.
Now, since the awakening of consciousness in a living creature
is the more complete, the greater the latitude of choice allowed
to it and the larger the amount of action bestowed upon it, it is
clear that the development of consciousness will appear to be
dependent on that of the nervous centres. On the other hand,
every state of consciousness being, in one aspect of it, a
question put to the motor activity and even the beginning of a
reply, there is no psychical event that does not imply the entry
into play of the cortical mechanisms. Everything seems,
therefore, to happen as if consciousness sprang from the
brain, and as if the detail of conscious activity were modelled
on that of the cerebral activity. In reality consciousness does
not spring from the brain, but brain and consciousness
correspond because equally they measure ... the quantity of
choice that the living being has at its disposal” (Creative
Evolution, pp. 266–7).
398
“Instead of starting from affection [or ‘sensation’ in the old
sense of the haphazard sensation] of which we can say
nothing, since there is no reason why it should be what it is
rather than anything else, we start from action, that is to say,
from our power of effecting changes in things, a faculty
attested by consciousness, and towards which all the powers
of the organised body are seen to converge. So we place
ourselves at once in the midst of extended images [to Bergson
as an idealist things are at the same time images or ideas for a
consciousness in other things, or in us, or in beings other than
ourselves], and in this material universe we perceive centres of
 indetermination characteristic of life” (Matter and Memory, p.
67).
399
Cf. the words in the Preface to Matter and Memory: “The whole
personality, which, normally narrowed down by action,
expands with the unscrewing of the vice in which it has allowed
itself to be squeezed,” or the words in the same place about
the task of metaphysics being the attempt of the “mind striving
to transcend the conditions of useful action.”
400
We refer elsewhere in this chapter to Bergson’s idea that living
beings are “centres of indetermination,” that is to say,
creatures who hold their place in nature and that of their
species by “persisting in their own being” (the language of
Spinoza) by acting and reacting upon some of the many forces
of nature that act upon them, and by avoiding the action of
other forces and other animals. “They allow to pass through
them,” he says, “so to speak, those external influences which
are indifferent to them; the others isolated become
‘perceptions’ by their very isolation” (Matter and Memory, pp.
28, 29). We also refer to Bergson’s idea that the life-force has
expressed itself along different grades of being (mineral,
animal, and so on). Both these ideas are a partial explanation
of what we mean by the presence of a spiritual activity in both
inanimate and animate nature. So also is Bergson’s idea that
the purely mechanical explanation either of nature or of life is
but a device of the intellect for the purposes of description.
More specifically it is expressed, too, in his idea that “Our
representation of matter is the measure of our possible action
upon bodies; it results from the discarding of what has no
interest for our needs, or more generally for our functions”
(Matter and Memory, p. 30), or that “Consciousness” is just this
choice of “attaining to” or attending to “certain parts and certain
aspects of those parts” of the “material universe” (ibid. p. 31),
or that “sense-perception” is an “elementary question to my
motor activity.” “The truth is that my nervous system,
interposed between the objects which affect my body and
those which I can influence, is a mere conductor, transmitting,
 sending back, or inhibiting movement. This conductor is
composed of an enormous number of threads which stretch
from the periphery to the centre, and from the centre to the
periphery. As many threads pass from the periphery to the
centre, so many points of space are there able to make an
appeal to my will, and to put, so to speak, an elementary
question to my motor activity. Every such question is what is
termed a perception” (ibid. 40, 41; italics mine). Or, as he puts
it, on p. 313, “No doubt the choice of perception from among
images in general is the effect of a discernment which
foreshadows spirit.... But to touch the reality of spirit we must
place ourselves at the point where an individual
consciousness, continuing and retaining the past in a present
enriched by it, thus escapes the law of necessity, the law
which ordains that the past shall ever follow itself in a present
which merely repeats it in another form, and that all things
shall ever be flowing away. When we pass from pure
perception to memory, we definitely abandon matter for spirit.”
401
Bergson is always able to detect the relapses even of
“mechanism” and of the mechanical philosophy of science into
“finalism,” as when he says on p. 72 of his Creative Evolution,
“To sum up, if the accidental variations that bring about
evolution are insensible variations, some good genius must be
appealed to—the genius of the future species—in order to
preserve and accumulate these variations, for “selection” will
not look after this. If, on the other hand, the accidental
variations are sudden, then, for the previous function to go on,
or for a new function to take its place, all the changes that
have happened together must be complementary. So we have
to fall back on the good genius again to obtain the
convergence of simultaneous changes, as before to be
assured of the continuity of direction of successive variations.”
402
We must remember that to Bergson evolution has taken place
along different lines—those of Automatism (in plant-life),
Instinct (in animal life), and Intelligence (in human life and the
higher animals), and that along none of those lines are we to
 fall into the errors either of materialism, or of “Darwinism” (the
belief in “accidental variations”), or of the “design-philosophy,”
or even of theories like “neo-Lamarckianism” or neo-vitalism.
To him all these philosophies are but imperfect and
hypothetical attempts to grasp “movement” and “life” which
both “transcend finality, if we understand by finality the
realisation of an idea conceived or conceivable in advance”
(Creative Evolution, p. 236).
403
“Paleyism” or “Miltonism” are still good names for the thing, I
have read in some competent book upon Evolution.
404
See below, p. 261.
405
To Bergson concepts are just as hypothetical in the realm of
science, as they are to thinkers like Mach and Poincaré, and
Professor Ward of Cambridge. See the following, for example,
from Matter and Memory (p. 263): “We shall never explain by
means of particles, whatever these may be, the simple
properties of matter; at most we can thus follow out into
corpuscles as artificial as the corpus, the body itself—the
actions and reactions of this body with regard to all the others.
This is precisely the object of chemistry. It studies bodies
rather than matter; and so we understand why it stops at the
atom, which is still endowed with the general properties of
matter. But the materiality of the atom dissolves more and
more under the eyes of the physicist. We have no reason, for
instance, for representing the atom to ourselves as a solid,
rather than as a liquid or gaseous, nor for picturing the
reciprocal action of atoms by shocks rather than in any other
way.” Or, the following characteristic passage from the same
book (p. 280) in respect of the hypothetical character of the
concepts of “pure time” and “pure space”: “Homogeneous
space and homogeneous time are then neither properties of
things nor essential conditions of our faculty of knowing them;
they express, in an abstract form, the double work of
solidification and of division, which we effect on the moving
continuity of the real in order to obtain there a fulcrum for our
 action, in order to fix within it starting-points for our operation,
in short, to introduce into it real changes. They are the
diagrammatic designs of our eventual action upon matter.”
406
Like his celebrated contemporary Eucken, and like many other
thinkers of their time, Bergson is profoundly convinced of the
one-sidedness of the so-called scientific culture of our day, and
of the error of any and all conceptions of education and of
social policy that are based upon it. Although I refer below to
the limitations of his view that the intellect is adapted only to
matter and to mechanical construction, I append the following
quotation as symptomatic of his value as a spiritual teacher in
our scientific age: “As regards human intelligence (Creative
Evolution, pp. 145–6) it has not been sufficiently noted that
mechanical invention has been from the first its essential
feature, that even to-day our social life gravitates around the
manufacture and use of artificial instruments.... This we hardly
realise, because it takes longer to change ourselves than to
change our tools.... In thousands of years, when seen from the
distance, only the broad lines of our present age will be visible,
our wars and our revolutions will count for little, even
supposing they are remembered at all, but the steam-engine,
and the procession of inventions of every kind that
accompanied it, will perhaps be spoken of as we speak of the
bronze or of the chipped stone of prehistoric times; it will serve
to define an age.”
407
I find this in Bergson’s whole attribution of much of our
“perceptual” and “scientific” knowledge of things to the “needs
of action,” and in the detailed reasons that we attempt on
pp. 236–238 to indicate for his polemic against rationalism.
408
This confirmation I find in Bergson’s whole philosophy of
perception and sensation referred to on p. 236, and in his idea
of a living being as a “centre of action” or “a centre of
indetermination.” In fact it is obvious that he is one of the very
greatest of the upholders of the “freedom” of the life of the
individual, and of the fact that each new individual contributes
 something new of its own to the sum-total of existence, to the
life of its species, and to the life of the world. Of course there is
no more an explanation in his teaching of the causes of
“variation” or the differences at birth between the off-spring of
men and of animals, than there is in the philosophy of Darwin.
409
The idea of this necessity is confirmed in Bergson’s whole
philosophy of man’s life as a life of action, as a constant
surmounting of obstacles, as a life that reacts in its own way
upon the life of nature, upon the life of the human species as
such, upon the infinite life and energy and “love” of God—if we
may soar to this great thought. See, for example, what he
writes in explanation of the “discordance” of which he speaks
thus: “Our freedom, in the very movements by which it is
affirmed, creates the growing habits that will stifle it if it fails to
renew itself by a constant effort: it is dogged by automatism.
The letter kills the spirit. And our most ardent enthusiasm, as
soon as it is externalised into action, is so naturally congealed
into the cold calculation of interest or vanity, the one takes so
easily the shape of the other, that we might confuse them
together, doubt our sincerity, deny goodness and love.” The
explanatory words are the following. [They are quite typical of
the kind of philosophy of life that Bergson thinks of as alone
worthy of the name of a philosophy of the living. And the
reference to “love,” as the highest “dynamic” force in this world
of ours, occurs at their close.] “The profound cause of this
discordance lies in an irremediable difference of rhythm. Life is
general, is mobility itself; particular manifestations of life accept
this mobility reluctantly, and constantly lag behind. It is always
going ahead; they want to mark time. Evolution in general
would fain go on in a straight line; each special evolution is a
kind of circle. Like eddies of dust raised by the wind as it
passes, the living turn on themselves, borne up by the great
blast of life. They are therefore relatively stable, and counterfeit
immobility so well that we treat each of them as a thing rather
than as a progress, forgetting that the very permanence of
their form is only the outline of a movement. At times, however,
 in a fleeting vision, the invisible breath that bears them is
materialised before our eyes. We have this sudden illumination
before certain forms of maternal love, so striking and in most
animals so touching, observable even in the solicitude of the
plant for its seed. This love, in which some have seen the great
mystery of life, may possibly deliver us life’s secret. It shows us
each generation leaning over the generation that shall follow. It
allows us a glimpse of the fact that the living being is above all
a thoroughfare, and that the essence of life is in the movement
by which life is transmitted” (Creative Evolution, pp. 134–5;
italics mine). It is surely needless to point out how much truer
to human nature, truer therefore to an important part of reality,
this life-philosophy is than the abstractionism of Professor
Bosanquet in the preceding chapter.
410
This insistence is, I think, amply confirmed by the very fact of
the immediate contact with life and reality indicated in the
quotation that is given in the preceding note upon the “motive-
awakening,” or the “dynamic” character of the philosophy of
Bergson. It is also confirmed in his manifest insistence upon
the one fact that all philosophy must assume (and has for ever
assumed) the fact of life, the fact of the life and thought of God
that underlies all our life and all our thought.
411
This position of the pragmatists is certainly confirmed by
Bergson’s entire doctrine of the brain and of the intellect—that
their main service is, in the first instance, to interpret the “life”
of things, its relation to our own will and to our practical activity.
I have suggested, too, in this chapter that it is obviously a
characteristic, or a consequence, of the philosophy of Bergson
that our highest thought about ourselves and about the world
should be relative to, and provocative, of our highest emotion.
412
It is only with some degree of care and reservation that I wish
to refer to any apparent confirmation of this idea by Bergson.
And, as always, I object to the idea of any ultimate separation
or “dualism” between faith and knowledge—faith being implied
in all “knowledge.” There is no opposition in Bergson, or in the
 principles of his philosophy, between faith and knowledge; it is
rather his idea that “the faculty of seeing should be made one
with the act of willing” (Creative Evolution, 250; his italics), and
that “philosophy” should “proceed, with the powers of
conceptual thought alone, to the ideal reconstruction of all
things, even of life” (C.E. xi.; italics mine). My reasons for
finding in his writings a confirmation of the idea that it is indeed
our rational and spiritual faith, rather than our demonstrable
knowledge, that is to us the measure of truth and reality, are
such considerations as the following (in addition to those of the
clauses just quoted), his close association between the
intellectual and the “volitional,” his general faith in “creative
evolution,” in the idea that our “consciousness” means for us
“new choices” and (real) “new possibilities,” his faith in the
higher intuitions of the mind, in the spiritual nature of man, his
belief that the building up of the true philosophy of the future
will involve “the collective and progressive effort of many
thinkers, of many observers also, completing, correcting, and
improving one another” (C.E. xiv.), etc. etc.
413
See below, p. 257, note 1.
414
See p. 14 in reference to Dr. Schiller’s suggestion that
“freedom” may “pervade the universe.”
415
“From time to time, however, in a fit of absent-mindedness,
nature raises up souls that are more detached from life....
Were this detachment complete, did the soul no longer cleave
to action by any of its perceptions, it would be the soul of an
artist such as the world has never yet seen” (Laughter, p. 154).
416
Cf. p. 235.
417
Cf. “We must break with scientific habits which are adapted to
the fundamental requirements of thought, we must do violence
to the mind, go counter to the natural bent of the intellect. But
that is just the function of philosophy” (Creative Evolution, p.
31).