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Contents Preface

.....................................................................................................................................

Part 1:

Foundations

Chapter 1

Introducing Money and the Financial System.............................................................

Chapter 2

Money and the Payments System................................................................................

Chapter 3

Interest Rates and Rates of Return ..............................................................................

Chapter 4

Determining Interest Rates ..........................................................................................

Part 2:

Financial Markets

Chapter 5

The Risk Structure and Term Structure of Interest Rates ...........................................

Chapter 6

The Stock Market, Information, and Financial Market Efficiency .............................

Chapter 7

Derivatives and Derivatives Markets ..........................................................................

Chapter 8

The Market for Foreign Exchange ..............................................................................

101

Part 3:

Financial Institutions

Chapter 9

Transactions Costs, Asymmetric Information, and the Structure of the Financial System ...................................................................

117

Chapter 10

The Economics of Banking .........................................................................................

127

Chapter 11

Beyond Commercial Banks: Shadow Banks and Nonbank Financial Institutions......

144

Chapter 12

Financial Crises and Financial Regulation ..................................................................

158

Part 4:

Monetary Policy

Chapter 13

The Federal Reserve and Central Banking ..................................................................

178

Chapter 14

The Federal Reserve’s Balance Sheet and the Money Supply Process .......................

191

Chapter 15

Monetary Policy ..........................................................................................................

207

Chapter 16

The International Financial System and Monetary Policy ..........................................

230

Part 5:

The Financial system and the Macroeconomy

Chapter 17

Monetary Theory I: The Aggregate Demand and Aggregate Supply Model ..............

247

Chapter 18

Monetary Theory II: The IS–MP Model .....................................................................

266

Preface Revisions to the Main Textbook If you used Hubbard/O’Brien MONEY, BANKING, AND THE FINANCIAL SYSTEM, Third Edition, here is a summary of the changes the authors made to the main text. Knowing about these changes will help you revise your teaching notes and class presentations. We’ve added coverage of new topics and revised and updated our coverage of other topics. Examples include: • • • • • • • • • •

The effects of the Covid-19 pandemic on the financial system The Fed’s policy response to the pandemic The continuing debate over the Fed’s independence and its structure The issues raised by the Fed’s collaboration with the Treasury during the pandemic and the Fed’s expansion into lending to nonfinancial businesses The continuing evolution of the Fed’s policy tools The expanding role of the Fed in providing liquidity to foreign central banks The effects on the financial system of historically low interest rates The policy and regulatory implications of new developments in the shadow banking system The evolution of the U.S. dollar’s role in the international financial system New developments in the U.S. payment system and in digital banking

We’ve also made the following changes: • • • • • • •

Replaced many chapter-opening cases and updated the cases we retained. Added new Apply the Concept features (formerly titled Making the Connection), including several that are relevant to students’ personal lives and decisions (titled Apply the Concept: In Your Interest), and updated the retained Apply the Concepts. Added new Solved Problem features and updated retained Solved Problems. Some Solved Problems involve subjects that are relevant to students’ personal lives and financial decisions. Added new figures and updated the remaining figures and tables with the latest available data. Replaced or updated many of the end-of-chapter Review Questions and Problems and Applications, which students can complete on MyLab Economics. Revised the 55 end-of-chapter real-time data exercises. Students can complete these exercises on MyLab Economics, where they can also view the very latest data from FRED, the online macroeconomic data bank of the Federal Reserve Bank of St. Louis. Cut Apply the Concepts that had become less relevant.

These changes were made in all chapters 1. 2. 3. 4. 5. 6.

Updated graphs and tables with the latest data available. Replaced or updated all Chapter-Opening business vignettes. Changed the feature title of Making the Connection to Apply the Concept Added several new Apply the Concepts and updated those retained from previous edition. Replaced or updated several Solved Problems. Added several new end-of-chapter problems, updated others, and cut out-of-date problems.

Assessment located in eText and MyLab Economics MyLab Economics is a powerful assessment and tutorial system that works hand-in-hand with Money, Banking, and the Financial System. MyLab Economics includes comprehensive homework, quiz, test, and tutorial options, allowing instructors to manage all assessment needs in one program. Key innovations in the MyLab include the following: • •

• •

Students can complete exercises in each chapter’s Problems and Applications section and many other exercises online; get tutorial help; and receive instant feedback and assistance on exercises they answer incorrectly. Fifty-five Real-time Data Analysis Exercises allow students and instructors to use the very latest data from FRED, the online macroeconomic data bank from the Federal Reserve Bank of St. Louis. By completing the exercises, students become familiar with a key data source, learn how to locate data, and develop skills to interpret data. In the Multimedia Library available in MyLab Economics, select figures labeled MyLab Economics Real-time data allow students to display a popup graph updated with real-time data from FRED. Current News Exercises provide a turnkey way to assign gradable news-based exercises in MyLab Economics. Every week, Pearson locates a current news article, creates an exercise around the article, and adds it to MyLab Economics.

Chapter-by-chapter changes Chapter 1: Introducing Money and the Financial System Chapter 1 opens with a new discussion of how the Covid-19 pandemic affected financial markets. That topic continues in Section 1.2, “The Crises of 2007–2009 and 2020” and also in a new section titled “The Financial Crisis Caused by the Covid-19 Pandemic.” The two retained Apply the Concept features, “The Rise of Peer-to-Peer Lending and Fintech” and “What Do People Do with Their Savings?” contain recent examples and data. Chapter 2: Money and the Payments System Chapter 2 opens with a discussion of the Federal Reserve, the 2020 presidential campaign, and Covid-19. The chapter includes a new Apply the Concept, “Why Is the U.S. Payments System So Slow?” Section 2.3 has new coverage of real-time payments systems. The section “Should Central Banks be Independent?” has been extensively updated based on recent events. Chapter 3: Interest Rates and Rates of Return Chapter 3 opens with a discussion of evaluating the risk of investing in Treasury bonds during the 2020 pandemic. The Apply the Concepts “Interest Rates and Student Loans” and “How to Follow the Bond Market: Reading the Bond Tables” have been extensively updated and revised. In Section 3.5, the section “How Much Interest-Rate Risk Do Investors in Treasury Bonds Face?” has been updated with a discussion of the state of the financial system during the 2020 Covid-19 pandemic. Chapter 4: Determining Interest Rates Chapter 4 begins with an updated discussion of the persistence of historically low interest rates. A new Solved Problem feature, “Investing in Bonds When a Change in Policy Leads to Higher Inflation,” covers the 2020 presidential race and “modern monetary theory (MMT)”. The chapter’s Apply the Concepts have all been updated with recent data and take into account recent events.

Chapter 5: The Risk Structure and Term Structure of Interest Rates Chapter 5 opens with a discussion of whether the term structure of interest rates can help predict recessions. A new Solved Problem feature, “Political Uncertainty and Bond Yields,” discusses the U.S.– China trade war and the Covid-19 pandemic. The new section “Using the Term Structure to Evaluate Market Expectations” discusses how investors, managers at firms, and policymakers can use information from the term structure of interest rates to forecast economic variables. This section includes a new Apply the Concept, “What Happened to the Recession of 2019?” Chapter 6: The Stock Market, Information, and Financial Market Efficiency Chapter 6 opens with a discussion of investing in the stock market featuring Tesla. Section 6.1 includes new coverage of the ways that artificial intelligence and robo-advisors are disrupting the financial services industry. Section 6.4 includes a new Apply the Concept, “Do the Stock Market Fluctuations During the Covid-19 Pandemic Disprove the Efficient Markets Hypothesis?” The Apply the Concepts and Solved Problems in the chapter have been updated with the latest data and include recent economic events. Chapter 7: Derivatives and Derivatives Markets Chapter 7 opens with a discussion of day trading oil futures and the incident from Spring 2020 when the price of oil was briefly negative. Sections 7.3, 7.4, and 7.5 have been extensively updated to include recent data and important developments in the markets for derivatives. Chapter 8: The Market for Foreign Exchange Chapter 8 opens with a new discussion of the effect of the Covid-19 pandemic on the exchange rate of the U.S. dollar and on U.S.-based multinational firms like Coca-Cola. The Apply the Concepts “Brexit, Covid19, Exchange Rates, and the Profitability of British Firms,” and “What Explains Movements in the Dollar Exchange Rate?” have been updated to take into account recent events, including the Covid19 pandemic. Solved Problem 8.2 on the Big Mac index has been updated with new data. Chapter 9: Transactions Costs, Asymmetric Information, and the Structure of the Financial System Chapter 9 opens with an updated discussion of fintech and crowdsourcing. New Solved Problem 9.2 examines why banks ration credit. There are two new Apply the Concepts: “Moral Hazard, Adverse Selection, and Covid-19 in the Mortgage Market” and “When Stocks Are Risky, Should You Buy Bonds Instead?” Section 9.2 includes expanded coverage of the problems facing small investors and new coverage of the effects of the Covid-19 pandemic on the financial system. Chapter 10: The Economics of Banking Chapter 10 opens with a new discussion of the importance to small businesses of banks, particularly community banks, during the Covid-19 pandemic. Section 10.4 includes new coverage of the effects of the Covid-19 pandemic on trends in the commercial banking industry as well as a new Apply the Concept, “Would You Want a Bank Account at the Fed or the Post Office?” Chapter 11: Beyond Commercial Banks: Shadow Banks and Nonbank Financial Institutions Chapter 11 opens with updated discussions of shadow banks other than investment banks. Section 11.1 includes an updated discussion of investment banking and the role of repo financing. The section also has two updated Apply the Concepts: “Should Congress Bring Back Glass–Steagall?” and “So, You Want to Be an Investment Banker?” The remaining sections include updated discussions of other shadow banks and of how shadow banks fared during the Covid-19 pandemic.

Chapter 12: Financial Crises and Financial Regulation Chapter 12 includes a new discussion on the role of shadow banks during the 2007–2009 and 2020 financial crises. The chapter includes the new sections “The Covid-19 Pandemic and the Financial Crisis of 2020” (in Section 12.3) and “The 2020 Financial Crisis: Is the Debate over the Too-Big-to-Fail Policy Still Relevant?” (in Section 12.4). The Making the Connection on the Dodd-Frank Act is cut. Chapter 13: The Federal Reserve and Central Banking Chapter 13 opens with a revised and updated discussion about the debate over the structure of the Federal Reserve System. A new Apply the Concept, “Should Congress Change the Structure of the Fed?” reviews this debate in light of the political reaction to recent Fed policy. The chapter also covers the issues raised by the Fed’s close collaboration with the Treasury in formulating the policy response to the Covid-19 pandemic. Chapter 14: The Federal Reserve’s Balance Sheet and the Money Supply Process Chapter 14 opens with an updated discussion of gold as a hedge against economic chaos in light of investors driving up the price of gold to record highs during the Covid-19 pandemic. The discussion of the money supply process has been extensively revised to take into account the Fed’s decision to eliminate reserve requirements and the new normal of banks holding very large reserve deposits. The figures and features have been revised to reflect the effects of the Covid-19 pandemic on the Fed’s balance sheet and on the movements in monetary aggregates. Chapter 15: Monetary Policy Chapter 15 begins with a new chapter opener that discusses how the Fed’s approach to monetary policy has changed in an era of very large bank reserves and chronically low rates of inflation. A new Apply the Concept discusses whether the Fed has done enough to reduce Black unemployment. The chapter has been thoroughly revised and updated to reflect the new reality that during recessions, the Fed typically faces a zero lower bound to the federal funds rate. The discussion of the Fed’s monetary policy tools shifts the emphasis away from open market operations to quantitative easing and forward guidance. Similarly, we have given increased emphasis to the Fed’s use of the interest rate on reserves and the rate on its reverse repo operations to manage the federal funds rate. The Apply the Concept “Are Negative Interest Rates an Effective Monetary Policy Tool?” has been updated to reflect the Fed’s stance during the 2020 recession. We have also updated our discussion of international comparisons of monetary policy to reflect the policies pursued by foreign central banks during the 2020 recession. The Making the Connection on asset bubbles is cut. Chapter 16: The International Financial System and Monetary Policy Chapter 16 opens with an updated and revised discussion about countries using a single currency. Solved Problem 16.2 now examines the Swiss National Bank’s response to the rising value of the Swiss franc. The chapter has been updated to include recent developments in the international financial system, including the strain resulting from the Covid-19 pandemic. Chapter 17: Monetary Theory I: The Aggregate Demand and Aggregate Supply Model Chapter 17 opens with a new discussion about recent college graduates struggling in the labor market. A new section applies the aggregate demand and aggregate supply model to the recession of 2020. A new Apply the Concept discusses whether the Covid-19 pandemic will result in an end to the fracking revolution in U.S. oil production. A revised section assesses the effectiveness of monetary policy during the years since the 2007–2009 recession, including the effects of labor market scarring and the argument that Fed policy was insufficiently expansionary.

Chapter 18: Monetary Theory II: The IS–MP Model Chapter 18 has a new chapter opener on the importance of economic forecasts to the Fed. A revised Apply the Concept assesses the recent performance of Okun’s law and the stability of the relationship between the output gap and the cyclical unemployment rate. The chapter also includes a new discussion of the problems the Fed faced in dealing with the economic consequences of the Covid-19 pandemic. A revised Apply the Concept discusses the steps taken during 2020 to begin the process of privatizing Fannie Mae and Freddie Mac. A new Apply the Concept, “Modern Monetary Theory: A Controversial New Approach,” discusses the debate among economists and policymakers over “modern monetary theory (MMT).”

Features of this Instructor’s Manual Each chapter of this Instructor’s Manual contains the following elements: Chapter Summary and Learning Objectives: An overview of the main concepts covered, organized by learning objectives. Key Terms and Concepts: Key terms and definitions. Chapter Outline, organized by learning objectives: Detailed descriptions of the concepts in the book and teaching tips. Solutions to Review Questions and Problems and Applications, organized by learning objectives: Each chapter of this Instructor’s Manual includes solutions to the following end-of-chapter materials: • • •

Review Questions Problems and Applications Data Exercises

Supplements Supplements Available to Instructors Download at www.pearsonhighered.com Instructor’s Resource Manual

Test Bank

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PowerPoint Lecture Presentation

Features of the Supplement • Chapter-by-chapter summaries • Learning objectives • Extended examples and class exercises • Teaching outlines incorporating key terms and definitions • Teaching tips, topics for class discussion, and additional applications. • Solutions to the end-of-chapters problems • More than 1,500 multiple-choice and short-answer questions. • Test questions are annotated with the following information: o Difficulty: 1 for straight recall, 2 for some analysis, and 3 for complex analysis o Type: Multiple-choice, short-answer, and essay o Topic: The term or concept that the question supports o Learning objective o Page number o Special features in the main book: Chapter-opening story, Key Issue and o Question, Solved Problems, and Apply the Concepts. o Advanced Collegiate Schools of Business (AACSB) Assurance of Learning o Standards: Communication; Ethical Reasoning Analytic Skills; Use of Information Technology; Multicultural and Diversity; Reflective Thinking • Allows instructors to easily create and administer tests on paper, electronically, or online. • Instructors can select test items from the publisher-supplied test bank, which is organized by chapter and based on the associated textbook material, or create their own questions from scratch. With both quick-and-simple test creation and flexible and robust editing tools, TestGen is a complete test generator system for today’s educators. • The slides include all the graphs, tables, and equations from the textbook. • Student versions of the PowerPoint slides are available as PDF files. These files allow students to print the slides and bring them to class for note taking.

Chapter 1 Introducing Money and the Financial System 

Brief Chapter Summary and Learning Objectives

1.1

Key Components of the Financial System (pages 2–15) Identify the key components of the financial system. • Financial assets, financial institutions, the Federal Reserve, and financial regulators are the key components of the financial system. • There are many different types of financial assets with distinctive characteristics. • Financial institutions are distinguished by how they transfer funds from savers or lenders to borrowers. • There are various regulators that provide oversight to different sectors of the financial system.

1.2

The Crises of 2007–2009 and 2020 (pages 15–19) Provide an overview of the financial crises of 2007–2009 and 2020. • The financial crisis of 2007-2009 provides an opportunity to explore the role and significance of the financial system in the economy. • The crisis of 2020 again shows the uses of Fed tools in supporting the economy.

1.3

Key Issues and Questions About Money, Banking, and the Financial System (pages 19–21) Explain the key issues and questions concerning the financial system. • Beginning with Chapter 2, the start of each chapter highlights one key issue and a related question. Answers to the questions appear at the end of the chapters, using analysis from the chapters.



Key Terms

Asset, p. 2. Anything of value owned by a person or a firm. Bond, p. 3. A financial security issued by a corporation or a government that represents a promise to repay a fixed amount of money. Bubble, p. 16. An unsustainable increase in the price of a class of assets. Commercial bank, p. 6. A financial firm that serves as a financial intermediary by taking in deposits and using them to make loans. Diversification, p. 13. Splitting wealth among many different assets to reduce risk.

Interest rate, p. 3. The cost of borrowing funds (or the payment for lending funds), usually expressed as a percentage of the amount borrowed. Liquidity, p. 13. The ease with which an asset can be exchanged for money. Monetary policy, p. 11. The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives. Money, p. 3. Anything that is generally accepted in payment for goods and services or to pay off debts.

Hubbard & O’Brien • Money, Banking, and the Financial System, Fourth Edition

Dividend, p. 3. A payment that a corporation makes to its shareholders.

Money supply, p. 3. The total quantity of money in the economy.

Federal funds rate, p. 12. The interest rate that banks charge each other on short-term loans. Federal Reserve, p. 11. The central bank of the United States; usually referred to as “the Fed.”

Portfolio, p. 8. A collection of assets, such as

Financial asset, p. 2. An asset that represents a claim on someone else for a payment. Financial crisis, p. 16. A significant disruption in the flow of funds from lender to borrowers. Financial intermediary, p. 4. A financial firm, such as a bank, that borrows funds from savers and lends them to borrowers. Financial liability, p. 4. A financial claim owed by a person or a firm. Financial market, p. 2. A place or channel for buying or selling stocks, bonds, and other securities. Foreign exchange, p. 4. Units of foreign currency.

stocks and bonds. Primary market, p. 9. A financial market in which stocks, bonds, and other securities are sold for the first time. Risk sharing, p. 13. A service the financial system provides that allows savers to spread and transfer risk. Secondary market, p. 9. A financial market in which investors buy and sell existing securities. Securitization, p. 4. The process of converting loans and other financial assets that are not tradable into securities. Security, p. 2. A financial asset that can be bought and sold in a financial market. Stock, p. 3. A financial security that represents partial ownership of a firm; also called an equity.

Information, p. 14. Facts about borrowers and expectations of returns on financial assets.



Chapter Outline

The Coronavirus, Financial Markets, and the Flow of Funds March 16, 2020 was “one of the worst days the financial markets have seen,” according to an article in the Wall Street Journal, due to the effects of the Covid-19 pandemic. As it became clear that the pandemic would cause a significant recession, many investors stopped buying financial assets. Corporations, cities, and school districts all found it difficult to use financial markets to borrow money and so had difficulty paying their bills, including the salaries and wages of their employees. The Federal Reserve took steps to stabilize the financial system and restore the flow of credit to borrowers. A well-functioning financial system is a crucial determinant of economic prosperity. Without an efficient financial system, there will be little borrowing or lending, and so people will be stuck earning low incomes and the country will make very little economic progress. To see the importance of borrowing and lending to an economy, suppose that you come up with an idea for a company: You design a smartphone application (“app”) that will deliver a textbook chapter to a student’s phone for a limited time for a low price. You have a lot of work to do to get your company off the ground— perfecting the software, designing the page in the app store where you will sell it, negotiating with textbook publishers to gain access to their books, and marketing your idea to students. You will have to spend a lot of money before you receive any revenue from sales. Where will you get this money?

Chapter 1

Introducing Money and the Financial System

We can demonstrate the importance of borrowing and lending to an economy by considering the process a company uses to develop a new product. The company will have to spend a lot of money before it receives any revenue from sales of the new product. Nearly every entrepreneur faces the same challenge. The role of the financial system is to channel funds from savers to businesses. During the economic crisis that began in 2007, the financial system was disrupted and large sections of the U.S. economy were cut off from the flow of funds they needed to thrive. The result was the worst recession the world had experienced since the Great Depression. Officials of the U.S. Treasury Department and the Federal Reserve took strong actions to restore financial markets. Although some of these actions were controversial, most economists believe that some government intervention was necessary to pull the economy out of a deep recession.

Teaching Tips This chapter contains two innovations worth noting: (1) An overview of the Federal Reserve System and (2) an overview of the financial crises of 2007-2009 and 2020. Federal Reserve policy plays an important role in most money and banking courses. Because of the variety of new policies the Fed implemented during the financial crisis, many instructors have begun discussing the Fed earlier in their courses. In their own teaching, the authors found that they couldn’t always rely on students recalling the basics of how the Fed operates from their principles courses. So the authors included an overview in this first chapter. Many students have become more interested in the financial system due to the financial crises of 2007–2009 and 2020. The Covid-19 pandemic will be fresh in the minds of undergraduates and many of their families still bear financial scars from the deep recession of 2007–2009. Some students have formed their opinions of what happened during these episodes based on incomplete or erroneous information. Discussion of the two financial crises at the beginning of the semester can help to motivate the study of money, banking, and financial markets while also highlighting why students need to grasp the fundamental concepts underlying the financial system, including how financial assets are traded in financial markets, how financial institutions operate, and the role of regulatory agencies (including the Fed). Instructors who prefer to leave discussion of the Federal Reserve and the financial crises for later in the course should feel free to do so by omitting these sections of the chapter. None of the discussion in later chapters directly requires knowledge of these topics. 1.1

Key Components of the Financial System (pages 2–15) Learning Objective: Identify the key components of the financial system. There are three major components of the financial system: Financial assets, financial institutions, and the Federal Reserve and other financial regulators. A. Financial Assets Financial assets can be divided among five categories: money, stocks, bonds, foreign exchange, and securitized loans. Money is anything that people are willing to accept in payment for goods and services or to pay off debts. Stocks, also called equities, are financial securities that represent partial ownership of a firm. When you buy a bond issued by a corporation or a government, you are lending the corporation or the government a fixed amount of money. Foreign exchange refers to units of foreign currency. Loans that banks could sell on financial markets become securities, so the process of converting loans into securities is known as securitization. B. Financial Institutions The financial system is made up of two types of financial institutions: (1) banks and other financial intermediaries and (2) financial markets. Funds flow from lenders to borrowers

Hubbard & O’Brien • Money, Banking, and the Financial System, Fourth Edition

indirectly through financial intermediaries, such as banks, or directly through financial markets. Commercial banks are the most important financial intermediaries. Some financial intermediaries, such as savings-and-loans, savings banks, and credit unions, are legally distinct from banks, although these “nonbanks” operate in a very similar way by taking in deposits and making loans. Other financial intermediaries include investment banks, insurance companies, pension funds, mutual funds and exchange-traded funds (ETFs), and hedge funds. Financial markets are places or channels for buying and selling stocks, bonds, and other securities. C. The Federal Reserve and Other Financial Regulators The federal government of the United States has several agencies that are devoted to regulating the financial system, including: • The Securities and Exchange Commission, which regulates financial markets • The Federal Deposit Insurance Corporation, which insures deposits in banks • The Office of the Comptroller of the Currency, which regulates federally chartered banks • The Federal Reserve System, which is the central bank of the United States • The Consumer Finance Protection Bureau, which was created by Congress to protect consumers from fraud and deceptive practices in financial markets. Two of the major roles of the Fed are serving as the lender of last resort and conducting monetary policy. Monetary policy is the actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives such as high levels of employment, low rates of inflation, high rates of growth, and stability of the financial system. Figure 1.2 shows the location of the 12 districts of the Federal Reserve System. D. What Does the Financial System Do? The financial system provides three key financial services: risk sharing, liquidity, and information. Risk sharing gives savers and borrowers ways to reduce the uncertainty to which they are exposed. Liquidity is a measure of how easily an asset can be converted to cash. The financial system gathers and communicates information about borrowers’ circumstances.

Teaching Tips Solved Problem 1.1, “The Services That Securitized Loans Provide,” shows students how to solve an economic problem by breaking it down step by step. Encourage students to read the Solved Problems in each chapter because this feature can help them solve homework problems on their own and develop the skills they’ll need to perform well on exams. 1.2

The Crises of 2007–2009 and 2020 (pages 15–19) Learning Objective: Provide an overview of the financial crises of 2007–2009 and 2020. The only episode comparable to the financial crises and recessions of 2007–2009 and 2020 during the past 100 years was the Great Depression of the 1930s. A. Origins of the 2007-2009 Financial Crisis The origins of the financial crisis lie in large part in the housing bubble of 2000–2005. Many economists believe that changes in the market for mortgages played a key role in the housing bubble. By the 2000s, significant changes had taken place in the mortgage market. First, investment banks became significant participants in the secondary market for mortgages. Second, by the height of the housing bubble in 2005 and early 2006, lenders had greatly loosened the standards for obtaining a mortgage loan. The decline in housing prices that began

Chapter 1

Introducing Money and the Financial System

in 2006 led to rising defaults among subprime and Alt-A borrowers, borrowers with adjustablerate mortgages, and borrowers who had made only small down payments. By mid-2007, the decline in the value of mortgage-backed securities and the large losses suffered by commercial and investment banks began to cause turmoil in the financial system. Many investors refused to buy mortgage-backed securities, and some investors would only buy bonds issued by the U.S. Treasury. Banks began to restrict credit to all but the safest borrowers. The flow of funds from savers to borrowers, on which the economy depends, began to be greatly reduced. B. The Deepening Crisis and the Response of the Fed and Treasury Some economists and policymakers criticized the Fed and the Treasury for arranging the sale of the investment bank Bear Stearns to JP Morgan Chase in March 2008. The main concern was with moral hazard, which is the possibility that managers of other financial firms would make risky investments if they believed that the government would also save them from bankruptcy. In September 2008, the Fed and Treasury allowed another investment bank, Lehman Brothers, to go bankrupt. The fallout from the Lehman Brothers bankruptcy had widespread repercussions, including a sharp decline in most types of lending. In October 2008, Congress passed the Troubled Asset Relief Program (TARP), under which the Treasury provided funds to commercial banks in exchange for stock in those banks. These actions by the Fed and the Treasury were meant to restore the flow of funds from savers to borrowers. C. The Financial Crisis Caused by the COVID-19 Pandemic The financial system suffered an immediate shock from the effects of the Covid-19. By midMarch 2020, many non-essential businesses were closed, reducing revenues and leading firms to lay off workers. Savers and investors became reluctant to lend because they worried that both household and business borrowers might have difficulty repaying loans. The Fed revived some of the lending programs used during the 2007–2009 financial crisis and set up new facilities with the goal of maintaining the flow of funds. The federal government also passed several aid packages. The main aid package was the Coronavirus Aid, Relief, and Economic Security (CARES) Act, a more than $2 trillion spending bill—the largest fiscal policy action in U.S. history. Many economists and policymakers believed the severity of the financial crisis resulting from the Covid-19 pandemic justified the Fed’s use of innovative policies, but some worried that the Fed’s actions in working closely with the U.S. Treasury during the crisis might reduce the Fed’s independence. 1.3

Key Issues and Questions About Money, Banking, and the Financial System (pages 19-21) Learning Objective: Explain the key issues and questions the concerning the financial system. This section lists the issues and questions that are addressed in the main text, beginning with Chapter 2.

Teaching Tip The “Issues and Questions” in Section 1.3 serve as a roadmap for the topics the book will explore in the remaining chapters.

Hubbard & O’Brien • Money, Banking, and the Financial System, Fourth Edition

 Solutions to the End-of-Chapter Questions, Problems, and Data Exercises 1.1 Key Components of the Financial System Learning Objective: Identify the key components of the financial system. Review Questions 1.1

a. Money: Anything that people are willing to accept in payment for goods and services or to pay off debts. b. Stocks: Financial securities that represent partial ownership of a firm. c. Bonds: Financial securities issued by a corporation or government to borrow money, in exchange for the rights to interest and principal payments. d. Foreign Exchange: Units of foreign currency. e. Securitized Loans: Loans that are tradable–that can be bought and sold in financial markets. Not every financial asset is a financial security. Only a financial asset that can be bought and sold in a financial market is a financial security. It is possible that a saver’s asset could be a borrower’s liability. For example, a bond issued by a corporation is a liability to the corporation because it represents a loan that corporation is legally obliged to pay back. From the point of view of the saver who buys the bond, however, the bond is an asset because it represents a financial claim on the corporation that issued the bond.

1.2

With direct finance, one party lends directly to the other party. Buying the stock of a firm’s initial public offering (IPO) is direct financing. Direct financing requires financial markets. Indirect finance involves three parties: the borrower, the lender, and a financial intermediary who accepts the savings of the first party and independently lends those savings to the other party. A bank is an example of indirect finance because banks accept deposits from savers and lend the funds to borrowers. Indirect finance involves financial intermediaries.

1.3

The financial system is highly regulated because when left largely alone the financial system has experienced periods of instability that have led to economic recessions.

1.4

The Federal Reserve is the central bank of the United States. The president appoints the members of the Board of Governors with the consent of the Senate. The Federal Reserve’s initial responsibility was to act as a lender of last resort. As the financial system and banking system have evolved, the Fed’s role has expanded from being a lender of last resort to include the conduct of monetary policy to manage inflation, unemployment, and the stability of the financial system.

1.5

The financial system provides these services to savers: i. Risk sharing, which allows savers to spread and transfer risk. ii. Liquidity, which is the ease with which an asset can be exchanged for money. iii. Collection and communication of information about borrowers and expectations of returns on financial assets.

Chapter 1

Introducing Money and the Financial System

Problems and Applications 1.6

Disagree. Insurance companies specialize in contracts to protect their policyholders from the risk of financial loss. These companies invest the insurance premiums they collect in stocks, bonds, and mortgages. Insurance companies channel funds from savers to borrowers, which makes them financial intermediaries.

1.7

a. A systemic problem is one that is inherent in the system, a problem of the system itself rather than specific firms or institutions. b. While many industries are very important to the economy, banks are critical because of their important role as financial intermediaries in the economy, providing credit to households and businesses. Without bank loans to pay for inventories, help meet payrolls, and fund long-term capital projects, many businesses would have to cut back on operations or shut down.

1.8

a. Affirm is a financial intermediary in the sense that it channels funds from savers (from bank loans, so originally from savers) to borrowers. Borrowers on a peer-to-peer lending site can get a loan that they could not qualify for from a bank and at an interest rate lower than the interest rate charged on credit cards. Savers on a peer-to-peer lending site can get a higher interest rate than they would receive on bank savings accounts, many bonds, and other financial assets. b. Affirm’s borrowers may not meet bank lending standards, or the size of the loans offered by Affirm may be too small to be considered worthwhile by banks.

1.9

An IRA is an individual retirement account, and a 401(k) is a retirement savings plan sponsored by an employer. IRAs and 401(k) accounts allow households to invest in stocks and bonds which have a higher rate of return in the long run than bank deposits, and the income deposited in IRAs and 401(k) accounts is not taxed until the funds are withdrawn during retirement.

1.10

Directly lending your funds to an individual or a business decreases your liquidity (your money would be tied up in the loans); increases your risk (the loans may default); and increases your cost of determining whether the loans would be paid off because you would need to investigate the financial situation of the individual or business you are making a loan to. Depositing your funds in a bank allows you to withdraw your money when needed, transfers the risk of default to the bank, and eliminates your need to evaluate the loan.

1.11

Direct finance would make the process of an individual buying a car or a house much more difficult. The car or house buyer would either have to accumulate the savings to pay for the car or house or find someone willing to lend them the funds. Direct finance, as opposed to indirect finance through financial intermediaries, incurs more risk, less liquidity, and greater information costs. These drawbacks would increase the interest rate that the lender charges and reduce the quantity of loans.

1.12

Lenders win because borrowers would be more likely to make their mortgage payments. Borrowers win because they would be better able to afford their mortgage payments. Securitization slices the mortgages into numerous pieces because the mortgages are bundled together with similar mortgages in mortgaged-backed securities. Securitization makes renegotiating the loan more difficult because the bank does not own the loan; investors who purchased mortgage-backed securities generally own the loan. Moreover, the cost of negotiation with every investor holding the security may be very high. These difficulties substantially reduce the liquidity of mortgaged-backed securities and the amount of risk-sharing they provided during the 2007–2009 financial crisis was much less than expected. Also, the originators of some of the mortgage loans did a poor job of gathering information about the borrowers, particularly borrowers with poor credit histories. Copyright © 2022 Pearson Education, Inc.

Hubbard & O’Brien • Money, Banking, and the Financial System, Fourth Edition

1.2 The Crises of 2007–2009 and 2020 Learning objective: Provide an overview of the financial crises of 2007–2009 and 2020. Review Questions 2.1

A bubble is an unsustainable increase in the price of a class of assets. Many economists believe that there was a housing bubble in the United States between 2000 and 2005 because, among other things, housing prices rose rapidly from 2000 to the beginning of 2006 and then fell more than 30% from 2006 to 2009.

2.2

Investment banks became significant participants in the secondary market for mortgages. Investment banks began buying mortgages, bundling large numbers of them together as mortgage-backed securities, and reselling them to investors. Also, lenders greatly loosened their standards for granting a mortgage loan. A subprime borrower is a borrower with a flawed credit history. Alt-A borrowers are borrowers who simply state their incomes but do not document their incomes.

2.3

The decline in housing prices led to rising defaults among subprime and Alt-A borrowers, borrowers with adjustable rate mortgages, and borrowers who had made only small down payments. As a result, mortgage-backed securities declined in value, causing losses for the investment institutions that owned them.

2.4

The Federal Reserve made loans to commercial banks and to investment banks. Congress passed the Troubled Asset Relief Program (TARP) under which the U.S. Treasury provided funds to commercial banks in exchange for stock in those banks. The Fed and U.S. Treasury also worked together to find a buyout partner for the investment bank Bear Stearns, and the Fed provided an $85 billion loan to American International Group (AIG). Likewise, the Fed and the Treasury worked together in 2020 to create lending facilities and make loans to businesses and governments affected by the Covid-19 pandemic. The interaction between the Treasury and the Fed has caused some concern about the independence of the Fed.

Problems and Applications 2.5

There can be no bubble in automobiles and refrigerators because those products do not gain value over time. If an increase in demand causes the prices of automobiles or refrigerators to rise, manufacturers can easily increase production, which should cause prices to quickly fall to their previous levels. Increasing the supply of houses is more time consuming and can be difficult to achieve in some urban areas or in places where zoning restrictions make new construction difficult.

2.6

The primary issue involved in measuring housing prices is that houses are not homogeneous goods. Because no two houses are exactly the same, the price of an “average” house can be difficult to determine. In addition, in constructing an index of housing prices, economists need to decide whether to use the sale price as the value of the house, or the appraised value. Even if the housing index is based solely on selling prices, it may not account for quality improvements (renovations to the home) or declines (the quality of neighborhood schools has deteriorated). There are many other features of a home or a neighborhood that are not easily identifiable from an index number.

Chapter 1

Introducing Money and the Financial System

2.7

The secondary mortgage market allows banks to transfer the risk of holding mortgage loans to investors who buy mortgage-backed securities. Access to the funds from these investors allows banks to offer a lower interest rate than if the banks held the loans themselves. The Federal government has intervened in the housing market to promote ownership by creating Fannie Mae and Freddie Mac. The federal government believes that there are positive externalities to home ownership. Neighborhoods become more stable with less litter, vandalism, and crime when more of the people who live there own their homes rather than rent them. Because individual homebuyers don’t take this externality into account when deciding whether to purchase a home, an inefficiently small number of homes may be purchased. Government intervention may result in a more efficient quantity of homes being purchased. Economists and policymakers debate how large the positive externality associated with homeownership may be and whether establishing Fannie Mae and Freddie Mac was the best way to deal with the externality.

2.8

During the financial crisis of 2007–2009, the federal government’s role was largely in helping the Fed to purchase troubled assets and in restoring the flow of funds from savers to borrowers. The disruption in the flow of funds during this period was the worst since the Great Depression of the 1930s. During the Covid-19 crisis, the federal government was faced with the unusual situation of many businesses being closed or operating at reduced capacity because of orders from mayors and governors or because consumers were reluctant to dine in restaurants, go to movies or plays, or attend sporting events for fear of contracting the virus. As a result, the federal government took a far more active role than it had during the 2007–2009 financial crisis, particularly in supplementing unemployment benefits and sending checks to most families, as well as acting with the Fed to facilitate lending to a number of sectors of the economy.

Data Exercises D1.1

The first graph that follows shows the annual percentage change in real GDP (in chained 2009 dollars) for 2000–2020. The second graph that follows and the data from Figure 1.3(b) is updated and changed to a quarterly frequency and percentages change from a year ago. Movements in real GDP correspond well, but not perfectly, to movements in the Case-Shiller price index of houses from 2000 through 2012. From 2000 through 2005, the Case-Shiller price index of houses increased, as did real GDP. The decline in housing prices, which started in 2006, preceded the decline in real GDP, which began in 2008. Both housing prices and real GDP declined in 2008 and 2009. Real GDP rose through the 2010 to 2019 period, but housing prices did not begin to rise until 2012. In early 2020, the growth rate of real GDP plummeted, but housing prices did not fall, fueled by low mortgage rates and a persistent shortage of housing in some areas.

Hubbard & O’Brien • Money, Banking, and the Financial System, Fourth Edition

Chapter 2 Money and the Payments System 

Brief Chapter Summary and Learning Objectives

2.1

Do We Need Money? (pages 25–28) Analyze the inefficiencies of a barter system. • Money reduces the transactions costs of exchange as well as other inefficiencies of a barter system.

2.2

The Key Functions of Money (pages 28–32) List and describe the four key functions of money. • Money serves four key functions in the economy: It acts as a medium of exchange, a unit of account, and a store of value, and it offers a standard of deferred payment.

2.3

The Payments System (pages 32–39) Explain the role of the payments system in the economy. • The efficiency of the payments system has increased over time as new instruments have reduced the cost of settling transactions.

2.4

Measuring the Money Supply (pages 40–42) Explain how the U.S. money supply is measured. • There are currently two measures of the money supply in the United States, M1 and M2. • M1 includes liquid assets that can directly be used as a medium of exchange, while M2 includes short-term assets that are less liquid but can readily be converted to currency and used as a medium of exchange.

2.5

The Quantity Theory of Money: A First Look at the Link Between Money and Prices (pages 42–48) Use the quantity theory of money to analyze the relationship between money and prices in the long run. • The quantity theory of money helps to explain the long-run relationship between the growth of the money supply and inflation.



Key Terms

Barter, p. 26. A system of exchange in which individuals trade goods and services directly for other goods and services.

Money, p. 25. Anything that is generally accepted as payment for goods and services or in the settlement of debts.

Checks, p. 33. A promise to pay on demand money deposited with a bank or other financial institution.

Payments system, p. 32. The mechanism for conducting transactions in the economy.

Hubbard & O’Brien • Money, Banking, and the Financial System, Fourth Edition

Commodity money, p. 27. A good used as money that has value independent of its use as money. E-money, p. 36. Digital cash people use to buy goods and services over the Internet; short for electronic money. Fiat money, 30. Money, such as paper currency, that has no value apart from its use as money. Hyperinflation, p. 46. Extremely high rates of inflation, exceeding 50% per month. Legal tender, p. 30. The government designation that currency is accepted as payment of taxes and must be accepted by individuals and firms in payment of debts. M1, p. 40. A narrower definition of the money supply: The sum of currency in circulation and checking account and savings account deposits. [In January 2021, the Fed began including savings account deposits in M1.] M2, p. 40. A broader definition of the money supply: All the assets that are included in M1, as well as time deposits with a value of less than $100,000, savings accounts—including money market deposit accounts—and noninstitutional money market mutual fund shares. Medium of exchange, p. 28. Something that is generally accepted as payment for goods and services; a function of money. Monetary aggregate, p. 40. A measure of the quantity of money that is broader than currency; M1 and M2 are monetary aggregates.



Quantity theory of money, p. 43. A theory about the connection between money and prices that assumes that the velocity of money is determined mainly by institutional factors and so is roughly constant in the short run. Real-time payments system, p. 35. A system that makes checks and other payments available within a few minutes and which operates 24 hours per day, 365 days per year. Specialization, p. 27. A system in which individuals produce the goods or services for which they have the best ability relative to others. Standard of deferred payment, p. 29. The characteristic of money by which it facilitates exchange over time; a function of money. Store of value, p. 28. The accumulation of wealth by holding dollars or other assets that can be used to buy goods and services in the future—in effect moving your purchasing power forward in time; a function of money. Transactions cost, p. 26. The costs in time or other resources that parties incur in the process of agreeing and carrying out an exchange of goods and services. Unit of account, p. 28. A way of measuring value in an economy in terms of money; a function of money. Wealth, p. 29. The sum of the value of a person’s assets minus the value of the person’s liabilities.

Chapter Outline

The Federal Reserve: Good for Main Street or Wall Street – or Both? During the 2020 presidential election, President Donald Trump criticized Federal Reserve Chair Jerome Powell for not doing more to lower interest rates and spur the economy. Senators Elizabeth Warren of Massachusetts and Bernie Sanders of Vermont also criticized the Fed, arguing that the Fed focused too much on the interests of financial firms and not enough on the needs of the average person. Many members of Congress and the public also had an unfavorable view of the Fed. And then the Covid-19 pandemic hit. The Fed and the U.S. Treasury offered trillions of dollars of direct and indirect support to businesses and households. The Fed and the Treasury had taken similar actions during the 2007–2009 financial crisis and recession, and many economists credit those actions with saving the financial system from further disruption. It remains to be seen how effective the Fed and the Treasury’s actions will be during the current crisis.

Chapter 2 Money and the Payments System

The source of dissatisfaction among some economists and policymakers with the Fed actions during both periods has to do more with the belief that the Fed had acted contrary to the basic idea embodied in the Federal Reserve Act of 1913, which granted the Fed substantial independence from Congress and the president, but in exchange, the Fed was only to engage in narrowly defined monetary policy. Senators Warren and Sanders, among others, argued that over the years, the Fed has used its independence to pursue policies that favored “Wall Street”—large financial firms—rather than “Main Street”—households and small businesses. A key reason many countries have granted their central banks considerable independence is that changes in the money supply have effects on the inflation rate. When a central bank is under direct control of the government, the money supply often increases rapidly, and so does the inflation rate. In Zimbabwe, the government ordered the country’s central bank to rapidly increase the money supply to help pay for the government’s spending. The result was an inflation rate that reached an almost unimaginable 15 billion percent in 2008. The extraordinary inflation rates in Zimbabwe contributed to disastrous declines in production and employment. In 2009, in an attempt to rein in inflation, the Zimbabwean government decided to abandon its own currency entirely in favor of the U.S. dollar. More recently, the government of Venezuela also financed much of its government spending by requiring the central bank to print money at a rapid rate. The result was an estimated inflation rate of 10 million percent in 2019.

Teaching Tips For most students, Sections 2.1, 2.2, and 2.4 on the functions and definitions of money should be a review of material they learned in their principles class. You can cover this material briefly with well-prepared students. Section 2.3 discusses the payments system—a term that may be unfamiliar to many students— including electronic funds and blockchain payment technology, which are topics not often covered in principles classes. Section 2.5 contains material on the quantity theory that is likely to be less familiar to students. Given the debate over the likely outcome of monetary policies that have resulted in large increases in the money supply, students are often interested in this material. For this reason, the authors cover it early in their classes. The material on hyperinflation is interesting to most students and may help to reinforce the discussion of the quantity theory. Nevertheless, if you are pressed for time, you can omit the material. Similarly, the background on the quantity theory and hyperinflation helps motivate the last section on central bank independence, although discussion of this material can be postponed to later in the course. 2.1

Do We Need Money? (pages 25–28) Learning Objective: Analyze the inefficiencies of a barter system. A. Barter Barter is a system of exchange in which individuals trade goods and services directly for other goods and services. Sources of inefficiency for barter include (1) the time and effort spent looking for trading partners; (2) each good having many prices (in terms of all other goods with which it can be exchanged); (3) a lack of standardization of the products being traded; and (4) difficulty in accumulating wealth (people need to store various products). B. The Invention of Money Money reduces transactions costs as well as other inefficiencies of barter. Money allows for specialization, a system in which individuals produce the goods or services for which they have relatively the best ability.

Hubbard & O’Brien • Money, Banking, and the Financial System, Fourth Edition

2.2

The Key Functions of Money (pages 28–32) Learning Objective: List and describe the four key functions of money. A. Medium of Exchange Medium of exchange describes the role of money as a generally accepted payment for goods and services. B. Unit of Account Unit of account is the function of money in which money can be used to measure value in an economy. C. Store of Value Money is a store of value in that it allows for the accumulation of wealth by holding dollars or other assets that can be used to buy goods and services in the future. D. Standard of Deferred Payment Money is considered a standard of deferred payment in that it facilitates exchange over time. E. Remember That Money, Income, and Wealth Measure Different Things Money, like other assets, is a component of wealth, which is the sum of the value of a person’s assets minus the value of the person’s liabilities. A person’s income is equal to his or her earnings over a period of time. F. What Can Serve as Money? An asset is suitable to use as money if it is (1) acceptable to (that is, usable by) most people; (2) standardized in terms of quality, so that any two units are identical; (3) durable, so that it does not quickly become too worn out to be usable; (4) valuable relative to its weight, so that amounts large enough to be useful in trade can be easily transported; and (5) divisible, because prices of goods and services vary. G. The Mystery of Fiat Money Money, such as paper currency, that has no value apart from its use as money is called fiat money. The most important reason paper currency circulates as a medium of exchange is the confidence consumers and firms have that if they accept paper currency they will be able to pass it along when they need to buy goods and services.

2.3

The Payments System (pages 32–39) Learning Objective: Explain the role of the payments system in the economy. A. The Transition from Commodity Money to Fiat Money Centuries ago, people had difficulty transporting large quantities of gold coins to settle transactions and also ran the risk of being robbed. To get around this problem, beginning around the year A.D. 1500 in Europe, governments and private firms—early banks—began to store gold coins in safe places and issue paper certificates. In modern economies, central banks issue fiat money. B. The Importance of Checks It can be expensive to transport paper money to settle large commercial or financial transactions. Checks are promises to pay on demand money deposited with a bank or other financial institution. C. New Technology and the Payments System Breakthroughs in electronic telecommunication have improved the efficiency of the payments system, reducing the time needed for clearing checks and for transferring funds. Examples of computerized payment-clearing devices include debit cards and payment apps, Automated Clearing House (ACH) transactions, and automated teller machines (ATMs).

Chapter 2 Money and the Payments System

D. The Real-Time Payments Systems A real-time payments system would allow checks and other payments to be cleared electronically so the funds could be available within minutes. The United States has been slow to adopt this technology, compared to Japan and the countries of Western Europe, although the Fed plans to implement FedNow—its real-time payments system—within five years. although the Fed plans to implement a version within five years. E. E-money, Bitcoin and Blockchain E-money is digital cash used to buy goods and services over the Internet. The use of e-money has increased in recent years. The Fed does not control e-money, so it is essentially a private payments system. One type of e-money is bitcoin, which is a product of a decentralized system of linked computers. To produce bitcoin, people perform calculations necessary to ensure that purchases made with bitcoin are legitimate. Bitcoins can be bought with dollars and other currencies and stored in “digital wallets” on smartphones. Unlike credit card purchases, no record is made of transactions that use bitcoins. Some retailers prefer bitcoin to credit card transactions because bitcoin purchases have lower processing costs. However, some firms question whether bitcoin software can handle large numbers of transactions. Some policymakers fear that investors might manipulate the prices of bitcoins and other virtual currencies. Despite these problems the technology underlying bitcoin, known as blockchain, has the potential to increase the speed, efficiency and security of the payments system. Blockchain and other new payments technologies have led some commentators to predict a coming “cashless society.” But an entirely cashless society may be difficult to achieve. One problem is the high cost of the infrastructure needed for an e-payments system. Another problem is the concern many households and firms have about the potential for computer hackers to violate the privacy of an electronic system.

Teaching Tips Ask students if they have bought items on eBay using PayPal. Next, ask how many of those students would have bought those items if they could not have used PayPal. The discussion that follows should help them to understand how money evolves over time and how increased efficiency of the payments systems allows for increased economic activity.

2.4

Measuring the Money Supply (pages 40-42) Learning Objective: Explain how the U.S. money supply is measured.

Teaching Tips For the upcoming section, Section 2.4 part A, note that in January 2021, the Fed began including savings account deposits in M1. Since the 4th edition of the main book was published in December 2020, that change is not reflected in the definitions of M1 and M2. We will try to adjust definitions in the second printing of the main book. A. Measuring Monetary Aggregates M1 is a narrow definition of money that includes traditional mediums of exchange: currency in circulation and checking deposits. M2 is a broader definition of money that includes all the assets in M1 as well as short-term investments that can be easily converted to currency including time deposits valued under $100,000, savings deposits, money market deposits held at banks, and noninstitutional money market shares. B. Does it Matter which Definition of the Money Supply We Use?