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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-
Hill Education. All rights reserved. Printed in the United States of America. No part of this publication
may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system,
without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network
or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the
United States.

This book is printed on acid-free paper.

1 2 3 4 5 6 7 8 9 LWI 25 24 23 22 21 20

ISBN 978-1-260-57136-3
MHID 1-260-57136-X

Cover Image: ©NASA images/Shutterstock

All credits appearing on page or at the end of the book are considered to be an extension of the ­copyright page.

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guarantee the accuracy of the information presented at these sites.

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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 Kermit L. Schoenholtz

Rosen Family Chair in In- is the Henry Kaufman
ternational Finance at the Professor of the History
Brandeis International of Financial Institutions
Business School (http:// and Markets in the
people.brandeis.edu/~ Department of Eco-
­
cecchett/). He previously nomics of New York
taught at Brandeis from University’s Leonard N.
2003 to 2008. Before re- Stern School of Busi-
joining Brandeis in 2014, ness, where he teaches
­Cecchetti completed a five- courses on money and
year term as Economic Ad- banking (http://pages.
viser and Head of the Monetary and Economic stern.nyu.edu/~kschoenh). He also directs NYU
Department at the Bank for International Settlements in Stern’s Center for Global Economy and Business
Basel, Switzerland. During his time at the Bank for In- (www.stern.nyu.edu/cgeb). Schoenholtz was
ternational Settlements, ­Cecchetti was involved in nu- ­Citigroup’s global chief economist from 1997 until
merous postcrisis global regulatory reform initiatives, 2005.
including the work of the Basel Committee on Banking Schoenholtz joined Salomon Brothers in 1986,
Supervision and the ­Financial Stability Board. working in its New York, Tokyo, and London of-
He has also taught at the New York University fices. In 1997, he became chief economist at
­Leonard N. Stern School of Business and at The Ohio ­Salomon, after which he became chief economist at
State University. In addition to his other appointments, Salomon Smith ­Barney and later at Citigroup.
­Cecchetti served as Executive Vice President and Direc- Schoenholtz has published extensively for the
tor of Research, Federal Reserve Bank of New York professional investment community about financial,
(1997–1999); Editor, Journal of Money, Credit, and economic, and policy developments; more recently,
Banking (1992–2001); Research Associate, National he has contributed to policy-focused scholarly re-
Bureau of Economic Research (1989–2011); and search in economics. He is a member of the Finan-
­Research ­Fellow, Centre for Economic Policy Research cial Research Advisory Committee of the U.S.
(2008–present), among others. Treasury’s Office of Financial Research, a panel
Cecchetti’s research interests include inflation and member of the U.S. Monetary Policy Forum, and a
price measurement, monetary policy, macroeconomic member of the Council on Foreign Relations.
theory, economics of the Great Depression, and the eco- He also has served as a member of the Executive
nomics of financial regulation. Committee of the London-based Centre for Eco-
Cecchetti received an SB in Economics from the nomic Policy Research.
Massachusetts Institute of Technology in 1977 and a From 1983 to 1985, Schoenholtz was a Visiting
PhD in Economics from the University of California Scholar at the Bank of Japan’s Institute for Monetary
at Berkeley in 1982. In 2016, he received an Honor- and Economic Studies. He received an MPhil in eco-
ary Doctorate in Economics from the University of nomics from Yale University in 1982 and an AB
Basel. from Brown University in 1977.

iv
Preface

The world of money, banking, and financial markets on the tools, rules, and structures themselves. It is an
is constantly evolving. Every year, people explore approach designed to give students the lifelong abil-
new ways to pay for purchases, save for the future, ity to understand and evaluate whatever financial in-
and borrow to meet current needs. novations and developments they may one day
New technology is an ongoing source of change. confront.
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- The Core Principles
dreds of millions of people in poor countries their
first access to the financial system.
Approach
In some instances, crises provided the impetus for Toward that end, the entire content of this book is
change. For example, new regulations aimed at mak- based on five core principles. Knowledge of these
ing the financial system safer have pushed many banks principles is the basis for understanding what the
to take fewer risks than they did just a few years ago. financial system does, how it is organized, how it is
Financial markets also have become more resilient and linked to the real economy, and how it is changing. If
less likely to need public support. And monetary poli- you understand these five principles, you will under-
cymakers, especially in places where economic growth stand the future:
has slowed and deflation is a risk, have adopted a slew
of policies never seen before. In much of Europe and 1. Time has value.
Japan, interest rates have fallen below zero—breaking 2. Risk requires compensation.
through what had long been seen as a permanent 3. Information is the basis for decisions.
­barrier—while new policies are in place to boost 4. Markets determine prices and allocate
bank lending and restore inflation and growth to pre- resources.
crisis levels. 5. Stability improves welfare.
The same things that are reshaping the global fi-
nancial system also are transforming the study of These five core principles serve as a framework
money and banking. Some old questions are surfac- through which to view the history, current status,
ing with new intensity: How can individuals use the and future development of money and banking.
changing financial system to improve their lives? They are discussed in detail in Chapter 1; through-
How can governments ensure that the financial sys- out the rest of the text, marginal icons remind
tem remains stable? How should we balance the need students of the principles that underlie particular
for financial resilience with the goals of competition, discussions.
efficiency, and innovation? And how can monetary Focusing on core principles has created a book
policymakers keep inflation low, employment high, that is both concise and logically organized. This ap-
and both of them stable? proach does require some adjustments to the tradi-
Against this background, students who memorize tional methodology used to teach money and
the operational details of today’s financial system are banking, but for the most part they are changes in
investing in a short-lived asset. Our purpose in writ- emphasis only. That said, some of these changes have
ing this book is to focus on the basic functions served greatly improved both the ease of teaching and the
by the financial system while deemphasizing its cur- value students draw from the course. Among them
rent structure and rules. Learning the economic ratio- are the emphasis on risk and on the lessons from the
nale behind current financial tools, rules, and financial crisis; use of the term financial instrument;
structures is much more valuable than concentrating parallel presentation of the Federal Reserve and the
v
vi l Preface

European Central Bank; a streamlined, updated sec- Federal Reserve Economic

tion on monetary economics; and the adoption of an
integrated global perspective. Data (FRED)
Money, Banking, and Financial Markets systemati-
cally integrates the use of economic and financial
Innovations in This Text data from FRED, the online database provided free
of charge to the public by the Federal Reserve Bank
In addition to the focus on core principles, this book of St. Louis. As of this writing, FRED offers nearly
introduces a series of innovations designed to foster 600,000 data series from more than 85 sources,
coherence, relevance, and timeliness in the study of including indicators for about 200 countries. Infor-
money and banking. mation on using FRED appears in Appendix B to
Chapter 1.
The Money and Banking Blog Through frequent use of FRED, students will
gain up-to-date knowledge of the U.S. and other
The global economy and financial system of the 21st economies and an understanding of the real-world
century is evolving quickly. Changes in technology, challenges of economic measurement; they will also
in the structure of financial institutions and markets, gain skills in analysis and data manipulation that
and in monetary and regulatory policy are occur- will serve them well for years to come. Many of the
ring at a pace that far outstrips the normal three- graphs in this book were produced (and can be eas-
or four-year cycle at which textbooks are revised. ily updated) using FRED. In addition, end-of-­
We designed the Money and Banking blog to keep chapter Data Exploration problems call on students
examples and applications current. Available at to use FRED to analyze key economic and financial
www.moneyandbanking.com, the blog provides timely indicators highlighted in that chapter. (For detailed
commentary on events in the news and on questions of instructions for using FRED online to answer the
more lasting interest. Data Exploration problems in Chapters 1 to 10, visit
The blog is closely linked to this book. Like the www.mhhe.com/moneyandbanking6e and click on
book, it aims to enhance students’ understanding of Data Exploration Hints.) Students can even do some
the world around them. Based on the five core prin- assignments using the FRED app for their mobile
ciples of money and banking, each blog entry is as- devices.
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
Impact of the Crises
instruments, financial markets, financial institutions, The effects of the global financial crisis of 2007–
financial regulators, and central banks. 2009 and the euro-area crisis that began in 2010
The material from the blog also is integrated into transformed money, banking, and financial markets.
the book in two ways. First, each chapter includes a Accordingly, from beginning to end, the book inte-
“Money and Banking Blog” boxed reading. These grates the issues raised by these crises and by the
are short versions of postings that have appeared on responses of policymakers.
www.moneyandbanking.com since the publication of The concept of a liquidity crisis surfaces in
the previous edition of this text. These excerpts de- ­Chapter 2, and the risks associated with leverage and
scribe current issues that highlight the lessons in the the rise of shadow banking are introduced in Chapter 3.
body of the chapter. Second, the website includes a Issues specific to the 2007–2009 crisis—including
listing of the posts by chapter. This listing allows stu- securitization, rating agencies, subprime mort-
dents and instructors alike to find new, up-to-date gages, over-the-counter trading, and complex financial
material that illustrates the lessons and core princi- instruments like credit-default swaps—are included in
ples emphasized in each chapter. the appropriate intermediate chapters of the text.
To receive the latest commentary as it is posted ­Chapter 16 explores the role of the European Central
every week or so, subscribe to the blog at Bank in managing the euro-area crisis. More broadly,
www.moneyandbanking.com. You can also follow the sources of threats to the financial system as a whole
the authors on Twitter (@MoneyBanking1). are identified throughout the book, and there is a
 Preface l vii

f­ocused discussion on regulatory initiatives to limit bonds, stocks, futures, options, and insurance
such systemic threats. Finally, we present—in a logical ­contracts. Doing so clears up the confusion that
and organized manner—the unconventional monetary can arise when students arrive in a money and bank-
policy tools, including the use of negative interest rates ing class fresh from a course in the principles of
and the concept of the effective lower bound, that have ­economics.
become so prominent in postcrisis policy debates and
remain relevant today.
Parallel Presentation of the
Federal Reserve and the
Early Introduction of Risk
European Central Bank
It is impossible to appreciate how the financial sys-
tem works without understanding risk. In the mod- To foster a deeper understanding of central banking
ern financial world, virtually all transactions transfer and monetary policy, the presentation of this material
some degree of risk between two or more parties. begins with a discussion of the central bank’s role and
These risk trades can be extremely beneficial, as they objectives. Descriptions of the Federal Reserve and
are in the case of insurance markets. But there is still the European Central Bank follow. By starting on a
potential for disaster. In 2008, risk-trading activity at theoretical plane, students gain the tools they need to
some of the world’s largest financial firms threatened understand how all central banks work. This avoids
the stability of the international financial system. focusing on institutional details that may quickly
Even though risk is absolutely central to an under- become obsolete. Armed with a basic understand-
standing of the financial system, most money and ing of what central banks do and how they do it, stu-
banking books give very little space to the topic. In dents will be prepared to grasp the meaning of future
contrast, this book devotes an entire chapter to defin- changes in institutional structure.
ing and measuring risk. Chapter 5 introduces the Another important innovation is the parallel dis-
concept of a risk premium as compensation for risk cussion of the two most important central banks in
and shows how diversification can reduce risk. Be- the world, the Federal Reserve and the European
cause risk is central to explaining the valuation of fi- Central Bank (ECB). Students of the 21st century are
nancial instruments, the role of financial ill-served by books that focus entirely on the U.S. fi-
intermediaries, and the job of central bankers, the nancial system. They need a global perspective on
book returns to this concept throughout the chapters. central banking, the starting point for which is a de-
tailed knowledge of the ECB.

Emphasis on Financial Instruments

Modern Treatment of Monetary
Financial instruments are introduced early in the
book, where they are defined based on their eco-
Economics
nomic function. This perspective leads naturally to The discussion of central banking is followed by a
a discussion of the uses of various instruments and simple framework for understanding the impact of
the determinants of their value. Bonds, stocks, and monetary policy on the real economy. Modern cen-
derivatives all fit neatly into this framework, so they tral bankers think and talk about changing the inter-
are all discussed together. est rate when inflation deviates from its target and
This approach solves one of the problems with output deviates from its normal level. Yet traditional
existing texts, use of the term f­ inancial market to re- treatments of monetary economics employ aggregate
fer to bonds, interest rates, and foreign exchange. In demand and aggregate supply diagrams, which relate
its conventional microeconomic sense, the term mar- output to the price level. Our approach is consistent
ket signifies a place where trade o­ ccurs, not the in- with that in the most recent editions of the leading
struments that are traded. This book follows standard macroeconomics textbooks and directly links output
usage of the term market to mean a place for trade. It to inflation, simplifying the exposition and highlight-
uses the term financial instruments to describe virtu- ing the role of monetary policy. Because this book
ally all financial arrangements, including loans, also skips the IS-LM framework, its presentation
viii l Preface

of monetary economics is several chapters shorter. d­ atabase of the Federal Reserve Bank of St. Louis.
Only those topics that are most important in a mon- The book often uses FRED data for figures and
etary economics course are covered: long-run money tables, and every chapter calls on students to use
growth and inflation and short-run monetary policy FRED to solve end-of-chapter problems. Chapter 2
and business cycles. This streamlined treatment of examines money both in theory and in practice.
monetary theory is not only concise but more mod- Chapter 3 follows with a bird’s-eye view of finan-
ern and more relevant than the traditional approach. cial instruments, financial markets, and financial
It helps students to see monetary policy changes as institutions. (Instructors who prefer to discuss the
part of a strategy rather than as one-off events, and financial system first can cover Chapters 2 and 3 in
it gives them a complete understanding of business reverse order.)
cycle fluctuations.
Part II: Interest Rates, Financial Instru-
ments, and Financial Markets. ​Part II con-
Integrated Global Perspective tains a detailed description of financial instruments
Technological advances have dramatically reduced and the financial theory required to understand
the importance of a bank’s physi­cal location, produc- them. It begins with an explanation of present value
ing a truly global financial system. Twenty-five years and risk, followed by specific discussions of bonds,
ago money and banking books could afford to focus stocks, derivatives, and foreign exchange. Students
primarily on the U.S. financial system, relegating benefit from concrete examples of these concepts.
international topics to a separate chapter that could be In Chapter 7 (The Risk and Term Structure of In-
considered optional. But in today’s financial world, terest Rates), for example, students learn how the
even a large country like the United States cannot be information contained in the risk and term struc-
treated in isolation. The global financial system is ture of interest rates can be useful in forecasting. In
truly an integrated one, rendering separate discussion Chapter 8 (Stocks, Stock Markets, and Market Ef-
of a single country’s institutions, markets, or policies ficiency), they learn about stock bubbles and how
impossible. This book incorporates the discussion of those anomalies influence the economy. And in
international issues throughout the text, emphasizing Chapter 10 (Foreign Exchange), they study the Big
when national borders are important to bankers and Mac index and learn to understand the concepts of
when they are not. purchasing power parity and interest rate parity.
Throughout this section, two ideas are emphasized:
that financial instruments transfer resources from
Organization savers to investors, and that in doing so, they trans-
fer risk to those best equipped to bear it.
This book is organized to help students understand
both the financial system and its economic effects on Part III: Financial Institutions. In Part III,
their lives. That means surveying a broad series of top- the focus shifts to financial institutions. Chapter 11
ics, including what money is and how it is used; what introduces the economic theory that is the basis for
a financial instrument is and how it is valued; what a our understanding of the role of financial intermedi-
financial market is and how it works; what a financial aries. Through a series of examples, students see the
institution is and why we need it; and what a central problems created by asymmetric information as well
bank is and how it operates. More important, it means as how financial intermediaries can mitigate those
showing students how to apply the five core principles problems. The remaining chapters in Part III put the-
of money and banking to the evolving financial and ory into practice. Chapter 12 presents a detailed dis-
economic arrangements that they inevitably will con- cussion of banking, the bank balance sheet, and the
front during their lifetimes. risks that banks must manage. Chapter 13 provides a
brief overview of the financial industry’s structure,
Part I: Money and the Financial S
­ ystem. and Chapter 14 explains financial regulation, includ-
Chapter 1 introduces the core principles of money ing a discussion of regulation to limit threats to the
and banking, which serve as touchstones throughout financial system as a whole and of efforts to limit the
the book. It also presents FRED, the free online increased regulatory burden.
 Preface l ix

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. asset price bubbles, the effective lower bound for
This part of the book begins with a discussion of the nominal rates, and the evolving structure of the fi-
role and objectives of central banks, which leads nat- nancial system.
urally to the principles that guide central bank de- For those instructors who have the time, we rec-
sign. Chapter 16 applies those principles to the ommend closing the course with a rereading of the
Federal Reserve and the European Central Bank, first chapter and a review of the core principles.
highlighting the strategic importance of their numeri- What is the future likely to hold for the six parts of
cal inflation objectives and their communications. the financial system: money, financial instruments,
Chapter 17 presents the central bank balance sheet, financial markets, financial institutions, regulatory
the process of multiple deposit creation, and the agencies, and central banks? How do students envi-
money supply. Chapters 18 and 19 cover operational sion each of these parts of the system 20 or even
policy, based on control of both the interest rate and 50 years from now?
the exchange rate. Chapter 18 also introduces the
monetary transmission mechanism and presents a va-
riety of unconventional monetary policy tools, in- What’s New in the
cluding negative interest rates and the concept of the
effective lower bound, that have become so promi- Sixth Edition?
nent in recent years. The goal of Part IV is to give Many things have happened since the last edition. For
students the knowledge they will need to cope with that reason, all of the figures and data have been updated
the inevitable changes that will occur in central bank to reflect the most recent available information. In addi-
structure. tion, the authors have made many changes to enhance
the sixth edition of Money, Banking, and Financial Mar-
Part V: Modern Monetary Economics. The kets. What follows is only a sample of these changes.
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-
New Topics in the Integrated
lined approach concentrates on what is important, Global Perspective
presenting only the essential lessons that students The sixth edition reflects the wide range of monetary
truly need. Chapter 20 sets the stage by exploring and regulatory developments that have taken place
the relationship between inflation and money since 2018. New topics introduced or discussed in
growth. Starting with inflation keeps the presenta- much greater detail include:
tion simple and powerful, and emphasizes the way
monetary policymakers think about what they do. A ∙ The role of paper money and virtual currencies
discussion of aggregate demand, aggregate supply, ∙ Mobile banking and financial inclusion
and the determinants of inflation and output follows. ∙ Modernizing the payments system
Consistent with the presentation in recent editions of ∙ Bond market liquidity
leading macroeconomic textbooks, Chapter 21 pres-
∙ The distribution of wealth
ents a complete macroeconomic model with a dy-
namic aggregate demand curve that integrates ∙ Replacing LIBOR
monetary policy directly into the presentation, along ∙ Private versus public equity
with short- and long-run aggregate supply curves. In ∙ Intangible capital
Chapter 22 the model is used to help understand the ∙ Fiscal sustainability
sources of business cycles, as well as a number of ∙ Stress testing banks to ensure resilience
important applications that face monetary policy-
∙ Cyber risk
makers in the world today. Each application stands
on its own, and the applications are ordered in in- ∙ Negative interest rates
creasing difficulty to allow maximum flexibility in ∙ Chinese exchange rate policy
their use. Finally, Chapter 23 explores the monetary ∙ The threat to Fed independence
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x l Preface

∙ Measuring tail risk The Cloudy Future of Peer-to-Peer Lending

∙ Big data and the macroeconomy (Chapter 12)
∙ Secular stagnation Fiscal Sustainability (Chapter 15)
Is 2 Percent Still the Right Inflation Target?
∙ Balance of payments crises
(Chapter 18)
Sudden Stops: Understanding Balance-of-
The most extensive changes are in Chapter 12, which Payments Crises (Chapter 19)
includes a new section on cyber risk; in Chapter 14, The Phillips Curve (Chapter 21)
which includes a discussion of continued reforms to Secular Stagnation (Chapter 22)
financial regulation in the aftermath of the financial GDP at Risk (Chapter 23)
crisis; and in Chapter 18, which includes a full treat-
ment of the Federal Reserve’s evolving operational Applying the Concept
policy regime. Modernizing U.S. Payments: Faster, Cheaper and
More Secure (Chapter 2)
Raising Equity: Public versus Private (Chapter 8)
Changes at the Federal Reserve Financing Intangible Capital (Chapter 11)
and the ECB Eclipsing LIBOR (Chapter 13)
Better Capitalized Banks Lend More and Lend
The discussion of the Federal Reserve and the ECB Better (Chapter 14)
now considers their evolving communications strat- The Threat to Fed Independence (Chapter 15)
egy (Chapter 16); the use of unconventional policy Time Consistency (Chapter 15)
tools, including negative interest rates and the dra- Central Bank Digital Currency (Chapter 16)
matic growth in central bank balance sheets, aimed What Should the Fed Own? (Chapter 17)
at addressing first the financial crisis and then the GDP: One Size No Longer Fits All (Chapter 18)
weak economic recoveries that followed (Chapter China’s Changing Exchange Rate Regime
18); the interactions between monetary policy and (Chapter 19)
financial stability (Chapter 18); and the impairment GDP-Linked Bonds (Chapter 22)
of the monetary transmission process during the cri-
sis (Chapter 23). It also reflects the sharply increased Lessons from the Crisis
threat to Fed independence under President Trump Central Counterparties and Systemic Risk
(Chapter 15). (Chapter 9)
The Three Phases of the Financial Crisis of
Updated Coverage of 2007–2009 (Chapter 14)
Current Events
Overall, nearly 30 of the 140 inserts in the previous edi- Supplements for
tion have been replaced or altered substantially. These Instructors
changes capture new developments in the key areas of
technological change, the financial crisis, inequality, The following ancillaries are available for quick
regulatory reform, and monetary policy. download and convenient access via the Instructor
Here is a partial list of the new or revised features: Resource material available through McGraw-Hill
Connect®.
Money and Banking Blog
Virtual Frenzies: Bitcoin and Blockchain
­(Chapter 2)
Solutions Manual
Banking the Masses: 2018 Edition (Chapter 3) Prepared by James Fackler (University of Kentucky)
Investing in College (Chapter 4) and Roisin O’Sullivan (Smith College), this manual
On the Distribution of Wealth (Chapter 5) contains detailed solutions to the end-of-chapter
Bond Market Liquidity: Should We Be Worried? questions—Conceptual and Analytical problems and
(Chapter 6) Data Exploration questions.
 Preface l xi

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∙ add instructions and configure default settings. AACSB qualification or evaluation, we have within
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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

digital currencies in recent years.
on housing, and 25 percent on transportation. That’s was
And, despite
done. But adjustments in wages based on fixed-
the survey information. Examples of the prices are in expenditure-weight inflation indexes like the CPI are known to
Table 2.2. Importantly, these are the prices of exactly the overcompensate people in an unintended way. This overstate-
Many people worry about the challenges their descend- What discount rate should we use to value things in the
same bundle of food, the same size and quality of housing, ment of inflation comes from what is known as substitution
ants will face. There are plenty of things to fret about, rang- distant future? For questions like this, economists usually bias. Because inflation is not uniform, the prices of some prod-
and the same transportation for each year.
ing from the threat of rising sea levels in this century to the look at market prices. ucts will increase by more than the prices of others. People can
Using the numbers in Table 2.2 we can compute the cost
long-range challenge of managing radioactive waste, Various measures suggest that the appropriate rate is in escape some of the inflation by substituting goods and ser-
of the basket of goods in each year:
which can be toxic for many thousands of years. Physicist the range of 1 to 2½ percent. For example, in recent years vices that have sustained less inflation for those that have sus-
Stephen Hawking has argued that human beings “won’t the long-term U.S. Treasury inflation-indexed bond yield has Cost of the basket in 2020 tained more. By assuming that any substitution makes people
survive another 1,000 years without escaping our fragile averaged around 1 percent. At the upper end of the range, = 0.25 × Price of food + 0.5 × Price of housing worse off, the index overstates the impact of price changes. To
planet.” research examining land leases with several hundred years + 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.
Exploring the Variety of Random
Documents with Different Content
ear-plate attached to each upright under the bar (and to which the
stanchion wires are fastened) is made of one-inch tire-iron a quarter
of an inch thick; it is bolted to the wood as shown at D in Fig. 14. A
blacksmith will make the strap and ear-plates for a small sum; and at
a hardware store staple or eye plates may be purchased and
screwed to the floor, into which the turn-buckles can be caught.
Four turn-buckles and some stout wire form the stanchions; and
the floor-plates should be located so that they not only brace the
structure forward and backward, but also from side to side, as may
be seen at the right side of Fig. 13. If the plates are five feet apart,
they should be eighteen inches out from each upright.

Fig. 13. Fig. 14.

The particular advantage of this bar over a swinging one lies in its
absolute rigidity. Also, when not in use, it may be cleared away by
loosening the turn-buckles and unhooking them, lifting the pins out of
the floor and carrying off the frame bodily.

Striking-bags

There are various kinds and shapes of striking-bags to be had at

the shops, but a converted Rugby football will answer very well for
home use. Remove the bladder and sew two large bone buttons to
the leather cover at each end, as shown in Fig. 15. The bladder
should then be replaced, inflated, and the cover laced up tightly.
Leather straps, in the ends of which button-holes have been
made, are caught over the buttons to form loops to which the ends of
the suspension and draw ropes are attached. These straps are
reinforced with a patch of leather sewed at the middle, as shown in
Fig. 16. The patches will strengthen the straps and prevent them
from stretching too much when the ropes are drawn taut.
Between the ball and the floor a spring, or some stout rubber
bands, should be placed so as to make the ball rebound quickly
when struck.
The portable striking-bag (Fig. 17) is attached to the top of a staff,
and is made of leather or canvas and stuffed with paper wads. Or a
bladder, inflated the same as a football, may be used. The bag or
cover for a bladder should be made of strips of leather or canvas
sewed together. The inflated bag is then covered by a stout leather
cap. Straps of canvas or leather are sewed to this cap and brought
down below the bag, where they are attached to the staff with a
thong or cord, as shown in Fig. 17.
 STRIKING-BAGS

Fig. 15. Fig. 16. Fig. 17.

The regulation portable bags are mounted on an iron base, but in

our home-made apparatus a plate of hard-wood will have to answer.
From oak, ash, or other hard-wood, two inches thick, cut a base
fifteen inches square, and round off the edges on the upper side.
Make a hole in each corner through which to pass a screw, and a
large hole at the middle to receive a spiral spring. The staff (about
the size of a broomstick) is screwed down into the top of the spring
for five or six inches, or enough to hold it securely; and at the bottom
the spring is held in the block with screws or nails driven through the
wires of the spring and into the wooden base.
When using the bag it should be fastened to the floor with two or
three screws, so that it will not topple over. As it is struck it bends
over from the bottom, and the spring, if stiff enough, will cause it to
immediately rebound or come to an erect position.
A striking-bag and disk, like the one shown in Fig. 18, may be
made from wood and leather, a few thumb-nuts, and a pair of
braces. To make the adjustable disk, obtain two pieces of white-
wood or pine three inches wide, two feet long, and one and a quarter
inches in thickness. Also two other pieces, each an inch thick, three
inches wide, and thirty inches long. The first pieces are the wall-
plates, and laps are to be cut one and a half inches in from each
end, as shown in Fig. 19, to receive the upright pieces.
In the middle of each lap a bolt two and a half inches long is to be
set. This projects through a slot cut in the upright pieces, and at the
outer end of the bolt a thumb-nut and washer will make it possible to
clamp the uprights fast to the wall-plates, so that the disk may be
raised or lowered to any required position.
Two slots, as wide as the thickness of the bolts, are cut in each
upright with a bit and compass-saw; and on the uncut space, at the
middle of the frame, a disk twenty-one inches wide and twenty-six
inches long is made fast with screws and short angle-brackets
attached to the under side of the rear corners. This disk should be
made of hard-wood one and a half inches in thickness, and it is
braced from above with two irons that extend from the top of the disk
to the upper ends of the uprights. A blacksmith will make these for a
few cents each, and they, as well as the other hardware, should be
painted black to give them a good appearance.
 Fig. 18. Fig. 19. Fig. 20. Fig. 21.

The bag is shaped like an inverted balloon, and is made of six

pieces of leather, or canvas, five and a half inches wide and fifteen
inches long, sewed together at the edges. Each piece should be
shaped as in Fig. 17, and when they are sewed together a round cap
should be made fast to the large extremity to secure the ends of the
side-pieces. A patch is sewed along the edges of two sides to
strengthen them and to pass the lacings through, as shown at the
lower left-hand side of Fig. 20. This method of construction gives an
opening through which to pass a filling of rubber scraps and bits of
leather. If a rubber bladder is to be inserted and inflated, this opening
will not be required, for the bladder, when collapsed, may be pushed
into the opening at the neck.
One inch below the top of the neck some slits are to be made in
the leather, through which the throat-laces are interwoven, as shown
in Fig. 21. After the knot at the end of the suspension-rope has been
inserted in the throat of the bag, the laces are drawn tight and tied.
This is the best means of attaching the bag to the rope from which it
is suspended; and by means of a hollow stick, which projects down
five inches below the under side of the disk, the bag may be centred
and held rigidly. As a result it flies up at varying angles from this
centre-drop when struck from different sides.
The suspension-stick may be made from a piece of inch-and-a-
half curtain-pole, the hole being bored out with a bit. The stick should
be inserted through a hole made in the disk eleven inches in from
the outer or projecting edge. It should be of such a size that it will be
necessary to drive the stick in with a mallet to make it fit snugly. A
coat or two of white paint will finish the wood-work nicely, or it may
be given a coat of varnish.

A Medicine-ball

A medicine-ball should be ten inches in diameter, and should

weigh from three or four to six or eight pounds, according to the size
of the boys and girls who use it. The case of a round football may be
used, or a leather case may be made of six pieces and two ends, so
that it will lace up, as shown in Fig. 22. The case is stuffed with small
balls made of pebbles or small stones wrapped in newspaper. The
newspaper makes a soft cushion, and does not allow the hard edges
of the stones to come in contact with the leather. Larger or smaller
stones may be used according to the weight desired, or sand
wrapped in paper may be used in place of the stones.
 Fig. 22. Fig. 23. Fig. 25. Fig. 26.

If the case is to be made, obtain some russet leather from a

shoemaker and cut six pieces, fourteen inches long and six inches
wide, as shown in Fig. 23. With doubled linen thread sew the edges
together so that the seam is at the inside, as shown at the lower end
of Fig. 23. Reinforce two sides of adjoining strips with a patch of
leather sewed securely all around the edges and through the middle.
Punch holes along the patch half an inch from the edge, through
which to lace the draw-strings, as shown at the left-hand side of Fig.
23. At the open ends of the leather case sew on circular patches,
four inches in diameter, to securely hold the ends of the six leather
sides. The case will then be ready for the filling.
By substituting a bladder for the filling, this medicine-ball may be
used as a volley-ball. The volley-ball is played over a net, either in
the “gym” or out-of-doors, in a fashion similar to Badminton. It may
be played by any number of persons at the same time, the object
being to keep the ball in motion over the high net.

Pulley-weights and Exercisers

No apparatus for home exercise covers the field so generally and

thoroughly as the chest-weights, or pulley-weights. No instructions
are necessary, for the boy who uses the apparatus can follow his
own idea for strokes, and every muscle in the body may be easily
and pleasantly exercised, there being sufficient variation in the
movements to relieve them of monotony.
 An exerciser similar to the one in Fig. 24 may be constructed out
of a piece of plank, two pulleys, a pair of sash-weights, and some
cotton rope or clothes-line.
fig. 24.—an exercising weight
 Obtain a piece of pine or spruce plank twelve or fourteen inches
wide, five feet long, and one and a quarter inches thick; also another
piece to form the foot, so that it will project six inches from the base
of the plank. Two blocks of wood, four inches long, two inches wide,
and an inch thick, will be necessary for the pulleys to swing on.
Attach these to the upper end of the plank by means of hinges, as
shown in Fig. 25. They should stand out from the board, and in from
the edges, the distance of the width of the hinge-leaf, as also shown
in Fig. 25. Plate-pulleys are screwed fast to the front edges of these
blocks, through which the ropes pass that raise the weights.
The foot-board should be padded with hair or excelsior and
covered with leather or burlap, so that the weights may drop on it
without making any noise.
From two old tin pails remove the handles and bend the wires
around so that a rope may be passed through the eyes at the ends,
as shown in Fig. 26. At a hardware store purchase a pair of five-
pound sash-weights, and pass the rope ends through the eyes. They
should then be spliced or bound with fine line. When the ropes are
reeved through the pulleys, a knot should be made in each one, so
that it will chock in the top of the pulley and allow the weights to just
reach and lightly rest upon the foot-pad. Therefore, when the
handles are released the weights will not fall about on the floor as
they would otherwise do. The ropes should be about five feet long
from the eyes of the weights to the handles. That is quite sufficient to
give a good long stroke while bending the body forward or from side
to side.
This exerciser may be screwed fast to the rail that should extend
all around the “gym,” and also into the floor at the foot to steady it.
Lighter or heavier weights may be employed, as the strength of the
boy will warrant, but light weights are preferable to heavy ones for
continued use.

An Attic Gymnasium
 In Fig. 27 a good idea is given for the arrangement of an attic
gymnasium; it shows the locations of the paraphernalia in a room
about fourteen by sixteen feet. A smaller room may be arranged in a
somewhat similar manner, but each piece of apparatus must be
cleared away directly it is out of use.

Fig. 27.

Across the top of the room, from a window-casing to a batten

screwed fast to the opposite wall, a ladder may be suspended. Over
the window-casing it would be well to attach a batten, so that the
ladder will not spring out of place. A rope hanging from one end will
make it possible to reach the rings.
A strip or band of wood four or five inches wide should be nailed
all around the room four feet above the floor, against which to place
parts of the gymnasium equipment, and on which to hang dumb-
bells, Indian clubs, wands, and ball-bars, as shown in the illustration.
Under the trapeze or rings it is well to place an old mattress, a
useful thing in the event of a fall. If the room is wide enough, double
sets of hooks may be driven in the ceiling-beams from which both a
flying trapeze and rings may be suspended. When one or the other
is in use, the extra apparatus may be drawn up or to one side of the
room. A light room is always more cheerful than a dark one, and
plenty of ventilation is necessary in the home gymnasium.
 Chapter XVII
A MINIATURE THEATRE

A miniature theatre, equipped with curtain, flies, drops, wings, and

several good sets of scenery, is an unfailing source of interest and
amusement. It has long been popular in Paris even as a professional
form of entertainment. Fig. 1 gives the front elevation of a miniature
theatre; and Fig. 2, a side view, illustrates the location of the working
parts, and the manner of arranging the wings, drops, and flies.

Fig. 1.
 This theatre must be made of such a size that when it is placed at
one end of a room the audience will have a good view of the fore,
middle, and back ground. A good size for the stage is four feet wide
and five feet long over all, the front being slightly curved, as shown
at B in Fig. 3. The proscenium should be four feet wide, three feet
high, and with a sight-opening three feet wide and thirty inches high.
The proscenium is made from three boards seven inches wide and
seven-eighths of an inch thick. The upper corners are bevelled and
mitred, so that the inner edges will be recessed, as shown in the
plan drawing Fig. 3 A A. The top-rails are caught at the front to the
top of the proscenium with screws, and are supported at the rear and
middle by uprights, the lower ends of which are let into the sides or
edge of the stage, and then made fast with glue and screws, as
shown at C C C C in Fig. 3. Cross-braces at the back and middle of
the top are screwed to the top-rails for strength. Bracket or brace
pieces are caught at the rear of the last rail and to the rear of the last
uprights midway between stage and top, and are made fast with glue
and screws, as shown in Fig. 4. These will hold the framework
securely in position.
Gas, electric light, or candles may be used for the footlights. If gas
is employed a small pipe should run along under the front of the
stage. Over this pipe a tin cornice is arranged with holes made
through it every three inches. These holes should be just large
enough to admit gas-jets which project through it, as shown in Fig. 5.
The supply of gas can be controlled at one side by means of a key,
so that the lights may be lowered or turned up full. If candles are
used they should be arranged on a board, so that as they burn lower
and lower the board can be raised. If electric lights are available,
they are the best of all, since the danger of fire is reduced to a
minimum. The small sockets, wire, and lamps used for Christmas-
trees can be employed, and will give very good results.

Scenery and Equipment

After the constructional work of the stage and frame is complete, it

will be necessary to make the scenery and equipment. It will be best
to have two curtains, the first a fancy one which can be painted on
muslin or a window-shade. Window-shades come printed with
pictures on them, and these can be strengthened with oil paints
diluted or thinned with benzine. A very pretty outer curtain can be
made from a printed Japanese silk panel, such as are for sale in the
art and dry goods-stores. This can be sewed on a plain piece of
goods, and the upper end made fast to a shade-roller, as shown in
Fig. 9. The main curtain may be of denim, stout muslin, or any
suitable cloth or fabric. It is nailed to a round stick (a curtain-pole is
preferable), which is cut at the ends as shown in Fig. 6. The draw-
string is wound in this groove, and so the curtain is raised and
lowered. The shade-roller curtain is the outer one, and is attached to
the frame at the top, and just back of the proscenium, as shown at B
in Fig. 2. The main curtain is just inside the outer one, and is made
fast to a stick near the outer curtain-roller. When down, the roller
rests on the stage just back of the proscenium, as shown at C in Fig.
2. When the curtain is rolled up to the top of the proscenium-
opening, a few turns of cord are taken about each end of the roller in
the groove. The cords then pass through screw-eyes to the back of
the stage-frame, where they can be held on a small cleat. Both cords
pass through the same eyes, so that the pair of strings may be
operated by one hand. The drop-curtains at the back of the stage are
painted on window-shades, the rollers of which are hung on blocks
at the under side of the top-rails and close to the rear uprights, as
shown at A A A in Fig. 2.
 DETAILS OF STAGE

Fig. 2. Fig. 3. Fig. 4. Fig. 5.

The flies are strips of muslin painted to represent sky in out-door

scenes and ceilings in interior sets. The flies are tacked on a stick,
the ends of which project beyond the body part of the fly so that they
may rest on the top-rails of the stage-frame, as shown in Fig. 7. The
fly part drops down two or three inches below the upper framework,
so as to be visible to the spectators. The wings are of card-board or
stiffened muslin tacked on frames, the bottoms of which rest on the
stage. The upper part is held between the runners, or cross-rails,
fastened to the under side of the top-rails, as shown in Figs. 1 and 2.
The front and back of a wing is shown at Fig. 8. The front, A, is the
smooth side on which the tree or other feature can be painted. The
back, B, shows how the frame is made to support this piece of
scenery. The frame should be constructed of pine sticks three-
quarters of an inch wide and half an inch thick. Where they cross
each other laps should be cut out of each piece, so that one will lie
flat in the lap of the other. The surfaces of all the sticks being on one
plane, the frame offers a flat surface for the material to back against.
An independent piece of scenery, such as the house, tree, fence,
and bushes shown in Fig. 10, will have to be built upon a frame, and
a foot must be provided so that it will stand on the stage independent
of any top, bottom, or side braces. The manner of doing this is
shown in Fig. 11, the two feet being “loaded” with pieces of lead at
the ends of the feet so that the house cannot topple forward. Very
pretty scenes can be made from card-board and of stiffened goods,
such as crinoline, over which the painting can be done. Books,
magazines, and photographs can be drawn on to offer suggestions
for scenery and interiors, and the smart boy, who has some idea of
perspective, can design and make some most attractive stage-
settings for this miniature theatre.

The Puppets

The actors and actresses should be celluloid or papier-maché

dolls, their feet being attached to thin strips of wood, which can lie
flat on the stage and be operated from the sides. When the stage is
on a line with the eyes of the audience, these thin strips will hardly
be noticed. Jointed dolls may be used for the actors who have
occasion to sit during the performance, but it is difficult to bring about
the change of posture without destroying the illusion. Trap doors and
other pieces of stage machinery may be added as found necessary,
and there is no limit to the ingenuity that may be exercised in
equipping our miniature stage.

SCENERY SETS

Fig. 7. Fig. 8. Fig. 9. Fig. 10. Fig. 11.

Of course the speaking parts are taken by boy and girl performers,
who stand on either side of the stage, and are concealed from the
view of the spectators by screens or curtains. The stage-manager
and his assistant stand still closer in, so as to manipulate the
puppets. A curtain-bell arranged under the stage, and rung by a
knocker or electric apparatus, adds to the realism.
This theatre is to be mounted on two horses, and it must so be
screened off that nothing is visible but the proscenium, fore-stage,
and footlights. This curtaining may be done with heavy muslin, or
Canton flannel of dark color, or any material through which light will
not show.
 Chapter XVIII
FITTING UP A BOY’S ROOM

When once a boy realizes what may be done in the way of fitting
up his den or room, he is sure to take an interest in the subject. A
certain amount of manual skill and artistic feeling are, of course,
desirable, but these qualities may be cultivated, and to a much
greater extent than one would at first be willing to believe.
The color schemes, designs, and general suggestions in artistic
handicraft that may be carried out in fitting up a boy’s room are
almost without limit; but the following ideas are all practical, and the
illustrations and explanations should enable the young craftsman to
get satisfactory results at the minimum of labor and expense.
In the selection of woods from which to build furniture, the natural
product of the locality in which the boy lives must be taken into
consideration. Some States grow pine, white-wood (cottonwood),
poplar, or cypress, while in others spruce, hemlock, maple, and fir
will be found easier to obtain. In the Far West, gumwood, redwood,
cedar, and cypress form the staple supply. The cost of the wood is a
matter to be considered, and often the more artistic result may be
secured by using an inexpensive wood, since the beautiful grain of
the finer varieties can only be brought out by the skilled and
experienced workman. Many woods have an open and broad grain
that, if carefully filled and varnished over, will give a very pleasing
effect. Chestnut, butternut, quartered oak, and ash have this quality,
and all of them are adapted to furniture construction and room
trimmings. For chairs and other furniture, spruce, apple-wood, and
cypress will give good results; and all of them have a pretty grain
when stained and varnished. Ash is harder, and makes good, solid
furniture. If not found too difficult to work, it will prove a very
satisfactory and serviceable wood for chairs, tables, benches, and
other pieces of furniture that are subjected to hard usage.
In the construction of the various pieces of furniture illustrated, the
simple rules of carpentry are to be followed, and only the lap,