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

SIXTH EDI TIO N

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

Stephen G. Cecchetti
Brandeis International Business School

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

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

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

To my wife, Elvira Pratsch, who continues to teach me what is true, good, and
beautiful.
Kermit L. Schoenholtz
About the Authors

Stephen G. Cecchetti is 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
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

Test Bank support your assurance of learning initiatives with a

simple, yet powerful solution.
The revised test bank includes more than 2,500 Instructors can use Connect to easily query for
multiple-choice and 600 short-answer and essay learning outcomes/objectives that directly relate to the
questions. The test bank can be used both as a study learning objectives of your course. You can then use
guide and as a source for exam questions. It has been the reporting features of Connect to aggregate student
computerized to allow for both selective and random results in similar fashion, making the collection and
­generation of test questions. presentation of assurance of learning data simple
and easy.
Test Builder
Available within Connect, Test Builder is a cloud-
based tool that enables instructors to format tests AACSB Statement
that can be printed or administered within an LMS. McGraw-Hill Global Education is a proud corporate
Test Builder offers a modern, streamlined interface member of AACSB International. Understanding
for easy content configuration that matches course the importance and value of AACSB accreditation,
needs, without requiring a download. Money, Banking, and Financial Markets has sought
Test Builder allows you to: to recognize the curricula guidelines detailed in the
∙ access all test bank content from a particular AACSB standards for business accreditation by con-
title. necting questions in the text and test bank to the
∙ easily pinpoint the most relevant content general knowledge and skill guidelines found in the
through robust filtering options. AACSB standards.
The statements contained in ­Money, Banking, and
∙ manipulate the order of questions or scramble Financial Markets are provided only as a guide for
questions and/or answers. the users of this text. The AACSB leaves content cov-
∙ pin questions to a specific location within a test. erage and assessment within the purview of individ-
∙ determine your preferred treatment of algorith- ual schools, the mission of the school, and the faculty.
mic questions. While Money, Banking, and Financial Markets and
∙ choose the layout and spacing. the teaching package make no claim of any specific
∙ add instructions and configure default settings. AACSB qualification or evaluation, we have within
Money, Banking, and Financial Markets labeled
Test Builder provides a secure interface for bet- questions according to the general knowledge and
ter protection of content and allows for just-in-time skills areas.
updates to flow directly into assessments.

PowerPoint Slides McGraw-Hill Customer Care

Updated presentation slides outline the main points
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This handy, colorful supplement can be edited, printed, At McGraw-Hill, we understand that getting the most
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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.
Acknowledgments

I owe thanks to many more people than I can ­possibly student who has sat in a classroom with me. Several
list, including a large number of academics, central deserve special mention for the time and effort they
bankers, and financial market participants around put into helping with the manuscript: Margaret Mary
the world. A few of these deserve special mention. McConnell of the Federal Reserve Bank of New York,
I would like to thank Robert M. Solow, who set Roisin O’Sullivan of Smith College, Stefan Krause for-
me on the path doing economics as a 20-year-old merly of the Banque de France, Lianfa Li of Peking
undergraduate; George A. A ­ kerlof, whose inspiration University, Craig Evers of Brevan Howard, and
still guides me, even more than 35 years after he Georgios Karras of the University of Illinois at Chicago.
signed my dissertation; William J. McDonough, who And finally, there is my family; my wife, Ruth, and
gave me the opportunity to watch and ask questions our sons, Daniel and Ethan. For years they put up with
from inside the Federal Reserve; Peter R. Fisher, who my daily routine of writing, rewriting, and rewriting
was my day-to-day guide to what I was seeing during again and again. To them I owe the biggest thanks.
my time at the Fed; and Jaime Caruana and Hervé
­Hannoun, whose patience and understanding helped
me appreciate the global central bank community. Stephen G. Cecchetti
Of my numerous collaborators and colleagues Brandeis International Business School
over the years, Nelson Mark (now at the University
of Notre Dame) is the most important. In addition,
­Michael Bryan has been a constant source of help There is not enough space here to thank the many
and encouragement, as have numerous friends people who taught me about financial markets and
throughout the central banking world. ­institutions during my more than two decades of
Among all of the professional colleagues who work as a market economist, but a few deserve spe-
took the time to read early versions of the manu- cial mention. Hugh Patrick was an inspiration in
script, I would like to single out Jim Fackler for his graduate school and remains a friend and guide. In
insight and patience. This book is much better for the the financial markets, I benefited especially from the
time he generously devoted to correcting my logical wisdom of Henry Kaufman and the economists he
mistakes and helping ensure that the exercises would gathered at S ­ alomon Brothers in the 1980s—Richard
reinforce the lessons in each chapter. Berner, Robert ­ D iClemente, John Lipsky, and
Without all the people at McGraw-Hill this book ­Nicholas Sargen. The members of the economics
would never have been written. Gary Burke and Paul team that I was privileged to lead at Salomon (and
Shensa first convinced me that I could write this book, later at Citi) continued my education, including
and then taught me how. Erin Strathmann worked tire- (among many others) Lewis A ­ lexander, Robert
lessly (and daily) to improve the book. Betty Morgan D iClemente, Don Hanna, Michael Saunders,
­
made my sentences and paragraphs readable. And all ­Christopher ­Wiegand, and Jeffrey Young.
of the people in production and design turned the I also owe an extraordinary debt to my colleagues
words and charts into a beautiful, readable book. Start- at the New York University ­Leonard N. Stern School
ing with the third edition, Gregg Forte has made of Business, who welcomed me, gave me the privi-
notable contributions through his skilled editing of the lege of teaching excellent students, and entrusted me
manuscript. And, for the last three editions, Christina with the honor of directing Stern’s ­Center for Global
Kouvelis has done the hard work of ensuring everyone Economy and Business (www.stern.nyu.edu/cgeb).
maintained the high standard. For their sustained ­support and guidance, I thank for-
Without students, universities would not exist. And mer Deans Thomas Cooley and Peter Henry, current
without a class in money and banking to teach, I would Dean Rangarajan Sundaram, former Vice Dean Ingo
not have written this book. I owe a debt to every Walter, and the distinguished current and former
xv
xvi l Acknowledgments

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

Reviewers
Thank you to the following contributing reviewers for this and previous editions.
Burton Abrams James Butkiewicz
University of Delaware University of Delaware
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Thomas Martin Allen Bolong Cao
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Robert Boatler Seija Doolittle
Texas Christian University Delaware Technical Community College at Wilmington
Christa Bouwman David Doorn
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Bowie State University William Patterson University
 Acknowledgments l xvii

Paul Emberton Chris Kauffman

Texas State University University of Tennessee at Knoxville
Robert Eyler Andrew Kayanga
Sonoma State University Dillard University
Gregory Fallon Kathy Kelly
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California State University at Sacramento Wabash College
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Texas Technical University University of Central Florida
xviii l Acknowledgments

Kyoko Mona Souren Soumbatiants

Bernard M. Baruch College Franklin University
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Brigham Young University Louisiana State University at Baton Rouge
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Grand Valley State University Campbell University
Robert Sonora
Fort Lewis College
Brief Contents

Part I Money and the Financial System

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

Part II Interest Rates, Financial Instruments, and Financial Markets

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

Part III Financial Institutions

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

Part IV Central Banks, Monetary Policy, and Financial Stability

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

Part V Modern Monetary Economics

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

xix
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Contents

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

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

Lessons from the Crisis 9 Financial Instruments 46

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

xxiii
xxiv l Contents

Financial Institutions 63 Reducing Risk through Diversification 116

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

CHAPTER 7 THE RISK AND TERM STRUCTURE Key Terms 206

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

The Demand for Dollars 251 CHAPTER 12 DEPOSITORY INSTITUTIONS:

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

CHAPTER 14 REGULATING THE FINANCIAL Low, Stable Inflation 400

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

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

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

Mechanics of Exchange Rate Management 528 Targeting Money Growth:

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

Sterilized Intervention 531 Key Terms 573

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

Data Exploration 611 CHAPTER 23 MODERN MONETARY POLICY

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

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

Applying the Concept: Applying the Concept:

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

Money and Banking Blog: Lessons from the Crisis:

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

Chapter 23 Applying the Concept:

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

An Introduction to Money
and the Financial System

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

LO2 Identify the five core principles of money and banking.

LO3 Describe the special features and organization of the book.

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

*LO, Learning Objective.

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

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

The Six Parts of the Financial System

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

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

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

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

The Five Core Principles of Money and Banking

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

Core Principle 1: Time Has Value

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

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

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

Core Principle 2: Risk Requires Compensation

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

Core Principle 3: Information Is the Basis for Decisions

Most of us collect information before making decisions. The more important the deci-
sion, the more information we gather. Think of the difference between buying a $5
Exploring the Variety of Random
Documents with Different Content
Man. Base—
Ver. Damned—
Man. Covetous—
Ver. Mercenary whore.—[Aside.] I can hardly hold from laughing.
Man. Ay, a mercenary whore indeed; for she made me pay her
before I lay with her.
Ver. How!—Why, have you lain with her?
Man. Ay, ay.
Ver. Nay, she deserves you should report it at least, though you have
not.
Man. Report it! by Heaven, 'tis true!
Ver. How! sure not.
Man. I do not use to lie, nor you to doubt me.
Ver. When?
Man. Last night, about seven or eight of the clock.
Ver. Ha!—[Aside.] Now I remember, I thought she spake as if she
expected some other rather than me. A confounded whore, indeed!
Man. But what, thou wonderest at it! nay, you seem to be angry too.
Ver. I cannot but be enraged against her, for her usage of you:
damned infamous, common jade!
Man. Nay, her cuckold, who first cuckolded me in my money, shall
not laugh all himself: we will do him reason, shan't we?
Ver. Ay, ay.
Man. But thou dost not, for so great a friend, take pleasure enough
in your friend's revenge, methinks.
Ver. Yes, yes; I'm glad to know it, since you have lain with her.
Man. Thou canst not tell who that rascal, her cuckold, is?
Ver. No.
Man. She would keep it from you, I suppose.
Ver. Yes, yes.
Man. Thou wouldst laugh, if thou knewest but all the circumstances
of my having her. Come, I'll tell thee.
Ver. Damn her! I care not to hear any more of her.
Man. Faith, thou shalt. You must know—
Re-enter Freeman backwards, endeavouring to keep out Novel, Lord
Plausible, Jerry Blackacre, and Major Oldfox, who all press upon him.
Free. I tell you he has a wench with him, and would be private.
Man. Damn 'em! a man can't open a bottle in these eating-houses,
but presently you have these impudent, intruding, buzzing flies and
insects in your glass.—Well, I'll tell thee all anon. In the mean time
prithee go to her, but not from me, and try if you can get her to lend
me but a hundred pounds of my money, to supply my present
wants; for I suppose there is no recovering any of it by law.
Ver. Not any: think not of it. Nor by this way neither.
Man. Go try, at least.
Ver. I'll go; but I can satisfy you beforehand it will be to no purpose.
You'll no more find a refunding wench—
Man. Than a refunding lawyer; indeed their fees alike scarce ever
return. However, try her; put it to her.
Ver. Ay, ay, I'll try her; put it to her home with a vengeance. [Exit.
Nov. Nay, you shall be our judge, Manly—Come, major, I'll speak it to
your teeth; if people provoke me to say bitter things to their faces,
they must take what follows; though, like my lord Plausible, I'd
rather do't civilly behind their backs.
Man. Nay, thou art a dangerous rogue, I've heard, behind a man's
back.
L. Plau. You wrong him sure, noble captain; he would do a man no
more harm behind his back than to his face.
Free. I am of my lord's mind.
Man. Yes, a fool, like a coward, is the more to be, feared behind a
man's back, more than a witty man; for as a coward is more bloody
than a brave man, a fool is more malicious than a man of wit.
Nov. A fool, tar,—a fool! nay, thou art a brave sea-judge of wit! a
fool! Prithee when did you ever find me want something to say, as
you do often?
Man. Nay, I confess thou art always talking, roaring, or making a
noise; that I'll say for thee.
Nov. Well, and is talking a sign of a fool?
Man. Yes, always talking, especially too if it be loud and fast, is the
sign of a fool.
Nov. Pshaw! talking is like fencing, the quicker the better; run 'em
down, run 'em down, no matter for parrying; push on still, sa, sa,
sa! No matter whether you argue in form, push in guard or no.
Man. Or hit or no; I think thou always talkest without thinking,
Novel.
Nov. Ay, ay; studied play's the worse, to follow the allegory, as the
old pedant says.
Old. A young fop!
Man. I ever thought the man of most wit had been like him of most
money, who has no vanity in showing it everywhere, whilst the
beggarly pusher of his fortune has all he has about him still only to
show.
Nov. Well, sir, and make a pretty show in the world, let me tell you;
nay, a better than your close hunks. A pox, give me ready money in
play! what care I for a man's reputation? what are we the better for
your substantial thrifty curmudgeon in wit, sir?
Old. Thou art a profuse young rogue indeed.
Nov. So much for talking, which, I think, I have proved a mark of
wit; and so is railing, roaring, and making a noise; for railing is
satire, you know; and roaring and making a noise, humour.
Re-enter Fidelia; she takes Manly aside, and shows him a paper.
Fid. The hour is betwixt seven and eight exactly: 'tis now half an
hour to six.
Man. Well, go then to the Piazza, and wait for me: as soon as it is
quite dark, I'll be with you. I must stay here yet a while for my
friend.—[Exit Fidelia.] But is railing satire, Novel?
Free. And roaring and making a noise, humour?
Nov. What, won't you confess there's humour in roaring and making
a noise?
Free. No.
Nov. Nor in cutting napkins and hangings?
Man. No, sure.
Nov. Dull fops!
Old. O rogue, rogue, insipid rogue!—Nay, gentlemen, allow him
those things for wit; for his parts lie only that way.
Nov. Peace, old fool! I wonder not at thee; but that young fellows
should be so dull, as to say there's no humour in making a noise,
and breaking windows! I tell you there's wit and humour too in both;
and a wit is as well known by his frolic as by his smile.
Old. Pure rogue! there's your modern wit for you! Wit and humour in
breaking of windows: there's mischief, if you will, but no wit or
humour.
Nov. Prithee, prithee, peace, old fool! I tell you, where there's
mischief, there's wit. Don't we esteem the monkey a wit amongst
beasts, only because he's mischievous? and, let me tell you, as
good-nature is a sign of a fool, being mischievous is a sign of a wit.
Old. O rogue, rogue! pretend to be a wit, by doing mischief and
railing!
Nov. Why, thou, old fool, hast no other pretence to the name of a
wit, but by railing at new plays!
Old. Thou, by railing at that facetious noble way of wit, quibbling!
Nov. Thou callest thy dulness gravity; and thy dozing, thinking.
Old. You, sir, your dulness, spleen; and you talk much and say
nothing.
Nov. Thou readest much, and understandest nothing, sir.
Old. You laugh loud, and break no jest.
Nov. You rail, and nobody hangs himself; and thou hast nothing of
the satire but in thy face.
Old. And you have no jest, but your face, sir.
Nov. Thou art an illiterate pedant.
Old. Thou art a fool with a bad memory.
Man. Come, a pox on you both! you have done like wits now: for
you wits, when you quarrel, never give over till ye prove one another
fools.
Nov. And you fools have never any occasion of laughing at us wits
but when we quarrel. Therefore let us be friends, Oldfox.
Man. They are such wits as thou art, who make the name of a wit as
scandalous as that of bully: and signify a loud-laughing, talking,
incorrigible, coxcomb, as bully a roaring hardened coward.
Free. And would have his noise and laughter pass for wit, as t'other
his huffing and blustering for courage.
Re-enter Vernish.
Man. Gentlemen, with your leave, here is one I would speak with;
and I have nothing to say to you. [Puts all out of the room except
Vernish.
Ver. I told you 'twas in vain to think of getting money out of her. She
says, if a shilling would do't, she would not save you from starving
or hanging, or what you would think worse, begging or flattering;
and rails so at you, one would not think you had lain with her.
Man. O, friend, never trust for that matter a woman's railing; for she
is no less a dissembler in her hatred than her love; and as her
fondness of her husband is a sign he's a cuckold, her railing at
another man is a sign she lies with him.
Ver. He's in the right on't: I know not what to trust to. [Aside.
Man. But you did not take any notice of it to her, I hope?
Ver. So!—Sure he is afraid I should have disproved him by an inquiry
of her: all may be well yet. [Aside.
Man. What hast thou in thy head that makes thee seem so unquiet?
Ver. Only this base impudent woman's falseness; I cannot put her
out of my head.
Man. O, my dear friend, be not you too sensible of my wrongs; for
then I shall feel 'em too with more pain, and think 'em unsufferable.
Damn her, her money, and that ill-natured whore too, Fortune
herself! But if thou wouldst ease a little my present trouble, prithee
go borrow me somewhere else some money. I can trouble thee.
Ver. You trouble me, indeed, most sensibly, when you command me
anything I cannot do. I have lately lost a great deal of money at
play, more than I can yet pay; so that not only my money, but my
credit too is gone, and know not where to borrow: but could rob a
church for you.—[Aside.] Yet would rather end your wants by cutting
your throat.
Man. Nay, then I doubly feel my poverty, since I'm incapable of
supplying thee. [Embraces him.
Ver. But, methinks, she that granted you the last favour, (as they call
it,) should not deny you anything.
Nov. [Looking in.] Hey, tarpaulin, have you done? [Retires again.
Ver. I understand not that point of kindness, I confess.
Man. No, thou dost not understand it, and I have not time to let you
know all now; for these fools, you see, will interrupt us: but anon, at
supper, we'll laugh at leisure together at Olivia's cuckold, who took a
young fellow, that goes between his wife and me, for a woman.
Ver. Ha!
Man. Senseless, easy rascal! 'twas no wonder she chose him for a
husband; but she thought him, I thank her, fitter than me, for that
blind bearing office.
Ver. I could not be deceived in that long woman's hair tied up
behind, nor those infallible proofs, her pouting swelling breasts: I
have handled too many sure not to know 'em. [Aside.
Man. What, you wonder the fellow could be such a blind coxcomb?
Ver. Yes, yes—
Nov. [Looking in again.] Nay, prithee, come to us, Manly. Gad, all the
fine things one says in their company, are lost without thee.
Man. Away, fop! I'm busy yet. [Novel retires.] You see we cannot talk
here at our ease: besides, I must be gone immediately, in order to
meeting with Olivia again to-night.
Ver. To-night! it cannot be, sure—
Man. I had an appointment just now from her.
Ver. For what time?
Man. At half an hour after seven precisely.
Ver. Don't you apprehend the husband?
Man. He! snivelling gull! he a thing to be feared! a husband! the
tamest of creatures!
Ver. Very fine! [Aside.
Man. But, prithee, in the mean time, go try to get me some money.
Though thou art too modest to borrow for thyself, thou canst do
anything for me, I know. Go; for I must be gone to Olivia. Go, and
meet me here, anon.—Freeman, where are you? [Exit.
Ver. Ay, I'll meet with you, I warrant; but it shall be at Olivia's. Sure,
it cannot be: she denies it so calmly, and with that honest modest
assurance, it cannot be true—and he does not use to lie—but
belying a woman when she won't be kind, is the only lie a brave
man will least scruple. But then the woman in man's clothes, whom
he calls a man—well, but by her breasts I know her to be a woman
—but then again, his appointment from her, to meet him again to-
night! I am distracted more with doubt than jealousy. Well, I have
no way to disabuse or revenge myself, but by going home
immediately, putting on a riding-suit, and pretending to my wife the
same business which carried me out of town last, requires me again
to go post to Oxford to-night. Then, if the appointment he boasts of
be true, it's sure to hold, and I shall have an opportunity either of
clearing her, or revenging myself on both. Perhaps she is his wench,
of an old date, and I am his cully, whilst I think him mine; and he
has seemed to make his wench rich, only that I might take her off
his hands. Or if he has but lately lain with her, he must needs
discover by her my treachery to him; which I'm sure he will revenge
with my death, and which I must prevent with his, if it were only but
for fear of his too just reproaches; for I must confess, I never had till
now any excuse but that of interest, for doing ill to him. [Exit.
Re-enter Manly and Freeman.
Man. Come hither; only, I say, be sure you mistake not the time. You
know the house exactly where Olivia lodges, 'tis just hard by.
Free. Yes, yes.
Man. Well then, bring 'em all, I say, thither, and all you know that
may be then in the house; for the more witnesses I have of her
infamy, the greater will be my revenge: and be sure you come
straight up to her chamber without more ado. Here, take the watch;
you see 'tis above a quarter past seven; be there in half an hour
exactly.
Free. You need not doubt my diligence or dexterity; I am an old
scourer, and can naturally beat up a wench's quarters that won't be
civil. Shan't we break her windows too?
Man. No, no; be punctual only. [Exeunt.

SCENE III.—A Room in the same.

Enter Widow Blackacre, and two Knights of the Post,[126] a Waiter

following with wine.
Wid. Sweetheart, are you sure the door was shut close, that none of
those roysters saw us come in?
Wait. Yes, mistress; and you shall have a privater room above,
instantly. [Exit.
Wid. You are safe enough, gentlemen; for I have been private in this
house ere now, upon other occasions, when I was something
younger. Come, gentlemen; in short, I leave my business to your
care and fidelity: and so here's to you.
1st Knight. We are ungrateful rogues if we should not be honest to
you; for we have had a great deal of your money.
Wid. And you have done me many a good job for't; and so, here's to
you again.
2nd Knight. Why, we have been perjured but six times for you.
1st Knight. Forged but four deeds, with your husband's last deed of
gift.
2nd Knight. And but three wills.
1st Knight. And counterfeited hands and seals to some six bonds; I
think that's all, brother?
Wid. Ay, that's all, gentlemen; and so, here's to you again.
2nd Knight. Nay, 'twould do one's heart good to be forsworn for you.
You have a conscience in your ways, and pay us well.
1st Knight. You are in the right on't, brother; one would be damned
for her with all one's heart.
2nd Knight. But there are rogues, who make us forsworn for 'em;
and when we come to be paid, they'll be forsworn too, and not pay
us our wages, which they promised with oaths sufficient.
1st Knight. Ay, a great lawyer that shall be nameless bilked me too.
Wid. That was hard, methinks, that a lawyer should use gentlemen
witnesses no better.
2nd Knight. A lawyer! d'ye wonder a lawyer should do't? I was bilked
by a reverend divine, that preaches twice on Sundays, and prays half
an hour still before dinner.
Wid. How! a conscientious divine and not pay people for damning
themselves! sure then, for all his talking, he does not believe
damnation. But, come, to our business. Pray be sure to imitate
exactly the flourish at the end of this name. [Pulls out a deed or two.
1st Knight. O, he's the best in England at untangling a flourish,
madam.
Wid. And let not the seal be a jot bigger. Observe well the dash too,
at the end of this name.
2nd Knight. I warrant you, madam.
Wid. Well, these and many other shifts, poor widows are put to
sometimes; for everybody would be riding a widow, as they say, and
breaking into her jointure. They think marrying a widow an easy
business, like leaping the hedge where another has gone over
before. A widow is a mere gap, a gap with them.
Enter Major Oldfox, with two Waiters. The Knights of the Post huddle
up the writings.
What, he here! Go then, go my hearts, you have your instructions.
[Exeunt Knights of the Post.
Old. Come, madam, to be plain with you, I'll be fobbed off no longer.
—[Aside.] I'll bind her and gag her but she shall hear me.—[To the
Waiters.] Look you, friends, there's the money I promised you; and
now do you what you promised me: here my garters, and here's a
gag.—[To the Widow.] You shall be acquainted with my parts, lady,
you shall.
Wid. Acquainted with your parts! A rape! a rape!—what, will you
ravish me? [The Waiters tie her to the chair, gag her, and exeunt.
Old. Yes, lady, I will ravish you: but it shall be through the ear, lady,
the ear only, with my well-penned acrostics.
Enter Freeman, Jerry Blackacre, three Bailiffs, a Constable, and his
Assistants with the two Knights of the Post.
What, shall I never read my things undisturbed again?
Jer. O la! my mother bound hand and foot, and gaping as if she rose
before her time to-day!
Free. What means this, Oldfox? But I'll release you from him; you
shall be no man's prisoner but mine. Bailiffs, execute your writ.
[Unties her.
Old. Nay, then, I'll be gone, for fear of being bail, and paying her
debts without being her husband. [Exit.
1st Bail. We arrest you in the king's name, at the suit of Mr.
Freeman, guardian to Jeremiah Blackacre, esquire, in an action of
ten thousand pounds.
Wid. How, how, in a choke-bail action! What, and the pen and-ink
gentlemen taken too!—Have you confessed, you rogues?
1st Knight. We needed not to confess; for the bailiffs have dogged
us hither to the very door, and overheard all that you and we said.
Wid. Undone, undone then! no man was ever too hard for me till
now. O Jerry, child, wilt thou vex again the womb that bore thee?
Jer. Ay, for bearing me before wedlock, as you say. But I'll teach you
call a Blackacre bastard, though you were never so much my
mother.
Wid. [Aside.] Well, I'm undone! not one trick left? no law-mesh
imaginable?—[To Freeman.] Cruel sir, a word with you, I pray.
Free. In vain, madam; for you have no other way to release yourself
but by the bonds of matrimony.
Wid. How, sir, how! that were but to sue out a habeas-corpus, for a
removal from one prison to another.—Matrimony!
Free. Well, bailiffs, away with her.
Wid. O stay, sir! can you be so cruel as to bring me under covert-
baron[127] again, and put it out of my power to sue in my own
name? Matrimony to a woman is worse than excommunication, in
depriving her of the benefit of the law; and I would rather be
deprived of life. But hark you, sir, I am contented you should hold
and enjoy my person by lease or patent, but not by the spiritual
patent called a licence; that is, to have the privileges of a husband,
without the dominion; that is, Durante beneplacito. In consideration
of which, I will out of my jointure secure you an annuity of three
hundred pounds a year, and pay your debts; and that's all you
younger brothers desire to marry a widow for, I'm sure.
Free. Well, widow, if—
Jer. What! I hope, bully-guardian, you are not making agreements
without me?
Free. No, no. First, widow, you must say no more that he is a son of
a whore; have a care of that. And, then, he must have a settled
exhibition of forty pounds a year, and a nag of assizes, kept by you,
but not upon the common; and have free ingress, egress, and
regress, to and from your maids' garret.
Wid. Well, I can grant all that too.
Jer. Ay, ay, fair words butter no cabbage: but guardian, make her
sign, sign and seal; for otherwise, if you knew her as well as I, you
would not trust her word for a farthing.
Free. I warrant thee, squire.—Well, widow, since thou art so
generous, I will be generous too; and if you'll secure me four
hundred pounds a year, but during your life, and pay my debts, not
above a thousand pounds, I'll bate you your person, to dispose of as
you please.
Wid. Have a care, sir, a settlement without a consideration is void in
law; you must do something for't.
Free. Prithee, then let the settlement on me be called alimony; and
the consideration, our separation. Come; my lawyer, with writings
ready drawn, is within, and in haste. Come.
Wid. But, what, no other kind of consideration, Mr. Freeman? Well, a
widow, I see, is a kind of sinecure, by custom of which the
unconscionable incumbent enjoys the profits, without any duty, but
does that still elsewhere. [Exeunt.

SCENE IV.—Olivia's Lodging.

Enter Olivia with a candle in her hand.

Oliv. So, I am now prepared once more for my timorous young
lover's reception. My husband is gone; and go thou out too, thou
next interrupter of love.—[Puts out the candle.] Kind darkness, that
frees us lovers from scandal and bashfulness, from the censure of
our gallants and the world!—So, are you there?
Enter Fidelia, followed softly by Manly.
Come, my dear punctual lover, there is not such another in the
world; thou hast beauty and youth to please a wife; address and wit,
to amuse and fool a husband; nay, thou hast all things to be wished
in a lover, but your fits. I hope, my dear, you won't have one to-
night; and that you may not, I'll lock the door, though there be no
need of it, but to lock out your fits: for my husband is just gone out
of town again. Come, where are you? [Goes to the door and locks it.
Man. Well, thou hast impudence enough to give me fits too, and
make revenge itself impotent; hinder me from making thee yet more
infamous, if it can be. [Aside.
Oliv. Come, come, my soul, come.
Fid. Presently, my dear, we have time enough sure.
Oliv. How, time enough! True lovers can no more think they ever
have time enough, than love enough. You shall stay with me all
night; but that is but a lover's moment. Come.
Fid. But won't you let me give you and myself the satisfaction of
telling you how I abused your husband last night?
Oliv. Not when you can give me, and yourself too, the satisfaction of
abusing him again to-night. Come.
Fid. Let me but tell you how your husband—
Oliv. O name not his, or Manly's more loathsome name, if you love
me! I forbid 'em last night: and you know I mentioned my husband
but once, and he came. No talking, pray, 'twas ominous to us.—[A
noise at the door.] You make me fancy a noise at the door already,
but I'm resolved not to be interrupted. Where are you? Come, for
rather than lose my dear expectation now, though my husband were
at the door, and the bloody ruffian Manly here in the room, with all
his awful insolence, I would give myself to this dear hand, to be led
away to heavens of joys, which none but thou canst give.—[The
noise at the door increases.] But what's this noise at the door? So, I
told you what talking would come to. Ha!—O Heavens, my
husband's voice!—[Listens at the door.
Man. [Aside.] Freeman is come too soon.
Oliv. O, 'tis he!—Then here's the happiest minute lost that ever
bashful boy or trifling woman fooled away! I'm undone! my
husband's reconcilement too was false, as my joy all delusion. But
come this way, here's a back door.—[Exit, and returns.] The officious
jade has locked us in, instead of locking others out: but let us then
escape your way, by the balcony; and whilst you pull down the
curtains, I'll fetch from my closet what next will best secure our
escape. I have left my key in the door, and 'twill not suddenly be
broken open. [Exit.
[A noise as if people were forcing the door.
Man. Stir not, yet fear nothing.
Fid. Nothing but your life, sir.
Man. We shall know this happy man she calls husband.
Re-enter Olivia.
Oliv. Oh, where are you? What, idle with fear? Come, I'll tie the
curtains, if you will hold. Here take this cabinet and purse, for it is
thine, if we escape;—[Manly takes them from her]—therefore let us
make haste. [Exit.
Man. 'Tis mine indeed now again, and it shall never escape more
from me, to you at least. [The door is broke open, enter Vernish with
a dark-lantern and a sword, running at Manly, who draws, puts by
the thrust, and defends himself, whilst Fidelia runs at Vernish behind.
Ver. So, there I'm right, sure—[In a low voice.
Man. [Softly.] Sword and dark-lantern, villain, are some odds; but—
Ver. Odds! I'm sure I find more odds than I expected. What, has my
insatiable two seconds at once? but—[In a low voice.
[Whilst they fight, Olivia re-enters, tying two curtains together.
Oliv. Where are you now?—What, is he entered then, and are they
fighting? O do not kill one that can make no defence!—[Manly throws
Vernish down and disarms him.] How! but I think he has the better
on't. Here's his scarf, 'tis he. So, keep him down still: I hope thou
hast no hurt, my dearest? [Embracing Manly.
 Enter Freeman, Lord Plausible, Novel, Jerry Blackacre, and Widow
Blackacre, lighted by the two Sailors with torches.
Ha!—what! Manly! and have I been thus concerned for him!
embracing him! and has he his jewels again too! What means this?
O, 'tis too sure, as well as my shame! which I'll go hide for ever.
[Offers to go out, Manly stops her.
Man. No, my dearest; after so much kindness as has passed
between us, I cannot part with you yet.—Freeman, let nobody stir
out of the room; for notwithstanding your lights, we are yet in the
dark, till this gentleman please to turn his face—[Pulls Vernish by the
sleeve.] How, Vernish! art thou the happy man then? thou! thou!
speak, I say; but thy guilty silence tells me all.—Well, I shall not
upbraid thee; for my wonder is striking me as dumb as thy shame
has made thee. But what? my little volunteer hurt, and fainting!
Fid. My wound, sir, is but a slight one in my arm; 'tis only my fear of
your danger, sir, not yet well over.
Man. But what's here? more strange things—[Observing Fidelia's hair
untied behind, and without a peruke, which she lost in the scuffle.]
What means this long woman's hair, and face! now all of it appears
too beautiful for a man; which I still thought womanish indeed!
What, you have not deceived me too, my little volunteer?
Oliv. Me she has, I'm sure. [Aside.
Man. Speak!
Enter Eliza and Lettice.
Eliza. What, cousin, I am brought hither by your woman, I suppose,
to be a witness of the second vindication of your honour?
Oliv. Insulting is not generous. You might spare me, I have you.
Eliza. Have a care, cousin, you'll confess anon too much; and I
would not have your secrets.
Man. Come, your blushes answer me sufficiently, and you have been
my volunteer in love. [To Fidelia.
Fid. I must confess I needed no compulsion to follow you all the
world over; which I attempted in this habit, partly out of shame to
own my love to you, and fear of a greater shame, your refusal of it;
for I knew of your engagement to this lady, and the constancy of
your nature; which nothing could have altered but herself.
Man. Dear madam, I desired you to bring me out of confusion, and
you have given me more. I know not what to speak to you, or how
to look upon you; the sense of my rough, hard, and ill usage of you,
(though chiefly your own fault,) gives me more pain now 'tis over,
than you had when you suffered it: and if my heart, the refusal of
such a woman—[Pointing to Olivia]—were not a sacrifice to profane
your love, and a greater wrong to you than ever yet I did you, I
would beg of you to receive it, though you used it as she had done;
for though it deserved not from her the treatment she gave it, it
does from you.
Fid. Then it has had punishment sufficient from her already, and
needs no more from me; and, I must confess, I would not be the
only cause of making you break your last night's oath to me, of
never parting with me; if you do not forget or repent it.
Man. Then take for ever my heart, and this with it;—[Gives her the
cabinet] for 'twas given to you before, and my heart was before your
due: I only beg leave to dispose of these few.—Here, madam, I
never yet left my wench unpaid. [Takes some of the jewels, and
offers them to Olivia; she strikes them down: Lord Plausible and
Novel take them up.
Oliv. So it seems, by giving her the cabinet.
L. Plau. These pendants appertain to your most faithful humble
servant.
Nov. And this locket is mine; my earnest for love, which she never
paid: therefore my own again.
Wid. By what law, sir, pray?—Cousin Olivia, a word. What, do they
make a seizure on your goods and chattels, vi et armis? Make your
demand, I say, and bring your trover, bring your trover. I'll follow the
law for you.
Oliv. And I my revenge. [Exit.
Man. [To Vernish.] But 'tis, my friend, in your consideration most,
that I would have returned part of your wife's portion; for 'twere
hard to take all from thee, since thou hast paid so dear for't, in
being such a rascal. Yet thy wife is a fortune without a portion; and
thou art a man of that extraordinary merit in villany, the world and
fortune can never desert thee, though I do; therefore be not
melancholy. Fare you well, sir.—[Exit Vernish doggedly.] Now,
madam, I beg your pardon [Turning to Fidelia] for lessening the
present I made you; but my heart can never be lessened. This, I
confess, was too small for you before; for you deserve the Indian
world; and I would now go thither, out of covetousness for your sake
only.
Fid. Your heart, sir, is a present of that value, I can never make any
return to't.—[Pulling Manly from the company.] But I can give you
back such a present as this, which I got by the loss of my father, a
gentleman of the north, of no mean extraction, whose only child I
was, therefore left me in the present possession of two thousand
pounds a-year; which I left, with multitudes of pretenders, to follow
you, sir; having in several public places seen you, and observed your
actions thoroughly, with admiration, when you were too much in
love to take notice of mine, which yet was but too visible. The name
of my family is Grey, my other Fidelia. The rest of my story you shall
know when I have fewer auditors.
Man. Nay, now, madam, you have taken from me all power of
making you any compliment on my part; for I was going to tell you,
that for your sake only I would quit the unknown pleasure of a
retirement; and rather stay in this ill world of ours still, though
odious to me, than give you more frights again at sea, and make
again too great a venture there, in you alone. But if I should tell you
now all this, and that your virtue (since greater than I thought any
was in the world) had now reconciled me to't, my friend here would
say, 'tis your estate that hast made me friends with the world.
Free. I must confess I should; for I think most of our quarrels to the
world are just such as we have to a handsome woman; only because
we cannot enjoy her as we would do.
Man. Nay, if thou art a plain dealer too, give me thy hand; for now
I'll say, I am thy friend indeed; and for your two sakes, though I
have been so lately deceived in friends of both sexes,—
I will believe there are now in the world
Good-natured friends, who are not prostitutes,
And handsome women worthy to be friends;
Yet, for my sake, let no one e'er confide
In tears, or oaths, in love, or friend untried.
[Exeunt.

EPILOGUE.
SPOKEN BY THE WIDOW BLACKACRE.

To you the judges learned in stage-laws,

Our poet now, by me, submits his cause;
For with young judges, such as most of you,
The men by women best their business do:
And, truth on't is, if you did not sit here,
To keep for us a term throughout the year,
We could not live by'r tongues; nay, but for you,
Our chamber-practice would be little too.
And 'tis not only the stage-practiser
Who by your meeting gets her living here:
For as in Hall of Westminster
Sleek sempstress vents amidst the courts her ware;
 So, while we bawl, and you in judgment sit,
The visor-mask sells linen too i' th' pit
O, many of your friends, besides us here,
Do live by putting off their several ware.
Here's daily done the great affairs o' th' nation
Let love and us then ne'er have long-vacation.
But hold; like other pleaders I have done
Not my poor client's business, but my own.
Spare me a word then now for him. First know,
Squires of the long robe, he does humbly show,
He has a just right in abusing you,
Because he is a Brother-Templar too:
For at the bar you rally one another;
Nay, fool and knave, is swallowed from a brother:
If not the poet here, the Templar spare,
And maul him when you catch him at the bar.
From you, our common modish censurers,
Your favour, not your judgment, 'tis he fears:
Of all love begs you then to rail, find fault;
For plays, like women, by the world are thought,
When you speak kindly of 'em, very naught.

NOTES.
[1] Correspondence between Pope and Wycherley: Letter 26. See also Letter 15.
[2] I ought to have remembered that this maxim is Rochefoucauld's. It may stand,
however, as an instance of the untrustworthiness of Wycherley's memory. See p.
xxxvi.
[3] Letters on several Occasions; published by John Dennis: London, 1696.
[4] Letters on several Occasions: p. 57.
[5] An Essay against Pride and Ambition, in the Posthumous Works.
[6] Spence's Anecdotes.
[7] From Macaulay's Essay on The Comic Dramatists of the Restoration.
[8] Daniel Wycherley, Esq., of Clive or Cleve, in Shropshire, about seven miles
north of Shrewsbury.—Ed.
[9] The dates assigned by Macaulay to the first representations of Wycherley's
plays are in every case incorrect. See the Introduction to each play.—Ed.
[10] Macaulay's version of the above story is derived from Spence's Anecdotes. It
differs entirely from Dennis's version, which is evidently the correct one, as the
former totally misses the point, and makes the Duchess guilty merely of a piece of
unmeaning rudeness. Dennis's account is as follows.—"The writing of that Play
[Love in a Wood] was the Occasion of his becoming acquainted with one of King
Charles's Mistresses after a very particular manner. As Mr. Wycherley was going
thro' Pall Mall towards St. James's in his Chariot, he met the foresaid lady in hers,
who, thrusting half her Body out of the Chariot, cry'd out aloud to him, 'You,
Wycherley, you are a Son of a Whore,' at the same time laughing aloud and
heartily.... Mr. Wycherley was certainly very much surpriz'd at it, yet not so much
but he soon apprehended it was spoke with Allusion to the latter End of a Song in
the foremention'd Play—
'Great Wits and great Braves
Have always a Punk to their Mother.'
As, during Mr. Wycherley's Surprize, the Chariots drove different ways, they were
soon at a considerable Distance from each other, when Mr. Wycherley, recovering
from his Surprize, ordered his Coachman to drive back, and to overtake the Lady.
As soon as he got over-against her, he said to her, 'Madam, you have been pleased
to bestow a title on me which generally belongs to the Fortunate. Will your
Ladyship be at the Play to-night?' 'Well,' she reply'd, 'what if I am there?' 'Why,
then I will be there to wait on your Ladyship, tho' I disappoint a very fine Woman
who has made me an Assignation.' 'So,' said she, 'you are sure to disappoint a
Woman who has favour'd you for one who has not.' 'Yes,' reply'd he, 'if she who
has not favour'd me is the finer Woman of the two. But he who will be constant to
your Ladyship, till he can find a finer Woman, is sure to die your Captive.' The
Lady blush'd, and bade her Coachman drive away.... In short, she was that Night
in the first Row of the King's Box in 'Drury Lane,' and Mr. Wycherley in the Pit
under her, where he entertain'd her during the whole Play." Dennis's Familiar
Letters, London, 1721.—Ed.
[11] This anecdote is given by Leigh Hunt on the authority of Voltaire's Letters
concerning the English Nation. But Leigh Hunt's memory appears to have played
him false. The only allusion, in Voltaire's Letters, to the connection between
Wycherley and the Duchess, is contained in the following words:—"Mr. Wycherley,
who was a long Time known publickly to be happy in the good Graces of the most
celebrated Mistress of King Charles the Second."—Ed.
[12] Wycherley accordingly journeyed into France, about the beginning of the
winter of 1678, and returned, entirely restored, at the end of the following spring.
The King received him with the utmost favour, and made choice of him as
governor to his son. It was immediately after this that Wycherley went down to
Tunbridge (in the summer of 1679), where he met the Countess of Drogheda,
whom he soon afterwards married.—Ed.
[13] Mr. Leigh Hunt supposes that the battle at which Wycherley was present was
that which the Duke of York gained over Opdam, in 1665. We believe that it was
one of the battles between Rupert and De Ruyter, in 1673.
The point is of no importance; and there cannot be said to be much evidence
either way. We offer, however, to Mr. Leigh Hunt's consideration three arguments—
of no great weight certainly—yet such as ought, we think, to prevail in the
absence of better. First, it is not very likely that a young Templar, quite unknown in
the world—and Wycherley was such in 1665—should have quitted his chambers to
go to sea. On the other hand, it would have been in the regular course of things
that, when a courtier and an equerry, he should offer his services. Secondly, his
verses appear to have been written after a drawn battle, like those of 1673, and
not after a complete victory, like that of 1665. Thirdly, in the epilogue to The
Gentleman Dancing-Master, written in 1673, he says that "all gentlemen must
pack to sea;" an expression which makes it probable that he did not himself mean
to stay behind. The epilogue to The Gentleman Dancing-Master was probably
written about the end of 1671. See the Introduction to that play.—Ed.
[14] There are no grounds whatever for this surmise.—Ed.
[15] "He lost his memory (forty years before he died) by a fever, and would repeat
the same thought, sometimes in the compass of ten lines, and did not dream of its
being inserted but just before: when you pointed it out to him, he would say,
'Gads-so, so it is! I thank you very much: pray blot it out.'"—Pope, in Spence's
Anecdotes.
Elsewhere Pope states that he was forty years of age when the illness occurred. It
is possible that this illness may have been the fever before mentioned, from which
he sought recovery by travel, in the winter of 1678; though Dennis certainly
describes him as returning "entirely restored," both in body and mind.—Ed.
[16] This assertion is wholly without foundation.—Ed.
[17] I can find no authority for this observation. It may have been spoken in a
moment of peevishness, but it is certainly very far from conveying Wycherley's real
estimate of his friend's genius.—Ed.
[18] This "strange friendship" only terminated, as has been already shown, with
Wycherley's death.—Ed.