Innovations in This Text

In addition to the focus on core principles, this book introduces a series of innovations designed to foster coherence and relevance in the study of money and banking, in both today’s financial world and tomorrow’s.

Early Introduction of Risk

It is impossible to appreciate how the financial system works without understanding risk. In the modern financial world, virtually all transactions transfer some degree of risk between two or more parties. These risk trades can be extremely beneficial, as they are in the case of insurance markets. But there is still potential for disaster. In 1998, risk-trading activity at Long-Term Capital Management (LTCM) threatened the stability of the international financial system.

Even though risk is absolutely central to an understanding of the financial system, most money and banking books give very little space to the topic. In contrast, this book devotes an entire chapter to defining and measuring risk. Chapter 5 introduces the concept of a risk premium as compensation for risk and shows how diversification can reduce risk. Because risk is central to explaining the valuation of financial instruments, the role of financial intermediaries, and the job of central bankers, the book returns to this concept throughout the chapters.

Emphasis on Financial Instruments

Financial instruments are introduced early in the book, where they are defined based on their economic function. This approach leads naturally to a discussion of the uses of various instruments and the determinants of their value. Bonds, stocks, and derivatives all fit neatly into this framework, so they are all discussed together.

This approach solves one of the problems with existing texts, use of the term financial market to refer to bonds, interest rates, and foreign exchange. In its conventional microeconomic sense, the term market signifies a place where trade occurs, not the instruments that are traded. This book follows standard usage of the term market to mean a place for trade. It uses the term financial instruments to describe virtually all financial arrangements, including loans, bonds, stocks, futures, options, and insurance contracts. Doing so clears up the confusion that can arise when students arrive in a money and banking class fresh from a course in the principles of economics.

Parallel Presentation of the Federal Reserve and the European Central Bank

To foster a deep understanding of central banking and monetary policy, the presentation of this material begins with a discussion of the central bank’s role and objectives. Descriptions of the Federal Reserve and the European Central Bank follow. By starting on a theoretical plane, students gain the tools they need to understand how all central banks work. They avoid focusing on institutional details that may quickly become obsolete. Armed with a basic understanding of what central banks do and how they do it, students will be prepared to grasp the meaning of future changes in institutional structure.

Another important innovation is the parallel discussion of the two most important central banks in the world, the Federal Reserve and the European Central Bank (ECB). Students of the 21st century are ill-served by books that focus entirely on the U.S. financial system. They need a global perspective on central banking, the starting point for which is a detailed knowledge of the ECB.

Modern Treatment of Monetary Economics

The discussion of central banking is followed by a simple framework for understanding the impact of monetary policy on the real economy. Modern central bankers think and talk about changing the interest rate when inflation and output deviate from their target objectives. Yet traditional treatments of monetary economics employ aggregate demand and aggregate supply diagrams, which relate output to the price level, and discuss inflation in terms of shifts in the AD and AS curves. The resulting development is lengthy and difficult. Because this book skips the ISLM framework, its presentation of monetary economics is several chapters shorter. Only those topics that are most important in a monetary economics course are covered: long-run money growth and inflation and short-run monetary policy and business cycles. This streamlined treatment of monetary theory is not only concise, but more modern and more relevant than the traditional approach. Moreover, it gives students a complete understanding of business-cycle fluctuations.

Recent technological advances have dramatically reduced the importance of a bank’s physical location, producing a truly global financial system. Twenty years ago money and banking books could afford to focus primarily on the U.S. financial system, relegating international topics to a separate chapter that could be considered optional. But in today’s financial world, even a huge country like the United States cannot be treated in isolation. The global financial system is truly an integrated one, rendering separate discussion of a single country’s institutions, markets, or policies impossible. This book incorporates the discussion of international issues throughout the text, emphasizing when national borders are important to bankers and when they are not.

Learning Tools

In a sense, this book is a guide to the principles students will need to critically evaluate and use what they read in the financial press. Reading the newspaper and applying the information it contains require some basic knowledge. Supplying that knowledge is the purpose of the four types of inserts that complement the chapters, providing a break from the more technical material in the body of the text:

Your Financial World inserts provide students with practical information that is based on lessons covered in the chapter. Most chapters contain two of these boxes, each of which examines a personal finance problem that everyone faces. These boxes show students that the concepts taught in the money and banking course are relevant to their everyday lives. Among the topics covered are the importance of saving for retirement, the risk in taking on a variable-rate mortgage, the desirability of owning stocks, and techniques for getting the most out of the financial news.

Applying the Concept sections show how ideas introduced in the chapter can be applied to the world around us. Most describe historical episodes or examine issues relevant to the public policy debate. Subjects include how debt problems in emerging-market countries can create an increase in the demand for U.S. Treasury debt; why Long-Term Capital Management nearly caused a collapse of the world financial system; and what monetary policymakers learned from the Great Depression of the 1930s. Most chapters contain two of these applications.

In the News boxes present articles drawn from The New York Times, The Wall Street Journal, The Financial Times, The Economist, and BusinessWeek. These readings show how concepts introduced in the chapter are applied in the financial press. Each article is accompanied by a brief analysis that reinforces key concepts. One In the News box appears in each chapter.

Finally, the end-of-chapter material is divided into three sections:

Key Terms A listing of all the technical terms introduced and defined in the chapter. The key terms are defined in full in the glossary at the end of the book.

Chapter Lessons A list of the key lessons in the chapter. Other textbooks summarize a small number of points at length. This book summarizes a larger number of points, each of them short, clear, and couched in the form of an outline that matches the chapter headings—a format designed to aid student comprehension and retention.

Problems Each chapter contains 15 problems, both conceptual and computational, of varying levels of difficulty. These problems are designed to reinforce the lessons in the chapter.