The Economics of Money, Banking & Financial Markets

Economics of Money, Banking, and Financial Markets


Although this text has undergone a major revision and adaptation for the European context
it retains the basic hallmarks of all past Global editions that have made it the best-selling
textbook on money and banking over the past editions:

■ A unifying, analytic framework that uses a few basic economic principles to organize stu-
dents’ thinking about the structure of financial markets, the foreign exchange markets, financial institution management and the role of monetary policy in the economy;
■ A careful, step-by-step development of models (an approach found in the best principles of economics textbooks), which makes it easier for students to learn
■ The complete integration of an international perspective throughout the text
■ A thoroughly up-to-date treatment of the latest developments in monetary theory
■ A special feature called ‘Following the financial news’ to encourage reading of a financial newspaper
■ An applications-oriented perspective with numerous applications and special-topic boxes that increase students’ interest by showing them how to apply theory to real-
world examples

What’s new in the European adaptation

The basis of the adaptation was the 9th Global edition. The figures and data have been replaced by or supplemented with UK and other European countries’ data. The text in each chapter reflects the Europeanization of the material while retaining the essential features of the original Global editions. There is major new material in every part of the text.

Chapter 1 Why study money, banking and financial markets?
This chapter lays the foundations for the following chapters. It contains new material that refers to the interest rates of the UK and the major economies of the euro area. The broad sweep of the history and volatility of stock markets in the twentieth and twenty-first centuries is discussed by comparing the evolution of the FT30 index and the Dow-Jones from 1935. The foreign exchange market is given greater prominence in the book and is intro- duced earlier in this chapter.

The structure of the chapter follows closely the 9th Global edition but the examples of money and business cycles and the long-run relationship between inflation and money is taken from the UK. There are two reasons why the UK is used to illustrate the long-run relationships between money, interest rates, the business cycle and inflation. The first is that the euro area has not been in existence for long enough to provide an undisturbed long series of data that will adequately illustrate the economic relationships explored in the chapter. The second reason is that the UK provides an undisturbed example of long-term trends that have relevance for the euro area.

Chapter 2 An overview of the financial system
This chapter stays close to the structure of the 9th Global edition and provides data on the principal money market and capital market instruments in the UK as examples of the types of financial instruments that are traded in an advanced financial market. The principal financial intermediaries in the euro area and the UK are described and the boxes on ‘Following the financial news’ take examples from the Financial Times.

Chapter 3 What is money? A comparative approach to measuring money

The difference between the definition of money and the measurement of money is discussed in a special ‘Closer look’ box. It uses the evolution of the measures of money in the UK as examples of circumstances when financial innovation blurs the distinction between different means of payment systems, leading to changes in the measures of money while retaining the fundamental definition. The different measures of money in the euro area, the UK and the US are discussed and presented in Table 3.1 and the detailed components of the various measures of the euro area money supply are shown in Table 3.2.

Chapter 4–6 Understanding interest rates, The behaviour of interest rates and The risk and term structure of interest rates

These three chapters have remained largely unchanged as they are theoretical in substance. A notable addition in Chapter 4 is the ‘Closer look’ box that discusses the observation of real interest rates from the yields on UK index-linked bonds. Additionally Figure 4.1 shows how real interest rates can be backed out by subtracting econometrically generated inflation expectations following the Mishkin (1981) method, from the UK short-term rate of interest. Figure 5.7 uses the UK data on short-term interest to illustrate the relationship between the rate of interest and the business cycle. The ‘Following the financial news’ box contains a column from the Financial Times on UK index-linked bonds which is explained and analysed in the text. Chapter 6 uses the spread between the UK commercial bill rate and the UK risk-free rate of interest to illustrate the risk premium in short-term bonds. It also includes a discussion of the risk premium on interest rates due to sovereign debt default within the euro area. ‘Following the financial news’ includes a discussion and an analysis on UK yield curves produced by the Financial Times for yield curve shapes from 1981 to 2011.

Chapter 8 An economic analysis of financial structure
The context for this chapter is the European sovereign debt crisis that followed the global financial crisis which was itself sparked by the subprime crisis. The banking crisis and the impacts on the financial system in the euro area and the UK are explored in this chapter.
The financial structure of the three largest economies in the euro area, the UK and the US are described. The chapter shows data for the sources of external funds for non-financial businesses in the US, the UK, France, Germany and Italy. The euro area and UK financial structure fits in with the eight basic facts about company financial structure. The attempts to remedy conflicts of interest in the US (Sarbanes–Oxley Act of 2002 and the Global Legal Settlement of 2002) are supplemented with a discussion of European Union Directives.

Chapter 9 Financial crises and the subprime meltdown

The 9th Global edition included an extensive analysis of why financial crises like the subprime crisis occur and why they have such devastating effects on the economy. This chapter follows the structure of the original edition and examines why financial crises occur and why they have such devastating effects on the economy. This analysis is used to explain the course of events in a number of past financial crises throughout the world, including the collapse of the European Exchange Rate Mechanism. A particular focus of the chapter is the explanation of the recent subprime crisis and the sovereign debt crisis in the euro area economies. A special section is on the dynamics of the euro area financial crisis and an additional application is the box on the sovereign debt crisis in the EU and the attempts by the ECB, the EU and the IMF to deal with a crisis that keeps on developing. The material in this chapter is very exciting for European students as it is as bang up to date in its information and analysis as the publication of a textbook will allow. As this book goes to print the sovereign debt crisis and the banking crisis have had political upheavals in Europe with changing governments in Italy, France and Greece. Far from coming to any form of resolution, the banking crisis has worsened in Spain.

Chapter 10 Banking and the management of financial institutions
Understanding the workings of banks begins with understanding the balance sheet of the banks. This chapter begins with the consolidated balance sheet of all commercial banks in the euro area. This is then compared with the balance sheet of a single univer- sal bank in Germany as an example with the similarities and differences highlighted in the discussion. The process of maturity transformation is explained and the methods by which banks make profits are described by referring to the income statement of a large German bank.

advantages and disadvantages of bank regulation is included as well as an EU-wide discussion on where regulation is going in the light of banking crises in Europe and the sovereigndebt crisis.

Chapter 12 Banking industry: structure and competition
This chapter begins with the creation and development of the single banking market in the Union. The result of attempts to promote competition has led to greater consolidation. Deregulation has occured in phases and these phases are discussed in a special section on deregulation and competition. The impact of deregulation and competition on bank structures is discussed in a special section on consolidation and downsizing. A special
section on the structure of the banking sector in Europe discusses issues of concentration and competitiveness. A further section discusses the internationalization of banking.

Chapter 13 The goals and structure of central banks
This chapter has been substantially rewritten and contains a wider coverage of the goals and structure of central banks with special emphasis on the Bank of England, the ECB and the Federal Reserve. It includes a box on the benefits of price stability. Also the description of the Federal Reserve System includes a box on the differing styles of Bernanke and Greenspan as Governors. The independence of the ECB contains material that discusses the pressures it faces during the current financial crisis. Additional material in the section on
central banks around the world includes a description of the central banks of Sweden and Norway. The chapter also includes an additional section on central banks in transition countries. The discussion on central bank behaviour is expanded and includes two additional boxes on making central banks more accountable and whether independence for central banks leads to lower inflation.

Chapters 14–15 The money supply process and The tools of monetary policy While retaining the theoretical features of the 9th Global edition, these chapters have been reorganized to reflect the European context. The specific factors that determine the money supply in the context of the money multiplier are elaborated in Chapter 14.
The historic trend of the UK M3 money multiplier is described as an example and recent trends are examined with the M3 multiplier of the euro area and the M1 multiplier of the US. A special box describing the operations of the monetary counterparts process explains the link between bank lending, the government budget deficit and funding of the deficit through bond sales. The counterparts process has a stronger resonance with the operations of the monetary process in the UK and the ECB than the simple textbook money supply process.

Chapter 15 on the tool of monetary policy has been substantially rewritten to accommodate a more general framework which is useful to analyse the market for reserves in the euro area, the UK and the US, and to understand how the respective central banks can use their tools to affect the interest rates. This chapter also includes a number of boxes describing the unconventional monetary policies implemented by the Bank of England, the ECB and the Fed over the last few years.

More specifically, a new box describes the mechanics of quantitative easing by the Bank

Chapters 17–18 The foreign exchange market and The international
financial system The structure and theoretical content of the working of the foreign exchange market in
Chapter 17 remains mostly unchanged with the context focusing on Europe.

Additions worth mentioning are a discussion of alternative methods used in expressing the exchange rate and an updated application on the euro and the global financial crisis. Chapter 18 has also been rewritten to reflect a European focus, but the theoretical aspects remain largely unchanged. The section on the balance of payments describes the UK system as an example. The box on why large current account deficits worry economists has been extended to Germany and the UK. Following the recent proposals of policymakers, a new ‘Reading the financial news’ section on the Tobin tax has been added. The section that covers dollarization, currency boards and monetary unions now includes an extensive coverage of the benefits and costs of a monetary union. On top of a special box on the potential for a monetary union in the Arab Gulf Cooperation Council, this section features two new boxes discussing whether the existing euro area constitutes an optimal currency area and whether the EU countries outside the euro area will join the euro area.

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