Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 32
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The chapter then moves on to discuss monetary policy tactics: in particular, what policy
instrument should be chosen to conduct monetary policy. Figures 3 and 4 illustrate why targeting
on a monetary aggregate like nonborrowed reserves implies a loss of control of interest rates like
the federal funds rate, while targeting on the federal funds rate implies a loss of control of
monetary aggregates. This analysis can also be done in terms of the supply and demand for
money framework. Indeed, covering this topic is an excellent way of providing students with
another application to give them practice with the supply and demand analysis for the market for
reserves or the market for money.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 33
Chapter 17
The Foreign Exchange Market
Chapter 17 explains behavior in the foreign exchange market by using a modern asset-market
approach to exchange rate determination. This asset-market approach is now the dominant
method of analyzing exchange rate movements in the literature, and it has major advantages over
the more conventional treatment of the foreign exchange market typically found in money and
banking textbooks.
As the second application in the chapter indicates, the asset-market approach, in contrast to
earlier approaches emphasizing import and export demand, can be used to explain a feature of
the foreign exchange market that has received much attention in the press in recent years: the
high volatility of exchange rates. This phenomenon is not well explained by the earlier flow
approach because it does not predict that exchange rates should be highly volatile.
To help students achieve an intuitive grasp of how the relative expected return on domestic
assets, and hence the demand curve shifts, tell them to put themselves in the shoes of an investor
who is thinking about putting his or her money into foreign or domestic assets. When a factor
changes, have them ask themselves whether at the same exchange rate they would earn a higher
expected return on domestic assets—if so, the demand curve has shifted to the right. This kind of
thinking will help them manipulate the demand curve so they can predict which way the
exchange rate changes. Several summary tables in the chapter should help students master the
material, and I have found that using them in class helps greatly in clarifying the discussion.
The four applications in the chapter on the Economist’s Big Mac Index and PPP, on the response
of exchange rates to changes in interest rates, the effect of global financial crisis on the dollar,
and the impact of Britain’s exit (Brexit) and the subsequent collapse of the pound, can all be used
in class to show students that the material they have learned has practical uses.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 34
Chapter 18
The International Financial System
Chapter 18 shows why international financial transactions have important implications for the
conduct of monetary policy. The beginning of the chapter explains how foreign exchange market
intervention affects the exchange rate, a country’s international reserves, and the money supply.
It then discusses the balance of payments, but this sometimes-dry topic can be spiced up for
students by a discussion of the box on why large current account deficits worry economists.
The chapter then goes on to discuss the evolution of the international financial system and how
fixed exchange rate systems work. Two applications in this section make the material come alive
for students. The first examines the September 1992 foreign exchange crisis and recent foreign
exchange crises in emerging market countries. This application captures the imagination of
students because huge profits were made during this crisis and because government intervention
in the markets was massive. The second examines how China has accumulated over $4 trillion
of international reserves, a subject of great interest to students. These applications also give
students further practice with the model of the foreign exchange market developed in Chapter 17.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 35
Chapter 19
Quantity Theory, Inflation, and the Demand for Money
Chapter 19 discusses two of the basic building blocks of monetary theory, the quantity theory of
money and the demand for money, examining how these theories can explain inflation in the
long run, This material is more appropriate for a course that emphasizes monetary theory, and
many professors will prefer not to cover it. Later chapters do not depend on this material, so
dropping it from your course will not hinder students’ ability to understand later chapters.
The chapter starts with the quantity theory of money. The key equation to get students to
understand is the equation of exchange in Equation 2, which is then transformed into the quantity
theory Equation 4. The quantity theory embedded in Equation 6 is then tested in the application,
“Testing the Quantity Theory of Money,” which shows that the theory helps explain long-run
inflation.
This chapter then describes the two basic approaches to theories of the demand for money:
Keynesian theories and portfolio-choice theories. This seems to be the natural way to organize
this material. It is important to emphasize in class that a central question in monetary theory is
whether the demand for money is affected by changes in interest rates, because this issue is
crucial to how we view money’s effect on aggregate economic activity. This is why the
discussion in this chapter always focuses on the role of interest rates in the demand for money.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 36
Chapter 20
The IS Curve
This chapter introduces the basic concept of aggregate demand and develops one of the key
building blocks of the AD/AS model, the IS curve. The framework here is pretty conventional,
first outlining the components of planned expenditure—consumption expenditure, planned
investment spending, government purchases, and net exports. Then the chapter goes into detail
about goods market equilibrium, when planned equals actual expenditure, and shows how this
equilibrium generates the IS curve, the relationship between the real interest rate and equilibrium
output. Spending a fair amount of time in class on the concept of goods market equilibrium, and
why the economy will gravitate to this equilibrium, is worthwhile because this concept is so
important to short-run macroeconomic analysis.
One element of the framework here that is not conventional is that I build directly into the IS
curve the impact of financial frictions on aggregate demand. After the global financial crisis, it is
now imperative to discuss the interaction of finance and the macroeconomy and this is done at
the outset in this textbook’s discussion of monetary theory.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 37
Chapter 21
The Monetary Policy and Aggregate Demand Curves
Chapter 21 develops two other building blocks of the AD/AS framework, the monetary policy
curve and the aggregate demand curve. It explains why monetary policymakers raise interest
rates when inflation rises so that there is a positive relationship between real interest rates and
inflation, which is called the monetary policy (MP) curve. It also explains that shifts in monetary
policy involve autonomous easing or tightening of monetary policy, which involve changes in
the real interest rate for a given level of inflation. Students often struggle with the difference
between movements along the MP Curve and shifts in the MP curve. Two applications help
clarify this for students: Movement Along the MP Curve: The Rise in the Federal Funds Rate
Target, 2004–2006,” and “Autonomous Monetary Easing at the Onset of the 2007–2009
Financial Crisis.” These two applications provide useful illustration to cover in class to hammer
home the distinction between movements along and shifts in the MP curve.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 38
Chapter 22
Aggregate Demand and Supply Analysis
The basic tool used to analyze the role of money in the economy in this book is a dynamic
aggregate demand and supply analysis. The aggregate demand/aggregate supply model in this
book differs from that in many other textbooks because it is inherently dynamic and emphasizes
the interaction of inflation and economic activity. In contrast to older AD/AS frameworks that
have the price level on the vertical axis, the dynamic AD/AS approach in this textbook has
inflation on the vertical axis.
There are several advantages to the approach used here. First, students have to learn only one
model to understand fluctuations in output and inflation, the AD/AS model here, while older
approaches require two models, the ISLM model and then a separate AD/AS model. Learning just
The chapter starts with a recap of the aggregate demand curve. There are two reasons for doing
so. First, it drives home the intuition behind the aggregate demand curve, and recaps like this
are a good way of getting students to really understand the material. Second, many instructors
who are pressed for time might not want to go into so much detail about the derivation of the
aggregate demand curve and so would prefer to skip Chapters 20 and 21. The recap in Chapter
22 allows instructors to skip Chapters 20 and 21 and still get across the major ideas in monetary
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 39
The chapter then develops the remaining building block of the AD/AS framework, the aggregate
supply curve. This chapter develops the aggregate supply intuitively, stressing that the long-run
aggregate supply curve is a vertical line determined by the amount of capital in the economy,
the amount of labor supplied at full (the natural rate level of) employment, and the available
The rest of the chapter shows how inflation and equilibrium output changes as a result of either
aggregate demand shocks or aggregate supply (inflation) shocks. To drive home the analysis and
also show students how useful the AD/AS model is, the chapter goes through a large number of
applications. The first two, “The Volcker Disinflation, 1980–1986” and “Negative Demand
Shocks, 2001–2004,” demonstrate how the economy responded to demand shocks. The next two,
“Negative Supply Shocks, 1973–1975” and 1978–1980,” and “Positive Supply Shocks, 1995–
1999,” demonstrate how the economy responded to supply shocks. The application, “Negative
Supply and Demand Shocks and the 2007–2009 Financial Crisis,” shows how the economy can
be devastated by the double whammy of adverse supply and demand shocks. The chapter ends
with two applications involving foreign countries, “The United Kingdom and the 2007–2009
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 40
For those instructors who want to spend more time on monetary theory and delve deeper into the
dynamic AD/AS model, the chapter has four appendices available in MyLab Economics. The
first, “The Effects of Macroeconomic Shocks on Asset Prices,” is worth teaching to students who
are interested in pursuing careers in finance. It shows how the AD/AS model can explain how
macroeconomic events that students are seeing reported in the media every day affect both stock
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 41
Chapter 23
Monetary Policy Theory
Chapter 23 brings a new set of actors into the AD/AS framework—policymakers—and develops
the theory behind monetary policy making, examining how monetary policymakers react to
shocks to the economy in order to stabilize both inflation and economic activity. One unique
feature of the dynamic AD/AS framework in this book is that it can address policy questions that
other frameworks cannot, such as “When does stabilizing inflation, stabilize output (i.e., when
does the divine coincidence occur)?”
Another big issue in macroeconomics is whether policymakers should be activist—i.e., respond
aggressively to fluctuations in economic activity—or alternatively, not respond and be
nonactivist. One way of bringing home to the students the importance of this issue is to discuss
in class the box on the activist/nonactivist debate over the Obama fiscal stimulus package.
The chapter also discusses what causes inflation and one of the most famous adages in
macroeconomics, coined by Milton Friedman: “Inflation is always and everywhere a monetary
phenomenon.” It then delves more deeply into why inflationary monetary policy occurs. The
The chapter ends with a discussion of monetary policy at the zero lower bound, which is of great
interest currently because the Federal Reserve cannot lower the federal funds rate below the zero
lower bound and so has to resort to nonconventional monetary policy. The dynamic aggregate
demand and supply framework in this text is especially suited to explaining the impact of the
zero lower bound and how nonconventional monetary policy works in this situation. The first
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 42
Chapter 24
The Role of Expectations in Monetary Policy
Over the last thirty years, the role of the public and the market’s expectations has moved to the
front and center of the thinking about how the macro economy works. Chapter 24 discusses the
most widely used theory to describe the formation of household and business expectations—
rational expectations—and develops it from microeconomic principles. Using the AD/AS model
developed earlier in the book, it then explores how this theory has shaped current policy-making
and debates.
The chapter next turns to a set of policy issues. The first is the debate over whether policymakers
should follow rules or instead conduct policy with complete discretion, in which policy is
conducted on a day-to-day basis. The argument for rules is based on the time-inconsistency
problem, another one of the most important ideas in macroeconomics over the last thirty years.
The problem with discretion is that policymakers can’t commit to good long-run strategies.
Instead they have incentives to renege on the good strategy and therefore pursue policy that leads
to poor outcomes. I like to illustrate this concept in class by presenting everyday examples. One
is how we eat. We don’t want to eat unhealthy food, but when we see that juicy hamburger, we
just can’t resist it. Another example is the inability to stay on a diet, as discussed in the text. I
also like discussing the problem of child rearing and the temptation to give in to bad behavior.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 43
The next policy issue the chapter discusses is the role of credibility and a nominal anchor. Here,
the rational expectations conclusion that expectations about policy affect inflation expectations is
embedded in the AD/AS model, which is then used to show that having a credible commitment to
a nominal anchor produces better outcomes on both inflation and output when there are either
Students also enjoy historical examples showing how credibility is critical to the success of anti-
inflation policies. The box on ending the Bolivian hyperinflation drives home the importance of
credibility because it is so dramatic. The application that discusses credibility and the Reagan
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 44
Chapter 25
Transmission Mechanisms of Monetary Policy
Chapter 25 discusses the transmission mechanisms of monetary policy so that students can
understand how monetary policy affects the economy. The two applications on monetary
transmission mechanisms during the Great Recession and the lessons this research provide
to monetary policymaking for Japan also stimulate student interest.
Once students understand the advantages and disadvantages of reduced-form versus structural-
model evidence, encourage them to discuss the problems with the Keynesian and monetarist
evidence described in the appendix in order to give them practice in using this knowledge. An
important point to stress is that evidence is much easier to interpret if we have controlled
experiments in which an event is exogenous; we can then look for what happens afterward.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 45
MyLab Chapter 1
Financial Crises in Emerging Market Economies
This MyLab chapter is for instructors who want to have a more international orientation of their
courses. It extends the analysis in Chapter 12 on financial crises to economies that are just
entering the world marketplace. The analysis is parallel to that in Chapter 12, with Figure 1,
which is similar to Figure 1 in Chapter 12, outlining the dynamics of financial crises in emerging
market economies. Then the chapter takes students through two detailed applications, South
Korea in 1997–1998 and Argentina in 2001–2002, to illustrate how useful the analysis in the
chapter is.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 46
MyLab Chapter 2
The ISLM Model
This MyLab chapter allows instructors to teach the ISLM model if they so choose. It lays out
the ISLM model step by step by deriving the LM curve and then putting the IS curve developed
in Chapter 20 and the LM curve in one diagram and explains why equilibrium occurs at their
intersection. The application in the middle of the chapter on the Economic Stimulus Act of 2008
livens up the material and should convince the student that Keynesian analysis does have
something to say about real-world phenomena.
The application on targeting money supply versus interest rates shows how the ISLM model has
something important to say about an issue raised in Chapter 16: Should the Fed conduct
monetary policy by targeting the monetary aggregates or interest rates?
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 47
MyLab Chapter 3
Nonbank Finance
This MyLab chapter supplements Chapter 2 by going into greater detail about the structure and
regulation of nonbank financial institutions. To again stress the economic way of thinking, the
chapter has a section that applies the concepts of moral hazard and adverse selection to explain
many principles of insurance management. These concepts are also utilized in a section on
government financial intermediation to look at the potential crisis that is brewing because of
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 48
MyLab Chapter 4
Financial Derivatives
The treatment of financial derivatives markets (forwards, futures, options, and swaps) in this
book differs markedly from that in other money and banking textbooks. Financial derivatives
are approached from the perspective of managers of financial institutions, and this is why this
material is placed in the financial institutions part of the book. Rather than go into a lot of facts
One problem that I have encountered in teaching students about financial derivatives is that
many do not find the financial derivative contracts to be particularly intuitive. In order to get
them to understand how these contracts work, I find it helps to first discuss what hedging is and
drive home the principal that hedging risk involves engaging in a financial transaction that
offsets a long position by taking an additional short position, or vice versa. Then I find it
important to walk them through a numerical example in class that shows them what the profits
are for these contracts given different outcomes. In addition, to hammer home how these
contracts work, this chapter contains several applications that provide specific examples of how
hedges are conducted with financial futures, forward contracts, options, and swaps. I know of no
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 49
MyLab Chapter 5
Conflicts of Interest in the Financial Industry
Recent corporate and accounting scandals have attracted tremendous public attention and are of
particular interest to students because resulting bankruptcies have cost employees of these firms
their jobs and their pensions, and because the scandals may have hampered the efficient
functioning of the financial system.
When I teach this material, I start by emphasizing that conflicts of interest occur when people
who are supposed to act in the interests of the investing public by providing them with reliable
information instead have incentives (conflicting interests) to deceive the public to benefit
themselves and their corporate clients.
I then encourage the students to discuss which conflicts of interest arise in different sectors
of the financial services industry. Then I emphasize how central information issues are in
understanding why conflicts of interest occur and what remedies make sense to deal with them.
The key point that comes out of this analysis is that conflicts of interest are only damaging if
The chapter ends by describing five approaches to remedying conflicts of interest: (1) leave it to
the market, (2) regulate for transparency, (3) supervisory oversight, (4) separation of functions,
and (5) socialization of information production. Teaching the case at the end of the chapter that
applies the analysis to Sarbanes-Oxley, the Global Legal Settlement, and the Dodd-Frank Bill