PART TWO
Overviews
of the Textbook
Chapters and
Teaching Tips
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 14
Chapter 1
Why Study Money, Banking, and Financial Markets?
Before embarking on a study of money, banking, and financial markets, the student must be
convinced that this subject is worth studying. Chapter 1 pursues this goal in two ways. First, it
shows the student that money and banking is an exciting field because it focuses on economic
phenomena that affect everyday life. Second, using eight figures, this chapter encourages the
student to look at data that bear on the central issues in this field. An additional purpose of
Chapter 1 is to provide an overview for the entire book, previewing the topics that will be
covered in later chapters, and to indicate how the book will be taught.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 15
Chapter 2
An Overview of the Financial System
Chapter 2 is an introductory chapter that contains the background information on the structure
and operation of financial markets that is needed in later chapters of the book. This chapter
allows the instructor to branch out to various choices of later chapters, thus allowing different
degrees of coverage of financial markets and institutions.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 16
Chapter 3
What Is Money?
Before becoming immersed in the study of money and banking, the student must understand how
money is defined and measured. The first half of Chapter 3 discusses the definition of money:
how the economist’s definition differs from that of common speech, the functions of money, and
a historical view of how what serves as money has changed over time. The second half of the
chapter describes the tricky issues involved in applying the definition of money in order to
measure it.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 17
Chapter 4
Understanding Interest Rates
In my years of teaching money and banking, I have found that students have trouble with what I
consider to be easy material because they do not understand what an interest rate is: that it is
negatively associated with the price of a bond, that it differs from the return on a bond, and that
there is an important distinction between real and nominal interest rates.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 18
Chapter 5
The Behavior of Interest Rates
As is clear in the Preface to the textbook, I believe that money and banking is taught effectively
by emphasizing a few economic principles and then applying them over and over again to the
subject matter of this exciting field. Chapter 5 introduces one of these basic economic principles:
the theory of portfolio choice. This theory indicates that there are four primary factors that
influence people’s decisions to hold assets: wealth, expected returns, risk, and liquidity. The
For instructors who have a greater finance orientation in their course and so want to discuss the
theory of portfolio choice in more detail, I have provided an appendix in MyLab Economics that
describes finance models of asset pricing.
One teaching device that I have found helps students develop their intuition is the use of
summary tables such as Table 1 in class. I use the blackboard to write a list of changes in
variables that affect the demand for an asset and then ask students to fill in the table by reasoning
how demand responds to each change. This exercise gives them good practice in developing
their analytic abilities. I use this device continually throughout my course and in this book, as is
evidenced from similar summary tables in later chapters. I recommend this approach highly.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 19
Another important feature of this chapter is that it lays out supply and demand analysis of the
bond and money markets at a similar level to that found in principles of economics textbooks.
The ceteris paribus derivation of supply and demand curves with numerical examples are
presented, the concept of equilibrium is carefully developed, the factors that shift the supply and
demand curves are outlined, and the distinction between movements along a demand or supply
curve and shifts in the curve are clearly drawn. My feeling is that the step-by-step treatment in
this chapter is worthwhile because supply and demand analysis is such a basic tool throughout
the study of money, banking, and financial markets. I have found that even those students who
have had excellent training in their principles course find that this chapter provides a valuable
review of supply and demand analysis.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 20
Chapter 6
The Risk and Term Structure of Interest Rates
Chapter 6 applies the tools the students learned in Chapter 5 to understanding why and how
various interest rates differ. In courses that emphasize financial markets, this chapter is important
because students are curious about the risk and term structure of interest rates. On the other hand,
professors who focus on monetary theory and policy in their courses might want to skip this
chapter. The book has been designed so that skipping this chapter will not hinder the student’s
understanding of later chapters.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 21
Chapter 7
The Stock Market, the Theory of Rational Expectations,
and Efficient Market Hypothesis
Because the stock market is of such great interest to students, this chapter discusses theories
of how stocks are priced and how information is incorporated into stock prices. Laying out the
simple models of the one-period valuation model, the generalized dividend valuation model,
and the Gordon growth model gives students the tools to understand how stock prices are
determined. Two applications show students how relevant these models are by applying them
to see how monetary policy influences stock prices.
The implications of rational expectations theory become much clearer when this theory is used to
understand behavior in the financial markets as in the efficient market hypothesis. Another area
of exciting new research has been on the validity of rational expectations and efficient markets,
and this is discussed in more detail in an appendix to the chapter, which can be found in MyLab
Economics. Research has been dredging up fascinating anomalies that cast doubt on these
theories. This chapter has therefore been written to give a more balanced view of these theories:
It reflects this latest research, including a discussion of the new field of behavioral finance,
which applies concepts from other social sciences such as anthropology, sociology, and
particularly psychology, to understand the often anomalous behavior of security prices.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 22
Chapter 8
An Economic Analysis of Financial Structure
The development of the literature in economics on asymmetric information and financial
structure in recent years now enables financial institutions to be taught with basic economic
principles rather than placing emphasis on a set of facts that students may find boring and so will
forget after the final exam. This chapter provides an outline of this literature to the student and
provides him or her with an economic understanding of why our financial system is structured
the way it is. In addition, it emphasizes the ideas of adverse selection and moral hazard, which
are basic economic concepts that are useful in understanding principles of bank credit risk
management in Chapter 9, principles of bank regulation in Chapter 10, the economics of
financial regulation in Chapter 11, and financial crises in Chapter 12.
Two applications give students practice with using the concepts in the earlier asymmetric
information analysis. They examine the role of financial development on economic growth and
whether China is a counter-example to the importance of financial development. Students find
these applications to be very stimulating because there is something inherently exciting about
economic growth. These applications can be skipped without loss of continuity, especially for
courses focusing on financial institutions.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 23
Chapter 9
Banking and the Management of Financial Institutions
Although this chapter performs the conventional function of outlining what banks (depository
institutions) do and what their balance sheets look like, it also emphasizes the economic way of
thinking about how banks manage their assets and liabilities to make a profit. Three tools are
used throughout this chapter and the rest of the book—the asymmetric information concepts of
adverse selection and moral hazard, introduced in Chapter 2, the theory of portfolio choice
developed in Chapter 5, and T-accounts, introduced in this chapter. In teaching this material, it is
worth emphasizing to the student that mastery of these tools will pay high dividends in helping
them to learn (and perform well on exams) in this course.
The subsection, “Capital Adequacy Management,” and the final three sections in the chapter,
“Managing Credit Risk,” “Managing Interest-Rate Risk,” and “Off-Balance-Sheet Activities,”
discuss issues that have become increasingly important in recent years. Many instructors may
therefore want to include this material in their courses, yet none of this material is essential to
understanding later chapters, so it can be skipped without any loss of continuity. The application
on how a capital crunch caused a credit crunch during the global financial crisis particularly
piques the interest of students because it shows how changes in banks’ behaviors can have major
effects on the economy.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 24
Chapter 10
Economic Analysis of Financial Regulation
Chapter 10 stresses the economic way of thinking by conducting an economic analysis using the
adverse selection and moral hazard concepts to show why our regulatory system takes the form it
does and how it can lead to banking crises.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 25
Chapter 11
Banking Industry: Structure and Competition
Chapter 11 supplements Chapter 2 by going into much greater detail about the structure of the
banking system. This chapter differs from conventional chapters on the banking industry in other
money and banking textbooks by stressing a more dynamic, analytical framework than in other
books. In particular, it provides an analytic framework for understanding the process of financial
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 26
Chapter 12
Financial Crises
Financial crises are inherently interesting because they are so dramatic. This has become even
more the case with the recent global financial crisis that has had such devastating consequences
for not only the U.S. economy, but for Europe as well. Indeed, teaching this material on the
financial crises has engaged students’ interest more than anything else I have taught in my entire
career of over thirty years of teaching.
This chapter makes use of an asymmetric information analysis (agency theory) to explain the
dynamics and adverse impact of financial crises. Teaching Chapter 8 in full is not necessary to
cover Chapter 12 as long as the instructor goes over the concepts of asymmetric information,
adverse selection, and moral hazard. Although Chapter 12 defines these concepts, many
instructors will prefer to cover these concepts in more detail using the material in the first part
of Chapter 8.
Students will be most interested in using the analysis to discuss the application on recent
financial crisis in 2007–2009, which was the worst financial crisis to hit the world since the
Great Depression. Nonetheless, the application on the Great Depression is worth covering
because it contains so many lessons for today.
For those instructors who would like to internationalize their course, a chapter available in
MyLab Economics extends the analysis to emerging market economies, economies in an early
stage of market development that have recently opened up to the flow of goods, services, and
capital from the rest of the world.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 27
Chapter 13
Central Banks and the Federal Reserve System
Chapters 13–16 explore in detail how monetary policy is conducted. Although most professors
covering monetary theory will want to include much of this material in their courses, later
chapters on monetary theory do not directly depend on Chapters 13–16, so they can be skipped
without loss of continuity. Other professors covering monetary theory may prefer to teach this
material after they have taught the chapters on monetary theory.
To help the instructor spice up the discussion of the Federal Reserve, I try to provide an inside
view of the Fed by including material on such topics as the political genius of the way the
Federal Reserve was set up to preserve its independence, the special role of the Federal Reserve
Bank of New York and the research staff in the Federal Reserve System, how a typical FOMC
meeting is conducted, the evolution of the Fed’s communication strategy, how Ben Bernanke
and Janet Yellen’s style differs from that of the former Chairman of the Fed, Alan Greenspan,
and how the foreign exchange and open market desks at the Federal Reserve Bank of New York
operate. To feature this new material I have included some of it in a set of special interest boxes,
titled “Inside the Fed,” which provide insights on how the Federal Reserve System operates
although they are based on information that is entirely in the public domain.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 28
Until recently, the Federal Reserve had no significant rivals in the central banking world. This
changed in January 1999 with the startup of the European Central Bank (ECB), which now
conducts monetary policy for countries that are members of the European Monetary Union,
which in total have a population that exceeds that of the United States and a GDP comparable
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 29
Chapter 14
The Money Supply Process
This chapter provides an analysis of how the money supply is determined. One point that needs
to be emphasized at the outset is that the money supply is not determined solely at the whim of
the central bank; rather, there are two other players in the money supply process who also play
an important role: banks and depositors. Chapter 14 first extensively discusses the simple model
of multiple deposit creation, even though it is unrealistic and does not feature all of the players,
because it illustrates the basic principles used later in the chapter. The critique of the simple
model of multiple deposit creation then leads to a discussion of the money multiplier and a more
complete treatment of the money supply process.
This chapter has four appendices in MyLab Economics: The first provides more detail on the
Fed’s balance sheet and the factors that affect the monetary base; the second derives the M2
money multiplier and explains the intuition behind it; the third provides an economic analysis of
what determines the currency ratio; and the fourth looks at how bank panics during the 1930s
affected the money supply. Some instructors may want to cover this material in class because it
shows how money supply analysis can be extended to monetary aggregates other than M1 and
provides more detail on how the money supply is determined. In addition, it provides students
with additional practice in using the concepts they have learned in the chapter.
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 30
Chapter 15
Tools of Monetary Policy
Chapter 15 examines in detail the tools at the Fed’s (and the European Central Bank’s) disposal
for conducting monetary policy. To fully understand how these tools are used in the conduct of
monetary policy, this chapter shows how they affect the federal funds rate directly. Students are
introduced to the nitty gritty of how the Fed wields these tools and are exposed to current debates
on whether Fed policymaking could be made more effective by altering their use of these tools.
One topic that frequently does not get enough attention in money and banking courses is the
lender-of-last-resort function of discounting. I feel this function should be stressed in class
because students find it inherently interesting in the wake of the recent massive operations by the
Fed during the global financial crisis. Also students will be particularly interested in the section
on the nonconventional monetary policy tools used to combat the financial crisis and the Great
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 31
Chapter 16
The Conduct of Monetary Policy: Strategy and Tactics
Chapter 16 outlines the goals, strategies, and tactics of central bank policymaking. It starts by
laying out modern theories of central banking: It first discusses the price stability goal and the
role of a nominal anchor in solving the time-inconsistency problem, and then discusses the other
goals of monetary policy and why price stability is now viewed as the primary goal of monetary
policy.
The chapter then goes on to discuss two monetary policy strategies. The first is inflation
targeting, which involves announcement of an inflation target objective, with a commitment by
the central bank to achieve it. The Fed has been considering adoption of an inflation target, and I
was a strong proponent of this policy framework when I was a governor of the Federal Reserve.
The second, what I refer to as the “Just Do It” approach, is the one the Federal Reserve used
before it adopted inflation targeting, which entails a strong commitment to control inflation, but
without an explicit inflation target. There is an additional monetary policy strategy that central
banks used in the past, but not currently—monetary targeting. For those instructors who would
like to cover this material, I have provided an appendix to Chapter 16 found in MyLab