Chapter 1: Money, Banking, and Your World

negative amortization mortgage

A mortgage with periodic payments lower than what would be required to pay the interest on the loan. Instead of declining over time, the principal owed increases as unpaid interest is added to it.

balloon payment

A principal payment due in a large lump sum, usually at the end of the loan period.

interest rate

The price of borrowed money.

foreign exchange

Buying and selling of foreign currencies, for example, the British pound, the Japanese yen, and the European Union’s euro.

life insurance

A contract that promises to pay a sum of money to beneficiaries upon the death of an insured person.

exchange rate

The price of one currency in terms of another.

Chapter 2: The Financial System

financial system

A densely interconnected network of financial intermediaries, facilitators, and markets that allocates capital, shares risks, and facilitates intertemporal trade.

positive net present value project

A project likely to be profitable at a given interest rate after comparing the present values of both expenditures and revenues. This will make more sense after you navigate .

internal finance

Financing that comes from the company itself, the plowing of profits back into the business.

external finance

Obtaining short- or long-term funding from outside sources (those external to the company).

minimum efficient scale

The smallest a business can be and still remain efficient and/or profitable.

scarcity

The finite availability of resources coupled with the infinite demand for them; the fact that goods are not available in sufficient quantity to satisfy everyone’s wants.

adverse selection

The fact that the least desirable borrowers and those who seek insurance most desire loans and insurance policies.

moral hazard

Any postcontractual change in behavior that injures other parties to the contract.

liquidity

The ease, speed, and cost of sale of an asset.

capital

In this context, long-term financing.

facilitators

In this context, businesses that help markets to function more efficiently.

markets

Institutions where the quantity and price of goods are determined.

intermediaries

Businesses that connect investors to entrepreneurs via various financial contracts, like checking accounts and insurance policies.

derivatives

Derivatives are complex financial instruments, the prices of which are based on the prices of underlying assets, variables, or indices. Some investors use them to hedge (reduce) risks, while others (speculators) use them to increase risks.

dealers

Businesses that buy and sell securities continuously at bid and ask prices, profiting from the difference or spread between the two prices.

collateral

Property pledged as security for the repayment of a loan.

direct placement

A sale of financial securities, usually bonds, via direct negotiations with buyers, usually large institutional investors like insurance and investment companies.

merger

A merger occurs when two or more extant business firms combine into one through a pooling of interests or through purchase.

acquisition

When one company takes a controlling interest in another; when one business buys another.

assets

Assets are “things owned” as opposed to liabilities, which are “things owed.”

risk

The probability of loss.

return

The percentage gain or loss from an investment.

liabilities

Liabilities are “things owed” to others, as opposed to assets, which are “things owned.”

deregulation

Generally, deregulation refers to any industry where regulations are eliminated or significantly reduced. In this context, deregulation refers to a series of regulatory reforms of the financial industry undertaken in the 1980s and 1990s.

premium

In this context, a sum paid for an insurance contract.

nonnegotiable

Nontransferable to third parties.

redeemable

In this context, changeable into cash money by the fund.

GDP

GDP, or gross domestic product, is one of several different measures of aggregate output, the total value of all final goods and services produced in an economy.

ceteris paribus

All else equal.

default

Non- or partial payment of a loan, bond, or other payment obligation.

transparency

In general, the opposite of opacity. In this context, transparency means a relatively low degree of asymmetric information.

lender of last resort

During a financial crisis or panic, a lender of last resort makes loans when no one else will.

deposit insurance

Insurance that pays off if a bank defaults on its deposit liabilities.

too big to fail (TBTF) policy

The notion that some financial institutions cannot be allowed to go bankrupt because they owe so much money to so many people and companies that their failure to continue making payments would have catastrophic negative consequences for the economy.

Great Inflation

Peacetime inflation rates in the United States in the 1970s were higher than any time before or since.

Chapter 3: Money

consumer surplus

In a standard supply and demand graph, that area above the price line and below the demand curve.

Federal Reserve notes

Fiat paper money issued by America’s central bank, the Federal Reserve.

commodity money

Forms of money that have intrinsic value as a commodity.

representative money

Intrinsically value-less (or nearly so) tokens that represent commodities because they can be exchanged for commodities or converted into commodities at a fixed, predetermined rate.

balance sheet

A financial statement showing the sum or stock of an economic entity’s assets (things owned) and liabilities (things owed). Assets should equal liabilities, including equity (aka capital or net worth).

automatic transfer from savings account (ATS)

An account that automatically moves funds from your savings account if your checking account is depleted. (Of course, such an account doesn’t help if you don’t have any money in your savings account either.)

sweep account

An account that automatically moves funds from your savings account if your checking account is depleted. (Of course, such an account doesn’t help if you don’t have any money in your savings account either.)

money market mutual fund (MMMF)

MMMFs are mutual funds that invest in short-term, or money market, instruments. Fund owners earn the going market interest rates, minus management fees, and can draw upon their shares by check but at a cost higher than that of most bank checking accounts.

credit risk

The probability of not being paid a sum due.

Chapter 4: Interest Rates

interest

The opportunity cost of money.

interest rate

The price of borrowed money.

economic growth

Real per capita GDP.

ceteris paribus

All else equal.

yield to maturity (YTM)

The most economically accurate way of measuring interest rates.

present value (PV)

The value of money today.

future value (FV)

The value of money at some point in the future.

inflation

A sustained increase in the price level or average prices.

nominal interest rates

The price of borrowing money as it is usually stated, unadjusted for inflation.

real interest rate

The price of borrowing money adjusted for inflation.

compounding

Earning interest on interest.

compounding period

The amount of time that passes before interest begins to earn interest.

debt instrument

A bond, IOU, or other contract (like a discount bond, simple loan, fixed payment loan, or coupon bond) promising the payment of money in the future.

discount bond

A debt instrument that makes only one payment, its face value on its maturity or redemption date. Also known as a zero coupon bond.

zero coupon bond

See discount bond.

zero

See discount bond.

simple loan

A debt instrument where the borrower repays the principal and interest at the end of the loan.

fixed-payment loan

A debt instrument in which the borrower makes periodic repayments of principal and interest.

coupon bond

A debt instrument that makes interest payments periodically until its maturity or redemption date, when the final interest payment and the principal are to be paid.

coupon

The interest rate promised to the owner of a coupon bond.

Consol

A type of perpetual bond issued by the British government.

current yield

A quick (i = FV/PV) but flawed method for calculating interest rates of nonperpetual debt.

rate of return

A measure of the profitability of an investment that takes into account changes in the value of the bond or other asset.

interest rate risk

The risk that the market price of a bond or other debt instrument will decrease due to increases in the interest rate.

default risk

The risk that a bond or other debt instrument will not make the promised payments.

ex post

After the fact.

ex ante

Before the fact.

Chapter 5: The Economics of Interest-Rate Fluctuations

investment portfolio

The set of financial and other investments or assets held by an economic entity.

Great Depression

An almost worldwide decrease in per capita income during the 1930s.

economic funk

Funk is not a technical term, but it is used widely because it encapsulates the economic situation in Japan in a single interesting word. After World War II, Japan experienced rapid economic growth. That growth slowed considerably in the 1990s, following a major financial crisis.

independent central bank

A monetary authority that is controlled by public-interested technocrats rather than by self-interested politicians. For more information, see .

Chapter 6: The Economics of Interest-Rate Spreads and Yield Curves

liquidity preference

The name of one of the theories that economists use to explain the yield curve.

preferred habitat

The name of one of the theories that economists use to explain the yield curve.

Chapter 7: Rational Expectations, Efficient Markets, and the Valuation of Corporate Equities

market volatility

In this context, frequent changes in securities prices.

rational expectations

An economic theory that posits that market participants, in this case investors, input all available relevant information into the best forecasting model available.

economic fundamentals

Key variables in the pricing of assets. They include expected inflation, interest, default, and earnings rates.

investors

Participants in financial markets; purchasers of financial securities.

model

In this context, a theory about the most accurate way to price securities or to estimate the value of future variables such as interest rates, risk, earnings, and other fundamentals.

gold

At one time, gold was money, that is, the unit of account against which the value of all goods was measured. It is now just a precious metal that trades on world markets like other commodities, its price rising and falling with shifts in supply and demand.

zero coupon bond

A discount bond that pays no coupon or interest. The interest is earned by the difference between the bond”s face or par value and the price at which it is sold.

inside information

Information relevant to the valuation of stock or other security and known only to a small group of people.

valuation models

Theories of securities prices and their determinants.

asset bubble

In this context, a rapid increase in asset prices that is not easily justified by fundamentals like expected earnings, interest rates, and the like.

stockholders (or shareholders)

Owners of corporate equities. Generally, they are entitled to one vote per share in corporate elections for directors and a proportionate share of the corporation’s profits.

dividends

In this context, cash distributions of corporate earnings to shareholders.

Internal Revenue Service (IRS)

The tax collector of the U.S. federal government.

required rate of return (or k)

Serves the same purpose as i in present value calculations. In other words, it measures the opportunity cost of making an investment; k is influenced by i but also by default and other risks.

hedge fund

A type of relatively unregulated mutual fund that engages in sophisticated trading strategies. Only wealthy individuals and institutional investors are allowed to invest directly in such funds.

behavioral finance

A new interdisciplinary subject matter that tries to understand the limits of human rationality, especially as it applies to financial markets.

short selling

Selling a stock at a high price and buying it back later at a lower price. It is the logical equivalent of buying low and selling high, but many investors don’t attempt it.

transparency

In general, the opposite of opacity. In this context, transparency means a relatively low degree of asymmetric information.

Chapter 8: Financial Structure, Transaction Costs, and Asymmetric Information

trade credit

Credit granted in the course of trade, as when suppliers ship their wares, then bill net 15 or 30, or when customers, like libraries for academic journals, pay for goods or services before they are provided.

collateralize

Pledge some asset, like land or financial securities, for the repayment of a loan.

minimum efficient scale

The smallest a business can be and still remain efficient and/or profitable.

peer-to-peer banking

In this new type of banking, a facilitator links lenders to borrowers, acting more like a securities broker than a bank.

stock options

In this context, a form of compensation given to executives, managers, and sometimes other employees to reward them for increasing their company’s stock price. By backdating the options, managers were able to profit from their stock options, although stock prices declined (or did not rise very much).

free-rider problem

Trying to hop a ride without paying for it. More technically, it is any behavior where a party takes more than his or her fair share of the benefits, or does not pay his or her fair share of the costs, of some activity.

restrictive covenants

Clauses in loan contracts that restrict the uses to which borrowed funds can be put and otherwise direct borrower behavior.

efficiency wages

Wages higher than the equilibrium or market clearing rate. Employers offer them to reduce agency problems, hoping employees will value their jobs so much they will try to please owners by behaving in the owners’ interest.

initial public offering (IPO)

Offering of stock to investors with the aid of an investment bank.

direct public offering (DPO)

Offering of stock to investors without the aid of an investment bank.

Chapter 9: Bank Management

reserves

In this context, cash funds that bankers maintain to meet deposit outflows and other payments.

required reserves

A minimum amount of cash funds that banks are required by regulators to hold.

secondary reserves

Noncash, liquid assets, like government bonds, that bankers can quickly sell to obtain cash.

bank holding company

A corporate entity than owns one or more banks and banking-related subsidiaries.

liquidity management

Ensuring that the bank has just the right amount of reserves—not too little, which would endanger the bank’s solvency, nor too much, which would decrease its profitability.

asset management

Ensuring that the bank’s assets have the right combination of liquidity, safety, and return.

liability management

Attracting enough deposits or borrowing enough to ensure that the bank can make the loans or purchase the assets it wants.

capital adequacy management

Ensuring that the bank has enough capital, equity, or net worth to remain in operation while maintaining bank profitability as measured by return on equity (ROE).

nonperforming loan

A loan that is in default, where the borrower is not making stipulated payments of interest or principal.

Chapter 10: Innovation and Structure in Banking and Finance

permissive regulatory system

A system that allows financiers to engage in any activities they wish that are not explicitly forbidden. It is easier for financial innovation than a restrictive regulatory system.

disintermediation

The opposite of intermediation, when investors pull money out of banks and other financial intermediaries.

Herfindahl index

A measure of market concentration calculated by summing the square of the market shares of the companies operating in a given market.

Chapter 11: The Economics of Financial Regulation

public interest model

A model of government developed by political scientists that posits that politicians, bureaucrats, and other government workers serve the public in lieu of themselves.

public choice model

See private interest model.

private interest model

A model of government developed by economists that posits that politicians, bureaucrats, and other government workers serve themselves in lieu of the citizens or public.

democracy

A type of government that is of, for, and by the people because it allows citizens to choose candidates and policies via elections.

predatory government

A type of government that is of, for, and by the ruling elite and that fails to supply basic public goods like life, liberty, and property.

externalities

Costs or benefits of an economic activity that are not included in the price, that are not internalized by the buyer and/or seller. Negative externalities, like pollution, impose costs on society; positive externalities, like education, provide societal benefits.

regulatory forbearance

Whenever regulators, for whatever reason, consciously decide not to enforce one or more regulations.

too-big-to-fail (TBTF) policy

The explicit or implicit promise of regulators that they will not allow a given financial institution to fail because to do so would cause too large of a shock for the financial system to handle. While that sounds reassuring and noble, the policy increases moral hazard, encouraging large financial institutions to take on large risks.

Chapter 12: The Financial Crisis of 2007–2008

financial crisis

The functioning of one or more financial markets or intermediaries becomes erratic or ceases altogether.

nonsystemic crisis

A particular market or intermediary functions erratically or inefficiently.

systemic crisis

The functioning of all, or nearly all, of the financial system degrades.

asset bubble

In this context, a rapid increase in asset prices that is not easily justified by fundamentals like expected earnings, interest rates, and the like.

financial panic

Panicked selling occurs during the rapid de-leveraging of the financial system following the bursting of an asset bubble.

call

A lender asks a borrower to repay, usually because interest rates have increased and/or the value of collateral has declined.

burst

When an asset bubble rapidly deflates, i.e., the price of the asset rapidly decreases.

de-leveraging

Lenders force borrowers to invest more of their own equity in assets.

credit crunch

The volume of loans decreases dramatically, usually in response to the bursting of an asset bubble during a financial crisis.

negative bubble

A bubble characterized by prices that are far below their rational value.

bailout

When taxpayer money is used to restore losses suffered by economic agents.

negative equity

The market price of an asset is less than the sum borrowed to acquire it. Also known as being “in the bucket” or “under water.”

subprime mortgages

Loans to risky borrowers collateralized with real estate, usually primary residences but sometimes vacation homes.

financial engineer

A person who engages in financial engineering, the process of creating new, hopefully improved, financial products by redesigning or repackaging existing financial instruments.

mortgage-backed securities (MBSs)

A bundle of home mortgages.

collateralized mortgage obligations (CMOs)

A type of derivative formed by financial engineering mortgage-backed securities into tranches with different risk-return characteristics.

tranches

French for “slice.” Part of a structured finance instrument such as a collateralized mortgage obligation.

Chapter 13: Central Bank Form and Function

central bank

A bank that regulates the money supply, interest rates, and/or other financial institutions on behalf of the government.

base money

The most elementary form of money in a given society at a given time. The only type of money that can compose a bank’s primary reserve.

dollarization

The process of using a foreign country’s money as a domestic currency. Often this entails a country adopting the U.S. dollar as a medium of exchange and unit of account.

district bank

One of the twelve banks comprising the Federal Reserve system.

independence

In this context, a central bank is independent to the degree that it need not follow the dictates of the government that created it.

autonomy

Central bank autonomy is largely synonymous with central bank independence.

Chapter 14: The Money Supply Process

monetary base (MB)

The most basic, powerful types of money in a given monetary system, that is, gold and silver under the gold standard, FRN, and reserves (Federal Reserve deposits) today.

open market operations (OMO)

The purchase or sale of assets by a central bank in order to adjust the money supply. See monetary base.

Chapter 15: The Money Supply and the Money Multiplier

M1

M1 is a measure of the money supply that includes currency in circulation plus checkable deposits.

M2

M2 is a measure of the money supply that includes M1 plus time deposits and noninstitutional (retail) money market funds.

checkable deposits

Deposits that can easily, cheaply, and quickly be drawn upon by check in order to make payments. Also known as transaction deposits.

Chapter 16: Monetary Policy Tools

make a market

Buying securities from all comers at a bid price and reselling them to all comers at a slightly higher ask price.

special-purpose vehicle (SPV)

An organizational entity created to perform a specific, or special, task.

best practice

Policies generally considered to be state of the art in a given industry, to be something that nonconforming organizations ought to emulate.

Chapter 17: Monetary Policy Targets and Goals

time inconsistency problem

Whenever somebody’s preferences change over time to such an extent that what is preferred at one time becomes inconsistent with what is preferred at another time.

rule

In this context, a monetary policy rule, an equation that tells central bankers what interest rate policies they should put in place given employment, output, inflation, and perhaps other macroeconomic variables.

Chapter 18: Foreign Exchange

spot exchange rate

The price of one currency in terms of another today.

forward exchange rate

The price of one currency in terms of another in the future.

Chapter 19: International Monetary Regimes

foreign exchange rate (FX or forex)

The price of one currency in terms of another.

Bretton Woods System (BWS)

A system of fixed exchange rates based on gold and the USD used by most of the world’s free (noncommunist) countries in the quarter century after World War II.

gold standard (GS)

A fixed exchange rate regime based on gold.

specie standard

A fixed exchange rate regime based on specie, i.e., gold and/or silver.

special drawing rights (SDRs)

Liabilities of the International Monetary Fund (IMF), an institution established as part of the BWS.

Chapter 20: Money Demand

Chapter 21: IS-LM

consumption function

A mathematical equation thought to express the level of consumer spending.

positive net present value project

A project likely to be profitable at a given interest rate after comparing the present values of both expenditures and revenues. This will make more sense after you navigate .

+NPV

See positive net present value.

Chapter 22: IS-LM in Action

natural rate level of output (Ynrl)

The rate of output at which the price level has no tendency to rise or fall.

Chapter 23: Aggregate Supply and Demand, the Growth Diamond, and Financial Shocks

economic growth

Real per capita GDP.

shocks

In economics, sudden, unexpected changes. They usually have adverse consequences, but some shocks can be salutary. The ones discussed here are all bad for the financial system and hence the economy.

Chapter 24: Monetary Policy Transmission Mechanisms

transmission mechanisms

How A leads to B in a causal chain; how A is transmitted, so to speak, to B.

Chapter 25: Inflation and Money

lag (n)

The time it takes for a policy to change on a variable, a cause to create an observable effect.

Chapter 26: Rational Expectations Redux: Monetary Policy Implications