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equipment Dan needs. • Rachel and Serafina join an association that offers relatively cheap organic products. In return, they pay a small monthly membership fee. • The Portswood Road Church Club provides a free food service for the poor of the neighborhood. Challenge Imagine a cooperative you and your friends might form. Describe how it would operate and how it would save you money. Types of Business Organizations 251 Case Study Find an update on this Case Study at ClassZone.com Apple: The Evolution of One Company Background Steve Jobs and Steve Wozniak joined forces when they were students. Together, they created a personal computer, named it Apple, and in 1976 started a company with the same name. In the years that followed, their company attained worldwide prominence. While the success story of Jobs and Wozniak often sounds like a fairy tale, the evolution of the company was not without its ups and downs. But by 2005, Apple had annual revenues of nearly $14 billion. What’s the issue? How does a company evolve from an idea into a billiondollar enterprise? Study these sources to discover the factors behind the success of Apple Inc. A. Online Biography This article describes how two young men with an interest in computers created the basis for Apple Inc. Two American Entrepreneurs Start Out in a Garage Young inventors build their first of many computers. When the two first met, Wozniak (born 1950) was 18, Jobs (born 1955) only 13. The pair put their electronics and inventing talents to work making unusual devices, and a few years later purchased a $25 microprocessor with the intention of building a computer. Although this first computer was crude and came without memory, a power supply or even a keyboard, it was very reliable. Jobs and Wozniak decided on a name that would convey the simplicity of the product’s design and use: the Apple. Jobs had a passionate belief in bringing computer technology to everyone. So in 1976, Jobs and Wozniak started a company to build and distribute their invention. In true American-dream fashion, their company began in a garage. To finance their venture, Jobs sold his Volkswagen van and Wozniak sold his programmable calculator to raise $1,300. Weeks later, Jobs secured the company’s first sale: 50 Apple I computers at [the retail price of] $666 each. Source: Inventor of the Week Archive, MIT Steve Wozniak (left) and Steve Jobs
(right) founded Apple Computer in 1976. Thinking Economically According to the document, why were Jobs and Wozniak able to succeed in starting their own company? 252 Chapter 8 B. Interview In this interview, Evelyn Richards, who covered computers for Mercury News in the 1980s, describes Apple’s innovative approach to introducing Macintosh, the company’s new personal computer. 1984–Apple Launches Macintosh Marketing plays key role in product’s success. They [Apple] were really more attuned to magazines much more than other tech companies, because magazines can reach a mass market.... Steve Jobs got on the cover of Time right around then. The press kit was all really well-packaged. There was the press release for the non-techie people that just talked about how wonderful Macintosh was and how it was going to change the world. Then there were techier press releases, where they talked about the RAM, or the keyboard, or other things.... It was really easily digestible, and easy to use by the press. Lots of great photos, professionally done. Now all that is standard. Source: Stanford Library; Interview with Evelyn Richards, 22 June 2000 Thinking Economically How did Apple’s marketing of Macintosh contribute to its success? C. Timeline This timeline shows some of the highlights and challenges that Apple Inc. has experienced. Highlights in Apple Company History 1976–Jobs and Wozniak incorporate Apple Computer 1977–Apple II computer, the first PC with color graphics, introduced 1980–Apple becomes public company, offering 4.6 million shares for sale 1984–Commercial during Super Bowl XVIII introduces the first Macintosh 1985–Both Jobs and Wozniak leave Apple 1988–Apple sues Microsoft when Windows begins using features similar to those developed by Apple 1989–First portable Macintosh introduced 1993–Debut of Newton, an early personal digital assistant 1995–Apple loses its case against Microsoft 1997–Jobs returns to Apple as chief executive officer 1998–Newton discontinued 2001–Portable digital music player iPod introduced 2003–Safari browser introduced; iTunes Music Store debuts 2006–Apple computers begin using Intel Core Duo processors Sources: Macworld March 30, 2006; Apple Inc. Thinking Economically How might Apple’s history have been different if it had become a partnership instead of a corporation? Explain your answer. THINKING ECONOMICALLY Synthesizing 1. Based on information in the documents, how would you describe the evolution of Apple
Inc.? 2. How did Apple’s advertising and marketing affect its success or failure? Use examples from the documents in your answer. 3. What single overriding concern has defined the evolution of Apple and determined its success? Use information from the documents to support your answer. Types of Business Organizations 253 CHAPTER 8 Assessment Sole Proprietorships (pp. 226–231) 1. What are the advantages of a sole proprietorship? 2. What are the disadvantages? Forms of Partnerships (pp. 232–237) 3. What are three different kinds of partnerships, and how do they differ? 4. What are the advantages and disadvantages of a partnership? Corporations, Mergers, and Multinationals (pp. 238–247) 5. What are the advantages and disadvantages of a corporation? 6. In what three ways can companies consolidate? Franchises, Co-ops, and Nonprofits (pp. 248–253) 7. How is a franchise “an almost independent” business? 8. What is the difference between a cooperative and a nonprofit organization? A P P LY. What might be the outcome of raising the fees and requiring more paperwork in order to start a corporation? What would happen if fees were lowered and the application process was simplified? 10. Do you think the number of multinationals will continue to increase? Give reasons for your answer. 11. As you have read, sometimes merged companies are not more efficient than they were separately. In some cases, the chief executive officers (CEOs) who arranged the deal make an enormous amount of money from the merger even though the deal itself does not improve profits. What incentives might a board of directors offer to CEOs to make sure they make deals that pay off in profits? Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. bond conglomerate cooperative corporation dividend franchise general partnership horizontal merger limited liability limited liability partnership limited life limited partnership merger multinational corporation nonprofit organization partnership regulation sole proprietorship stock unlimited liability unlimited life vertical merger In a 1, the business is owned and managed by a single person. One key drawback of this is that the owner has 2, putting even personal savings at risk. A 3 is a business structure in which two or more owners share the management of the business
, profits, and full liability. The 4 and 5 provide ways for some partners to risk only the amount of their investment. A 6 is a business that can raise money by selling 7 and allows for limited liability of its owners and 8 of the enterprise. Two or more businesses can consolidate through a 9. If they provide the same kinds of goods or services, their consolidation is known as a 10. When a business has branches in other countries, it is known as a 11. If someone pays for the right to sell a company’s goods or services in a certain area, that person is operating a 12. A business whose owners are also its customers is known as a 13. A 14 is structured like a business but pursues goals other than profits. 254 Chapter Use the following graph showing the number of mergers in the years from 1970 to 2000 to answer questions 12–14. FIGURE 8.10 MERGERS I N THE UN I TED STATES 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000. 1970 1975 1980 1985 1990 1995 2000 Source: Mergerstat Review Year 12. Analyzing Graphs Which of the following can you determine from the information about mergers in the graph? a. how many companies merged in any given year from 1970 to 2000 b. how many more mergers took place in 2000 than in 1990 c. how long each of the new companies lasted after the merger 13. Predicting Economic Trends Which decade saw the greatest increase in the number of mergers? What probably happened after that decade? 14. Challenge The number of mergers can reflect the economic times, which in turn are often affected by national and world events. What events may have contributed to tighter economic times—and therefore a decrease in mergers—in the 1970s? Design a New Business Structure Each business structure you have read about in this chapter has both advantages and disadvantages. Follow the steps below to design a new business structure that attempts to avoid the worst disadvantages and to capitalize on the most important advantages of the other structures. You can imagine changing laws to accommodate your new structure, but try to make sure your creation makes economic sense. Step 1. Break into small groups. In your group, draw up a list of advantages and disadvantages of all the business structures. The table on page 242 will help you begin the list. Step 2. Discuss how the advantages and disadvantages would affect the ability of a business to earn a profit. Choose
the three advantages and three disadvantages that your group feels have the most impact. Step 3. Brainstorm possible ways to avoid the disadvantages and make the most of the advantages. Remember that in brainstorming any idea is allowed, no matter how crazy or simple it might sound. Step 4. Sort through your brainstorming ideas. Use them to develop a new “ideal” business structure. Step 5. Share your business structure with the rest of the class, and compare your efforts to those of your classmates. Types of Business Organizations 255 The Role of Labor The service sector makes up the largest part of the U.S. economy. More people work in offices than ever before. 256 CHAPTER 9 SECTION 1 How Are Wages Determined? SECTION 2 Trends in Today’s Labor Market SECTION 3 Organized Labor in the United States CASE STUDY Managing Change in Your Work Life The Role of Labor Labor productivity is the value of the goods or services a worker can produce in a set amount of time Labor, the human effort used to produce goods and services, is subject to the same forces of demand and supply that govern the rest of the economy AT T E R S The value of your labor depends on the demand for what you do and the supply of other people able to do the same thing. It’s up to you to figure out what you do best and to distinguish yourself from other workers. Maybe what you really want to do will require special training or years of experience. Think of your dream job, and write a plan for how you will get that job. Evaluate the demand for the job and the supply of people capable of performing it. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on managing change in your worklife. (See Case Study, pp. 282–283.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. The world of work is changing. Will you be able to keep pace? See the Case Study on pages 282–283. The Role of Labor 257 S E C T I O N 1 How Are Wages Determined TA K I N G N O T E S In Section 1, you will wages, p. 258 • identify what wages are equilibrium wage, p. 258 • describe how the interaction derived demand, p. 259 of supply and demand determines wages • explain why wage rates differ wage rate, p.
261 human capital, p. 261 glass ceiling, p. 262 minimum wage, p. 262 As you read Section 1, complete a cluster diagram like the one below to record what you learn about wages. Use the Graphic Organizer at Interactive Review @ ClassZone.com Wages Labor: Demand and Supply QUICK REFERENCE Wages are payments received in return for work. Equilibrium wage is the wage at which the quantity of workers demanded equals the quantity of workers supplied; the market price for labor. KEY CONCEPT S Have you ever wondered why working at a fast food restaurant pays so little? This section will help answer that question. In Chapter 1 you learned about the four factors of production: land, labor, capital, and entrepreneurship. Each of those has a price that must be figured into production costs. The price of labor is wages, the payments workers receive in return for work. Wages, just like the other factors of production, are governed by the forces of supply and demand. The interaction of these two economic forces produces an equilibrium, or balance. An equilibrium wage is the wage at which the number of workers needed equals the number of workers available. In other words, an equilibrium wage produces neither a surplus nor a shortage of workers. Let’s look at demand and supply separately and see how they affect wages at fast food restaurants. Demand for Labor In a competitive labor market, wages reflect a worker’s labor productivity—the value of the goods or services a worker produces in a set amount of time. A business hires workers to help it produce goods or provide 258 Chapter 9 services. A producer’s demand for labor is therefore a derived demand, a demand for a product or resource because of its contribution to the final product. Workers with higher productivity tend to earn higher wages. In one hour, a fast food chef might be able to produce $50 worth of food that customers want. An attorney, by contrast, might be able to provide services worth $300 in the same hour’s time. Employers, then, are willing to pay attorneys higher wages than fast food chefs. The demand for labor depends in part on its price. As with anything else, when the price goes down, the quantity demanded goes up; and when the price goes up, the quantity demanded goes down. For example, suppose that fast food chefs are paid $12 per hour. If the wage should fall to $10 per hour, many restaurants would hire additional chefs. On the other hand, if the wage rose
to $14 per hour, some restaurants would stop hiring and others would have to lay off some chefs. This is illustrated in Figure 9.1. The demand curve for labor, then, is a downward slope—the lower the price of labor, the greater the quantity of labor employers would demand. FIGURES 9.1 AND 9.2 DEMAND AND SUPPLY CURVES FOR LABOR FIGURE 9.1 DEMAND CURVE FIGURE 9.2 SUPPLY CURVE ) 20 15 10 5 0 a 2 4 6 8 10 ) 20 15 10 5 0 b 2 4 6 8 10 Number of workers Number of workers QUICK REFERENCE Derived demand is a demand for a product or resource based on its contribution to the final product. These graphs show demand and supply curves for fast food chefs. a The restaurant is willing to hire more chefs if the hourly wage is lower. b As the wage increases, so does the number of workers willing to work as fast food chefs. ANALYZE GRAPHS 1. How many fast food chefs would the restaurant hire at the wage $10 per hour? 2. How many workers would be willing to be fast food chefs at the wage of $10 per hour? 3. What would happen if the restaurant tried to hire chefs at $10 per hour? Use interactive demand and supply curves for labor at ClassZone.com Supply of Labor Now let’s consider the situation from the worker’s point of view, to see how the supply of labor works. Suppose a new fast food restaurant opens and wants to hire chefs. If it puts an ad in the newspaper for chefs who would be paid $10 per hour, fewer people will respond—and probably none of the chefs currently employed at $12 per hour. Workers who are earning less than $10 per hour in some other kind of job might leave their jobs and become fast food chefs because the wages are higher than their current wages. Find an update on demand and supply of labor at ClassZone.com The Role of Labor 259 But suppose the new restaurant offers fast food chefs $15 per hour. Any worker earning less than that will be interested—including experienced chefs currently employed at $12 per hour. More workers will be willing to work at higher wages than at lower wages. For this reason, the supply curve for labor is upward sloping, as illustrated in Figure 9.2 on page 259. Equilibrium Wage You learned in Chapter 6 that the equilibrium price for goods or
services is the price at which there is neither a surplus nor a shortage—in other words, the point at which the supply curve and the demand curve intersect. Since wages are the price of labor, they too gravitate toward equilibrium. For example, fast food restaurants might offer higher wages to attract chefs. Given the upward-sloping supply curve, before long there would be more people wanting to be chefs than there are jobs, resulting in a labor surplus. With so many chefs to choose from, restaurants could lower the wage and still attract workers. If they offered a wage that was too low, however, people would have less incentive to work as fast food chefs. A shortage would eventually result, so restaurants would need to raise the wages to attract more. The downward and upward forces push until an equilibrium wage is reached, as illustrated in Figure 9.3. FIGURE 9.3 EQUILIBRIUM WAGE ) 20 15 10 5 0 a 2 4 6 8 10 Number of workers This graph shows how demand and supply interact to determine the equilibrium wage for fast food chefs. a In this case, five workers are demanded and five are available at the wage of $12 per hour. The equilibrium wage for fast food chefs is $12 per hour. ANALYZE GRAPHS 1. How many fast food chefs would the restaurant hire at the wage of $15 per hour? 2. How many workers would be willing to be fast food chefs if the wage rose to $15 per hour? 3. What would result if the wage rose to $15 per hour? APPLICATION Applying Economic Concepts A. Suppose that a new high school opens next to a popular fast food restaurant. Explain what will happen to the derived demand for chefs at the restaurant. 260 Chapter 9 QUICK REFERENCE Wage rate is the established rate of pay for a specific job or work performed. Human capital is the knowledge and skills that enable workers to be productive. Why Do Wage Rates Differ? KEY C ONCEPT S Different jobs have different wage rates, the rates of pay for specific jobs or work performed. Wage rates are determined by supply and demand, which in turn are influenced by four key factors: (1) human capital, which is the knowledge and skills that enable workers to be productive, (2) working conditions, (3) discrimination in the workplace, and (4) government actions. FACT OR 1 Human Capital Economists group workers according to the amount of human capital they have. Unskilled workers, such as house cleaners and
sanitation workers, have a low level of human capital. Semiskilled workers—construction and clerical workers, for example—have received some training, so their human capital is higher. Skilled workers, such as plumbers and electricians, have made a significant investment in human capital in the form of specialized training. Professional workers—doctors, lawyers, and others with intensive specialized training—have the highest human capital. The demand for skilled and professional workers is high, but the supply of these workers is relatively low. For this reason and because training increases their productivity, highly skilled workers tend to receive higher wages. The prospect of higher wages leads many people to invest in their human capital and enroll in vocational school, specialist training programs, and higher education. FIGURE 9.4 AND 9.5 U.S. LABOR FORCE BY EDUCATION FIGURE 9.4 MEDIAN EARNINGS FIGURE 9.5 NUMBER OF WORKERS BY EDUCATION BY EDUCATION ) 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 Less th an hig h sch o ol So m e colleg e Hig h sch o ol grad u ate ) olleg e grad u ate A dvanced d egree 50 40 30 20 10 0 Less th an hig h sch o ol So m e colleg e Hig h sch o ol grad u ate C olleg e grad u ate A dvanced d egree Source: U.S. Bureau of Labor Statistics, 2005 data Source: U.S. Bureau of Labor Statistics, 2005 data ANALYZE GRAPHS 1. In terms of average annual salary, about how much is graduating from high school worth? 2. There are almost as few people without a high school diploma as with an advanced degree. Why doesn’t the reduced supply make their salaries as high as the salaries for people with an advanced degree? The Role of Labor 261 FACTOR 2 Working Conditions “It’s a tough job, but someone has to do it.” That statement is often used humorously by people who have dream jobs, such as vacation planners who get to go on fabulous trips as “research” or taste testers who sample chocolate or other goodies. However, some jobs really are tougher than others. Some jobs, such as washing windows on a skyscraper, are very dangerous. Other jobs can be very unpleasant, such as collecting garbage. Higher wages are often paid to
workers in dangerous and unpleasant occupations in order to attract qualified people to those jobs. While the disadvantages of some jobs may be offset by higher wages, the advantages of other jobs may make up for low wages. These advantages vary widely, depending on the worker. For example, a student who loves movies might take a job as a clerk at a video store. Although the pay is low, the student might get to borrow movies free of charge. Someone tired of a long commute in rush hour traffic might welcome a lower-paying job that is only minutes away from home. FACTOR 3 Discrimination Another factor affecting differences in wage rates is discrimination. Wage discrimination may be based on race, ethnicity, gender, or other factors. For example, the average pay of women tends to be lower than that of men doing the same job. Racial prejudices sometimes lead to discrimination in wages. A prejudiced employer might be unwilling to hire a minority candidate except at a lower wage. However, employers who discriminate may actually lose money. By eliminating qualified candidates because of their gender, ethnic group, or other trait irrelevant to performance, employers may miss out on the best worker for the job. Wage differences may also result from occupational segregation. Some low-paying jobs have been viewed as the “realm” of women or certain racial or ethnic groups. Occupational segregation becomes a vicious cycle: groups can become trapped in these jobs, unable to earn enough to invest in human capital that could move them upward. In the United States, the federal government has tried to break this cycle by passing such antidiscrimination laws as the Equal Pay Act (1963) and the Civil Rights Act (1964). Artificial barriers to advancement may also limit the wages of women and minorities. They may have the skills and experience necessary to advance, but find that they are never promoted. The term glass ceiling describes these unseen barriers to advancement. FACTOR 4 Government Actions In a pure market economy, wages would be set strictly by economic forces. However, in many countries, including the United States, the government steps in when market forces produce results that people disagree with. The minimum wage, the lowest wage legally allowed for one hour of work, is one example. As you read in Chapter 6, the minimum wage acts as a price floor designed to boost wages for lowincome workers. The forces of supply and demand might set the equilibrium wage Working Conditions Painters who work at high altitudes receive higher wages. QUICK REFERENCE Glass ceiling is an artificial barrier to advancement faced by women and minorities
. The minimum wage is the legal minimum amount that an employer must pay for one hour of work. 262 Chapter 9 M AT. 6 Calculating Annual Wages Suppose you are offered two jobs, one that pays $12.50 per hour or another that pays $30,000 per year. In both jobs, you will work 40 hours per week and get two weeks off per year. Assuming both offer the same benefits, which job pays better? You could either figure out how much you would make in a year at the hourly job or you could convert the annual salary into an hourly wage. In this exercise, we will calculate how much a wage of $12.50 per hour pays for a year’s worth of work. Step 1: Multiply to determine the number of hours worked per year. Assume the job includes two weeks of unpaid vacation. Example Calculations Hours per week Weeks per year Total hours per year 40 50 2,000 Step 2: Then, multiply to find the amount of pay annually. Total hours per year Hourly wage Annual wages 2,000 $12.50 $25,000 The job that pays a salary of $30,000 per year pays better than the one that pays a wage of $12.50 per hour. Comparing Earnings Use the calculations to determine the annual wages of a job that pays $15 per hour for 40 hours per week. What about one that pays $20 per hour but only offers 20 hours of work each week? What other factors do you need to consider when comparing pay between jobs? for certain jobs so low that no one could reasonably make a living at these jobs. The minimum wage attempts to help the people who hold these jobs to make ends meet. However, businesses point out that they might hire more workers if they were allowed to pay a lower wage. The first national minimum wage law in the United States was passed in 1933 during the Great Depression. In part, it was intended to raise wages so that workers could consume products and help the economy recover. In 1938, the minimum wage became part of the Fair Labor Standards Act, which included other protections for workers. The U.S. Congress has increased the minimum wage several times, but the increases have not kept up with the general rise in prices. In response, some state and local governments have passed their own laws requiring minimum wages higher than the federal standard. AP P LI CATION Applying Economic Concepts B. Explain how each of the four factors influences wages at fast food restaurants. The Role
of Labor 263 ECO N O M I C S PAC ES E T T E R Gary Becker: The Importance of Human Capital “I believe an economist should... express concepts in simple language and show how to deal with important problems in a fairly simple way.” With those words, Nobel laureate economist Gary Becker aptly described his own approach. He proposed that the general economic principle of rational choice could be applied to the decisions people make in all spheres of life. Becker extended an economic way of thinking into new areas, including crime and punishment, households and family relations, and human competence. Investing in Yourself When Gary Becker graduated from high school, he was torn between following a career in mathematics and doing something to help solve social problems. He studied economics at Princeton University and the University of Chicago, and he went on to teach at Chicago and at Columbia University. In 1957, Becker published The Economics of Discrimination, which examined the “effects of prejudice on the earnings, employment, and occupations of minorities.” However, most economists did not pay much attention, feeling that such a study belonged in the fields of sociology or psychology. Today, though, Becker’s approach is widely appreciated and has led economists to explore new areas. Becker is best known for his contri- butions to the idea of human capital and for formulating the economic theory that explains differences in wages in terms of investments in human capital. To Becker, human capital is more than education and training: it is all the investments people make in themselves to improve their output, including the development of good work habits and receiving good medical treatment. The more abundant the capital, the more productive the labor. Becker helped to quantify the importance of education and on-the-job training and, by doing so, broadened the reach of economics. Gary Becker won the Nobel Prize for Economics in 1992 and the National Medal of Science in 2000. APPLICATION Conducting Cost-Benefit Analysis C. Becker debated with himself about whether to park illegally, weighing the possible costs against the advantages. Explain a decision you made using cost-benefit analysis. Is that always the best way to make a decision? Why or why not? FAST FACTS Gary Becker Born: December 2, 1930 Pottsville, Pennsylvania Major Accomplishment: Extending an economic way of thinking into other areas of life and using economics to explain social behavior Inspiration for Ideas About Economics and Crime: When he arrived late one day at Columbia University in New York, Becker decided to save time
by parking illegally, even though he knew he might get caught and fined. This led him to wonder if people committing other crimes considered the consequences of their decisions rationally. Famous Quotation: “No discussion of human capital can omit the influence of families on the knowledge, skills, values, and habits of their children.” Find an update on Gary Becker at ClassZone.com 264 Chapter 9 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. wages derived demand b. equilibrium wage minimum wage c. wage rate human capital 2. What market forces influence wages? 3. What nonmarket forces influence wages? 4. Why are education and training considered a kind of capital? 5. Why would a star athlete receive wages so much higher than an insurance sales representative? 6. Using Your Notes Suppose you are the owner of a video store. Explain how you would decide what to pay your workers, making reference to the terms in your completed cluster diagram. Wages Use the Graphic Organizer at Interactive Review @ ClassZone.com. Analyzing Cause and Effect If the equilibrium wage for bowling alley managers is $16 per hour, why would a wage of $20 per hour result in a labor surplus? Why would a wage of $12 per hour lead to a labor shortage? 8. Solving Economic Problems What economic problem does the minimum wage try to address? 9. Applying Economic Concepts Explain why working conditions can either justify higher wages or make up for lower wages. 10. Making Inferences and Drawing Conclusions Despite efforts to close the wage gap between men and women, the gap has actually been widening. Using what you have learned in this section, write a paragraph discussing what could be done to close the gap. 11. Challenge Gary Becker said that economics “is easy in the sense that there are only a few principles that really guide most economic analysis.” Identify the basic principles behind how wages operate. Graphing Equilibrium Wages Read each job description below. Then make a graph showing a hypothetical equilibrium wage for each job using the same values for both axes in each graph. Job Description #1 Job Description #2 Structural metal worker for highrise construction project. Must have at least 2 years of experience. Filing clerk, small accounting office. No experience necessary, but must have a high school diploma or GED. Apply Economic Concepts Using the economic knowledge you gained in this section,
briefly explain why each graph appears as it does. Challenge In many dangerous industries, including mining, safety laws establish standards that protect workers. Explain what effect these laws might have on wages. Use to complete this activity. @ ClassZone.com The Role of Labor 265 S E C T I O N 2 Trends in Today’s Labor Market TA K I N G N O T E S In Section 2, you will civilian labor force, p. 266 • identify the changes that have taken place in the labor force • explain how occupations have changed • explain how the way people work has changed outsourcing, p. 269 insourcing, p. 269 telecommuting, p. 270 contingent employment, p. 270 independent contractor, p. 270 As you read Section 2, complete a hierarchy chart like the one below. In each box write the main ideas. Use the Graphic Organizer at Interactive Review @ ClassZone.com Trends in Labor Market changing labor force A Changing Labor Force KEY CONCEPT S The labor market in the United States has changed dramatically since the 1950s, and it continues to change. For example, in the 1950s, many companies hired workers with the expectation that they would stay with the company for most of their working lives. After a lifetime of service, workers could count on company pension plans to help fund their retirement. Today, few workers stay with the same company their entire career, and workers take more responsibility for funding their retirement. Those are only some of the profound changes that affect the civilian labor force, people who are 16 or older who are employed or actively looking for and available to do work. The civilian labor force excludes people in the military, in prison, or in other institutions. In 2005, about 150 million Americans made up the civilian labor force. That figure was up from 126 million workers in 1990 and is expected to rise to almost 165 million workers by 2020. Labor Force The civilian labor force is composed of people age 16 or older who are working or looking for work. QUICK REFERENCE The civilian labor force is made up of people age 16 or older who are employed or actively looking for and available to do work. 266 Chapter 9 FIGURES 9.7 AND 9.8 MEN AND WOMEN IN THE U. S. LABOR FORCE FIGURE 9.7 NUMBER OF MEN AND WOMEN IN THE LABOR FORCE FIGURE 9.8 PERCENTAGE OF MEN AND WOMEN IN THE LABOR FORCE MEN WOMEN ) 80 70 60 50 40 30 20
10 MEN WOMEN 100 80 60 40 20 1950 1960 1970 1980 1990 2000 Source: U.S. Bureau of Labor Statistics Year 0 1950 1960 1970 1980 1990 2000 Year Source: U.S. Bureau of Labor Statistics ANALYZE GRAPHS 1. About how many more men were in the labor force than women in 1950? in 2000? 2. What percentage of the labor force did women account for in 1950? in 2000? Changes in the U.S. Labor Force To understand some of the changes in the U.S. labor force, consider these two scenes. In the first scene, the year is 1955. A young woman pulls into a gas station, and the attendant fills up her car with gas. Then she picks up her children at school and heads home to get dinner ready in time for her husband’s arrival from work. The second scene is set in today’s world. A young mother pulls into a gas station, swipes her credit card, and fills up her tank. Her business meeting ran long, and she is late getting to the daycare center. Her husband will pick up dinner for the family on his way home from work. One obvious change these scenes demonstrate is the addition of many more women to the work force. As shown in Figures 9.7 and 9.8, women have been a significant factor in the growth of the labor market in the United States. Since the 1950s, the kinds of jobs open to women have expanded. As job opportunities have improved, wages for women have risen, and many more women have been drawn into the work force. The U.S. work force has also become better educated. About 30 percent of people in the labor force have a college degree, and an additional 30 percent of workers have some college credits. In a work force with such a high degree of human capital, productivity and wages are also high compared with many other nations. AP P LI CATION Evaluating Economic Decisions A. Explain how rising opportunity costs have led more women into the workplace. Find an update on the U.S. work force at ClassZone.com The Role of Labor 267 Changing Occupations KEY CONCEPT S Economists group occupations into three economic sectors. The primary sector is made up of jobs related directly to natural resources, such as farming, forestry, fishing, and mining. Jobs in the secondary sector are related to the production of goods, including the materials and energy needed to produce them. Examples include welders, truck drivers, and construction workers
. The tertiary sector is made up of service-related jobs in such industries as banking, insurance, retail, education, and communications. As you can see in Figures 9.9 and 9.10, U.S. manufacturing jobs have declined since the 1950s, while service-sector jobs have increased dramatically. All of the ten fastest-growing occupations are service related, most of them in the area of medical services. FIGURES 9.9 AND 9.10 EMPLOYMENT IN THE UNITED STATES BY ECONOMIC SECTOR FIGURE 9.9 EMPLOYMENT IN 1950 FIGURE 9.10 EMPLOYMENT IN 2000 3% 14% 33% 53% 18% 79% Primary Secondary Tertiary Primary Secondary Tertiary Source: U.S. Bureau of Labor Statistics Source: U.S. Bureau of Labor Statistics ANALYZE GRAPHS 1. Which sector grew the most from 1950 to 2000? By how much did it grow? 2. How much of the civilian labor force was employed in the combined primary and secondary sectors in 1950? How much in 2000? Technology and Change Think back for a moment to the young mother at the gas station. In the years between 1955 and today, the job of gas station attendant has been mainly replaced by the computerized, credit-card operated gasoline pump. In the same way, ATMs have greatly affected the occupation of bank teller. Technological changes have eliminated or redefined many other jobs in all three sectors. The personal computer and the Internet have drastically changed the way onthe-job information is stored, transferred, and used. About half of all American workers use a computer on the job. As a result, those occupations that support the 268 Chapter 9 1950s gas station 2000s gas station use of computers—software engineers and network and data communications analysts, for example—have been among the fastest growing in the United States. More than 80 percent of managers and professionals use a computer at work. However, even in less skilled jobs, more and more workers are using computers. About 20 percent of machine operators, laborers, and farmers use a computer on the job. Basic computer skills have become necessary for many different types of jobs. Globalization and Jobs Today’s labor market is global. Technology allows companies to employ people not just all over the country, but all over the world. Many companies have sought to cut their costs by outsourcing, the practice of contracting with an outside company to provide goods or services. Most outsourcing
by U.S. companies goes to other U.S. companies. For example, many American businesses hire other American firms to handle their accounting. However, the term outsourcing has become connected with the practice of moving jobs from the United States to foreign countries where wages are lower. As this happens more frequently, it would seem that their American operations would lose jobs. But many companies actually add more jobs in the United States than they outsource abroad, just in different parts of their businesses. In 2004, IBM decided to send about 3,000 jobs overseas. But at the same time, it created about 4,500 jobs in the United States. The American economy has also benefited from insourcing, the practice of foreign companies establishing operations in, and therefore bringing jobs to, the United States. Both outsourcing and insourcing are tied to the trends toward more service-related jobs and more technology-related work. AP P LI CATION Predicting Economic Trends B. Think of an example of an occupation that is likely to be eliminated or substantially redefined as a result of technology. QUICK REFERENCE Outsourcing is the practice of contracting with an outside company, often in a foreign country, to provide goods or services. Insourcing is the practice of foreign companies establishing operations in, and therefore bringing jobs to, the United States. The Role of Labor 269 Changes in the Way People Work KEY CONCEPT S QUICK REFERENCE Telecommuting means performing office work in a location other than the traditional office. Contingent employment refers to temporary or part-time work. An independent contractor is someone who sells their services on a contract basis. The way people work has been transformed by technology. In the past, many workers needed to physically commute to and from an office in order to accomplish their work. The Internet and laptop computers have allowed some of these workers to engage in telecommuting, the practice of doing office work in a location other than the traditional office. But the job market has also changed. In the past, companies offered most workers permanent positions. Today, companies offer fewer permanent positions and more contingent employment, work that is temporary or part-time. Similarly, more people work as independent contractors, selling their services to businesses on a contract basis. People used to enter a field and stay in more or less the same line of work for most of their work life. Now, most people will change careers several times as the world of work continues to evolve. Working at the Office from Home Many telecommuters enjoy the reduced stress
, flexibility in work time, and increased free time they have by avoiding a commute to work. Employers benefit from an expanded labor pool, increased productivity, and lower real estate costs. Society benefits, too, from fewer drivers on crowded freeways and lower pollution. However, there are also costs. People who work at home may feel that their work too often spills over into their personal time. Some miss the social life of the office and the chance to network. Some at-home workers also fear that on-site workers might be more likely to get promoted. Still, experts estimate that the number of telecommuting workers grew by about 20 percent each year from 2000 to 2005. YO U R EC TELECOM M UTING Where would you want to work? Technology allows people to work in many different places. Alternative work places have different benefits—and drawbacks—than the traditional office.? ▲ Work at the office ▲ Work at the coffee shop 270 Chapter 9 Alternatives to Permanent Employment Through much of the 1900s, U.S. companies would hire workers for permanent, full-time jobs. Employees would work 40 hours per week in exchange for both wages and benefits. In the 1990s, companies began to hire fewer full-time employees and more contingent employees and contract workers. Contingent workers, sometimes called temps, make up over 5 percent of the total work force. Independent contractors make up over 7 percent of the work force. Hiring contingent employees and contract workers makes it easier for businesses to adjust their work force to suit production demands. Discharging temporary workers is easier and less costly than discharging permanent employees. Since most temporary workers do not receive benefits, labor costs are also lower. Most contingent workers would prefer to have the steady income and benefits that come with permanent, full-time employment. But many independent contractors prefer the flexibility of being their own boss to working in a permanent position. They are willing to take the risk of not having enough work to support themselves, and they find alternative ways to pay for health insurance and retirement. Businesses sometimes offer permanent positions to contingent and contract workers who have done a good job. Changing Careers More Often As technology has advanced, jobs have changed, too. Much of the work done today in the United States and other advanced countries did not exist 100 years ago. Some of the work did not exist even ten years ago. With every new technology, new types of jobs are created. But as technology advances, many older professions become less in demand or even obsolete
. To fill the new jobs, workers must learn and adapt to the new technologies. Someone who started out as a radio repair technician might need to learn how to work with cellular phone technology. In a similar way, the economy changes more quickly than it did in the past. Companies have become more flexible, changing their business plans constantly to maximize profits. Globalization allows companies to move jobs across national boundaries. As the economy changes, workers must change and adapt. The technician who adapted to cellular phone technology might need to change yet again in a few years. AP P LI CATION Analyzing Cause and Effect Changing Careers As the demand for healthcare workers increases, some people will change careers to ﬁ ll these jobs. C. A 2003 report concluded that telecommuters can save their employers $5,000 a year. Explain how that savings may come about. The Role of Labor 271 For more on interpreting graphs, see the Skillbuilder Handbook, page R29. Drawing Conclusions from Graphs Drawing conclusions means analyzing a source of information and forming an opinion. You have already had some practice analyzing line and pie graphs in Chapters 6 and 8. These graphs are bar graphs. PRACTICING THE SKILL Begin by using the following strategies to analyze the graphs. They are similar to the strategies you used in Chapter 6 to analyze a line graph. Your analysis will enable you to draw conclusions about the information shown on the graphs. F I G U R E 9.11 A N D 9.12 FA S T ES T G ROW I N G O CC U PAT. S., 2004-2014 Read the title to identify the main idea of the graphs. FIGURE 9.11 FIGURE 9.12 Check the vertical axes. Note that the axes use different scales. Check the horizontal axes. Both axes list a variety of occupations. 800 700 600 500 400 300 200 100 il n o e r s s e R 60 50 40 30 20 10 is ti it d e r s n n Occupations N H e h e s a lt ti sis t a y si c i a n n a s sis Occupations o C h P p li ti o e g i n Source: U.S. Bureau of Labor Statistics projections Source: U.S. Bureau of Labor Statistics projections NOW PUT IT ALL TOGETHER Both graphs claim to present the same information. Compare the two graphs, and consider their differences. Read the source lines to confirm that the data come from a reliable source. T HINKING
ECONOMICALLY Drawing Conclusions 1. What is the main difference between the two graphs? 2. Which graph really shows the fastest growing occupations? Explain your answer. 3. What would be a better title for each graph? 4. Which of these jobs are most likely to have higher than average wages? Why? 272 Chapter 9 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs. a. outsourcing insourcing b. contingent employment independent contractor 2. Name three of the fastest growing occupations. What do they have in common? 3. What are the economic reasons that explain why so many women joined the labor force in the late 1900s? 4. Name two ways technology has altered the U.S. labor market. 5. For an employee, what are the advantages and disadvantages of telecommuting? 6. Using Your Notes Write a paragraph explaining how you can use the information in this section to prepare for your future career. Refer to your completed hierarchy chart to help you anticipate the employment trends you will be facing. Trends in Labor Market changing labor force Use the Graphic Organizer at Interactive Review @ ClassZone.com. Making Inferences and Drawing Conclusions Given the trends in the labor market, do you think today’s employees will need to be more independent than the last generation’s or less independent? Why? 8. Analyzing Cause and Effect Explain how changing technologies have led to workers changing careers more often. 9. Evaluating Economic Decisions The United States has shifted to an economy driven by service industries. The primary sector, which deals in natural resources, and the secondary sector, which produces goods, are both shrinking. Do you think the shift toward a service economy is helping American workers or hurting them? Give reasons for your answer. 10. Challenge Adam Smith explained that countries maximize their wealth when they concentrate on producing the goods that they produce most efficiently and rely on international trade for goods they don’t produce efficiently. Explain how outsourcing is an example of this concept. Examining Labor Market Trends Make a copy of the table below. On your copy, list the reasons for the trend toward contingent labor in the left column. In the right column, describe its impact on the labor force. Move to Contingent Labor Why? Impact on Labor Force Analyze Cause and Effect In what ways have women in the work force influenced the growth of contingent labor? In what ways has the growth of contingent labor influenced
women? Challenge What personal issues might lead a worker to seek part-time employment? The Role of Labor 273 S E C T I O N 3 Organized Labor in the United States TA K I N G N O T E S In Section 3, you will labor union, p. 274 • describe how the labor strike, p. 274 movement developed in the United States • discuss why organized labor has declined in the United States • explain how labor unions affect wage rates and employment closed shop, p. 279 union shop, p. 279 right-to-work law, p. 279 collective bargaining, p. 280 binding arbitration, p. 280 As you read Section 3, complete a summary chart like the one below. In each box, write the main ideas for each topic. Use the Graphic Organizer at Interactive Review @ ClassZone.com Topic Main Ideas Related Facts Labor movement’s rise to power The Labor Movement’s Rise to Power KEY CONCEPT S Organized labor helped to shape the modern workplace. Most of the benefits that workers in the United States take for granted today did not exist 200 years ago. The eight-hour workday, the five-day work week, vacations, even sick leave—none of these basic amenities would have existed without the efforts of organized labor. In the industries of the 1800s, workers put in long hours—often 60 hours per week or more—for low pay. Factory laborers often worked in dangerous conditions. Individual workers had little power to demand improvements from a business owner. If a worker complained too much, they would be fired. Workers in industrialized nations around the world faced similar problems, but this section will focus on the labor movement in the United States. To improve their bargaining power, factory workers in the 1800s began to join together and act as a group. A labor union is an organization of workers who collectively seek to improve wages, working conditions, benefits, job security, and other work-related matters. Unions attempted to negotiate with businesses to achieve their goals, but businesses often resisted. As unions sought ways to gain negotiating power, they turned to the strike, or work stoppage. The threat of shutting down production demonstrated the power of organized labor. Different types of unions addressed different needs. Some workers joined a craft union, a union of workers with similar skills who work in different industries for different employers. Examples include typesetters or, more recently, electricians. Others joined an industrial union, a union for workers with different skills who work in the
same industry. For example, workers in the textile industry formed some of the earliest industrial unions. QUICK REFERENCE A labor union is an organization of workers that seeks to improve wages, working conditions, fringe benefits, job security, and other work-related matters for its members. A strike is a work stoppage used to convince an employer to meet union demands. 274 Chapter 9 Early Developments Local craft unions were the main kind of worker association during the early years of the United States. By the 1830s, local unions began joining together into federations to advance their common cause. The first national federation was the National Trades Union (NTU), founded in 1834. A financial crisis that gripped the country in 1837 brought an end to the NTU and temporarily subdued union activity. In 1869, organized labor took a huge step forward when Uriah Stephens founded the Knights of Labor. Unlike other unions, it organized workers by industry, not by trade or skill level. The Knights of Labor became a nationwide union and adopted political goals including an eight-hour workday for all workers and the end of child labor. Its membership grew quickly, especially after the union helped workers win concessions from the big railroad companies in the 1880s. During the explosion of industrialism in the late 1800s, employers strongly resisted the efforts of workers to organize, and many labor protests turned violent. • In 1886, one person was killed and several others were seriously wounded when police attacked workers protesting for an eight-hour workday outside the McCormick Harvester Company in Chicago. The next day, people gathered at Haymarket Square to protest the deaths, and police troops arrived to disperse the crowd. Someone threw a bomb into the police, killing seven officers, and the riot that followed left dozens of other people dead and hundreds injured. • In 1892, ten workers were killed in a strike against Carnegie Steel in Homestead, Pennsylvania, and the union was broken up. • In 1894, a strike in Illinois against the Pullman Palace Car Company won the support of railway workers across the country, who collectively brought the nation’s railroads to a halt. The dispute turned violent when National Guard troops were brought in to keep the nation’s railroads running. A federal court ruled that the American Railway Union could not interfere with the trains, and the strike was broken. A New Model for Unions The violence associated with organized labor, as well as its often controversial political agenda, led to a decline in union membership. But Samuel
Gompers offered a different model for union organization. In 1886, he founded the American Federation of Labor (AFL), an organization of craft unions that focused on the interests of skilled labor. The AFL continued to seek improvements in wages, benefits, and working conditions, but it focused on achieving these goals through the economic power of workers, instead of through legislation. By the early 1900s, the AFL had a membership of about 1.7 million workers. Legal action against organized labor forced Gompers to modify his stance against political activity, and the AFL began supporting pro-union candidates. The International Ladies’ Garment Workers Union was founded in 1900. The union gained strength following successful strikes in 1909 and 1910. Perhaps the most famous Union Organizing A union rally takes place at a shipyard in 1943. The Role of Labor 275 F I G U R E 9.13 History of the American Labor Movement 1893 ▲ Eugene V. Debs founds the American Railway Union. 1869 ▲ Uriah Stephens founds the Knights of Labor. 1900 ▲ International Ladies’ Garment Workers’ Union founded. 1825 1850 1875 1834 National Trades Union formed. 1886 ▲ Protest in Chicago, advertised by this flyer, turns into the Haymarket Riot. 1900 1894 Labor Day becomes a national holiday. 1886 American Federation of Labor (AFL) founded by Samuel Gompers. woman to participate in the U.S. labor movement was Mary Harris Jones, known as Mother Jones. In 1903, she led 80 children, many of whom had been injured while working, on a march to the home of President Theodore Roosevelt. The march helped to emphasize the need for child labor laws. Unions Gain Power During the Great Depression of the 1930s, union membership in the United States declined as millions of people lost their jobs. Yet unions gained power through laws passed as part of the New Deal, a series of reforms that attempted to revive the country’s economy. • The Norris-LaGuardia Act (1932) outlawed the practice of hiring only workers who agreed not to join a union. It also required employers to allow workers to organize without interference from their employer. • The National Labor Relations Act (1935), also known as the Wagner Act, protected the rights of workers in the private sector to form unions and to use strikes and other job actions. • The Fair Labor Standards Act (1938) set a minimum wage, required extra pay for overtime work, and made most child labor
illegal. During this period, the Congress of Industrial Organizations (CIO) organized unions for industrial workers. Originally part of the AFL, which favored skilled workers in craft unions, the CIO broke away in 1938. The two organizations came together again in 1955 as the AFL-CIO. The AFL succeeded in organizing the United Auto Workers (UAW) union in 1935. After a tense sit-down strike in Flint, Michigan, in 1937, General Motors 276 Chapter 9 2005 Service Employees International Union breaks away from AFL-CIO. 2000 1962 ▲ Cesar Chavez founds National Farm Workers Association (NFWA), which later becomes United Farm Workers. 1975 1981 ▲ Air traffic controllers’ strike is unsuccessful. 1925 1950 1935 Congress passes the National Labor Relations Act, also called the Wagner Act. 1959 Congress passes Landrum-Griffin Act. 1935 United Auto Workers organized. became the first automaker to recognize the union. Chrysler and Ford soon followed. In the 1940s, Walter Philip Reuther, as president of the UAW, helped auto workers become some of the nation’s highest paid industrial workers. Also in the 1940s, John L. Lewis, the tough-talking, cigar-smoking leader of the CIO, brought his own United Mine Workers back from near failure and waged a fierce and successful fight to organize the nation’s steelworkers. Backlash Against Unions Following World War II The end of World War II ushered in a period of anti-union legislation. In 1947, over the veto of President Harry S. Truman, the Taft-Hartley Act was passed. It amended the Wagner Act and limited union activities, increasing the government’s power to intervene if a strike might threaten national security. America’s fear of Communism, the political and economic system of the Soviet Union, led to further restrictions on unions. The Landrum-Griffin Act (1959) forbade communists from holding union offices and required tighter financial and electoral accounting. George Meany, president of the AFL-CIO from 1955 to 1979, was a strong anti-communist and worked to get rid of unions that he considered sympathetic to communist ideas. AP P LI CATION Comparing and Contrasting Economic Information A. What motivated workers in the 1800s to form unions? Why did they continue to form unions in the early- to mid-1900s? The Role of Labor 277 The Labor Movement’s Steady Decline KEY CONCEPT S For 30 years following World War II,
labor unions represented about 30 percent of the U.S. work force. Since the mid-1970s, membership in unions has declined steadily, falling to about 12.5 percent in 2005. The decline in unions can be traced to three causes: unions’ tarnished reputations, changes in the labor force, and laws restricting union influence. Loss of Reputation and Labor Force Changes In the late 1900s, labor unions began to lose their luster in the eyes of many Americans. Prolonged strikes both disrupted the public and placed a burden on the striking families. Some unions began requiring companies to employ more workers than necessary, a tactic known as featherbedding. Featherbedding, especially in the railroad industry, raised criticisms of wastefulness. Investigators discovered that a few labor unions had ties to organized crime, which reflected badly on all unions. The changing nature of the U.S. work force also led to reduced union membership. Union membership was traditionally rooted in manufacturing industries. But the number of manufacturing jobs in the United States fell sharply in the second half of the 20th century as the economy shifted toward service industries. The increase in the number of contingent and contract workers also led to lower union membership because such workers are less likely to pursue union representation. As manufacturing declined, unions shifted their organizing efforts toward service workers. The American Federation of State, County, and Municipal Employees FIGURE 9.14 UNION MEMBERSHI P I N THE U N I T ED STATES Find an update on labor unions at ClassZone.com 40 30 20 10 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: U.S. Bureau of Labor Statistics Year ANALYZE GRAPHS 1. During this time period, when was union membership highest? What percent of the labor force belonged to a union that year? 2. Which year was union membership lowest, and what percent of the labor force belonged to a union then? 278 Chapter 9 had about 1.4 million members in 2005. The Service Employees International Union (SEIU), which organizes such service workers as caregivers and janitors, had a membership of 1.8 million in 2005. The SEIU was the largest union in the AFL-CIO, but in 2005 it left the group. Several other smaller unions also left the AFL-CIO and joined SEIU to form a new coalition with different priorities. Right-to-Work Laws Another factor in the steady decline of union membership in the United States is legislation that
tries to limit union influence. Unions had developed the closed shop, a business required to hire only union members. The closed shop was intended to maintain union standards for workers who only work at a business briefly, such as musicians or restaurant employees. Unions also developed the union shop, a business where workers are required to join a union within a set time period after being hired. Union shops allowed businesses to hire nonunion workers without diluting the strength of the union. The Taft-Hartley Act outlawed the closed shop and weakened possibilities for a union shop. It also gave states the power to make it illegal to require workers to join unions. Such laws became known as right-to-work laws, a name meant to emphasize that workers are free not to join a union. However, the effect of right-to-work laws and similar legislation is to weaken unions and to help businesses operate without unions. Most right-to-work states are in the Southeast and the central West, and union membership in these areas is low. F I G U R E 9.15 RIGHT-TO-WORK STATES MAP QUICK REFERENCE A closed shop is a business where an employer can hire only union members. A union shop is a business where workers are required to join a union within a set time period after being hired. Right-to-work laws make it illegal to require workers to join unions. Wash. Oregon Montana N.Dak. Minn. Idaho Wyoming S.Dak. Wisc. Mich. Nev. Calif. Utah Colorado Nebr. Iowa Kansas Mo. Arizona N. Mex. Okla. Ark. Ill. Ind. Pa. Ohio Ky. Tenn. W.Va. Va. N.C. S.C. N.H. Maine Vt. N.Y. Mass. R.I. Conn. N.J. Del. Md. Alaska Hawaii Miss. Ala. Ga. Texas La. Fla. Right-to-Work State AP P LI CATION Predicting Economic Trends B. Consider the trends in today’s labor force that you learned about in Section 2. As more service industries unionize, is union membership, as a percent of the labor force, likely to return to the levels of the mid-1900s? Why or why not? The Role of Labor 279 Union Negotiating Methods KEY CONCEPT S QUICK REFERENCE Collective bargaining is the way businesses and unions negotiate wages and working conditions. Despite the decline in membership, organized labor still wield
s power in the American economy. Unions continue to use collective bargaining, the process of negotiation between businesses and their organized employees to establish wages and to improve working conditions. Since it represents many employees together, a union can arrive at a better deal for workers than if each employee bargained with the employer separately. As a result, unionized companies tend to pay higher wages than companies without unions. Collective Bargaining In the 1930s and 1940s, unions negotiated for higher wages, better working conditions, and fair grievance procedures for workers who felt that they had been treated unjustly. As these demands were increasingly met, unions negotiated for job security and such fringe benefits as health insurance. Benefits and job security are important issues in today’s negotiations as well, but in many cases today’s workers are not pressing for higher wages. Instead they are trying to hold the line against pay cuts and reductions in benefits, including pensions. Unions have the threat of a strike to provide a motivation for management to come to terms, but strikes occur much less frequently than in the past. Large-scale work stoppages in the United States occurred hundreds of times a year before the 1980s but dropped to about 20 per year by the 2000s. This is partly a result of the decline in union membership, but it also reflects the willingness of management to use replacement workers or to close a plant permanently. The vast majority of union contracts are settled without such action. However, some negotiations require additional interventions if the two sides cannot agree. First, a mediator may be brought in to help the sides come to terms. If that fails, the dispute may be settled by binding arbitration—a decision by a neutral third party that each side agrees ahead of time to accept. For industries related to public safety, the government might issue an injunction to force workers back to work after a stoppage, or to stop protest activities that may interfere with public safety. Collective Bargaining Union leaders meet with business management to negotiate the details of union contracts. APPLICATION Analyzing Cause and Effect C. Explain why high wages and high employment do not necessarily go hand in hand. QUICK REFERENCE Binding arbitration is a process in which an impartial third party resolves disputes between management and unions. 280 Chapter 9 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs. a. closed shop union shop b. strike collective bargaining 2. Why was the formation of the Knights of Labor a
key event for organized labor in the United States? 3. Name two laws that supported labor’s rights and two laws that restricted them. 4. Opponents of right-to-work laws sometimes call them “work-for- less” laws. Why do you think they use that name? 5. Why would a business care if its workers went on strike? 6. Using Your Notes Write a paragraph explaining why unions grew in the 1800s and the first half of the 1900s. Refer to your completed summary chart to help you develop your argument with strong supporting detail. Topic Main Ideas Related Facts Labor movement’s rise to power Use the Graphic Organizer at Interactive Review @ ClassZone.com. Analyzing Cause and Effect What effect might outsourcing have on union membership? 8. Evaluating Economic Decisions In 1981, a group of air traffic controllers, employees of the Federal Aviation Administration, went on strike. They wanted to reduce their workweek to 32 hours instead of the usual 40 because of the high stress of their jobs. President Ronald Reagan broke the strike and disbanded the union of air traffic controllers, claiming that they were striking illegally. About 100 strikers were arrested, and all of them were banned for life from jobs in air traffic control. Did Reagan do the right thing by firing the striking workers? Explain your answer. 9. Challenge The firing of the air traffic controllers and the breaking of their union was one of the key events for labor in the United States. What trends in organized labor are evident in that event? Automated factories reduced the need for assembly line workers. Analyzing Economic Data Look at Figure 9.14 on page 278, which shows changes in union membership in the United States. Analyze Union Membership Compare the upward and downward movements of the graph to the events going on in the United States and world. 1930s—The Great Depression 1940s—World War II; postwar recovery 1950s—Korean War; economy thrives 1960s—Civil Rights movement; Vietnam War; steady economy 1970s—End of Vietnam War; oil embargo; inflation 1980s—Recession and recovery 1990s—Fall of Communism in Europe and Russia; Internet boom 2000s—September 11; Iraq War; recession and recovery Challenge Does there seem to be a relationship between how well the economy is doing and union membership? Explain. The Role of Labor 281 Case Study Find an update on this Case Study at ClassZone.com Managing Change in Your Work Life Background The United States economy has shifted from manufacturing to service and
knowledge-based industries. New technologies offer increasingly sophisticated tools. Telecommuting provides businesses the option of having employees work effectively from outside the office. Globalization has revolutionized the way companies do business. Companies are no longer tied to a specific location. Instead, they establish offices around the globe. The outsourcing and insourcing of jobs result both in benefits and challenges. The dynamics of the workplace are defined by a single factor—change. What’s the issue? How will you respond to the changing dynamics of the work environment? Study these sources to discover how change affects the type of work we do, as well as where and how we do it. A. Online Magazine Article Call centers in India help businesses reduce costs because local wages are low. But some Westerners accept the low wages for a chance to live in India. Subcontinental Drift More Westerners are beefing up their resumés with a stint in India After a year answering phones for Swiss International Air Lines Ltd. in a Geneva call center, Myriam Vock was eager to see something of the world. So she packed her bags and hopped a plane to India. Two and a half years later she’s still there, sharing a five-bedroom apartment in an upscale New Delhi suburb with four other foreigners. And how does she pay the bills? She works in a call center, getting paid a fraction of what she did back home. “I’m not earning much, but there is enough to live well and travel,” says Vock, 21.... “I don’t pay taxes here, and life is so much cheaper,” she says. Worried about your job fleeing to India? One strategy is to chase it—an option a growing number of twentysomething Westerners are choosing. Sure, the trend will never make up for the thousands of positions lost back home, but for adventurous young people, a spell in a call center in Bangalore or Bombay can help defray the costs of a grand tour of the subcontinent and beyond. Source: BusinessWeek.com, January 16, 2006 Call centers in India serve customers of companies all over the world. Thinking Economically Explain Myriam’s decision to work in a call center in India using cost-benefit analysis. 282 Chapter 9 B. Business Cartoon Canadian cartoonist Andrew Toos drew this cartoon about working in an increasingly technological society. Source: www.CartoonStock.com Thinking Economically What does the cartoon
work law strike telecommuting union shop wages 1 are the cost of labor. The demand for labor is a 2, growing out of the demand for the goods or services workers can produce. The forces of supply and demand determine the 3, at which there is neither a surplus nor a shortage of workers. Wages are directly correlated to a worker’s 4. Workers with the lowest level often earn only the 5. Since the 1950s, many women have entered the 6. They are sometimes limited by the 7, which keeps them from reaching the highest levels of management. Other trends in the labor market include 8, working away from a central office, and 9, working part-time or temporary jobs. U.S. firms sometimes use 10 to hire workers in other countries. When foreign companies open plants in the United States, it is called 11. Changes in the work force have reduced the number of workers who belong to a 12. Such organizations press for higher pay and better working conditions through 13. If talks fail, union workers might 14, putting pressure on employers to meet their demands. 284 Chapter 9 CHAPTER 9 Assessment How Are Wages Determined? (pp. 258–265) 1. What forces determine the equilibrium wage? 2. What four factors contribute to differences in wages? Trends in Today’s Labor Market (pp. 266–273) 3. How has the labor market in the United States changed since the 1950s? 4. Name two new developments in the way Americans work. Organized Labor in the United States (pp. 274–283) 5. Name an important U.S. labor leader and describe what he or she contributed to the labor movement. 6. What are some of the reasons membership in unions has declined since the 1950s? A P P LY The table below shows the median weekly earnings of full-time wage and salary workers by union affiliation and selected characteristics. FIGURE 9.16 UNION AND NONUNION WAGES Median Weekly Earnings of Full-Time Workers in the United States (in dollars) Race or Ethnicity Union Nonunion Men Women Men Women African-American Asian Hispanic White 689 819 713 884 632 789 609 749 523 827 473 714 478 643 414 576 Source: U.S. Bureau of Labor Statistics, 2005 data 7. What is the only group for which union affiliation does not yield higher pay? 8. Calculate the percentage difference between each group’s union
and nonunion wages. Which group gains the most in wages from union membership. Creating Graphs Create a bar graph using the following information about alternative work arrangements in the United States. Include an appropriate title and a source line showing that the data, which are for 2005, come from the Bureau of Labor Statistics. Independent contractors (Self-employed workers, such as independent sales consultants or freelance writers): 10.3 million On-call workers (Workers called as needed, sometimes working several days or weeks in a row, such as substitute teachers): 2.5 million Temporary workers (Workers paid by the hour, such as file clerks, hired through a temporary employment agency): 1.2 million Contract workers (Workers paid a salary, such as training specialists, provided by contract firms and hired for a limited contract): 0.8 million Use to complete this activity. @ ClassZone.com 10. Synthesizing Economic Data Explain the differences in median weekly earnings in Figure 9.16 in terms of this chapter’s key concepts. 11. Explaining an Economic Concept Have you ever been paid to work? If so, explain how the rate you were paid was determined. If not, think of someone you know who has earned money and explain how that person’s wages were determined. 12. Applying Economic Concepts Think back to a time when you negotiated with someone in a position of authority for something you strongly wanted. Briefly describe the tactics you used and look for similarities or differences between those and the tactics unions use with employers. 13. Challenge In 2003, the Fair Labor Standards Act was amended to clarify who was entitled to overtime pay. At the center of the issue were computer programmers, who lost entitlement to overtime if their regular pay is $65,000 per year or more. What impact might this have had on the workers and the economy Collective Bargaining It’s time to renegotiate the union contract at the Acme auto parts factory in Springfield. Read these descriptions of the two sides, then follow the instructions to experience what union negotiations are like. Union workers currently earn $25 per hour, plus overtime pay if they have to work more than 35 hours per week. Benefits include health-care insurance paid for by the company, plus vision and dental coverage, also funded by the company. The workers’ pension fund is handled through the union. The Acme company is a conglomerate based in the United States. Its auto parts business has been struggling to make a profit, so it is considering outsourcing the
work to a factory in China. It would then like to turn the Springfield factory into a computer manufacturing facility. Step 1 Divide the class evenly into union members and the Acme management team. Step 2 Separately and privately, each group discusses its objectives and negotiating strategies. Try to keep the conversation quiet so that the other side does not gain an advantage by learning your bargaining points. Step 3 Each group chooses three representatives to conduct the negotiations. Step 4 The representatives from both sides meet and negotiate the new contract. The rest of the two groups may listen to the negotiations, but they may not participate. If the two sides still disagree on an issue after several minutes of negotiations, put that issue aside for the moment. Keep a list showing the status of each issue. Step 5 If time permits, repeat steps 2–4 to address the unresolved issues. Discuss what happened. Did one side have more bargaining power? How did the two sides resolve their differences? Why were some issues more difficult to resolve than others? The Role of Labor 285 Macroeconomics U n i t 4 Money, Banking, and Finance What constitutes money? Money isn’t born, it’s made. Each society decides what it will accept as money, but effective moneys all share certain attributes and perform certain functions. 286 CHAPTER 10 SECTION 1 Money: Its Functions and Properties SECTION 2 The Development of U.S. Banking SECTION 3 Innovations in Modern Banking CASE STUDY Student Loans Money and Banking Macroeconomics is the study of the behavior of the economy as a whole and how major economic sectors, such as industry and government, interact. C H A P T E R 10 Money provides a low-cost method of trading one good or service for another. It makes the system of voluntary exchange efficient AT T E R S What were the last three economic transactions you completed using money? Perhaps you put four quarters in the fare machine on the bus to school or bought a slice of pizza and a drink in the cafeteria at lunch. Or maybe you caught an early movie after school yesterday. To gauge the importance of money to the economy, imagine trying to make such transactions without the familiar paper bills and coins. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on student loans. (See Case Study, pp. 312–313.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities.
Source: www.CartoonStock.com How important are student loans in the U.S. higher education system? See the Case Study on pages 312–313. Money and Banking 287 S E C T I O N 1 Money: Its Functions and Properties TA K I N G N O T E S In Section 1, you will money, p. 288 • outline the functions that money performs and the characteristics that money possesses • explain why the different types of money have value • describe how the money supply in the United States is measured medium of exchange, p. 288 barter, p. 288 standard of value, p. 289 store of value, p. 289 commodity money, p. 291 representative money, p. 291 fiat money, p. 291 currency, p. 293 demand deposits, p. 293 near money, p. 293 Functions of Money As you read Section 1, complete a cluster diagram summarizing key information about money. Use the Graphic Organizer at Interactive Review @ ClassZone.com Money QUICK REFERENCE Money is anything that people will accept in exchange for goods and services. A medium of exchange is a means through which goods and services can be exchanged. Barter is the exchange of goods and services without using money. KEY CONCEPT S What do the following things have in common: cattle, corn, rice, salt, copper, gold, silver, seashells, stones, and whale teeth? At different times and in different places, they have all been used as money. In fact, money is anything that people will accept as payment for goods and services. Whatever it is that people choose to use as money, it should perform three important functions. FUNCTION 1 Medium of Exchange Money must serve as a medium of exchange, or the means through which goods and services can be exchanged. Without money, economic transactions must be made through barter—exchanging goods and services for other goods and services. Barter is cumbersome and inefficient because two people who want to barter must at the same time want what the other has to offer. For example, suppose you want to trade two T-shirts for a pair of jeans. One classmate might have the jeans but not want your shirts; another might want your shirts but not have jeans to trade. It is much easier for you to buy a pair of jeans by giving money to the seller who, in turn, can use it to buy something else. Money allows for the precise and flexible pricing of goods and services, making any economic transaction convenient. 288
Chapter 10 A World of Money Currencies come in a wide variety of colors and sizes. This is a collage of the currencies of South America. FUNC T ION 2 Standard of Value Money also serves as a standard of value, the yardstick of economic worth in the exchange process. It allows people to measure the relative costs of goods and services. A $20 T-shirt is worth two $10 phone cards, four $5 burritos, or twenty $1 bus rides. The basic monetary unit in the United States is the dollar, which serves as the standard by which the economic worth of all goods and services can be expressed and measured. FUNC T ION 3 Store of Value Finally, money acts as a store of value, that is, something that holds its value over time. People, therefore, do not need to spend all their money at once or in one place; they can put it aside for later use. They know that it will be accepted wherever and whenever it is presented to purchase goods and services. One situation where money does not function well as a store of value is when the economy experiences significant inflation—a sustained rise in the general level of prices. For example, in Argentina in the first half of 2002, prices rose by about 70 percent. Basic goods that cost 150 pesos in January cost 255 pesos in June. In other words, in that time period, Argentina’s money lost over two-thirds of its purchasing power. You’ll learn more about inflation in Chapter 13. QUICK REFERENCE A standard of value determines the economic worth in the exchange process. A store of value is something that holds its value over time. Find an update on the functions of money at ClassZone.com 10.1 Functions of Money?What Functions Does Money Perform? Standard of Value Money provides both a way to express and measure the relative costs of goods and services and a way to compare the worths of different goods and services. Medium of Exchange Money provides a flexible, precise, and convenient way to exchange goods and services. Store of Value Money holds its value over time. It can be saved for later use because it can be exchanged at any time for goods and services. ANALYZE CHARTS You’ve read that salt was used as money in the past. How effectively do you think salt would function as money? Use the three functions of money in the chart to frame your answer. AP P LI CATION Applying Economic Concepts A. How does money
help to make clear the opportunity cost of an economic decision? Money and Banking 289 Properties of Money KEY CONCEPT S To perform the three functions of money, an item must possess certain physical and economic properties. Physical properties of money are the characteristics of the item itself. Economic properties are linked to the role that money plays in the market. PROPERTY 1 Physical The following are physical properties of useful money: Durability Money should be durable, or sturdy, enough to last throughout many transactions. Something that falls apart when several people handle it or that spoils easily would not be a good item to use as money. Portability Money needs to be small, light, and easy to carry. It’s easy to see why paper bills are preferable to cattle as money. Divisibility Money should also be divisible so that change can be made. For example, the dollar can be divided an endless number of ways using different combinations of pennies, nickels, dimes, or quarters. Divisibility also allows flexible pricing. Uniformity Lastly, money must be uniform, having features and markings that make it recognizable. Coins that are used as money look different from other flat metal disks. Paper money is a consistent size and uses special symbols and printing techniques. All money that represents a certain amount in a given country has distinctive characteristics that help identify its value. These distinctive markings also make it more difficult to counterfeit. Chinese Coins Bronze, spadeshaped coins, 8th–7th century B.C. PROPERTY 2 Economic Useful money must also have the following economic properties: Stability of Value Money’s purchasing power, or value, should be relatively stable. In other words, the amount of goods and services that you can buy with a certain amount of money should not change quickly. Rapid changes in purchasing power would mean that money would not successfully serve as a store of value. Scarcity Money must be scarce to have any value. As you recall from Chapter 7, when the supply of a product outstrips demand, there is a surplus and prices for that product fall. Similarly, when the supply of money outstrips demand, money loses value, or purchasing power. Acceptability People who use the money must agree that it is acceptable—that it is a valid medium of exchange. In other words, they will accept money in payment for goods and services because others will also accept it as payment. APPLICATION Applying Economic Concepts B. Describe how U.S. dollars serve each of the three functions of
money. 290 Chapter 10 Types of Money KEY C ONCEPT S In the discussion of the functions and properties of money, one theme recurs—value. Money draws its value from three possible sources. Commodity money derives its value from the type of material from which it is composed. Representative money is paper money backed by something tangible—such as silver or gold—that gives it value. Fiat money has no tangible backing, but it is declared by the government that issues it, and accepted by citizens who use it, to have worth. T YPE 1 Commodity Money Commodity money is something that has value for what it is. Items used as commodity money have value in and of themselves, apart from their value as money. Over the course of history, for example, gold, silver, precious stones, salt, olive oil, and rice have all been valued enough for their scarcity or for their usefulness to be used as money. QUICK REFERENCE Commodity money has intrinsic value based on the material from which it is made. Representative money is backed by something tangible. Fiat money is declared by the government and accepted by citizens to have worth. However, the most common form of commodity money throughout history has been coins made from precious metals. Such coins contain enough of the precious metal that if each was melted down it would be worth at least its face value. One problem with commodity money is that if the item becomes too valuable, people will hoard it rather than circulate it, hoping it will become more valuable in the future. Commodity money is rarely used today. Commodity Money Until recently, cattle was an important medium of exchange for the Masai people of East Africa. T YPE 2 Representative Money Representative money is paper money that can be exchanged for something else of value. The earliest forms of representative money were seen in the Middle Ages, when merchants, goldsmiths, and moneylenders began issuing receipts that promised to pay a certain amount of gold or silver. This came about because it was not always convenient or safe to transport large quantities of those precious metals from place to place for the purpose of trading. These practices signal the beginning of the widespread modern use of paper money. Eventually, governments got involved with representative money by regulating how much metal needed to be stored to back up the paper money. One problem with representative money is that its value fluctuates with the supply and price of gold or silver, which can cause problems of inflation or deflation—a sustained rise or fall, respectively,
in the general level of prices. Money and Banking 291 The Euro as a Common Currency EU Members That Adopted the Euro in 2002 On January 1, 2002, a new currency—the euro—was put into full use in 12 European countries, each a member of the European Union (EU). The symbol for the euro is. Each country that adopted the euro gave up its own national currency The EU seeks the economic and political integration of Europe, and the euro is a key step toward this goal. The common currency makes trade among member nations easier and cheaper. As the EU expands, new members must meet specific economic standards before they can adopt the euro. Several small European countries that are not members of the EU have also begun using the euro. Like all modern currencies, the euro is categorized as fiat money. Its value is derived from public confidence in the EU. Control of the supply of euros is maintained by the European Central Bank, located in Frankfurt, Germany. Each member nation of the EU has a seat on the Central Bank’s decision-making board. CONNECTING ACROSS THE GLOBE 1. Making Inferences How do you think having a common currency might benefit the EU? 2. Recognizing Effects Why does the euro have value as currency? Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain TYPE 3 Fiat Money Unlike representative money, fiat money has value only because the government has issued a fiat, or order, saying that this is the case. The value of the U.S. dollar was linked to the value of gold until 1971. Since then, a $10 bill can no longer be exchanged for gold; it can only be converted into other combinations of U.S. currency that also equal $10. In fiat money, coins contain only a token amount of precious metal that is worth far less than the face value of those coins. Paper money has no intrinsic value, and people cannot exchange it for a certain amount of gold or silver. Fiat money has value because the government says it can be used as money and because people accept that it will fulfill all the functions of money. Dollar bills in the United States carry the statement “This note is legal tender for all debts, public and private.” This statement assures people that sellers will accept such money from buyers as payment for goods or services and lenders will accept it as payment for debts. A crucial role of the government in maintaining the value of fiat money is controlling its supply—in other words, maintaining its scarcity. APPLICATION Analy
zing Cause and Effect C. Which type of money’s value would be most affected by political instability? Why? 292 Chapter 10 Money in the United States KEY C ONCEPT S In this section so far, you have learned what has been used as money, what functions money performs, what properties it possesses, and why money has value. But what serves as money in the United States today? In its narrowest sense, money consists of what can be used immediately for transactions—currency, demand deposits, and other checkable deposits. Currency is paper money and coins. Checking accounts are called demand deposits because funds in checking accounts can be converted into currency “on demand.” There are other monetary instruments that are almost, but not exactly, like money. Known as near money, it includes savings accounts and other similar time deposits that cannot be used as a medium of exchange but can be converted into cash relatively easily. QUICK REFERENCE Currency is paper money and coins. Demand deposits are checking accounts. Near money is savings accounts and time deposits that can be converted into cash relatively easily. Money in the Narrowest Sense In the narrowest sense, money is what can be immediately used for transactions. This definition of money sometimes uses the term transactions money. Most of the money that you and your friends and family spend is transactions money. About half of such money is currency, both paper money and coins, that is used by individuals and businesses. Most demand deposits are noninterest-bearing checking accounts that can be converted into currency simply by writing a check. Traveler’s checks, which are drafts that can be purchased in a number of money amounts and redeemed in many parts of the world, represent a small share of overall demand deposits. Other checkable deposits include negotiable order of withdrawal (NOW) accounts, which are interest-bearing savings accounts against which drafts may be written. Are Savings Accounts Money? Near money, such as savings accounts and other interest-bearing accounts, cannot be used directly to make transactions. Your local sporting goods store will not accept a savings passbook as payment for a new basketball or for your tennis racket to be restrung. But money in a savings account can be easily transferred into a checking account or removed directly from an automatic teller machine and put toward a desired good or service. Near money takes many forms in addition to traditional savings accounts. Time deposits are funds that people place in a financial institution for a specific period of time in return for a higher interest rate. These deposits are
often placed in certificates of deposit (CDs). Money market accounts place restrictions on the number of transactions you can make in a month and require you to maintain a certain balance in the account (as low as $500 but often substantially more) in order to receive a higher rate of interest. Near Money A savings account contains money but is not, strictly, money. Money and Banking 293 How Much Money? How much money is in supply in the United States? Economists use various instruments to measure the money supply, but the most often cited are M1 and M2. M1 is the narrowest measure of the money supply, consisting of currency, demand deposits, and other checkable deposits. It is synonymous with transactions money. The elements of M1 are referred to as liquid assets, which means that they are or can easily become currency. M2 is a broader measure of the money supply, consisting of M1 plus various kinds of near money. M2 includes savings accounts, other small-denomination time deposits (CDs of less than $100,000), and money market mutual funds. You will learn about these financial instruments in Chapter 11. Figure 10.2 shows the amounts of the different forms of money that make up M1 and M2. You can see that M1 is almost evenly split between currency and checkable deposits. Notice that more of M2 comes from savings than from M1. You will learn the importance of the money supply in the economy and how the government manages it in Chapter 16. Find an update on measures of the money supply at ClassZone.com FIGURE 10.2 COMPONENTS OF THE U. S. MONEY SUPPLY M1 (in billions of dollars) Currency Demand deposits* Other checkable deposits TOTAL * includes traveler’s checks 723.8 328.2 316.9 1,368.9 M2 (in billions of dollars) Savings deposits M1 Small time deposits Money market mutual funds 3,620.5 1,368.9 973.7 717.4 23.1% 52.9% 24.0% 14.6% 10.7% 54.2% TOTAL includes money market accounts 6,680.5 20.5% Source: U.S. Federal Reserve Board (data from 2005) Currency Demand deposits Other checkable deposits Savings deposits M1 Small time deposits Money market mutual funds ANALYZE TABLES 1. What amount of M2 does not come from currency and checkable
deposits? 2. If currency is 52.9 percent of M1, and M1 is 20.5 percent of M2, what percentage of M2 is currency? APPLICATION Applying Economic Concepts D. Classify each of the following as M1 and M2: a. dollar bill; b. savings account; c. money market account; d. traveler’s check; e. $50,000 CD. 294 Chapter 10 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the difference between the terms in each of these pairs. a. standard of value store of value b. commodity money c. demand deposits representative money near money 2. Why are economic transactions easier with money than with barter? 3. Why is it important that money be divisible? 4. Why are checking accounts called demand deposits? 5. What aspect of fiat money allows it to have more stability than representative money? 6. Using Your Notes How are the economic properties of money related to its functions? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Money 7. Categorizing Economic Information Which of these forms of money are included in M1: • checking accounts • coins • money market accounts • paper money • savings accounts • time deposits • traveler’s checks • NOW accounts 8. Making Inferences The U.S. government has tried to get people to use dollar coins rather than dollar bills. Most consumers prefer to use dollar bills. Which physical properties of money are involved in these different preferences? 9. Applying Economic Concepts Maria’s parents told her that for the ten years prior to her high school graduation, they saved $200 per month for her college education—$24,000 (plus interest). Which function of money does this example best illustrate? Why? 10. Challenge Why is there more near money than transactions money in the U.S. money supply? Evaluating Economic Decisions In the past, indigenous people of Central and South America used cacao beans (the source of chocolate) as currency. Evaluate Money In Section 1, you learned that money should function as a medium of exchange, a standard of value, and a store of value. Use what you’ve learned about these functions to evaluate how useful cacao beans might be as money today. Show your answer by filling in the table below. Possible Problems Function Medium of exchange Standard of value Store of value Challenge How well do
cacao beans exhibit each of the physical and economic properties of money? Money and Banking 295 S E C T I O N 2 The Development of U.S. Banking TA K I N G N O T E S In Section 2, you will • describe how banking developed in the United States • identify the banking institutions that operate in the United States state bank, p. 296 national bank, p. 299 gold standard, p. 299 As you read Section 2, complete a chart using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Development of U.S. Banking Origins 19th Century 20th Century The Origins of Banking KEY CONCEPT S Modern banking arose in Italy in the late Middle Ages. Italian merchants stored money or valuables for wealthy people and issued receipts that promised to return the property on demand. They realized that they did not have to hold all the deposits, since all depositors did not reclaim their property at the same time, but could lend some of the deposits and earn interest on those loans. This was the beginning of fractional reserve banking (see Section 3), the practice of holding only a fraction of the money deposited in a bank and lending the rest. In colonial America, many Early “Bankers” The Italian word banco, means “bench.” From benches in the street, Italian merchants used some practices that are part of banking today. QUICK REFERENCE A state bank is a bank chartered by a state government. 296 Chapter 10 merchants followed the same practice. However, these banks were far from secure. If a merchant’s business failed, depositors lost all of their savings. After the Revolutionary War, many state banks—banks chartered, or licensed, by state governments—were established. Some of these banks, however, followed practices that tended to create instability and disorder. Many issued their own currency that was not linked to reserves of gold or silver held by the bank. ECO N O M I C S PAC ES E T T E R Alexander Hamilton: Shaping a Banking System Imagine what it would be like if every bank issued its own currency. How would buyers know if sellers would accept their money? How would sellers know if the money they received was worth anything? That was the confusing situation that Alexander Hamilton faced when he became Secretary of the Treasury in 1789. He immediately set to work to bring stability to U. S. banking. The First Bank of the United States Hamilton was
a leading Federalist who believed in a strong central government. He proposed chartering a privately owned national bank to put the government on a sound financial footing. This bank would issue a national currency and help control the money supply by refusing to accept currency from state banks that was not backed by gold or silver. It also would lend money to the federal government, state banks, and businesses. The Constitution did not specifically authorize Congress to charter a national bank. The Antifederalists, led by Thomas Jefferson and James Madison, interpreted the Constitution strictly and feared putting too much power in the hands of the central government. Hamilton argued that the Constitution implied that the federal government had the authority to create a national bank to carry out its duty to regulate the currency. Hamilton won the fight, and the First Bank of the United States was chartered in 1791. Over time, it achieved the financial goals that Hamilton had set. However, opponents argued that the bank’s policies restrained economic growth, and Congress refused to renew the charter in 1811. The fact that Hamilton was the architect of the bank was always a strike against it, as he had made many enemies during his career. (One, Aaron Burr, killed him in a duel.) Maybe Hamilton was right when he said, “Men often oppose a thing merely because they have had no agency in planning it, or because it may have been planned by those whom they dislike.” Alexander Hamilton (above) and the First Bank of the United States (right) FAST FACTS Alexander Hamilton Position: First Secretary of the Treasury (1789–1795) Born: January 11, 1755 in Nevis, British West Indies Died: July 12, 1804 Writings: The Federalist Papers (1787), with James Madison and John Jay; Report on a National Bank (1790) Major Accomplishment: Strengthened the national government and established the First Bank of the United States Hamilton’s Visible Legacy: Portrait on the $10 bill AP P LI CATION Making Inferences A. How did the First National Bank force state banks to become more stable? Learn more about Alexander Hamilton at ClassZone.com Money and Banking 297 F I G U R E 10. 3 Major Developments in American Banking 1816 ▲ Congress charters Second Bank of the United States. 1863 ▲ Congress creates national banks and currency. 1775 1800 1825 1850 1875 196 1791 Congress charters First Bank of the United States. 1837–18
65 Wildcat banking leads to unstable currency. ▲ 19th-Century Developments KEY CONCEPT S Without a central bank, the government had difficulty financing the War of 1812 against Britain. Furthermore, state banks soon returned to the unrestrained issuing of currency that was not linked to reserves of gold or silver held by the banks. The resulting increase in the money supply led to inflation during the war. The Second Bank of the United States Congress finally agreed to charter the Second Bank of the United States in 1816. The new bank had greater financial resources than the First Bank and succeeded in making the money supply more stable. Opponents continued to see the central bank as too powerful and too closely aligned with the wealthy. President Andrew Jackson was an outspoken critic who mistrusted banks and paper money He vetoed the renewal of its charter in 1832. Wildcat Banking After the Second Bank’s charter lapsed in 1836, there was no federal oversight of the banking industry. During this period, all banks were state banks, each of which issued its own paper currency, called bank notes. States passed free banking laws that allowed individuals or groups that met its requirements to open banks. 298 Chapter 10 Jackson and the Second Bank This 1828 cartoon lampoons Jackson’s battle against the bank. 1913 President Wilson establishes Federal Reserve System. ▲ 1950 Banks issue ﬁ rst credit cards. 1980s Savings and Loan crisis rocks U.S. banking industry. 60 1900 1925 1950 1975 Present 1900 ▲ United States adopts gold standard. 1933 Banking Act creates Federal Deposit Insurance Corporation. 1971 ▲ President Nixon ends the dollar’s link to gold. 1999 Deregulation opens up bank competition. Some of these banks were located in remote areas to discourage people from redeeming their bank notes, which were often worth less outside the region where they had been issued. It was this practice, along with the questionable quality of many bank notes that resulted in the term wildcat bank. In addition, such banks were susceptible to bank runs when depositors demanded gold or silver for their currency. Since the banks often did not have sufficient reserves of these precious metals, financial panics and economic instability were common results. The Struggle for Stability During the Civil War, it was particularly difficult for the government to finance its operations without a national currency and a federal bank. The government’s first solution to this problem was to issue a new currency backed by government bonds. These U.S. bank notes, called greenbacks, were
printed with green ink. In 1863, Congress passed the National Banking Act, which led to the creation of a system of national banks, banks chartered by the national government. The act provided for a national currency backed by U.S. Treasury bonds and regulated the minimum amount of capital required for national banks as well as the amount of reserves necessary to back the currency. Congress taxed state bank notes issued after 1865, effectively eliminating these notes from circulation. In 1900, the government officially adopted the gold standard, a system in which the basic monetary unit—for example, one dollar—is equal to a set amount of gold. The national currency and gold standard helped to bring some stability to the banking system. Money was now uniform throughout the country, backed by something of intrinsic value, and limited by the supply of gold. AP P LI CATION Analyzing Effects B. How did the National Banking Act of 1863 attempt to eliminate the problems caused by wildcat banking? QUICK REFERENCE National banks are banks chartered by the national government. The gold standard is a system that backs the basic monetary unit with a set amount of gold. Money and Banking 299 20th-Century Developments KEY CONCEPT S The system of national banks and a national currency linked to the gold standard initially brought stability to U.S. banking. Yet the economy still experienced periods of inflation and recession and financial panics. This economic instability was largely due to the lack of a central decision-making institution that could manage the money supply in a flexible way to meet the economy’s changing needs. A New Central Bank In 1913, Congress passed the Federal Reserve Act, which established the Federal Reserve System (commonly known as the Fed)—a true central bank. It consists of 12 regional banks with a central decision-making board. The Fed provides financial services to the federal government, makes loans to banks that serve the public, issues Federal Reserve notes as the national currency, and regulates the money supply to ensure that money retains its purchasing power. You’ll learn more about the structure and functions of the Federal Reserve in Chapter 16. The Great Depression and the New Deal At the start of the Great Depression in 1929, many banks failed due to bank runs, as consumers panicked and withdrew all of their money. When the banks failed, many more depositors lost their money. Part of President Franklin Roosevelt’s New Deal program was the Banking Act of 1933, which instituted reforms such as regulating interest rates that banks could pay and prohibiting banks from selling stocks
. The Federal Deposit Insurance Corporation (FDIC) provided federal insurance so that if a bank failed, people would no longer lose their money. This legislation set the tone for almost 50 years by increasing the regulation of banking in the United States. Deregulation and the S&L Crisis In 1980 and 1982, Congress passed laws that lifted government limits on savings interest rates. This allowed savings and loans associations (S&Ls) to operate much like commercial banks. Deregulation encouraged the S&Ls to take more risks in the types of loans they made. As a result, many S&Ls failed and lost their depositors’ money. Congress agreed to fund the S&L industry’s restructuring in order to protect consumers, which cost taxpayers hundreds of billions of dollars. The S&L Crisis Depositors camp out to withdraw their money in May 1985. APPLICATION Comparing and Contrasting C. How are the First Bank of the United States and the Federal Reserve different? 300 Chapter 10 Find an update on U.S. financial institutions at ClassZone.com Financial Institutions in the United States KEY C ONCEPT S The term bank is used to refer to almost any kind of financial institution that takes in deposits and makes loans, helping individuals, businesses, and governments to manage their money. In the end, though, the goal of a bank is to earn a profit. All financial institutions receive a charter from the government, either state or federal. Government regulations set the amount of money the owners of a bank must invest in it, the size of the reserves a bank must hold, and the ways that loans may be made. The term may refer to commercial banks, savings and loan associations, or credit unions. In the past, these institutions provided very different and distinct services. Today, however, because of the deregulation of banking, these distinctions are much less apparent. The distinctive characteristics of each type of financial institution are described in more detail below. Figure 10.4 on page 302 compares the three types of banks based on numbers of institutions and total assets. T YPE 1 Commercial Banks Privately owned commercial banks are the oldest form of banking and are the financial institutions most commonly thought of as banks. As their name implies, commercial banks were initially established to provide loans to businesses. Now they provide a wide range of services, including checking and savings accounts, loans, investment assistance, and credit cards to both businesses and individual consumers. You will learn more about these services in Section 3. In 2003
, there were about 2,000 national commercial banks and about 5,800 state-chartered banks insured by the FDIC. All national commercial banks belong to the Federal Reserve System, but only about 16 percent of state-chartered banks choose to join the Fed. About 1,500 of these commercial banks are large ones with assets of $300 million dollars or more. In 2005, the seven largest banks in the United States held 50 percent of the total assets controlled by all these large banks. T YPE 2 Savings Institutions Savings and loan associations (S&Ls) began in the United States in the 1830s. They were originally chartered by individual states as mutual societies for two purposes— to take savings deposits and provide home mortgage loans. In other words, groups of people pooled their savings in a safe place to earn interest and have a source of financing for families who wanted to buy homes. The S&Ls continue to fulfill these purposes, but they now also offer many of the services provided by commercial banks. Since 1933, the federal government may also charter S&Ls, and since 1982, many federally chartered S&Ls have chosen to call themselves savings banks. Many savings institutions are now financed through the sale of stock, just as commercial banks are. Money and Banking 301 In 2003, there were about 800 federally chartered savings institutions and 600 state-chartered institutions. These institutions are now insured under a specific fund of the FDIC as part of the reforms that followed the S&L crisis of the 1980s. TYPE 3 Credit Unions Credit unions are cooperative savings and lending institutions, rather like the early S&Ls. They offer services similar to commercial banks and S&Ls, including savings and checking accounts, but specialize in mortgages and auto loans. The first credit union in the United States was chartered in 1909. The Federal Credit Union Act of 1934 created a system of federally chartered credit unions. In 2003, there were about 5,800 federally chartered credit unions and about 3,600 chartered by the states. Most credit unions have deposit insurance through the National Credit Union Association (NCUA), similar to the FDIC. The major difference between credit unions and other financial institutions is that credit unions have membership requirements. To become a member, a person must work for a particular company, belong to a particular organization, or be part of a particular community affiliated with the credit union. Credit unions are cooperatives—nonprofit organizations owned by and operated for members, who numbered
more than 80 million nationwide in 2003. F I G U R E 10 TAT ES $8,413 7,630 9,014 Key: Number of Institutions Assets (in billions of dollars) 1,345 $1,692 Commercial banks Savings institutions $647 Credit unions Source: Statistical Abstract of the United States, 2006 (Data from 2004) ANALYZE CHARTS 1. Which type of bank has the largest number of institutions? Why? 2. How do the assets held in savings institutions compare to the assets held in commercial banks? APPLICATION Analyzing and Interpreting Data D. Which type of bank described above has the largest percentage of its institutions chartered by the federal government? Why might this situation have developed? 302 Chapter 10 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Use each of the three terms below in a sentence that illustrates the meaning of the term. a. state bank b. national bank c. gold standard 2. Explain the relationship between the gold standard and the concept of representative money. 3. How does the Federal Reserve System serve as a central bank? 4. What is the difference between a national bank and a state bank? 5. How did the FDIC make fractional reserve banking less risky for consumers? 6. Using Your Notes What role Development of U.S. Banking did state banks play in the era of wildcat banking? Refer to your completed chart. Origins 19th Century 20th Century Use the Graphic Organizer at Interactive Review @ ClassZone.com. Creating Graphs Use the information in Figure 10.4 to create two pie graphs, one showing the percentage that each type of bank contributes to the total number of financial institutions and another showing the percentage that each type of bank contributes to total bank assets. State one conclusion that you can draw from the two graphs. Use activity. @ ClassZone.com to complete this 8. Synthesizing Economic Information On the basis of what you learned about the history of U.S. banking in the 19th and 20th centuries, were Alexander Hamilton’s ideas about the need for a central bank and a national currency shown to be mostly accurate? Cite specific examples to support your answer. 9. Applying Economic Concepts Suppose that Mariel deposits $100 in her local bank. If the Fed’s reserve requirement is 15 percent, how much can the bank loan out on the basis of Mariel’s deposit? What concept does this scenario illustrate? 10
. Challenge How do banks facilitate saving and borrowing in the same way that money facilitates buying and selling? Constructing Graphs Consider what you have learned about different types of financial institutions. The table below shows how the numbers of commercial banks and savings institutions have changed over time. Year 1985 1990 1995 2000 2004 Commercial Banks Savings Institutions 14,417 12,347 9,942 8,315 7,630 3,626 2,815 2,030 1,589 1,345 Create Line Graphs Use the information in the table to create two line graphs that show the changes in the numbers of each type of bank. Use ClassZone.com to complete this activity. @ Challenge On the basis of this information, what trends can you identify? Which type of financial institution experienced a greater percentage loss from 1985 to 2004? Money and Banking 303 S E C T I O N 3 Innovations in Modern Banking TA K I N G N O T E S In Section 3, you will automated teller machine, p. 308 • describe the services that debit card, p. 308 stored-value card, p. 308 banks provide • discuss the changes that deregulation has brought to banking • explain how technology has changed banking in the United States As you read Section 3, complete a hierarchy diagram to track main ideas and supporting details. Use the Graphic Organizer at Interactive Review @ ClassZone.com Innovations in Banking main idea main idea main idea details details details What Services Do Banks Provide? KEY CONCEPT S Banks offer a number of services that allow them to act like “money stores.” In other words, just as stores are places where goods are bought and sold, banks are places where money can be bought (borrowed) and sold (lent). By using these services, customers are able to do three things—store money, earn money, and borrow money. Banks are businesses that earn money by charging interest or fees on these services. SERVICE 1 Customers Can Store Money As you read in Section 2, banks began as safe places to store money and other valuables. They still serve the same purpose today. Customers deposit money in the bank, and the bank stores currency in vaults and is also insured against theft and other loss. Customers’ bank accounts are also insured in case the bank fails. Banks are also a safe place to store important papers and valuables—through the use of safe deposit boxes. SERVICE 2 Customers Can Earn Money When customers deposit their money in bank accounts, they can earn money
on their deposits. Savings accounts and some checking accounts pay some level of interest. Banks offer other accounts, such as money market accounts and certificates of deposits (CDs), that pay a higher rate of interest. You will learn more about saving and investing in Chapter 11 and in Consumer and Personal Finance, which begins on page 574. 304 Chapter 10 S E RVI CE 3 Customers Can Borrow Money Banks also allow customers to borrow money through the practice of fractional reserve banking. (See Figure 10.5.) The percent of deposits that banks must keep in reserve is set by the Fed. Banks provide customers, each of whom must be approved by the bank, with different loans for different circumstances. One common loan is a mortgage. A mortgage loan allows a buyer to purchase a real estate property, such as a house, without paying the entire value of the property up front. The lender and the borrower agree on a time period for the loan (often up to 30 years) and an interest rate to be paid to the lender. From this, a monthly mortgage payment amount is settled. In this arrangement, the real estate property acts as collateral. So if the borrower defaults on the loan (stops making the payments), the lender takes control of the property. It can then be sold by the bank to cover the balance of the mortgage. It may not seem so, but a purchase made on a credit card is a loan too. Credit cards are issued by banks to users who are, in effect, borrowers. When you use a credit card to buy a new skateboard or a tank of gasoline, the issuing bank pays the seller and lends you the money. When you pay the bank back, you’re repaying a loan. And if you don’t pay it back within a month, you’ll owe the bank extra in interest. F I G U R E 10. 5 Fractional Reserve Banking Deposit of $10,000 A bank customer deposits $10,000 into her account in Bank A. Loan of $8,100 Bank B lends $8,100 to a customer who uses it to buy a used car. Deposit of $8,100 The seller of the car deposits the $8,100 in Bank C. Bank A Fed’s reserve requirement is 10%, or $1,000. Bank B Fed’s reserve requirement is 10%, or $900. Bank C Fed’s reserve requirement is 10%, or $810. Loan of $9,000 Bank
A lends $9,000 to a customer who uses it to ﬁx his roof. Deposit of $9,000 The rooﬁng contractor deposits the $9,000 into his account in Bank B. Loan of $7,290 Bank C lends $7,290 to a customer who uses it to open a small business. ANALYZE CHARTS The customer who deposited $10,000 in Bank A can withdraw her money even though a loan may have been made based on her deposit. This is known as creating money. Why? Use an interactive fractional reserve banking chart at ClassZone.com AP P LI CATION Applying Economic Concepts A. Explain the ways in which bank transactions are beneficial to customers and banks. Money and Banking 305 Banking Deregulation KEY CONCEPT S Prior to the 1980s, government tightly regulated the amount of interest that banks could pay on deposits and could charge on loans. Regulations also prevented banks from operating in more than one state. Several states also had limitations on the number of branches that a bank could have within a state. Deregulation in the 1980s and 1990s ended these restrictions and brought major changes to what we think of as banks and how they operate. Bank Mergers The end of restrictions on interstate banking led to a large number of mergers, as larger banks acquired smaller ones and smaller ones joined together to be able to enter different geographic markets. The number of mergers has steadily declined since 1998, when there were almost 500, to less than 200 in 2003. Yet as Figure 10.6 shows, mergers that created very large banking organizations continued. In 2004, F I G U R E 10. 6 Major Bank Mergers Bank of America Continental Bank Security Bank Nations Bank Barnet Bank Boston Bay Bank Fleet Shawmut Bank of America Fleet Boston Manufacturers Hanover Trust Chemical Bank Chase Manhattan Bank J.P. Morgan J.P. Morgan Chase Bank One First Commerce First Chicago NBD First Bank US Bank Bank One US Bank Bank of America J.P. Morgan Sources: The Canadian Treasurer, March 19, 2003; Encyclopaedia Britannica ANALYZE CHARTS In most of the mergers shown here, the acquiring banks hoped to increase their customer base by gaining offices in regions where they had no presence. What reasons might target banks (the banks acquired) have for entering into a merger? 306 Chapter 10 Bank of America Investment Services Inc. and J. P. Morgan Chase & Co. became two of the largest
banks in the United States, with assets of around $1 trillion each. In contrast, some 95 percent of commercial banks have assets of $1 billion or less. One benefit from the mergers has been increased competition that has kept interest rates low and resulted in more consumer services. There has also been an increase in the number of bank branches, even while the number of banks has declined. Larger banks and more branches offer customers greater availability of services. Many banks also cite economies of scale made possible by the mergers, as banks are able to spread their costs, especially for new technology, over more customers. However, some see potential problems associated with mergers. Although competition between these merged banks has heated up, there are increasingly fewer banks to choose from. Further, it is feared that larger banks may show less interest in small customers and local community issues. If this is the case, consumers will choose a bank that provides them with what they want, and the large banks will either respond or lose customers. Banking Services The Financial Services Act of 1999 lifted the last restrictions from the Banking Act of 1933 that had prevented banks, insurance companies, and investment companies from selling the same products and competing with one another. This change allowed banks to sell stocks, bonds, and insurance. At the same time, some investment companies and insurance companies began offering traditional banking services. The change in banking services was based on the idea that consumers would prefer to have a single source for all their financial services needs—something that might function as a kind of “financial supermarket.” However, banks have not always been able to effectively realize the benefits they had envisioned from offering this array of services. While banks establish relationships with customers through deposit accounts and loans for homes and autos, they have not been as successful in selling insurance or in helping customers to buy and sell stocks and bonds. Most bank customers continue to look to traditional insurance companies for their insurance needs and investment brokers and mutual fund companies to meet investment desires. Financial Freedom President Clinton signs the bill that eliminated restrictions in place since 1933. ▲ Roosevelt and the Banking Act of 1933 ▲ Clinton and the Financial Services Act of 1999 AP P LI CATION Analyzing Effects B. How did deregulation change the ways that banks competed? Money and Banking 307 Technology and Banking KEY CONCEPT S Deregulation is not the only thing that has changed the nature of banking. Technology—particularly computer technology—has changed the way customers use banks, producing a system generally referred to as electronic banking. For example, banks have
begun using automated teller machines (ATMs), electronic devices that allow bank customers to make deposits, withdrawals, and transfers and check their account balances at any time without seeing a bank officer. Other innovations include debit cards, cards that can be used like an ATM card to withdraw cash or like a check to make purchases, and stored-value cards—cards that represent money that the holder has on deposit with the issuer, such as a department store. These cards give customers the ability to use the money in their accounts in more convenient ways. (You’ll learn more about ATM and debit cards in Consumer and Personal Finance.) Automated Teller Machines Between school, sports practice, and a parttime job, you might find it difficult to get to the bank while it is open to deposit your paycheck and to withdraw spending money. The ATM solves that problem. ATMs are the oldest and most familiar of the developments in electronic banking. They began to be used widely in the 1970s and are now located not just at banks but also at retail stores, workplaces, airports, and entertainment venues, such as movie theaters and sports stadiums. ATMs are basically data terminals that ATM Boom Between 1998 and 2003, the number of ATMs in the United States nearly doubled, from 187,00 to 371,000. By 2007, there were over 1.5 million ATMs worldwide. are linked to a central computer that is in turn linked to individual banks’ computers. The bank provides you with a plastic ATM card with a magnetic strip on the back that contains your account information. You insert your card into the ATM, enter your personal identification number (PIN), and follow the instructions on the screen. You may check your account balance, make deposits, withdraw cash, transfer money between accounts, and make loan payments through the ATM. All ATM networks are connected so that consumers can use their ATM cards at any machine, no matter what bank owns it. Some banks charge fees for ATM use, especially to consumers who do not have an account at the bank that owns the particular ATM. ATMs allow people to bank even when the bank is closed and to avoid waiting in line for simple transactions. Many drive-through ATMs allow customers to bank from their cars. ATMs save banks money because it is much less expensive to process ATM transactions than transactions that involve a teller. They also allow banks to provide services at more locations without constructing complete bank branch offices. QUICK REFERENCE An automated teller machine (ATM) is an elect
ronic device that allows bank customers to make transactions without seeing a bank officer. A debit card can be used like an ATM card or like a check. A stored-value card represents money that the holder has on deposit with the issuer. 308 Chapter 10 Debit Cards Debit cards are similar to ATM cards but offer additional benefits. Like ATM cards, debit cards can be used to withdraw cash and make other transactions at ATM machines. Debit cards are sometimes called check cards because they are linked to bank accounts and can be used like checks to make purchases at many retail outlets. Retailers often prefer debit cards because they avoid the problem of people writing checks with insufficient funds in their accounts. Debit cards often look like credit cards, and they are similar in that they can be used to make purchases at stores. An important difference is that credit card purchases involve getting a loan. Your money stays in your account until you pay your credit card bill. With a debit card you make an immediate payment, since the price of your purchase is deducted from the account that is linked to your card. Therefore, it is important to keep track of debit card purchases along with checks so that you know how much money is available in your account at any given time. Because of the way debit cards work, they are often seen as safer ways to manage your money than with credit cards. With credit cards, if you do not pay your balance in full each month, you pay interest on the outstanding balance and can build up considerable debt. With debit cards, you can only spend money that you actually have in a bank account. YO U R EC EDIT C ARD VS. DE BIT C ARD Which one should you use? You have $250 in your checking account, and you don’t get your next paycheck for a week. You want to buy a $75 birthday gift for a friend, and you have to pay $225 for a car repair. With your classmates, talk through each of the ways to handle the situation to find out what works best.? Entering a PIN for a debit card Signing for a credit card Stored-Value Cards Stored-value cards, which represent money that the holder has on deposit with the card issuer, give consumers another convenient way to use electronic banking. These cards are sometimes called prepaid cards because customers have paid a certain amount of money for the card and can then use it to make payments for various goods and services. Some examples of stored-value cards include transit fare cards, gift cards from retail
stores, and telephone cards. Consumers benefit from using transit fare cards and telephone cards because they do not have to worry about having the exact change needed each time they ride the bus or use a pay phone. Money and Banking 309 In 2004, there were more than 2,000 different stored-value card programs in the United States with about 20 million users. The number of users was expected to be 49 million by 2008. The $42 billion in transactions in 2003 was expected to grow to more than $72 billion by 2006. Multipurpose stored-value cards—cards that can be used like debit cards—are becoming more popular. This type of card may take the place of a checking account, especially for people who have not traditionally used banks. While stored-value cards are a convenient way for people to make purchases and pay bills, consumers need to evaluate the fees involved in using such cards to determine whether they are less expensive than having a checking account or using a check-cashing service. In addition, the money paid into such cards is not always covered by FDIC insurance to protect customer deposits in case of a bank’s failure. Electronic Banking Electronic banking allows customers who have set up accounts with a bank to perform practically every transaction without setting foot in a bank. Indeed, some banks are virtual banks with no physical buildings at all. Through the use of the Internet, customers can arrange for direct deposit of their paychecks, transfer funds from account to account, and pay their bills. Most bank Web sites allow customers to review the most recent transactions on their accounts, view images of canceled checks, and download or print their periodic statements. Through electronic fund transfers, consumers can pay a credit card bill at one bank with funds from a checking account at another bank. Recurring bills, such as mortgage payments, may be paid automatically from a customer’s checking account each month or through their bank’s bill paying service. However, electronic banking presents several challenges. Information security and identity theft are related, high-profile issues for the industry. Electronic banking allows banks to amass large amounts of information about their customers. Banks contend that this allows them to provide customers with better service. New laws require that banks make customers aware of privacy policies and offer them the opportunity to decide what information may be shared with others. Consumer concerns have led banks to developing increasingly sophisticated information security systems. (For information on identity theft, see Consumer and Personal Finance, which begins on p. 574.) Online Convenience Online bill paying cuts
time and expense by eliminating the need to mail checks. APPLICATION Contrasting Economic Information C. How are debit cards different from most stored-value cards? 310 Chapter 10 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. How are these three terms related? How are they different? a. automated teller b. debit card c. stored-value card machine 2. What are two reasons that people deposit money in banks? 3. It is said that fractional reserve banking allows banks to create money? What is meant by this? 4. How did deregulation lead to a decrease in the number of banks between 1980 and the present? 5. How are debit cards related to automated teller machines? 6. Using Your Notes How does computer technology support home banking? Refer to your completed hierarchy diagram. Innovations in Banking main idea main idea main idea details details details Use the Graphic Organizer at Interactive Review @ ClassZone.com. Analyzing Data Over the course of one year, Hometown Bank paid Mary Lee 3 percent interest on a $1,000 deposit and charged Owen’s Bakery 8 percent interest on a $900 loan. How much net income did Hometown bank make? Show your calculations. 8. Applying Economic Concepts Suppose that Liz inherits $2,000 from her grandmother and deposits it into her college savings account at Hamilton Savings Bank. Assume that the reserve requirement is 20 percent. Create a chart showing five successive loans that could be made from this initial deposit. 9. Making Inferences Some parents think that allowing teenagers to use a debit card prepares them for using a credit card. What are the possible reasons behind this thinking? Do you think this reasoning is sound? Why or why not? 10. Challenge Look again at Figure 10.5, Fractional Reserve Banking, on page 305. Suppose that when Bank A made the $9,000 loan to the man with the leaky roof, it turned out the job cost only $7,000. The contractor deposited that money into Bank B. How much could Bank B then lend to the used-car buyer? If she bought a car for that amount, and the seller of the car deposited the money in Bank C, what size small-business loan could Bank C then turn around and make? Starting a Bank Think about what you have learned about the services that banks provide and how banks make money. Imagine that you are starting a bank for the other members of the class. Consider the following questions
: • What services would you provide? Why? • How would your bank make a profit? • What challenges might you face in making your bank profitable? Write a Proposal Answer the above questions in a one-page proposal outlining what your bank would be like. Share your proposal with a classmate. Challenge Include a section in your proposal about what you would do to make your bank more attractive to customers than the other banks run by your classmates. Money and Banking 311 Case Study Find an update on this Case Study at ClassZone.com Student Loans Background In the United States, the cost of higher education may still be affordable to some, but it certainly is not cheap. Because of rising costs, more and more students (and their parents) borrow money to finance at least part of their college education. According to the U.S. Department of Education, about 10 million students take out Stafford loans each year, while about 800,000 parents take out PLUS loans. Although banks, S&Ls, and credit unions are the primary lenders of money in the United States, this is not the case for student loans. Students and parents have the option of borrowing wherever they choose, but federally guaranteed loans are their main source of funding. What’s the issue? What is the current situation with student loans? What are the future ramifications of the increasing cost of paying for college? Study these sources to learn about student loans. A. Online News Story This story explains a change in the way the government figures the interest rate on student loans. Text not available for electronic use. Please refer to the text in the textbook. FIGURE 10.7 AVERAGE COST OF TUITION, ROOM, AND BOARD AT A FOUR- YEAR INSTITUTION ) 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 1989– 1990 1991– 1992 1993– 1994 1995– 1996 1997– 1998 1999– 2000 2001– 2002 2003– 2004 School Year Source: National Center for Education Statistics Thinking Economically If interest rates hit 10 percent, would the new fixed rate established by Congress still harm student borrowers? Why or why not? 312 Chapter 10 B. Cartoon Ralph Hagen drew this cartoon about student loans as a factor in higher education. Thinking Economically What does the cartoon suggest about student reliance on college loans? Explain your answer. Source: www.CartoonStock.com C. Newspaper Article This article discusses the problems associated with debt and loan repayment after college
graduation. It’s Payback Time More student loans increase debt pressure on graduates. Student loans are two-edged: the more money a student can borrow, the more schooling falls within reach. But of course, the more debt a student has, the more painful repayment becomes.... “More students will be required to take out more money from the federal government and from private lenders,” says Jasmine L. Harris, legislative director at the United States Student Association, a student advocacy group in Washington. Over time, she continues, ‘’It’s a great formula for unmanageable levels of debt and hence higher default rates.’’... The consequences of defaulting, too, are worse than they have been in years past. A provision of a law that took effect last year, for example, makes it next to impossible to discharge private student loans in personal bankruptcy proceedings (federal loans were already barred).... [Theresa] Shaw of the Education Department advises that a struggling borrower should try to make a payment of any kind, however small, to avoid default. Source: The New York Times, April 23, 2006 Thinking Economically Explain in your own words why you think the article calls student loans “two-edged.” THINKING ECONOMICALLY Synthesizing 1. Compare the financial news presented in documents A and C. What bearing do you think the information in document A might have on what you learned from document C? 2. Document B humorously points to the prominence of student loans in U.S. higher education. Specifically, what parts of documents A and C support this view? 3. In document A, what does the federal government seem to be saying about who should pay for a college education? With this in mind, what does Figure 10.7 mean for students and parents? Money and Banking 313 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. automated teller machine barter commodity money currency debit card demand deposits fiat money fractional reserve banking gold standard M1 M2 medium of exchange money national bank near money representative money standard of value state bank store of value stored-value card 1 is anything that people will accept as payment
for goods and services. Money makes trade easier by serving as a 2. As a 3, money allows people to compare the prices of goods and services. Money must be a 4, or something that holds its value over time. Gold coins and salt are both examples of 5. Most money in the world today is 6, which has no tangible value but is declared by the government to have worth. 7 consists of 8, which includes paper money and coins and 9, which is another name for checking accounts. Savings accounts and time deposits are called 10 because they can be converted into cash easily. 11 allows banks to hold only part of their deposits and make loans based on the rest. The Federal Reserve Bank is the central 12 in the nation. The 13 is the oldest form of electronic banking. A 14 can be used like an ATM card or like a check. 314 Chapter 10 CHAPTER 10 Assessment Money: Its Functions and Properties (pp. 288–295) 1. What three functions does money serve in the economy? 2. Why do economists make a distinction between M1 and M2? The Development of U.S. Banking (pp. 296–303) 3. Why does fractional reserve banking leave banks vulnerable to failure if too many consumers demand their money at the same time? 4. How is the Federal Reserve System different from the system of national banks created in the 1860s? Innovations in Modern Banking (pp. 304–313) 5. How did the automated teller machine change the nature of banking? 6. Which type of stored-value card is most like a debit card? A P P LY Look at the table below showing changes in use of electronic payments between 1995 and 2001. 7. Which type of electronic banking increased the most among all households between 1995 and 2001? 8. How did education generally affect the use of electronic payments? FIGURE 10.8 PERCENTAGE OF HOUSEHOLDS USING ELEC TRONIC BANKING Education of head of household All households No college degree College degree ATM Debit card Automatic bill paying 1995 2001 1995 2001 1995 2001 61.2 69.8 17.6 47.0 21.8 40.3 52.8 63.7 14.3 42.3 18.2 33.7 80.1 81.6 25.2 56.2 30.1 53.2 Source: Statistical Abstract of the United States, 2006. Analyzing Effects Suppose that the government changes the tax policy so that people pay lower taxes if they save more
money. The benefits are significant enough that people shift about 10 percent of their money from their checking accounts into certificates of deposit. How would this change affect the amount of money in M1 and M2? 10. Drawing Conclusions Today, there are about three times as many state chartered commercial banks as there are nationally chartered commercial banks. How does the current U.S. economy avoid the kinds of problems caused by state banks in the 19th century? 11. Applying Economic Concepts One Saturday, four friends go shopping at the local mall. Catherine uses her ATM card to withdraw some cash. Tara has a gift card that she received for her birthday. It is worth $50 at her favorite clothing store. Charlotte uses a credit card, and Alyssa pays with a debit card. a. Which of the shoppers has a stored-value card? Why does she have less flexibility in her shopping than the other shoppers? b. If Catherine, Charlotte, and Alyssa each spend $50, which one has not reduced the amount of money in her checking account at the end of the day? Why? c. Which shopper may end up paying more than face value for her purchases? 12. Analyzing Causes What are the different motives behind these two mergers: a stock brokerage firm buys a bank; a California bank buys a Florida bank? 13. Challenge Why are credit cards and debit cards not considered to be money? Promote Electronic Banking Step 1 Choose a partner. Imagine that you work for a bank in the late 1990s. Your bank intends to be a pioneer in Internet banking and asks you to design its first Web page. Your boss gives you the following criteria for the Web page: • Allow existing customers to access account balances and transfer funds between accounts. • Promote traditional bank products, including checking, savings, CDs, credit cards, mortgages, and auto loans. • Allow customers to find the most convenient branch or ATM location. Step 2 Sketch out a design for the Web page to meet your boss’s criteria, showing appropriate links. Step 3 Two years later, deregulation has led to significant changes in the banking industry. In addition, more consumers are interested in Internet banking. Your boss asks you to redesign the Web page with these additional criteria: • Allow customers to pay bills, apply for loans, buy stocks, and shop for insurance through the bank’s Web site. • Allow customers to view transactions on all their accounts, including credit and debit card transactions, and receive statements and other bank
communications electronically. • Reassure customers that online banking is secure and that their privacy will be protected. Step 4 Sketch out a new Web page that shows the complete range of services the bank now offers and that meets all six criteria. Step 5 Share your Web page designs with another pair of students and discuss what aspects would be most important and effective for you as a customer. Money and Banking 315 Stock Market The stock market, which consists of institutions such as the NASDAQ, is where stocks and bonds are traded. 316 CHAPTER 11 SECTION 1 Savings and Investment SECTION 2 Investing in a Market Economy SECTION 3 Buying and Selling Stocks SECTION 4 Bonds and Other Financial Instruments CASE STUDY The Rise and Fall of Dot-Coms Financial Markets Voluntary exchange is a trade in which both parties involved believe that what they are getting is worth more than what they are giving up. C H A P T E R 11 The financial system consists of institutions, such as banks, insurance markets, bond markets, and stock markets, that help transfer funds between savers and investors AT T E R S Do you have a savings account? If so, you play a very important role in our economy. Your savings—what you gave up to get those assets—will be borrowed and invested by businesses and the government to build factories, offices, roads, and so on. The jobs and new products and services created by these investments, in turn, further help to fuel the nation’s economy. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on investing in Internet companies. (See Case Study, pp. 344–345.) Go to SMART GRAPHER to complete graphing activities in this chapter. Source: www.CartoonStock.com Go to INTERACTIVE REVIEW for concept review and activities. Why did the dot-com companies experience such a rapid rise and fall? See the Case Study on pages 344–345. Financial Markets 317 S E C T I O N 1 Savings and Investment TA K I N G N O T E S In Section 1, you will • identify what constitutes the financial system • describe the various financial intermediaries • explain how economists categorize the various markets where financial assets are sold savings, p. 318 investment, p. 318 financial system, p. 318 financial asset, p. 319 financial market, p. 319 financial intermediary, p. 319 mutual fund, p. 320 capital market, p. 322 money market, p. 322 primary market,
p. 322 secondary market, p. 322 As you read Section 1, complete a hierarchy diagram to track main ideas and supporting details. Use the Graphic Organizer at Interactive Review @ ClassZone.com Savings and Investments main idea main idea main idea details details details The Financial System QUICK REFERENCE Savings is income not used for consumption. Investment is the use of income today that allows for a future benefit. The financial system is all the institutions that help transfer funds between savers and investors. Find an update on saving at ClassZone.com 318 Chapter 11 KEY CONCEPT S There are two things you can do with your money—spend it or save it. Savings is income not used for consumption, in other words not spent on immediate wants. Savings that are put to use are investments. In general, investment is the use of income today in a way that allows for a future benefit. More specifically, economic investment refers to money lent to businesses—to finance the construction of a new factory, for example. Personal investment refers to the act of individuals putting their savings into financial assets, such as CDs, stocks, bonds, or mutual funds. Consider what happens when you put money in a savings account. Through this act, you benefit—your savings account earns interest—but others do too. By saving, you make funds available for the bank to lend. Borrowers use these funds for many purposes, such as investing in new businesses or in new equipment for established businesses. The financial system, which consists of institutions such as banks, insurance markets, bond markets, and stock markets, allows for this transfer of funds between savers and investors. ATM Deposits Using an ATM to make deposits makes saving easy and convenient. F I G U R E 11.1 The Financial System savings Financial Intermediaries loans Commercial Banks Savings and Loans Credit Unions Finance Companies Life Insurance Companies Mutual Funds Pension Funds Borrowers Savers Financial Intermediaries assets interest and dividends ANALYZE CHARTS 1. What do savers get in exchange for the funds they deposit with financial intermediaries? 2. Why do you think that financial intermediaries perform their vital function? Think back to Chapter 10 if you need help. Bringing Savings and Investment Together Individuals and businesses can save surplus funds in many ways, including savings accounts at commercial banks or S&Ls, certificates of deposit (CDs), corporate or government bonds, and stocks. The agent receiving these funds is a borrower, who issues savers written confirmation of the transaction. This written
confirmation is called a financial asset, or a claim on the property of the borrower. Sometimes savers and borrowers come together directly in a financial market, a situation in which buyers and sellers exchange particular types of financial assets. For example, an individual or business might buy corporate bonds or shares of stock. More often, however, financial intermediaries bring savers, borrowers, and financial assets together. A financial intermediary is a financial institution that collects funds from savers and then invests these funds in loans and other financial assets. Figure 11.1 shows how funds flow from savers to investors through the financial markets and financial intermediaries that make up the financial system. QUICK REFERENCE A financial asset is a claim on the property of the borrower. A financial market is where buyers and sellers exchange financial assets. A financial intermediary is an institution that collects funds from savers and invests the funds in financial assets. AP P LI CATION Applying Economic Concepts A. Look again at the example opposite of a person depositing money into a savings account. How is this an example of Adam Smith’s “invisible hand”? Financial Markets 319 Financial Intermediaries KEY CONCEPT S Financial intermediaries bring savers and investors together. In Chapter 10, you learned about one group of financial intermediaries—commercial banks, S&Ls, and credit unions. These financial institutions take in deposits from savers and provide loans to individuals and businesses. Many offer other financial assets as well. Other common financial intermediaries include finance companies, which make small loans; pension funds, which invest money for groups of workers; and life insurance companies, which invest funds collected from policyholders. A mutual fund is a pool of money managed by an investment company that gathers money from individual investors and purchases a range of financial assets. Investors own shares of the entire fund based on the amount of their investment. These institutions gather their money in different ways and provide many different financial assets to a variety of investors. EXAMPLE Banking Financial Intermediaries This group of financial intermediaries includes commercial banks, S&Ls, and credit unions. All of these institutions provide checking and savings accounts. Depositors earn interest on their savings deposits and some checking deposits. Most also offer CDs and money market deposit accounts that pay slightly higher rates of interest. (Figure 11.2 explains how savers earn money from interest.) The federal government insures deposits, including CDs and money market accounts, up to $100,000 per depositor in any given bank.
These institutions lend a portion of their deposits to borrowers. Banks charge borrowers a higher rate of interest than they pay to savers and hope to earn a profit. The loans are financial assets to the bank. If a borrower does not pay back the loan on time, the bank may repossess the property, such as a home or a car. Deregulation has allowed banks to offer other financial assets, such as money market mutual funds, stocks, bonds, and insurance. The federal government does not insure funds invested in these financial assets. EXAMPLE Nonbank Financial Intermediaries This group of financial intermediaries includes finance companies, mutual funds, pension funds, and life insurance companies. Finance companies make loans to households and small businesses. Generally, the loans are under $2,000 and are paid back in monthly installments, including interest, over a few years. A mutual fund pools money from many personal investors. In return, each investor receives shares in a fund that is made up of a large number and variety of stocks, bonds, or other financial assets. Mutual funds make it easier and more affordable for individual investors to own a wide variety of financial assets. Once investors purchase shares of a fund, they allow its managers to make investment decisions. QUICK REFERENCE A mutual fund is an investment company that gathers money from individual investors and purchases a range of financial assets. The New York Stock Exchange Stocks are an important element of the assets that make up a mutual fund. 320 Chapter 11 Pension funds allow employees to save money for retirement and sometimes include contributions from employers. The pension fund then invests these pooled contributions in various financial assets that will increase in value and provide workers with more money when they retire. Life insurance companies allow individuals to accumulate savings by building cash values and protect against losses from death or disability. Just as banks lend some of their deposits, insurance companies lend or invest some of the income earned from policyholders in a variety of financial assets. M AT 11 Banks pay savers interest in order to use their money. A saver’s initial deposit is called the principal. Simple interest is the interest paid on the principal alone. Compound interest is paid on the principal plus any earned interest. The following steps show how an annual rate of 5 percent interest is paid on the principal ($1,000) over three years. Year 1 Simple interest is calculated using the following formula: Principal Interest rate = Interest earned $1,000.05 = $50.00 Year 2 The amount in this account is now
$1,050.00. Compound interest, which is paid on the principal plus the earned interest, is calculated as follows: (Principal + Year 1 interest) Interest rate = Interest earned ($1,000.00 + $50.00).05 = $52.50 Year 3 There is now $1,102.50 in the account. Interest continues to compound. (Principal + Year 1 interest + Year 2 interest) Interest rate = Interest earned ($1,000.00 + $50.00 + 52.50).05 = $55.13 After three years, the total in the account is $1,157.63. Using a Formula Instead of using the multiple steps shown above, you can calculate the total value of an account using the following formula (wherein P=principal, r=interest rate, and t=number of years): P(1+r) t = total value $1,000.00(1+.05)3 = $1,157.63 NEED HELP? Math Handbook, “Calculating Compound Interest,” page R6 AP P LI CATION Comparing and Contrasting B. How is a pension fund like a savings account? How is it different? Financial Markets 321 Financial Asset Markets KEY CONCEPT S The different financial assets discussed in this section are bought and sold on various financial markets. Economists tend to categorize these markets based on two factors—time (how long the loan is for) and whether the financial assets can be resold. Based on time, economists distinguish between the capital market, the market for buying and selling long-term financial assets, and the money market, the market for buying and selling short-term financial assets. In regard to resalability, economists distinguish between the primary market, which is the market for buying newly created financial assets directly from the issuing entity, and the secondary market, which is the market where financial assets are resold. FACTOR 1 Time There are two time-sensitive markets. Capital markets are markets where assets are held for longer than a year. Some examples of assets sold on the capital market include certain kinds of securities, namely stocks and bonds, mortgages, and longterm CDs. Because these loans are for longer periods of time, the money may be invested in projects that require large amounts of capital, such as buying homes, building new factories, retooling established factories, or financing government projects. Money markets are markets where loans are made for less
than a year. Examples of assets traded in these markets include short-term CDs that depositors can redeem in a few months and Treasury bills, which allow the U.S. government to borrow money for short periods of time. Return on Investment Time is an important factor in the level of return for many investments. FACTOR 2 Resalability There also are two kinds of markets based on whether the financial assets can be resold. Primary markets are markets for financial assets that can be redeemed only by the original buyer. Examples include savings bonds and small denomination CDs. The term primary market also refers to the market where the first issue of a stock is sold to the public through investment bankers. Secondary markets are resale markets for financial assets. These markets offer liquidity to personal investors. So, investors are able to turn their assets into cash relatively quickly. Stocks and bonds, which you’ll learn more about later in this chapter, are two of the most prominent financial assets sold on the secondary market. APPLICATION Analyzing Effects C. Why are stocks and bonds part of the capital market and the secondary market? QUICK REFERENCE The capital market is where long-term financial assets are bought and sold. The money market is where short-term financial assets are bought and sold. The primary market is for buying financial assets directly from the issuer. The secondary market is where financial assets are resold. 322 Chapter 11 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the difference between the terms in each of these pairs. a. savings investment b. capital market money market c. primary market secondary market 2. What is the purpose of the financial system? 3. Why do banks receive financial assets when they make loans? 4. How does a mutual fund serve as a financial intermediary? 5. What determines whether a loan is part of the capital market or the money market? 6. Using Your Notes What is the relationship between financial intermediaries and the financial system? Refer to your completed hierarchy diagram. Savings and Investments main idea main idea main idea details details details Use the Graphic Organizer at Interactive Review @ ClassZone.com. Categorizing Information Which of the following are banking financial intermediaries and which are nonbanking financial intermediaries? • Consumer Finance Company • Family Life Insurance Company • First National Bank • Home Savings and Loan • Investors’ Mutual Fund • Employee Credit Union • Employee Pension Fund 8. Making Inferences A local bank offers savings accounts that have no minimum
balance requirement and pay 3 percent interest per year. Account holders can withdraw any amount of money from their accounts at any time. The bank also offers money market accounts that require a $500 minimum balance and pay 4 percent interest each year. Account holders are allowed two withdrawals per month, but each must be for at least $100. Why does the money market account pay a higher interest rate? 9. Applying Economic Concepts Suppose that you deposit $100 into your savings account, which earns 3 percent interest per year. Use what you’ve learned about calculating interest to determine how much money you’ll have in your account at the end of one year and at the end of six years. 10. Challenge Why might a decrease in household savings have an adverse effect on small businesses in a local community? Stock certificates Identifying Markets Consider how economists categorize financial markets. Copy the table shown below. Review the bulleted list of financial assets and place each one in the correct location(s) in the table. Assets may be placed in more than one category. • 15-year mortgage • 6-month CD for $1,000 • 2-year CD for $25,000 • 5-year corporate bond • 10-year savings bond • Shares of stock • 26-week Treasury bill • 30-year Treasury bond Capital Market Money Market Primary Market Secondary Market Challenge Why do savings bonds and small certificates of deposit have less liquidity than shares of stock? Financial Markets 323 S E C T I O N 2 Investing in a Market Economy TA K I N G N O T E S In Section 2, you will investment objective, p. 324 • discuss the issues that should be considered when making investment decisions • explain how risk and return are related risk, p. 327 return, p. 327 diversification, p. 327 As you read Section 2, complete a chart like the one shown using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Investing in a Market Economy objectives risk vs. return Why Are You Investing? KEY CONCEPT S In Section 1, you saw that there are two types of investing: personal and economic. Note that for the remainder of the chapter, we’ll be using all forms of the word invest as a quick way to refer to personal investing—which is, in effect, saving. You’ve now learned that there are a number of assets you can own. But how do you determine which is, or are,
right for you? The first thing that you might do is to decide why you are investing. This reason is your investment objective, a financial goal that an investor uses to determine if an investment is appropriate. Some possible financial goals are saving money for retirement, for a down payment on a house or an automobile, for college tuition, or for a vacation. Your goal helps you to determine the right investments. Investment Objectives Two issues play a major role in determining which investments work best to achieve different investment objectives. The first issue is time. For example, is this a short-term financial goal, such as saving for a vacation, or a longterm financial goal, such as saving for Savings Goals Saving for a car down payment suggests certain kinds of longer-term investments. QUICK REFERENCE An investment objective is a financial goal used to determine if an investment is appropriate. 324 Chapter 11 YO U R EC INVESTM ENT OB J EC TIVES What reasons do you have for investing? Do you have any investment objectives? Maybe you have a short-term objective, such as saving money to go on spring break. Or your objective is more long term, such as saving for college. What kinds of investments might be appropriate for your objective?? Saving for vacation Saving for college Find an update on investing at ClassZone.com retirement? The amount of time you have to build your savings influences the kinds of investments that would be most appropriate. The second issue is income. How much money do you have available to save after meeting current expenses? The answer to this question is influenced by a series of other questions: Will your income change in the future? Is there money available for emergencies? To respond to all these questions, having a savings plan that is realistic and that is flexible enough to adjust to changing circumstances can be a big help. Other important questions are: Do you have any outstanding debts? Are you paying taxes on time? Paying off debts is an important first step to investing. Generally, the interest you pay on debts, such as credit card balances, is higher than what you can earn through most investments. Tax considerations are most important for investors with higher incomes who are subject to higher tax rates. Different types of investments are suitable to various investment objectives. For example, savings for emergencies should be in highly liquid investments, such as savings accounts or money market accounts. With these investments, the risk of loss is low and money can be withdrawn at any time. Saving for a vacation would also require investments that are short-term
and liquid. Investors who are saving for longer-term goals may be less concerned with immediate liquidity and may want to invest in stocks that increase in value over a longer period of time. CDs that commit funds for a certain length of time may be chosen to coincide with the timing of certain savings goals, such as making a major purchase or starting college. Many bonds offered by state and local governments offer tax-free earnings. AP P LI CATION Drawing Conclusions A. Would a CD be a more appropriate way to save for a down payment on a car or for emergencies? Why? Financial Markets 325 ECO N O M I C S PAC ES E T T E R Mellody Hobson: Investing in the Future What do the Chicago Bulls, hip-hop stars, and inner-city elementary school students have in common? All are part of Mellody Hobson’s efforts to get investment “discussed around every dinner table.” Hobson believes that many people lack the necessary knowledge to determine their investment objectives and manage their money to create wealth. How is she trying to change this situation? Creating Educated Investors Mellody Hobson discovered her career in investing as a college intern. When she got her degree in 1991, Hobson landed a position in the marketing department at Ariel Capital Management LLC. In 2000, she became the president of the company, making her the most powerful African-American woman in the mutual-fund industry. As president of Ariel, Hobson runs an operation with over $21 billion in assets. Ariel was the first minority-owned mutual fund company in the Mellody Hobson country and pioneered programs to teach inner-city schoolchildren about investing. Hobson’s passion for investment education led her to give presentations in locations from PTA meetings to union halls. She developed the first ongoing study of investing by African Americans and looked for ways to increase their participation in the stock market. “The stock market represents a major source of wealth creation in this country,” Hobson has stated, “but... African Americans have been largely left out.” Ariel’s marketing efforts to the black community included cosponsoring events with the Chicago Bulls and creating a stock-picking contest involving well-known hip hop stars. When Hobson became the financial contributor to the Good Morning America television program in 2000, she was able to reach millions of people with easy-to-understand information about economic matters. Hobson believes that more knowledge about the benefits of investing in
stocks and greater diversity in the investment industry will help bring the benefits of investing to people of all racial and economic backgrounds. APPLICATION Making Inferences B. Why might Mellody Hobson think it is important for families to talk about investing at the dinner table? FAST FACTS Mellody Hobson Title: President of Ariel Capital Management, LLC Born: April 3, 1969, Chicago, Illinois Major Accomplishment: Educates millions of people about the benefits of investing. Ariel’s Assets Under Management: $21.3 billion (2005) Other Roles: Financial contributor to Good Morning America on ABC Board Member: Chicago Public Library, the Field Museum, the Chicago Public Education Fund, and the Sundance Institute Director: DreamWorks Animation SKG, Inc., the Estée Lauder Companies Inc., and Starbucks Corporation Find an update on Mellody Hobson at ClassZone.com 326 Chapter 11 Risk and Return KEY C ONCEPT S Once investors have decided their financial objectives, there are two other related issues they might consider—risk and return. Risk is the possibility for loss on an investment, and return is the profit or loss made on an investment. While savings deposits in banks are insured against loss, most investments carry some possibility of losing part of the money invested. Return may refer to the interest paid on a savings account or CD or the increase in value of a stock over time. Most investors try to balance risk and return through diversification, the practice of distributing investments among different financial assets to maximize return and limit risk. QUICK REFERENCE Risk is the possibility for loss on an investment. Return is profit or loss made on an investment. Diversification is the practice of distributing investments among different financial assets. What Kind of Risk Are You Willing to Take? When most investors think about risk, they think about the possibility of losing some of their initial investment, often referred to as their principal. Even if they don’t earn a lot of money on the investment, they want to get back at least what they put in. Investments that guarantee no loss of principal include insured savings deposits and CDs. Bonds that are backed by the U.S. government are also considered to be almost risk-free because it is highly unlikely that the government would not pay back its loans. Almost all other investments carry some risk. One of the biggest risks investors face, even with safe investments like those described above, is loss of the purchasing power of the money invested due to inflation. (Remember that inflation is a general rise in the
level of prices.) That is why many financial advisers warn against investing everything in safe investments that pay a guaranteed rate of interest that may not keep up with inflation. FIGURE 11. 3 THE REL AT IONSHI P OF R ISK AND RE TURN Other investments, such as stocks and corporate bonds, carry a higher degree of risk because the return depends on how profitable the company is. Investors who purchase stock with the expectation that it will appreciate in value over time may lose some of their money if the company runs into problems or other economic factors affect the value of the stock. In that case, investors may find that they cannot sell the stock for as much as they paid for it, and they suffer a loss. Investors in corporate bonds face similar risks, although bonds are considered less risky than stocks because creditors such as bondholders are paid off before stockholders if a company has financial problems. k s i R Return Risk and Return Risk and return have a direct relationship—the higher the risk of the investment, the greater the possible return. Financial Markets 327 YO U R EC RISK AND R ETU RN How can you balance risk and return? When you consider what financial assets further your investment objective, you must address both risk and return. A high-risk investment may bring large returns, but can you absorb the potential losses? A low-risk investment may provide a steady return, but because of inflation you may be losing money. How would you decide which type of investment to make?? ▲ Return ▲ Risk What Kind of Return Do You Want? When making investment decisions, investors estimate what kind of return they expect to earn. The safest investments, such as Treasury bills, interest-bearing savings accounts, and shorter-term CDs, generally offer the lowest return in the form of fixed rates of interest. The returns on stocks and bonds are not guaranteed and may vary considerably at different times, depending on how the company you invest in performs and the state of the economy as a whole. Generally, stocks provide a higher return over time than do other investments. As Figure 11.3 on page 327 shows, risk and return are directly related—the greater the possible return, the higher the risk that the investment will lose value. Investors always want the highest return possible, but they must balance that desire with a realistic understanding about the level of risk they can tolerate. The factors of time and income come into play here. People who are investing for retirement over a period of 20 to 30 years may be willing to take more
risk by investing in stocks because their investments are likely to increase over that period, even though they might have losses in some years. People with less time and less income to invest might not be willing to risk possible losses. Diversification is the most common way for investors to maximize their returns and limit their risks. For example, you might put 70 percent of your investments for retirement in a variety of stocks, 20 percent in bonds, and 10 percent in CDs. By spreading out your money in a variety of assets, you have a better chance of offsetting losses from one investment with gains from another. Mutual funds, which invest in a large number of stocks or bonds, help small investors diversify their investments. APPLICATION Drawing Conclusions C. Is it possible to have a low-risk, high-return investment? Why or why not? 328 Chapter 11 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Use each of the three terms below in a sentence that illustrates the meaning of the term: a. investment objective b. return c. diversification 2. What is the relationship between risk and return? 3. How would the risk of investing in a single stock compare with the risk of investing in a mutual fund? Why? 4. How is diversification related to risk and return? 5. How are risk and return related to investment objectives? 6. Using Your Notes How do time and income influence investment objectives? Refer to your completed chart. Investing in a Market Economy objectives risk vs. return Use the Graphic Organizer at Interactive Review @ ClassZone.com. Comparing and Contrasting Matthew’s parents started saving for his college education when he was born. When Matthew turned 16, he got a part-time job and saved part of his earnings for his college expenses. Compare and contrast the investment objectives of Matthew and his parents and describe the factors that influenced their investment decisions. 8. Drawing Conclusions Ryan owns shares in a single mutual fund that includes stocks and bonds. Maggie invests her money in Treasury bonds, state bonds, and corporate bonds. Joshua invests in shares of stock in five different high-tech companies. Which of these investors best understands the concept of diversification? Give reasons for your answer. 9. Applying Economic Concepts Inez bought 100 shares of a mutual fund for $10 each and sold them five years later for $15 each. Ethan put $1,000 in a 5-year CD and received a total of $235 in interest. Which
investment provided the better return? How does this illustrate the relationship between risk and return? 10. Challenge Stocks that are sold on the secondary market and savings accounts both provide liquidity. For each of these investments, what kinds of risks does this liquidity entail? Evaluating Investments Consider what you have learned about risk and return as they relate to various investments, then study the table below and evaluate each investment. Identify Risk and Return Place a check mark in the appropriate columns for each investment. Investment Risk Return Low High Low High $1,000 CD 100 shares of a mutual fund 100 shares of stock Corporate bond Government bond Regular savings account Challenge Rank the investments in order from the lowest risk to the highest risk and from the lowest return to the highest return. Make a generalization about risk and return based on your rankings. Financial Markets 329 S E C T I O N 3 Buying and Selling Stocks TA K I N G N O T E S In Section 3, you will stock exchange, p. 330 • discuss why people buy stocks capital gain, p. 330 • describe how stocks are traded • explain how the performance of stocks is measured common stock, p. 331 preferred stock, p. 331 stockbroker, p. 332 future, p. 333 option, p. 333 stock index, p. 334 bull market, p. 335 bear market, p. 335 As you read Section 3, complete a cluster diagram using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Stocks The Stock Market KEY CONCEPT S Recall that in Chapter 8 you learned that corporations raise money through stock and bond issues. You will learn more about the sale—and resale—of stocks in this section. When a company first issues stock, it is sold to investment bankers in the primary market. Known as an initial public offering, or IPO, this is the stock sale that raises money for the corporation. However, most stock is then resold to investors through a stock exchange, a secondary market where securities (stocks and bonds) are bought and sold. Most people buy stocks as a financial investment, with the expectation that the stock price will rise and that they can resell the stock for a profit. Gains made from the sale of securities are called capital gains. QUICK REFERENCE A stock exchange is a market where securities are bought and sold. Capital gain is profit made from the sale of securities. Why Buy Stock? Investors buy stock for two reasons. The first is
to earn dividend payments, which are a share of the corporation’s profits that are paid back to the corporation’s stockholders. The second reason is to earn capital gains by selling the stock at a price greater than the purchase price. If stock is sold below the buying price, the seller makes a capital loss. Investors who want to earn income 330 Chapter 11 from their investment will be most interested in dividends. Those who want to see their investment grow over time will be most interested in potential for capital gain. As you learned in the previous section, investing in stocks carries a higher risk than most other investments but provides the opportunity for higher returns over time. Corporations are not required to pay dividends, so an investor has no guarantee that they will earn income from stocks. Similarly, there is no guarantee that the stock price will be higher when the investor wants to sell the stock. Types of Stock Source: www.CartoonStock.com No Guarantees Dividend payments are a possibility, not a certainty; stocks come with risk. There are essentially two types of stock—common stock and preferred stock. Common stock is share of ownership in a corporation, giving holders voting rights and a share of profits. Preferred stock is share of ownership in a corporation giving holders a share of profits (paid before common stockholders) but no voting rights. Most people who buy stock choose to buy common stock. Figure 11.4 shows the similarities and differences between the two types of stock. Notice that both types of stock give a share of ownership in the corporation that entitles a shareholder to receive dividends. The difference is that holders of preferred stock receive guaranteed dividends and will be paid before common stockholders if the company is liquidated. As a tradeoff for this preference, holders of preferred stock generally have no voting rights in the corporation, and their dividends do not increase if the company’s stock increases in value. Each holder of common stock generally gets one vote per share owned to elect the board of directors, which makes important decisions about how the company conducts business. QUICK REFERENCE Common stock gives shareholders voting rights and a share of profits. Preferred stock gives shareholders a share of profits but, in general, no voting rights. F I G U R E 11. 4 Common Stock and Preferred Stock Characteristic Preferred Stock Common Stock Share of ownership Eligible for dividends Guaranteed dividends Voting rights Yes Yes Yes No Yes Yes No Yes ANALYZE CHARTS 1. What preference do holders of preferred stock have? 2. What do
holders of common stock have that holders of preferred stock do not have? AP P LI CATION Drawing Conclusions A. What kind of stock do you think investors who wanted a steady income from their investment would buy? Why? Financial Markets 331 Trading Stock KEY CONCEPT S Most people who invest in stock do so with the hope of earning capital gains when they sell it. Like anything else sold in a free market, stock prices are determined by demand and supply. Some factors that affect stock prices include company profits or losses, technological advances that may affect a company’s business or a whole industry, and the overall state of the economy. When investors perceive that a company’s value is likely to increase, the demand for the stock will increase and its price will rise. As the price rises, more people will want to sell the stock for a profit. Few companies sell stock directly to investors. When investors want to buy or sell stock, they use a stockbroker, an agent who, for a commission, buys and sells securities for customers. Stockbrokers, sometimes just called brokers, generally work for brokerage firms. Investors may interact with brokers in person, by phone, or online. The broker’s primary job is to carry out the investor’s instructions to make trades. Some brokers also provide investment advice. Brokers buy and sell stocks for their customers on a variety of stock exchanges. QUICK REFERENCE A stockbroker buys and sells securities for customers. Organized Stock Exchanges The New York Stock Exchange (NYSE) is the oldest and largest of the organized stock exchanges in the United States. It is located on Wall Street in New York City, and the street name has become synonymous with the U.S. stock market. Almost 1.5 billion shares of about 2,800 of the largest and most successful U.S. companies are traded on the NYSE each day. Brokerage firms pay for the privilege of being one of the 1,336 members of the exchange. Traditionally, trading on the NYSE was in an organized auction format. Each stock had a specified location or trading post on the floor of the exchange. A specialist representing that stock ran the auction that matched buyers and sellers through open bidding to determine the price of shares. Prices for a stock often varied from minute to minute as the auction process continued throughout the day. Changes in technology have brought changes to the NYSE. Since 1996, floor traders have used small hand-held computers to execute many trades, and more
than half of the orders to buy and sell are now sent electronically. In 2006, the NYSE merged with Archipelago Exchange, an electronic trading company. This allowed the NYSE not only to speed up its transactions, but also to trade stocks normally traded in electronic markets. The smaller American Stock Exchange (AMEX) is also located in New York City. Trading at the AMEX is structured in a similar way to the NYSE, although AMEX-traded companies are generally smaller than those listed on the NYSE. In 2006, AMEX introduced new practices that combined the benefits of floor trading and electronic trading. Controlled Chaos Don’t be fooled by the seeming disorder of the exchange floor. It is a secure and organized trading system. 332 Chapter 11 Electronic Markets The term over-the-counter (OTC) is used to describe the market for stocks that are not traded on the NYSE or AMEX. In 1970, the National Association of Securities Dealers (NASD) introduced a centralized computer system that allows OTC traders around the country to make trades at the best prices possible. This automated quotation system is known as NASDAQ. In 2005, NASDAQ was the second-largest stock exchange in the world in number of companies listed (about 3,200) and number of shares traded daily. The companies listed on NASDAQ cover many sectors of the U.S. economy, although the majority are involved in technology. The NASD also regulates the OTC Bulletin Board as an electronic market for trading shares in companies that are too small to be traded on NASDAQ. Futures and Options Markets Most investors do not trade futures and options because they are complicated and high-risk investments that involve trying to predict the future. A future is a contract to buy or sell a stock on a specified future date at a preset price. An investor who wants to buy in the future wants to lock in a low price. An investor who wants to sell in the future wants to lock in a high price. An option is a contract giving the investor the right, but not the obligation, to buy or sell stock at a future date at a preset price. As you can see, the difference between a future and an option is that a futures contract requires the investor to buy or sell, while an option contract offers the possibility of buying or selling but does not require it. In options trading, an investor pays a small fraction of a stock’s current price for an option to buy or sell the stock at a better price
in the future. Recent Developments In the late 1990s, new stock market regulations and advances in computer technology changed the way that stocks were traded. Stocks listed on any exchange are now available to any trading firm. The growth of electronic communications networks (ECNs) increased electronic stock trading, especially on the NASDAQ market. Trades now take place 24 hours a day, not just when the stock exchanges are open. Many individual investors have access to the Internet and have become more knowledgeable about investing. They wanted ways to trade stocks without relying on traditional stockbrokers. The result has been huge growth in online brokerage companies. Investors now have the ability to make trades at any time and generally pay lower commissions than those charged by traditional brokers. Computer technology matches buyers and sellers automatically, providing rapid trades at the best possible prices. AP P LI CATION Drawing Conclusions B. How is NASDAQ similar to the NYSE? How are they different? FIGURE 11. 5 SOME NA SDAQ STOC K S Apple Inc. Dell Inc. Fujifilm Corporation Google Intel Corporation Peets Coffee & Tea Priceline.com Sirius Satellite Radio Sun Microsystems Inc. United Stationers Inc. QUICK REFERENCE A future is a contract to buy or sell a stock on a specific future date at a preset price. An option gives an investor the right to buy or sell stock at a future date at a preset price. Financial Markets 333 Measuring How Stocks Perform KEY CONCEPT S About half of all U.S. households now own stocks, and the stock market’s performance is followed closely on the nightly news, not just in specialized business media. Perhaps you have heard a statement like this one: “Wall Street responded positively to the latest employment figures, with the Dow making robust gains for the first time in several weeks.” The Dow is a stock index, an instrument used to measure and report the change in prices of a set of stocks. Stock indexes measure the performance—whether gaining or declining in value—of many individual stocks and the stock market as a whole. Stock Indexes Stock indexes provide a snapshot of how the stock market is performing. The Dow— short for the Dow Jones Industrial Average (DJIA)—is the most well known. (For help reading Figure 11.6, turn to the Skillbuilder on page 342.) Other U.S. indexes often cited include the Standard & Poor’s 500 (S&P 500) and the NASDAQ Composite. Global stock indexes
include the Hang Seng Index (Hong Kong), the DAX (Germany), the Nikkei 225 (Japan), and the FTSE 100 (Britain). Each index measures the performance of a different group of stocks. QUICK REFERENCE A stock index measures and reports the change in prices of a set of stocks. Find an update on stocks in the Dow Jones Industrial Average at ClassZone.com FIGURE 11.6 DOW JONES INDUSTRIAL AVERAGE, 1929–2006 12,000 10,000 DJI 8,000 6,000 4,000 2,000 1B 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 1935 Volume © 2006 Yahoo! Inc. YAHOO! and the YAHOO! logo are trademarks of Yahoo! Inc. FIGURE 11.7 THE DOW’ S BEST AND WORST YEARS The Dow’s Best Years Rank 1 2 3 4 5 Rank 1 2 3 4 5 Year 1915 1933 1928 1908 1954 % Change 81.66 66.69 48.22 46.64 43.96 The Dow’s Worst Years Year 1931 1907 1930 1920 1937 % Change –52.67 –37.73 –33.77 –32.90 –32.82 ANALYZE CHARTS 1. Does Figure 11.6 suggest a relationship between the level of the DJIA (above) and the volume of shares traded (below)? Explain. 2. What were the most recent best and worst years for the Dow? 334 Chapter 11 F I G U R E 11. 8 THE 30 STOC K S I N THE DJ I A Alcoa Inc. Altria Group, Inc. American Express Co. American International Group Inc. AT&T Inc. Boeing Co. Caterpillar Inc. Citigroup Inc. Coca-Cola Co. Dupont Co. Exxon Mobil Corp. General Electric Co. General Motors Corp. Hewlett-Packard Co. Home Depot Inc. Honeywell International Inc. Intel Corp. International Business Machines Corp. J.P. Morgan & Co. Johnson & Johnson McDonald’s Corp. Merck & Co. Microsoft Corp. 3M Pfizer Inc. Procter & Gamble Co. United Technologies Corp. Verizon Communications Inc. Wal-Mart Stores Inc. Walt Disney Co The Dow Jones Company, publisher of the Wall Street Journal newspaper, first published the DJIA in 1896. The index included the stocks of 12 companies that reflected the economy of the time, which was focused heavily
on agriculture and mining. Since 1928, the Dow has included 30 companies. General Electric is the only one of the original companies that is on the current index. As the U.S. economy has changed from agriculture to industry to services, the companies in the index have changed to reflect the most successful companies in the most important sectors of the economy. These stocks are often referred to as blue chip stocks. The DJIA is a price index, in other words it measures changes in the prices at which the stocks on the index are traded. The original DJIA was the actual average of the prices of the 12 stocks. Now the average is weighted so that higher-priced stocks have more influence on the average than lower-priced stocks. The number that is quoted is not a price but an average measured in points not dollars. QUICK REFERENCE A bull market occurs when stock market prices rise steadily over time. A bear market occurs when stock market prices decline steadily over time. Tracking the Dow Changes in the Dow reflect trends in stock market prices. The terms bull market and bear market are commonly used to describe these trends. A bull market is a situation where stock market prices rise steadily over a relatively long period of time. A bear market is a situation where stock market prices decline steadily over a relatively long period of time. Those who follow the stock market track the Dow and other indexes to determine if the market is trending toward bull or bear. The first DJIA measure was 40.94. In 1972, it reached 1,000 for the first time, and in May 1999, it topped 11,000. When the Dow hit its all-time high of 11,722.98 on January 14, 2000, it marked the end of the longest bull market in history. During the 1990s the Dow had climbed from 2,800 to its peak. Most bull markets last two to three years. A well-known bear market followed the Stock Market Crash of 1929. During the 1920s, the Dow had risen from 60 to a high of 381.17 in early September of 1929. In the month after October 29, 1929, it fell to a low of just under 199. The next time it achieved a closing price of 400 was December 29, 1954. Source: www.CartoonStock.com Financial Markets 335 Investing Money Overseas In an increasingly international economy, the NYSE is no longer the “only game in town” for U.S. investors. There are over 20 major stock markets overseas. With
U.S. stocks representing only about half of the total value of global markets, international investing has become an important option for Americans. Investing money overseas offers both advantages and risks. For example, an investment in an emerging country—one with an economy that is rapidly growing—offers the prospect of a greater and more rapid return. Such an investment also may involve greater risk, for political instability in an emerging country can drive stock prices down in a hurry. However, many investors view increased diversification as the primary advantage of investing overseas. F I G U R E 11. 9 Leading World Stock Markets Market Number of Companies Listed Value of Stocks (in billions of US dollars) Main Index New York Stock Exchange (United States) Tokyo Stock Exchange (Japan) London Stock Exchange (United Kingdom) Bombay Stock Exchange (India) Sao Paulo Stock Exchange (Brazil) Cairo and Alexandria Stock Exchanges (Egypt) 2,278 2,392 3,231 4,786 347 618 15,138 Dow Jones Industrial Average 4,550 3,718 801 660 Nikkei 225 FTSE 100 Sensex Ibovespa 88 CASE 30 Source: World Federation of Exchanges, November 2006 data CONNECTING ACROSS THE GLOBE 1. Synthesizing Economic Information Do you think it likely that U.S. investment in overseas stock markets will become increasingly common? Explain your answer. 2. Drawing Conclusions Compare the total value of stocks to the number of companies listed. Which two exchanges have the least expensive stocks, on average? Which exchange has the most expensive stocks? Many factors affect the Dow’s performance. Among these are the market’s previous close, actions by the Federal Reserve that affect interest rates or the money supply, the performance of foreign indexes, and the trade balance between imports and exports. APPLICATION Drawing Conclusions C. Why have the stocks on DJIA changed over time? 336 Chapter 11 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs: a. stock exchange stockbroker b. future option c. bear market bull market 2. Are owners of common stock generally more interested in dividends or capital gains? Why? 3. Why do most people who buy stock choose common stock over preferred stock? 4. What is the difference between a bear market and a bull market? 5. How has the growth of individual online trading affected stockbrokers? 6. Using Your Notes What
are the four different ways that stocks are traded? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Stocks. Applying Economic Concepts Rachel paid $10 per share for 100 shares of common stock in her favorite clothing store. a. If she receives 10 cents per share in dividends each year, about how many years would it take her to earn $100 on her investment? b. If the share price increases to $11 in two years and she chooses to sell the stock, how much capital gain would she make? 8. Analyzing and Interpreting Data Rearrange the data in Figure 11.7 into one table in chronological order. Use a plus sign to indicate a best year and a minus sign to indicate a worst year. a. What relationship, if any, do you see between best years and worst years? b. What does the data reveal about the stock market in the 1930s? 9. Challenge The Standard and Poor’s 500 (S&P 500) is an index composed of 500 stocks, while the Dow Jones Industrial Average is composed of 30 stocks. Many analysts feel the S&P 500 is a better representation of the U.S. stock market. Do you agree? Why? Analyzing Demand for Stock The graph below shows the combined market demand and supply curve for the stock of a company that makes mp3 players 25 20 15 10 5 0 S D 100 300 200 Number of shares 400 500 600 Draw New Demand Curves Copy the graph above on your own paper and draw new demand curves to reflect each of the following scenarios: a. A competitor announces a technological breakthrough that will dramatically cut its production costs. b. The company announces a new product that offers features that consumers have been asking for. Challenge How does the change in demand in each scenario affect the price of the stock? Financial Markets 337 S E C T I O N 4 Bonds and Other Financial Instruments TA K I N G N O T E S In Section 4, you will par value, p. 338 • discuss why people buy bonds maturity, p. 338 • describe the different kinds of coupon rate, p. 338 bonds • explain the factors that affect bond trading • outline investment options other than stocks and bonds yield, p. 338 junk bond, p. 339 As you read Section 4, summarize what you learn by completing a chart using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Bonds Other Financial Instruments Why Buy
Bonds? KEY CONCEPT S QUICK REFERENCE Par value is the amount a bond issuer must pay the buyer at maturity. Maturity is the date when a bond is due to be repaid. The coupon rate is the interest rate a bondholder receives every year until maturity. Yield is the annual rate of return on a bond. 338 Chapter 11 You learned in Chapter 8 that a bond is a contract issued by a corporation promising to repay borrowed money, plus interest, on a fixed schedule. Governments also issue bonds. The amount that the bond issuer promises to pay the buyer at maturity is its par value. Maturity is the date when the bond is due to be repaid. The coupon rate is the interest rate a bondholder receives every year until a bond matures. There are two reasons to invest in bonds—the interest paid on bonds and the gains made by selling bonds. Most people buy bonds for the interest. Generally, bonds are considered less risky than stocks because bondholders are paid before stockholders. It is important to determine the yield—the annual rate of return—for a bond when deciding to buy and sell bonds. If a bond is sold at par value, the yield is the same as the coupon rate. If a bond is sold for less than par value, the yield will be higher than the coupon rate. On the other hand, if demand is strong and the price of a bond is higher than the par value, the yield will be lower than the coupon rate. Generally speaking, bonds with longer maturity dates have higher yields than those with shorter dates. This is because there is more uncertainty and risk involved with repayment dates that are farther in the future. Types of Bonds Investors may choose to invest in many different kinds of bonds. The yields and risks associated with these bonds vary considerably. As is the case with stocks, the higher the risk the greater the potential yield of a bond. Figure 11.10 shows the yields for different types of bonds. Bonds are classified based on who issues the bonds. FIGURE 11.9 AVERAGE BOND YIELDS, 1993–2003 Corporate bonds help businesses expand. CORPORATE BONDS 10-YEAR TREASURY NOTES MUNICIPAL BONDS Treasury bonds help keep the federal government operating. 1997 1998 1999 2000 2001 2002 2003 2004 Source: Statistical Abstract of the United States Year ANALYZE GRAPHS 1. Which type of bond had the lowest average yield in most years? 2. Which type of bond carries
the highest risk? How do you know? Municipal bonds make state and local projects possible. The U.S. government issues securities called Treasury bonds, notes, or bills. The different terms denote loans with different maturity dates, with Treasury bonds having the longest maturity (more than ten years) and Treasury bills having the shortest (one year or less). The money borrowed through the sale of these securities helps keep the government running. Because they are backed by the “full faith and credit” of the federal government, these securities are considered to be virtually risk free. Governments all over the world issue bonds for the same reasons as the U.S. government. The risk level of international bonds depends on the financial strength of the particular government. Bonds issued by state and local governments are called municipal bonds. Funds raised by these bonds finance government projects such as construction of roads, bridges, schools, and other public facilities. The interest earned on many municipal bonds is not subject to federal income tax. Generally, municipal bonds are considered low-risk investments. A major reason for this is that state and local governments collect taxes, so it is assumed that they’ll be able to make interest payments and repay the buyer upon maturity. However, there have been instances of governments being unable to repay bondholders the full amount of their loans. One way that companies finance expansion is by issuing corporate bonds. These bonds generally pay a higher coupon rate than government bonds because the risk is higher. One kind of corporate bond, a junk bond, is considered high risk but has the potential for high yields. The risk involved with investing in junk bonds is similar to that of investing in stocks. QUICK REFERENCE Junk bonds are highrisk, high-yield corporate bonds. Financial Markets 339 Buying Bonds Investors need to determine their reason for buying bonds in order to purchase the right type of bond. Most investors purchase bonds because they want the guaranteed interest income. Yield will be most important to those investors. Coupon rate and price relative to the par value will determine the yield. Investors who want to sell bonds before they reach maturity study the bond market to see if they can sell their investment at a profit. Market interest rates are another important consideration for bond investors. There is an inverse relationship between the price of existing bonds and interest rates. For example, as interest rates rise, the price of existing bonds falls because bonds that were issued with a lower interest rate will be less in demand. Conversely, if interest rates fall, the price of existing bonds rises because
there will be more demand for those bonds issued at a higher interest rate. The main risk that bond buyers face is that the issuer will default, or be unable to repay the borrowed money at maturity. Therefore, the level of risk is directly tied to the financial strength of the bond issuer. When governments or corporations want to issue bonds, they pay a credit-rating company to evaluate how likely it is that they will repay the loans. In this way, investors have a standard by which to judge the risk of the bonds. The two most well-known systems of bond ratings are those established by Standard & Poor’s and Moody’s. These companies use a system of letters to designate the relative credit risk of bonds. Bonds are rated from the lowest risk of U.S. Treasury securities (Aaa or AAA) to the higher risks associated with junk bonds. (See Figure 11.11.) F I G U R E 11.11 Bond Ratings Bond Rating Grade Risk Moody’s Standard & Poor’s Aaa Aa A Baa Ba, B Caa/Ca C AAA AA A BBB BB, B CCC/CC/C D Investment Investment Investment Investment Junk Junk Junk Lowest risk Low risk Low risk Medium risk High risk Highest risk In default ANALYZE TABLES 1. What are the lowest-rated investment grade bonds in each system? 2. Why do junk bonds have lower ratings than investment grade bonds? APPLICATION Drawing Conclusions A. Why is bond yield not always the same as the coupon rate? 340 Chapter 11 Other Financial Instruments KEY C ONCEPT S Investors have investment options other than bonds and stocks. The most common of these are certificates of deposit (CDs) and money market mutual funds. Both of these investments have very low risk and provide income in the form of interest. Individual investors do not generally sell these financial instruments for profit. Certificates of Deposit As you learned earlier, CDs are a form of time deposit offered primarily by banks, savings and loans, and credit unions. Like bonds, CDs have a maturity date (usually 6 months to 5 years), when the investor receives the principal back with interest. The issuer of the CD pays the investor a rate of either fixed or variable interest during the period that the CD is held. Usually the interest is reinvested in the CD so that the investor enjoys the benefits of compound interest. In general, CDs with longer maturity dates pay higher rates of interest. For example, a 6-month CD might pay 3
.4 percent interest while a 5-year CD might pay 4.4 percent. The federal government insures funds deposited in CDs at most banks and credit unions up to $100,000 per depositor in any given institution. The main risk that investors in CDs face is the loss of interest or possibly some principal if funds are withdrawn before the maturity date. In addition, investors might face interestrate risk if rates rise and funds are locked in for a length of time at a lower rate. Money Market Mutual Funds Recall from Section 1 that the money market involves financial assets with maturities of one year or less. Also, remember that mutual funds allow investors to buy shares that represent an investment in all the financial assets held by the fund. Money market mutual funds (MMMF) allow investors to own a variety of short-term financial assets, such as Treasury bills, municipal bonds, large-denomination CDs, and corporate bonds. These mutual funds give investors a higher yield than bank savings accounts, but provide a similar level of liquidity. Investors can redeem their shares by check, by phone, or by electronic transfer to a separate checking account. Although the federal government does not insure MMMFs, the funds are tightly regulated, and these investments are considered to be quite safe with regard to loss of principal. There is less interest-rate risk than with CDs because the money is not committed for a specified length of time. The yield of the MMMF varies based on the yield of the assets in the fund. AP P LI CATION Making Inferences B. Why do longer-term CDs pay higher interest rates than shorter-term CDs? Source: www.CartoonStock.com Financial Markets 341 For more information on interpreting graphs, see the Skillbuilder Handbook, page R29. Interpreting Graphs: Online Financial Information Evaluating means to make a judgment about information. Investors make judgments about stocks based on their analysis of financial information. Many use the Internet as a resource for acquiring minute-to-minute information about stock market trading. The graphs on this page provide information about Apple Computer Inc., a stock traded on the NASDAQ. These graphs, which are updated online throughout trading, offer an example of the type of online information investors use to evaluate stocks. TIPS FOR EVALUATING ONLINE INFORMATION Use the following guidelines to evaluate economic information online: Read the title to identify the company for which stock information is shown. Here it is Apple Computer (AAPL), traded on the NASDAQ (Q). Read the
vertical axis. This graph has two parts. The upper part shows the stock’s price; the lower part shows the volume of shares traded. Look for other information This statement shows the lag time for information—15 minutes in this case. 342 Chapter 11 Read the horizontal axis. This graph shows stock prices and volume traded from May 2005 through April 2006. Quotes delayed 15 minutes except NYSE and Amex which are 20 minutes. Source: TheGlobeandMail.com T HINKING ECONOMICALLY Evaluating 1. As an investor, which month would have been best for you to acquire Apple stock? Why? 2. How does the price per share at the beginning of June 2005 compare with the price in mid-January 2006? Use information from the graph in your answer. 3. From January through April of 2006, the price of Apple shares fluctuated greatly. Volume of trading was also very heavy. Are these two facts related? Why? S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. Use each of the three terms below in a sentence that illustrates the meaning of the term: a. coupon rate b. maturity c. yield 2. What does par value represent to the issuer of a bond? 3. What is the relationship between par value and maturity? 4. When does yield equal the coupon rate? 5. Why do junk bonds offer a higher yield than other types of bonds? 6. Using Your Notes Compare the risk of investing in a CD with the risk of investing in a money market mutual fund. Refer to your completed chart. Bonds Other Financial Instruments Use the Graphic Organizer at Interactive Review @ ClassZone.com. Comparing and Contrasting Dmitri bought a $1,000 bond at par value with a coupon rate of 5 percent. He determines the yield by dividing the amount of interest he earns by the price. a. How much interest would he earn in the first year and what would be the yield? b. How much interest would he earn in the first year and what would be the yield if he had paid $950 for the bond? What would be the interest and yield if he paid $1,050? 8. Making Inferences In 2003, Molly bought a 10-year Treasury note for $1,000. The market interest rate was 3.5 percent. In 2005, Molly wanted to sell the note to pay for college expenses. Interest rates had risen to 4.5 percent. How would the change in
interest rates affect the price that Molly was likely to receive for her note? Give reasons for your answer. 9. Applying Economic Concepts Julie has accumulated $1,000 in a bank savings account, which pays 2.7 percent interest. She investigates several options and finds that she can invest her money in a 1-year Treasury note paying 4.4 percent interest, a 1-year CD paying 3.9 percent interest, or a money market mutual fund with an average yield of 3.7 percent. What are the pros and cons of each of these investment options? 10. Challenge How would a lower bond rating by Moody’s or Standard & Poor’s affect the coupon rate that a corporation has to offer when it issues its bonds? Give reasons for your answer. Making Investment Decisions Suppose that you have been advised to invest in bonds. Recall what you have learned about the factors to consider when buying and selling bonds and then complete the following activities. Ask Investment Questions Fill in the chart by developing a series of questions you might ask to help you decide which type of bond to buy. My Questions Categories of Questions to Ask About Bonds Investment objectives Tolerance for risk Desired return Resalability of bonds Challenge How might you apply the concept of diversification to a portfolio of bond investments? Financial Markets 343 Case Study Find an update on this Case Study at ClassZone.com The Rise and Fall of Dot-Coms Background The availability of products and services on the Internet is old news. But when the Internet first emerged, it provided a unique and exciting tool for almost instant access to potential buyers worldwide. Young people in particular were quick to grasp the possibilities of the electronic marketplace. As a result, many new companies, known as dot-coms, quickly appeared on the Internet. Like the stock of many companies based on new technologies, the value of dot-com stocks rose quickly. Investors, attracted by the initial success of dot-coms and spurred on by low interest rates in the late 1990s, were quick to join the dotcom boom. The boom, however, proved to be a financial bubble. In 2000 and 2001, the bubble burst as dot-com stocks fell dramatically. Many dot-coms went out of business, and their investors sustained heavy financial losses. What’s the issue? Why did so many dot-com companies fail? Study these sources to discover what investors learned when the dot-com bubble burst. A. Online Encyclopedia Article Many young entrepreneurs jumped into the dot-com market,
often with disastrous results. This article describes one such venture. 344 Chapter 11 Kozmo.com Offered New Yorkers Free, One-Hour Delivery Despite millions in capital investment, Kozmo.com’s choices led to failure. Kozmo.com was a venture-capital-driven online company that promised free one-hour delivery of anything from DVDs to Starbucks coffee. It was founded by young investment bankers Joseph Park and Yong Kang in March 1998 in New York City. The company is often referred to as an example of the dot-com excess. Kozmo promoted an incredible business model; it promised to deliver small goods free of charge. The company raised about $280 million, including $60 million from Amazon.com. The business model was heavily criticized by business analysts, who pointed out that onehour point-to-point delivery of small objects is extremely expensive and there was no way Kozmo could make a profit as long as it refused to charge delivery fees. Not surprisingly, the company failed soon after the collapse of the dot-com bubble, laying off its staff of 1,100 employees and shutting down in April 2001. Source: Wikipedia.org Thinking Economically Why do you think Park and Kang were so successful in raising capital to fund their business venture? B. Cartoon Cartoonist Andrew Toos drew this commentary about the dot-com bubble. Source: www.CartoonStock.com Thinking Economically What comment does the cartoon make about investing in the dot-com financial market? C. Online News Story Early dot-coms typically spent huge amounts of money on advertising. This article compares purchases of advertising during the 2000 Super Bowl telecast to Napoleon’s 1815 defeat at Waterloo. The Bubble Bowl Expensive advertising failed to market dot-com products. It was just five years ago, although it seems like a different age entirely. It was a time of singing-sock-puppets, 21-year-old chief executives, gravity-defiant stock prices, revolutionary technologies and half-baked business plans. And in this atmosphere, during the final, halcyon days of the Internet boom, the St. Louis Rams played the Tennessee Titans in Super Bowl XXXIV, a moment that will be forever remembered as the dot-com bubble’s Waterloo. Football fans got a heavy dose of the fever that day: More than a dozen internet companies spent an average of $2.2 million for 30-second spots, amounting to more than $40 million of stockholder cash and not
30 stocks. 14 is the interest rate paid on a bond. The 15 is the amount that a bond issuer promises to pay the buyer at maturity. 346 Chapter 11 CHAPTER 11 Assessment Savings and Investment (pp. 318–323) 1. How are savings and investment related? 2. What is the role of financial intermediaries in the circular flow of the financial system? Investing in a Market Economy (pp. 324–329) 3. Why do investors need to determine their investment objective before they invest? 4. Explain the relationship between risk and return. Buying and Selling Stocks (pp. 330–337) 5. How do people earn money by investing in stocks? 6. How does the Dow Jones Industrial Average reveal trends in the stock market? Bonds and Other Financial Instruments (pp. 338–345) 7. What are the two reasons people buy bonds? 8. How are interest rates and bond prices related? A P P LY Look at the graph below showing savings as a percentage of after-tax income in various countries. 9. Which country has the lowest rate of savings? 10. What is the overall trend from 1980 to 2000? FIGURE 11.12 SAV I NGS R ATES I N DIFFERENT COUNTRIES 20 18 16 14 12 10 8 6 4 2 0 1980 1985 1990 1995 2000 Source: Statistical Abstract of the United States Key: Japan France United Kingdom United States 11. Analyzing Causes and Effects In 2005, many leading advertisers announced plans to increase use of online advertising and to decrease the amount of advertising dollars spent in traditional print media, such as newspapers. In addition, newspaper circulation figures declined steadily as more people read news on the Internet. a. How was this situation likely to affect the stock prices of online search-engine companies that featured banner ads and sponsored links on their Web pages? b. How would it affect the stock prices of newspa- pers? Explain your answers. 12. Comparing and Contrasting What are the similarities and differences between stock dividends, a bond coupon rate, and interest on a CD? 13. Drawing Conclusions Alex, Kate, and Rashid all invested money in a software company. Alex bought a corporate bond, Kate bought shares of common stock, and Rashid bought shares of preferred stock. Which of these investors would be least at risk of losing money if the company became unprofitable? 14. Making Inferences Suppose that you heard the following statement on the financial news: “Bonds fell as the yield on 10
-year Treasury notes rose to 4.56 percent, the highest in two years.” What does “bonds fell” mean and how is it related to the increase in yield? 15. Challenge Steve purchases an option contract to buy 100 shares of stock in a big high-tech company for $50 per share in six months. The stock is currently selling for $40 per share. Steve pays $5 per share for the option contract. If the share price rises to $60, Steve exercises his option to buy the shares at $50 and then resells the stock on the market for $60 per share. How much profit does Steve make per share? If the price never rises to $50 before the option expires, how much money does Steve lose? Advise Your Clients Choose a partner. Imagine that you are financial planners whose job is to help clients meet their investment objectives and use diversification to maximize return and limit risk. Step 1 Make a list of several possible financial instruments that you might recommend and rate them for risk and return. Step 2 Review each client’s objectives and risk tolerance to consider what investments to recommend. a. Carlos and Juanita Diaz want to invest for their two young children’s college education. They would like a return of 7 to 10 percent a year and have a moderate tolerance for risk. b. Patrick Hurd is 30 years old and wants to begin saving for his retirement. He wants the highest return possible and is willing to take risks. c. Alison Leveridge has recently retired. She wants to invest the money from her pension fund so that she can have a guaranteed amount of income and little risk of losing her capital. Step 3 Decide what percentage of each client’s money to invest in different types of financial instruments. Create pie graphs to show your recommendations for each client. Step 4 Present your recommendations to another pair of students. Discuss the choices that each of you made. Step 5 As a class, discuss how changes in your clients’ financial circumstances or changes in the stock market might affect your recommendations. Use to complete this activity. @ ClassZone.com Financial Markets 347 Macroeconomics U n i t 5 Measuring and Monitoring Economic Performance Measuring the Economy Millions of workers and businesses participate in the U.S. economy. Measuring the country’s economy requires special economic tools. 348 CHAPTER 12 SECTION 1 Gross Domestic Product and Other Indicators SECTION 2 Business Cycles SECTION 3 Stimulating Economic Growth CASE STUDY Poland:
Economic Freedom and Economic Growth Economic Indicators and Measurements Macroeconomics is the study of the economy as a whole and how major sectors of the economy interact. C H A P T E R 12 National income accounting uses statistical measures of income, spending, and output to help people understand what is happening to a country’s economy AT T E R S Your economic decisions—combined with those of millions of other people—determine the fate of the nation’s economy. Can you afford to buy a new car? Is now a good time to change jobs? Should you take a risk in the stock market or keep your money safe in the bank? Understanding what is happening to the country’s economy will help you make better economic decisions. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on the economy of Poland. (See Case Study, pp. 376–377.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. How has free enterprise transformed Poland’s economy? See the Case Study on pages 376–377. Economic Indicators and Measurements 349 S E C T I O N 1 Gross Domestic Product and Other Indicators TA K I N G N O T E S In Section 1, you will • define GDP and describe how it is measured • explain how GDP has certain limitations • identify other national income accounting measures national income accounting, p. 350 gross domestic product (GDP), p. 350 nominal GDP, p. 352 real GDP, p. 352 nonmarket activities, p. 354 underground economy, p. 354 gross national product (GNP), p. 355 net national product (NNP), p. 355 national income (NI), p. 355 personal income (PI), p. 355 disposable personal income (DPI), p. 355 As you read Section 1, complete a hierarchy chart like the one below to record what you learn about national income accounting. Use the Graphic Organizer at Interactive Review @ ClassZone.com National Income Accounting GDP What Is GDP? KEY CONCEPT S As you have read, microeconomics and macroeconomics look at the economy through different lenses. While microeconomics examines the actions of individuals and single markets, macroeconomics examines the economy as a whole. Macroeconomists analyze the economy using national income accounting, statistical measures that track the income, spending, and output of a nation
. The most important of those measures is gross domestic product (GDP), the market value of all final goods and services produced within a nation in a given time period. The Components of GDP To be included in GDP, a good or service has to fulfill three requirements. First, it has to be final rather than intermediate. For example, the fabric used to make a shirt is an intermediate good; the shirt itself is a final good. Second, the good or service must be produced during the time period, regardless of when it is sold. For example, cars made this year but sold next year would be counted in this year’s GDP. Finally, the good or service must be produced within the nation’s borders. Products made in foreign countries by U.S. companies are not included in the U.S. GDP. Products Included in GDP Cars made in the United States are an example of goods counted toward U.S. gross domestic product (GDP). QUICK REFERENCE National income accounting is a way of evaluating a country’s economy using statistical measures of its income, spending, and output. Gross domestic product (GDP) is the market value of all final goods and services produced within a nation in a given time period. 350 Chapter 12 Calculating GDP Although there are several different ways to calculate GDP, economists often use the expenditures approach. With this method, they group national spending on final goods and services according to the four sectors of the economy: spending by households, or consumption; spending by businesses, or investment; government spending; and total exports minus total imports, or net exports. Economists identify consumption with the letter C; investment with the letter I; government spending with the letter G; and net exports with the letter X. To calculate GDP, economists add the expenditures from all sectors together: C+I+G+X=GDP. F I G U R E 12.1 CO. S. G ROSS D OM ES T I C P RO 10 Key: Consumption (C) Investment (I) Government Spending (G) Net Exports (X) C I G X Source: U.S. Bureau of Economic Analysis, 2005 data ANALYZE GRAPHS 1. In 2005, net exports was a negative number. What does this say about the relative amounts of exports and imports? 2. Did households, businesses, or the government contribute the most to U.S. GDP in 2005? Consumption includes all spending by households on durable goods, nond
urable goods, and services. You drive to the movies in a durable good (an item that does not wear out quickly). You purchase a service when you pay for the movie (since you are not buying to own something). And you obtain a nondurable good (a good that is used up relatively soon after purchase) when you buy popcorn. Investment, which measures what businesses spend, has two categories. One is fixed investment, which includes new construction and purchases of such capital goods as equipment, machinery, and tools. The other is inventory investment. This category, also called unconsumed output, is made up of the unsold goods that businesses keep on hand. Government spending includes all the expenditures of federal, state, and local governments on goods and services. Examples include spending for defense, highways, Find an update on the U.S. GDP at ClassZone.com Economic Indicators and Measurements Economic Indicators and Measurements 351 and public education. However, government spending on transfer payments, such as social security and unemployment benefits, is not included. These payments allow the recipients to buy goods and services, and these are counted as consumption. Net exports, the final component of GDP, represents foreign trade. This component takes into account the goods and services produced in the United States but sold in foreign countries—in other words, exports. However, U.S. consumers and businesses also buy, or import, goods made in foreign countries. Cars, car parts, and crude oil are the largest imports in dollar value. The GDP counts only net exports— the value of U.S. exports minus the value of U.S. imports. Two Types of GDP Economists use GDP to gauge how well a country’s economy is doing. When GDP is growing, an economy creates more jobs and more business opportunities. When GDP declines, jobs and more business opportunities become less plentiful. To get a clearer picture of a country’s economic health, economists calculate two forms of GDP—nominal and real. The most basic form is nominal GDP, which is stated in the price levels for the year in which the GDP was measured. If prices never changed, nominal GDP would be sufficient. But prices tend to increase over time. In Figure 12.2, find the line that represents nominal GDP. If you estimate the difference from 1990 to 2005, the nominal GDP of the United States about doubled. However, during this time prices went up, adding dollars to GDP without adding value to the nation’s output. To
factor out rising prices, economists use real GDP, which is nominal GDP adjusted for changes in prices. Real GDP is an estimate of the GDP if prices were to FIGURE 12.2 U. S. NOMINAL AND REAL GROSS DOMESTIC PRODUCT QUICK REFERENCE Nominal GDP states GDP in terms of the current value of goods and services. Real GDP states GDP corrected for changes in prices from year to year. 14 12 10 NOMINAL GDP REAL GDP (IN 2000 DOLLARS) 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: U.S. Bureau of Economic Analysis Year ANALYZE GRAPHS 1. About how much did nominal GDP increase from 1990 to 2000? 2. About how much did real GDP increase over the same period? 3. Why do the two lines cross at the year 2000? 352 Chapter 12 M AT 12. 3 Understanding Nominal and Real GDP To better understand nominal and real GDP, imagine a country that produces only one good: TVs. If you know the price of TVs and the number produced, you can calculate that country’s nominal and real GDP. Use the table to find the data for these calculations. Step 1: Calculate nominal GDP for 2004. Nominal GDP is the product of the number of TVs produced and the price of TVs that year. 2004 500 $100 2005 600 $100 2006 600 $120 $50,000 $60,000 $72,000 $50,000 $60,000 $60,000 TVs Produced TV Price Nominal GDP Real GDP, base: 2004 Number produced Price in that year Nominal GDP 500 $100 $50,000 The table shows that nominal GDP grew each year. If you judged only by nominal GDP, the economy of this country would seem to be growing. Step 2: Analyze the nominal GDP figures. Why did nominal GDP increase from 2004 to 2005? The number of TVs produced increased. Why did nominal GDP increase from 2005 to 2006? The price of TVs increased. The output of the country’s economy grew from 2004 to 2005, but it stayed the same from 2005 to 2006, despite the increase in prices. Calculating real GDP produces a better estimate of how much a country’s economy is growing. Step 3: Calculate real GDP for 2006. Real GDP is the product of the number of TVs produced in the current year and the price of TVs in the base year. In this case, use 2004 as the base year. Number produced Price in
the base year Real GDP 600 $100 $60,000 Since 2004 is the base year, nominal and real GDP are the same for 2004. Real GDP allows you to compare the output of the country’s economy in different years. remain constant from year to year. To find real GDP, economists compare nominal GDP to a base year. Look again at Figure 12.2, which uses 2000 as a base year. Since real GDP eliminates price differences, the line for real GDP rises more gradually than the line for nominal GDP. Real GDP provides a more accurate measure of economic performance. AP P LI CATION Applying Economic Concepts A. If output remained the same, how would a year of falling prices affect nominal GDP? How would it affect real GDP? Economic Indicators and Measurements 353 What GDP Does Not Measure KEY CONCEPT S Although GDP provides an important estimate of how well the economy is performing, it does not measure all output. It does not measure nonmarket activities, such as home childcare or performing one’s own home repairs. GDP also does not measure output from the underground economy, market activities that go unreported because they are illegal or because those involved want to avoid taxation. Further, GDP does not measure “quality of life” issues related to economic output. Nonmarket Activities Some productive activities do not take place in economic markets. For example, there is no effective way to measure the output of plumbers who install or repair plumbing systems in their own homes or people who do volunteer work for schools or hospitals. By far the biggest nonmarket activity, also left out of GDP, consists of the many services—cooking, cleaning, childcare—provided by homemakers. Underground Economy Nonmarket Activities Housework is an example of a productive activity not measured by GDP. Also missing from GDP is the underground sector of the economy. Some activities are kept underground because they are illegal—drug dealing, smuggling, gambling, and selling stolen goods, for example. When goods are rationed or otherwise restricted, illegal trading occurs on what is called the black market. Other underground activities are themselves legal, but the way the payment is handled is not. For example, a plumber who does repairs for a neighbor might receive payment in cash and not declare it as taxable income. Estimates suggest that the underground economy would make up 8 to 10 percent of the U.S. GDP. Quality of Life Countries with high GDPs have high living standards. But GDP does not show how the goods and services are distributed. The United
States has the largest GDP of any country, but more than 10 percent of its people still live in poverty. GDP also does not express what products are being built and services offered: for example, are there more jails being built than schools? APPLICATION Explaining an Economic Concept B. If you get paid in cash to baby-sit, mow lawns, or do other chores for neighbors, are you part of the underground economy? Why or why not? QUICK REFERENCE Nonmarket activities are services that have potential economic value but are performed without charge. Underground economy describes market activities that go unreported because they are illegal or because those involved want to avoid taxation. 354 Chapter 12 Other Economic Performance Measures KEY C ONCEPT S GDP is not the only measure that economists use to gauge economic performance. Several other measures are derived by making adjustments to GDP. • Gross national product (GNP) is the market value of all final goods and services a country produces in a given time period. GNP equals GDP plus the income from goods and services produced by U.S. companies and citizens in foreign countries but minus the income foreign companies and citizens earn here. • Net national product (NNP) is GNP minus depreciation of capital stock—in other words, the value of final goods and services less the value of capital goods that became worn out during the time period. • National income (NI) is the total income earned in a nation from the production of goods and services in a given time period. It is calculated by subtracting indirect business taxes, such as property and sales taxes, from NNP. • Personal income (PI) is the income received by a country’s people from all sources in a given time period. It can be calculated from NI by subtracting social security taxes, corporate profit taxes, and corporate profits not paid to stockholders and by adding social security, unemployment, and welfare payments. • Disposable personal income (DPI) is personal income minus personal income taxes. It shows how much money is actually available for consumer spending. F I G U R E 12. 4 National Income Accounting QUICK REFERENCE Gross national product (GNP) is the market value of all final goods and services produced by a country. Net national product (NNP) is the value of final goods and services less the value of capital goods that have become worn out. National income (NI) is the total income earned in a nation from the production of goods and services. Personal income (PI) is
the income received by a country’s people from all sources. Disposable personal income (DPI) is personal income minus taxes. GDP + income earned abroad by U.S. businesses and citizens – income earned in U.S. by foreign businesses and citizens = GNP – depreciation of capital stock = NNP – indirect business taxes = NI – income earned but not received + income received but not earned = PI – personal taxes = DPI ANALYZE CHARTS What three figures do you need in order to calculate personal income (PI)? AP P LI CATION Making Inferences C. Under what circumstances might a country’s GNP be greater than its GDP? Economic Indicators and Measurements 355 For more on synthesizing economic data, see the Skillbuilder Handbook, page R23. Synthesizing Economic Data Synthesizing is a skill used by economists to interpret economic trends. Synthesizing involves interpreting various data to form an overview of economic performance. A synthesis is often stated as a broad summary statement. PRACTICING THE SKILL National income accounting involves the collection and analysis of data on key economic variables. Economists synthesize the data to arrive at an overview of national economic performance. The table below presents data for variables used to determine gross domestic product (GDP), a key factor in national income accounting. Read the title to learn the main idea of the table. This table shows the components of U.S. GDP for selected years. F I G U R E 12. 5 COMPONENTS OF U.S. GDP (IN BILLIONS OF DOLLARS) Read the column heads carefully. The four types of expenditures are used to determine GDP. Determine how the types of data relate to one another. For 1990, calculating the sum of the four expenditures yields $5,803 billion, the nominal GDP for 1990. Check the source of the data to evaluate its reliability. Year 1980 1985 1990 1995 2000 2005 Consumption Expenditure Investment Expenditure Government Expenditure Net Export Expenditure Nominal GDP 1,757 2,720 3,840 4,976 6,739 8,746 479 736 861 1,144 1,736 2,105 566 879 1,180 1,369 1,722 2,363 13 115 78 91 380 727 2,789 4,220 5,803 7,398 9,817 12,487 Source: U.S. Bureau of Economic Analysis Look for patterns in the
data. For example, notice that net exports have been negative. T HINKING ECONOMICALLY Synthesizing 1. What trend can be seen in U.S. nominal GDP? What can you tell from this about the growth of the U.S. economy? Do you need more information? 2. Which expenditure accounts for most of GDP? 3. Does the proportion of this expenditure to the other two positive expenditures remain about the same in the six years shown here? Briefly explain how you estimated this. 356 Chapter 12 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. nominal GDP real GDP b. gross national product net national product c. personal income disposable personal income 2. What are the four components of GDP? 3. What is an example of a durable good? a nondurable good? 4. Name two economic activities that GDP does not measure. 5. Why are transfer payments not included as a government expenditure when calculating GDP? 6. Using Your Notes Write a brief summary of the methods used to calculate national income and the purposes of each accounting method. Refer to your completed hierarchy chart. National Income Accounting GDP Use the Graphic Organizer at Interactive Review @ ClassZone.com. Drawing Conclusions List some things that have become more expensive during your lifetime. Explain how a rise in price level affects nominal GDP and real GDP. 8. Making Inferences If consumption is especially high compared with other years, what might you generalize about the health of the economy? 9. Explaining an Economic Concept What is the underground economy? What impact does it have on a nation’s GDP? 10. Drawing Conclusions Imagine that a new country is discovered on an island in the middle of the Pacific Ocean. The country’s people have never left the island, and no foreigners have ever been there. What would the relationship be between the country’s GDP and its GNP? Why? 11. Challenge How would the following affect GDP? a. Government transfer payments increase. b. Student sells used CD to record store. c. Car owner pays auto repair shop $500 to fix his car. Identifying Intermediate and Final Goods Look at the following list of goods and who purchased them. Goods Purchaser copier paper accounting firm refrigerator home consumer stainless steel manufacturer eggs eggs battery paint home consumer factory that makes frozen baked goods car owner furniture maker Categorize Economic Information Decide whether each good is
an intermediate good or a final good. Challenge Why is it important to make a distinction in national income accounting between intermediate and final goods? 357 S E C T I O N 2 Business Cycles TA K I N G N O T E S In Section 2, you will • describe the phases of the business cycle • discuss aggregate demand and aggregate supply • identify the causes of the changes in the business cycle • explain how economists predict business cycle changes • outline major business cycles in U.S. history business cycle, p. 358 economic growth, p. 358 recession, p. 359 depression, p. 359 stagflation, p. 359 aggregate demand, p. 360 aggregate supply, p. 360 macroeconomic equilibrium, p. 361 leading indicators, p. 364 coincident indicators, p. 364 lagging indicators, p. 364 As you read Section 2, complete a cluster diagram like the one below to record what you learn about business cycles. Use the Graphic Organizer at Interactive Review @ ClassZone.com stages Business Cycle What Is the Business Cycle? QUICK REFERENCE The business cycle is the series of growing and shrinking periods of economic activity, measured by increases or decreases in real GDP. Economic growth is the increase in a nation’s real GDP over a period of time. 358 Chapter 12 KEY CONCEPT S Economic changes often follow a broad pattern. During the 1990s, the U.S. economy expanded. In 2001, the economy slowed down. It then returned to a period of growth. Such changes are an example of the business cycle, a series of periods of expanding and contracting economic activity. The business cycle is measured by increases or decreases in real GDP. The cycle has four distinct stages: expansion, peak, contraction, and trough. STAGE 1 Expansion In the expansion phase, real GDP grows from a low point, or trough, as you can see in the graph in Figure 12.6. The expansion is a period of economic growth, an increase in a nation’s real gross domestic product (GDP). During an expansion, jobs are relatively easy to find, so unemployment goes down. More and more resources are needed to keep up with spending demand. As resources become more scarce, their prices rise. The length of each phase may vary both within a cycle and from cycle to cycle. The longest expansion in U.S. history took place over the course of ten years from 1991 to 2001. Business Cycles Workers and businesses ride the ups and downs of the economy. FIGURE 12.6
THE BUSINESS CYCLE In the expansion phase, real GDP grows rapidly. b The peak is where real GDP reaches its highest point in the cycle. c In the contraction phase, real GDP declines. d The trough marks the end of the contraction. Time ANALYZE CHARTS 1. What stage occurred before point A? 2. What stage will occur after point D? 3. How might the business cycle curve change if nominal GDP was used instead of real GDP? S TAGE 2 Peak The point at which real GDP is the highest represents the peak of the business cycle. As prices rise and resources tighten, businesses become less profitable. From that point on, real GDP declines as businesses curtail production. S TAGE 3 Contraction The contraction phase begins after the peak. As producers cut back, resources become less scarce and prices tend to stabilize or fall. Unemployment rises because employers produce less. Sometimes the contraction phase becomes a recession, a contraction lasting two or more quarters (six months or more). On rare occasions, as in the 1930s, a contraction turns into a depression, an extended period of high unemployment and limited business activity. While prices usually remain about the same or go down during the contraction phase, sometimes they go up. These are periods of stagflation—stagnation in business activity and inflation of prices. S TAGE 4 Trough The final phase of the business cycle is the trough, the point at which real GDP and employment stop declining. A business cycle is complete when it has gone through all four phases, from trough to trough or from peak to peak. AP P LI CATION Explaining an Economic Concept A. In terms of the business cycle, what is unusual about stagflation? QUICK REFERENCE QUICK REFERENCE Recession is a prolonged economic contraction lasting two or more quarters (six months or more). Depression is an extended period of high unemployment and reduced business activity. Stagflation describes periods during which prices rise at the same time that there is a slowdown in business activity. Economic Indicators and Measurements Economic Indicators and Measurements 359 QUICK REFERENCE Aggregate demand is the sum of all the demand in the economy. Aggregate supply is the sum of all the supply in the economy. Aggregate Demand and Supply KEY CONCEPT S One way to understand business cycles is through the concepts of demand and supply. In this case the concepts apply not to a single product or business but to the economy as a whole. Aggregate Demand Aggregate demand is the total amount of goods and
services that households, businesses, government, and foreign purchasers will buy at each and every price level. In Figure 12.7, the vertical axis, labeled “Price level,” shows the average price of all goods and services. The horizontal axis, labeled “Real GDP,” shows the economy’s total output. The aggregate demand curve (AD) is downward sloping. As the price level decreases the purchasing power of money increases. Aggregate Supply Aggregate supply is the total amount of goods and services that producers will provide at each and every price level. Note that in Figure 12.8 the aggregate supply curve (AS) does not look like the supply curves in Chapter 5. The aggregate supply curve is almost horizontal when real GDP is low—during times of recession or depression—because businesses try not to raise their prices when the economy is weak. The middle part of the aggregate supply curve slopes upward, with prices increasing as real GDP increases. But during times of high inflation, prices rise without contributing to real GDP, and the aggregate supply curve becomes almost vertical. FIGURES 12.7 AND 12.8 AGGREGATE DEMAND AND SUPPLY CURVES FIGURE 12.7 AGGREGATE DEMAND FIGURE 12.8 AGGREGATE SUPPLY AD Real GDP AS Real GDP ANALYZE GRAPHS 1. What does a normal demand or supply graph use as an x-axis? What does it use as a y-axis? 2. Why are the x and y axes different for the aggregate demand and supply graphs? Use an interactive aggregate demand and aggregate supply graph at ClassZone.com 360 Chapter 12 QUICK REFERENCE QUICK REFERENCE Macroeconomic equilibrium is the point where the quantity of aggregate demand equals the quantity of aggregate supply. Macroeconomic Equilibrium When the quantity of aggregate demand equals the quantity of aggregate supply, the economy reaches macroeconomic equilibrium. Figures 12.9 and 12.10 illustrate a variety of different possibilities, but let’s consider one particular example shown in Figure 12.9. Macroeconomic equilibrium occurs where the aggregate demand curve (AD1) intersects the aggregate supply curve (AS). P1 indicates the equilibrium price level, and Q1 shows the equilibrium level of real GDP. Think about business cycles. An increase in aggregate demand shifts the aggregate demand curve to the right (AD2). Aggregate demand becomes greater at all price levels, and equilibrium real GDP rises (Q2), marking an

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