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time. The money is owed to savers for the bonds they purchase and the interest paid on them. However, the actual debt situation is somewhat more complicated. The government also borrows from trust funds, which are funds being held for specific purposes to be expended at a future date. Examples of government trust funds include Social Security, Medicare, Medicaid, and government pension funds. When the trust funds accumulate surpluses by taking in more tax revenue than is needed for annual benefit payments, the surplus is invested in government bonds until the specific programs need the funds. In essence, therefore, the government borrows from itself to cover some deficit spending. Some economists do not consider this to truly be debt. The money is transferred from one part of the government to another. This borrowing does not place a burden on the current economy because the current budget is not used to pay for it. QUICK REFERENCE Trust funds are held for specific purposes to be expended at a future date. The Size of the National Debt In August 2006, the total national debt was about $8.4 trillion. About $4.8 trillion was privately owned by the creditors shown in Figure 15.9, and about $3.6 trillion was in government trust funds. Find an update about the national debt at ClassZone.com There were only five years from 1962 to 2005 in which the federal government had a surplus of funds. In all the other years of that period, the government borrowed money to cover its deficits. Each time it borrowed money, it increased the size of the national debt. From 1980 to 1994 alone, the national debt grew by more than five times, from about $930 billion in 1980 to about $4.7 trillion in 1994. Economists often look at the country’s debt as a percentage of GDP. That perspective allows them to see how the burden of borrowing compares to the strength of the overall economy. The national debt was 33 percent of GDP in 1981. By 2006, it had doubled to nearly 68 percent of GDP. However, in 1981 about 80 percent of the debt was privately owned. In 2006, less than 60 percent was privately owned. More About the National Debt a A stack of $100 bills totaling the national debt would stand over 5,790 miles high. $28,000 c If everyone in the United States helped to pay off the national debt, each person’s share would be about $28,000. b The U.S. Bureau of Engraving prints about $635 million worth of currency
each day. At this rate, it would take more than 36 years to print enough currency to pay off the national debt. Using Fiscal Policy 465 The Effect of the Debt on the Economy The national debt can have positive or negative effects on the economy. When government spending stimulates the economy, jobs are created and public goods such as the infrastructure may be improved. These improvements benefit everyone. However, when the government competes with the private sector to raise money by paying higher interest rates to get the savers’ dollars, the results often are negative. The crowding-out effect is what happens when the government outbids private bond interest rates to gain loanable funds. Money leaves the private sector, and interest rates increase. Repaying the interest on government bonds, or servicing the debt, also can have a negative impact on the economy. The 2007 federal budget estimate showed interest payments to be nearly 10 percent of all federal spending. Constant borrowing raises the amount of interest to be paid. This, in turn, increases the need for taxes to service the debt. Higher taxes mean less spending by consumers and less investment by businesses, both of which may hurt the economy. F I G U R E 15.10 Actions to Control Deficits and Debt Budget Action Goal Key Points Analysis Gramm-Rudman Hollings (1985) Eliminate the deficit by 1991 Set annual deficit targets; automatic spending cuts Unrealistic goals; deficits increased Budget Enforcement Act (1990) Ensure new laws do not increase deficits Caps on discretionary spending; “pay-as-you-go” financing Deficits declined after 1992 Omnibus Budget Reconciliation Act (1993) Cut deficit by $500 billion over 5 years Balanced Budget Agreement (1997) Balance the budget by 2002 Make income tax more progressive; some spending cuts Cut some entitlement spending; increase education spending; targeted tax cuts Deficits declined significantly; strong economy Budget surpluses 1998–2001 Attempts To Control Deficits and Debt Sharp increases in deficits and the debt in the 1980s led government officials to look for ways to control deficit spending. (These efforts are summarized in Figure 15.10 above.) One measure set annual deficit targets with the goal of eliminating the deficit completely within five years. Another set limits on discretionary spending and mandated that new spending required cuts elsewhere in the budget, an approach known as “pay-as-you-go” financing. A third attempted to trim the deficit with a combination of tax increases and spending cuts. Still another sought to balance the budget
through spending cuts in entitlement programs. Some of these measures failed, and deficits actually increased. Others enjoyed only limited success. As a result, the government continues to struggle to control the national debt. APPLICATION Making Inferences B. Why is paying interest on the national debt considered mandatory spending? QUICK REFERENCE The crowding-out effect is the result of the government’s outbidding private bond interest rates. 466 Chapter 15 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the difference between the terms in each of these pairs. a. budget surplus budget deficit b. national debt c. Treasury bills deficit spending Treasury bonds 2. How do budget deficits affect the national debt? Why? 3. What do Treasury bills, Treasury notes, and Treasury bonds have in common? 4. Why is government borrowing from trust funds different from privately-owned debt? 5. How is the crowding-out effect related to the national debt? 6. Using Your Notes What are the four causes of budget deficits? Refer to your completed chart. Federal Deficits National Debt Use the Graphic Organizer at Interactive Review @ ClassZone.com. Applying Economic Concepts In 2007, the federal government was expected to have tax revenue of $2,350.8 billion. Total federal spending was estimated at $2,592.1 billion. Would the government have a budget deficit or a budget surplus that year? How much would it be? 8. Analyzing Causes Each of the following headlines reflects an example of deficit spending. Which of the causes of budget deficits is suggested by each headline? a. President Proposes Tax Cut Extensions to Keep Economy on Track b. Baby Boomers’ Retirement Will Strain Social Security and Medicare c. Hurricane Recovery Effort to Require Massive Federal Aid 9. Analyzing Data Assume that the privately-owned part of the debt is $4,900 billion and the amount held by government trust funds is $3,500 billion. Use the percentages shown in Figure 15.9 to calculate the dollar amounts held by different creditors. 10. Challenge The Social Security Administration estimates that annual revenue from payroll taxes will be insufficient to meet annual benefit payments beginning in 2018. The Social Security trust fund will be used to make up the difference. How will this change affect the nature of the national debt? Government bonds Applying Economic Concepts Recall what you learned about the crowding-out effect and then complete the following activities. Analyze the Crowding-Out Effect
The graph below shows the crowding-out effect in terms of supply and demand. Why would some private bond issuers be crowded out as a result of government borrowing? THE C ROWDI NG- OUT EFFEC 16 14 12 10 8 6 4 2 0 S D1 D2 S DEMAND BEFORE GOVERNMENT BORROWING DEMAND AFTER GOVERNMENT BORROWING SUPPLY OF LOANABLE FUNDS D1 D2 5 10 15 20 25 30 35 40 Quantity of loanable funds Challenge What part of the national debt might cause the crowding-out effect, the public-owned portion, the portion in government trust funds, or both? Explain your answer. Using Fiscal Policy 467 Case Study Find an update on this Case Study at ClassZone.com Is the Federal Deficit Too Large? Background The federal deficit is a matter of interest not only to economists but also to the average American, because it is the taxpayer who ultimately pays the interest on the country’s debt. This debt was created by pursuing a policy of deficit spending that requires the government to borrow money to make up the difference between how much it takes in and the amount it spends. There are several reasons for using deficit spending. One major reason is the need to deal with national emergencies, such as the September 11 terrorist attacks or natural disasters like Hurricane Katrina. Another is to implement expansionary fiscal policies during periods of recession. Regardless of the reasons for deficit spending, the larger the deficit grows, the more controversial it becomes. What’s the issue? Is the federal deficit too large? Study these sources offering various opinions regarding what is a manageable federal deficit. Federal Budget Deﬁ cit Sparks Worries Higher Borrowing Costs Could Slow Economic Activity... Here’s the worry: Persistent deficits will lead to higher borrowing costs for consumers and companies, slowing economic activity. As Uncle Sam seeks to borrow... to finance those deficits, rates on Treasury securities would rise to entice investors. That would push up other interest rates, such as home mortgages, many auto loans, some home equity lines of credit and some credit cards.... For businesses, rates on corporate bonds would climb. It would become more expensive to borrow to pay for new plants and equipment and other capital investments. Economists are troubled by the prospects of budget deficits as far as the eye can see and want to see them trimmed. But the size of the current budget deficits, while unwelcome, do
not signal that a crisis is imminent.... Yearly deficits add to the country’s growing national debt. [But] there is more concern about higher borrowing costs over time crimping business investment and ultimately the production of goods and services.... Source: “Federal Budget Deficit Sparks Worries,” Associated Press, January 15, 2006. Thinking Economically What negative impact of deficit spending is discussed in this article? A. Online News Story This article discusses a major problem that could arise from the government’s continued deficit spending. 468 Chapter 15 B. Political Cartoon Cartoonist Harley Schwadron made this comment about government spending. Source: www.CartoonStock.com Thinking Economically In what way is the statement on the bureau door contrary to valid economic principles? C. Online News Story In this article, former Secretary of the Treasury John Snow outlines the Bush administration’s fiscal policy designed to reduce the federal deficit. Setting Sights on the Deﬁ cit Reducing the Deficit by Controlling Spending The Bush administration’s highest economic priority for its remaining three years is to control the growth of federal spending and bring down the U.S. budget deficit, John Snow, [former] U.S. Treasury secretary, said. “The clear priority of the administration right now is the deficit, making sure that we achieve the president’s objective of cutting the deficit in half by the time he leaves office,” he said... This would put the deficit below 2 per cent of gross domestic product, low by historical standards.... When he came to office in 2001, the president inherited a projected 10-year surplus of $5,600 billion. But tax cuts and growing spending for the military and homeland security have contributed to a sharp reversal, with the Congressional Budget Office now predicting a $2,100 billion deficit over the next decade. The annual deficit has been falling, however, from $413 billion in the 2004 fiscal year to $316 billion this year, according to CBO figures... Mr. Snow made it clear that, in spite of the focus on the deficit, the administration would not reconsider its low tax policies. Source: “U.S. Sets its Sights on Deficit,” by Edward Alden, Andrew Balls and Holly Yeager. Financial Times, November 4, 2005. Thinking Economically How does the Bush administration plan to cut the deficit by half in three years? What other steps
might it take to control the deficit? THINKING ECONOMICALLY Synthesizing 1. Identify the economic cause-and-effect relationships described in Documents A and C. 2. How does Document B illustrate the challenge facing the Bush administration in its efforts to carry out the plan discussed in Document C? 3. Do you think the Bush administration shares the concerns about the deficit expressed in Document A? Use information from the documents to explain your answer. Using Fiscal Policy 469 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. automatic stabilizers budget deficit budget surplus contractionary fiscal policy Council of Economic Advisers crowding-out effect deficit spending demand-side fiscal policy discretionary fiscal policy expansionary fiscal policy fiscal policy Keynesian economics Laffer Curve national debt spending multiplier effect supply-side fiscal policy Treasury bills Treasury bonds Treasury notes trust funds 1 is the government’s use of taxes and government spending to affect the economy. 2 is a plan to stimulate a weak economy. 3 is a plan to slow the economy when it is expanding too rapidly. 4 refers to actions chosen by the government to stabilize the economy. Public transfer payments and progressive income taxes are examples of 5. 6 is the idea that aggregate demand needed to be stimulated by government action. It forms the basis of 7. The 8 means that small changes in income cause a larger change in spending. 9 is fiscal policy that provides incentives to producers to increase aggregate supply. The 10 illustrates how tax cuts affect tax revenues and economic growth. A 11 occurs when the government takes in more than it spends. When it spends more than it takes in 12 occurs. The 13 is the total amount of money owed to federal bondholders. The 14 results when the government outbids private bond interest rates. 470 Chapter 15 CHAPTER 15 Assessment What Is Fiscal Policy? (pp. 446–453) 1. What is the difference between expansionary fiscal policy and contractionary fiscal policy? 2. How do automatic stabilizers avoid the limitations that affect discretionary fiscal policy? Demand-Side and Supply-Side Policies (pp. 454–461) 3. Why does Keynesian economics advocate government spending during a recession? 4. What economic problems does supply-side economics try to address simultaneously? Deficits and
the National Debt (pp. 462–469) 5. How does government finance deficit spending? 6. How does deficit spending contribute to the national debt? A P P LY Look at the bar graph below showing national debt as a percentage of GDP in several countries. 7. Which European countries on this graph have lower ratios of debt to GDP than the United States? 8. How does U.S. debt compare to Japan’s debt as a percentage of GDP? FIGURE 15.11 GOVERNMENT DEB T A S A PERC ENTAGE OF GDP Australia Belgium Canada France Germany Greece Italy Japan Luxembourg South Korea United Kingdom United States 0 50 100 150 200 Source: OECD Factbook 2005. Analyzing Cause and Effect In early 2001, the Advise the President federal budget had shown surpluses for the previous three fiscal years and was predicted to continue to do so. The President and Congress thought the best thing to do was to return some of the surplus to taxpayers through tax cuts. How would supply-side economics describe the expected outcome of these tax cuts? 10. Applying Economic Concepts Suppose that you got a better job that increased your take-home pay each week from $250 to $300. Assume that you spent 80 percent of that increase. Give specific examples to show how your spending would create a multiplier effect. 11. Drawing Conclusions Recessions in 1990–1991 and in 2001 lasted about eight months each and were relatively mild in their effects on the overall economy. Why would policy lags limit the effectiveness of discretionary fiscal policy in bringing the country out of such recessions? 12. Making Inferences Between 1998 and 2001, the annual federal budgets showed surpluses, and the amount of national debt held by the public decreased by about $450 billion, yet the total federal debt grew by about $400 billion during that same time period. What do you think accounts for this difference? 13. Challenge In 1997, some members of Congress proposed a constitutional amendment that would require the federal budget to be balanced each year. Opponents argued that such an amendment would make recessions worse by requiring the government to use contractionary fiscal policy during such times. Why would a balanced budget require that kind of fiscal policy? Step 1 Form a team with two other students. Imagine that you are the Council of Economic Advisers whose job is to advise the president on the best fiscal policy to use in different economic situations. The current state of the economy is indicated by the following facts: a. The unemployment rate has risen
from 4.5 percent to 6 percent. b. Automobile dealers, home improvement stores, and computer retailers have noted that their sales have dropped off sharply from the previous year. c. Fewer houses and commercial buildings are being built. Decide whether an expansionary or contractionary fiscal policy is needed. Step 2 Develop some specific government spending and taxation recommendations to follow through with your decision in Step 1. Think about what kinds of federal spending you would increase or decrease and what kinds of taxes you would cut or increase to achieve your objectives. Step 3 Some economic indicators have improved. However, the unemployment rate has not changed, and high energy costs have led to rapid increases in the Consumer Price Index. In light of this new information, recommend changes in fiscal policy to solve these problems. Step 4 The economy seems to be back on track. However, annual budget deficits are getting larger each year, and there is concern about the growing national debt. Recommend some ways to control deficit spending without harming the economy. Step 5 Present your policy suggestions to the rest of the class. As a class, discuss the differences and similarities among the plans offered by various groups. Using Fiscal Policy 471 The Money Supply Paper currency—an important part of the money supply—is distributed by the Federal Reserve. 472 CHAPTER 16 SECTION 1 The Federal Reserve System SECTION 2 Functions of the Federal Reserve SECTION 3 Monetary Policy SECTION 4 Applying Monetary and Fiscal Policy CASE STUDY Interpreting Signals from the Fed The Federal Reserve and Monetary Policy Fiscal policy is the federal government’s use of taxes and government spending to affect the economy. It has one of two goals: to decrease unemployment or to fight inflation. C H A P T E R 16 Monetary policy includes all the Federal Reserve actions that change the money supply in order to influence the economy. Its purpose is to curb inflation or to reduce economic stagnation or recession AT T E R S All economies experience the business cycle, a series of periods of growing and shrinking economic activity. Sometimes, these ups and downs become extreme, and the government takes action to even out the business cycle. The government has many tools available to do this—monetary policy is one of the most important. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on monetary policy. (See Case Study, pp. 504–505). Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review
and activities. FIGURES 16.10 AND 16.11 SHORT- TERM EFFECTS OF MONETARY POLICY FIGURE 16.10 MONETARY EXPANSION FIGURE 16.11 MONETARY CONTRACTION MS2 MS1 12 10 8 6 4 2 0 MS2 MS1 12 10 8 6 4 2 0 MD MD Quantity of money Quantity of money How do interest rates affect the demand for money? See Figures 16.10 and 16.11 on page 495. The Federal Reserve and Monetary Policy 473 S E C T I O N 1 The Federal Reserve System TA K I N G N O T E S In Section 1, you will • examine the purpose and duties of a central bank • identify the distinctive features of the Federal Reserve System • explain the structure of the Federal Reserve System central bank, p. 474 monetary, p. 474 Federal Reserve System, p. 474 currency, p. 475 Board of Governors, p. 476 Federal Open Market Committee, p. 477 thrift institution, p. 478 As you read Section 1, complete a cluster diagram to identify the major characteristics of the Federal Reserve System. Use the Graphic Organizer at Interactive Review @ ClassZone.com Federal Reserve System Creating the Fed KEY CONCEPT S QUICK REFERENCE A central bank is a nation’s main monetary authority. Monetary is a term that means “relating to money.” The Federal Reserve System is the central bank of the United States. As you recall from Chapter 10, there were times when the U.S. economy suffered from panics and banking was very unstable. The government made many efforts to address this problem, but had only limited success. Perhaps the most far-reaching of these efforts to stabilize the American financial system was the passage of the Federal Reserve Act in 1913. This act created a central bank for the United States. A central bank is a nation’s main monetary authority, which is able to conduct certain monetary practices. (Monetary means “relating to money.”) The Federal Reserve System is the central bank of the United States and is commonly called the Fed. The Fed is an independent organization within the government, which has both public and private characteristics. The Duties of a Central Bank Most countries have a central bank to oversee their banking system. The central bank may be owned and controlled by the government or it may have considerable political independence. There are three common duties that all central banks perform: holding
reserves, assuring stability of the banking and monetary systems, and lending money to banks and the government. Holding Reserves Central banks are sometimes called reserve banks. You learned in Chapter 10 that banks lend only a part of their funds to individuals and businesses and keep the rest in reserve. The central bank holds these reserves to influence the amount of loanable funds banks have available. This allows the central bank to control the money supply. 474 Chapter 16 Assuring Stability The central bank also acts to assure stability in the national banking and monetary systems. For example, it is one of the banking regulatory agencies that regulate and supervise banks to make sure that they act in ways that serve the interests of depositors and of the economy. Also, by controlling the way money is issued and circulated, the central bank attempts to avoid the confusion that might result when individual banks issue their own bank notes. Lending Money The final duty of the central bank involves one of the primary functions of all banks— it lends money. Its lending practices are unlike those other banks, however. It does not seek to make a profit through lending, and it serves private banks and the government rather than individual customers and businesses. The Duties of the Fed With the passage of the Federal Reserve Act of 1913, Congress created the first national bank in the United States that could truly fulfill the duties of a central bank. The Fed supervises banking in the United States by providing regulation and oversight to make sure that banks follow sound practices in their operations. The Fed also takes steps to ensure that banks do not defraud customers and works to protect consumers’ rights as they relate to borrowing money. Like all central banks, the Fed provides banking services for both private banks and the national government. It accepts and holds deposits in the form of cash reserves, transfers funds between banks or between banks and the government, and makes loans to these institutions. Because it performs such functions, the Fed is sometimes referred to as the bankers’ bank. This responsibility of the Fed is especially important in times of emergency. Shortly after the Fed was created, it played a major role in financing U.S. involvement in World War I by purchasing government war bonds. The Fed also took emergency action after the terrorist attacks on New York City and Washington, D.C. in 2001. It issued $45 billion in loans to banks throughout the United States in order to ensure that there would be as little disruption to the banking system as possible in light of the destruction in these cities. The Fed also distributes currency
, which is coins and paper money, and regulates the supply of money. The supply of money does not mean actual cash but all available sources of money. Specifically, the amount of money that banks have available to lend has important effects on the whole economy. You will learn more about these functions of the Fed in Section 2. AP P LI CATION Comparing and Contrasting A. Recall what you learned about the structure and functions of commercial banks in Chapter 10. What are the similarities and differences between the Federal Reserve and a commercial bank? Creating the Fed President Woodrow Wilson proposed the Federal Reserve Act, in part, to break the power of the nation’s biggest banks. Find an update on the duties of the Fed at ClassZone.com QUICK REFERENCE Currency is coins and paper money. The Federal Reserve and Monetary Policy The Federal Reserve and Monetary Policy 475 The Structure of the Fed KEY CONCEPT S The Fed is different from most countries’ central banks because it is not a single national bank but has both a national and a regional structure. This structure represents a compromise between power resting at the regional level and at the national level. As you may recall from Chapter 10, many U.S. citizens were hesitant to give too much power to a national bank. In addition, the United States is a large and economically diverse country with a complex banking system. Elements of the Fed The elements that make up the Fed reflect this balance between national and regional authority. An appointed board sets national Fed policy, and a regional system of district banks carries out this policy and performs the duties of the central bank. This approach gives the Fed some independence from political influence. Even so, the Fed is ultimately accountable to Congress. Figure 16.1 shows how the Fed is organized. Board of Governors The Board of Governors is a board of seven appointed members who supervise the operations of the Fed and set policy. The president appoints members for a single 14-year term, with the approval of the Senate. One board member’s term expires every two years, and the president may also appoint replacements to fill vacancies created by members who leave before the end of their terms. The president chooses the chairman and vice-chairman, who serve four-year terms, from among F I G U R E 16. Federal Open Market Committee (FOMC) 12 members— the Board of Governors plus the presidents of 5 Federal Reserve district banks Board of Governors 7 members appointed for 14-year terms Federal Reserve Banks 12 district banks and 25 branch
banks Member Banks About 2,900 commercial banks Advisory Councils Federal Advisory Council Consumer Advisory Council Thrift Institutions Advisory Council QUICK REFERENCE The Board of Governors supervises the operations of the Fed. 476 Chapter 16 the seven members. The chairman is considered the most influential member and is the spokesperson for the board. Alan Greenspan, who held the position for nearly 20 years, was so influential as Fed chairman that he almost came to personify the institution. (You can read more about Alan Greenspan on page 494.) Twelve District Banks The Federal Reserve System is organized into 12 districts. Figure 16.2 shows these districts and the cities where the Federal Reserve district banks and the offices of the Board of Governors are located. While the district banks are responsible for carrying out the national policy set forth by the Board of Governors, each one also serves the needs of its particular region. F I G U R E 16. 12 12 San Francisco 12 12 9 9 Minneapolis 10 10 Kansas City Dallas 11 11 7 7 Chicago St. Louis 8 1 1 2 2 Boston Cleveland 4 4 3 3 5 5 New York Philadelphia Washington, D.C. Richmond Atlanta 6 6 12 12 Board of Governors Federal Reserve Bank City Member Banks All nationally chartered banks automatically are members of the Federal Reserve System. State-chartered banks, if they wish, may apply to join the Fed. In 2004, there were about 2,000 national bank members and 900 state bank members, about 37 percent of all commercial banks. Each member bank must purchase stock in its Federal Reserve district bank. However, this stock ownership is not the same as ownership of stock in a private corporation or a commercial bank. It may not be bought or sold on the open market. Member banks earn a set dividend rate on the stock they hold. This helps to make up for the interest they do not earn on the reserves that the Fed requires them to hold. (See the information on reserve requirements on page 484.) Federal Open Market Committee The Federal Open Market Committee (FOMC) is a board of the Fed that supervises the sale and purchase of federal government securities. The term open market refers to the way that government securities are bought and sold. The FOMC consists of 12 voting members, including the Board of Governors, the president of the Federal Reserve Bank of New York, and four other Fed district bank presidents who take turns serving one-year terms. All Fed bank presidents attend the meetings and provide input even when they have no vote. QUICK RE
FERENCE The Federal Open Market Committee (FOMC) supervises the sales and purchase of government securities. The Federal Reserve and Monetary Policy 477 Comparing Central Banks Today, more than 160 nations have central banks. These banks function as the main monetary authority for their respective nations. They also serve the same purpose— maintaining economic stability. Further, they use similar tools to fulfill this purpose. Even so, these central banks do have several differences. One difference is historical. The Federal Reserve, for example, was established by an act of Congress in 1913. The Bank of England, Great Britain’s central bank, claims a royal pedigree, having been established in 1694 during the reign of William and Mary. In China, the People’s Bank of China (PBC) began as a commercial bank in 1948. It functioned as a central bank and a commercial bank until 1983, when it was reorganized solely as a central bank. Another difference lies in the production of money. The Chinese bank note British bank note central banks of Great Britain and China both produce and distribute currency. In the United States, the Treasury produces currency and the Federal Reserve distributes it. CONNECTING ACROSS THE GLOBE 1. Why do you think central banks are common to countries that have very different forms of government, such as the United States and China? 2. In terms of money production, how does the Bank of England differ from the Federal Reserve? The sale and purchases of federal government bonds on the open market are the principal tools used by the Fed to promote a stable, growing economy. At the end of each of its meetings, the FOMC issues a public statement to explain its assessment of the economy and its latest actions. You will learn more about the functions of the FOMC in Section 3. Advisory Councils Three committees provide advice directly to the Board of Governors. The 12 members of the Federal Advisory Council, one from each Fed district, represent the commercial banking industry. The Consumer Advisory Council advises the board on matters concerning the Fed’s responsibilities in enforcing consumer protection laws related to borrowing. Its 30 members, for the most part, are drawn from consumer groups and the financial services industry. The Federal Reserve Board created the Thrift Institutions Advisory Council in 1980 to provide advice about the needs of this important segment of the financial services industry. Thrift institutions are savings and loan institutions, savings banks, or other institutions that serve savers. While the Fed does not regulate thrift institutions, the thr
ifts must conform to the Fed’s reserve requirements and may borrow from the Fed. APPLICATION Making Inferences B. How does the 14-year term of members of the Board of Governors help make the Fed an independent government agency? QUICK REFERENCE A thrift institution is a financial institution that serves savers. 478 Chapter 16 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. central bank c. Board of Governors Federal Reserve System Federal Open Market Committee b. monetary currency 2. What are the three duties of a central bank? 3. How is the Fed different from other central banks? 4. How does the composition of the Federal Open Market Committee reflect the blend of national and regional power in the Fed? 5. What do all thrift institutions have in common? 6. Using Your Notes What are the five elements of the Fed? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Federal Reserve System Analyzing Information Refer to Figure 16.2 on page 477 to answer the following questions about the creation and present alignment of the Fed. Analyze Maps Complete the chart below by indicating your answer to each question in the space provided Question Response 7. Analyzing Causes and Effects If all members of the Board of Governors served 14-year terms, no president would appoint more than four members during two terms in office. However, many board members do not serve full terms, and vacancies occur on average more than once every two years. How does this situation affect a president’s influence on the Board? 8. Drawing Conclusions The four rotating members on the Federal Open Market Committee are chosen from these groups: • Boston, Philadelphia, and Richmond • Cleveland and Chicago • Atlanta, St. Louis, and Dallas • Minneapolis, Kansas City, and San Francisco Why does the Fed mandate that one of the rotating members must come from each of these four groups? 9. Challenge The Federal Reserve Act of 1913 created the Federal Advisory Council. The Consumer Advisory Council was not created until 1976. How does this difference reflect changes in the duties of the Fed? Which region of the country has the most Fed district banks? How does the size of Fed districts 1–5 compare with districts 9–12? Where is the Board of Governors located? In which Fed district is your community located? How do the Federal Reserve Districts reflect U.S. geographic and economic diversity?
Challenge How might the Federal Reserve districts be different if they were created today? 479 S E C T I O N 2 Functions of the Federal Reserve TA K I N G N O T E S In Section 2, you will check clearing, p. 480 bank holding company, p. 481 bank exams, p. 481 required reserve ratio, p. 484 deposit multiplier formula, p. 485 • identify the services the Fed provides for the banking system • explain how the Fed acts as a banker for the federal government • describe the creation of money • discuss what factors influence the money supply As you read Section 2, complete a chart to identify the major functions of the Federal Reserve. Use the Graphic Organizer at Interactive Review @ ClassZone.com Functions of the Federal Reserve Serving the banking system Serving the federal government Creating money Serving the Banking System KEY CONCEPT S As the banker’s bank, the Fed has the responsibility of helping banks do their jobs. The Fed serves the banking system in a variety of ways, including providing check clearing and other services that facilitate the transfer of funds, lending money, and regulating and supervising banking activity. QUICK REFERENCE SERVICE 1 Check Clearing Check clearing is a service offered by the Fed to record receipts and expenditures of bank clients. One of the services that the Fed offers to banks is check clearing, a process in which banks record the receipts and expenditures of their clients. Each Fed district processes millions of checks every day, but most checks clear in two days or less. Figure 16.3 on the next page shows how a check is cleared by following its path from the time it is written until the money is taken from the check writer’s account. Electronic-payment methods, such as credit and debit cards, have begun to replace checks. Further, more private companies are involved in the check-clearing process. As a result, check clearing has become a less important function of the Fed. SERVICE 2 Lending Money Banks often loan each other money on a short-term basis. Sometimes all the banks in a region are faced with short-term cash flow issues, usually during natural disasters. At such times, the Fed will provide 480 Chapter 16 F I G U R E 16. 3 The Federal Reserve and Check Clearing 1 Mike—who lives in Evanston, Illinois —buys a 10-pack of guitar strings from Gary’s Guitar Garage in Portland, Oregon. He writes a check for $30. 2 Gary, the store owner, deposits
the check at his bank Mike’s bank transfers $30 from its reserve to the Federal Reserve Bank of Chicago and deducts $30 from Mike’s account. This transaction is reﬂ ected on Mike’s next bank statement. MIKE’S BANK D AT PAY The Federal Reserve Bank of Chicago transfers $30 from its reserves to the San Francisco Fed district bank and then sends Mike’s check to his bank in Evanston. 3 Gary’s bank credits his account with $30 and then sends Mike’s check to the Federal Reserve Bank of San Francisco—the Fed district bank that serves Portland. 4 The Federal Reserve Bank of San Francisco credits $30 to Gary’s bank’s reserve account and then sends Mike’s check to the Federal Reserve Bank of Chicago—the Fed district bank that serves Evanston. ANALYZE CHARTS This diagram illustrates the steps in the check-clearing process for a typical check transaction. Note how many banks handle Mike’s check during the process. What is the importance of the Fed’s role in clearing Mike’s check? loans to banks and may charge reduced interest rates. Banks must have sufficient assets and capital to qualify for Fed loans. In addition, smaller banks that have seasonal cash flow needs due to the nature of their local economy may borrow from the Fed. The Fed also acts as the lender of last resort to prevent a banking crisis. S E RVI CE 3 Regulating and Supervising Banks Each Federal Reserve Bank supervises the practices of state-chartered member banks and bank holding companies in its district. A bank holding company is a company that owns, or has a controlling interest in, more than one bank. This supervision includes bank exams, which are audits of the bank’s financial practices. These exams make sure that banks are not engaged in risky or fraudulent practices, especially in lending. The Fed monitors bank mergers to ensure that competition is maintained and enforces truth-in-lending laws to protect consumers in such areas as home mortgages, auto loans, and retail credit. QUICK REFERENCE A bank holding company owns, or has a controlling interest in, more than one bank. A bank exam is an audit of the bank’s financial practices. AP P LI CATION Making Inferences A. Why might the Fed help a small bank in an agricultural region stabilize its cash flow? The Federal Reserve and Monetary Policy The
Federal Reserve and Monetary Policy 481 Serving the Federal Government KEY CONCEPT S A second function of the Fed is to serve as the federal government’s banker. As you learned in Chapter 14, the federal government receives billions of tax dollars each year and uses this money on a variety of programs through direct spending and transfer payments. In its role as the federal government’s banker, the Fed also fulfills certain fiscal responsibilities by helping the government to carry out its taxation and spending activities. SERVICE 1 Paying Government Bills When the IRS collects tax revenues, the funds are deposited with the Fed. The Fed then issues checks or makes electronic payments, via the U.S. Treasury, for such programs as Social Security, Medicare, and IRS tax refunds. When these funds are deposited in the recipient’s bank account or the check is cashed, the Fed deducts that amount from the government’s account. Including military personnel, the federal government employs about 4.6 million people, and their wages and benefits are processed through the Fed. Direct government spending also comes from accounts at the Fed. Whether the government is buying office supplies or military equipment or paying contractors to maintain federal highways, the money is funneled through the Fed. The Fed also processes food stamps, which are issued by the Department of Agriculture, and postal money orders, which are issued by the U.S. Postal Service. The Fed, therefore, facilitates government payments in a way that is similar to the way it clears checks and processes electronic payments in the private sector. SERVICE 2 Selling Government Securities As you learned in Chapter 15, the federal government has different kinds of securities that it sells when it wants to borrow money. (Remember that securities are another name for bonds and stocks.) The Fed processes U.S. savings bonds and auctions other kinds of securities for the U.S. Treasury to provide funds for various government activities. The Fed has many roles in this process. It provides information about the securities to potential buyers, receives orders from customers, collects payments from buyers, credits the funds to the Treasury’s account, and delivers the bonds to their owners. It also pays the interest on these bonds on a regular basis or at maturity. Many of these transactions are now handled electronically. Even when individuals purchase government securities on the Treasury Department’s Web site, the Fed transfers funds between the purchaser and the Treasury and pays the interest when it is due. The Fed does not charge fees for these services. In addition to selling government securities to raise money
to fund government activities, the Federal Open Market Committee supervises the sales and purchases of government securities as a way to stabilize the economy. You’ll learn more about this aspect of the Fed’s work in Section 3. Find an update on the Fed’s role in the sale of government securities at ClassZone.com 482 Chapter 16 S E RVI CE 3 Distributing Currency One of the important functions of a central bank is to issue a standard currency that is used throughout the economy. In the United States, Federal Reserve notes are the official paper currency. These notes are fiat money backed by the confidence of the federal government and managed by the Federal Reserve. The government’s backing is made plain by the statement on each note: “This note is legal tender for all debts, public and private.” Figure 16.4 highlights several important features of Federal Reserve notes. The Department of the Treasury’s Bureau of Engraving and Printing prints Federal Reserve notes, which are distributed by the Fed to its district banks. The notes are then moved on to depository institutions and finally into the hands of individuals and businesses. The Fed makes sure that bills are distributed to banks in the amounts that they need. Paper money has a life span of between two and five years. Smaller denomination bills tend to have a shorter life span. Larger denomination bills stay in circulation longer. When bills get worn out, they are taken out of circulation, destroyed, and replaced with new ones. In a similar way, the Fed distributes coins that are produced by the U.S. Mint. FIGURE 16.4 A FEDERAL RESERVE NOTE Federal Reserve Notes are the official U.S. paper currency. b Code indicates to which Federal Reserve Bank the Treasury issued the note. For example, B2 is New York, E5 is Richmond, and K11 is Dallas. c Each note has a unique serial number. The second letter identifies the Fed district to which the note was issued. d The Federal Reserve seal is on the left, the Treasury Department seal on the right. e The signature of the Treasurer is on the left, the signature of the Secretary of the Treasury on the right. f In 1955, Congress required that the phrase “In God We Trust” be used on all currency and coins. ANALYZE 1. To which Federal Reserve Bank was this bill issued? 2. How might serial numbers help the authorities detect counterfeit bills? AP P LI CATION Comp
aring Economic Information B. How are the banking services the Fed provides to the government similar to the services it provides to banks? The Federal Reserve and Monetary Policy 483 Creating Money KEY CONCEPT S Creating money does not mean printing paper currency and minting coins. It refers to the way money gets into circulation through deposits and loans at banks. (You learned briefly about this process in Chapter 10.) Because the United States has a fractional reserve banking system, banks are not allowed to loan out all the money they have in deposits. The Fed establishes a required reserve ratio (RRR), which is the fraction of the bank’s deposits that must be kept in reserve by the bank, to control the amount a bank can loan. Money on deposit in excess of the required reserve amount can be loaned out. The money in reserve may be stored as cash in the bank’s vault or deposited with the Fed. EXAMPLE Money Creation The banking system creates money whenever banks receive deposits and make loans. The level of the RRR determines how much money may be loaned and, therefore, how much money gets created. Let’s see how this works by studying Figure 16.5. At the top of the chart, the RRR is set at 20 percent. If Bank A has $10,000 in deposits, it must keep 20 percent, or $2,000, on reserve. It lends the remaining $8,000 to Kecia’s Fitness Studio, which Kecia deposits in Bank B. Bank B keeps 20 percent of the $8,000, or $1,600, on reserve as required. Bank B lends the remaining $6,400 to Juan’s Computer Repair, and Juan deposits it in Bank C. At this point, the money supply has increased by $14,400, the total of the loans made. The process could continue until there was nothing left to lend. F I G U R E 16. 5 The Fed Creates Money $ $ $ $ $ $ 20% The Fed sets the RRR at: 10% Loans available RRR $ $ $ $ $ $ ANALYZE CHARTS Remember that the amount of money that each bank can loan is limited by the RRR. Suppose that Bank C loaned its available funds to Miles and Miles deposited the money in Bank D. How much money would Bank D have to hold in reserve and how much would it have available for loans if the RRR is set at 20 percent? What would
these figures be if the RRR were set at 10 percent? QUICK REFERENCE Required reserve ratio (RRR) is the fraction of a bank’s deposits that it must keep in reserve. 484 Chapter 16 Now look at what happens if the Fed reduces the RRR to 10 percent. The change is shown at the bottom of Figure 16.5. Bank A can now lend $9,000 to Kecia and Bank B can lend $8,100 to Juan. In this scenario, the money supply would increase by $17,100. The decrease in the RRR allowed the money supply to increase by an additional $2,700. How do you figure out how much the money supply will increase after all possible loans have been made? The deposit multiplier formula is a mathematical formula that tells how much the money supply will increase after an initial cash deposit in a bank. The formula is 1/RRR. For example, if the RRR is 10 percent the deposit multiplier equals 10. Figure 16.6 illustrates how the deposit multiplier formula is used to determine the amount of increase in the money supply from an initial deposit of $100 and a reserve requirement of 10 percent. QUICK REFERENCE Deposit multiplier formula tells how much the money supply will increase after an initial cash deposit. M AT 16. Step 1: Study the table below, which shows how an initial deposit of $100 can increase the money supply. To quantify the total amount of money that can be created from this initial deposit, economists use the deposit expansion multiplier. Bank A Bank B Bank C Bank D --- Money deposited $100.00 $90.00 $81.00 $72.90 --- Total = = = = = 10% held as reserves $10.00 $ 9.00 $ 8.10 $ 7.29 --- $100.00 + + + + + 90% loaned out $90.00 $81.00 $72.90 $65.61 --- $900.00 Step 2: Calculate the deposit expansion multiplier. Sample Calculations 1 Required reserve ratio = Deposit expansion multiplier 1 1 = 10% 0.10 = 10 Step 3: Use the deposit expansion multiplier to calculate the total money that can be loaned. Initial deposit Deposit expansion – 1 multiplier = Total available for loans $100 [10 – 1] = $100 9 = $900 AP P LI CATION Analyzing Effects C. If the Fed raised the RRR from 10 percent to 12 percent, how would it affect
the money supply and by approximately how much, if the initial deposit was $5,000? Show your calculations. The Federal Reserve and Monetary Policy 485 Factors Affecting Demand for Money KEY CONCEPT S The Fed monitors two major indicators of the money supply, namely M1 and M2. Recall that you learned in Chapter 10 that M1 includes cash and checkable deposits, while M2 includes M1 plus savings deposits and certain time deposits. The Fed needs to know how large each type of money is in order to act appropriately to manage the supply of money. Four factors influence how much money individuals and businesses need—cash on hand, interest rates, the cost of consumer goods and services, and the level of income. FACTOR 1 Cash on Hand Individuals and businesses need cash to complete certain financial transactions. Recall that M1, which includes cash and checkable deposits, is also called transactions money. Consumers use this money to pay for things such as food, clothing, transportation costs such as gasoline and bus or train fares, and entertainment. Businesses also use cash and checks for many day-to-day expenses. The fastest growing form of payment is the debit card, which was used for more than 23 billion transactions in 2005. While a debit card is not money, it is linked to a checking account, and the funds in the account are considered money. The Fed understands that there are certain times when people need more cash. It routinely increases the amount of cash at banks during the holiday season because people want more money to buy gifts. Similarly, during the summer months the Fed ensures that banks in areas popular with tourists have more cash. Natural disasters also influence the amount of cash the Fed puts into circulation. In response to Hurricane Katrina’s devastation of the Gulf Coast in 2005, the Fed shipped large amounts of currency to banks in several nearby districts because of the immediate demand for more cash by residents. Since many parts of the Gulf Coast were without electricity, people were not able to use debit cards and credit cards as they ordinarily would. FACTOR 2 Interest Rates When interest rates are high, individuals and businesses may place excess cash in savings instruments, such as bonds, stocks, or savings accounts. This of course pulls cash out of circulation. The money then exists as a part of M2. Figure 16.7 shows how the demand for money is affected by interest rates. When interest rates are high, the demand for money is lower because there is less incentive for individuals and businesses to spend and more incentive to save and
earn interest. When interest rates are lower, however, more money is demanded because people have less incentive to save and more incentive to spend. Cash on Hand Portable ATMs dispensed muchneeded cash to evacuees from the Gulf Coast after Hurricane Katrina. 486 Chapter 16 FIGURE 16.7 DEMAND FOR MONEY Here, the term money refers to M1. Note that when interest rates are high the quantity demanded of money is lower. Conversely, when interest rates decrease the quantity demanded of money increases. Quantity of money demanded FACT OR 3 Cost of Consumer Goods and Services As the cost of consumer goods or services increases, buyers may wish to have more money available. Suppose that adverse weather conditions and higher energy prices have driven up the prices of fresh fruits and vegetables. People may need to have more cash when they buy groceries at the supermarket than they did before the prices increased. They might also find that it takes more cash to buy gasoline than it used to. Businesses face the same challenges. They would also wish to have more cash to purchase the goods and services they need for their operations. Of course, when businesses pay more for goods and services, production costs increase and the higher costs are often passed on to consumers. This, in turn, may lead consumers to want to have more money available. FACT OR 4 Level of Income As income increases, individuals and companies have a tendency to hold more cash. Recall that level of income is one of the factors that affect demand. Suppose that Bob has a part-time job cooking at a restaurant. When he gets a raise, he notices that he keeps more money in his wallet because he feels he can afford to spend more on clothes and DVDs. The same holds true for businesses. When their income increases, they will keep more cash because they are able to spend more on the goods and services that they need to pay for operations. In general, when income levels rise, so will the demand for money. The Fed can take several actions to change the money supply in response to changes in demand for money. More important, the Fed can use these methods of increasing or decreasing the money supply to stabilize the economy. In the next section, you’ll learn about the nature of these methods and how they are used to establish economy stability. AP P LI CATION Analyzing Effects D. Which factor is likely to increase the size of M2? Why? The Federal Reserve and Monetary Policy 487 For more information on comparing economic information, see Skillbuilder Handbook, page R19
Comparing the Treasury and the Fed The following passage provides information about the U.S. Treasury and the Federal Reserve System. Compare the two by looking for similarities and differences between them. This will help you understand the role that each plays in the nation’s economy. TIPS FOR COMPARING Use the following tips to help you compare economic information. The U.S. Treasury and the Federal Reserve System Although the U.S. Treasury and the Federal Reserve are both essential to the functioning of the nation’s economy, they differ in many ways. The U.S. Treasury Department was established by an act of Congress in 1789. It is the primary federal agency responsible for the economic prosperity of the United States. As such, it is responsible for managing federal finances, including the collection of taxes, duties, and other monies due to the United States; the paying of the nation’s bills; and the management of government accounts and the public debt. In addition, the Treasury Department produces stamps, currency, and coinage. The Federal Reserve System similarly was established by an act of Congress but much later, in 1913. Unlike the U.S. Treasury, which is a department of the federal government, the Fed is the nation’s central bank. According to its mission statement, the purpose of the Federal Reserve is “to provide the nation with a safer, more flexible, and more stable monetary and financial system.” The duties of the Federal Reserve fall into four general areas: conducting the nation’s monetary policy in pursuit of maximum employment and economic stability; supervising and regulating the nation’s banking institutions; maintaining the stability of the financial system; and providing financial services such as check clearing and shortterm loans to member banks. The Fed consists of a board of governors and 12 regional banks, a structure that varies considerably from that of the Treasury. Look for words that signal similarities, such as both, similarly, and also. Look for words that signal differences, or contrasts, such as unlike, differ, and varies. T HINKING ECONOMICALLY Analyzing 1. In what ways are the Treasury and the Fed similar? 2. What are some important differences between the Fed and the Treasury? 3. Which do you think is more policy oriented, the Fed or the Treasury? Explain why you think so. 488 Chapter 16 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. check clearing b. bank holding company c. required reserve ratio 2. Why are bank exams an important way for the Fed to help create a sound banking system? 3. What is the relationship between the required reserve ratio and the deposit multiplier formula? 4. How does the Fed’s check-clearing service help the banking system? Buying school supplies 5. How does the deposit multiplier formula allow the Fed to create money through the banking system? 6. Using Your Notes What are the three services that the Fed provides to the federal government? Refer to your completed chart. Functions of the Federal Reserve Serving the banking system Serving the federal government Creating money Use the Graphic Organizer at Interactive Review @ ClassZone.com. Applying Economic Concepts Daniel is a high school senior living in California. He receives a check from his grandmother in Florida as a graduation gift. How is the Federal Reserve involved in transferring the money from Daniel’s grandmother’s bank account to his account? Illustrate your answer with a flow chart. 8. Applying Economic Concepts You’ve been planning your college finances and you know that you’ll have to take a bank loan to cover tuition costs. You read that the Fed intends to raise the RRR from 10 percent to 20 percent. How will this change affect the money supply and your ability to borrow money for college tuition? 9. Analyzing Data The Fed sets the required reserve ratio at 10 percent. What is the initial deposit if the money supply increases by $40,000? Use the deposit multiplier formula to determine your answer and show your calculations. 10. Challenge Banks do not earn interest on the funds they hold as reserves. How does this provide an incentive to banks to create money by making loans rather than to deposit excess funds in a Fed bank? Evaluating Demand for Money Consider the factors that affect the demand for money and then complete the following activities. Identify Changes in Demand The chart below shows some scenarios that would cause demand for money to change. For each example, note if demand is increasing or decreasing. Factor Affecting Demand for Money Increasing or Decreasing? Back-to-school shopping begins Banks lower the interest rate on CDs from 6% to 3% Energy costs for home heating are up by 20% Interest rates on savings deposits increase from 1% to 4.5% Challenge What type of potential economic instability is suggested by rising prices? How might the Fed adjust the money supply in such a
situation? You will learn more about this topic in Section 3. 489 S E C T I O N 3 Monetary Policy TA K I N G N O T E S In Section 3, you will monetary policy, p. 490 • examine the Fed’s tools for open market operations, p. 490 monetary policy • explain how the Fed’s monetary policy promotes growth and stability • analyze the challenges the Fed faces in implementing its policy federal funds rate, p. 490 discount rate, p. 491 prime rate, p. 491 expansionary monetary policy, p. 492 contractionary monetary policy, p. 492 Monetary Policy easy-money policy, p. 492 tight-money policy, p. 493 monetarism, p. 496 main ideas main ideas main ideas details details details As you read Section 3, complete a hierarchy diagram to track main ideas and supporting details about monetary policy. Use the Graphic Organizer at Interactive Review @ ClassZone.com The Fed’s Monetary Tools KEY CONCEPT S Monetary policy involves Federal Reserve actions that change the money supply in order to influence the economy. There are three actions the Fed can take to manage the supply of money: open market operations, adjusting the reserve requirement, and adjusting the discount rate. They may be taken individually or in combination with one another. The impact of these actions is shown in Figure 16.8. ACTION 1 Open Market Operations Open market operations are the sales and purchase of marketable federal government securities. This is the monetary policy tool most used by the Fed to adjust the money supply. When the Fed wants to expand the money supply, it buys government securities. The Fed pays for the bonds it buys from commercial banks or the public by writing checks on itself. When sellers receive the funds from the Fed, they deposit them in banks. The banks can then lend their new excess reserves. When the Fed wants to contract the money supply, it sells government bonds on the open market. The purchasers of the bonds transfer funds to the Fed to pay for the bonds. These funds are taken out of circulation, and the reserves available for loans decrease. The Fed communicates its intention to buy or sell bonds by announcing a target for the federal funds rate. The federal funds rate (FFR) is the interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight. When the Fed lowers the target for the FFR, it buys bonds. When it raises the target,
it sells bonds. The Fed does not set the rate directly but influences it through its actions. QUICK REFERENCE Monetary policy includes the Fed’s actions that change the money supply in order to influence the economy. Open market operations are the sales and purchase of federal government securities. The federal funds rate (FFR) is the interest rate that banks charge one another to borrow money. 490 Chapter 16 FIGURE 16.8 TOOLS OF MONETARY POLICY The Fed sells bonds; FFR rises Excess reserves and lending decrease; money supply contracts The Fed raises RRR; banks hold more reserves Banks decrease lending; money supply contracts The Fed raises the discount rate; banks borrow less Banks have fewer reserves to lend; money supply contracts OPEN MARKET OPERATIONS RESERVE REQUIREMENT DISCOUNT RATE The Fed buys bonds; FFR falls Excess reserves and lending increase; money supply expands The Fed lowers RRR; banks hold fewer reserves Banks increase lending; money supply expands The Fed lowers the discount rate; banks borrow more Banks have more reserves to lend; money supply expands ACT I ON 2 Adjusting the Reserve Requirement As you recall from Section 2, the Fed sets the required reserve ratio (RRR) for all depository institutions. The RRR affects the money supply through the deposit multiplier formula. Increasing the RRR can reduce the money supply; decreasing the RRR can expand the money supply. Since the early 1990s, the RRR has been between 10 and 12 percent for transaction deposits and between 0 and 3 percent for time deposits. ACT I ON 3 Adjusting the Discount Rate The discount rate is the interest rate that the Fed charges when it lends money to other banks. The discount rate affects the money supply because it sets the reserves that banks have available to lend. When the Fed increases the discount rate, banks tend to borrow less money from the Fed. They must then use their existing funds to meet reserve requirements and have less excess reserves to lend. Therefore, the money supply decreases. The opposite happens when the discount rate is lowered. Banks borrow more money from the Fed and increase their reserves. When this happens, they have more money to lend, and the money supply increases. The Fed’s actions also impact businesses and individuals who borrow. The prime rate is the interest rate that banks charge their best customers. Interest rates for other borrowers tend to be two or three percentage points above prime. To make a profit on the loans they make, banks need to charge higher rates than they
pay to borrow. So when the discount rate increases, so does the prime rate and, therefore, the cost of business and consumer credit. AP P LI CATION Analyzing Causes A. Which open market operation causes the money supply to expand? Why? QUICK REFERENCE The discount rate is the interest rate that the Fed charges when it lends money to other banks. The prime rate is the interest rate that banks charge their best customers. The Federal Reserve and Monetary Policy The Federal Reserve and Monetary Policy 491 Approaches to Monetary Policy KEY CONCEPT S The most important job of the Fed is to promote growth and stability in the American economy. The purpose of monetary policy is to curb inflation and reduce economic stagnation or recession. By focusing on these goals, the Fed tries to promote full employment and growth without rapid increases in prices or high interest rates. The Fed uses two basic policies—expansionary or contractionary monetary policy. Expansionary monetary policy is a plan to increase the amount of money in circulation. Contractionary monetary policy is a plan to reduce the amount of money in circulation. When the economy slows, the Fed uses expansionary monetary policy to pump more money into the economy. When the economy is overheated, the Fed uses a contractionary policy to reduce the amount of money in the economy. POLICY 1 Expansionary Policy In Chapter 15 you studied expansionary policy as it related to the federal government’s fiscal-policy actions. This type of fiscal policy is used during a slowdown in economic activity. The Fed’s expansionary monetary policy is used at the same point in the business cycle. It is sometimes called the easy-money policy because it puts more money into circulation by making it easier for borrowers to secure a loan. During a recession, when unemployment is high, the Fed wants to have more money circulating in the economy to stimulate aggregate demand. When it is easier to borrow money, consumers will take out more loans to buy homes, automobiles, and other goods and services. In response, businesses then produce more, which creates jobs and decreases unemployment. An easy-money policy allows businesses to borrow funds to help them expand. When more loans are made, more money is created in the banking system. The Fed enacts an easy-money policy by buying bonds on the open market, by decreasing reserve requirements, by decreasing the discount rate, or by some combination of these tools. The Fed’s most common action in this situation is to buy bonds on the open market. When the Fed decides
to buy more bonds, it increases the demand for them, which raises their price. Recall that bond prices have an inverse, or opposite, relationship to interest rates. When bond prices rise, interest rates fall. Lower interest rates will encourage more lending. More lending increases consumer spending and investment. This, in turn, increases aggregate demand, resulting in the growth of GDP and lower unemployment. If the Fed expands the money supply too much, however, aggregate demand may increase to a level that causes inflation. QUICK REFERENCE Expansionary monetary policy is a plan to increase the money supply. Contractionary monetary policy is a plan to reduce the money supply. Easy-money policy is another name for expansionary monetary policy. Monetary Policy The Fed’s monetary policy must be well-timed and well-balanced to have the required effect. 492 Chapter 16 QUICK REFERENCE Tight-money policy is another name for contractionary monetary policy. P OL ICY 2 Contractionary Policy In Chapter 15, you also studied the federal government’s contractionary fiscal policy, used during an expansionary period. The Fed’s contractionary monetary policy also is used when economic activity is rapidly increasing. It is sometimes called a tightmoney policy because it is designed to reduce inflation by making it more difficult for businesses and individuals to get loans. Suppose that aggregate demand is increasing faster than aggregate supply, leading to higher prices and concerns about inflation. The Fed would want to have less money circulating because more money fuels demand and may lead to inflation in wages and prices. In other words, the Fed would want to make it harder for businesses and individuals to borrow money. Therefore, it would decrease the money supply by decreasing reserves available for loans. The Fed enacts a tight-money policy by selling bonds on the open market, increasing reserve requirements, or increasing the discount rate. As with easymoney policy, the Fed’s most likely action involves open market operations. Selling bonds causes bond prices to fall and interest rates to increase. Higher interest rates discourage lending. Less lending decreases aggregate demand, which decreases growth in GDP, and lowers the general price level. If the Fed contracts the money supply too much, however, aggregate demand may decrease to a level where unemployment increases. Figure 16.9 summarizes how the Fed uses expansionary and contractionary monetary policies 16. 9 Approaches to Monetary Policy How does the Fed use its monetary policy tools? Expansionary Policy • Buy bonds on the open market • Lower the reserve requirement
• Reduce the discount rate Contractionary Policy • Sell bonds on the open market • Raise the reserve requirement • Increase the discount rate ANALYZE CHARTS Monetary policy is designed to even out the extremes of the business cycle by expanding or contracting the money supply. Explain how the actions listed under Expansionary Policy increase the supply of money and those under Contractionary Policy decrease the supply of money. AP P LI CATION Comparing and Contrasting B. What are the similarities and differences between expansionary fiscal policy and expansionary monetary policy? The Federal Reserve and Monetary Policy 493 ECO N O M I C S PAC ES E T T E R Alan Greenspan: Fighting Inflation During his 18-plus years as chairman of the Fed, Alan Greenspan came to personify the institution. The worldwide financial community and the media waited eagerly to hear what he would say after each meeting of the FOMC. Why did so many people come to believe that one man’s decisions could have such a profound impact on everything from the performance of the stock market to mortgage rates? Managing Monetary Policy President Ronald Reagan appointed Alan Greenspan chairman of the Federal Reserve Board of Governors in 1987. He had a reputation as a committed inflation fighter and fulfilled that role with great success. The core inflation rate was 3.9 percent when he became chairman and was 2 percent in 2005. Although the chairman has only one vote on the FOMC, Greenspan’s economic insight and persuasiveness gave him much greater power. He led the Fed in using open market operations to help raise interest rates to cool down the economy when it experienced inflationary periods. At other times, for example, when the stock market crash of October 1987 threatened to lead the economy into a severe recession, Greenspan responded by expanding the money supply as needed to cushion the shock. Then, in the late 1990s, he pushed the Fed to edge up interest rates, and the economy experienced a period of unprecedented growth without inflation. Greenspan’s success was due to his clear understanding of the tools of monetary policy and how to apply them, as well as in-depth knowledge of a wide range of economic indicators. Also, throughout his years as chairman, he developed a sense of timing, knowing just when to direct the Fed to expand the money supply and when to contract it. A Celebrity During his tenure as Fed chairman, Alan Greenspan practically achieved celebrity status. APPLICATION Making Inferences C. Did Greenspan advocate a tight-money policy or an easy-
money policy in the late 1990s? How do you know? FAST FACTS Alan Greenspan Title: Chairman of the Federal Reserve Board (1987–2006) Born: March 6, 1926, New York City Major Accomplishment: Controlled inflation while supporting unprecedented economic growth Presidents Served Under: Ronald Reagan, George H. W. Bush, Bill Clinton, George W. Bush Time as Fed Chairman: 18 years, 5 months (second longest tenure) Notable Quotation: I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said. Find an update about Alan Greenspan at ClassZone.com 494 Chapter 16 Impacts and Limitation of Monetary Policy KEY C ONCEPT S As you recall, the purpose of monetary policy is to curb inflation and to halt recessions, which result in unemployment. But what impact does monetary policy have on the economy, and how successful is it in fulfilling its purpose? IMPACT 1 Short-Term Effects Adjustments to monetary policy have both short-term and long-term effects. The short-term effect is change in the price of credit—in other words, the interest rates on loans. The Fed’s open market operations influence the FFR fairly quickly by increasing or decreasing the level of reserves that banks have available to lend. Figure 16.10 shows that when the Fed uses an easy-money policy to expand the money supply, interest rates decline. When the Fed uses a tight-money policy, as shown in Figure 16.11, interest rates rise. FIGURES 16.10 AND 16.11 SHORT- TERM EFFECTS OF MONETARY POLICY FIGURE 16.10 MONETARY EXPANSION FIGURE 16.11 MONETARY CONTRACTION MS2 MS1 12 10 8 6 4 2 0 MS2 MS1 12 10 8 6 4 2 0 MD MD Quantity of money Quantity of money ANALYZE GRAPHS 1. What happens to the equilibrium interest rate in Figure 16.10? What happens to it in Figure 16.11? 2. How do these graphs show the effects of easy- money and tight-money policy? Use an interactive money supply curve at ClassZone.com The money supply (MS1, MS2) is a vertical line because it represents the fixed amount of money available as determined by the Fed. Demand for money (MD) is the same as demand for any product. As prices (interest rates) fall,
demand increases. As prices rise, demand falls. a The supply curve shifts to the right when the money supply expands. b The supply curve shifts to the left when the money supply contracts. IMPACT 2 Policy Lags Some lags, or delays, that affect monetary policy are related to identifying the problem. The Fed needs specific information and statistics in order to identify the problem and take action. Other lags have to do with how quickly the change in policy The Federal Reserve and Monetary Policy 495 takes effect. Many economists suggest that it may take as long as two years for adjustments in monetary policy to take full effect. This may have long-term effects on the economy. For example, businesses often delay plans for expansion if interest rates are too high. Because policies designed to lower rates may take some time to take effect, actual investment in expansion may lag months or years behind the plans. IMPACT 3 Timing Issues As with fiscal policy, monetary policy must be coordinated with the business cycle in order to provide a stable economic environment. If the policy is correct and the timing is good, extremes in the business cycle will be evened out. If the timing is bad, a business cycle phase may be exaggerated. For example, high interest rates in 1990 that were intended to help fight inflation actually took effect as the economy was going into a recession, worsening the effects of that recession. Supporters of monetarism cite such situations to show that using monetary policy to influence short-term changes in the business cycle can create major problems. Monetarism is a theory that suggests that rapid changes in the money supply are the main cause of economic instability. Milton Friedman is the most prominent monetarist. (You can read more about Friedman on page 76.) He studied how changes in the growth rate of the money supply affected prices and concluded that inflation is always accompanied by rapid monetary growth. Conversely, he noted that there has been little or no inflation when the money supply has grown slowly and steadily. QUICK REFERENCE Monetarism is a theory that holds that rapid changes in the money supply cause economic instability. Monetarists do believe that monetary policy is an important tool. However, they argue that best way to ensure economic growth and stability is to allow the money supply to grow slowly and steadily—by around 3 percent a year. They disapprove of the Fed’s use of monetary policy to constantly tinker with the money supply. Other Issues The use of the monetary policy tools is just one way the economy can be corrected. It
is more effective if it is coordinated with fiscal policy. In addition, the goals of the Fed may clash with those of Congress or the president. Since members of the Fed’s Board of Governors serve for 14-year terms, they are not as susceptible to political pressure as are politicians, who are elected every two to six years. Monetarism According to monetarists, a slow, steady growth in the amount of money in circulation is the best monetary policy. APPLICATION Analyzing Causes D. What will happen to interest rates when the Fed sells bonds in open market 496 Chapter 16 operations? Why? S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the difference between the terms in each of these pairs. a. monetary policy monetarism b. easy-money policy tight-money policy c. discount rate prime rate 2. How should a contractionary monetary policy affect interest rates and the rate of inflation? Why? 3. How should an expansionary monetary policy affect interest rates and the unemployment rate? Why? 4. How does the Fed use open market operations as a monetary policy tool? 5. What is the main short-term effect of monetary policy? 6. Using Your Notes Which monetary policy tool does the Fed use least often? Refer to your completed hierarchy diagram. Monetary Policy main ideas main ideas main ideas Use the Graphic Organizer at Interactive Review @ ClassZone.com details details details. Analyzing Causes To curb inflation, why is it easier for the Fed to use monetary policy to raise interest rates than it is for Congress to implement contractionary fiscal policy? 8. Making Inferences What are the Fed’s underlying assumptions about the state of the economy, based on these Fed actions? a. The Fed’s open market operations caused the FFR to drop from 6.25 percent to 1 percent. b. The FFR rose from 1 percent to 4.25 percent. 9. Applying Economic Concepts In 2005, the Fed set the discount rate for banks in good financial condition at 1 percent above the targeted FFR. a. Would these banks be more likely to borrow short-term funds from another bank or from the Fed? Why? b. How does this policy help keep the federal funds rate close to the target set by the Fed? 10. Challenge Explain how the Fed buying bonds affects interest rates, aggregate demand, price level, and GDP. Illustrate your answer using two graphs, one showing the money market and one showing
aggregate supply and aggregate demand. Durable goods—washing machines Applying Economic Concepts Think about the ways monetary policy is used to address economic problems. Then complete the following activities. Determine Monetary Policy The chart below lists several economic situations. For each one, decide whether an easy-money or tightmoney policy is needed. Monetary Policy Needed Economic Situation Consumer spending on durable goods rises faster than production Rising energy prices are pushing prices of many products higher Unemployment rate increases from 5.4% to 6.8% over six months Challenge Choose one example that requires an easy-money policy and one that requires a tight-money policy and explain how open market operations would be used in each case. 497 S E C T I O N 4 Applying Monetary and Fiscal Policy TA K I N G N O T E S In Section 4, you will wage and price controls, p. 501 • describe how monetary and fiscal policy can coordinate to improve the economy • understand how monetary and fiscal policy can work against each other • identify other measures that can be used to manage the economy As you read Section 4, complete a cause-and-effect chart using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Expansionary Policies Contractionary Policies Conflicting Policies results results results Policies to Expand the Economy KEY CONCEPT S The goals of both fiscal and monetary policy are to stabilize the economy by easing the effects of recession and controlling inflation. Fiscal policy relies on government spending and taxation to achieve its goals. Monetary policy uses open market operations, the discount rate, and reserve requirements as its tools. These policies, as well as affecting the economy, also have an impact on each other. As you recall, both monetary and fiscal policy have limitations. These include policy lags, political constraints, and timing issues. Policy lags relate to the time it takes to identify the problem and for policy actions to take effect. Political considerations may limit government’s ability to do what is best for the economy. Timing, too, is important because to be effective government actions must counteract the negative effects of the business cycle. Intervention at the wrong time may skew the cycle and make the problem worse. A second phenomenon affecting timing is explained by the rational expectations theory. As you recall from Chapter 15, this states that individuals and business firms learn, through experience, to anticipate changes in monetary and fiscal policy and take steps to protect their interests. For example, if there is debate in Congress about tax cuts,
individuals and businesses may take actions before the legislation is even passed, based on their expectations that tax cuts will increase their income. Individuals may decide to purchase durable goods, such as automobiles, refrigerators, and washing machines. Similarly, businesses may decide to expand their operations by building new factories and hiring more workers. On the other hand, if individuals and businesses think the tax cuts will be temporary, they may choose not to spend as the policy intended. Rational Expectations Expectations that tax cuts will increase their incomes may cause people to buy “big-ticket” items such as refrigerators. 498 Chapter 16 People who disagree with the use of most discretionary policy often support their argument with the rational expectations theory. They suggest that rather than fiddling with fiscal and monetary policy, the government should aim for a stable monetary policy so that business decisions are made for economic reasons and not in anticipation of new policies. E XAMPLE Expansionary Monetary and Fiscal Policy The goal of expansionary policy is to stimulate the economy by reducing unemployment and increasing investment. As you recall, expansionary fiscal policy involves increased government spending or tax cuts. Also, to enact expansionary monetary policy, the Fed buys government bonds or reduces the discount rate or the reserve requirement. For example, suppose that the unemployment rate is 9.5 percent and the Consumer Price Index (CPI) is at 2 percent. The economy is in recession and inflation is a minimal concern. In order to increase the money supply, the Fed buys bonds on the open market and lowers the discount rate. The federal government also cuts personal income taxes and increases government spending. These expansionary policies are designed to increase aggregate demand and decrease unemployment. Real GDP will expand and prices will rise as aggregate demand increases. Figure 16.12 shows how expansionary policies affect these key economic indicators. Expansionary fiscal policy is likely to raise interest rates, while expansionary monetary policy should decrease interest rates. Therefore, the actual change in interest rates will depend on the relative strength of the two policies. The amount of investment spending will depend on what happens with interest rates. F I G U R E 16.12 Effects of Expansionary Policies Policies Effects a b Monetary Policy The Fed buys bonds and lowers the discount rate to increase money supply Fiscal Policy Increased spending/ tax cuts to increase aggregate demand Real GDP increases and prices rise Unemployment falls ANALYZE CHARTS 1. According to the chart, what are the goals of expansionary policies? 2. Which indicator in the chart suggests that expansionary policy might lead toward inflation
? a Here, fiscal and monetary policies work together to expand the economy. b These policies tend to increase aggregate demand, increase real GDP, and lower unemployment. AP P LI CATION Analyzing Effects A. What effect would government borrowing to finance increased spending have on interest rates and why? The Federal Reserve and Monetary Policy The Federal Reserve and Monetary Policy 499 Policies to Control Inflation KEY CONCEPT S The goal of contractionary monetary policy is to tighten up the economy by decreasing inflation and increasing interest rates. Contractionary fiscal policy tools include decreased government spending or tax increases. The Fed will sell bonds on the open market or raise the discount rate or the reserve requirement as contractionary monetary policy tools. EXAMPLE Contractionary Monetary and Fiscal Policy Suppose that the unemployment rate is 4.5 percent and the CPI is running in excess of 10 percent. The economy is operating at or above a sustainable level of output, and inflation is very high. In order to decrease the money supply, the Fed sells bonds on the open market and raises the discount rate. The federal government cuts spending on government programs. It also may raise taxes. These contractionary policies are designed to decrease aggregate demand and bring inflation under control. Real GDP will decrease, and prices will fall as aggregate demand decreases. Further, unemployment tends to rise as real GDP decreases. Figure 16.13 shows how contractionary monetary and fiscal policies affect the key economic indicators of unemployment and real GDP. Contractionary fiscal policy is likely to lower interest rates because decreased government spending will decrease demand for loans. Contractionary monetary policy should raise interest rates. Therefore, the actual change in interest rates will depend on the relative strength of the two policies. The amount of investment spending depends on what happens with interest rates. F I G U R E 16.13 Effects of Contractionary Policies a Policies b Effects Monetary Policy The Fed sells bonds and raises the discount rate to cut money supply Fiscal Policy Decreased spending/ tax increases to decrease aggregate demand Real GDP and prices fall Unemployment increases a Here, fiscal and monetary policies work together to contract the economy. b These policies decrease aggregate demand, control inflation, and raise unemployment. ANALYZE CHARTS 1. According to the chart, what are the goals of contractionary policies? 2. In what way might the fiscal policy shown here not help to control inflation? 500 Chapter 16 YO U R EC ATIONAL E XPEC TATIONS TH EORY Will you begin to build or wait? You and several business partners have purchased an empty lot
and plan to build a new store on it. There has been discussion in the media recently about rising inflation and the possibility that the Fed will raise interest rates. Do you go forward with your plan to build, or do you wait? Why?? ▲ Empty lot QUICK REFERENCE Wage and price controls are government limits on increases in wages and prices. ▲ Completed store E XAMPLE Wage and Price Controls At times in the past, the government has taken extreme measures to control the economy, especially during wartime. For example, the government may establish a set of wage and price guidelines that are not mandatory. Wage and price controls are limits, established by the government, on increases in certain wages and prices. These controls, unlike wage and price guidelines, are mandatory and enforced by the government. World War II led to increased production of goods needed by the military. This situation created shortages of many consumer goods as well as a labor shortage, which tended to drive up prices and wages. In an effort to control inflation, President Franklin D. Roosevelt established the Office of Price Administration (OPA) in 1942. This agency set strict wage and price controls on all sectors of the economy. These measures had some, but not total, success. They were phased out almost immediately after the end of the war. In 1971, President Richard M. Nixon was faced with stagflation, a situation in which rising unemployment is accompanied by rising inflation rates. In August of that year, Nixon announced a 90-day freeze on wages and prices to try to control inflation. The program was renewed several times and lasted until April 1974. Even so, it had little impact. From late 1971 to early 1974, the inflation rate actually rose from about 4 percent to 11 percent. AP P LI CATION Comparing and Contrasting B. What are the similarities and differences between contractionary monetary policy and wage and price controls? The Federal Reserve and Monetary Policy 501 Policies in Conflict KEY CONCEPT S As you have seen, coordinated policies are, for the most part, effective in reaching a mutually agreed upon goal—that is, a stable but growing economy with little inflation. When fiscal and monetary policies are not coordinated, however, one policy can counter the effect of the other and thwart this goal, creating economic instability instead. EXAMPLE Conflicting Monetary and Fiscal Policies Suppose that the unemployment rate is 7 percent and the CPI stands at 6 percent and is steadily rising. The Fed may decide that the most pressing problem for the economy is rising inflation. So, to
cool down the economy it follows a contractionary monetary policy, selling bonds on the open market and raising the discount rate. At the same time, the federal government may decide that rising unemployment needs is a bigger problem. To stimulate aggregate demand, it follows an expansionary fiscal policy, cutting personal taxes and increasing spending on public works programs. The only clear result of these conflicting policies is that interest rates will increase. Because the policies are in conflict, the effects on GDP, prices, and unemployment cannot be predicted. This is illustrated in Figure 16.14. F I G U R E 16.14 Effects of Conflicting Policies Policies Effects a b Monetary Policy The Fed sells bonds and raises the discount rate to cut money supply Fiscal Policy Tax cuts/ increased spending to increase aggregate demand Real GDP and prices may rise or fall Unemployment may rise or fall a This shows that the policies are working against each other in efforts to stabilize the economy. b Here, conflicting policies make it impossible to predict the effects on GDP, prices, and unemployment. ANALYZE GRAPHS 1. According to the chart, which policy is designed to increase GDP? 2. How do you think conflicting monetary and fiscal policies, like those described above, will affect consumer spending? Why? APPLICATION Analyzing Causes C. Why do tax cuts and increased government spending result in a rise in interest rates? 502 Chapter 16 S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. Use the term below in a sentence that illustrates the meaning of the term. wage and price controls 2. How is rational expectations theory related to the limitations of fiscal and monetary policy? 3. Why does rational expectations theory oppose most discretionary fiscal and monetary policy? 4. Does monetary policy or fiscal policy most directly affect the economy? Why? 5. Why might an expansionary fiscal policy and a contractionary monetary policy work against each other? 6. Using Your Notes What are the effects of expansionary fiscal and monetary policies? Refer to your completed diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Expansionary Policies Contractionary Policies Conflicting Policies results results results. Drawing Conclusions What happens to interest rates if the Fed implements a contractionary monetary policy when Congress and the president cut taxes and increase government spending? What effect do you think this would have on the economy? Why? 8. Applying Economic Concepts When President Nixon imposed wage and price controls in the 1970s in an attempt to control inflation, he felt he could then use
expansionary fiscal policy to decrease unemployment. These policies helped him win reelection in 1972, but inflation rose sharply over the next three years. Use the economic concepts you have learned in this section to explain what happened. 9. Challenge Many economists argue that the economy is better off when monetary policy is used most often to stabilize the economy, with fiscal policy being used primarily as a backup to bring the economy out of longer recessions. Do you agree or disagree with this assessment? Why or why not? Applying Economic Concepts Recall what you have learned about the effectiveness of monetary policy, then complete the activities below. Interpreting Economic Models Which graph shows poor timing of monetary policy in relation to the business cycle? What is the effect of monetary policy on the business cycle shown on each graph? Challenge How do these graphs reflect rational expectations theory NORMAL BUSINESS CYCLE BUSINESS CYCLE WITH MONETARY POLICY APPLIED Time Time 503 Case Study Find an update on this Case Study at ClassZone.com Interpreting Signals from the Fed Background The Federal Reserve is a powerful institution, so people pay attention to the Fed chairman’s comments. A hint that the Fed might raise the discount rate can lead to a great deal of activity in the stock market. Some people might buy stock because they are confident that the Fed will keep inflation low. Others might sell stock because they are worried that the economy is slowing down. Over the 18 years that Alan Greenspan was Fed chairman, economists and financial observers scrutinized his every word in an attempt to predict how his statements would affect the economy. When Ben Bernanke was appointed as Fed chairman in 2006, observers had to learn a new language. What’s the issue? How much does the market rely on signals from the Fed to make economic decisions? Read the following to see what happened when the status quo changed and the signals were different. A. Internet Article This article demonstrates how Fed Chairman Ben Bernanke had to carefully review his public comments. Crossed Economic Signals Fed Expected to Boost Key Interest Rates After nearly two decades of decoding Alan Greenspan’s famously opaque speaking style, financial markets are having to learn to interpret his successor Ben Bernanke. So far, the results have been a little rocky.... Some economists believe the Fed will stop with the funds rate at 5 percent, up significantly from the 46-year low of 1 percent in effect before the rate increases began. Others think the Fed will only pause for a meeting or two and then raise rates
one or two more times. And still a third group thinks there won’t be any pause as the Fed continues a steady march toward higher rates. Part of the blame for the confusion is being assigned to Bernanke, who took over as Fed chairman on Feb. 1. He roiled markets over the past two weeks, first with testimony before the Joint Economic Committee on April 27 that the markets read as a strong signal that the Fed was going to pause in its string of rate increases, and then the next week when he told a reporter that the markets had misinterpreted his comments. Economists said that the incident showed that there is a new Fed chairman with a different speaking style.... In any event, forecasters predicted Bernanke will be brushing up on his communication techniques. Source: “Fed Expected to Boost Key Interest Rates,” by Martin Crutsinger. Associated Press, May 10, 2006. Thinking Economically Why does the Fed chairman need to develop strong communication techniques? 504 Chapter 16 B. Political Cartoon Harley Schwadron drew this cartoon about the new Fed chairman following in his predecessor’s footsteps. Newspaper Article This article reports on a speech Chairman Bernanke made at an international financial conference and the reaction that followed. Thinking Economically What message does this cartoon convey about how the Fed has been known to give information? Open to Analysis Bernanke Talks Tough on Inflation Ben S. Bernanke, chairman of the Federal Reserve, warned Monday that recent inflation trends were “unwelcome developments,” indicating that he was far less worried about signs of weaker economic growth than about the danger of higher prices. In his toughest comments yet about the risks of inflation, Mr. Bernanke said consumer prices were rising faster than he would like.... Investors, increasingly convinced that the central bank will raise rates... immediately began selling stocks. The Dow industrials and the broader Standard & Poor’s 500-stock index each fell about 1.75 percent, and the Nasdaq index tumbled more than 2 percent.... Speaking to a conference... on international monetary issues with other central bankers, Mr. Bernanke said inflation had climbed to the upper limits of his acceptability. “Core inflation, measured over the past three to six months, has reached a level that, if sustained, would be at or above the upper range that many economists, including myself, would consider consistent with price stability,” Mr. Bernanke said....
Mr. Bernanke made clear that he thought the economy was now in a “transition” to slower economic growth.... Instead of highlighting signs of a cooling economy, which would ease inflationary pressures, Mr. Bernanke placed top emphasis on the need for vigilance against rising prices. Source: “Bernanke Talks Tough on Inflation,” by Edmund L. Andrews. New York Times, June 6, 2006 Thinking Economically What kind of monetary policy did investors expect Bernanke to follow—expansionary or contractionary policy? Explain your answer. THINKING ECONOMICALLY Synthesizing 1. How do articles A and C illustrate the rational expectations theory? 2. Based on these three sources and your own knowledge, how would you describe the differences and similarities between Greenspan and Bernanke and their impact on the market? The Federal Reserve and Monetary Policy 505 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. bank holding company Board of Governors central bank contractionary monetary policy deposit multiplier formula discount rate easy-money policy expansionary monetary policy federal funds rate Federal Open Market Committee Federal Reserve System monetarism monetary policy open market operations prime rate required reserve ratio thrift institution tight-money policy wage and price controls The 1 is the 2 of the United States and is commonly known as the Fed. The 3 supervises the operations of the Fed. The 4 supervises the sales and purchase of federal government securities. The Fed controls the amount of money a bank can loan through the 5. The 6 tells how much the money supply will increase after an initial cash deposit. 7 is actions by the Fed that change the money supply in order to influence the economy. The three tools used by the Fed to change the money supply are reserve requirements, the 8, which is the rate the Fed charges when it lends money to banks, and 9. The last tool allows the Fed to influence the 10, the rate banks charge one another to borrow funds overnight. 11 seeks to increase the amount of money in circulation and is also known as 12. 13 seeks to decrease the amount of money in circulation and is also known as 14. 506 Chapter 16 CHAPTER 16 Assessment The Federal Reserve System (pp. 474–479)
1. What are the three duties of the Federal Reserve? 2. What are the different responsibilities of the Board of Governors and the Federal Open Market Committee? Functions of the Federal Reserve (pp. 480–489) 3. What are the three functions of the Federal Reserve? 4. How does the size of the RRR affect the banking system’s ability to create money? Monetary Policy (pp. 490–497) 5. What is the Fed’s most frequently used monetary policy tool? 6. What is the purpose of monetary policy? Applying Monetary and Fiscal Policy (pp. 498–505) 7. What tools would be used to implement contractionary monetary and fiscal policy? 8. Why might it be important to coordinate monetary and fiscal policy? A P P LY Look at the line graph below showing the FFR and the prime rate over several years. FIGURE 16.15 SHORT- TERM INTEREST RATES 10 Source: Federal Reserve 1 1 9 9 PRIME RATE FFR. What is the relationship of the prime rate to the FFR as shown on this graph? 10. What conclusion can you draw about the U.S. economy based on interest rates in 2002–2004 11. Making Inferences Eight times per year the Fed collects economic information from each of its districts and compiles a report to help the FOMC make its decisions. How does this practice reflect the benefits of the Fed’s structure? 12. Applying Economic Concepts In response to the terrorist attacks of September 11, 2001, the Fed started lowering the FFR target the following week. Congress was unable to agree on a program to help stimulate the economy until March 2002. How does this situation illustrate the effects of policy lags on monetary and fiscal policy? 13. Analyzing Causes and Effects Suppose that the Fed buys a $10,000 T-bond from the First National Bank. What effect will this have on First National’s reserves and on the FFR? Why? 14. Drawing Conclusions In 2001, Congress approved a major tax cut package, while the Fed lowered the FFR target. In January 2006, the president asked Congress to make the tax cuts permanent, and the Fed raised the FFR target. When were fiscal and monetary policies working together, and when were they in conflict? 15. Challenge The FOMC issued the following statement after one of its meetings: Although recent economic data have been uneven, the expansion in economic activity appears solid. Core inflation has stayed
relatively low in recent months, and longer-term inflation expectations remain contained. Nevertheless, possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures. The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. Did the committee raise, lower, or maintain the target for the FFR? Cite evidence from the statement to support your answer. Stabilize the Economy Step 1 Choose a partner. Imagine that you are advisers to the president of your Federal Reserve District bank. Your job is to prepare the president for the next FOMC meeting. The current state of the economy is shown in column A of the Key Economic Indicators table below. Decide whether an expansionary or contractionary monetary policy is needed. Recommend the type of open market operations needed as well as a target for the FFR. Give reasons for your recommendation and outline what you expect to happen to the other indicators as a result of this policy. KEY ECONOMIC INDIC ATORS ( I N PE RC E N T) Indicator A GDP CPI 3.00 6.25 B 2.00 3.00 C 6.50 1.50 Unemployment Rate Federal Funds Rate 5.60 7.50 4.50 7.75 4.75 5.25 Step 2 The state of the economy two years later is shown in column B. Develop a new recommendation based on this data, with the same kind of details you included in Step 1. Step 3 The economy has experienced several years of growth as indicated by the information in column C. Develop a new recommendation based on your evaluation of this situation. Step 4 Share your three recommendations with the class. As a class, decide on a final monetary policy recommendation for each scenario. Step 5 Consider what would happen if the government used a coordinated fiscal policy for the data in columns A and B and a conflicting fiscal policy with the data in column C. Discuss as a class what would happen to the three key indicators when fiscal policy effects are considered. The Federal Reserve and Monetary Policy 507 U n i t 7 The Global Economy A Global Marketplace International trade allows nations to produce some items and trade them for other items. How do they decide what to produce and what to trade for? 508 CHAPTER 17 SECTION 1 Benefits and Issues of International Trade SECTION 2 Trade Barriers SECTION 3 Measuring the Value of Trade SECTION 4 Modern International Institutions CASE STUDY Analyzing Tariffs: Who
Wins and Who Loses? International Trade The global economy is the sum of all economic interactions that cross international boundaries. C H A P T E R 17 Economic interdependence involves producers in one nation that depend on producers in other nations to supply them with certain goods and services AT T E R S Japan is a world-class producer of automobiles, in spite of the fact that it has few mineral resources. How can this be? The answer lies in the realm of international trade, where nations choose to produce some things and trade for others. In the case of Japan, it must trade for the raw materials it uses in order to produce automobiles. It then turns around and trades the automobiles for other goods. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on how tariffs and subsidies affect the sugar market. (See Case Study, pp. 538–539). Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. Why do many people believe that U.S. government subsidies to sugar producers are a problem? See the Case Study on pages 538–539. International Trade 509 S E C T I O N 1 Benefits and Issues of International Trade TA K I N G N O T E S In Section 1, you will specialization, p. 510 • determine why nations choose to specialize their economies • examine the difference between absolute and comparative advantage • explain how international trade impacts prices and quantity economic interdependence, p. 510 absolute advantage, p. 513 comparative advantage, p. 513 law of comparative advantage, p. 514 exports, p. 516 imports, p. 516 As you read Section 1, complete a diagram that shows how the concepts in the section relate to international trade. Use the Graphic Organizer at Interactive Review @ ClassZone.com International Trade Resource Distribution and Specialization KEY CONCEPT S A nation’s economic patterns are based on its unique combination of factors of production: natural resources, human capital, physical capital, and entrepreneurship. For example, a nation rich in arable land but lacking well-educated workers is less likely to develop a strong technology sector than a country with better-educated citizens and diverse natural resources. Economic patterns may also change over time. The United States, for example, once relied heavily on its agricultural sector, but the U.S. economy is now also extremely high-tech and highly
skilled. Because each nation has certain resources and cannot produce everything it wants, individuals and businesses must decide what goods and services to focus on. The result is specialization, a situation that occurs when individuals or businesses produce a narrow range of products. Through specialization, businesses can increase productivity and profit—the driving force of world trade. Specialization also leads to economic interdependence, a situation in which producers in one nation depend on others to provide goods and services they do not produce. QUICK REFERENCE Specialization is a situation that occurs when individuals or businesses produce a narrow range of products. Economic interdependence is a situation in which producers in one nation depend on others to provide goods and services they do not produce. Specialization A coal-rich nation that lacks advanced technology can trade its coal for manufactured goods, such as automobiles, from nations with higher levels of technology. 510 Chapter 17 YO U R EC SPEC IALIZ ATION Will you specialize in lawn mowing or babysitting? Do you have a lawn mower? Do you know children that need to be watched? What other questions might you ask yourself before deciding what you will specialize in?? Mow lawns Babysit E XAMPLE Specialization The concept of specialization can be illustrated by looking at the agricultural production of two nations: Costa Rica and New Zealand. The climate, the labor conditions, and the level of technology of each nation have made some agricultural products more important than others. In other words, each nation has decided to specialize in certain agricultural areas because they have an advantage in doing so. For Costa Rica, the product of choice is bananas. It is the world’s seventh-largest producer and second-largest exporter of bananas. For New Zealand, the product of choice is sheep. It is the world’s third-largest producer and second-largest exporter of wool and is responsible for about 50 percent of the world’s lamb and mutton exports. What explains each nation’s specialization? Costa Rica has the necessary climate for bananas—warm and wet. In addition, agricultural wages are relatively low, an important point as banana production is quite labor intensive. On the other hand, New Zealand has the temperate climate, water resources, and vast expanses of open grasslands to support the grazing of millions of sheep. (Today, there are about 10 sheep for every person in New Zealand.) Raising sheep is not nearly as labor intensive as banana production, and this suits the fairly low population
density of this remote island nation. Also, scientific breeding practices and mechanized wool- and meat-processing operations are available to a developed nation such as New Zealand. It makes sense for each nation to specialize as it does and to trade for the things it cannot produce as efficiently. AP P LI CATION Drawing Conclusions A. Why should nations specialize in what they produce most efficiently and trade for the rest? Find an update on Costa Rica’s economy at ClassZone.com International Trade International Trade 511 ECO N O M I C S PAC ES E T T E R David Ricardo: The Theory of Comparative Advantage Many things about London-born economist David Ricardo make him a memorable figure. He was one of 17 children in a Jewish family. At age 14, he went to work in his father’s stockbrokerage. He married a Quaker at age 21 and broke from the Jewish faith, at which time his father disinherited him. And finally, when he died at age 51, he left a $126 million fortune. Ricardo is most remembered, however, for the idea that has become the backbone for free trade—comparative advantage. It states, in short, that a trading nation should produce a certain product if it can do so at a lower opportunity cost than that of another trading nation. EXAMPLE Trading in Opportunity The prevailing view about international trade in Ricardo’s time was based on the idea of absolute advantage, the ability of one trading nation to make a product more efficiently than another trading nation. Most people believed that if Portugal, for example, could make grape juice more efficiently than England, and if England could make cloth more efficiently than Portugal, then trade would be beneficial to both. Ricardo, however, set up a different problem, one that challenged this outlook. What if, he thought, Portugal makes both products more efficiently than England? Would trade, at least for Portugal, no longer be beneficial? His surprising answer was that trade would indeed still be beneficial. He based his conclusion on the opportunity costs each nation spends to make its products. Suppose that in Portugal, it takes two hours of labor to produce a jug of grape juice, while in England, it takes four hours. Suppose also that in Portugal, a yard of cloth takes six hours to make; in England it takes eight hours. Ricardo reasoned that in Portugal, every yard of cloth costs three jugs of grape juice in lost opportunity. In England, however, every yard of cloth costs only two jugs
of grape juice. Portugal, then, would be wise to buy cloth from England and to specialize in grape juice. This understanding has become known as the law of comparative advantage: countries gain when they produce items they are most efficient at producing and that have the lowest opportunity cost. David Ricardo APPLICATION Applying Economic Concepts B. Does the law of comparative advantage apply only to nations, or does it apply to individuals as well? Explain your answer. FAST FACTS David Ricardo Title: Economist, stockbroker Born: 1772 Died: 1823 Major Accomplishment: Brilliantly thinking through economic principles and laying the foundation for free trade Major Work: On the Principles of Political Economy and Taxation (1817) Famous Quotation: “The labor of 100 Englishmen cannot be given for that of 80 Englishmen, but the produce of the labor of 100 Englishmen may be given for the produce of the labour of 80 Portuguese, 60 Russians, or 120 East Indians.” Learn more about David Ricardo at ClassZone.com 512 Chapter 17 Absolute and Comparative Advantage KEY C ONCEPT S Absolute advantage is the ability of one trading nation to make a product more efficiently than another trading nation. Some regions or nations have absolute advantage in producing certain products or services because of the uneven distribution of production factors. Comparative advantage, in contrast, is the idea that a nation will specialize in what it can produce at a lower opportunity cost than any other nation. When determining comparative advantage, you look not for the absolute cost of a product, but for its opportunity cost. E XAMPLE Absolute Advantage Consider the trade relations between two countries on the Pacific Rim today, China and Australia. Both countries produce iron ore; both also produce steel. Suppose that every week, Australia produces 5,000 tons of iron ore and 1,000 tons of steel. In the same period of time, and with the same amount of labor, China produces 2,700 tons of iron ore and 900 tons of steel. In this case, Australia has an absolute advantage over China in both areas. Before Ricardo, the standard logic held that, in this situation, the nation that held the absolute advantage for both commodities would trade for neither. But, as you’ve read, when the important factor of opportunity cost is considered, this logic doesn’t stand up. Why would it benefit Australia to import steel from China, in spite of its absolute advantage? The answer is comparative advantage. QUICK REFERENCE Absolute advantage is the ability of one trading nation
to make a product more efficiently than another trading nation. Comparative advantage is a trading nation’s ability to produce something at a lower opportunity cost than that of another trading nation. What Does Opportunity Cost? Should Australia specialize in mining iron ore (left) and leave the steel production (right) to China? Where does the comparative advantage lie? International Trade 513 EXAMPLE Comparative Advantage Let’s start with a simple example of comparative advantage. After years as an office manager at a law firm by day and a law student by night, Ellen becomes a lawyer and starts her own practice. She charges $150 per hour for her legal services. She hires Miguel to run her office, and she pays him $25 per hour. Although Miguel works hard and is good at his job, Ellen soon realizes that, due to her years of experience, she could run her own office better than Miguel. Should she take over these duties? The answer lies in opportunity cost. Every hour that Ellen spends engaged in the duties that are worth $25 per hour costs her an hour that could be spent doing work that is worth $150 per hour. Clearly it makes sense for her to employ an office manager and concentrate on the legal end of her practice. Back to our previous example of Australia and China, we see that Australia’s production ratio of steel to iron ore is 1:5. In other words, Australia’s opportunity cost for one ton of steel is five tons of iron ore. Applying the same logic to China, we find that its production ratio of steel to iron ore is 1:3. Its opportunity cost for one ton of steel is three tons of iron ore. So, in the production of steel, China has a comparative advantage. Australia would benefit by trading for Chinese steel. This is the law of comparative advantage: countries gain when they produce items that they are most efficient at producing and that are at the lowest opportunity cost. QUICK REFERENCE The law of comparative advantage states that countries gain when they produce items they are most efficient at producing and are at the lowest opportunity cost. F I G U R E 17.1 Specialization and Trade No Specialization One day’s labor in France results in 40 tons of cheese and 80 tons of fish. One day’s labor in Japan results in 50 tons of cheese and 200 tons of fish. France’s opportunity cost for 1 ton of cheese is 2 tons of fish. Japan’s opportunity cost for 1 ton of cheese
is 4 tons of fish. Specialization and Trade France trades 1 ton of cheese. Japan trades 3 tons of fish. It used to cost France 1 ton of cheese to get 2 tons of fish; now it trades 1 ton of cheese for 3 tons of fish. It used to cost Japan 4 tons of fish for 1 ton of cheese; now it trades only 3 tons of fish for 1 ton of cheese. 514 Chapter 17 Economic Success with Few Natural Resources Some economies thrive as a direct result of natural resources—Saudi Arabia and its oil, for instance. But, many nations, such as the Republic of Ireland, thrive economically in spite of a relative lack of natural resources. It is not rich in mineral resources and relies on imports for the majority of its energy supply. However, it has formulated and carried out certain policies that have helped to produce today’s dynamic economy. In the mid-1950s, Ireland began a continuing process The headquarters of the Industrial Development Agency of Ireland, in Dublin of reversing protectionist tariff and quota policies. The Programmes for Economic Expansion (1958 and 1963) attracted large amounts of foreign direct investment through financial grants and tax concessions. Levels of human capital were increased through educational reforms in the 1960s. It was also an original member of the EU and took advantage of EU funds to shore up its infrastructure. These and other policies set the stage for Ireland’s economic boom of the 1990s. During this decade, it became a major manufacturer of high-tech electronics, computer products, chemicals, and pharmaceuticals. It has also become an important center for banking and finance. CONNECTING ACROSS THE GLOBE 1. Drawing Conclusions What specialization has, for the most part, driven Ireland’s economic boom? 2. Applying Economic Concepts Why might an economy like Ireland’s be more desirable than one that relies solely on natural resources? E XAMPLE Advantages of Free Trade If China and Australia decide to specialize and trade, they can improve their ratio of return. Previously, China’s ratio of steel production to iron ore production was 1:3 and Australia’s was 1:5. If the two nations establish a trade ratio of 1:4 (China trades one ton of its steel for four tons of Australian iron ore), both countries win. China now gets four tons of iron ore for a ton of steel; it got three before. Also, one ton of steel now costs Australia only four tons of iron ore; it previously
cost five. When countries specialize and trade, they not only improve their production ratios but they also increase world output. If China specializes in steel and Australia in iron ore, each can make more of their products than the two nations could have made together if they had not specialized. Increased output is a mark of economic growth, which is a factor in raising standards of living. AP P LI CATION Interpreting Tables C. Use the example in Figure 17.1 to explain how output for both nations increases through specialization and trade. International Trade 515 International Trade Affects the National Economy KEY CONCEPT S Because of the law of comparative advantage, nations gain through trading goods and services. Goods and services produced in one country and sold to other countries are called exports. Goods and services produced in one country and purchased by another are called imports. The costs and benefits of international trade vary by nation. To understand how trade affects a nation’s economy, economists use supply and demand analysis. They look at the impact of exports and imports on prices and quantity. IMPACT 1 Exports on Prices and Quantity Suppose that a county called Plecona existed and that it did not trade with other countries. Figure 17.2 shows the equilibrium price for Plecona’s motorbikes. What would happen to prices and demand if Plecona decided to become a trading nation and export its motorbikes? In some countries, such as Nepocal, people would give up their bicycles and begin to buy Pleconese motorbikes. This results in an increase in demand for Pleconese motorbikes, shifting the demand curve to the right and establishing a new equilibrium price. Motorbikes will now cost more in Plecona too. However, the greater demand resulting from exporting offsets this by creating more jobs and more income in Plecona, as the motorbike producer invests its profits to expand production and hire more workers. IMPACT 2 Imports on Prices and Quantity Now suppose that Nepocal and Plecona agree that Nepocal may sell its major product, microwave ovens, in Plecona. Instead of having only Pleconese-made microwaves, consumers in Plecona may now purchase ovens imported from Nepocal. This change adds to the number of microwave oven producers in the Pleconese market. Adding producers shifts the supply curve of microwave ovens to the right and thereby establishes a new, lower equilibrium price. (See Figure 17.3.) In other words, there are now more microwave ovens
in Plecona, and the consumers are paying a lower price for them. However, because of the lower price, Pleconese producers of microwave ovens will choose to offer fewer microwaves for sale. So imports have the effect of initially increasing supply and of providing consumers with greater selection and lower prices. The competition also establishes incentives for domestic producers to become more efficient in production, improve worker productivity, and enhance customer service. Both consumers and producers, then, benefit from international trade. Consumers benefit from imports because the selection of goods increases and prices decrease. Producers benefit from exports by gaining a new market for their products, and thereby giving them the opportunity to increase revenues and earn a profit. QUICK REFERENCE Exports are goods and services produced in one country and sold to other countries. Imports are goods and services produced in one country and purchased by another. 516 Chapter 17 FIGURES 17.2 AND 17.3 THE EFFECTS OF INTERNATIONAL TRADE 17.2 PLECONA’ S MOTORBIKE EXPORT MARKET 17.3 PLECONA’ S MICROWAVE OVEN IMPORT MARKET $12 10 D2 D1 $120 100 ) 80 60 40 20 0 S1 b S2 D 5 15 Quantity supplied and demanded 25 10 20 30 a Increased demand causes the demand curve to shift to the right. b Increased supply causes the supply curve to shift to the right. 5 10 15 20 25 30 Quantity supplied and demanded of motorbikes (in thousands) of microwave ovens (in thousands) ANALYZE GRAPHS What are the initial and then post-shift equilibrium prices for motorbikes in Figure 17.2? for microwaves in Figure 17.3? Use an interactive supply and demand graph at ClassZone.com IMPACT 3 Trade Affects Employment As nations specialize in their changing areas of strength, the availability of certain jobs can undergo dramatic changes. For example, if Australia specializes in producing iron ore or providing educational services (another area of strength for that nation) at the expense of making steel, then some Australian steelworkers may lose their jobs. At the same time, however, the overall number of Australian jobs may increase significantly. The Australian Trade Commission estimates that a ten percent increase in exports results in 70,000 new jobs for workers in Australia. In the United States, manufacturing output increased 600 percent between Biotech Jobs The U.S. economy’s move to the technology sector has meant a sharp
rise in biotechnology employment. 1950 and 2000. During the same period, however, employment in manufacturing, as a share of total employment, declined by nearly two-thirds. The United States was shifting its specialization from manufacturing to technology. In the process, it became a world leader in technology exports. So, while many manufacturing jobs in some sectors were lost, the shift in specialization and the resulting trade had positive effects on U.S. employment in general. During the 1990s, for example, U.S. exports were responsible for about 25 percent of the nation’s economic growth, supporting about 12 million jobs. About 20 percent of all U.S. factory jobs depend on trade. Also, jobs in plants that export their products pay an average of 18 percent higher wages than jobs in non-exporting plants. International Trade 517 The United States in the World Economy The United States is a leading nation in a number of aspects of the world economy. It is the largest exporter in the world, selling more than $900 billion in goods and services in 2005. The United States mostly exports capital goods (computers, machinery, civilian aircraft, and so on), automobiles, industrial supplies, consumer goods, and agricultural products. It is also the world’s largest importer, buying nearly $1.7 trillion worth of goods and services from all over the world. It imports mainly crude oil and refined petroleum products, machinery, automobiles, consumer goods, and industrial raw materials. While the United States imports more goods than it exports, it exports more services than it imports. Such services as travel and tourism, transportation, architecture and construction, and information systems find ready customers in Europe, Japan, Canada, and Mexico. The four most important trading partners for the United States in goods and services are Canada, accounting for 20 percent of trade, China (12 percent), Mexico (11 percent), and Japan (7 percent). Trade with these four partners accounts for half of U.S. foreign trade. Find an update on U.S. imports at ClassZone.com FIGURE 17.4 U.S. INTERNATIONAL TRADE IN GOODS BY CATEGORY 521 ( 600 500 400 300 200 100 0 407 380 362 232 240 Key: Imports Exports 116 98 Automobiles and parts 68 59 Food and beverages Industrial supplies and materials Consumer goods Capital goods Categories of goods Source: U.S. Bureau of Economic Analysis, 2005 data ANALYZE GRAPHS 1. In what
two areas do U.S. export totals approach import totals? 2. What do these graphs show about the United States and specialization? In recent years, as shown in Figure 17.4, the United States has imported an increasingly larger amount than it has exported. You will learn more about this in Section 4 of this chapter. APPLICATION Interpreting Graphs D. In what category of goods is the difference between imports and exports the greatest? Why do you think this is so? 518 Chapter 17 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the difference between the terms in the following pairs: a. specialization and economic interdependence b. absolute advantage and comparative advantage c. export and import 2. What principle explains why nations specialize and trade? 3. Explain why trade is good for nations that produce exports as well as buy imports. 4. What effect do imports have on price and supply? Why? 5. What effect do exports have on price and demand? Why? 6. Using Your Notes Write a speech for the president of Australia, explaining why your nation should specialize in the production of iron ore and trade for steel. Use the Graphic Organizer at Interactive Review @ ClassZone.com International Trade. Analyzing Cause and Effect You have just learned that high- quality electric guitars made in South Korea will soon be exported to the United States. Should you buy a new guitar now or wait until after the imports begin arriving? Explain your answer. 8. Making Inferences and Drawing Conclusions Why does the law of comparative advantage explain that all people and nations can trade? 9. Explaining an Economic Concept How does international trade help create jobs? How does it shift jobs? 10. Challenge Shelley started her own comedy improvisation club right after college, and at first she did everything: developed new material, starred in the show, handled publicity, and sold tickets. As the enterprise grew, however, she hired an assistant to handle publicity and sell tickets, even though she was better at doing those things than he was. Explain why that was a good idea, using terms from this lesson. Figuring Absolute and Comparative Advantage Review the following scenario that describes cordless drill and drill bit production in the fictional nations of Freedonia and Sylvania. Freedonia and Sylvania both produce cordless drills and drill bits. Over the span of a month, Freedonia can produce 3,000 cordless drills and 21,000 drill bits. During this same period, Sylvania
can produce 2,000 cordless drills and 10,000 drill bits. Drawing Conclusions Use what you’ve learned in this section to answer the following questions: 1. For each product, which nation has the absolute advantage? 2. What are the production ratios for each nation? What is each nation’s opportunity cost for each cordless drill produced? 3. Which country has the comparative advantage in cordless drill production? Challenge Draw up and explain a scenario whereby Freedonia and Sylvania agree to trade, and each gets a better deal by adjusting its trade ratio. International Trade 519 S E C T I O N 2 Trade Barriers TA K I N G N O T E S In Section 2, you will • identify barriers to trade • examine the economic consequences of trade barriers • describe protectionism and the arguments for it trade barrier, p. 520 quota, p. 520 dumping, p. 521 tariff, p. 521 revenue tariff, p. 521 protective tariff, p. 521 voluntary export restraint, p. 521 embargo, p. 521 trade war, p. 522 protectionism, p. 523 infant industries, p. 523 As you read Section 2, complete a chart that shows the causes and effects of trade barriers. Use the Graphic Organizer at Interactive Review @ ClassZone.com Cause quota Effect higher prices Barriers to Trade KEY CONCEPT S In order to offer some short-term protection to jobs and industries located within their borders, almost all nations pass some sort of laws that limit trade. These laws lead to higher prices on the restricted items or to economic retaliation by other nations. In the end, these industries and the jobs they provide can only be saved by becoming more competitive. The issue of trade restrictions is basically political in nature, and governments struggle to find the best policies to enact. QUICK REFERENCE Types of Trade Barriers A trade barrier is any law that limits free trade between nations. A quota is a limit on the amount of a product that can be imported. 520 Chapter 17 A trade barrier is any law passed to limit free trade among nations. There are five basic types of trade barriers. Most are mandatory, but some are voluntary. Quotas Nations often impose quotas, limits on the amount of a product that can be imported. For example, the United States had quotas on the amount of textiles allowed to be imported. These quotas limited supply and kept textile prices relatively high. These quotas expired on January 1, 2005. Chinese
producers then flooded the United States (and the European Union) with low-priced textiles. Prices for Chinese textiles Quota Lifted Chinese textiles cross the Great Wall on their way to markets in the United States and the EU. increased, however, in other nations. This practice of dumping, the sale of a product in another country at a price lower than that charged in the home market, hurts domestic producers but provides consumers a lower price. Tariffs Another trade barrier is the tariff, a fee charged for goods brought into a country from another country. There are two types of tariffs: revenue and protective. Revenue tariffs, taxes on imports specifically to raise money, are rarely used today. In the past, however, nations regularly used them as a source of income. Today nations use protective tariffs, taxes on imported goods, to protect domestic goods. Protective tariffs raise prices on goods produced more cheaply elsewhere, thereby minimizing the price advantage the imports have over domestic goods. Tariff rates have fallen worldwide since the late 1980s. (See Figure 17.5.) Voluntary Export Restraint Sometimes, to avoid a quota or a tariff, a country may choose to limit an export. This is called a voluntary export restraint (VER). It usually comes about when a trade ambassador from one nation makes appeals to a counterpart, warning of possible consequences without the VER. Embargoes An embargo is a law that cuts off most or all trade with a specific country. It is often used for political purposes. Since the early 1960s, for example, the United States has had an embargo on trade with Communist Cuba. Informal Trade Barriers Other trade restrictions are indirect. Licenses, environmental regulations, and health and safety measures (such as a ban on the use of certain herbicides) are, in effect, trade barriers. QUICK REFERENCE Dumping is the sale of a product in another country at a price lower than in the home market. A tariff is a fee charged for goods brought into one country from another. A revenue tariff is a tax levied on imports specifically to raise money. A protective tariff is a tax on imported goods to protect domestic goods. A voluntary export restraint (VER) is a country’s self-imposed restriction on exports. An embargo is a law that cuts off trade with a specific country. FIGURE 17.5 TARIFF RATES ARE FALLING Developed Nations Less Developed Countries Middle East and North Africa East Asia and the Pacific Latin America and the Caribbean Sub-Saharan Africa South Asia
0 10 Key: Import tariff rate in the late 1980s Import tariff rate in 2004 60 70 30 50 20 Import tariffs (by percent) 40 Source: United Nations Human Development Report, 2005 AP P LI CATION Categorizing Economic Information A. Aside from imposing an embargo, how might one nation limit the import of a product from another nation? International Trade 521 The Impact of Trade Barriers KEY CONCEPT S Trade barriers have numerous effects. They may temporarily save domestic jobs in certain industries, but without competition, those industries might continue to operate inefficiently. In the end, consumers pay higher prices. Further, limits on trade sometimes lead to a trade war, a succession of trade barriers between nations. IMPACT 1 Higher Prices Trade barriers raise prices or keep them high. For example, in the early 2000s, the United States and Japan, who both produce semiconductor chips, imposed tariffs on chips from South Korea. The reason for the tariff was that the Korean government had subsidized the chip maker, allowing the chips to be sold at a very low price. The result was a higher price in U.S. and Japanese markets for both the Korean chips (up 27 to 44 percent) as well as for those produced domestically. (See Figure 17.6.) FIGURE 17.6 THE EFFECT OF AN IMPORT TARIFF ON PRICE c e c i r P S2 b S1 a D a This is the pre-tariff price of an imported good. b A tariff increases the price, moving the supply curve up the demand curve by the amount of the tariff. c There is less demand at the new, higher price, so the supply of imported goods is reduced. Quantity supplied IMPACT 2 Trade Wars Trade wars often occur when nations disagree on quotas or tariffs. One recent trade war, however, came about in 1999 when the European Union banned the importation of hormone-treated U.S. beef. Many U.S. ranchers treat their cattle with hormones, which cause the animals to develop muscle faster than untreated animals. But EU scientists, citing health concerns, helped push through a ban. In response, the United States levied 100 percent tariffs on a range of EU products, including ham, onions, mustard, chocolate, and Roquefort cheese. APPLICATION Applying an Economic Concept B. Boeing, a U.S. airplane producer, and Airbus, its European competitor, each claim the other receives unfair governmental support. Why does each object to the alleged unfair support? QUICK RE
FERENCE trade war succession of increasing trade barriers between nations 522 Chapter 17 Arguments for Protectionism KEY C ONCEPT S Considering all the disadvantages of trade barriers, why would a country enact such laws? The answer lies in the concept of protectionism, the use of trade barriers between nations to protect domestic industries. Protectionists argue that trade barriers protect domestic jobs, promote infant industries (new industries that are often unable to compete against larger, more established competitors), and protect national security. ARGUM ENT 1 Protecting Domestic Jobs Between 2000 and 2003, Stark County, Ohio, lost ten percent of its manufacturing jobs, including hundreds at a plant that makes Hoover vacuum cleaners. Imports from Asia and Mexico forced a ten percent drop in the price of vacuum cleaners. The U.S. workers, many of whom earned high wages to do their skilled work, were understandably upset by the shift of their jobs to overseas facilities. In Ohio and elsewhere, people argue that trade barriers are needed to protect domestic jobs, even though, in reality, these actions generally protect inefficient production and result in higher prices for everyone. Voters in industrial areas bring their voices to the national debate about foreign trade. By doing so, they have helped bring about federal job training programs for workers who find themselves unemployed as a result of the movement of jobs to places where the per unit cost of labor is lower. QUICK REFERENCE Protectionism is the use of trade barriers between nations to protect domestic industries. Infant industries are new industries that are often unable to compete against larger, more established competitors. Irish Success Bono suggested that Ireland’s ability to protect its industries helped the Irish economy become stronger. ARGUM ENT 2 Protecting Infant Industries What was an Irish rock star, Bono, doing at the 2006 World Economic Conference in Davos, Switzerland? For one thing, this performer, known for his commitment to Africa, was arguing that African infant industries should be protected. Referring to the history of his own country, he said that Irish infant industries were protected in their day but that such protection is “denied... to the poorest countries in the world.” The idea behind protecting infant industries is to assist newly developing industries in their growth process until they are able to compete with better-developed foreign rivals. This argument is often used by newly developing nations to keep out goods from economically well developed nations. In Africa, for example, Uganda has received protection for its infant industries in the form of tariffs on exports from neighboring Kenya. However
, even with these protective tariffs, Ugandan industry has not yet found a way to become competitive on its own and continues to request extensions of the tariff. This example points to a potential problem. Critics say that, provided with a sheltered existence that is free from the need to compete on equal terms, these industries settle into perpetual infancy. And a perpetual infant needs perpetual support. International Trade 523 Non-Economic Trade Barriers Some nations impose trade barriers for religious reasons. Iran, for instance, has banned any Western movies that portray secularism, feminism, and other activities deemed unethical. Western popular music has also been deemed indecent and “un-Islamic” and, therefore, banned. These barriers have driven demand for Western movies and music underground, where they can be found on the black market. Some nations enact trade barriers based on more general notions of culture. During the 1994 round of negotiations related to the Global Agreement on Tariffs and Trade (GATT), the French movie industry won a victory on a principal close to its heart. It’s known as the cultural exception, and it basically states that cultural goods are different from other goods and should not be covered by trade agreements. The cultural exception has been used, notably by France and Canada, to boost domestic television and film industries (through subsidies and quotas) and limit foreign competition, mostly from the United States. French movie poster Without these protections, the exception’s proponents say, a handful of U.S. media multinationals would be able to dominate the area of audiovisual entertainment, thereby overwhelming the traditional cultures of other nations. CONNECTING ACROSS THE GLOBE 1. Explaining an Economic Concept Some would argue that all trade barriers lack sound, economic reasoning. Do you agree? Why? 2. Making Inferences and Drawing Conclusions Which one of the three arguments for protectionism most resembles the actions taken by France and Canada? Explain. ARGUMENT 3 Protecting National Security National security affects the trade of industries that nations consider to be vital to their safety. The energy industry is considered vital by most. In 2005, a governmentrun Chinese company bid on U.S. oil company UNOCAL. Many in Congress and elsewhere in the United States warned against allowing a foreign government to take over an important U.S. energy supplier. After the House of Representatives voted 398 to 15 to ask President Bush to step in, the Chinese company withdrew its bid. But sharp political differences exist over what industries are truly vital to national security
. In 2006, a company from Dubai, which had purchased the rights to operate port facilities in New York, Miami, New Orleans, and elsewhere, was forced to abandon the deal in light of political pressure over port security. Many analysts were skeptical of the security concerns, however, and worried more about the implications of interference in free international trade for purely political reasons. APPLICATION Making Inferences and Drawing Conclusions C. Do you think that political pressure for protectionist trade barriers rises or falls during a recession? Explain your answer. 524 Chapter 17 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in the following pairs: a. trade barrier b. tariff c. trade war d. infant quota voluntary export restraint protective tariff industries protectionism 2. Why would a country engage in dumping? 3. How does a trade war get started? What effects does it have? 4. Why do some people feel that barriers to free trade are essential for national security? 5. Who benefits from trade barriers, inefficient or efficient producers? Cause quota Effect higher prices 6. Using Your Notes Take a position on free trade vs. protectionism and explain your position in a brief essay. Refer to your completed cause-and-effect chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com. Analyzing Cause and Effect In 1996, the United States expanded the embargo against Cuba, declaring that any foreign corporation that engaged in trade with Cuba would lose its privilege of trading with the United States. Give two possible effects of this embargo expansion. 8. Solving Economic Problems If you were the CEO of a manufacturing company facing stiff foreign competition, what are some ways you could adjust your business to stay competitive? What are the advantages and disadvantages of these changes? 9. Applying Economic Concepts Give three examples of U.S. citizens earning an income by selling products domestically that were made in other countries. Give three examples of U.S. citizens earning an income by selling products or services that are ultimately purchased by people in other countries. 10. Challenge A trade agreement between Kenya and some nations in Europe requires Kenyan farmers, most of whom have small peasant farms, to comply with 400 conditions before they can export their produce to European countries. They must be able to document the fertilizers, pesticides, and other additives used in the growing of their crops. How would you categorize this trade restriction? What impact do you think it will have on Kenyan exports and prices in the European nations
? Analyzing Tariff Rates Look at the graph below showing selected U.S. tariff rates for nations with which it has “Normal Trade Relations” (NTR), also known as the “most-favored nation” (MFN) status. Item NTR/MFN Tariff (%) Ceramic tableware Cars Trucks Most bicycles Sports footwear 4.5 2.5 25.0 11.0 10.5 Analyzing and Interpreting Data How much does the cost of a $32,000 truck increase because of the tariffs? If you pay $245.31 for a bicycle, what amount is the tariff? Challenge Suppose a pair of imported running shoes costs $10. With the tariff added, the importer has to pay $11.50. The importer, however, has to raise the price of the shoes to cover the expense of selling and shipping them to retailers, and retailers have to raise the price to cover their expenses in selling the shoes. Assuming the price increases by 50 percent at each stage of the process, what amount does the initial $1.50 tariff grow into? International Trade 525 S E C T I O N 3 Measuring the Value of Trade TA K I N G N O T E S In Section 3, you will • describe how nations determine the value of their currency in a world market • explain why nations want a favorable balance of trade foreign exchange market, p. 526 foreign exchange rate, p. 526 fixed rate of exchange, p. 526 flexible rate of exchange, p. 527 trade weighted value of the dollar, p. 528 balance of trade, p. 529 balance of payments, p. 529 trade surplus, p. 529 trade deficit, p. 529 As you read Section 3, complete a cluster diagram summarizing key information about measuring trade. Use the Graphic Organizer at Interactive Review @ ClassZone.com Measuring Trade Foreign Exchange KEY CONCEPT S If a certain good costs $100, how many euros does it cost? How many Mexican pesos? Or Russian rubles? International trade requires some way to establish the relative value of the different currencies of the nations doing the trading. So nations have worked out systems that facilitate the exchange of currencies between buyers and sellers. One key element is the foreign exchange market, a market in which currencies of different countries are bought and sold. This market is a network of major commercial and investment banks that link the economies of the world. Another key element in facilitating international trade is the
foreign exchange rate, the price of one currency in the currencies of other nations. Rates of Exchange During the 1800s and early 1900s, gold was the standard against which the value of a nation’s currency was determined. Nations traded on the basis of a fixed rate of exchange, a system in which the currency of one nation Currency Exchange The Mexican peso, the Australian dollar, and the Chinese yuan are all bought and sold on the foreign exchange market. QUICK REFERENCE In the foreign exchange market, the currencies of different countries are bought and sold. The foreign exchange rate is the price of a currency in the currencies of other nations. With a fixed rate of exchange, the currency of one nation is fixed, or constant, in relation to other currencies. 526 Chapter 17 QUICK REFERENCE The flexible rate of exchange is a system in which the exchange rate for currency changes as supply and demand for the currency changes. is fixed, or constant, in relation to other currencies—in this case to gold. After the profound economic disruption of World War II, other currencies were “pegged” to the stable U.S. dollar. That is, their currency was valued according to its relation to the U.S. dollar. The price of an ounce of gold was fixed at $35. The volatile 1970s brought another change. As the United States ran up a trade deficit and the dollar declined in value, the standard of $35 per ounce of gold was no longer sustainable, and the flexible rate of exchange, also called the floating rate, became predominant. This is a system in which the exchange rates for currencies change as the supply of and demand for the currencies change. For example, suppose that one British pound (GBP) is worth two U.S. dollars (USD). If an American importer wants to buy 100 British-made watches valued at 100 GBP each, then the importer would sell 20,000 USD in the foreign exchange market to obtain the necessary 10,000 GBPs. As the supply of dollars increases, their relative value drops. So the next time the importer wants to buy watches, the exchange rate might be 1 GPB:2.5 USD, and the watches would cost 25,000 U.S. dollars, making them less attractive as imports. Over time, the flexible exchange rate acts as a regulator on foreign exchange, balancing imports and exports. M AT 17.7 Calculating Exchange Rates Suppose you want to buy a book in
Germany, where the currency is the euro (€). The book costs €25, and the seller wants you to pay in euros, but you have U.S. dollars. To buy the book you must first buy euros. To find out how much €25 costs in U.S. dollars, you must know the exchange rate. In this case, let’s say the exchange rate is 1.25, which means that one euro costs $1.25. Now use the following formula. Example Calculation Amount of currency you want to buy × Exchange rate = Cost in currency you have €25 × 1.25 $/€ = $31.25 To buy €25, you must pay $31.25. Reciprocal exchange rate The exchange rate 1.25 can be written as a fraction: $1.25/€1. You can use this fraction to find the exchange rate a German must use to buy U.S. dollars with euros. First take the reciprocal of the fraction by swapping the numerator and the denominator; then use a calculator to write the fraction as a decimal. The reciprocal of $1.25 €1 is €1, $1.25 which is 0.80 €/$ So to convert from U.S. dollars to euros, multiply by the exchange rate 0.80. International Trade 527 QUICK REFERENCE The trade-weighted value of the dollar is a measure of the international value of the dollar. Strong and Weak Currencies AND U. S. TRADE FIGURE 17.8 THE STRONG DOLLAR The Federal Reserve keeps a measure of the international value of the dollar called the trade-weighted value of the dollar. It determines if the dollar is strong or weak as measured against another currency. Because of the flexible exchange rate, as currencies are traded, some increase or decrease in value when measured against another currency. For example, if the U.S. dollar becomes stronger in comparison to the Mexican peso, then the U.S. dollar buys more Mexican pesos than it could previously. What this means is that imports from Mexico now cost less. As you can see in Figure 17.8, importers in the United States benefit because they are able to buy foreign goods and services relatively cheaply. but exports from the U.S. become more expensive and decrease imports to the U.S. become less expensive and increase As the value of the dollar increases At the same time, however, goods made in the United States
may have a hard time competing with these inexpensive imports in the U.S. domestic market. Also, the strong dollar has a negative effect on U.S. exporters, since goods made here would be more costly to purchase abroad at the strong dollar rate. The weak dollar has the same effects but in reverse, as imported goods become more expensive and exporters are able to sell relatively cheaply. YO U R EC STRONG DOLL AR AND WE AK DOLL AR Which sweater will you buy? The U.S. dollar is very weak versus the Hong Kong dollar (HKD). How might this influence your decision to buy a new sweater made in the United States, or one imported from Hong Kong?? Domestically produced Imported from overseas APPLICATION Applying Economic Concepts A. If you are an American exporter, does a strong dollar help your business? Explain. 528 Chapter 17 Balance of Trade KEY C ONCEPT S In Chapter 12, you read about net exports as an economic measure. Another name for the difference between the value of a country’s imports and exports is its balance of trade. It is tallied through the balance of payments, a record of all the transactions that occurred between the individuals, businesses, and government units of one nation and those of the rest of the world. The U.S. balance of payments includes the goods and services traded between it and other nations, as well as the investments foreign interests make in the United States and those made by Americans in a foreign country. A nation is said to have a favorable balance of trade if it has a trade surplus—that is, it exports more than it imports. If a nation imports more than it exports it has a trade deficit, also known as an unfavorable balance of trade. E XAMPLE U.S.-China Trade In recent years, China has undergone one of the most rapid industrializations in history. In addition to its fast-growing output of manufactured goods, the Chinese currency, the RenMinBi (RMB), or yuan, has also been weak compared to the U.S. dollar. The yuan’s weakness versus the dollar resulted from China’s decision to peg its value at a fixed rate versus the dollar, beginning in 1994. This artificially weak position helped make the United States the number-one destination for Chinese exports. By 2005, China had a record trade surplus of just over $200 billion with the United States. The surplus helps China fuel its continued manufacturing growth. QUICK REFERENCE
A nation’s balance of trade is the difference between the value of its imports and exports. The balance of payments is a record of all the transactions that occurred between the individuals, businesses, and government units of one nation and those of the rest of the world. A nation with a trade surplus exports more than it imports. A nation with a trade deficit imports more than it exports. FIGURE 17.9 BAL ANCE OF U. S. T R ADE WITH CHINA Year 2000 2001 2002 2003 2004 2005 –83.8 –83.1 –103.1 –124.1 –162.0 –201.25 –50 –75 –100 –125 –150 –175 –200 –225 Source: U.S. Census Bureau Foreign Trade Statistics ANALYZE GRAPHS 1. Between which two years did the trade deficit with China grow the most? 2. If the dollar were weaker than the yuan, would you expect the trend shown in the graph to continue? Why? International Trade 529 For an update on the U.S. balance of trade go to ClassZone.com EXAMPLE The U.S. Trade Balance The balance of trade in the United States has gone through roughly five phases. From about 1770 to 1870, the young nation had a deficit in goods and services but a surplus in capital investment from foreign countries that recognized the nation’s potential for growth. Between 1870 and 1920, the nation was paying back foreign debts from the previous phase, but it was also exporting more goods and services than it was importing. In the years between 1920 and 1945, the United States had a surplus in exports but a deficit in foreign investments, as the nation sought to help rebuild Europe after World War I. From 1945 to 1980, the nation had a deficit in merchandise and continued its deficit in foreign investments as large amounts of money went to post–World War II reconstruction. In the current phase, the United States has a large surplus of foreign investment, which is attracted by a relatively low inflation rate and a generally stable economy. However, high rates of consumer spending (versus low rates of saving), as well as high oil prices (which significantly increased the dollar value of U.S. imports) have helped create a very large merchandise deficit. An advantage of this deficit is that it allows U.S. consumers to buy low-priced imports. A disadvantage is that financing the deficit may require borrowing money from the rest of the world, selling off assets, or tapping into foreign currency reserves
. FIGURE 17.10 U. S. BAL ANCE OF TR ADE 2000 2001 Year 2002 2003 2004 2005 –416.0 –389.5 –475.2 –520.0 –668.1 –805.150 –300 –450 –600 –750 –900 Source: U.S. Department of Commerce, Bureau of Economic Analysis ANALYZE GRAPHS 1. In what year did the U.S. balance of trade improve? 2. Does this overall trend point to rising or falling prices for U.S. consumers? APPLICATION Analyzing Cause and Effect B. Between 1870 and 1920, the United States was exporting more goods and services than it imported. What does this say about the relative strength of the dollar during this period? 530 Chapter 17 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. foreign exchange market foreign exchange rate b. fixed rate of exchange flexible rate of exchange c. trade surplus trade deficit 2. What is an advantage of a trade surplus? A disadvantage? 3. What is an advantage of a trade deficit? A disadvantage? 4. How does the value of the U.S. dollar affect the U.S. trade surplus or deficit? 5. How does a flexible exchange rate help to stabilize trade balances? 6. Using Your Notes Write a brief essay arguing for or against a single world currency. Refer to your completed cluster and use the section’s key words. Use the Graphic Organizer at Interactive Review @ ClassZone.com Measuring Trade 7. Analyzing Cause and Effect In July 2005, the Chinese RMB became fixed to a “market-basket” of currencies, including the U.S. dollar and the Japanese yen, removing a decade-long peg to the U.S. dollar alone. The new formula slightly raised the value of the RMB. If China’s trade surpluses continue, what will happen to the value of the RMB? 8. Applying an Economic Concept While you are in France on a business trip, you find out that the euro has gained strength against the U.S. dollar. Will your hotel room and food now be more or less expensive? Why? What about the goods you’re trying to sell on your trip; will they be more or less expensive to your customers in France? Why? 9. Making Inferences and Drawing Conclusions Japan
has the world’s largest foreign currency reserves, followed by China. State two conclusions you can draw about the economies of these two nations based on their foreign currency reserves. 10. Challenge What are the advantages of a large supply of foreign investment in a domestic economy? What are the disadvantages? Understanding Exchange Rates Just as there are stock markets for trading company shares, there are currency markets for trading currencies. The picture shows the prices of three currencies in dollars and how the prices have changed. One Buys U.S. Dollar U.S. Dollar Euro Chinese Yuan Indian Rupee 1.00 1.32 0.13 0.02 Euro 0.76 1.00 0.10 0.02 Chinese Yuan Indian Rupee 7.82 10.33 1.00 0.18 44.48 58.72 5.69 1.00 Average rates, December 2006 Analyze Data Use this exchange rate table to answer the following questions. • How much of each of the other currencies will $5 U.S. purchase? • If the exchange rate from euros to dollars changed from 1.32 to 1.40, which currency has gotten weaker? • How would that affect EU businesses that export to the United States? Challenge Why might businesses need to buy foreign currencies? International Trade 531 S E C T I O N 4 Modern International Institutions TA K I N G N O T E S In Section 4, you will free-trade zone, p. 532 • describe what agreements customs union, p. 532 were made to start the freetrade movement • identify international and regional trade groups • explain what role multinationals play in world trade European Union, p. 532 euro, p. 533 NAFTA, p. 533 OPEC, p. 535 cartel, p. 535 WTO, p. 535 As you read Section 4, complete a summary chart like the one shown, using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Regional International Regional and World Trade Organizations KEY CONCEPT S Following the failed protectionist policies of the 1930s, nations have sought to expand trade and reduce or eliminate trade barriers. They have organized regional trading groups to create free-trade zones, specific regions in which trade between nations takes place without protective tariffs. Some have created customs unions, agreements that abolish trade barriers among the members and establish uniform tariffs for non-members. Some of these organizations are called common markets. As a result of these efforts,
global tariffs have dropped by about one-third. GROU P 1 The European Union In 1957, six European nations recognized the benefits of abolishing trade barriers and formed a customs union called the European Economic Community. It was widely known as the Common Market. In 1993 the Common Market evolved into the European Union, or EU, which tightly bound its member nations to one another both economically and politically. The political nature of the EU, the fact that its members surrender some sovereignty in specified areas, makes it unique among EU Expansion Lithuanians celebrate their nation’s admission to the EU in 2004. QUICK REFERENCE A free-trade zone is a specific region in which trade between nations takes place without protective tariffs. A customs union is an agreement that abolishes trade barriers among its members and establishes uniform tariffs for non-members. The European Union, the EU, is an economic and political union of European nations established in 1993. 532 Chapter 17 trading groups. The Treaty on European Union had monetary union and a common foreign policy as key goals. Monetary union was established in 2002, as 12 member states adopted the euro. (See “The Euro as Common Currency” on p. 292.) The six original members were Belgium, France, Germany, Italy, Luxembourg, and the Netherlands. In 1973, Denmark, Ireland, and the United Kingdom became members. Greece joined in 1981, and Portugal and Spain in 1986. In 1995, after the Common Market became the European Union, Austria, Finland, and Sweden joined. In 2004, ten nations became members: Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia. In 2007, Bulgaria and Romania joined, raising the total number of members to 27. The EU accounts for about 20 percent of global exports and imports, making it the world’s biggest trader. It has removed barriers to free trade among member nations, with the ultimate goal that Europe’s national borders will be no more a barrier to free trade than are the borders of U.S. states. GRO UP 2 NAFTA In 1990, negotiations began on a free-trade agreement among the United States, Canada, and Mexico. The result of these negotiations, the North American Free Trade Agreement, or NAFTA, created the largest free-trade zone in the world. When it went into effect on January 1, 1994, it immediately eliminated tariffs on half of the goods exported to Mexico from the United States. The agreement called for an eventual phase-out of
all trade barriers on goods and services. It also called for improved protection of intellectual property rights, stronger environmental and worker protections, and standardized investment policies. The advantages of NAFTA include specialization and increased efficiency, a competitive advantage over the EU and Japan, expanded markets, and new jobs. And while some object to NAFTA on a number of political, social, and even environmental grounds, the economic results appear robust. (See Figure 17.11.) Between 1993 and 2003, Mexico and Canada experienced economic gains as well. Two-way agricultural QUICK REFERENCE The euro is the currency of the European Union. QUICK REFERENCE NAFTA, the North America Free Trade Agreement, is designed to ensure trade without barriers between Canada, Mexico, and the United States. FIGURE 17.11 NAFTA’S FIRST TEN YEARS 145.3 87. ( 150 120 90 60 30 0 1993 2003 Years Source: Office of the U.S. Trade Representative ANALYZE GRAPHS ( 150 120 90 60 30 0 105.4 46.5 1993 2003 Years 1. Which nation, Canada or Mexico, increased its trade with the United States by a larger percentage? 2. Is an increase in trade typically beneficial for nations? Explain. International Trade 533 trade between Mexico and the United States increased 125 percent—from $6.2 billion in 1993 to $14.2 billion in 2003. Productivity in Mexico increased a remarkable 55 percent. Canada’s exports to its NAFTA partners increased by 104 percent, and its overall economy grew by over 30 percent. Overall trade between the three partners more than doubled during this period, from $289.3 billion in 1993 to $623.1 billion in 2003. GROU P 3 Other Regional Trade Groups Throughout the world, nations are forming trade organizations to specialize, promote free trade, and stay competitive with other trade groups. Descriptions of a number of these agreements from all parts of the world follow: Mercosur (Mercado Comun del Cono Sur) This group promotes the movement of goods and people in South America. Formed in 1995, Mercosur eliminated tariffs on 90 percent of goods traded between the group’s full members (Argentina, Brazil, Paraguay, and Uruguay). Venezuela became a full member in July of 2006. Counting associate members Mexico, Chile, Bolivia, and Peru, Mercosur has become the world’s fourth-largest trade association. ASEAN The Association of Southest Asian Nations was formed in 1967
to accelerate economic growth, social progress, and cultural development in the region, and to promote regional peace and stability. Its members include Indonesia, the Philippines, Singapore, Thailand, Vietnam, Laos, Cambodia, and others. F I G U R E 17.12 Some Regional Trade Groups G8 G8 G8 G8 G8 G8 G8 G8 Andean Community Asia-Pacific Economic Cooperation (APEC) Association of Southeast Asian Nations (ASEAN) Common Market for Eastern & Southern Africa (COMESA) Commonwealth of Independent States (CIS) European Union (EU) G8 Group of Eight (G8) North American Free Trade Agreement (NAFTA) Organization of Petroleum Exporting Countries (OPEC) Southern Common Market (MERCOSUR) Southern African Development Community (SADC) ANALYZE MAPS How many trading groups do the United States and Canada belong to? Why does it make sense for such developed nations to be part of multiple trading groups? 534 Chapter 17 QUICK REFERENCE OPEC is the Organization of Petroleum Exporting Countries. A cartel is a group of producers that regulates the production, pricing, and marketing of a product. QUICK REFERENCE The World Trade Organization, or WTO, is a group of nations that adhere to the policies of the General Agreement on Tariffs and Trade. APEC The Asia-Pacific Economic Cooperation group is a trade organization of nations on the Pacific Rim—those that are adjacent to or within the Pacific Ocean. It includes developed nations such as Australia, Japan, and the United States, transitional economies such as Russia and China, as well as less developed countries such as Thailand, Papua New Guinea, and Chile. The group has set ambitious goals for trade liberalization throughout the region by 2020. However, since all APEC decisions require a unanimous vote, progress toward its goals has been slow. OPEC The Organization of Petroleum Exporting Countries is a cartel—a group of producers who regulate the production, pricing, and marketing of a particular product. In OPEC’s case, that product is petroleum, or oil. It has had mixed results in controlling the oil market since its formation in 1960. However, surging demand, from nations such as China and the United States, and periods of regional political instability have strengthened OPEC’s position in recent years. SADC Founded in 1979, the South African Development Community’s original goal was to act as a counterbalance to the region’s main economic power—South Africa.
(After South Africa finally abandoned minority white rule—the apartheid system—it also became a member in 1994.) A regional free-trade zone was established in 2000. Dedication to free trade is a key element in boosting the region’s economies. However, corruption, political instability, various health issues (most importantly, AIDS), substandard education, and poor infrastructure consistently hamper development. (You’ll learn about these and other development issues in Chapter 18.) GRO UP 4 World Trade Organization In 1944, the Allied nations met to plan for recovery after World War II. Among other important outcomes, they produced the General Agreement on Tariffs and Trade (GATT), which laid out rules and policies for international trade. In 1995, the GATT principles were incorporated into a new organization, the World Trade Organization, or WTO. At the end of 2005, the WTO had 149 member nations. The purposes of the WTO include negotiating and administering trade agreements, resolving trade disputes, monitoring the trading policies of member nations, and providing support for developing countries. The principles underlying these purposes are that trade rules should apply equally to domestic and imported products. To that end all member nations should extend one another Normal Trade Relation (NTR) status, formerly known as Most Favored Nation (MFN) status. This means that no nation should extend more favorable trade terms to one WTO member than it does to another. Members should also work toward lowering trade barriers of all kinds and support fair trade as well as free trade. To varying degrees, the WTO has been successful. It has helped reduce tariffs on manufactured goods, lower trade barriers in agriculture, and promote intellectual property rights. It has also resolved disputes among members while maintaining each nation’s sovereignty, and promoted stability among member nations. AP P LI CATION Making Inferences and Drawing Conclusions A. Why do you think the term most favored nation has been replaced by normal trade relations? International Trade 535 Multinationals Bring Changes to International Trade KEY CONCEPT S Multinational corporations (see Chapter 8) cross many borders and must deal with tariffs, labor restrictions, and taxes in different nations. They often bring jobs and technology to developing nations, while boosting overall levels of international trade—something that benefits everyone involved. International Trade Within Multinationals As multinationals have become more prevalent, trade between the various divisions of multinationals has become an area of increasing interest. Intrafirm trade, as it is known, can simply be the exchange of goods between two parts of a multinational.
But international intrafirm trade also covers the coordination of production between parts of a multinational. This means, for instance, that when a U.S. parent company sends parts to an overseas affiliate to assemble, that is counted in the export column for U.S. statistics on trade. Likewise, when the assembled goods are shipped back to the U.S. parent from its overseas affiliate, that is counted in the import column. In general, intrafirm imports account for about 40 percent of total U.S. imports. Intrafirm exports account for about one-third of total U.S. exports. EXAMPLE A Multinational Telecom Corporation Consider the case of Worldwide Cellular, a U.S.-based multinational that makes, markets, and services cellular phones. It imports an essential raw material from its mining arm in Australia, manufactures the phones at its facility in South Korea, markets the phones in Europe, and then directs customers who have questions or complaints to technical support and customer service representatives in India. Throughout the process, the people and the economies of each nation benefit. South Korean manufacturing Indian call center ▲ Australian mining ▲ European marketing and sales APPLICATION to come B. In 1969, there were about 7,200 known multinationals. By 2000, that number had grown to more than 63,000. Give three possible contributing reasons for that growth. 536 Chapter 17 S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs: a. free-trade zone customs union b. EU NAFTA c. OPEC cartel 2. What circumstances led to a liberalization in global trading? 3. How do customs unions help member nations? 4. How is the EU different from other regional trading groups? 5. What are some advantages of NAFTA? 6. Using Your Notes Write a brief Regional International summary of the major regional and international trade organizations. Refer to your completed summary chart and use the section’s key words. Use the Graphic Organizer at Interactive Review @ ClassZone.com. Making Inferences and Drawing Conclusions Some regional trade associations are viewed as an attempt by less developed countries to protect themselves and their regions from globalization’s aggressive momentum. Explain how regional groups might have that effect. 8. Analyzing Cause and Effect Many multinationals grew out of exporting businesses. How might the exporting business prepare a company to become a multinational? 9. Predicting Economic Trends Before NAFTA was passed, some experts predicted a
reduction in illegal immigration from Mexico to the United States. In fact, in the first few years after NAFTA went into effect, illegal immigration increased. What reasoning might have explained the prediction that illegal immigration would decline? What reasons might explain the increase? 10. Challenge At the Hong Kong gathering of the World Trade Organization in 2005, Supachai Panitchpakdi, secretary general of the United Nations Conference on Trade and Development (UNCTAD) said: “Rich countries will have to reject not just protectionism, but populism, too. They will have to speak honestly to their people about the changing economies of the 21st century, and about global interdependence and the fact that prosperity elsewhere means prosperity and jobs at home.” Write a brief essay that “speaks honestly” to the rich countries about the changing economies of the 21st century. The Effects of NAFTA Between 1993 and 2002, the total trade among Canada, the United States, and Mexico more than doubled. The table below shows export figures for NAFTA members Canada and Mexico in each of those years. Exports (in billions of dollars) Nation 1993 2002 Canada to United States 113.6 213.9 to Mexico Mexico.9 1.6 to United States to Canada 31.8 2.9 136.1 8.8 Analyzing and Interpreting Data Canada has a higher export amount than Mexico, but did its level of trade increase more than Mexico’s in the interval? Explain. Challenge Can Canadian companies produce, package, and market products for both of its NAFTA partners in the same way? Explain why or why not. International Trade 537 Case Study Find an update on this Case Study at ClassZone.com Analyzing Tariffs—Who Wins and Who Loses? Background Tariffs on foreign sugar have been around almost as long as the United States itself. Although early tariffs were a form of revenue, their purpose expanded in the 19th century to provide protection for the domestic sugar industry. That protection continues to this day. Globalization, however, is having a direct impact on the way nations trade. Agricultural subsidies and tariffs have become a point of contention in recent WTO talks, with less-developed countries unhappy about the lack of market access for their goods and about their price disadvantage. What’s the issue? How do the trade barriers set up by the U.S. government affect producers (both foreign and domestic) and consumers? A. Online Article This article describes how the U.S. government supports sugar prices. Note
that sugar subsidies are paid to the processor, rather than the farmer. The farmer receives a share once the sugar is processed. Sugar Interests Harm the National Interest USDA loan rates set floor on price of sugar. The [government] program allows sugar processors to take out loans from the USDA [U.S. Department of Agriculture] by pledging sugar as collateral. The loan rates—18 cents per pound for cane sugar, 22.9 cents per pound for beet sugar—are significantly higher than average world sugar prices. These loans must be repaid within nine months, but processors also have the option of forfeiting their sugar to the government in lieu of repaying their debt. This arrangement effectively guarantees that the processors receive a price for their sugar that is no lower than the loan value: If prices fell below that level, they would simply forfeit their sugar and keep the government’s money. In order to avoid that scenario, the USDA must prop up the domestic price of sugar. It does this by controlling supply through two mechanisms. First, it sets quotas on how much foreign sugar can be imported without facing prohibitive tariffs; second, it regulates the amount of sugar that domestic processors can sell. Source: Jason Lee Steorts, National Review, July 18, 2005 Thinking Economically In your own words, describe the mechanisms by which the U.S. government props up domestic sugar prices. 538 Chapter 17 B. Government Report This information from the U.S. Department of Agriculture charts U.S. raw sugar prices versus raw sugar prices for the rest of the world. FIGURE 17.13 U. S. AND WORLD RAW SUGAR PRICES 25 20 15 10 Key: U.S. raw sugar prices World raw sugar prices 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Source: U.S.D.A., Economic Research Service, Sugar and Sweeteners Yearbook, 2006 Year Thinking Economically On average, how much greater are U.S. raw sugar prices than those for the rest of the world? C. Trade Association Web Page The American Sugar Alliance’s Web site makes the case that the U.S. sugar industry is an important part of the overall U.S. economy. Sweetener’s Impact on the U.S. Economy The American sweetener industry has a significant impact on the nation’s economy. • Economic impact: $21.1 billion of economic activity in 42 states is generated in the U.S. each year by the sugar and corn sweetener
industries. • Beet sugar industry: Over 1,400,000 acres of sugarbeets are grown in 12 states and are processed in 25 sugarbeet factories. The industry creates 88,200 full time direct and indirect jobs for people across the nation. • Cane sugar industry: Seven cane refineries and 22 mills process sugar cane raised in four states: Florida, Hawaii, Louisiana and Texas. The production and processing of sugarcane creates 71,900 full time direct and indirect jobs. • Jobs: 372,000 jobs in the U.S. rely on a strong U.S. sweetener industry. Source: www.sugaralliance.org Thinking Economically Why does the American Sugar Alliance want to emphasize the economic impact of the sugar industry? THINKING ECONOMICALLY Synthesizing 1. Which argument for protection does document C seem to make? Use the document and pages 523 and 524 to formulate your answer. Is this argument economically valid? Explain. 2. Is the difference in price shown in document B an unavoidable outcome of the program outlined in document A? Explain your answer. 3. How does U.S. government intervention in the sugar industry limit the functioning of the economy as a free market? Use examples from the documents in your answer. International Trade 539 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. absolute advantage balance of trade comparative advantage economic interdependence embargo exports foreign exchange market foreign exchange rate free trade zone imports NAFTA protectionism quota revenue tariffs tariff trade barrier trade deficit trade surplus trade war WTO When nations can produce something at a lower cost than other nations, they are said to have a(n) 1. This is different from a(n) 2, which means that goods or services are produced at a lower opportunity cost. Through trade, nations develop 3, relying on one another. Policies of 4 have created 5 between nations, including 6 —limits on imports—and 7 —fees charged on goods brought into a country. International trade would not be possible without the 8, where currencies of different countries are bought and sold. Nations keep track of their 9, the difference between their exports and their imports. With a 10, large reserves of foreign currency accumulate. With a 11, domestic
consumers enjoy lower prices. The trend since the end of World War II has been toward free trade. Nations have formed regional 12 that abolish trade barriers among members. In 1994 the United States became part of a trading organization with Mexico and Canada known as 13. 540 Chapter 17 CHAPTER 17 Assessment Benefits and Issues of International Trade (pp. 510–519) 1. How do nations gain by specializing in products for which they have a comparative advantage? 2. How does trade affect a national economy? Trade Barriers (pp. 520–525) 3. Name and describe four trade barriers. 4. What three reasons are protectionists likely to offer to support their position? Measuring the Value of Trade (pp. 526–531) 5. Explain how an importer purchases a foreign product and what effect those actions would have on the value of each currency. 6. What does the term strong dollar mean? Modern International Institutions (pp. 532–539) 7. What agreements helped launch the free trade movement? 8. Create a fictional multinational and explain how it might operate from raw materials all the way through marketing the finished product. A P P LY Look at the graph below showing U.S. imports and exports to and from various trading regions. 9. To which group does the United States export the lowest dollar value of goods and services? 10. With which group does the United States have the largest trade deficit? the smallest trade deficit? FIGURE 17.14 U.S. TRADE WITH REGIONAL GROUPS 1,000 ( 800 600 400 362.2 266.9 200 0 814.0 496.6 Key: Imports from Exports to 21.4 14.5 81.9 45.3 NAFTA MERCOSUR APEC ASEAN Source: www.eurunion.org Trade groups 11. Creating Graphs Create a bar graph to illustrate the following trade data for selected regions. The EU25 is made up of the 15 countries that were members of the European Union in 2003 and the 10 that would become members in 2004. FIGURE 17.15 SELEC TED REG IONS Country or region United States EU25 Japan Total imports (billions of U.S. dollars) Total exports (billions of U.S. dollars) World import share (percent) World export share (percent) 1,517 1,047 477 1,021 1,250 597 22.9 14.0 13.8 13.1 6
.8 8.5 Source: Eurostat, 2003 data Use to complete this activity. @ ClassZone.com 12. Analyzing and Interpreting Data Which two of the three trading entities in the table above are likely to have good reserves of foreign currency? 13. Synthesizing Economic Data In which trading entity in the table above are imports the highest percent of total trade value? The lowest? 14. Comparing and Contrasting Economic Information What are developed nations hoping to gain through reduced global trade barriers? What are developing nations hoping to gain? 15. Challenge The World Trade Organization, unlike GATT, has an organizational structure to implement its principles. However, it has no authority to force a nation to do something against its own laws. How is it able, then, to resolve disputes among members? The Advantages of International Trade The concept of comparative advantage explains why specialization and international trade are so important to economic success. Complete this exercise with a partner to help further your understanding. Each of you will represent a trading nation. One of you will be El Estado, and the other will be Lichtenbourg. Both countries produce lemons and televisions. The following table shows monthly production by each nation. El Estado Lichtenbourg Lemons (in pounds) Televisions 20,000 4,000 9,000 3,000 Step 1 Decide whether El Estado or Lichtenbourg has the absolute advantage for each product. Explain why this is so. Step 2 Each student should calculate what his or her nation’s production ratio is. Express your ratio in terms of opportunity cost. How many pounds of lemons does it cost to make one TV? Step 3 With your ratios calculated, decide which nation has the comparative advantage in the production of TVs. On this basis, decide which nation should specialize in the production of each product. Step 4 Now that you’ve decided to specialize and trade, calculate a trade ratio that makes trade between your two nations even more advantageous. Explain how the new ratio achieves this goal. International Trade 541 Economic Development Issues of economic development are as much about the basic building blocks of societies as they are about money. When governments are stable and help to provide their people with resources and opportunities, economic development can become a reality. 542 CHAPTER 18 Issues of Economic Development SECTION 1 Definitions of Development SECTION 2 A Framework for Economic Development Objectives SECTION 3 Transition to a Market Economy CASE STUDY China’s Campaign for Economic Power Free enterprise system is another name for capitalism
, an economic system based on private ownership of productive resources. C H A P T E R 18 transitional economy is a country that has moved (or is moving) from a command economy, such as communism, to a market economy AT T E R S The development of the world’s less developed countries has grown increasingly important as globalization has taken hold. Promoting development also promotes good government and economic opportunity in less developed countries. When a nation’s government is democratic and stable and its citizens are prosperous, the benefits reach beyond that emerging economy to the world community, which gains a new economic and political partner. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on trade and China’s transition to a market economy. (See Case Study, pp. 570–571.) Go to SMART GRAPHER to complete graphing activities in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. How has international trade helped China make the transition to a market economy? See the Case Study on pages 570–571. Issues of Economic Development 543 S E C T I O N 1 Definitions of Development TA K I N G N O T E S In Section 1 you will • determine how economic development is defined • explain how certain indicators can illustrate the level of economic development of a nation developed nations, p. 544 transitional economies, p. 545 less developed countries (LDC), p. 545 infrastructure, p. 545 per capita GDP, p. 546 infant mortality rate, p. 547 life expectancy, p. 547 literacy rate, p. 547 human development index (HDI), p. 547 As you read Section 1, complete a summary table like the one shown. Use the Graphic Organizer at Interactive Review @ ClassZone.com Definitions of Development Levels of Development Standards of Economic Development Levels of Development KEY CONCEPT S Do you have at least $1 in your pocket at the moment? If so, you have more money than over a billion of the world’s people have for food, shelter, and clothing for today. Economists gather this type of data to compare the economies of nations and the impact of those economies on people’s standard of living. They use the data to measure the nations’ level of economic development. QUICK REFERENCE Developed Nations Developed nations have a market economy, a relatively high standard of living, a high GDP, industrialization, widespread
private ownership of property, and stable and effective governments. 544 Chapter 18 Economists have defined three major levels of economic development. The nations with the highest standards of living are known as developed nations. In addition to a relatively high standard of living, these nations have a market economy, a high GDP, industrialization, widespread private ownership of property, and stable and effective governments. The nations of Western Europe, the United States, Canada, Australia, New Zealand, Japan, and South Korea are all developed nations. You can identify some of the features of a developed nation by looking around you. Most people live fairly comfortable lives and enjoy such consumer goods as television sets, washing machines, and cars. You will also see that most people live in urban areas, where they have jobs in service and industrial enterprises: banks, insurance companies, auto parts manufacturing, and so on. Even though few people work in agriculture, the nation produces a surplus of agricultural products using advanced science and technology and highly efficient farming methods. You will also see that, on the whole, people are generally healthy and well-educated. They have political and economic freedom, and they exercise those freedoms in pursuit of well-being. You will see exceptions to all of these features—poverty, unemployment, poor living conditions—but they are not the prevailing features of the society. Transitional Economies Economists have also defined the development that occurs in transitional economies. These are countries that have moved (or are moving) from a command economy to a market economy. China, Russia, and a number of Eastern European countries are considered to be transitional economies. Poland, in Eastern Europe, is in transition and categorized as a less developed country. Like other transitional economies, however, it is on a clear path toward improving standards of living. As democracy and economic freedom begin to take hold, Poland’s economy and its citizens’ quality of life have steadily improved. QUICK REFERENCE A transitional economy is a country that has moved (or is moving) from a command economy to a market economy. In Transition A developed economy, such as the United States (left), generally has greater access to technology than a transitional economy, such as China (right). QUICK REFERENCE A less developed country (LDC) has a lower GDP, less well developed industry, and a lower standard of living. Infrastructure is the basic support systems needed to keep an economy going, including power, communications, transportation, water, sanitation, and education systems. Find an update on health statistics
in LDCs at ClassZone.com Less Developed Countries Less developed countries (LDCs), such as many African, South American, and Eastern European countries, have a lower GDP, less well developed industry, and a lower standard of living. Often, these nations have ineffective or even outright corrupt governments that fail to protect private property rights. LDCs are sometimes called emerging economies, but some have emerged, so to speak, more than others. As a result, they can be divided into middle-income nations, such as Brazil and Thailand, and low-income nations, such as Mozambique and Cambodia. The picture in the low-income nations is starkly different from what you see when you look around the United States. A high percentage of people live in substandard housing. Few families own televisions or washing machines. Even if they owned cars, there are few good roads to drive them on, since developing nations often lack infrastructure. Infrastructure is the basic set of support systems needed to keep an economy going. It includes such things as power, communications, transportation, water, sanitation, and education systems. In these economies, a relatively high percentage of the people work at subsistence farming and have little savings. Often, even children toil with the rest of the family. Some go to school for only three or four years; some children receive no schooling. Health conditions are substandard, as medical care is hard to come by in rural areas. In many developing nations, political freedom is still a dream. AP P LI CATION Economies A. What role does technology play in economic development? Issues of Economic Development 545 Standards of Economic Development KEY CONCEPT S How is it possible to compare economies when each country may have its own ideas of what is valuable? For example, the number of television sets per thousand households yields valid information about the economic conditions in most nations. However, not every culture values television ownership to the same extent. Such statistics need to be used in conjunction with others, so that a more nuanced image of a nation’s overall level of development can be obtained. Economists use the following standards of development to bring this detailed image into focus. QUICK REFERENCE Per Capita Gross Domestic Product Per capita gross domestic product is a nation’s GDP divided by its total population. The most popular measure of economic development is per capita gross domestic product, a nation’s overall GDP divided by its total population. This statistic is informative because it estimates the amount of goods and services produced
per person in a given year. These figures can be used to compare one country to another. (See Figure 18.1.) For example, the per capita GDP of the United States is among the world’s highest—over $40,000. In Tanzania, in east Africa, it is $700—among the lowest. Often these figures are adjusted to take into account the idea that a dollar may go further in some less developed countries where goods and services are less costly. F I G U R E 18.1 World Per Capita GDPs Rank Order - GDP - per capita $22,000 and over $21,800 to $8,400 $8,300 to $4,700 $4,600 to $1,900 $1,800 to $400 No information available 546 Chapter 18 ANALYZE MAPS 1. Which continent is the least developed? 2. Which continents have no countries in the top per capita GDP bracket? Health Statistics showing various aspects of health and health care are also useful in determining economic development. Especially indicative are statistics on the survival rate of babies. This measure is called the infant mortality rate, the number of children who die within the first year of life per 1,000 live births. The infant mortality rate in Japan is 3. In China it is 23. In Angola it is 185. What can economists learn from these figures? The answer lies in understanding the conditions in which infants thrive. These conditions include a safe and sanitary birth environment with access to needed emergency care, adequate nutrition, an adequately fed mother who has access to clean drinking water and acceptable shelter, and protection from disease in the form of early-childhood vaccinations. A subsistence society, or one in extreme poverty, is unlikely to be able to provide these conditions. Less developed economies may be able to provide them to some degree, but in developed economies, these conditions are the norm. Dangerous Water More than a billion people worldwide use unsafe drinking water sources. Disease and death can be real consequences of this fact. Another useful standard is life expectancy, the average number of years a person could expect to live if current mortality trends were to continue for the rest of that person’s life. For example, people born today in Japan can expect to live to age 82, in China, to age 72, while in Angola, only to age 39. Education The World Education Forum declares in its Framework for Action that “education is... the key to sustainable development and peace and stability within and
among countries, and thus an indispensable means for effective participation in the societies and economies of the twenty-first century....” Since education is so clearly tied into the economy, education statistics are tracked as useful indicators of the development level of a nation. One key education figure is the literacy rate, the percentage of people older than 15 who can read and write. Japan’s literacy rate is 99 percent; Somalia’s is 38 percent. Another useful statistic is student enrollment at all levels. This figure tells the percentage of school-age individuals who are actually going to school. In Belgium and Japan, for example, primary-school enrollment is 100 percent. In Niger, it is about 40 percent. In 1990, another standard was introduced that combines some of these other statistics. It is the human development index (HDI)—the brainchild of Pakistani economist Mahbub ul Haq. A nation’s HDI is a combination of its real GDP per capita, life expectancy, adult literacy rate, and student enrollment figures. Its measures are an important indicator of what life is like in a specific country. QUICK REFERENCE Infant mortality rate is the number of children who die within the first year of life per 1,000 live births. Life expectancy is the average number of years a person can expect to live if current mortality trends were to continue for the rest of that person’s life. Literacy rate is the percentage of people older than 15 who can read and write. The human development index (HDI) uses targeted economic, education, and health statistics to assess a nation’s level of development. Issues of Economic Development 547 Consumption of Goods and Services In the mid-1990s, home appliances were still relatively rare in less developed countries like China. By the year 2000, however, the refrigerator had become a familiar part of Chinese city life; three out of four dwellings in major urban areas had one. Refrigerators have even begun to reach the secondary cities and rural areas, though they are still so rare there that they are sometimes displayed proudly in the living room rather than hidden away in the kitchen. Washing machines are also becoming increasingly commonplace. China’s consumption of cell phones has risen rapidly in recent years too. At the beginning of 2001, there were approximately 65 million cell phones in use in China; by 2004, there were about 335 million—more than in any other country. The number of personal computers owned in China is doubling every 28 months. What do
these statistics say about China’s economic development? These data show how people choose to spend their income after they have food and shelter. When consumption of such big-ticket items as refrigerators, automobiles, and washing machines increases, an economy is growing and developing. This indicates that people’s living standards are rising. Goods that once were available only to the rich are now purchased by middle- and even low-income families. In the less developed nations of China and India, 16 percent of the population is following this consumption pattern, compared with 89 percent of the population in Europe. The less developed nations therefore have the greatest room for growth in the consumption of consumer goods and services. For now, however, consumers in North America and Western Europe, whose population is about 12 percent of the global total, are responsible for 60 percent of the global total of consumption of goods and services. The 30 percent of the world population that lives in South Asia and subSaharan Africa, on the other hand, spends only 3.2 percent. Comparisons like the one below in Figure 18.2 offer another way to measure relative growth. F I G U R E 18. 2 Ownership of Typical Consumer Goods (per thousand residents) Country Television Sets Telephone Mainlines United States 835 Ukraine 456 India 83 Source: The State of the World, 2004 548 Chapter 18 659 212 40 Energy Use Of the roughly 6.5 billion people in the world, as many as 2 billion are without electricity. Since electricity and other forms of energy contribute to economic development, statistics on energy use can reveal an aspect of a nation’s economic development. Energy use is not spread evenly throughout the population. Asia, with 50 percent of the world’s people, accounts for just over 21 percent of annual energy consumption. For another example, the average global consumption of electricity is 2,744 kilowatt hours (KWh) per capita. Japan’s annual per capita consumption of electricity, like that of other industrialized nations, is well over 7,000 KWhs. Colombia’s annual rate of about 820 KWh per capita is typical of LDCs, which average about 750 KWh per capita each year. How the energy is put to use is another revealing statistic, especially the amount used for commercial purposes. The United States, for example, uses the equivalent energy of 8,148 kilograms of oil per person in commercial enterprises. India uses the equivalent of about 494 kilograms of oil per person for commercial activities.
The amount of energy used for commercial purposes correlates to a nation’s level of technological achievement and other economic measures. Projected energy use to the year 2025 follows the same pattern as the projected consumption of consumer goods and services, with LDCs outpacing developed nations. The LDCs are expected to increase their energy use by about 3.2 percent a year. In Asia, including China and India, the demand for energy is expected to double between 2002 and 2025. The relatively rapid increase in energy use coincides with the move toward industrialization and technological advances. In fact, transportation and industry account for nearly all of the projected increase in the use of fossil fuels. Personal Computers Mobile cells Wind Power Wind farms, such as this one in northwest China, contribute a small but growing part of the world’s electricity. 625 18 6 451 44 6 Issues of Economic Development 549 In contrast, the developed nations are projected to increase their energy use by only 1.1 percent a year. Developed economies use fuel more efficiently, which accounts in part for their slower rate of increase in energy use. Transitional economies are expected to increase their energy use by 1.6 percent each year as they face the challenges of moving to a market economy. Labor Force In what kind of job do most of a nation’s workers find themselves employed? The answer to this question reveals one aspect of a nation’s level of development. According to the World Bank, this measure includes all the economically active people between the ages of 15 and 65 in a country—including the employed, the unemployed, and soldiers, but excluding students and unpaid caregivers. The fewer workers there are engaged in agriculture, and the greater the number of workers in manufacturing and service industries, the more developed the nation Botswana’s Growing Economy Since it became independent in 1966, Botswana’s per capita income growth has been among the fastest of any nation in the world. This small African country transformed itself from one of the world’s poorest countries to a middle-income nation in under 50 years. In 2004, Botswana received an A credit rating from Moody’s and from Standard and Poor’s. Botswana has succeeded largely by maintaining a stable and responsible governmental system. The government has managed the income from large-scale mining operations wisely, reinvesting it in the nation’s physical and human infrastructure. In recent years, the development of the financial services and tourism industries has been stressed. Together, they now represent about one
-quarter of the nation’s GDP. Botswana still faces a number of social and economic challenges, including high unemployment, low manufacturing output, and one of the world’s highest rates of HIV/AIDS infection. But through its moves to diversify the economy, the government has put the nation on a solid development track. CONNECTING ACROSS THE GLOBE 1. How has the government of Botswana helped keep the nation’s economy growing? 2. In the article, what tells investors that Botswana is a relatively safe place to invest? APPLICATION Drawing Conclusions B. Would you expect a positive or negative correlation between literacy rates and infant mortality rates? Explain. 550 Chapter 18 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. developed nations b. human development index less developed countries infant mortality rate 2. What does the state of a nation’s infrastructure say about the country’s level of economic development? 3. Why is per capita GDP a more useful statistic than overall GDP when comparing nations? 4. What does an analysis of the labor force and energy usage tell economists about a nation? 5. Why are health and longevity statistics useful in determining a nation’s level of development? 6. Using Your Notes Pick one example of a developed nation, one of a transitional economy, and one of a less developed nation. Use your notes to explain why you chose each. Definitions of Development Levels of Development Standards of Economic Development Use the Graphic Organizer at Interactive Review @ ClassZone.com. Comparing and Contrasting Compare and contrast three characteristics of a developed nation and a less developed nation. 8. Making Inferences and Drawing Conclusions One measure of economic development is the extent to which a nation buys big-ticket consumer goods. Does the production of those goods also indicate a level of economic development? Explain your answer. 9. Writing About Economics Some economists argue that GDP does not give an accurate picture of a nation’s well-being. They point out that GDP reflects economic activity that pollutes the environment and depletes resources as well as economic activity that counteracts the pollution. In other words, it shows both the polluting enterprises and the cost of cleaning up the pollution on the plus side of the balance sheet. Write a paragraph speculating on how to revise GDP figures to reflect this concern. 10. Challenge In poorer countries, where does the money
for development initiatives come from? Health care in Bangladesh Understanding Levels of Development The chart below shows life expectancy, infant mortality rates, and literacy rates for five countries. Country Bolivia Germany Moldova Philippines Bangladesh Life Expectancy (years) Infant Mortality (per 1,000 live births) Literacy Rate (%) 65.8 78.8 65.7 70.2 62.5 51.8 4.1 38.4 22.8 60.8 87.2 99.0 99.1 92.6 43.1 Source: CIA World Factbook, 2006 Drawing Conclusions Which nation is probably the most developed? Which nation is probably the least developed? Which nation is more developed, Bolivia or the Philippines? Explain your answers. Challenge If you were “weighting” the various measures used to show economic development, which would you consider most meaningful: life expectancy, infant mortality, or literacy rate? Explain your answer. Issues of Economic Development 551 S E C T I O N 2 A Framework for Economic Development Objectives TA K I N G N O T E S In Section 2 you will capital flight, p. 558 • evaluate the importance default, p. 559 of developing human and physical capital • examine the importance of stability and opportunity in economic development • describe how developing nations raise money for development programs World Bank, p. 559 International Monetary Fund ( IMF), p. 559 debt restructuring, p. 559 stabilization program, p. 559 As you read Section 2, complete a cluster diagram like the one shown for each major concept. Include key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Development Framework stability stable prices Resources KEY CONCEPT S What does a nation need to develop economically? Natural resources such as minerals and fossil fuels play a role in economic development. A nation’s climate and the amount of land suited for agriculture are also factors. Each nation uses the resources it has. However, natural resources are not enough. Investing in human capital and physical capital, for example, are ways that many nations promote economic expansion. High Levels of Human Capital People are the most valuable resources in a market economy. One element of a healthy and growing market economy is a commitment to make the most of its human resources through education and training. Education and training help people develop the skills to enter into and function productively in the economy. Human Capital Societies benefit in many ways when their citizens are well educated. 552 Chapter 18 Invest
ing in education also affects other aspects of a society. Educated citizens are able to make informed decisions about health matters. Educated parents are likely to vaccinate their children and invest in their children’s education. Furthermore, educated citizens are likely to vote, participate in civic affairs, rise above poverty, and avoid criminal activity. FIGURE 18.3 RATES OF PRIMARY SCHOOL COMPLETION AND SECONDARY SCHOOL ENROLLMENT 100 90 80 70 60 50 40 30 20 10 t n e c r e P 100 96 100 93 99 100 98 KEY: Primary school completion Secondary school enrollment 76 73 62 52 55 33 22 Esto nia U nite d States G er m a ny M exico B a n gla d esh C a m b o dia C a m ero o n Nation Source: World Development Indicators, World Bank Group, 2002 ANALYZE GRAPHS 1. What nation shows the largest drop-off between the percentage of students that complete primary school and the percentage who go on to secondary school? 2. Do you think the amount of drop-off between education levels is a clue to a nation’s level of development? Explain your answer. High Levels of Physical Capital Physical capital is also an important factor contributing to economic growth. As you read in Chapter 1, physical capital consists of the human-made goods—machines— that are used in the production of other goods and services. Investments in physical capital make people more productive. Fortunately, LDCs do not have to reinvent the wheel. Technology and other innovative capital resources are always being refined in developed nations. LDCs need only copy or import the technology. The desire to copy or import technologies points to the link between human and physical capital. Copying technology requires educated and well-trained people. Importing technology requires money, which is generally in short supply in LDCs, so these nations look to foreign investment. However, a country that lacks human capital is less attractive to investors that might supply this money. AP P LI CATION Explaining an Economic Concept A. Think of your own examples to explain the ripple effect that education has on a society and economy. Issues of Economic Development 553 Stability KEY CONCEPT S While such inputs as human capital and physical capital are necessary for increased output, they are only part of the framework for economic growth. The overall governmental and economic environments must be stable enough to support growth before those inputs can best be put to use. Effective Government
Institutions In the United States, the rule of law is so fundamentally a part of the culture that it may be taken for granted. We are used to laws made by a legislature that we elect according to the principles laid out in the Constitution. We take for granted that the laws will then be made public for all to know and follow. We expect those laws to be applied fairly. When there are disputes, we trust that our legal system will sort out the differences according to the law, not by bribery or intimidation. In many countries, however, the rule of law is still out of reach, and in those places, economic growth suffers. Business investment always carries risk, even in a nation with effective government institutions. That risk rises sharply in countries where the enforcement of laws is unpredictable, where private property rights are unprotected, where a bureaucracy is corrupt or bloated or both, and where judges can be bought and sold. The rule of law provides a foundation of predictability and certainty that reduces economic risk. Democracy itself is a key factor of economic growth. Democratic nations have a higher rate of economic growth than nations with a different form of government. In nations where people can choose their representatives in free and open elections, they can promote their economic self-interest with the same degree of power as other citizens. When the press is uncensored, views that oppose government policy can be aired and debated. In a famous study, one Nobel Prize–winning economist, Amartya Sen, concluded that crop failures are not the chief cause of famines: political systems are. He points out that no widespread famine has ever occurred in a democratic nation. India has had famines, but none since it became a democracy in 1947. The democratic process reduces the likelihood that the government will interfere with the selfcorrecting market forces that could prevent widespread famine. Law Enforcement A fair and transparent court system is key to the kind of governmental stability that promotes development. 554 Chapter 18 Stable Prices In areas where prices are stable and where the governments’ fiscal and monetary policies are sound, economic growth can take root. Investors in such an environment know what to expect. They do not see volatile changes in interest rates, prices, or the level of the government debt. With price stability, businesses can make long-term plans with some assurance that conditions will not change too dramatically and that the government will not go bankrupt. In contrast, in nations with a high inflation rate or with unstable interest rates, investors run a high risk. Many will choose to avoid investing in such
an environment in the first place. And even if they do take a chance, they are likely to withdraw their investment at the first sign of trouble. That leaves the unstable country further behind, since the funds it could use for economic expansion are placed in more stable nations. Monetary Stability Runaway prices in post–World War I Germany made money into children’s toys (left). A stable currency and stable prices create real purchasing power (right). Protected Property Rights Guaranteed protection of private property provides an incentive for economies to grow. If businesses have no way to assert ownership of their enterprises, they will have little incentive to take economic risks, since they will have no guarantee of reaping the rewards if they succeed. Assured property rights give investors confidence and stimulate entrepreneurship. Business owners also need private property rights to prevent the government from interfering with or restricting their operations. In such unstable nations as Haiti, Kazakhstan, and Indonesia, where corruption and favoritism are widespread, private property rights are insecure. This lack of stability is more than enough to cause investors to look elsewhere to locate their enterprises. In some LDCs, especially former colonies of Western nations, land ownership is in the hands of a very small percentage of the population—usually the descendants of the colonists. In some cases, this land is seized by the government for redistribution to the majority population. Foreign investors are wary of locating businesses in countries that threaten private property. AP P LI CATION Drawing Conclusions B. Why is the rule of law a stabilizing force that promotes development? Issues of Economic Development 555 Opportunity KEY CONCEPT S Economic opportunity depends on a number of functions that fall to the government. These include opening international trade, helping people move up the income ladder, controlling corruption, and limiting regulations. Open International Trade The government can also create opportunities for economic growth by lowering restrictions on international trade. As you read in Chapter 17, trade benefits the trading nations by allowing them to produce what they are most efficient at producing and trading for the rest. Partners in a trading relationship produce more than they would without trade, leading to economic growth. However, in less developed countries, governments have imposed high tariffs on imports and instituted other protectionist measures in an effort to give local producers an advantage. Governments often justify these protections as a shortterm effort to help local industries until they grow strong enough to compete with foreign competitors. Protectionist measures come with costs, though. Consumers have to pay more for goods than they would in a market open to imports. Also, government protections may reduce incentives
for producers to become more efficient. Industries may become dependent on tariffs and other trade barriers. Increase Social and Economic Mobility Economic opportunity leads to the most vigorous economic growth when that opportunity is open to the entire population. If all citizens have an equal opportunity under the law to engage in economic enterprise, many will be motivated to lift themselves into a higher income bracket. A number of studies have found that in the United States, for example, about 25 to 33 percent of the population moves into a new income quintile each year. Over a ten-year period, that number rises to 60 percent. In the process of seeking personal economic reward, these people are also helping the economy to grow. In some traditional cultures, however, social conditions do not promote equal opportunity. For example, in some LDCs with a traditional culture, the lower status of women keeps half the labor force from developing its full potential. Further, an entrenched class structure in some nations hampers growth, since the rich do not want changes that could deprive them of their wealth. Governmental changes that promote equal opportunity will help create a successful framework for economic growth. Find an update on women in the workplace in LDCs at ClassZone.com 556 Chapter 18 Economic Potential In many traditional societies, women are an untapped resource that could give development a boost. Control Corruption Corruption, the abuse of public office for private gain, is an especially urgent problem that helps explain why some nations are able to develop and others are not. When government officials are at liberty to enrich themselves and others—by taking bribes and kickbacks, funneling lucrative government jobs and contracts to relatives and allies, skimming aid and loan money, and so on— the rest of the nation, especially the poor, pays the price. (See Figure 18.4.) Although there is not an exact correlation between corruption and per capita GDP, much more often than not, countries with less corruption have higher per capita GDPs. Corruption Index* Country Australia Finland Chile 8.7 9.6 7.3 F I G U R E 18. 4 Corruption and Per Capita GDP Limit Regulation Governments with reasonable tax levels and business regulations help to create economic opportunity. Businesses and other investors are more likely to be attracted to nations with relatively little “red tape.” United States Slovenia Bhutan South Korea South Africa Turkey Bolivia 7.3 6.4 6.0 5.1 4.6 3.8 2.7 Uganda 2.7 2.6 2.5 Russia Albania Kyr
gyzstan Even in the United States, which has relatively few regulations on business, it is estimated that companies with 20 or fewer employees have to pay over $7,500 per employee each year to comply with government regulations. In many LDCs, the number of regulations is significantly higher. In a climate lead to corruption. of Rather tempted to bypass them through payoffs. As you have read, a corrupt environment removes economic incentive and slows economic growth. *10=least corrupt; 0=most corrupt Sources: Transparency International; CIA World Factbook; instability, the high number of regulations can the regulations, businesses are than comply with all 2006 and earlier data Cambodia 2.2 2.1 Per Capita GDP (in U.S. dollars) 31,000 31,600 11,900 41,600 21,500 1,400 22,600 12,200 8,400 2,900 1,800 5,300 11,000 2,000 2,500 AP P LI CATION Applying Economic Concepts C. Nations with the highest corruption index tend to have their wealth distributed less evenly, with a large percentage of people living in poverty. Why might this be so? Issues of Economic Development 557 Financing Development KEY CONCEPT S Nations seeking to finance economic development can look to four main sources: internal investment, foreign investment, aid from foreign governments, or investments from international agencies. A developing nation must consider both the positive and negative aspects of each source. Internal Investment Investment funds for economic development can come from both public and private internal investment. Banks within the nation invest in economic enterprises, such as roads, bridges, and other infrastructure. Egypt, for example, has a goal to make domestic savings the key force in development and has been working toward increasing the savings rate to 25 percent of GDP. To do so, it has an initiative to bolster the insurance industry, which is successful at pooling and channeling savings. In poorer nations, personal savings are very low, so banks have little to invest. Compounding the problem, the wealthy citizens of these countries sometimes invest their funds in developed countries rather than their own country, a problem known as capital flight. If private banks lack the funds to invest, the country’s government may provide funds. It might also seek foreign investment from multinational corporations of through sales of government bonds. Foreign Investment There are several ways in which foreign interests can invest in an economy. One is foreign direct investment (FDI), the establishment of a business enterprise in a foreign country. A
second is foreign portfolio investment, through which foreign investors take part in a nation’s stock and other financial markets. Foreign investment in less developed countries increased from $44 billion in 1990 to $226 billion in 2000. One reason for the increase is that less developed nations had created a more attractive business climate for investors. Multinationals that open manufacturing plants in foreign nations provide jobs and training to the local population and reap the benefits of cheaper labor. Foreign Direct Investment Multinational corporations bring employment, training, and new technology to less developed countries. This factory in Beijing is a joint venture between a Chinese company and DaimlerChrysler. QUICK REFERENCE Capital flight occurs when capital from a country is invested outside that country. 558 Chapter 18 Loans and Aid Developing nations have also turned to loans to help finance their economic development. External debt, money borrowed from foreign banks or governments, has become an issue of great concern in some LDCs. Some countries, especially in South America and Africa, have more debt than they can pay back. When a nation cannot pay interest or principle on a loan, it is said to be in default. Nations may also seek foreign aid—money from other nations. (See Figure 18.5 for aid figures from the U.S. Agency for International Development [USAID]). FIGURE 18. 5 USA ID ALLOC AT IONS BY REG I ON 6% 7.7% 13.2% 30.8% Africa ($2,050) East and South Asia ($1,559) Middle East ($1,251) Latin America / Caribbean ($877) Central Asia ($512) Europe ($402) 18.8% 23.5% Source: U.S. Agency for International Development, 2006 All figures are in millions of dollars. International Help Agencies LDCs also receive aid from several important international organizations. The World Bank, the International Monetary Fund, and the United Nations Development Program are the main international organizations devoted to economic development. • World Bank is a financial institution that provides loans, policy advice, and tech- nical assistance to low- and middle-income countries to reduce poverty. • International Monetary Fund (IMF) is an international organization established to promote international monetary cooperation, foster economic growth, and provide temporary financial assistance to countries to help ease balance of payments adjustment. The IMF helps nations overloaded with debt to develop debt restructuring, a method used by countries with outstanding debt obligations to alter the terms of the debt agreements in order to achieve some advantage.
It often oversees stabilization programs, in which it requires these troubled nations to carry out reforms—reducing foreign trade deficits and external debt, eliminating price controls, closing inefficient public enterprises, and slashing budget deficits. • United Nations Development Program (UNDP) is a United Nations agency working to fight poverty. In 2006 it had active programs in 174 nations. AP P LI CATION Making Inferences and Drawing Conclusions D. Why would Kuwait, a developing nation, offer aid to countries in its region? QUICK REFERENCE Default is when a nation cannot pay interest or principle on a loan The World Bank is a financial institution that provides loans, policy advice, and technical assistance to low- and middle-income countries to reduce poverty. The International Monetary Fund (IMF) promotes international monetary cooperation, fosters economic growth, and provides temporary financial assistance to countries to help ease balance of payments adjustment. Debt restructuring is a method used by countries to alter the terms of their debt agreements in order to achieve some advantage. A stabilization program is a required program of reforms imposed by the IMF to steady the economy of a debtor nation in danger of default. Issues of Economic Development 559 ECO N O M I C S PAC ES E T T E R Anne Krueger: Reforming IMF Development Policy On September 1, 2001, Anne Krueger became First Deputy Director of the International Monetary Fund. Ten days later, the terrorist attacks on the United States sent shockwaves through the global economy. Three months later, Argentina suspended payments on its $132 billion foreign debt. At the time, this was the biggest default in history. All the while, there were significant economic upheavals as well as international protests over the burden of debt in developing nations. Clearly, she didn’t have the luxury of easing into her new position. A New Role for IMF Luckily, Krueger came very well prepared for her new job. In addition to her professorships at Stanford University, Duke University, and the University of Minnesota, Krueger had also been Director of the Center for Research on Economic Development and Policy Reform, at Stanford, and the Vice President of Economics and Research at the World Bank. In November 2001, anticipating Argentina’s default, Krueger put forward a proposal for the role of the IMF in debt restructuring and dispute resolution. In her proposal, the IMF would oversee the restructuring of the debt rather than simply providing bailout funds. The reform effort also called for collective action clauses, measures that let a supermajority of creditors overrule
a creditor who is holding out for more repayment than may be possible. In fact, after several years of negotiations, most of Argentina’s creditors accepted 35 cents on the dollar in early 2005, and Argentina’s credit rating climbed once again. Even 35 cents on the dollar, however, seems too high to many critics, who believe that debt in most developing nations should be forgiven 100 percent so the money used to service the debt can be put to use providing such needed human services as health care and education. Krueger has disagreed: “... Unless there is radical change from past behavior on the part of the debtors, their priorities for the use of released resources are not likely to be on education, health, or other expenditures that will enable the poor to improve their lot.” Nonetheless, the IMF is part of a plan to forgive debt completely in 18 of the most heavily indebted poor nations in exchange for economic policies that favor trade liberalization and other development goals. Anne Krueger APPLICATION Solving Economic Problems C. Krueger believes that direct aid to nongovernmental organizations working in health or education are more effective than debt cancellation. Critics argue that grants with conditions show the IMFs desire to control nations’ economies. Who do you agree with? Give reasons for your answers. FAST FACTS Anne O. Krueger Title: First Deputy Managing Director of the IMF, September 2001 to August 2006 Born: February 12, 1934, New York City Major Publications Edited: Reforming India’s Economic, Financial, and Fiscal Policies. Edited with Sajjid Z. Chinoy, 2003 Latin American Macroeconomic Reform: The Second Stage. Edited with Jose Antonion Gonzales, Vittorio Corbo, and Aaron Tornell, 2003 Selected Awards: • Distinguished Fellow and past President of the American Economic Association • Frank E. Seidman Distinguished Award in political economy (1993) • Bernard Harms Prize awarded by the Kiel Institute of World Economics (1990) Find an update on Anne Krueger at ClassZone.com 560 Chapter 18 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the relationship between this pair of terms: a. International Monetary Fund b. stabilization program 2. What are four key sources of funding for development? 3. How can a nation develop its human capital? 4. How can a nation improve its business climate? 5. What roles do foreign nations play in a country
’s development? 6. Using Your Notes Use your completed cluster diagram to help you explain how the economic development of one nation might be an opportunity for growth for another nation. Use the Graphic Organizer at Interactive Review @ ClassZone.com Development Framework stability stable prices. Analyzing Cause and Effect How might the bailout by an international agency of a nation that has defaulted on foreign debt lead to more corruption in the future? 8. Writing About Economics Many economists believe that a country that is rich in a particular natural resource may actually be at a developmental disadvantage. They point out that nations such as these tend to put all of their resources into this one industry. Write a paragraph about how you, as leader of a nation, would use the large income from your nation’s natural resource to take other avenues to developing your economy. 9. Applying Economic Concepts Look again at Figure 18.5. The United States grants aid money each year to nations in the developing world. Do you think Anne Krueger would think this aid money should come with certain terms or conditions? Explain. 10. Challenge If you were in charge of development efforts for a poor nation, which source of development funds would you focus on? Why? Understanding the Path to Development Read the following scenarios of fictional less developed countries: • In nation A, there is a democratically elected government, but a corrupt law enforcement system has made property rights shaky. There is little foreign trade, and few foreign firms have set up manufacturing facilities. However, a foreign nation gives nation A hundreds of millions of dollars in aid each year. • In nation B, the move toward democracy has begun. A system of fair and transparent law enforcement is in place, and international trade and foreign direct investment are on the rise. High levels of foreign debt, however, could pose a problem in the future. Categorizing Economic Information Is nation A or nation B more likely on a path to successful development? Explain why you think so. Challenge What’s more beneficial to development— a connection to a large amount of foreign aid money or a plan to increase social, political, and economic stability? Why? Issues of Economic Development 561 S E C T I O N 3 Transition to a Market Economy TA K I N G N O T E S privatization, p. 563 shock therapy, p. 563 perestroika, p. 564 special economic zone (SEZ), p. 567 In Section 3 you will • identify problems that emerge when an economy goes from command
to market • describe the transitions to a market economy in the former Soviet Union and nations it dominated • discuss the transitions to a market economy in China As you read Section 3, complete a cluster diagram like the one shown, using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Transition to a Market Economy new challenges New Challenges KEY CONCEPT S In Chapter 2, you read about different economic systems, including a command, or centrally planned, economy in which all economic decisions are made by the society’s leaders, usually government officials acting in a central location. For a while, much of the world’s population lived in a command economy. However, China, the nations that formerly made up the Soviet Union, and many Eastern European countries have taken steps toward a market economy. The transition requires new answers to the basic economic questions that central planners used to answer. Both the government and private individuals and companies face a number of challenges. CHALLE NGE 1 Poor Infrastructure A market economy needs a solid infrastructure to facilitate the production and distribution of goods and services. In a command economy, transportation, communications, banking, and education—the infrastructure of an industrialized nation—are as inefficient as other industries tend to be. With no competition there is little incentive to create a more robust physical and institutional infrastructure. Modernized airports, phone systems, roads, harbors, bridges, and computer connections help a transitional economy support and spread the goods and services it produces. Bridging the Gap Transportation infrastructure is vital to develop a successful market economy. 562 Chapter 18 C HAL LENGE 2 Privatization Under communism, the government owns all property. As transitional nations move toward a market economy, they have all undertaken the challenges of privatization, the process of transferring state owned-property and businesses to individuals. A major problem with privatization is how to sell the property. It can, for example, be auctioned off, but command economies have little private savings, and few people have the needed finances. Also, as you’ll read later, these auctions can sometimes be rigged to benefit those close to the ruling elites. A second method is to sell shares of businesses through a vehicle like the stock market. A third way is to give vouchers to people to purchase shares of a business, making cash unnecessary. QUICK REFERENCE Privatization is the process of transferring state owned property and businesses to individuals. C HAL LENGE 3 Rise in Prices In a command economy, some
goods may have artificially low prices. Part of the switch to a market economy is the removal of price controls, allowing the market to operate. On January 1, 1990, Poland’s government gave the go-ahead for an economic program referred to as shock therapy, involving the abrupt shift from a command to a free-market economy. The initial result indeed shocked consumers; the inflation rate that first month was 78 percent. However, this inflationary “correction” eased as the free-market policies were allowed to take hold. (See Figure 18.6.) QUICK REFERENCE Shock therapy is an economic program involving the abrupt shift from a command economy to a free-market economy. FIGURE 18.6 POLAND’ S INFLATION RATE AFTER SHOCK THERAPY ) 70 60 50 40 30 20 10 0 1991 1992 1993 1994 1995 Year 1996 1997 1998 1999 Source: “The Polish Zloty 1990–1999: Success and Under-Performance,” Dominico Nuti ANALYZE GRAPHS 1. After 1991, how many years did it take Poland to cut its inflation rate in half? 2. Why did the inflation rate consistently decrease after the initial “shock” of 1991? AP P LI CATION Making Inferences and Drawing Conclusions A. Which of the challenges above do you think is the most serious? Give reasons for your answer. Issues of Economic Development 563 Economic Change in the Former Soviet Bloc KEY CONCEPT S QUICK REFERENCE Perestroika was a gradual plan to incorporate markets into the Soviet Union’s command economy. In the 1980s, Soviet leader Mikhail Gorbachev introduced perestroika, a plan to gradually incorporate markets into the Soviet Union’s command economy. People began to push for political freedom as well, and in 1991 the Soviet Union dissolved. The collapse of the Soviet Union caused a period of dramatic transition throughout Eastern Europe and Central Asia. EXAMPLE 1 Russia The transition has been a turbulent time for Russia. Like Poland and several other Eastern European nations, it pursued a program of economic “shock therapy.” The resulting inflation was devastating. Supplies of goods were very low, and many industries were forced into bankruptcy when faced with the need to become “self-financing.” Further, the state was poorly equipped to carry out even the most basic functions of government, such as tax collection. As a result, with little revenue to work with, it
could not offer welfare services to cover the disruptions of the economic shift, and the burden of government debt began to rise. Amid the upheaval, some market forces began to exert themselves. Without directives from central planners, regional business initiatives could address the real demands of consumers. In 1992, a program of privatization began to put the means of production into private ownership, introducing incentives for success. The privatization process, however, was fixed in favor of certain individuals. As a result, a small group of politically well-connected business people snapped up many of Russia’s former public assets through a series of rigged auctions. These oligarchs, as they’re known, went on to build massive corporations and became the most powerful economic force in modern Russia. The best-known oligarch, Mikhail Khodorkovsky, has recently been sentenced to nine years in prison on fraud and tax evasion charges. In addition, his giant oil company, Yukos, was taken over by the government. It is widely believed that the charges against him were motivated by his support for political parties that were opposed to Russia’s president, Vladimir Putin. Many saw this case and others as symptoms of Putin’s reluctance to truly adopt democratic reforms and a market economy. Taken together, Putin’s actions, the power of Russian organized crime, and the persistence of widespread corruption threatened to undermine Russia’s successful development. At Will Oligarchs? The prosecution of Khodorkovsky was seen by many as a warning to Russia’s oligarchs: the price of opposition to Putin’s government may be your freedom. 564 Chapter 18 E XAMPLE 2 Former Soviet Republics The transition of the former Soviet Republics has been varied. The Baltic Republics—Latvia, Lithuania, and Estonia—have fared better than others, experiencing a 45 percent inflation rate while Ukraine had a 400 percent rate and Kazakhstan in Central Asia had a rate higher than 1,000 percent. Of all the former republics, only the Baltic Republics, Armenia, Belarus, and Kazakhstan have a higher output now than they did before the collapse of the Soviet Union. Nevertheless, many economists believe the quality of goods and services produced is higher. In the other republics, poor infrastructure, complicated bureaucracies, undeveloped property laws, and corruption have interfered with economic growth. Vilnius Since independence, the capital of Lithuania has thrived. It accounts for one-third of the nation’s GDP and attracted 2.815 billion euros in F
DI in 2005. E XAMPLE 3 Eastern Europe The formerly Communist nations of Eastern European have faced some of the same challenges as their neighbors and had similarly varying degrees of success. The largest nations, the Czech Republic, Hungary, and Poland, are now much like Western countries. They are members of the European Union, but some experts believe they will need until 2035 to catch up economically with other member nations. Nonetheless, progress is apparent. Since the transition, Poland’s economy has been growing at an average rate of 6 percent annually, industrial productivity has increased by more than 20 percent, and the private sector is responsible for more than 70 percent of the national income. There are more than 2.5 million small- or medium-sized businesses operating today, and Western franchises, such as the McDonald Corporation and the IKEA Group, have become entrenched. However, Poland also has problems that are common across the nations of Eastern Europe. Its infrastructure is out of date, and telephone and internet services are very costly. The laws for registering to do business in the Polish market are confusing, and the patent process that protects property rights is slow. The health care and pension systems have weakened, and unemployment is high. Averaged throughout the country, the unemployment rate is about 18 percent, but in some regions it is as high as 40 percent, and workers are discouraged. In Hungary, the illegal “hidden economy” may account for up to 30 percent of GDP. APPLICATION Comparing and Contrasting Economic Information B. Which of the three regions—Russia, the former Soviet Republics, or Eastern European nations—has had the hardest transition? Explain your answer. Issues of Economic Development 565 China Moves Toward a Market Economy KEY CONCEPT S China became a Communist country in 1949, but it began a transition to a free market economy in 1978. At that time, its leader, Deng Xiaoping, introduced free market economic principles to stimulate China’s economy. The result was a vastly changed and rapidly growing economy. EXAMPLE Rapid but Uneven Growth In the early years of China’s Communist economy, central planners focused on redistributing land, developing heavy industry, and improving China’s transportation system. In 1958, the government introduced the Great Leap Forward. This plan focused on the building of huge collective farms and the development of the steel industry. For a while, both agricultural and steel output increased. However, the gains were short-lived. Poor economic planning and a series of natural
disasters led to stark times. Millions of people died in famines. When Deng Xiaoping came to power in the late 1970s, hundreds of millions of Chinese villagers lived in poverty, sometimes sharing one pair of trousers among a whole family. Deng brought hope and practical programs to the people. “It is time to prosper.... To get rich is glorious,” he said. Deng began a far-reaching but gradual program to relax government control over the economy and let market forces drive economic growth. In agriculture, farmland that had been confiscated was returned to the farmers in household units. Under this “household responsibility system,” farms still had to supply a quota of staple goods to the government at set prices, but beyond that the farmers could grow what they wanted and sell any surplus on the open market. China reported a ten percent annual growth in agricultural output between 1979 and 1984. Brick homes began to replace thatched huts as farmers’ income soared. A Growing Divide Modernization has come at breakneck speed in many of China’s urban centers, while life in rural China can seem to be in a different century. 566 Chapter 18 In the mid-1980s, Deng focused his reform effort on industry, where two-thirds of the manufacturing plants were still state-owned. Deng moved slowly and cautiously. Instead of privatizing suddenly or making drastic, uniform changes, he scattered the reforms among different industries. In one industry, local managers might have more decision-making power. In another, workers might get raises based on the profits of the factory. Deng’s reforms also called for localities to invest in the industries they thought would thrive. In this process, resources were re-allocated from heavy to light industry, a key factor in China’s rapid growth. Deng also created special economic zones (SEZs), regions that have economic laws that are different from a country’s usual economic laws, with the goal of increasing foreign investment. The first four were begun in 1979 as an experiment. In 1984, fourteen more were created in cities along the coast, including Shanghai; now there are hundreds. The SEZs have tax incentives for foreign investment, and the economic activities are driven entirely by market forces. Further, when capitalist Hong Kong was returned to China in 1997 after a 99-year lease by the United Kingdom, it was reunified under the “one country, two systems” framework. The government did not interfere with its economy; in fact
, it became a model for the nation. Areas with high foreign investment have raced ahead of other parts of the country economically, contributing to China’s annual growth in GDP of between 5 and 15 percent since the reforms began. Some people, encouraged by Deng’s proclamation, have become very rich. However, in 2003, the number of people living in extreme poverty (on less than $77 a year) rose for the first time in 25 years, to about 3 percent of the population. In some villages of western China, 90 percent of the people live on government welfare and do not have indoor plumbing or telephones. FIGURE 18.7 A N N UA L ECO N O M I C G ROW T H R AT E EC T E D D E V E LO P E D N AT I O N S QUICK REFERENCE A special economic zone (SEZ) is a geographical region that has economic laws that are different from a country’s usual economic laws, with the goal of increasing foreign investment. Find an update on China’s special economic zones at ClassZone.com ( 10 1 -2 -3 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 KEY: China Ireland Japan United States Source: CIA World Factbook Year AP P LI CATION Explaining an Economic Concept C. What role do the SEZs play in China’s transition to a market economy? 567 For more on using a decision-making process, see the Skillbuilder Handbook, page R17. Using a Decision-Making Process Making decisions in complicated situations can be extremely difficult. Having a plan, or process, in place can be quite helpful. TECHNIQUES USED IN MAKING DECISIONS Making decisions involves (1) gathering information to identify the situation in question, (2) identifying options, (3) predicting consequences, and (4) implementing a decision. The following passage describes the problem of flooding on China’s Chang River. It illustrates the decision-making process. Look for information that points to a situation that requires a decision. Figures on the deadly toll of flooding show that a decision on damming was needed. Predict possible consequences. The positive and negative results of the dam are listed. Controlling the Chang River In the past 100 years, more than 1 million people have died as a result of flooding along China’s Chang (Yangtze) River. After devastating floods in the 1950s, Chinese leader Mao Zedong ordered studies to see whether
damming the river was feasible. Finally, in the 1990s, construction began on the Three Gorges Dam, which— when completed—will be the largest dam in the world. In addition to providing flood control, the dam will be a source of hydropower. Its turbines are expected to produce up to one-ninth of China’s electricity. The dam’s series of locks will allow ocean-going ships to sail 1,500 miles inland. Nevertheless, the project has serious drawbacks. For one thing, it will require the resettlement of an estimated 1.2 million people. Environmentalists warn of water pollution, as well as the eradication of migratory fish and rare plants. The dam is scheduled for completion in 2009. In the meantime, the Chinese government has already begun to address the problem of pollution with the building of at least one comprehensive sewage treatment plant. Look for any options that are offered. Here, only the option of damming the river is considered. Decide what the result was. The dam is scheduled to be completed in 2009. THINKING ECONOMICALLY Making Decisions 1. What choice did the government have regarding the flooding of the Chang River? 2. What economic incentives do you think may have added to the government’s decision? 3. What consequences of the decision might be contrary to economic growth? Explain your answer. 568 568 Chapter 18 Chapter 18 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. 1. Explain the difference between these terms: a. shock therapy b. perestroika 2. What makes privatization a challenge in transitional economies? 3. What role does infrastructure play in transitional economies? 4. Why are special economic zones important to the growth of the Chinese economy? 5. In what way(s) is privatization an element of China’s shift to a market economy? 6. Using Your Notes Write a summary of the challenges of economic transitions and explain how they have been addressed in the former Soviet bloc and in China. Refer to your completed cluster diagram. Transition to a Market Economy Use the Graphic Organizer at Online Review @ ClassZone.com new challenges. Comparing and Contrasting Economic Information What are three key differences between the economic transitions of the former Soviet bloc and China? 8. Making Inferences and Drawing Conclusions While China has welcomed western economic principles, it has continued to come down hard on political freedoms. For example, Deng crushed protesters in Tianan

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