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of the London Stock Exchange. Taking Their Business Elsewhere If the state-owned Russian giant OAO Rosneft Oil Co. had been going public a decade ago, it would have jumped through hoops to list its shares on a U.S. stock exchange. Back then a U.S. listing was viewed as a rite of passage for up-and-coming global companies, offering not only direct access to the world’s largest capital market but also a certain cachet. This is 2006, though, and Rosneft plans to list its shares on the London Stock Exchange.... Rosneft isn’t alone. Companies are increasingly forsaking the U.S. for friendlier overseas environs. The New York Stock Exchange and NASDAQ pin much of the blame on the Sarbanes-Oxley Act (SarbOx), the controversial 2002 corporate governance rules, for their recent woes in attracting new listings.... The exchanges say the expense and difficulty of dealing with SarbOx could transform the U.S. from one of the most attractive markets in the world to one of the least. But beyond SarbOx lies a troubling trend that’s far less easily remedied—companies N UMBER OF N EW F OREIGN L ISTINGS AT N EW Y ORK AND L ONDON S TOCK E XCHANGES 140 120 100 80 60 40 20 0 1999 NASDAQ NYSE London 2000 2001 2002 Year 2003 2004 2005 Sources: NASDAQ, NYSE, London Stock Exchange 312 UNIT 3 Economic Institutions and Issues Daniel Berehulak/Getty Images Europe/Getty Images simply don’t need to list in New York anymore. Globalization and electronic trading have made U.S. investors mobile as never before. While some argue that the higher governance standards in the U.S. boost investor confidence, lead to higher valuations, and could prevent fraud, many companies no longer want to put up with the regulatory nuisances given the availability of money abroad.... Europe’s three main exchanges—the London Stock Exchange, the Deutsche Börse, and Euronext, which runs the Paris, Amsterdam, and Brussels exchanges—are ready for the business.... —Reprinted from BusinessWeek Examining the Newsclip 1. Determining Cause and Effect What has enabled investors to buy shares on overseas exchanges? 2. Drawing Conclusions Why did SarbOx have a negative impact on
American stock exchanges? CHAPTER 11 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Financial System Households and businesses invest their surplus funds to earn interest. Governments and businesses invest this money for economic growth. Surplus funds Households, businesses Financial Intermediaries Commercial banks Savings and loan associations Savings banks Mutual savings banks Credit unions Life insurance companies Mutual funds Pension funds Finance companies Governments, businesses Financial assets Investment Risk and Return Investors must weigh the risks of their investments against the returns they expect. Generally, the higher the risk of an investment, the higher the return investors require. T HE R ELATIONSHIP B ET WEEN R ISK AND R ETURN Junk bonds Speculative stock Common stock Preferred stock Investment-grade bonds Prime commercial paper U.S. Treasury bills Increasing degrees of risk Equities and Futures The riskiest investments consist of equities and futures. Equities can be purchased as individual stocks, or as part of a mutual fund or 401(k) plan. Futures allow investors to speculate on future prices of commodities. Equities Futures Single stock Mutual fund 401(k) plan Futures contract Call option Put option CHAPTER 11 Financial Markets 313 CHAPTER 11 Assessment & Activities Review Content Vocabulary Review the Main Ideas Assume that you are an investment adviser who has to advise a 30-year-old, single client who earns $35,000 a year and has saved $10,000 to invest for retirement. Use the terms below to prepare a report advising your client of the best investment course. 1. financial asset 2. financial system 3. risk 4. capital market 5. money market 6. bond 7. Treasury note 8. IRA 9. 401(k) plan 10. mutual fund 11. pension fund 12. certificate of deposit 13. portfolio diversification 14. stock exchange 15. over-the-counter market Section 1 (pages 289–294) 22. Describe how financial assets are created in a free enterprise system. 23. Explain the role of the major nondepository financial institutions in the financial system. 24. Identify the factors one should consider when investing by completing a graphic organizer like the one below. Basic Investment Considerations 1. 2. 3. 4. Section 2 (pages 296–303) 25. Explain what determines a bond’s current yield. 26. Explain how CDs can appear in multiple markets. 27. Identify the characteristics of Treasury notes, bonds, and bills. Section 3 (
pages 305–311) 28. Describe how options contracts are different from Review Academic Vocabulary futures contracts. Match each term with its synonyms in the list below. a. sector b. compensation c. offset d. presumed e. prospects f. implication 16. payment, reparation, payback 17. supposed, expected, believed 18. likelihood, possibilities, expectations 19. counterbalance, neutralize, cancel out 20. section, part, segment 21. association, meaning, consequence 314 UNIT 3 Economic Institutions and Issues 29. Explain why equity markets are reasonably competitive. 30. Explain how the NASDAQ differs from the NYSE. Critical Thinking 31. The BIG Idea How might the four basic investment considerations vary for people in different age groups? Write a paragraph explaining your answer. 32. Making Generalizations Why might an individual choose to borrow money from a finance company that charges higher interest rates rather than from a commercial bank with lower interest rates? Economics: Principles and Practices Web site at glencoe.com and click on Chapter 11—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the 33. Determining Cause and Effect How does each of the following affect saving? a. A decrease in the federal personal income tax is implemented. b. The United States undergoes a prolonged period of inflation. Analyzing Visuals 38. Look at Figure 11.1 on page 291. In a brief paragraph, describe the financial assets savers would receive from financial intermediaries. Then describe those that savers would receive directly from governments and businesses. 34. Drawing Conclusions Interest rates on CDs usually 39. Look at Figure 11.7 on page 308 and compare the vary only slightly from one institution to another. What do you think causes these similarities? 35. Drawing Conclusions Which investments are the safest and which are the riskiest? Why would investors choose either of those investments? Explain. Math Practice 36. Determine income, consumption, and saving in each row by completing the following table. Total Income Consumption Saving a. b. c. $2,000 $7,000 d. $10,000 e. $12,500 $1,800 $2,500 $10,000 $1,000 –$500 $400 Applying Economic Concepts 37. Investing in Stocks Assume that you have saved $10,000 and have decided to invest in stocks. Research the performance of 2 to 3 stocks listed on the NYSE, AMEX, or
NASDAQ. Then write a short paper that includes the following: a. Reasons you chose the stocks b. Stock performance c. Factors influencing the gain/loss in value d. Analysis of why you would hold your stocks for either the short term or the long term John S.Pritchett/www.pritchettcartoons.com returns for investments in traditional IRAs and 401(k) plans. If the annual investment amounts and interest rates are the same, what accounts for the large difference in returns for these investment options? Writing About Economics 40. Expository Writing Return to the activity in the chapter opener on page 288. Based on what you have learned in the chapter, devise a general investment plan for Miguel. In your planning, keep in mind the mid-term goals of college cost and long-term goals of retirement. Interpreting Cartoons 41. Critical Thinking What do the figures of bulls and bears in the cartoons depict? What point is the cartoonist trying to make about the stock market.. CHAPTER 11 Financial Markets 315 n h o J UNIT 4 Macroeconomics: Performance and Stabilization CHAPTER 12 Macroeconomic Performance CHAPTER 13 Economic Instability CHAPTER 14 Money, Banking, and the Fed CHAPTER 15 Economic Stabilization Policies Economists like to monitor all economic activity, including the productivity of the workers and the output of this aircraft engine plant. 316 UNIT 4 Stewart Cohen/Getty Images Stewart Cohen/Getty Images CHAPTER 12 Macroeconomic Performance Why It Matters Have you ever thought about what it means when someone is described as “successful”? Is the person wealthy, happy, or well known? Work with a partner and develop a list of the qualities or characteristics for your definition of successful. Share your list with the class and listen carefully to what the other students think. Is there a consensus among your classmates? Read Chapter 12 to learn more about how economists assess the success of a nation’s economy by measuring its growth and performance. The BIG Idea Economists look at a variety of factors to assess the growth and performance of a nation’s economy. Busy factories such as this car manufacturing plant are indicators of economic growth. Economics: Principles and Practices Web site at glencoe.com and click on Chapter 12—Chapter Overviews to preview chapter information. Chapter Overview Visit the 318 UNIT 4 Jose Luis Pelaez, Inc./Corbis SECTION 1 Measuring the Nation’s Output and Income GUIDE TO READING Section
Preview In this section, you will learn how we measure the output and income of a nation. Content Vocabulary • macroeconomics (p. 319) • gross domestic product (GDP) (p. 320) • intermediate products (p. 321) • secondhand sales (p. 321) • nonmarket transactions (p. 321) • underground economy (p. 321) • base year (p. 321) • real GDP (p. 322) • current GDP (p. 322) • GDP per capita (p. 322) • gross national product (GNP) (p. 324) • net national product (NNP) (p. 324) • national income (NI) (p. 324) • personal income (PI) (p. 324) • disposable personal income (DPI) (p. 324) • household (p. 325) • unrelated individual (p. 326) • family (p. 326) • output-expenditure model (p. 327) • net exports of goods and services (p. 327) Academic Vocabulary • excluded (p. 321) • components (p. 325) Reading Strategy Describing As you read the section, complete a graphic organizer like the one below by describing how the different economic sectors contribute to the nation’s economic activity. Economic Sectors Consumer sector Investment sector Government sector Foreign sector ISSUES IN THE NEWS GDP posts smallest gain in 3 years The nation’s economy grew at its slowest pace in three years in the fourth quarter, according to the government’s gross domestic product report Friday, which came in far weaker than economists’ forecasts. The broad measure of the nation’s economic activity showed an annual growth rate of 1.1 percent in the fourth quarter, down from the 4.1 percent growth rate in the final reading of third-quarter growth. ■ —CNNMoney.com The report in the news story above may be of little interest to many people, but it was worrisome for economists. When the nation’s economic growth rate drops to a meager 1.1 percent, the news is not good. Welcome to macroeconomics, the branch of economics that deals with the economy as a whole, using aggregate measures of output, income, prices, and employment. Gross Domestic Product is one of our most important macro measures and the most important statistic in the National Income and Product Accounts (NIPA). The NIPA keeps track of the nation’s production, consumption
, saving, and investment. Other key measures exist, and collectively they tell us a great deal about the economic health and performance of our country. macroeconomics part of economics that deals with the economy as a whole and uses aggregate measures of output, income, prices, and employment James Leynse/Corbis CHAPTER 12 Macroeconomic Performance 319 gross domestic product (GDP) the dollar value of all final goods, services, and structures produced within a country’s national borders during a oneyear period (also see page 9) GDP—The Measure of National Output MAIN Idea GDP measures national output. Economics and You Did you know that your work may be counted in our GDP? Read on to find out how we measure output. Gross domestic product (GDP) is our most comprehensive measure of national output. This means that Japanese automobiles produced in Kentucky, Ohio, and Indiana count in GDP even if the owners of the plants live outside the United States. On the other hand, production in U.S.owned plants located in Mexico, Canada, or other countries is not counted in GDP. Measuring Current GDP The measurement of GDP is fairly easy to understand. Conceptually, all we have to do is to multiply all of the final goods and services produced in a 12-month period by their prices, and then add them up to get the total dollar value of production. Figure 12.1 provides an example. The first column contains three product categories— goods, services, and structures—used in the NIPA. The third of these categories, structures, includes residential housing, apartments, and buildings for commercial purposes. The total number of final goods and services produced in the year is in the quantity column, and the price column shows the average price of each product. To get GDP, we simply multiply the quantity of each good by its price and then add the results, as is done in the last column of the table. Of course it is not possible to record every single good and service produced during the year, so government statisticians instead use scientific sampling techniques to estimate the quantities and prices Figure 12.1 Estimating Total Annual Output E STIMATING G ROSS D OMESTIC P RODUCT Product Automobiles Replacement tires Shoes...* Haircuts Income tax filings Legal advice...* Single family Multifamily Commercial...* Goods Services Structures Quantity (millions) Price (per 1 unit) Dollar value (millions) 6 10 55...* 150 30 45.
..* 3 5 1...* $25,000 $60 $50...* $8 $150 $200...* $175,600 $300,000 $1,000,000...* $150,000 $600 $2,700...* $1,200 $4,500 $9,000...* $525,000 $1,500,000 $1,000,000...* Note: *... other goods, services, and structures Total GDP = $13.5 trillion Gross domestic product is the total dollar value of production within a country’s borders in a 12-month period. It can be found by multiplying all of the goods and services produced by their prices, and then adding them up. Economic Analysis How is the dollar value for each of the products on the table calculated? of the individual products. To keep the report as current as possible, they estimate GDP quarterly, or every three months, and then revise the numbers for months after that. As a result, it takes several months to discover how the economy actually performed. Some Things Are Excluded GDP is a measure of final output. This means that intermediate products— goods used to make other products already counted in GDP—are excluded. If you buy new replacement tires for your automobile, for example, the tires are counted in GDP because they were intended for final use by the customer and not combined with other parts to make a new product. However, tires on a new car are not counted separately because their value is already built into the price of the vehicle. Other goods such as flour and sugar are part of GDP if they are bought for final use by the consumer. However, if a baker buys them to make bread for sale, only the value of the bread is counted. Secondhand sales—the sales of used goods—are also excluded from GDP because no new production is created when products already in existence are transferred from one owner to another. Although the sale of a used car, house, or compact disc player may give others cash that they can use on new purchases, only the original sale is included in GDP. Nonmarket transactions—economic activities that do not generate expenditures in the market—also are excluded. For example, GDP does not take into account the value of your services when you mow your own lawn or do your own home repairs. Instead, these activities are counted only when they are done for pay outside Underground Economy Although there
is no consensus on the size of the underground economy, estimates suggest that it is between 5 and 15 percent of the recorded GDP. What activities make up the underground economy intermediate products products that are components of other final products included in GDP secondhand sales sales of used goods not included in GDP nonmarket transaction economic activity not taking place in the market and, therefore, not included in GDP underground economy unreported legal and illegal activities that do not show up in GDP statistics base year year serving as point of comparison for other years in a price index or other statistical measure the home. For this reason, services that homemakers provide are excluded from GDP even though they would amount to billions of dollars annually if actually purchased in the market. Finally, transactions that occur in the underground economy—economic activities that are not reported for legal or tax collection purposes—are not counted in GDP. Some of these activities are illegal, such as those found in gambling, smuggling, prostitution, and the drug trade. Other activities are legal, such as those in flea markets, farmers’ markets, garage sales, or bake sales, but they involve cash payments, which are difficult to trace. Current GDP vs. Real GDP Because of the way it is computed, GDP can appear to increase whenever prices go up. For example, if the number of automobiles, replacement tires, and other products in Figure 12.1 stays the same from one year to the next while prices go up, GDP will go up every year. Therefore, in order to make accurate comparisons over time, GDP must be adjusted for inflation. To do so, economists use a set of constant prices in a base year—a year that serves as the basis of comparison for all CORNERED © 2004 Mike Baldwin. Reprinted with permission of UNIVERSAL PRESS SYNDICATE. All rights reserved. CHAPTER 12 Macroeconomic Performance 321 real GDP gross domestic product after adjustments for inflation current GDP gross domestic product measured in current prices, unadjusted for inflation GDP per capita gross domestic product on a per person basis; can be expressed in current or constant dollars Skills Handbook See page R56 to learn about Understanding Nominal and Real Values. other years. For example, if we compute GDP over a period of time using only prices that existed in 2000, then any increases in GDP must be due to changes in the quantity column and cannot be caused by changes in the price column. This measure is called real GDP, or GDP measured with a set of constant base year prices. In contrast, the terms GDP, current
dollar GDP, nominal GDP, and current GDP all mean that the output in any given year was measured using the prices that existed in those years. Because these prices change from one year to the next, nominal or current GDP is not adjusted for inflation. When the two series are plotted together, as in Figure 12.2, you can see that real GDP grows more slowly than current GDP. The difference in growth rates occurs because current GDP reflects the distortions of inflation. The U.S. Department of Commerce uses 2000 as the base year, so the two series are equal in that year. The U.S. Department of Commerce updates the base year in fouryear increments and will eventually switch to 2004, but only after a substantial lag. Any other year would work just as well. GDP per Capita There may be times when we want to adjust GDP for population. For example, we may want to see how the economy of a country is growing over time, or how the output of one country compares to that of another. If so, we use GDP per capita, or GDP divided by the population, to get the amount of output on a per person basis. Per capita GDP can be computed on a current or constant basis. Limitations of GDP Despite GDP’s advantages, there are several limitations to keep in mind. First, by itself GDP tells us nothing about the composition of output. If GDP increases Figure 12.2 Current GDP and Real GDP C URRENT VS. R EAL GDP GDP in current dollars GDP in 2000 dollars $14,000 12,000 10,000 8,000 6,000 4,000 2,000 1960 1965 1970 1975 1980 1985 Year 1990 1995 2000 2005 2010 Source: Bureau of Economic Analysis, U.S. Department of Commerce Because prices tend to rise over time, current GDP rises faster than real GDP, which uses a constant set of prices to value the output in every year. Economic Analysis Which series is distorted by inflation? 322 UNIT 4 Macroeonomics: Performance and Stabilization &The Global Economy YOU World GDP Why should you be concerned about the size of the U.S. economy or that of other countries? A healthy U.S. economy means manufacturing and employment increase, tax revenues go up, and the standard of living improves. When the economies of other countries also do well, they are better able to purchase products that American firms export, which further improves the U.S. economy. How big is the U.S. economy, and how big
is the world economy? One way to find out is to look at GDP. According to economists at the Central Intelligence Agency (CIA), the United States accounted for one out of every five dollars of output produced worldwide in 2005. The 25 countries in the European Union had a GDP only slightly lower. China, the world’s third-largest economy, produced 13.7 percent, or more than one-eighth, of total Country GDP (in billions) Percentage of World GDP United States China Japan India Germany United Kingdom France Italy Brazil European Union World $12,410 $8,182 $3,914 $3,699 $2,454 $1,869 $1,822 $1,651 $1,568 $12,180 $59,590 20.8% 13.7% 6.6% 6.2% 4.1% 3.1% 3.0% 2.8% 2.6% 20.4% 100.0% Source: www.cia.gov/cia/publication/factbook/rankorder world output. This means that GDP for the remaining countries in the world was less than half of world GDP. by $10 billion, for example, we know that production is growing and that jobs and income are generated, so we are likely to view the growth as a good thing. However, we might feel differently if we discovered that the extra output consisted of military nerve gas stockpiles rather than new libraries and parks. Second, GDP also tells little about the impact of production on the quality of life. The construction of 10,000 new homes may appear to be good for the economy. However, if the homes threaten a wildlife refuge, the value of the homes may be viewed differently. In practice, GDP does not take into account quality of life issues, so it is helpful to be aware of such matters to gain a better understanding of GDP. Finally, some GDP is produced to control activities that give us little utility or satisfaction, thus making GDP even larger. The money spent to fight crime is one example. If we had less crime, our GDP might actually be smaller because of lower government spending to control it—leaving us better off as well. A Measure of Economic Performance and Well-Being Even with these minor limitations, GDP is still our best measure of overall economic performance and well-being, because it is a measure of the voluntary transactions that take place in the market. Voluntary transactions occur only when both parties in a transaction think they
are better off after they have made it than before. This is one reason why GDP is considered an indicator of our overall economic health. Changes in GDP even influence national elections. Whenever the economy is growing slowly or contracting, the political party in power usually does not fare as well as it would have during a time of economic growth. Economic growth, as measured by increases in real GDP, means that jobs are plentiful and that incomes are rising. Such economic trends often influence the decisions of voters. As a result, GDP is the single most important economic statistic compiled today. Reading Check Explaining What does GDP measure, and why is it important? CHAPTER 12 Macroeconomic Performance 323 gross national product (GNP) total dollar value of all final goods, services, and structures produced in one year with labor and property supplied by a country’s residents, regardless of where the production takes place net national product (NNP) GNP less depreciation charges for wear and tear on capital equipment national income (NI) net national product less indirect business taxes personal income (PI) total amount of income going to the consumer sector before individual income taxes are paid disposable personal income (DPI) personal income less individual income taxes GNP—The Measure of National Income capital consumption allowances. It represents the capital equipment that wore out or became obsolete during the year. MAIN Idea National income can be measured in a number of different ways National Income Economics and You Have you ever wondered about the deductions on your pay stub? Read on to find out how your net pay is part of an economic measure. Whenever business activity creates output, it generates jobs and income for someone. GDP, then, is like a two-sided coin, where one side represents output and the other side an equal amount of income. If we want to see how much output is produced, we look at one side of the coin. If we want to see how much income is generated, we look at the other side of the coin. Economists recognize one major category and several subcategories of national income. Gross National Product When economists focus on total income rather than output, they measure it with gross national product (GNP)—the dollar value of all final goods, services, and structures produced in one year with labor and property owned by a country’s residents. While GDP measures the value of all the final goods and services produced within U.S. borders, GNP measures the income of all Americans, whether the goods and services are produced in the United States or in other countries.
To go from GDP to GNP, we add all payments that Americans receive from outside the United States, then subtract the payments made to all foreign-owned businesses located in the United States. The result, GNP, is the most comprehensive measure of our nation’s income. Net National Product The second measure of national income is net national product (NNP), or GNP less depreciation. Depreciation is also called The third measure in the NIPA is national income (NI). National income is the income that is left after all taxes except the corporate profits tax are subtracted from NNP. Examples of these taxes, also known as indirect business taxes, are excise taxes, property taxes, licensing fees, customs duties, and general sales taxes. Personal Income The fourth measure of the nation’s total income is personal income (PI)—the total amount of income going to consumers before individual income taxes are subtracted. To go from national to personal income, several adjustments must be made. For example, personal income would not include payments into the Social Security fund that working people make. It would include Social Security checks that retired individuals receive. Disposable Personal Income The fifth measure of income in the NIPA is disposable personal income (DPI)—the total income the consumer sector has at its disposal after personal income taxes. Although it is the smallest measure of income, it is important because it reflects the actual amount of money consumers are able to spend. At the individual level, a person’s disposable income is equal to the amount of money received from an employer after taxes and Social Security have been taken out. When you look at the pay stub that is illustrated in Figure 9.6 on page 248, the disposable personal income consists of the $586.89 net pay on the check plus the $3.20 of deductions which the individual chose to make. Reading Check Summarizing What are the different measures of national income? 324 UNIT 4 Macroeconomics: Performance and Stabilization Economic Sectors and Circular Flows MAIN Idea The production of output generates income which flows though different sectors of the economy. Economics and You Have you ever thought about your role as a consumer? Read on to find out how consumers are part of an economic model. It helps to think of the economy as consisting of several different parts, or sectors. These sectors receive various components of the national income, which they then use to purchase the total output. These sectors are part of the circular flow of economic activity illustrated in Figure
12.3. Income generated by production flows to the business, government, and consumer sectors. These sectors then use the income to purchase the nation’s output. household basic unit of consumer sector consisting of all persons who occupy a house, apartment, or separate living quarters Consumer Sector The largest sector in the economy is the consumer, or household, sector. Its basic unit, the household, consists of all persons who occupy a house, apartment, or room that constitutes separate living quarters. Figure 12.3 Circular Flow of Economic Activity Personal Income Disposable Income National Income Net National Product GDP* GNP* Wages, salaries, and tips Rent Interest Dividends Proprietor’s income Corporate income taxes Retained earnings Indirect business taxes Depreciation expenditures Businesses (I) Government purchases of goods and services Government (G) Transfer payments Personal savings * GNP equals GDP in a closed economy. Personal consumption expenditures Income generated by production flows to the business, government, and consumer sectors. These sectors then use the income to purchase the nation’s output. Economic Analysis What is the difference between national income and personal income Consumer (C) See StudentWorks™ Plus or glencoe.com. Investment Sector Businesses such as this auto manufacturer that produce the nation’s output are included in the investment sector. What other sectors are part of the circular flow of economic activity? unrelated individual person living alone even though that person may have relatives living elsewhere family two or more persons living together who are related by blood, marriage, or adoption Households include related family members and all others—such as lodgers, foster children, and employees—who share the living quarters. A household also can consist of an unrelated individual—a person who lives alone even though he or she may have family living elsewhere. Finally, we have the family—a group of two or more persons related by blood, marriage, or adoption who are living together in a household. The consumer sector, shown as C in Figure 12.3, receives its income in the form of disposable personal income. This is the income that is left over after all of the depreciation, business and income taxes, and FICA payments are taken out, and after any income received in transfer payments is added back in. Investment Sector The next sector of the macro economy is the business, or investment, sector, which is labeled I in Figure 12.3. This sector is made up of proprietorships, partnerships, and corporations that are responsible for producing the nation
’s output. The income of this sector comes from the retained earnings—the profits not paid out to owners— that are subtracted from NI and the depreciation or capital consumption allowances that are subtracted from GNP. Government Sector The third sector is the public sector, which includes all local, state, and federal levels of government. Shown as G in Figure 12.3, this sector receives its income from indirect business taxes, corporate income taxes, Social Security contributions, and individual income taxes. Foreign Sector The fourth sector of the macro economy is the foreign sector. Although not shown in Figure 12.3, it includes all consumers and producers outside the United States. This sector does not have a specific source of income. Instead, it represents the difference between the dollar value of goods sent abroad and that of goods purchased from abroad, identified as (X – M). If the two are reasonably close, the foreign sector appears to be small, even when large numbers of goods and services are traded. Reading Check Contrasting How do households and families differ? 326 UNIT 4 Macroeconomics: Performance and Stabilization AP Images outputexpenditure model macroeconomic model describing aggregate demand by the consumer, investment, government, and foreign sectors net exports of goods and services net expenditures by the foreign sector; equal to total exports less total imports The Output-Expenditure Model MAIN Idea The output-expenditure model is used to explain aggregate economic activity. Economics and You Have you learned in math class how to write a problem as an equation? Read on to learn how this can be done in economics. The circular flow can be represented by the output-expenditure model. This macroeconomic model shows how GDP is equal to the sum of aggregate demand by the consumer, investment, govern ment, and foreign sectors. When written as GDP = C + I + G + (X – M) the equation becomes a formal outputexpenditure model used to explain and analyze the economy’s performance. According to this model, the consumer sector spends its income on the goods and services used by households. These personal consumption expenditures include groceries, rent, and almost anything else people buy. Income that is not spent appears as personal saving, which is borrowed by the business and government sectors. The investment, or business, sector spends its income on labor, factories, equipment, inventories, and other investment goods. These expenditures include the total value of capital goods created in the economy during the year. The government sector spends its income on many
categories, including national defense, income security, interest on the national debt, health care, and roads. The only major government expenditure not included in total output is transfer payments, because this money is diverted for use by others to buy goods and services. The foreign sector also buys many U.S. goods—such as tractors, airplanes, and agricultural products—and services—such as insurance—that make up our GDP. In return, it supplies products—such as Japanese cars, Korean steel, and Brazilian shoes—to U.S. consumers. For this reason, the foreign sector’s purchases are called net exports of goods and services. They are abbreviated as (X – M) to reflect the difference between exports and imports. Reading Check Describing How does the foreign sector fit into the output-expenditure model? SECTION 1 Review Vocabulary 1. Explain the significance of macroeconomics, gross domestic product, intermediate products, secondhand sales, nonmarket transactions, underground economy, base year, real GDP, current GDP, GDP per capita, gross national product, net national product, national income, personal income, disposable personal income, household, unrelated individual, family, output-expenditure model, and net exports of goods and services. Main Ideas 2. Comparing Use a graphic organizer like the one below to compare GDP and GNP. GDP plus: less: GNP 3. Stating What is the circular flow of economic activity? Critical Thinking 4. The BIG Ideas Explain why GDP is important to economists. 5. Synthesizing Information Describe the limitations of GDP. 6. Analyzing Visuals Use Figure 12.3 on page 325 to describe how your personal spending and saving contribute to the circular flow of economic activity. 7. Drawing Conclusions What would be the effects of a decline in GDP? Applying Economics 8. Gross Domestic Product What effect do you think the computer industry has had on GDP? Use examples. CHAPTER 12 Macroeconomic Performance 327 ECONOMIST Profiles in Economics John Kenneth Galbraith (1908–2006) • advocated public works funding in The Affluent Society • served as economic adviser to five presidents Galbraith attended college during the early years of the Great Depression. His experiences taught him to question accepted theories and challenge what he called “conventional wisdom.” Iconoclast Economist Shaped by his experiences during the Great Depression, John Kenneth Galbraith believed in the government’s ability to solve problems. Early in his career,
he also developed a love of writing and an engaging, witty style. This turned the Harvard professor of economics into the most widely read American economist of his generation and turned his books into bestsellers. Galbraith developed a reputation as an iconoclast—a person willing to challenge accepted belief. Other economists objected to the liberal ideas Galbraith promoted. For example, in his classic The Affluent Society, Galbraith argued that Americans needed to reconsider their values. The U.S. economy had resulted in individual wealth, while public projects such as education and highways were neglected or underfunded. According to Galbraith, Americans were “artificially affluent” because corporations convinced people to buy goods they did not want or need. Government regulation of prices on certain goods would steer Americans away from spending and help them refocus on more important matters, such as attaining an education or appreciating culture. Presidential Influence Unlike most other economists, Galbraith was able to apply his economic theories in the social and political arenas. As an adviser to presidents Franklin Roosevelt, Harry Truman, John Kennedy, Lyndon Johnson, and Bill Clinton, Galbraith was a major force in directing the Democratic Party’s economic platform. Under President Roosevelt, he administered wage and price controls in the Office of Price Administration. His most direct influence, though, is reflected in President Johnson’s “war on poverty,” which incorporated many of Galbraith’s ideas, and increased funding for public works projects. Examining the Profile 1. Making Inferences Which viewpoint made Galbraith an iconoclast to other economists? 2. Drawing Conclusions How might living through the Great Depression lead to liberal economic thought? 328 UNIT 4 Macroeconomics: Performance and Stabilization Time Life Pictures/Getty Images SECTION 2 Population and Economic Growth GUIDE TO READING Section Preview Academic Vocabulary We are interested in population because it makes up the economy’s largest sector, the consumer sector, and affects the economic performance of a nation. • residence (p. 329) • projected (p. 334) Content Vocabulary • census (p. 329) • urban population (p. 330) • population pyramid (p. 333) • dependency ratio • rural population (p. 333) (p. 330) • center of population (p. 331) • infrastructure (p. 332) • baby boom (p. 332) • demographers (p. 334) • fertility rate (p. 334
) • life expectancy (p. 334) • net immigration (p. 334) Reading Strategy Identifying As you read the section, complete a graphic organizer like the one below by identifying changes in the United States in the listed categories. Rate of growth Size of household Regional change ISSUES IN THE NEWS Census Bureau Selects Sites for Census Dress Rehearsal —U.S. Census Bureau San Joaquin County, Calif., and the city of Fayetteville, N.C., and surrounding area... have been selected by the U.S. Census Bureau to serve in 2008 as the dress rehearsal sites for the 2010 Census.... San Joaquin County [is] an urban location with a multilingual population and an assortment of group quarters housing such as hospitals, college residence halls, nursing homes, prisons and facilities for the homeless.... The Fayetteville site [has] a mix of... urban, suburban and rural areas and has two military bases (Fort Bragg and Pope Air Force Base). ■ Population is important for a number of reasons. First, a country’s population is the source of its labor, one of the four factors of production. Second, the population is the primary consumer of the nation’s output and has a direct effect on how much is produced. Because of this, the size, composition, and rate of growth of a country’s population has an impact on macroeconomic performance. The Constitution of the United States requires the government to periodically take a census, an official count of all people living in the United States, including their place of residence. Because the official census occurs every 10 years, it is called the decennial census. As you can see in the news story, the U.S. Census Bureau begins making plans for the decennial census several years ahead of time. census complete count of population, including place of residence RON KUENSTLER/AP Images CHAPTER 12 Macroeconomic Performance 329 urban population those persons living in incorporated cities, towns, and villages with 2,500 or more inhabitants rural population those persons not living in urban areas Census Some census workers interview a select group of people in person. How are census data used? Population in the United States MAIN Idea The country’s population has shifted from a fast-growing, mostly rural population to a slower-growing, mostly urban one. Economics and You Have you ever wondered how we know the size of the U.S. population? Read on to
learn how it is measured. One of the original uses of the census was to apportion the number of representatives that each state elects to Congress. Ever since, the census has given us a wealth of data about our nation, and we even use it to make projections into the future. Counting the Population The federal government conducted the first census in 1790. Throughout the 1800s, it created temporary agencies each decade to do the counting. In 1902, Congress permanently established the U.S. Census Bureau. Today, the Bureau works yearround, conducting monthly surveys relating to the size and other characteristics of the population. When the Census Bureau conducted the last decennial census, it used the household as its primary survey unit. In this census, about five in every six households received a “short form,” which took just a few minutes to fill out. The remaining households received a “long form,” which included more questions and served to generate a more detailed profile of the population. Bureau employees also used different methods to count special groups, such as homeless persons, who do not normally conform to the household survey unit. The Census Bureau tabulates and presents its data in a number of ways. One such classification considers the size of the urban population—people living in incorporated cities, villages, or towns with 2,500 or more inhabitants. The rural population makes up the remainder of the total, including those persons who live in sparsely populated areas along the fringes of cities. Historical Growth The population of the United States has grown considerably since colonial times. The rate of growth, however, has slowly declined. Between 1790 and 1860, the population grew at a compounded rate of about 3.0 percent a year. From the beginning of the Civil War until 1900, the average fell to 2.2 percent. From 1900 to the beginning of World War II, the rate dropped to 1.4 percent. The rate of increase declined slowly but steadily after that, and today the rate of population growth is less than 1.0 percent annually. The census also shows a steady trend toward smaller households. During colonial times, household size averaged about 5.8 people. By 1960, the average had fallen to 3.3 and today is about 2.6 people. The figures reflect a worldwide trend toward Rhoda Sidney/PhotoEdit Figure 12.4 Center of Population, 1790–2000 The center of population is the point where the country would balance if the map were flat and every person weighed the same. Economic Analysis Why
has the center moved since the first census was conducted in 1790? C ENTER OF P OPULATION See StudentWorks™ Plus or glencoe.com. IOWA MISSOURI ILLINOIS INDIANA OHIO Springfield Indianapolis 1930 1910 1890 1880 1900 1920 St. Louis 1960 1950 1940 1970 1980 1990 2000 Louisville KENTUCKY Columbus 1870 1860 1850 1840 Charleston WEST VIRGINIA ARKANSAS TENNESSEE Source: U.S. Census Bureau PENNSYLVANIA Pittsburgh Baltimore 1800 1790 MD 1820 1810 DC 1830 Richmond VIRGINIA NORTH CAROLINA Mean center of population smaller families in industrialized countries. The figures also show that more individuals are living alone today than ever before. Regional Change An important population shift began in the 1970s with a migration to the western and southern parts of the United States. These regions have grown quite rapidly, while most of the older industrial areas in the North and East have grown more slowly or even lost population. As people have left the crowded, industrial Northeast for warmer, more spacious parts of the country, the population in states such as Nevada, Arizona, Colorado, Utah, Idaho, Georgia, and Florida has been increasing steadily. Another indicator of population shift is the center of population—the point where the country would balance if it could be laid flat and everyone weighed the same. In 1790, the center was 23 miles east of Baltimore, Maryland. Since then, as you can see in Figure 12.4, it has moved farther west. By the 2000 decennial census, the center of population had reached a point about 2.8 miles east of Edgar Springs, Missouri. center of population point where the country would balance if it were flat and everyone weighed the same Consequences of Growth Changes in population can distort some macroeconomic measures like GDP and GNP. As a result, both measures are often expressed on a per capita, or per person, basis. One result is GDP per capita, which is determined by dividing GDP by the population. GDP per capita is especially useful when making comparisons between countries. Population growth can have several consequences. If a nation’s population grows faster than its output, per capita output grows more slowly, and the country could CHAPTER 12 Macroeconomic Performance 331 Urban Sprawl When the population grows, it results in heavier traffic. What are other effects of population growth? Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click
on Chapter 12—Student Web Activities for an activity about population trends. infrastructure the highways, mass transit, communications, power, water, sewerage, and other public goods needed to support a population baby boom historically high birthrate years in the United States from 1946 to 1964 end up with more mouths than it can feed. On the other hand, if a nation’s population grows too slowly, there may not be enough workers to sustain economic growth. In addition, a growing population puts more demand on resources. When a growing population shifts toward certain areas, such as cities or suburbs, it puts different pressures on existing resources. In Atlanta, Georgia, for example, urban sprawl and traffic congestion have become major problems. In heavily populated areas of Arizona, Nevada, and southern California, adequate supplies of fresh water have become concerns. Because it takes a long time to plan and construct a country’s infrastructure— the highways, levees, mass transit, communications systems, electricity, water, sewer, and other public goods needed to support a population—we need to pay attention to future population trends. If we neglect them, even modest shifts in the population can cause enormous problems in the future. Reading Check Explaining What have been the major population changes since the first census in 1790? Projected Population Trends MAIN Idea Fertility, life expectancy, and net immigration influence population trends. Economics and You Have you considered how immigration affects population growth? Read on to learn how the U.S. population is expected to change. Population trends are important to many groups. Political leaders watch population shifts to see how voting patterns may change. Community leaders are interested because changes in local population affect services such as sanitation, education, and fire protection. Businesses use census data to help determine markets for products and sales territories. Age and Gender When making its projections, the Census Bureau assumes that the aging generation of baby boomers will drive many characteristics of the population. People born during the baby boom, the high birthrate years from 1946 to 1964, make up a sizable portion of the current population. As 332 UNIT 4 Macroeconomics: Performance and Stabilization Barry Williams/Getty Images population pyramid diagram showing the breakdown of population by age and gender dependency ratio number of children and elderly people in the population for every 100 persons in the 18 to 64 working-age bracket shown in Figure 12.5, people born during this time span created a significant bulge in the population pyramid, a type of bar graph that shows the breakdown of population
by age and gender. The bulge in the middle of the pyramid represents the baby boomers. A second, minor bulge represents the children born to the baby boom generation. As years pass, more births add to the bottom of the pyramid and push earlier groups upward into higher age brackets. Eventually, the baby boomers will reach their retirement years and want to collect pensions, Social Security, and Medicare benefits. Because most of these payments are transfer payments, they will place a heavy burden on the younger and relatively smaller working population. The burden becomes evident with changes in the dependency ratio—the number of children and elderly people in the population for every 100 persons in the working- age bracket of ages 18 through 64. The dependency ratio was 63.9 in 1998, but according to Census Bureau projections, it will rise to 67.5 by 2020, to 77.5 by 2030, and to 78.0 by 2040. Finally, if you compare the left side of the population pyramid with the right, you will see that women tend to outlive men. Separate population pyramids can also be created for any racial or ethnic group. Race and Ethnicity The Census Bureau also makes projections for racial and ethnic groups. In 2000, whites were the largest component of the total population. The numbers of African Americans, Hispanic Americans, Asian Americans, and Native Americans followed in that order. Differences in fertility rates, life expectancies, and immigration rates will change the racial statistics dramatically in the future. By 2050, the Asian and Hispanic Figure 12.5 Projected Distribution of the Population by Age and Gender, 2010 P OPULATION P YRAMID Male Female Age 85+ 80–84 75–79 70–74 65–69 60–64 55–59 50–54 45–49 40–44 35–39 30–34 25–29 20–24 15–19 10–14 5–9 0–4 12 10 10 12 Population (in millions) Source: U.S. Census Bureau, International Data Base. Population pyramids are one way to show the distribution of population. In this pyramid, the population is divided by age and gender. Economic Analysis To which age bracket do most males belong? Most females? Figure 12.6 Projected Change in U.S. Population by Race and Ethnic Origin, 2000–2050 P ROJECTED P OPULATION, 2000–2050 The distribution of population by race is projected to change dramatically by the year 2050. Economic Analysis Which ethnic groups are expected
to increase the most? Which will decrease in proportion to the total population? t n e c r e P 90 80 70 60 50 40 30 20 10 0 2000 2010 Source: U.S. Census Bureau. White Hispanic Other races Asian American African American 2040 2050 2020 2030 Year demographer person who studies growth, density, and other characteristics of the population fertility rate number of births that 1,000 women are expected to undergo in their lifetime life expectancy average remaining life span in years for persons who attain a given age net immigration net population change after accounting for those who leave as well as enter a country portions of the population are expected to nearly double. The number of African Americans will also increase. The white non-Hispanic population is expected to remain a majority of the total population at just over 50 percent. Figure 12.6 shows how the Census Bureau projects the ethnic makeup of the U.S. population to change over the next few decades. Population Growth According to demographers—people who study the growth, density, and other characteristics of population—three major factors affect population growth. These factors are fertility, life expectancy, and net immigration levels. The fertility rate is the number of births that 1,000 women are expected to undergo in their lifetime. A fertility rate of 2,119, for example, translates to 2.119 births per woman. According to the Bureau of the Census, this rate is projected as the most likely fertility rate for the United States. That rate is barely above the replacement population rate—the rate at which the number of births in a population offsets the number of deaths and the size of the population neither increases nor decreases. This was not always the case. In the late 1800s and early 1900s, Americans tended to have large families. In the days before modern machines and appliances, the work of maintaining a home and family and earning a living was difficult and time consuming. Children were needed to do household chores, work on family farms, and bring in additional money from outside jobs. Later, as life became mechanized and fewer people lived on farms, having large families became less important. As a result, the nation’s birthrate dropped steadily throughout the last century. The second factor, life expectancy, is the average remaining life span of a person who has reached a given age. The Bureau of the Census predicts that life expectancy at birth will go from about 75.9 years today to 82.1 years by 2050. The third factor is net immigration—the overall change in population caused by 334 UN
IT 4 Macroeconomics: Performance and Stabilization Skills Handbook See page R47 to learn about Making Predictions. people moving into and out of the country. The Census Bureau recently estimated a constant net immigration of about 880,000 per year. This figure is based on 1,040,000 immigrants—those entering the country— and 160,000 emigrants—those leaving the country—in the future. Taking into account these three factors, analysts expect the rate of population growth in the United States to continue to decline. The growth rate, already below 1 percent today, is likely to decrease further until the year 2050. At that time, the resident United States population is expected to be about 420 million people. Future Population Growth Most of the demographic factors examined in this section point to a population that is likely to grow more slowly in the future. While this may seem like a matter for concern, it is important to note that increases in productivity can easily offset the negative effects of declining population growth. If slightly fewer people produce significantly more on average, then total output will continue to grow. The larger concern is the age composition of the future population. As the population matures, a greater percentage of people reach retirement age. This will cause an increase in the demand for medicines, medical facilities, retirement homes, and other products that are needed for the retired and the elderly. At the same time, there may be a declining need for schools, playgrounds, and other facilities as the young become a smaller percentage of the population. These changes tend to be gradual, and their impact on the economy can be anticipated with some degree of certainty. As you learned in Chapter 2, one of the major advantages of a market economy is that it accommodates change with the least amount of disruption of daily life. Reading Check Summarizing Why is the rate of population growth declining? SECTION 2 Review Vocabulary 1. Explain the significance of census, urban population, rural population, center of population, infrastructure, baby boom, population pyramid, dependency ratio, demographers, fertility rate, life expectancy, and net immigration. Main Ideas 2. Explaining How does the rate of population growth affect economic growth? 3. Listing Use a graphic organizer like the one below to list the three most important factors that determine future population. Critical Thinking 4. The BIG Idea How can the projection of population trends help determine the direction of economic development? 5. Drawing Conclusions How will the retirement of baby boomers affect your generation? How do you think the baby boomers
will feel about this? 6. Determining Cause and Effect What special demands does a high birthrate put on a nation’s economy? 7. Analyzing Visuals Look at the photograph of traffic congestion on page 332. What effect does urban sprawl have on the city of Atlanta? What could the city do to alleviate the problem? Factors Influencing Population Trends Applying Economics 8. Population Growth Search your local newspaper for articles related to population issues. Summarize the population-related problems affecting your community, and assess the local or state government’s solutions. CHAPTER 12 Macroeconomic Performance 335 CASE STUDY Falabella Flourishes Chilean Retail Giant Latin American countries have experienced tremendous population growth. Yet this alone does not guarantee business success, because it is hard to get people to buy your products when they have very little money to spend. Big-name foreign companies, such as Sears and J.C. Penney, have called it quits in Chile because of this roadblock. A domestic retail company, however, has found a highly successful way around it. Tailored to Consumers Chile’s S.A.C.I. Falabella began in 1889 as a small tailor shop and has since grown to become the largest department store chain in Chile and one of the largest in South America. Falabella’s strategy for growth is simple: find a way to satisfy consumers’ needs. In 1980, Falabella created CMR—its own credit card. Today, the CMR card, issued to more than 4 million people in Chile, Peru, Argentina, and Colombia, is the most widely used credit card in Chile. As an added incentive for frequent CMR users, Falabella offers rewards in the form of cellular phone minutes. Customers can even charge a cellular account directly to their card. F ALABELLA R EVENUE ).0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0 2000 2001 2002 2003 2004 2005 Year Source: Falabella R EVENUE C OMPOSITION 2% 15% 5% 9% 8% 27% 34% Source: Falabella Falabella Chile Sodimac Chile Tottus Chile CMR Chile Argentina Peru Others Diversify, Diversify Despite great success with the CMR card, the department store did not realize its potential for growth until it expanded and diversified. Falabella opened stores in neighboring Argentina and Peru, acquired a large share of ownership in The Home Depot Chile
, and purchased the home improvement chain Sodimac. Building on these successes, it created a travel agency and an insurance brokerage, then built a chain of Tottus super stores called hypermarkets. To help all financial aspects of the company work together smoothly, the company added a financial division with the new Banco Falabella (Falabella Bank). This explosive growth has nearly tripled the number of Falabella-owned stores, and they all accept the CMR card. Analyzing the Impact 1. Summarizing What services does Falabella provide? 2. Making Inferences Why has Falabella succeeded where others have failed? 336 UNIT 4 Macroeconomics: Performance and Stabilization SECTION 3 Poverty and the Distribution of Income GUIDE TO READING Section Preview In this section, you will learn about the factors that contribute to income inequality and the programs that have been implemented to reduce poverty. Content Vocabulary • poverty threshold (p. 338) • poverty guidelines (p. 338) • Lorenz curve (p. 339) • welfare (p. 342) • food stamps (p. 342) • Medicaid (p. 343) • Earned Income Tax Credit (EITC) (p. 343) • enterprise zone (p. 344) • workfare (p. 344) • negative income tax (p. 344) Academic Vocabulary • impact (p. 340) • uniform (p. 342) Reading Strategy Outlining As you read the section, complete a graphic organizer similar to the one below by outlining three explanations for a growing income gap. Income Gap —Toledo Blade ISSUES IN THE NEWS Need for Food Help Is Growing Once believed to affect only the homeless or unemployed, hunger in America has taken on a new face: the working poor. According to a new nationwide study, more than 25 million Americans seek emergency food assistance each year. In the Toledo area, nearly 297,000 visits were made by people seeking help from a local food distribution agency last year. Nearly 26 percent of those local clients had at least one adult working in the family. The study, called “Hunger in America 2006,” shows hunger has become an issue for even those with jobs. “What is really telling about this study is that such a large number of clients we’re serving have at least one adult working,” said Maura Daly, director of the study. “It’s difficult to imagine that people who have a job are coming home at the end of the
day and have to make choices between food and other basic necessities like rent, utilities, or medicine.” ■ In the world today, poverty can be viewed as an indicator of macroeconomic performance. Unfortunately, about one person in eight in the United States lives in poverty despite several years of solid economic growth. As you can read in the news story, this number includes people who hold jobs but do not earn enough money to fully support their families. Governments on all levels have initiated programs to reduce poverty. Before we discuss these programs, however, we must first understand how poverty is defined and measured. Marcio Jose Sanchez/AP Images CHAPTER 12 Macroeconomic Performance 337 poverty threshold annual dollar income used to determine the number of people in poverty poverty guidelines administrative guidelines used to determine eligibility for certain federal programs Poverty MAIN Idea A portion of the U.S. population lives in poverty, and the gap in the distribution of income is widening every year. Economics and You Have you ever thought about what it would be like to be either very rich or very poor? Read on to find out how income is distributed in the United States. Poverty is a relative measure that depends on prices, the standard of living, and the incomes that others earn. What may seem like poverty to one person may seem like riches to another, so we first need to understand how poverty is defined. Defining Poverty People are classified as living in poverty if their incomes fall below a predetermined level, or threshold. The poverty threshold is the benchmark used to evaluate the income that people receive. If they have incomes below the threshold, they are considered to be in poverty even if they have supplements such as food stamps, subsidized housing, and Medicaid. The Social Security Administration developed the thresholds in 1964 using two studies done by the U.S. Department of Agriculture in the 1950s. The first study developed four alternative but nutritionally adequate food plans for individuals and families of different sizes. The least expensive food plan was then selected as the food budget that would keep people out of poverty. The second study found that families typically spend one-third of their total income on food. To obtain the threshold, the Social Security Administration simply took the least expensive food budget of the four food plans and multiplied it by three. Today the thresholds are adjusted upward every year by an amount just enough to offset increases in inflation. For administrative purposes, the poverty threshholds are then simplified to appear as poverty guidelines, or administrative guides used to determine eligibility for certain federal programs such as the Food Stamps Program
and Head Start. Figure 12.7 shows the guidelines that had been established for two recent years. Figure 12.7 Poverty Guidelines The table lists the poverty guidelines for families of different sizes for two recent years. Families and households with incomes below the official poverty guidelines are eligible for certain federal programs. Economic Analysis How are the poverty guidelines used today? Persons in Family or Household 1 2 3 4 5 6 7 8 For each additional person, add Source: Federal Register 2005 $9,570 12,830 16,090 19,350 22,610 25,870 29,130 32,390 3,260 2006 $9,800 13,200 16,600 20,000 23,400 26,800 30,200 33,600 3,400 Figure 12.8 The Distribution of Income Panel A shows the rankings of all household income for two separate years. When the 2004 data are plotted in Panel B, the curve shows the cumulative income from the lowest to the highest quintiles. Because incomes are not distributed evenly among households, the Lorenz curve is not a diagonal line. Economic Analysis What percentage of income is received by the richest quintile in 1980? In 2004? A H OUSEHOLD I NCOME R ANKED BY Q UINTILES 1980 Quintiles Quintiles 2004 Cumulative Lowest fifth Second fifth Third fifth Fourth fifth Highest fifth Top 5 percent 4.2% 10.2% 16.8% 24.7% 44.1% 16.5% 3.4% 8.7% 14.7% 23.1% 50.1% 21.8% 3.4% 12.1% 26.8% 49.9% 100.0% See StudentWorks™ Plus or glencoe.com. B T HE L ORENZ C URVE 100 e 80 m o c n i 1980 2004 Equality of income 60 40 a = 3.4% 31.2% 55.9% 49.9% 20 4.2% 0 14.4% 26.8% b = 12.1% 20 Percentage of total households 80 40 60 100 Source: U.S. Census Bureau. Lorenz curve graph showing how the actual distribution of income differs from an equal distribution Distribution of Income In addition to determining the actual number of people in poverty, economists are interested in finding out how income is distributed among households. To do so, the incomes of all households are ranked from highest to lowest, and the ranking is then divided into quintiles, or fifths,
for examination. Then the total amount of the nation’s income earned by each quintile is calculated. The table in Panel A of Figure 12.8 shows household income quintiles for two different years. As before, only money income is counted, while other aid such as Medicaid, food stamps, or subsidized housing is excluded. Using the most recent year in the figure as our example, the percentage of income earned by each quintile is added to the other quintiles. These incomes are plotted as a Lorenz curve. The Lorenz curve, which shows how the actual distribution of income varies from an equal distribution, appears in Panel B. To illustrate, in 2004 the 3.4 percent of total income received by the lowest quintile is plotted in Panel B as point a. This amount is added to the 8.7 percent the next quintile earns and plotted as point b. This process continues until the cumulative amounts of all quintiles are plotted. If all households received exactly the same income—so that 40 percent of the households earn 40 percent of the total income and so on—the Lorenz curve would appear as a diagonal line running from one corner of the graph to the other. Because all households do not receive the same income, however, the Lorenz curve is not a diagonal. As you can see in the figure, the distribution of income recently has become more unequal than it was in 1980. A Lorenz curve can also be shown for groups other than households. These would include Lorenz curves for individuals, families, or occupations. Reading Check Describing How were poverty thresholds developed? CHAPTER 12 Macroeconomic Performance 339 Reasons for Income Inequality MAIN Idea Lack of education and uneven distribution of wealth are among the reasons for poverty. Economics and You Have you ever considered how your education could affect your income? Read on to find out about the way income is distributed in the United States. There are at least eight, if not more, reasons why incomes vary. Education and wealth are among the most important of these reasons. Education One of the most important reasons for income inequality is the difference in individuals’ educational levels. People’s income normally goes up as they get more education. However, in the last 30 years, the gap between well-educated and poorly educated workers has widened. This has caused wages for highly skilled workers to soar, while wages for the less skilled have remained about the same. You saw proof of the importance of education earlier in Figure 1.4 on page 16. This figure
shows that someone who has earned a college degree makes about three times more on average than someone without a high school diploma. Likewise, someone with a college degree makes nearly twice as much as someone with a high school diploma. Wealth Income also varies because some people hold more wealth than others, and the distribution of wealth is even more unequal than the distribution of income. When wealth holders are ranked from highest to lowest, the top fifth holds about 75 percent of all the wealth in the country. The bottom two-fifths, or 40 percent of the people in the country, have less than 2 percent of the total wealth. This inequality has a dramatic impact on people’s ability to earn income. Wealthy families can send their children to expensive colleges and universities. The wealthy also can afford to set their children up in businesses where they can earn a better Personal Finance Handbook See pages R16–R19 for information on getting an education. Inequality of Income Some Americans live in mansions, while others cannot afford to pay rent and are homeless. What are the major reasons for varying incomes? 340 UNIT 4 Macroeconomics: Performance and Stabilization Joel Stettenheim/Corbis income. Even if the very wealthy choose not to work, they can make investments that will earn additional income. Tax Law Changes In recent years, Congress has changed many tax laws, reducing taxes for almost all Americans. Marginal tax rates on high incomes, however, have been reduced more than rates on lower incomes, thereby adding to the growing inequality of income. The 15 percent tax rate that applies to corporate dividend payments and capital gains, for example, is the same as the second-lowest rates that apply to the poorest Americans. This means that a millionaire who receives tens of thousands of dollars in corporate dividends pays the same percentage rate on those dividends as someone who only earns $20,000 a year. Decline of Unions As heavy manufacturing has declined in the United States, union membership has fallen, especially among less-skilled workers, adding to the growing income gap. High school graduates who once followed their parents into high-paying factory jobs can no longer do so. This leaves them to find other work, often for much less pay. More Service Jobs A structural change in the U.S. economy saw industry convert from goods production to service production. This event widened the income differential. Because wages are typically lower in service industries such as restaurants, movie theaters, and clothing stores, annual incomes also tend to be lower. Monopoly Power Another
factor is the degree of monopoly power that some groups have. You learned in Chapter 8 that unions have been able to obtain higher wages for their members. Some white-collar workers—clerical, Income Gap The rising inequality of income is a worldwide phenomenon, especially for the developing countries of Asia. A major reason for this trend is the lack of jobs for the growing population. The widening income gaps have troubling results. More and more countries experience public complaints, protests, and political crises. In one year alone, China was faced with tens of thousands of protests, often in rural areas where people’s earnings are a small fraction of the average income their fellow citizens in cities and coastal regions receive. business, or professional workers who generally are salaried—also hold a degree of monopoly power. The American Medical Association, for example, has successfully limited the number of people entering the profession by restricting medical school certifications. This has been a major factor in driving up the incomes of doctors. Discrimination Discrimination also affects the distribution of income. Women may not be promoted to executive positions because male executives simply are not accustomed to women in roles of power. Some unions may deny membership to immigrants or ethnic minorities. Although workplace discrimination is illegal, it still occurs. When it does, it causes women and minority groups to be crowded into other labor markets where oversupply drives wages down. Changing Family Structure A final reason for the growing income gap concerns the changing structure of the American family. The shift from two-parent families to single-parent families and other household living arrangements tends to decrease the average family income. This and the other factors mentioned above contribute to the trend of the rich getting richer and the poor getting poorer. Reading Check Synthesizing Which factors are most important in unequal income distribution? Why? CHAPTER 12 Macroeconomic Performance 341 welfare government or private agency programs that provide general economic and social assistance to needy individuals food stamps government-issued coupons that can be exchanged for food Skills Handbook See page R48 to learn about Problems and Solutions. Antipoverty Programs MAIN Idea Since the 1960s, the government has experienced modest success with a number of anti-poverty programs. Economics and You Did you know there are programs designed to help people escape or avoid poverty? Read on to find out about these programs. Over the years, the federal government has tried a number of programs to help the needy. Most come under the general heading of welfare—economic and social assistance from the government or private agencies because of need. Reducing poverty has been difficult.
As Figure 12.9 shows, even the record economic expansions of the 1980s and 1990s failed to make a significant dent in the percentage of Americans living in poverty. In fact, the proportion of the population living in poverty today is about the same as it was in the 1970s—and it might have been worse without some of the following programs. Income Assistance Programs that provide direct cash assistance to those in need fall into the category of income assistance. One such program is the Temporary Assistance for Needy Families (TANF), which began in 1997. Although provisions and benefits vary from state to state, many families qualify for modest cash payments because of the death, continuous absence, or permanent disability of a parent. More recently, Congress voted to tighten provisions of the law and toughen work standards for twoparent households. Another income assistance program is the Supplemental Security Income (SSI), which makes cash payments to blind or disabled persons or to people age 65 and older. Originally, the states administered the program, but because benefits varied so much from state to state, the federal government took it over to assure more uniform coverage. General Assistance Programs that assist poor people but do not provide direct cash assistance fall into the category of general assistance. One example is the food stamp program that serves millions of Americans. Food stamps are government-issued coupons that can be redeemed for food. They may be given or sold to eligible low-income persons. Figure 12.9 Poverty in the United States: Total Number and Rate Since the mid-1960s, the poverty rate has hovered between 10 and 15 percent of the population. In that same time span, the number of people in poverty has increased. Economic Analysis When was the poverty rate lowest? When did it reach the highest numbers? P OVERTY IN THE U NITED S TATES Number in poverty (in millions) Poverty rate (percent) 40 30 20 10 See StudentWorks™ Plus or glencoe.com. 0 1960 1965 1970 1975 1980 1990 1995 2000 2005 2010 1985 Year Source: U.S. Census Bureau Job Training Many states have introduced job training, such as this computer class, to help people out of poverty. How are such programs usually funded? For example, if a person pays 40 cents for a $1 food stamp, that person can get a dollar’s worth of food for a fraction of its cost. The program, which became law in 1964, is different from other programs because eligibility is based solely on income. Another general assistance program is Medicaid—a
joint federal-state medical insurance program for low-income people. Under the program, the federal government pays a majority of health-care costs, and the state governments cover the rest of the cost. Medicaid serves millions of Americans, including children, the visually impaired, and the disabled. Social Service Programs Over the years, individual states have developed a variety of social service programs to help the needy. These include such areas as child abuse prevention, foster care, family planning, job training, child welfare, and day care. Although states control the kinds of services the programs provide, the federal Lester Lefkowitz/Corbis government may match part of the cost. To be eligible for matching funds, a state must file an annual service plan with the federal government. If the plan is approved, the state is free to select social issues it wishes to address, set the eligibility requirements for the programs, and decide how the programs are to be carried out. As a result, the range of services and the level of support may vary from state to state. Medicaid joint federal-state medical insurance program for low-income people (also see page 271) Earned Income Tax Credit (EITC) federal tax credits and cash payments for low-income workers Tax Credits Many working Americans qualify for special tax credits. The most popular is the Earned Income Tax Credit (EITC) which provides federal tax credits and even cash to low-income workers. The credit was created to partially offset the payroll tax burden on working families. The credit is applied first to federal income taxes. Lowincome workers can take the remainder of the credit in cash if the credit is larger than the taxes owed. The credit has proved to be popular, with millions of working families receiving benefits annually. CHAPTER 12 Macroeconomic Performance 343 enterprise zone area free of tax laws and other operating restrictions workfare program requiring welfare recipients to work in exchange for benefits negative income tax tax system that would make cash payments to individuals with incomes below certain levels Enterprise Zones Special enterprise zones are areas where companies can locate free of some local, state, and federal tax laws and other operating restrictions. Many enterprise zones are established in run-down or depressed areas. This benefits area residents because they can find work without worrying about transportation. Enterprise zones thus help depressed areas to grow again in several different ways. Nearly everyone agrees that a healthy and growing economy helps alleviate poverty. CAREERS Actuary The Work * Help businesses assess risks and formulate policies * Gather and analyze statistics on death, sickness, injury
, disability, retirement, and property loss * Design insurance and pension plans and calculate premium rates that are high enough to cover any claims and expenses Qualifications * Strong background in mathematics, statistics, probability, finance, and business * Knowledge of economic, social, health, and legislative trends * Ability to develop and use spreadsheets, databases, and statistical analysis software * Bachelor’s degree in mathematics or statistics * Must pass a series of actuarial examinations Earnings * Median annual earnings: $76,340 Job Growth Outlook * Faster than average Source: Occupational Outlook Handbook, 2006–2007 Edition The enterprise zone concept is an attempt to focus some of that growth directly in the areas that need it most by making more employment opportunities available. Workfare Programs Because of rising welfare costs, many state and local governments require individuals who receive welfare to provide labor in exchange for benefits. Workfare is a program in which welfare recipients work for their benefits. People on workfare often assist law enforcement officials or sanitation and highway crews, work in schools or hospitals, or perform other types of community service work. Most states that have workfare programs require almost everyone except for the disabled, the elderly, and those with very young children to work. If the workfare assignments are well designed, then recipients have a valuable opportunity to learn new skills that will eventually help them get other jobs. Many welfare-to-work programs have had promising results. In some cases, companies can even earn federal tax credits when they hire workers directly from the welfare rolls. Under these circumstances, the employment is a win-win situation for both employer and employee. Negative Income Tax The negative income tax is a proposed type of tax that would make cash payments to certain groups below the poverty line. While the program is not in use today, the proposal is attractive because cash payments would take the place of existing welfare programs rather than supplementing them. Also, everyone would qualify for the program, not just working people as with the EITC. Under the negative income tax, the federal government would set an income level below which people would not have to pay taxes. Then the government would pay a certain amount of money to anyone who earned less than that amount. 344 UNIT 4 Macroeconomics: Performance and Stabilization Myrleen Ferguson Cate/PhotoEdit For example, suppose that an individual’s tax liability was computed using the following formula: taxes = (25% of income) – $8,000 Under this formula, a person with no income would have a tax of minus
$8,000— which is another way of saying that the person will receive $8,000 from the government. If the person earned exactly $12,000, then the taxes would be $3,000 minus $8,000, so they would receive $5,000 for a total of $17,000 (or $5,000 from the tax formula plus the $12,000 in earned income). Under this formula, a person would have to make $32,000 before he or she actually paid any taxes. The negative income tax differs from other antipoverty programs in two respects. First, it is a market-based program designed to encourage people to work. The objective is to make the minimum payment large enough to be of some assistance, yet small enough so that people are better off working. Then, when people do go to work, the taxes they pay need to be low enough to not discourage them from working. Second, the negative income tax would be cost-effective because it would take the place of other, more costly, welfare programs. In addition, government would save on administrative costs. A Difficult Problem We might ask how the U.S. economy has done as a result of all these programs with the strong economic growth since the 1980s. The answer, unfortunately, is that poverty has been a remarkably difficult problem to solve. Economic growth is important, of course, but by itself it is not sufficient to reduce poverty. Even so, there are sound reasons to try to improve the problem of poverty. Not only would millions of Americans be better off, but everyone else in the economy would be better off as well. After all, if too many people find themselves without the capacity to earn and spend, there will be fewer people to purchase the products that our economy produces. Reading Check Summarizing What are the benefits of the EITC to a working person? SECTION 3 Review Vocabulary 1. Explain the significance of poverty threshold, poverty guidelines, Lorenz curve, welfare, food stamps, Medicaid, Earned Income Tax Credit (EITC), enterprise zone, workfare, and negative income tax. Main Ideas 2. Defining How is poverty defined? 3. Describing What are reasons for income inequality? 4. Identifying Use a graphic organizer like the one below to identify the major programs and proposals designed to alleviate the problem of poverty Alleviating the problem of poverty 1. 2. Critical Thinking 5. The BIG Idea Which of the factors that contribute to income inequality do you feel
has the most impact? Explain your answer. 6. Drawing Conclusions Do you think that a workfare program is the best way to address income inequalities within our economy? Explain your answers. 7. Analyzing Visuals Look at Figure 12.9 on page 342. How do the lines for the number of people in poverty and the poverty rate compare? Why are the lines not more similar? Applying Economics 8. Distribution of Income What would happen to the Lorenz curve if nonfinancial aid such as food stamps and Medicaid were treated as income? Explain why this would occur. CHAPTER 12 Macroeconomic Performance 345 NEWSCLIP A gap in income between high- and low-paid workers has always existed. Some people argue that income inequality today is as high as before the Great Depression. The Rich Get (Much) Richer Shame on... us, passive witnesses to the emergence of a second Gilded Age, another Roaring Twenties, in which the fruits of economic success have gone not to the broad populace but to a slim sliver at the top. For this handful, life is a sweet mélange [mix] of megafortunes, grand houses, and massive yachts. Meanwhile, the bottom 80% endures economic stagnation.... Much of the recent commentary has focused on class mobility, the opportunity for individuals to move up the ladder. But trumpeting mobility as a reason for ignoring growing income inequality is a chimera [illusion]. Even if mobility is high— a questionable assertion—it is hardly a consolation for those who remain at the bottom, gazing across a growing distance at the more successful. We can debate a lot of economic data but not income inequality. Every serious study shows that the U.S. income gap has become a chasm [gulf]. Over the past 30 years, the share of income going to the highest-earning Americans has risen steadily S HARE OF H OUSEHOLD I NCOME Top 20% of households earned 50.1% of all income Next 20% earned 23.1% of all income Next 20% earned 14.7% of all income Next 20% earned 8.7% of all income Bottom 20% earned 3.4% of all income to levels not seen since shortly before the Great Depression.... What’s to blame for this sorry situation? Certainly globalization has taken its toll. Cheaper labor in emerging markets means relentless wage pressure on U.S. workers. Meanwhile, the fruits of
American success in fast-growing services and technology remain available only to the slice of our workforce with the necessary skills. Other factors, such as an increasingly regressive tax code, have also played a role. Growing inequality helps explain why so many Americans feel so vulnerable even as the overall economy continues to expand. Moods understandably darken when many have to take second jobs and go into debt to improve their living standards.... Sadly, there is no magic bullet. We need to provide more education and training to fix our problem of too many low-skilled workers. We don’t need to become tax-code Robin Hoods, but we can be vigilant about tax plans... that widen the gulf between haves and have-nots. Finally, we can provide more protection for those at risk, such as better wage insurance to cushion the effects of globalization. —Reprinted from BusinessWeek Examining the Newsclip 1. Identifying Points of View What words and phrases can you identify in the article that help reveal the author’s point of view? 2. Detecting Bias Does the author state opinions or facts? What bias might be evident in these statements? 346 UNIT 4 Macroeconomics: Performance and Stabilization CHAPTER 12 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. National Output and Income Gross domestic product (GDP) measures the nation’s output, while gross national product (GNP) measures the nation’s income. GDP GNP • Market value of all final goods, services, and structures produced within a country’s national borders in a year • Indicator of the condition of the nation’s economy • Includes output of foreign-owned firms located in the United States • Includes only final products • Market value of all final goods, services, and structures produced in one year with labor and property supplied by a country's residents • Includes all payments to citizens, regardless of where the production takes place • Excludes income earned by foreign-owned resources in the country Population Governments count the population and project population trends to plan the use of resources and to prepare infrastructure. Fertility rate Life expectancy Net immigration Population growth Planning for the future Poverty People are described as living in poverty if they live below an income level called the poverty threshold. Poverty has a number of causes, and governments have established some programs to reduce it. Lack of education Lack of access to some professions Low-paying service jobs
Unfavorable tax laws Lack of financial resources Decline of unions Discrimination Shift to singleparent families Poverty CHAPTER 12 Macroeconomic Performance 347 CHAPTER 12 Assessment & Activities Review Content Vocabulary Review the Main Ideas Examine the pairs of words below. Then write a sentence explaining what each pair has in common. Section 1 (pages 319–327) 1. food stamps, Medicaid the GDP. 16. Describe what goods and services are included in 2. gross national product, net national product 3. household, unrelated individuals 4. intermediate products, secondhand sales 5. underground economy, nonmarket transactions 6. workfare, welfare 7. life expectancy, dependency ratio 8. demographer, center of population 9. baby boom, population pyramid 17. Explain the connections between the various measures of income using a graphic organizer like the one below. Begin with... Add Subtract Equals GDP GNP NDP NI PI GNP NDP NI PI DPI Review Academic Vocabulary Identify which of the following terms correctly complete the sentences below. a. excluded b. components c. residence d. projected e. impact f. uniform 10. The Census Bureau has ____ the most likely U.S. fertility rate as 2.119 births per woman. 11. Nonmarket transactions are ____ from GDP. 12. The federal government now administers the Supplemental Security Income program to assure more ____ coverage across the nation. 13. The unequal distribution of wealth has an enormous 18. Identify the source of income for the four sectors of the economy. 19. Identify the components of GDP by decoding the formula GDP = C + I + G + (X – M). Section 2 (pages 329–335) 20. Describe the historical growth of population in the United States. 21. Identify the political and economic importance of the census. 22. Explain how the age composition of the future population might impact our economy. Section 3 (pages 337–345) ____ on people’s ability to earn income. 23. Explain what is meant by the term distribution of 14. The sectors of our economy receive various ____ of the national income, which they then use to purchase the total output. income. 24. Identify the major reasons for inequality in the distribution of income. 15. Every ten years the U.S. government takes an official count of all people, including their place of ____. 25. Explain how enterprise zones benefit residents of run-down or depressed areas. 348 UNIT 4 Macroeconomics
: Performance and Stabilization Economics: Principles and Practices Web site at glencoe.com and click on Chapter 12—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the Critical Thinking Math Practice 26. The BIG Idea How do the different measures of output and income allow us to assess the economy of a nation? 27. Comparing and Contrasting Which program do you think is more effective, workfare or welfare? Why? 28. Determining Cause and Effect Which of the factors affecting population growth will have the greatest impact on the United States in the next 50 years? Why? 29. Synthesizing Under what circumstances might you prefer economic security to a better standard of living? 30. Synthesizing Suppose you were told that you would earn $95,000 in 2020. Explain why this information would say little about the standard of living you might enjoy. What other information would you need before you could evaluate how well you could live in 2020? Applying Economic Concepts 31. Economic Sectors Imagine you must teach a younger class the differences among the four sectors that make up our economy. Then take the following steps: a. For one week, c lip articles from newspapers that refer to expenditures by one or more of the economic sectors. Log the expenditures in a graphic organizer similar to the one below. b. Prepare a poster or computer presentation that explains how the sectors work together. Consumer sector Investment sector Government sector Foreign sector 33. Based on the information in the table below, determine the percentage of total expenditures that consumers spend on durable goods, nondurable goods, and services. Personal Consumption Expenditures Amount (in billions) Percentage 100% Total expenditures Durable goods Motor vehicles and parts Furniture and household equipment Other Nondurable goods Food Clothing and shoes Gasoline and other energy goods Other Services Housing Household operation Transportation Medical care Recreation Other $9,081.7 1,047.6 432.3 397.7 217.6 2,687.7 1,282.4 358.4 327.4 719.5 $5,346.4 1,318.9 495.2 337.1 1,578.9 365.2 1,251.2 Thinking Like an Economist 34. In your own words, explain why greater life expectancies and declining birthrates make some entitlements like Social Security and Medicare more difficult to fund. Analyzing Visuals 32. Critical Thinking Look at Figure 12.5 on page 333. How can you use this figure
to help you plan expenditures for education? Writing About Economics 35. Expository Writing Research the following topic: Is there an income gap between men’s and women’s wages? If so, is the income gap narrowing or widening? Prepare a three-page written report. Be sure to include a list of the references you used in your report. CHAPTER 12 Macroeconomic Performance 349 &The Global Economy YOU Global Fruit Take a stroll through the produce department of your local supermarket, and you will discover an amazing variety of fresh fruits. Americans are eating more fruit—in both quantity and variety—and these fresh fruits are available not only during the summer months. Produce that was once deemed “seasonal” can now be found year-round. Global Goodness Fresh fruit choices at any grocery store in the United States include the standard fare of apples, oranges, and grapes. But you also find more exotic items, such as star fruit and papaya. How do tropical fruits find their way to grocery shelves in the dead of winter? And why can we purchase a gallon of orange juice when Florida and California farmers have been hit with an early frost? We have the global economy to thank for turning the produce aisle into a perpetual smorgasbord, continuously delivering fruits from around the world. From There to Here For many fruits, the trip from field to market involves a specific process of packing and shipping. For example, bananas leave Costa Rica and other Central and South American countries F RUIT I MPORTS AND E XPORTS Exports Imports 12 10 1990 1995 2000 2005 Year Source: U.S. Department of Agriculture packed in boxes weighing about 40 pounds each. Roughly 970 boxes fit into a refrigerated cargo container, which is then placed aboard a ship. The bananas must remain at a temperature of around 57ºF to keep them from ripening while in transit. Bananas take two to seven days to reach U.S. ports. There the cargo containers full of not-yet-ripe bananas are taken to different warehouse locations around the country. Before the bananas can be sent to your local supermarket, however, they must spend some time in special “ripening rooms.” Considering this lengthy journey, bananas seem like quite a bargain at less than fifty cents per pound. From Here to There Americans not only buy fruits—we sell them, too. The United States is the world’s fifth-largest fruit producer and the largest exporter of fresh fruit. Canada is our biggest
customer, importing 350 UNIT 4 Macroeconomics: Performance and Stabilization Gail Mooney/Corbis S OURCES OF F RESH F RUIT Fruit Apples Bananas Kiwi Mangoes Papaya Peaches Pears Strawberries U.S. Producers Foreign Producers Washington, New York, California, Michigan, Pennsylvania, Virginia Canada, New Zealand California Florida Florida California, South Carolina, Georgia, Michigan, Pennsylvania, New Jersey, Washington Washington, Oregon, California, Michigan, Pennsylvania, New York California, Oregon, Florida Colombia, Costa Rica, Ecuador, Guatemala, Honduras, Panama, Mexico, Nicaragua New Zealand, Chile India, South America Jamaica, Central America Chile, Canada, Mexico Chile, New Zealand, Australia, Argentina, Canada New Zealand, Mexico Source: Food and Agriculture Organization of the United Nations photo: unloading containers in U.S. port 47 percent of all U.S. fresh fruit exports. U.S. producers also export to Japan, Hong Kong, the European Union, and South Korea, among others. Yet the United States faces new competitors in the fruit trade. Mexico, China, Chile, and South Africa all impact the marketplace as they expand their reach. What Does It Mean For You? Global trade provides you with your favorite fruits throughout the year. While most U.S. fields and orchards lie dormant during winter, countries in the Southern Hemisphere are harvesting and shipping their summer crops. The worldwide competition also means lower prices for you and other fruit lovers. In addition, you now have more choices. The global exchange allows new and unusual fruits to make their way to U.S. stores for curious palates. Analyzing the Issue 1. Identifying What country is the largest buyer of U.S. fruit? 2. Analyzing What are concerns about shipping fresh fruit from other countries? 3. Applying Check out the fruit section of your local grocery store. What fruit is available because of global trade? David Maung/AP Images CHAPTER 13 Economic Instability Why It Matters Do your grandparents talk about the “good old days” when gas was 25 cents per gallon and a loaf of bread cost 10 cents? Compile a list of things that you have been purchasing for several years. Note the prices you paid in the past and those you are currently paying. What do you think accounts for the price differences? Read Chapter 13 to find out what factors can lead to economic instability. The BIG Ideas 1. Economists look at a
variety of factors to assess the growth and performance of a nation’s economy. 2. The labor market, like other markets, is determined by supply and demand. During times of economic instability, people may lose their jobs and have problems finding new ones. Economics: Principles and Practices Web site at glencoe.com and click on Chapter 13—Chapter Overviews to preview chapter information. Chapter Overview Visit the 352 UNIT 4 Jack Star/PhotoLink/Getty Images SECTION 1 Business Cycles and Fluctuations GUIDE TO READING Section Preview In this section, you will learn that business cycles are the alternating increases and decreases in the level of economic activity. Content Vocabulary • business cycles (p. 353) • business fluctuation (p. 353) • recession (p. 354) • peak (p. 354) • trough (p. 354) • expansion (p. 354) • trend line (p. 354) • depression (p. 354) • depression scrip (p. 356) • leading economic indicator (p. 358) • composite index of leading economic indicators (p. 359) • econometric model (p. 359) ISSUES IN THE NEWS Economic Growth Totters Academic Vocabulary • innovation (p. 355) • series (p. 358) Reading Strategy Identifying As you read the section, complete a graphic organizer like the one below by identifying factors that can cause changes in the business cycle. Changes in the Business Cycle —Associated Press The economy has slowed to a snail’s pace, growing... at the slowest rate in more than three years and stirring fresh debate about the country’s financial health heading into the elections. The Commerce Department reported Friday that economic growth during the July-to-September period [of 2006] clocked in at an annual rate of just 1.6 percent, a subpar performance.... The fresh reading... disappointed economists, rattled investors and gave Republicans and Democrats plenty to argue about. Economic matters are expected to influence voters’ choices when they go to the polls Nov. 7. On Wall Street, stocks sagged. The Dow Jones industrials, which had hit new highs in recent sessions, lost 73.40 points.... The third quarter’s performance was the weakest since a 1.2 percent growth rate eked out in the first quarter of 2003, when a nervous nation hunkered down for the start of the Iraq war. ■ Economic growth is something that is
beneficial to almost everyone. However, we cannot take economic growth for granted. Sometimes business cycles—regular ups and downs of real GDP—interrupt economic growth. Business fluctuations—the rise and fall of real GDP over time in an irregular manner—interrupt growth at other times. Slower economic growth, as you read in the news story, is always a matter of concern. Businesses lose sales, voters become unhappy, investors get nervous—and even the stock market shows its disapproval. Because of this, economists have developed elaborate forecasting models and statistical tools. After all, we all want to know where we are headed. business cycles regular increases and decreases in real GDP business fluctuations irregular increases and decreases in real GDP Richard R. Hansen/Photo Researchers, Inc CHAPTER 13 Economic Instability 353 recession decline in real GDP lasting at least two quarters peak point in time when real GDP stops expanding and begins to decline trough point in time when real GDP stops declining and begins to expand expansion period of uninterrupted growth of real GDP trend line growth path the economy would follow if it were not interrupted by alternating periods of recession and recovery depression state of the economy with large numbers of unemployed people, declining real incomes, overcapacity in manufacturing plants, and general economic hardship Business Cycles: Characteristics and Causes MAIN Idea Business cycles are marked by alternating periods of expansion and recession. Economics and You Has a slow economy ever shut down a factory in your community? Read on to learn about some possible causes. We can describe the basic features of an expansion or a recession, or the phases of the business cycle as they are sometimes called. When it comes to identifying the actual causes, though, no one theory seems to explain all past events or predict future ones because each seems to be a little different from the last. Phases of the Business Cycle The two phases of the business cycle are illustrated in Figure 13.1. The first phase is recession, a period during which real GDP—GDP measured in constant prices— declines for at least two quarters in a row, or six consecutive months. The recession begins when the economy reaches a peak— the point where real GDP stops going up. It ends when the economy reaches a trough— the turnaround point where real GDP stops going down. As soon as the declining real GDP bottoms out, the economy moves into the second phase, expansion—a period of recovery from a recession. Expansion continues until the economy reaches a new peak. When it does, the current business cycle ends and a new one begins. If periods of recession
and expansion did not occur, the economy would follow a steady growth path called a trend line. As Figure 13.1 shows, the economy departs from, and then returns to, its trend line as it passes through phases of recession and expansion. To make it easier to read, recessions in figures such as this are usually shaded to separate them from periods of expansion. If a recession becomes very severe, it may turn into a depression—a state of the economy with large numbers of people out of work, acute shortages, and excess capacity in manufacturing plants. Most experts agree that the Great Depression of the 1930s was the only depression the United States experienced during the twentieth century. Changes in Investment Spending Changes in capital expenditures are thought to be one cause of business cycles. When the economy is expanding, businesses expect future sales to be high, so Figure 13.1 Business Cycles See StudentWorks™ Plus or glencoe.com. P HASES OF THE B USINESS C YCLE EXPANSION EXPANSION N O I S S E C E R Peak REAL Trough A business cycle is normally measured from peak to peak so that it includes one recession and one expansion. Peak Economic Analysis What does a trough indicate? Trough N O I S S E C E R BUSINESS CYCLE they invest heavily in capital goods. Companies may build new plants or buy new equipment to replace older equipment. At first this generates jobs and income, but after a while businesses may decide they have expanded enough. If they then cut back on their capital investments, layoffs and eventually recession may result. negative, as when high oil prices hit the United States in mid-2005. Finally, in many cases, several factors seem to work together to create a cycle. In these situations, a disturbance in one part of the economy seems to have an impact somewhere else, causing an expansion to begin or a recession to end. Innovation and Imitation Another possible cause of business cycles is an innovation that may be a new product or a new way of performing a task. When a business innovates, it often gains an edge on its competitors because costs go down or sales go up. In either case, profits increase and the business grows. If other businesses in the same industry want to remain competitive, they must copy what the innovator has done or develop something even better. The imitating companies must invest heavily to do this, and an investment boom follows. After the innovation takes hold in the industry, further investments are unnecessary, and economic activity may slow
down. Monetary Policy Decisions Another possible cause of business cycles is the Federal Reserve System’s policy on interest rates. When “easy money” policies are in effect, interest rates are low and loans easy to get. Easy money encourages the private sector to borrow and invest, which stimulates the economy for a short time. Eventually the increased demand for loans causes interest rates to rise, which in turn discourages new borrowers. As borrowing and spending slow down, the level of economic activity may decline. External Shocks Another potential cause of business cycles is external shocks, such as increases in oil prices, wars, and international conflict. Some shocks drive the economy up, as when Great Britain discovered North Sea oil in the 1970s. Other shocks can be Michael Newman/PhotoEdit Reading Check Summarizing What are thought to be the causes of business cycles? CAREERS Statistician The Work * Scientifically apply mathematical principles to the collection, analysis, and presentation of numerical data * Gather and interpret data pertaining to a variety of fields, including biology, finance, economics, engineering, insurance, medicine, public health, psychology, marketing, education, scientific research, and sports * Gauge the public’s feelings on certain topics by taking samples of opinions Qualifications * Aptitude for and an interest in mathematics and computers * Knowledge in subject matter of chosen field * Strong communication skills * Bachelor’s degree in mathematics or statistics, with many private sector jobs requiring a master’s degree Earnings * Median annual earnings: $58,620 (private sector), $81,262 (government sector) Job Growth Outlook * Average Source: Occupational Outlook Handbook, 2006–2007 Edition CHAPTER 13 Economic Instability 355 depression scrip currency issued by towns, chambers of commerce, and other civic bodies during the Great Depression of the 1930s Great Depression During the height of the depression, the unemployed lined up in employment offices. How many people were unemployed during the Great Depression? Business Cycles in the United States MAIN Idea Business cycles have become much more moderate since the Great Depression of the 1930s. Economics and You Do you have a savings account at a bank? Read on to learn why the money in your account is insured. Economic activity in the United States followed an irregular course throughout the twentieth century. The worst downturn was the Great Depression of the 1930s. The years since World War II have taken on a special pattern of their own. The Great Depression The stock market crash on October 29, 1929, known as �
�Black Tuesday,” marked the beginning of the Great Depression, one of the darkest periods in American history. Between 1929 and 1933, real GDP declined nearly 50 percent, from approximately $103 billion to $55 billion. At the same time, the number of people out of work rose nearly 800 percent—from 1.6 million to 12.8 million. During the worst years of the Depression, one out of every four workers was unemployed. Even workers who had jobs suffered. The average manufacturing wage, which was 55 cents an hour in 1929, plunged to 5 cents an hour by 1933. Many banks across the country failed. Federal bank deposit insurance did not exist at the time, so depositors were not protected. To prevent panic withdrawals, the federal government declared a “bank holiday” in March 1933 and closed every bank in the country. The closure lasted for only a few days, but about one-quarter of the banks never reopened. The size of the money supply fell by one-third. Official paper currency was in such short supply that people began using depression scrip—unofficial currency that towns, counties, chambers of commerce, and other civic bodies issued. Billions of dollars of scrip were used to pay salaries for teachers, firefighters, police officers, and other municipal employees. Causes of the Great Depression An enormous gap in the distribution of income was one important cause. Poverty prevented workers from stimulating the economy by spending. The rich had the income but often used it for such nonproductive activities as stock market speculation. Easy credit also played a role. Many people borrowed heavily in the late 1920s to buy stocks. Then, as interest rates rose, it was difficult for them to repay their loans. When the crunch came, heavily indebted people had nothing to fall back on. Global economic conditions also played a part. During the 1920s, the United States had made many loans to foreign countries to help support international trade. When these loans suddenly 356 UNIT 4 Macroeconomics: Performance and Stabilization Bettmann/Corbis Recovery Wartime production during the 1940s provided an additional stimulus in the postDepression era. What other efforts led to economic recovery? were harder to get, foreign buyers purchased fewer American goods, and U.S. exports fell sharply. the same time. New unemployment programs gave some relief to people who were temporarily out of work. At the same time, high U.S. tariffs kept many countries from selling goods to the United States, leading to economic crises abroad. As world
trade declined, American exports dropped even further. Recovery and Legislation The Great Depression finally ended ten years after it started, when real GDP returned to its 1929 high. The economy recovered partly because of increased government spending and partly on its own. The massive spending during World War II added another huge stimulant that further propelled the economy. The country was so shaken by the Great Depression that a number of laws were passed and agencies established from 1933 to 1940 both to protect people and to prevent another such disaster. The Social Security Act of 1935 was one of the most important and significant pieces of legislation passed during this time. To protect people during their working years, the minimum wage was established at about Because so many public stock companies went out of business, the Securities and Exchange Commission (SEC) was created to put requirements on the disclosure of financial statements by public corporations. The resulting federal regulation made stock ownership by the public much safer. Finally, the newly established Federal Deposit Insurance Corporation (FDIC) provided modest bank insurance for depositors. Such safeguards were not available earlier, when nearly one-third of the banks had failed. In all, the period from 1933 to 1940 saw the establishment of many federal institutions to make working, banking, investing, and retirement safer. The reforms of the 1930s seemed to help, and most economists today think that it would be unlikely, if not impossible, for another Great Depression to occur. Cycles After World War II Business cycles became much more moderate after World War II, with shorter recessions and longer periods of expansion. Bettmann/Corbis CHAPTER 13 Economic Instability 357 See StudentWorks™ Plus or glencoe.com. Figure 13.2 The Index of Leading Economic Indicators The index of leading economic indicators is one of the tools used to predict future economic activity. Economic Analysis How do economists use this index to predict recession? T HE I NDEX OF LEI 140 120 100 80 60 ) Occasionally, the index predicted a recession that never occurred. On average, the index turns down 9 months before a recession begins. On average, the index turns up 4 months before a recovery begins. 1965 1970 Recession years 1975 1980 1985 Year 1990 1995 2000 2005 2010 Source: The Conference Board leading economic indicator statistical series that turns down before the economy turns down, or up before the economy turns up During this time, the average length of recessions was about 10 months, while expansions averaged about 54 months. With the possible exception of the Vietnam War period, most recessions from 1965 to 1980 occurred on a fairly regular basis
. After the early 1980s, recessions occurred less frequently. A record-setting peacetime expansion during the Reagan administration began in November 1982 and lasted for almost eight years. This was followed by a longer, and even more prosperous, expansion during the Clinton years from 1991 to 2001. In fact, this 10-year period of uninterrupted economic growth is the longest peacetime expansion in U.S. history. Although the Clinton expansion ended in March 2001, a new one began again in November of that year, shortly after the 9/11 terrorist attacks. Whether the latest expansion can set another record is yet to be seen, but it has already exceeded the historical 54-month average. Reading Check Inferring What impact did the Great Depression have on the United States? Forecasting Business Cycles MAIN Idea Economists use statistics and models to predict business cycles. Economics and You Would you change your post-graduation plans if you knew a recession was coming? Read on to find out how economists try to predict future recessions and expansions. Economists use several methods to predict business cycles. One uses the statistical series shown in Figure 13.2. Another makes use of macroeconomic modeling. Using Everyday Economic Statistics A change in a single statistic often indicates a change in future GDP. For example, the length of the average workweek may change just before a recession begins if people work fewer hours. This makes the measure a leading economic indicator—a statistical series that normally turns down 358 UNIT 4 Macroeconomics: Performance and Stabilization before the economy turns down or turns up before the economy turns up. However, no single series has proven completely reliable, so several individual series are combined into an overall index. This is the approach used by the composite index of leading economic indicators (LEI), a monthly statistical series that uses a combination of 10 individual indicators to forecast changes in real GDP. The composite index is shown in Figure 13.2, where the shaded areas represent recessions. The average time between a dip in the index and the onset of a recession is about nine months. The average time between a rise in the index and the start of an expansion is about four months. Using Econometric Models An econometric model is a mathematical model that uses algebraic equations to describe how the economy behaves. Most models start with the output-expenditure model we examined on page 327: GDP = C + I + G + (X – M) To see how we use it, suppose that a survey of consumers revealed that
households annually spend a fixed amount of money called ‘a’, along with 95 percent of their disposable personal income, or DPI. We could express this as C = a +.95(DPI) and then substitute this equation into the output-expenditure model to get: GDP = a +.95(DPI) + I + G + (X – M) This process is repeated until each of the terms in the model is expanded and the equation is broken down into smaller and smaller components. To find GDP, forecasters put in the latest values for the variables on the right side of the equation and solve for GDP. Over time, actual changes in the economy are compared to the model’s predictions. The model is then updated by changing some of the equations. In the end, some models give reasonably good forecasts for up to nine months into the future. Reading Check Analyzing Why are short-term econometric models more accurate than long-term models? composite index of leading economic indicators (LEI) composite index of 10 economic series that move up and down in advance of changes in the overall economy; statistical series used to predict turning points in the business cycle econometric model mathematical expression used to describe how the economy is expected to perform in the future SECTION 1 Review Vocabulary 1. Explain the significance of business cycles, business fluctuation, recession, peak, trough, expansion, trend line, depression, depression scrip, leading economic indicator, composite index of leading economic indicators, and econo metric model. Main Ideas 2. Explaining How are business cycles forecast? 3. Describing What are the two main phases of a business cycle? 4. Identifying Use a graphic organizer like the one below to identify the causes and effects of the Great Depression. Causes: The Great Depression Effects: Critical Thinking 5. The BIG Idea Why is it difficult to explain the causes of business cycles? 6. Analyzing Visuals Use Figure 13.1 on page 354 to explain how a business cycle can be compared to a roller coaster. 7. Determining Cause and Effect Assume that business inventories are falling, the average number of hours worked per week is going up, and there is an increase in the number of new building permits. What would these indicators say about the economy, and why? Applying Economics 8. Economic Security Suppose you were the head of a household. How would you plan spending for your family if you had an accurate prediction of future business cycles? Include
is responsible for calling turns in the business cycle? 2. Determining Cause and Effect According to the article, what do people do when they expect a recession? 360 UNIT 4 Macroeconomics: Performance and Stabilization Jenifer S. Altman SECTION 2 Inflation GUIDE TO READING Section Preview In this section, you will find out that inflation is a rise in the general level of prices that disrupts the economy. Content Vocabulary • inflation (p. 361) • deflation (p. 361) • price index (p. 362) • consumer price index (CPI) (p. 362) • market basket (p. 362) • base year (p. 362) • creeping inflation (p. 364) • hyperinflation (p. 364) • stagflation (p. 364) • producer price index (PPI) (p. 364) • implicit GDP price deflator (p. 364) • demand-pull inflation (p. 365) • cost-push inflation (p. 365) • creditor (p. 367) • debtor (p. 367) Academic Vocabulary • construction (p. 362) • recover (p. 365) Reading Strategy Illustrating As you read the section, complete a graphic organizer similar to the one below by illustrating the steps in a wage-price spiral. Higher Prices Step 2 Step 1 —The New York Times ISSUES IN THE NEWS Hyperinflation in Zimbabwe How bad is inflation in Zimbabwe? Well, consider this: at a supermarket near the center of the capital, Harare, toilet paper costs $417. No, not per roll. Four hundred seventeen Zimbabwean dollars is the value of a single two-ply sheet. A roll costs $145,750—in American currency, about 69 cents. For untold numbers of Zimbabweans, toilet paper—and bread, margarine, meat, even the once ubiquitous morning cup of tea—have become unimaginable luxuries. All are casualties of the hyperinflation that is roaring toward 1,000 percent a year, a rate usually seen only in war zones. ■ Macroeconomic instability is not limited to fluctuations in the level of national output (GDP) or national income (GNP). Changes in prices can be equally disruptive to the economy. When the general level of prices rises, the economy is experiencing inflation. A decline in the general level of prices is called deflation. Both situations are harmful to the economy and should be avoided whenever possible. Inflation in the
United States has varied over the years. We may grumble when the price of gas goes up by a few cents. As you can see in the news story, though, price increases can go to extremes and turn everyday products into luxury items. inflation increase in the general level of prices of goods and services deflation decrease in the general level of prices for goods and services REUTERS/Howard Burditt CHAPTER 13 Economic Instability 361 price index statistical series used to measure changes in the price level over time consumer price index (CPI) series used to measure price changes for a representative sample of frequently used consumer items market basket representative selection of goods and services used to compile a price index base year year serving as point of comparison for other years in a price index or other statistical measure (also see page 221) Measuring Prices and Inflation MAIN Idea Several price indexes are used to measure inflation. Economics and You Have you noticed that prices for some items go up while others go down? Read on to learn how this affects the rate of inflation. To understand inflation, we must first examine how it is measured. This involves the construction of a price index—a statistical series used to measure changes in the level of prices over time. A price index can be compiled for a range of items. We will focus on the consumer price index (CPI), a statistical series that tracks monthly changes in the prices paid by urban consumers for a representative “basket” of goods and services. The Market Basket The first step we have to take is to select a market basket—a representative selection of commonly purchased goods and services. The CPI uses the prices of approximately 364 goods and services, such as those shown in Figure 13.3. While this may seem like a small number, these items are scientifically selected to represent the types of purchases that most consumers make. The next step is to find the average price of each item in the market basket. To do so, every month employees of the U.S. Census Bureau sample prices on nearly 80,000 items in stores across the country. They then add up the prices to find the total cost of the market basket. The hypothetical results of such a monthly activity are shown in Figure 13.3 for three separate periods. A base year—a year that serves as the basis of comparison for all other years, is then selected. While almost any year will do, the Bureau of Labor Statistics (BLS) in the U.S. Department of Commerce currently uses average prices as they existed from 1982
to 1984. While this is likely to be updated in the future, it is still the most popular base year used for prices today. Figure 13.3 Constructing the Consumer Price Index Item Description Price Base Period (1982–1984) Price Second Period (1998) Price Third Period (January 2006) 1 2 3 4..... 364 Toothpaste (7 oz.) Milk (1 gal.) Peanut butter (2-lb. jar) Lightbulb (60 watt)..... Automobile engine tune-up Total cost of market basket Current market basket cost Base market basket cost $1.40 1.29 2.50.45..... 40.00 $1,792.00 $1.49 1.29 2.65.48..... 42.00 $2,925.00 $2.25 1.79 3.73.65..... 84.75 $3,582.00 $1,792 $1,792 = 1.000 $2,925 $1,792 = 1.632 $3,582 $1,792 = 1.999 Index Number (%): 100 (%) 163.2 (%) 199.9 (%) Every month the Bureau of Labor Statistics reprices its market basket of commonly used consumer items and reports the results as a percentage of the cost for the base period. Economic Analysis How do we interpret a CPI of 163.2? Figure 13.4 Measuring Prices and Inflation Consumer prices have risen steadily since the mid-1960s. Inflation peaked in the early 1980s and then declined. Economic Analysis How is the CPI used to compute inflation? T HE R ATE OF I NFLATION AND THE C ONSUMER P RICE I NDEX, 1965–2006 CPI Inflation 15 10 5 1965 1970 1975 1980 1985 1990 1995 2000 2005 Recession years Year Source: Bureau of Labor Statistics ) 200% 150 100 50 0 2010 The Price Index The last step in the process is to make the numbers in the table easier to interpret by converting the dollar cost of a market basket to an index value. This is done by dividing the cost of every market basket by the base-year market basket cost. For example, the $3,582 cost for January 2006 is divided by the $1,792 base-period cost to get 1.999, or 199.9 percent. The index number for January—199.9—represents the level of prices in comparison to the baseperiod prices. In practice, all of the conversions are understood to be a percentage
of the baseperiod cost even though the % sign or the word percent is not used. For example, prices in January 2006 are 199.9 percent of those in the base period, which is another way of saying that prices have nearly doubled. A different base year would give a different index number. However, to avoid confusion, the base year is changed only infrequently. Because so many prices are sampled all over the country, the BLS publishes specific consumer price indexes for selected cities and large urban areas, as well as one for the economy as a whole. Skills Handbook See page R54 to learn about Understanding Percentages. Measuring Inflation Now that we have the price index, we can find the percentage change in the monthly price level, which is how inflation is measured. To illustrate, suppose that the CPI in January of one year is 199.9, and it was 190.4 exactly one year earlier. To find the percentage change, we would divide the change in the CPI by the beginning value of the CPI in the following manner: (199.9-190.4) 190.4 = 9.5 190.4 = 0.05 = 5% In other words, the rate of inflation was 5 percent for the 12-month period. Figure 13.4 shows what the level of prices and the resulting inflation look like over a much longer period. The two lines are CHAPTER 13 Economic Instability 363 Hyperinflation During the 1920s, inflation in Germany reached such levels that banknotes in denominations of “100 Billionen Reichsmark” (the equivalent of 100 trillion) circulated. How is hyperinflation defined? creeping inflation relatively low rate of inflation, usually 1 to 3 percent annually hyperinflation inflation in excess of 500 percent per year stagflation period of slow economic growth coupled with inflation producer price index (PPI) index used to measure prices received by domestic producers implicit GDP price deflator index used to measure price changes in GDP shown together because the level of prices is sometimes confused with the rate of inflation, when in fact the level of prices is used to compute the inflation rate. The rate of inflation tends to change over long periods of time. In the last 20 years, the United States could be described as having creeping inflation—inflation in the range of 1 to 3 percent per year. When inflation is this low, it is generally not seen as much of a problem. However, inflation can rise to the point where it gets out of control. Hyperinflation—inflation in
the range of 500 percent a year and above— does not happen very often. When it does, it is generally the last stage before a total monetary collapse. The record for hyperinflation was set in Hungary during Word War II. At that time, huge amounts of currency were printed to pay the government’s bills. By the end of the war, it was claimed that 828 octillion (828,000,000,000,000,000,000,000,000,000) pengös equaled 1 prewar pengö. An economy also may experience stagflation, a period of stagnant economic growth coupled with inflation. Stagflation was a concern in the 1970s, a time of rising prices coupled with high unemployment. Even today, some people worry that the high price of oil could cause prices to go up and economic growth to slow down. Other Price Indexes A price index can be constructed for any segment of the economy in exactly the same way. The agricultural sector, for example, constructs a separate price index for the products it buys (diesel fuel, fertilizer, and herbicides), and then compares it to the prices it gets for its products. The producer price index (PPI) is a monthly series that reports prices received by domestic producers. Prices in this series are recorded when a producer sells its output to the very first buyer. This sample consists of about 100,000 commodities, using 1982 as the base year. Although it is compiled for all commodities, it is broken down into various subcategories, including farm products, fuels, chemicals, rubber, pulp and paper, and processed foods. The implicit GDP price deflator, used to measure changes in GDP, is another series. This series is used less frequently because the figures for real GDP, or GDP already adjusted for price increases, are provided when GDP is announced. Finally, these are just a few of the many price indexes that the government maintains. Even so, the CPI is by far the most popular and the one we watch most often. Reading Check Analyzing How is a market basket used to measure the price level? 364 UNIT 4 Macroeconomics: Performance and Stabilization akg-images Causes of Inflation MAIN Idea Causes of inflation include strong demand, rising costs, and wage-price spirals, along with a growing supply of money. Economics and You Have you ever wanted something so much you did not care about the price? Read on to learn how such behavior can fuel inflation. Econom
ists have offered several explanations for the causes of inflation. Nearly every period of inflation is due to one or more of the following causes: demand-pull inflation, cost-push inflation, wage-price spiral, or excessive monetary growth. products for manufacturers and thus cause inflation. This situation might occur, for example, when a strong national union wins a large wage contract, forcing manufacturers to raise prices to recover the increase in labor costs. Another cause of cost-push inflation could be a sudden rise in the international price of oil, which can raise the price of everything from plastics and gasoline to shipping costs and airline fares. Such an increase in prices occurred during the 1970s, when prices for crude oil went from $5 to $35 a barrel. It happened again in 2006, when the price of oil surged to over $75 a barrel. demand-pull inflation explanation that prices rise because all sectors of the economy try to buy more goods and services than the economy can produce cost-push inflation explanation that rising input costs, especially energy and organized labor, drive up the prices of products Demand-Pull According to the explanation called demand-pull inflation, all sectors in the economy try to buy more goods and services than the economy can produce. As consumers, businesses, and governments converge on stores, they cause shortages, which drives up prices. Thus prices are “pulled” up by excessive demand. This could happen, for example, if consumers decided to use their credit cards and go into debt to buy things they otherwise could not afford. Wage-Price Spiral A more neutral explanation does not blame any particular group or event for rising prices. According to this view, a selfperpetuating spiral of wages and prices becomes difficult to stop. The spiral might begin when higher prices force workers to ask for higher wages. If they get the higher wages, producers try to recover that cost with higher A similar explanation blames inflation on excessive spending by the federal government. After all, the government borrows and then spends billions of dollars, thus putting upward pressure on prices. Unlike the demand-pull explanation, however, which cites the excess demand on all sectors of the economy, this explanation holds only the federal government’s deficit spending responsible for inflation. Cost-Push The cost-push inflation explanation claims that rising input costs, especially energy and organized labor, drive up the cost of KAZ -Larry Katzman Inflation Several causes of inflation exist, but an increase in allowance would probably not have a large impact. Which explanation does the father in the
cartoon use © “... but if daddy raised your allowance he’d be hurting the economy by stimulating inflation. You wouldn’t want him to do that would you?” CHAPTER 13 Economic Instability 365 Figure 13.5 The Purchasing Power of the Dollar V ALUE OF THE D OLLAR When the price level goes up, the purchasing power of the dollar goes down. When the price level rises more slowly, as it did after 1980, the value of the dollar does not decline as fast. Economic Analysis What happens to the purchasing power of the dollar during a period of inflation1.00.90.80.70.60.50.40.30.20.10 1950 1955 1960 1965 70 19 75 19 1980 Year 1985 1990 1995 2000 2005 2010 Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 13— Student Web Activities for an activity on working with economic statistics. Source: Bureau of Labor Statistics, 2006 prices. As each side tries to improve its relative position with a larger increase than before, the rate of inflation keeps rising. Consequences of Inflation Excessive Monetary Growth The most popular explanation for inflation is excessive monetary growth. This occurs when the money supply grows faster than real GDP. According to this view, any extra money or additional credit created by the Federal Reserve System will increase someone’s purchasing power. When people spend this additional money, they cause a demand-pull effect that drives up prices. Advocates of this explanation point out that inflation cannot be maintained without a growing money supply. For example, if the price of gas goes up sharply, but the amount of money people have remains the same, then consumers will simply have to buy less of something else. While the price of gas may rise, the prices of other things will fall, leaving the overall price level unchanged. Reading Check Explaining Which explanation do you think gives the most reasonable cause of inflation? Why? MAIN Idea Inflation can reduce purchasing power, distort spending, and affect the distribution of income. Economics and You What would you do if the price of your favorite food became too high? Read on to learn how inflation changes people’s buying habits. While low levels of inflation may not be a problem, inflation can have a disruptive effect on an economy if it gets too high. Reduced Purchasing Power The most obvious effect of inflation is that the dollar buys less as prices rise, and thus it loses value over time. Figure 13.
5 shows the declining value of the dollar since 1947 as inflation has eroded its purchasing power. This may not be a problem for everyone, but decreasing purchasing power can be especially hard on retired people or those with fixed incomes because their money buys a little less each month. Those not on fixed incomes are better able to cope. They can increase their fees or wages to keep up with inflation. 366 UNIT 4 Macroeconomics: Performance and Stabilization Distorted Spending Patterns Inflation has a tendency to make people change their spending habits. For example, when prices went up in the early 1980s, interest rates—the cost of borrowed money—also went up. This caused spending on durable goods, especially housing and automobiles, to fall dramatically. To illustrate, suppose that a couple wanted to borrow $100,000 over 20 years to buy a house. At a 7 percent interest rate, their monthly mortgage payments would be $660.12. At 14 percent, their payments would be $1,197.41. In 1981 some mortgage rates reached 18 percent, which meant a monthly payment of $1,517.32 for the same size loan! As a result of the high interest rates in that period, the homebuilding industry almost collapsed. Encouraged Speculation Inflation tempts some people to speculate heavily in an attempt to take advantage of rising prices. People who ordinarily put their money in reasonably safe investments begin buying luxury condominiums, SECTION 2 Review diamonds, and other exotic items that might be expected to increase in price. Some people actually make money on speculative ventures like this, but even speculators lose money on deals from time to time. For the average consumer, a large loss could have devastating consequences. creditor person or institution to whom money is owed debtor person who borrows and therefore owes money Distorted Distribution of Income Inflation can alter the distribution of income. During long inflationary periods, creditors, or people who lend money, are generally hurt more than debtors, or borrowers, because earlier loans are repaid later with dollars that buy less. Suppose, for example, that you borrow $100 to buy bread that costs $1 a loaf. You could buy 100 loaves of bread today. If inflation set in, and if the price level doubled by the time you paid back the loan, the lender would be able to buy only 50 loaves of bread because each loaf now would cost $2. Reading Check Identifying Why is inflation especially hard on people with fixed incomes? Vocabulary 1. Explain the significance of inflation
, deflation, price Critical Thinking 4. The BIG Idea How can inflation destabilize a nation’s index, consumer price index, market basket, base year, creeping inflation, hyperinflation, producer price index, stagflation, implicit GDP price deflator, demand-pull inflation, cost-push inflation, creditor, and debtor. Main Ideas 2. Listing What are the main causes and consequences of inflation? 3. Identifying Use a graphic organizer like the one below to identify the steps in measuring inflation. Steps Details 1. 2. economy? 5. Understanding Cause and Effect In 2005 and 2006, the price of crude oil suddenly increased. What type of inflation might this development cause? Why? 6. Categorizing Information What kind of inflation might be described as “too many dollars chasing too few goods”? Why? 7. Analyzing Visuals Look at Figure 13.4 on page 363. How does the rate of inflation change during times of recessions? What might explain these changes? Applying Economics 8. Market Basket Construct a market basket of goods and services that high school students typically consume. Would it be a useful economic indicator? Explain. CHAPTER 13 Economic Instability 367 ECONOMIST Profiles in Economics Milton Friedman (1912–2006) • received the Nobel Prize for economics for his theories on economic stabilization policy • strong proponent of monetary policy A popular column in Newsweek helped Milton Friedman become one of the best-known economists. His views appealed to people: “I am in favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it’s possible.” It’s About the Money Supply As a founder of the Chicago school of economic thought, Milton Friedman has largely defined modern monetary policy. In an era when most economists believed in fiscal policy, or government spending on public projects, Friedman disagreed. He argued that monetary policy, or controlling the supply of money in circulation, was the key to economic health and stability. Friedman’s research fundamentally changed U.S. economic policy on inflation, unemployment, and business cycles. His findings, for example, rejected the idea that high inflation helped to limit unemployment. His influential books and articles in Newsweek promoted the steadying role of the Federal Reserve in monitoring the amount of money available to individuals, households, and businesses in order to maintain the value of the dollar. Stay Off Our Backs A fervent believer in individual freedom, Friedman advocated free markets with minimal government involvement. In his book
Capitalism and Freedom, he argued for a flat tax rate and the elimination of deductions, such as those for mortgage interest. Friedman also voiced opposition to such popular policies as agricultural subsidies, price controls, and the minimum wage. Friedman also wanted parents to be free to choose their children’s schools. Together with his wife Rose Director Friedman, he established the Friedman Foundation to promote the use of school vouchers in the United States. Vouchers, he thought, would improve education by forcing schools, through free market competition, to either excel or shut down. While many of Friedman’s ideas were once considered radical, some have become widely accepted. Examining the Profile 1. Contrasting How did Friedman disagree with other economists about achieving economic stability? 2. Predicting Consequences How do you think the quality of education would be affected if free market principles were applied to schools? 368 UNIT 4 Macroeconomics: Performance and Stabilization Roger Ressmeyer/Corbis SECTION 3 Unemployment GUIDE TO READING Section Preview Academic Vocabulary In this section, you will find out how unemployment is measured as well as what causes it. Content Vocabulary • civilian labor force (p. 370) • labor force (p. 370) • unemployed (p. 370) • unemployment rate (p. 370) • frictional unemployment (p. 372) • structural unemployment (p. 372) • outsourcing (p. 372) • technological unemployment (p. 372) • cyclical unemployment (p. 373) • seasonal unemployment (p. 373) • GDP gap (p. 374) • misery index (p. 374) • discomfort index (p. 374) • confined (p. 370) • fundamental (p. 372) • unfounded (p. 374) Reading Strategy Describing As you read the section, complete a graphic organizer similar to the one below by describing the different sources of unemployment. Sources of Unemployment PEOPLE IN THE NEWS Opting Out —The Atlanta Journal-Constitution Louis Myer is one of the uncounted.... [He volunteers at] a Stone Mountain-based nonprofit that refurbishes donated medical equipment and gives it to those who need it. Laid off in 2001 from a job as an engineer, the Atlanta native struggled in vain to catch another employer’s interest. He volunteered for a while at Habitat for Humanity. In October, he started helping out at the Stone Mountain nonprofit. It is good work, but it is not paid work. Even so, he
is not counted as unemployed....[T]he unemployment rate... does not include people who have abandoned the job search, for whatever reason. ■ Approximately half of the people in the United States belong to the labor force, and at any given time millions are without jobs. Sometimes this is because they choose not to work, as when they have quit one job to look for another. In most cases, however, people are out of work for reasons largely out of their control. Most Americans identify strongly with their work. If you were to ask someone to describe themselves, most likely they would tell you their occupation, such as a cook, a teacher, or a sales associate. Some people, such as Louis Myer in the news article, work for no pay when they cannot find another job. Coby Burns/Zuma/Corbis CHAPTER 13 Economic Instability 369 civilian labor force or labor force non-institutionalized part of the population, aged 16 and over, either working or looking for a job (also see page 204) unemployed working for less than one hour per week for pay or profit in a nonfamily-owned business, while being available and having made an effort to find a job during the past month unemployment rate percentage of people in the civilian labor force who are classified as unemployed Measuring Unemployment People are considered unemployed if they are out of work and actively seeking a job. What other factors are considered? Measuring Unemployment MAIN Idea The government takes monthly surveys to measure the unemployment rate. Economics and You Have you ever wanted a job but couldn’t find one? Read on to learn how the government measures such unemployment. To understand the severity of joblessness, we need to know how it is measured and what is overlooked. The measure of joblessness is the unemployment rate, one of the most closely watched and politically charged statistics in the economy. Civilian Labor Force The Bureau of Labor Statistics defines the civilian labor force, more commonly called the labor force, as the sum of all persons age 16 and above who are either employed or actively seeking employment. This measure excludes members of the military. Since only people able to work are included in the labor force, those persons who are confined in jail or reside in mental health facilities are also excluded. realize. In the middle of any given month, about 1,500 specialists from the Bureau of the Census begin their monthly survey of about 60,000 households in nearly 2,000 counties, covering all 50 states. Census workers are looking for the unemployed—
people available for work who made a specific effort to find a job during the past month and who, during the most recent survey week, worked less than one hour for pay or profit. People are also classified as unemployed if they worked in a family business without pay for less than 15 hours a week. After the census workers collect their data, they turn it over to the Bureau of Labor Statistics for analysis and publication. This data is then released to the American public on a monthly basis. Unemployment Rate Unemployment is normally expressed in terms of the unemployment rate, or the individuals number of unemployed divided by the total number of persons in the civilian labor force. For example, in May 2006 the unemploy- ment rate was calculated as follows: Unemployed Persons The process of deciding if someone is able to work, willing to work, or even at work is more complicated than most people Number of unemployed persons Civilian Labor Force = 7,015,000 150,991,000 = 0.046 = 4.6% The monthly unemployment rate is expressed as a percentage of the entire labor force. Monthly changes in the unemployment rate, often as small as one-tenth of 1 percent, may seem minor even though they have a huge impact on the economy. With a civilian labor force of approximately 151 million people, a one-tenth of 1 percent rise in unemployment would mean that nearly 150,000 people had lost their jobs. This number is more than AP Images Figure 13.6 The Unemployment Rate The unemployment rate goes up sharply during a recession and then comes down slowly afterward. When the rate moves as little as 0.1 percent, approximately 151,000 workers are affected. Economic Analysis How would you characterize the unemployment rate during the period from 1990 to 2007? T HE U NEMPLOYMENT R ATE 12% 9% 6% 3 1965 1970 1975 1980 1985 Recession years Source: Bureau of Labor Statistics, 2006 1990 1995 2000 2005 2010 Year Personal Finance Handbook See pages R20–R23 for more information on getting a job. the current population of cities such as Kansas City, Kansas; Syracuse, New York; Bridgeport, Connecticut; or Savannah, Georgia. Figure 13.6 shows how much the unemployment rate can vary over time. In general, it tends to rise just before a recession begins and then continues to rise sharply during the recession. Sometimes the unemployment rate continues to rise well after the recession ends, as it did in 2003. When the rate finally starts to go back down, it may take from five to seven years for
it to reach its previous low. Underemployment It might seem that a measure as comprehensive as the unemployment rate would include all of the people who are without a job. If anything, however, the unemployment rate understates employment conditions for two reasons. First, the unemployment rate does not count those too frustrated or discouraged to look for work. During recessionary periods, these labor force “dropouts” may include nearly a million people. Although they are not working and probably would like to find work, these people are not classified as unemployed because they did not actively seek a job within the previous fourweek period. Second, people are considered employed even when they only hold part-time jobs. For example, suppose a worker lost a highpaying job requiring 40 hours a week and replaced it with a minimum-wage job requiring one hour a week. Although that worker would work and earn less, he or she would still be considered employed. In other words, being employed is not the same as being fully employed. Reading Check Summarizing How do we calculate the monthly unemployment rate? CHAPTER 13 Economic Instability 371 frictional unemployment unemployment involving workers changing jobs or waiting to go to new ones structural unemployment unemployment caused by a fundamental change in the economy that reduces the demand for some workers outsourcing hiring outside firms to perform non-core operations to lower operating costs technological unemployment unemployment caused by technological developments or automation that makes some workers’ skills obsolete Sources of Unemployment MAIN Idea Unemployment is often caused by circumstances outside an individual’s control and is therefore very difficult to remedy. Economics and You Did you ever have a job and then lose it for no fault of your own? Read on to learn about the different causes of unemployment. Economists have identified several kinds of unemployment. The nature and cause of each kind affects how much the unemployment rate can be reduced. Frictional Unemployment A common type of unemployment is frictional unemployment—the situation where workers are between jobs for one reason or another. This is usually a shortterm condition, and workers suffer little economic hardship. As long as workers have the freedom to choose or change occupations, some people will always be leaving their old jobs to look for better ones. Because there are always some workers doing this, the economy will always have some frictional unemployment. Structural Unemployment A more serious type of unemployment is structural unemployment—when economic progress, a change in consumer tastes and preferences, or a fundamental change in the operations of the economy reduces the demand for workers and their skills. In the early 1900
s, for example, technological and economic progress resulted in the Measuring Unemployment Some countries measure unemployment by counting the number of persons filing unemployment claims. Others count only those receiving unemployment insurance payments. This makes for relatively low unemployment rates, because some people may not be eligible for unemployment insurance. development of the automobile, which soon replaced horses and buggies and left highly skilled buggy whip makers out of work. Later, consumer tastes changed away from American-made automobiles in favor of foreign-made cars, causing considerable unemployment in Michigan, Ohio, and the industrial Northeast. More recently, outsourcing—the hiring of outside firms to perform non-core operations to lower operating costs—has become popular. Outsourcing was first used when firms found that they could have other companies perform some routine internal operations, such as the preparation of weekly paychecks. Later, improvements in technology and communications made it possible for companies to move some of their customer service operations abroad where wages are much lower. For example, if you call your telephone company or a computer software maker for customer assistance, your call is likely to be routed to an English-speaking worker in China or India rather than a U.S. office. Sometimes the government contributes to structural unemployment. Congress’s decision to close military bases in the 1990s is a prime example. Military bases are much larger than most private companies, and the impact of the base closings was concentrated in selected regions and communities. A few areas were able to attract new industry that hired some of the unemployed workers, but most workers either developed new skills or moved to other locations to find jobs. Technological Unemployment A third kind of unemployment is technological unemployment—unemployment that occurs when workers are replaced by machines or automated systems that make their skills obsolete. Technological unemployment is closely related to structural unemployment, although the technological changes are not always as broad in scale or as influential on society as cars replacing buggies. 372 UNIT 4 Macroeconomics: Performance and Stabilization &The Global Economy YOU Finding Work Overseas Unemployment can be the first step toward expanding your horizons. Can’t find a job in your area? Then look abroad. U.S. businesses are becoming increasingly global, and companies are scrambling to expand overseas. As many as 400,000 Americans relocate inter nationally each year. Some human resource specialists encourage people to travel and work abroad. This will increase the chances of being hired for management positions in the future. Many books and Web sites offer advice to Americans who want to work in other countries. Here are
some tips: • Find the nearest consulate of the country in which you wish to work. The consulate is your ticket to learning about all the entry or residency requirements you’ll need to work in another country. • A nation’s main presence in a foreign country is the embassy. Embassy workers can provide information and help you find a nearby consulate office. • Different countries require dif- ferent documentation for a visa or work permit. These often include a valid passport, a statewide criminal history record check, and a medical certificate. One example is the reduced need for bank tellers by commercial banks because of the increased use of automated teller machines. Another example would be the introduction of word processing programs whose spell-checking, formatting, and text manipulation functions have greatly reduced the demand for typists. Cyclical Unemployment A fourth kind of unemployment is cyclical unemployment—unemployment directly related to swings in the business cycle. During a recession, for example, many people put off buying durable goods such as automobiles and refrigerators. As a result, some industries must lay off workers until the economy recovers. If we look at Figure 13.6 on page 371, we can see that the unemployment rate rose dramatically whenever the economy was in recession. During the 2001 recession, more than 2 million jobs were lost. Laid-off workers may eventually get their jobs back when the economy improves, but it usually takes several years of economic growth before the unemployment rate returns to where it was before the recession. In the meantime, the pain of unemployment is a fact of life for those who are out of work. Seasonal Unemployment Finally, a fifth kind of unemployment is seasonal unemployment—unemployment resulting from seasonal changes in the weather or in the demand for certain products or jobs. Many carpenters and builders, for example, have less work in the winter because some tasks, such as replacing a roof or digging a foundation, are harder to do during cold weather. Department store sales clerks often lose their jobs after the December holiday season is over. The difference between seasonal and cyclical unemployment relates to the period of measurement. Cyclical unemployment takes place over the course of the business cycle, which may last three to five years. Seasonal unemployment takes place every year, regardless of the general health of the economy. Reading Check Interpreting Which categories of unemployment do you think are the most troublesome for the U.S. economy? Why? cyclical unemployment unemployment directly related to swings in the business cycle seasonal unemployment unemployment caused by annual changes in the weather
or other conditions that reduce the demand for jobs Karen Huntt/Corbis CHAPTER 13 Economic Instability 373 Figure 13.7 Measuring Consumer Discomfort The misery index is an unofficial measure of consumer discomfort that is compiled by adding the monthly inflation and unemployment rates. Economic Analysis When did the misery index reach its highest point? See StudentWorks™ Plus or glencoe.com. T HE M ISERY I NDEX 25% 20% 15% 10% 5 1965 1970 1975 1980 1985 Recession years Source: Bureau of Labor Statistics, 2006 1990 1995 2000 2005 2010 Year GDP gap difference between what the economy can and does produce misery index or discomfort index unofficial statistic that is the sum of the monthly inflation and unemployment rates Costs of Instability MAIN Idea Unemployment can cause uncertainty, political instability, and social problems. Economics and You What would you do if you wanted a job but could not find one? Read on to learn about the costs of unemployment. Recession, inflation, and unemployment are all forms of instability that hinder economic growth. These problems can occur separately or at the same time. Fears about these conditions are not unfounded, because economic instability carries enormous costs that can be measured in economic as well as human terms. GDP Gap One measure of the economic cost of unemployment is the GDP gap—the difference between the actual GDP and the potential GDP that could be produced if all resources were fully employed. In other words, the gap is a type of opportunity cost—a measure of output not produced because of unemployed resources. If we were to illustrate the gap with a production possibilities curve, the amount that could be produced would be any point on the frontier. The amount actually produced would be represented by a point inside the frontier. The distance between the two would be the GDP gap. In a more dynamic sense, the business cycle may cause the size of this gap to vary over time. The scale of GDP is such that if GDP declines even a fraction of a percentage point, the amount of lost production and income could be enormous. For example, suppose that an economy with a $13.5-trillion-dollar GDP declines by just one-tenth of one percent. This translates into $13.5 billion in lost output. Misery Index Figure 13.7 shows the misery index, sometimes called the discomfort index— the sum of the monthly inflation and 374 UNIT 4 Macroeconomics: Performance and Stabilization unemployment rates. As the figure shows, the index usually reaches a peak either during or immediately following a recession. Although it
is not an official government statistic, the misery index provides a reasonable measurement of consumer suffering during periods of high inflation and high unemployment. Uncertainty When the economy is unstable, a great deal of uncertainty exists. Workers may not buy something because of concern over their jobs. This uncertainty translates into many consumer purchases that are not made, causing unemployment to rise as jobs are lost. Workers are not the only ones affected by uncertainty. The owner of a business that is producing at capacity may decide against an expansion even though new orders are arriving daily. Instead, the producer may try to raise prices, which increases inflation. Even the government may decide to spend less on schools and roads if it is not sure of its revenues. Political Instability Politicians also suffer the consequences of economic instability. When times are hard, voters are dissatisfied and incumbents often voted out of office. For example, many experts agree that Bill Clinton’s victory over President George Bush in 1992 was due in part to the 1991 recession. If too much economic instability exists, as during the Great Depression of the 1930s, some voters are willing to vote for radical change. As a result, economic stability adds to the political stability of our nation. Crime, Poverty, and Family Instability Recession, inflation, and unemployment can also lead to higher rates of crime and poverty. They can contribute to problems such as fights and divorce when individuals and families face uncertainty because lost jobs and income make it difficult to pay the bills. Thus all of us have a stake in reducing economic instability. Reading Check Identifying What makes the GDP gap a type of opportunity cost? SECTION 3 Review Vocabulary 1. Explain the significance of civilian labor force, unem- Critical Thinking 5. The BIG Idea Why is structural unemployment a ployed, unemployment rate, frictional unemployment, structural unemployment, outsourcing, technological unemployment, cyclical unemployment, seasonal unemployment, GDP gap, misery index, and discomfort index. more difficult problem for the economy and for individual workers than other types of unemployment? 6. Drawing Inferences What factors make it difficult to determine the unemployment rate? Main Ideas 2. Explaining How do economists measure the economic 7. Categorizing Information List three reasons why a person may become discouraged from finding a job. cost of instability? 3. Defining What is frictional unemployment? 4. Identifying Use a graphic organizer like the one below to identify the people who are considered unemployed and those excluded from the civilian labor force. Unemployed: Excluded from the labor force: 8. Analyzing Visual
below. 4. caused by a shift in demand or a change in the way the economy operates 5. caused by periodic swings in business activity 6. used to measure price changes for a market basket of consumer items Destabilizing effects of inflation 7. growth path in absence of recession or expansion Section 3 (pages 369–375) 8. measured by changes in the CPI 9. lowest point of the business cycle 10. works less than one hour per week for pay or profit 11. real GDP declines for two consecutive quarters 12. all persons aged 16 or older who are working or actively seeking a job 26. Describe the five major kinds of unemployment by using a graphic organizer like the one below. UNEMPLOYMENT Description Example Type Frictional Structural Cyclical Technological Seasonal Review Academic Vocabulary Use each of the following terms in a sentence that relates to either inflation or unemployment. 13. innovation 14. series 15. construction 16. recover 17. confined 18. fundamental 19. unfounded 27. Describe the costs and benefits of outsourcing. 28. Identify the political costs of economic instability. Critical Thinking 29. The BIG Idea Why do leading economic indicators and econometric models not provide long-term predictions of economic behavior? 378 UNIT 4 Macroeconomics: Performance and Stabilization Economics: Principles and Practices Web site at glencoe.com and click on Chapter 13—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the 30. Determining Cause and Effect How would a 10 percent inflation rate affect both lenders and borrowers? Why? 31. Drawing Conclusions Which type of unemployment do you think is the most troublesome for the U.S. economy? Why? 32. Comparing and Contrasting What are the similarities and differences between the CPI and the PPI? 36. Inflation Explain why inflation cannot take place without an expansion of the money supply. 37. Misery Index How might the psychological strains that many people feel during difficult economic times help prolong an economic downturn? Provide at least one example with your answer. 33. Synthesizing Information Describe structural and Math Practice technological unemployment and give an example of each. Why are these kinds of unemployment serious problems for an economy? Applying Economic Concepts 34. Inflation Go to the Minneapolis Fed’s site at http://www. minneapolisfed.org/ and click on “Inflation Calculator.” Follow the directions to find the adjusted prices for the items listed in the
chart below. Then use the Internet or other sources to find the current price for each item. Write a paragraph on the topic: “Were the ‘good old days’ really all that good?” 38. Look at Figure 13.3 on page 362. Then find current prices for the first four items on the list. Use the equation on page 363 to determine the percentage change in prices since 1998. Analyzing Visuals 39. Look at Figure 13.6 on page 371. What was the lowest unempoyment rate immediately before the 1991 recession, and when was it recorded? How long did it take for the unemployment rate to reach this previous low? Item Year and Price Price Adjusted for Inflation Today’s Price Interpreting Cartoons Teacher’s starting salary (Richmond, VA) 2-bdrm apartment with den; gas for heating/cooking included (Richmond, VA) Gallon of gas Minimum wage Tuition/room and board at Longwood Univ. (VA) 1969 $6,500 1969 $147.50 1969 $0.25 1978 $2.65 1968 $550 per semester 35. Recession If we were to enter a period of recession, what would likely happen to the unemployment rate? The inflation rate? The poverty rate? Explain your answers. 40. Critical Thinking How does the cartoon below relate to what you have learned in this chapter Copyright 2006, Jeff Parker/Cagle Cartoons INC. CHAPTER 13 Economic Instability 379 DEBATES IN ECONOMICS Should the Trade Embargo on Cuba Be Lifted? $ T hree years after Fidel Castro took power in Cuba and installed a Communist regime, the U.S. government initiated a trade embargo against the nation. The embargo was intended to put economic pressure on the Cuban government. Today the embargo is still in effect— one of the longest trade embargos in modern history. Opponents on each side of the issue debate its effectiveness. Who is right? As you read the selections, ask yourself: Should the trade embargo on Cuba be lifted or remain in place? PRO A HALF-CENTURY OF FAILURE For almost half a century, the U.S. government has tried to isolate Cuba economically in an effort to undermine the [Communist] regime [of Fidel Castro] and deprive it of resources. Since 1960, Americans have been barred from trading with, investing in, or traveling to Cuba.... As a foreign policy tool, the embargo actually
enhances Castro’s standing by giving him a handy excuse for the failures of his homegrown Caribbean socialism.... If the embargo were lifted, the Cuban people would be a bit less deprived and Castro would have no one else to blame for the shortages and stagnation that will persist without real market reforms.... Many of the dollars Cubans could earn from U.S. tourists would come back to the United States to buy American products, especially farm goods. In 2000, Congress approved a modest opening of the embargo. The Trade Sanctions Reform and Export Enhancement Act of 2000 allows cash-only sales to Cuba of U.S. farm products and medical supplies. The results of this opening have been quite amazing. Since 2000, total sales of farm products to Cuba have increased from virtually zero to $380 million.... —Daniel Griswold, Professor of Law and Economics, Columbia University P OTENTIAL A GRICULTURAL E XPORTS TO C UBA, T OP T EN S TATES s e t a t S Missouri Nebraska Minnesota Mississippi Illinois Texas Louisiana Iowa California Arkansas 0 50 100 Millions of dollars 150 200 Source: Cuba Policy Foundation 380 UNIT 4 Macroeconomics: Performance and Stabilization Stephen Ferry/Liaison/Getty Images CON SUBSIDIZE COMMUNIST CUBA? At the end of July [2002], the U.S. House of Representatives voted on two amendments, each approved by 95 vote margins, to end restrictions on travel and lift restrictions on financing exports to Cuba.... While the White House has threatened to veto any legislation that would “bolster the Cuban dictatorship,” the anti-Embargo lobby argues that U.S. tourism will benefit Cubans without strengthening Castro, and that trade with Havana will mean substantial American profits. These arguments are misguided at best and disingenuous at worst. Fidel Castro is broke, and at issue is not trade, but extending American export credit and export insurance to his regime, both of which are funded by American taxpayers. Since [2006], American companies are allowed to ‘trade’ with Castro’s government on a cash and carry basis. But when Castro defaults on his purchases, under the proposed policy American taxpayers will have the burden of picking up his tab.... France, Spain, Italy and Venezuela have suspended official credits to Castro’s Cuba—not because of the Cuban communities in those nations—but because Cuba has failed to make payments on its debt, including debt incurred on
agricultural purchases.... Havana owes billions of dollars to western banks and former socialist countries. —Frank Calzon, executive director of Center for a Free Cuba C UBA’S I NTERNATIONAL D EBT ) 25 20 15 10 5 0 Russia Europe Japan Country Argentina Others Source: U.S. Department of State Analyzing the Issue 1. Summarizing What argument does Griswold use to support his argument that the embargo should be lifted? 2. Analyzing Review Calzon’s argument. Do you agree with him that trade with Cuba would be a misguided policy? 3. Deciding With which opinion do you agree? Explain your reasoning. CHAPTER 13 Economic Instability 381 Stephen Ferry/Liaison/Getty Images CHAPTER 14 Money, Banking, and the Fed Why It Matters Congratulations, you have just been hired by the federal government to completely redesign our money. Before getting started on your design, think about how we use money. Working with a partner, create a design for the new bills and coins. Share your finished product with the class and explain why your money will serve the same purpose(s) as our existing money. Read Chapter 14 to learn more about our monetary system and how the government works to promote economic stability and growth. The BIG Idea Governments strive for a balance between the costs and benefits of their economic policies to promote economic stability and growth. Our modern banking system allows you to access your money anywhere in the world. 382 UNIT 4 Corbis Economics: Principles and Practices Web site at glencoe.com and click on Chapter 14—Chapter Overviews to preview chapter information. Chapter Overview Visit the SECTION 1 The Evolution, Functions, and Characteristics of Money GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn that money functions as a medium of exchange, a measure of value, and a store of value. Content Vocabulary • Federal Reserve System (Fed) (p. 383) • Federal Reserve notes (p. 383) • barter economy (p. 384) • specie (p. 385) • monetary unit (p. 386) • medium of exchange (p. 387) • measure of value (p. 387) • store of value (p. 387) • demand deposit accounts • commodity money (DDAs) (p. 388) (p. 384) • fiat money (p. 384) • M1 (p. 388) • M2 (p. 388) • revolution (p
. 385) • converted (p. 387) Reading Strategy Describing As you read the section, complete a graphic organizer similar to the one below that describes the characteristics of money. Characteristics of money PRODUCTS IN THE NEWS Early Money —www.ptma.org Before there was money as we know it, there was barter. People in early societies developed forms of proto-money—the use of commodities that everyone agreed to accept in trade. Aztecs used cacao beans. Norwegians once used butter. The early U.S. colonists used tobacco leaves and animal hides (settlers traded deer hides—the origin of our modern word for money: “bucks”). Some items, such as arrowheads, salt, and animal hides, were useful in and of themselves. Gradually, however, people began exchanging items that had no intrinsic value, but which had only agreed-upon or symbolic value. An example is the cowrie shell. Cowrie shells are found on an island off the coast of India. They have been widely used as currency in China, India, Thailand, and in West Africa. ■ It may seem odd that people once used tobacco or shells as a form of money. Frequently, people used things that were easily available and valued by others as a form of money. As a result money came in a variety of forms, shapes, and sizes. The use of money developed because it makes life easier for people and serves everyone’s best interests. In fact, over time money has become a social convention, much like the general acceptance of laws and government. Today most of our money is issued by the Federal Reserve System (Fed), the privately owned, publicly controlled central bank of the United States. It issues paper currency known as Federal Reserve notes, a key part of our money supply. Federal Reserve System (Fed) privately owned, publicly controlled central bank of the United States Federal Reserve note paper currency issued by the Fed in use today Michael Freeman/IPNstock CHAPTER 14 Money, Banking, and the Fed 383 barter economy moneyless economy that relies on trade or barter commodity money money that has an alternative use as an economic good fiat money money by government decree Barter Economy As the cartoon shows, trading in a barter economy can be difficult for those wanting to exchange goods for products they may use. How does money function as a medium of exchange. The Evolution of Money MAIN Idea People invented money to make life easier. Economics and You Have you ever tried
to trade for something with your friends? Read on to learn how societies began using money to make exchange easier. Take a moment to think what life would be like in a barter economy, a moneyless economy that relies on trade. Without money, the exchange of goods and services would be more difficult because the products some people have to offer are not always acceptable or easy to divide for payment. For example, how could a farmer with a pail of milk obtain a pair of shoes if the cobbler wanted a basket of fish? Unless there is a “mutual coincidence of wants”— where two people want exactly what the other has and are willing to trade what they have for it—it is difficult for trade to take place. Life is simpler in an economy with money. The farmer sells the milk for cash and then exchanges the cash for shoes. The cobbler takes the cash and looks for some- one selling fish. Money, as it turns out, makes life easier for everybody in ways we may have never considered. Money in Primitive Societies Tea leaves compressed into “bricks” comprised money in ancient China, and compressed cheese was used in early Russian trade. In early colonial America, corn and even animal pelts were used as a form of money. Today, this money would be classified as commodity money—money that has an alternative use as an economic good, or commodity. For example, the compressed tea leaves could be used to make tea when not needed for trade. Other items became fiat money—money by government decree—such as tiny metallic coins used in Asia Minor in the seventh century b.c. These coins served as money because the government said they were money. Money in Colonial America The money used by early settlers in the American colonies was similar to that found in early societies. Some of it consisted of commodity money, and some was fiat money. Many products—including corn, hemp, gunpowder, and musket balls—served as commodity money. They could be used to settle debts and make purchases. At the same time, colonists could consume these products if necessary. A commonly accepted commodity money was tobacco, for which the governor of colonial Virginia set a value of three English shillings per pound in 1618. Two years later, colonists used some of this money to bring wives to the colonies. Other colonies established fiat monies. For example, in 384 UNIT 4 Macroeconomics: Performance and Stabilization www.CartoonStock.com Specie Immigrants
brought coins made of gold and silver, such as the Austrian taler on the left and the Spanish peso on the right. These coins were used throughout the colonies. Why were such coins desirable? 1637 Massachusetts established a monetary value for wampum—a form of currency the Wampanoag Native Americans made out of white and purple mussel shells. The Wampanoag and the settlers used these shells in trade. White shells were more plentiful than purple ones, so one English penny was made equal to six white or three purple shells. Early Paper Currency As time passed, Americans used other forms of money. In some cases, state laws allowed individuals to print their own paper currency. Usually backed by gold and silver deposits in banks, it served as currency for the immediate area. States even printed money in the form of taxanticipation notes and used them to pay salaries, buy supplies, and meet other expenditures until they received taxes and redeemed the notes. The Continental Congress issued paper money to finance the Revolutionary War. In 1775 it printed Continental dollars, a form of fiat paper currency with no gold or silver backing. By the end of the war, nearly one-quarter billion Continental dollars had been printed—a volume so large that it was virtually worthless by the end of the revolution. (l) imagebroker/Alamy, (r) akg-images/Gilles Mermet specie money in the form of gold or silver coins Specie in the Colonies Colonists also used modest amounts of specie—or money in the form of silver or gold coins. These included English shillings, Austrian talers, and various European coins that immigrants had brought to the colonies. Coins were the most desirable form of money, not only because of their mineral content, but because they were in limited supply. By 1776 only $12 million in specie circulated in the colonies, compared to nearly $500 million in paper currency. The most popular coin in the colonies was the Spanish peso that came to America through trade and piracy. Long before the American Revolution had begun, the Spanish were mining silver in Mexico. They melted the silver into bullion—ingots or bars of precious metals—or minted it into coins for shipment to Spain. When the Spanish treasure ships stopped in the West Indies to buy fresh provisions, however, they often became victims of Caribbean pirates who spent their stolen treasure in America’s southern colonies. The “triangular trade” between the colonies, Africa, and
the Caribbean brought more pesos to America. Traders took molasses and pesos from the Caribbean to the colonies. There they sold the molasses to be made into rum and spent their pesos on other goods. The rum was shipped to CHAPTER 14 Money, Banking, and the Fed 385 monetary unit standard unit of currency in a country’s money supply Dollars Today’s money is available in both bills and coins. Why was the dollar divided into tenths? Africa, where it was traded for enslaved Africans. The enslaved Africans were taken to the Caribbean to be sold for pesos and more molasses. The trade cycle started anew when molasses and pesos were taken to the colonies. From “Talers” to “Dollars” Pesos were known as “pieces of eight,” because they were divided into eight subparts known as “bits.” Because the pesos resembled the Austrian talers, they were nicknamed “talers,” which sounds similar to the word dollars. This term became so popular that the dollar became the basic monetary unit, or standard unit of currency, in the U.S. money system. Rather than divide the dollar into eighths as the Spanish had done with the peso, it was decided to divide it into tenths, which was easier to understand. Still, some of the terminology associated with the Spanish peso remains, as when people sometimes call a 25-cent coin—one quarter of a dollar—“two bits.” Reading Check Describing What kind of money was used in colonial America? Characteristics and Functions of Money MAIN Idea Anything can be used as money as long as it is portable, durable, divisible, and limited in supply. Economics and You When you go shopping, you carry your money with you. Read on to learn how this feature of money is helpful to us. The study of early money is useful because it helps us understand the characteristics that give money its value. In fact, any substance can serve as money if it possesses four main characteristics. Characteristics of Money First, money must be portable, or easily transferred from one person to another, to make the exchange of money for products easier. Most money in early societies was very portable—including shells, wampum, tobacco, and compressed blocks of tea. Second, money must also be reasonably durable so it does not deteriorate when it is handled. Most colonial money was quite durable, especially monies
like musket balls and wampum. Even the fiat paper money of the colonial period was durable in the sense that it could be easily replaced by new bills when old ones became worn. Third, money should be easily divisible into smaller units so that people can use only as much as they need for a transaction. Most early money was highly divisible. The blocks of tea or cheese were cut with a knife. Bundles of tobacco leaves could easily be broken apart. Even Spanish pesos were cut with a knife into eights to make “bits” for payment. Finally, if something is to serve as money, it must be available, but only in limited supply. Stones used as money on the Yap Islands, for example, were carried in open canoes from other islands 400 miles away. Because navigation was uncertain and the weather was unpredictable, only one canoe in 20 completed the round-trip, resulting in a limited supply of stone money. 386 UNIT 4 Macroeconomics: Performance and Stabilization The McGraw-Hill Companies &The Global Economy YOU The Euro Go to any U.S. coin shop, and you can buy German marks, French francs, Italian lira, and Greek drachmas— often a whole bag of coins—for just a few bucks. Why so cheap? Because those coins have been replaced by the euro, they are now virtually worthless. In January 2002, most European Union (EU) nations replaced their own money with the euro. A historic milestone in the process of European integration, the euro has created a new monetary reality for 300 million Europeans. A generation ago, few would have believed this possible. People take their money personally. It usually includes national symbols, heroic figures, or government leaders. So how did the EU countries agree on a single type of currency? The fact is, they didn’t. The euro bills depict stylized buildings from different architectural periods. The coins, however, are unique for each country. While one side of the coins is the same, the other side reflects the country from which it originated. medium of exchange money or other substance generally accepted as payment for goods and services measure of value a function of money that allows it to serve as a common way to express value store of value a function of money that allows people to preserve value for future use Money, like almost everything else, loses its value whenever there is too much of it. This was a major problem for most types of commodity money. In Virginia, the price of
tobacco went from 36 pennies a pound to 1 penny a pound after every-one started growing their own money. Wampum even lost its value when settlers used industrial dyes to turn white shells into purple— thereby doubling their value. Functions of Money Any substance that is portable, durable, divisible, and limited in supply can serve as money. If it does, it will serve three roles in the economy. Money is a medium of exchange— something accepted by all parties as payment for goods and services. Throughout history, societies have used many materials as a medium of exchange, including gold, silver, and even salt. In ancient Rome, salt was so valuable that each soldier received an annual salt payment called a “salarium.” The modern term for an annual income— salary—is based on this Latin term. The second function of money is to serve as a measure of value—a common measuring stick that can be used to express worth in terms that most individuals understand. This is what we observe whenever we see a price tag on something—a value that we can use to make comparisons with other products. In the United States, our measure of value is expressed in dollars and cents. Third, money serves as a store of value— the quality that allows purchasing power to be saved until needed. For example, goods or services can be converted into money, which is easily stored until needed. This feature of money allows a period of time to pass between earning and spending an income. Modern Money Today we have several different types of money. Some of it is in the form of Federal Reserve notes and some in the form of The McGraw-Hill Companies CHAPTER 14 Money, Banking, and the Fed 387 demand deposit account (DDA) account from which funds can be removed by writing a check and without having to gain prior approval from the depository institution M1 component of the money supply relating to money’s role as a medium of exchange M2 component of the money supply relating to money’s role as a store of value Skills Handbook See page R46 to learn about Drawing Conclusions. metallic coins issued by the U.S. Bureau of the Mint. Other forms of money include demand deposit accounts (DDAs), or funds deposited in a bank that can be accessed by writing a check and without having to secure prior approval of the institution. Because of this, the Fed uses different definitions for the money supply. The first is M1, which includes coins and currency, traveler’s checks,
DDAs, and checking accounts held at other depository institutions. This definition of the money supply relates to money’s function as a medium of exchange. A broader definition is M2, which includes M1 along with savings deposits, time deposits, and money market funds—all of which relate to money’s function as a store of value. While our modern money may seem to be quite different from earlier forms of money, it shares the fundamental characteristics and functions of money. Modern money is portable. Our currency is lightweight, convenient, and can be easily transferred from one person to another. The same applies to the use of checks. Modern money is reasonably durable. Metallic coins last about 20 years under normal use. Paper currency is also reasonably durable, with a $1 bill lasting about 18 months in circulation. The introduction of the Sacagawea dollar coin was part of an attempt to make the money supply even more durable by replacing the $1 bill, a low-denomination currency, with longerlasting coins. Modern money is divisible. The penny, which is the smallest denomination of coin, is small enough for almost any purchase. In addition, people can write checks for the exact amount of a purchase. If anything, modern money has an uneven track record when it comes to limited availability and stability in value. The money supply often grew at a rate of 10 to 12 percent a year in the 1970s, which contributed greatly to the inflation of the early 1980s. It has slowed considerably since then, which has led to a period of price stability. Reading Check Explaining How does modern money reflect the functions and characteristics of money? SECTION 1 Review Vocabulary 1. Explain the significance of Federal Reserve System (Fed), Critical Thinking 4. The BIG Idea How does money advance the exchange Federal Reserve note, barter economy, commodity money, fiat money, specie, monetary unit, medium of exchange, measure of value, store of value, demand deposit account (DDA), M1, and M2. Main Ideas 2. Explaining Why was the “dollar” adopted as the basic monetary unit of the United States? 3. Identifying Use a graphic organizer like the one below to identify the functions of money. Functions of Money of goods and services? 5. Inferring Why would some people be more willing to accept commodity money rather than fiat money? 6. Drawing Conclusions Why did the use of money replace the barter system? 7. Analyzing Visuals Study the cartoon on page 384
. How does this cartoon spotlight the basic problem of a barter economy? Applying Economics 8. Functions of Money Create a list of the ways you have used money during the last week. Write the actions on a piece of paper. Next to each, identify which of the functions of money your actions illustrated. 388 UNIT 4 Macroeconomics: Performance and Stabilization CASE STUDY Keep the Change Thinking Outside the Bank When you think of banks, you probably see an unimaginative, conservative industry. Most banks offer very similar services and interest rates on loans, savings accounts, and certificates of deposit. So how can a bank differentiate itself to attract new customers? “Keep the Change” Bank of America came up with a plan and in 2005 launched a new program called “Keep the Change.” The bank tallies each purchase its customers make with their debit cards and rounds it up to the next higher dollar. The bank then transfers the difference, or “change,” into the Bank of America savings accounts of customers. To sweeten the pot, the bank matches the first three months of savings at 100 percent and each month H OW IT W ORKS Go into a store, buy a cup of coffee for $1.50 Pay for it with your Keep the Change debit card, B of A rounds it off to $2 B of A transfers $.50 from your checking to your savings account, matching 5% of the annual total up to $250 thereafter at 5 percent, up to a yearly total of $250. The bank’s contributions are made annually, but customers can still watch their money grow with interest on a daily basis. I T A DDS U P! Daily Purchases Purchase Price Amount Transferred to Savings CD: Latte: Burger: Total: $9.63 $3.80 $2.29 $15.72 $.37 $.20 $.71 $1.28 Don’t Even Think About Saving How did Bank of America come up with such a new idea in an industry not known for innovation? In early 2004, the bank hired researchers to study people’s banking and spending habits. They found that some people rounded up their payments to make balancing their checkbooks easier and quicker. They also saw purchasing behaviors that reinforced the stereotype that Americans are big spenders but not big savers. The “Keep the Change” program takes the responsibility for saving out of customers’ hands while it rewards spending. Even so, it�
�s still money in the bank. Instead of tossing change into a jar each night, 2.5 million new Bank of America customers allow the bank to slip their change into an interestbearing savings account. Analyzing the Impact 1. Summarizing Why did Bank of America introduce its “Keep the Change” program? 2. Drawing Conclusions How much money would a person save per month and per year if making a weekly purchase of the items in the table? CHAPTER 14 Money, Banking, and the Fed 389 SECTION 2 The Development of Modern Banking GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn that many different types of money have been used throughout American history, and fiat money is used today. • clauses (p. 391) • initially (p. 395) Content Vocabulary • state bank (p. 391) • legal tender (p. 392) • national bank (p. 392) • national currency (p. 392) • gold certificate (p. 393) • silver certificate (p. 393) • central bank (p. 394) • bank run (p. 395) • bank holiday (p. 395) • fractional reserve system (p. 396) • legal reserves (p. 396) • reserve requirement (p. 396) • member bank reserve (MBR) (p. 396) • excess reserves (p. 396) Reading Strategy Listing As you read the section, complete a time line similar to the one below by listing major events in U.S. monetary history in the appropriate spaces. 1860 1880 1900 1920 1940 1862 1900 1886 1861 Gold certificates issues 1934 —Bureau of Engraving and Printing PRODUCTS IN THE NEWS New $10 Bills On March 2, 2006, the Federal Reserve banks issued a redesigned Series 2004 $10 note to the public through commercial banks. The notes will begin circulating immediately in the United States, and will then be introduced in other countries.... New money designs are being issued as part of an ongoing effort to stay ahead of counterfeiting, and to protect the economy and the hard-earned money of U.S. currency users. The new series began with the introduction of the $20 note on October 9, 2003, and continued with the $50 note issued on September 28, 2004. ■ Creating and maintaining a dependable money supply is more difficult than most people think. Over the years, the United States has experimented with different kinds of money with varying success. Early
attempts included coins made of gold and silver, as well as paper currency backed by gold and silver. Today some of our money circulates as paper currency, but most of it exists in the form of electronic bookkeeping entries. Neither is backed by gold or silver. Instead, we have a managed money supply that is accepted by everyone simply because people have faith in it. Managing this money supply takes an enormous amount of work. As you read in the news story, we even have to make it difficult for others to copy money so that it stays in limited supply—lest it go the way of the Continental dollar. 390 UNIT 4 Macroeconomics: Performance and Stabilization The McGraw-Hill Companies The Development of Banking in America MAIN Idea The United States experimented with many different kinds of money before it created the Federal Reserve System. Economics and You Have you ever wondered why the dollar bill is green? Read on to learn why the government decided to print our money this way. Banking in the United States has gone through many changes. At one time, banking was virtually unregulated. This led to abuses, and problems with the money supply eventually required the intervention of government. Privately Issued Bank Notes During the Revolutionary War, nearly 250 million Continental dollars were printed. By the end of the Revolution, Continental currency had become worthless, and people did not trust the government to issue anything except coins. Accordingly, Article 1, Section 8, of the United States Constitution states: The Congress shall have the power To coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures; To provide for the punishment of counterfeiting the securities and current coin of the United States;... To make all laws which shall be necessary and proper for carrying into execution the foregoing powers, and all other powers vested by this Constitution in the government of the United States, or in any department or officer thereof. Article 1, Section 10, further states: No State shall... coin money; emit bills of credit; make anything but gold and silver coin a tender in payment of debts.... Because of these clauses, the federal government did not print paper currency until the Civil War. Instead, the printing, The Library of Congress distribution, and regulation of the paper money supply were left to the discretion of privately owned banks. state bank bank that receives its charter from the state in which it operates Growth of State Banking Banking became popular after the Revolution because the new Constitution allowed private banks to issue paper currency. By
1811 the country had about 100 state banks. A state bank is a bank that receives its operating charter from a state government. Banks issued their own currency by printing their notes at local printing shops. The banks then put these notes in circulation with the assurance that people could exchange them for gold or silver if they ever lost faith in the bank or its currency. At first, most banks printed only the amount of currency they could reasonably back with their gold and silver reserves. Others, however, were not as honest and printed large amounts of currency in remote areas to make it difficult for people to redeem their currency. Problems With Currency Even when banks were honest, problems with their currency arose. First, each bank issued its own currency in different sizes, Money Paper currency such as this Continental dollar helped finance the Revolutionary War. Why did the federal government stop printing paper currency? CHAPTER 14 Money, Banking, and the Fed 391 Private Bank Notes After the Revolutionary War, private banks issued their own currencies. What were the major problems with such currencies? legal tender fiat currency that must be accepted for payment by decree of the government national bank commercial bank chartered by the National Banking System national currency currency backed by government bonds and issued by commercial banks in the National Banking System colors, and denominations. As a result, hundreds of different kinds of notes could be in circulation in any given city. Second, banks were tempted to issue too many notes because they could print more money whenever they wanted. Third, counterfeiting became a major problem. With so many different types of notes in circulation, many counterfeiters did not even bother to copy other notes. Instead, they just made up new ones. By the time of the Civil War, more than 1,600 banks were issuing more than 10,000 different kinds of paper currency. Each bank was supposed to have backing for its notes in the form of gold or silver, but this was seldom the case. As a result, when people tried to buy something, merchants would often check their notes against the latest listing of good and bad currencies before deciding which ones they would accept in payment. The paper currency component of the nation’s money supply was badly in need of an overhaul. Politically powerful local bankers, however, resisted change until an event came along that would change commercial banking in the United States forever—the Civil War. Greenbacks When the Civil War erupted, both the Union and the Confederacy needed to raise enormous sums to finance the war. Congress tried to borrow money by selling bonds, but this did not
raise as much money as the federal government needed. As a result, Congress decided to print paper currency for the first time since the Constitution was adopted. In 1861 Congress authorized the printing of $60 million in the new currency. Although this currency had no gold or silver backing, it was declared legal tender— fiat currency that must be accepted in payment for debts. These new notes were soon dubbed “greenbacks” because the reverse sides of the notes were printed with green ink. The green backs distinguished the new notes from the state notes already in circulation, because these were usually blank on the back. The National Banking System As the war dragged on, people feared that the greenbacks—like the Continental dollars used almost a century earlier to finance the Revolutionary War—might become worthless. When the greenbacks did lose some of their value, people avoided using them, forcing Congress to find another way to pay for the war. In 1863 Congress enacted the National Currency Act, which created a National Banking System (NBS) made up of national banks. A national bank is a privately owned bank that receives its operating charter from the federal government. These banks issued their own notes called national currency that were backed with 392 UNIT 4 Macroeconomics: Performance and Stabilization Courtesy of the Federal Reserve Bank of San Francisco bonds that the banks bought from the federal government. The government hoped that rigorous bank inspections and other high standards would give people confidence in the new banking system and its currency. The new system also would help the government because banks that joined the NBS would buy the bonds that helped supply the government with funds needed to finance the Civil War. Initially, only a few state-chartered banks joined the system because it was easier for them to print their money at local printers. Finally, in 1865 the federal government forced state banks to become part of the National Banking System by placing a 10 percent tax on all privately issued bank notes. Because state-chartered banks could not afford the tax, they withdrew their notes, leaving only the greenbacks and currency issued by the NBS in circulation. As a result of the need to finance the Civil War, the makeup of the paper component of the money supply shifted from being entirely privately issued to being entirely publicly issued. Other Federal Currencies The 10 percent tax greatly simplified the money supply by causing the removal of more than 10,000 different sizes and denominations of state bank notes. Before long, however, new types of federal currency appeared. In the same year the NBS was created, the government issued
gold certificates— paper currency backed by gold placed on deposit with the United States Treasury. At first, these certificates were printed in large denominations for use exclusively by banks, but by 1882 they were also issued in smaller denominations for use by the general public. In 1878 the government introduced silver certificates—paper currency backed by silver dollars and bullion placed on reserve with the Treasury. The government was already minting silver dollar coins, but their bulky size made them inconvenient. RubberBall/SuperStock When silver dollars were used as backing, the certificates became more popular and increased the demand for silver. This appeased both the silver miners and the public who wanted an alternative to the bulky silver dollars. Reading Check Explaining Why did the govern- ment issue greenbacks in 1861? gold certificate paper currency backed by gold and issued between 1863 and 1934 silver certificate paper currency backed by, and redeemable for, silver from 1878 to 1968 CAREERS Bank Teller The Work * Handle a wide range of banking transactions, including cashing checks, accepting deposits and loan payments, and processing withdrawals * Sell savings bonds and traveler’s checks, and handle foreign currencies or commercial accounts * Explain to customers the various types of accounts and financial services the bank offers Qualifications * Solid computer, numerical, clerical, and communication skills * Consistent attention to detail * Must enjoy public contact, feel comfortable handling large amounts of money, and should be discreet and trustworthy * High school diploma Earnings * Median annual earnings: $21,120 Job Growth Outlook * Slower than average Source: Occupational Outlook Handbook, 2006–2007 Edition CHAPTER 14 Money, Banking, and the Fed 393 The Creation of the Fed MAIN Idea The Federal Reserve System is the nation’s central bank. Economics and You Have you ever wondered where the money you might borrow to buy a car comes from? Read on to learn how banks generate these funds. By the turn of the twentieth century, the banking system was showing signs of strain. First, the National Banking System, designed primarily to help the federal government finance the Civil War, was having difficulty providing enough currency for the growing nation. Second, checking accounts were becoming more popular, and the banking system was not designed to deal with this new method of payment. Third, even minor recessions were causing major problems for banks and other lending institutions. The Federal Reserve System Reform came in 1913 when Congress created the Federal Reserve System, or Fed, as the nation’s central bank. A central bank is a bank
that can lend to other banks in times of need. To ensure membership in the Fed, all national banks were required, and all statechartered banks were eligible, to become “members”—or part owners—of the Fed. Because the Fed was organized as a corporation, any bank that joined had to purchase shares of stock in the system, just as a private individual purchases shares in a regular corporation. As a result, privately owned banks, not the government, own the Federal Reserve System. The Fed issued its own currency, called Federal Reserve notes, which eventually replaced all other types of federal currency. Because the Fed had the resources to lend to other banks during periods of difficulty, the Fed became the nation’s first true central bank. Banking in the Great Depression Despite the creation of the Fed, many banks were only marginally sound during the 1920s. Part of the reason was an overexpansion of banking between the Civil War and 1921, when the total number of banks exceeded 31,000. Although some consolidation occurred between 1921 and 1929, the banking industry was overextended when the Great Depression began in 1929. central bank bank that can lend money to other banks in times of need The Great Depression When depositors became concerned about the safety of their money, they often started bank runs, such as this on on the Federal American Bank. Why did bank runs occur? 394 UNIT 4 Macroeconomics: Performance and Stabilization Hulton-Deutsch Collection/Corbis Figure 14.1 State and National Banks The number of banks in the United States grew rapidly after 1880 and peaked in 1921. A period of mergers and consolidations took place from 1921 to 1929, after which the Great Depression took its toll. The number of banks remained relatively constant from 1933 to 1985, when another wave of mergers took place. Economic Analysis What can you infer about the ratio of state banks to national banks? See StudentWorks™ Plus or glencoe.com. As Figure 14.1 shows, a staggering number of bank failures occurred during the 1930s. At the start of the Depression, about 25,500 banks existed—none of which had deposit insurance for their customers. As a result, concern about the safety of bank deposits often caused a bank run—a rush by depositors to withdraw their funds from a bank before it failed. This made the situation worse, causing more banks to fail. On March 5, 1933, President Roosevelt announced a bank holiday—a brief period during which every bank in the
country was required to close. Several days later, after Congress passed legislation to strengthen the banking industry, most banks were allowed to reopen. Still, the Great Depression took its toll, and by 1934 more than 10,000 banks had closed or merged with stronger banks. Federal Deposit Insurance When banks failed during the Great Depression, depositors lost all their savings. The Banking Act of 1933, also known as the Glass-Steagall Act, was passed to strengthen the banking industry. The act also created the Federal Deposit Insurance Corporation (FDIC), which initially insured customer deposits to a maximum of $2,500 in the event of a bank failure. The insurance did little for those who lost their savings before 1934, but it has provided a sense of security in banking bank run sudden rush by depositors to withdraw all deposited funds, generally in anticipation of bank failure or closure bank holiday brief period during which all banks or depos i tory institutions are closed to prevent bank runs CHAPTER 14 Money, Banking, and the Fed 395 Figure 14.2 Fractional Reserves and the Money Supply With a 20 percent reserve requirement, a $1,000 cash deposit will result in a fivefold expansion of the money supply. Economic Analysis If the initial reserves were $2,000, how large could the money supply get? fractional reserve system system requiring financial institutions to set aside a fraction of their deposits in the form of reserves legal reserves currency and deposits used to meet the reserve requirement reserve requirement formula used to compute the amount of a depository institution’s required reserves member bank reserve (MBR) reserves kept by member banks at the Fed to satisfy reserve requirements excess reserves financial institution’s cash, currency, and reserves not needed for reserve requirements ever since. After the FDIC was created, people worried less about the safety of their deposits, reducing the number of runs on banks. If a bank is in danger of collapse today, the FDIC can seize the bank and either sell it to a stronger one or liquidate it and pay off the depositors. If it is sold, the sale is done in secrecy to prevent panic withdrawals or to keep shareholders from selling their worthless stock to unsuspecting investors. Either way, depositors today have little to fear because they are now covered up to the current $100,000 FDIC insurance limit per customer per bank. If an account holds more than this amount, the depositor may go to court and sue the bank’s owners to recover the rest. Fractional Reserves and Deposit Expansion
The growing popularity of checking accounts in the last century led to the refinement of another important banking practice, the use of fractional bank reserves. Under a fractional reserve system, banks are required to keep only a portion of their total deposits in the form of legal reserves. Legal reserves consist of coins and currency that banks hold in their vaults, plus deposits at the Fed. The size of the reserves are determined by a reserve requirement, the percentage of every deposit that must be set aside as legal reserves. The result is a money supply that is several times larger than the total reserves of the banking system. To see how this works, let us assume that on Monday, a depositor named Kim opens a demand deposit account (DDA) by depositing $1,000 in a bank that is subject to a 20 percent reserve requirement. We will also assume that no one else has any money, so the size of the entire money supply is also $1,000. Figure 14.2 illustrates the monetary expansion process that takes place under these conditions. Because of the 20 percent reserve requirement, $200 of Kim’s deposit must be set aside as a reserve in the form of vault cash or in a member bank reserve (MBR)— a deposit a member bank keeps at the Fed to satisfy reserve requirements. The remaining $800 of excess reserves—legal reserves beyond the reserve requirement—represents the bank’s lending power and can be loaned out. At the end of Monday the total money supply in the hands of the public amounts to Kim’s $1,000 checking account. On Tuesday, the bank lends its $800 excess reserves to Bill. Bill decides to take the loan in the form of a DDA so that the 396 UNIT 4 Macroeconomics: Performance and Stabilization Personal Finance Handbook See pages R14– R15 to learn more about loans. cash never leaves the bank. Even so, the bank treats the new DDA as a new deposit, so 20 percent, or $160, must be set aside as a reserve. This leaves $640 of excess reserves to be lent to someone else. By the end of Tuesday, the total money supply in the hands of the public amounts to $1,800—the sum of Kim’s and Bill’s DDAs. On Wednesday, Maria enters the bank and borrows the $640 excess reserves. If she takes the loan in the form of a DDA, the bank treats it as a new $640 deposit,
20 percent of which must be set aside as a required reserve, leaving $512 of excess reserves. By the end of the day, the money supply in the hands of the public (DDAs and cash) has grown to $2,440—the sum of the DDAs owned by Kim, Bill, and Maria. The $2,440 result would be exactly the same if Maria had borrowed the bank’s $640 excess reserves in cash. Had she done so, the money supply in the hands of the public would have consisted of the $1,800 in Kim’s and Bill’s checking accounts, plus Maria’s $640. However, the money expansion process will now come to a temporary halt until the $640 cash returns to the bank as a deposit. If Maria spends the money, and if the person who receives it opens a new deposit account so that additional excess reserves are created, the expansion process can resume. This expansion will continue as long as the bank has excess reserves to lend and as long as lenders deposit part or all of that money. In fact, as long as every dollar of DDAs is backed by 20 cents of legal reserves, the total amount of DDAs would be: Total MBRs Reserve Requirement = $1,000.20 = $5,000 Some people will use cash, of course, so the DDA component of the money supply may never reach $5,000. Even so, it is clear that fractional reserve banking allows the DDA component of the money supply to grow several times larger than the total amount of member bank reserves. Reading Check Describing What is the purpose of the FDIC? SECTION 2 Review Vocabulary 1. Explain the significance of state bank, legal tender, Critical Thinking 4. The BIG Idea Why did the United States move to national bank, national currency, gold certificate, silver certificate, central bank, bank run, bank holiday, fractional reserve system, legal reserves, reserve requirement, member bank reserve (MBR), and excess reserves. Main Ideas 2. Describing How did experiences during and after the Revolutionary War affect banking in the United States? 3. Listing Use a graphic organizer like the one below to list the reasons for creating the Federal Reserve System. a single national currency in the 1860s? 5. Synthesizing How does the system of fractional reserves “create” money? 6. Making Comparisons How do the operations of a central bank like the Fed compare to the operations of a
normal bank? 7. Analyzing Visuals Examine the photo on page 394. What weaknesses in the banking system led to the actions pictured in this photo? Reasons for Creating the Federal Reserve System Applying Economics 8. National and State Banks Interview the branch managers of different banks in your locality. Ask whether the bank is a national bank or a state bank and how that designation affects the bank’s operation and relationship with the Fed. CHAPTER 14 Money, Banking, and the Fed 397 Profiles in Economics ECONOMIST When his high school did not offer calculus, Ben Bernanke taught it to himself—not an unusual feat for the student with the highest SAT score in his state that year. Bernanke went on to major in economics at Harvard and MIT because he thought it combined math and people. Ben S. Bernanke (1953– ) • distinguished academic career as an economics professor • sworn in as chairman of the Federal Reserve Board in 2006 Maestro of the Economy Before becoming the second most powerful man in America (after the president), Ben S. Bernanke was professor of Economics and Public Affairs at Princeton University. As chair of the Fed, Bernanke now is responsible for U.S. monetary policy. His tenure follows that of Alan Greenspan, Fed chair from 1987 to 2006, who is credited with presiding over the period of greatest economic growth in U.S. history. These are large shoes to fill. Bernanke’s academic career, with a focus on monetary policy, prepared him well for the task. Clear Talk, Clear Target Unlike Greenspan, who was known to be vague when reporting his monetary decisions to Congress, Bernanke promotes transparency and straightforward communication. He believes that “as public servants whose policy actions affect the lives of every citizen, central bankers have a basic responsibility” to clearly state reasons for any Fed action. “Fedspeak,” as U.S. media and financial markets called earlier central bank talk, was out. Even so, Bernanke learned to be careful about what he says in public. When he mentioned offhand at a dinner party that rising inflation concerned him, the stock market dropped 250 points in two days. Such is the power of the Fed chair’s words. Besides his transparency, Bernanke differs from Greenspan in how he looks at inflation. Rather than relying on hunches, Bernanke wants to base Fed policy on analysis of economic data and predetermined inflation targets. The Fed can then adjust monetary policy to meet those targets.
It is a strategy he advocated several years before his appointment, when he wrote that “the Fed needs an approach that consolidates the gains of the Greenspan years and ensures that those successful policies will continue.” Examining the Profile 1. Contrasting How does Bernanke differ from his predecessor Greenspan? 2. Making Inferences What effect would a more transparent monetary policy have on financial markets? 398 UNIT 4 Macroeconomics: Performance and Stabilization AP Images/Stephen Chernin SECTION 3 The Federal Reserve System and Monetary Policy GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn how the Federal Reserve System is organized and conducts monetary policy. • aspects (p. 401) • functions (p. 401) Content Vocabulary • member bank (p. 400) • monetary policy (p. 402) • interest rate (p. 402) • easy money policy (p. 402) • tight money policy (p. 402) • open market operations (p. 403) • discount rate (p. 404) • prime rate (p. 404) • quantity theory of money (p. 405) • currency (p. 406) • coins (p. 406) • bank holding companies (p. 407) • Regulation Z (p. 407) PEOPLE IN THE NEWS Fed Raises Rates Reading Strategy Describing As you read this section, complete a graphic organizer similar to the one below by describing the features of the Federal Reserve System. The Federal Reserve System —Associated Press The Federal Reserve, in the last major piece of business for retiring chairman Alan Greenspan, pushed borrowing costs to the highest point in nearly five years Tuesday and hinted that another rate increase was possible. Shortly after the Fed’s rate announcement, the Senate [approved] Ben Bernanke’s nomination to be the 14th chairman of the central bank. Bernanke, 52, will be sworn in as Fed chief Wednesday morning in a private ceremony at the Fed’s marble headquarters. At Greenspan’s final meeting, the Fed boosted the federal funds rate... to 4.50 percent.... In response, commercial banks raised their prime lending rates... by a corresponding amount to 7.50 percent. ■ The U.S. economy reached a milestone in early 2006 when Alan Greenspan ended his tenure of over 18 years as Chairman of the Federal Reserve System’s Board of Governors. This position is important because the Fed Chair has immense influence over the economy. The
new chairman is Ben Bernanke. As the head of the Fed, he has an unusual degree of independence. Along with other Fed officials and without the approval of elected officials, he can change interest rates to try to speed up the economy when it is growing too slowly, or try to slow it down when it is growing too fast. Like his predecessor, the new chairman will be especially concerned about economic instability, recessions, and inflation. Getty Images CHAPTER 14 Money, Banking, and the Fed 399 member bank bank belonging to the Federal Reserve System Skills Handbook See page R51 to learn about Using Tables and Charts. Structure of the Fed MAIN Idea The Fed is organized as a corporation, owned by its member banks, and directed by a government-appointed board. Economics and You Does your local school board have advisory committees to help with board decisions? Read on to find out about similar advisory committees for the Fed. The main components of the Fed, shown in Figure 14.3, have remained practically unchanged since the Great Depression. Private Ownership One of the unique features of the Fed is that it is privately owned by its member banks. A member bank is a commercial bank that is a member of, and holds shares of stock in, the Fed. National banks—those chartered by the national government— must belong to the Fed. State banks—those receiving their charters from state governments—have the choice to belong or not. The original decision to make the Fed a stock corporation was a matter of necessity because the government did not have enough money to set up a new banking system. Instead, banks were required to purchase shares when they joined. This made the banks part-owners of the Fed, just as someone might own shares in IBM or Ford Motor Company. Private individuals are not allowed to buy shares in the Fed, although they become indirect owners by buying shares of stock in a Fed-member bank. Board of Governors The Fed is directed by a seven-member Board of Governors. Each member is appointed by the president of the United Figure 14.3 Structure of the Federal Reserve System The Board of Governors supervises the Federal Reserve System. The FOMC has primary responsibility for monetary policy. Three advisory councils provide direct advice to the Board on a regular basis. The district banks are located throughout the nation near the institutions they serve. Member banks contribute a small amount of funds and receive stock ownership shares in return. Economic Analysis What functions does the Board of Governors perform? See StudentWorks™ Plus or glencoe.com.
States and approved by the Senate to serve a 14-year term of office. The appointments are staggered, so that one appointment becomes vacant every two years. In addition, care is taken to appoint people who will govern the Fed in the public interest. Because of this, it is often said that the Fed is “privately owned, but publicly controlled.” The Board is primarily a regulatory and supervisory agency. It sets general policies for its member banks to follow and regulates certain aspects of state-chartered member banks’ operations. It helps make policies that affect the level of interest rates and the general availability of credit. Finally, it reports annually to Congress and puts out a monthly bulletin that covers national and international monetary matters. District Banks The Fed was originally intended to operate as a system of 12 independent and equally powerful banks. Each reserve bank was responsible for a district, and some Federal Reserve notes today still have the district bank’s name in the seal to the left of the portrait. More recently, advances in technology have minimized the need for a regional structure, so the new Fed seal on our currency does not incorporate any mention of the district banks. Today the 12 Federal Reserve district banks and their branches are strategically located to be near the institutions they serve. The district banks provide many of the same functions for banks and depository institutions that banks provide for us. For example, the district banks accept deposits from, and make loans to, privately owned banks and thrift institutions. Federal Open Market Committee The Federal Open Market Committee (FOMC) makes decisions about the level of interest rates. It has 12 voting members: seven members from the Board of Governors, the president of the New York The Fed When the Federal Reserve was first established in 1913, the individual states fought over the right to have one of the 12 district banks placed in their state. One state, however, was more equal than all the others and got two banks. One bank is located in St. Louis and the other bank is located in Kansas City—but both are located in the state of Missouri. It turns out that a powerful senator by the name of James A. Reed would not let the bill creating the Fed pass the Senate unless his state got two district banks. district Fed, and four district Federal Reserve bank presidents who serve oneyear rotating terms. The FOMC meets eight times a year to review the economy and to evaluate factors such as trends in construction, wages, prices, employment, production, and consumer spending. Its decisions
have a direct impact on the cost and availability of credit. While decisions are made in private, they are announced almost immediately. The FOMC is the Fed’s primary monetary policy-making body. Advisory Committees Three advisory committees advise the Board of Governors. The Federal Advisory Council consists of one representative from each of the 12 district banks. It provides advice to the Federal Reserve on matters concerning the overall health of the economy. The Consumer Advisory Council’s 30 members meet with the Board three times a year to advise on consumer credit laws. Members include educators, consumer legal specialists, and representatives from consumer and financial industry groups. The third advisory group is the Thrift Institutions Advisory Council, with representatives from savings and loan associations, savings banks, and credit unions. It meets with the Board three times a year to advise on matters pertaining to the Savings and Loan industry. Reading Check Explaining What is the purpose of the Federal Open Market Committee? CHAPTER 14 Money, Banking, and the Fed 401 monetary policy actions by the Federal Reserve System to expand or contract the money supply in order to affect the cost and availability of credit interest rate the price of credit to a borrower easy money policy monetary policy that results in lower interest rates and greater access to credit tight money policy monetary policy that results in higher interest rates and restricted access to credit Conducting Monetary Policy MAIN Idea Monetary policy involves expanding and contracting the money supply to change the level of interest rates. Economics and You Have you noticed that prices for some items go up faster than those for others? Read on to learn that inflation is one of the Fed’s main concerns. One of the most important functions of the Fed is to conduct monetary policy— changes in the money supply in order to affect the availability and cost of credit. This in turn influences economic activity. How Monetary Policy Works Monetary policy is based on the mechanism of supply and demand. Figure 14.4 shows that the demand curve for money has the usual shape, which illustrates that more money will be demanded when the interest rate, or the price of credit to a borrower, is low. However, the supply curve does not have its usual shape. Instead, its vertical slope indicates that the supply of money is fixed at any given time. When the Fed conducts its monetary policy, it changes interest rates by changing the size of the money supply. Under an easy money policy, the Fed expands the money supply, causing interest rates to fall. Such a policy stimulates the economy because people borrow more at lower interest rates. This is illustrated
in Panel A, where a larger money supply lowers the rate from 10 to 8 percent. Under a tight money policy, the Fed restricts the size of the money supply. This is shown in Panel B, where a contraction of the money supply drives the cost of borrowing up from 10 to 12 percent. This tends to slow economic growth because higher interest rates normally encourage everyone to borrow and spend less. The Fed can use three major tools to conduct monetary policy. Each tool works in a different way to change the amount of excess reserves—the amount of money a bank can lend to others. Figure 14.4 Short-Run Impact of Monetary Policy B M ONETARY C ONTRACTION S1 S 12% 10 Quantity of money In the short run, monetary policy impacts interest rates, or the price of credit. When the money supply expands, the price of credit goes down. When the money supply contracts, the price of credit goes up. Economic Analysis Why is the supply curve of money shown as a vertical line? Figure 14.5 The Reserve Requirement as a Tool of Monetary Policy The Fed can control the size of the money supply by changing the reserve requirement. A low requirement, such as 10 percent, can be used to expand the money supply. A higher requirement, such as 40 percent, has the opposite effect. Economic Analysis What would be the size of the money supply if the Fed set the reserve requirement at 25 percent? See StudentWorks™ Plus or glencoe.com. A M ONETARY E XPANSION (10% Reserve Requirement) B MONETARY CONTRACTION (40% Reserve Requirement) Additions to money supply Existing money supply Initial deposit $1,000 $900 $1,000 $810 $900 $1,000 Monday Tuesday Wednesday Nth Day $10,000 2,710 1,900 1,000 0 Additions to money supply Existing money supply Initial deposit $1,000 $600 $360 $600 $1,000 $1,000 Monday Tuesday Wednesday Nth Day $2,500 1,960 1,600 1,000 0 open market operations sales or purchases of U.S. government securities by the Fed Reserve Requirement The first tool of monetary policy is the reserve requirement. Within limits that Congress sets, the Fed can change this requirement for all checking, time, and savings accounts. For instance, in Figure 14.2 on page 396 we assumed that a 20 percent reserve requirement applied to the DDAs held by Bill, Maria, and other
depositors. In the figure, an initial deposit of $1,000 could expand to as much as $5,000 in total bank deposits. However, the Fed could also lower the reserve requirement to 10 percent or increase it to 40 percent. Figure 14.5 shows the results of such changes with the same initial deposit of $1,000. In Panel A, the 10 percent reserve requirement means that $900 of excess reserves could be lent out on the second day, $810 on the third day, and so on. Excess reserves are available until the DDAs reach a maximum of: Total MBRs Reserve Requirement = $1,000.10 = $10,000 In Panel B, the reserve requirement increases to 40 percent. The result is that $600 of excess reserves are available for the first loan, $360 of excess reserves are available for the second loan, and so on until $2,500 of DDAs are generated. Historically, the Fed has been reluctant to use the reserve requirement as a policy tool, in part because other monetary policy tools work better. Even so, the reserve requirement can be powerful should the Fed decide to use it. Open Market Operations The second tool of monetary policy is open market operations—the buying and selling of government securities in financial markets. This method is the Fed’s most popular tool and allows the Fed to influence short-term interest rates. Suppose the Fed wants to expand the money supply. All it has to do is buy a bond from an investor and pay for it with a check drawn on itself or an equivalent amount of cash. When the money is put in a bank, the CHAPTER 14 Money, Banking, and the Fed 403 discount rate interest rate that the Federal Reserve System charges on loans to the nation’s financial institutions prime rate lowest rate of interest rate that banks charge their best customers bank will have additional excess reserves and the loan expansion process can begin. The result is that whenever the Fed buys government securities, excess reserves are created and the money supply expands. Suppose the Fed were to sell some of its government securities. When a buyer takes money out of the banking system to pay for the securities, member bank reserves go down, forcing the money supply to contract. A smaller money supply, as we saw in Panel B of Figure 14.4, raises the interest rate. In the end, whenever the Fed sells government securities, excess reserves contract and the money supply contracts. In practice, every day the Fed buys and sells billions of dollars of government
securities through dealers. The Fed pays for the securities by writing checks drawn on itself. The dealers deposit the checks in their banks—thereby creating excess reserves. If the Fed sells securities, it accepts checks from the dealers, which reduces both dealers’ bank deposits and member banks’ reserves. The Federal Open Market Committee (FOMC) is the part of the Fed that conducts open-market operations. Normally the Discount Rate The Fed monitors consumer behavior so it knows when to adjust the money supply with tools such as the discount rate and open market operations. Why do changes in the discount rate affect the prime rate and most other interest rates The leading economic indicator the Fed watches to know when to raise interest rates is you. FOMC decides whether interest rates are too high, too low, or just right. After the committee votes to set targets, officials at the trading desk take over. The trading desk at the Fed’s New York district bank is the physical location where the daily buying and selling actually occurs. It is permanently located in New York to be close to the nation’s major financial markets. Discount Rate As a central bank, the Fed makes loans to other depository institutions. The discount rate—the interest the Fed charges on loans to financial institutions—is the third major tool of monetary policy. Only financial institutions can borrow from the Fed; private individuals and companies are not allowed to do so. The discount rate is the price of credit for an institution that borrows from the Fed. If the discount rate goes up, fewer banks will want to borrow from the Fed, and banks will have fewer excess reserves available to loan out. If the Fed wants to expand the money supply, it might lower the rate to encourage additional borrowing, thus increasing excess reserves. A bank may want to borrow from the Fed if it has an unexpected drop in its required reserves. A bank could also have high seasonal demands for loans. For example, a bank in an agricultural area might face a heavy loan demand during the planting season. In either case, a shortterm loan from the Fed could restore its reserves. Effects on Other Interest Rates While the Fed directly sets only one interest rate—the discount rate—its monetary policy actions influence other interest rates. For example, changes can directly affect the prime rate—the lowest rate of interest commercial banks charge their best customers. At many large banks, the prime rate is linked to other interest rates, so the banks usually adjust 404 UNIT 4 Macroeconomics: Performance and Stabilization
REAL LIFE ADVENTURES © 2004 GarLanco. Reprinted with permission of UNIVERSAL PRESS SYNDICATE. All rights reserved. Figure 14.6 Monetary Policy Tools The key to understanding monetary policy is to see how the excess reserves in the system are affected. Economic Analysis How does the Fed use the reserve requirement to affect the money supply? their prime rate up or down whenever the Fed changes the discount rate. slowly, though, and the unemployment rate took unusually long to recover. Changes in monetary policy spill over to almost all other interest rates as well. Any tightening of the money supply will affect the interest rate on home mortgages, savings bonds, certificates of deposits, and even Treasury bills and bonds. Monetary Policy Dilemmas The impact of monetary policy on the economy is complex. The problem is that we never know for sure how long it will take for a particular policy to take effect. As a result, it is often difficult for the Fed to please everyone. For example, some people blamed the 2001 recession on the Fed’s tight money policy of 2000. The Fed was worried about inflation and raised interest rates to slow the economy. When the economy went into recession in 2001, the Fed acted quickly to reverse itself and lower interest rates to stimulate GDP. The economy responded In the long run, the money supply also affects the general price level. If the money supply were to expand for a prolonged period of time, we would have too many dollars chasing too few goods, and demandpull inflation would result. This is the basis for the quantity theory of money, and it often has been observed in history. When the Spanish brought gold and silver back to Spain from the Americas in the 1700s, the increase in the money supply started an inflation that lasted for 100 years. During the Revolutionary War, the economy suffered severe inflation when the Continental Congress issued $250 million of currency. The country saw similar effects during the Civil War when the Union printed nearly $500 million of greenbacks. As a result, the Fed normally proceeds with a great deal of caution. Reading Check Examining Why does the Fed use open market operations? quantity theory of money hypothesis that the supply of money directly affects the price level over the long run CHAPTER 14 Money, Banking, and the Fed 405 currency paper component of the money supply, today consisting of Federal Reserve notes coins metallic forms of money such as pennies, nickels, dimes, and quarters Other Fed Responsibilities MAIN Idea As the nation’s central bank, the Fed
is responsible for most aspects of banking and the payments system. Economics and You Have you ever bought anything on credit and seen the loan information disclosed to you by the merchant? Read to learn how the Fed helped provide this information. The Federal Reserve has other responsibilities as well. These include maintaining the money supply and the payments system, regulating and supervising banks, preparing consumer legislation, and serving as the federal government’s bank. Money Today’s bills are printed on large sheets of paper. They undergo exten sive inspection before being cut up for circulation. What are other Fed responsibilities? Maintaining the Money Supply Today’s currency, the paper component of the money supply, is made up of Federal Reserve notes that are printed by the U.S. Bureau of Engraving and Printing. This currency, issued in amounts of $1, $2, $5, $10, $20, $50, and $100, is distributed to the Fed’s district banks for storage until it is needed by the public. The Bureau of the Mint produces coins— metallic forms of money—such as pennies, nickels, dimes, quarters, and the new presidential dollar coin. After the coins are minted, they are shipped to the Fed district banks for storage. When member banks need additional coins or currency, they contact the Fed to fulfill their needs. When banks come across coins or currency that are mutilated or cannot be used for other reasons, they return them to the Fed for replacement. The Fed then destroys the old money so that it cannot be put back into circulation. Maintaining the Payments System The payments system involves more than the money supply. It also covers the electronic transfer of funds between businesses, state and local governments, financial institutions, and foreign central banks. In addition, specialized operations called clearinghouses process the billions of checks that are written every year. The Fed works with all of these agencies to ensure the payments system operates smoothly. Next to cash, checks are the most popular form of payment in the United States. A 2003 law, however, has changed the way checks are processed. Whereas checks used to be returned to the person who originally wrote them, now only electronic images of the checks are returned to the issuer. Online banking is another major innovation in the banking system. Now that people can open an account anywhere in the country using the Internet, the Fed is designing new procedures to make sure that no abuses occur. Regulating and Supervising Banks The Fed is
responsible for establishing specific guidelines that govern banking behavior. It also has the responsibility for monitoring, inspecting, and examining various banking agencies to verify that they comply with existing banking laws. Paul Conklin/PhotoEdit As a result, the Fed is charged with watching over foreign branches of its own member banks, as well as U.S. branches of foreign-owned banks. The Fed also has jurisdiction over many activities of state banks. This includes the operations of bank holding companies—firms that own and control one or more banks. Preparing Consumer Legislation The Fed is responsible for implementing some consumer legislation, such as the federal Truth in Lending Act, which requires sellers to make complete and accurate disclosures to people who buy on credit. Under Regulation Z, the Fed has the authority to extend truth-in-lending disclosures to millions of individuals who borrow from retail stores, automobile dealers, banks, and lending institutions. If you buy furniture or a car on credit, for example, you will discover that the seller must explain several items before you make the purchase. These items include the size of the down payment, the number and size of the monthly payments, and the total amount of interest over the life of the loan. All of the disclosures that the seller makes were determined by the Fed. bank holding company company that owns and controls one or more banks Regulation Z provision extending truth-in-lending disclosures to consumers Acting as the Government’s Bank A final Fed function is the range of financial services it provides to the federal government and its agencies. For example, the Fed conducts nationwide auctions of Treasury securities. It also issues, services, and redeems these securities on behalf of the Treasury. In the process, it maintains numerous demand depos it accounts for the Treasury. The Fed also maintains accounts for the government. In fact, any check written to the U.S. Treasury is deposited in the Fed. Any federal agency check, such as a monthly Social Security payment, comes from accounts held at the Fed. In essence, the Fed serves as the government’s bank. Reading Check Summarizing How does the Fed regulate banks? SECTION 3 Review Vocabulary 1. Explain the significance of member bank, monetary policy, interest rate, easy money policy, tight money policy, open market operations, discount rate, prime rate, quantity theory of money, currency, coins, bank holding companies, and Regulation Z. Main Ideas 2. Listing What are the components of the Federal Reserve System? 3. Describing What are the additional responsibilities
the Fed has beyond monetary policy? 4. Identifying Use a graphic organizer like the one below to identify the tools of monetary policy. Tools of Monetary Policy Critical Thinking 5. The BIG Idea Why and how does the Fed conduct monetary policy? 6. Contrasting How do “tight money” and “easy money” impact the economy? 7. Drawing Conclusions What are the advantages of having the Fed oversee the U.S. banking system? 8. Analyzing Visuals Look at Figure 14.4 on page 402. What would happen if supply shifted to the right? To the left? Why? Applying Economics 9. Truth-in-Lending Laws Visit any local store that sells goods on credit, such as appliances, cars, or furniture. Ask the owner or manager about the type of information that the store is required to disclose when the sale is made. Obtain copies of the disclosure forms and share the disclosure details with your classmates. CHAPTER 14 Money, Banking, and the Fed 407 NEWSCLIP As head of the Federal Open Market Committee (FOMC), the Fed chair monitors a number of economic indicators to help him make decisions on monetary policy. One of these indicators is the rate of inflation. The chairman also likes to watch something new these days: inflation expectations. Inflation: What You Foresee Is What You Get What... are inflation expectations, anyway? You won’t find the term in any of the major economic data releases put out by the government. Yet whether inflation expectations are rising or falling may turn out to be a critical factor in determining how far and how fast the Federal Reserve raises interest rates. That, at least, is the new line coming out of the Fed these days. Inflation expectations—a bit of a touchy-feely concept—represent the beliefs of consumers, investors, corporate execs, and economists about how fast prices will rise in the future. To new Fed Chairman Ben S. Bernanke, inflation expectations are a key indicator. If people believe inflation will stay low, the Fed can afford to relax a bit. But if the masses start anticipating faster inflation, the odds are greater that the Fed will need to hit them with higher rates even if actual price hikes remain moderate.... How are beliefs about future inflation measured? One way is to ask economists what they think is U NIVERSIT Y OF M ICHIGAN I NFLATION E XPEC TATION n o i t a fl 12% 10 8 6
4 2 0 1978 1986 1996 2006 Year going to happen. According to the Philadelphia Fed’s Survey of Professional Forecasters, economists expect consumer inflation to average 2.5% over the next 10 years, only a tad above their 2.45% forecast of a year earlier. That’s not very worrisome. Another way to judge expectations is to look at the behavior of investors—in particular, the people who buy [s]ecurities... which are indexed to inflation to give investors a fixed real return.... The danger, of course, is that expectations about future prices might jump, forcing the Fed to raise rates sharply to maintain its credibility as an inflation fighter. That’s what happened in the 1970s, when the public’s lack of faith in the Fed’s inflation-fighting resolve sent prices—and expectations of future inflation—spiraling out of control after the oil shock. Contrast that with [the situation] today. The Fed has built credi bility by both aggressively fighting inflation and communicating its commitment to price stability. As a result, even as energy prices skyrocketed in recent years, inflation expectations hardly budged, and non-energy inflation stayed relatively low. —Reprinted from BusinessWeek Examining the Newsclip 1. Defining How does the author of the article define inflation expectations? 2. Analyzing Why are inflation expectations important to the Fed? Source: Survey Research Center: University of Michigan 408 UNIT 4 Macroeconomics: Performance and Stabilization CHAPTER 14 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Money People began using money because it made buying and selling easier than barter. Money Characteristics Functions Portable Durable Divisible Limited supply Medium of exchange Measure of value Store of value Development of Modern Banking Problems with the money supply before 1914 led to the creation of the Federal Reserve System. 1861 Congress authorizes the printing of greenbacks 1913 Congress creates the Federal Reserve System (the Fed) as the nation’s first true central bank 1934 More than 10,000 banks close or merge with stronger partners 1862 $150 million of federal currency with no gold or silver backing is authorized 1929 About 25,500 banks exist 1933 Glass-Steagall Act passes, creating the FDIC 1990 Wave of merger activity begins 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Monetary Policy The Federal Reserve System has three main policy tools at its disposal. It uses
these tools to affect the money supply and interest rates. S UMMARY OF M ONETARY P OLICY T OOLS Tool Fed Action Effect on Excess Reserves Money Supply Reserve requirement Lower Raise Frees excess reserves because fewer are needed to back existing deposits in the system. More reserves are required to back existing deposits. Excess reserves contract. Open market operations Discount rate Buy securities Checks written by the Fed add to reserves in the banking system. Sell securities Checks written by buyers are subtracted from bank reserves. Excess reserves in the system contract. Lower Raise Additional reserves can be obtained at lower cost. Excess reserves expand. Additional reserves through borrowing are now more expensive. Excess reserves are not added. Expands Contracts Expands Contracts Expands Contracts CHAPTER 14 Money, Banking, and the Fed 409 CHAPTER 14 Assessment & Activities Review Content Vocabulary Review the Main Ideas Write the key term that best completes the following sentences. Section 1 (pages 383–388) 15. Describe the characteristics of money. a. fiat money b. central bank c. Regulation Z d. easy money policy e. excess reserves f. M1 g. barter economy h. open market operations 16. Explain why trade was difficult in a barter system. 17. Identify and provide examples of the types of money used in different periods of American history by using a graphic organizer like the one below. 1. The Fed serves as the _____ of the United States. Time period Type of money Example(s) History of American Money 2. A(n) _____ would expand the money supply and tend to lower interest rates. 3. In a _____ people rely on trade to obtain goods and services. 4. If a bank has _____, it is able to make additional loans to customers. 5. The most popular and effective tool of monetary policy is that of _____. 6. _____ is money that must be accepted by government decree. 7. _____ is the component of the money supply that acts as a medium of exchange. 8. _____ gives the Fed the authority to extend truth-in- lending disclosures to consumers. Review Academic Vocabulary 18. Compare M1 and M2. Section 2 (pages 390–397) 19. Identify the problems that existed with pre–Civil War currency. 20. Explain why the National Banking System was created during the Civil War. 21. Explain why the U.S. government created the Federal Deposit Insurance Corporation. Section 3 (pages 399–

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