ECONOMICS

101
FROM CONSUMER BEHAVIOR TO
COMPETITIVE MARKETS—EVERYTHING YOU
NEED TO KNOW ABOUT ECONOMICS

ALFRED MILL

Avon, Massachusetts
 CONTENTS
INTRODUCTION

WHAT IS ECONOMICS?

TRADE-OFFS AND OPPORTUNITY COST

THE EMERGENCE OF FREE TRADE AND THE IMPORTANCE OF

COMPARATIVE ADVANTAGE

INTERNATIONAL TRADE AND TRADE BARRIERS

TRADITIONAL ECONOMIES, COMMAND ECONOMIES, AND MARKET

ECONOMIES

CAPITALISM VERSUS SOCIALISM

BARTER AND THE DEVELOPMENT OF MONEY

INCONVERTIBLE FIAT EXPLORED

THE TIME VALUE OF MONEY AND INTEREST RATES

THE ORIGIN OF BANKING

HOW BANKS CREATE MONEY
BANKS AS A SYSTEM: REGULATION AND DEREGULATION

SUPPLY AND DEMAND: MARKETS

SUPPLY AND DEMAND: CONSUMER BEHAVIOR

SUPPLY AND DEMAND: A PRICE IS BORN

CHANGES IN SUPPLY AND DEMAND
ACCOUNTING VERSUS ECONOMICS

THE PRODUCTION FUNCTION

CONTROLLING COSTS
PERFECT COMPETITION IN THE SHORT RUN

PERFECT COMPETITION IN THE LONG RUN

OLIGOPOLIES AND IMPERFECTLY COMPETITIVE MARKETS

COLLUSION AND CARTELS

GAME THEORY
PRICING BEHAVIORS

MONOPOLY: THE GOOD, THE BAD, AND THE UGLY

GOVERNMENT IN THE MARKETPLACE: PRICE CEILINGS AND

PRICE FLOORS

GOVERNMENT IN THE MARKETPLACE: TAXES AND SUBSIDIES

MARKET FAILURES
FINANCIAL MARKETS AND LOANABLE FUNDS THEORY

THE MONEY MARKET

THE BOND MARKET

THE STOCK MARKET

FOREIGN EXCHANGE AND EXCHANGE RATES
EXPORTS AND THE BALANCE OF TRADE

OFFICIAL RESERVES AND EXCHANGE RATE POLICY

THE PRIVATE SECTOR AND THE PUBLIC SECTOR

THE FOREIGN SECTOR

THE FINANCIAL SECTOR AND FINANCIAL MARKETS

THE GROSS DOMESTIC PRODUCT

GDP: PRIVATE SPENDING AND INVESTMENT

GDP: GOVERNMENT SPENDING AND EXPORTS

APPROACHES TO GDP
REAL GDP CHANGES AND THE BUSINESS CYCLE

WHAT GDP DOESN’T TELL US

UNEMPLOYMENT DEFINED

UNEMPLOYMENT CLASSIFIED

WHY UNEMPLOYMENT IS BAD

INFLATION DEFINED

TYPES OF INFLATION

INFLATION: WINNERS AND LOSERS

DISINFLATION AND DEFLATION

AGGREGATE DEMAND AND AGGREGATE SUPPLY

MACROECONOMIC EQUILIBRIUM
THE KEYNESIAN VIEW AND FISCAL POLICY

THE FEDERAL RESERVE SYSTEM

MONETARY POLICY

SUPPLY-SIDE ECONOMICS
ECONOMIC GROWTH
CONDITIONS FOR ECONOMIC GROWTH
HOW ECONOMIC POLICY AFFECTS GROWTH

THE GREAT DEPRESSION MEETS THE GREAT RECESSION

THE COLLAPSE OF INVESTMENT BANKING

FISCAL POLICY UNDER FIRE

THE ENVIRONMENT AND THE ECONOMY

INTRODUCTION
WHY UNDERSTANDING
ECONOMICS MATTERS
Do you have preconceived ideas about economics? Do you want to know how
the economy works, but find yourself nodding off? Do you want to learn more
but are turned off by the dry, technical language and “all this talk about money”?
In Economics 101, you’ll realize that economics doesn’t have to boring. In
fact, exploring this subject will make you look at the world in ways that you
would have never considered before. Economics lets you make connections
between seemingly disparate things like the rate of unemployment and dear old
Dad’s tendency to replace his underwear. And you’ll understand the world
better. When interest rates change, you’ll be able to predict the ramifications. A
meaningful discussion of stocks, bonds, mutual funds, and collateralized debt
obligations will no longer sound like some strange dialect of Portuguese. While
this is not a personal finance book, the principles of economics it describes will
help you keep your own financial house in order.
In economics, expectations become reality and money is just a social
construct. That’s not boring, that’s mind-blowing! After reading Economics 101,
you’ll come to know and love concepts like diminishing marginal utility, and
everyone’s new favorite, quantitative easing. Wrapping your mind around these
ideas will help you make better sense of the economy around you and why
people behave as they do in money matters (hint: it’s not always rationally!).
You can even put the information to use by teaching your boss about controlling
variable costs and maximizing profits. Exchange rates and savings flows will be
like child’s play for you, capital and investment will take on a whole new
meaning, and constructing a CPI and deflating nominal GDP will be second
nature to you. Your poet hippie cousin that lives in a van and plays guitar will be
thrilled when you explain to him why he is technically not unemployed.
Economics isn’t just about defining abstract terms like some of those I’ve
mentioned. It’s actually an exercise in philosophy! By that I mean economics
impacts every aspect of your life and influences everything that you do. And I
mean everything! Economics teaches that nothing is free. Costs are involved
with every choice, even if the choice doesn’t seem to have any bearing on
money matters at all.
Economics isn’t something done by nameless groups somewhere far from
home. All economic decisions are made by individuals. Individuals bear the cost
of these decisions. Yes, that means you. Economics is personal. They do not set
prices. We set prices.
After reading Economics 101, you’ll know why the world works as it does.
Here, you’ll learn such things as:

Why you can have too much of a good thing. (Utility is diminishing).
Why unemployment by any other name is probably not unemployment.
Why what is true in the long run might not be true in the short run.
Why policymakers who manage expectations can manage reality.
Why, if given a choice between inflation and deflation, you should choose
inflation.
Why individuals are better at managing their finances than are
governments.

Ready to start exploring the mind-expanding world of economics? Let’s go!

WHAT IS ECONOMICS?
Taking the Dismal Out of “the Dismal Science”

You open the door to your fridge and gaze at the food inside and declare,
“There’s nothing to eat in this house.” Later, you walk into a closet full of
clothes and then think, “I have nothing to wear.” You are faced with scarcity.
You never have enough of what you need or want. The fact is, you have plenty
to eat and many clothes to wear. You chose to ignore the options you faced then
and there, but eventually you know you will relent and eat the apple next to the
shriveled grapes at the bottom of the bin, and then put on the shirt and pants you
hate. You are a creature of economics. Given scarcity, you look at the choices
you face, evaluate, and then choose.

STUDYING SCARCITY
Economics is the study of how individuals, institutions, and society choose to
deal with the condition of scarcity. It is fascinating to see how people react to
scarcity. Some create complex plans and systems to make sure that everyone
gets their fair share of scarce resources. Others make things up as they go along.
Everybody practices economics on a daily basis. From a single individual to the
largest society on earth, people are constantly engaged in the struggle to survive,
make ends meet, and even thrive given the relative scarcity they face.

The Child of Philosophy

Economics has been around a long time, though it has not always
been known by that name. Philosophers studied scarcity and choice
 been known by that name. Philosophers studied scarcity and choice
long before the field was so named. The father of modern
economics, Adam Smith, was considered a moral philosopher, not
an economist.

The people who study these choices are economists. The field of economics is
huge because people have an immense range of choices. Some economists study
the decision-making of individuals and institutions; others study how nations
handle scarcity. Economists develop theories to explain the behavior of whatever
it is they are studying. Some of these theories are then tested against real-world
data, and sometimes these theories are put into practice without ever being
tested. Economists work for universities, financial institutions, major
corporations, and governments.

MICROECONOMICS
The field of microeconomics focuses its attention on the decision-making of
individuals and businesses. Microeconomics is primarily concerned with
markets for goods, services, and resources. Markets are central to understanding
microeconomics. Whenever and wherever buyers and sellers come together to
exchange resources, goods, or services, a market is created and the behavior of
these markets is of particular interest to economists. Are they functioning
efficiently? Do participants have access to adequate information? Who and how
many participate in the market? How do the decisions made in one market
impact the decisions in a related market?

MACROECONOMICS

Macroeconomics is the study of how entire nations deal with scarcity.

Macroeconomists analyze the systems nations create or allow for the allocation
of goods and services. The questions they ask are varied and of great interest to
individuals and policymakers alike:

How do you measure the economy?

Why does unemployment exist?
How do changes in the amount of money affect the entire economy?
What impact does government spending or tax policy have on the
economy?
How can you make the economy grow?

SCARCITY

Without scarcity there would be no need for the study of economics. For that
matter, if scarcity did not exist, there would be no need for this book. You’re not
that lucky, however. Scarcity is the universal condition that exists because there
is not enough time, money, or stuff to satisfy everyone’s needs or wants. The
stuff that everyone wants is made from resources. In an effort to make
economics sound more “economic-y,” resources are referred to as the factors of
production. The factors of production include land, labor, capital, and
entrepreneurship.

Is There Really Scarcity in America, a Land of

Plenty?

Scarcity exists for everyone. From rich to poor, all face the condition.
Scarcity in America looks different from scarcity in Somalia to be
sure. Here, there is plenty of food and clean water, but in Somalia
both are lacking. Scarcity isn’t just a function of limited resources,
but also of unlimited wants, and that is something both America and
Somalia share.
Somalia share.

Land is inclusive of all natural resources and not just some random piece of
property. Trees, mineral deposits, fish in the ocean, ground water, and plain
old land are all included. Land can be divided into renewable and
nonrenewable natural resources. Renewable resources, like pine trees and
chickens, are easily replenished. Nonrenewable resources, like oil and
Atlantic cod, are difficult to replenish. The payment for land is referred to
as rent.
Labor refers to people with their skills and abilities. Labor is divided into
unskilled, skilled, and professional. Unskilled labor refers to people without
formal training who are paid wages to do repetitive tasks like make
hamburgers or perform assembly-line production. Skilled labor refers to
people paid wages for what they know and what they can do. Welders,
electricians, plumbers, mechanics, and carpenters are examples of skilled
laborers. Professional laborers are paid wages for what they know. Doctors,
lawyers, engineers, scientists, and even teachers are included in this
category.
Capital in economics does not refer to money, but to all of the tools,
factories, and equipment used in the production process. Capital is the
product of investment. Stop. Isn’t that confusing? Up until now you have
probably lived a happy life thinking that capital was money and that
investing is what you do in the stock market. Well, sorry. Capital is
physical stuff used to make other stuff, and investment is the money spent
on buying that stuff. To make capital, you have to have capital. Because
capital is always purchased with borrowed money, it incurs an interest
payment.

Money Talks
allocation
allocation
Economists describe getting the right resources to the right people
as allocation. Allocative efficiency occurs when marginal benefit
equals marginal cost. When this condition is met, the greatest
benefit accrues to society.
TRADE-OFFS AND
OPPORTUNITY COST
Making an Assumption Out of You and Me

Whenever you use a factor of production, a cost is going to be incurred. Why?

The factors of production are limited, not limitless. As a result, whenever you
choose to use land, labor, capital, or entrepreneurship for one purpose, you lose
the ability to use it for another. Take a resource like labor—your labor. Say that
you can spend an hour writing a book, teaching a class, or weaving a hammock.
The choices you face are called trade-offs. Assume you choose to weave a
hammock. You can neither teach a class nor write a book in that hour of time. If
writing a book is your next best alternative, then economists would say that the
opportunity cost of spending an hour weaving a hammock is the hour you could
have spent writing a book. Opportunity cost is the next best alternative use of a
resource.

Implicit and Explicit Costs

Opportunity cost is sometimes referred to as implicit cost. For any

productive activity there are explicit costs like labor, raw materials,
and overhead, which are easily calculated, and there are the implicit
costs, which are more difficult to assess.

CONSIDERING OPPORTUNITY COST

For example, suppose it’s a beautiful Friday morning and you think to yourself,
“I could go to work like I’m supposed to, I could stay home and sleep away the
day, or I could fly to Cozumel and hang out on the beach and do some scuba
diving.” Assume that you chose to take the trip to Cozumel, but going to work
was your next best alternative. What was the cost of your trip? You paid for the
taxi to the airport, the plane ticket, an all-inclusive hotel package, and a dive on
Palancar Reef. Was that your only cost? No. You also sacrificed the money you
could have made working. Opportunity cost is a bummer. Make sure to always
count it when making a decision.

MARGINAL ANALYSIS
Economists like to think of people as little computers who always count the
benefit of their decisions versus the cost of those decisions. Because you usually
make decisions one at a time, economists refer to the benefit of a decision as
marginal benefit. Marginal benefit can be measured in dollars or utils, whichever
you prefer. Utils are the amount of utility or happiness you get from doing
something. They can be converted into dollars easily.
Say that you like to swim laps in the pool for an hour. How many utils do you
receive from swimming laps? How much would you have to be paid to not swim
laps? If your friend were to keep offering you ever-increasing amounts of money
to not swim in the pool, then it is probably safe to assume that the dollar amount
you accept to not swim in the pool is at least equal to the amount of happiness or
utility you would have received had you taken a swim. If it takes $20 to keep
you from swimming, then you value swimming no more than $20. Swimming is
worth 20 utils to you.
Marginal cost is a related concept. Marginal cost is simply what it costs to
either produce or consume one extra unit of whatever it is you are producing or
consuming. Go back to the swimming example. Assume that swimming in the
pool has a marginal cost of $5. If you earn 20 utils from swimming, would you
pay $5 to earn $20 worth of benefit? Of course you would. Now assume that
swimming in the pool costs $20.01. Would you spend $20.01 to earn $20 worth
of benefit? Probably not. Economists conclude that you will swim as long as the
marginal benefit exceeds or equals the marginal cost. For you that means you
will swim as long as the marginal cost is less than or equal to $20. If the
marginal benefit outweighs the marginal cost, you would probably do it. If the
marginal benefit is less than the marginal cost, you probably would not do it. If
the marginal benefit equals the marginal cost, it means you are indifferent.

ASSUMPTIONS IN ECONOMICS

Economists make certain assumptions when they’re talking about their favorite
subject. They expect you to know (and agree with) these assumptions. The three
big ones are:

1. Nothing else changes. Whenever economists make an argument such as:

“If income taxes fall, then consumption increases,” it should be
understood as: “If income taxes fall and nothing else changes, then
consumption increases.” Did you catch the difference between the two
statements? And nothing else changes is also referred to as the ceteris
paribus assumption. Loosely translated, ceteris paribus means “to hold all
other things constant.” So as you continue reading the book, remember
that all statements about cause-and-effect relationships are made with the
ceteris paribus assumption.
2. People are rational and behave rationally. Another assumption made by
economists, and a big one at that, is that people behave rationally.
Economists assume that people’s choices are made with all available
information taken into account as well as the costs and benefits of the
choice. Furthermore, economists assume that the choices make sense.
The assumption that people behave rationally is subject to debate among
 different schools of economic thought, but for most economic decisions
it is a useful assumption.
3. People are selfish. The last assumption made by economists is that
people are self-interested. First and foremost, people think of themselves
whenever it comes time to make a decision. Pure altruism is not possible
in economics. Economists cynically assume that human behavior is
motivated by self-interest. For example, a grenade is thrown into a trench
with a platoon of soldiers and one soldier sacrifices his life by jumping
on top of the grenade, thus saving the others. To economists, this soldier
instantly calculated the marginal benefit and marginal cost of the
decision, determined that the marginal benefit of saving his fellow
soldiers outweighed the marginal cost of his life, and jumped on the
grenade as an act of utility, maximizing self-interest. He saved his friends
in order to maximize his utility as a soldier.

The assumptions economists make are subject to criticism and debate. Many
critics believe that the field has a tendency to be too abstract and theoretical to
have any real-world value. The failure of most economists to predict the most
recent economic downturn seems to support the view that economics ignores
human psychology at its own peril.
Economics is at a turning point as a field of study, and the assumptions that
economists hold dear need to be carefully examined. Instead of being tidy,
abstract, and mathematical like physics, economics must become a little more
messy, complex, and organic, like biology.

Money Talks
consumption
Household spending on new domestic goods and services.
THE EMERGENCE OF FREE
TRADE AND THE IMPORTANCE
OF COMPARATIVE ADVANTAGE
Why All Roads Lead to Rome

Which leads to a higher standard of living, dependence on others or complete

self-sufficiency? Before you answer the question, consider which approach
better represents your life. Do you have a job and pay all your own bills, or do
you live at home with your parents while they foot the bill for your upkeep? If
you are on your own, you most likely consider yourself to be self-sufficient. If
you are still living at home with your parents, you probably consider yourself to
be somewhat dependent. The truth, however, is whether you are on your own or
living at home, you are highly dependent on others for the food you eat, the
clothes you wear, and the roof over your head. In order for you to get what you
need and want and enjoy a higher standard of living, you must trade with others.

The History of Trade in Sixty Seconds

For as long as there have been people, there has been trade. At
first, trade was a simple matter. For example, people in a family
exchanged food with their neighbors. Over time, trade expanded as
people were exposed to new goods from faraway places and
developed a taste for them. As tribes became kingdoms and
kingdoms became empires, trade grew in importance. This growth in
trade led to the emergence of the influential merchant class. These
 merchants braved hardships in search of profit, and their activities
helped to form the modern world. Although the scale of trade has
grown incredibly throughout history, what has not changed is that
trade always occurs between individuals.

MERCANTILISM

One early theory of trade was mercantilism, which dominated seventeenth-and

eighteenth-century European trade policy. Mercantilism is founded on the idea
that a country, and therefore, individuals, are better off if the value of a country’s
exports are greater than the value of its imports. Under mercantilism, the more
gold a country amassed, the wealthier it became. As a result, countries competed
to import cheap natural resources and then convert them into more expensive
manufactured goods for export. It is easy to see why the countries of Europe
were eager to compete against each other in order to colonize and exploit the
newly discovered and resource-rich Americas.
Mercantilism had an obvious flaw. If a country is always trying to export
more than it imports and everyone else is playing the same game, then someone
is going to lose. In order to maintain a country’s export advantage, governments
enacted many laws and taxes that distorted the flow of goods without necessarily
making the people better off. In the end, mercantilism created a win-lose
condition that harmed more than it helped.

FREE TRADE

The insights of eighteenth-century Scottish thinker Adam Smith were influential

in bringing an end to mercantilism. He and others at the time saw governments’
mercantilist policies as misguided and prone to influence by special interests. He
argued in The Wealth of Nations that if a country specialized in what it produced
best and freely traded those products, then society would be better off. Adam
Smith saw wealth as being the sum total of all that the people of a nation
produced. In his view, free trade led to greater wealth, even if it meant that
sometimes you imported manufactured goods from people in other countries.
One argument used in support of the idea of free trade is the theory of
comparative advantage. Whereas Adam Smith had argued for a country to
specialize in what it does best and then trade with others, another influential
thinker, David Ricardo, argued that it is better for a country to specialize in what
it produces at the lowest opportunity cost, and then trade for whatever else it
needs. These two concepts are referred to as absolute advantage and comparative
advantage.

Absolute Advantage
An absolute advantage exists if you can produce more of a good or service
than someone else, or if you can produce that good or service faster than
someone else. An absolute advantage implies that you are more efficient, that is,
able to produce more with the same amount of resources. For example, Art can
write one hit song per hour, whereas Paul can write two hit songs per hour. Thus,
Paul has an absolute advantage in songwriting.

Comparative Advantage
A comparative advantage exists if you can produce a good at a lower
opportunity cost than someone else. In other words, if you sacrifice less of one
good or service to produce another good or service, then you have a comparative
advantage. In the example given earlier, Art and Paul are songwriters, but what
if both are also capable of performing complex brain surgery? If Art and Paul
can both successfully complete two brain surgeries in an hour, then which has a
comparative advantage in songwriting, and which has a comparative advantage
in brain surgery?
To calculate the comparative advantage, you must determine the opportunity
cost that each person faces when producing. In Art’s case, for every hit song he
cost that each person faces when producing. In Art’s case, for every hit song he
writes, he sacrifices two successful brain surgeries. In an hour, Paul can produce
either two hit songs or two brain surgeries. This means that Paul sacrifices one
brain surgery for every hit song he writes, and therefore, has the comparative
advantage in songwriting. Art, on the other hand, has the comparative advantage
in brain surgery because for every brain surgery he performs, he only sacrifices
half of a hit song, compared to Paul, who sacrifices a whole hit song for the
same surgery. In conclusion, Art should specialize in brain surgery and Paul in
songwriting because that is where they find their comparative advantage.

Efficiency and Comparative Advantage

It is easy to overlook comparative advantage when determining who

should produce what. Just because one person might be more
efficient than another does not always mean that that person should
be the one doing the task. Remember to always count the
opportunity cost.

COMPARATIVE ADVANTAGE AND ECONOMIC

CHANGE

The theory of comparative advantage allows you to better understand how the
American economy has changed over the last sixty years. In that time period, the
United States transitioned from a low-skilled, manufacturing economy to a high-
skilled, diversified economy. Sixty years ago, most of your clothes would have
been produced domestically, but today the tags on your clothing indicate that
they were manufactured in places as diverse as Vietnam, Bangladesh, Honduras,
Morocco, and of course, China.
In the same time period, a great wave of technological innovation and other
cultural advances have taken place. For example, if you were to poll a group of
cultural advances have taken place. For example, if you were to poll a group of
high school freshman about their post–high school plans sixty years ago and
another group today, you would likely discover that today’s students are far
more likely to pursue higher education than they were in the 1940s and 1950s. In
the past, dropping out of high school and working at the mill or the factory was
the norm; today, dropping out of high school is cause for concern. There are
more jobs as well as more job titles than there were sixty years ago. In other
words, there are greater opportunities today than there were sixty years ago. Of
course, this comes with one major catch: You must have the education or
training in order to take advantage of the opportunity.
So what does this have to do with comparative advantage? An example might
help. Consider 100 typical American high school students and then consider 100
young people of the same age in Bangladesh. In which country is the opportunity
cost of producing a T-shirt higher? If you look at the American students, you
would have to agree that they have more opportunities than the Bangladeshi.
When Americans specialize in T-shirts, more potential doctors, nurses, teachers,
engineers, mechanics, firefighters, police officers, business managers,
machinists, and social workers are sacrificed than in Bangladesh, where the
majority of workers will most likely become subsistence farmers. The
opportunity cost of producing T-shirts is much lower in Bangladesh than in
America, and therefore Bangladesh has a comparative advantage in producing T-
shirts. Even though the United States has the capacity to produce T-shirts more
efficiently (absolute advantage), from an economic standpoint, it makes sense to
trade pharmaceuticals, refined chemicals, capital equipment, and know-how for
T-shirts.
INTERNATIONAL TRADE AND
TRADE BARRIERS
Free Trade Without Borders

When trade is both voluntary and free, the buyer and the seller both benefit (if
you buy a quart of milk, the dairy farmer gets money and you get milk without
having to milk a cow). Because voluntary free trade is mutually beneficial, it
creates wealth. Wealth is nothing more than the collective value of all you own.
In an interesting experiment from the Foundation for Teaching Economics, a
group of participants were each given a random object to which they assigned a
value. Then the group traded their objects freely. Soon after, participants were
again asked to assign a value to the object in their possession. The sum of the
second set of values was greater than the first. Without anything new being
added, wealth was (and is) created through the simple act of voluntary free trade.

INTERNATIONAL TRADE
When you trade with people in other countries, the same results of mutual
benefit and wealth creation occur. Prior to World War II, trade agreements
between nations were for the most part bilateral, that is, between the two parties,
with special interests protected and trade barriers (such as taxes on imports and
exports) common. The benefits of free trade were not realized, and nations
drifted toward isolationism and protectionism.
Toward the end of World War II, representatives from much of the
industrialized free world gathered in Bretton Woods, New Hampshire, to address
the economic issues that were often the cause of international conflict. The
conference produced the International Monetary Fund (IMF) and the World
conference produced the International Monetary Fund (IMF) and the World
Bank, but not a trade organization for encouraging international cooperation. In
1947, many nations including the United States came together and formed the
General Agreement on Tariffs and Trade (GATT). The goal of GATT was to
reduce trade barriers so that member countries could equally enjoy the benefits
of free trade.
The growth in international trade was accompanied by a rise in living
standards among the members of the agreement. In 1995, the GATT became the
World Trade Organization (WTO). Under GATT and later the WTO, more and
more countries have become supporters of fewer barriers to trade. As a result,
international trade has continued to expand, and many nations have reaped the
benefits. For example, since joining the EU and opening itself to international
trade, Ireland has gone from being one of Europe’s poorest countries to one of
its wealthiest.

THE CASE AGAINST INTERNATIONAL TRADE

Despite its obvious benefits, free international trade has many detractors:

Environmentalists are concerned that as countries specialize, production

will concentrate in countries that have fewer regulations to protect the
environment from pollution and habitat destruction.
Labor unions oppose free trade on the grounds that production will shift
toward low-wage countries that have little or no union representation, and
therefore negatively impact their membership.
Human rights activists often oppose free trade as production shifts toward
countries where working conditions are miserable and often inhumane, and
where workers are not afforded the same rights and privileges as in
industrialized nations.
 Politicians and their constituents concerned with loss of national
sovereignty often oppose free trade agreements on the grounds that
decisions affecting the nation are being made by an international body not
directly subject to the people.

A LOOK AT TRADE BARRIERS

From time to time, countries will seek to tax, limit, or even ban international
trade. Why? Even though voluntary trade is mutually beneficial, the benefits are
spread out over society, and the costs are sometimes borne directly by a specific
group. People might have a strong interest in preserving their industry, raising
tax revenue, saving the environment, or even creating social change. At times a
country might limit trade in order to punish another country. Tariffs, quotas, and
embargoes are a few of the tools that a country will use in order to accomplish
these other interests.

Tariffs
A tariff is a tax on trade. Tariffs can be used to raise revenue for the
government or in order to benefit a certain segment of the economy. You might
pressure Congress to enact a tariff on imports if your industry is subject to
foreign competition. For example, for years the U.S. steel industry was protected
from cheap foreign competition by protective tariffs. In 2007, India proposed a
tariff on rice exports in order to prevent food shortages. The Smoot-Hawley
tariff of 1930 was intended to protect American industry and raise much-needed
tax revenue for the government.
Tariffs are not without their downsides:

Protective tariffs often have the effect of preventing competition and

encouraging waste and inefficiency.
 Revenue tariffs often fail to raise tax revenue because people stop buying
the now-expensive imports.
Export tariffs might give producers an incentive not to produce.

Quotas
Quotas are limits on trade. Instead of a tax on imports, you might use a quota
to limit the number of imported goods coming into your country. In the 1970s
and 1980s, U.S. automobile manufacturers and labor unions supported
government quotas on foreign car imports to limit competition and preserve
American jobs. The result was higher prices and lower quality.

Money Talks
price
The monetary amount for which consumers and producers buy and
sell some quantity of a good or service.

Eventually, Japanese and German firms bypassed the quotas by establishing

their factories in the United States. In the end, domestic producers faced more
competition at home, and labor unions suffered as foreign firms established their
factories in states where unions had less power.
Quotas create other problems as well:

They do not generate tax revenue for the government, but do create more
responsibility.
They provide an incentive to smuggle goods illegally in order to avoid the
quota, thus creating black markets.
In addition, quotas may be manipulated by foreign firms to limit
competition from other foreign firms. For example, if there is a quota on
German cars imported into the United States, then the German firm that
 first fills the quota has effectively blocked other German firms from
competing in the American market.

Embargoes
An embargo is a ban on trade with another country. The purpose of an
embargo is usually to punish a country for some offense. The embargo you may
be most familiar with is America’s embargo against Cuba. In the wake of the
communist revolution, and later the Cuban Missile Crisis, the United States
enacted an embargo that banned all trade with the island nation. Even though the
events are now far in the past, the embargo persists. Once again, you might
consider who benefits from the trade embargo in order to understand why it is
still in place.
TRADITIONAL ECONOMIES,
COMMAND ECONOMIES, AND
MARKET ECONOMIES
That’s Not the Way We Do Things!

Why are some countries so rich and others so poor? Does the presence of
abundant natural resources account for a country’s wealth? Why is there such a
lack of economic development among different indigenous groups around the
world? How important is government to an economy and what are the
government’s appropriate economic roles? A study of different economic
systems will shed some light.

DIFFERENT ECONOMIC SYSTEMS

In order to survive, societies must make decisions about how to best use their
scarce resources (land, labor, capital, and entrepreneurial ability). Economists
have concluded that for societies to survive with their limited resources, they
must answer three basic questions:

1. What to produce?
2. How to produce?
3. Whom to produce for?

The Other Reason to Remember 1776

 The eighteenth century, also known as the Age of Reason, or the
Enlightenment, saw a fundamental shift in the way people viewed
their world. The year 1776 was especially important, for it not only
was the year that Thomas Jefferson wrote the Declaration of
Independence, but it was also the year that Adam Smith’s An Inquiry
into the Nature and Causes of the Wealth of Nations was published.

Throughout history, people have developed a variety of systems to answer

these questions. Most primitive societies developed what economists refer to as
traditional economies. With the development of civilization came command
economies, and following the Enlightenment, market economies finally
emerged. In addition, combinations of these primary systems developed,
including communism, socialism, and capitalism (discussed later in the book).

Traditional Economies
In a traditional economic system, the questions of what and how to produce
and whom to produce for are answered by tradition. If you’ve seen a
documentary on a primitive culture, then you’ve also seen a traditional economy
in action. The Kalahari Bushmen live in one of the world’s harshest
environments, where even the most basic resources are in meager supply. In
order to survive and have enough food, the Bushmen have developed a division
of labor based on gender. Women perform the food gathering and men perform
the hunting. The food is then shared with the whole tribe. In this type of system,
stability and continuity are favored over innovation and change. The roles of the
people are defined by gender and status in the community. In this system, the
old, young, weak, and disabled are cared for by the group. The group shares the
few possessions they have, and private property is an alien concept. For the most
part, everyone in this system understands his or her relationship to the
community, and as a result, life hums along in a fairly predictable way.

Command Economies
 Command Economies
As hunter-gatherer societies grew and eventually exhausted their natural food
supplies, some survived by becoming sedentary farmers. With the advent of
farming came a need for an organized system of planting, harvesting, and storing
crops. This required a greater amount of structure than existed in a traditional
economy. In order to ensure the survival of the society, decisions had to be made
about what crops to grow and how much of the harvest to store. Over time,
decision-making became centralized, and the command economic system
developed. The key characteristic of the command economy is centralized
decision-making. One leader (or a group of powerful individuals) makes the key
economic decisions for the entire society.
Examples of command systems include most, if not all, ancient civilizations,
plus the communist countries of today. The pharaohs of Egypt represent the
centralized decision-making present in a command economy. The pharaoh and
his various officials made the key economic decisions of what to produce, how
to produce, and for whom to produce. The decisions might have gone something
like this, “I command you to construct a big pyramid of brick and mortar using
slaves for labor, and all of it is for me.” The advantage of this type of system is
the ability for decision-makers to produce rapid changes in their society. For
example, Soviet dictator Josef Stalin’s five-year plans quickly transformed the
Soviet Union from a peasant-based agrarian society into one of the world’s
industrial superpowers.

At Your Command

During World War II, the United States practiced command economy
when the government took over factories and planned production for
the war effort. Every aspect of American life was in some way
influenced by government involvement in the economy. Even today
you can see the influence. The modern payroll withholding system
 was instituted during the war to provide the government with a
steady stream of tax revenue.

History reveals the tragic downside of command economic systems. As

previously discussed, the pharaohs used slave labor, and Stalin’s five-year plans
were only accomplished through the forced relocation of millions of people and
at the cost of millions of lives. Rarely do the decision-makers meet the wants
and needs of the common citizen. The citizens serve the economy and state as
opposed to the economy and state serving the citizens. North Korea is a perfect
example. Property belongs only to the state. Many workers have little personal
incentive to produce, and those that do may have little regard for quality.
Individuality, innovation, and variety are completely lacking in the command
system.

Market Economies
In total contrast to the command economic system is the market economy.
Market economies are characterized by a complete lack of centralized decision-
making. As opposed to top-down planning, market economies operate bottom-
up. Individuals trying to satisfy their own self-interest answer the questions of
what, how, and for whom to produce. Private citizens, acting on their own free
will as buyers or sellers, trade their resources or finished products in the market
in order to increase their own well-being. Though it might appear
counterintuitive, market economies achieve greater abundance, variety, and
satisfaction than either traditional or command economic systems.
Although they cannot be classified as pure market systems, Hong Kong, the
United States, Australia, and New Zealand are representative of market
economies. In each you will see a greater variety of goods and services being
produced than anywhere else. Also, because the focus is not on serving the state,
individuals are free to choose their vocation, own private property, and
determine for themselves how to best use the resources they possess. Markets
reward innovation, productivity, and efficiency but discourage complacency,
idleness, and waste. If markets have a downside, it is that those who are unable
or unwilling to produce because of either circumstance or choice are often
sidelined and unable to enjoy the benefits of the system.

Money Talks
productivity
The amount of output produced with a given amount of resources.
CAPITALISM VERSUS
SOCIALISM
Adam Smith and Karl Marx Duke It Out

Today, traditional economies are few and far between, command economies are
waning, and pure market economies are nonexistent. What does exist is a variety
of command and market systems; in effect, economic hybrids. The two most
common economic hybrids are socialism and capitalism. Imagine an economic
continuum with a pure command economic system on the left and a pure market
system on the right. If you were to arrange modern nations along this continuum,
toward the far left would be places like North Korea and Iran, in the middle
would appear many western European and Latin American nations, and to the
right would appear many former British colonies, such as the United States,
Australia, and Hong Kong. For all practical purposes, those nations on the left
were described in the discussion on command economies. However, the middle
and the right of the continuum represent the dichotomy of socialism and
capitalism.

Capitalism and Democracy

Do not confuse capitalism with democracy. The two do not

necessarily go together. India is the world’s largest democracy, but it
is considered a socialist economy. Hong Kong has never really
experienced democracy and yet it is the epitome of capitalism.

The difference between socialism and capitalism lies in the degree of

 The difference between socialism and capitalism lies in the degree of
government influence and state ownership of the factors of production.
Countries that are capitalist rely on market prices for efficient product allocation,
promote the private ownership of economic resources, and leave most economic
decisions to individuals. They do, however, permit the government to:

regulate markets
preserve competition
subsidize and tax firms
enforce private contracts
redistribute income from workers to non-workers

For example, the U.S. government creates rules for the labor market, breaks
up monopolies, subsidizes some farmers, taxes polluters, hears cases involving
breaches of contract, and collects Social Security taxes.
In socialism, the government takes a much more active role in the economy.
Although individuals are allowed private property, the state may own firms in
key industries and regulate even more economic decisions than in capitalism. In
France it is not uncommon for the government to take a major stake in French
companies, if not outright own them. The French labor market is more heavily
regulated than its American counterpart. In 2006, French students poured into
the streets, protesting the fact that the government was being pressured by
French firms for the right to fire employees at will during their first two years of
employment. Compare this to the United States, where there is no guarantee of
employment.

The Anti-Socialist Prime Minister

British Prime Minister Margaret Thatcher is credited with reversing

the United Kingdom’s drift toward socialism. With the end of World
War II, the British had moved toward socialism with the
 War II, the British had moved toward socialism with the
nationalization of several key industries. While in office, she began
the process of privatization, where state-owned companies were
sold to private shareholders.

More often than not, socialist countries manage the prices of many goods and
services. The EU manages prices on such things as pharmaceuticals, cell
telephone service, and food. Also, socialist countries are more active in taxing in
order to redistribute income from workers to non-workers. Germany is well
known for its generous cradle-to-grave social welfare system that promises care
for its citizens. The German welfare state is financed by a redistributive tax
system that many Americans would find intolerable. As of 2015, the highest
marginal tax rate on personal income in Germany was 47.5% compared to the
United States’ rate of 39.6%.

ADAM SMITH, KARL MARX, AND HUMAN

NATURE

According to John Maynard Keynes, “The ideas of economists and political

philosophers, both when they are right and when they are wrong, are more
powerful than is commonly understood. Indeed the world is ruled by little else.
Practical men, who believe themselves to be quite exempt from any intellectual
influences, are usually the slaves of some defunct economist.” Keynes’s insight
into the influence of economic thought on the lives of people can be seen in the
various economic systems that have developed over time. In one camp are those
who would have the state as the primary caretaker of the people. In the other are
those who believe that the problem of scarcity can only be addressed through
individual economic freedom.
Karl Marx said, “From each according to his abilities, to each according to his
needs.” Marx envisioned an economy where the problem of scarcity was
addressed through the complete redistribution of wealth and income, from the
addressed through the complete redistribution of wealth and income, from the
owners of land and capital to the workers. In his utopian vision, social justice,
economic equality, and relief from scarcity would be achieved when society was
organized in such a way that all were equal regardless of their level of
productivity.
According to Adam Smith, “It is not from the benevolence of the butcher, the
brewer, or the baker, that we expect our dinner, but from their regard to their
own interest. We address ourselves, not to their humanity but to their self-love,
and never talk to them of our own necessities but of their advantages.” Adam
Smith had a different vision of society. In his view, productivity was the
determinant of wealth, and rational self-interest was the motivating force that
would provide society a means of escape from scarcity. Adam Smith believed
that when society harnessed the power of self-interest, the greatest good could be
accomplished.
These two men had two very different ways of addressing the fundamental
problem of scarcity. Which do you think better captures human nature? If you
believe that people are basically good and seek to serve one another, then the
ideas of Marx ring true. However, if you believe that people are at heart selfish
and pursue their own ambition, then the words of Adam Smith might appear
more valid. Regardless of what you believe, both Smith and Marx have managed
to influence society in ways that are still evident today.
BARTER AND THE
DEVELOPMENT OF MONEY
Have You Got Change for a Cow?

Of all humankind’s inventions, money stands out as one of the most widespread
and useful. A day probably does not go by that you don’t use it or think about it.
It’s hard to imagine a time when people didn’t have money, and it can be scary
to imagine what your life would be without it. From barter to shells to coin to
paper to digital, the story of money spans much of human history.

BARTER
Before money was invented, and in times when money was either worthless or
extremely scarce, barter was used as a means for people to get what they needed
or wanted. Barter is simply the act of exchanging one good or service for another
good or service. An example of barter is when a farmer trades a dozen chicken
eggs with a baker for a fresh loaf of bread. Although barter was more common in
the past, it still exists today.
Barter is not without its downsides. Obviously, trade will not occur unless
both parties want what the other party has to offer. This is referred to as the
double coincidence of wants. In the example of the farmer and baker, if the
baker has no need or desire for eggs, then the farmer is out of luck and does not
get any bread. However, if the farmer is enterprising and utilizes his network of
village friends, he might discover that the baker is in need of some new cast-iron
trivets for cooling his bread, and it just so happens that the blacksmith needs a
new lamb’s wool sweater. Upon further investigation, the farmer discovers that
the weaver has been craving an omelet for the past week. The farmer will then
the weaver has been craving an omelet for the past week. The farmer will then
trade the eggs for the sweater, the sweater for the trivets, and the trivets for his
fresh-baked loaf of bread. Whew! There has got to be an easier way to do things.

THE DEVELOPMENT OF MONEY

The previous example illustrates the need for a more efficient means of
exchanging goods and services. As a result of the downsides to barter, cultures
in different times and places eventually developed money.

Functions and Characteristics of Money

Regardless of the form it takes (gold bar, dollar bill, oyster shell), money is
anything that functions as a medium of exchange, store of value, or standard of
value. Money acts as a:

medium of exchange when it is being used for the purpose of buying and
selling goods or services.
store of value when you get it today and are still able to use it later.
standard of value when you are using it to measure how much a good or
service is worth.

Money works best when it is has the following characteristics: portability,

durability, divisibility, stability, and acceptability.

Portability refers to the ease with which money can be carried from place to
place.
Durability means that when you forget to remove it from your pocket
before doing the laundry, you do not wind up broke.
Divisibility means your money can be broken into smaller units and end up
finding its way between the cushions of your couch.
 Stability exists when money’s value does not vary too much (a dollar today
buys pretty much the same amount of something as it did last week and will
next week).
Acceptability means people agree that the money represents what it is
supposed to represent and are willing to exchange goods and services for it.

Nonportable Money

The Pacific island of Yap is known for its money, which is decidedly
not portable. Large rounded stones weighing hundreds of pounds
are used as a medium of exchange. If you plan on visiting Yap, wait
until you are there to exchange your currency because it will not fit
under the seat or in the overhead compartment of an airliner.

The Evolution of Money

Across time and cultures, many things have served as money, including salt,
tobacco, shells, large stones, precious and nonprecious metals, leather, and
cigarettes, to name a few. Money can be a commodity in itself, a representation
of a commodity, or a completely abstract symbol of value.

Commodity Money
When relatively scarce minerals, metals, or agricultural products are used as a
means of exchange, they are considered commodity money. Gold and silver
struck into coins are examples of commodity money. An advantage of
commodity money is that it can be used for purposes other than money. In the
1980s, many women adorned themselves in jewelry featuring gold coins, such as
the Chinese Panda or the Canadian Maple Leaf. American colonists not only
smoked tobacco, but they also used it as money. The salt we take for granted
was at one time scarce enough that Roman soldiers were paid in it. On the other
hand, a commodity’s usefulness also makes it a disadvantage to using it as
money. If a country is dependent upon using a commodity for its money and as a
resource, then money may be too precious to spend.

Representative Money
Representative money developed as an alternative to commodity money. One
of the properties of gold is its high density. Transactions requiring large amounts
of gold would have been unpleasant due to it being extremely heavy and difficult
to transport. Goldsmiths offered a solution to this problem. By issuing receipts
for gold they had on deposit, representative paper money was born. Instead of
trading the physical gold, all people had to do was trade the receipts for the gold.
Whenever they wanted the actual gold, they could redeem their receipts. After
years of acceptance, people became more comfortable with the idea of
representative paper money and the concept stuck.

Inconvertible Fiat Money

Because people were already familiar with representative paper money, the
next step in the evolution of money was not all that difficult to understand. Why
bother making the paper money redeemable in anything? Several times in
history, the convertibility of representative money into gold or silver had been
halted because of war or other crises. In 1933, President Franklin Delano
Roosevelt signed an executive order that transformed the dollar from being a
form of representative money into what is called inconvertible fiat. Inconvertible
fiat refers to both paper and virtual money that is intrinsically worthless and is
not redeemable or backed by some real commodity. It is money because the
government says so and we are willing to accept it. The U.S. dollar, the euro, the
pound, the yen, and most other world currencies meet the definition of
inconvertible fiat.

The Gold Standard

Under a gold standard, money is backed by a fixed amount of gold.
You could actually trade your money for gold. The gold standard
allows a country to only print as much currency as there is gold to
back it up, preventing overprinting and devaluation. Downside: it
acts as a limit on economic growth. As an economy’s productive
capacity grows, so should its money supply. Because a gold
standard requires that money be backed in gold, the scarcity of the
metal constrains the ability of the economy to produce more capital
and grow.
INCONVERTIBLE FIAT
EXPLORED
Welcome to the Matrix

The inconvertible fiat standard that exists today addresses the weakness of the
gold standard. The gold standard’s major disadvantage is that it acts as a limit on
economic growth. According to economist Adam Smith, wealth is not a function
of how much gold or silver a country has, but is rather the sum of all the goods
and services an economy produces. It makes sense that the amount of money an
economy has should in some way reflect its capacity to produce wealth. As
businesses expand, they require money in order to purchase the tools, factories,
and equipment necessary to meet both their productive needs and the demand for
their goods and services. Because it is not backed by anything real or tangible,
the money supply is able to grow as the economy grows.

MONEY: EVERYONE’S IMAGINARY FRIEND

This flexibility explains why the inconvertible fiat standard persists. But
remember that inconvertible fiat is only money because the government says it is
and people agree. For people to agree, they must have confidence that the money
won’t suddenly become worthless or the government backing it won’t topple
tomorrow. So that people do not lose confidence in the money supply, the
central bank of a country must carefully control its availability so that it does not
become too plentiful or too scarce.

Promises, Promises
 Promises, Promises

Money is debt. The U.S. dollar is a promise to pay from the U.S.
Federal Reserve to the holder. You might ask, “A promise to pay
what?” The answer is another dollar.

When you stop to think about it, the inconvertible fiat standard sounds like
science fiction. Today’s money is intrinsically worthless and is only redeemable
for more of the same. The system works because the government says so and
everyone collectively believes it. Money is backed by nothing more than faith.
When you think about direct deposit, online bill payments, debit cards, and
checks, the idea of money is weirder still. You work, pay your bills, buy your
groceries, and manage to survive and even thrive in the economy, yet you can go
for days or weeks without even touching, seeing, or smelling money. Money is
imaginary. Ponder your bank account. There are not little stacks of dollar bills
sitting in the bank vault with your name on them. Instead, checking and savings
accounts are nothing more than information stored on computers.

LOSING FAITH AND COLLECTIVE DESPAIR

Because money is backed by faith, anything that erodes that faith is destructive
to it. One of the biggest destroyers of money, or at least of the value that money
represents, is inflation. Inflation is ultimately caused by too much money in
circulation. This excess money drives up prices and makes most things more
expensive. Under a gold standard, people’s expectations of inflation are held in
check, and that leads to not only greater price stability, but also serves to
stabilize employment and the economy as a whole. With a gold standard, money
has to be backed by actual gold sitting in a bank somewhere. This prevents the
government from overprinting its money, greatly reducing the chance for
inflation to creep into the economy and also acts as a check against governments
borrowing too heavily.
borrowing too heavily.
Overprinting is dangerous because it causes the money to lose value and is
therefore highly inflationary. During the interwar period, the German Weimar
Republic overprinted their currency, and this led to rampant inflation and
financial ruin. When the money is inconvertible fiat, the checks and balances
inherent in the gold standard do not exist.
Overprinting and counterfeiting pose a serious threat to any money supply.
In response to these dangers, governments are constantly coming up with new
ways to better secure their money and make it more difficult to counterfeit.

MONEY SUPPLY MEASURES: M1 AND M2

This strange stuff called money is managed and measured by the Federal
Reserve Bank (the Fed) in the United States. There are two primary measures
that the Fed uses when describing the money supply, M1 and M2.

The M1 measurement is composed of all of the checking account balances,

cash, coins, and traveler’s checks circulating in the economy.
The M2 is composed of everything in the M1 plus all savings account
balances, certificates of deposit, money market account balances, and U.S.
dollars on deposit in foreign banks.

The M1 is mainly used as a medium of exchange, whereas the M2 is used as a

store of value. The M2 is larger and less liquid than the M1.

Noncirculating “Money”

The currency and coin inside of a bank is not counted in the M1.
Why not? Because it’s not money until you walk out of the bank. So
technically, it is inaccurate for a bank robber to demand money while
in a bank.
 in a bank.

Changes in the M1 and M2 are monitored by the Fed and act as indicators of
economic activity. Sudden changes in the ratio of M1 to M2 might indicate
either imminent inflation or recession. In general, if the M1 grows faster than the
combined rate of labor force and productivity growth, then inflation will result.
If, however, the M2 were to suddenly grow at the expense of M1 because people
are saving and not spending, then that would tend to indicate that the economy is
headed toward recession.
THE TIME VALUE OF MONEY
AND INTEREST RATES
Carpe Diem!

Economists observe that money’s value is affected by time: a dollar today is

worth more than a dollar tomorrow. This has to do with opportunity cost and
inflation. If you lend your friend the money in your wallet, your opportunity cost
is the sacrifice of its immediate use. When your friend eventually pays you back,
the money will have lost purchasing power due to inflation. For example, the
chair that cost $50 when you loaned the money might cost $55 two years later
when your friend pays you back, meaning not only were you unable to buy the
chair when you first needed it, but it will cost you more to buy it now. There is
also the risk that your friend will move to Costa Rica and “forget” to pay you
back.
As a result, when people lend money, they often ask to be rewarded with an
additional payment—interest—to offset the opportunity cost and inflation. When
you deposit money in your savings account, you expect to earn interest for the
same reason. Otherwise you would just stuff the money under your mattress.

PRINCIPLES OF INTEREST

Interest is nothing more than a payment for using money. An interest rate is the
price of using money. What determines this price? It helps to think of an interest
rate as a set of blocks stacked upon each other. These blocks include:

opportunity cost
 expected inflation rate
default risk premium
liquidity premium
maturity risk premium

Let’s look at each of these more closely.

Basic Interest Rate

The first block represents the opportunity cost of using money. Some people
will readily forgo the immediate use of their funds in order to receive interest.
Others might be unwilling to sacrifice the immediate use of their money. In the
absence of inflation or risk, the interest rate that equates the level of saving to the
level of borrowing is the basic interest rate or real interest rate.
In other words, if you’re willing to forgo the opportunity to use your money
for a 2% interest payment (also called a return), then that would be the basic
interest rate for the money you’re lending. As you can imagine, the real interest
rate varies from place to place and time to time. If most people are more
interested in spending their money now than in forgoing its use to earn interest,
the interest rate will have to rise to make them change their thinking.

The Inflationary Past

Many older Americans can remember a time in the late 1970s and
early 1980s when interest rates on loans like home mortgages were
as high as 20%. Compared to today’s low rates, that is quite a
difference. The explanation for the difference is inflation. Interest
rates include a premium for inflation. So even though your savings is
earning a much lower rate today, when you adjust for inflation, the
differences pretty much disappear.
 Expected Inflation Rate
While the basic interest rate of 2% may repay you for your opportunity cost, it
doesn’t account for inflation, which will eat away at that return. So, the second
block of interest represents the cost of expected inflation. Assume that inflation
has been stable for years at a rate of 3% and people are pretty confident that it
will remain at 3%. A lender or investor will cover the cost of expected inflation
and add 3% to the 2% real interest rate, to arrive at a nominal interest rate of 5%.
The nominal interest rate is the basic rate that an investor or lender will charge
for the use of money.

Default Risk Premium

If there is a chance that the loan or investment will go bad, then it makes sense
to add another block to the stack. This third block is referred to as default risk
premium. The bigger the risk of default or nonpayment, the bigger the block, and
the bigger the total nominal interest rate. Someone with a track record of paying
back loans in a timely fashion will be considered less risky to loan money to
than someone who has a spotty record of paying back loans and will thus pay a
lower total interest rate.

Liquidity Premium
If there is a chance that the investment or loan will be difficult to turn around
and sell to another lender or investor, like a ten-year car loan, another interest
block is added. This is because there’s money to be made in buying and selling
loans but not so much when those loans are for non-liquid commodities. Not
many people are willing to assume the risk of buying a loan that is backed by a
fully depreciated asset, such as a car at the end of a ten-year loan. This fourth
block is referred to as a liquidity premium. Commodities that are difficult to turn
into cash demand a higher interest rate.

Maturity Risk
One final block is added for maturity risk. As time passes, there is a chance
that interest rates will increase. If this happens, the value of the investment
that interest rates will increase. If this happens, the value of the investment
decreases, because who would want an investment that earns only 2% when you
can get a similar one that earns 4%?
So, here’s an example of how an interest rate is calculated: The real interest
rate is 2% and the inflation rate is 3%, which combine to form a 5% nominal
interest rate. Assume the risk premium is 4%, the liquidity premium is 2%, and
the maturity risk premium is 1%. The total nominal interest rate would stack up
to 12% (2% + 3% + 4% + 2% + 1%).
THE ORIGIN OF BANKING
Est. 2000 B.C.

Hushed tones, cool marble counters, the smell of cash, pens chained to tables
with blank deposit slips, solid steel doors with impressive locks, velvet-lined
cords directing customers to the appropriate teller—a bank is an important place.
Banks are everywhere. In the time it takes to walk from one Starbucks to
another, you’ll pass at least a few banks! From small towns to large cities, the
ubiquity of banks reveals their importance to the economy. Much maligned of
late, banks are an integral part of the economy. Without them, capitalism would
not function.

EARLY BANKING
The roots of banking can be traced to the earliest civilizations. The Egyptians
and early societies of the Middle East developed the prototype upon which
modern banking is based. Agricultural commodities were stored in granaries
operated by the government, and records of deposits and withdrawals were
maintained. Ancient civilization introduced the moneychangers, who would
exchange currency from different countries so that merchants, travelers, and
pilgrims could pay taxes or make religious offerings.
In the Renaissance era, Italian city-states were home to the first banks, which
financed trade, the state, and the Catholic Church. In order to avoid the Church’s
prohibition against usury (charging interest), the bankers would lend in one
currency but demand repayment in another currency. Profit was thus earned by
using different exchange rates at the time the loan was made and when it was
repaid. The successes of the Italian bankers induced a spread of banking further
repaid. The successes of the Italian bankers induced a spread of banking further
across the continent. In England, goldsmiths were responsible not only for
storing gold and issuing receipts, but also for developing what is now termed
fractional reserve banking. By issuing more receipts than there was gold on
deposit, the goldsmiths increased the profit potential of the banking industry.
From the time of the American Revolution to the Civil War, the United States
saw an expansion of relatively unregulated banking that helped finance the
growth of the young republic. Modern banking in the United States traces its
origins to the National Bank Act of 1863, which gave the government a means to
finance the Civil War.

THE FUNCTION OF BANKS

Banks serve a variety of functions in the economy. They act as safe places for
people to store their wealth, they help to facilitate trade by providing alternative
methods of payment, but most important, they bring together savers and
borrowers. Each of these functions is critical to the smooth operation of the
economy.
In John Locke’s Second Treatise of Civil Government, he observes that in
order for people to enjoy their private property, they must be secure in that
property. Thomas Jefferson paraphrases Locke in the Declaration of
Independence when he states: “they are endowed by their Creator with certain
unalienable rights, that among these are life, liberty and the pursuit of
happiness.” What Jefferson refers to as happiness, Locke refers to as property.
Although Locke and Jefferson were not referring to banks, but governments,
banks do serve an important security function. When you know that your private
property is secure, then you are better able to enjoy your freedoms.

The Precursor to the Debit Card

Historians trace the development of the check to the Knights

 Historians trace the development of the check to the Knights
Templar and Hospitallers, who used signed documents in order to
transfer wealth among their orders’ houses.

By providing their customers with check-writing privileges, debit cards, credit

cards, and cashier’s checks, banks help to facilitate trade. With multiple means
of access to stored wealth, consumers are able to make purchases more often and
in more places. This allows businesses to employ more land, labor, and capital,
which in turn results in a fully employed economy.
Acting as a go-between or intermediary between savers and borrowers is
probably the most important function of banks. Banks induce people to save
their money by offering to pay interest. These savings are then lent to borrowers
at an interest rate higher than that paid to savers, allowing the bank to profit. The
saver benefits because he earns interest on a safe and relatively liquid financial
investment without having to evaluate whether a potential borrower is a good
risk. The borrower benefits by having access to a large pool of funds. This is
important to the economy because borrowers can now purchase durable goods or
invest in capital or housing, which creates jobs and leads to economic growth.
HOW BANKS CREATE MONEY
Beyond “Abracadabra!”

Contrary to popular belief, most money is not created on government printing

presses. When banks accept deposits and make loans, money is created. To
understand how this works, you have to know some accounting principles. (I’ll
try to make this as painless as possible, I promise.)

BALANCE SHEETS

A balance sheet compares the assets a bank owns with the liabilities it owes. If
you have never taken a course in accounting, then you might not be familiar with
the following equation: Assets = Liabilities + Stockholder’s Equity. If you
haven’t fallen asleep yet, please bear with me through the following explanation:

A bank’s assets include buildings, equipment, loans to customers, Treasury

securities, vault cash, and reserves. This is basically everything the bank
owns.
The liabilities of a bank include customers’ deposits and loans from either
other banks or the Fed. This is basically everything the bank owes.
Stockholder equity, or a bank’s financial capital, is the ownership interest in
the bank represented by shares of stock.

Because assets equal liabilities plus stockholder’s equity, a bank with (for
example) $1 million in assets and $500,000 in liabilities would have $500,000 in
stockholder’s equity. Additionally, changes in a bank’s liabilities can create an
equal change in a bank’s assets. For example, if customers deposit $100,000 in a
bank (a liability), then the bank’s reserves increase by $100,000 (an asset). On
bank (a liability), then the bank’s reserves increase by $100,000 (an asset). On
the other hand, if customers withdraw $25,000, then bank reserves are reduced
by $25,000 as well.

Capital Requirements Defined

Banks are required by law to maintain capital requirements. This is

actual cash money (capital) that a bank must keep on hand to
conduct its operations, usually a ratio that is related to the riskiness
of its loans (riskier loans create greater capital requirements). The
purpose of the capital requirement is to ensure that the bank is able
to pay depositors if some of the bank’s borrowers are unable to
repay their loans. Capital requirements also mean that banks have a
vested interest in making sound loans.

BANK RESERVES
What exactly are bank reserves? Reserves are funds that are either available for
lending or held against checkable deposits. The reserves available for lending are
called excess reserves and those held against checkable, but not savings, deposits
are called required reserves (see sidebar, “Capital Requirements Defined”).
Required reserves are held either as cash in the bank’s vault or are deposited in
the bank’s reserve account with the Fed.
In the United States, the required reserve ratio, set by the Fed, is the
percentage of checkable deposits that a bank cannot lend. For large banks, the
required reserve ratio is 10%. Therefore, assuming a 10% required reserve ratio,
if customers deposit $100,000 into checking accounts, required reserves increase
by $10,000 and excess reserves increase by $90,000. When the economy is
healthy, banks tend to lend out all excess reserves. Why? Banks profit by
charging interest on loans, so they have a strong incentive to maximize the
charging interest on loans, so they have a strong incentive to maximize the
amount they lend.

THE ABRACADABRA PART

Money is created when the bank continues to lend its excess reserves. For
example, a $100,000 checking deposit generates an increase in excess reserves
of $90,000. If the bank lends the full $90,000 to a customer who in turn
purchases a recreational vehicle, the seller of the vehicle might then deposit the
$90,000 in the bank.
What happened to the checkable deposit balance in the bank? It grew from
$100,000 to $190,000 in a short period of time. Money was created. The process
does not stop with just this transaction. You can see that the bank now has
$90,000 in new deposits. The bank will hold 10% as required reserve and lend
the rest. The proceeds of the loan will be re-deposited, and now $81,000 of new
money is created. This process continues until all excess reserves are loaned out.

The Money Multiplier

Economists are able to estimate the growth in the money supply with the
money multiplier. While this may sound like a gizmo you’d like to have in your
basement, it’s basically a formula: the number one divided by the required
reserve ratio multiplied by the excess reserve.
Given that the reserve ratio is 10%, the money multiplier is 10 (if the reserve
ratio were 25%, then the money multiplier would be 4). If $30,000 is deposited
into a checking account, economists would predict that the money supply will
grow by a maximum of $270,000 ([$30,000 – $3,000] × 10).
The accuracy of the money multiplier as a predictor of the money supply is
constrained by two factors. The multiplier assumes that banks lend all excess
reserves and that the loans are all re-deposited. If either of these assumptions
does not hold, the multiplier effect is reduced. Many Americans hold onto their
cash, and that acts as a limit to the money multiplier.
cash, and that acts as a limit to the money multiplier.

The Money Divider

Just as easily as money is created, money can also be destroyed (the horror!).
Remember, money is created when customers make deposits and banks make
loans. Money is destroyed when customers withdraw balances and pay off loans.
Consider the following example. If Maria writes a $10,000 check to pay off her
car loan, checkable deposits are reduced by $10,000, and the money supply
shrinks. What’s good for you personally may not be so good for the economy.
BANKS AS A SYSTEM:
REGULATION AND
DEREGULATION
You Scratch My Back and I’ll Scratch Yours

Banks work together as a system in bringing together savers and borrowers.

They accomplish this by lending and borrowing directly from each other.
Sometimes banks may have excess reserves, but businesses or households may
not be willing to borrow. Assume that Bank East is holding excess reserves, but
has no opportunities to lend in its region. Bank West has no excess reserves, but
has businesses and consumers clamoring for loans. Bank West can borrow from
Bank East in the fed funds market and provide loans for its customers. Bank East
profits by earning the fed funds rate, and Bank West profits by earning the
higher interest rate it charges its customers. Everyone is happy happy happy.

Helping a Poor Banker Out

If a bank is low on reserves and will not fulfill their daily reserve requirement,
they are able to borrow from other banks overnight in the fed funds market. For
example, assume that Acme Bank has a customer who withdraws her entire life
savings at the end of the business day so she can run off to Cozumel with her
next-door neighbor. Because banks do not hold reserves against savings
deposits, this might leave Acme Bank without the required reserves it must hold
against checking deposits. Roadrunner Bank, however, may have excess reserves
available only earning minimal interest in their reserve account with the Fed. For
Roadrunner Bank, it is profitable to lend its excess reserves to Acme Bank at the
higher fed funds rate.
higher fed funds rate.

Bank Runs
Bank runs or bank panics have occurred multiple times throughout American
history. Because banks operate with far less than 100% required reserves, it is
possible that if enough customers demand their account balances on a single day,
the bank will not be able to meet the demand. This of course would be
catastrophic for the bank and its customers. The bank would be insolvent and the
customers unable to withdraw their funds would be broke.
What would cause customers to demand their account balances all at once?
Fear, whether based in truth or not. Many bank panics have been caused because
of rumor or speculation about a bank’s financial health. If enough people believe
the rumor, they will logically want to withdraw their funds and move them to
another financial institution or stuff them under the mattress. Once the line starts
forming at the bank’s door, other customers will notice and the rumor will
spread. Banks can avert a run if they are able to borrow from other banks and
provide their customers’ balances. However, if the speculation or rumors are
pervasive, then banks may become unwilling to lend to each other. When this
happens, it sparks even more speculation, and can create a run on the entire
financial system.

BANK REGULATION AND DEREGULATION

Prior to the Civil War, banks were chartered by the states and were capable of
issuing their own currency. In response to the government’s need for revenue to
pay for the war, Congress passed the National Bank Act of 1863, which created
federally chartered banks capable of issuing the new national currency and
government bonds.

Money Talks
 bond
A security that is a promise from a borrower to pay a lender on a
specified date with interest.

To ensure liquidity in case of a crisis, larger banks accepted deposits from

smaller banks that could be withdrawn in case the smaller banks experienced a
bank run. The system was premised on the notion that a small bank run could be
handled by tapping into a much larger bank’s reserves. However, the system
failed to recognize the possibility that a small bank run could create a contagion
that would lead to a systemic run on the banks.

Bank Regulations Since the 1900s

A widespread bank panic in 1907 led Congress to pass the Federal Reserve
Act of 1913, which created the modern Federal Reserve System, America’s
version of a central bank. The Fed serves as the nation’s chief bank regulator.
The Federal Reserve Board of Governors regulates member banks while the
Federal Reserve district banks supervise and enforce the board’s regulations.
Unfortunately, the Fed did not respond appropriately to the run on banks that
occurred during the Great Depression. Instead of providing needed liquidity, the
Fed dried up credit, prolonging (at least in some economists’ opinion) the
Depression.
Another test of the banking system came in the 1980s with the savings and
loan crisis. Aggressive lending by the savings and loan industry and lax
underwriting led to a series of savings and loan failures. Similar to the FDIC, the
Federal Savings and Loan Insurance Corporation (or FSLIC) paid depositors
whose institutions had failed. The American taxpayer was ultimately the loser as
billions were spent to clean up the financial mess and refund depositors.
Throughout the twentieth century, the American economy grew and industry
began to increase in size and importance. Soon, local and regional firms were
competing against national firms. American businesses that were national in
scope were being served by a banking system that was fragmented and regional.
scope were being served by a banking system that was fragmented and regional.
Bank regulation kept American banks relatively small compared to banks in
other countries. The banking sector effectively lobbied for deregulation in order
to grow and compete at a national and even international level.

Bank Deregulation
The deregulation of banking that occurred in the late twentieth century
allowed banks to operate nationwide and also allowed them to expand the level
of services they provided. Eventually certain regulations were repealed and
banks engaged in the business of speculative investment. As the walls separating
traditional banks from bank-like institutions came down, the seeds for another
financial crisis were sowed. Today, the banking industry is in flux. A push for
regulation to prevent future bank crises exists. As the line between banks and
other financial institutions has blurred, the task for lawmakers is to create a
regulatory framework that encompasses all bank-like activities. History will
show whether or not they were successful.
SUPPLY AND DEMAND:
MARKETS
Horse-Trading 101

You’re watching the news when someone says, “Higher gas prices should lower
demand.” How do you evaluate a statement like that? This guy is on television,
so he must know what he’s talking about, right? Don’t be so sure. Many
intelligent individuals throw around economic arguments using economic
terminology and may even sound convincing, but there is a lot of bad economics
going around! To have a good understanding of economics, you must have a
grasp of supply and demand. The concepts are central to even the most complex
of economic arguments, yet they are easily understood.

WHAT’S A MARKET?
Markets are places that bring together buyers and sellers. However, markets do
not have to be physical places. Markets exist whenever and wherever buyer and
seller interact, be it a physical location, via mail, or over the Internet. Several
conditions must be met in order for markets to function efficiently. Typical
conditions for an efficient market include a large number of buyers and sellers
acting independently according to their own self-interest, perfect information
about what is being traded, and freedom of entry and exit to and from the
market.

Market Efficiency
 Economists disagree over the efficiency of markets. Some argue
that the market price effectively captures all of the available
information about the product. Others argue that prices do not reflect
all available information. They argue that this information asymmetry
undermines market efficiency.

A large number of participants in the market ensures that no one buyer or

seller has too much influence over the price or the amount traded. It is obvious
that if there is a single seller or single buyer, they will be able to exercise
considerable influence over prices. For example, Walmart has what is called
monopsony power over several producers. Because Walmart is the sole retailer
for these producers, it is able use that power to influence the price it pays. In
competitive markets, no one producer or consumer exercises that level of
influence.

Money Talks
monopsony and monopoly
A monopsony is when there’s basically only one buyer for a product.
A monopoly is when there’s basically only one seller for a product.

Perfect information implies that both buyer and seller have complete access to
the costs of production and perfect knowledge of the product, and no
opportunities exist for arbitrage, which is buying low in one place and selling
high in another. Contrast that condition with the experience of buying a car.
Chances are the seller has the bulk of information about the cost and
specifications of the vehicle, whereas you deal with limited information at best
in making your purchase decision.
Freedom of entry and exit into the market also increases the market’s
efficiency by allowing the maximum number of buyers and sellers to participate.
Licensing requirements are an example of a barrier to entry. By requiring
licenses to sell or produce goods and services, the government limits the
potential number of sellers, resulting in less competition and higher prices.

COMPETITIVE MARKETS
A variety of factors affect supply and demand, which in turn affect price and
quantity. Changes in the market for one good will create changes in the market
for another good. This happens as price changes are communicated across
markets. This phenomenon should be considered when policymakers attempt to
influence markets, or unintended consequences can result.
How might driving an SUV contribute to starvation in Southeast Asia?
Several years ago gas prices suddenly began to climb. As a result, there was
considerable political pressure to alleviate the squeeze placed on the
pocketbooks of many Americans. Instead of driving less or commuting, many
wanted to continue their lifestyle of driving an inefficient vehicle without having
to pay higher prices. According to Thomas Sowell of the Hoover Institution,
politicians and many people are fond of ignoring the aphorism “there is no such
thing as a free lunch.” So, here is what happened.
As gas prices increased, demand for alternative fuels increased. This increase
in demand for alternative fuels was popular among corn growers who had a
product called ethanol. In order to provide ethanol at a lower cost, corn growers
lobbied Congress for greater subsidies. This resulted in more land being placed
into corn production at the expense of other crops, namely wheat. As wheat
supplies decreased and wheat prices rose, the price of the substitute crop, rice,
also rose because there was now more demand for rice. This led to the price of
rice increasing to the point where people in South and Southeast Asia were
unable to afford their basic staple. Starvation quickly ensued. Markets talk to
each other. No one intended for starvation to occur, but when people ignore
scarcity, unintended consequences can and do occur.
scarcity, unintended consequences can and do occur.

Unrealistic Models Explained

Do you remember the first time you learned about atoms in science class? The
teacher probably drew a sketch on the chalkboard that looked like a model of the
solar system: a big nucleus in the middle orbited by a tiny electron. Later you
probably learned that atoms do not actually look like the drawing on the board,
but the model your teacher showed you helped you to understand atoms. In
economics, when studying markets, you begin by learning something that is
somewhat unrealistic, but a simple model of perfect competition will help you to
understand real-world conditions.

Conditions
Certain conditions are necessary for the functioning of an efficient market: a
large number of buyers and sellers each acting independently according to their
own self-interest, perfect information about what is being traded, and freedom of
entry and exit to and from the market. Add to this list that firms deal in identical
products and that they are “price-takers” (that is, they are unable to influence
price much), and you now have perfect competition.
Identical products mean that there are no real differences in the output of
firms. They are all making and selling the same stuff. Think of things like wheat,
corn, rice, barley, and whatever else goes into making breakfast cereal. Wheat
grown by one farmer is not significantly different from wheat grown by another
farmer.

Advantages of Competitive Markets

Why are perfectly competitive markets preferable to other types of

market? Perfectly competitive markets are what economists call
allocatively efficient. Consumers get the most benefit at the lowest
price without creating any loss for producers. Perfect competition is
 price without creating any loss for producers. Perfect competition is
also productively efficient because in the long run, firms produce at
the lowest total cost per unit.

Economists refer to firms as “price-takers” when a firm does not set the price
of its output, but instead sells its output at the market price. Remember, one
outcome when markets have many different small buyers and sellers is that none
are able to influence the price of the product.
SUPPLY AND DEMAND:
CONSUMER BEHAVIOR
In Which Economists Define Happiness

Economists are always making assumptions about people’s behavior. One

assumption that seems to make sense is that people try to make themselves as
happy as possible. In economics-speak, this is called utility maximization. When
consumers buy goods and services, they are doing so to maximize their utility.
The ability of consumers to maximize utility is constrained by the amount they
have to spend; this is called a budget constraint. When it comes to consumer
behavior, economists argue that consumers seek to maximize their utility subject
to their budget constraint.
When studying consumer behavior, it is important to focus on marginal
decisions. Suppose you are faced with a bowl of your favorite candy. Each time
you benefit from consuming a piece, economists say that you are experiencing
marginal utility, but you do not care what economists say because you are eating
candy and getting fat and happy. You might describe the feeling you are having
as getting happy points. The more candy you eat, the more happy points you get.
You are maximizing your utility.
If you have ever overindulged on candy, cookies, brownies, or ice cream, you
know that at first the eating was enjoyable, but after a few (or a dozen), you were
not quite as happy as when you started. Economists refer to this phenomenon as
diminishing marginal utility. In other words, each piece of candy you eat gives
you fewer happy points than the prior piece. Diminishing marginal utility is a
useful concept. Throw the term around the next time you’re at a dinner party and
see how it goes.
Diminishing marginal utility helps to explain many of your behaviors. If one
 Diminishing marginal utility helps to explain many of your behaviors. If one
peppermint makes your breath smell fresh, then why not eat fifty? Answer:
diminishing marginal utility. If exercising for one hour is good for your health,
then why not exercise for twenty-four straight hours? Again, the answer is:
diminishing marginal utility. If a drop of perfume makes you smell nice, why not
wear the whole bottle? You guessed it—diminishing marginal utility.

DEMAND

If you have ever witnessed an auction, then you might have noticed that there are
many more low bids for an item than high bids. That is, people are more willing
and able to pay a low price for an item than to pay a high price. This willingness
and ability to buy something is referred to as demand. The fact that more people
are willing to buy at lower prices than at higher prices is called the law of
demand.

Reasons for the Law of Demand

Three reasons explain why the law of demand exists:

diminishing marginal utility

income effect
substitution effect

Diminishing Marginal Utility

The reason that diminishing marginal utility is an explanation of the law of
demand is easy to understand. As you consume more and more of an item, each
successive unit provides less utility, or happy points, than the previous unit. As a
result, the only way that you will buy more of an item is if the price is lower.
You consume until the marginal benefit (utility) equals the marginal cost (price).
Assume that your favorite doughnut stand is offering a “buy two and get the
third for half-price” deal. On a normal day, you would just buy two doughnuts
because a third is not worth it to you due to diminishing marginal utility. But in
because a third is not worth it to you due to diminishing marginal utility. But in
the case of the deal they are offering, if they lower the price or marginal cost to
the point where it is equal or less than the marginal utility or marginal benefit, it
makes sense for you to purchase the third doughnut.

Income Effect
Income effect is based on your budget constraint. As the price of a good
drops, your purchasing power increases. As the price increases, your purchasing
power falls. Income effect explains the logic behind discounts and sale prices.
When goods go on sale at a lower price, your limited income is able to purchase
more, so that is what you do.

Substitution Effect
Substitution effect is another explanation for the law of demand. The
substitution effect says that you substitute relatively less expensive items for
relatively more expensive items. For example, imagine you are at the grocery
store to buy food for five days’ worth of meals—three chicken dinners and two
dinners with beef. If the store happens to have beef on sale, you might substitute
one day’s chicken with beef. So what happened? The law of demand happened.
Beef prices were relatively lower and you bought more beef.

Elasticity of Demand
Think about all of the things that you buy in a year. You might purchase
goods and services as diverse as chewing gum, emergency room visits, and cars.
Sometimes you are very sensitive to the price and at other times you are not. For
example, you’re more likely to shop around for a good price on a car than on an
emergency room visit. Economists refer to this sensitivity to price as elasticity of
demand.

When you can delay the purchase of a good, if it has many close substitutes,
or if it takes a large percentage of your income, demand is typically price
 sensitive or elastic.
If, however, the purchase must be made immediately, no close substitutes
exist, or the purchase does not take a significant percentage of income,
demand is price insensitive or inelastic.

Compare an emergency appendectomy with a facelift. Both are surgeries, but

consumer demand for these surgeries is quite different. Acute appendicitis does
not wait for you to shop for the best price on surgery. Price is probably the last
thing on your mind when experiencing this illness. Your demand for the surgery
is inelastic. Facelifts are an entirely different matter. First, the purchase can be
delayed. Next, a facelift has available substitutes, like Botox and collagen
injection. Finally, because facelifts are optional and not covered by most health
insurance plans, they tend to take a large percentage of a person’s income. The
result of this combination of factors is that, for most, facelift demand is elastic.
SUPPLY AND DEMAND: A PRICE
IS BORN
Finding Common Ground for Producers and Consumers

Consumers demand, producers supply. Supply reflects producers’ changing

willingness and ability to make or sell at the various prices that occur in the
market. If you were selling cookies or crude oil, which would entice you to
produce more, a low price or a high price? If you said low price, you would
quickly find yourself broke. However, if you said high price, you just might have
a chance to make a profit. The law of supply states that producers are able and
willing to sell more as the price increases. The reason for the law of supply is the
simple fact that as production increases, so do the marginal costs. As rational,
self-interested individuals, suppliers are only willing to produce if they are able
to cover their cost.

ELASTICITY OF SUPPLY
Elasticity of supply is the producers’ sensitivity to changes in price on the
quantity they are willing to produce. The key factor in supply elasticity is the
amount of time it takes to produce the good or service. If producers can respond
to price changes rapidly, supply is relatively elastic. However, if producers need
considerable time to respond to changes in the market price of their product,
supply is relatively inelastic. Compare corn tortillas and wine. Corn tortillas are
easily produced with readily available materials. If the market price of corn
tortillas were to suddenly increase, producers would have little difficulty in
producing more tortillas in response to the price change. Now, if the market
price of Pinot Noir were to suddenly increase, winemakers would have much
price of Pinot Noir were to suddenly increase, winemakers would have much
more difficulty responding to the price change. Vines take years to develop,
grapes take time to ripen, and wine needs time to age. All of these factors give
wine a relatively inelastic supply.

A PRICE IS BORN
When supply meets demand, something interesting happens. A price is born. In
an efficient market, prices are a function of the supply and demand for the good
or service. Instead of central planners, government officials, or oligarchs
dictating artificial prices or rationing who gets what, the market relies on the
impersonal forces of supply and demand to determine prices and to serve the
rationing function. The pitting of consumers trying to maximize their utility
against producers trying to maximize their profits is what determines the price of
goods in the market and also the quantity that is bought and sold.
Supply and demand ration goods and services efficiently and fairly. Prices are
efficient because they are understood by most participants in the market. If you
give a child $5 and send her into a candy shop, she could figure out what she can
afford without having to ask anyone for help. A price conveys much
information. The price of a good communicates to consumers whether or not to
purchase and to the producer whether or not to produce it. Prices are fair because
they are neutral; they favor neither buyer nor seller.

FINDING EQUILIBRIUM

A market is said to be in equilibrium when at the prevailing price there is neither

a surplus nor shortage of the good or service. When this condition is present,
then the price is called the equilibrium or market-clearing price. Market
equilibrium is the most desirable outcome because it allows for consumers to
maximize utility while also allowing producers to maximize profits.
There are times when the market is not in equilibrium. Sometimes, the market
 There are times when the market is not in equilibrium. Sometimes, the market
price is greater than the equilibrium price.
When this happens, a surplus results. The amount producers supply is greater
than the amount consumers demand. If you have ever walked past a clearance
rack full of sweaters and wondered to yourself, “Who would wear that?” you are
not alone. Countless others had walked past those now-surplus sweaters before
they were placed on the clearance rack. They walked past because the marginal
cost of the sweater to the consumer was greater than the marginal utility. The
purpose of the clearance rack is to offer these sweaters at a price low enough to
induce some hapless, utility-maximizing individual to purchase them.
If the market price is too low, then a shortage might result. Shortages occur
when the quantity demanded is greater than the quantity supplied. When
shortages occur in the market, buyers compete against each other to purchase an
item and bid up the price until equilibrium is reached. Auctions take advantage
of this phenomenon, and the consumer who wants the good the most gets it.
How do you know he wanted it the most? He offered the most money. Prices are
fair, efficient, and effective at rationing most goods and services.
CHANGES IN SUPPLY AND
DEMAND
What Goes Up Must Come Down

Change in either demand or supply will cause change in both price and quantity.
As price changes, producers are willing to produce more or less. Price affects the
quantity producers supply, but it does not affect supply. For example, the supply
of coffee is influenced by weather, land prices, other coffee producers, coffee
futures, cocoa profits, and subsidies to coffee producers. The one thing that does
not influence the supply of coffee is the current price of coffee. This often causes
confusion, but it need not. Understand that supply refers to producers’
willingness to produce various amounts at various prices, and not to some fixed
quantity.

WHAT CAUSES SUPPLY TO CHANGE

Supply is influenced by nature, the price of inputs, competition, expected prices,
related profits, and government.

Nature plays a big part in determining the supply of coffee. Rain, sunshine,
temperature, and disease are obvious examples of variables in nature that
will affect the coffee harvest. Excellent weather conditions often lead to
large increases in supply, and poor weather leads to the opposite.
Input or resource prices have a direct influence on producers’ supply
decisions. Land, seed, fertilizer, pesticide, harvesting equipment, labor, and
storage are just a few of the costs that coffee producers face. Supply
decreases as those costs rise, making growers less able to produce at each
and every market price. Supply increases when the cost of production falls.
The presence of more or less competition causes increases or decreases in
supply. As the popularity of coffee has risen, more and more producers
have entered the market. The introduction of more competition increased
the quantity of coffee supplied at each market price.
Expectations of future price increases tend to decrease supply, but
expectations of future price decreases have the opposite effect. If producers
expect higher prices in the future, they will be less willing to supply in the
present. Coffee producers might withhold production in order to sell when
prices are higher. If prices are expected to move lower in the future,
producers have an incentive to sell more in the present.
The profitability of related goods and services also affects the supply of a
good like coffee. For example, coffee-growing land is also favorable for
growing cocoa. If the profits are greater in the cocoa market than in the
coffee market, over time more land will be pulled from coffee production
and put into cocoa production. Likewise, if profits in the coffee market are
greater, eventually, more land will be put into coffee production at the
expense of cocoa production.
Government policies can also affect supply. Government can tax, subsidize,
or regulate production, and this will affect supply. If Brazil wants to reduce
the local production of coffee in order to restore forests, the Brazilian
government can tax coffee production. This would increase the cost of
production and reduce the supply. If government wants to encourage
production and increase supply, it can subsidize producers, that is, pay them
to produce. Vietnam might subsidize coffee production in its highlands in
order to increase the supply of this valuable export commodity. Regulation
often has the effect of limiting supply. If Vietnam wanted to preserve its
highland rainforests, it might make rules or regulations that effectively limit
the ability of coffee growers to produce.
 Technology and the availability of physical capital are key determinants of
supply. Technological innovation has allowed producers in many different
industries to increase the quantity of goods that they are willing and able to
produce at each and every price.
Increases in the amount of physical capital available relative to labor also
help firms to increase output. Economists refer to this phenomenon as
capital deepening. As capital deepening increases for a firm, so does
supply.

Money Talks
capital
Capital in economics does not refer to money, but to all of the tools,
factories, and equipment used in the production process. Capital is
the product of investment.

WHAT CAUSES CHANGES IN DEMAND

Consumer tastes for goods and services are subject to change and when these
changes happen, demand shifts. A few years back, there was a recall of fresh leaf
spinach because of E. coli contamination. This contamination effectively
reduced demand for fresh spinach. Advertising can affect the taste for goods and
services as well. The ShamWow is a case in point. The ads for this product were
on several channels on TV. After watching that ad for the hundredth time, many
people decided that they had to have one. The increase in ShamWow sales was
not in response to some change in the price of the product, but was caused by a
change in consumers’ tastes due to advertising.

Complements and Substitutes

The price of related goods can affect the demand for a good as well. Related
 The price of related goods can affect the demand for a good as well. Related
goods are classified as either complements or substitutes. Complements are
goods used in conjunction with other goods, and substitutes are goods used in
lieu of each other. Movie tickets and Junior Mints are complements. As the price
of movie tickets rises, people are less willing to buy them and go to the movies.
Therefore, there is less demand for Junior Mints. If ticket prices fall, the opposite
occurs. Air travel and bus travel are substitutes. As the price of airline tickets
falls, demand for bus tickets decreases, and as the price of airline tickets rises,
demand for bus tickets increases.

Cross-Price Elasticity

Determining whether goods are substitutes or complements is not a

matter of opinion. Economists calculate cross-price elasticity to
determine whether goods are complements or substitutes by
dividing the percentage change in the quantity demanded of one
good by the percentage change in the price of another good. If
cross-price elasticity is less than zero, goods are complements, and
if cross-price elasticity is greater than zero, goods are substitutes.

Normal and Inferior Goods

Changes in consumers’ income will lead to changes in demand. If income and
demand move in the same direction, you are dealing with a normal good. If
income and demand move in opposite directions, the good is considered inferior.
If organic milk is a normal good and powdered milk is an inferior good, what
effect will an increase in consumers’ income have on demand for the two?
Demand for organic milk increases with increased income and demand for
powdered milk decreases with increased income.
The number of buyers is directly related to the demand for goods and services.
As the number of buyers increases, so will demand, and vice versa. This obvious
As the number of buyers increases, so will demand, and vice versa. This obvious
relationship should be considered before investing in the Russian housing
market. The population there is shrinking.
Expected prices can have a direct influence over the demand for goods and
services. If investors believe that a stock’s price will increase in the future,
demand for the stock increases. Likewise, if the price of a stock is expected to
fall, the demand for the stock will decrease.
ACCOUNTING VERSUS
ECONOMICS
You Say Potato, I Say Rutabaga

An accountant asked an economist why she had chosen a career in economics

over accounting. The economist replied, “I’m good with numbers, but I don’t
have enough personality to be an accountant.” Personality differences aside, a
key distinction between economics and accounting is in determining total cost
and profit. To the accountant, total costs are the sum of all of the explicit fixed
and variable costs of production—things like the cost of clay to make the
ceramic pots you sell. Explicit costs are easily identifiable and quantifiable. The
cost of overhead is a known quantity. The cost of labor can readily be calculated.
In addition, to the accountant, profits are equal to total revenue minus total
cost. If your business generates $1 million in revenue (what it earns through
sales) and has fixed and variable costs equal to $800,000, then your profits are
equal to $200,000. Your focus will be on maximizing revenue and reducing the
costs of production. This will increase your profits.
To the economist, however, total cost is equal to all of the explicit fixed and
variable costs plus opportunity cost. Opportunity cost is an implicit cost, and it
can be much harder to define and quantify than the explicit costs of production.
To the economist, profits are equal to total revenue minus total cost including
opportunity cost. Factoring in opportunity cost gives a clearer picture not just of
whether the business is profitable but whether it is the best use of resources.

A CASE IN POINT

Imagine that you are a teacher earning $5,000 a month and decide to quit your
Imagine that you are a teacher earning $5,000 a month and decide to quit your
job and start selling snow cones instead. You buy a freezer cart that you can
wheel around, order all of the supplies you need, and pay the required licensing
fees. Assume your total cost equals $2,000. So you get out there and start
hustling snow cones, and you’re actually good at it. At the end of the month, you
calculate that you have earned $6,000 in total revenue. What are your accounting
profits? $6,000 in total revenue – $2,000 in total cost = $4,000 in accounting
profit.
What are your economic profits? $6,000 in total revenue – ($2,000 in explicit
cost + $5,000 in opportunity cost) = −$1,000 economic loss. The opportunity
cost is what you could have been earning as a teacher.
In this example, we knew what salary the teacher earned so we could calculate
the opportunity cost more easily. But what if the situation were slightly
different? Suppose the teacher was selling snow cones in the summer, not during
the school year, so her teaching salary was unaffected. She might be giving up
other opportunities, but perhaps it isn’t clear what those opportunities would be
or how much she might earn pursuing them. What’s the going rate for tutoring, a
common summertime pursuit for teachers? Maybe it varies from $10 an hour to
$100 an hour, depending on a variety of factors. Or maybe the opportunities
aren’t income generating—maybe she could be lying on the beach, recuperating
so she can be ready for another round of teaching in the fall.
In another scenario, suppose our snow-cone seller was a twelve-year-old kid.
Instead of selling snow cones, what else could he be doing? Mowing lawns or
delivering newspapers? (Does anyone deliver newspapers anymore?) In this
case, the opportunity cost is likely to be close to zero.

Revenue and Profit

Many people confuse the concepts of revenue and profit. Revenue

is all of the income a business earns. For a firm selling a single type
 is all of the income a business earns. For a firm selling a single type
of product at one price, revenue is equal to the quantity sold
multiplied by the price. If you’ve got a hundred apples that you sell
for $1 each, then your total revenue, assuming you sell all the
apples, is $100. Profit, on the other hand, is the income a company
has left over after covering all of its costs. Revenue – Cost = Profit.

Economic profits in an industry are important because they provide firms in

other industries with an incentive to employ their land, labor, capital, and
entrepreneurial ability in the economically profitable industry. Economic profits
draw resources to their most efficient use. In the long run, competition
eliminates economic profits. Industry is most efficient when economic profits
are equal to zero. At zero economic profit, there is no incentive for existing firms
to leave or for new firms to enter the market. In the example just presented, the
$1,000 economic loss is a signal for you to leave the snow-cone industry because
your resources could be put to better use in another industry. But for the kid
whose alternative is mowing the lawn, making snow cones is as efficient a way
to use his resources as the other options available to him, so he has no incentive
to leave the market.
THE PRODUCTION FUNCTION
The Only Constant Is Change

Businesses frequently have to make production decisions in response to market

conditions. If the price of tea goes up, should Green Tea Inc. expect less demand
for their tea bags and therefore decide not to hire a new person to fill Dwayne’s
spot on the line? Does a big order of tablet computers now indicate that
production capacities at I Heart Electronics Inc. should be increased to deal with
future big orders, or is that order just an anomaly?
Both microeconomics and macroeconomics make distinctions between
production decisions in the short run and production decisions in the long run.
These distinctions have very little to do with some fixed period of time, but
rather are based on the ability of firms to make changes in their inputs.

THE LONG AND SHORT OF IT

The short run is defined as the period of time in which firms are able to vary
only one of the inputs to production, usually labor. The long run is the period in
which firms are able to vary all the inputs in the production process.
If you operate a restaurant, in the short run (today and next week) you can
only add or subtract workers to adjust the level of production. If your place is
busy, you schedule or call up more of your workers. If business is slow, you
send the employees home. The long run is the period in which you are able to
expand the kitchen or add new equipment. So in response to an increase in
business activity, in the short run you can schedule more workers, but in the long
run you can make the restaurant bigger.
A firm’s short-run production decisions are based on the firm’s production
 A firm’s short-run production decisions are based on the firm’s production
function. A production function shows how a firm’s output changes as it makes
changes to a single input, like labor.

The Stages of Production Function

The production function is divided into three distinct stages based on what is
happening to the firm’s output or product:

1. The first stage of a production function occurs when firms experience

increasing returns. This means that as a firm adds workers, each
additional worker contributes more to output than the previous worker.
The additional contribution to output from each worker is referred to as
marginal product. So in the stage of increasing returns, both output and
marginal product are increasing. If one worker laboring alone can
produce ten candles a day at the Cheerful Candle Company, but a second
worker can (through the miracles of the division of labor and mass
production) produce fifteen candles a day, that’s an increase in output
and marginal production, and an indication that the business is in the
increasing returns stage.
2. The second stage of production is called diminishing returns. In this
stage, as the firm increases the number of workers, output still increases,
but the additional contribution of each worker decreases. By the time the
Cheerful Candle Company hires its fiftieth employee, that employee may
be able to produce fifteen candles a day but that level of production
(while perfectly satisfactory) does not contribute more to output than the
previous worker contributed. It could be by the time the Cheerful Candle
Company hires its hundredth employee, that employee could be
producing less than #50 but still adding to the overall bottom line
(output) of the company.
3. Finally, the firm experiences the third stage of production called negative
returns. In this stage, as firms add workers, both output and marginal
 product decrease. If you’ve ever worked for a large company with a lot
of middle managers, you can imagine how this might happen.

Production Function Illustrated

To illustrate the production function, picture a restaurant on a normal business
day. Assume that you are the manager responsible for scheduling workers, but
you have no experience and are a little slow at figuring things out. At 6 A.M. the
first customer arrives for breakfast. You immediately call up one of your
employees and have her rush to work. Employee 1 is able to prepare the food,
serve it, and then act as a cashier for the transaction. Later, as more customers
arrive and begin demanding service, it becomes obvious to you that more help is
needed. Taking out your cell phone, you call up Employees 2 and 3 and order
them to work. As they settle in and begin working, a division of labor develops,
which increases their individual productivity and the total productivity of the
restaurant.
Witnessing the marvelous outcome, you conclude that more is always better
and decide to call up Employees 4 through 7. As they begin to work, you notice
that the restaurant is able to serve more customers, but the earlier gains in
productivity are beginning to diminish. You chalk up these diminishing gains as
a fluke, and in order to break through this impasse you bring in Employees 8
through 256. Pretty soon, the restaurant’s kitchen is full of employees, with
every worker pretty much immobilized like a sardine in a can. The customers are
now outraged at the extremely slow service and a little freaked out by your lack
of management ability. As a matter of fact, with 256 workers, you are unable to
produce anything. This is referred to as negative returns.
CONTROLLING COSTS
Because of Profit Motive

Businesses or firms strive to earn the most profits possible. Call that the Law of
Gordon “Greed Is Good” Gekko. Businesses try to increase profitability by
trying to increase revenue and decrease cost. In a competitive environment,
firms can’t do much to increase revenue. If Target is selling Beautiful Brand
toilet paper for $1 per four-pack, Walmart is also going to have to sell Beautiful
Brand toilet paper for about $1 per four-pack. They lack pricing power. Firms
do, however, have the ability to control costs, so in order to maximize their
profits they try to produce at the lowest cost possible.
Think of it this way: If you’d like to have enough money in the bank to retire
someday, you may be able to work toward getting a raise (or a better job with an
increase in pay), but you may not have a lot of control over this—your
boss/company will determine how much, if any, of a raise you can get, and your
ability to get a better-paying job depends on where you live, your credentials,
your work experience, how competitive your job market is, and other factors.
But even if you couldn’t easily get an increase in salary, you probably could cut
out Netflix and save a few bucks that way.

Money Talks
depreciation
As capital ages, its value declines because it breaks down and
eventually needs replacement.
 TYPES OF COSTS

Economists break down costs into different categories:

1. The first category of costs is fixed costs or overhead. A firm’s fixed costs
are those costs that don’t change regardless of the level of production.
Rent, property tax, management salaries, and depreciation are examples.
Whether a factory is running at full capacity or is idle, the overhead
remains the same.
2. Firms also face variable costs. Variable costs change with the level of a
firm’s output. Utilities, hourly wages, and per-unit taxes are
representative of variable costs. As a firm’s production increases, so do
its variable costs.
3. Total cost is the sum of a firm’s fixed and variable costs.

Remember how we said earlier that economists also consider opportunity cost
when calculating profitability? Forget that for now. For the purposes of this
discussion on costs, we’re looking at profit exactly the way an accountant does:
Revenue − Costs (Fixed and Variable) = Profit.

Costs over the Long Run

In the long run, all costs are variable. Over time, firms are able to
add or subtract capital, renegotiate rent, and alter management
salaries. The distinction between fixed and variable costs disappears
with the passage of time.

Marginal Cost of Production

The marginal cost of production is of special interest to economists. Marginal
cost is the change in total cost for each unit produced. Think of marginal cost as
cost is the change in total cost for each unit produced. Think of marginal cost as
the additional cost of producing one more item. For each additional unit of
output a firm produces, it incurs more variable cost and hence more total cost.
This means that its marginal cost increases as well. For example, each Big Mac
costs more to produce than the previous Big Mac because McDonald’s had to
pay for more ingredients and pay its workers more for the extra time it took to
produce the additional Big Mac.

Marginal Revenue
Firms like McDonald’s maximize their profits when they produce at the point
where marginal cost equals marginal revenue. In other words, if a firm wants to
make the largest profits it can, it will produce up to the point where the
additional cost of producing one more item is the same as the additional revenue
earned by producing one more item.
If the additional cost of making “one more hamburger” is 99 cents (for
example) and that hamburger can be sold for 99 cents, then marginal cost and
marginal revenue are equal. This is the happy place economists dream of. If the
additional cost of making “one more hamburger” is instead $1.29 and selling it
can only generate revenue of 99 cents, McDonald’s will have some explaining to
do to their stockholders and will probably shortly be in search of a new CEO.
PERFECT COMPETITION IN THE
SHORT RUN
Let’s Pretend!

Perfect competition is the kind of hypothetical situation that economists love to

talk about even though it exists in the same fairy-tale realm as unicorns and sea
dragons. Perfect competition is the made-up idea that businesses will behave in
certain ways if we stipulate that all of the businesses in a particular industry are
playing on a level field. The theory of perfect competition allows economists to
describe what would happen if only people would listen to them. These
economics lectures usually include charts containing complicated formulas but
we’re omitting them here. You’re welcome.

PERFECT COMPETITION IN FOUR EASY PIECES

What constitutes the aforementioned level playing field? For starters:

Consumers and producers have perfect knowledge—they know all there is

to know about the product and the market—and they make rational
decisions. That means consumers are trying to maximize utility (i.e., happy
points) and producers are trying to maximize profit, and both groups have
all the information they need to be able to do these things.
Businesses can enter and exit the market without barriers. Here we pretend
that businesses don’t have to beg venture capitalists for start-up funds or
hold going-out-of-business sales.
 All producers make things (“outputs” or finished goods) that are identical
and all of them have inputs (e.g., labor) that are the same. In Perfect
Competition World, a pair of Keds and a pair of Dolce & Gabbana shoes
are exactly equivalent and require exactly the same resources to produce.
Lots of producers are competing in the same area, meaning that no producer
(business) has pricing power—none is big enough or monopolistic enough
to manage it. Everyone prices their goods in relationship to everyone else.
If Blue Skies Coffee Company sells a pound of arabica coffee beans for
$20, then Green Earth Coffees Inc. will have to sell their arabica coffee
beans for about the same amount of money or the business won’t have any
buyers. Remember, in this scenario, all outputs are the same and all
consumers have perfect knowledge, so they know Blue Skies coffee is just
as good as Green Earth coffee.

In other words, businesses must compete against each other without any
advantages (or disadvantages!). The result is that the industry sets the price
rather than individual businesses, and demand is perfectly elastic. (Remember
that if a good has many acceptable substitutes, the demand is price sensitive,
which is another way of saying demand is elastic.)

COMPETITION AND THE SHORT RUN

For an industry, the short run is the period of time in which firms are unable to
enter or exit the market because they are only able to vary their labor and not
their fixed capital. That is to say, if demand plummets, a business cannot quickly
reduce their fixed costs; if demand skyrockets, they cannot quickly expand to
produce more. In the short run, it is possible for firms in a perfectly competitive
industry to earn economic profits or even operate at a loss as supply and demand
for the entire industry’s output changes.
For example, assume that the glazed doughnut industry is perfectly
competitive. Imagine that scientists working in New Zealand discover that
competitive. Imagine that scientists working in New Zealand discover that
glazed doughnuts, when consumed with coffee, are extremely beneficial to
consumers’ health. As a result of this great news, the demand for doughnuts
increases. This results in a new, higher equilibrium price. Remember that the
market price represents the firm’s marginal revenue, so for firms in the doughnut
industry, their total revenue has increased by more than their total economic
cost. This means that glazed doughnut firms are earning economic profits.
Six months later, scientists in California reveal that the earlier New Zealand
doughnut research was flawed, and that, in fact, consuming large amounts of
glazed doughnuts with coffee might pose a risk to consumers’ health. First there
is denial, then consumers slowly awaken to the reality that they are fifty pounds
heavier and finding it difficult to sleep. At this point, the demand for glazed
doughnuts decreases below its original equilibrium. For many firms in the
doughnut industry, this decrease in the market price means that they are now
producing at a short-run loss, because their total revenue is less than their total
cost of production.
PERFECT COMPETITION IN THE
LONG RUN
The Race to Zero

Unlike the short run, in the long run, firms are able to enter and exit the market.
New firms enter the market in response to the presence of economic profits, and
old firms exit the market in response to losses. To continue the doughnut
example from the last section, consider how in light of the New Zealand
research, economic profits in the glazed doughnut industry would attract new
firms to the industry. As new firms enter, competition increases, which means
that the industry supply of glazed doughnuts increases. The increased supply
reduces the equilibrium price of doughnuts and economic profits disappear.
Considering the California research, in the face of economic losses, some
firms will reach the shutdown point and withdraw from the industry. This
reduces competition and decreases the industry supply of glazed doughnuts.
Decreased supply increases the equilibrium price in the market. In the end, fewer
firms remain as the industry returns to its long-run equilibrium with zero
economic profits.

FROM COMPETITION TO IMPERFECT

COMPETITION: A CONTINUUM

Perfect competition does not really exist. It is unlikely that you will find an
industry in which all of the conditions for perfect competition are met. However,
perfect competition provides an example with which to compare the market
structures that do exist. Although it isn’t real, it provides a nice frame of
reference.

The Evolution of Markets

The continuum of market structures can be seen as an evolution of

markets. Firms may begin in a very competitive market and over
time become monopolists. The late nineteenth and early twentieth
centuries witnessed the rise of the trusts from once-competitive
industries. Some even called for an end to “ruinous competition.”

Most firms face barriers to entry, either in terms of cost or government

requirements. Firms rarely deal in identical products, as they invest heavily in
differentiating themselves from the competition. This ability to differentiate
gives firms some ability to affect prices. In mature markets like the United
States, firms tend to be large and not necessarily independent. Finally, access to
information is not equally shared, and as a result, the condition of perfect
information does not exist either. What you are left with is not perfect
competition, but imperfect competition.
Economists classify markets according to their level of competition. On one
end of the spectrum lie perfectly competitive, albeit fictional, markets. On the
other end of the continuum lies monopoly. In between you will find the market
structures that are most familiar, monopolistic competition and oligopoly.

Monopolistic Competition
Monopolistic competition is a market structure very similar to perfect
competition. There are many buyers and sellers, barriers to entry are minimal or
at least equal for all firms, and information is readily available. However, in
monopolistic competition, firms do not offer identical products, but differentiate
their products from those of their competition. Product differentiation is the
process by which producers are able to convince consumers that their particular
process by which producers are able to convince consumers that their particular
product is different from other producers’ products.
The industry that should come to mind when you think of monopolistic
competition is fast food. The fast-food industry has many different producers
competing for the dollars of many different consumers. All are welcome to start
a fast-food restaurant as long as they pay the required licenses. Most producers
have a good idea of what they are getting into and customers tend to understand
the products quite well. Why is fast food monopolistically competitive? Product
differentiation. Each firm offers a different menu. Taco Bell, Chick-fil-A,
McDonald’s, and Subway all compete against each other in the fast-food market
while providing customers with a variety of choices. Product differentiation is
one of the reasons that new entrants are able to survive in this cutthroat industry.
If you are different enough, then you might have a chance.
Next time you are in the produce section of the grocery store, take a look at
how many varieties of apples are available. Do you remember the days when
apples were either red or green? Today there are Red Delicious, Pink Lady,
Granny Smith, Gala, Fuji, and Honeycrisp, to name a few. In addition, there are
small, medium, and large. There are organic and pesticide-treated. Some are sold
individually and some are packaged. Apple producers have differentiated their
products. Why? Remember how competitive firms were unable to influence
price? When producers differentiate their products and are successful, they are
able to charge a higher price than their competition.

Monopolies and Profit

Can monopolistically competitive firms maintain economic profits in

the long run? No. Over time, the presence of competition will
eventually erode the monopolistically competitive firm’s profits. The
end result is an industry with excess capacity, high cost, and no
economic profits.
 The problem with product differentiation is that it becomes a never-ending
process. Firms must continually find ways to differentiate. This explains why
firms will spend large sums of money on advertising. Much of the advertising is
not so much an attempt to gain new customers as it is an effort to build brand
loyalty. However, firms have limited resources, so engaging in product
differentiation through advertising means that resources used in advertising are
no longer available for production. As a result, industries that are
monopolistically competitive do not produce as much output as they could if
they were perfectly competitive. Consumers are missing out on what could have
been. Not to worry, it seems that consumers have a strong preference for the
variety that monopolistic competition brings, and so the benefits may at least
equal the costs.
OLIGOPOLIES AND
IMPERFECTLY COMPETITIVE
MARKETS
World Domination or Die!

Many of the companies with which you are most familiar do not exist in
perfectly competitive markets or even in highly competitive markets. The major
automobile manufacturers, airlines, telecommunications companies, food
producers, and discount retailers compete in an oligopolistic market structure—
that is, a market with few producers.
At a local level, many of the utilities you use are monopolies. Oligopoly and
monopoly are common market structures in the United States. In the last section,
we briefly described monopolies. Now, let’s look at oligopolies. To know how
the American economy works, you need a good understanding of these
imperfectly competitive market structures.

OLIGOPOLY

Oligopoly describes a market where a few large producers dominate. Unlike

competitive and monopolistically competitive markets, oligopolistic firms have
more pricing power. In addition, oligopoly is characterized by considerable
barriers to entry because of the sheer scale of the firms. Oligopoly is often the
result of once-competitive markets maturing. As monopolistically competitive
firms grow and merge with other firms, fewer firms result. Oligopolies are of
concern to government regulators attempting to preserve and enforce
competition in industries.
competition in industries.

Loss of Competition
Why does it matter if firms consolidate, industries mature, and markets
become oligopolistic? As competition decreases, a number of negative effects
occur. Prices become higher, and productive and allocative efficiency, which
benefit society, are lost. Notice how these are industries where consumers tend
to dislike the producers. (Has anyone ever actually loved an airline the way they
love a chocolate-chip cookie?) An interesting coincidence, wouldn’t you say?
To determine whether a market meets the condition of oligopoly, economists
calculate the Herfindahl-Hirschman Index (HHI) for the market. A relatively low
index number identifies a market as competitive, and a relatively high index
number indicates oligopoly. The Federal Trade Commission (FTC) and the
Justice Department can use the index numbers as a way to determine whether or
not to approve mergers between companies in an industry. If the merger would
significantly increase the HHI, then the merger would most likely be blocked
because it would reduce competition.
Regulators and economists also use concentration ratios to determine if a
market is oligopolistic. The more market share is dominated by a few firms, the
higher the concentration ratio. For example, if the four-firm concentration ratio
is 80%, then the four largest firms have 80% of the market share. According to
the 2002 census, the four-firm concentration ratio for the vacuum-cleaner
industry was 78%, and the eight-firm concentration ratio was 96.1%. It is safe to
say that the vacuum-cleaner industry is an example of oligopoly. By way of
comparison, a perfectly competitive industry would have a four-firm
concentration ratio of about 0%, and an industry dominated by a monopoly
would have a one-firm concentration ratio of 100%.

What Defines an Industry?

What defines an industry for the purpose of determining

 What defines an industry for the purpose of determining
concentration ratios? It depends. Today the definition of industry is
becoming blurred. In the past, the newspaper industry was an
industry. Today it is part of a larger industry known as the media.
Even though the local paper may have 100% of the local newspaper
market share, other forms of media reduce its effective share in the
overall industry.

The large market share that oligopolists enjoy shapes the way they view the
market. Unlike firms in more competitive market structures that behave
independently of each other, the oligopolists have an interdependent relationship
with each other. Because the oligopolists control so much market share, their
individual decisions have considerable impacts on market prices. Knowing this
to be the case, the oligopolist tends to be more aware of the competition and
takes this into account when making production and pricing decisions.
COLLUSION AND CARTELS
World Domination or Die! Revisited

One of the blessings of competition is that it leads to lower prices for consumers.
For the producer, however, this blessing is a curse. Low prices often mean low
profits. Given a choice between competition and cooperation, profit-maximizing
firms would more often than not prefer cooperation. Regardless of what you
learned in kindergarten, you do not want the businesses you buy from to
cooperate because they might all decide that chocolate should cost $100 a pound
or they might all agree to throttle back production to create an artificial scarcity.
It’s in your best interest for businesses to compete against each other to produce
those low low prices consumers like so well. Adam Smith, the father of modern
capitalism, warned that nothing beneficial comes from the heads of business
getting together, and history has proven him right.

Money Talks
cartel
A group of producers that agree to cooperate instead of compete
with each other. Cartels seek higher profits for their members by
collectively reducing production in order to increase prices.

Collusion
In the United States, firms are forbidden from cooperating to set prices or
production. The abuses of the late nineteenth-and early twentieth-century trusts
were the impetus for the “trust-busting” of President Theodore Roosevelt. With
the Sherman Antitrust Act and later the Clayton Antitrust Act, the government
the Sherman Antitrust Act and later the Clayton Antitrust Act, the government
prohibited outright collusion and other business practices that reduced
competition.

Money Talks
collusion
Collusion means any type of illegal conspiracy. For economists,
collusion also implies an intent to cheat or defraud consumers (and
others) by artificially reducing competition.

Even though it violates the law, businesses from time to time will collude in
order to set prices. Colluding firms can divide up the market in a way that is
beneficial for them. The firms avoid competition, set higher prices, and reduce
their operating costs. Because collusion is illegal and punishable by fine and
prison, executives at firms are reluctant to engage in the practice. The meetings
of business leaders are almost always in the presence of attorneys in order to
avoid the accusation of collusion.

Forming Cartels
Businesses that collude may form cartels. A cartel is a group of businesses
that effectively function as a single producer or monopoly able to charge
whatever price the market will bear. Probably the best-known modern cartel is
the Organization of the Petroleum Exporting Countries, or OPEC. OPEC is
made up of thirteen oil-exporting countries and is thus not subject to the antitrust
laws of the United States. OPEC seeks to maintain high oil prices and profits for
their members by restricting output. Each member of the cartel agrees to a
production quota that will eventually reduce overall output and increase prices.
OPEC is bad news for anyone who enjoys cheap gasoline.
Fortunately for consumers, cartels have an Achilles’ heel. The individual
members of a cartel have an incentive to cheat on their agreement. Cartels go
through periods of cooperation and competition. When prices and profits are
low, the members of the cartel have an incentive to cooperate and limit
production. It is the cartel’s success that brings the incentive to cheat. If the
cartel is successful, the market price of the commodity will rise. Individual
members driven by their own self-interest will have an incentive, the law of
supply, to ever-so-slightly exceed their production quota and sell the excess at
the now higher price. The problem is that all members have this incentive and
the result is that eventually prices will fall as they collectively cheat on the
production quota. Cartels must find ways to discourage cheating. Drug cartels
use assassination and kidnapping, but OPEC uses something a little more
civilized. The single largest producer in the cartel is Saudi Arabia. Saudi Arabia
also has the lowest cost of production. If a member or members cheat on the
cartel, then Saudi Arabia can discipline the group by unleashing its vast oil
reserves, undercutting other countries’ prices, and still remain profitable. After a
few months or even years of losses, the other countries would then have an
incentive to cooperate and limit production once again.
GAME THEORY
I’d Like to Buy a Vowel, Please

Economists have discovered that game theory is useful for understanding the
behavior of oligopolists. Game theory looks at the outcomes of decisions made
when those decisions depend upon the choices of others. Game theory is a study
of interdependent decision-making.

THE PRISONER’S DILEMMA

One game that is particularly applicable to the study of oligopoly is the

prisoner’s dilemma.
Two men, Adam and Karl, are picked up by the police on suspicion of
burglary. The chief investigator knows that she has little evidence against the
men and is counting on a confession from either one or both in order to
prosecute them for burglary. Otherwise, she can only prosecute them for
unlawful trespass.
Upon entering police headquarters, the men are immediately separated and
taken to different rooms for interrogation. The interrogator individually informs
Adam and Karl that if one confesses to the crime and implicates his partner
while the other remains silent, then the one who confesses will receive a two-
year jail sentence while the silent partner will likely serve a ten-year sentence in
a notorious prison. If both confess then they will likely each serve a three-year
prison sentence.
What is the best strategy for Adam and Karl? If they could get together and
collude, both would probably decide that it would be wise to remain silent and
serve a one-year jail term for unlawful trespass. However, they are unable to
serve a one-year jail term for unlawful trespass. However, they are unable to
collude, so they each must consider their options. Adam thinks to himself, “If I
confess, then I’ll either go to jail for two years or three years. If I’m silent, then
I’ll either spend a year in jail or go to prison for ten years.” Karl thinks exactly
the same thing. Because they are separated and have no idea what the other is
doing, they both confess in order to avoid a possible ten-year prison sentence.
They both end up doing three years in jail. This logical conclusion is referred to
as a dominant strategy.

GAME THEORY IN BUSINESS

Some business decisions follow the same logic. Assume in an isolated small
town there are only two gas stations and they are out of direct sight from each
other. By law they are only allowed to change their price once a day. Each firm
has two pricing options available to them. They can charge a high price or a low
price. From past experience they know that when they both charge a high price,
they both profit by $1,000. When one charges a high price and the other a low
price, then the high-priced station earns $300 in profits while the low-priced
station earns $1,200. When they both charge a low price, then profits are $750
for each.
If given the chance to collude, which strategy would they both take? Given
collusion, both would agree to set a high price for gas and each would earn daily
profits of $1,000. What should the gas stations do if they are unable to collude?
The thinking goes like this: “If I charge a high price, I’ll either earn $1,000 or
$300. If I charge a low price, I’ll either earn $1200 or $750.” Because the firms
are out of sight from each other and have no legal way to know the other’s
pricing strategy, then their best course of action or dominant strategy is to set a
low price, which guarantees at least $750 in profits and as much as $1200. Just
like in the prisoner’s dilemma, when the players do not have the ability to
collude, they select a strategy that results in an outcome that is not necessarily
the one that maximizes profits.
the one that maximizes profits.
Unlike the prisoner’s dilemma, which is a one-time game, firms compete
against each other day after day. Given the chance to play the “game” over and
over results in something called tacit collusion. By playing a game of tit for tat,
the firms can eventually reach a point where they both charge a high price and
maximize their profits. How does it work?

1. Assume that on the first day, both gas stations charge a high price. Both
earn profits of $1,000.
2. On the second day, one of the stations charges a high price, but the other
cheats and charges a low price to earn profits of $1,200.
3. Predictably, the next day the other station retaliates and lowers its price,
resulting in profits of $750 for each.
4. Eventually both gas stations come to the realization that if they both set a
high price and do not cheat, they both will earn higher profits in the long
run. They learn that if they cheat, their additional profit for the next day
will not offset the lower profits that will ensue.
PRICING BEHAVIORS
Money, Money, Money

Businesses engage in many pricing (and non-price-related) competitions in order

to increase their profits. The pricing behaviors they choose are related to the type
of market they’re in, whether an oligopoly or a monopoly.

PRICING AND OLIGOPOLIES

Interdependence leads oligopolists to behave strategically. The strategic pricing
behaviors that occur in oligopoly include price leadership and price wars. In
addition to these pricing behaviors, oligopolies also engage in non-price
competition. The purpose of these price and non-price behaviors is the same,
however, and that is to maximize oligopolistic firms’ profits.

Price Leadership
Price leadership takes place when a dominant firm makes the pricing decision
for the rest of the market. These decisions are often made public long before the
new price goes into effect, and represent a form of tacit collusion. Smaller firms
in the industry will usually follow suit and match the price leader’s price. Price
leadership offers firms an opportunity to capture a price that is higher than
would occur if the firms directly competed on price. Consumers usually fare
better under price leadership than they would if the firms formed a cartel but
worse than if they were highly competitive.

Price Wars
Price wars occur when firms break out of the price leadership model and
begin undercutting one another’s prices. Although it sounds bad, price wars are
begin undercutting one another’s prices. Although it sounds bad, price wars are
often advantageous to consumers because of the competitive prices created in
the process. Some firms have been accused of financing price wars by raising
prices in one part of their market in order to cut their price in another part of
their market. A price war continues until the firms once again reach tacit
collusion and return to the price leadership model.

Product Differentiation
While in the price leadership operating mode, firms compete on the basis of
product differentiation as opposed to price. By emphasizing their product’s
differences and uniqueness, firms attempt to wrest market share from one
another. As in the monopolistically competitive market, oligopolists engaging in
non-price competition will spend large sums on advertising. For example, the
major American beer brands do not compete on price, but instead rely on non-
price competition in the form of advertising in order to gain market share from
one another.

PRICING AND MONOPOLIES

On the opposite end of the spectrum from perfect competition lies monopoly. As
the name suggests, monopoly is a market dominated by a single seller. In the
United States, monopolies are generally not allowed to exist, and every effort is
made by government regulators at the FTC to prevent their creation. The reason
for this prohibition is that monopolies create a serious problem for both
consumers and likely competitors in the marketplace. Despite the fact that
monopolies are undesirable, there are several good reasons for some to exist.
The following are the primary reasons for the existence of most monopolies in
the United States:

economies of scale
geography
 government protection
government mandate

Price Increases
Monopoly occurs when a competitive firm eliminates all competition.
Through control of key resources, mergers, and even a little help from
government, once-competitive firms may find themselves in the enviable
position of being a monopolist. A typical pricing behavior for a monopoly is to
increase prices as much as possible.
John D. Rockefeller’s Standard Oil Trust is probably the most notable
American monopoly. By controlling the resource, purchasing the competition,
and having political influence, Standard Oil at its height of power virtually
controlled all oil production in the United States. This was good for Mr.
Rockefeller as it made him the world’s wealthiest man, but for consumers and
possible competitors, the results of the Standard Oil Trust were high prices,
inefficient production, and significant barriers to entry. Eventually, the Sherman
Antitrust Act was used to break up Standard Oil, and ever since the government
has taken an active role in preventing further monopolies.

Price Discrimination
Because they lack competition, monopolies can engage in price discrimination
to make it difficult for other firms to do business. Price discrimination is the
ability to charge different customers different prices for the same good or
service. For example, a railroad monopolist could charge different rates to
different customers for carrying the same amount of freight. Today, thanks to the
Clayton Antitrust Act, price discrimination for the most part is illegal.
Some forms of price discrimination still exist because they are seen as
acceptable.
You might have benefited from price discrimination the last time you went to
a movie theater or flew on an airplane. Senior citizen, student, and military
discounts are usually offered at theaters. Business travelers and vacationers often
discounts are usually offered at theaters. Business travelers and vacationers often
pay very different prices for tickets on the same flight even though they might
both fly coach. How do the airlines get away with it? It is defensible because
vacationers and business travelers have different elasticities of demand for
airline tickets. Vacationers have elastic demand for tickets because they are able
to book travel months in advance and are often willing to purchase
nonrefundable fares. Business travelers’ demand is much more inelastic, and
thus they are willing to pay the higher price for the convenience of refundable
fares and the privilege of booking tickets at short notice. By being allowed to
charge different prices for basically the same ticket, the airline is able to better
ration tickets between those who need a ticket and those who want a ticket.
MONOPOLY: THE GOOD, THE
BAD, AND THE UGLY
Not Just a Board Game

Monopoly isn’t always a bad thing. Then again, it isn’t always a good thing.
Sometimes monopoly is downright ugly, unless of course, you are the proud
parent of a monopoly. When monopoly is allowed to exist, it is for a good
reason. Yet, even though the reason is good, monopolies can have some negative
effects. History has shown that left unchecked, monopolies can harm an
economy.

THE GOOD
Good monopolies come in several forms depending on the type of output
(good/item/service) being produced.

Natural Monopoly
The first is natural monopoly. When the average cost of production falls as a
factory grows larger, then economies of scale are present. Natural monopoly
exists when economies of scale encourage production by a single producer. A
commonly cited example of natural monopoly is your local electrical utility. A
feature of power plants that encourages natural monopoly is that as the size of a
power plant increases, the cost per kilowatt hour of electricity falls. You might
own a small electrical generator. Imagine the cost of operating the generator or
multiple small generators just to meet your home’s electrical needs. Now
imagine the cost of every household in a city running on multiple portable
generators. The total fixed cost of generators for the community would be quite
generators. The total fixed cost of generators for the community would be quite
high, and the variable cost of running gas or diesel generators would be
astronomical.
Compare that situation with the one that most likely exists in your city.
Instead of multitudes of portable generators, a few large coal-fired power plants
are able to generate electricity for the entire city at a much lower total cost.
Remember that utilities are monopolies. What keeps the utility from charging a
monopoly price for electricity? Government regulates the prices that utilities are
able to charge their customers for electricity. By controlling prices, government
encourages low-cost production while allowing the utility to experience an
accounting profit on production.

Technological Monopoly
The technological monopoly is another form of monopoly that is encouraged.
When a firm invents a new product or process and receives patent protection, the
firm becomes a technological monopolist for that particular product. According
to the U.S. Patent and Trademark Office, patent protection lasts for twenty years
from the date on which it was originally applied. During that period of time, no
other firm may develop or import the technology. The patent holder may
develop or sell the rights to develop the technology to a firm that can legally
operate as a monopolist.
During the period of patent protection, the patent holder as a monopolist can
charge a monopoly price and earn economic profits. If monopoly prices are
higher than competitive prices, why is this encouraged? Patent protection
encourages innovation, invention, and research and development. Without the
protection, firms would have little incentive to invest billions of dollars in
research knowing the firm next door could just copy the product without having
made the investment and profit nonetheless. It is because of patent protection
and the ability to earn monopoly profits that American and European
pharmaceutical companies develop so many life-saving medications. Without
patent protection, there would be little incentive for the pharmaceutical industry
patent protection, there would be little incentive for the pharmaceutical industry
to pursue its research.

THE BAD?

At times government may decide to step into the marketplace in order to provide
a good or service. An example of government monopoly is the U.S. Postal
Service.

The U.S. Postal Service’s Monopoly

You may wonder why the USPS is considered a monopoly when

other delivery companies exist. What about UPS and FedEx? Only
the U.S. Postal Service is allowed to deliver a “letter” written on
paper and delivered in a paper envelope. UPS and FedEx are in the
package delivery business, even if that package is a letter written on
paper and delivered in a flat paper-cardboard envelope.

Other examples of government monopoly include the various departments and

agencies of the executive branch. Much of what they do and provide could be
done by the private sector of the economy, but for many reasons the government
has deemed them to be government functions.
The arguments for and against government monopolies fall mainly on
philosophical grounds. Many conservatives and libertarians are opposed to
government performing the functions of private enterprise on the grounds that
government is wasteful and inefficient. Those with more populist viewpoints
tend to see a need for government performing some of the functions of private
enterprise on the grounds that government is less wasteful and more efficient.
You decide.

The Ugly
 The Ugly
Pure, unregulated monopoly is ugly. A firm that is the sole provider of a good
or service is able to prevent competition. It can charge whatever price the
consumer will pay. This is the monopoly that is most harmful to society.
Although one may say “to the victor go the spoils,” once-competitive firms that
become monopolists need to be checked by regulation or broken up into
competing firms. Competition benefits society by providing a variety of goods
and services at competitive prices that accurately reflect the costs of production.
Pure monopoly is the opposite of this condition. Pure monopoly is one good at a
price that in no way reflects the true cost of production.
The diamond monopoly of De Beers is the classic example of monopoly gone
bad. De Beers at the height of its power dictated the diamond industry. By
controlling the resource and coercing the wholesalers and cutters to abide by its
demands, De Beers created an illusion of scarcity and value in the diamond
market that allowed it to earn economic profits for over 100 years. Now, before
you sell your diamonds in disgust, you should remember that you were not
coerced to buy the diamond. You bought the diamond because the benefit
outweighed the cost. The problem for the buyer is that you never realized how
much of the cost was De Beers’s profit.
GOVERNMENT IN THE
MARKETPLACE: PRICE
CEILINGS AND PRICE FLOORS
But They Meant Well

From time to time, people will petition government to step in and correct
perceived wrongs in the market. Often this leads to unexpected results. Without
considering how people might respond to incentives, well-intentioned policies
can go astray. Because people are not going to stop acting like people,
governments must consider whether or not their actions create perverse
incentives. Likewise, there are times when the market fails to provide goods or
properly assign costs. This calls for government intervention to either provide or
redirect incentives in such a way that the market functions better. Two
approaches governments use are price ceilings and price floors.

PRICE CEILINGS
In the early 1970s, America was faced with ever-increasing food prices. As a
result, people clamored for the government to step in and halt the increases.
Instead of considering the source of the problem and doing something about that,
government attempted to treat the symptoms. In an effort to alleviate the
suffering of households, the Nixon administration enacted price controls. One
such price control was an effective price ceiling on food. Retailers could not
charge a price higher than the government-mandated ceiling.
A price ceiling is a legal maximum price for a good, service, or resource. At
the time, the theory was that if the government imposed a price ceiling on food,
the time, the theory was that if the government imposed a price ceiling on food,
prices would stop going up and everyone would have the food they wanted at the
price they wanted. Of course, this assumes that people do not behave like people.
Remember that prices are the result of the equilibrium of supply and demand.
Also remember that these two forces are completely shaped by human nature.
The law of demand, which governs consumer behavior, says that as prices
fall, consumers have an incentive to buy more, and as prices rise, consumers
have an incentive to buy less. The law of supply, which governs producer
behavior, says that as prices rise, producers have an incentive to produce more,
and as prices fall, producers have an incentive to produce less.
What effect does a price ceiling have on the market for food? Look at the
incentives. A price ceiling encourages consumers to purchase, but discourages
producers from producing. Assume that meat is currently selling for $5 per
pound. Consumers feel that the price is too high, so they petition government for
a price ceiling of $3 per pound. Representatives, senators, and presidents all like
to get re-elected, so they cater to consumers and enact the price ceiling. The $3
price signals to consumers to purchase more, but signals to producers to produce
less. The result of the price ceiling is a shortage of meat at the price of $3 per
pound. At that price, more meat is demanded than is supplied. Consumers got a
price ceiling of $3, but many consumers did not get any meat at all.

Why Price Controls Are Inefficient

Price controls are inefficient for many reasons. One reason worth
considering is that they increase the need for monitoring and
enforcement. That means increased government bureaucracy,
which does not come cheap. Increased government spending
equals more taxes or more borrowing.

Eventually, America abandoned price controls, but it took a decade to get the
 Eventually, America abandoned price controls, but it took a decade to get the
underlying inflation under control. Even today you still hear of people
demanding that government cap prices of various commodities. As late as 2007,
people were asking for price limits on gasoline. People continue to behave like
people, and they still want low prices. Government and consumers would be
wise to learn from the mistakes of the past and realize that attempts to control
the market result in unintended consequences.

PRICE FLOORS

Consumers are not the only ones who ignore the basics of supply and demand.
Producers have at times called for price floors. A price floor is a legal minimum
price for a good, service, or resource. Probably the best-known price floor is
minimum wage. In the market for resources like labor, households supply and
businesses demand. Politicians representing areas with large populations of
unskilled labor are often pressured by voters to increase minimum wage. It’s
believed that an increase in the minimum wage is justified because employers
will pay the higher wage and maintain the same number of workers. However,
that works only if you assume that people do not behave like people.
For example, suppose that the city council of a major city, under pressure
from voters, raises the minimum wage from the federal minimum to a city
minimum of $10 an hour. Further assume that the equilibrium wage in the inner
city area was already $8 an hour and that in the suburbs it was $11 an hour.
What will happen in the inner city and what will happen in the suburbs? In the
inner city more producers (workers) will be willing to supply their labor at the
higher price, but fewer consumers (employers) will be willing to employ that
labor at the higher price. As a result, a surplus of unskilled labor develops, better
known as unemployment. In the suburbs, the increase in the minimum wage has
no effect, as the equilibrium wage was already $11. In the end, the policy meant
to help the poor helped those who maintained their jobs, but resulted in
unemployment for those who were laid off and those who entered the job market
unemployment for those who were laid off and those who entered the job market
looking for work at $10 an hour.
Interestingly enough, those most in favor of increasing the minimum wage are
often the same people who would be most harmed by the increase. Politicians
know this now and will often pass increases in the minimum wage that keep it
less than the average equilibrium wage for unskilled labor. For example, if the
average market equilibrium unskilled labor wage is $8 an hour, then politicians
will gladly increase minimum wage from $6 to $7.50, knowing that it will have
little economic effect. Yet, they can still put a feather in their cap for “raising”
the minimum wage.
GOVERNMENT IN THE
MARKETPLACE: TAXES AND
SUBSIDIES
The Only Certainties in Life

Government has a power that businesses envy. It is the power to coerce

payment, better known as taxation. The opposite of a tax is a subsidy. A subsidy
is a sum of money given by the government to an industry or business in order to
help support it. Government uses taxes and subsidies not only to raise revenue or
redistribute income but also to shape people’s incentives and to change the
marketplace.

HOW TAXATION SHAPES MARKETS

All effective governments have the power to tax. Taxes can be used as a tool of
microeconomic policy. For example, if government wants to reduce the
production of a certain good, they can tax the producer. This raises the cost of
production for the producer and reduces the supply in the market. Prior to the
Civil War, thousands of different forms of currency were in circulation as there
was no national currency. The war provided impetus for a national currency. In
order to ensure the success of the new greenback, Congress taxed all the other
forms of currency, which had the effect of removing them from the market.
How? Would you issue a dollar if it cost you $1.50?
The government can use taxation to raise revenue without the intention of
reducing production. For example, luxury taxes on expensive goods and services
raise revenue without necessarily affecting the market. If you’re going to buy an
raise revenue without necessarily affecting the market. If you’re going to buy an
expensive automobile, whether you spend $500,000 or $501,000 doesn’t make a
great deal of difference in your purchasing decision.
So-called “sin” taxes (taxes on nonessential but popular products like alcohol
and cigarettes) are intended to generate revenue but they are also intended to
reduce consumption of products considered undesirable (although not illegal) by
the government. High taxes on such goods can lead to black markets in them
(more on that later in the book!).

HOW SUBSIDIES SHAPE MARKETS

Subsidies are used by government to encourage rather than discourage the
production of certain goods and services. Subsidies have the effect of increasing
the supply of the good or service and reducing its price. Many farmers and
ranchers are subsidized by the government. Subsidizing farm goods ensures that
there is always more than enough food and gives American farm exports a price
advantage. Sometimes subsidies are given to owners of farmland to encourage
them not to produce, allowing an artificially lower production of agricultural
goods to keep prices artificially high (good for farmers, not so good for
consumers). Critics of farm subsidies argue that it creates inefficiency and
misallocates scarce resources.

Subsidies Impede Competition

Many poor countries depend on agriculture as their chief export. A

sticking point in WTO negotiations is that industrialized nations want
poor nations to open up to free trade, yet industrialized nations are
reluctant to end farm subsidies. These subsidies make it difficult for
the poor nations to compete.
 Although a large number of government subsidies are agriculture related, not
all of them are. For example, export subsidies are used by governments to help
domestic markets compete internationally. Redevelopment subsidies encourage
producers to locate in certain geographical areas.
Some government subsidies are indirect (such as a tax break or low-interest
loan guarantee) but are still used to implement economic policies and to affect
the market. (Tax subsidies are one reason the income tax code is so
complicated!)

College Loan Subsidies

Some economists argue that subsidized loans and grants for college
students are part of the problem, not the cure. The financial aid
system, while well intentioned, has the effect of increasing demand
for college. As you know, increased demand leads to higher prices.

Other subsidies are directed at consumers rather than producers (for example,
a rent subsidy for a low-income earner). Consumer subsidies are often meant to
protect the disadvantaged rather than to affect supply or demand, but such
subsidies do affect the market.

CONSUMER SUBSIDIES AND THE BLACK

MARKET

Black markets allow illegal trade to occur. Even food subsidies for needy
families are subject to black market activity. Some receiving food assistance will
willingly trade $2 in food assistance for $1 cash. They benefit because they now
have the freedom to purchase what they want. The buyer benefits by purchasing
groceries at half price. The problem with the system is that it is inefficient and
creates disutility for the recipients. The taxpayer wins under a cash payment
creates disutility for the recipients. The taxpayer wins under a cash payment
system because he is able to give the same value of service at a fraction of the
cost. The recipient wins because he is able to buy groceries without the stigma of
having to pay using food stamps, and if he so chooses he can buy other things he
values more.
The obvious argument against a system like this is that some might not buy
food with the food assistance, but instead purchase alcohol, cigarettes, or even
illegal drugs. Consider this example: Assume that a person receiving food
assistance also has an addiction to cigarettes. She receives $100 in food stamps
and immediately sells them on the black market so that she can buy $50 in
cigarettes. In the end, she has $50 in cigarettes and no food. Now assume that a
person receiving food assistance receives $100 cash. He purchases $50 in
cigarettes, but now has $50 left for food. He is better off and the taxpayer is
better off. In addition, the cash payment system removes the black market and is
much less expensive to administer.
MARKET FAILURES
Come on and Take a Free Ride

Sometimes the market fails to provide a necessary good or service or fails to

properly assign costs. Economists refer to this as a market failure. Government
has the capacity to step in and deal with such market failures in a variety of
ways.

PUBLIC GOODS

Sometimes the market does not provide a good or service that people want. If a
good is non-rival and non-excludable, the free market will probably not provide
it.

A good or service is non-rival when one person’s consumption of the good

or service does not diminish another’s consumption of the good or service.
For example, when you go to the movie theater, the presence of another
person does not diminish your ability to consume the service, unless of
course he has a screaming infant on his lap. A candy bar is an example of a
rival good. If you eat the candy bar, then another consumer cannot.
A good is non-excludable if the producer can’t withhold it from those
unwilling to pay for it. Public highways are an example of a non-rival, non-
excludable good. (The movie theater is a good example of a non-rival but
excludable good.) A private firm has little incentive to produce a public
highway at its own cost. Therefore, it is up to government to provide these
types of goods.

POSITIVE EXTERNALITY
 POSITIVE EXTERNALITY

Sometimes the production of a good or service creates a spillover or unintended

benefit for someone who is neither the producer nor the consumer. Such a
spillover benefit is called a positive externality. Assume you live in a typical
American neighborhood. If your neighbors were to landscape and remodel their
home in such a way that significantly increased its value, you also would benefit.
Your home would also appreciate in value, but you paid nothing for the increase.
Flu vaccines create a positive externality as well. If you’re concerned about
catching the flu, you would go to your doctor and pay for a flu shot. Your
decision to get a flu shot creates spillover benefits for the people around you.
Your immunity reduces the chance that they will contract the disease even
though they did not pay for it. Economists refer to these people as free-riders.
When production of a good or service creates a positive externality, there is
never enough of it. In order to increase the desirable good or service,
government might choose to subsidize its production. Government subsidizes
public schools for this reason. Even though private schools exist, there are not
enough private schools to educate the population. An educated population
creates a positive externality, so government subsidizes education for all
children. Businesses in America do not have to teach their workers to read the
employee manual or compute math problems.

NEGATIVE EXTERNALITY

Negative externalities occur when the production or consumption of a good or

service creates spillover costs to society. Pollution is an example of a negative
externality of the production process. For example, a shoe manufacturer
produces shoes, but it also produces air pollution that is released outside the
factory. When the firm sells the shoes to its customers, the cost of the pollution
is not factored into the price of the shoes. People living near the factory bear part
of the cost of production in the form of pollution, but do not receive payment for
the shoes that the factory makes. When a firm’s production creates a negative
externality, there is too much of the good being produced. In a situation like this,
government can tax the producer to reduce the amount of shoes, and pollution,
produced.

BLACK MARKETS

Despite the best efforts of government, whenever and wherever government

attempts to control prices or meddle with the forces of supply and demand, you
can be sure a black market (illegal trade) will develop. Markets develop when
there is a supply of and a demand for a product. It does not matter what it is. If
someone makes it and people want it, there is a market for it. Furthermore, if
government intervention creates surpluses or shortages, some enterprising
individual will step in and provide a means of circumventing government and
clearing the market.

Thwarting Price Ceilings

When government establishes a maximum price, shortages result for the good
or service. This shortage is remedied by the market. In New York City, a system
of rent controls dating back to World War II is still in place. As a result, very
desirable apartments can be rented at extremely low prices. But at the low prices,
very few apartments are available. People with significant income might be
willing to rent some of these apartments, but are unable to do so legally. The
market has responded with black market subletting. A renter benefiting from the
rent control will turn around and sublet the apartment to a renter willing to pay a
much higher rent (which is still lower than average). Recall that voluntary trade
is wealth creating, so both the new renter and the original renter benefit from the
transaction. In addition, the landlord is no worse off than before the sublet
occurred. Yet the city of New York actively pursues these illegal sublets. Every
year, the city uses scarce resources to enforce this system of price controls. A
year, the city uses scarce resources to enforce this system of price controls. A
solution would be to remove the rent controls and allow the market to determine
the price of rent.
Sporting events also provide an example of the inefficient outcome created by
price controls. Who wants to see an event more, someone willing to pay $50 or
someone willing to pay $1,000? When ticket prices are limited, those willing to
pay more are forced to compete with those who would actually receive less
utility from seeing the event.

Thwarting Price Floors

Markets also develop to thwart price floors. Workers willing to work for less
than minimum wage might resort to contract labor or receiving illegal cash
payments. Situations where workers are forced to accept low wages or face
deportation are not mutually beneficial, nor are they voluntary. Exploitation
occurs when one party to a transaction is unable to freely choose whether or not
to engage in the transaction. Assuming that the transaction is voluntary, both
business and workers benefit. If the transaction were not mutually beneficial,
then it would not occur.
FINANCIAL MARKETS AND
LOANABLE FUNDS THEORY
What’s Behind the Curtain?

Have you ever wondered what the people on the news are talking about when
they say something like, “The Dow Jones Industrial Average closed up 30 points
today on heavy trading. The S&P 500 also edged higher. The NASDAQ was
mixed. Foreign markets opened lower on news that the Fed will maintain near-
zero interest rates for the foreseeable future. Corporate bond prices sank as many
issues were downgraded while the yield on the ten-year treasury ended lower”?
If you subscribe to the Wall Street Journal or Financial Times, or regularly
watch CNBC, Bloomberg, or the Fox Business channel, you probably
understand the lingo. But if you’re like many Americans, the financial markets
are a complete mystery. Even though they appear complicated, financial markets
serve a very basic purpose: to connect the people who have money with the
people who want money.

LOANABLE FUNDS THEORY

Economists offer a simple model for understanding financial markets and how
the real interest rate is determined. (Remember that the real interest rate is the
amount of nominal interest left standing after the rate of inflation is accounted
for/subtracted.) Like many bright ideas economists come up with, this model is
purely imaginary but it helps to explain what happens in financial markets. The
hypothetical market they’ve identified is referred to as the loanable funds
market. It exists to bring together “savers” and “borrowers.” Savers supply and
borrowers demand. The real interest rate occurs at the point where the amount
borrowers demand. The real interest rate occurs at the point where the amount
saved equals the amount borrowed.
According to the law of supply, producers are only willing to offer more if
they can collect a higher price because they face ever-increasing costs. In the
loanable funds market, the price is the real interest rate. Savers, the producers of
loanable funds, respond to the price by offering more funds as the rate increases
and less as the rate decreases. Borrowers act as consumers of loanable funds—
their behavior is explained by the law of demand. When the interest rate is high,
they are less willing and able to borrow, and when interest rates are low, they are
more willing and able to borrow.

Money Talks
investment
Newcomers to economics are often confused by the use of the term
investment. In economics, investment means borrowing in order to
purchase physical capital. If the topic is stocks and bonds, then
investment is understood to mean pretty much the same thing as
saving. Savers engage in financial investment, which provides the
funds for borrowers to engage in capital investment.

According to the expanded view of the loanable funds theory, savers are
represented by households, businesses, governments, and the foreign sector.
Borrowers also are represented by these same sectors. Changes in the saving and
borrowing behavior of the various sectors of the economy result in change in the
real interest rate and change in the quantity of loanable funds exchanged. For
example, a decision by foreign savers to save more in the United States results in
a lower real interest rate and a greater quantity of loanable funds exchanged for
the country. A decision by the U.S. government to borrow money and engage in
deficit spending would increase the demand for loanable funds, and result in a
deficit spending would increase the demand for loanable funds, and result in a
higher real interest rate and a greater quantity of loanable funds exchanged. The
loanable funds theory of interest rate determination is useful for understanding
changes in long-term interest rates.

LIQUIDITY PREFERENCE
John Maynard Keynes’s liquidity preference theory explains short-term nominal
interest rates. Instead of looking at saving and borrowing behavior as the
determinant of interest rates, Keynes taught that short-term interest rates are a
function of consumers’ liquidity preference or inclination for holding cash. In
Keynes’s theory, the money market, as opposed to the loanable funds market,
was central to explaining interest rates.
The money market is where the central bank supplies money, and households,
businesses, and government demand money at various nominal interest rates.
Central banks like America’s Federal Reserve act as regulated monopolies and
issue money independent of the interest rate. Liquidity preference is the demand
for money. At high nominal interest rates, people would rather hold interest-
bearing non-cash assets like bonds, but as interest rates fall, people are more
willing to hold cash as an asset because they are not sacrificing much interest to
do so.

Economic Theories Compete, Too

Why are there two theories of interest rate determination?

Economists have competing theories for many economic
phenomena. Interest rates are just one of many concepts on which
economists have differing points of view. The loanable funds theory
is associated with classical economics, whereas the money market
theory is associated with Keynesian economics.
 If the Fed wants to lower the nominal interest rate to encourage investment
and consumption, they increase the money supply, and if they wish to raise
nominal interest rates in order to curtail investment and consumption, they
decrease the available supply of money. Increases or decreases in the nominal
gross domestic product cause the demand for money to either increase or
decrease.
Assuming that the Fed holds the supply of money constant, increases in
money demand result in a higher nominal interest rate, whereas decreases in
money demand reduce the nominal interest rate.
THE MONEY MARKET
I’ll Have a T-Bill with a Side of Fries

As previously described, the money market is where the central bank supplies
money, and households, businesses, and government demand money at various
nominal interest rates. Firms, banks, and governments are able to obtain short-
term financing in the money market. Securities (financial instruments such as
stocks and bonds) with maturities of less than one year are included in this
market.

COMMERCIAL PAPER
Businesses with excellent credit can easily borrow in the money market by
issuing commercial paper, which is nothing more than a short-term IOU. For
example, Behemoth Corporation is expecting payment from its customers at the
end of the month, but has to pay its employees before then. In this case,
Behemoth Corporation can issue commercial paper in exchange for cash with
which to pay its employees. As soon as the customers make their payment to
Behemoth Corporation, the company can turn around and repay whoever holds
its commercial paper. For the company, commercial paper allows them to
manage their cash flow at a cheaper rate than taking on longer-term debt would
allow, and for the lender it provides a liquid and relatively safe way to earn some
interest on their extra cash.
Commercial paper is an unsecured debt, meaning that it doesn’t represent any
type of ownership interest and no collateral is offered in exchange. You’re
repaid by cash flow (as in the example just presented, once the customers pay
Behemoth Corporation at the end of the month, you’ll get your original
Behemoth Corporation at the end of the month, you’ll get your original
investment plus interest back). If the firm defaults on their repayment, you’re
stuck without a lot of good options. It’s not as if you can send out the
neighborhood repo guy and seize the office furniture.
Companies with less-than-perfect credit have to offer higher interest rates in
order to get any takers, who will be assuming more than the usual risk. Demand
is much greater for higher-rated commercial paper. Commercial paper is usually
sold in big chunks (say, $100,000 per issue), the interest is taxable, and the
Securities and Exchange Commission (SEC) doesn’t regulate their sale. This is
why money market funds are popular with private investors (the little guys like
you and me). They allow for diversification, spreading the risk out over a
number of different commercial paper investments.

TREASURY BILLS
Like corporations, sometimes the U.S. government needs a little cash on hand to
make the wheels of governance run smoothly. When it does, it auctions Treasury
bills (T-bills) for its short-term cash needs. The T-bills have various maturities
of less than one year. Investors like T-bills because they allow them to earn risk-
free interest while maintaining liquidity in case they need their cash quickly for
other purposes. The government benefits because T-bills provide the government
with easy access to cash for government spending, and what government doesn’t
love easy access to cash?

How Discounting Works

T-bills are different from other forms of government securities in that

they are sold at a discount from face value. T-bills have a face value
of $1,000, but buyers pay less than that. The difference between the
face value and the amount paid represents an interest payment. For
example, if Rich Personne buys a 52-week $1,000 T-bill for $950, he
 example, if Rich Personne buys a 52-week $1,000 T-bill for $950, he
will receive interest of $50 at maturity, which is equivalent to earning
5.26% on a $950 investment.

FEDERAL FUNDS
Banks, like any other business, sometimes have to have access to more cash than
they have tucked away in the vault. To meet their short-term financing needs,
they lend and borrow federal funds, also known as fed funds. Banks may borrow
from each other in the fed funds market to satisfy their legal reserve
requirements or to meet their contractual clearing balances. This component of
the money market is important for maintaining bank liquidity. It also increases
efficiency by encouraging banks to put all of their available excess reserves to
work earning a return. Because banks keep most of their reserves on deposit with
the Fed, the exchange of these federal funds occurs almost immediately as the
banks exchange their reserve balances between each other. The Federal Reserve
affects this market by influencing the fed funds rate, which is the interest rate
banks charge each other for the use of overnight federal funds.
THE BOND MARKET
Call Me Bond, Coupon Bond

For long-term financing, governments and firms are able to borrow in the bond
market. When investors buy bonds, they are lending money to sellers with the
expectation that they will be repaid their principal plus interest. For bond issuers,
the bond market provides an efficient means of borrowing large sums of money.
For the buyer, bonds provide a relatively secure financial investment that
provides interest income.

FEDERAL GOVERNMENT BONDS

You are probably familiar with two types of bonds:

Coupon bonds are sold at or near face value and provide guaranteed interest
payments.
Zero coupon bonds are sold at a discount from face value and pay face
value at maturity.

Either type makes an attractive investment for people seeking interest income
while preserving their principal. The ability to sell bonds on the secondary
market makes them relatively liquid, which is also important to investors.
The U.S. government issues several types of bonds with maturities greater
than a year. Treasury notes and Treasury bonds are primary sources for
financing the federal budget.
 Treasury notes are medium-term securities with maturities ranging from
two to ten years.
Treasury bonds are long-term securities that mature after thirty years.

The interest rate on the ten-year Treasury note is important because it serves
as a benchmark interest rate for both corporate bonds and mortgages. As the
interest rate on the ten-year Treasury note fluctuates, corporate rates and
mortgage rates fluctuate as well.
In addition to the Treasury, independent agencies of the U.S. government are
able to borrow by issuing bonds. Although they lack the guarantee of repayment
that Treasury securities have, agency securities are backed by the government
and as such are seen as virtually guaranteed. The Federal National Mortgage
Association (Fannie Mae), the Federal Home Loan Mortgage Corporation
(Freddie Mac), and the Student Loan Marketing Association (Sallie Mae) are
well-known agencies that issue bonds in order to finance their operations.
Agency securities provide an alternative for investors looking for the security of
government bonds but with higher interest rates.

STATE AND LOCAL GOVERNMENT BONDS

State and local governments are also able to borrow through the bond market.
Municipal bonds often finance schools, roads, and other public projects. The
interest paid on the municipal bonds is exempt from federal income taxes, which
makes them attractive to investors. Because the interest is tax exempt, municipal
bonds do not have to offer as high an interest rate to attract investors. As a result,
state and local governments are able to borrow more cheaply than the private
sector.

CORPORATE BONDS
Firms are able to borrow in the bond market by issuing corporate bonds.
Firms are able to borrow in the bond market by issuing corporate bonds.
Corporate bonds provide businesses with the money they need for capital
investment without having to arrange bank financing. In addition, corporate
bonds allow for businesses to obtain funds without diluting ownership in the
company. The chief advantage of bonds is that they provide firms with financial
leverage. For example, if a company has $1,000 to invest in capital and can
expect a return of 10%, the company will earn $100 from the investment. If,
however, the firm borrows $1,000,000 and invests in capital that returns 10% a
year, the firm is able to earn $100,000 without risking its own money. Because
firms lack the ability to tax to repay bonds (and therefore occasionally default on
them), investors require a higher interest rate on corporate bonds than on
Treasury and municipal bonds to offset the increased risk.

BOND RISKS
Bonds are not without their downsides. Investors face investment risk, inflation
risk, interest rate risk, and the risk of early call (early call means the issuer can
recall [“retire”] the bond before the expected maturity date).

Since the possibility exists that governments or firms may fail to pay back
their borrowed money, all bondholders face investment risk.
If the rate of inflation increases during the life of a bond, the investor’s
return is offset by the inflation.
If interest rates increase during the life of a bond, the value of the bond
decreases until its effective yield equals the new higher interest rate. For
bondholders, this means that they might lose principal if they try to sell it
before maturity.
If interest rates decline during the life of a bond, the issuer may find it
beneficial to retire or call the old bonds and refinance at the new lower
 interest rate. For bondholders, this means that they lose out on earning the
higher interest they would have had when the bond matured.

Prospective investors rely on rating agencies to determine the quality of the

bonds. Moody’s, Standard & Poor’s, and Fitch rate bonds from “prime” to
“investment grade” to “junk,” and all the way to “in default.” As a bond’s rating
falls, the issuer must reward the investor with a higher interest rate to
compensate for the additional risk. The rating agencies provide a useful service
and provide much-needed information for the consumer.
However, consumers should not rely only on bond ratings. Serious questions
have arisen from the 2008 financial crisis about the rating process. During that
time, many bonds were so quickly downgraded that investors who believed they
were holding prime-rated bonds discovered that they had junk bonds within a
short period of time.

INTEREST RATES REVISITED

Interest rates are made up of several components: the real rate, expected inflation
premium, default risk premium, liquidity premium, and maturity risk. The real
rate and the expected inflation premium make up the risk-free rate of return. This
risk-free rate of return acts as the benchmark on which all other interest rates are
based. Today the various bonds issued by the U.S. Treasury are the proxies for
the risk-free rate of return.
Treasury securities have this distinction because the United States has never
defaulted on its debt in its 220-plus-year history, and the secondary market for
U.S. Treasury securities is considered “deep” because it is backed by the full
faith and credit of the United States. The importance of the secondary market in
the Treasury cannot be understated. Because so many governments, banks,
businesses, and individuals desire U.S. Treasury securities as a risk-free place to
park their money, a condition is created where there is no doubt to the liquidity
of the securities. The only appreciable risk faced by the holders of Treasury
of the securities. The only appreciable risk faced by the holders of Treasury
securities is maturity risk. The longer the term of a bond, the greater the chance
that interest rates will change from the one that existed at the time of purchase. If
interest rates were to unexpectedly rise during the life of the bond, the value of
the bond would decrease. As new bond prices fall, the effective interest rate on
the bonds increase, which makes previously issued bonds less attractive. This, in
turn, makes them less valuable.
THE STOCK MARKET
Taking Stock of Companies

Of all the financial markets, none receives as much media coverage as the stock
market. Unlike bond markets, where investors are making loans to governments
and firms, the stock market is where investors are able to purchase partial
ownership in firms represented by shares of stock.

STOCKS, SIMPLIFIED

Companies that are privately held don’t issue stock for public purchase. Instead,
they keep the shares among a small group of owners, often the founders. But for
companies that want or need outside investment, trading on one of the stock
exchanges is a good way to do this.

Firms are able to raise the money they need for capital investment by
issuing stock in an initial public offering (IPO).
Investors purchase the stock with the expectation that it will either pay
dividends or earn capital gains. Investors earn dividends when a company
divides a portion of the profits among all of the owners according to the
number of shares each owns. For example, if there are 100 shares of stock
for a company, and the firm earns profits of $1,000,000 and decides to
distribute half of the profits to its shareholders while reinvesting the other
half, each share will earn a dividend of $500,000/100 or $5,000.
Stock earns capital gains when it is sold at a higher price than for what it
was purchased. Suppose you purchase a share of General Motors for $35.75
and a few months later, GM announces a hot new car that runs on sunlight
 rather than gasoline. It seems likely that GM will earn lots of lovely money
selling that car, so people want to buy stock in the company. Demand
drives the price of the stock higher. When it reaches $50.25, you decide to
sell and realize a capital gain of $14.50.

Money Talks
stock options
Stock options are a type of derivative that allow for the purchase of
shares of stock at a predetermined price. Companies often issue
stock options to key employees as a reward for performance. The
recipients can either sell their option contract on the options
exchange or wait and exercise their option when the share price of
the stock increases.

The majority of stock purchases and sales occur in the secondary market.
When you place an order to buy stock, you are most likely buying shares that
were previously owned by another individual. If Tina buys Coca-Cola stock in
the market, she is buying it from someone else, not Coca-Cola. If she pays $150
for two shares of Coca-Cola stock, some other investor who sold the stock will
receive $150, but Coca-Cola will receive nothing. The only time the firm
receives money in a stock purchase is through an IPO or when the firm sells
stock that it had repurchased earlier.

TYPES OF STOCKS

Companies issue two types of stock, common or preferred. Common stock

provides investors with partial ownership of a firm and also grants them the right
to vote for the firm’s leadership. Preferred stock also provides an ownership
claim on a firm, but does not allow for voting privileges. Preferred stock is so
claim on a firm, but does not allow for voting privileges. Preferred stock is so
named because preferred stockholders get paid before common stockholders
when it comes time to pay dividends. The decision to issue common stock or
preferred stock is influenced by the possible downsides of each. Because
common stock allows shareholders a voice in corporate governance, the original
founders of a firm might find themselves displaced if new common stockholders
gain either a majority or plurality of the shares and elect new leadership.
Because preferred stock guarantees dividends to shareholders, firms seeking to
grow by reinvesting profits in the company might be hindered by this liability.

SO WHAT’S THE POINT?

Ultimately the function of these various markets is to allow savers to connect

with borrowers. Businesses seeking to expand their capital investment look to
the bond market and stock market as a source of needed funds. Firms are very
conscious of their operating cost, so finding the appropriate combination of stock
and bond financing, or capital structure, with which to finance investment is
important both to the business and the economy as a whole.

Interest Rate and Investment

There is an inverse relationship between the interest rate and

investment. The lower the interest rate, the lower the cost of capital,
and the more firms are able to invest in physical capital. Likewise, as
the interest rate increases, the cost of capital increases, and firms
become less willing to invest in physical capital.

Are low interest rates enough to encourage investment? Unfortunately, the

answer to that question is no. A firm’s decision to invest in capital is also
conditioned on the expected rates of return. If firms expect higher rates of return,
conditioned on the expected rates of return. If firms expect higher rates of return,
they are more willing to invest at each and every interest rate. If firms think there
is little chance to earn a profit, then they are much less willing to invest in
capital.
Here’s a way of looking at the effects of interest rates and expected rates of
return on a business. Imagine that the expected rate of return is the pressure
applied to a car’s gas pedal and the interest rate is the pressure applied to the
brake pedal. Increased profit opportunities are represented by pressing down on
the gas pedal and decreased profit opportunities are represented by letting your
foot off of the gas pedal. Similarly, increased interest rates are represented by
pressing down on the brake pedal, lower interest rates are represented by putting
less pressure on the brake pedal, and zero interest rate is analogous to not putting
any pressure on the brake pedal. If interest rates are low and expected profits are
high, the business moves forward with investment and grows. If, however, the
interest rate is higher than the expected rate of return, firms are stationary. In the
end, increases in the expected rate of return will accelerate investment while
increases in interest rate will slow investment or even bring it to a complete stop.
FOREIGN EXCHANGE AND
EXCHANGE RATES
C’est La Vie, No Es?

Whether you know it or not, foreign exchange is a part of your everyday life.
From the products you buy to the vacations you take, foreign exchange affects
much of what you do. The flow of currency between nations is also a matter of
record keeping. The balance of payments records all of the inflows and outflows
of currency from a country. The sum of net exports, net foreign factor income,
and net transfers is the current account balance, while net foreign investment and
official reserves make up the financial account.

EXCHANGE RATES

What determines the price of apples? If you answered supply and demand, then
you would be correct. What determines the foreign exchange price of a dollar?
Once again, if you said supply and demand, then you are right on target.
Whenever one currency is exchanged for another, foreign exchange has occurred
and an exchange rate has been paid. The exchange rate is nothing more than the
current price of a currency in terms of another currency. For example, $1 may
buy you €0.73, £0.64, ¥89.41, or SFr 1.07.
Exchange rates are determined in the world’s largest market, the foreign
exchange market. Annual trade volume approaches $1 quadrillion (a thousand
trillion), with transactions occurring twenty-four hours a day. The foreign
exchange market is dominated by the British, Americans, and Japanese with the
vast majority of trades occurring in the U.S. dollar. The euro (€), pound sterling
(£), Japanese yen (¥), and Swiss franc (SFr) are the other hard currencies most
often traded.
Who’s involved?

Large banks are the main players in the foreign exchange market, brought
together through a system of interconnected brokers. The banks serve both
corporate and individual customers who need foreign exchange in order to
conduct business.
Central banks also participate in the foreign exchange market in order to
either manipulate exchange rates or to correct imbalances between their
country’s current and financial accounts.
Finally, speculators looking to profit from arbitrage opportunities also
participate in this immense market.

Finding Good Exchange Rates

When traveling, you can often find the best exchange rates on your
credit card or by accessing an ATM. Banks are the major players in
the foreign exchange market and are able to grant their customers
some of the most competitive rates.

Exchange rates are subject to the forces of supply and demand. As exchange
rates rise, people are more willing to sell their currency, but others are less
willing to buy, and vice versa. Appreciation occurs when an exchange rate
increases, and depreciation occurs when exchange rates fall. Changes in
exchange rates can wreak havoc on businesses and entire economies.
Economists and policymakers must therefore consider the implications of their
actions on exchange rates. Tastes, interest rates, inflation, relative income, and
speculation affect exchange rates and thus economies as a whole.
 Taste and Preference
As consumers’ tastes for imported goods change, so does the exchange rate
between the countries involved. The popularity of cars and consumer electronics
from South Korea among American consumers necessarily creates a demand for
South Korea’s currency, the won (W). In order for American importers to
acquire South Korean products, they must supply dollars and demand won in
foreign exchange. The result of this change in tastes is a depreciation of the
dollar and appreciation of the won.
Over time, appreciation of a country’s currency may reduce the popularity of
its products as they become relatively more expensive. Given that people often
prefer relatively cheaper goods, foreign manufacturers that export goods to the
United States might choose to price their products directly in dollars as opposed
to their domestic currency. This helps to insulate the manufacturer from
changing exchange rates, which might reduce their product’s competitiveness on
the American market. German automakers engage in this practice to offset the
effects of the euro’s relative strength against the dollar.

Interest Rates and Inflation

Changes in real interest rates also affect the foreign exchange market. Unlike
trade flows, which tend to be rather stable, changing interest rates can cause
sudden fluctuations in exchange rates. Savers are attracted to high interest rates,
so when one country’s real interest rate rises relative to another country, savings
flow toward the higher interest rate. With all other things equal, increases in
American interest rates relative to Japanese interest rates will cause an increased
supply of yen and increased demand for dollars as Japanese savers seek to earn
higher American interest rates. The result is an appreciated dollar and
depreciated yen. Eventually, the dollar’s appreciation relative to the yen will
offset any gains made off of the interest rate difference. This is referred to as
interest rate parity.

The Cost of Foreign Exchange

 The Cost of Foreign Exchange

Foreign exchange has a definite cost attached to it. If you choose to

participate in the foreign exchange market, know that you will likely
face different exchange rates in buying and selling currencies. So
before you open up a CD in a French bank, consider the cost of
purchasing and selling your euros before cashing in on a higher
interest rate.

The presence of inflation in an economy provides an incentive for its people

to exchange their currency for one that is more stable. Zimbabwe’s inflation has
reduced the value of its currency to the point where a sheet of paper is more
valuable than a single unit of its currency. Rational Zimbabweans trying to store
value will eagerly supply the Zimbabwe dollar for any available currency like
South Africa’s rand. The result of inflation is to not only reduce the value of the
currency domestically but also in foreign exchange.

Relative Income and Speculation

Probably the most counterintuitive outcome results from differences in
economic rates of growth. As an economy’s income increases relative to another
country, the exchange rate between the two changes. For example, if Canada’s
income increases relative to the United States’ income, the Canadian dollar
weakens relative to the U.S. dollar. Why? As Canadians experience higher
incomes, their propensity to import also increases. In other words, as you get
richer, you go shopping more often and supply more currency in foreign
exchange. The counterintuitive outcome is that as an economy strengthens, its
currency weakens, and as an economy weakens, its currency strengthens.

The Strong and the Weak, the Good and the

Bad
 Bad

Over the course of a year you might hear experts lamenting the size
of the trade deficit, while later others might complain of a weak
dollar. Actually, a weak dollar is the remedy for a trade deficit.
Depreciated dollars encourage exports and discourage imports.
Words like strong and weak can be misleading. They do not
necessarily mean good or bad.

Banks, companies, and individuals attempting to profit from foreign exchange

will speculate in the market. For example, a speculator may suspect that
European interest rates will rise faster than American interest rates, so she will
purchase euros and hold them until they have appreciated enough to show a
profit. For most people, however, speculating in foreign exchange is about as
profitable as playing craps in Las Vegas.
Although speculating is risky, speculators do perform an important economic
function by bearing exchange rate risk. Risk-averse companies engaging in
foreign exchange would rather know exactly what exchange rate they will be
paying or earning when conducting transactions. These companies will purchase
a futures contract that guarantees a specified exchange rate in order to avoid
sudden shifts in exchange rates that might reduce the profitability of the
underlying transaction.

The Law of One Price and Purchasing Power Parity

Specialization and trade are based upon comparative advantage, differences in
capital and labor, and diversity in consumption. Exchange rates, however, should
not determine specialization. According to the economic law of one price, or
purchasing power parity, after accounting for the exchange rate, the prices of
similar goods should be the same regardless of where they are purchased.
 Assume that the exchange rate between the U.S. dollar and Swiss franc is such
that $1 = SFr 1.10. In the long run, a pair of snow skis that sell for an average
price of $500 in the United States should therefore sell for an average of SFr 550
in Switzerland. What if the skis were selling in Switzerland at an average price
of SFr 600? Swiss consumers would benefit from importing the skis from
America, supplying Swiss francs and demanding U.S. dollars in foreign
exchange until the exchange rate reflected purchasing power parity.
EXPORTS AND THE BALANCE
OF TRADE
Nothing but Net

In the United States, most producers focus on meeting the demands of the
domestic market. Some, however, produce goods and services for export to
foreign markets. Other businesses import those goods and services for which
there is a demand or the United States does not produce. Half of the United
States’ trade occurs with Canada, Mexico, China, Japan, Germany, and the
United Kingdom.

THE BALANCE OF TRADE

Net exports, or the balance of trade, is equal to the value of all exports minus the
value of all imports. Net exports in the United States are negative because the
value of imports exceeds the value of exports. This is referred to as a balance of
trade deficit.
Other countries like China, Germany, and Japan have balance of trade
surpluses because the value of their exports exceeds that of their imports.
Surprisingly, even though the United States has a balance of trade deficit, it is
still the world’s largest exporter with 12% of the global share, compared to
China with only 6.4%.
The balance of trade can be further broken down into the balance of trade in
goods and the balance of trade in services. For the United States, the balance of
trade in goods is what contributes to the trade deficit. Americans have a
preference for foreign consumer goods and resources. On the other hand, the
United States tends to be a net exporter of services. America’s transportation
United States tends to be a net exporter of services. America’s transportation
services and logistical know-how, as well as engineering, legal, and other
technical services, are exported to the rest of the world.

The Bureau of Economic Analysis

The Commerce Department’s Bureau of Economic Analysis (BEA) is

the government agency responsible for measuring the balance of
trade. According to the BEA, in 2008 the trade deficit measured
approximately $696 billion. This total trade deficit was composed of
an $840 billion trade in goods deficit combined with a $144 billion
trade in services surplus.

Net Foreign Factor Income

Whenever land, labor, capital, and entrepreneurship are employed, they
receive payments of rent, wages, interest, and profits. It doesn’t matter whether
the factors are employed domestically or abroad. When factors of production are
employed abroad or the owners of those factors reside abroad, then the factor
payments require foreign exchange. Regardless of whether it is an inflow of
foreign factor income or an outflow of foreign factor payments, foreign
exchange is required.

Net Transfers
Other actions besides trade require foreign exchange. Transfer payments,
called remittances, and foreign aid create outflows of currency from rich
countries to poor countries in foreign exchange markets. Remittances differ from
foreign factor income in that they are unearned by the recipients. Foreign aid in
the form of cash payments also creates a need for foreign exchange. The United
States’ aid payments to Pakistan, Israel, and Egypt are examples.
 Net Foreign Investment
Unlike net exports, net foreign factor income, and net transfers, which involve
one-time exchanges, net foreign investment creates recurring payments and
income. When citizens of one country purchase the real or financial assets of
another country, it is classified as net foreign investment. Net foreign investment
also includes portfolio investment. Portfolio investment occurs when foreigners
purchase the financial assets of another country. During the recent financial
crisis, the dollar appreciated quickly as foreign investors sought the safety of
U.S. Treasury bills, notes, and bonds. Purchasing shares of stock in foreign
companies is another form of portfolio investment. Because developing
countries often have higher rates of economic growth and higher rates of
interest, financial investors might purchase bonds and stocks in these countries.

The Weak versus the Strong

Which is better, a weak dollar or a strong dollar? It depends. Are you

importing or exporting? Importers benefit from a strong dollar
because it makes foreign goods relatively cheap. Exporters benefit
from a weak dollar because it makes U.S. goods relatively cheap.
So if you are going on a foreign vacation, hope for a strong dollar
while you are there, and then hope it weakens on the flight back so
that you profit on the exchange when you return.

Foreign investment is an important source of savings for the host country.

These savings can be used to invest in physical capital and expand a country’s
economy. This brings up an important point. The balance on the current account
is completely offset by the balance on the financial account.
Foreign investment is not without its downside. Just as easily as savings can
flow into a country through portfolio investment, the savings can flow out. A
sudden outflow of savings may precipitate a currency crisis, inflation, and high
sudden outflow of savings may precipitate a currency crisis, inflation, and high
interest rates for the affected country. This phenomenon has occurred before.
The 2001 Argentine financial crisis is a notable example. Argentina defaulted on
its foreign debt, and soon savings flowed out, which led to financial troubles and
political turmoil as well.

Capital Controls

Countries that fear capital outflows often enact capital controls.

Capital controls limit the ability of savings to flow out of a country.
During the Asian financial crisis of the late 1990s, India fared rather
well as capital controls limited the outflow of savings from the
country. The downside of capital controls is that they provide a
reason for foreign investors to avoid placing their savings in a
country. The mere mention of capital controls is sometimes all it
takes for capital outflow to occur.
OFFICIAL RESERVES AND
EXCHANGE RATE POLICY
Or Why the Euro Exists

In addition to foreign investment, the financial account of the balance of

payments includes official reserves. Central banks, like the U.S. Federal Reserve
System, maintain reserves of foreign currency or official reserves. The purpose
of official reserves is to provide a stabilizing influence in the foreign exchange
market. If a balance of payments deficit occurs, the Federal Reserve reduces its
foreign reserves in order to zero out the balance. In the case of a balance of
payments surplus, the Federal Reserve acquires additional foreign reserves to
zero out the balance.

THE U.S. DOLLAR AS FOREIGN RESERVE

The United States is in the unique position of issuing the reserve currency for the
majority of countries as most countries’ foreign reserve holdings are in U.S.
dollars. The size of China’s and Japan’s official reserves has been a cause of
concern for many in the financial community. As of 2015, these Asian countries
have over $5 trillion worth of reserves. Some politicians, economists, and
financial experts fear that if China or Japan were to reduce their dollar holdings,
a collapse could ensue from a sudden increase in the supply of dollars in foreign
exchange. Others contend that this would be every bit as harmful to the Chinese
or Japanese, and thus they have little incentive to dump their dollars.

TO FIX OR FLOAT? THAT IS THE QUESTION

At the end of World War II, countries wanting to promote international
cooperation and reduce the economic incentives for war met in Bretton Woods,
New Hampshire, and established a fixed exchange rate system pegged to the
dollar. The benefit of such a system was that businesses could easily engage in
foreign trade without fear of losing money from fluctuating exchange rates. In
addition, by pegging currencies to the stable dollar, foreign governments were
responsible for practicing sound economic policies such as not creating inflation
by recklessly printing currency. The Bretton Woods system was at first very
successful, but by 1971 it had completely collapsed.
Today many approaches to exchange rates exist. Some countries let their
currency float, others peg their currency to the dollar, and still others have
unified under a single currency.
The United States and United Kingdom allow their respective currencies to
float on the foreign exchange market, which means that they do not use official
reserves to maintain exchange rates.
The benefit of this system is that it gives policymakers the ability to practice
interest rate policies to encourage domestic growth or slow inflation without
having to consider exchange rates.
China, Japan, and Hong Kong, however, peg their currencies to the U.S. dollar
by actively trading their holdings of foreign reserves. This allows their
respective countries to maintain a competitive advantage against others in the
American market. China’s exchange rate policy is what keeps Chinese exports
relatively cheap. Under a floating exchange rate, American demand for Chinese
goods would force up the exchange rate and eventually make Chinese goods less
desirable. The downside for China is that all of the money spent on stabilizing
the exchange rate could probably be put to more profitable use. Also, managing
the exchange rate means acquiring more and more dollar-denominated financial
assets, which makes China vulnerable to America’s economic troubles.
The turn of this century saw another approach to exchange rate policy. Europe
unified its economy under a single currency, the euro. France and Germany, for
example, can now trade freely without regard to exchange rates. The advent of
the euro created the world’s second largest currency after the dollar. For all of its
benefits, the euro suffers a major drawback—individual countries can’t manage
it.

Money Talks
monetary policy
Efforts by the central bank of a country to stabilize prices, promote
full employment, and encourage long-run economic growth through
controlling the money supply and interest rates.

In 2010, Greece suffered a severe financial blow when its sovereign debt’s
credit rating was reduced. Unable to implement independent monetary policy,
the Greeks have been forced to reduce their spending and raise taxes or risk
default. The EU’s reaction to this crisis will either weaken or bolster the euro’s
chances of becoming the dominant world currency.
THE PRIVATE SECTOR AND THE
PUBLIC SECTOR
Just Goin’ with the Flow

In an economic system, people’s self-interest is manifested in markets and

through the political process. Both are intertwined and affect each other; an
economist would be unlikely to look at any part of the political process without
considering how it affects markets. An economic model called the circular flow
model shows the relationship between households, firms, governments, and the
foreign sector as they all interact in product (e.g., goods), factor (e.g., labor), and
financial (e.g., stock, bond) markets. These markets are also interrelated, as you
no doubt have concluded from the previous discussions of them, but this theory
helps show and describe this interrelationship.

THE PRIVATE SECTOR

The starting point for understanding the entire economy is a very simple model
that illustrates how households and firms interact in the product market and the
factor market. The private sector is nothing more than the households and
businesses in an economy. Households buy goods and services from firms in the
product market.

The Factor Market

Where did the households get the money to buy the goods and services?
 Households sell their labor and entrepreneurship to the firms (via the factor
market) in exchange for wages and profits.
Households also sell natural resources to the firms in exchange for rents.
If you work for someone else, you are selling your labor in the factor
market so that you can get the goods and services you want and need in the
product market.
As a business owner or entrepreneur, you sell your entrepreneurial ability in
exchange for profits from the firm.

Firms employ land, labor, capital, and entrepreneurship in order to provide

goods and services.

Factor Flow and Market Flow

There are two sets of flows between households and firms. Flowing in one
direction are goods and services in the product market, and land, labor, capital,
and entrepreneurship in the factor market. Consumption spending flows in the
opposite direction of the goods and services. Flowing opposite the factors of
production are factor payments, which include rent, wages, interest, and profits.

THE PUBLIC SECTOR

Notice that the simple model of the private sector overlooks everything the
government does. So we have to consider the public sector of the economy as
well as the private sector. The public sector refers to all levels of government,
from local to federal. The public sector interacts with households by purchasing
some of the factors of production (such as land or labor) in exchange for the
factor payments (such as wage, rent, or interest). Government also interacts with
firms by buying goods and services in the product market.
Government combines the factors of production with the goods and services it
buys from firms in order to provide public goods and services to the private
sector. National defense, police, fire protection, schools, libraries, and roads are
sector. National defense, police, fire protection, schools, libraries, and roads are
examples of the types of public goods and services provided by the public sector.

Taxes in the Factor and Product Markets

Where is the government getting the income with which to buy the
factors of production from households and goods from the firms?
Taxes, in both the factor market and the product market, are the
source of governments’ income. Taxes on personal income and
corporate profits are collected in the factor market. Sales tax is an
example of a tax collected in the product market. Sometimes the
government subsidizes firms, which represents a flow of money from
government to firms. Like firms that receive subsidies, many
households receive transfer payments like Social Security and
welfare.
THE FOREIGN SECTOR
It’s a Small, Small World

Of course, the domestic economy does not exist in isolation, with the United
States floating in its own little economic bubble. The United States is part of the
much larger world economy. The foreign sector refers to the rest of the world.

YOU SAY POTATO, I SAY POMME DE TERRE

The U.S. economy interacts with the rest of the world in both the product and
factor markets (not to mention the financial markets, discussed later in the book).
The circular flow theory accounts for the interaction of markets throughout this
larger world economy, not just domestically.

Import and Export

In the product market, not all goods and services flow to the domestic
government and domestic households. Some of the domestically produced goods
and services are exported to people in other countries. In the same manner, not
all of the goods and services that are purchased by households and government
are domestically produced. Americans import goods and services from the rest
of the world.

Foreign Factor Payments and Income

Not only do Americans trade goods and services with the rest of the world in
the product market, they also trade the factors of production with the rest of the
world. Land, labor, capital, and entrepreneurship flow from the rest of the world
in exchange for foreign factor payments. Also, the factors of production flow to
the rest of the world in exchange for foreign factor income. If a U.S. citizen
the rest of the world in exchange for foreign factor income. If a U.S. citizen
earns income abroad, that is foreign factor income. Payments to foreigners for
the use of the factors of production incur a foreign factor payment. When
domestic factors of production are employed abroad, they earn foreign factor
income. Wages paid to American workers abroad from foreign employers are an
example of foreign factor income.

Interest and Foreign Factor Income

The use of foreign capital requires that interest payments be

submitted to the country of origin. This represents a foreign factor
payment. In addition, dividends earned by Americans holding shares
of stock in foreign companies are included as foreign factor income.

Foreign Transfers
A considerable amount of money is transferred to other countries not in
payment for goods and services but to help support family members. This type
of transfer, called a remittance, affects the economy but does not constitute a
direct exchange in a market. India is a prime example of a country dependent
upon a large expatriate community. Many Indians living abroad remit money to
their extended families back in India. Likewise, Mexico is heavily dependent
upon remittances from emigrants working in the United States.

The Extent of Remittances

Remittances are the second largest source of income for Mexico

after oil exports. As of 2006, Mexico and India received annual
remittances of $25 billion each, much of which originated from the
United States.
 Foreign Investment
The goal of foreign investment is to earn foreign factor income in the form of
interest and profits. A decision by American entrepreneurs to buy land and
develop a theme park in Iceland, although not the best idea, would create an
inflow of dollars to Iceland with the purpose of creating an outflow of kronur to
America as foreign factor income.
Foreign investment can also be used to finance a trade deficit, as is the case
with the United States. Currently, the United States is able to enjoy cheap
Chinese imports in excess of U.S. exports to China because of a
counterbalancing flow of savings from China to the United States. For every
dollar spent on Chinese imports, there is a return flow as the Chinese use the
same dollars to purchase both American exports and also American financial
assets.
THE FINANCIAL SECTOR AND
FINANCIAL MARKETS
A Finger in Every Pie

So far in our discussion of the circular flow theory, financial intermediaries have
been left out of the picture, literally. The financial sector, or intermediaries like
banks, credit unions, insurance companies, and stock exchanges, help to
facilitate all of the transactions that have been mentioned in this discussion. The
importance of financial intermediaries cannot be underestimated. They stand in
the middle of almost all transactions. Without them, most modern markets would
be unable to function. They are the grease that makes the wheels turn smoothly,
the key that unlocks the door, the wind beneath your wings.

FINANCIAL INTERMEDIARIES
Most of the transactions that are conducted in the product market either involve
the use of checks, debit cards, credit cards, cash drawn from ATMs (rather than
from under your mattress), or in the case of exports and imports, foreign
exchange. All of these services are provided by the financial intermediaries but
of course not out of the goodness of their hearts. Rather, like any business, they
are motivated by the potential of profit, so they charge a fee for their services.

Financial Intermediaries and the Product Market

The financial sector is all about making it easy for people to spend money. If
you have an app that lets you wave your phone at a cash register in order to pay
for that cup of coffee, you know exactly what I’m talking about. The financial
sector is everywhere:
sector is everywhere:

If you want to buy or sell a stock, the financial sector is involved.

If you plan to travel to Paris and want to trade some dollars for euros before
you go, the financial sector is involved.
If you’d like to open a doggie daycare and need some start-up funding, the
financial sector is involved.
If you’d like to pay your electrical bill through auto-pay, you got it. The
financial sector is involved.

Financial Intermediaries and the Factor Market

It’s fairly obvious how financial intermediaries such as banks are involved in
product markets—just a little observation of your own habits will demonstrate.
It’s kind of hard to give Amazon.com that $20 bill in your wallet, but it’s a piece
of cake to give them your credit card number. However, financial intermediaries
are equally involved in the factor market. This is not because they use land and
labor (although they do). It is because they are involved in many, if not most,
transactions on the factor market. Most working Americans receive a paycheck,
not cash. The paycheck gets deposited in a bank or credit union, not in a jar
buried out in the backyard. Buying and selling land (a factor) almost always
involves financial intermediaries. Capital itself is a factor of production. Where
do people find capital? Yup. In the financial sector.

The Financial Sector and Savings

The financial sector generates a significant amount of revenue in the

form of interest payments for mortgages and loans. That fact is
connected to a dimension of the circular flow theory that we haven’t
discussed yet—the part of the economy that involves savings, not
spending.
 THE FINANCIAL MARKETS

Up to this point, all of the income that has been earned by households, firms,
government, and the rest of the world has been spent in the circular flow model.
Dollar in = dollar out. But private, public, and foreign sectors don’t only spend
money—they also save it. To account for the fact that the different economic
sectors save a portion of their income, the circular flow model enters the third
dimension.
This third dimension is the financial markets. Households save for the future,
government can run a budget surplus, businesses retain earnings for future
investment, and the foreign sector engages in real and portfolio investment in the
United States. Where do all of these savings go? Savings flow to financial
intermediaries and from there (in the form of loans) to all sectors of the
economy:

When households save, they may buy shares of stock, bonds, or certificates
of deposit.
Government finances its spending in excess of taxes by issuing the various
Treasury securities.
THE GROSS DOMESTIC
PRODUCT
Keeping Score

Keeping score is important. If you are trying to lose a few extra pounds, stepping
on the scale from time to time allows you to evaluate your performance. In
school, teachers assign grades to assess students’ level of understanding. In
baseball, statistics on nearly every aspect of the game are used to determine the
pitchers and the batting order. Data and statistics are useful for making informed
decisions. During World War II, the U.S. government wanted to better
understand the economy’s ability to generate the necessary materials for the war
effort. This led to the development of gross domestic product (GDP) as a means
of measuring economic output. GDP is important today as an overall indicator of
economic performance.

WEALTH AND INCOME

Gross domestic product (GDP) measures the total value of all final production
that occurs within a country during the course of a year. GDP is also a measure
of annual spending on new domestic production and a measure of income earned
from domestic production. To better understand GDP, consider the following
example. Assume a simple economy made up of Frank and Louise. Lately Frank
has been complaining about the cold weather, so he offers Louise $1 to knit a
blanket. Louise jumps at the opportunity to make a buck and commences
knitting a new blanket. Upon completion, Louise exchanges the blanket for the
dollar. In this simple example, what was the value of the economy’s spending,
income, and output? The answer is $1. The $1 spent by Frank was earned by
income, and output? The answer is $1. The $1 spent by Frank was earned by
Louise in exchange for the knitted blanket. In 2015, U.S. GDP was $18.12
trillion, because considerably more than one knitted blanket was produced.

GDP versus GNP

GDP is not the only measure of economic performance that has

been employed. You might remember GNP, or gross national
product. The key difference between GDP and GNP is a single
preposition. GDP is a measure of all new production that is done in a
country during the year, while GNP is a measure of all new
production that is done by a country during the year. Toyotas made
in Texas are part of U.S. GDP, but not U.S. GNP.

GDP is not static. Instead, GDP is a flow. Imagine a bathtub with a running
faucet and open drain. The water flowing from the faucet is GDP, the water
accumulating in the tub is the wealth of the nation, and the water exiting the
drain represents an outflow like depreciation. As long as the GDP exceeds
outflows of wealth, the wealth of the nation grows. Essentially GDP measures
that production that is new and is not a measure of accumulated wealth.

A LOOK BACK AT CIRCULAR FLOW

In the circular flow model, the economy has three primary sectors: private,
public, and foreign. The private sector is further divided into households and
businesses. Each sector contributes to the gross domestic product. Households
provide the factors of production that businesses use to produce goods and
services. In addition, government provides the public goods not provided by the
private sector. Furthermore, the foreign sector acts as a source of the factors of
production as well as a source for goods and services. The foreign sector also
production as well as a source for goods and services. The foreign sector also
functions as a market for domestic production.
GDP is represented in three ways in the circular flow model. The goods and
services that business and government provide represent the value of all
domestic production. The spending that the private, public, and foreign sector
adds to the circular flow represents total spending. Finally, the rent, wages,
interest, and profits earned in the factor market are a nation’s income.

COUNTED OR NOT?

GDP includes much economic activity but not all of it. As a measure of
production, GDP does not include purely financial transactions. When you
purchase shares in the stock market, only the broker’s commission would be
counted in GDP. This is because the purchase of stock represents a transfer of
ownership from one shareholder to another, and neither a good nor service is
produced. Similarly, transfer payments like Social Security are not computed in
GDP. Social Security payments are not made in return for the production of a
new good or service, but instead represent a transfer from a taxed wage earner to
a recipient.
Production for which no financial transaction occurs is also excluded from
GDP. A stay-at-home parent who cares for the children, cleans the house, cooks,
and runs errands certainly produces something of great value, but because no
monetary payment is made, the value is undetermined and excluded.
Interestingly, paying someone to do all of those activities would be included in
GDP. Building a deck on your house, mowing your own grass, and changing
your own oil are all services that can be purchased, but when you perform them
for yourself, they are not included in GDP.
Apartment and house rent is included in consumption, and therefore GDP.
Homeowners and mortgage payers do not pay rent, so the BEA imputes a rental
payment on their housing. Whether you are an owner or a renter, when it comes
to GDP, everyone is a renter.
to GDP, everyone is a renter.
To avoid overstating GDP, resale and intermediate production is excluded.
Most home purchases are not counted in GDP. The resale of homes does not
represent new production and is excluded. The only time home purchases are
included is when the house is newly constructed. The primary reason resale is
not counted is to avoid double-counting. Older homes were included in a
previous year’s GDP. Consider the sale of flour, butter, and sugar to a bakery
that produces fresh bread. If the purchase of ingredients were included in GDP
along with the sale of the fresh bread, the GDP would be overstated. To avoid
this, GDP includes only final production of the bread. The price of the bread
includes the earlier cost incurred in acquiring the ingredients.
GDP: PRIVATE SPENDING AND
INVESTMENT
Because You’re Worth It

GDP can be calculated by adding all of the expenditures on new domestic

output. Households, businesses, governments, and other nations all spend money
in the economy and each is represented in GDP by a different spending variable.
Each type of expenditure is subject to various influences, and each can reveal
important information about economic activity.

PERSONAL CONSUMPTION EXPENDITURE

Households engage in personal consumption expenditure. Personal consumption
expenditure, or simply consumption, is the act of purchasing goods and services.
More than two-thirds of all U.S. GDP expenditures fall under the heading of
consumption. In other words, Americans shop to the tune of $9 trillion or more
per year for new domestic output.
The ability of households to consume is chiefly constrained by disposable
income, which is income after paying taxes. This fact gives government
considerable leverage over households’ capacity to consume. When it comes to
available disposable income, consumers choose to either spend it in the product
market or save it in the financial markets. This means that increased
consumption results in less saving, and increased saving leads to decreased
consumption.

Disposable Income Variables

Consumption is also sensitive to changes in consumers’ wealth, interest rates,
 Consumption is also sensitive to changes in consumers’ wealth, interest rates,
and expectations of the future. Increases in consumers’ wealth tend to encourage
consumption, while decreases tend to discourage it. The recent implosion of
housing prices has had a negative effect on consumers’ wealth. As a result,
consumption has declined and saving has increased because consumers are
attempting to rebuild their net worth. In addition to housing, much of consumers’
wealth is in the form of retirement accounts. Therefore, changes in the stock
market’s key indicators like the Dow Jones Industrial Average and the S&P 500
often indicate the direction of household wealth, and thus consumption.
Durable goods like cars, appliances, and furniture are often purchased using
borrowed money. Interest rates are then part of the equation to consume
durables. High interest rates discourage durable goods consumption, and lower
interest rates tend to encourage the purchase of durable goods. Plans designed to
encourage durable goods consumption include 0% financing, interest-free for
three years, and no payments until the next year.
Expectations as a determinant of consumption are easily understood. When
people fear the future, they tend to save and not make any major purchases. In
contrast, people that are upbeat about the future are more inclined to shop and
less inclined to save.

Autonomous Consumption
Economists recognize that some consumption is independent of disposable
income and refer to this as autonomous consumption. During periods of
recession, consumption of durable goods is curtailed while consumption of
essentials like food, rent, clothing, and healthcare remains relatively unaffected.
Do you remember what it was like on September 12, 2001? What type of
consumption occurred and what type did not? Chances are that autonomous
consumption of necessities and nondurables continued unabated, but
consumption of durable goods (except for guns and ammo) and discretionary
spending came to a halt.
 GROSS PRIVATE INVESTMENT

Households and businesses engage in another expenditure referred to as gross

private investment.

Gross private investment includes business purchases of capital and

inventory, and household purchases of new homes. Gross private
investment is further broken down into net investment and depreciation.
Net investment is the purchase of new capital that expands the economy’s
productive capacity.
Depreciation is investment spending to replace worn capital.

It is important to note what investment is not. When it comes to calculating

GDP, investment is not the purchase of stocks and bonds. That is financial
investment or saving. What is being considered here is real investment.
However, this real investment in the economy is financed by the financial
investment that occurs in financial markets.

Future Expectation
The level of investment in the economy is influenced by expectations of future
business conditions and interest rates. Positive expectations tend to boost
investment while negative expectations result in less investment. Businesses
respond this way in order to have the right amount of productive capacity to
meet the expected future demand for their products. Interest rates are also a
major consideration in the decision to invest. As interest rates rise, the relative
profitability of investment decreases. Decisions to invest compare the expected
rate of return to the current interest rate. As long as the expected rate of return
exceeds the interest rate, businesses will undertake investment with the
expectation of profit. Increased interest rates have the effect of making fewer
investments profitable.

Planned and Unplanned Investment

 Planned and Unplanned Investment
Investment is divided into planned and unplanned investment. During periods
of economic “normalcy,” businesses invest in capital and in inventory in order to
turn around and sell it at a profit. This planned investment assumes that business
conditions will continue according to the producers’ expectations. When
unplanned investment occurs, it is a sign of bad things to come. Auto dealers
order inventory from the factories to sell to consumers. If inventory begins to
accumulate, that means consumers are not buying. The dealers stop ordering and
the factory stops production. If this halt in production is pervasive, mass
unemployment and economic recession occurs.
GDP: GOVERNMENT SPENDING
AND EXPORTS
Spend It If You Got It

The GDP isn’t measured just by adding together private spending and
investment by households and businesses in the domestic market. It is also
affected by government spending and international trade.

GOVERNMENT SPENDING
Government spending includes federal, state, and local expenditures on capital,
infrastructure, and employee compensation. Military expenditures, road
construction, and teacher salaries are all included. Government spending is
financed by taxation and borrowing. The opportunity cost of government
spending is the forgone consumption and gross private investment that might
have otherwise occurred (you might have spent that $500 on a nice new
television but you had to send it to Uncle Sam instead). Transfer payments (such
as Social Security benefits and certain subsidies to businesses) are not included
as government spending for the purpose of calculating GDP.
Government spending accounts for about 40% of the GDP in the United
States. Government spending as a percentage of GDP varies widely throughout
the world from a low of about 16% in countries such as Bangladesh and the
Central African Republic, to about 65% in countries such as Cuba and Lesotho.
In most developed countries, government spending as a percentage of GDP runs
about 35–50%.

Limits on Government Spending

 Limits on Government Spending
Government spending is limited by the amount of tax revenue and the ability
to borrow. For a country like the United States, this is not much of a limiting
factor, as taxes are mandatory and U.S. government debt is a popular vehicle for
financial investment. Regardless of the political party in power, government
spending tends to have an upward trajectory.

Pork-Barrel Politics

In the United States, all politics is local. This means that

representatives and senators have a strong incentive to direct
federal spending toward their respective districts and states in order
to win support for re-election. Failure of politicians to bring home the
pork is usually cause for a new politician to replace the incumbent.

Government spending is often used to stimulate consumption during

recessions because government often has the ability and will to spend when
other sectors of the economy do not. The effectiveness of this spending—which
often results in a deficit because the government is spending more than it
generates in tax revenue—is hotly debated among the different schools of
economic thought. Those economists influenced by the work of John Maynard
Keynes tend to support government spending as a stimulus to the economy. The
idea is that government spending has a multiplier effect: a dollar spent by the
government helps increase the GDP by more than a dollar. Economists with a
classical or libertarian bias often argue that government spending offsets more
efficient private spending (e.g., the government should let you buy your
television in peace instead of taking your money off your hands through taxes)
and should not be used as a tool of stimulus.

NET EXPORTS
 NET EXPORTS

Net exports, or exports minus imports, are the last spending variable in
measuring GDP. Export of new domestic production adds to GDP. Imports, on
the other hand, subtract from GDP. The United States typically runs a balance of
trade deficit, so in most years net exports are deducted from, instead of added to,
GDP. In recent years, export growth has helped to sustain GDP. Compared to
most other nations, U.S. net exports represent a very small percentage of
economic activity. Even though no country engages in as much international
trade by volume as the United States, the United States remains one of the least
trade-dependent nations in the world.

Exports and Economic Growth

Net exports may not be a real big deal in America, but for developing
countries, net exports are the road to economic growth. China is a
key example of a country dependent on net exports for growth. As
the Chinese economy matures, its industry may become more
oriented toward domestic production.

Net exports are influenced by exchange rates, and like consumption and
investment, also by interest rates. Appreciation of the dollar makes American
goods relatively expensive, so exports decline and imports rise. Depreciation of
the dollar, on the other hand, makes American goods relatively cheap, so exports
increase and imports decrease. Interest rates impact net exports through their
effect on the exchange rate. High interest rates in America lead to an
appreciation of the dollar, which reduces net exports, but low American interest
rates help to depreciate the dollar and encourage net exports.
APPROACHES TO GDP
Lies, Damned Lies, and Statistics

So far we have looked at GDP as a sum of expenditures: add together consumer

spending, private investment, government spending, and net exports, and voila!
The GDP. But this is not the only way to measure the growth of the economy.
Economists can also use the income approach (adding together income) or the
production approach (adding together outputs). Note that each of these
approaches is meant to give the same answer—the GDP. They are not supposed
to calculate different things. If you measure the economy using each of the three
approaches, you should come up with roughly the same answer.
In addition, for economists to compare GDP from year to year, they also need
to address the difference between the real and nominal GDP.

INCOME APPROACH TO GDP

If we can look at expenditures as a signal of economic growth (or contraction),

we can also look at income. Theoretically, the GDP should remain the same
whether you use the income approach or the expenditure approach (because
income equals expenditures—saving is a form of expenditure in this
calculation). The ability to engage in consumption, investment, government
spending, and net exports derives from the income earned, producing domestic
output. Again, income includes all of the rent, wages, interest, and profits earned
by selling the factors of production in the factor market.
Measuring income is more complex than measuring spending, and this
requires some mental gymnastics on the part of economists. One reason is that
profits flow to corporations, shareholders, and proprietors. Also, taxes and
profits flow to corporations, shareholders, and proprietors. Also, taxes and
subsidies distort the difference between the price paid in the market and the
income earned by producers. In the end, measuring income is a bit more
complex for economists than measuring expenditures, but for now it is sufficient
to conclude that income equals the sum of rent, wages, interest, and profits. Let
the economists at the BEA fret over the details.

Income Underreporting

One last practical problem arises when measuring income versus

spending. Producers and households have an incentive to
underreport income in order to reduce their tax liability.

PRODUCTION OR OUTPUT APPROACH

Another way of calculating the GDP is to add together all of the production
activity in a country. In this approach, the value added at each stage of the
production process is calculated. For example, a car is the final output but the
engineer’s intermediate input has a value that can be determined. An obvious
drawback to this approach is determining the difference between intermediate
and final goods. Is a pound of sugar an intermediate or final good? The answer
is, it depends on who is buying it and why.
In this approach, market and nonmarket production must both be valued.
Market production is goods produced for sale in the marketplace (such as
widgets produced by corporations). Nonmarket production includes services not
for market sale (such as that provided by the government or nonprofits—for
example, the free lunch program offered each summer by your local school).
Nonmarket production can be difficult to value as it doesn’t have a price tag
attached to it, so generally it is considered to be the cost of production.
U.S. government agencies do not use this approach to calculate GDP.
 U.S. government agencies do not use this approach to calculate GDP.

NOMINAL VERSUS REAL GDP

The concepts of nominal and real appear throughout economics, and GDP is no
exception. Nominal GDP is reported using current prices. In order for
economists to make valid comparisons in GDP from year to year, the price
changes that occur with time’s passage have to be addressed. Real GDP reports
output, holding prices constant. If the change in prices (inflation) is not
accounted for in calculating GDP, results may be misleading—the economy may
appear to be growing when in fact all that’s happening is inflation.
Nominal GDP must be deflated in order to calculate real GDP. Assume an
extremely simple economy that produces multicolored beach balls. In 2014, the
economy produced 100 beach balls that were all purchased by consumers at $1
apiece. In 2015, the economy produced 100 identical beach balls that were all
purchased by consumers for $1.25 apiece. Given this information, nominal GDP
for each year can be calculated by multiplying the number of beach balls by that
year’s current price, so in 2014 nominal GDP was $100, and in 2015 it was
$125. An outside observer might come to the incorrect conclusion that output
increased by 25%. The reality was that output did not change, but prices rose by
25%. To compare what really happened, prices must be held constant. Using
2014 prices, the real GDP for 2014 and 2015 is $100; in other words, real output
remained constant.

The GDP Deflator

You can determine the overall inflation (or deflation) in an economy

by dividing a specific year’s nominal GDP by its real GDP. For
example, if the nominal GDP was $125 and the real GDP was $100,
then inflation was 25%.
REAL GDP CHANGES AND THE
BUSINESS CYCLE
Buckle Your Seat Belts

Over the last fifty years, America has undergone alternating periods of recession
and economic expansion. The ups and downs have occurred against a
background of long-run economic growth. In other words, from year to year the
GDP may go up and down overall but the trend is upward. Since 1960, the U.S.
real GDP has increased by more than $10 trillion.

EXPANSION AND CONTRACTION

Economists refer to this series of expansions and contractions as the business
cycle (some economists prefer the term “fluctuation” since “cycle” implies a
predictable pattern, which does not exist).
As the workforce and productivity grow, so does the economy’s capacity to
produce. This explains why the economy has grown over time. The periods of
expansion and contraction are attributed to differences between total spending on
output relative to the economy’s long-term capacity to produce. During periods
of expansion, spending increases to the point where the economy exceeds its
long-run production capacity. Contractions occur as total spending decreases and
excess productive capacity remains.

Business Cycle Measurements

Business cycles are measured by looking at both GDP and

 Business cycles are measured by looking at both GDP and
unemployment. During periods of economic expansion,
unemployment is reduced and the GDP grows. The opposite
happens in periods of recession.

If you have ever been on a long car trip, you can understand the business
cycle. Imagine cruising along a two-lane highway, going with the flow of traffic.
This going with the flow is the norm and represents the average rate of economic
growth. Occasionally, somebody will be moving a little too slowly, so you scan
for oncoming traffic. If it’s clear, you accelerate and pass the slower driver.
Passing represents those periods where spending exceeds the productive
capacity. Every once in a while, you make a mistake while trying to pass slower
traffic. You scan for oncoming traffic and make your move, only to discover that
a fully loaded eighteen-wheeler is barreling down the highway in the oncoming
lane. You immediately switch back into your lane, shaking violently, and slow to
thirty miles per hour, thankful that you are still alive. Events like this are
representative of economic contractions. Eventually, you compose yourself and
start to travel with the flow of traffic again.
Now, to really understand the business cycle, imagine that you are blindfolded
the whole time and relying on an extremely myopic passenger speaking Swahili
to provide information about what is happening. To be sure, it would be an
interesting ride. Why the blindfold and Swahili? Outside of psychics, prophets,
meteorologists, and the rare economist, most Americans have difficulty seeing
into the future. The language of economists and financial experts is often
difficult to interpret.

The Four Stages of the Business Cycle

Economists generally point to four stages in the business cycle:

 1. Expansion, which occurs when the GDP grows month-over-
month, and unemployment declines.
2. Peak, which occurs when real GDP spending is at its highest
—the period just before unemployment begins to rise and
other economic indicators fall.
3. Contraction, which occurs when GDP growth slows or
declines. A recession is specifically defined as two
consecutive quarters of declining real GDP.
4. Trough, which is the period between contraction and
expansion as GDP begins to recover.

As this description makes clear, economists can only determine

what stage the economy is in after it has happened.

THEORIES OF BUSINESS CYCLES

Economists disagree on exactly why the economy fluctuates as it does. Is the

culprit external causes, such as wars? Or internal factors, such as business
innovation? They also disagree on what should be done during downturns. How
much should the government meddle? That depends on which economist you
talk to.

Milton Friedman’s monetarists explain the business cycle as being caused

by poor management of the money supply. Periods of overexpansion are
produced by too much money, and periods of contraction are caused by too
little money in circulation.
Keynes explained the business cycle as being caused by “animal spirits”
where businesses are in effect bipolar. Keynes’s animal spirits represent the
emotion that clouds rational decision-making. These animal spirits are
expressed through businesses’ willingness to invest. When businesses are
manic, they invest heavily, only to fall into stages of depression where they
are unwilling to invest.
Most other theories explain the business cycle as ultimately being caused
by spending changes, but one referred to as the Real Business Cycle Theory
focuses on changes in productivity as being the ultimate cause of the cycle.
WHAT GDP DOESN’T TELL US
Money Isn’t Everything

In a 1968 speech, the late presidential candidate Robert F. Kennedy stated the
following about the weaknesses of our key measure of economic performance at
that time, gross national product. The same weaknesses apply to GDP:

“Too much and for too long, we seemed to have surrendered personal
excellence and community values in the mere accumulation of material
things. Our gross national product . . . if we judge the United States of
America by that . . . counts air pollution and cigarette advertising, and
ambulances to clear our highways of carnage. It counts special locks for
our doors and the jails for the people who break them. It counts the
destruction of the redwoods and the loss of our natural wonder in chaotic
sprawl. It counts napalm and it counts nuclear warheads, and armored cars
for the police to fight the riots in our cities. It counts Whitman’s rifle and
Speck’s knife, and the television programs which glorify violence in order
to sell toys to our children.
“Yet the gross national product does not allow for the health of our
children, the quality of their education, or the joy of their play. It does not
include the beauty of our poetry or the strength of our marriages; the
intelligence of our public debate or the integrity of our public officials. It
measures neither our wit nor our courage; neither our wisdom nor our
learning; neither our compassion nor our devotion to our country; it
measures everything, in short, except that which makes life worthwhile. And
it can tell us everything about America except why we are proud that we
are Americans.”
 REAL GDP AND SOCIAL GOOD

Kennedy’s point should be clear. GDP, for all of its inclusiveness, excludes
many important things—not least of which is the value of unpaid labor such as
caring for your children or elderly parents. However, consider the fact that as
real GDP has increased, the burdens of scarcity and the incidence of absolute
poverty have been lifted for millions of people. Yesterday’s relative wealth is
today’s relative poverty. Compared to the lives of Americans of previous
generations, the availability of healthcare, education, nutrition, sanitation, and
housing has increased with the increases in real GDP. These have led to an
increase in longevity.
The increase in real GDP has been accompanied by more leisure time as well.
The average workweek has steadily declined, and the average number of
vacation days has increased. As a measure of well-being, the GDP has both
strengths and weaknesses.

GDP per Capita

GDP per capita is the GDP divided by the population. As an

indicator of overall well-being, it is subject to a major flaw. GDP per
capita gives no indication as to how income is distributed among the
population. The United States and Norway both have high GDPs per
capita, but the key difference is that U.S. incomes are unequally
distributed compared to Norway. High GDP per capita does not
necessarily mean that there are not those in society living in relative
poverty.

GDP AND THE ENVIRONMENT

Critics of GDP say that it does not take into account environmental degradation.
Because GDP is focused on spending and output, it creates an incentive to
pursue greater amounts of production in order for growth to continue. This
growth can come at the cost of the environment. Deforestation, climate change,
pollution, and other environmental ills are, according to critics of the measure,
the logical outcome of this narrow-sighted focus on GDP. Others defend GDP,
stating that it is because of the increase in real GDP that people are wealthy
enough and have the time to care for the environment. Today, the countries with
the highest real GDPs are often the very ones that are doing the most to address
the issues that environmentally conscious citizens raise.
Some countries are exploring measures called “green GDP” that take into
account the environmental cost of economic growth.

OTHER MEASURES OF ECONOMIES

In response to complaints about what GDP measures, other formulas have been
explored that address its shortcomings. Some of these include:

Index of Sustainable Economic Welfare, which also calculates income

distribution and pollution
Genuine Progress Indicator, which seeks to measure the welfare of a
country’s citizens by including unpaid labor (household work, childcare,
volunteer work) and other statistics
Fordham Index of Social Health, which takes into account social well-
being, such as drug use, homicide, and income inequality
United Nations Human Development Index, which includes life expectancy
and access to education
The Happy Planet Index, which tries to measure personal happiness or well-
being instead of economic health
Money Talks
income inequality
The uneven distribution of income among households in a country.
UNEMPLOYMENT DEFINED
Where Did My Job Go?

One of the most gratifying things that you can hear is, “We like you, and you’re
the right fit for this company. Congratulations, you’re hired!” One of the worst
things you can hear is, “You’re fired.” Unemployment can make economics
suddenly appear very relevant to your life. Economists define, measure, classify,
evaluate, and seek to understand this all-too-common phenomenon. Many
economists have made it their life’s work to minimize the problem of
unemployment, and policymakers are under political pressure to do so as well.

WHAT UNEMPLOYMENT IS AND IS NOT

According to the Census Bureau, the 2008 U.S. population was approximately
300 million, of which 145 million were employed. How many were
unemployed? It might come as a surprise to you that the answer to that question
cannot be determined from the information given. True, you can infer that 155
million did not work, but that does not necessarily mean that they were all
unemployed. Are toddlers and kindergarteners unemployed? To determine the
number of unemployed, you must first define the term unemployment.
Persons sixteen years of age or older are considered unemployed if they have
actively searched for work in the last four weeks, but are not currently
employed. The employed are those who have worked at least one hour in the
previous two weeks. People who meet neither criterion are not considered in the
labor force, which is the number of employed persons plus the number of
unemployed persons. The unemployment rate that you hear quoted in the news is
not a percentage of the population, but a percentage of the labor force that is not
not a percentage of the population, but a percentage of the labor force that is not
currently employed.

Unemployment Rate Increases

Does an increase in the unemployment rate mean that fewer people

are employed? Not necessarily. It is possible for the unemployment
rate to increase at the same time the number of employed is
increasing. A demographic shift in the labor force like the entrance of
women during World War II or the return to civilian life of members
of the military can create a condition where the ratio of unemployed
to the labor force increases even while overall employment is
increasing.

There are many reasons for not participating in the labor force. Full-time
students, retirees, stay-at-home parents, the disabled, and the institutionalized do
not participate. Members of the military on active duty are not considered part of
the labor force either. At any point in time there are people entering, exiting, and
re-entering the labor force. Furthermore, people are forever getting hired, fired,
and furloughed. They are also quitting, cutting back, and retiring. The labor
force is in constant flux, which makes measuring unemployment a daunting task.

MEASURING UNEMPLOYMENT

The U.S. Department of Labor’s Bureau of Labor Statistics (BLS) monitors

unemployment in the United States. Once a month, the Census Bureau conducts
the Current Population Survey. Approximately 60,000 sample households are
briefly questioned about their participation in the labor force. The BLS uses the
data from the survey to calculate the various employment statistics used by
economists and policymakers.
 Unemployment Data

The latest unemployment and labor force data can be found at

www.bls.gov. The Bureau of Labor Statistics website allows you to
access hundreds of tables, graphs, press releases, and research
articles. In addition to unemployment data, the website also contains
the latest information on inflation.

In addition to the population survey, economists look at payroll employment

records, new claims for unemployment insurance, and other data to get a
complete picture of the country’s unemployment. Non-farm payroll employment
records give economists a good idea of how much hiring is taking place in the
economy. New claims for unemployment insurance act as a verification of the
Current Population Survey’s results. Policymakers also look at the weekly hours
worked in manufacturing. Declines in the weekly hours worked indicates that
factories are idling back and may be laying off workers. Increases in weekly
hours worked may indicate that firms will hire in the future.
In addition to calculating unemployment, the BLS uses the survey data to
calculate the labor force participation rate and the employment-to-population
ratio. The labor force participation rate is the percentage of the working age
population classified as either employed or unemployed. In the United States,
the average labor force participation rate is about 65%. The employment-to-
population ratio is the percentage of the working age population that is classified
as employed. Both ratios have declined over the last ten years as numbers of
young people have delayed entry into the labor force. This may be as a result of
increased college or university enrollment and increases in military enlistment.
UNEMPLOYMENT CLASSIFIED
Falling Through the Cracks

Because of unemployment’s narrow definition, many people that you might

consider unemployed or underemployed are not captured in the official
unemployment statistic.

Marginally attached workers are not considered in the official

unemployment rate. These are people ready and available to work, who
have conducted a job search within the past twelve months, but have not
searched in the last four weeks.
Some people have given up the job search in frustration. These
“discouraged workers” are unemployed in the general sense, but because
they do not meet the technical definition, the official unemployment rate
does not reflect their numbers.
In addition, many full-time workers who have lost jobs have been rehired as
part-time workers. The automotive engineer in Detroit who now works the
drive-through lane at a fast-food restaurant is an example of this.

The BLS publishes several unemployment rates in addition to the official

unemployment rate:

U1 only includes people unemployed fifteen weeks or longer.

U2 only includes people who have lost a job as opposed to those who have
quit or those who have entered or re-entered the labor force.
U3 is the official unemployment rate.
U4 adds discouraged workers to the official unemployment rate.
 U5 includes all marginally attached workers.
Finally, U6 is the most all-inclusive measure of unemployment and
includes all of the previous plus those who are employed part-time because
of economic reasons.

TYPES OF UNEMPLOYMENT

Economists make qualitative distinctions in the reasons for various

classifications of unemployment. Not all unemployment is the same. Some types
are actually positive for the individual and the economy. Other types are bad for
the individual but benefit society. Last, there is one type of unemployment that is
both bad for the individual and is costly to society. The three types of
unemployment are frictional, structural, and cyclical.

Frictional Unemployment
Is 0% unemployment a good goal for society? It is most definitely not. A 0%
unemployment goal ignores the presence of frictional unemployment. Frictional
unemployment occurs when people voluntarily enter the labor force, or when
they are between jobs for which they are qualified. It is frictional because the
labor market does not automatically match up all available jobs with all available
workers.
Instead, a job search requires time for the right worker to find the right job.
Both workers and society benefit when job applicants are matched to the
appropriate job. You want mechanical engineers to get jobs in mechanical
engineering, not pet grooming.
The rate of frictional unemployment is relatively low, and as technology
increases and search times diminish, it becomes even lower. The advent of
online job search sites and social networking has reduced job search times for
many workers.
 Government Incentives and Frictional
Unemployment

Government incentives create variations in frictional unemployment

rates between countries. Generous unemployment benefits give
workers an incentive to spend more time searching for a job and
thus increase the rate of frictional unemployment for the country.
Compared to Europe, American unemployment benefits are less
generous. As a result, Americans spend less time searching for jobs
and the rate of frictional unemployment is relatively lower.

Structural Unemployment
Structural unemployment occurs when job seekers’ skill sets are not in
demand because of geography or obsolescence. As industries die out in certain
regions of the country or relocate to other regions, the workers may not be able
to move with the job. This leaves workers with a skill set that is no longer in
demand. These workers must either retrain or accept a lower-paying job in an
industry that requires less skill. Structural unemployment is often the outcome of
what economist Joseph Schumpeter called creative destruction. As innovation
occurs, old technologies and industries are destroyed, which frees up the
resources for the new technology and its industry.
The invention of the personal computer was the death knell for the typewriter.
As the new technology advanced, the old technology and its industry were
destroyed. Over time, skilled typewriter repair technicians found that their skill
set was no longer in demand and faced the permanent destruction of their jobs.
As this was occurring, new jobs were being created in the new industry. The
problem for workers is that their skill sets may not translate into the new
industry. The solution for structural unemployment is education and retraining.

Unemployment Classifications
 Unemployment Classifications

Is it possible for a person to be both frictionally and structurally

unemployed? The classification of unemployment is not an exact
science. A person who voluntarily leaves a job to search for another
job for which he is unqualified would be both frictionally and
structurally unemployed. Throw in a recession and this person might
find himself frictionally, structurally, and cyclically unemployed.

Another reason for the presence of structural unemployment is the presence of

efficiency wages in the labor market. Efficiency wages are those that exceed the
equilibrium market wage. The purpose of efficiency wages is to encourage
worker productivity. Employees who earn efficiency wages know that they are
unable to earn equivalent wages with competing firms, so they are motivated to
produce more output for the paying firm. The efficiency wages have the added
effect of enticing more people to enter the labor market. Because these entrants
are attracted to the efficiency wage and not willing to work for the lower market
wage, they represent an increase in the level of structural unemployment. As
more entrants are attracted to the market, less skilled workers face more
competition for jobs and suffer higher rates of unemployment.

Cyclical Unemployment
The most insidious type of unemployment is cyclical. Cyclical unemployment
occurs because of contractions in the business cycle. It is not voluntary, nor is it
the result of a skill-set mismatch. During periods of recession, the official
unemployment rate increases as cyclical unemployment adds to the always-
present frictional and structural rates of unemployment. The recession that began
in 2007 saw the official unemployment rate increase from 5% to 10%. The
additional increase is directly attributed to cyclical unemployment.
The real problem with cyclical unemployment is that it creates a feedback
loop. As one group becomes cyclically unemployed, they cut back on spending,
which leads to more cyclical unemployment. This feedback loop resulted in 25%
unemployment during the Great Depression. Policymakers respond to cyclical
unemployment with discretionary fiscal and monetary policy. In addition,
automatic stabilizers like unemployment compensation help to dampen the
feedback loop by allowing affected workers to have some capacity for spending.
Ultimately the goal of policymakers is to eliminate cyclical unemployment
altogether.

FULL EMPLOYMENT

When the economy is producing at its optimum capacity, cruising down the road
at the speed limit, neither speeding nor driving too slowly, it is safe to assume
that the economy is also at full employment. Full employment occurs when
cyclical unemployment is not present in the economy. This economic nirvana is
the goal that policymakers seek to maintain.
Economists associate full employment with the natural rate of unemployment.
The natural rate hypothesis advanced by Nobel economists Milton Friedman and
Edmund Phelps suggests that in the long run there is a level of unemployment
that the economy maintains independent of the inflation rate. The idea is that left
alone, the economy will maintain full employment and experience the natural
rate of unemployment most of the time.
It is possible for the natural rate of unemployment to vary. If frictional or
structural rates of unemployment were to change, then the natural rate of
unemployment would change. A technology that permanently reduces search
times for job seekers would have the effect of reducing both frictional
unemployment and the natural rate of unemployment. Permanent changes in
unemployment compensation that encourage or discourage lengthy periods of
unemployment would also affect the natural rate. Finally, lasting increases in
worker productivity would reduce the natural rate of unemployment.
 Different countries have different natural rates of unemployment. Economies
that are more market oriented like the United States have low natural rates of
unemployment. Socialist economies tend to have higher natural rates of
unemployment. Economists theorize that socialist economies have both higher
frictional and structural rates of unemployment because of government policies
that lead to less flexible labor markets. The highest natural rates of
unemployment occur in countries where labor is unskilled and immobile, and job
creation is stymied by corrupt, inefficient governments.
WHY UNEMPLOYMENT IS BAD
Living Up to Your Potential

Unemployment creates a measurable cost for the economy and individuals. The
opportunity cost of unemployment is immense when considering the scale of the
U.S. economy.
When workers are unemployed, they are unable to produce output. According
to the economist Arthur Okun, for every 1% that the official unemployment rate
exceeds the natural rate of unemployment, there is a 2% gap between actual and
potential real GDP. Given the GDP and unemployment figures from 2009, when
actual output was $14 trillion and unemployment was 10%, and assuming a
natural rate of 5%, actual output may have been $1 trillion to $2 trillion below its
potential. By way of comparison, a $2 trillion output gap is like sacrificing the
entire economic output of France.

PERSONAL AND SOCIAL COSTS OF

UNEMPLOYMENT

The costs to the individual are heavy as well. An extended period of

unemployment can wipe out a family’s personal savings and leave them in debt.
Unemployment disrupts the normal flow of life and if prolonged can possibly
lead to health and psychological problems for affected individuals. Also, the
incidence of family violence is directly related to changes in the unemployment
rate. Furthermore, periods of high unemployment are also associated with
increases in the divorce rate and child abandonment.
Prolonged, pervasive unemployment is directly linked to crime and civil
unrest. Areas plagued with persistent high unemployment are also plagued with
unrest. Areas plagued with persistent high unemployment are also plagued with
both violent and property crime. A trip to America’s inner cities provides the
anecdotal evidence for this. Much of the unrest in the developing world
coincides with high rates of unemployment. It is a very rare day when someone
takes the morning off of work to riot or blow something up. Unemployment, it
seems, creates the necessary condition for many of the world’s problems.

The Unemployment Tax

High rates of unemployment also affect businesses, since

unemployment benefits are largely provided through taxes on
businesses. Additionally, state and local governments trying to raise
revenue during periods of high unemployment often raise tax rates
on businesses, reducing their ability to hire workers.

TRENDS IN UNEMPLOYMENT
The U.S. economy has undergone several major shifts. Initially, the United
States was an agrarian nation and most employment was related to farming. The
Industrial Revolution saw a shift toward manufacturing employment. Today,
most jobs are created in the service sector. As America moves away from
agriculture and manufacturing, fewer and fewer jobs in those areas will remain.
Globalization has shifted many low-skill jobs overseas, which leaves America’s
unskilled workers with fewer opportunities.
Demand for labor is driven by worker productivity. The more skills workers
possess, the greater the demand for their labor. To stay competitive, future
workers must realize that they are not just competing against their fellow
Americans but against the rest of the world. The days when you could graduate
from high school and get a good-paying job at the factory are gone, unless, of
course, you live in China. To compete in the global job market, Americans must
course, you live in China. To compete in the global job market, Americans must
be willing to train, stay mobile, and constantly adjust to the changing needs of
their employers.

UNEMPLOYMENT DEMOGRAPHIC DISPARITIES

When it comes to the demographics of unemployment, the facts show significant
differences between subpopulations:

Men have higher rates of unemployment than women.

Whites have lower rates of unemployment than Hispanics.
Hispanics have lower rates of unemployment than blacks.
Younger workers are more likely to be unemployed than older workers.
Educated workers are far less likely to be unemployed than dropouts.

To demonstrate the variance in unemployment, consider the difference in

2008 unemployment rates between married, white females over age 25 and
single, black males under age 25. The rate for the first group was 3.3% while the
rate for the second group was 17.5%. The most important demographic
determinant of unemployment, however, is educational attainment. Even during
recessions, unemployment rates for college graduates remain below 6%.

The Education Advantage

A glance at the Bureau of Labor Statistics report for May 2015

shows the unemployment rates for the following groups:

Less than a high school diploma: 8.6% (in May 2014, it was
9.2%)
High school graduate, no college: 5.8% (in May 2014, it was
6.5%)
Some college or associate’s degree: 4.4% (in May 2014, it was
5.5%)
Bachelor’s degree or higher: 2.7% (in May 2014, it was 3.2%)
INFLATION DEFINED
The Incredible Shrinking Dollar

Were you a little frustrated a few years back when gas prices suddenly rose? The
increase in gas prices probably created some hardship as you altered your
spending in order to accommodate its higher cost. Now imagine that not just gas
prices, but the price of almost everything you buy, suddenly and unexpectedly
increases. If you are on a fixed income, then there is only so much altering you
can do to a budget before you realize that high prices are killing your finances.
Inflation is a phenomenon that you need to understand if you want to
comprehend how the economy works.

WHAT IS INFLATION?
No word strikes more fear into the hearts of central bankers than inflation.
Defined as a general increase in prices or as a decrease in money’s purchasing
power, inflation creates problems for more than central bankers. Inflation affects
everyone in the economy. Governments, businesses, and households are subject
to inflation’s influence.
Inflation is either created by excessive demand or increases in producers’ per-
unit costs, but it is sustained by too much money in circulation. Left unchecked,
inflation can have cataclysmic results for a society.
During the 1920s, the Weimar Republic of Germany suffered from extreme
inflation. Instead of taxing or borrowing to raise revenue, the government began
to print money for the purpose of making its purchases. The result was runaway
inflation. Some historians credit the period of inflation and the resulting loss of
confidence in the Weimar Republic for sowing the seeds of Hitler’s eventual rise
confidence in the Weimar Republic for sowing the seeds of Hitler’s eventual rise
to power.

Hyperinflation

Hungarian inflation was so severe in 1945 and 1946 that prices were
measured in not tens or hundreds, but billions, trillions, and even
octillions. By the end of the period of Hungarian hyperinflation, the
total supply of pengos in circulation had less value than a single
pengo did at the beginning.

If you were around in the 1970s, then you might remember the time period
known as the Great Inflation. The Vietnam War, OPEC, the collapse of the
adjustable peg system (where world currencies were pegged to the dollar), and
poorly managed monetary policy created conditions of rising prices and
uncertainty. Although American inflation did not even come close to
approaching the levels of inflation in the Weimar Republic and modern-day
Zimbabwe, it was enough to cause political turmoil and bring lasting change to
the way policymakers manage the price level.

MEASURING INFLATION

Inflation is the rate of increase in the average price level of the economy. To
measure inflation first requires that the price level be measured. Economists
have come up with different ways to measure the general price level in the
economy, and therefore, inflation. The most often cited measure of inflation is
the change in the consumer price index (CPI). In addition, economists and
policymakers pay attention to changes in the producer price index (PPI) and
personal consumption expenditure (PCE) deflator.
 Consumer price index (CPI): The consumer price index is a market basket
approach to measuring inflation constructed by the Bureau of Labor
Statistics. Changes in the CPI indicate inflation or deflation. CPI is the most
widely used measure of inflation in the American economy.
Producer price index (PPI): A measure of producer price inflation that acts
as a leading indicator of future consumer price inflation.
Personal consumption expenditure (PCE) deflator: A price index used to
measure consumer price inflation that is more inclusive than the popular
consumer price index (CPI).

Inflation Measurement and Public Policy

Economists and policymakers pay careful attention to inflation. In

order to make appropriate policy, though, they must choose to
ignore certain types of inflation measures. The BLS and BEA both
publish headline and core inflation measures. Headline CPI includes
the entire market basket, while core CPI excludes more volatile food
and energy prices. The Fed pays attention to core PCE when
making its policy decisions. You do not want to raise interest rates
just because corn and gas prices increased.

The CPI
The CPI is a market basket approach to measuring the price level and inflation
published by the BLS. The CPI measures the average cost of food, clothing,
shelter, energy, transportation, and healthcare that the average urban consumer
buys. To understand CPI, imagine that you are given a shopping list of
thousands of different items. You are then told to research and write down the
price of each specific item, and afterward add them all together. The total cost of
the list would represent an average price level. Further assume that a year later
you took the same list and repeated the process. Increases in the shopping list’s
you took the same list and repeated the process. Increases in the shopping list’s
total would represent inflation.

The PPI
The PPI is similar to the CPI, but instead of consumer prices, the PPI looks at
producer prices. The PPI includes all domestic production of goods and services.
Unlike the CPI, the PPI also includes the prices of goods sold by one producer to
another. Changes in the PPI can be used as a predictor of future changes in the
CPI. Before consumer prices change, the producer price changes. Because it
predicts changes in the CPI, the government and central bank use the PPI to
create fiscal and monetary policy in anticipation of possible consumer inflation.

The PCE Deflator

The PCE deflator is a broad measure of consumer inflation published by the
BEA. Unlike the CPI, which measures a fixed market basket, the PCE deflator
measures all of the goods and services consumed by households and nonprofit
institutions. The PCE deflator is a more comprehensive measure. Because it does
not deal with a fixed market basket, it better reflects consumers’ tendency to
substitute more expensive items with less expensive items and their tendency to
vary consumption as time passes.
TYPES OF INFLATION
Hyperventilating over Hyperinflation

There are two primary types of inflation: demand-pull and cost-push.

Understanding which type of inflation is occurring at any given point in time is
important if policymakers want to respond appropriately. The two types of
inflation are not mutually exclusive, so it is possible for both to occur
simultaneously. Left untreated, inflation can cause a wage-price spiral or even
hyperinflation.

DEMAND-PULL INFLATION
Demand-pull inflation occurs when spending on goods and services drives up
prices. In other words, aggregate demand is greater than aggregate supply.
Demand-pull inflation is fueled by income, so efforts to stop it involve reducing
consumers’ income or giving consumers more incentive to save than to spend.

Money Talks
aggregate demand
The inverse relationship that exists between the real GDP and the
price level in the economy. Aggregate demand (AD) is the
willingness and ability of households, firms, government, and the
foreign sector to buy the new, domestic production of a nation.

Money Talks
 Money Talks
aggregate supply
The real gross domestic product that firms are willing to produce at
each and every price level. In the short run, real GDP and price level
are directly related, but in the long run, real GDP is independent of
the price level.

Demand-pull inflation persists if the public or foreign sector reinforces it. Low
taxes and profligate government spending exacerbate demand-pull inflation. A
failure of the central bank to reign in the money supply also makes the demand-
pull inflation worse.
Demand-pull inflation can spread across borders as well. China’s and India’s
economic growth not only puts pressure on prices in these countries, but also
prices worldwide as the demand for imports increase.

Money Talks
asset inflation
Asset inflation is a type of inflation that occurs only in a specific
industry, such as the housing market, and can happen when overall
inflation is otherwise low. This creates what is popularly called a
“bubble,” where prices rise quickly, beyond a sustainable point. It
can be made worse by a supply shortage. Eventually the market
collapses, rapidly devaluing the assets in that class.

If government spending is financed by printing currency or by the central

bank monetizing the debt, demand-pull inflation can become hyperinflation.
Hyperinflation is defined as annual inflation of 100% or greater. All cases of
hyperinflation have been accompanied by the government or central bank
hyperinflation have been accompanied by the government or central bank
issuing too much money.

Monetizing the Debt

Monetizing the debt refers to the process by which the central bank
buys new government debt, thus increasing the supply of money in
circulation. When debt is monetized, the government is able to
spend without raising taxes or borrowing from the private sector. The
downside is that debt monetization is extremely inflationary.

COST-PUSH INFLATION

Cost-push inflation occurs when the price of inputs increases. Businesses must
acquire raw materials, labor, energy, and capital to operate. If the price of these
were to rise, it would reduce the ability of producers to generate output because
their unit cost of production had increased. If these increases in production cost
are relatively large and pervasive, the effect is to simultaneously create higher
inflation, reduce real GDP, and increase the unemployment rate.

Stagflation

You might recognize the combination of higher inflation, reduced

real GDP, and increased unemployment by another name:
stagflation. In the 1970s, OPEC cut oil production, which led to much
higher energy prices along with double-digit inflation and
unemployment. Because producers faced higher operating costs,
they reduced output. Relative to the demand for their products, the
supply decreased, which resulted in cost-push inflation.
 If cost-push inflation has a bright side, it is the fact that it is self-limiting.
Cost-push inflation is associated with decreases in GDP. The decreased GDP
and resulting high unemployment helps to bring producer prices back down. The
trick to combating cost-push inflation is realizing that it is not demand-pull. The
policy prescription for each is different, and applying the wrong prescription can
create more problems than it solves.

Money Talks
assets
Everything that is owned by an individual or firm. For banks, assets
include its reserves, loans to customers, securities, and real estate.

It is the unemployment issue that usually spurs policymakers to action. If they

respond to the increased unemployment by increasing spending, the inflation
problem is made worse. A wage-price spiral can result if the policy responses
create more demand for goods and services at the same time that unit costs are
rising. By way of analogy, the prescription for a grease fire is different from that
of a forest fire. Grease fires are put out by removing the source of oxygen, while
a forest fire is extinguished with water. If you pour water on a grease fire, then
things only get worse. This is what happened in the 1970s. Instead of letting
cost-push inflation run its natural course, the Fed poured money on it, and
inflation worsened.

Good Inflation

A small amount of inflation is considered healthy for the economy,

as the anticipation that prices will rise increases demand. This
increased demand helps the economy expand. But when inflation
jumps higher, demand increases too much (as people anticipate
much higher prices), creating demand-pull inflation and ever-higher
prices. The magic number seems to be 2%. At a 2% annual rate of
inflation, prices are relatively stable and slow-growing. A 2% inflation
rate results in prices doubling about every thirty-six years.
INFLATION: WINNERS AND
LOSERS
Or When You Should Borrow Instead of Save

Inflation creates winners and losers. Knowing who wins is important for
understanding why it is sometimes allowed to persist. When inflation is expected
and stable, it is rather benign. People and institutions can plan for it and build it
into their decision-making. If inflation is unexpected, it creates a win-lose
situation in society. Who stands to gain from inflation?

BENEFITING FROM INFLATION

First consider what inflation is: a general increase in prices and a corresponding
decrease in money’s purchasing power. Borrowers benefit from a general
increase in prices or a reduction in purchasing power. When individuals,
businesses, and governments borrow, it is usually at a fixed rate of interest that
had some expected level of inflation built into it. If higher than expected
inflation occurs, then the real value of the borrower’s debt is reduced.
Assume that banks lend billions of dollars at a fixed nominal interest rate of
5%. If inflation were to unexpectedly increase from 2% to 4%, then borrowers’
real interest rate paid would be reduced from 3% to 1%. In simpler terms, the
money that was lent was more precious than the money being repaid.
Another group that benefits from an increase in consumer prices in the short
run is producers. When unexpected inflation occurs, consumer prices rise while
wages paid to employees remain relatively stable. This allows producers to
experience higher profits for a time until wages adjust to reflect the higher prices
consumers are paying.
consumers are paying.

Overprinting and Inflation

In the past, many governments in the developing world tried erasing

their foreign debts by overprinting their currency. Faced with much
external debt, governments would devalue their currency in order to
satisfy the debt. Given the current size of the U.S. debt, some fear
that the American government might be tempted to do something
similar. Most developed nations have independent central banks to
act as a check on government’s incentive to overprint currency. In
the United States, the Federal Reserve is somewhat insulated from
political pressure and can constrain the money supply when
government’s incentives are to expand it.

LOSING WITH INFLATION

Inflation harms more than helps. Lenders and savers both lose when inflation
exceeds expectations. Both earn interest rates that assume some rate of inflation,
and when the actual rate exceeds the expected rate, savers and lenders are
harmed. Maybe you save money in a bank CD. Assume you purchase a $1,000
one-year simple CD that pays 4% nominal interest. If inflation increases
unexpectedly from 2% to 5%, then the real interest rate you earn is
approximately −1%. You’re worse off than when you started. In nominal terms
you still made $40 of interest. The problem is that the $1,040 that you now have
has less purchasing power than the $1,000 you started with.
Inflation is thought to be harder on those with lower incomes. People with low
incomes tend to have more of their wealth in the form of cash than do those with
higher incomes. High-income earners have cash to be sure, but they also are
more likely to have much of their wealth in other real and financial assets. For
the poor, inflation exacts a heavier toll because it destroys the value of their
chief asset, which is cash. The higher income earners are able to offset some of
inflation’s effect by holding assets that actually appreciate with inflation.
Those living on fixed incomes are also harmed by inflation. During periods of
unanticipated inflation, fixed income earners see their real incomes decline.
Professionals on a fixed salary or retirees living on a fixed pension lose
purchasing power as long as the rate of inflation exceeds the rate at which their
pay increases. To mitigate some of these effects, employers, or in the case of
Social Security recipients, the government, will adjust pay to inflation through
the use of cost-of-living adjustments (COLA). Even with COLA, fixed income
earners are still harmed by inflation as the cost adjustment lags inflation. During
periods of higher-than-expected inflation, fixed income earners are forever
playing a game where their pay increases are too little and come too late.

The Restaurant Menu As Inflation Indicator

Next time you sit down at a restaurant with laminated menus,

consider what that says about inflation. When restaurants laminate
their menus, they are not only protecting them from spills, but they
are also testifying that prices are relatively stable. When inflation is
out of control, restaurants must continually update their prices, so
they do not want to fix prices on the menu. Unlike most restaurant
prices, seafood prices are highly volatile; that is why they are usually
priced on a chalkboard.

Inflation creates practical problems for individuals and businesses in an

economy. Because money is quickly losing value, consumers must engage in
transactions more frequently as they rush to spend whatever money they have.
The increase in transactions creates what is called shoe-leather costs. You wear
The increase in transactions creates what is called shoe-leather costs. You wear
out your shoes quicker when inflation is present because of the increase in your
transactions. Inflation also poses a problem for producers who constantly have to
re-price their goods as inflation continues. Remember that there is no such thing
as a free lunch. Placing prices on goods is not free. If inflation is high, then
significant costs are created as businesses pay employees to re-price their items.
Persistent inflation results in forgone output as labor resources are put to the task
of keeping up with ever-changing prices.
DISINFLATION AND DEFLATION
Popping the Balloon

One of the triumphs of Fed policy came in the early 1980s when the central bank
under the direction of then-chairman Paul Volcker raised interest rates and
helped bring inflation down from double digits to a more modest 4%, thus
ending the period known as the Great Inflation. If you were around at the time,
then you will recall that the Fed action also resulted in the worst recession in
decades. In retrospect, many economists agree that the reduction in inflation or
disinflation that resulted was worth the cost of recession. From the 1980s
onward, inflation remained relatively low and stable and ushered in an economic
era known as the Great Moderation.

DISINFLATION
Disinflation is beneficial to an economy for several reasons. Disinflation reduces
pressure to increase wages, as prices are more stable. Disinflation also results in
lower, more stable interest rates, which makes capital investment less costly and
easier to plan. Arguably the most important outcome of disinflation is that
producers’ and consumers’ inflationary expectations are lowered, which results
in a profoundly more stable economic environment.

The Role of Expectations

One of the interesting features of economics is the possibility for self-
fulfilling prophecies. In the realm of inflation, fear or hubris is often realized
with changes in the rate of inflation. The fear of inflation or the general
expectation that inflation will occur is often enough to spark an inflationary
period. Consumers fearful of inflation will spend more and save less, which
results in demand-pull inflation. The resulting demand-pull inflation reinforces
the expectation of future inflation, and wage earners demand higher nominal
wages to offset the effects. This of course results in cost-push inflation. If
policymakers fail to manage the expectations of inflation, a higher expected
inflation rate embeds itself into the economic consciousness. With this higher
expected rate of inflation, the economy is not able to produce as much output as
it otherwise would, and faces higher prices than it otherwise should.

Watch What You Say!

Managing inflation expectations means that the Fed chairman must

be very careful about what he says. Former chairman Alan
Greenspan was famous for his cryptic quotes, often referred to as
Fed speak. According to Greenspan, “I guess I should warn you, if I
turn out to be particularly clear, you’ve probably misunderstood what
I’ve said.”

Central bank authorities try to manage not only actual inflation, but more
importantly, the expectation of future inflation. Because the fear of inflation is
often enough to create it, policymakers are in the business of acting as a
psychologist to the economy.
It is not enough to talk the talk when it comes to managing expectations,
however; the Fed must walk the walk. If you have ever dealt with children, you
know that words without action are meaningless. A parent may respond to a
teenager’s rude behavior by threatening, “If you don’t stop behaving this way, I
will confiscate your cell phone for the weekend.” If the rude behavior continues
and the parent doesn’t act on the threat, the parent’s credibility is undermined. A
parent who consistently follows through, however, is much more credible.
Likewise, the Federal Reserve bolsters its credibility when it raises interest
 Likewise, the Federal Reserve bolsters its credibility when it raises interest
rates in response to inflation fears, but loses credibility when it fails to respond
forcibly to the possibility of inflation. The Fed’s credibility as an inflation
fighter was greatly reinforced by Paul Volcker’s chairmanship because he said
what he meant and meant what he said.

DEFLATION
If inflation is bad and disinflation is better, then deflation must be best, right?
Wrong. Deflation occurs when the average price level is declining and money’s
purchasing power is increasing. What could be wrong with that? The problem
with deflation is that it creates a perverse set of incentives in the economy. If
prices are steadily declining, then consumers delay their purchase of durable
goods as the deals just keep getting better as time passes. If this behavior
continues, manufacturing grinds to a halt and widespread unemployment results.
The unemployment would then reinforce the deflation, as fewer and fewer
consumers would be willing and able to purchase goods and services. Producers
respond similarly to deflation by delaying investment and compounding the
effects of the delayed consumption.
Deflation poses a policy dilemma for central banks that primarily use interest
rates to influence economic activity. In response to increased inflation, central
banks raise interest rates to reduce the flow of credit and cool inflation pressure.
There is no upper limit to how high an interest rate can go, but the opposite is
not true. Given deflation, central banks will lower interest rates to encourage
investment and consumption. If the lower interest rates do not have the desired
effect, central banks will continue to lower them until they hit what economists
refer to as the zero bound. Once interest rates are at zero, they cannot go lower.
John Maynard Keynes referred to this weakness in monetary policy as
liquidity trap. If consumers and investors will not borrow at 0% interest, then
you are out of options.
The Deflation Solution

The solution for deflation is to create inflation. Milton Friedman

suggested that in economies with an inconvertible fiat money
standard, deflation should never be a problem. All the monetary
authorities would need to do is print money, or in the case of
economies with independent central banks, monetize the debt, and
the deflation would end. It’s been said that this policy is like a
government ending deflation by dropping cash from helicopters over
the landscape. This policy solution was reiterated in 2002 by
Benjamin Bernanke, which earned the Fed chairman the nickname
“Helicopter Ben.”
AGGREGATE DEMAND AND
AGGREGATE SUPPLY
The Economist’s Crystal Ball

Once you understand the concepts of supply and demand, GDP, unemployment,
and inflation, you have a toolkit for understanding the economic fluctuations that
occur. The aggregate demand and aggregate supply model will allow you to
analyze the entire economy. You’ll even be able to predict what might happen
given certain events. If you’re not careful, you might end up sounding like an
economist the next time the Fed raises interest rates.

AGGREGATE DEMAND
Recall that demand is the willingness and ability of consumers to purchase a
good or service at various prices in a specific period of time. Aggregate demand
(AD) is a similar concept, but has some important distinctions. AD is the
demand for all final domestic production in a country. Instead of just
households, AD comes from all sectors of the economy. Furthermore, AD relates
the price level to the amount of real GDP instead of price to quantity.
The relationship between the price level and the amount of real GDP is
inverse. The higher the price level, the less real GDP is demanded, and the lower
the price level, the more real GDP is demanded. This is true because as the price
level rises, money and other financial assets lose purchasing power. Fewer
people demand our exports, and corresponding higher interest rates discourage
investment and consumption. As the price level decreases, purchasing power
increases, exports become more affordable to foreigners, and the corresponding
lower interest rates encourage investment and consumption.
lower interest rates encourage investment and consumption.
Changes in AD occur when consumption, private investment, government
spending, or net exports change independent of changes in the price level. For
example, if the general mood of the country improves and consumers and
businesses are feeling more confident, they will consume and invest more,
regardless of the price level. This increase in consumption and investment
increases AD.
Likewise, increases in government spending or net exports also tend to
increase AD. Reductions in any of the spending components of GDP will tend to
suppress AD. If government raises the average tax rates on income, households’
disposable income is reduced, and they consume less, which reduces AD.

AGGREGATE SUPPLY
Supply is the willingness and ability of producers to generate the output of some
good or service at various prices in a specific time period. Aggregate supply is a
much broader concept than supply because it is inclusive of all domestic
production, not just a singular good or service. Like an individual firm, an
economy has a production function that relates the amount of labor employed
with the amount of output or real GDP that the economy can produce with some
fixed level of capital. In the short run, the amount of real GDP supplied is
directly related to the price level. However, in the long run, the amount of real
GDP producers collectively supply is independent of the price level.

The Short Run

Why do firms respond in the short run to price level increases by producing
more output and vice versa? Before answering this question, it’s important to
recall what is meant by short run in the macroeconomic sense. The short run is
the period of time in which input prices (primarily nominal wages) do not adjust
to price level changes. If the economy experiences unexpected inflation, the
short run is the period in which money wages remain fixed before finally
short run is the period in which money wages remain fixed before finally
adjusting to the inflation. During this period, firms realize higher profits as their
output earns ever-higher prices while they maintain the same wage payments to
their workers. Firms respond to the higher profits by increasing their collective
output, or real GDP. In response to decreases in the price level, firms reduce
output as they experience losses. This relationship is called the short-run
aggregate supply (SRAS).
SRAS is affected by changes in per-unit production cost. As per-unit
production costs fall, the economy is able to produce more real GDP at every
price level, and as unit costs rise, the economy’s ability to generate real GDP is
reduced. In true economic style, per-unit production costs themselves are subject
to influence by productivity, regulation, taxes, subsidies, and inflationary
expectations.

Productivity is output per worker and as it increases, per-unit costs fall.

Decreases in productivity lead to higher per-unit production costs.
Regulations place compliance costs on businesses and act to reduce SRAS.
For example, to reduce sulfur dioxide emissions, factories must pay for
smoke-stack scrubbers, which means that money cannot be used to increase
output.
Taxes on producers directly reduce their capacity to produce while
subsidies increase their productive capacity.

Inflationary Expectations and Changes in

SRAS

Inflationary expectations influence the unit costs of production and

therefore SRAS. As inflationary expectations increase, workers
demand higher wages, lenders demand higher interest rates, and
commodity prices increase as a result of speculation. The outcome
is for SRAS to be reduced by inflationary expectations. Decreases in
 is for SRAS to be reduced by inflationary expectations. Decreases in
inflationary expectations have an opposite effect and serve to
increase SRAS.

The Long Run

In the long run, the price level is irrelevant to the level of real GDP firms are
willing to produce. The long run is the period of time in which input prices
adjust to changes in the price level. Unlike the short run, where increases in the
price level induce more output, in the long run firms do not realize higher profits
and thus have no incentive to increase output. Why? Input prices match the
increases in the price level. Therefore, in the long run, firms’ input prices
(wages) increase at the same rate as general price inflation, and in real terms are
constant. The independence of real GDP from the price level is referred to as
long-run aggregate supply (LRAS).

Changes in LRAS

LRAS is directly influenced by the availability of the factors of

production. If land, labor, capital, and entrepreneurship increase,
then LRAS increases. Decreases in the availability of these
resources reduce LRAS. Increases in LRAS are characterized as
economic growth. Decreases in LRAS represent a long-term
economic decline. The medieval Black Plague that wiped out a third
of the European population is an example of an event that reduces
LRAS. The invention of the steam engine exemplifies the type of
technology that expands LRAS.
MACROECONOMIC EQUILIBRIUM
Putting It All Together

Macroeconomic equilibrium occurs when the real GDP that is demanded by the
different economic sectors equals the real GDP that producers supply. Short-run
equilibriums occur when AD equals SRAS, and long-run equilibriums occur
when AD equals LRAS. Changes in macroeconomic equilibrium occur when
there are changes in AD, SRAS, or LRAS.
Increases in AD relative to SRAS result in both increased price level and
increased real GDP in the short run, but just increased price level in the long run.

THE INTERPLAY OF AD, LRAS, AND SRAS

As consumers, businesses, government, and the foreign sector demand more

scarce output, firms respond to the increased price level by increasing output. In
the long run, wages adjust to the increased price level, and GDP returns to its
long-run potential at a higher price level. Demand-pull inflation results from
increases in AD. Decreases in AD result in the opposite. As AD decreases
relative to SRAS, both real GDP and price level fall. In the long run, wages and
other input prices adjust to the lower price level and the economy returns to its
long-run potential GDP at a lower price level than when the process began.

Unemployment and Aggregate Demand

Changes

What happens to unemployment as aggregate demand changes?

Increases in AD lead to increases in real GDP. The increase in real
 Increases in AD lead to increases in real GDP. The increase in real
GDP creates more demand for labor and reduces the unemployment
rate. The reduced unemployment comes at the cost of an increase
in the price level.

Changes in SRAS relative to AD also lead to changes in real GDP and price
level. Unlike AD changes, which lead to GDP and price level moving in the
same direction, SRAS changes result in GDP and price level moving opposite
from each other.

An increase in SRAS relative to AD will lead to a higher real GDP at a

lower price level because as production costs fall, firms are more willing to
produce more output at each and every price level.
A decrease in SRAS relative to AD leads to the economic condition
previously described as stagflation. Stagflation occurs when GDP decreases
are combined with increases in the price level. When the costs of
production rise, firms produce less output at each and every price level.

THE CLASSICAL VIEW

Prior to the Great Depression, orthodox economic thought could be described as
classical. Today, classical refers not only to those economists with pre-
Depression notions of the economy, but also can be used to describe a much
broader group of economists who favor market-based solutions to economic
problems. The classical camp espouses what is best described as a laissez-faire
philosophy.
The classical view of the economy is one that emphasizes the inherent
stability of aggregate demand and aggregate supply. Efficient markets are able to
quickly and effectively reach equilibrium conditions, so periods of extended
unemployment are not possible. When consumers stop spending, they are saving
instead. This increased saving reduces the real interest rate and spurs investment
instead. This increased saving reduces the real interest rate and spurs investment
in capital, so any decreases in consumption are offset by increases in investment.
This leads to the conclusion that AD is stable.
If shocks do occur to the economy, flexible wages and prices allow the
economy to quickly adjust to changes in the price level, as rational economic
actors take into account all available information when making decisions. For
example, workers will accept lower wages in response to deflation and demand
higher wages in response to inflation. This quick response implies that the
economy tends to remain at its long-run equilibrium of full employment.
Government interference is not warranted given this assumption, and as a result,
laissez faire is the best policy.

Say’s Law

One of the assumptions at the heart of classical economic thought is

Say’s law. French economist Jean-Baptiste Say believed that supply
creates its own demand, and as a result, surpluses and gluts could
not be sustained in a market economy.

The classical response to economic recession is to do nothing. A decrease in

AD leads to lower GDP and a lower price level. The resulting high
unemployment puts downward pressure on wages as workers will willingly go
back to work for less money. These lower wages encourage firms to increase
SRAS, and the economy returns to equilibrium at full employment. No
government action is necessary as market forces are working to bring the
economy back to full employment.
The classical response to inflation is also to do nothing. Increased AD leads to
a higher GDP and higher price level. As the unemployment rate falls below the
natural rate, considerable upward wage pressure results. With few unemployed
workers available, firms compete with each other for already-employed workers;
workers available, firms compete with each other for already-employed workers;
this means offering higher wages to entice them to leave their current jobs. This
intense competition for workers and other resources increases the costs of
production for businesses. They eventually reduce production, and the economy
returns to full employment at a higher but stable price level. Once again, no
government intervention is necessary because market forces return the economy
to its long-run full-employment equilibrium.
THE KEYNESIAN VIEW AND
FISCAL POLICY
The Meddler

Britain’s John Maynard Keynes was a classically trained economist who

eventually came to the conclusion that the classical assumptions did not describe
the reality of his day. During the Depression, Keynes wrote The General Theory
of Employment, Interest, and Money. In it he challenged the prevailing
assumptions and concluded that government intervention was warranted in the
case of the Depression. He observed that saving did not instantly translate into
new capital investment. Savings gluts could and did occur, and this implied that
AD was inherently unstable, as decreases in consumption were not offset by
increases in investment.

Free Market Enemy?

Keynes is a polarizing figure in economics. His ideas challenged the

status quo, and he is seen by many as the enemy of free-market
economics. The writings of Friedrich von Hayek and Ludwig von
Mises of the Austrian school of economic thought are often quoted
today as a counter to Keynes’s arguments.

He also observed that wages and other input prices were not downwardly
flexible. Workers did not readily accept pay decreases, nor did employers offer
them. As a result, periods of high unemployment could persist as market forces
did not function to bring the economy to full employment. The implication of
did not function to bring the economy to full employment. The implication of
these observations was that government intervention was necessary in the case
of high unemployment.

KEYNES AND RECESSION

Given a recession, the Keynesian response is to increase government spending

and to reduce income taxes in order to spur aggregate demand and return the
economy to full employment. This means that government must be willing to
run deficits in order to carry out the policy. On the bright side, Keynes shows
that returning the economy to full employment can be done relatively cheaply
because of the multiplier effect. If real GDP is $14 trillion but potential real
GDP is $15 trillion, government does not have to spend $1 trillion to close the
recessionary gap, but instead only a fraction of that because of the multiplier
effect.
Here is how Keynes defined the multiplier effect. Keynes observed that
individuals have a marginal propensity to consume and save. In other words, if
you give people a dollar, they are inclined to spend some of it and save some of
it. If government spent money on public works, the contractors and employees
would then turn around and spend a portion of the resulting income and save the
rest. This process would continue and lead to a multiplier effect throughout the
economy.
For example, if Americans have a marginal propensity to consume 80% of
their income, then an increase in government spending on infrastructure of $50
billion will result in $50 billion in government spending and then $40 billion of
new consumer spending, followed by $32 billion and so on until eventually total
spending equals $400 billion. How did that work? $50 billion in government
spending kicks off a continuing cycle of consumption and income. The higher
the marginal propensity to consume, the higher the multiplier effect. Keynes also
recognized that government spending yielded a larger multiplier effect than
equal-sized tax cuts because people save a portion of their incomes. Thus, not all
equal-sized tax cuts because people save a portion of their incomes. Thus, not all
of the tax cuts’ value is spent on consumption.
Keynes’s observations and influence completely changed the study of
economics. Today’s policy framework is based on the ideas of Keynes and his
followers. Although much of the modern debate is framed in terms of free-
market capitalism versus socialism, Keynes was an advocate of capitalism, and
his approach is better characterized as a hybrid form of capitalism than
socialism.

Embracing Keynes

Keynesian economic policy was made the law of the land through
the passage of the Employment Act of 1946. Signed by President
Truman, the law requires government to pursue maximum
employment, production, and purchasing power. The law also
created the Council of Economic Advisors.

THE INFLATION-UNEMPLOYMENT TRADE-OFF

The influence of Keynesian thought grew from the 1930s until the 1970s. The
research of New Zealand–born economist A.W. Phillips helped reinforce
Keynes’s influence on governments during this period. Phillips studied the
relationship between wage inflation and the unemployment rate in Britain and
concluded that periods of wage inflation were associated with periods of low
unemployment. Periods of stagnating wages were associated with periods of
high unemployment. American economists Paul Samuelson and Robert Solow
adapted the Phillips curve for the U.S. economy. Using this model, they
compared general price inflation (instead of wage inflation) to the
unemployment rate. Many policymakers and economists reached the logical
conclusion that Keynesian-style fiscal policies that stimulate AD could be used
conclusion that Keynesian-style fiscal policies that stimulate AD could be used
to sustain low unemployment at the cost of some known amount of inflation.
The idea worked something like this: If policymakers wanted to reduce
unemployment from 7% to 5%, the trade-off would be a known change in the
inflation rate from 1% to 2%.
The experience of the 1970s caused some serious doubts about the legitimacy
of the Phillips curve. Remember stagflation? During the 1970s, both inflation
and unemployment simultaneously increased. These results did not align with
the predictions of the Phillips curve, which implied the two were trade-offs.
Milton Friedman and Edmund Phelps viewed this real-world data as a
disproof of the Phillips curve, and more importantly, of the validity of Keynesian
economics. Friedman and Phelps introduced the natural rate hypothesis, which
concluded that the rate of unemployment is independent of inflation in the long
run. Efforts by government to reduce unemployment by creating temporary
inflation would be ineffective. Workers would try to keep their real wages from
falling by demanding higher nominal wages in line with inflation.

The Money Illusion

An assumption of Keynesian economics is that people suffer from

money illusion. They prefer earning $100 per hour and paying $10
per gallon of gasoline to earning $10 per hour and paying $1 per
gallon of gasoline. Even though real purchasing power is the same
in each example, people have a strong preference for higher
nominal wages.

The new consensus on the Phillips curve is that there are two types of curves.
There is a short-run Phillips curve that implies a trade-off between inflation and
unemployment, and there is a long-run Phillips curve that exists at an economy’s
natural rate of unemployment. Sampling a few years of inflation and
natural rate of unemployment. Sampling a few years of inflation and
unemployment data may suggest an inverse relationship between the two, but
including all available data reveals no relationship between the two variables.
Economists chalk up changes in the short-run Phillips curve versus the long-
run Phillips curve as being the result of changing inflation expectations.
Phillips’s original observations about the British economy were about a time
period where expected inflation was stable. The breakdown of the adjustable peg
exchange rate regime in 1971 effectively ended any type of gold standard and
introduced a period of uncertainty about inflation. The resulting increases in
inflation expectations help to explain the increased inflation and unemployment
that occurred. Short-run Phillips curves exist during periods of stable inflation
expectations. When inflation expectations change, the short-run Phillips curve
relationship breaks down, and either simultaneous increases or decreases in
inflation and unemployment can occur. Once a new expected inflation rate
embeds itself into the economy, a new short-run Phillips curve emerges.
Alan Greenspan attributes the reduction in inflation expectations as the reason
for the low inflation and unemployment that occurred during his chairmanship at
the Fed. According to Greenspan, productivity gains from globalization subdued
inflation fears for much of his tenure. Taking into account the influence of
inflationary expectations, Keynesian policies will only work as long as inflation
expectations remain stable. If the Keynesian AD policies create higher inflation
expectations, they will be thwarted as attempts to stimulate AD and reduce
unemployment will only create more inflation.
THE FEDERAL RESERVE
SYSTEM
The Bank We Love to Hate

America has a long and storied love-hate relationship with its banking system.
The most vilified institution is the nation’s central bank, the Federal Reserve, or
just the Fed. The Fed is not America’s first central bank or even its second.
Regardless of your feelings toward it or the history behind it, the Fed is at the
center of the American economy and deserves your careful consideration.

HISTORY OF BANKING REVISITED

At the end of the American Revolution, the United States was saddled with
significant war debt. In order to handle the debt and to create a unified currency,
Alexander Hamilton proposed the creation of a central bank for the young
nation. The First Bank of the United States, headquartered in Philadelphia, was
modeled after the Bank of England. It served as the nation’s central bank from
its charter in 1791 until 1811 when the charter was allowed to expire.
In the nineteenth century, America went through a series of economic panics
that led to the creation of another central bank. This bank eventually became a
political target and failed to bring economic stability to the country.
The Second Bank of the United States was given a twenty-year charter in
1816 to help the U.S. economy recover from the economic effects of the War of
1812. The Second Bank established a uniform currency and acted as a
depository for the Treasury’s accounts. The Second Bank of the United States
was believed by many to be corrupt, and political pressure from President
Andrew Jackson sealed its fate. In 1833, three years before its charter expired,
Andrew Jackson sealed its fate. In 1833, three years before its charter expired,
Jackson had his Treasury secretary withdraw the U.S. government’s deposits
from the bank and place them in state-chartered banks. This effectively killed the
bank, and by 1841 the Second Bank of the United States was bankrupt.
During and after the Civil War, the United States created more national banks
and reintroduced a single uniform currency. These national banks were
instrumental in allowing the government to borrow by issuing bonds. Unlike the
First and Second Banks of the United States, however, these national banks were
decentralized.
The Bank Panic of 1907 was the impetus for creating the Federal Reserve
System. A failed attempt by a Montana investor to corner the copper market led
to a loss of confidence in the financial institutions associated with him and his
brother. The contagion spread to unassociated institutions and within a few days,
an all-out run on the New York financial system was under way. Fortunately,
J.P. Morgan and Theodore Roosevelt’s Treasury secretary brought calm to the
situation by injecting cash into the banking system and eventually bringing an
end to the bank runs. The Panic of 1907 showed that America needed a central
bank to act as a lender of last resort to ensure liquidity in the banking system.

THE CREATION OF THE FEDERAL RESERVE

SYSTEM
The 1913 passage of the Federal Reserve Act, signed into law by Woodrow
Wilson, created the Federal Reserve System. Unlike previous attempts at central
banking, the Fed drew from the strengths of its predecessors. Instead of creating
a single central bank, the Federal Reserve Act established a decentralized,
public-private banking system. The Fed is not headquartered in a single location,
but has separate locations across the United States. The Federal Reserve is
neither a purely governmental institution, nor is it a purely private institution.
The Fed has features of both.
 The Fed is the bank for the U.S. government. The Treasury keeps its accounts
with the U.S. government and the government in turn writes checks from its
accounts with the Fed. The taxes collected and the money borrowed through
issuing government bonds are all deposited in the U.S. Treasury’s account with
the Fed. Every time a taxpayer receives a refund, or a Social Security recipient
receives their check, the checks are being drawn from the Treasury’s account
with the Fed.

Cash on Hand

Most of the money on deposit with the Federal Reserve exists in

electronic form, but each of the district banks has a significant vault
with millions of dollars under heavy security. In the early days of the
Fed, the teller window was protected from bank robbers by pillbox-
encased machine guns.

The Federal Reserve System’s government arm, the Board of Governors, is

headquartered in Washington DC. The governors are appointed by the President
of the United States and confirmed by the Senate for single, staggered fourteen-
year terms. The Board is supervised by the Fed chairman and vice chairman,
who are also members of the Board. The chairman and vice chairman are
appointed by the president and confirmed by the Senate for unlimited four-year
terms. The Fed chairman is the face of the Federal Reserve System and is
considered by many to be second in power only to the President of the United
States when it comes to economic influence. The Board of Governors creates
policy and regulations for the nation’s banking system, sets reserve
requirements, and approves changes in the discount rate.
In keeping with the United States’ federal nature, the Fed is divided into
twelve distinct geographic districts with headquarters for each district located in
cities across the United States. Each district is an equal part of the Federal
cities across the United States. Each district is an equal part of the Federal
Reserve System. The district banks act as the bankers’ banks and accept deposits
from member banks. The district banks also perform a regulatory role in their
district by monitoring the member banks and enforcing regulations within their
respective districts. The district banks serve a vital role in processing paper
checks and electronic payments for the banking system. Finally, the district
banks issue the currency to the banking system that they acquire from the U.S.
Department of Treasury.

THE FOMC
The Federal Open Market Committee (FOMC) is the chief architect of the
nation’s monetary policy. The twelve voting members of the committee are
made up of the Fed chairman, the Board of Governors, the Federal Reserve Bank
of New York’s president, and four other district bank presidents who serve on a
rotating basis, although all the district bank presidents are present at the
committee meetings. The FOMC meets eight times a year, or about once every
six weeks, to review economic performance and decide the course of monetary
policy by targeting the fed funds rate. FOMC meetings are closely monitored by
the press and financial markets. Members of the media and investors carefully
analyze the FOMC’s press releases, looking for clues as to what might be the
future direction of policy.

Briefcase Speculation

Investors attempting to profit by speculating on the Fed’s interest

rate policies would study the size of Alan Greenspan’s briefcase
during his tenure as Fed chairman. They theorized that if the
briefcase was big and heavy, he was carrying documentation to
support his argument for changing interest rates. If the briefcase was
support his argument for changing interest rates. If the briefcase was
light, then interest rates would probably remain unchanged.
MONETARY POLICY
Leave the Driving to Us

The goal of monetary policy is to promote price stability, full employment, and
economic growth. The Fed, a monopolist over the money supply, is in a unique
position to influence aggregate demand in the economy. Fed policy affects
excess reserves in the banking system, which directly influences the money
supply, which, in turn, changes interest rates. These changes in interest rates lead
to changes in aggregate demand via consumption, investment, and net exports.
The resulting change in AD affects GDP, inflation, and unemployment.

HOW THE FEDERAL RESERVE AFFECTS THE

ECONOMY
The Federal Reserve influences the economy by applying pressure to interest
rates and talking to the public. In the case of economic growth, the Fed can warn
against inflation by ever so slightly raising interest rates whenever the economy
seems to be growing too quickly. During periods of inflation, the Fed can mash
down on the interest rate brake pedal, give a stern warning to the driver, and
bring the economy back under control.
In the case of recession, the most the Fed can do is let off the brake pedal, or
lower interest rates and encourage the driver to hit the gas. The Fed’s power is
asymmetrical; it is capable of stopping inflation, but only capable of encouraging
full employment.

Reserve Requirement
A bank’s reserve requirement is the percentage of checking account balances
that the bank is not able to lend against. If the Fed were to raise the requirement,
banks would have fewer excess reserves from which they could lend. This would
reduce the money supply and result in higher interest rates, discouraging capital
investment and durable goods consumption. This decrease in investment and
consumption lowers AD and leads to less real GDP, higher unemployment, and a
reduction in inflation. Lowering the reserve requirement would have the exact
opposite effect.

Drawbacks to Changing the Reserve

Requirement

The problem with changing the reserve requirement is that it is easy

to lower, but much more difficult to raise. If the Fed lowers it, banks
are able to lend more of their reserves and no real problem is
created. However, raising the reserve requirement during periods of
inflation would be nearly impossible for banks, as they probably
have no excess reserves not already lent. The increase in the
reserve requirement would precipitate an immediate liquidity crisis in
the banking sector. Banks would call in loans and do whatever they
could to meet the new higher requirement.

Discount Rate
The discount rate is the interest rate that member banks pay the Fed to borrow
money overnight, usually when they are in financial distress. Raising the
discount rate discourages borrowing, but lowering the discount rate encourages
it. If the Fed wants to reduce inflation, it raises the discount rate. When the Fed
does this, the following chain of events is set into motion: The Fed announces an
increase in the discount rate; banks are discouraged from borrowing; excess
reserves are less likely to be lent; the money supply does not grow; interest rates
rise; consumption, investment, and net exports fall; AD decreases; GDP falls;
rise; consumption, investment, and net exports fall; AD decreases; GDP falls;
unemployment rises; and inflation falls. Lowering the discount rate would have
the exact opposite effect.

Drawbacks to Changing the Discount Rate

The problem with the discount rate is that banks are reluctant to
borrow directly from the Fed. The reluctance stems from the fact that
other forms of borrowing are available at lower rates, so going to the
Fed’s discount window is a public admission that something is wrong
with the borrowing bank. A bank in good financial position will
usually borrow to cover its short-term needs in the interbank lending
market. The principal decision-makers at a bank do not want to
scare away investors or current shareholders by borrowing from the
Fed.

The discount rate is useful as a signal of future interest rate policy. This
signaling function is important, as financial markets do not like surprises.

Open Market Operations

The primary way that the Fed enacts monetary policy is through the process
known as open market operations (OMO). OMO is the buying and selling of
U.S. Treasury securities (Treasuries) between the Federal Reserve Bank of New
York’s open market desk and a select group of eighteen primary security dealers.
The dealers include most of the world’s major banks and securities broker-
dealers. They are expected to participate as counterparties to the Fed’s open
market operations and share market information with the Fed. OMO transactions
have the effect of either increasing excess reserves in the banking system when
the Fed buys Treasuries from the primary security dealers, or reducing excess
reserves in the banking system when the Fed sells Treasuries to the primary
reserves in the banking system when the Fed sells Treasuries to the primary
dealers.

WHEN POLICIES COLLIDE: FISCAL/MONETARY

MIXER
Federal Reserve policy does not exist in a political vacuum. Instead, monetary
policy functions alongside government’s fiscal policies. At times the two are at
odds, but most of the time monetary policy is used to accommodate fiscal policy.
For this to work, the Fed chairman, the president, the Treasury secretary, and
key members of Congress communicate to create a coherent policy that
addresses the fundamental goals of price stability, full employment, and
economic growth.

Money Talks
fiscal policy
The use of the federal budget in order to reduce unemployment or
stabilize prices.

During periods of recession, expansionary fiscal policy is reinforced with

expansionary monetary policy. As government spending increases and taxes
decrease, upward pressure is placed on interest rates. Expansionary monetary
policy offsets the upside pressure on interest rates by expanding the money
supply and lowering short-term interest rates.
Inflationary periods are more problematic for presidents and lawmakers. The
contractionary fiscal policy prescription calls for reduced spending and increased
taxes, which are politically unpopular. Contractionary monetary policy is
effective at stopping inflation, and the Fed’s insulation from political pressure
makes it perfectly suited for the task. Former Fed chairman Paul Volcker was
credited with whipping inflation when government was unable to do so.

MONETARY POLICY IN THE SHORT RUN AND

THE LONG RUN

Monetary policy has different effects in the short run and the long run.
Expansionary monetary policies designed to reduce short-term interest rates and
spur full employment and economic growth eventually lead to higher interest
rates as they induce inflation. This means that monetary policy must be carefully
applied. If the Fed introduces a monetary stimulus, they must also plan to
remove the stimulus in order to prevent future inflation. The problem for
policymakers is in timing the policy. Early removal of monetary stimulus might
result in a protracted recession, but maintaining low interest rates for too long
will almost certainly lead to higher inflation.
Too much reliance on monetary policy to reduce inflation can also lead to
problems. Over the business cycle, if government uses expansionary fiscal
policy to offset recessions and then relies on the Fed to contain periods of
inflation, interest rates will ratchet up and long-term economic growth will be
stymied. At some point government must reign in its spending and/or raise taxes
to keep long-term interest rates from rising too high.
SUPPLY-SIDE ECONOMICS
The Rise of Voodoo Economics

The concurrent high unemployment and inflation of the 1970s was a painful
period in American economic history. Stagflation came as a shock to many
politicians and economists alike. By the 1970s, Keynesian economic thought
was embedded in the minds of most policymakers. Although Milton Friedman
and Edmund Phelps had publicly refuted the idea that there is stable trade-off
between inflation and unemployment, policymakers were not quite willing to let
go of the belief.

The Misery Index

Arthur Okun developed a simple index of economic hardship called

the misery index. The misery index is the sum of the unemployment
rate and the inflation rate. Given normal conditions, the misery index
is usually around 7. During the Carter administration, the misery
index steadily increased because of stagflation and reached an all-
time high of 20.76.

The Keynesian economic framework so permeated policy decisions by the

1970s that data challenging the effectiveness of Keynesian economics created
cognitive dissonance for many. When unemployment is high, government
should spend more, and when inflation becomes a problem, the Fed should
tighten. What stagflation presented was an intractable problem for many in
positions of power. Spending to alleviate unemployment would only make
inflation worse. Fed tightening would reduce employment. The policy options of
those influenced by Keynes focused on either increasing or decreasing aggregate
demand. What to do? The answer offered by some was to focus on the supply
side of the aggregate supply and aggregate demand model.

Coining a Phrase

Although it might appear that all things Keynes are associated with
Democrats and supply side with Republicans, this is not the case.
Much of the criticism of supply-side economic theory came in the
1980 Republican primary from Reagan’s chief opponent, George
H.W. Bush, who referred to Reagan’s economic plan as “voodoo
economics.”

SUPPLY-SIDE ECONOMICS

Stagflation was fundamentally a supply problem, which is why a demand-side

solution would not work. Classical economics’ laissez-faire approach enjoyed
something of a renaissance after Ronald Reagan’s election. In the classical view
of the economy, flexible and efficient markets ensure that the economy will
maintain full employment. When recessions or periods of inflation set in,
flexible input prices cause aggregate supply to increase or decrease and bring the
economy back to full employment without government intervention. In the years
from the 1930s to the 1970s, there was a decrease in the flexibility and
efficiency of the labor market. The supply-side argument was that government
had gummed up the works and the markets needed to be de-Keynesed.
Deregulation, which began under President Carter, picked up steam under
Ronald Reagan. The airlines, which in the past had been heavily regulated by
government, were set free and forced to compete with each other. This resulted
government, were set free and forced to compete with each other. This resulted
in far more flights at cheaper prices. It also meant that the least efficient airlines
were driven out of business.
Labor unions saw a decline in power under the Reagan administration.
Foreign competition in the steel and car industry weakened the position of the
unions. Probably the most powerful symbol of the loss in union power came at
the hands of the newly elected president. The air traffic controllers union had
lobbied for better pay and working conditions. In 1981, the union went on strike
in violation of federal law. After being warned to return to work or be fired, over
11,000 air traffic controllers refused to return and were summarily fired by
President Ronald Reagan. The message was clear.
While running for office, Reagan promoted the idea that tax cuts on high-
income earners would enrich all Americans, as people had more incentive to
spend and save. The spending and saving would lead not only to more
consumption, but also more capital investment. As investment increases,
businesses expand their productive capacity, and this leads to higher
employment. The resulting increase in capital also leads to greater productivity,
and eventually, lower prices.
The power of tax cuts to stimulate aggregate demand was well known to
Keynesian economists. But the supply-side spin was that tax cuts would not only
stimulate aggregate demand, but supply as well. At the same time that Reagan
was proposing tax cuts, he also called for an increase in defense spending to
counter the Soviet threat. Economists, politicians, and average people questioned
the idea of simultaneously cutting taxes and increasing government spending. It
appeared obvious that such a combination of policies would result in the federal
government running large deficits as it spent more and taxed less.

CHALLENGES TO SUPPLY-SIDE ECONOMICS

Sometimes reality has a way of ruining a great idea. Reagan got his tax cuts and
he got his increases in defense spending, but he also got huge deficits. Increased
he got his increases in defense spending, but he also got huge deficits. Increased
tax revenues failed to materialize. Instead, tax revenues drastically fell, and
government budget deficits increased steadily during Reagan’s administration.
A criticism of supply-side economics is that it effectively redistributes income
to the rich. Because the mantra of supply-side economics is “tax-cuts on income
and capital gains,” it stands to reason that the immediate beneficiary is going to
be those with significant income.
Although supply-side economics is not mentioned much anymore, its
arguments and logic are still part of the Republican and Libertarian political
platforms. Cutting taxes, creating incentives for people to save and invest, and a
general distrust of government involvement in the economy are supply-side
ideas that still resonate with many voters. Democrats tend to promote a more
populist agenda. Tax cuts for the middle class with tax increases on the wealthy,
increased regulation of business, and the use of transfer payments to redistribute
income are all ideas advanced by the Democrats and associated for good or bad
with the Keynesians.

A COMPLETE TOOLBOX
Although supply-side economics as a field of study is derided by most
mainstream economists, it has served to remind people that incentives matter.
Policymakers must consider not only what voters want, but also how their
policies shape the incentives of consumers and producers. Whenever
government creates a new mandate that seeks to regulate economic behavior, it
must also be prepared to deal with the unintended consequences that occur as the
new mandate alters the incentives of individuals and institutions.
Ignoring the supply side of the economy leads to a unilateral approach to
policymaking that ultimately boxes government into two choices: increase
aggregate demand or decrease aggregate demand. By recognizing the role of
aggregate supply, policymakers can promote more policy solutions to achieve
their ultimate economic goals. For example, recognizing that a tax cut on
their ultimate economic goals. For example, recognizing that a tax cut on
personal income has demand-side and supply-side effects allows policymakers
to sell the option to their diverse constituencies.
ECONOMIC GROWTH
Building a Better Society

In Jared Diamond’s study of human history, Germs, Guns, and Steel, he talks
about the question that prompted him to study the course of human events. As an
avid bird watcher, Diamond took many trips to New Guinea, where he
befriended a man named Yali. Yali asked Diamond why it was that the European
descendants had so much while the people of New Guinea had so little.
Diamond’s fascinating account of the forces that shaped human history and the
distribution of wealth is great reading. But for an economist, economic growth is
described more simply—it’s merely an increase in the GDP.

WHAT GROWTH MEANS

Economic growth occurs when there is a sustained increase in a nation’s real
gross domestic product per person over time. In most years the United States’
real GDP grows at a rate of approximately 2%. This means that on average, the
economy doubles in size every thirty-six years. At the same time, the population
increases at a rate of 1%, which means that current real GDP per capita is almost
three times greater than in 1960. Economic growth is not guaranteed. Indeed,
there are years in which no or negative growth occurs. These periods are
associated with recession.
Growth reveals itself in positive and negative ways. Economic growth leads to
increases in living standards, nutrition, healthcare, longevity, and material
abundance. The downside is that economic growth often results in
environmental destruction and increased income inequality. Economic growth as
a goal for society is hotly debated, and both sides offer well-reasoned rationales
a goal for society is hotly debated, and both sides offer well-reasoned rationales
for their positions.

WHY GROW?

Proponents of economic growth focus on the benefits it creates for society. The
advances in food production, healthcare, longevity, and material abundance
would not be possible without economic growth. A century ago, most Americans
were involved in agricultural production and yet subsisted on far fewer calories
than today’s Americans, less than 2% of whom are farmers. The average life
span has increased from 48 to 78 years in the same period because of the
eradication of many diseases and advances in basic sanitation and healthcare.
The quality and quantity of material goods has increased as well, allowing more
Americans the things that only the wealthy could acquire in previous
generations. The average workweek has decreased in the same period of time,
allowing people more leisure. For most, economic growth has been a blessing.

Money and Happiness

Can money actually buy happiness? When economists compare

GDP per capita with a country’s overall level of happiness, an
interesting trend occurs. As GDP per capita increases from $0 to
$10,000, the level of happiness increases. This relationship breaks
down after that. So to answer the question, the first $10,000 does
buy happiness. After that, who knows?

As the economy grows and diversifies, more and more people are able to
escape subsistence farming and pursue other areas of interest. This freedom for
most everyone to pursue their interest and passion did not exist for most of
recorded history. The creative explosion of production that has occurred over the
last 150 years has yielded advances in all fields of human endeavor. Where life
was nasty, brutal, and short for most, it is now relatively humane, peaceful, and
long. If you have ever visited an old cemetery, you might have noticed the
number of graves for young children. What was once a common occurrence is
now a rare tragedy. The diseases that ravaged the population less than a century
ago are for the most part eradicated. All of this is possible because of economic
growth.

Material Abundance and Economic Growth

Material abundance is a benefit of growth and is often seen by critics

as the driving force behind growth policy. They may be right, but if
growth also yields substantive benefits for humanity, an extra iPod
or McMansion might be a small price to pay. Material abundance is
a natural outflow of humans being set free from subsistence
agriculture to think, invent, and create. And even for those who
choose to return to the land and farm, that freedom exists as well.

As people have become more specialized and more productive, their value to
society has increased as well. Consider the amount of time and resources now
devoted to raising an American child. The average American child has over
$250,000 invested in her human capital. Aid organizations understand that
increasing an individual’s value to society is important for developing a stable,
productive society. Organizations that provide food assistance in the developing
world have discovered that delivering families’ food rations to the daughters in
school increases the value of the daughter to the family, which reduces the
incidence of childhood pregnancy and prostitution.
CONDITIONS FOR ECONOMIC
GROWTH
Planting the Seeds of Production

Economic growth doesn’t happen by itself. It requires a number of different

elements to occur. Some of these are obvious—people to make the products and
resources to make the products from. But others are less obvious. Consider
countries where laws are not equitably enforced. Can sustainable economic
growth occur?

HUMAN CAPITAL
The most important element in economic growth is human capital. Human
capital consists of the education, skills, and abilities possessed by an individual.
Countries that invest heavily in human capital tend to have more economic
growth than similarly endowed countries that do not. The United States is one of
the world leaders in developing human capital. Compulsory primary and
secondary education, mandatory vaccinations, and abundant nutrition have
contributed to making America the most productive nation on earth. No nation
spends more on educating and developing human capital than the United States.
Individual freedom and the ability to acquire private property are also
essential elements in developing human capital. When individuals are free to
choose their vocation and enjoy the benefits of private property, their
productivity is higher than in places where individual freedom or private
property is not valued. By way of comparison, the average German was far more
productive in capitalist West Germany than in communist East Germany, and the
average South Korean today is far more productive than the average North
average South Korean today is far more productive than the average North
Korean, because economic freedom provides the incentive to produce more in
order to have more.

Population Growth and Economic Growth

To have human capital, you must have humans. For economies to

develop and grow, it is important that the population grows as well.
Population growth must also occur alongside productivity growth.
Larger populations are capable of producing more output as well as
more innovation because the greater the population, the greater the
number of productive resources. The more people a country has, the
more probable entrepreneurs it has. And entrepreneurs are one of
the drivers of economic growth.

The presence of immense natural resources can sometimes be a deterrent to

developing human capital. The paradox of natural resource wealth is that
governments are often so eager to exploit their natural resources for export that
they neglect to invest in their population’s human capital. At first glance, a
comparison of Russia and Japan would lead most observers to believe that
Russia is far wealthier than Japan. After all, it has the largest deposits of
minerals and natural wealth in the world. Japan, on the other hand, has few
natural resources. However, Japan has enjoyed much greater economic growth
because it has invested far more in its human capital.

PHYSICAL CAPITAL

Developing human capital alone is not enough to create economic growth.

Economies must also invest in developing physical capital. Physical capital is
the tools, factories, and equipment that are used in the production process. As the
the tools, factories, and equipment that are used in the production process. As the
stock of physical capital increases, the nation experiences capital deepening.
Capital deepening refers to the amount of capital available to each worker.
Capital deepening provides for a more productive labor force. The average
American worker is backed by $130,000 worth of physical capital. This is one of
the reasons for America’s productivity edge.

Human Capital versus Physical Capital

Some capital replaces labor, while other capital enhances it. A robot
that welds automobile frames replaces workers, but a pneumatic
jackhammer both enhances and replaces workers. One worker with
a pneumatic jackhammer can do the work of several workers armed
with sledgehammers. Regardless of whether or not it replaces or
enhances, capital leads to greater productivity.

Because physical capital is the result of investment, interest rates play a key
role in its development. Low, stable interest rates encourage investment. In the
short run, investment creates increased aggregate demand, but in the long run it
expands the economy’s stock of capital. High interest rates or unstable interest
rates are injurious to investment decisions and result in the formation of less
capital.
Once capital is deployed, it must be maintained. Capital needs adequate
infrastructure to realize its potential. Roads, waterways, rail systems, and reliable
utility systems make capital easier to access and greatly improve the chances that
it will be used effectively. One of the failures of the Soviet Union was an
ineffective use of capital. The Soviets built factories that dwarfed their Western
counterparts. But because of inadequate infrastructure, they were often difficult
to get to. This made distributing their output more difficult. The developing
world lacks steady sources of power and the transportation networks that are
world lacks steady sources of power and the transportation networks that are
necessary for efficient use of factories. Europe, Japan, and the United States, by
comparison, have ample infrastructure to facilitate the continuous use and
transport of capital’s output.

RESEARCH AND DEVELOPMENT

Creativity, innovation, and invention are necessary for economic growth to
continue. Western and Japanese firms spend far more on research and
development than do firms in the developing world. Research and development
requires sacrificing current profits in order to gain even greater profits in the
future. For firms to take this risk, incentives must exist and be protected. Patents,
which provide legal protection for inventors, provide the protection firms need to
realize the profits of their research and development.
If developing countries want to continue economic growth, they must find
ways to encourage innovation. China’s impressive growth over the last fifteen
years has mainly come from the production of goods developed elsewhere.
Although China has many capable, intelligent, and innovative people, the laws in
China do not adequately protect intellectual property. Very little incentive exists
for Chinese manufacturers to spend money on research and development of new
products if the factory next door can just copy them and produce them without
expending the research dollars. Over time, expect to see China make strides in
protecting the intellectual property of its manufacturers.

THE RULE OF LAW

Another condition for growth is the rule of law. Government officials should
obey the law and should also apply the law uniformly and fairly. Corruption and
cronyism discourage domestic and foreign investment by effectively raising the
cost of capital. Firms, individuals, and foreign investors must know that their
property is protected by law. One reason that capital investment is lacking in the
property is protected by law. One reason that capital investment is lacking in the
developing world stems from the fact that corrupt governments are far more
likely to seize private property in the name of national interests. Venezuela’s
seizure of foreign-owned oil fields in 2007 most likely deters future foreign
investment. Unlike Venezuela, former British colonies such as the United States,
Canada, Australia, New Zealand, and Hong Kong inherited the English common
law with its emphasis on private property, which makes them safe and attractive
to foreign investors. Foreign owners of capital have basically the same rights as
domestic investors. As a result, more capital accumulates in these countries than
in most others.
HOW ECONOMIC POLICY
AFFECTS GROWTH
The Government Gets Involved

Government policies also play a role in determining economic growth.

Stabilization policies by the central bank affect interest rates and thus capital
investment. Fiscal policy impacts capital investment indirectly through the effect
of government debt on interest rates. Tax policies that affect consumption and
saving decisions influence economic growth by way of their impact on interest
rates and work incentives.

INTEREST RATE POLICY

The Fed promotes economic growth when it maintains a predictable, stable
interest rate policy. Although monetary policy primarily affects short-term
interest rates, it is the Fed’s effect on long-term interest rates that influences
growth. Firms are unlikely to make long-term investments in capital if they are
uncertain about future interest rates and inflation. To avoid uncertainty, the Fed
must maintain a firm lid on actual and expected inflation. The Fed’s policy
stance during a recession is to target a lower fed funds rate to encourage
borrowing. However, if the Fed keeps interest rates too low for too long, future
inflation is more likely. This expected inflation and increased long-term interest
rates will discourage capital investment, and ultimately, long-run economic
growth. Short-term increases in interest rates to dampen inflation may not please
Wall Street, but since the increases reduce expected inflation, they help to keep
long-term interest rates low and stable. And low, stable long-term interest rates
encourage capital investment.

Market Reform in Chile

A group of Chilean economists referred to as the Chicago Boys who

studied under Milton Friedman at the University of Chicago were
instrumental in bringing market reform to the country under the
dictator Augusto Pinochet. The reforms they introduced helped to
halt inflation and make Chile one of South America’s fastest-growing
economies. Unfortunately, the association with the dictator gave
market economics a bad name on the rest of the continent.

Fiscal policy that does not lead to a balanced budget impacts long-term
interest rates and capital investment. Budget deficits in the absence of capital
inflow or increased domestic saving lead to higher long-term interest rates and
hinder investment in capital. If capital inflows or domestic savings are enough to
offset government borrowing, the interest rate effect of a deficit is negated.
Regardless of immediate interest rate effects, budget deficits, if large enough,
create uncertainty and may effectively discourage investment. The presence of
budget surpluses reduces long-term interest rates and encourages capital
investment.

TAX POLICY
Changes in tax policy affect businesses and are likely to also impact the rate of
economic growth. Increasing the tax burden on firms reduces their ability and
incentive to invest in capital. Increasing the capital gains tax on financial
investors reduces the flow of savings firms use to make real investments in
physical capital. Businesses faced with too high a tax burden may choose to
physical capital. Businesses faced with too high a tax burden may choose to
produce elsewhere. It is important to understand that capital is free to flow.
Placing taxes on business, although politically popular, is a recipe for reduced
growth.

Money Talks
flat tax
A flat tax is one that taxes all households at the same rate
regardless of the level of income. Given a flat tax of 15%, a
household earning $40,000 would pay $6,000 in taxes, while a
household earning $100,000 would pay $15,000 in taxes. The
benefit of a flat tax is its simplicity. The downside is that for many
households a flat tax would represent an increase in their tax
burden. Even though many are in the 20% to 30% marginal tax
brackets, their average tax rates are much lower because of
exemptions, deductions, and the fact that the marginal tax rate is
only on the incremental income and not the total income.

Taxes on personal income affect work incentives and can thus also influence
the rate of growth. In the United States, the more productive you are, the more
income you earn. The more income you earn, the higher your marginal tax rate.
This is what economists call a progressive tax system. If tax rates are increased
on upper incomes, they increase the tax burden of the most productive members
of society. Although American tax rates are much lower than in Europe, given a
high enough tax rate, the productive worker will either reduce productivity or
move to where productivity is not taxed as highly. So far, America has been the
beneficiary of high tax rates in Europe. Europe has suffered a brain drain as its
best and brightest, thus most highly taxed, move toward countries with lower tax
rates.
rates.
According to the Organisation for Economic Co-operation and Development
(OECD), the brain drain is serious enough that European countries are
establishing government programs to encourage expatriates to migrate back.
Maybe they should try a tax cut. Europe’s loss is America’s gain as human
capital has increased steadily in the United States.

THE DOWNSIDES TO ECONOMIC GROWTH

Economic growth is not without its downsides or its detractors. Economic

growth has led to increased income inequality, which, if ignored, threatens
continued economic growth. Over the last fifty years, income inequality in the
United States has increased for a variety of reasons. The loss of union power,
reduction in marginal tax rates, foreign competition, and meritocracy are some
frequently cited reasons. Union membership has steadily declined since the
1980s, and as a result, workers have lost leverage in negotiating wages. This
decline has occurred because of structural changes in the economy and as a
result of government taking a more adversarial role with unions. Decreases in
marginal tax rates have also widened the gap between low-and high-income
earners.
According to the Census Bureau, from 1980 to 2008, the bottom quintile of
households saw little or no change in average household income, while the top
saw a steady increase in income. Globalization has contributed to income
inequality. Much of this country’s unskilled manufacturing has moved overseas,
leaving unskilled Americans in lower-paying service-sector jobs. Another theory
of why income inequality has increased has to do with the development of a
meritocracy.
In a meritocracy, the best and brightest marry the best and brightest and
reproduce more of the best and brightest, leaving the not so best and not so
bright in the proverbial dust.
For economic growth to continue, the gains must be more evenly distributed
 For economic growth to continue, the gains must be more evenly distributed
across the population. Whether that is fair or not is irrelevant. America practices
both capitalism and democracy. The more productive members of society are
rewarded by capitalism, while less-productive or less-skilled members of society
see their income stagnate. This fact does not sit well with the latter and creates
an opportunity for a political solution. Though not all Americans see the direct
benefits of capitalism, they do have a vote. Therefore, those who wind up on the
short end of capitalism’s stick are likely to exercise their right to vote and
change the equation. Income redistribution is a fact of life in a society with
universal suffrage. Proponents of economic growth must be prepared to share
their earned gains with those who may not have earned it.
THE GREAT DEPRESSION
MEETS THE GREAT RECESSION
History Repeats Itself, Sort Of

Before 2007, had you ever heard of subprime mortgages, CDOs, or credit default
swaps? In 2007, possibly the worst financial crisis in U.S. history began.
Through 2008 and 2009 the financial crisis became a global recession. The scale
of the financial and economic crisis is measured in tens of trillions of dollars. As
this is being written, the economy has slowly begun to recover, but no one is
sure if the recovery will be sustained.

LINKS TO THE GREAT DEPRESSION

Of course you can’t talk about the Great Recession without talking first about
the Great Depression, another economic disaster that affected the country for
years. You may recall that stock prices began to drop in the fall of 1929 and then
crashed on October 29 of that year, a day known as Black Tuesday. Over the
next ten years, personal income plunged, investment stalled, unemployment
reached a high of 25%, and international trade plummeted.
Unfortunately, the Fed, which was created after an earlier banking crisis (the
Panic of 1907), was put to the test during the Great Depression, where it failed to
provide the necessary liquidity to stem another systemic bank panic. Critics of
the Fed place much of the blame for the severity of the Depression on the Fed.
The general consensus is that the Fed restricted the flow of credit when it should
have flooded the system with inexpensive credit.
After the stock market collapse in 1929 and the ensuing financial and
economic crisis, Congress passed the Glass-Steagall Act of 1933, which created
economic crisis, Congress passed the Glass-Steagall Act of 1933, which created
the Federal Deposit Insurance Corporation (FDIC) to insure bank deposits and
prevent future bank runs. Glass-Steagall also prohibited commercial banks from
engaging in most investment activities. The Bank Holding Company Act
prohibited banks from underwriting insurance, further reinforcing Glass-
Steagall. Bank regulations had the effect of restoring confidence in the industry.
That confidence lasted for just about seventy-five years.

THE RUN-UP TO THE MELTDOWN

The Great Recession, as it is often called, had its beginnings in the twentieth
century during a period of deregulation and rampant financial innovation. The
Depression-era Glass-Steagall Act, which acted as a barrier between commercial
banks and investment banks, was repealed and a new shadow banking industry
was created. At the same time, the Fed and government regulators increasingly
relied on business to regulate itself, believing that market forces would lead to
self-enforcement of sound practices. While all of this was going on, the stock
market was booming, leading to overconfidence by investors.

Expectations and Reality

Consumer and producer expectations are important forces in the

economy. Positive expectations tend to boost economic activity
while negative expectations tend to suppress economic activity. The
president and the Fed chairman are as much cheerleaders for
economic optimism as they are serious policymakers.

On September 11, 2001, terrorists hijacked civilian aircraft and flew them into
the World Trade Center and Pentagon while another plane crashed in a
Pennsylvania field. The impact of the terrorist attacks created fear in a by-then
Pennsylvania field. The impact of the terrorist attacks created fear in a by-then
retreating stock market. This fear helped to send the United States into a shallow
recession in 2001 and 2002. The Federal Reserve responded by immediately
lowering the fed funds rate and injecting large amounts of money into the
banking system.
These injections, along with the Bush tax cuts, two wars, and a deregulated
financial sector, led to a pool of money that created a boom in residential and
commercial real estate investment. Much of the spending that occurred during
the years 2002 through 2005 was fueled by home-equity borrowing at
historically low rates of interest. Deregulated banks added fuel to the fire by
lending money to pretty much anybody who showed up for a loan. Consumers
went on a credit spending binge as the booming housing market created a wealth
effect. Interest rates that should have otherwise crept up were unusually low as
China, Japan, and the oil-producing states continued to save large sums in the
United States. Furthermore, faith in the Fed’s inflation-fighting capability kept
inflation fears at bay. The private, public, financial, and foreign sectors all had a
hand in creating the conditions for disaster.

Asset Price Bubbles

Asset price bubbles occur when easy credit flows toward a certain
class of asset, like stocks, houses, or commodities. Precious metals
are currently trading at all-time highs and may be the next bubble to
burst. There is a debate among economists as to whether central
bankers should raise interest rates to contain asset bubbles or allow
them to run their natural course.

In 2006, the overheated housing market began to slow down. Savvy investors
soon began pulling away from housing and putting money into commodities like
oil and precious metals. In 2007, the housing market went into complete free-fall
oil and precious metals. In 2007, the housing market went into complete free-fall
while oil prices shot up. This combination of events brought the spending party
to a halt as consumers saw their wealth decreasing at the same time highly
visible energy and food prices increased. Real estate investors, and eventually
homeowners, began to walk away from properties that were now worth less than
the balance on the mortgage or mortgages. Murmurs of stagflation were heard in
the media. They were wrong.

SECURITIZATION
One of the culprits in the run-up to the meltdown was a financial innovation
called securitization. Traditionally, banks made loans to customers, carried the
loan on their balance sheet, and earned profit from the interest and fees. This
gave banks a strong incentive to carefully assess a borrower’s risk of default.
With financial innovation and shareholders hungry for ever-greater returns, more
and more pressure was put on banks to increase profits by expanding their
lending activities. Banks delivered these profits by becoming loan originators
that charged fees to make the original loans, which they then sold to investment
banks. The investment banks packaged the loans into bundles and sold them as a
type of bond called a collateralized debt obligation (CDO).

Principal-Agent Problems

A principal-agent problem occurs when the incentives of one party

come into conflict with the party they represent. In the case of
CDOs, investors relied on banks to carefully underwrite the loans
that were issued. However, because the banks were no longer on
the hook if the loans went bad, they had little incentive to be careful
in assessing a borrower’s risk of default.
 CDOs were sold to institutional investors, insurance companies, other banks,
and hedge funds. The investors believed that CDOs were a basically sound
investment because borrowers usually pay their mortgages, and if they don’t, the
property is used as collateral. The popularity of CDOs expanded, which
increased the size of the market. The increased popularity meant that banks
could lend more and more as a ready market existed for their loans. Banks
competed for customers by offering even lower interest rates and relaxing their
underwriting standards. This led to more loans being offered, and house prices
continued to climb. This reinforced the market for CDOs, and a vicious cycle
was created that would eventually come crashing down.
THE COLLAPSE OF INVESTMENT
BANKING
Bursting a Bubble

Many of the institutional investors, banks, and pension funds have conservative
investment policies that limit the types of investments they can make. These
investors rely on bond rating agencies like Moody’s and Standard & Poor’s to
determine the overall level of risk of an investment. Many can only invest in
AAA or AA+ rated bonds. These are the highest ratings and typically indicate
that the investment is extremely safe. Many of the CDOs that investors bought
had these high ratings.

RISK MANAGEMENT AND CREDIT DEFAULT

SWAPS
The underlying problem was that the rating agencies were only rating the top
layer of the CDO. The CDOs are divided into tranches, or parts, with secure,
high-quality loans in the top tranche, and lesser-quality loans in the lower
tranches. The CDOs were packaged this way so that they would yield higher
returns to the investors. The lower, riskier tranches paid higher interest rates,
which made the entire CDO have a higher yield than a CDO made up of only
high-quality mortgages.

The Principal-Agent Problem Strikes Again

Once again, a principal-agent problem was at work. The rating

 Once again, a principal-agent problem was at work. The rating
agencies earn fees from those marketing the CDOs, so they have an
incentive to award high ratings to their customers’ products. The
institutional investors are investing other people’s money, so as long
as they are following the protocol and buying the highly rated
investment, they have little incentive to do anything other than
maximize the return to their paying customers.

To sweeten the deal, some investment banks that marketed CDOs to investors
sold a type of insurance called a credit default swap (CDS) that would pay the
investor if the CDO went into default. For the investor, this was enough to make
CDOs the perfect investment. For the investment banks, they were making
money hand over fist selling the CDOs and then again charging for the CDSs.
Profits went through the roof, as did the incentive for managers and chief
executive officers to market these products to their customers. There was only
one small problem. The CDOs were much less secure than people believed and
the CDSs were not adequately funded. If the CDOs were to default en masse, the
investment banks that sold the CDSs would be liable for hundreds of billions of
dollars. That is exactly what happened.

THE CRISIS HITS INVESTMENT BANKING

Bear Stearns was the first Wall Street victim of the mortgage crisis. When the
housing bubble burst, the value of the CDOs came into question. Bear had
heavily marketed the CDOs and also invested in them. In the face of heavy
financial losses, Bear Stearns’s balance sheet became toxic. If they sold their
assets, the value of the firm would plummet. Soon other investment banks
refused to lend to Bear, and the company faced insolvency. The New York
Federal Reserve president, Tim Geithner, orchestrated a bailout of Bear Stearns
by lending money to banking giant JPMorgan Chase with the understanding that
JPMorgan would use the funds to purchase Bear Stearns at a deep discount. It
JPMorgan would use the funds to purchase Bear Stearns at a deep discount. It
was hoped that this would prevent a widespread panic, but exactly the opposite
happened. Soon Lehman Brothers was on the ropes, but this time no one came to
the rescue of the firm. The panic had spread.

Money Talks
moral hazard
A moral hazard is created when insurance or expectation of a
government bailout encourages risk-taking behavior. Economists
and policymakers must address moral hazard when making
decisions. Failure to do so encourages more risk taking. Ignoring
moral hazard is a moral hazard.

As CDOs defaulted, investors exercised their CDSs, which insurance giant

AIG had marketed. AIG faced losses of hundreds of billions of dollars. AIG is a
key player in America’s financial system, and many on Wall Street and in
Washington DC believed that AIG was “too big to fail.” If AIG failed, the entire
financial system could have possibly collapsed. The U.S. government and the
Federal Reserve took the unprecedented action of bailing out AIG in order to
prevent further catastrophe.
As the mortgage crisis spread, the value of CDOs, in which financial
institutions had invested heavily, collapsed. With the high-profile failure of two
of America’s largest investment banks and the bailout of AIG, financial
institutions stopped lending to each other. Banks were fearful of each other’s
balance sheets. When the banks stop lending to each other, banks stop lending
altogether. Soon businesses not tied to housing or banking were unable to
borrow, and the commercial paper market froze. Business ground to a halt. The
Great Recession had begun.
FISCAL POLICY UNDER FIRE
You’re Going to Need a Bigger Boat

The collapse of the mortgage security market meant that trillions of dollars’
worth of financial assets had become worthless. This economic recession was a
deadly combination of a financial crisis compounded with a wider economic
crisis. In the face of economic recession, the Keynesian prescription is for
expansionary monetary and fiscal policy to stimulate the economy. The problem
was that the tools of policy that are normally effective were both severely
hampered.

THE FED

The usual prescription for a recession is for the Fed to buy Treasury bills from
primary security dealers and then allow the money creation process to work its
magic. When banks are unwilling to lend, this prescription does not work.
Instead of money being created, the financial system was destroying money.
Because many of the failures in the financial system had occurred outside of
traditional banking, the Fed was hard-pressed to get money where it needed to
be.
The Fed is set up by law to work with the banks. The tools it has at its
disposal are aimed at banks, but this financial crisis was different. The shadow
banking system that had been created by deregulation was out of the scope of the
Fed. In order for the Fed to get things working again, the shadow system had to
be transformed into the more regulated traditional banks. That is what they did.
Goldman Sachs and Morgan Stanley, the last of the great investment banks,
changed their status under SEC regulations and submitted to the Fed.
changed their status under SEC regulations and submitted to the Fed.

Quantitative Easing
A visit to the Federal Reserve Board of Governors website throughout the
financial crisis indicated that something interesting was happening. Almost on a
monthly basis, the Fed was inventing new tools of monetary policy. The first
was the Term Auction Facility (TAF), which allowed banks to bid on loans from
the Fed without the perceived downside risk to borrowing from the discount
window. Soon the Fed was creating other lending facilities to inject money into
the system. The Fed started buying up mortgage-backed securities and agency
debt. Ultimately what the Fed was doing was creating markets for assets in
exchange for cash, a process called quantitative easing.
In the end, most of the facilities created during 2008 to halt the financial
collapse expired in February of 2010. The Federal Reserve did not forgo
traditional policy measures during the recession. The FOMC reduced its target
for the fed funds rate to 0%. This is as expansionary as the Fed can get with open
market operations.

Government Gets Inventive

While the Fed was busy trying to simultaneously repair a frozen banking
system and return the broader economy to normalcy, the government responded
by taking extraordinary measures. The Treasury under Henry Paulson attempted
to fix the immediate financial crisis in banking and the mortgage security
market. Congress and the president, first Bush and then Obama, planned a
massive policy response. The problem for government was that when the crisis
hit, government was already engaged in heavy-duty fiscal expansion. Taxes were
extremely low and spending was extremely high. Economists questioned how
much more stimulus government could deliver.
Congress passed the Troubled Asset Relief Program (TARP) in 2008, giving
the Treasury the ability to recapitalize the banks that had been hit hard by the
collapse of the housing market and CDOs. This was only the beginning of the
government’s efforts to stabilize the economy. The government also purchased
government’s efforts to stabilize the economy. The government also purchased
control of failing automaker General Motors for $50 billion to keep it from
going out of business.

Cash for Clunkers

Another program aimed at encouraging durable goods consumption

was the Car Allowance Rebate System (CARS), also known as
“cash for clunkers.” Under the program, buyers would receive a
rebate from car dealers when trading in a used, less fuel-efficient
vehicle for a new, more fuel-efficient vehicle. The dealer would then
be reimbursed by the government. According to the government,
680,000 cars were sold under the program, which helped spur
domestic spending in the economy.

To stimulate investment in housing, the government awarded a substantial tax

credit of $8,000 for homebuyers. Furthermore, unemployment benefits were
extended for millions of out-of-work Americans. The largest of all the
government’s programs was the Recovery Act of 2009, which planned to spend
almost $790 billion in order to expand the economy. Combined with tax cuts,
two wars, and 0% interest rates, the stimulus is quite aggressive by historical
standards. Most economists believe that the government and central bank’s
response to the crisis averted a second Great Depression.

Theory versus Practice

Theories affect the way economists and policymakers tell the story
of what is actually happening. These narratives of reality have the
power to affect reality if enough people believe them. The story of
expected inflation creating inflation is a powerful story, and if
 expected inflation creating inflation is a powerful story, and if
policymakers do not address it, the story could become the reality.

When an economy falls into recession, businesses cut production and quickly
lay off workers. During economic recovery, the logical conclusion is that this
process should run in reverse, but that is not necessarily the case. As production
begins to pick back up, firms often discover that their remaining workforce has
become much more productive. As a result, firms are able to steadily increase
output without hiring more workers. As output continues to increase, firms
increase the number of hours their labor force works before hiring more. Finally,
after accounting for increased productivity and increased working hours, if
demand is present then firms begin to hire. Unfortunately for the unemployed,
this process can take a very long time. Jobless recovery is the bane of the
politician’s existence. The GDP may increase, but unemployment can still
remain high for a while. The unemployed vote and do not really care for the neat
explanation just given.
The Federal Reserve is walking a precarious tightrope when it comes to
inflation. It does not help that so many pundits are warning of coming inflation.
Expecting inflation is often enough to spark inflation. The Fed has introduced
hundreds of billions in reserves to the financial system in order to unfreeze the
flow of credit. The danger to the economy comes in two forms. First, if the Fed
begins contracting the money supply too soon, the economy may fall back into
deeper recession. Second, if the Fed waits too long to contract the money supply,
then inflation may take hold, and that would require the Fed to respond by
sending the economy back into recession.
THE ENVIRONMENT AND THE
ECONOMY
Tree-Huggers Unite!

Most Americans believe that protecting the environment is a valuable goal for
our society. The way that government and environmentalists have gone about
achieving this goal has for the most part ignored the realities of economics. The
Endangered Species Act, the Clean Air Act, and the Clean Water Act all have
laudable goals. Critics of the legislation are not pro-extinction, pro-smog, and
pro–dirty water. For most, the criticism is in how these goals are achieved and
not the goals themselves. Economists offer a unique perspective on the
environment, and inclusion of economic principles can be used to bring about
the goal of environmental protection more efficiently and with greater utility.

IS GROWTH SUSTAINABLE?
One of the costs of an ever-growing economy is the strain that it places on the
environment. As the population expands more and more, resources are required
to sustain the population. This growth need not necessarily lead to environmental
collapse. Instead, markets can be used to alter the incentives of individuals and
firms as they face trade-offs in their use of resources.
Demand for resources tends to increase the price of those resources. As the
price increases, individuals and firms that use these resources face an incentive
to use less in the case of nonrenewables. In the case of renewable resources,
entrepreneurs gain an incentive to increase the production of the renewable
resource. These incentives are powerful and efficient.
 Renewable Resources
Consider the case of lumber, a renewable resource. Increased demand for
lumber has led to an increase in the price of lumber. This price increase leads
tree farmers to expand their output to meet the demand. The net effect of
increased demand for lumber is increased demand for forests. Increased demand
for forests makes the land more desirable and leads to more land being placed
into forest production. Some would argue that if you cut down the trees,
eventually there will be none left. However, this statement ignores economic
incentives. Would there be more corn or less corn if people stopped eating it? If
you answered less, you would be correct. If people stop eating corn, farmers
have no incentive to grow corn. Likewise, if people eat more corn, then farmers
grow more corn. The same is true with trees. Trees take longer to grow, though,
and as a result they’re priced much higher than corn.

Nonrenewable Resources
In the case of nonrenewables like coal, oil, and natural gas, markets provide
incentives to both producers and consumers. As demand increases for these
factors of production, the price increases. This leads to higher prices and higher
costs of production for firms that use the resources. These higher costs provide
firms with an incentive to become more efficient in the use of the resource. For
example, if a firm uses natural gas in production and gas prices rise, the firm has
a strong incentive to use its natural gas in the most efficient way possible. Firms
that are wasteful and inefficient will find it difficult to compete against firms that
use resources more efficiently. They’ll eventually go out of business.

Economic Efficiency

Economic efficiency occurs as resources are used with less waste.

Efficiency should be a goal of not only economists, but anyone who
cares about the planet. Less waste means that fewer resources are
 required in production.

The Role of Incentives

Protecting endangered species is important to many people. There is
considerable political pressure for governments to enact legislation to protect
species. One way to protect endangered species that is promoted by economists
is to kill them for food.
Why did the American bison population almost go extinct while the cow
population increased exponentially? Is it because the cows ate the bison? No, the
reason bison faced extinction while cows thrived is because cows were private
property while bison were not. The population of bison fell from the millions to
just over 1,000 by 1889. Today, fortunately, the American bison is back from the
brink of extinction because they became private property. Today there are more
than 500,000 bison, and their numbers are growing as a market has developed
for bison meat.

THE RIGHT TO POLLUTE

Pollution is an economic bad. All production processes create some form of
pollution, so zero pollution is not a reasonable goal. What is the right amount of
pollution? The right amount, or socially optimal amount, of pollution occurs
when the marginal social benefit equals the marginal social cost of production.
That means that firms should produce to the point where the extra benefit of
production to society equals the extra cost, inclusive of the cost of pollution to
society. Because of tragedy of the commons, firms often do not have an
incentive to produce the amount of output that is socially optimal. Firms do not
pay the cost of pollution, and so they produce too much output and thus too
much pollution. In order to get firms to produce the appropriate amount of
pollution, the cost of pollution must enter into their production decision.
Governments can tax or sell pollution permits. Another option is for affected
Governments can tax or sell pollution permits. Another option is for affected
individuals who bear the cost of the pollution to negotiate a payment from the
polluter.

Per-Unit Taxes
A per-unit tax on the production of a good or service could be used to reduce
the amount of pollution that the firm produces. The tax on the producer increases
the cost of production, which reduces their willingness and ability to produce
their product. The market outcome is for the price of the good or service to
increase and for the quantity to decrease. The result is less production, and
therefore, less pollution. The problem with a per-unit tax is that it would most
likely be levied on all producers in an industry, which means that cleaner, more
efficient producers are taxed at the same rate as the heavier polluters. The tax
reduces pollution in the industry, but does not increase the incentive for
individual producers to clean up their act. Also, if demand for the good or
service increases, then the quantity of pollution would still increase. The
ultimate goal is to reduce pollution and not just punish producers.

Pollution Permits
Another option is to create a market for pollution permits. Under a permit
scheme, the government establishes a cap on how much of a certain pollutant
will be allowed in the atmosphere that year. For example, assume that last year 7
million tons of nitrogen oxide gas was released into the atmosphere and
government wants to reduce it to 6 million tons. Government would allocate to
industry the number of permits required to achieve this goal. If each permit
allowed one ton of emissions, then government would allocate 6 million permits
to firms. The firms would be required to surrender one permit for each ton of
pollutant they produced. Under the system, firms and even individuals could buy
and sell the permits in an exchange. Firms that are relatively clean could sell
their unused permits to firms that are heavier polluters. Individuals could also
buy permits and effectively keep a certain amount of pollution out of the
atmosphere. This scheme encourages firms to become more efficient and reduce
atmosphere. This scheme encourages firms to become more efficient and reduce
pollution simultaneously. Unlike pollution taxes, this solution rewards firms for
reducing pollution instead of punishing all firms equally.

Climate Exchanges

Climate exchanges exist worldwide for trading permits in various

industrial pollutants. Climate exchanges act much like stock
exchanges, allowing firms to buy and sell permits. In the future,
students interested in the environment and economics may become
climate brokers.

The Coase Theorem

A final option for firms that pollute or harm the environment is to directly pay
those who are harmed by the pollution. This option is referred to as the Coase
theorem. Ronald Coase, a British economist, suggested that an efficient outcome
could be achieved if polluters and those who bear the cost directly negotiated a
payment that was acceptable to both parties. Some assumptions of the Coase
theorem are that there are no bargaining costs for either party, property rights are
clearly defined, and the number of people involved is small.
The Nature Conservancy and Sierra Club use this strategy to preserve
environmentally sensitive areas. Many concerned with the environment have
applied this strategy in preserving the rainforest. It is much easier to save a forest
that you own than to save a forest that everyone owns. In the end, economic
principles can be used to effectively and efficiently achieve environmental goals.
George Segal’s Depression Bread Line sculpture, which symbolizes the
struggles of the Great Depression, at the Franklin Delano Roosevelt
Memorial in Washington DC.
Photo Credits: © Michael Thompson/123RF; Victor Pelaez Torres/123RF
The U.S. Department of the Treasury in Washington DC.
Photo Credits: © Michael Thompson/123RF; Victor Pelaez Torres/123RF
 Treasury checks.
Photo Credits: © iStockphoto.com/agshotime; Visions Of America LLC/123RF
 The Federal Reserve Bank in Washington DC.
Photo Credits: © iStockphoto.com/agshotime; Visions Of America LLC/123RF
Arturo Di Modica’s Charging Bull sculpture in New York City’s Financial
District, symbolizing America’s financial power.
Photo Credits: © konstantin32/123RF; Dusit Panyakhom/123RF
 Supply and demand chart.
Photo Credits: © konstantin32/123RF; Dusit Panyakhom/123RF

U.S. currency.
Photo Credits: © Joo Lee/123RF; Ashwin Kharidehal Abhirama/123RF; Robert Brown/123RF
 World currency.
Photo Credits: © Joo Lee/123RF; Ashwin Kharidehal Abhirama/123RF; Robert Brown/123RF

Nineteenth-century stock certificate.

Photo Credits: © Joo Lee/123RF; Ashwin Kharidehal Abhirama/123RF; Robert Brown/123RF
 Stock market electronic board.
Photo Credits: © Thomas Pajot/123RF; Stuart Monk/123RF
 New York Stock Exchange.
Photo Credits: © Thomas Pajot/123RF; Stuart Monk/123RF
 The North Side Headquarters for the World Bank in Washington DC.
Photo Credits: © Jim Pruitt/123RF; Dmitry Rukhlenko/123RF

Under the gold standard, money is backed by a fixed amount of gold,

which allows a country to only print as much currency as there is gold to
which allows a country to only print as much currency as there is gold to
back it up.
Photo Credits: © Jim Pruitt/123RF; Dmitry Rukhlenko/123RF

President Woodrow Wilson who signed the Federal Reserve Act into law
in 1913, creating the Federal Reserve System.
Photo Credits: © Olga Popova/123RF; Norman Kin Hang Chan/123RF
 Newspaper headlines from the Great Recession.
Photo Credits: © Olga Popova/123RF; Norman Kin Hang Chan/123RF

Statue in Edinburgh, Scotland, memorializing Scottish thinker Adam

 Statue in Edinburgh, Scotland, memorializing Scottish thinker Adam
Smith, considered the father of modern economics.
Photo Credits: © zechal/123RF; Public domain via Wikimedia Commons

John Maynard Keynes was a British economist who influenced a school

of thought in which government spending is seen as an economic
stimulus.
Photo Credits: © zechal/123RF; Public domain via Wikimedia Commons

Alan Greenspan, an American economist, served as Chairman of the

Federal Reserve of the U.S. from 1987 to 2006.
Photo Credits: © zechal/123RF; Public domain via Wikimedia Commons
 Copyright © 2016 by F+W Media, Inc.
All rights reserved.
This book, or parts thereof, may not be reproduced in any form without
permission from the publisher; exceptions are made for brief excerpts used in
published reviews.

Published by
Adams Media, a division of F+W Media, Inc.
57 Littlefield Street, Avon, MA 02322. U.S.A.
www.adamsmedia.com

Contains material adapted from The Everything® Economics Book by David A.

Mayer, copyright © 2010 by F+W Media, Inc., ISBN 10: 1-4405-0602-7, ISBN
13: 978-1-4405-0602-4.

ISBN 10: 1-4405-9340-X

ISBN 13: 978-1-4405-9340-6
eISBN 10: 1-4405-9341-8
eISBN 13: 978-1-4405-9341-3

Library of Congress Cataloging-in-Publication Data Mill, Alfred.

Economics 101 / Alfred Mill.
pages cm
Includes bibliographical references and index.
ISBN 978-1-4405-9340-6 (pob) -- ISBN 1-4405-9340-X (pob) -- ISBN 978-1-
4405-9341-3 (ebook) -- ISBN 1-4405-9341-8 (ebook) 1. Economics. II. Title.
HB171.M46126 2016
330--dc23

2015025897
2015025897

Many of the designations used by manufacturers and sellers to distinguish their

products are claimed as trademarks. Where those designations appear in this
book and F+W Media, Inc. was aware of a trademark claim, the designations
have been printed with initial capital letters.

Cover design by Alexandra Artiano.

Cover images © Clipart.com and iStockphoto.com/FrankRamspott.
Interior images © iStockphoto.com, 123RF, and Wikimedia Commons.