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e for bowling alley managers is $16 per hour, why would a wage of $20 per hour result in a labor surplus? Why would a wage of $12 per hour lead to a labor shortage? 8. Solving Economic Problems What economic problem does the minimum wage try to address? 9. Applying Economic Concepts Explain why working conditions can either justify higher wages or make up for lower wages. 10. Making Inferences and Drawing Conclusions Despite efforts to close the wage gap between men and women, the gap has actually been widening. Using what you have learned in this section, write a paragraph discussing what could be done to close the gap. 11. Challenge Gary Becker said that economics “is easy in the sense that there are only a few principles that really guide most economic analysis.” Identify the basic principles behind how wages operate. Graphing Equilibrium Wages Read each job description below. Then make a graph showing a hypothetical equilibrium wage for each job using the same values for both axes in each graph. Job Description #1 Job Description #2 Structural metal worker for highrise construction project. Must have at least 2 years of experience. Filing clerk, small accounting office. No experience necessary, but must have a high school diploma or GED. Apply Economic Concepts Using the economic knowledge you gained in this section, briefly explain why each graph appears as it does. Challenge In many dangerous industries, including mining, safety laws establish standards that protect workers. Explain what effect these laws might have on wages. Use to complete this activity. @ ClassZone.com The Role of Labor 265 S E C T I O N 2 Trends in Today’s Labor Market TA K I N G N O T E S In Section 2, you will civilian labor force, p. 266 • identify the changes that have taken place in the labor force • explain how occupations have changed • explain how the way people work has changed outsourcing, p. 269 insourcing, p. 269 telecommuting, p. 270 contingent employment, p. 270 independent contractor, p. 270 As you read Section 2, complete a hierarchy chart like the one below. In each box write the main ideas. Use the Graphic Organizer at Interactive Review @ ClassZone.com Trends in Labor Market changing labor force A Changing Labor Force KEY CONCEPT S The labor market in the United States has changed dramatically since the 1950s, and it continues to change. For example, in the 1950s, many companies hired workers with the expectation that they would stay with the company for most of their working lives. After a lifetime of service, workers could count on company pension plans to help fund their retirement. Today, few workers stay with the same company their entire career, and workers take more responsibility for funding their retirement. Those are only some of the profound changes that affect the civilian labor force, people who are 16 or older who are employed or actively looking for and available to do work. The civilian labor force excludes people in the military, in prison, or in other institutions. In 2005, about 150 million Americans made up the civilian labor force. That figure was up from 126 million workers in 1990 and is expected to rise to almost 165 million workers by 2020. Labor Force The civilian labor force is composed of people age 16 or older who are working or looking for work. QUICK REFERENCE The civilian labor force is made up of people age 16 or older who are employed or actively looking for and available to do work. 266 Chapter 9 FIGURES 9.7 AND 9.8 MEN AND WOMEN IN THE U. S. LABOR FORCE FIGURE 9.7 NUMBER OF MEN AND WOMEN IN THE LABOR FORCE FIGURE 9.8 PERCENTAGE OF MEN AND WOMEN IN THE LABOR FORCE MEN WOMEN ) 80 70 60 50 40 30 20 10 MEN WOMEN 100 80 60 40 20 1950 1960 1970 1980 1990 2000 Source: U.S. Bureau of Labor Statistics Year 0 1950 1960 1970 1980 1990 2000 Year Source: U.S. Bureau of Labor Statistics ANALYZE GRAPHS 1. About how many more men were in the labor force than women in 1950? in 2000? 2. What percentage of the labor force did women account for in 1950? in 2000? Changes in the U.S. Labor Force To understand some of the changes in the U.S. labor force, consider these two scenes. In the first scene, the year is 1955. A young woman pulls into a gas station, and the attendant fills up her car with gas. Then she picks up her children at school and heads home to get dinner ready in time for her husband’s arrival from work. The second scene is set in today’s world. A young mother pulls into a gas station, swipes her credit card, and fills up her tank. Her business meeting ran long, and she is late getting to the daycare center. Her husband will pick up dinner for the family on his way home from work. One obvious change these scenes demonstrate is the addition of many more women to the work force. As shown in Figures 9.7 and 9.8, women have been a significant factor in the growth of the labor market in the United States. Since the 1950s, the kinds of jobs open to women have expanded. As job opportunities have improved, wages for women have risen, and many more women have been drawn into the work force. The U.S. work force has also become better educated. About 30 percent of people in the labor force have a college degree, and an additional 30 percent of workers have some college credits. In a work force with such a high degree of human capital, productivity and wages are also high compared with many other nations. AP P LI CATION Evaluating Economic Decisions A. Explain how rising opportunity costs have led more women into the workplace. Find an update on the U.S. work force at ClassZone.com The Role of Labor 267 Changing Occupations KEY CONCEPT S Economists group occupations into three economic sectors. The primary sector is made up of jobs related directly to natural resources, such as farming, forestry, fishing, and mining. Jobs in the secondary sector are related to the production of goods, including the materials and energy needed to produce them. Examples include welders, truck drivers, and construction workers. The tertiary sector is made up of service-related jobs in such industries as banking, insurance, retail, education, and communications. As you can see in Figures 9.9 and 9.10, U.S. manufacturing jobs have declined since the 1950s, while service-sector jobs have increased dramatically. All of the ten fastest-growing occupations are service related, most of them in the area of medical services. FIGURES 9.9 AND 9.10 EMPLOYMENT IN THE UNITED STATES BY ECONOMIC SECTOR FIGURE 9.9 EMPLOYMENT IN 1950 FIGURE 9.10 EMPLOYMENT IN 2000 3% 14% 33% 53% 18% 79% Primary Secondary Tertiary Primary Secondary Tertiary Source: U.S. Bureau of Labor Statistics Source: U.S. Bureau of Labor Statistics ANALYZE GRAPHS 1. Which sector grew the most from 1950 to 2000? By how much did it grow? 2. How much of the civilian labor force was employed in the combined primary and secondary sectors in 1950? How much in 2000? Technology and Change Think back for a moment to the young mother at the gas station. In the years between 1955 and today, the job of gas station attendant has been mainly replaced by the computerized, credit-card operated gasoline pump. In the same way, ATMs have greatly affected the occupation of bank teller. Technological changes have eliminated or redefined many other jobs in all three sectors. The personal computer and the Internet have drastically changed the way onthe-job information is stored, transferred, and used. About half of all American workers use a computer on the job. As a result, those occupations that support the 268 Chapter 9 1950s gas station 2000s gas station use of computers—software engineers and network and data communications analysts, for example—have been among the fastest growing in the United States. More than 80 percent of managers and professionals use a computer at work. However, even in less skilled jobs, more and more workers are using computers. About 20 percent of machine operators, laborers, and farmers use a computer on the job. Basic computer skills have become necessary for many different types of jobs. Globalization and Jobs Today’s labor market is global. Technology allows companies to employ people not just all over the country, but all over the world. Many companies have sought to cut their costs by outsourcing, the practice of contracting with an outside company to provide goods or services. Most outsourcing by U.S. companies goes to other U.S. companies. For example, many American businesses hire other American firms to handle their accounting. However, the term outsourcing has become connected with the practice of moving jobs from the United States to foreign countries where wages are lower. As this happens more frequently, it would seem that their American operations would lose jobs. But many companies actually add more jobs in the United States than they outsource abroad, just in different parts of their businesses. In 2004, IBM decided to send about 3,000 jobs overseas. But at the same time, it created about 4,500 jobs in the United States. The American economy has also benefited from insourcing, the practice of foreign companies establishing operations in, and therefore bringing jobs to, the United States. Both outsourcing and insourcing are tied to the trends toward more service-related jobs and more technology-related work. AP P LI CATION Predicting Economic Trends B. Think of an example of an occupation that is likely to be eliminated or substantially redefined as a result of technology. QUICK REFERENCE Outsourcing is the practice of contracting with an outside company, often in a foreign country, to provide goods or services. Insourcing is the practice of foreign companies establishing operations in, and therefore bringing jobs to, the United States. The Role of Labor 269 Changes in the Way People Work KEY CONCEPT S QUICK REFERENCE Telecommuting means performing office work in a location other than the traditional office. Contingent employment refers to t
emporary or part-time work. An independent contractor is someone who sells their services on a contract basis. The way people work has been transformed by technology. In the past, many workers needed to physically commute to and from an office in order to accomplish their work. The Internet and laptop computers have allowed some of these workers to engage in telecommuting, the practice of doing office work in a location other than the traditional office. But the job market has also changed. In the past, companies offered most workers permanent positions. Today, companies offer fewer permanent positions and more contingent employment, work that is temporary or part-time. Similarly, more people work as independent contractors, selling their services to businesses on a contract basis. People used to enter a field and stay in more or less the same line of work for most of their work life. Now, most people will change careers several times as the world of work continues to evolve. Working at the Office from Home Many telecommuters enjoy the reduced stress, flexibility in work time, and increased free time they have by avoiding a commute to work. Employers benefit from an expanded labor pool, increased productivity, and lower real estate costs. Society benefits, too, from fewer drivers on crowded freeways and lower pollution. However, there are also costs. People who work at home may feel that their work too often spills over into their personal time. Some miss the social life of the office and the chance to network. Some at-home workers also fear that on-site workers might be more likely to get promoted. Still, experts estimate that the number of telecommuting workers grew by about 20 percent each year from 2000 to 2005. YO U R EC TELECOM M UTING Where would you want to work? Technology allows people to work in many different places. Alternative work places have different benefits—and drawbacks—than the traditional office. ? ▲ Work at the office ▲ Work at the coffee shop 270 Chapter 9 Alternatives to Permanent Employment Through much of the 1900s, U.S. companies would hire workers for permanent, full-time jobs. Employees would work 40 hours per week in exchange for both wages and benefits. In the 1990s, companies began to hire fewer full-time employees and more contingent employees and contract workers. Contingent workers, sometimes called temps, make up over 5 percent of the total work force. Independent contractors make up over 7 percent of the work force. Hiring contingent employees and contract workers makes it easier for businesses to adjust their work force to suit production demands. Discharging temporary workers is easier and less costly than discharging permanent employees. Since most temporary workers do not receive benefits, labor costs are also lower. Most contingent workers would prefer to have the steady income and benefits that come with permanent, full-time employment. But many independent contractors prefer the flexibility of being their own boss to working in a permanent position. They are willing to take the risk of not having enough work to support themselves, and they find alternative ways to pay for health insurance and retirement. Businesses sometimes offer permanent positions to contingent and contract workers who have done a good job. Changing Careers More Often As technology has advanced, jobs have changed, too. Much of the work done today in the United States and other advanced countries did not exist 100 years ago. Some of the work did not exist even ten years ago. With every new technology, new types of jobs are created. But as technology advances, many older professions become less in demand or even obsolete. To fill the new jobs, workers must learn and adapt to the new technologies. Someone who started out as a radio repair technician might need to learn how to work with cellular phone technology. In a similar way, the economy changes more quickly than it did in the past. Companies have become more flexible, changing their business plans constantly to maximize profits. Globalization allows companies to move jobs across national boundaries. As the economy changes, workers must change and adapt. The technician who adapted to cellular phone technology might need to change yet again in a few years. AP P LI CATION Analyzing Cause and Effect Changing Careers As the demand for healthcare workers increases, some people will change careers to ﬁ ll these jobs. C. A 2003 report concluded that telecommuters can save their employers $5,000 a year. Explain how that savings may come about. The Role of Labor 271 For more on interpreting graphs, see the Skillbuilder Handbook, page R29. Drawing Conclusions from Graphs Drawing conclusions means analyzing a source of information and forming an opinion. You have already had some practice analyzing line and pie graphs in Chapters 6 and 8. These graphs are bar graphs. PRACTICING THE SKILL Begin by using the following strategies to analyze the graphs. They are similar to the strategies you used in Chapter 6 to analyze a line graph. Your analysis will enable you to draw conclusions about the information shown on the graphs. F I G U R E 9.11 A N D 9.12 FA S T ES T G ROW I N G O CC U PAT . S., 2004-2014 Read the title to identify the main idea of the graphs. FIGURE 9.11 FIGURE 9.12 Check the vertical axes. Note that the axes use different scales. Check the horizontal axes. Both axes list a variety of occupations. 800 700 600 500 400 300 200 100 il n o e r s s e R 60 50 40 30 20 10 is ti it d e r s n n Occupations N H e h e s a lt ti sis t a y si c i a n n a s sis Occupations o C h P p li ti o e g i n Source: U.S. Bureau of Labor Statistics projections Source: U.S. Bureau of Labor Statistics projections NOW PUT IT ALL TOGETHER Both graphs claim to present the same information. Compare the two graphs, and consider their differences. Read the source lines to confirm that the data come from a reliable source. T HINKING ECONOMICALLY Drawing Conclusions 1. What is the main difference between the two graphs? 2. Which graph really shows the fastest growing occupations? Explain your answer. 3. What would be a better title for each graph? 4. Which of these jobs are most likely to have higher than average wages? Why? 272 Chapter 9 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs. a. outsourcing insourcing b. contingent employment independent contractor 2. Name three of the fastest growing occupations. What do they have in common? 3. What are the economic reasons that explain why so many women joined the labor force in the late 1900s? 4. Name two ways technology has altered the U.S. labor market. 5. For an employee, what are the advantages and disadvantages of telecommuting? 6. Using Your Notes Write a paragraph explaining how you can use the information in this section to prepare for your future career. Refer to your completed hierarchy chart to help you anticipate the employment trends you will be facing. Trends in Labor Market changing labor force Use the Graphic Organizer at Interactive Review @ ClassZone.com . Making Inferences and Drawing Conclusions Given the trends in the labor market, do you think today’s employees will need to be more independent than the last generation’s or less independent? Why? 8. Analyzing Cause and Effect Explain how changing technologies have led to workers changing careers more often. 9. Evaluating Economic Decisions The United States has shifted to an economy driven by service industries. The primary sector, which deals in natural resources, and the secondary sector, which produces goods, are both shrinking. Do you think the shift toward a service economy is helping American workers or hurting them? Give reasons for your answer. 10. Challenge Adam Smith explained that countries maximize their wealth when they concentrate on producing the goods that they produce most efficiently and rely on international trade for goods they don’t produce efficiently. Explain how outsourcing is an example of this concept. Examining Labor Market Trends Make a copy of the table below. On your copy, list the reasons for the trend toward contingent labor in the left column. In the right column, describe its impact on the labor force. Move to Contingent Labor Why? Impact on Labor Force Analyze Cause and Effect In what ways have women in the work force influenced the growth of contingent labor? In what ways has the growth of contingent labor influenced women? Challenge What personal issues might lead a worker to seek part-time employment? The Role of Labor 273 S E C T I O N 3 Organized Labor in the United States TA K I N G N O T E S In Section 3, you will labor union, p. 274 • describe how the labor strike, p. 274 movement developed in the United States • discuss why organized labor has declined in the United States • explain how labor unions affect wage rates and employment closed shop, p. 279 union shop, p. 279 right-to-work law, p. 279 collective bargaining, p. 280 binding arbitration, p. 280 As you read Section 3, complete a summary chart like the one below. In each box, write the main ideas for each topic. Use the Graphic Organizer at Interactive Review @ ClassZone.com Topic Main Ideas Related Facts Labor movement’s rise to power The Labor Movement’s Rise to Power KEY CONCEPT S Organized labor helped to shape the modern workplace. Most of the benefits that workers in the United States take for granted today did not exist 200 years ago. The eight-hour workday, the five-day work week, vacations, even sick leave—none of these basic amenities would have existed without the efforts of organized labor. In the industries of the 1800s, workers put in long hours—often 60 hours per week or more—for low pay. Factory laborers often worked in dangerous conditions. Individual workers had little power to demand improvements from a business owner. If a worker complained too much, they would be fired.
Workers in industrialized nations around the world faced similar problems, but this section will focus on the labor movement in the United States. To improve their bargaining power, factory workers in the 1800s began to join together and act as a group. A labor union is an organization of workers who collectively seek to improve wages, working conditions, benefits, job security, and other work-related matters. Unions attempted to negotiate with businesses to achieve their goals, but businesses often resisted. As unions sought ways to gain negotiating power, they turned to the strike, or work stoppage. The threat of shutting down production demonstrated the power of organized labor. Different types of unions addressed different needs. Some workers joined a craft union, a union of workers with similar skills who work in different industries for different employers. Examples include typesetters or, more recently, electricians. Others joined an industrial union, a union for workers with different skills who work in the same industry. For example, workers in the textile industry formed some of the earliest industrial unions. QUICK REFERENCE A labor union is an organization of workers that seeks to improve wages, working conditions, fringe benefits, job security, and other work-related matters for its members. A strike is a work stoppage used to convince an employer to meet union demands. 274 Chapter 9 Early Developments Local craft unions were the main kind of worker association during the early years of the United States. By the 1830s, local unions began joining together into federations to advance their common cause. The first national federation was the National Trades Union (NTU), founded in 1834. A financial crisis that gripped the country in 1837 brought an end to the NTU and temporarily subdued union activity. In 1869, organized labor took a huge step forward when Uriah Stephens founded the Knights of Labor. Unlike other unions, it organized workers by industry, not by trade or skill level. The Knights of Labor became a nationwide union and adopted political goals including an eight-hour workday for all workers and the end of child labor. Its membership grew quickly, especially after the union helped workers win concessions from the big railroad companies in the 1880s. During the explosion of industrialism in the late 1800s, employers strongly resisted the efforts of workers to organize, and many labor protests turned violent. • In 1886, one person was killed and several others were seriously wounded when police attacked workers protesting for an eight-hour workday outside the McCormick Harvester Company in Chicago. The next day, people gathered at Haymarket Square to protest the deaths, and police troops arrived to disperse the crowd. Someone threw a bomb into the police, killing seven officers, and the riot that followed left dozens of other people dead and hundreds injured. • In 1892, ten workers were killed in a strike against Carnegie Steel in Homestead, Pennsylvania, and the union was broken up. • In 1894, a strike in Illinois against the Pullman Palace Car Company won the support of railway workers across the country, who collectively brought the nation’s railroads to a halt. The dispute turned violent when National Guard troops were brought in to keep the nation’s railroads running. A federal court ruled that the American Railway Union could not interfere with the trains, and the strike was broken. A New Model for Unions The violence associated with organized labor, as well as its often controversial political agenda, led to a decline in union membership. But Samuel Gompers offered a different model for union organization. In 1886, he founded the American Federation of Labor (AFL), an organization of craft unions that focused on the interests of skilled labor. The AFL continued to seek improvements in wages, benefits, and working conditions, but it focused on achieving these goals through the economic power of workers, instead of through legislation. By the early 1900s, the AFL had a membership of about 1.7 million workers. Legal action against organized labor forced Gompers to modify his stance against political activity, and the AFL began supporting pro-union candidates. The International Ladies’ Garment Workers Union was founded in 1900. The union gained strength following successful strikes in 1909 and 1910. Perhaps the most famous Union Organizing A union rally takes place at a shipyard in 1943. The Role of Labor 275 F I G U R E 9.13 History of the American Labor Movement 1893 ▲ Eugene V. Debs founds the American Railway Union. 1869 ▲ Uriah Stephens founds the Knights of Labor. 1900 ▲ International Ladies’ Garment Workers’ Union founded. 1825 1850 1875 1834 National Trades Union formed. 1886 ▲ Protest in Chicago, advertised by this flyer, turns into the Haymarket Riot. 1900 1894 Labor Day becomes a national holiday. 1886 American Federation of Labor (AFL) founded by Samuel Gompers. woman to participate in the U.S. labor movement was Mary Harris Jones, known as Mother Jones. In 1903, she led 80 children, many of whom had been injured while working, on a march to the home of President Theodore Roosevelt. The march helped to emphasize the need for child labor laws. Unions Gain Power During the Great Depression of the 1930s, union membership in the United States declined as millions of people lost their jobs. Yet unions gained power through laws passed as part of the New Deal, a series of reforms that attempted to revive the country’s economy. • The Norris-LaGuardia Act (1932) outlawed the practice of hiring only workers who agreed not to join a union. It also required employers to allow workers to organize without interference from their employer. • The National Labor Relations Act (1935), also known as the Wagner Act, protected the rights of workers in the private sector to form unions and to use strikes and other job actions. • The Fair Labor Standards Act (1938) set a minimum wage, required extra pay for overtime work, and made most child labor illegal. During this period, the Congress of Industrial Organizations (CIO) organized unions for industrial workers. Originally part of the AFL, which favored skilled workers in craft unions, the CIO broke away in 1938. The two organizations came together again in 1955 as the AFL-CIO. The AFL succeeded in organizing the United Auto Workers (UAW) union in 1935. After a tense sit-down strike in Flint, Michigan, in 1937, General Motors 276 Chapter 9 2005 Service Employees International Union breaks away from AFL-CIO. 2000 1962 ▲ Cesar Chavez founds National Farm Workers Association (NFWA), which later becomes United Farm Workers. 1975 1981 ▲ Air traffic controllers’ strike is unsuccessful. 1925 1950 1935 Congress passes the National Labor Relations Act, also called the Wagner Act. 1959 Congress passes Landrum-Griffin Act. 1935 United Auto Workers organized. became the first automaker to recognize the union. Chrysler and Ford soon followed. In the 1940s, Walter Philip Reuther, as president of the UAW, helped auto workers become some of the nation’s highest paid industrial workers. Also in the 1940s, John L. Lewis, the tough-talking, cigar-smoking leader of the CIO, brought his own United Mine Workers back from near failure and waged a fierce and successful fight to organize the nation’s steelworkers. Backlash Against Unions Following World War II The end of World War II ushered in a period of anti-union legislation. In 1947, over the veto of President Harry S. Truman, the Taft-Hartley Act was passed. It amended the Wagner Act and limited union activities, increasing the government’s power to intervene if a strike might threaten national security. America’s fear of Communism, the political and economic system of the Soviet Union, led to further restrictions on unions. The Landrum-Griffin Act (1959) forbade communists from holding union offices and required tighter financial and electoral accounting. George Meany, president of the AFL-CIO from 1955 to 1979, was a strong anti-communist and worked to get rid of unions that he considered sympathetic to communist ideas. AP P LI CATION Comparing and Contrasting Economic Information A. What motivated workers in the 1800s to form unions? Why did they continue to form unions in the early- to mid-1900s? The Role of Labor 277 The Labor Movement’s Steady Decline KEY CONCEPT S For 30 years following World War II, labor unions represented about 30 percent of the U.S. work force. Since the mid-1970s, membership in unions has declined steadily, falling to about 12.5 percent in 2005. The decline in unions can be traced to three causes: unions’ tarnished reputations, changes in the labor force, and laws restricting union influence. Loss of Reputation and Labor Force Changes In the late 1900s, labor unions began to lose their luster in the eyes of many Americans. Prolonged strikes both disrupted the public and placed a burden on the striking families. Some unions began requiring companies to employ more workers than necessary, a tactic known as featherbedding. Featherbedding, especially in the railroad industry, raised criticisms of wastefulness. Investigators discovered that a few labor unions had ties to organized crime, which reflected badly on all unions. The changing nature of the U.S. work force also led to reduced union membership. Union membership was traditionally rooted in manufacturing industries. But the number of manufacturing jobs in the United States fell sharply in the second half of the 20th century as the economy shifted toward service industries. The increase in the number of contingent and contract workers also led to lower union membership because such workers are less likely to pursue union representation. As manufacturing declined, unions shifted their organizing efforts toward service workers. The American Federation of State, County, and Municipal Employees FIGURE 9.14 UNION MEMBERSHI P I N THE U N I T
ED STATES Find an update on labor unions at ClassZone.com 40 30 20 10 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: U.S. Bureau of Labor Statistics Year ANALYZE GRAPHS 1. During this time period, when was union membership highest? What percent of the labor force belonged to a union that year? 2. Which year was union membership lowest, and what percent of the labor force belonged to a union then? 278 Chapter 9 had about 1.4 million members in 2005. The Service Employees International Union (SEIU), which organizes such service workers as caregivers and janitors, had a membership of 1.8 million in 2005. The SEIU was the largest union in the AFL-CIO, but in 2005 it left the group. Several other smaller unions also left the AFL-CIO and joined SEIU to form a new coalition with different priorities. Right-to-Work Laws Another factor in the steady decline of union membership in the United States is legislation that tries to limit union influence. Unions had developed the closed shop, a business required to hire only union members. The closed shop was intended to maintain union standards for workers who only work at a business briefly, such as musicians or restaurant employees. Unions also developed the union shop, a business where workers are required to join a union within a set time period after being hired. Union shops allowed businesses to hire nonunion workers without diluting the strength of the union. The Taft-Hartley Act outlawed the closed shop and weakened possibilities for a union shop. It also gave states the power to make it illegal to require workers to join unions. Such laws became known as right-to-work laws, a name meant to emphasize that workers are free not to join a union. However, the effect of right-to-work laws and similar legislation is to weaken unions and to help businesses operate without unions. Most right-to-work states are in the Southeast and the central West, and union membership in these areas is low. F I G U R E 9 .15 RIGHT-TO-WORK STATES MAP QUICK REFERENCE A closed shop is a business where an employer can hire only union members. A union shop is a business where workers are required to join a union within a set time period after being hired. Right-to-work laws make it illegal to require workers to join unions. Wash. Oregon Montana N.Dak. Minn. Idaho Wyoming S.Dak. Wisc. Mich. Nev. Calif. Utah Colorado Nebr. Iowa Kansas Mo. Arizona N. Mex. Okla. Ark. Ill. Ind. Pa. Ohio Ky. Tenn. W.Va. Va. N.C. S.C. N.H. Maine Vt. N.Y. Mass. R.I. Conn. N.J. Del. Md. Alaska Hawaii Miss. Ala. Ga. Texas La. Fla. Right-to-Work State AP P LI CATION Predicting Economic Trends B. Consider the trends in today’s labor force that you learned about in Section 2. As more service industries unionize, is union membership, as a percent of the labor force, likely to return to the levels of the mid-1900s? Why or why not? The Role of Labor 279 Union Negotiating Methods KEY CONCEPT S QUICK REFERENCE Collective bargaining is the way businesses and unions negotiate wages and working conditions. Despite the decline in membership, organized labor still wields power in the American economy. Unions continue to use collective bargaining, the process of negotiation between businesses and their organized employees to establish wages and to improve working conditions. Since it represents many employees together, a union can arrive at a better deal for workers than if each employee bargained with the employer separately. As a result, unionized companies tend to pay higher wages than companies without unions. Collective Bargaining In the 1930s and 1940s, unions negotiated for higher wages, better working conditions, and fair grievance procedures for workers who felt that they had been treated unjustly. As these demands were increasingly met, unions negotiated for job security and such fringe benefits as health insurance. Benefits and job security are important issues in today’s negotiations as well, but in many cases today’s workers are not pressing for higher wages. Instead they are trying to hold the line against pay cuts and reductions in benefits, including pensions. Unions have the threat of a strike to provide a motivation for management to come to terms, but strikes occur much less frequently than in the past. Large-scale work stoppages in the United States occurred hundreds of times a year before the 1980s but dropped to about 20 per year by the 2000s. This is partly a result of the decline in union membership, but it also reflects the willingness of management to use replacement workers or to close a plant permanently. The vast majority of union contracts are settled without such action. However, some negotiations require additional interventions if the two sides cannot agree. First, a mediator may be brought in to help the sides come to terms. If that fails, the dispute may be settled by binding arbitration—a decision by a neutral third party that each side agrees ahead of time to accept. For industries related to public safety, the government might issue an injunction to force workers back to work after a stoppage, or to stop protest activities that may interfere with public safety. Collective Bargaining Union leaders meet with business management to negotiate the details of union contracts. APPLICATION Analyzing Cause and Effect C. Explain why high wages and high employment do not necessarily go hand in hand. QUICK REFERENCE Binding arbitration is a process in which an impartial third party resolves disputes between management and unions. 280 Chapter 9 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs. a. closed shop union shop b. strike collective bargaining 2. Why was the formation of the Knights of Labor a key event for organized labor in the United States? 3. Name two laws that supported labor’s rights and two laws that restricted them. 4. Opponents of right-to-work laws sometimes call them “work-for- less” laws. Why do you think they use that name? 5. Why would a business care if its workers went on strike? 6. Using Your Notes Write a paragraph explaining why unions grew in the 1800s and the first half of the 1900s. Refer to your completed summary chart to help you develop your argument with strong supporting detail. Topic Main Ideas Related Facts Labor movement’s rise to power Use the Graphic Organizer at Interactive Review @ ClassZone.com . Analyzing Cause and Effect What effect might outsourcing have on union membership? 8. Evaluating Economic Decisions In 1981, a group of air traffic controllers, employees of the Federal Aviation Administration, went on strike. They wanted to reduce their workweek to 32 hours instead of the usual 40 because of the high stress of their jobs. President Ronald Reagan broke the strike and disbanded the union of air traffic controllers, claiming that they were striking illegally. About 100 strikers were arrested, and all of them were banned for life from jobs in air traffic control. Did Reagan do the right thing by firing the striking workers? Explain your answer. 9. Challenge The firing of the air traffic controllers and the breaking of their union was one of the key events for labor in the United States. What trends in organized labor are evident in that event? Automated factories reduced the need for assembly line workers. Analyzing Economic Data Look at Figure 9.14 on page 278, which shows changes in union membership in the United States. Analyze Union Membership Compare the upward and downward movements of the graph to the events going on in the United States and world. 1930s—The Great Depression 1940s—World War II; postwar recovery 1950s—Korean War; economy thrives 1960s—Civil Rights movement; Vietnam War; steady economy 1970s—End of Vietnam War; oil embargo; inflation 1980s—Recession and recovery 1990s—Fall of Communism in Europe and Russia; Internet boom 2000s—September 11; Iraq War; recession and recovery Challenge Does there seem to be a relationship between how well the economy is doing and union membership? Explain. The Role of Labor 281 Case Study Find an update on this Case Study at ClassZone.com Managing Change in Your Work Life Background The United States economy has shifted from manufacturing to service and knowledge-based industries. New technologies offer increasingly sophisticated tools. Telecommuting provides businesses the option of having employees work effectively from outside the office. Globalization has revolutionized the way companies do business. Companies are no longer tied to a specific location. Instead, they establish offices around the globe. The outsourcing and insourcing of jobs result both in benefits and challenges. The dynamics of the workplace are defined by a single factor—change. What’s the issue? How will you respond to the changing dynamics of the work environment? Study these sources to discover how change affects the type of work we do, as well as where and how we do it. A. Online Magazine Article Call centers in India help businesses reduce costs because local wages are low. But some Westerners accept the low wages for a chance to live in India. Subcontinental Drift More Westerners are beefing up their resumés with a stint in India After a year answering phones for Swiss International Air Lines Ltd. in a Geneva call center, Myriam Vock was eager to see something of the world. So she packed her bags and hopped a plane to India. Two and a half years later she’s still there, sharing a five-bedroom apartment in an upscale New Delhi suburb with four other foreigners. And how does she pay the bills? She works in a call center, getting paid a fraction of what she did back home. “I’m not earning much, but there is enough to live well and travel,” says Vock, 21. . . . “I don’t pay taxes here, and life is so much cheaper,” she says. Worried about your job fleeing to India? One strategy is to chase it—an option a growing number of twen
tysomething Westerners are choosing. Sure, the trend will never make up for the thousands of positions lost back home, but for adventurous young people, a spell in a call center in Bangalore or Bombay can help defray the costs of a grand tour of the subcontinent and beyond. Source: BusinessWeek.com, January 16, 2006 Call centers in India serve customers of companies all over the world. Thinking Economically Explain Myriam’s decision to work in a call center in India using cost-benefit analysis. 282 Chapter 9 B. Business Cartoon Canadian cartoonist Andrew Toos drew this cartoon about working in an increasingly technological society. Source: www.CartoonStock.com Thinking Economically What does the cartoon suggest about new technological developments in the world of work? Explain your answer. C. Online Newspaper Article Many worry that outsourcing may reduce the number of jobs in the United States. This article presents a different perspective. Outsourcing Beneﬁ ts Permac Employees Permac creates a win-win situation. Permac Industries in Burnsville [Minnesota] fashions parts ranging from rings that tie parachutes to small planes to parts for soda fountain machines and construction trucks. President and CEO Darlene Miller plans to send some work to China, but she said it’s to the benefit of her 27 Minnesota employees. “No one here will lose a job. We’re not planning to let anybody go—in fact, we’re hiring,” she said. Miller is investing in a $700,000 piece of equipment to give workers in Burnsville better tools for specialized work that demands higher skills than the work she plans to send to China. A side benefit for the company’s Burnsville workers is that the work going to China will reduce the need for what at times has seemed relentless overtime. “The simple parts eat up a lot of machine time,” said John Keith, a Permac team leader. “If we farm that out we have time to look at getting new business, more complicated business.” Source: www.startribune.com, September 5, 2004 Thinking Economically How will Permac employees benefit from outsourcing? Identify others who also will benefit and explain why. THINKING ECONOMICALLY Synthesizing 1. What skills are you likely to need in order to manage change successfully in your work life? Support your answer with examples from the documents. 2. In documents A and B, are the types of change similar or different? Are their effects on workers positive or negative? Explain your answer. 3. Compare the opportunities afforded by change in documents A and C. How are they similar? How are they different? The Role of Labor 283 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. civilian labor force closed shop collective bargaining contingent employment craft union derived demand equilibrium wage glass ceiling human capital industrial union insourcing labor union minimum wage outsourcing productivity right-to-work law strike telecommuting union shop wages 1 are the cost of labor. The demand for labor is a 2 , growing out of the demand for the goods or services workers can produce. The forces of supply and demand determine the 3 , at which there is neither a surplus nor a shortage of workers. Wages are directly correlated to a worker’s 4 . Workers with the lowest level often earn only the 5 . Since the 1950s, many women have entered the 6 . They are sometimes limited by the 7 , which keeps them from reaching the highest levels of management. Other trends in the labor market include 8 , working away from a central office, and 9 , working part-time or temporary jobs. U.S. firms sometimes use 10 to hire workers in other countries. When foreign companies open plants in the United States, it is called 11 . Changes in the work force have reduced the number of workers who belong to a 12 . Such organizations press for higher pay and better working conditions through 13 . If talks fail, union workers might 14 , putting pressure on employers to meet their demands. 284 Chapter 9 CHAPTER 9 Assessment How Are Wages Determined? (pp. 258–265) 1. What forces determine the equilibrium wage? 2. What four factors contribute to differences in wages? Trends in Today’s Labor Market (pp. 266–273) 3. How has the labor market in the United States changed since the 1950s? 4. Name two new developments in the way Americans work. Organized Labor in the United States (pp. 274–283) 5. Name an important U.S. labor leader and describe what he or she contributed to the labor movement. 6. What are some of the reasons membership in unions has declined since the 1950s? A P P LY The table below shows the median weekly earnings of full-time wage and salary workers by union affiliation and selected characteristics. FIGURE 9.16 UNION AND NONUNION WAGES Median Weekly Earnings of Full-Time Workers in the United States (in dollars) Race or Ethnicity Union Nonunion Men Women Men Women African-American Asian Hispanic White 689 819 713 884 632 789 609 749 523 827 473 714 478 643 414 576 Source: U.S. Bureau of Labor Statistics, 2005 data 7. What is the only group for which union affiliation does not yield higher pay? 8. Calculate the percentage difference between each group’s union and nonunion wages. Which group gains the most in wages from union membership. Creating Graphs Create a bar graph using the following information about alternative work arrangements in the United States. Include an appropriate title and a source line showing that the data, which are for 2005, come from the Bureau of Labor Statistics. Independent contractors (Self-employed workers, such as independent sales consultants or freelance writers): 10.3 million On-call workers (Workers called as needed, sometimes working several days or weeks in a row, such as substitute teachers): 2.5 million Temporary workers (Workers paid by the hour, such as file clerks, hired through a temporary employment agency): 1.2 million Contract workers (Workers paid a salary, such as training specialists, provided by contract firms and hired for a limited contract): 0.8 million Use to complete this activity. @ ClassZone.com 10. Synthesizing Economic Data Explain the differences in median weekly earnings in Figure 9.16 in terms of this chapter’s key concepts. 11. Explaining an Economic Concept Have you ever been paid to work? If so, explain how the rate you were paid was determined. If not, think of someone you know who has earned money and explain how that person’s wages were determined. 12. Applying Economic Concepts Think back to a time when you negotiated with someone in a position of authority for something you strongly wanted. Briefly describe the tactics you used and look for similarities or differences between those and the tactics unions use with employers. 13. Challenge In 2003, the Fair Labor Standards Act was amended to clarify who was entitled to overtime pay. At the center of the issue were computer programmers, who lost entitlement to overtime if their regular pay is $65,000 per year or more. What impact might this have had on the workers and the economy Collective Bargaining It’s time to renegotiate the union contract at the Acme auto parts factory in Springfield. Read these descriptions of the two sides, then follow the instructions to experience what union negotiations are like. Union workers currently earn $25 per hour, plus overtime pay if they have to work more than 35 hours per week. Benefits include health-care insurance paid for by the company, plus vision and dental coverage, also funded by the company. The workers’ pension fund is handled through the union. The Acme company is a conglomerate based in the United States. Its auto parts business has been struggling to make a profit, so it is considering outsourcing the work to a factory in China. It would then like to turn the Springfield factory into a computer manufacturing facility. Step 1 Divide the class evenly into union members and the Acme management team. Step 2 Separately and privately, each group discusses its objectives and negotiating strategies. Try to keep the conversation quiet so that the other side does not gain an advantage by learning your bargaining points. Step 3 Each group chooses three representatives to conduct the negotiations. Step 4 The representatives from both sides meet and negotiate the new contract. The rest of the two groups may listen to the negotiations, but they may not participate. If the two sides still disagree on an issue after several minutes of negotiations, put that issue aside for the moment. Keep a list showing the status of each issue. Step 5 If time permits, repeat steps 2–4 to address the unresolved issues. Discuss what happened. Did one side have more bargaining power? How did the two sides resolve their differences? Why were some issues more difficult to resolve than others? The Role of Labor 285 Macroeconomics U n i t 4 Money, Banking, and Finance What constitutes money? Money isn’t born, it’s made. Each society decides what it will accept as money, but effective moneys all share certain attributes and perform certain functions. 286 CHAPTER 10 SECTION 1 Money: Its Functions and Properties SECTION 2 The Development of U.S. Banking SECTION 3 Innovations in Modern Banking CASE STUDY Student Loans Money and Banking Macroeconomics is the study of the behavior of the economy as a whole and how major economic sectors, such as industry and government, interact. C H A P T E R 10 Money provides a low-cost method of trading one good or service for another. It makes the system of voluntary exchange efficient AT T E R S What were the last three economic transactions you completed using money? Perhaps you put four quarters in the fare machine on the bus to school or bought a slice of pizz
a and a drink in the cafeteria at lunch. Or maybe you caught an early movie after school yesterday. To gauge the importance of money to the economy, imagine trying to make such transactions without the familiar paper bills and coins. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on student loans. (See Case Study, pp. 312–313.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. Source: www.CartoonStock.com How important are student loans in the U.S. higher education system? See the Case Study on pages 312–313. Money and Banking 287 S E C T I O N 1 Money: Its Functions and Properties TA K I N G N O T E S In Section 1, you will money, p. 288 • outline the functions that money performs and the characteristics that money possesses • explain why the different types of money have value • describe how the money supply in the United States is measured medium of exchange, p. 288 barter, p. 288 standard of value, p. 289 store of value, p. 289 commodity money, p. 291 representative money, p. 291 fiat money, p. 291 currency, p. 293 demand deposits, p. 293 near money, p. 293 Functions of Money As you read Section 1, complete a cluster diagram summarizing key information about money. Use the Graphic Organizer at Interactive Review @ ClassZone.com Money QUICK REFERENCE Money is anything that people will accept in exchange for goods and services. A medium of exchange is a means through which goods and services can be exchanged. Barter is the exchange of goods and services without using money. KEY CONCEPT S What do the following things have in common: cattle, corn, rice, salt, copper, gold, silver, seashells, stones, and whale teeth? At different times and in different places, they have all been used as money. In fact, money is anything that people will accept as payment for goods and services. Whatever it is that people choose to use as money, it should perform three important functions. FUNCTION 1 Medium of Exchange Money must serve as a medium of exchange, or the means through which goods and services can be exchanged. Without money, economic transactions must be made through barter—exchanging goods and services for other goods and services. Barter is cumbersome and inefficient because two people who want to barter must at the same time want what the other has to offer. For example, suppose you want to trade two T-shirts for a pair of jeans. One classmate might have the jeans but not want your shirts; another might want your shirts but not have jeans to trade. It is much easier for you to buy a pair of jeans by giving money to the seller who, in turn, can use it to buy something else. Money allows for the precise and flexible pricing of goods and services, making any economic transaction convenient. 288 Chapter 10 A World of Money Currencies come in a wide variety of colors and sizes. This is a collage of the currencies of South America. FUNC T ION 2 Standard of Value Money also serves as a standard of value, the yardstick of economic worth in the exchange process. It allows people to measure the relative costs of goods and services. A $20 T-shirt is worth two $10 phone cards, four $5 burritos, or twenty $1 bus rides. The basic monetary unit in the United States is the dollar, which serves as the standard by which the economic worth of all goods and services can be expressed and measured. FUNC T ION 3 Store of Value Finally, money acts as a store of value, that is, something that holds its value over time. People, therefore, do not need to spend all their money at once or in one place; they can put it aside for later use. They know that it will be accepted wherever and whenever it is presented to purchase goods and services. One situation where money does not function well as a store of value is when the economy experiences significant inflation—a sustained rise in the general level of prices. For example, in Argentina in the first half of 2002, prices rose by about 70 percent. Basic goods that cost 150 pesos in January cost 255 pesos in June. In other words, in that time period, Argentina’s money lost over two-thirds of its purchasing power. You’ll learn more about inflation in Chapter 13. QUICK REFERENCE A standard of value determines the economic worth in the exchange process. A store of value is something that holds its value over time. Find an update on the functions of money at ClassZone.com 10 .1 Functions of Money ?What Functions Does Money Perform? Standard of Value Money provides both a way to express and measure the relative costs of goods and services and a way to compare the worths of different goods and services. Medium of Exchange Money provides a flexible, precise, and convenient way to exchange goods and services. Store of Value Money holds its value over time. It can be saved for later use because it can be exchanged at any time for goods and services. ANALYZE CHARTS You’ve read that salt was used as money in the past. How effectively do you think salt would function as money? Use the three functions of money in the chart to frame your answer. AP P LI CATION Applying Economic Concepts A. How does money help to make clear the opportunity cost of an economic decision? Money and Banking 289 Properties of Money KEY CONCEPT S To perform the three functions of money, an item must possess certain physical and economic properties. Physical properties of money are the characteristics of the item itself. Economic properties are linked to the role that money plays in the market. PROPERTY 1 Physical The following are physical properties of useful money: Durability Money should be durable, or sturdy, enough to last throughout many transactions. Something that falls apart when several people handle it or that spoils easily would not be a good item to use as money. Portability Money needs to be small, light, and easy to carry. It’s easy to see why paper bills are preferable to cattle as money. Divisibility Money should also be divisible so that change can be made. For example, the dollar can be divided an endless number of ways using different combinations of pennies, nickels, dimes, or quarters. Divisibility also allows flexible pricing. Uniformity Lastly, money must be uniform, having features and markings that make it recognizable. Coins that are used as money look different from other flat metal disks. Paper money is a consistent size and uses special symbols and printing techniques. All money that represents a certain amount in a given country has distinctive characteristics that help identify its value. These distinctive markings also make it more difficult to counterfeit. Chinese Coins Bronze, spadeshaped coins, 8th–7th century B.C. PROPERTY 2 Economic Useful money must also have the following economic properties: Stability of Value Money’s purchasing power, or value, should be relatively stable. In other words, the amount of goods and services that you can buy with a certain amount of money should not change quickly. Rapid changes in purchasing power would mean that money would not successfully serve as a store of value. Scarcity Money must be scarce to have any value. As you recall from Chapter 7, when the supply of a product outstrips demand, there is a surplus and prices for that product fall. Similarly, when the supply of money outstrips demand, money loses value, or purchasing power. Acceptability People who use the money must agree that it is acceptable—that it is a valid medium of exchange. In other words, they will accept money in payment for goods and services because others will also accept it as payment. APPLICATION Applying Economic Concepts B. Describe how U.S. dollars serve each of the three functions of money. 290 Chapter 10 Types of Money KEY C ONCEPT S In the discussion of the functions and properties of money, one theme recurs—value. Money draws its value from three possible sources. Commodity money derives its value from the type of material from which it is composed. Representative money is paper money backed by something tangible—such as silver or gold—that gives it value. Fiat money has no tangible backing, but it is declared by the government that issues it, and accepted by citizens who use it, to have worth. T YPE 1 Commodity Money Commodity money is something that has value for what it is. Items used as commodity money have value in and of themselves, apart from their value as money. Over the course of history, for example, gold, silver, precious stones, salt, olive oil, and rice have all been valued enough for their scarcity or for their usefulness to be used as money. QUICK REFERENCE Commodity money has intrinsic value based on the material from which it is made. Representative money is backed by something tangible. Fiat money is declared by the government and accepted by citizens to have worth. However, the most common form of commodity money throughout history has been coins made from precious metals. Such coins contain enough of the precious metal that if each was melted down it would be worth at least its face value. One problem with commodity money is that if the item becomes too valuable, people will hoard it rather than circulate it, hoping it will become more valuable in the future. Commodity money is rarely used today. Commodity Money Until recently, cattle was an important medium of exchange for the Masai people of East Africa. T YPE 2 Representative Money Representative money is paper money that can be exchanged for something else of value. The earliest forms of representative money were seen in the Middle Ages, when merchants, goldsmiths, and moneylenders began issuing receipts that promised to pay a certain amount of gold or silver. This came about because it was not always convenient or safe to transport large quantities of those precious metals from place to place for the purpose of trading. These practices signal the beginning of the wid
espread modern use of paper money. Eventually, governments got involved with representative money by regulating how much metal needed to be stored to back up the paper money. One problem with representative money is that its value fluctuates with the supply and price of gold or silver, which can cause problems of inflation or deflation—a sustained rise or fall, respectively, in the general level of prices. Money and Banking 291 The Euro as a Common Currency EU Members That Adopted the Euro in 2002 On January 1, 2002, a new currency—the euro—was put into full use in 12 European countries, each a member of the European Union (EU). The symbol for the euro is . Each country that adopted the euro gave up its own national currency The EU seeks the economic and political integration of Europe, and the euro is a key step toward this goal. The common currency makes trade among member nations easier and cheaper. As the EU expands, new members must meet specific economic standards before they can adopt the euro. Several small European countries that are not members of the EU have also begun using the euro. Like all modern currencies, the euro is categorized as fiat money. Its value is derived from public confidence in the EU. Control of the supply of euros is maintained by the European Central Bank, located in Frankfurt, Germany. Each member nation of the EU has a seat on the Central Bank’s decision-making board. CONNECTING ACROSS THE GLOBE 1. Making Inferences How do you think having a common currency might benefit the EU? 2. Recognizing Effects Why does the euro have value as currency? Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain TYPE 3 Fiat Money Unlike representative money, fiat money has value only because the government has issued a fiat, or order, saying that this is the case. The value of the U.S. dollar was linked to the value of gold until 1971. Since then, a $10 bill can no longer be exchanged for gold; it can only be converted into other combinations of U.S. currency that also equal $10. In fiat money, coins contain only a token amount of precious metal that is worth far less than the face value of those coins. Paper money has no intrinsic value, and people cannot exchange it for a certain amount of gold or silver. Fiat money has value because the government says it can be used as money and because people accept that it will fulfill all the functions of money. Dollar bills in the United States carry the statement “This note is legal tender for all debts, public and private.” This statement assures people that sellers will accept such money from buyers as payment for goods or services and lenders will accept it as payment for debts. A crucial role of the government in maintaining the value of fiat money is controlling its supply—in other words, maintaining its scarcity. APPLICATION Analyzing Cause and Effect C. Which type of money’s value would be most affected by political instability? Why? 292 Chapter 10 Money in the United States KEY C ONCEPT S In this section so far, you have learned what has been used as money, what functions money performs, what properties it possesses, and why money has value. But what serves as money in the United States today? In its narrowest sense, money consists of what can be used immediately for transactions—currency, demand deposits, and other checkable deposits. Currency is paper money and coins. Checking accounts are called demand deposits because funds in checking accounts can be converted into currency “on demand.” There are other monetary instruments that are almost, but not exactly, like money. Known as near money, it includes savings accounts and other similar time deposits that cannot be used as a medium of exchange but can be converted into cash relatively easily. QUICK REFERENCE Currency is paper money and coins. Demand deposits are checking accounts. Near money is savings accounts and time deposits that can be converted into cash relatively easily. Money in the Narrowest Sense In the narrowest sense, money is what can be immediately used for transactions. This definition of money sometimes uses the term transactions money. Most of the money that you and your friends and family spend is transactions money. About half of such money is currency, both paper money and coins, that is used by individuals and businesses. Most demand deposits are noninterest-bearing checking accounts that can be converted into currency simply by writing a check. Traveler’s checks, which are drafts that can be purchased in a number of money amounts and redeemed in many parts of the world, represent a small share of overall demand deposits. Other checkable deposits include negotiable order of withdrawal (NOW) accounts, which are interest-bearing savings accounts against which drafts may be written. Are Savings Accounts Money? Near money, such as savings accounts and other interest-bearing accounts, cannot be used directly to make transactions. Your local sporting goods store will not accept a savings passbook as payment for a new basketball or for your tennis racket to be restrung. But money in a savings account can be easily transferred into a checking account or removed directly from an automatic teller machine and put toward a desired good or service. Near money takes many forms in addition to traditional savings accounts. Time deposits are funds that people place in a financial institution for a specific period of time in return for a higher interest rate. These deposits are often placed in certificates of deposit (CDs). Money market accounts place restrictions on the number of transactions you can make in a month and require you to maintain a certain balance in the account (as low as $500 but often substantially more) in order to receive a higher rate of interest. Near Money A savings account contains money but is not, strictly, money. Money and Banking 293 How Much Money? How much money is in supply in the United States? Economists use various instruments to measure the money supply, but the most often cited are M1 and M2. M1 is the narrowest measure of the money supply, consisting of currency, demand deposits, and other checkable deposits. It is synonymous with transactions money. The elements of M1 are referred to as liquid assets, which means that they are or can easily become currency. M2 is a broader measure of the money supply, consisting of M1 plus various kinds of near money. M2 includes savings accounts, other small-denomination time deposits (CDs of less than $100,000), and money market mutual funds. You will learn about these financial instruments in Chapter 11. Figure 10.2 shows the amounts of the different forms of money that make up M1 and M2. You can see that M1 is almost evenly split between currency and checkable deposits. Notice that more of M2 comes from savings than from M1. You will learn the importance of the money supply in the economy and how the government manages it in Chapter 16. Find an update on measures of the money supply at ClassZone.com FIGURE 10.2 COMPONENTS OF THE U. S. MONEY SUPPLY M1 (in billions of dollars) Currency Demand deposits* Other checkable deposits TOTAL * includes traveler’s checks 723.8 328.2 316.9 1,368.9 M2 (in billions of dollars) Savings deposits M1 Small time deposits Money market mutual funds 3,620.5 1,368.9 973.7 717.4 23.1% 52.9% 24.0% 14.6% 10.7% 54.2% TOTAL includes money market accounts 6,680.5 20.5% Source: U.S. Federal Reserve Board (data from 2005) Currency Demand deposits Other checkable deposits Savings deposits M1 Small time deposits Money market mutual funds ANALYZE TABLES 1. What amount of M2 does not come from currency and checkable deposits? 2. If currency is 52.9 percent of M1, and M1 is 20.5 percent of M2, what percentage of M2 is currency? APPLICATION Applying Economic Concepts D. Classify each of the following as M1 and M2: a. dollar bill; b. savings account; c. money market account; d. traveler’s check; e. $50,000 CD. 294 Chapter 10 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the difference between the terms in each of these pairs. a. standard of value store of value b. commodity money c. demand deposits representative money near money 2. Why are economic transactions easier with money than with barter? 3. Why is it important that money be divisible? 4. Why are checking accounts called demand deposits? 5. What aspect of fiat money allows it to have more stability than representative money? 6. Using Your Notes How are the economic properties of money related to its functions? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Money 7. Categorizing Economic Information Which of these forms of money are included in M1: • checking accounts • coins • money market accounts • paper money • savings accounts • time deposits • traveler’s checks • NOW accounts 8. Making Inferences The U.S. government has tried to get people to use dollar coins rather than dollar bills. Most consumers prefer to use dollar bills. Which physical properties of money are involved in these different preferences? 9. Applying Economic Concepts Maria’s parents told her that for the ten years prior to her high school graduation, they saved $200 per month for her college education—$24,000 (plus interest). Which function of money does this example best illustrate? Why? 10. Challenge Why is there more near money than transactions money in the U.S. money supply? Evaluating Economic Decisions In the past, indigenous people of Central and South America used cacao beans (the source of chocolate) as currency. Evaluate Money In Section 1, you learned that money should function as a medium of exchange, a standard of value, and a store of value. Use what you’ve learned about these functions to evaluate how useful cacao beans might be as money today. Show your answer by filling in the table below. Possible Problems Function Medium of ex
change Standard of value Store of value Challenge How well do cacao beans exhibit each of the physical and economic properties of money? Money and Banking 295 S E C T I O N 2 The Development of U.S. Banking TA K I N G N O T E S In Section 2, you will • describe how banking developed in the United States • identify the banking institutions that operate in the United States state bank, p. 296 national bank, p. 299 gold standard, p. 299 As you read Section 2, complete a chart using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Development of U.S. Banking Origins 19th Century 20th Century The Origins of Banking KEY CONCEPT S Modern banking arose in Italy in the late Middle Ages. Italian merchants stored money or valuables for wealthy people and issued receipts that promised to return the property on demand. They realized that they did not have to hold all the deposits, since all depositors did not reclaim their property at the same time, but could lend some of the deposits and earn interest on those loans. This was the beginning of fractional reserve banking (see Section 3), the practice of holding only a fraction of the money deposited in a bank and lending the rest. In colonial America, many Early “Bankers” The Italian word banco, means “bench.” From benches in the street, Italian merchants used some practices that are part of banking today. QUICK REFERENCE A state bank is a bank chartered by a state government. 296 Chapter 10 merchants followed the same practice. However, these banks were far from secure. If a merchant’s business failed, depositors lost all of their savings. After the Revolutionary War, many state banks—banks chartered, or licensed, by state governments—were established. Some of these banks, however, followed practices that tended to create instability and disorder. Many issued their own currency that was not linked to reserves of gold or silver held by the bank. ECO N O M I C S PAC ES E T T E R Alexander Hamilton: Shaping a Banking System Imagine what it would be like if every bank issued its own currency. How would buyers know if sellers would accept their money? How would sellers know if the money they received was worth anything? That was the confusing situation that Alexander Hamilton faced when he became Secretary of the Treasury in 1789. He immediately set to work to bring stability to U. S. banking. The First Bank of the United States Hamilton was a leading Federalist who believed in a strong central government. He proposed chartering a privately owned national bank to put the government on a sound financial footing. This bank would issue a national currency and help control the money supply by refusing to accept currency from state banks that was not backed by gold or silver. It also would lend money to the federal government, state banks, and businesses. The Constitution did not specifically authorize Congress to charter a national bank. The Antifederalists, led by Thomas Jefferson and James Madison, interpreted the Constitution strictly and feared putting too much power in the hands of the central government. Hamilton argued that the Constitution implied that the federal government had the authority to create a national bank to carry out its duty to regulate the currency. Hamilton won the fight, and the First Bank of the United States was chartered in 1791. Over time, it achieved the financial goals that Hamilton had set. However, opponents argued that the bank’s policies restrained economic growth, and Congress refused to renew the charter in 1811. The fact that Hamilton was the architect of the bank was always a strike against it, as he had made many enemies during his career. (One, Aaron Burr, killed him in a duel.) Maybe Hamilton was right when he said, “Men often oppose a thing merely because they have had no agency in planning it, or because it may have been planned by those whom they dislike.” Alexander Hamilton (above) and the First Bank of the United States (right) FAST FACTS Alexander Hamilton Position: First Secretary of the Treasury (1789–1795) Born: January 11, 1755 in Nevis, British West Indies Died: July 12, 1804 Writings: The Federalist Papers (1787), with James Madison and John Jay; Report on a National Bank (1790) Major Accomplishment: Strengthened the national government and established the First Bank of the United States Hamilton’s Visible Legacy: Portrait on the $10 bill AP P LI CATION Making Inferences A. How did the First National Bank force state banks to become more stable? Learn more about Alexander Hamilton at ClassZone.com Money and Banking 297 F I G U R E 10 . 3 Major Developments in American Banking 1816 ▲ Congress charters Second Bank of the United States. 1863 ▲ Congress creates national banks and currency. 1775 1800 1825 1850 1875 196 1791 Congress charters First Bank of the United States. 1837–1865 Wildcat banking leads to unstable currency. ▲ 19th-Century Developments KEY CONCEPT S Without a central bank, the government had difficulty financing the War of 1812 against Britain. Furthermore, state banks soon returned to the unrestrained issuing of currency that was not linked to reserves of gold or silver held by the banks. The resulting increase in the money supply led to inflation during the war. The Second Bank of the United States Congress finally agreed to charter the Second Bank of the United States in 1816. The new bank had greater financial resources than the First Bank and succeeded in making the money supply more stable. Opponents continued to see the central bank as too powerful and too closely aligned with the wealthy. President Andrew Jackson was an outspoken critic who mistrusted banks and paper money He vetoed the renewal of its charter in 1832. Wildcat Banking After the Second Bank’s charter lapsed in 1836, there was no federal oversight of the banking industry. During this period, all banks were state banks, each of which issued its own paper currency, called bank notes. States passed free banking laws that allowed individuals or groups that met its requirements to open banks. 298 Chapter 10 Jackson and the Second Bank This 1828 cartoon lampoons Jackson’s battle against the bank. 1913 President Wilson establishes Federal Reserve System. ▲ 1950 Banks issue ﬁ rst credit cards. 1980s Savings and Loan crisis rocks U.S. banking industry. 60 1900 1925 1950 1975 Present 1900 ▲ United States adopts gold standard. 1933 Banking Act creates Federal Deposit Insurance Corporation. 1971 ▲ President Nixon ends the dollar’s link to gold. 1999 Deregulation opens up bank competition. Some of these banks were located in remote areas to discourage people from redeeming their bank notes, which were often worth less outside the region where they had been issued. It was this practice, along with the questionable quality of many bank notes that resulted in the term wildcat bank. In addition, such banks were susceptible to bank runs when depositors demanded gold or silver for their currency. Since the banks often did not have sufficient reserves of these precious metals, financial panics and economic instability were common results. The Struggle for Stability During the Civil War, it was particularly difficult for the government to finance its operations without a national currency and a federal bank. The government’s first solution to this problem was to issue a new currency backed by government bonds. These U.S. bank notes, called greenbacks, were printed with green ink. In 1863, Congress passed the National Banking Act, which led to the creation of a system of national banks, banks chartered by the national government. The act provided for a national currency backed by U.S. Treasury bonds and regulated the minimum amount of capital required for national banks as well as the amount of reserves necessary to back the currency. Congress taxed state bank notes issued after 1865, effectively eliminating these notes from circulation. In 1900, the government officially adopted the gold standard, a system in which the basic monetary unit—for example, one dollar—is equal to a set amount of gold. The national currency and gold standard helped to bring some stability to the banking system. Money was now uniform throughout the country, backed by something of intrinsic value, and limited by the supply of gold. AP P LI CATION Analyzing Effects B. How did the National Banking Act of 1863 attempt to eliminate the problems caused by wildcat banking? QUICK REFERENCE National banks are banks chartered by the national government. The gold standard is a system that backs the basic monetary unit with a set amount of gold. Money and Banking 299 20th-Century Developments KEY CONCEPT S The system of national banks and a national currency linked to the gold standard initially brought stability to U.S. banking. Yet the economy still experienced periods of inflation and recession and financial panics. This economic instability was largely due to the lack of a central decision-making institution that could manage the money supply in a flexible way to meet the economy’s changing needs. A New Central Bank In 1913, Congress passed the Federal Reserve Act, which established the Federal Reserve System (commonly known as the Fed)—a true central bank. It consists of 12 regional banks with a central decision-making board. The Fed provides financial services to the federal government, makes loans to banks that serve the public, issues Federal Reserve notes as the national currency, and regulates the money supply to ensure that money retains its purchasing power. You’ll learn more about the structure and functions of the Federal Reserve in Chapter 16. The Great Depression and the New Deal At the start of the Great Depression in 1929, many banks failed due to bank runs, as consumers panicked and withdrew all of their money. When the banks failed, many more depositors lost their money. Part of President Franklin Roosevelt’s N
ew Deal program was the Banking Act of 1933, which instituted reforms such as regulating interest rates that banks could pay and prohibiting banks from selling stocks. The Federal Deposit Insurance Corporation (FDIC) provided federal insurance so that if a bank failed, people would no longer lose their money. This legislation set the tone for almost 50 years by increasing the regulation of banking in the United States. Deregulation and the S&L Crisis In 1980 and 1982, Congress passed laws that lifted government limits on savings interest rates. This allowed savings and loans associations (S&Ls) to operate much like commercial banks. Deregulation encouraged the S&Ls to take more risks in the types of loans they made. As a result, many S&Ls failed and lost their depositors’ money. Congress agreed to fund the S&L industry’s restructuring in order to protect consumers, which cost taxpayers hundreds of billions of dollars. The S&L Crisis Depositors camp out to withdraw their money in May 1985. APPLICATION Comparing and Contrasting C. How are the First Bank of the United States and the Federal Reserve different? 300 Chapter 10 Find an update on U.S. financial institutions at ClassZone.com Financial Institutions in the United States KEY C ONCEPT S The term bank is used to refer to almost any kind of financial institution that takes in deposits and makes loans, helping individuals, businesses, and governments to manage their money. In the end, though, the goal of a bank is to earn a profit. All financial institutions receive a charter from the government, either state or federal. Government regulations set the amount of money the owners of a bank must invest in it, the size of the reserves a bank must hold, and the ways that loans may be made. The term may refer to commercial banks, savings and loan associations, or credit unions. In the past, these institutions provided very different and distinct services. Today, however, because of the deregulation of banking, these distinctions are much less apparent. The distinctive characteristics of each type of financial institution are described in more detail below. Figure 10.4 on page 302 compares the three types of banks based on numbers of institutions and total assets. T YPE 1 Commercial Banks Privately owned commercial banks are the oldest form of banking and are the financial institutions most commonly thought of as banks. As their name implies, commercial banks were initially established to provide loans to businesses. Now they provide a wide range of services, including checking and savings accounts, loans, investment assistance, and credit cards to both businesses and individual consumers. You will learn more about these services in Section 3. In 2003, there were about 2,000 national commercial banks and about 5,800 state-chartered banks insured by the FDIC. All national commercial banks belong to the Federal Reserve System, but only about 16 percent of state-chartered banks choose to join the Fed. About 1,500 of these commercial banks are large ones with assets of $300 million dollars or more. In 2005, the seven largest banks in the United States held 50 percent of the total assets controlled by all these large banks. T YPE 2 Savings Institutions Savings and loan associations (S&Ls) began in the United States in the 1830s. They were originally chartered by individual states as mutual societies for two purposes— to take savings deposits and provide home mortgage loans. In other words, groups of people pooled their savings in a safe place to earn interest and have a source of financing for families who wanted to buy homes. The S&Ls continue to fulfill these purposes, but they now also offer many of the services provided by commercial banks. Since 1933, the federal government may also charter S&Ls, and since 1982, many federally chartered S&Ls have chosen to call themselves savings banks. Many savings institutions are now financed through the sale of stock, just as commercial banks are. Money and Banking 301 In 2003, there were about 800 federally chartered savings institutions and 600 state-chartered institutions. These institutions are now insured under a specific fund of the FDIC as part of the reforms that followed the S&L crisis of the 1980s. TYPE 3 Credit Unions Credit unions are cooperative savings and lending institutions, rather like the early S&Ls. They offer services similar to commercial banks and S&Ls, including savings and checking accounts, but specialize in mortgages and auto loans. The first credit union in the United States was chartered in 1909. The Federal Credit Union Act of 1934 created a system of federally chartered credit unions. In 2003, there were about 5,800 federally chartered credit unions and about 3,600 chartered by the states. Most credit unions have deposit insurance through the National Credit Union Association (NCUA), similar to the FDIC. The major difference between credit unions and other financial institutions is that credit unions have membership requirements. To become a member, a person must work for a particular company, belong to a particular organization, or be part of a particular community affiliated with the credit union. Credit unions are cooperatives—nonprofit organizations owned by and operated for members, who numbered more than 80 million nationwide in 2003. F I G U R E 10 TAT ES $8,413 7,630 9,014 Key: Number of Institutions Assets (in billions of dollars) 1,345 $1,692 Commercial banks Savings institutions $647 Credit unions Source: Statistical Abstract of the United States, 2006 (Data from 2004) ANALYZE CHARTS 1. Which type of bank has the largest number of institutions? Why? 2. How do the assets held in savings institutions compare to the assets held in commercial banks? APPLICATION Analyzing and Interpreting Data D. Which type of bank described above has the largest percentage of its institutions chartered by the federal government? Why might this situation have developed? 302 Chapter 10 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Use each of the three terms below in a sentence that illustrates the meaning of the term. a. state bank b. national bank c. gold standard 2. Explain the relationship between the gold standard and the concept of representative money. 3. How does the Federal Reserve System serve as a central bank? 4. What is the difference between a national bank and a state bank? 5. How did the FDIC make fractional reserve banking less risky for consumers? 6. Using Your Notes What role Development of U.S. Banking did state banks play in the era of wildcat banking? Refer to your completed chart. Origins 19th Century 20th Century Use the Graphic Organizer at Interactive Review @ ClassZone.com . Creating Graphs Use the information in Figure 10.4 to create two pie graphs, one showing the percentage that each type of bank contributes to the total number of financial institutions and another showing the percentage that each type of bank contributes to total bank assets. State one conclusion that you can draw from the two graphs. Use activity. @ ClassZone.com to complete this 8. Synthesizing Economic Information On the basis of what you learned about the history of U.S. banking in the 19th and 20th centuries, were Alexander Hamilton’s ideas about the need for a central bank and a national currency shown to be mostly accurate? Cite specific examples to support your answer. 9. Applying Economic Concepts Suppose that Mariel deposits $100 in her local bank. If the Fed’s reserve requirement is 15 percent, how much can the bank loan out on the basis of Mariel’s deposit? What concept does this scenario illustrate? 10. Challenge How do banks facilitate saving and borrowing in the same way that money facilitates buying and selling? Constructing Graphs Consider what you have learned about different types of financial institutions. The table below shows how the numbers of commercial banks and savings institutions have changed over time. Year 1985 1990 1995 2000 2004 Commercial Banks Savings Institutions 14,417 12,347 9,942 8,315 7,630 3,626 2,815 2,030 1,589 1,345 Create Line Graphs Use the information in the table to create two line graphs that show the changes in the numbers of each type of bank. Use ClassZone.com to complete this activity. @ Challenge On the basis of this information, what trends can you identify? Which type of financial institution experienced a greater percentage loss from 1985 to 2004? Money and Banking 303 S E C T I O N 3 Innovations in Modern Banking TA K I N G N O T E S In Section 3, you will automated teller machine, p. 308 • describe the services that debit card, p. 308 stored-value card, p. 308 banks provide • discuss the changes that deregulation has brought to banking • explain how technology has changed banking in the United States As you read Section 3, complete a hierarchy diagram to track main ideas and supporting details. Use the Graphic Organizer at Interactive Review @ ClassZone.com Innovations in Banking main idea main idea main idea details details details What Services Do Banks Provide? KEY CONCEPT S Banks offer a number of services that allow them to act like “money stores.” In other words, just as stores are places where goods are bought and sold, banks are places where money can be bought (borrowed) and sold (lent). By using these services, customers are able to do three things—store money, earn money, and borrow money. Banks are businesses that earn money by charging interest or fees on these services. SERVICE 1 Customers Can Store Money As you read in Section 2, banks began as safe places to store money and other valuables. They still serve the same purpose today. Customers deposit money in the bank, and the bank stores currency in vaults and is also insured against theft and other loss. Customers’ bank accounts are also insured in case the bank fails. Banks are also a safe place to store important papers and valuables—through the use of safe deposit boxes. SERVIC
E 2 Customers Can Earn Money When customers deposit their money in bank accounts, they can earn money on their deposits. Savings accounts and some checking accounts pay some level of interest. Banks offer other accounts, such as money market accounts and certificates of deposits (CDs), that pay a higher rate of interest. You will learn more about saving and investing in Chapter 11 and in Consumer and Personal Finance, which begins on page 574. 304 Chapter 10 S E RVI CE 3 Customers Can Borrow Money Banks also allow customers to borrow money through the practice of fractional reserve banking. (See Figure 10.5.) The percent of deposits that banks must keep in reserve is set by the Fed. Banks provide customers, each of whom must be approved by the bank, with different loans for different circumstances. One common loan is a mortgage. A mortgage loan allows a buyer to purchase a real estate property, such as a house, without paying the entire value of the property up front. The lender and the borrower agree on a time period for the loan (often up to 30 years) and an interest rate to be paid to the lender. From this, a monthly mortgage payment amount is settled. In this arrangement, the real estate property acts as collateral. So if the borrower defaults on the loan (stops making the payments), the lender takes control of the property. It can then be sold by the bank to cover the balance of the mortgage. It may not seem so, but a purchase made on a credit card is a loan too. Credit cards are issued by banks to users who are, in effect, borrowers. When you use a credit card to buy a new skateboard or a tank of gasoline, the issuing bank pays the seller and lends you the money. When you pay the bank back, you’re repaying a loan. And if you don’t pay it back within a month, you’ll owe the bank extra in interest. F I G U R E 10 . 5 Fractional Reserve Banking Deposit of $10,000 A bank customer deposits $10,000 into her account in Bank A. Loan of $8,100 Bank B lends $8,100 to a customer who uses it to buy a used car. Deposit of $8,100 The seller of the car deposits the $8,100 in Bank C. Bank A Fed’s reserve requirement is 10%, or $1,000. Bank B Fed’s reserve requirement is 10%, or $900. Bank C Fed’s reserve requirement is 10%, or $810. Loan of $9,000 Bank A lends $9,000 to a customer who uses it to ﬁx his roof. Deposit of $9,000 The rooﬁng contractor deposits the $9,000 into his account in Bank B. Loan of $7,290 Bank C lends $7,290 to a customer who uses it to open a small business. ANALYZE CHARTS The customer who deposited $10,000 in Bank A can withdraw her money even though a loan may have been made based on her deposit. This is known as creating money. Why? Use an interactive fractional reserve banking chart at ClassZone.com AP P LI CATION Applying Economic Concepts A. Explain the ways in which bank transactions are beneficial to customers and banks. Money and Banking 305 Banking Deregulation KEY CONCEPT S Prior to the 1980s, government tightly regulated the amount of interest that banks could pay on deposits and could charge on loans. Regulations also prevented banks from operating in more than one state. Several states also had limitations on the number of branches that a bank could have within a state. Deregulation in the 1980s and 1990s ended these restrictions and brought major changes to what we think of as banks and how they operate. Bank Mergers The end of restrictions on interstate banking led to a large number of mergers, as larger banks acquired smaller ones and smaller ones joined together to be able to enter different geographic markets. The number of mergers has steadily declined since 1998, when there were almost 500, to less than 200 in 2003. Yet as Figure 10.6 shows, mergers that created very large banking organizations continued. In 2004, F I G U R E 10 . 6 Major Bank Mergers Bank of America Continental Bank Security Bank Nations Bank Barnet Bank Boston Bay Bank Fleet Shawmut Bank of America Fleet Boston Manufacturers Hanover Trust Chemical Bank Chase Manhattan Bank J.P. Morgan J.P. Morgan Chase Bank One First Commerce First Chicago NBD First Bank US Bank Bank One US Bank Bank of America J.P. Morgan Sources: The Canadian Treasurer, March 19, 2003; Encyclopaedia Britannica ANALYZE CHARTS In most of the mergers shown here, the acquiring banks hoped to increase their customer base by gaining offices in regions where they had no presence. What reasons might target banks (the banks acquired) have for entering into a merger? 306 Chapter 10 Bank of America Investment Services Inc. and J. P. Morgan Chase & Co. became two of the largest banks in the United States, with assets of around $1 trillion each. In contrast, some 95 percent of commercial banks have assets of $1 billion or less. One benefit from the mergers has been increased competition that has kept interest rates low and resulted in more consumer services. There has also been an increase in the number of bank branches, even while the number of banks has declined. Larger banks and more branches offer customers greater availability of services. Many banks also cite economies of scale made possible by the mergers, as banks are able to spread their costs, especially for new technology, over more customers. However, some see potential problems associated with mergers. Although competition between these merged banks has heated up, there are increasingly fewer banks to choose from. Further, it is feared that larger banks may show less interest in small customers and local community issues. If this is the case, consumers will choose a bank that provides them with what they want, and the large banks will either respond or lose customers. Banking Services The Financial Services Act of 1999 lifted the last restrictions from the Banking Act of 1933 that had prevented banks, insurance companies, and investment companies from selling the same products and competing with one another. This change allowed banks to sell stocks, bonds, and insurance. At the same time, some investment companies and insurance companies began offering traditional banking services. The change in banking services was based on the idea that consumers would prefer to have a single source for all their financial services needs—something that might function as a kind of “financial supermarket.” However, banks have not always been able to effectively realize the benefits they had envisioned from offering this array of services. While banks establish relationships with customers through deposit accounts and loans for homes and autos, they have not been as successful in selling insurance or in helping customers to buy and sell stocks and bonds. Most bank customers continue to look to traditional insurance companies for their insurance needs and investment brokers and mutual fund companies to meet investment desires. Financial Freedom President Clinton signs the bill that eliminated restrictions in place since 1933. ▲ Roosevelt and the Banking Act of 1933 ▲ Clinton and the Financial Services Act of 1999 AP P LI CATION Analyzing Effects B. How did deregulation change the ways that banks competed? Money and Banking 307 Technology and Banking KEY CONCEPT S Deregulation is not the only thing that has changed the nature of banking. Technology—particularly computer technology—has changed the way customers use banks, producing a system generally referred to as electronic banking. For example, banks have begun using automated teller machines (ATMs), electronic devices that allow bank customers to make deposits, withdrawals, and transfers and check their account balances at any time without seeing a bank officer. Other innovations include debit cards, cards that can be used like an ATM card to withdraw cash or like a check to make purchases, and stored-value cards—cards that represent money that the holder has on deposit with the issuer, such as a department store. These cards give customers the ability to use the money in their accounts in more convenient ways. (You’ll learn more about ATM and debit cards in Consumer and Personal Finance.) Automated Teller Machines Between school, sports practice, and a parttime job, you might find it difficult to get to the bank while it is open to deposit your paycheck and to withdraw spending money. The ATM solves that problem. ATMs are the oldest and most familiar of the developments in electronic banking. They began to be used widely in the 1970s and are now located not just at banks but also at retail stores, workplaces, airports, and entertainment venues, such as movie theaters and sports stadiums. ATMs are basically data terminals that ATM Boom Between 1998 and 2003, the number of ATMs in the United States nearly doubled, from 187,00 to 371,000. By 2007, there were over 1.5 million ATMs worldwide. are linked to a central computer that is in turn linked to individual banks’ computers. The bank provides you with a plastic ATM card with a magnetic strip on the back that contains your account information. You insert your card into the ATM, enter your personal identification number (PIN), and follow the instructions on the screen. You may check your account balance, make deposits, withdraw cash, transfer money between accounts, and make loan payments through the ATM. All ATM networks are connected so that consumers can use their ATM cards at any machine, no matter what bank owns it. Some banks charge fees for ATM use, especially to consumers who do not have an account at the bank that owns the particular ATM. ATMs allow people to bank even when the bank is closed and to avoid waiting in line for simple transactions. Many drive-through ATMs allow customers to bank from their cars. ATMs save banks money because it is much less expensive to process ATM transactions than transactions that involve a teller. They also allow banks to provide services at more locations without constructing complete bank branch offices. QUICK REFERENCE An automated teller machine (ATM) is an ele
ctronic device that allows bank customers to make transactions without seeing a bank officer. A debit card can be used like an ATM card or like a check. A stored-value card represents money that the holder has on deposit with the issuer. 308 Chapter 10 Debit Cards Debit cards are similar to ATM cards but offer additional benefits. Like ATM cards, debit cards can be used to withdraw cash and make other transactions at ATM machines. Debit cards are sometimes called check cards because they are linked to bank accounts and can be used like checks to make purchases at many retail outlets. Retailers often prefer debit cards because they avoid the problem of people writing checks with insufficient funds in their accounts. Debit cards often look like credit cards, and they are similar in that they can be used to make purchases at stores. An important difference is that credit card purchases involve getting a loan. Your money stays in your account until you pay your credit card bill. With a debit card you make an immediate payment, since the price of your purchase is deducted from the account that is linked to your card. Therefore, it is important to keep track of debit card purchases along with checks so that you know how much money is available in your account at any given time. Because of the way debit cards work, they are often seen as safer ways to manage your money than with credit cards. With credit cards, if you do not pay your balance in full each month, you pay interest on the outstanding balance and can build up considerable debt. With debit cards, you can only spend money that you actually have in a bank account. YO U R EC EDIT C ARD VS. DE BIT C ARD Which one should you use? You have $250 in your checking account, and you don’t get your next paycheck for a week. You want to buy a $75 birthday gift for a friend, and you have to pay $225 for a car repair. With your classmates, talk through each of the ways to handle the situation to find out what works best. ? Entering a PIN for a debit card Signing for a credit card Stored-Value Cards Stored-value cards, which represent money that the holder has on deposit with the card issuer, give consumers another convenient way to use electronic banking. These cards are sometimes called prepaid cards because customers have paid a certain amount of money for the card and can then use it to make payments for various goods and services. Some examples of stored-value cards include transit fare cards, gift cards from retail stores, and telephone cards. Consumers benefit from using transit fare cards and telephone cards because they do not have to worry about having the exact change needed each time they ride the bus or use a pay phone. Money and Banking 309 In 2004, there were more than 2,000 different stored-value card programs in the United States with about 20 million users. The number of users was expected to be 49 million by 2008. The $42 billion in transactions in 2003 was expected to grow to more than $72 billion by 2006. Multipurpose stored-value cards—cards that can be used like debit cards—are becoming more popular. This type of card may take the place of a checking account, especially for people who have not traditionally used banks. While stored-value cards are a convenient way for people to make purchases and pay bills, consumers need to evaluate the fees involved in using such cards to determine whether they are less expensive than having a checking account or using a check-cashing service. In addition, the money paid into such cards is not always covered by FDIC insurance to protect customer deposits in case of a bank’s failure. Electronic Banking Electronic banking allows customers who have set up accounts with a bank to perform practically every transaction without setting foot in a bank. Indeed, some banks are virtual banks with no physical buildings at all. Through the use of the Internet, customers can arrange for direct deposit of their paychecks, transfer funds from account to account, and pay their bills. Most bank Web sites allow customers to review the most recent transactions on their accounts, view images of canceled checks, and download or print their periodic statements. Through electronic fund transfers, consumers can pay a credit card bill at one bank with funds from a checking account at another bank. Recurring bills, such as mortgage payments, may be paid automatically from a customer’s checking account each month or through their bank’s bill paying service. However, electronic banking presents several challenges. Information security and identity theft are related, high-profile issues for the industry. Electronic banking allows banks to amass large amounts of information about their customers. Banks contend that this allows them to provide customers with better service. New laws require that banks make customers aware of privacy policies and offer them the opportunity to decide what information may be shared with others. Consumer concerns have led banks to developing increasingly sophisticated information security systems. (For information on identity theft, see Consumer and Personal Finance, which begins on p. 574.) Online Convenience Online bill paying cuts time and expense by eliminating the need to mail checks. APPLICATION Contrasting Economic Information C. How are debit cards different from most stored-value cards? 310 Chapter 10 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. How are these three terms related? How are they different? a. automated teller b. debit card c. stored-value card machine 2. What are two reasons that people deposit money in banks? 3. It is said that fractional reserve banking allows banks to create money? What is meant by this? 4. How did deregulation lead to a decrease in the number of banks between 1980 and the present? 5. How are debit cards related to automated teller machines? 6. Using Your Notes How does computer technology support home banking? Refer to your completed hierarchy diagram. Innovations in Banking main idea main idea main idea details details details Use the Graphic Organizer at Interactive Review @ ClassZone.com . Analyzing Data Over the course of one year, Hometown Bank paid Mary Lee 3 percent interest on a $1,000 deposit and charged Owen’s Bakery 8 percent interest on a $900 loan. How much net income did Hometown bank make? Show your calculations. 8. Applying Economic Concepts Suppose that Liz inherits $2,000 from her grandmother and deposits it into her college savings account at Hamilton Savings Bank. Assume that the reserve requirement is 20 percent. Create a chart showing five successive loans that could be made from this initial deposit. 9. Making Inferences Some parents think that allowing teenagers to use a debit card prepares them for using a credit card. What are the possible reasons behind this thinking? Do you think this reasoning is sound? Why or why not? 10. Challenge Look again at Figure 10.5, Fractional Reserve Banking, on page 305. Suppose that when Bank A made the $9,000 loan to the man with the leaky roof, it turned out the job cost only $7,000. The contractor deposited that money into Bank B. How much could Bank B then lend to the used-car buyer? If she bought a car for that amount, and the seller of the car deposited the money in Bank C, what size small-business loan could Bank C then turn around and make? Starting a Bank Think about what you have learned about the services that banks provide and how banks make money. Imagine that you are starting a bank for the other members of the class. Consider the following questions: • What services would you provide? Why? • How would your bank make a profit? • What challenges might you face in making your bank profitable? Write a Proposal Answer the above questions in a one-page proposal outlining what your bank would be like. Share your proposal with a classmate. Challenge Include a section in your proposal about what you would do to make your bank more attractive to customers than the other banks run by your classmates. Money and Banking 311 Case Study Find an update on this Case Study at ClassZone.com Student Loans Background In the United States, the cost of higher education may still be affordable to some, but it certainly is not cheap. Because of rising costs, more and more students (and their parents) borrow money to finance at least part of their college education. According to the U.S. Department of Education, about 10 million students take out Stafford loans each year, while about 800,000 parents take out PLUS loans. Although banks, S&Ls, and credit unions are the primary lenders of money in the United States, this is not the case for student loans. Students and parents have the option of borrowing wherever they choose, but federally guaranteed loans are their main source of funding. What’s the issue? What is the current situation with student loans? What are the future ramifications of the increasing cost of paying for college? Study these sources to learn about student loans. A. Online News Story This story explains a change in the way the government figures the interest rate on student loans. Text not available for electronic use. Please refer to the text in the textbook. FIGURE 10.7 AVERAGE COST OF TUITION, ROOM, AND BOARD AT A FOUR- YEAR INSTITUTION ) 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 1989– 1990 1991– 1992 1993– 1994 1995– 1996 1997– 1998 1999– 2000 2001– 2002 2003– 2004 School Year Source: National Center for Education Statistics Thinking Economically If interest rates hit 10 percent, would the new fixed rate established by Congress still harm student borrowers? Why or why not? 312 Chapter 10 B. Cartoon Ralph Hagen drew this cartoon about student loans as a factor in higher education. Thinking Economically What does the cartoon suggest about student reliance on college loans? Explain your answer. Source: www.CartoonStock.com C. Newspaper Article This article discusses the problems associa
ted with debt and loan repayment after college graduation. It’s Payback Time More student loans increase debt pressure on graduates. Student loans are two-edged: the more money a student can borrow, the more schooling falls within reach. But of course, the more debt a student has, the more painful repayment becomes. . . . “More students will be required to take out more money from the federal government and from private lenders,” says Jasmine L. Harris, legislative director at the United States Student Association, a student advocacy group in Washington. Over time, she continues, ‘’It’s a great formula for unmanageable levels of debt and hence higher default rates.’’. . . The consequences of defaulting, too, are worse than they have been in years past. A provision of a law that took effect last year, for example, makes it next to impossible to discharge private student loans in personal bankruptcy proceedings (federal loans were already barred). . . . [Theresa] Shaw of the Education Department advises that a struggling borrower should try to make a payment of any kind, however small, to avoid default. Source: The New York Times, April 23, 2006 Thinking Economically Explain in your own words why you think the article calls student loans “two-edged.” THINKING ECONOMICALLY Synthesizing 1. Compare the financial news presented in documents A and C. What bearing do you think the information in document A might have on what you learned from document C? 2. Document B humorously points to the prominence of student loans in U.S. higher education. Specifically, what parts of documents A and C support this view? 3. In document A, what does the federal government seem to be saying about who should pay for a college education? With this in mind, what does Figure 10.7 mean for students and parents? Money and Banking 313 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. automated teller machine barter commodity money currency debit card demand deposits fiat money fractional reserve banking gold standard M1 M2 medium of exchange money national bank near money representative money standard of value state bank store of value stored-value card 1 is anything that people will accept as payment for goods and services. Money makes trade easier by serving as a 2 . As a 3 , money allows people to compare the prices of goods and services. Money must be a 4 , or something that holds its value over time. Gold coins and salt are both examples of 5 . Most money in the world today is 6 , which has no tangible value but is declared by the government to have worth. 7 consists of 8 , which includes paper money and coins and 9 , which is another name for checking accounts. Savings accounts and time deposits are called 10 because they can be converted into cash easily. 11 allows banks to hold only part of their deposits and make loans based on the rest. The Federal Reserve Bank is the central 12 in the nation. The 13 is the oldest form of electronic banking. A 14 can be used like an ATM card or like a check. 314 Chapter 10 CHAPTER 10 Assessment Money: Its Functions and Properties (pp. 288–295) 1. What three functions does money serve in the economy? 2. Why do economists make a distinction between M1 and M2? The Development of U.S. Banking (pp. 296–303) 3. Why does fractional reserve banking leave banks vulnerable to failure if too many consumers demand their money at the same time? 4. How is the Federal Reserve System different from the system of national banks created in the 1860s? Innovations in Modern Banking (pp. 304–313) 5. How did the automated teller machine change the nature of banking? 6. Which type of stored-value card is most like a debit card? A P P LY Look at the table below showing changes in use of electronic payments between 1995 and 2001. 7. Which type of electronic banking increased the most among all households between 1995 and 2001? 8. How did education generally affect the use of electronic payments? FIGURE 10.8 PERCENTAGE OF HOUSEHOLDS USING ELEC TRONIC BANKING Education of head of household All households No college degree College degree ATM Debit card Automatic bill paying 1995 2001 1995 2001 1995 2001 61.2 69.8 17.6 47.0 21.8 40.3 52.8 63.7 14.3 42.3 18.2 33.7 80.1 81.6 25.2 56.2 30.1 53.2 Source: Statistical Abstract of the United States, 2006 . Analyzing Effects Suppose that the government changes the tax policy so that people pay lower taxes if they save more money. The benefits are significant enough that people shift about 10 percent of their money from their checking accounts into certificates of deposit. How would this change affect the amount of money in M1 and M2? 10. Drawing Conclusions Today, there are about three times as many state chartered commercial banks as there are nationally chartered commercial banks. How does the current U.S. economy avoid the kinds of problems caused by state banks in the 19th century? 11. Applying Economic Concepts One Saturday, four friends go shopping at the local mall. Catherine uses her ATM card to withdraw some cash. Tara has a gift card that she received for her birthday. It is worth $50 at her favorite clothing store. Charlotte uses a credit card, and Alyssa pays with a debit card. a. Which of the shoppers has a stored-value card? Why does she have less flexibility in her shopping than the other shoppers? b. If Catherine, Charlotte, and Alyssa each spend $50, which one has not reduced the amount of money in her checking account at the end of the day? Why? c. Which shopper may end up paying more than face value for her purchases? 12. Analyzing Causes What are the different motives behind these two mergers: a stock brokerage firm buys a bank; a California bank buys a Florida bank? 13. Challenge Why are credit cards and debit cards not considered to be money? Promote Electronic Banking Step 1 Choose a partner. Imagine that you work for a bank in the late 1990s. Your bank intends to be a pioneer in Internet banking and asks you to design its first Web page. Your boss gives you the following criteria for the Web page: • Allow existing customers to access account balances and transfer funds between accounts. • Promote traditional bank products, including checking, savings, CDs, credit cards, mortgages, and auto loans. • Allow customers to find the most convenient branch or ATM location. Step 2 Sketch out a design for the Web page to meet your boss’s criteria, showing appropriate links. Step 3 Two years later, deregulation has led to significant changes in the banking industry. In addition, more consumers are interested in Internet banking. Your boss asks you to redesign the Web page with these additional criteria: • Allow customers to pay bills, apply for loans, buy stocks, and shop for insurance through the bank’s Web site. • Allow customers to view transactions on all their accounts, including credit and debit card transactions, and receive statements and other bank communications electronically. • Reassure customers that online banking is secure and that their privacy will be protected. Step 4 Sketch out a new Web page that shows the complete range of services the bank now offers and that meets all six criteria. Step 5 Share your Web page designs with another pair of students and discuss what aspects would be most important and effective for you as a customer. Money and Banking 315 Stock Market The stock market, which consists of institutions such as the NASDAQ, is where stocks and bonds are traded. 316 CHAPTER 11 SECTION 1 Savings and Investment SECTION 2 Investing in a Market Economy SECTION 3 Buying and Selling Stocks SECTION 4 Bonds and Other Financial Instruments CASE STUDY The Rise and Fall of Dot-Coms Financial Markets Voluntary exchange is a trade in which both parties involved believe that what they are getting is worth more than what they are giving up. C H A P T E R 11 The financial system consists of institutions, such as banks, insurance markets, bond markets, and stock markets, that help transfer funds between savers and investors AT T E R S Do you have a savings account? If so, you play a very important role in our economy. Your savings—what you gave up to get those assets—will be borrowed and invested by businesses and the government to build factories, offices, roads, and so on. The jobs and new products and services created by these investments, in turn, further help to fuel the nation’s economy. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on investing in Internet companies. (See Case Study, pp. 344–345.) Go to SMART GRAPHER to complete graphing activities in this chapter. Source: www.CartoonStock.com Go to INTERACTIVE REVIEW for concept review and activities. Why did the dot-com companies experience such a rapid rise and fall? See the Case Study on pages 344–345. Financial Markets 317 S E C T I O N 1 Savings and Investment TA K I N G N O T E S In Section 1, you will • identify what constitutes the financial system • describe the various financial intermediaries • explain how economists categorize the various markets where financial assets are sold savings, p. 318 investment, p. 318 financial system, p. 318 financial asset, p. 319 financial market, p. 319 financial intermediary, p. 319 mutual fund, p. 320 capital market, p. 322 money market, p. 322 primary market, p. 322 secondary market, p. 322 As you read Section 1, complete a hierarchy diagram to track main ideas and supporting details. Use the Graphic Organizer at Interactive Review @ ClassZone.com Savings and Investments main idea main idea main idea details details details The Financial System QUICK REFERENCE Savings is income not used for consumption. Investment is the use of incom
e today that allows for a future benefit. The financial system is all the institutions that help transfer funds between savers and investors. Find an update on saving at ClassZone.com 318 Chapter 11 KEY CONCEPT S There are two things you can do with your money—spend it or save it. Savings is income not used for consumption, in other words not spent on immediate wants. Savings that are put to use are investments. In general, investment is the use of income today in a way that allows for a future benefit. More specifically, economic investment refers to money lent to businesses—to finance the construction of a new factory, for example. Personal investment refers to the act of individuals putting their savings into financial assets, such as CDs, stocks, bonds, or mutual funds. Consider what happens when you put money in a savings account. Through this act, you benefit—your savings account earns interest—but others do too. By saving, you make funds available for the bank to lend. Borrowers use these funds for many purposes, such as investing in new businesses or in new equipment for established businesses. The financial system, which consists of institutions such as banks, insurance markets, bond markets, and stock markets, allows for this transfer of funds between savers and investors. ATM Deposits Using an ATM to make deposits makes saving easy and convenient. F I G U R E 11.1 The Financial System savings Financial Intermediaries loans Commercial Banks Savings and Loans Credit Unions Finance Companies Life Insurance Companies Mutual Funds Pension Funds Borrowers Savers Financial Intermediaries assets interest and dividends ANALYZE CHARTS 1. What do savers get in exchange for the funds they deposit with financial intermediaries? 2. Why do you think that financial intermediaries perform their vital function? Think back to Chapter 10 if you need help. Bringing Savings and Investment Together Individuals and businesses can save surplus funds in many ways, including savings accounts at commercial banks or S&Ls, certificates of deposit (CDs), corporate or government bonds, and stocks. The agent receiving these funds is a borrower, who issues savers written confirmation of the transaction. This written confirmation is called a financial asset, or a claim on the property of the borrower. Sometimes savers and borrowers come together directly in a financial market, a situation in which buyers and sellers exchange particular types of financial assets. For example, an individual or business might buy corporate bonds or shares of stock. More often, however, financial intermediaries bring savers, borrowers, and financial assets together. A financial intermediary is a financial institution that collects funds from savers and then invests these funds in loans and other financial assets. Figure 11.1 shows how funds flow from savers to investors through the financial markets and financial intermediaries that make up the financial system. QUICK REFERENCE A financial asset is a claim on the property of the borrower. A financial market is where buyers and sellers exchange financial assets. A financial intermediary is an institution that collects funds from savers and invests the funds in financial assets. AP P LI CATION Applying Economic Concepts A. Look again at the example opposite of a person depositing money into a savings account. How is this an example of Adam Smith’s “invisible hand”? Financial Markets 319 Financial Intermediaries KEY CONCEPT S Financial intermediaries bring savers and investors together. In Chapter 10, you learned about one group of financial intermediaries—commercial banks, S&Ls, and credit unions. These financial institutions take in deposits from savers and provide loans to individuals and businesses. Many offer other financial assets as well. Other common financial intermediaries include finance companies, which make small loans; pension funds, which invest money for groups of workers; and life insurance companies, which invest funds collected from policyholders. A mutual fund is a pool of money managed by an investment company that gathers money from individual investors and purchases a range of financial assets. Investors own shares of the entire fund based on the amount of their investment. These institutions gather their money in different ways and provide many different financial assets to a variety of investors. EXAMPLE Banking Financial Intermediaries This group of financial intermediaries includes commercial banks, S&Ls, and credit unions. All of these institutions provide checking and savings accounts. Depositors earn interest on their savings deposits and some checking deposits. Most also offer CDs and money market deposit accounts that pay slightly higher rates of interest. (Figure 11.2 explains how savers earn money from interest.) The federal government insures deposits, including CDs and money market accounts, up to $100,000 per depositor in any given bank. These institutions lend a portion of their deposits to borrowers. Banks charge borrowers a higher rate of interest than they pay to savers and hope to earn a profit. The loans are financial assets to the bank. If a borrower does not pay back the loan on time, the bank may repossess the property, such as a home or a car. Deregulation has allowed banks to offer other financial assets, such as money market mutual funds, stocks, bonds, and insurance. The federal government does not insure funds invested in these financial assets. EXAMPLE Nonbank Financial Intermediaries This group of financial intermediaries includes finance companies, mutual funds, pension funds, and life insurance companies. Finance companies make loans to households and small businesses. Generally, the loans are under $2,000 and are paid back in monthly installments, including interest, over a few years. A mutual fund pools money from many personal investors. In return, each investor receives shares in a fund that is made up of a large number and variety of stocks, bonds, or other financial assets. Mutual funds make it easier and more affordable for individual investors to own a wide variety of financial assets. Once investors purchase shares of a fund, they allow its managers to make investment decisions. QUICK REFERENCE A mutual fund is an investment company that gathers money from individual investors and purchases a range of financial assets. The New York Stock Exchange Stocks are an important element of the assets that make up a mutual fund. 320 Chapter 11 Pension funds allow employees to save money for retirement and sometimes include contributions from employers. The pension fund then invests these pooled contributions in various financial assets that will increase in value and provide workers with more money when they retire. Life insurance companies allow individuals to accumulate savings by building cash values and protect against losses from death or disability. Just as banks lend some of their deposits, insurance companies lend or invest some of the income earned from policyholders in a variety of financial assets. M AT 11 Banks pay savers interest in order to use their money. A saver’s initial deposit is called the principal. Simple interest is the interest paid on the principal alone. Compound interest is paid on the principal plus any earned interest. The following steps show how an annual rate of 5 percent interest is paid on the principal ($1,000) over three years. Year 1 Simple interest is calculated using the following formula: Principal Interest rate = Interest earned $1,000 .05 = $50.00 Year 2 The amount in this account is now $1,050.00. Compound interest, which is paid on the principal plus the earned interest, is calculated as follows: (Principal + Year 1 interest) Interest rate = Interest earned ($1,000.00 + $50.00) .05 = $52.50 Year 3 There is now $1,102.50 in the account. Interest continues to compound. (Principal + Year 1 interest + Year 2 interest) Interest rate = Interest earned ($1,000.00 + $50.00 + 52.50) .05 = $55.13 After three years, the total in the account is $1,157.63. Using a Formula Instead of using the multiple steps shown above, you can calculate the total value of an account using the following formula (wherein P=principal, r=interest rate, and t=number of years): P(1+r) t = total value $1,000.00(1+.05)3 = $1,157.63 NEED HELP? Math Handbook, “Calculating Compound Interest,” page R6 AP P LI CATION Comparing and Contrasting B. How is a pension fund like a savings account? How is it different? Financial Markets 321 Financial Asset Markets KEY CONCEPT S The different financial assets discussed in this section are bought and sold on various financial markets. Economists tend to categorize these markets based on two factors—time (how long the loan is for) and whether the financial assets can be resold. Based on time, economists distinguish between the capital market, the market for buying and selling long-term financial assets, and the money market, the market for buying and selling short-term financial assets. In regard to resalability, economists distinguish between the primary market, which is the market for buying newly created financial assets directly from the issuing entity, and the secondary market, which is the market where financial assets are resold. FACTOR 1 Time There are two time-sensitive markets. Capital markets are markets where assets are held for longer than a year. Some examples of assets sold on the capital market include certain kinds of securities, namely stocks and bonds, mortgages, and longterm CDs. Because these loans are for longer periods of time, the money may be invested in projects that require large amounts of capital, such as buying homes, building new factories, retooling established factories, or financing government projects. Money markets are markets where loans are made for less than a year. Examples of assets traded in these markets include short-term CDs that depositors can redeem in a few months
and Treasury bills, which allow the U.S. government to borrow money for short periods of time. Return on Investment Time is an important factor in the level of return for many investments. FACTOR 2 Resalability There also are two kinds of markets based on whether the financial assets can be resold. Primary markets are markets for financial assets that can be redeemed only by the original buyer. Examples include savings bonds and small denomination CDs. The term primary market also refers to the market where the first issue of a stock is sold to the public through investment bankers. Secondary markets are resale markets for financial assets. These markets offer liquidity to personal investors. So, investors are able to turn their assets into cash relatively quickly. Stocks and bonds, which you’ll learn more about later in this chapter, are two of the most prominent financial assets sold on the secondary market. APPLICATION Analyzing Effects C. Why are stocks and bonds part of the capital market and the secondary market? QUICK REFERENCE The capital market is where long-term financial assets are bought and sold. The money market is where short-term financial assets are bought and sold. The primary market is for buying financial assets directly from the issuer. The secondary market is where financial assets are resold. 322 Chapter 11 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the difference between the terms in each of these pairs. a. savings investment b. capital market money market c. primary market secondary market 2. What is the purpose of the financial system? 3. Why do banks receive financial assets when they make loans? 4. How does a mutual fund serve as a financial intermediary? 5. What determines whether a loan is part of the capital market or the money market? 6. Using Your Notes What is the relationship between financial intermediaries and the financial system? Refer to your completed hierarchy diagram. Savings and Investments main idea main idea main idea details details details Use the Graphic Organizer at Interactive Review @ ClassZone.com . Categorizing Information Which of the following are banking financial intermediaries and which are nonbanking financial intermediaries? • Consumer Finance Company • Family Life Insurance Company • First National Bank • Home Savings and Loan • Investors’ Mutual Fund • Employee Credit Union • Employee Pension Fund 8. Making Inferences A local bank offers savings accounts that have no minimum balance requirement and pay 3 percent interest per year. Account holders can withdraw any amount of money from their accounts at any time. The bank also offers money market accounts that require a $500 minimum balance and pay 4 percent interest each year. Account holders are allowed two withdrawals per month, but each must be for at least $100. Why does the money market account pay a higher interest rate? 9. Applying Economic Concepts Suppose that you deposit $100 into your savings account, which earns 3 percent interest per year. Use what you’ve learned about calculating interest to determine how much money you’ll have in your account at the end of one year and at the end of six years. 10. Challenge Why might a decrease in household savings have an adverse effect on small businesses in a local community? Stock certificates Identifying Markets Consider how economists categorize financial markets. Copy the table shown below. Review the bulleted list of financial assets and place each one in the correct location(s) in the table. Assets may be placed in more than one category. • 15-year mortgage • 6-month CD for $1,000 • 2-year CD for $25,000 • 5-year corporate bond • 10-year savings bond • Shares of stock • 26-week Treasury bill • 30-year Treasury bond Capital Market Money Market Primary Market Secondary Market Challenge Why do savings bonds and small certificates of deposit have less liquidity than shares of stock? Financial Markets 323 S E C T I O N 2 Investing in a Market Economy TA K I N G N O T E S In Section 2, you will investment objective, p. 324 • discuss the issues that should be considered when making investment decisions • explain how risk and return are related risk, p. 327 return, p. 327 diversification, p. 327 As you read Section 2, complete a chart like the one shown using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Investing in a Market Economy objectives risk vs. return Why Are You Investing? KEY CONCEPT S In Section 1, you saw that there are two types of investing: personal and economic. Note that for the remainder of the chapter, we’ll be using all forms of the word invest as a quick way to refer to personal investing—which is, in effect, saving. You’ve now learned that there are a number of assets you can own. But how do you determine which is, or are, right for you? The first thing that you might do is to decide why you are investing. This reason is your investment objective, a financial goal that an investor uses to determine if an investment is appropriate. Some possible financial goals are saving money for retirement, for a down payment on a house or an automobile, for college tuition, or for a vacation. Your goal helps you to determine the right investments. Investment Objectives Two issues play a major role in determining which investments work best to achieve different investment objectives. The first issue is time. For example, is this a short-term financial goal, such as saving for a vacation, or a longterm financial goal, such as saving for Savings Goals Saving for a car down payment suggests certain kinds of longer-term investments. QUICK REFERENCE An investment objective is a financial goal used to determine if an investment is appropriate. 324 Chapter 11 YO U R EC INVESTM ENT OB J EC TIVES What reasons do you have for investing? Do you have any investment objectives? Maybe you have a short-term objective, such as saving money to go on spring break. Or your objective is more long term, such as saving for college. What kinds of investments might be appropriate for your objective? ? Saving for vacation Saving for college Find an update on investing at ClassZone.com retirement? The amount of time you have to build your savings influences the kinds of investments that would be most appropriate. The second issue is income. How much money do you have available to save after meeting current expenses? The answer to this question is influenced by a series of other questions: Will your income change in the future? Is there money available for emergencies? To respond to all these questions, having a savings plan that is realistic and that is flexible enough to adjust to changing circumstances can be a big help. Other important questions are: Do you have any outstanding debts? Are you paying taxes on time? Paying off debts is an important first step to investing. Generally, the interest you pay on debts, such as credit card balances, is higher than what you can earn through most investments. Tax considerations are most important for investors with higher incomes who are subject to higher tax rates. Different types of investments are suitable to various investment objectives. For example, savings for emergencies should be in highly liquid investments, such as savings accounts or money market accounts. With these investments, the risk of loss is low and money can be withdrawn at any time. Saving for a vacation would also require investments that are short-term and liquid. Investors who are saving for longer-term goals may be less concerned with immediate liquidity and may want to invest in stocks that increase in value over a longer period of time. CDs that commit funds for a certain length of time may be chosen to coincide with the timing of certain savings goals, such as making a major purchase or starting college. Many bonds offered by state and local governments offer tax-free earnings. AP P LI CATION Drawing Conclusions A. Would a CD be a more appropriate way to save for a down payment on a car or for emergencies? Why? Financial Markets 325 ECO N O M I C S PAC ES E T T E R Mellody Hobson: Investing in the Future What do the Chicago Bulls, hip-hop stars, and inner-city elementary school students have in common? All are part of Mellody Hobson’s efforts to get investment “discussed around every dinner table.” Hobson believes that many people lack the necessary knowledge to determine their investment objectives and manage their money to create wealth. How is she trying to change this situation? Creating Educated Investors Mellody Hobson discovered her career in investing as a college intern. When she got her degree in 1991, Hobson landed a position in the marketing department at Ariel Capital Management LLC. In 2000, she became the president of the company, making her the most powerful African-American woman in the mutual-fund industry. As president of Ariel, Hobson runs an operation with over $21 billion in assets. Ariel was the first minority-owned mutual fund company in the Mellody Hobson country and pioneered programs to teach inner-city schoolchildren about investing. Hobson’s passion for investment education led her to give presentations in locations from PTA meetings to union halls. She developed the first ongoing study of investing by African Americans and looked for ways to increase their participation in the stock market. “The stock market represents a major source of wealth creation in this country,” Hobson has stated, “but . . . African Americans have been largely left out.” Ariel’s marketing efforts to the black community included cosponsoring events with the Chicago Bulls and creating a stock-picking contest involving well-known hip hop stars. When Hobson became the financial contributor to the Good Morning America television program in 2000, she was able to reach millions of people with easy-to-understand information about economic matters. Hobson bel
ieves that more knowledge about the benefits of investing in stocks and greater diversity in the investment industry will help bring the benefits of investing to people of all racial and economic backgrounds. APPLICATION Making Inferences B. Why might Mellody Hobson think it is important for families to talk about investing at the dinner table? FAST FACTS Mellody Hobson Title: President of Ariel Capital Management, LLC Born: April 3, 1969, Chicago, Illinois Major Accomplishment: Educates millions of people about the benefits of investing. Ariel’s Assets Under Management: $21.3 billion (2005) Other Roles: Financial contributor to Good Morning America on ABC Board Member: Chicago Public Library, the Field Museum, the Chicago Public Education Fund, and the Sundance Institute Director: DreamWorks Animation SKG, Inc., the Estée Lauder Companies Inc., and Starbucks Corporation Find an update on Mellody Hobson at ClassZone.com 326 Chapter 11 Risk and Return KEY C ONCEPT S Once investors have decided their financial objectives, there are two other related issues they might consider—risk and return. Risk is the possibility for loss on an investment, and return is the profit or loss made on an investment. While savings deposits in banks are insured against loss, most investments carry some possibility of losing part of the money invested. Return may refer to the interest paid on a savings account or CD or the increase in value of a stock over time. Most investors try to balance risk and return through diversification, the practice of distributing investments among different financial assets to maximize return and limit risk. QUICK REFERENCE Risk is the possibility for loss on an investment. Return is profit or loss made on an investment. Diversification is the practice of distributing investments among different financial assets. What Kind of Risk Are You Willing to Take? When most investors think about risk, they think about the possibility of losing some of their initial investment, often referred to as their principal. Even if they don’t earn a lot of money on the investment, they want to get back at least what they put in. Investments that guarantee no loss of principal include insured savings deposits and CDs. Bonds that are backed by the U.S. government are also considered to be almost risk-free because it is highly unlikely that the government would not pay back its loans. Almost all other investments carry some risk. One of the biggest risks investors face, even with safe investments like those described above, is loss of the purchasing power of the money invested due to inflation. (Remember that inflation is a general rise in the level of prices.) That is why many financial advisers warn against investing everything in safe investments that pay a guaranteed rate of interest that may not keep up with inflation. FIGURE 11. 3 THE REL AT IONSHI P OF R ISK AND RE TURN Other investments, such as stocks and corporate bonds, carry a higher degree of risk because the return depends on how profitable the company is. Investors who purchase stock with the expectation that it will appreciate in value over time may lose some of their money if the company runs into problems or other economic factors affect the value of the stock. In that case, investors may find that they cannot sell the stock for as much as they paid for it, and they suffer a loss. Investors in corporate bonds face similar risks, although bonds are considered less risky than stocks because creditors such as bondholders are paid off before stockholders if a company has financial problems. k s i R Return Risk and Return Risk and return have a direct relationship—the higher the risk of the investment, the greater the possible return. Financial Markets 327 YO U R EC RISK AND R ETU RN How can you balance risk and return? When you consider what financial assets further your investment objective, you must address both risk and return. A high-risk investment may bring large returns, but can you absorb the potential losses? A low-risk investment may provide a steady return, but because of inflation you may be losing money. How would you decide which type of investment to make? ? ▲ Return ▲ Risk What Kind of Return Do You Want? When making investment decisions, investors estimate what kind of return they expect to earn. The safest investments, such as Treasury bills, interest-bearing savings accounts, and shorter-term CDs, generally offer the lowest return in the form of fixed rates of interest. The returns on stocks and bonds are not guaranteed and may vary considerably at different times, depending on how the company you invest in performs and the state of the economy as a whole. Generally, stocks provide a higher return over time than do other investments. As Figure 11.3 on page 327 shows, risk and return are directly related—the greater the possible return, the higher the risk that the investment will lose value. Investors always want the highest return possible, but they must balance that desire with a realistic understanding about the level of risk they can tolerate. The factors of time and income come into play here. People who are investing for retirement over a period of 20 to 30 years may be willing to take more risk by investing in stocks because their investments are likely to increase over that period, even though they might have losses in some years. People with less time and less income to invest might not be willing to risk possible losses. Diversification is the most common way for investors to maximize their returns and limit their risks. For example, you might put 70 percent of your investments for retirement in a variety of stocks, 20 percent in bonds, and 10 percent in CDs. By spreading out your money in a variety of assets, you have a better chance of offsetting losses from one investment with gains from another. Mutual funds, which invest in a large number of stocks or bonds, help small investors diversify their investments. APPLICATION Drawing Conclusions C. Is it possible to have a low-risk, high-return investment? Why or why not? 328 Chapter 11 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Use each of the three terms below in a sentence that illustrates the meaning of the term: a. investment objective b. return c. diversification 2. What is the relationship between risk and return? 3. How would the risk of investing in a single stock compare with the risk of investing in a mutual fund? Why? 4. How is diversification related to risk and return? 5. How are risk and return related to investment objectives? 6. Using Your Notes How do time and income influence investment objectives? Refer to your completed chart. Investing in a Market Economy objectives risk vs. return Use the Graphic Organizer at Interactive Review @ ClassZone.com . Comparing and Contrasting Matthew’s parents started saving for his college education when he was born. When Matthew turned 16, he got a part-time job and saved part of his earnings for his college expenses. Compare and contrast the investment objectives of Matthew and his parents and describe the factors that influenced their investment decisions. 8. Drawing Conclusions Ryan owns shares in a single mutual fund that includes stocks and bonds. Maggie invests her money in Treasury bonds, state bonds, and corporate bonds. Joshua invests in shares of stock in five different high-tech companies. Which of these investors best understands the concept of diversification? Give reasons for your answer. 9. Applying Economic Concepts Inez bought 100 shares of a mutual fund for $10 each and sold them five years later for $15 each. Ethan put $1,000 in a 5-year CD and received a total of $235 in interest. Which investment provided the better return? How does this illustrate the relationship between risk and return? 10. Challenge Stocks that are sold on the secondary market and savings accounts both provide liquidity. For each of these investments, what kinds of risks does this liquidity entail? Evaluating Investments Consider what you have learned about risk and return as they relate to various investments, then study the table below and evaluate each investment. Identify Risk and Return Place a check mark in the appropriate columns for each investment. Investment Risk Return Low High Low High $1,000 CD 100 shares of a mutual fund 100 shares of stock Corporate bond Government bond Regular savings account Challenge Rank the investments in order from the lowest risk to the highest risk and from the lowest return to the highest return. Make a generalization about risk and return based on your rankings. Financial Markets 329 S E C T I O N 3 Buying and Selling Stocks TA K I N G N O T E S In Section 3, you will stock exchange, p. 330 • discuss why people buy stocks capital gain, p. 330 • describe how stocks are traded • explain how the performance of stocks is measured common stock, p. 331 preferred stock, p. 331 stockbroker, p. 332 future, p. 333 option, p. 333 stock index, p. 334 bull market, p. 335 bear market, p. 335 As you read Section 3, complete a cluster diagram using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Stocks The Stock Market KEY CONCEPT S Recall that in Chapter 8 you learned that corporations raise money through stock and bond issues. You will learn more about the sale—and resale—of stocks in this section. When a company first issues stock, it is sold to investment bankers in the primary market. Known as an initial public offering, or IPO, this is the stock sale that raises money for the corporation. However, most stock is then resold to investors through a stock exchange, a secondary market where securities (stocks and bonds) are bought and sold. Most people buy stocks as a financial investment, with the expectation that the stock price will rise and that they can resell the stock for a profit. Gains made from the sale of securities are c
alled capital gains. QUICK REFERENCE A stock exchange is a market where securities are bought and sold. Capital gain is profit made from the sale of securities. Why Buy Stock? Investors buy stock for two reasons. The first is to earn dividend payments, which are a share of the corporation’s profits that are paid back to the corporation’s stockholders. The second reason is to earn capital gains by selling the stock at a price greater than the purchase price. If stock is sold below the buying price, the seller makes a capital loss. Investors who want to earn income 330 Chapter 11 from their investment will be most interested in dividends. Those who want to see their investment grow over time will be most interested in potential for capital gain. As you learned in the previous section, investing in stocks carries a higher risk than most other investments but provides the opportunity for higher returns over time. Corporations are not required to pay dividends, so an investor has no guarantee that they will earn income from stocks. Similarly, there is no guarantee that the stock price will be higher when the investor wants to sell the stock. Types of Stock Source: www.CartoonStock.com No Guarantees Dividend payments are a possibility, not a certainty; stocks come with risk. There are essentially two types of stock—common stock and preferred stock. Common stock is share of ownership in a corporation, giving holders voting rights and a share of profits. Preferred stock is share of ownership in a corporation giving holders a share of profits (paid before common stockholders) but no voting rights. Most people who buy stock choose to buy common stock. Figure 11.4 shows the similarities and differences between the two types of stock. Notice that both types of stock give a share of ownership in the corporation that entitles a shareholder to receive dividends. The difference is that holders of preferred stock receive guaranteed dividends and will be paid before common stockholders if the company is liquidated. As a tradeoff for this preference, holders of preferred stock generally have no voting rights in the corporation, and their dividends do not increase if the company’s stock increases in value. Each holder of common stock generally gets one vote per share owned to elect the board of directors, which makes important decisions about how the company conducts business. QUICK REFERENCE Common stock gives shareholders voting rights and a share of profits. Preferred stock gives shareholders a share of profits but, in general, no voting rights. F I G U R E 11. 4 Common Stock and Preferred Stock Characteristic Preferred Stock Common Stock Share of ownership Eligible for dividends Guaranteed dividends Voting rights Yes Yes Yes No Yes Yes No Yes ANALYZE CHARTS 1. What preference do holders of preferred stock have? 2. What do holders of common stock have that holders of preferred stock do not have? AP P LI CATION Drawing Conclusions A. What kind of stock do you think investors who wanted a steady income from their investment would buy? Why? Financial Markets 331 Trading Stock KEY CONCEPT S Most people who invest in stock do so with the hope of earning capital gains when they sell it. Like anything else sold in a free market, stock prices are determined by demand and supply. Some factors that affect stock prices include company profits or losses, technological advances that may affect a company’s business or a whole industry, and the overall state of the economy. When investors perceive that a company’s value is likely to increase, the demand for the stock will increase and its price will rise. As the price rises, more people will want to sell the stock for a profit. Few companies sell stock directly to investors. When investors want to buy or sell stock, they use a stockbroker, an agent who, for a commission, buys and sells securities for customers. Stockbrokers, sometimes just called brokers, generally work for brokerage firms. Investors may interact with brokers in person, by phone, or online. The broker’s primary job is to carry out the investor’s instructions to make trades. Some brokers also provide investment advice. Brokers buy and sell stocks for their customers on a variety of stock exchanges. QUICK REFERENCE A stockbroker buys and sells securities for customers. Organized Stock Exchanges The New York Stock Exchange (NYSE) is the oldest and largest of the organized stock exchanges in the United States. It is located on Wall Street in New York City, and the street name has become synonymous with the U.S. stock market. Almost 1.5 billion shares of about 2,800 of the largest and most successful U.S. companies are traded on the NYSE each day. Brokerage firms pay for the privilege of being one of the 1,336 members of the exchange. Traditionally, trading on the NYSE was in an organized auction format. Each stock had a specified location or trading post on the floor of the exchange. A specialist representing that stock ran the auction that matched buyers and sellers through open bidding to determine the price of shares. Prices for a stock often varied from minute to minute as the auction process continued throughout the day. Changes in technology have brought changes to the NYSE. Since 1996, floor traders have used small hand-held computers to execute many trades, and more than half of the orders to buy and sell are now sent electronically. In 2006, the NYSE merged with Archipelago Exchange, an electronic trading company. This allowed the NYSE not only to speed up its transactions, but also to trade stocks normally traded in electronic markets. The smaller American Stock Exchange (AMEX) is also located in New York City. Trading at the AMEX is structured in a similar way to the NYSE, although AMEX-traded companies are generally smaller than those listed on the NYSE. In 2006, AMEX introduced new practices that combined the benefits of floor trading and electronic trading. Controlled Chaos Don’t be fooled by the seeming disorder of the exchange floor. It is a secure and organized trading system. 332 Chapter 11 Electronic Markets The term over-the-counter (OTC) is used to describe the market for stocks that are not traded on the NYSE or AMEX. In 1970, the National Association of Securities Dealers (NASD) introduced a centralized computer system that allows OTC traders around the country to make trades at the best prices possible. This automated quotation system is known as NASDAQ. In 2005, NASDAQ was the second-largest stock exchange in the world in number of companies listed (about 3,200) and number of shares traded daily. The companies listed on NASDAQ cover many sectors of the U.S. economy, although the majority are involved in technology. The NASD also regulates the OTC Bulletin Board as an electronic market for trading shares in companies that are too small to be traded on NASDAQ. Futures and Options Markets Most investors do not trade futures and options because they are complicated and high-risk investments that involve trying to predict the future. A future is a contract to buy or sell a stock on a specified future date at a preset price. An investor who wants to buy in the future wants to lock in a low price. An investor who wants to sell in the future wants to lock in a high price. An option is a contract giving the investor the right, but not the obligation, to buy or sell stock at a future date at a preset price. As you can see, the difference between a future and an option is that a futures contract requires the investor to buy or sell, while an option contract offers the possibility of buying or selling but does not require it. In options trading, an investor pays a small fraction of a stock’s current price for an option to buy or sell the stock at a better price in the future. Recent Developments In the late 1990s, new stock market regulations and advances in computer technology changed the way that stocks were traded. Stocks listed on any exchange are now available to any trading firm. The growth of electronic communications networks (ECNs) increased electronic stock trading, especially on the NASDAQ market. Trades now take place 24 hours a day, not just when the stock exchanges are open. Many individual investors have access to the Internet and have become more knowledgeable about investing. They wanted ways to trade stocks without relying on traditional stockbrokers. The result has been huge growth in online brokerage companies. Investors now have the ability to make trades at any time and generally pay lower commissions than those charged by traditional brokers. Computer technology matches buyers and sellers automatically, providing rapid trades at the best possible prices. AP P LI CATION Drawing Conclusions B. How is NASDAQ similar to the NYSE? How are they different? FIGURE 11. 5 SOME NA SDAQ STOC K S Apple Inc. Dell Inc. Fujifilm Corporation Google Intel Corporation Peets Coffee & Tea Priceline.com Sirius Satellite Radio Sun Microsystems Inc. United Stationers Inc. QUICK REFERENCE A future is a contract to buy or sell a stock on a specific future date at a preset price. An option gives an investor the right to buy or sell stock at a future date at a preset price. Financial Markets 333 Measuring How Stocks Perform KEY CONCEPT S About half of all U.S. households now own stocks, and the stock market’s performance is followed closely on the nightly news, not just in specialized business media. Perhaps you have heard a statement like this one: “Wall Street responded positively to the latest employment figures, with the Dow making robust gains for the first time in several weeks.” The Dow is a stock index, an instrument used to measure and report the change in prices of a set of stocks. Stock indexes measure the performance—whether gaining or declining in value—of many individual stocks and the stock market as a whole. Stock Indexes Stock indexes provide a snapshot of how the stock market is performing. The Dow— sh
ort for the Dow Jones Industrial Average (DJIA)—is the most well known. (For help reading Figure 11.6, turn to the Skillbuilder on page 342.) Other U.S. indexes often cited include the Standard & Poor’s 500 (S&P 500) and the NASDAQ Composite. Global stock indexes include the Hang Seng Index (Hong Kong), the DAX (Germany), the Nikkei 225 (Japan), and the FTSE 100 (Britain). Each index measures the performance of a different group of stocks. QUICK REFERENCE A stock index measures and reports the change in prices of a set of stocks. Find an update on stocks in the Dow Jones Industrial Average at ClassZone.com FIGURE 11.6 DOW JONES INDUSTRIAL AVERAGE, 1929–2006 12,000 10,000 DJI 8,000 6,000 4,000 2,000 1B 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 1935 Volume © 2006 Yahoo! Inc. YAHOO! and the YAHOO! logo are trademarks of Yahoo! Inc. FIGURE 11.7 THE DOW’ S BEST AND WORST YEARS The Dow’s Best Years Rank 1 2 3 4 5 Rank 1 2 3 4 5 Year 1915 1933 1928 1908 1954 % Change 81.66 66.69 48.22 46.64 43.96 The Dow’s Worst Years Year 1931 1907 1930 1920 1937 % Change –52.67 –37.73 –33.77 –32.90 –32.82 ANALYZE CHARTS 1. Does Figure 11.6 suggest a relationship between the level of the DJIA (above) and the volume of shares traded (below)? Explain. 2. What were the most recent best and worst years for the Dow? 334 Chapter 11 F I G U R E 11. 8 THE 30 STOC K S I N THE DJ I A Alcoa Inc. Altria Group, Inc. American Express Co. American International Group Inc. AT&T Inc. Boeing Co. Caterpillar Inc. Citigroup Inc. Coca-Cola Co. Dupont Co. Exxon Mobil Corp. General Electric Co. General Motors Corp. Hewlett-Packard Co. Home Depot Inc. Honeywell International Inc. Intel Corp. International Business Machines Corp. J.P. Morgan & Co. Johnson & Johnson McDonald’s Corp. Merck & Co. Microsoft Corp. 3M Pfizer Inc. Procter & Gamble Co. United Technologies Corp. Verizon Communications Inc. Wal-Mart Stores Inc. Walt Disney Co The Dow Jones Company, publisher of the Wall Street Journal newspaper, first published the DJIA in 1896. The index included the stocks of 12 companies that reflected the economy of the time, which was focused heavily on agriculture and mining. Since 1928, the Dow has included 30 companies. General Electric is the only one of the original companies that is on the current index. As the U.S. economy has changed from agriculture to industry to services, the companies in the index have changed to reflect the most successful companies in the most important sectors of the economy. These stocks are often referred to as blue chip stocks. The DJIA is a price index, in other words it measures changes in the prices at which the stocks on the index are traded. The original DJIA was the actual average of the prices of the 12 stocks. Now the average is weighted so that higher-priced stocks have more influence on the average than lower-priced stocks. The number that is quoted is not a price but an average measured in points not dollars. QUICK REFERENCE A bull market occurs when stock market prices rise steadily over time. A bear market occurs when stock market prices decline steadily over time. Tracking the Dow Changes in the Dow reflect trends in stock market prices. The terms bull market and bear market are commonly used to describe these trends. A bull market is a situation where stock market prices rise steadily over a relatively long period of time. A bear market is a situation where stock market prices decline steadily over a relatively long period of time. Those who follow the stock market track the Dow and other indexes to determine if the market is trending toward bull or bear. The first DJIA measure was 40.94. In 1972, it reached 1,000 for the first time, and in May 1999, it topped 11,000. When the Dow hit its all-time high of 11,722.98 on January 14, 2000, it marked the end of the longest bull market in history. During the 1990s the Dow had climbed from 2,800 to its peak. Most bull markets last two to three years. A well-known bear market followed the Stock Market Crash of 1929. During the 1920s, the Dow had risen from 60 to a high of 381.17 in early September of 1929. In the month after October 29, 1929, it fell to a low of just under 199. The next time it achieved a closing price of 400 was December 29, 1954. Source: www.CartoonStock.com Financial Markets 335 Investing Money Overseas In an increasingly international economy, the NYSE is no longer the “only game in town” for U.S. investors. There are over 20 major stock markets overseas. With U.S. stocks representing only about half of the total value of global markets, international investing has become an important option for Americans. Investing money overseas offers both advantages and risks. For example, an investment in an emerging country—one with an economy that is rapidly growing—offers the prospect of a greater and more rapid return. Such an investment also may involve greater risk, for political instability in an emerging country can drive stock prices down in a hurry. However, many investors view increased diversification as the primary advantage of investing overseas. F I G U R E 11. 9 Leading World Stock Markets Market Number of Companies Listed Value of Stocks (in billions of US dollars) Main Index New York Stock Exchange (United States) Tokyo Stock Exchange (Japan) London Stock Exchange (United Kingdom) Bombay Stock Exchange (India) Sao Paulo Stock Exchange (Brazil) Cairo and Alexandria Stock Exchanges (Egypt) 2,278 2,392 3,231 4,786 347 618 15,138 Dow Jones Industrial Average 4,550 3,718 801 660 Nikkei 225 FTSE 100 Sensex Ibovespa 88 CASE 30 Source: World Federation of Exchanges, November 2006 data CONNECTING ACROSS THE GLOBE 1. Synthesizing Economic Information Do you think it likely that U.S. investment in overseas stock markets will become increasingly common? Explain your answer. 2. Drawing Conclusions Compare the total value of stocks to the number of companies listed. Which two exchanges have the least expensive stocks, on average? Which exchange has the most expensive stocks? Many factors affect the Dow’s performance. Among these are the market’s previous close, actions by the Federal Reserve that affect interest rates or the money supply, the performance of foreign indexes, and the trade balance between imports and exports. APPLICATION Drawing Conclusions C. Why have the stocks on DJIA changed over time? 336 Chapter 11 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs: a. stock exchange stockbroker b. future option c. bear market bull market 2. Are owners of common stock generally more interested in dividends or capital gains? Why? 3. Why do most people who buy stock choose common stock over preferred stock? 4. What is the difference between a bear market and a bull market? 5. How has the growth of individual online trading affected stockbrokers? 6. Using Your Notes What are the four different ways that stocks are traded? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Stocks . Applying Economic Concepts Rachel paid $10 per share for 100 shares of common stock in her favorite clothing store. a. If she receives 10 cents per share in dividends each year, about how many years would it take her to earn $100 on her investment? b. If the share price increases to $11 in two years and she chooses to sell the stock, how much capital gain would she make? 8. Analyzing and Interpreting Data Rearrange the data in Figure 11.7 into one table in chronological order. Use a plus sign to indicate a best year and a minus sign to indicate a worst year. a. What relationship, if any, do you see between best years and worst years? b. What does the data reveal about the stock market in the 1930s? 9. Challenge The Standard and Poor’s 500 (S&P 500) is an index composed of 500 stocks, while the Dow Jones Industrial Average is composed of 30 stocks. Many analysts feel the S&P 500 is a better representation of the U.S. stock market. Do you agree? Why? Analyzing Demand for Stock The graph below shows the combined market demand and supply curve for the stock of a company that makes mp3 players 25 20 15 10 5 0 S D 100 300 200 Number of shares 400 500 600 Draw New Demand Curves Copy the graph above on your own paper and draw new demand curves to reflect each of the following scenarios: a. A competitor announces a technological breakthrough that will dramatically cut its production costs. b. The company announces a new product that offers features that consumers have been asking for. Challenge How does the change in demand in each scenario affect the price of the stock? Financial Markets 337 S E C T I O N 4 Bonds and Other Financial Instruments TA K I N G N O T E S In Section 4, you will par value, p. 338 • discuss why people buy bonds maturity, p. 338 • describe the different kinds of coupon rate, p. 338 bonds • explain the factors that affect bond trading • outline investment options other than stocks and bonds yield, p. 338 junk bond, p. 339 As you read Section 4, summarize what you learn by completing a chart using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Bonds Other Financial Instruments Why Buy Bonds? KEY CONCEPT S QUICK REFERENCE Par value is the amount a bond issuer must pay the buyer at maturity. Maturity is the date when a bond is due to be repaid. The coupon rate is the interest rate a bondholder receives every year until maturity. Yield is the annual rate of return on a bond. 338 Chapter 11 You learned in Chapter 8 that a bond is a contract issued by a corporation promising to repay borrowed money, plus interest, on a fixed schedule. Governments also issue bonds. The amount that the bond issuer promises to pay the buyer at maturity is its par value. Maturity is the date when the bond is due to be repaid. The coupon rate is the interest rate a bondhold
er receives every year until a bond matures. There are two reasons to invest in bonds—the interest paid on bonds and the gains made by selling bonds. Most people buy bonds for the interest. Generally, bonds are considered less risky than stocks because bondholders are paid before stockholders. It is important to determine the yield—the annual rate of return—for a bond when deciding to buy and sell bonds. If a bond is sold at par value, the yield is the same as the coupon rate. If a bond is sold for less than par value, the yield will be higher than the coupon rate. On the other hand, if demand is strong and the price of a bond is higher than the par value, the yield will be lower than the coupon rate. Generally speaking, bonds with longer maturity dates have higher yields than those with shorter dates. This is because there is more uncertainty and risk involved with repayment dates that are farther in the future. Types of Bonds Investors may choose to invest in many different kinds of bonds. The yields and risks associated with these bonds vary considerably. As is the case with stocks, the higher the risk the greater the potential yield of a bond. Figure 11.10 shows the yields for different types of bonds. Bonds are classified based on who issues the bonds. FIGURE 11.9 AVERAGE BOND YIELDS, 1993–2003 Corporate bonds help businesses expand. CORPORATE BONDS 10-YEAR TREASURY NOTES MUNICIPAL BONDS Treasury bonds help keep the federal government operating. 1997 1998 1999 2000 2001 2002 2003 2004 Source: Statistical Abstract of the United States Year ANALYZE GRAPHS 1. Which type of bond had the lowest average yield in most years? 2. Which type of bond carries the highest risk? How do you know? Municipal bonds make state and local projects possible. The U.S. government issues securities called Treasury bonds, notes, or bills. The different terms denote loans with different maturity dates, with Treasury bonds having the longest maturity (more than ten years) and Treasury bills having the shortest (one year or less). The money borrowed through the sale of these securities helps keep the government running. Because they are backed by the “full faith and credit” of the federal government, these securities are considered to be virtually risk free. Governments all over the world issue bonds for the same reasons as the U.S. government. The risk level of international bonds depends on the financial strength of the particular government. Bonds issued by state and local governments are called municipal bonds. Funds raised by these bonds finance government projects such as construction of roads, bridges, schools, and other public facilities. The interest earned on many municipal bonds is not subject to federal income tax. Generally, municipal bonds are considered low-risk investments. A major reason for this is that state and local governments collect taxes, so it is assumed that they’ll be able to make interest payments and repay the buyer upon maturity. However, there have been instances of governments being unable to repay bondholders the full amount of their loans. One way that companies finance expansion is by issuing corporate bonds. These bonds generally pay a higher coupon rate than government bonds because the risk is higher. One kind of corporate bond, a junk bond, is considered high risk but has the potential for high yields. The risk involved with investing in junk bonds is similar to that of investing in stocks. QUICK REFERENCE Junk bonds are highrisk, high-yield corporate bonds. Financial Markets 339 Buying Bonds Investors need to determine their reason for buying bonds in order to purchase the right type of bond. Most investors purchase bonds because they want the guaranteed interest income. Yield will be most important to those investors. Coupon rate and price relative to the par value will determine the yield. Investors who want to sell bonds before they reach maturity study the bond market to see if they can sell their investment at a profit. Market interest rates are another important consideration for bond investors. There is an inverse relationship between the price of existing bonds and interest rates. For example, as interest rates rise, the price of existing bonds falls because bonds that were issued with a lower interest rate will be less in demand. Conversely, if interest rates fall, the price of existing bonds rises because there will be more demand for those bonds issued at a higher interest rate. The main risk that bond buyers face is that the issuer will default, or be unable to repay the borrowed money at maturity. Therefore, the level of risk is directly tied to the financial strength of the bond issuer. When governments or corporations want to issue bonds, they pay a credit-rating company to evaluate how likely it is that they will repay the loans. In this way, investors have a standard by which to judge the risk of the bonds. The two most well-known systems of bond ratings are those established by Standard & Poor’s and Moody’s. These companies use a system of letters to designate the relative credit risk of bonds. Bonds are rated from the lowest risk of U.S. Treasury securities (Aaa or AAA) to the higher risks associated with junk bonds. (See Figure 11.11.) F I G U R E 11.11 Bond Ratings Bond Rating Grade Risk Moody’s Standard & Poor’s Aaa Aa A Baa Ba, B Caa/Ca C AAA AA A BBB BB, B CCC/CC/C D Investment Investment Investment Investment Junk Junk Junk Lowest risk Low risk Low risk Medium risk High risk Highest risk In default ANALYZE TABLES 1. What are the lowest-rated investment grade bonds in each system? 2. Why do junk bonds have lower ratings than investment grade bonds? APPLICATION Drawing Conclusions A. Why is bond yield not always the same as the coupon rate? 340 Chapter 11 Other Financial Instruments KEY C ONCEPT S Investors have investment options other than bonds and stocks. The most common of these are certificates of deposit (CDs) and money market mutual funds. Both of these investments have very low risk and provide income in the form of interest. Individual investors do not generally sell these financial instruments for profit. Certificates of Deposit As you learned earlier, CDs are a form of time deposit offered primarily by banks, savings and loans, and credit unions. Like bonds, CDs have a maturity date (usually 6 months to 5 years), when the investor receives the principal back with interest. The issuer of the CD pays the investor a rate of either fixed or variable interest during the period that the CD is held. Usually the interest is reinvested in the CD so that the investor enjoys the benefits of compound interest. In general, CDs with longer maturity dates pay higher rates of interest. For example, a 6-month CD might pay 3.4 percent interest while a 5-year CD might pay 4.4 percent. The federal government insures funds deposited in CDs at most banks and credit unions up to $100,000 per depositor in any given institution. The main risk that investors in CDs face is the loss of interest or possibly some principal if funds are withdrawn before the maturity date. In addition, investors might face interestrate risk if rates rise and funds are locked in for a length of time at a lower rate. Money Market Mutual Funds Recall from Section 1 that the money market involves financial assets with maturities of one year or less. Also, remember that mutual funds allow investors to buy shares that represent an investment in all the financial assets held by the fund. Money market mutual funds (MMMF) allow investors to own a variety of short-term financial assets, such as Treasury bills, municipal bonds, large-denomination CDs, and corporate bonds. These mutual funds give investors a higher yield than bank savings accounts, but provide a similar level of liquidity. Investors can redeem their shares by check, by phone, or by electronic transfer to a separate checking account. Although the federal government does not insure MMMFs, the funds are tightly regulated, and these investments are considered to be quite safe with regard to loss of principal. There is less interest-rate risk than with CDs because the money is not committed for a specified length of time. The yield of the MMMF varies based on the yield of the assets in the fund. AP P LI CATION Making Inferences B. Why do longer-term CDs pay higher interest rates than shorter-term CDs? Source: www.CartoonStock.com Financial Markets 341 For more information on interpreting graphs, see the Skillbuilder Handbook, page R29. Interpreting Graphs: Online Financial Information Evaluating means to make a judgment about information. Investors make judgments about stocks based on their analysis of financial information. Many use the Internet as a resource for acquiring minute-to-minute information about stock market trading. The graphs on this page provide information about Apple Computer Inc., a stock traded on the NASDAQ. These graphs, which are updated online throughout trading, offer an example of the type of online information investors use to evaluate stocks. TIPS FOR EVALUATING ONLINE INFORMATION Use the following guidelines to evaluate economic information online: Read the title to identify the company for which stock information is shown. Here it is Apple Computer (AAPL), traded on the NASDAQ (Q). Read the vertical axis. This graph has two parts. The upper part shows the stock’s price; the lower part shows the volume of shares traded. Look for other information This statement shows the lag time for information—15 minutes in this case. 342 Chapter 11 Read the horizontal axis. This graph shows stock prices and volume traded from May 2005 through April 2006. Quotes delayed 15 minutes except NYSE and Amex which are 20 minutes. Source: TheGlobeandMail.com T HINKING ECONOMICALLY Evaluating 1. As an investor, which month would have been best for you to acquire Apple stock? Why? 2. How does the price per share at the beginning of June 2005 compare w
ith the price in mid-January 2006? Use information from the graph in your answer. 3. From January through April of 2006, the price of Apple shares fluctuated greatly. Volume of trading was also very heavy. Are these two facts related? Why? S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. Use each of the three terms below in a sentence that illustrates the meaning of the term: a. coupon rate b. maturity c. yield 2. What does par value represent to the issuer of a bond? 3. What is the relationship between par value and maturity? 4. When does yield equal the coupon rate? 5. Why do junk bonds offer a higher yield than other types of bonds? 6. Using Your Notes Compare the risk of investing in a CD with the risk of investing in a money market mutual fund. Refer to your completed chart. Bonds Other Financial Instruments Use the Graphic Organizer at Interactive Review @ ClassZone.com . Comparing and Contrasting Dmitri bought a $1,000 bond at par value with a coupon rate of 5 percent. He determines the yield by dividing the amount of interest he earns by the price. a. How much interest would he earn in the first year and what would be the yield? b. How much interest would he earn in the first year and what would be the yield if he had paid $950 for the bond? What would be the interest and yield if he paid $1,050? 8. Making Inferences In 2003, Molly bought a 10-year Treasury note for $1,000. The market interest rate was 3.5 percent. In 2005, Molly wanted to sell the note to pay for college expenses. Interest rates had risen to 4.5 percent. How would the change in interest rates affect the price that Molly was likely to receive for her note? Give reasons for your answer. 9. Applying Economic Concepts Julie has accumulated $1,000 in a bank savings account, which pays 2.7 percent interest. She investigates several options and finds that she can invest her money in a 1-year Treasury note paying 4.4 percent interest, a 1-year CD paying 3.9 percent interest, or a money market mutual fund with an average yield of 3.7 percent. What are the pros and cons of each of these investment options? 10. Challenge How would a lower bond rating by Moody’s or Standard & Poor’s affect the coupon rate that a corporation has to offer when it issues its bonds? Give reasons for your answer. Making Investment Decisions Suppose that you have been advised to invest in bonds. Recall what you have learned about the factors to consider when buying and selling bonds and then complete the following activities. Ask Investment Questions Fill in the chart by developing a series of questions you might ask to help you decide which type of bond to buy. My Questions Categories of Questions to Ask About Bonds Investment objectives Tolerance for risk Desired return Resalability of bonds Challenge How might you apply the concept of diversification to a portfolio of bond investments? Financial Markets 343 Case Study Find an update on this Case Study at ClassZone.com The Rise and Fall of Dot-Coms Background The availability of products and services on the Internet is old news. But when the Internet first emerged, it provided a unique and exciting tool for almost instant access to potential buyers worldwide. Young people in particular were quick to grasp the possibilities of the electronic marketplace. As a result, many new companies, known as dot-coms, quickly appeared on the Internet. Like the stock of many companies based on new technologies, the value of dot-com stocks rose quickly. Investors, attracted by the initial success of dot-coms and spurred on by low interest rates in the late 1990s, were quick to join the dotcom boom. The boom, however, proved to be a financial bubble. In 2000 and 2001, the bubble burst as dot-com stocks fell dramatically. Many dot-coms went out of business, and their investors sustained heavy financial losses. What’s the issue? Why did so many dot-com companies fail? Study these sources to discover what investors learned when the dot-com bubble burst. A. Online Encyclopedia Article Many young entrepreneurs jumped into the dot-com market, often with disastrous results. This article describes one such venture. 344 Chapter 11 Kozmo.com Offered New Yorkers Free, One-Hour Delivery Despite millions in capital investment, Kozmo.com’s choices led to failure. Kozmo.com was a venture-capital-driven online company that promised free one-hour delivery of anything from DVDs to Starbucks coffee. It was founded by young investment bankers Joseph Park and Yong Kang in March 1998 in New York City. The company is often referred to as an example of the dot-com excess. Kozmo promoted an incredible business model; it promised to deliver small goods free of charge. The company raised about $280 million, including $60 million from Amazon.com. The business model was heavily criticized by business analysts, who pointed out that onehour point-to-point delivery of small objects is extremely expensive and there was no way Kozmo could make a profit as long as it refused to charge delivery fees. Not surprisingly, the company failed soon after the collapse of the dot-com bubble, laying off its staff of 1,100 employees and shutting down in April 2001. Source: Wikipedia.org Thinking Economically Why do you think Park and Kang were so successful in raising capital to fund their business venture? B. Cartoon Cartoonist Andrew Toos drew this commentary about the dot-com bubble. Source: www.CartoonStock.com Thinking Economically What comment does the cartoon make about investing in the dot-com financial market? C. Online News Story Early dot-coms typically spent huge amounts of money on advertising. This article compares purchases of advertising during the 2000 Super Bowl telecast to Napoleon’s 1815 defeat at Waterloo. The Bubble Bowl Expensive advertising failed to market dot-com products. It was just five years ago, although it seems like a different age entirely. It was a time of singing-sock-puppets, 21-year-old chief executives, gravity-defiant stock prices, revolutionary technologies and half-baked business plans. And in this atmosphere, during the final, halcyon days of the Internet boom, the St. Louis Rams played the Tennessee Titans in Super Bowl XXXIV, a moment that will be forever remembered as the dot-com bubble’s Waterloo. Football fans got a heavy dose of the fever that day: More than a dozen internet companies spent an average of $2.2 million for 30-second spots, amounting to more than $40 million of stockholder cash and not-so-hard-won venture capital. These startups hoped that Super Bowl exposure would sear their web address into the minds of consumers. But most viewers were left with only vague memories of chimpanzees dancing to “La Cucaracha” to promote whatchamacalit.com... while the businesses themselves were left with empty wallets. Today, most of these Internet pioneers are dead and gone, forgotten as the score of the game (St. Louis 23, Tennessee 16). Source: “The Bubble Bowl,” by David M. Ewalt. Forbes.com, January 27, 2005 Thinking Economically Why do you think the author compares the dot-com Super Bowl advertising to Waterloo, a major military defeat? THINKING ECONOMICALLY Synthesizing 1. During the dot-com bubble, do you think it was relatively easy or difficult for Internet start-up companies to raise capital? Explain your answer, using information from the documents. 2. Why do you think so many dot-coms failed? Use evidence from the documents in your answer. 3. What lessons might investors learn from the information presented in documents A and C? Financial Markets 345 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. capital gain capital market common stock coupon rate diversification financial asset financial intermediary investment investment objective maturity money market par value preferred stock primary market return risk savings secondary market stock index yield 1 is income not used for consumption. 2 is the use of income today that allows for greater production in the future. A 3 is a claim on the property of a borrower. A 4 collects funds from savers and invests the funds in loans and other financial assets. Examples include banks and mutual funds. The 5 is the market for buying and selling shortterm financial assets. The 6 is the market where financial assets are resold. The two issues that play a major role in setting an 7 are time and income. Investors try to maximize 8 and limit 9 through 10 , the practice of distributing investments among different financial assets. 11 is profit made from the sale of securities. 12 is share of ownership in a corporation that gives holders voting rights and a share of the profit. The Dow Jones Industrial Average is a 13 that measures the performance of a group of 30 stocks. 14 is the interest rate paid on a bond. The 15 is the amount that a bond issuer promises to pay the buyer at maturity. 346 Chapter 11 CHAPTER 11 Assessment Savings and Investment (pp. 318–323) 1. How are savings and investment related? 2. What is the role of financial intermediaries in the circular flow of the financial system? Investing in a Market Economy (pp. 324–329) 3. Why do investors need to determine their investment objective before they invest? 4. Explain the relationship between risk and return. Buying and Selling Stocks (pp. 330–337) 5. How do people earn money by investing in stocks? 6. How does the Dow Jones Industrial Average reveal trends in the stock market? Bonds and Other Financial Instruments (pp. 338–345) 7. What are the two reasons people buy bonds? 8. How are interest rates and bond prices related? A P P LY Look at the graph below showing savings as a percentage of after-tax income in various countries. 9. Which
country has the lowest rate of savings? 10. What is the overall trend from 1980 to 2000? FIGURE 11.12 SAV I NGS R ATES I N DIFFERENT COUNTRIES 20 18 16 14 12 10 8 6 4 2 0 1980 1985 1990 1995 2000 Source: Statistical Abstract of the United States Key: Japan France United Kingdom United States 11. Analyzing Causes and Effects In 2005, many leading advertisers announced plans to increase use of online advertising and to decrease the amount of advertising dollars spent in traditional print media, such as newspapers. In addition, newspaper circulation figures declined steadily as more people read news on the Internet. a. How was this situation likely to affect the stock prices of online search-engine companies that featured banner ads and sponsored links on their Web pages? b. How would it affect the stock prices of newspa- pers? Explain your answers. 12. Comparing and Contrasting What are the similarities and differences between stock dividends, a bond coupon rate, and interest on a CD? 13. Drawing Conclusions Alex, Kate, and Rashid all invested money in a software company. Alex bought a corporate bond, Kate bought shares of common stock, and Rashid bought shares of preferred stock. Which of these investors would be least at risk of losing money if the company became unprofitable? 14. Making Inferences Suppose that you heard the following statement on the financial news: “Bonds fell as the yield on 10-year Treasury notes rose to 4.56 percent, the highest in two years.” What does “bonds fell” mean and how is it related to the increase in yield? 15. Challenge Steve purchases an option contract to buy 100 shares of stock in a big high-tech company for $50 per share in six months. The stock is currently selling for $40 per share. Steve pays $5 per share for the option contract. If the share price rises to $60, Steve exercises his option to buy the shares at $50 and then resells the stock on the market for $60 per share. How much profit does Steve make per share? If the price never rises to $50 before the option expires, how much money does Steve lose? Advise Your Clients Choose a partner. Imagine that you are financial planners whose job is to help clients meet their investment objectives and use diversification to maximize return and limit risk. Step 1 Make a list of several possible financial instruments that you might recommend and rate them for risk and return. Step 2 Review each client’s objectives and risk tolerance to consider what investments to recommend. a. Carlos and Juanita Diaz want to invest for their two young children’s college education. They would like a return of 7 to 10 percent a year and have a moderate tolerance for risk. b. Patrick Hurd is 30 years old and wants to begin saving for his retirement. He wants the highest return possible and is willing to take risks. c. Alison Leveridge has recently retired. She wants to invest the money from her pension fund so that she can have a guaranteed amount of income and little risk of losing her capital. Step 3 Decide what percentage of each client’s money to invest in different types of financial instruments. Create pie graphs to show your recommendations for each client. Step 4 Present your recommendations to another pair of students. Discuss the choices that each of you made. Step 5 As a class, discuss how changes in your clients’ financial circumstances or changes in the stock market might affect your recommendations. Use to complete this activity. @ ClassZone.com Financial Markets 347 Macroeconomics U n i t 5 Measuring and Monitoring Economic Performance Measuring the Economy Millions of workers and businesses participate in the U.S. economy. Measuring the country’s economy requires special economic tools. 348 CHAPTER 12 SECTION 1 Gross Domestic Product and Other Indicators SECTION 2 Business Cycles SECTION 3 Stimulating Economic Growth CASE STUDY Poland: Economic Freedom and Economic Growth Economic Indicators and Measurements Macroeconomics is the study of the economy as a whole and how major sectors of the economy interact. C H A P T E R 12 National income accounting uses statistical measures of income, spending, and output to help people understand what is happening to a country’s economy AT T E R S Your economic decisions—combined with those of millions of other people—determine the fate of the nation’s economy. Can you afford to buy a new car? Is now a good time to change jobs? Should you take a risk in the stock market or keep your money safe in the bank? Understanding what is happening to the country’s economy will help you make better economic decisions. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on the economy of Poland. (See Case Study, pp. 376–377.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. How has free enterprise transformed Poland’s economy? See the Case Study on pages 376–377. Economic Indicators and Measurements 349 S E C T I O N 1 Gross Domestic Product and Other Indicators TA K I N G N O T E S In Section 1, you will • define GDP and describe how it is measured • explain how GDP has certain limitations • identify other national income accounting measures national income accounting, p. 350 gross domestic product (GDP), p. 350 nominal GDP, p. 352 real GDP, p. 352 nonmarket activities, p. 354 underground economy, p. 354 gross national product (GNP), p. 355 net national product (NNP), p. 355 national income (NI), p. 355 personal income (PI), p. 355 disposable personal income (DPI), p. 355 As you read Section 1, complete a hierarchy chart like the one below to record what you learn about national income accounting. Use the Graphic Organizer at Interactive Review @ ClassZone.com National Income Accounting GDP What Is GDP? KEY CONCEPT S As you have read, microeconomics and macroeconomics look at the economy through different lenses. While microeconomics examines the actions of individuals and single markets, macroeconomics examines the economy as a whole. Macroeconomists analyze the economy using national income accounting, statistical measures that track the income, spending, and output of a nation. The most important of those measures is gross domestic product (GDP), the market value of all final goods and services produced within a nation in a given time period. The Components of GDP To be included in GDP, a good or service has to fulfill three requirements. First, it has to be final rather than intermediate. For example, the fabric used to make a shirt is an intermediate good; the shirt itself is a final good. Second, the good or service must be produced during the time period, regardless of when it is sold. For example, cars made this year but sold next year would be counted in this year’s GDP. Finally, the good or service must be produced within the nation’s borders. Products made in foreign countries by U.S. companies are not included in the U.S. GDP. Products Included in GDP Cars made in the United States are an example of goods counted toward U.S. gross domestic product (GDP). QUICK REFERENCE National income accounting is a way of evaluating a country’s economy using statistical measures of its income, spending, and output. Gross domestic product (GDP) is the market value of all final goods and services produced within a nation in a given time period. 350 Chapter 12 Calculating GDP Although there are several different ways to calculate GDP, economists often use the expenditures approach. With this method, they group national spending on final goods and services according to the four sectors of the economy: spending by households, or consumption; spending by businesses, or investment; government spending; and total exports minus total imports, or net exports. Economists identify consumption with the letter C; investment with the letter I; government spending with the letter G; and net exports with the letter X. To calculate GDP, economists add the expenditures from all sectors together: C+I+G+X=GDP. F I G U R E 12 .1 CO . S. G ROSS D OM ES T I C P RO 10 Key: Consumption (C) Investment (I) Government Spending (G) Net Exports (X) C I G X Source: U.S. Bureau of Economic Analysis, 2005 data ANALYZE GRAPHS 1. In 2005, net exports was a negative number. What does this say about the relative amounts of exports and imports? 2. Did households, businesses, or the government contribute the most to U.S. GDP in 2005? Consumption includes all spending by households on durable goods, nondurable goods, and services. You drive to the movies in a durable good (an item that does not wear out quickly). You purchase a service when you pay for the movie (since you are not buying to own something). And you obtain a nondurable good (a good that is used up relatively soon after purchase) when you buy popcorn. Investment, which measures what businesses spend, has two categories. One is fixed investment, which includes new construction and purchases of such capital goods as equipment, machinery, and tools. The other is inventory investment. This category, also called unconsumed output, is made up of the unsold goods that businesses keep on hand. Government spending includes all the expenditures of federal, state, and local governments on goods and services. Examples include spending for defense, highways, Find an update on the U.S. GDP at ClassZone.com Economic Indicators and Measurements Economic Indicators and Measurements 351 and public education. However, government spending on transfer payments, such as social security and unemployment benefits, is not included. These payments allow the recipients to buy goods and services, and these are counted as consumption. Net exports, the final component of GDP, represents foreign trade. This component takes into account the goods and services produced in the United States but sold in foreign countries—in other words, exports. However, U.S. consumers and businesses als
o buy, or import, goods made in foreign countries. Cars, car parts, and crude oil are the largest imports in dollar value. The GDP counts only net exports— the value of U.S. exports minus the value of U.S. imports. Two Types of GDP Economists use GDP to gauge how well a country’s economy is doing. When GDP is growing, an economy creates more jobs and more business opportunities. When GDP declines, jobs and more business opportunities become less plentiful. To get a clearer picture of a country’s economic health, economists calculate two forms of GDP—nominal and real. The most basic form is nominal GDP, which is stated in the price levels for the year in which the GDP was measured. If prices never changed, nominal GDP would be sufficient. But prices tend to increase over time. In Figure 12.2, find the line that represents nominal GDP. If you estimate the difference from 1990 to 2005, the nominal GDP of the United States about doubled. However, during this time prices went up, adding dollars to GDP without adding value to the nation’s output. To factor out rising prices, economists use real GDP, which is nominal GDP adjusted for changes in prices. Real GDP is an estimate of the GDP if prices were to FIGURE 12.2 U. S. NOMINAL AND REAL GROSS DOMESTIC PRODUCT QUICK REFERENCE Nominal GDP states GDP in terms of the current value of goods and services. Real GDP states GDP corrected for changes in prices from year to year. 14 12 10 NOMINAL GDP REAL GDP (IN 2000 DOLLARS) 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: U.S. Bureau of Economic Analysis Year ANALYZE GRAPHS 1. About how much did nominal GDP increase from 1990 to 2000? 2. About how much did real GDP increase over the same period? 3. Why do the two lines cross at the year 2000? 352 Chapter 12 M AT 12 . 3 Understanding Nominal and Real GDP To better understand nominal and real GDP, imagine a country that produces only one good: TVs. If you know the price of TVs and the number produced, you can calculate that country’s nominal and real GDP. Use the table to find the data for these calculations. Step 1: Calculate nominal GDP for 2004. Nominal GDP is the product of the number of TVs produced and the price of TVs that year. 2004 500 $100 2005 600 $100 2006 600 $120 $50,000 $60,000 $72,000 $50,000 $60,000 $60,000 TVs Produced TV Price Nominal GDP Real GDP, base: 2004 Number produced Price in that year Nominal GDP 500 $100 $50,000 The table shows that nominal GDP grew each year. If you judged only by nominal GDP, the economy of this country would seem to be growing. Step 2: Analyze the nominal GDP figures. Why did nominal GDP increase from 2004 to 2005? The number of TVs produced increased. Why did nominal GDP increase from 2005 to 2006? The price of TVs increased. The output of the country’s economy grew from 2004 to 2005, but it stayed the same from 2005 to 2006, despite the increase in prices. Calculating real GDP produces a better estimate of how much a country’s economy is growing. Step 3: Calculate real GDP for 2006. Real GDP is the product of the number of TVs produced in the current year and the price of TVs in the base year. In this case, use 2004 as the base year. Number produced Price in the base year Real GDP 600 $100 $60,000 Since 2004 is the base year, nominal and real GDP are the same for 2004. Real GDP allows you to compare the output of the country’s economy in different years. remain constant from year to year. To find real GDP, economists compare nominal GDP to a base year. Look again at Figure 12.2, which uses 2000 as a base year. Since real GDP eliminates price differences, the line for real GDP rises more gradually than the line for nominal GDP. Real GDP provides a more accurate measure of economic performance. AP P LI CATION Applying Economic Concepts A. If output remained the same, how would a year of falling prices affect nominal GDP? How would it affect real GDP? Economic Indicators and Measurements 353 What GDP Does Not Measure KEY CONCEPT S Although GDP provides an important estimate of how well the economy is performing, it does not measure all output. It does not measure nonmarket activities, such as home childcare or performing one’s own home repairs. GDP also does not measure output from the underground economy, market activities that go unreported because they are illegal or because those involved want to avoid taxation. Further, GDP does not measure “quality of life” issues related to economic output. Nonmarket Activities Some productive activities do not take place in economic markets. For example, there is no effective way to measure the output of plumbers who install or repair plumbing systems in their own homes or people who do volunteer work for schools or hospitals. By far the biggest nonmarket activity, also left out of GDP, consists of the many services—cooking, cleaning, childcare—provided by homemakers. Underground Economy Nonmarket Activities Housework is an example of a productive activity not measured by GDP. Also missing from GDP is the underground sector of the economy. Some activities are kept underground because they are illegal—drug dealing, smuggling, gambling, and selling stolen goods, for example. When goods are rationed or otherwise restricted, illegal trading occurs on what is called the black market. Other underground activities are themselves legal, but the way the payment is handled is not. For example, a plumber who does repairs for a neighbor might receive payment in cash and not declare it as taxable income. Estimates suggest that the underground economy would make up 8 to 10 percent of the U.S. GDP. Quality of Life Countries with high GDPs have high living standards. But GDP does not show how the goods and services are distributed. The United States has the largest GDP of any country, but more than 10 percent of its people still live in poverty. GDP also does not express what products are being built and services offered: for example, are there more jails being built than schools? APPLICATION Explaining an Economic Concept B. If you get paid in cash to baby-sit, mow lawns, or do other chores for neighbors, are you part of the underground economy? Why or why not? QUICK REFERENCE Nonmarket activities are services that have potential economic value but are performed without charge. Underground economy describes market activities that go unreported because they are illegal or because those involved want to avoid taxation. 354 Chapter 12 Other Economic Performance Measures KEY C ONCEPT S GDP is not the only measure that economists use to gauge economic performance. Several other measures are derived by making adjustments to GDP. • Gross national product (GNP) is the market value of all final goods and services a country produces in a given time period. GNP equals GDP plus the income from goods and services produced by U.S. companies and citizens in foreign countries but minus the income foreign companies and citizens earn here. • Net national product (NNP) is GNP minus depreciation of capital stock—in other words, the value of final goods and services less the value of capital goods that became worn out during the time period. • National income (NI) is the total income earned in a nation from the production of goods and services in a given time period. It is calculated by subtracting indirect business taxes, such as property and sales taxes, from NNP. • Personal income (PI) is the income received by a country’s people from all sources in a given time period. It can be calculated from NI by subtracting social security taxes, corporate profit taxes, and corporate profits not paid to stockholders and by adding social security, unemployment, and welfare payments. • Disposable personal income (DPI) is personal income minus personal income taxes. It shows how much money is actually available for consumer spending. F I G U R E 12 . 4 National Income Accounting QUICK REFERENCE Gross national product (GNP) is the market value of all final goods and services produced by a country. Net national product (NNP) is the value of final goods and services less the value of capital goods that have become worn out. National income (NI) is the total income earned in a nation from the production of goods and services. Personal income (PI) is the income received by a country’s people from all sources. Disposable personal income (DPI) is personal income minus taxes. GDP + income earned abroad by U.S. businesses and citizens – income earned in U.S. by foreign businesses and citizens = GNP – depreciation of capital stock = NNP – indirect business taxes = NI – income earned but not received + income received but not earned = PI – personal taxes = DPI ANALYZE CHARTS What three figures do you need in order to calculate personal income (PI)? AP P LI CATION Making Inferences C. Under what circumstances might a country’s GNP be greater than its GDP? Economic Indicators and Measurements 355 For more on synthesizing economic data, see the Skillbuilder Handbook, page R23. Synthesizing Economic Data Synthesizing is a skill used by economists to interpret economic trends. Synthesizing involves interpreting various data to form an overview of economic performance. A synthesis is often stated as a broad summary statement. PRACTICING THE SKILL National income accounting involves the collection and analysis of data on key economic variables. Economists synthesize the data to arrive at an overview of national economic performance. The table below presents data for variables used to determine gross domestic product (GDP), a key factor in national income accounting. Read the title to learn the main idea of the table. This table shows the components of U.S. GDP for selected years. F I G U R E 12 . 5 COMPONENTS OF U.S. GDP (IN BILLIONS OF DOLLARS) Read the column heads carefully. The four types of expenditures are used to determine GDP. Determine how the types of data relate to one another. For 1990, calculating the sum of the four expen
ditures yields $5,803 billion, the nominal GDP for 1990. Check the source of the data to evaluate its reliability. Year 1980 1985 1990 1995 2000 2005 Consumption Expenditure Investment Expenditure Government Expenditure Net Export Expenditure Nominal GDP 1,757 2,720 3,840 4,976 6,739 8,746 479 736 861 1,144 1,736 2,105 566 879 1,180 1,369 1,722 2,363 13 115 78 91 380 727 2,789 4,220 5,803 7,398 9,817 12,487 Source: U.S. Bureau of Economic Analysis Look for patterns in the data. For example, notice that net exports have been negative. T HINKING ECONOMICALLY Synthesizing 1. What trend can be seen in U.S. nominal GDP? What can you tell from this about the growth of the U.S. economy? Do you need more information? 2. Which expenditure accounts for most of GDP? 3. Does the proportion of this expenditure to the other two positive expenditures remain about the same in the six years shown here? Briefly explain how you estimated this. 356 Chapter 12 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. nominal GDP real GDP b. gross national product net national product c. personal income disposable personal income 2. What are the four components of GDP? 3. What is an example of a durable good? a nondurable good? 4. Name two economic activities that GDP does not measure. 5. Why are transfer payments not included as a government expenditure when calculating GDP? 6. Using Your Notes Write a brief summary of the methods used to calculate national income and the purposes of each accounting method. Refer to your completed hierarchy chart. National Income Accounting GDP Use the Graphic Organizer at Interactive Review @ ClassZone.com . Drawing Conclusions List some things that have become more expensive during your lifetime. Explain how a rise in price level affects nominal GDP and real GDP. 8. Making Inferences If consumption is especially high compared with other years, what might you generalize about the health of the economy? 9. Explaining an Economic Concept What is the underground economy? What impact does it have on a nation’s GDP? 10. Drawing Conclusions Imagine that a new country is discovered on an island in the middle of the Pacific Ocean. The country’s people have never left the island, and no foreigners have ever been there. What would the relationship be between the country’s GDP and its GNP? Why? 11. Challenge How would the following affect GDP? a. Government transfer payments increase. b. Student sells used CD to record store. c. Car owner pays auto repair shop $500 to fix his car. Identifying Intermediate and Final Goods Look at the following list of goods and who purchased them. Goods Purchaser copier paper accounting firm refrigerator home consumer stainless steel manufacturer eggs eggs battery paint home consumer factory that makes frozen baked goods car owner furniture maker Categorize Economic Information Decide whether each good is an intermediate good or a final good. Challenge Why is it important to make a distinction in national income accounting between intermediate and final goods? 357 S E C T I O N 2 Business Cycles TA K I N G N O T E S In Section 2, you will • describe the phases of the business cycle • discuss aggregate demand and aggregate supply • identify the causes of the changes in the business cycle • explain how economists predict business cycle changes • outline major business cycles in U.S. history business cycle, p. 358 economic growth, p. 358 recession, p. 359 depression, p. 359 stagflation, p. 359 aggregate demand, p. 360 aggregate supply, p. 360 macroeconomic equilibrium, p. 361 leading indicators, p. 364 coincident indicators, p. 364 lagging indicators, p. 364 As you read Section 2, complete a cluster diagram like the one below to record what you learn about business cycles. Use the Graphic Organizer at Interactive Review @ ClassZone.com stages Business Cycle What Is the Business Cycle? QUICK REFERENCE The business cycle is the series of growing and shrinking periods of economic activity, measured by increases or decreases in real GDP. Economic growth is the increase in a nation’s real GDP over a period of time. 358 Chapter 12 KEY CONCEPT S Economic changes often follow a broad pattern. During the 1990s, the U.S. economy expanded. In 2001, the economy slowed down. It then returned to a period of growth. Such changes are an example of the business cycle, a series of periods of expanding and contracting economic activity. The business cycle is measured by increases or decreases in real GDP. The cycle has four distinct stages: expansion, peak, contraction, and trough. STAGE 1 Expansion In the expansion phase, real GDP grows from a low point, or trough, as you can see in the graph in Figure 12.6. The expansion is a period of economic growth, an increase in a nation’s real gross domestic product (GDP). During an expansion, jobs are relatively easy to find, so unemployment goes down. More and more resources are needed to keep up with spending demand. As resources become more scarce, their prices rise. The length of each phase may vary both within a cycle and from cycle to cycle. The longest expansion in U.S. history took place over the course of ten years from 1991 to 2001. Business Cycles Workers and businesses ride the ups and downs of the economy. FIGURE 12.6 THE BUSINESS CYCLE In the expansion phase, real GDP grows rapidly. b The peak is where real GDP reaches its highest point in the cycle. c In the contraction phase, real GDP declines. d The trough marks the end of the contraction. Time ANALYZE CHARTS 1. What stage occurred before point A? 2. What stage will occur after point D? 3. How might the business cycle curve change if nominal GDP was used instead of real GDP? S TAGE 2 Peak The point at which real GDP is the highest represents the peak of the business cycle. As prices rise and resources tighten, businesses become less profitable. From that point on, real GDP declines as businesses curtail production. S TAGE 3 Contraction The contraction phase begins after the peak. As producers cut back, resources become less scarce and prices tend to stabilize or fall. Unemployment rises because employers produce less. Sometimes the contraction phase becomes a recession, a contraction lasting two or more quarters (six months or more). On rare occasions, as in the 1930s, a contraction turns into a depression, an extended period of high unemployment and limited business activity. While prices usually remain about the same or go down during the contraction phase, sometimes they go up. These are periods of stagflation—stagnation in business activity and inflation of prices. S TAGE 4 Trough The final phase of the business cycle is the trough, the point at which real GDP and employment stop declining. A business cycle is complete when it has gone through all four phases, from trough to trough or from peak to peak. AP P LI CATION Explaining an Economic Concept A. In terms of the business cycle, what is unusual about stagflation? QUICK REFERENCE QUICK REFERENCE Recession is a prolonged economic contraction lasting two or more quarters (six months or more). Depression is an extended period of high unemployment and reduced business activity. Stagflation describes periods during which prices rise at the same time that there is a slowdown in business activity. Economic Indicators and Measurements Economic Indicators and Measurements 359 QUICK REFERENCE Aggregate demand is the sum of all the demand in the economy. Aggregate supply is the sum of all the supply in the economy. Aggregate Demand and Supply KEY CONCEPT S One way to understand business cycles is through the concepts of demand and supply. In this case the concepts apply not to a single product or business but to the economy as a whole. Aggregate Demand Aggregate demand is the total amount of goods and services that households, businesses, government, and foreign purchasers will buy at each and every price level. In Figure 12.7, the vertical axis, labeled “Price level,” shows the average price of all goods and services. The horizontal axis, labeled “Real GDP,” shows the economy’s total output. The aggregate demand curve (AD) is downward sloping. As the price level decreases the purchasing power of money increases. Aggregate Supply Aggregate supply is the total amount of goods and services that producers will provide at each and every price level. Note that in Figure 12.8 the aggregate supply curve (AS) does not look like the supply curves in Chapter 5. The aggregate supply curve is almost horizontal when real GDP is low—during times of recession or depression—because businesses try not to raise their prices when the economy is weak. The middle part of the aggregate supply curve slopes upward, with prices increasing as real GDP increases. But during times of high inflation, prices rise without contributing to real GDP, and the aggregate supply curve becomes almost vertical. FIGURES 12.7 AND 12.8 AGGREGATE DEMAND AND SUPPLY CURVES FIGURE 12.7 AGGREGATE DEMAND FIGURE 12.8 AGGREGATE SUPPLY AD Real GDP AS Real GDP ANALYZE GRAPHS 1. What does a normal demand or supply graph use as an x-axis? What does it use as a y-axis? 2. Why are the x and y axes different for the aggregate demand and supply graphs? Use an interactive aggregate demand and aggregate supply graph at ClassZone.com 360 Chapter 12 QUICK REFERENCE QUICK REFERENCE Macroeconomic equilibrium is the point where the quantity of aggregate demand equals the quantity of aggregate supply. Macroeconomic Equilibrium When the quantity of aggregate demand equals the quantity of aggregate supply, the economy reaches macroeconomic equilibrium. Figures 12.9 and 12.10 illustrate a variety of different possibilities, but let’s consider one particular example shown in Figure 12.9. Macroeconomic equilibrium occurs where the aggregate demand curve (AD1) intersects the aggregate supply curve (AS). P1 indicates the equilibrium price level, a
nd Q1 shows the equilibrium level of real GDP. Think about business cycles. An increase in aggregate demand shifts the aggregate demand curve to the right (AD2). Aggregate demand becomes greater at all price levels, and equilibrium real GDP rises (Q2), marking an expansion phase. If aggregate demand were to decrease, the aggregate demand curve would shift to the left (AD3). This would result in a lower equilibrium real GDP (Q3)—in other words, an economic contraction. Shifts in aggregate supply affect real GDP in a similar way, as you can see in Figure 12.10. An increase in aggregate supply shifts the aggregate supply curve to the right (AS2). As aggregate supply increases, the price level goes down (P2) and equilibrium real GDP rises (Q2), marking an expansion phase. If aggregate supply were to decrease, the aggregate supply curve would shift to the left (AS3). The result would be a higher price level (P3) and lower equilibrium real GDP (Q3)—in other words, stagflation. FIGURES 12.9 AND 12.10 CHANGES IN AGGREGATE DEMAND AND SUPPLY FIGURE 12.9 CHANGE IN AGGREGATE FIGURE 12.10 CHANGE IN AGGREGATE DEMAND SUPPLY AS AS3 AS1 AS2 AD2 AD1 AD3 P2 P1 P3 P3 P1 P2 AD Q3 Q1 Q2 Real GDP Q3 Q1 Q2 Real GDP ANALYZE GRAPHS 1. As aggregate demand decreases, what happens to price level and real GDP? 2. As aggregate supply decreases, what happens to price level and real GDP? AP P LI CATION Analyzing Cause and Effect B. Assuming aggregate demand remains the same, why does the price level go up when aggregate supply decreases? Economic Indicators and Measurements 361 Why Do Business Cycles Occur? KEY CONCEPT S You have seen that shifts in aggregate demand and aggregate supply indicate changes in the business cycle. But what causes these shifts? Four factors are especially important: (1) decisions made by businesses, (2) changes in interest rates, (3) the expectations of consumers, and (4) external shocks to the economy. These factors involve the “ripple effect,” the cause-and-effect interactions that ripple through the economy. FACTOR 1 Business Decisions When businesses decide to decrease or increase production, their decisions can have far-reaching effects. If enough businesses make similar decisions, it can lead to a change in the business cycle. Demand slump Consider the ripple effect of a decision by businesses in the recording industry. In response to a slump in demand, the producers decide to reduce production of compact discs. First, they reduce the number of hours worked at their compact disc manufacturing facilities. Some workers get laid off, others work shorter hours. In a related move, the recording businesses cut back on their investment in new CD manufacturing equipment. That decision will lead to a decrease in the demand for machinery, which puts producers of the machinery in the same situation that the recording businesses were in. The machinery businesses will also cut back on production and lay off workers. The recording industry businesses also decide to reduce the number of new recordings they commission, thereby reducing the income of musicians, recording engineers, record promoters, and other associated workers. All of the workers that are now unemployed or working less must cut back on their purchases. The single decision by the recording industry businesses had numerous consequences. By itself, it might not be enough to change the business cycle for the entire country. But if enough businesses make similar decisions, a contraction in the business cycle might result. New technology Alternatively, business decisions can also increase aggregate supply and fuel an expansion. For example, suppose computer chip manufacturers adopt a new technology that greatly reduces production costs. Those manufacturers become more productive—the supply of their products increases and the cost of their products goes down. Businesses that make products that use computer chips can make their products more cheaply. Other businesses may now be able to make new products with the more readily available computer chips. All of these businesses hire more workers to handle the increased production. The aggregate supply increases, and the economy experiences an expansion. Find an update on factors affecting the business cycle at ClassZone.com 362 Chapter 12 FACT OR 2 Changes in Interest Rates Another event that has a ripple effect in the economy and causes shifts in aggregate demand and supply is a change in interest rates. Rising interest rates, for example, make it more costly for consumers to borrow money to make purchases—from televisions to cars to houses. This decreased purchasing power lowers the level of aggregate demand and promotes a contraction in the economy. When interest rates fall, the opposite happens. Aggregate demand rises, promoting an expansion. Consider what may happen to businesses when interest rates rise. With the higher cost of borrowing money, businesses may cut back on their investment in capital goods. As you saw earlier, such a cutback would lead to less business activity for the producers of capital goods. As the aggregate supply decreases, a contraction in the economy is likely. But falling interest rates would lead to an increase in aggregate supply and an economic expansion. Higher or lower interest rates also affect the housing market. When interest rates are low, people are inclined to purchase housing rather than rent, so housing sales and all related economic activities increase, contributing to an economic expansion. When interest rates rise, the high cost of loans limits mortgage eligibility, so more people rent. Housing sales slow down, contributing to an economic contraction. FACT OR 3 Consumer Expectations Every month, 5,000 households are surveyed to find out how people are feeling about the economy, and the results are published in the Consumer Confidence Survey report. Why? The way consumers are feeling about prices, business activity, and job prospects influences their economic choices, and their choices can bring about changes in aggregate demand. For example, when consumers are confident about the future and believe that they are economically secure, they tend to consume more, driving up aggregate demand and encouraging an economic expansion. FACT OR 4 External Issues A nation’s economy can also be strongly influenced by issues and events beyond its control or outside of its borders. Examples include such natural disasters as Hurricanes Katrina and Rita, which struck the Gulf Coast in the summer of 2005. The hurricanes damaged oil refineries, oil wells, and offshore oil platforms. The effects of Katrina and Rita, combined with conflicts in other oil-producing countries, led to higher oil prices and slowed down the growth of the U.S. economy. The oil embargo of 1973 is another example. The Organization of the Petroleum Exporting Countries (OPEC) reduced the amount of oil supplied to Western nations that had supported Israel in the Yom Kippur and October wars. The price of oil rose by 400 percent. The higher prices raised production costs and resulted in an economic contraction in the United States. AP P LI CATION Analyzing Cause and Effect C. Describe the ripple effect of a natural disaster like Hurricane Katrina on the economy. External Issues Natural disasters can affect the economy. Hurricane Katrina washed this oil-drilling platform into this bridge. . Economic Indicators and Measurements 363 Predicting Business Cycles KEY CONCEPT S QUICK REFERENCE Leading indicators are measures of economic performance that usually change before real GDP changes. Coincident indicators are measures of economic performance that usually change at the same time as real GDP changes. Lagging indicators are measures of economic performance that usually change after real GDP changes. Economists try to predict changes in the business cycle to help businesses and the government make informed economic choices. They base their predictions on sets of economic indicators. • Leading indicators are measures of economic performance that usually change six to nine months before real GDP changes. Examples include new building permits, orders for capital goods and consumer goods, consumer expectations, average manufacturing workweek, stock prices, and the money supply. Economists look for trends in these indicators that last several months before they predict a change. • Coincident indicators are measures of economic performance that usually change at the same time as real GDP changes. These indicators include such items as employment, sales volume, and personal income. • Lagging indicators are measures of economic performance that usually change after real GDP changes. Such indicators are useful for confirming the end of an expansion or contraction in the business cycle. They include length of unemployment and the ratio of consumer credit to personal income. F I G U R E 12 .11 U. S. L E A D I N G ECO ATO INDEX OF LEI FIRST QUARTER GDP SECOND QUARTER GDP THIRD QUARTER GDP FOURTH QUARTER GDP RECESSION (MAR.-NOV. 2001 12.0 11.5 11.0 10.5 10.0 9.5 9.0 8. 1998 1999 2000 2001 2002 2003 2004 Sources: The Conference Board; U.S. Bureau of Economic Analysis; National Bureau of Economic Research Year and quarter ANALYZE GRAPHS 1. Find a period of at least four quarters in which the index of leading economic indicators accurately predicted a change in real gross domestic product. 2. Do changes in the real gross domestic product always echo changes in the index of leading economic indicators? What does this say about predicting changes in the nation’s economy? APPLICATION Using a Decision-Making Process D. If you were the manager of an electronics store, how might you use the news that leading indicators suggest a contraction in the economy in six months? 364 Chapter 12 The Great Depression Millions of Americans were thrown into poverty during the 1930s. These people received soup from a charity kitchen. Business Cycles in U.S. Histor
y KEY C ONCEPT S The agency that tracks economic indicators and business cycles in the United States is the National Bureau of Economic Research (NBER). It measures contractions from peak to trough and expansions from trough to peak. NBER identified about 20 extended contractions, or recessions, in the American economy in the 20th century. The worst of these by far was the Great Depression. The Great Depression “Back in those dark depression days,” President Ronald Reagan once recalled, “I saw my father on a Christmas Eve open what he thought was a Christmas greeting from his boss. Instead, it was the blue slip telling him he no longer had a job. The memory of him sitting there holding that slip of paper and then saying in a half whisper, ‘That’s quite a Christmas present’ –it will stay with me as long as I live.” Millions of people who lived through the Great Depression were haunted by such memories. For more than a decade, beginning with the stock market crash in 1929, the United States and much of the world suffered a terrible economic contraction. Not until the United States entered World War II in 1941 did the American economy begin a full recovery. Between the years 1929 and 1933, when the depression was at its worst, U.S. real GDP declined by about a third. Sales in some big businesses, including General Motors Corporation, declined by as much as 50 percent. In the resulting cutbacks, millions of workers lost their jobs. The unemployment rate skyrocketed from 1929 to 1933, leaving one in four American workers jobless. Businesses failed at a higher than usual rate, and banks failed at a tremendously high rate. The number of bank closings, either temporary or permanent, soared from 659 in 1929 to 4,000 in 1933. The New Deal President Herbert Hoover, who had been elected in 1928, was not able to bring about a recovery. Franklin D. Roosevelt, accepting the nomination to run for president against Hoover in 1932, promised Americans “a new deal,” and the programs he enacted after winning the election came to be known by that name. Roosevelt’s New Deal programs focused on federal spending to help the economy revive. Through a number of government agencies created just for this purpose, the American economy came under closer government regulation and many Americans were put back to work—employed by the federal government itself. Spending by the federal government rose from about 3 percent of GDP in the 1920s to about 10 percent in the mid-1930s. In this cartoon, Franklin D. Roosevelt is surrounded by children representing programs created as part of the New Deal. Economic Indicators and Measurements 365 Economists debate whether the New Deal programs led to sustained economic growth. But when the United States entered World War II in 1941, spending on the war effort also helped the economy to recover. Unemployment plunged to 1.2 percent by 1944. Business Cycles Since the Great Depression According to NBER, there have been about a dozen economic contractions and expansions in the U.S. economy since the Great Depression. The recessions have been less severe and have occurred less often than those before the 1930s. However, the contraction of the mid-1970s was an especially difficult time, triggered in part by the Oil Embargo of 1973. The unemployment rate rose from an average of 5.4 percent in the first half of the decade to an average of 7.4 percent from 1975 to 1979. At the same time, prices also rose, creating stagflation. FIGURE 12.12 U. S. BUSINESS CYCLES ) RECESSION PERIODS REAL GDP (IN 2000 DOLLARS) 12 10 8 6 4 2 1925 1935 1945 1955 1975 1985 1995 2005 1965 Year Sources: U.S. Bureau of Economic Analysis; National Bureau of Economic Research ANALYZE GRAPHS 1. According to the graph, how many recessions occurred from 1929 to 2005? 2. About how long was the longest business cycle shown on this graph? The 1990s, in contrast, saw strong economic expansion, fueled in part by the explosive growth of information technology. The economy experienced a brief recession in the early 2000s, which was extended slightly by the terrorist attacks on September 11, 2001. Through 2005, the U.S. economy continued to expand, although not at the heated pace of the 1990s. APPLICATION Making Inferences and Drawing Conclusions E. One industry that flourished during the Great Depression was the movie industry. Comedies were especially popular, and stories often portrayed the lives of the wealthy. Why do you think the movie industry fared so well? 366 Chapter 12 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. MACROECONOMIC EQUILIBRIUM a. contraction expansion b. aggregate demand aggregate supply c. leading indicators lagging indicators 2. Between which two points of the business cycle is a contraction measured? 3. What is the difference between demand and aggregate demand? 4. Name four factors that can trigger changes in the business cycle. 5. Name three coincident indicators of the Great Depression. 6. Using Your Notes Write a brief stages statement of your expectations for the economy from the point of view of the consumer. Use your completed cluster diagram and make references to what you have learned about the business cycle. Business Cycle Use the Graphic Organizer at Interactive Review @ ClassZone.com . Comparing and Contrasting Economic Information What were the similarities and differences between the Great Depression and the recession in the 1970s? 8. Solving Economic Problems Did President Roosevelt’s New Deal focus on generating aggregate demand, or was its main focus on increasing aggregate supply? Explain. 9. Analyzing Cause and Effect Are the components that are considered leading economic indicators causes or effects of changes in the business cycle? 10. Challenge In the 1990s many people speculated that the economy had been transformed by new technologies. Paul A. Volcker, former chairman of the U.S. Federal Reserve Bank, described it this way: “The speed of communication, the speed of information transfer, the cheapness of communication, the ease of moving things around the world are a difference in kind as well as degree.” Do you think that business cycles are inevitable? Can they ever be eliminated entirely? Explain your answer P1 AS1 AD1 Real GDP Q1 Interpreting Graphs The graph shows an economy at its macroeconomic equilibrium, where the aggregate demand curve (AD1) intersects the aggregate supply curve (AS1). P1 indicates the equilibrium price level, and Q1 shows the equilibrium level of real GDP. Draw Aggregate Demand and Aggregate Supply Curves Read the following scenarios. Copy the graph onto your own paper, then graph the changes that would occur in the Scenario 1 in blue. Graph the changes that would occur in the Scenario 2 in red. Scenario 1: In a booming economy, interest rates begin to rise. Manufacturers and other producers, wary of borrowing money at higher rates, begin to cut back on production. Scenario 2: Consumer confidence is high. Most people are optimistic about their job prospects and security, and they are willing to spend money on luxuries. Challenge As a consumer, how might your confidence be affected in Scenario 1? Use to complete this activity. @ ClassZone.com 367 S E C T I O N 3 Stimulating Economic Growth TA K I N G N O T E S In Section 3, you will real GDP per capita, p. 369 • explain how economists labor input, p. 371 measure growth • analyze the causes of economic growth • discuss how productivity and economic growth are related capital deepening, p. 371 productivity, p. 372 multifactor productivity, p. 372 As you read Section 3, complete a summary chart like the one below to record what you learn about economic growth. Use the Graphic Organizer at Interactive Review @ ClassZone.com What Is Economic Growth? What Is Economic Growth? KEY CONCEPT S In Section 2 you learned about the business cycle, the pattern of expansion and contraction in a nation’s economy. In this section you will learn more about economic growth, as measured by changes in real gross domestic product (GDP). Gauging Economic Growth Before Adam Smith (whom you learned about in Chapter 1, Section 4), many people believed that population growth and higher taxation were the secrets to economic growth. The theory held that more people paying more taxes was the best way to fill a nation’s treasury. Another view, called mercantilism, argued that increased national wealth came through exporting more goods than a country imports. In this way, the country would gain gold or silver currency from other countries. Adam Smith, however, saw that the real “wealth of nations” lay in their productive capacities. Taxes could be so high that they limit the amount of funds available for business investment and consumer spending, thereby reducing economic growth. In Smith’s view, foreign trade allows a country to focus its resources on what it does best. The more efficiently a nation uses its resources, the more productive it will be and the larger its economy will grow. Smith’s views proved to be accurate, and they serve as the basis for modern economics. The best measure of economic growth is not simply the amount of money a nation has or how much its population increases, but rather the increase in its real GDP. The rate at which real GDP changes is a good indicator of how well a country’s resources are being utilized. 368 Chapter 12 FIGURE 12.13 U. S. REAL GDP PER CAPITA 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 ) 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: U.S. Bureau of Labor Statistics ANALYZE GRAPHS 1. About how much was real GDP per capita in 1990? 2. About how many years did it take for real GDP per capita to double from its level in 1960? Population and Economic Growth Population growth influences economic growth. A country’s real GDP might be growing, but if its population is growing at an even faster rate, the increase in real
GDP might simply reflect more workers contributing to the economy. Think of a potluck dinner. If each person brings one dish, the amount of food per person will be the same whether you invite 10 people or 100. To get a clearer picture of economic growth, economists use a measure called real GDP per capita, which is real GDP divided by total population. Real GDP per capita reflects each person’s share of real GDP. In terms of the potluck dinner, if each person brings more than one dish to the next potluck, the amount of food per person will have increased. Real GDP per capita is the usual measure of a nation’s standard of living. Nations with higher real GDP per capita tend to have populations that are better educated and healthier. However, real GDP per capita does not mean that each person gets that amount of money. Some people will get more, others less. It also does not measure quality of life. For example, people might have to work longer hours to achieve higher rates of economic growth, leaving them with less leisure time. AP P LI CATION Explaining an Economic Concept A. Why does a nation’s real GDP have to increase at a faster rate than its population for significant economic growth to take place? Find an update on U.S. real GDP per capita at ClassZone.com QUICK REFERENCE Real GDP per capita is real GDP divided by total population. Economic Indicators and Measurements Economic Indicators and Measurements 369 What Determines Economic Growth? KEY CONCEPT S What drives economic growth? Why are some nations growing at a faster pace than others? Four key factors influence the rate of economic growth—natural resources, human resources, capital, and technology and innovation. FACTOR 1 Natural Resources One factor in economic growth is access to natural resources, especially arable land, water, forests, oil, and mineral resources. However, some countries, such as Japan, have very limited natural resources, yet their economies have grown rapidly. Others, such as India, which has the fourth-largest reserve of coal in the world and arable land covering more than half its territory, have developed more slowly Do Natural Resources Guarantee Wealth? Not necessarily. In fact, countries with abundant natural resources generally do not perform as well economically as countries with fewer natural resources—a phenomenon economists refer to as “the resource curse.” In Nigeria, for example, although oil is plentiful, personal income is low. GDP per capita is about $1,400 (in U.S. dollars). Poverty is widespread, with an estimated 60 percent of Nigeria’s population below the poverty line—and Nigeria has the largest population of any African country. At the other end of the spectrum is Japan. Although the country has few natural resources, the strength of Japan’s economy is second only to that of the United States. GDP per capita is about $30,000 (in U.S. dollars). What Nigeria lacks, but Japan has, are the basic structures of a free market economy—private ownership, the profit motive, an effective government, and economic competition. These economic institutions are more important than natural resources for generating economic growth. Japan, with few natural resources, achieved economic success by developing alternative sources of wealth—industry and foreign trade. FIGURE 12.14 OIL PRODUCTION AND CONSUMPTION ) Nigeria Japan production consumption Source: U.S. Central Intelligence Agency, 2003 data CONNECTING ACROSS THE GLOBE 1. Synthesizing Economic Information What role do natural resources play in a country’s economic strength? Explain your answer. 2. Drawing Conclusions Figure 12.14 illustrates oil production and consumption in Nigeria and Japan. What would happen to each country’s economy if it produced less oil? What if each produced more? 370 FACT OR 2 Human Resources Another key factor in economic growth is the labor force. Economists measure this partly through labor input—the size of the labor force multiplied by the length of the workweek. The steady declines in the length of the workweek in most countries since the early 1900s have been more than made up for by the growth in the population, so labor input has grown. Perhaps even more important than the raw numbers, however, is the level of human capital—the skills and knowledge—that the labor force brings to its tasks. Some economists believe that human capital is the single most important component in economic growth. QUICK REFERENCE Labor input is the size of the labor force multiplied by the length of the workweek. FACT OR 3 Capital You learned in Chapter 1 that natural resources, labor, and capital come together through the creativity of an entrepreneur to produce goods and services. Capital is critical to this process and to economic growth. More and better capital goods increase output: the more machines a factory has and the better designed they are, the more goods the factory can churn out. Multiply this by the number of factories across a nation and the increased output equals higher GDP. The economy also grows when more capital is available per worker. An increase in the capital to labor ratio is called capital deepening. In other words, workers are provided with more and better equipment to work with. The Industrial Revolution is a prime example of capital deepening. Sewing machines, for example, allowed clothing manufacturers to make more clothing per worker than if the workers had been sewing by hand. QUICK REFERENCE Capital deepening is an increase in the ratio of capital to labor. FACT OR 4 Technology and Innovation Technology and innovation are also important factors in economic growth. These factors promote the efficient use of other resources, which in turn leads to increased output. Some of the key technological developments that have contributed to economic growth include steam power, electricity, and the automobile. Innovations can also increase economic growth. Something as simple as adjusting an order form can contribute to economic growth by reducing the amount of time needed to complete a task. Other innovations might improve customer service or reduce the amount of material needed to create a product. Information technology has had a strong impact on economic growth. Technological advances in producing the information technology itself have led to a dramatic decline in prices. With lower prices for technology, firms are engaging in capital deepening without having to spend more money. AP P LI CATION Writing About Economics B. Using the four factors, explain how developing countries like Nigeria might improve their economic growth. Technology and Innovation Technological advancements have increased economic growth. Economic Indicators and Measurements 371 QUICK REFERENCE Productivity is the ratio of the amount of output produced to the amount of input. Productivity and Economic Growth KEY CONCEPT S Productivity refers to the amount of output produced from a set amount of inputs. When the same amount of inputs produces more output, productivity has increased. In Chapter 9, you learned about labor productivity—the amount of goods or services produced by a worker in an hour. But the broader sense of productivity includes the productivity of both labor and capital. For example, imagine that you begin building bookshelves. The inputs would include your labor plus capital, in the form of the workshop, hammers, glue, and other supplies. At first, it may take you a week to complete one bookshelf. In the process, you may waste materials as you make mistakes, and you may find that some of your tools are not ideal for the task. But after you have built several bookshelves and acquired the right tools for the job, your productivity increases. Using the same amount of input, you might now be able to produce two bookshelves per week. This section concerns the productivity of a country’s entire economy. As a country becomes more productive, its economy is likely to grow. How Is Productivity Measured? QUICK REFERENCE Multifactor productivity is the ratio between the amount of output produced by an industry or business sector and the amount of inputs used. To measure the productivity of a single business, you would compare the inputs to the outputs. Using the bookshelf example, you would compare the amount of capital and number of hours worked to the number of bookshelves produced. But how can we measure the productivity of a nation’s economy, which is made up of millions of different people and businesses? Economists use a measurement called multifactor productivity, the ratio between an industry’s economic output and its labor and capital inputs. By collecting multifactor productivity data on a country’s major industries and business sectors, economists can estimate the productivity of the entire economy. What Contributes to Productivity? Several factors contribute to changes in productivity. Quality of Labor A better educated, healthier workforce tends to be more productive. Using the bookshelf example, if you were to take classes in woodworking, your enhanced knowledge would enable you to produce more and better shelves. In general, the more educated the workforce, the more productive it is. As for health, people are usually more productive when they feel well than when they feel sluggish or ill. Technological Innovation Historically, as during the Industrial Revolution, new machines and technologies helped countries produce more output from the same amount of inputs. In recent times, the desktop computer and computer technology generally have generated productivity gains. Energy Costs Gas, electricity, and other fuels power the technologies that increase productivity. When energy costs rise, those tools become more expensive to use and productivity declines. By the same token, when energy costs fall, using advanced tools becomes less expensive and productivity rises. 372 Chapter 12 Financial Markets The easier it is for funds to flow to where they are
needed, the more productive the economy becomes. Banks, stock markets, and similar institutions allow a country’s funds to be put to their best use. When such institutions do not exist or when they do not function efficiently, productivity is reduced. FIGURE 12.15 U. S. PR IVATE BUSI NESS MULTIFAC TOR PRODUC TIVIT Y 100 90 80 70 60 50 40 30 20 10 ( 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Source: U.S. Bureau of Labor Statistics Year ANALYZE GRAPHS 1. What happened to productivity in the three years after the 1973 oil embargo? Why? 2. Compare this graph with Figure 12.13 on page 369, which shows real per capita GDP. How closely is economic growth related to productivity? How Are Productivity and Growth Related? Economic growth is a measure of change in production. It does not consider how much effort or how many resources it took to produce that quantity of production. Productivity, on the other hand, is a measure of efficiency. It reflects the amount of effort and resources it took to produce a certain quantity. A country could experience economic growth—as measured by real GDP— without increasing its productivity. Such growth would be tied to an increase in the quantity of natural resources, labor, capital, or technology. If the productivity of a country increases, its real GDP can grow without increasing the quantity of inputs. As shown in Figure 12.15, productivity in the United States grew at a steady pace from 1950 to 2000. Among other things, a better educated labor force and advances in information technology contributed to the increase. The dips in the graph represent productivity setbacks, such as tighter financial markets during recessions. AP P LI CATION Drawing Conclusions C. Some countries have limited natural resources but high economic growth. Does this prove that worldwide economic growth is unlimited by natural resources? Why or why not? Economic Indicators and Measurements 373 ECO N O M I C S PAC ES E T T E R Thomas Robert Malthus: The Population Problem In the late 1700s, many European thinkers and writers predicted a future of peace and harmony in which poverty and hunger would be eliminated. Discussing humanity’s future with his father led Thomas Robert Malthus to question whether the prevailing view was perhaps too rosy. Malthus saw a problem that others had overlooked, namely, that the world’s population seemed likely to outgrow the available supply of food. He published his ideas in 1798 in “An Essay on the Principle of Population as It Affects the Future Improvement of Society.” A Natural Limit to Economic Growth? Malthus’s essay argued that human population would increase geometrically—that is, it would double— every 25 years. Malthus also estimated that food production would only increase arithmetically—that is, by the same amount each time—over that time period. Figure 12.16 uses hypothetical numbers to illustrate the problem. As time went on, agriculture would produce less food per person, and millions would be thrown into poverty and starvation. “An Essay on the Principle of Population” caused a tremendous backlash. People could not accept that the rosy future they had imagined might not come to pass. Malthus and his essay were widely attacked and criticized—but no one could ignore his argument. Malthus’s estimates turned out to be flawed. Human population increased at a slower pace than he predicted. World population was about 1 billion in 1800, but it took until 1930 to reach 2 billion. Agricultural productivity rose dramatically with the introduction of mechanized farming and advances in fertilization and pest control. Although world population accelerated around 1950, reaching about 6.5 billion by 2005, agricultural production kept pace with the growing population. Elapsed Years 100 50 25 75 0 Thomas Robert Malthus Malthus predicted a population explosion that would result in poverty and famine. F I G U R E 12 .16 MALTHUS’ S POPULATION PROBLEM Bushels of Wheat (in millions) Population (in millions) Bushels per Person 10 20 30 40 50 10 20 40 80 160 1.00 1.00 0.75 0.50 0.31 APPLICATION Applying Economic Concepts D. How is Malthus’s population problem an example of the problem of scarcity? FAST FACTS Thomas Robert Malthus Career: British economist Born: February 17, 1766 Died: December 23, 1834 Major Accomplishment: Calling attention to the issue of population growth Major Work: Essay on the Principle of Population (1798, revised 1803) Famous Quotation: “Population, when unchecked, increases in geometrical ratio. Subsistence increases only in an arithmetical ratio.” Influenced: David Ricardo Charles Darwin Find an update on Thomas Robert Malthus at ClassZone.com 374 Chapter 12 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs. a. economic growth real GDP per capita b. capital deepening labor input 2. Name the key measurement of economic growth. 3. What four factors drive economic growth? 4. How are productivity and growth related? 5. Briefly explain the problem Malthus identified. What Is Economic Growth? 6. Using Your Notes Write a persuasive paragraph arguing one side or the other of economic growth possibilities. Refer to your completed summary chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com . Solving Economic Problems In 2000, the world’s population was about 6 billion, and about 800 million of those people did not have enough to eat. By 2050, the world’s population is expected to grow to about 9 billion. What steps should we take now to avoid having more than 1 billion people without enough to eat by 2050? Employ the ideas you learned about in this section in formulating your solution. 8. Explaining an Economic Concept Why is real GDP per capita a useful measure? Why couldn’t real GDP or GDP per capita be used for the same purpose? 9. Analyzing Cause and Effect Globalization opens international boundaries to companies, creating markets that stretch around the world. What role might global competition play in the development of innovations? 10. Challenge Going to school is your job. Your product is increasing your knowledge, and your grades are the main measure of this. Increasing your productivity would result in better grades—and more free time. Adapt the factors that contribute to economic productivity to explain how you might increase your productivity as a student. A busy factory is one route to economic growth. Stimulating Economic Growth Government policies affect economic growth. Some policies have immediate effects that last for a short time. Other policies take longer to show results but have lasting impact. Create a Healthy Economy Reflecting on what you learned in this section, consider the following possible government actions. • open a protected wilderness area for coal mining • increase funding for scholarships for low-income students • provide tax breaks for companies purchasing new equipment • strengthen laws protecting the rights of inventors Explain how each potential action might lead to economic growth. Challenge Estimate the costs and the benefits of each action. Which actions would have the most lasting positive effect on the economy? 375 Case Study Find an update on this Case Study at ClassZone.com Poland: Economic Freedom and Economic Growth Background Communists ruled Poland and controlled its economy from 1948 to 1989. After holding its first free elections in 1990, Poland made rapid progress toward full democracy and a free market economy. Economic reforms included ending government price controls, privatizing industries formerly controlled by the government, and entering the international marketplace. As Poland moved away from government control of the economy, it experienced a surge in economic growth—outdistancing many other former Communist countries in eastern and central Europe. In 2004, Poland became a member of the European Union, further increasing its economic potential. What’s the issue? How successful is Poland’s economy? Read these documents to learn about the challenges and rewards of the country’s economic transition. A. Online News Article Wroclaw, a city in southwest Poland, offers one example of the country’s success through embracing global capitalism. This article describes that phenomenon. Wroclaw, Poland: Europe’s Next Appliance Capital? Appliance Manufacturers Pour into Southwest Poland Money and companies are pouring in—not just the prestige nameplates like Bombardier, Siemens, Whirlpool, Toyota, and Volvo, but also the network of suppliers that inevitably follows them. At first, most of the new jobs were of the semi-skilled variety. Now they have been followed by design and engineering work that aims to tap into the largest concentration of university students in Eastern Europe. “Everyone is coming, and they are coming very fast,” reports Josu Ugarte . . . who heads the appliance manufacturing operations here of Mondragon, the giant Spanish industrial cooperative. He predicts, confidently, that the region around Wroclaw will soon surpass Northern Italy as Europe’s appliance capital. . . . The secret isn’t just lower wages. It’s also the attitude of workers who take pride and are willing to do what is necessary to succeed, even if it means outsourcing parts production or working on weekends or altering vacation schedules. . . . Source: “Europe’s Capitalism Curtain” WashingtonPost.com July 23, 2004 Many manufacturers have opened factories in Wroclaw, Poland. This Volvo factory produces buses. Thinking Economically How has Poland’s human capital contributed to the country’s economic growth? 376 Chapter 12 Source: The Economist B. Political Cartoon Poland’s farmers were sceptical about the benefits of European Union membership. This cartoon reflects their change of heart as agricultural exports increased and they received new subsidies from the European Union. Thinking Economically Does the cartoon emphasize the free mar
ket benefits of the European Union or other benefits? C. Magazine Article Joining the European Union brought tremendous growth to Poland’s economy. This article explains some of the elements that led to the success. Reaping the European Union Harvest How the new central European members learnt to stop worrying and love the European Union After grumbling furiously about dangers to their sovereignty and their social values when they joined the European Union in May, Poles are discovering themselves now to be among the Union’s most loyal citizens. Some three-quarters say they are happy with EU membership—and no wonder. In its first eight months of membership Poland got some is the euro, the currency of the European Union] ($3.4 billion) from the EU 2.5 billion [ budget, or roughly twice what it paid in, according to the newspaper Rzeczpospolita. Rural incomes have risen by one-third for small farmers and two-thirds for big ones, reversing eight years of stagnation and decline, thanks to munificent EU subsidies and an influx of foreign buyers offering high prices for Polish meat and fruit. Poland’s total exports rose by more than 30% in the first nine months of 2004, helped by the abolition of customs formalities. EU rules have opened the skies to budget airlines, boosting tourist numbers by 20% last year. Higher-than-expected tax revenues have meant lower-than-expected budget deficits. . . . Source: The Economist, January 8, 2005 Thinking Economically According to the document, how has membership in the EU helped Poland’s economic growth? THINKING ECONOMICALLY Synthesizing 1. Which economic measurements and indicators are evident in documents A and C? Explain what they convey about the strengths and weaknesses of Poland’s economy. 2. What factors have driven Poland’s economic growth? 3. Compare documents A and C, written about six months apart. What continued economic trends and new economic strengths do they describe? Economic Indicators and Measurements 377 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. aggregate demand aggregate supply business cycle capital deepening coincident indicators depression disposable personal income (DPI) economic growth gross domestic product (GDP) gross national product (GNP) lagging indicators leading indicators macroeconomic equilibrium national income (NI) national income accounting net national product (NNP) nominal GDP nonmarket activities per capita real GDP personal income (PI) real GDP recession stagflation underground economy 1 , the market value of all goods and services produced in a nation, is one of the key measurements used in 2 . 3 is especially useful because it gives the market value of all goods and services corrected for price level changes. Another very useful measurement is 4 , which shows the actual amount of money people have to spend. The economy goes through regular changes called the 5 . Economists watch 6 , such as building permits issued and stock prices, to predict changes in the economy. Low points in the economy are usually self-correcting, but in times of a 7 , such as the one that happened in the 1930s, government intervention may be needed. Several factors influence 8 , including an increase in capital. 9 , an increase in the ratio between capital and labor, increases productivity, helping the economy grow. Economists use 10 , real GDP divided by whole population, to distinguish an increase in population from a higher level of economic output. 378 Chapter 12 CHAPTER 12 Assessment Gross Domestic Product and Other Indicators (pp. 350–357) 1. What is the purpose of national income accounting? 2. In what way is GDP a baseline for other economic indicators? Business Cycles (pp. 358–367) 3. What do leading indicators say about the economy? 4. Explain how a business decision might have a ripple effect that would tilt the economy on a new phase of the business cycle. Stimulating Economic Growth (pp. 368–377) 5. Explain how a country with few natural resources can still have economic growth. 6. What are the four key factors that influence economic growth? A P P LY The table below shows the size of the underground economies of selected countries. F I G U R E 12 .17 U N D E RG RO U N D ECO N OM I ES I N SEL EC T ED COU N T R I ES Country GDP Per Capita (in U.S. dollars) Egypt Thailand Russia Chile Singapore Italy Switzerland United States 3,900 8,300 11,100 11,300 28,100 29,200 32,300 41,800 Underground Economy as Percent of GDP 69 70 44 19 14 27 9 10 Sources: International Monetary Fund, U.S. Central Intelligence Agency, 1998-2005 data 7. Is there a relationship between GDP per capita and the size of a country’s underground economy? 8. If a country incorporated its underground economy into the main economy, what would happen to its GDP per capita? Why. Creating Graphs Copy the blank graph onto your own paper. Then use the data in the table to create a line graph showing the percent change in U.S. real gross domestic product from 1999 through 2003. Use to complete this activity. @ ClassZone.com F I G U R E 12 .18 P E RC ROM P R EC E D I N G PE R I O D Year 1999 2000 2001 2002 2003 Quarter 1 Quarter 2 Quarter 3 Quarter 4 3.4 1.0 –0.5 2.7 1.7 3.4 6.4 1.2 2.2 3.7 4.8 –0.5 –1.4 2.4 7.2 7.3 2.1 1.6 0.2 3.6 Source: U.S. Bureau of Economic Analysis .0 6.0 4.0 2.0 0 –2.0 1999 2000 2001 2002 2003 Year and quarter 10. Analyzing and Interpreting Data Which year had the highest growth? The lowest? 11. Analyzing Cause and Effect The government enacted tax cuts and issued child tax credit refunds in 2003. What component of GDP would likely have increased because of these? 12. Distinguishing Fact from Opinion Does the graph support or counter the idea that the September 11, 2001 terrorist attacks caused a recession? 13. Challenge How could GDP grow by 5 percent a year but leave the economy no better off—or even worse off? Give two different explanations. Surveying Consumer Confidence The Consumer Confidence Survey is one poll used to determine consumer expectations. Another is the ABC/Washington Post Consumer Comfort Index, which makes 1,000 phone calls to adults each month and asks the following questions: • National Economy: “Would you describe the state of the nation’s economy these days as excellent, good, not so good, or poor?” • Personal Finances: “Would you describe the state of your own personal finances these days as excellent, good, not so good, or poor?” • Buying Climate: “Considering the cost of things today and your own personal finances, would you say now is an excellent time, a good time, a not so good time, or a poor time to buy the things you want and need?” To understand the consumer comfort index better, take a survey of your class. Step 1. Break into five small groups and discuss each of the questions. The point is to share your thoughts, not to debate who is right or wrong. Step 2. Return to your desk and write down your answers to each of the questions anonymously. Step 3. Collect the anonymous answers from the whole class. Have one person tabulate the answers to each question on the board. Step 4. Now calculate the consumer confidence of your class. For each question, add up the number of positive responses (either “excellent” or “good”). Then subtract the number of negative responses (either “not so good” or “poor”). Divide by the total number of students and multiply by 100. Add the result from all three questions together, and then divide by three. That will yield an overall comfort level. A level of 100 would mean everyone is satisfied with everything. A level of 100 would mean that everyone felt negatively about everything. Step 5. Discuss the result. Does it seem to accurately reflect the mood of the class? What would happen to the nation’s GDP if all consumers felt as you do? Economic Indicators and Measurements 379 Economic Challenges The national economy faces many challenges. Economics can help us understand and cope with these challenges. 380 CHAPTER 13 SECTION 1 Unemployment in Today’s Economy SECTION 2 Poverty and Income Distribution SECTION 3 Causes and Consequences of Inflation CASE STUDY The Effects of Inflation in the 1970s Facing Economic Challenges Business cycle is the series of growing and shrinking periods of economic activity, measured by increases or decreases in real gross domestic product. C H A P T E R 13 Unemployment has a variety of causes. Some level of unemployment is expected, even when an economy is healthy AT T E R S As the nation’s economy goes through business cycles, it will face the twin problems of unemployment and inflation. You may find yourself unemployed at some point during your working years, if only for a short period. For some people, persistent unemployment leads to poverty. During periods of inflation, you may have a job but your wages may buy less. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and further information on inflation in the 1970s. (See Case Study, pp. 404–405.) Go to SMART GRAPHER to complete graphing activities in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. How did inflation in the 1970s affect people and businesses? See the Case Study on pages 404–405. Facing Economic Challenges 381 S E C T I O N 1 Unemployment in Today’s Economy TA K I N G N O T E S In Section 1, you will • explain how economists measure unemployment • identify the different types of unemployment • discuss the impact that unemployment has on the economy and on individuals unemployment rate, p. 382 underemployed, p. 383 full employment, p. 383 frictional unemployment, p. 384 seasonal unemployment, p. 384 structural unemployment, p. 384 cyclical unemployment, p. 384 As you read Section
1, complete a cluster diagram like the one below to record and organize what you learn about unemployment. Use the Graphic Organizer at Interactive Review @ ClassZone.com Unemployment Measuring Unemployment Measuring Unemployment KEY CONCEPT S In November 2005, General Motors Corporation announced that it would close or scale back about a dozen plants and lay off about 30,000 workers. The impact of a decision like that on the towns where the factories are located can be extensive. Because the unemployed cannot buy as many goods and services as they did when they had a paycheck, other area businesses might decrease output, and they might even lay off some of their own workers. If businesses across the country decide to stop hiring or to cut back, the decreased production might reduce gross domestic product (GDP), the leading measure of a country’s economic health. Economists use unemployment figures to judge the performance of the economy. The measure they use most is the unemployment rate, the percentage of the labor force that is jobless and actively looking for work. Unemployment Job fairs allow people looking for work to meet with many potential employers. The Unemployment Rate The civilian labor force, as you learned in Chapter 9, is made up of people over the age of 16 who are employed or actively looking and available for work. It does not include people in the military or those in schools, prisons, or other institutions. To determine the unemployment rate, the U.S. Bureau of Labor Statistics (BLS) surveys the labor QUICK REFERENCE The unemployment rate is the percentage of the labor force that is jobless and looking for work. 382 Chapter 13 FIGURE 13.1 U. S. UNEMPLOYMENT R ATE 10 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: U.S. Bureau of Labor Statistics Year ANALYZE GRAPHS 1. From 1950 to 2005, when was the unemployment rate the highest? 2. From 1950 to 2005, when was the unemployment rate the lowest? force in 60,000 households each month. Workers over the age of 16 who are not working but are able to work and who have looked for work sometime during the previous four weeks are considered unemployed. The BLS then divides the number of unemployed persons by the total number of workers in the civilian labor force to arrive at the unemployment rate. While very useful, the unemployment rate does not account for discouraged workers who have stopped looking for work. Nor does it count the underemployed, those who work part-time when they want full-time employment or those who work at a job below their skill level. These include recently laid-off workers who may be in a temporary, lower-paying job. Full Employment Despite its name, full employment does not mean a zero unemployment rate. Instead, it means a level of unemployment in which none of the unemployment is caused by decreased economic activity. Even in a healthy economy there is always some level of unemployment. Sometimes people become unemployed when they relocate or when they leave one job to try to find another job that suits them better. Sometimes the available jobs do not match up with the skills of the available workers. In other words, some amount of unemployment is inevitable. Economists generally agree that an unemployment rate of four to six percent indicates full employment in the United States. In other countries, with different labor markets and economic policies, full employment may occur at higher or lower rates of unemployment. AP P LI CATION Explaining an Economic Concept A. Explain why the unemployment rate is based on a country’s civilian labor force, not its entire population. Find an update on the U.S. unemployment rate at ClassZone.com QUICK REFERENCE The underemployed are part-time workers who want to work full-time or people working below their skill level. Full employment means no unemployment caused by decreased economic activity. Facing Economic Challenges 383 Types of Unemployment QUICK REFERENCE Frictional unemployment is temporary unemployment of people changing jobs. Seasonal unemployment is unemployment linked to seasonal work. Structural unemployment is when jobs exist but do not match the skills of available workers. Cyclical unemployment is unemployment caused by a part of the business cycle with decreased economic activity. KEY CONCEPT S Economists pay attention not only to the unemployment statistics, but also to the reasons for unemployment. Economists recognize four types of unemployment: • Frictional unemployment, temporary unemployment experienced by people changing jobs • Seasonal unemployment, unemployment linked to seasonal work • Structural unemployment, a situation where jobs exist but workers looking for work do not have the necessary skills for these jobs • Cyclical unemployment, unemployment caused by a part of the business cycle with decreased economic activity TYPE 1 Frictional Unemployment Frictional unemployment refers to the temporary unemployment of workers moving from one job to another. The frictionally unemployed might include a parent who has spent time at home raising children and decides to move back into the work force; a magazine designer who leaves his job to seek work as a designer at a book publisher; or a recent college graduate who is looking for her first full-time job. Frictional unemployment is a reflection of workers’ freedom to find the work best suited for them at the highest possible wage. Economists consider frictional unemployment normal and not a threat to economic stability. TYPE 2 Seasonal Unemployment Demand for some jobs changes dramatically from season to season, resulting in seasonal unemployment. Demand for construction workers, for example, typically falls in the winter months when construction activities are more difficult. Tourism peaks at certain times of the year, and different regions have different tourist seasons. Migrant farm workers, who move from one area to another following the growing schedules of the crops, are hard hit by seasonal unemployment. The winter months are especially slow, resulting in economic hardship for many migrant families. TYPE 3 Structural Unemployment Structural unemployment results when the available jobs do not match up well with the skills and experience of the available workers. A dynamic economy will often create structural unemployment as businesses become more efficient and require fewer workers to create the same amount of output. There are a number of possible triggers for structural unemployment. New technology can replace human workers or require workers to retrain. New industries requiring specialized education can leave less well-educated workers Seasonal Unemployment Demand for lifeguards is high during the warmer months. 384 Chapter 13 Offshore Outsourcing: Scourge or Boon? Many American workers fear losing their jobs to offshore outsourcing—the contracting of work to suppliers in other countries. But the likelihood of offshore outsourcing varies widely from one occupation to the next. According to a report issued by the McKinsey Global Institute in 2005, about 11 percent of all service jobs in the United States have the potential to be outsourced to another country. Jobs in information technology, engineering, and accounting are much more likely to be outsourced than jobs in health care, retail sales, and other fields that require direct personal interaction. The offshore outsourcing trend has created some structural unemployment, as laid-off workers seek new jobs. But ultimately, it should make the U.S. economy more efficient. The firms that save money by outsourcing will be more competitive. As these businesses grow, they will hire more U.S. workers. Office worker in India For some U.S. workers, outsourcing may offer unique opportunities. India has been so successful in securing business outsourced by other countries that it has a shortage of qualified labor. Because many jobs outsourced to India require workers to be fluent in English or European languages, one study predicts that 120,000 Europeans, Americans, and Australians will be working in India by 2010. CONNECTING ACROSS THE GLOBE 1. Synthesizing Economic Information Explain how outsourcing might change the American economy. 2. Evaluating What career do you want to pursue? Explain whether it has the potential to be outsourced. out of work. A change in consumer demand—from compact discs to computer music files, for example—can shift the type of workers needed. Offshore outsourcing, when jobs once held by Americans are staffed overseas, is another cause of structural unemployment. TYP E 4 Cyclical Unemployment Cyclical unemployment results when the economy hits a low point in the business cycle and employers decide to lay off workers. Workers who lose their jobs during a recession can have trouble finding new jobs because the economy as a whole is scaling back, and the demand for labor declines. When the economy picks up again, many workers are again able to find jobs. The duration of unemployment in these four types ranges widely, but the average duration of unemployment is relatively short. More than a third of the unemployed are out of work for five weeks or less. AP P LI CATION Making Inferences B. If you owned a clothing factory, how would a high rate of unemployment affect your business? Facing Economic Challenges 385 The Impact of Unemployment KEY CONCEPT S Although some unemployment is unavoidable, excessive or persistent unemployment hurts the economy in several ways. It reduces efficiency; it hurts the least economically secure; and it damages workers’ self-confidence. Efficiency Unemployment is inefficient. It wastes human resources, one of the key factors of economic growth. Inequality Unemployment does not follow equal opportunity rules. In an economic slowdown, those with the least experience lose their jobs first—usually minorities and the young (see the graphs below). Also, with fewer jobs available, people on the lowe
r rungs of the employment ladder have less opportunity to advance. Discouraged Workers People who are unemployed—or underemployed—for long periods of time may begin to lose faith in their abilities to get a job that suits their skills. Potentially productive workers may give up their search for work. If they are underemployed, they may not be motivated to do their best work. F I G U R E 13. 2 U N E M P LOY M E N T R AT ES BY AG E F I G U R E 13. 3 U N E M P LOY M E N T R AT ES BY R AC E 16 to 19 years 20 to 24 years 20 18 16 14 12 10 8 6 4 2 0 25 to 34 years 35 to 44 years 45 to 54 years 55 to 64 years 65 and older 20 18 16 14 12 10 8 6 4 2 0 Black Hispanic White Asian Source: U.S. Bureau of Labor Statistics, 2005 data Source: U.S. Bureau of Labor Statistics , 2005 data ANALYZE GRAPHS 1. Which group, either age or race, has the highest rate of unemployment? 2. What happens to the unemployment rate as people get older? 3. If the majority of people aged 65 and older are retired, why is the unemployment rate for that group so low? APPLICATION Writing About Economics C. In 1889, Jane Addams founded the Hull House Association in Chicago to help newly arrived immigrants adjust to the challenges of city life. In 1910, she wrote that “of all the aspects of social misery nothing is so heartbreaking as unemployment.” Write a paragraph explaining the impact of unemployment on immigrants. 386 Chapter 13 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. frictional unemployment structural unemployment b. seasonal unemployment cyclical unemployment 2. Explain how the unemployment rate is calculated. 3. Why are economists interested in the unemployment rate? 4. Name a job that might be affected by structural unemployment. Explain why it might be affected. 5. What is full employment? 6. Using Your Notes Write a brief summary of this section, covering measuring unemployment, types of unemployment, and the impact of unemployment. Refer to your completed cluster diagram. Measuring Unemployment Unemployment Use the Graphic Organizer at Interactive Review @ ClassZone.com . Solving Economic Problems Unemployment insurance provides money to workers who have lost their jobs through no fault of their own. In most states, the insurance is funded entirely by employers. What else might business and government do to help unemployed workers? 8. Analyzing Cause and Effect In June 2005, claims for unemployment insurance in Illinois from construction workers made up about 14 percent of all claims. In December 2005, they made up about 21 percent. Why might more construction workers file for unemployment benefits in December than in June? What type of unemployment best explains the difference? 9. Applying Economic Concepts Give specific examples from the Great Depression of the 1930s of ways in which the widespread unemployment (1) affected efficiency, (2) was distributed unequally, and (3) eroded self-esteem. 10. Challenge Think about the type of career you hope to have when you are finished with your education. Do you think it is more likely or less likely than others to be affected by each of the various types of unemployment? Explain each of your answers. Identifying Types of Unemployment Read the following descriptions of unemployment scenarios. Categorize Economic Information Decide which of the four types of unemployment each scenario describes. • Because of reduced demand, an appliance company temporarily closes one of its factories and lays off workers. • In September, a part-time student at the University of Central Florida in Orlando loses his job at a theme park. • A newspaper journalist leaves her job to make a switch into television journalism. She has been looking for a new job for several months. • A local travel agency has to close down because of the widespread availability of direct online booking options. Challenge Young people are two to three times more likely than older people to be unemployed. Why is this? Facing Economic Challenges 387 S E C T I O N 2 Poverty and Income Distribution TA K I N G N O T E S In Section 2, you will poverty, p. 388 • explain how economists poverty threshold, p. 388 measure poverty • discuss the causes of poverty • describe how economists measure income inequality • identify what antipoverty programs are available poverty rate, p. 389 income distribution, p. 390 income inequality, p. 390 Lorenz curve, p. 391 welfare, p. 392 workfare, p. 393 As you read Section 2, complete a summary chart like the one below to pull together the most important ideas about poverty and income distribution. Use the Graphic Organizer at Interactive Review @ ClassZone.com What Is Poverty? What Is Poverty? KEY CONCEPT S QUICK REFERENCE Poverty is the condition where a person’s income and resources do not allow him or her to achieve a minimum standard of living. Poverty threshold is the minimum income needed to pay for the basic expenses of living. Persistent unemployment sometimes leads to poverty, a situation in which a person lacks the income and resources to achieve a minimum standard of living. This minimum standard varies from country to country because different countries have different ways of life. Someone who herds sheep and lives in a hut would probably be considered poor in the United States. But such a person might be thought to have a comfortable life in some other countries. Because of such disparities, there is no universal standard for what constitutes poverty. The U.S. government has established its own standard for poverty based on income levels. This poverty threshold is the official minimum income needed for the basic necessities of life in the United States. The Poverty Threshold The poverty threshold, also called the poverty line, is the amount of income the government has determined to be necessary for meeting basic expenses. People with incomes below that threshold are considered to live in poverty. The threshold, first formulated in the early 1960s, was calculated by finding the cost of nutritionally sound food and then multiplying by three, on the assumption that food costs are about a third of a person’s expenses. The threshold differs according to the size of the household and is adjusted annually to reflect changing prices. In 2005, the poverty threshold for a family of four in the United States was about $20,000. That same year, the median income for a family of four was over $65,000. 388 Chapter 13 QUICK REFERENCE The poverty rate is the percentage of people living in households that have incomes below the poverty threshold. The Poverty Rate The poverty rate is the percentage of people living in households that have incomes below the poverty threshold. Unlike the unemployment rate, the poverty rate is based on the population as a whole. Through census information, the poverty rate can be estimated for individuals, households, or specific segments of the population, such as African-American children or single-parent households. The overall poverty rate in the United States declined between 1993 and 2000 to a low of 11.3 percent. It began to rise in 2000 and by 2004 had climbed to 12.7 percent, with 37 million people living below the poverty line. (See Figure 13.4.) Poverty, like unemployment, does not hit all sectors of society equally. Children are especially at risk. Children made up more than half of the 1.3 million increase in the number of people living in poverty between 2002 and 2003. The number of families below the poverty line that are headed by a single mother also rose. Minorities and families that live in either an inner city or a rural area tend to have higher than average poverty rates. While the numbers tell the statistical story of poverty, only personal voices can convey the toll of being poor. James Baldwin, an African-American writer born in poverty, wrote that “anyone who has ever struggled with poverty knows how extremely expensive it is to be poor.” FIGURE 13.4 U. S. P OVER T Y R ATE, 1959 –20 0 4 25 20 15 10 Find an update on the U.S. poverty rate at ClassZone.com 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: U.S. Census Bureau ANALYZE GRAPHS 1. From 1959 to 2004, when was the poverty rate the highest? When was it lowest? 2. What decade saw the largest drop in the rate of poverty? AP P LI CATION Drawing Conclusions A. Why is the poverty rate based on the entire population, while the unemployment rate is based on the civilian work force? Facing Economic Challenges 389 The Problem of Poverty KEY CONCEPT S Across the globe, about half of the world’s 6 billion people live in poverty. In the United States, one of the world’s wealthiest countries, almost 40 million people live below the poverty level. Even good economic times, such as the boom that the United States experienced in the 1990s, do little to move large numbers of people out of poverty. Why is an adequate income out of reach for so many people? Factors Affecting Poverty Four major factors have the strongest influence on who lives in poverty in the United States: education, discrimination, demography, and changes in the labor force. Education As you learned in Chapter 9, usually there is a direct relationship between level of education and income: the higher the level of education, the higher the income. In the United States, the poverty rate of people who did not complete high school is 12 times higher than that of people with a college education. Discrimination White males tend to have higher incomes than racial minorities and women, even when there are no differences in education or experience. Certain groups sometimes face wage discrimination or occupational segregation and may find it difficult to move beyond low-paying jobs. Government initiatives, as well as the pressures of the competitive marketplace, have helped to reduce job discrimination. Demographic Trends In the 1950s, about one-fourth of all marriages ended in
divorce. Now, almost half of all marriages end in divorce. Over the same period, births to unmarried mothers jumped from about 5 percent of all births to over 30 percent. Such demographic trends lead to higher poverty rates because single-parent families are more likely to have economic problems than two-parent families. Changes in the Labor Force The shift in the labor force from mainly manufacturing to mainly service industries is one of the changes that affects the distribution of poverty. When manufacturing jobs were plentiful, even relatively low-skilled workers were able to earn a good wage. As the jobs shifted from manufacturing to service, the wages did not always follow. Workers in many service jobs, such as fast-food clerks, tend to earn lower wages than similarly skilled workers in manufacturing. Income Distribution The United States has one of the highest median family incomes in the world, yet millions of Americans live below the poverty line. This disparity is reflected in the country’s income distribution, the way income is divided among people in a nation. All countries have some degree of income inequality, an unequal distribution of income. Unless everyone earns the same amount, there will always be a difference between the incomes of the wealthiest citizens and those of the poorest. Compared to other advanced nations, the United States has relatively high income inequality. However, less advanced countries tend to have the most extreme differences between what the rich earn and what the poor earn. QUICK REFERENCE Income distribution is the way income is divided among people. Income inequality is the unequal distribution of income. 390 Chapter 13 FIGURE 13.5 INCOME DISTRIBUTION IN THE UNITED STATES GROUP 5 GROUP 4 a GROUP 3 GROUP 2 a If income were evenly divided, a line of income equality would result. b The actual income distribution is reflected by the Lorenz curve. c Each point reflects the cumulative income of that cumulative percent of households. b 50.0 GROUP 1 26.8 c 100 80 60 40 20 12.1 3.4 0 20 40 60 80 100 Cumulative percent of households Source: U.S. Census Bureau, 2004 data ANALYZE GRAPHS 1. According to the graph, about how much of the total income in the United States is earned by the lowest 60 percent of households? 2. How would the graph change if the lower groups earned a greater percent of the nation’s total income? A Lorenz curve graphically illustrates the degree of income inequality in a nation. The Lorenz curve in Figure 13.5, for example, plots income distribution in the United States. If income were distributed equally, then 20 percent of the population would receive 20 percent of the income, 40 percent would receive 40 percent, and so on. That distribution would be represented with a diagonal line. However, income is not equally divided. The Lorenz curve in Figure 13.5 shows that the lowest 20 percent of the population (Group 1) receives only about 3.4 percent of the nation’s total income. The lowest 40 percent (Group 2)—which includes the lowest 20 percent plus the next 20 percent—receive about 12.1 percent of the nation’s total income. The more the Lorenz curve dips away from the diagonal line of equality, the greater the level of income inequality. In the United States, the income gap between the lower 80 percent of the population and the top 20 percent grew steadily throughout the late 1900s. In 1970, the richest 20 percent of Americans earned on average 9 times more than the poorest. By 1997, they were earning 15 times more. Households are not stuck in one group. When people gain experience and education, their incomes tend to increase. When they retire or make poor economic decisions, their incomes decrease. AP P LI CATION Applying Economic Concepts B. In 2004, the richest 20 percent of households in the United States received about 50 percent of the nation’s income. Based on that proportion, if $100 was shared among five people, how much would the richest one receive? How much would each of the other four get if they shared the rest equally? QUICK REFERENCE Lorenz curve is a curve that shows the degree of income inequality in a nation. Facing Economic Challenges 391 Antipoverty Programs QUICK REFERENCE Welfare is government economic and social programs that provide assistance to the needy. Food Stamps The food stamp program helps those with low incomes to buy groceries. KEY CONCEPT S In 1964, in his first State of the Union Address, President Lyndon Johnson pledged: “This administration today, here and now, declares unconditional war on poverty in America.” Johnson’s antipoverty programs were among many that the U.S. government has tried in an effort to close the income gap. These programs are often referred to as welfare, government economic and social programs that provide assistance to the needy. Some of these programs, however, have been criticized for wasting government funds and for harming rather than helping the recipients. During the 1980s and 1990s, the government changed its approach, and it now uses tax breaks, grants, job training, and other “self-help” initiatives in addition to cash benefits. Programs for Low-Income Households The national food stamp program, which was established by the Food Stamp Act of 1964, helps ensure that no one will go hungry. Qualifying individuals and families receive electronic benefit transfers, which have replaced the paper food stamps that had been used originally. Recipients are given a card tied to an account into which the government makes monthly deposits of food benefits. The card can be used only to purchase food at grocery stores. Since 1975, the number of food stamp recipients has fluctuated from year to year from about 16 million to about 27 million. In 2005, almost 26 million people participated in the program. The Medicaid program is another antipoverty measure for low-income households. Medicaid offers health care for the poor and is funded by both the federal and state governments. The expense to each state is often as much as 25 percent of the state budget. Medicaid is the only health care coverage for about 40 million Americans, nearly half of them children. Another antipoverty program is the earned-income tax credit. This program provides the working poor a refund of payroll taxes and other taxes deducted from their paychecks. About 21 million people received these credits in 2004. One benefit of the program is that the money refunded to the recipients generally gets spent in their own communities. This spending helps to boost the economies of poor neighborhoods. General Programs The U.S. government’s Social Security program—which pays benefits to retirees, survivors, and the disabled—is the largest government program in the world. In the year 2004 alone, it paid out $500 billion, and that amount is expected to increase as people born during the baby boom after World War II reach retirement age. It was established in 1935 by the Social Security Act. 392 Chapter 13 The Social Security program is funded through a special payroll tax. At retirement, all workers—rich and poor alike—are entitled to monthly checks to help with living expenses. Another payroll tax helps to fund Medicare, a government health insurance program for seniors. Medicare became part of the Social Security program in 1965. These benefits have been key in reducing the number of older Americans in poverty. From 1960 to 1995, the poverty rate of those aged 65 and over fell from about 35 percent to about 10 percent. The Social Security Act also established a system of unemployment insurance administered through state governments. People who lose their jobs through no fault of their own are eligible to receive income while they look for work. Each state administers its own unemployment insurance program. Most of the programs are funded by taxes paid by employers, but in a few states employees contribute too. These benefits, which usually last no more than 26 weeks, help people avoid financial problems while they seek new employment. Other Programs Other antipoverty programs supplement the largest programs. One is the Community Services Block Grant program, which provides blocks of federal money to local communities to address such issues as employment, education, and housing. Job training is another. One such program provides grants to community colleges to develop training for hightech, high-growth jobs. Another way to provide jobs for the unemployed and at the same time boost the economy of a struggling neighborhood is through Empowerment Zones. The government tries to attract businesses to these specially designated neighborhoods by not charging them certain taxes. Businesses that operate in Empowerment Zones provide needed services and offer employment opportunities to area residents. In 1996, the federal welfare program under- Job Training Job training helps unemployed people to learn new skills. went substantial revision in a series of changes often referred to as welfare-to-work. These changes included new incentives for working, which older welfare programs often did not provide. Workfare, for example, is a program that requires welfare recipients to do some kind of work in return for their benefits. Their work provides a useful service and also helps prepare the workers for future jobs. Direct financial aid, now called Temporary Assistance for Needy Families (TANF), now has a limit of five years. QUICK REFERENCE Workfare is a program that requires welfare recipients to do some kind of work. AP P LI CATION Explaining an Economic Concept C. In terms of government spending, what is a fundamental difference between the food stamp program and the Empowerment Zone initiative? Facing Economic Challenges 393 ECO N O M I C S PAC ES E T T E R Hernando de Soto: Another Path out of Poverty Peruvian economist Hernando de Soto has attacked the problem of poverty by redefining it: “The poor . . . are essentially the biggest source of wealth
within [a] country.” According to de Soto, the poor have numerous assets—but in most countries they lack the basic property rights they need to grow economically. “They have houses but not titles; crops, but not deeds; businesses, but not statutes of incorporation.” In short, their wealth is not protected by the rule of law. Prosperity Through Property Rights As a young man, de Soto was struck by the sharp contrast between the poverty in Peru’s shantytowns and the energetic industry of the people. These thoughts led him, in time, to establish the Institute for Liberty and Democracy (ILD), which addresses this contrast in Peru and throughout the world. De Soto estimates that 4 billion of the world’s 6 billion people are shut out of the formal economy. Antiquated and needlessly complex laws make it difficult for these people to gain legal ownership of their homes and businesses, assets that are recognized as theirs in the informal economy. De Soto estimates that the assets of the world’s poor add up to about $10 trillion. He argues that until legal systems change to accommodate the poor, they will continue to prefer to operate in the informal economy—at the cost of lost economic opportunity for everyone. If the resources of the poor could be brought into the formal economy and developed, the wealth they would create could lift struggling nations out of poverty into prosperity. De Soto’s critics point to his non-scholarly Hernando de Soto De Soto developed innovative ideas about the origins of poverty. FAST FACTS Hernando de Soto Title: President and Chief Executive Officer of the Institute for Liberty and Democracy Born: 1941 in Arequipa, Peru Major Accomplishments: Founded Institute for Liberty and Democracy Major Publications: The Other Path (1986); The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (2000) Reputation: “The poor man’s capitalist”—New York Times Magazine One of the “100 most influential people in the world”—Time Magazine Find an update on Hernando de Soto at ClassZone.com approach, but he says that he purposely “closed the books and opened his ears” as he traveled throughout the world listening to the voices of the poor. Former U.S. President Bill Clinton echoed the sentiments of many world leaders when he described de Soto’s ILD as “the most promising antipoverty initiative in the world.” APPLICATION Writing About Economics D. De Soto said: “Capitalism . . . allowed the people that came from humble origins of the world to have economic rights the way only nobility . . . had it before. So capitalism is essentially a tool for poor people to prosper.” Do you agree with that explanation? Write a paragraph to explain your answer. 394 Chapter 13 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. poverty threshold poverty rate b. income distribution income inequality c. welfare workfare 2. Why is it difficult to determine a universal poverty threshold? 3. What groups are especially hard hit by poverty? 4. What four factors help explain the distribution of poverty? 5. What does the Lorenz curve show? 6. Using Your Notes Describe five different antipoverty programs and the problems each combats. Refer to your completed summary chart. What Is Poverty? Use the Graphic Organizer at Interactive Review @ ClassZone.com . Making Inferences and Drawing Conclusions A number of antipoverty programs are targeted specifically at children: • State Children’s Health Insurance Program (SCHIP) provides health insurance to low income children who do not qualify for Medicaid and have no health insurance • National School Lunch Program provides free or reduced price lunches to eligible children • School Breakfast Program provides cash to schools for offering breakfasts to more than 8 million children nationally What are the economic benefits of antipoverty programs aimed at children? 8. Solving Economic Problems Antipoverty programs in the United States are least effective for immigrant families and for non-elderly people without children. Why might this be so? 9. Analyzing Cause and Effect How does the earned income tax credit aid both the working poor and their communities? 10. Challenge In 2005, the poverty threshold for a family of four was an annual income of just over $19,800. Based on this income, devise a monthly budget for a family of four. Assume that no taxes or payroll deductions will reduce the family’s income. Also assume that the family lives in an apartment that costs $700 per month. Provide a detailed account of your estimated allowances for food, clothing, and other expenses. Food aid from the United States and other nations assists those in extreme poverty. Understanding World Poverty Different parts of the world have different levels of poverty. FIGURE 13.6 PERCENT OF POPULATION IN POVERTY Region Percent Sub-Saharan Africa South-Central Asia World China North Africa Latin America / Caribbean Eastern Europe Source: World Bank, 2004 data 75 75 53 47 29 26 14 Analyze and Interpret Data Use the information in the table to answer these questions. 1. The table uses a poverty threshold of living on less than $2 a day. Why doesn’t North America appear? 2. China has a population of about 1.3 billion people. About how many of them, in millions, live in poverty? Challenge Do the same factors that affect poverty in the United States apply to the rest of the world? Facing Economic Challenges 395 S E C T I O N 3 Causes and Consequences of Inflation TA K I N G N O T E S In Section 3, you will inflation, p. 396 • explain how economists consumer price index (CPI), p. 396 measure inflation • identify what causes inflation • describe how inflation affects the economy producer price index (PPI), p. 397 inflation rate, p. 397 hyperinflation, p. 398 deflation, p. 398 demand-pull inflation, p. 399 cost-push inflation, p. 399 wage-price spiral, p. 400 As you read Section 3, complete a cluster diagram like the one below to record what you learn about inflation. Use the Graphic Organizer at Interactive Review @ ClassZone.com Inflation How Is Inflation Measured? What Is Inflation and How Is It Measured? KEY CONCEPT S In 2006, militants attacked many of Nigeria’s oil installations, demanding that more of the country’s oil wealth be shared with the Nigerian people. Before the attacks, Nigeria produced about 2.5 million barrels of oil a day, and the country was the fifth largest source of oil imported by the United States. On news of the attacks, the price of oil rose by almost 20 percent. Some economists predicted that if oil stayed at those price levels, manufacturers might raise the prices of their products to compensate for higher fuel costs. They suggested that the high oil prices might ultimately lead to inflation, a sustained rise in the level of prices generally or a sustained fall in the purchasing power of money. Economists have several instruments for measuring inflation. Consumer Price Index One tool for gauging inflation is the consumer price index (CPI), a measure of changes in the prices of goods and services commonly purchased by consumers. Creating the index requires many different steps, but the following describes the basic process. The U.S. government surveys thousands of people across the country to find out what goods and services they buy on a regular basis. The government then creates a “market basket” of about 400 different QUICK REFERENCE Inflation is a sustained rise in the general price level or a fall in the purchasing power of money. Consumer price index (CPI) is a measure of changes in the prices of goods and services commonly purchased by consumers. 396 Chapter 13 goods and services purchased by a typical household. The basket is adjusted to account for how much of a household’s budget goes to purchase each type of item. For example, families tend to spend more on food than on lawn care, so the market basket is balanced to reflect this. Each month, government workers research the current prices of the items in the market basket. What consumers spend to fill the basket can then be compared to prices in the reference base, which reflects the level of prices in the three years 1982 to 1984. Those numbers are given the value of 100. See the Connect to Math sidebar for more information. Find an update about the U.S. consumer price index at ClassZone.com FIGURE 13.7 U. S. CONSUMER PRICE I NDE X 200 180 160 140 120 100 80 60 40 20 ) 1970 1975 1980 1985 1990 1995 2000 2005 Source: U.S. Bureau of Labor Statistics Year ANALYZE CHARTS 1. If you paid $500 to fill the market basket in 1984, about how much would you pay to fill the basket in 2005? 2. Prices doubled from 1971 to 1980. How long did it take them to double again after 1980? CONNECT TO MATH Suppose the original value of the market basket was $500 and the current year’s value is $550. To determine CPI, you divide the new value by the original value and multiply by 100. The current CPI, then, is 110. $550 / $500 x 100 = 110 Producer Price Index The CPI shows the level of inflation experienced by consumers, but producers also experience inflation. The tool that gauges that kind of inflation is the producer price index (PPI), a measure of changes in wholesale prices. The PPI is constructed in roughly the same way as the CPI, but it reflects the prices producers receive for their goods rather than the prices consumers pay. The difference between consumer prices and producer prices lies in all the additional fees consumers pay, such as sales taxes or shipping charges. Like the CPI, the PPI is tied to a reference base of producer prices. More than 10,000 PPIs for individual products and groups of products are available. The indices are grouped either by stage of production (finished goods, intermediate goods, and raw materials, for example) or by industry. Index changes from period to period are calculated in the same general way as the CPI. Because
producers tend to encounter inflation before consumers, PPI tends to lead CPI as an indicator of inflation. Economists use CPI and PPI to calculate the inflation rate, the rate of change in prices over a set period of time. QUICK REFERENCE Producer price index (PPI) is a measure of changes in wholesale prices. Inflation rate is the rate of change in prices over a set period of time. Facing Economic Challenges 397 M AT 13 . To calculate the rate of inflation, economists evaluate the prices of many different goods. This hypothetical example uses a simplified market basket consisting of prices for milk, bread, and juice. The table shows that the prices of milk and bread increased from Year B to Year C, but the price of juice decreased. To see the general trend in prices, you must look at the total price of the market basket of milk, bread, and juice. The steps below show how to use this simplified market basket to calculate the rate of inflation for Year C. The base year is Year A. Price of a Market Basket Year A Year B Year C $2.50 $2.40 $2.60 1 gallon milk 1 loaf bread $1.00 $1.35 $1.53 1 gallon juice Price of basket CPI, base: Year A $2.00 $2.30 $2.20 $5.50 $6.05 $6.33 100 110 115 Step 1: Calculate each year’s consumer price index (CPI). Price of market basket Price of basket in base year × 100 = CPI Calculations for Year C $6.33 $5.50 × 100 = 115 Step 2: Use the CPI to calculate the rate of inflation. CPI − CPI for preceding year CPI for preceding year × 100 = Rate of Inflation 115 − 110 110 × 100 = 4.5 The rate of inflation in Year C was about 4.5 percent. Choosing a market basket To calculate the rate of inflation, economists use a complicated market basket of hundreds of goods. The market basket is intended to represent the goods that are purchased by a typical urban consumer. Types of Inflation The different types of inflation are defined according to the degree or level of the inflation rate. Rates below 1 percent are negligible, and those between 1 and 3 percent are moderate. If a moderate rate continues over a period of time, the result is creeping inflation. A rapid increase in price level is known as galloping inflation. If galloping inflation gets out of hand, the result is hyperinflation—a rapid, uncontrolled rate of inflation in excess of 50 percent per month. One of the most dramatic episodes of hyperinflation happened in Germany in 1922 and 1923. At the height of the crisis, prices rose at a rate of about 322 percent per month. Deflation, a decrease in the general price level, happens more rarely. The Great Depression of the 1930s in the United States was marked by deflation. APPLICATION Applying Economic Concepts A. If the price of milk goes up, is that inflation? Why or why not? QUICK REFERENCE Hyperinflation is a rapid, uncontrolled rate of inflation in excess of 50 percent per month. Deflation is a decrease in the general price level. 398 Chapter 13 QUICK REFERENCE Demand-pull inflation results when total demand rises faster than the production of goods and services. Cost-push inflation results when increases in the costs of production push up prices. What Causes Inflation? KEY C ONCEPT S Economists generally distinguish between two kinds of inflation, each with a different cause. When the inflationary forces are on the demand side of the economy, the result is demand-pull inflation, a situation where total demand is rising faster than the production of goods and services. When the forces that lead to inflation originate on the supply side of the economy, the result is cost-push inflation, a situation where increases in production costs push up prices. Demand-Pull Inflation In demand-pull inflation, total demand rises faster than the production of goods and services, creating a scarcity that then drives up prices. Suppose, for example, that consumers gain confidence in the economy and decide they want to buy more durable goods—new refrigerators, stoves, second cars, and so on. It takes producers some time to recognize this rise in demand and to gear up for higher production. During this lag period, consumer demand pushes up prices on the currently available goods. Figure 13.9 illustrates how demand-pull inflation happens. As you will learn in Chapter 16, the U.S. government creates and controls money through the Federal Reserve Bank. If the government creates too much money during the lag period before an increase in production makes more goods available, there will be too much money chasing too few goods, and prices will rise. The creation of excess money is the main reason for demand-pull inflation. F I G U R E 13 . 9 Demand-Pull Inflation Consumers demand more of a product Producers are slow to respond Government creates more money Consumers have more money to spend $ 1 0 $ 1 5 Prices rise $ 2 0$ 1 5 Prices rise ANALYZE CHARTS 1. In the first scenario, did the demand curve shift or the supply curve? 2. In the second scenario, which curve shifts when the supply of money increases? Facing Economic Challenges 399 Cost-Push Inflation In cost-push inflation, prices are pushed upward by rising production costs. When production costs increase, producers make less of a profit. If consumer demand is strong, producers may raise their prices in order to maintain their profits. A general trend of rising prices leads to inflation. Cost-push inflation is often the result of supply shocks—sharp increases in prices of raw materials or energy. For example, in 1973 and 1974, many members of the Organization of Petroleum Exporting Countries (OPEC) limited the amount of oil they sold to the United States and other Western countries. The resulting rapid rise in the price of oil led to cost-push inflation. Cost-Push Inﬂ ation Shortages of raw materials or energy can lead to cost-push inﬂ ation. Wages are a large part of the production costs for many goods, so rising wages can lead to cost-push inflation. A wage-price spiral is a cycle in which increased wages lead to higher production costs, which in turn result in higher prices, which then lead to demands for higher wages. You can see the wage-price spiral in motion in Figure 13.10. F I G U R E 13 .10 Wage-Price Spiral Producers raise prices to pay for higher production costs $ $ QUICK REFERENCE A wage-price spiral is a cycle that begins with increased wages, which lead to higher production costs, which in turn result in higher prices, which result in demands for even higher wages. Workers demand a wage increase to pay higher prices Workers receive a wage increase The wage increase drives up the production costs ANALYZE CHARTS 1. Using the cotton industry as an example, explain how the cycle might proceed. Use the cotton workers, cotton growers, textile mills, and other intermediate industries in your explanation. 2. Do employers grant wage increases whenever employees ask for a raise? What economic principles determine wage levels? APPLICATION Categorizing Economic Information B. What type of inflation would result if bad weather hit farmers hard over a long stretch 400 Chapter 13 of time? What Is the Impact of Inflation? KEY C ONCEPT S Since the 1960s, the impact of inflation on the United States economy has been significant. Inflation has raised interest rates, limited the growth of the stock market, forced agricultural bankruptcies, and slowed production. It has also had a huge impact on politics. More than half of those who voted for Ronald Reagan in 1980 said that his promise to stop the long-running inflation of the 1970s was the decisive factor. Inflation is a major challenge to economic stability. For the economy as a whole and for individual consumers, inflation has an especially strong impact on the purchasing power of the dollar and on interest rates. E FFE CT 1 Decreasing Value of the Dollar With inflation, today’s dollar buys less than last year’s. The consumer price index, illustrated in Figure 13.7, shows that the real value of a dollar has declined steadily. The rising index represents the declining value of the dollar. Consider how this declining value affects people who are on a fixed income. Suppose, for example, that your cousin started college with a savings of $10,000 to see him through. He planned to spend $2,500 a year on carefully budgeted expenses. However, because of inflation, each of those dollars bought less each year. To pay for exactly the same things he bought in his freshman year for $2,500, by the time he was a senior he needed $2,750. Inflation had pushed prices up by 10 percent over the four-year period. Senior citizens living on a fixed retirement income—as well as anyone else with a fixed income—are especially vulnerable to the decreasing value of the dollar through inflation. YO U R EC IN FL ATION AND PU RC HA SES Buy now or wait? If condominium prices have skyrocketed, does it make more sense to buy a condo now or to continue renting until the market cools off? ? ▲ Apartment $750 per month ▲ Condominium $200,000 mortgage Facing Economic Challenges 401 Conversely, inflation can help borrowers. With inflation, those who borrow at a fixed rate of interest can repay their debts with dollars that are worth less, making their repayments smaller than they would have been without inflation. Suppose someone borrows $100 at 5 percent interest, promising to pay the lender $105 after a year. If inflation rises at 5 percent, the $105 the borrower pays the lender will have the same purchasing power as the $100 of the original loan. The borrower essentially paid no real interest on the money he borrowed. EFFECT 2 Increasing Interest Rates As prices increase, interest rates also tend to increase. Lenders raise their interest rates to ensure they earn money on their loans despite inflation. Higher interest rates mean that borrowing money becomes more expensive. For example, a $10,000 loan at 10 percent interest to be repaid over the course of five years would have a monthly payment of $212.47. At 5 percent interest, the monthly payme
nt would be only $188.71. At the end of five years, you would have paid over $1,425 more for the loan at the higher rate. When interest rates are high, businesses are less likely to borrow to expand or to make capital improvements. Consumers are less likely to make purchases of high-priced items that they would need to finance. People carrying debt on credit cards have to make higher monthly payments as their rates rise. EFFECT 3 Decreasing Real Returns on Savings Inflation also has a significant effect on savings. People who save at a fixed interest rate get a lower rate of return on their savings. While the interest paid on savings tends to increase during inflationary times, the difference between the rate of return and the rate of inflation still leaves them at a disadvantage. For example, if someone puts $100 in a savings account that pays 5 percent interest per year, they will have $105 at the end of a year. But if the rate of inflation for the year was 10 percent, that $105 will buy only about what $95 bought when they deposited their money. Although they have more dollars, that money will buy less. Inflation, then, can discourage savings, leading more people to make purchases today rather than saving for tomorrow. Inflation is the most commonly used economic term in the popular media, far outpacing the distant second, unemployment. Inflation worries many people, especially those who remember the volatile 1970s. Much of the worry centers on a person’s individual standard of living: Will my wages keep up with rising prices? Will my savings see me through retirement? Fear of inflation has contributed to the shift away from the traditional American belief in saving over consumption. APPLICATION Writing About Economics C. According to opinion polls, most Americans feel inflation is a more serious problem than unemployment. Write a paragraph stating your view on which is more serious. Use convincing reasons and examples. Increasing Interest Rates Higher interest rates make borrowing more expensive. 402 Chapter 13 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. MACROECONOMIC EQUILIBRIUM a. consumer price index producer price index b. hyperinflation deflation c. demand-pull inflation cost-push inflation 2. What are the stages in a wage-price spiral? 3. Use a specific example to explain cost-push inflation. 4. Use a specific example to explain demand-pull inflation P1 AS1 AD1 5. What are three effects of inflation? 6. Using Your Notes If you were a business owner, what decisions might you make on news of a steady rise in inflation? Refer to your completed cluster diagram and provide specific examples. How Is Inflation Measured? Inflation Use the Graphic Organizer at Interactive Review @ ClassZone.com . Analyzing Cause and Effect Why would producers tend to experience inflation before consumers? What type of inflation would the producers experience? 8. Explaining an Economic Concept How does the creation of excess money cause a demand-pull inflation? Refer to Figure 13.9 to help you answer this question. 9. Applying an Economic Concept Imagine that union leaders are meeting with the owners of a steel manufacturer to negotiate a new five-year contract for union employees. Explain how both sides of the union-management negotiation team must take the unpredictability of future inflation into account. 10. Challenge The cost of attending college has been rising faster than the inflation rate, at times twice as fast. For proof, ask your school guidance counselor for a catalog from a private college that shows prices from several years ago. Compare the old prices to the current prices shown on the college website. Calculate the percentage increase for this school. Real GDP Q1 Estimating the Effects of Inflation Suppose that a natural disaster disrupts the production of oil so dramatically that prices for oil and related products double in a short period of time. In this graph of macroeconomic equilibrium, P1 shows the price level before the natural disaster. Draw Aggregate Supply and Demand Curves On your own paper, recreate the graph of macroeconomic equilibrium. Then draw the new aggregate supply curve that would result from the natural disaster scenario, and indicate where P2 would fall. Challenge Explain what will happen to total economic output because of the change in prices. How does the new graph show this? Use ClassZone.com to complete this activity. @ Facing Economic Challenges 403 Case Study Find an update on this Case Study at ClassZone.com The Effects of Inflation in the 1970s Background Periods of high inflation can wreak havoc with a country’s economy. In the 1970s, for example, the United States experienced the biggest and most sustained period of inflation in the country’s history. By 1979, inflation had risen into the “double digits,” that is, to 10 percent per year or higher. The prices of consumer goods—everything from food and gas to cars and houses—rose dramatically. Those on fixed incomes were particularly hard-hit, because as prices rose their limited budgets bought less. What’s the issue? How did inflation affect people and businesses in the 1970s? Study these sources to discover what it was like to live with a high rate of inflation. A. Economic Analysis In the late 1960s, the rate of inflation began rising in many countries. This article explains inflation’s effects on the U.S. economy. The Industrialized World and Inﬂ ation How inflation affected the U.S. economy For the years 1967 through 1978, the U.S. inflation rate averaged 6.1 per cent a year, compared with an average of 2 per cent for the years 1952 through 1967. Even during the 1973–74 recession, unlike most previous recessions, the inflation rate continued at a relatively high rate. In the late 1970s inflation speeded up again, reaching unprecedented levels. Inflation would not be so bad, in the opinion of some economists, if it were accompanied by substantial increases in output and employment. But economic growth in the United States slowed during the highinflation 1970s, bringing on a condition that economists describe as “stagflation.” Another measure of economic health—productivity, or output per worker—also slowed dramatically in [those] years throughout the industrialized world, and in the United States and Great Britain for a time failed to increase at all. For the United States, a country long accustomed to ever-increasing material wealth, the fall-off in economic growth and the constantly eroding value of the dollar were traumatic developments. If the trends continued, the average American could no longer anticipate a constantly rising standard of living. Source: The Search for a New Economic Order, The Ford Foundation, 1982 Thinking Economically Explain how the effects of inflation might be offset by increases in output and employment. 404 Chapter 13 B. Cartoon In this cartoon by Larry Katzman, a father offers an early lesson in economics. Newspaper Editorial Prices rose dramatically during the 1970s. This editorial reflects the anger many consumers felt about the situation. Thinking Economically Which type of inflation does the cartoon reflect? Explain your answer. Protesting Inﬂ ation Consumers grew impatient with the government’s inability to control inflation. Here we are, spending more and getting less, but the [government] economists are optimistic. What makes them so happy? The rate of inflation may have dropped 1 per cent. Just suppose the rate of inflation had gone down from 5 per cent to 4 per cent. . . . To me this is another increase of four cents, and a further shrinkage of my dollar. Obviously this type of economics is good for someone. It certainly isn’t good for me, or my friends, or my relatives. Everyone is complaining, but the experts are satisfied. I have a family of meat eaters. . . . Long ago I discovered a marvelous cut of meat called skirt steak. It used to cost 89 cents a pound. It has inched its way up and has recently taken a leap to $1.59 and overtaken sirloin steak. Chopped meat is now where my skirt steak used to be. . . . Even the lowly onion is no longer cheap. A weekly trip to the supermarket, which in 1969 cost $50, now costs $70. Source: The New York Times, September 29, 1972 Thinking Economically Why might a small decrease in a large rate of inflation satisfy government economists but frustrate consumers? THINKING ECONOMICALLY Synthesizing 1. Name one example from each document that shows how inflation has a negative impact on the economy. 2. Inflation is a general rise in price levels. Are the examples of price increases in documents B and C symptoms of inflation or isolated price increases? 3. Compare the tone of documents A and C. Do economists care as much about inflation as consumers? Explain your answer. Facing Economic Challenges 405 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. consumer price index (CPI) cost-push inflation cyclical unemployment deflation demand-pull inflation frictional unemployment full employment hyperinflation income distribution income inequality inflation inflation rate Lorenz curve poverty poverty rate poverty threshold producer price index (PPI) seasonal unemployment structural unemployment underemployed unemployment rate wage-price spiral welfare workfare There are different types of unemployment. 1 represents workers changing jobs to increase their working satisfaction or to accommodate a move to another region. 2 results from significant changes in the economy and in the way work is done. Even during periods of 3 about 4 to 6 percent of the work force is still unemployed. Nearly 40 million p
eople in the United States have incomes below the 4 , even though the nation has one of the highest median incomes in the world. The poorest receive assistance through 5 . In recent years 6 , which requires an exchange of labor for government benefits, has replaced some direct cash payments. 7 , a rise in the general level of prices, is another economic challenge. To monitor it, government economists developed the 8 , which tracks what consumers pay for a market basket of items, and the 9 , which tracks prices from the producers’ point of view. They monitor the 10 using these indices. 406 Chapter 13 CHAPTER 13 Assessment Unemployment in Today’s Economy (pp. 382–387) 1. What are the four main kinds of unemployment and how do they differ from one another? 2. What are three negative impacts of unemployment? Poverty and Income Distribution (pp. 388–395) 3. Which of the following persons is most likely to live in poverty: a senior citizen, a disabled adult, a college graduate, or a child? Explain your answer with specific facts and reasons. 4. Describe three antipoverty programs you feel are most useful and give reasons for your position. Causes and Consequences of Inflation (pp. 396–405) 5. Describe two causes of inflation. 6. Which consequence of inflation would be the most troublesome to you personally? Explain your answer. A P P LY The table below shows employees laid off from selected industries in 2004. It also shows how many of these jobs were replaced by outsourcing. 7. What type of unemployment is it when an industry lays off workers but outsources their jobs? Name an example from the table. 8. Which industries’ job cuts are probably due to changes in the business cycle? FIGURE 13.11 L AYOFFS AND OUT SOU RC I NG Employees Laid Off Replaced by Outsourcing Industry Mining Apparel Manufacturing Computer and Electronic Products Transportation Equipment Retail Trade 6,123 11,583 14,979 40,634 143,660 Transportation and Warehousing 59,098 Educational Services 1,429 Health Care and Social Assistance 44,212 Source: U.S. Census Bureau, 2004 data 0 4,102 6,481 6,223 5,298 2,090 0 621 . Creating Graphs The population can be divided into five equal groups—or quintiles—according to income. Income mobility means moving from one quintile to another. A study done by the U.S. Treasury Department between 1979 and 1988 showed the following about taxpayers who started out in the lowest quintile: • 14.2 percent of the taxpayers in the bottom quintile in 1979 were still there in 1988 • 20.7 percent had moved to the next higher quintile • 25 percent had moved to the middle quintile • 25.3 percent had moved to the second highest quintile • 14.4 percent of those who started in the lowest quintile had moved into the highest quintile Create a bar graph that illustrates these facts about income mobility in the United States. Use to complete this activity. @ ClassZone.com 10. Analyzing and Interpreting Data What conclusions can you draw about income mobility based on the above data? 11. Analyzing Cause and Effect Think of three possible reasons a person might be able to move from one level of income to another. 12. Explaining an Economic Concept Which antipoverty programs use market forces to achieve their goals? Explain your answer. 13. Analyzing and Interpreting Data Consider the following data: Consumer Price Index: Unemployment Rate: Gross Domestic Product: up by 6 percent up to 7 percent up by 1 percent What’s the economic problem? To correct the problem, which of these measures would you address first and why? 14. Challenge Which economic challenge— unemployment, poverty, or inflation—represents the greatest threat to social stability, in your opinion? Explain your answer with reasons and examples. The Pursuit of Happiness Do you need money to be happy? Since income alone does not tell the whole story of someone’s quality of life, some people think other measures besides income should be used to determine a household’s well-being. Many elements beyond material possessions also affect a person’s quality of life. To better understand the relationship between wealth and happiness, create a quality-of-life threshold by following the steps below. Step 1. As a whole class, discuss the differences between income and quality of life. Step 2. Break into five small groups and devise a quality-of-life threshold, a standard below which a person would be considered seriously impoverished. Step 3. Try to find a measure for each of your criteria. For example, if one standard is “lives in warm climate,” define the temperature range that qualifies as warm. Step 4. Report your criteria to the rest of the class and explain how you would measure each. Step 5. With the whole class, debate the relative merits of each quality-of-life threshold and its measurement. Challenge Write a paragraph explaining how the quality-of-life threshold you developed relates to Hernando de Soto’s ideas about property and prosperity (see page 394). Facing Economic Challenges 407 Macroeconomics U n i t 6 The Role of Government in the Economy Government Spending Government funds pay for national parks such as the Grand Canyon National Park. Government raises the money for such services through taxation. 408 CHAPTER 14 SECTION 1 How Taxes Work SECTION 2 Federal Taxes SECTION 3 Federal Government Spending SECTION 4 State and Local Taxes and Spending CASE STUDY Should Online Sales Be Taxed? Government Revenue and Spending modified free enterprise economy is an economic system, like that of the United States, that includes some government involvement that influences the free enterprise system. C H A P T E R 14 tax is a mandatory payment to a local, state, or national government, while revenue is government income from taxes and other nontax sources AT T E R S Taxes are a part of your everyday life—from the income tax withheld from your paycheck to the sales tax you pay on the snack you bought at the sandwich shop. The revenues raised from these taxes fund programs that are familiar to you. For example, the highways you drive on, the police that protect you, and the parks that you use are all paid for by government revenues. More at ClassZone.com FIGURE 14.3 SHIFTING TAX INCIDENCE Go to ECONOMICS UPDATE for chapter updates and current news on sales taxes on Internet purchases. (See Case Study, pages 440–441.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter S2 S1 D 0 1 2 3 4 5 6 Quantity (thousands) Go to INTERACTIVE REVIEW for concept review and activities. Who pays more of a tax—the consumer or the producer? See Figures 14.3 and 14.4 on page 415. Government Revenue and Spending 409 S E C T I O N 1 How Taxes Work TA K I N G N O T E S In Section 1, you will • explain why the government establishes taxes • identify the principles and structure of taxes • examine the incidence of taxes • describe how taxes affect the economy progressive tax, p. 412 regressive tax, p. 412 incidence of a tax, p. 415 tax incentive, p. 417 tax, p. 410 revenue, p. 410 tax base, p. 412 individual income tax, p. 412 corporate income tax, p. 412 sales tax, p. 412 property tax, p. 412 proportional tax, p. 412 As you read Section 1, complete a cluster diagram, using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Taxes Government Revenue KEY CONCEPT S QUICK REFERENCE A tax is a mandatory payment to a government. Revenue is government income from taxes and other sources. Governments provide certain public goods that generally are not provided by the market, such as street lighting, highways, law enforcement, and the court system. Government also provides aid for people in need. Where does the money come from to pay for such goods and services? The most important source is taxes. A tax is a mandatory payment to a local, state, or national government. Revenue is government income from taxes and nontax sources. Nontax sources include borrowing and lotteries. The rights of government to tax are set down in the U.S. Constitution and in state constitutions. Principles of Taxation When Chelsea started her 20-hour-per-week job at the local library, she expected to receive $120 in her weekly paycheck. However, she was surprised to see that some money was deducted from her pay for various taxes. She wondered why she had to pay these taxes. 091988 AND DEDUCTIONS Economists use certain principles and criteria to evaluate whether or not taxes should be paid and who should pay them. These principles most often are based on the benefits taxpayers receive from taxes and their ability to pay. VACATION ANNUAL SICK OVERTIME COMP DESCRIPTIONS REGULAR 120.00 120.00 HOURS/ UNITS 20 00 CURRENT EARNINGS BEG BAL EARNED USED YTD Hazelmere Public Library END BAL SOC. SEC NUMBER 123 45 6789 DEPARTMENT AQUISITIONS PAY PERIOD WK ENDING 05/06/08 - 05/13/08 DATE DESCRIPTIONS REGULAR MEDIC 401 (K) OTHER DESCRIPTIONS CURRENT FED TAX SOC SEC MEDICARE ST TAX EMPLOYEE NAME CHELSEA SAMPSON 12.00 7.44 1.74 2.40 CHECK NUMBER 091988 CURRENT YTD TAXES AND DEDUCTIONS DESCRIPTIONS FED TAX SOC SEC MEDICARE ST TAX CURRENT 12.00 7.44 1.74 2.40 0 0 0 0 0 0 0 0 YTD 12.00 7.44 1.74 2.40 410 Chapter 14 SPLMNT ADDSCHD GROSS PAY 120.00 120.00 DEDUCTIONS 0 0 NET PAY 96.42 Benefits-Received Principle The benefits-received principle of taxation holds that people who benefit directly from public goods should pay for them in proportion to the amount of benefits received. One example of this principle is the financing of road construction and maintenance through taxes on gasoline. However, it is difficult for governments to assess exactly how much different taxpayers benefit from services like national defense, national parks, local police and fire protection, and public education. Ability-to-Pay Principle The ability-to-pay principle of taxation holds that people should be taxed on their ability to pay, no matter the level of benefits they receive. Acco
rding to this principle, people with higher incomes will pay more than people with lower incomes. The level of benefits received is not a consideration. Yet, income alone might not completely determine someone’s ability to pay taxes. Other questions also arise. For example, should everyone pay the same percentage of income, which still results in wealthier people paying more in taxes, or should those with higher incomes pay a higher percentage of their income in taxes? Criteria for Taxation Tax systems attempt to meet three criteria: equity, simplicity, and efficiency. However, the criteria are sometimes in conflict, and a given tax may not meet all of the criteria equally well. Equity The equity, or fairness, of a tax is established by how uniformly the tax is applied. Equity requires that people in similar situations pay a similar amount of taxes. For example, everyone who buys gasoline pays the same tax, or all people with the same level of income pay the same amount in taxes. In addition, some believe that equity requires that people with higher incomes pay more than people with lower incomes. Simplicity The simplicity of a tax is determined by how easy it is for the taxpayer to understand and how easy it is for the government to collect. In addition, there should be no confusion about the time the tax is due and the amount to be paid. The sales tax, which you’ll read about on the next page, meets the criterion of simplicity. A set percentage of the price of a taxed item is collected every time that item is purchased. Efficiency The efficiency of a tax can be judged by how well the tax achieves the goal of raising revenue for the government with the least cost in terms of administration. From the taxpayers’ viewpoint, tax efficiency can be judged by the amount of effort and expense it takes to pay the tax. Of all the types of taxes levied, the individual income tax—which you’ll learn more about on the next page—best meets the criterion of efficiency. AP P LI CATION Drawing Conclusions A. Businesses and homeowners both benefit from police protection. How does this state- ment show the limitations of the benefits-received principle of taxation? Simplicity One criticism of the U. S. tax code is that it is too complicated. Find an update on taxation at ClassZone.com Government Revenue and Spending 411 Tax Bases and Structures KEY CONCEPT S Government imposes taxes on various forms of income and wealth in order to raise the revenue to provide public goods and various other services. Each type of wealth subject to taxes is called a tax base. The four most common tax bases are individual income, corporate income, sales, and property. Tax Bases Individual income tax is a tax based on an individual’s income from all sources: wages, interest, dividends, and tips. All taxes are ultimately paid from income, but using income as a tax base means that the amount of tax is directly linked to a person’s earnings. For most individuals, income is earned mainly from work in the form of wages or tips. It may also come from savings and investment in the form of interest and dividends. Corporations pay income tax too. Corporate income tax is a tax based on a corporation’s profits. Sales tax is a tax based on the value of designated goods or services at the time of sale. Generally, sales taxes are imposed on a wide range of goods and services. The tax usually is a percentage of the posted price of the good or service and is included in the final price that the buyer pays. The seller then passes the tax revenue collected from customers on to the government that has imposed the tax. Property tax is a tax based on the value of an individual’s or business’s assets, generally real estate. Homeowners and business owners pay property taxes based on the value of their buildings and the land on which the buildings stand. Property tax is generally included in the rents charged by property owners to individuals or businesses that rent the property, whether it is an apartment, an office, a factory, or a retail store. Property tax may also be imposed on other assets such as automobiles. You may have heard references to a particular government’s tax base growing or shrinking. Such statements refer to the amount of wealth that is available to be taxed. If overall personal income rises, the individual income tax base grows. If there are fewer homes or businesses in a certain locality or if their value declines, the property tax base shrinks because there is less wealth for the government to tax. Tax Structures The way in which taxes are imposed on the different tax bases gives rise to three different tax structures. These tax structures are distinguished from one another based on the percentage of income that a particular tax takes. A proportional tax takes the same percentage of income from all taxpayers regardless of income level. A progressive tax places a higher percentage rate of taxation on high-income earners than on low-income earners. A regressive tax takes a larger percentage of income from people with low incomes than from people with high incomes. Proportional Tax A proportional tax is sometimes called a flat tax, because the rate of tax is the same for all taxpayers. For example, all taxpayers in a given country or state might be charged a flat 15 percent tax on their income, no matter how much QUICK REFERENCE A tax base is a form of wealth—such as income, property, goods, or services—that is subject to taxes. Individual income tax is based on an individual’s income from all sources. Corporate income tax is based on a corporation’s profits. Sales tax is based on the value of goods or services at the time of sale. Property tax is based on the value of an individual’s or a business’s assets. A proportional tax takes the same percentage of income from all taxpayers. A progressive tax places a higher percentage rate of taxation on highincome people. A regressive tax takes a larger percentage of income from low-income people. 412 Chapter 14 M AT 14 .1 Understanding a Progressive Tax Step 1: Study the table to the right, which shows income tax brackets for a progressive tax. Each marginal tax rate is applied only to the income in that tax bracket. For example, for a taxable income of $12,000, $10,000 is taxed at 10 percent and the remaining $2,000 is taxed at 15 percent. Income Bracket $0–$10,000 $10,000–$30,000 $30,000–$50,000 Step 2: Assume you have a taxable income of $40,000. The table to the right shows how much of that income is in each tax bracket. Income in Each Bracket $10,000 $20,000 $10,000 Marginal Tax Rate 10% 15% 25% Tax Bracket 10% 15% 25% Step 3: Calculate the marginal tax for the income in each bracket. Add these figures to get the total tax for a taxable of income of $40,000. The total tax on $40,000 of taxable income is $6,500. More Calculations Repeat calculations for taxable incomes of $25,000 and $45,000. Income in bracket Marginal tax rate Marginal tax $10,000 $20,000 $10,000 10% 15% 25% $1,000 $3,000 $2,500 Total tax: $6,500 NEED HELP? Math Handbook, “Understanding Progressive Taxes,” page R7 their income is. An individual who earns $20,000 would pay $3,000 in taxes, and an individual who earns $50,000 would pay $7,500 in taxes. In the United States, some state and local governments have proportional taxes on individual income. For example, the state of Michigan has a flat income tax rate of 3.9 percent, while the state of Massachusetts has a 5.3 percent rate. Similarly, the city of Bowling Green, Ohio, collects a flat rate of 1.92 percent on its residents’ incomes. Progressive Tax As you saw above, even with a proportional tax, the amount of tax increases as income increases. A progressive tax is one in which the tax rate also increases as a person’s income increases. In other words, under a progressive tax structure, a high-income person not only pays more in the amount of taxes but also pays a higher percentage of income in taxes. Figure 14.1 shows how a progressive income tax works. You can see that a progressive tax is most closely linked to the ability-to-pay principle. In the United States, the federal income tax is a progressive tax, because the tax rate increases as income increases. (You’ll learn more about the federal income tax in Section 2.) Many states, including California, Kansas, New York, and South Carolina, also have progressive income taxes. Government Revenue and Spending 413 14 . 2 Three Types of Tax Structures Proportional Tax A proportional tax takes the same percentage of income from all taxpayers, regardless of income level. ?What is the impact of each of the tax structures? Progressive Tax A progressive tax is based on income level. It takes a larger percentage of income from high-income earners and a smaller percentage of income from lowincome earners. Regressive Tax A regressive tax hits low-income earners harder than it hits high-income earners. This is because the proportion of income that goes to taxes falls as income rises. ANALYZE CHARTS Look again at the description of the various tax bases on page 412. Consider which kind of tax structure applies to each of these tax bases. Write a brief paragraph explaining your choices. Regressive Tax With a regressive tax, the percentage of income paid in taxes decreases as income increases. Some taxes are regressive because they are applied to sales, not income. For example, although a sales-tax rate is applied equally to all items subject to the tax, the tax as a percentage of income is regressive. This is because low-income earners tend to spend a higher proportion of income than do high-income earners. Suppose that a state charges 5 percent sales tax on certain goods sold in the state. If the Jones family earns $20,000 and spends $15,000 on taxable goods, they pay $750 in sales taxes (5 percent of $15,000), or 3.75 percent of their income. If the Smith family earns $50,000 and spends $25,000 on taxable goods, they pay $1,250 in sales tax
(5 percent of $25,000), or 2.5 percent of their income. For similar reasons, property taxes on homes are also considered regressive. Lowincome homeowners usually spend a higher percentage of their income on housing than do high-income homeowners. Therefore, property taxes take a higher percentage of their income. In addition, poorer communities often charge a higher tax rate, because the property has a lower value and therefore the property tax base is smaller. Even those who do not own homes are subject to the regressive property tax, because property taxes are generally passed on to renters. Figure 14.2 above shows the impact of each type of tax structure on low-income earners and high-income earners. APPLICATION Comparing and Contrasting B. How do proportional, progressive, and regressive taxes meet the criteria of simplicity 414 Chapter 14 and equity? Who Pays the Tax? KEY C ONCEPT S The impact of a tax can also be measured by who actually pays it. The incidence of a tax is the final burden of that tax. In other words, it is the impact of the tax on a taxpayer. For example, taxes imposed on businesses may get passed on to the consumer in the form of higher prices or rents. To understand this, you need to apply the concepts of supply and demand. QUICK REFERENCE The incidence of a tax is the final burden of the tax. Effect of Elasticity on Taxes Suppose that the government imposes a $1 tax on a product. Demand elasticity influences the incidence of this tax. If a product has elastic demand, the seller pays more of the tax, because the seller faces decreased quantity demanded if prices rise. If the product has inelastic demand, the consumer pays more of the tax in the form of higher prices. The seller recognizes that quantity demanded will go down only slightly for goods or services that have inelastic demand, because they are less pricesensitive. Figures 14.3 and 14.4 illustrate the difference in tax incidence between products with elastic and inelastic demand. FIGURES 14.3 AND 14.4 SHIFTING TAX INCIDENCE FIGURE 14.3 ELASTIC DEMAND AND TAXES FIGURE 14.4 INELASTIC DEMAND AND TAXES ) S2 S1 S2 S1 b D 1 2 3 4 5 6 Quantity (thousands) Quantity (thousands) When a $1 tax is imposed, the supply curve (S1) shifts to the left (S2) by the amount of the tax. a In Figure 14.3, the equilibrium price increases to $3.40, and the seller pays more of the tax. b In Figure 14.4, the equilibrium price rises to $3.80, and the consumer pays more of the tax. ANALYZE GRAPHS 1. In Figure 14.3, how does quantity demanded at equilibrium change? 2. Which producer’s revenues would be least affected by the $1 tax? Use interactive demand elasticity curves at ClassZone.com AP P LI CATION Applying Economic Concepts C. Who would bear the greater incidence of these taxes: a. $1 tax on movie tickets? b. $1 tax on gasoline? Give reasons for your answers. Government Revenue and Spending 415 Impact of Taxes on the Economy KEY CONCEPT S Taxes do more than provide government with the revenue that allows it to provide public goods and other programs. Taxes have an economic impact on resource allocation, productivity and growth, and the economic behavior of individuals and businesses. Government chooses what to tax and how to tax based on the amount of income it wants to raise and the other economic effects it wants to achieve. IMPACT 1 Resource Allocation A tax placed on a good or service will increase the costs of production and therefore shift the supply curve to the left. If the demand remains the same, the price of the good or service will go up. This shift will likely result in a shift in resources. Recall what you learned about tax incidence earlier. If a supplier is not able to pass increased costs along to the consumer in the form of higher prices, the supplier may choose to shift production to another good that will be more profitable. For example, if the government imposed a 10 percent tax on luxury yachts, which have elastic demand, the producer of the yachts would not be able to raise prices enough to cover the full cost of the tax. If it were no longer profitable to sell the yachts because of the extra cost of the tax, the producer might decide to shift resources to producing small fishing boats or go into a different business. IMPACT 2 Productivity and Growth When taxes on interest and dividends are high, people tend to save less than when taxes on this source of income are low. Therefore, taxes also have an impact on the amount of money available to producers to invest in their businesses. Some economists also believe that high taxes reduce incentives to work. They suggest that people may spend more time on activities other than work if a large percentage of their income goes to taxes. Other economists suggest that the underground economy is a result of high taxes. The underground economy refers to jobs, services, and business transactions conducted by word of mouth and, for the most part, paid for in cash to avoid paying taxes. For example, Bob has a part-time landscaping business. He works on the weekends, charges lower prices than larger landscaping companies, and insists that his customers pay him in cash. Since there are no records of Bob’s business transactions, it is difficult for the government to tax his income. 416 Chapter 14 Underground Economy Bob avoids paying taxes on his landscaping business by working on a cash-only basis. QUICK REFERENCE A tax incentive is the use of taxes to influence economic behavior. IMPACT 3 Economic Behavior A tax incentive is the use of taxes to encourage or discourage certain economic behaviors. By providing tax credits or rebates, the government may encourage behavior that it believes is good for the economy and for society. For example, it may give tax rebates to businesses for opening new factories, offices, and stores in economically depressed areas. Or government may give tax credits to consumers for activities such as recycling or using energy more efficiently. The positive tax incentive with the widest impact is perhaps the home mortgage interest deduction, which is designed to encourage home ownership. (You’ll learn more about tax deductions later in this chapter.) So-called sin taxes are often imposed on products or activities considered to be unhealthful or damaging to society, such as gambling, alcohol, and cigarettes. These taxes are generally levied on products or activities for which there is relatively inelastic demand, so that the incidence of the tax will fall on the consumer. Yet because demand for such products is relatively inelastic, the government knows that decline in quantity demanded will not cause tax revenues to decrease dramatically. (Figure 14.5 shows how the quantity demanded of cigarettes changes when states enact higher cigarette taxes.) Demand for sin-tax products becomes somewhat more elastic as tax increases get steeper. For example, cigarette sales in Washington fell by nearly 19 percent in the year after the state imposed a 60-cents-per-pack tax increase in 2002. Even so, since the tax increase was so large, cigarette tax revenues went up by more than 40 percent. FIGURE 14.5 THE EFFECT OF CIGARETTE TAXES ON QUANTITY DEMANDED ) S2 S1 D When a tax is imposed on cigarettes, the supply curve shifts to the left by the amount of the tax. On this graph, a 75-cent tax shifts the supply curve from $3.40 per pack to $4.15 per pack. The increased price results in less demand. 10 20 30 40 50 60 Cigarette packs sold (in millions) ANALYZE GRAPHS 1. How does the quantity demanded of cigarettes change when the price rises from $3.40 to $4.15 per pack? 2. How does this graph illustrate the concept of tax incentives? AP P LI CATION Analyzing Effects D. What effect does the underground economy have on government revenue? Government Revenue and Spending 417 For more information on evaluating sources, see the Skillbuilder Handbook, page R28. Using the Internet for Research The Internet is a powerful tool for researching information. The Web site of the U.S. Treasury Department, for example, provides information on government revenue and spending. RESEARCHING ON THE INTERNET Below is an example of FAQs, or “frequently asked questions.” Use the following tips to help you navigate this and similar Internet Web sites that you might use for research. FAQs are one of several formats that present information on the Web site. Menus often provide links to other areas of the Web site. This is an actual inquiry that was received by the Treasury from a student. Source: U.S. Department of the Treasury T HINKING ECONOMICALLY Using the Internet 1. Why do you think the student used the phrase “taxation without representation”? (If you are unfamiliar with the phrase, use a search engine to research its origin.) 2. How might you navigate this page of the U. S. Department of the Treasury Web site to locate a press release on new tax legislation? 3. Access this Web site and use the FAQs to discover how the Treasury Department answers the question: Why do I have to pay taxes? 418 Chapter 14 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the difference between the terms in each of these pairs. a. tax revenue b. sales tax property tax c. progressive tax regressive tax 2. Why do governments collect taxes? 3. What are the four most used tax bases? 4. How does demand elasticity influence the incidence of a tax? Driver’s license 5. What is the purpose of a tax incentive? 6. Using Your Notes What are the major criteria for a good tax system? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Taxes Evaluating Taxes Review what you have learned about the principles and criteria used to evaluate the effectiveness of a tax, and then complete the following activities. Draw Conclusions Evaluate the effectiveness of each tax listed in the chart below by indicating with a checkmark whether it meets each principle and criterion. 7. Categorizing
Economic Information Colorado has a state Tax Principles Criteria income tax of 4.63 percent on all income and a sales tax of 2.9 percent. Are these taxes proportional, progressive, or regressive? Give reasons for your answers. 8. Drawing Conclusions In 2005, Hurricane Katrina destroyed many homes and businesses along the Gulf Coast of the United States. How did this natural disaster affect the tax bases in communities in that region? 9. Analyzing Effects Where does the burden of an increase in a sin tax usually fall? Illustrate your answer with supply and demand curves. Use @ ClassZone.com to complete this activity. 10. Applying Economic Concepts Demand for insulin is highly inelastic. Would the government be likely to use a tax on insulin as a tax incentive? Why or why not? 11. Challenge Pennsylvania and Illinois each have state income taxes of about 3 percent of income. In Illinois, the first $2,000 of individual income is exempt from taxation. Pennsylvania has no similar individual tax exemptions. Is one state’s tax more progressive than the other? Why or why not? (You’ll learn more about tax exemptions in Section 2.) Fee for driver’s license Sales tax Flat rate income tax Progressive income tax Highway tolls Property tax Corporate income tax Challenge How would you evaluate a tax to support public education that was imposed only on families with children? Government Revenue and Spending 419 S E C T I O N 2 Federal Taxes TA K I N G N O T E S In Section 2, you will withholding, p. 421 • describe the process of paying taxable income, p. 421 individual income taxes • explain taxes for Social Security, Medicare, and unemployment • identify other taxes that are collected by the federal government tax return, p. 421 FICA, p. 423 Social Security, p. 423 Medicare, p. 423 estate tax, p. 425 gift tax, p. 425 excise tax, p. 425 customs duty, p. 425 user fee, p. 425 As you read Section 2, complete a cluster diagram using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Federal Taxes Individual Income Tax KEY CONCEPT S The federal government takes in around $2.5 trillion in revenue each year. This money comes from several sources, including individual income tax, social insurance taxes, corporate income taxes, estate taxes, gift taxes, excise taxes, and customs taxes. The largest source of taxes for the federal government is the individual income tax. (You can see the contribution of the various taxes to total revenue in Figure 14.8 on page 425.) The government began using the income tax after the Sixteenth Amendment to the U.S. Constitution, which recognized this type of direct taxation on individuals, was ratified in 1913. Prior to that time, excise taxes and customs duties were the main sources of federal revenue. (Figure 14.8 shows that today only a very small portion of federal tax revenue comes from excise taxes and customs duties.) Social insurance taxes are the second largest source of federal tax revenue. Workers and employers share the burden of these taxes. EXAMPLE Paying Your Taxes If taxpayers had to pay their income taxes in one lump sum at the end of each year, some people would have difficulty coming up with all the money at once. Also, receiving revenue just once a year would create problems for the government. Drawing up a budget for the year would be very difficult, and developing sound economic plans for the future would be almost 420 Chapter 14 impossible. Therefore, to make it easier for taxpayers and the government, a payroll tax—a tax that is taken from a worker’s paycheck—is collected. The payroll tax is deducted from a paycheck as withholding, or money taken from a worker’s pay before the worker receives it. To see how this works, let’s look at the example of Scott, who works part-time during the school year and full-time during the summer at the Main Street Grocery Store. For every hour Scott works, he earns $6. Because of withholding for taxes, the amount he receives in his paycheck is less than the total amount he earns. In this way, he pays his taxes as he earns income, and the government receives a steady stream of revenue. The Main Street Grocery Store forwards the money withheld from Scott’s paycheck to the Internal Revenue Service (IRS). The IRS is the government agency that collects the money for the federal government and administers the federal tax system. The federal income tax is a progressive tax based on the ability-to-pay principle of taxation. This means that people with higher incomes not only pay more in total taxes but also pay a higher percentage of their income in taxes. The amount owed is based on taxable income, the portion of income subject to taxation. Under federal income tax laws, taxpayers may take certain exemptions and deductions from their total earned income to reduce the amount of their taxable income. Exemptions are allowed for each individual adult and child, so larger families reduce their taxable income by a greater amount than do smaller families. In addition, taxpayers may take a standard deduction or itemize deductions, such as interest paid on a home mortgage, state and local taxes, charitable contributions, and a certain portion of medical expenses. Figure 14.6 below provides information on some of the itemized deductions taken by taxpayers in 2004. Each year, taxpayers must complete a tax return, a form used to report income and taxes owed to various levels of government. The federal tax return shows how much income has been earned, the exemptions being claimed, and how much tax has been paid through withholding. State and local tax returns show similar, but less detailed, information. Taxpayers who have too much tax withheld receive a refund for overpayment. Taxpayers who have not had enough withheld must then pay any additional taxes owed directly to the IRS or to state or local revenue departments. QUICK REFERENCE Withholding is money taken from pay before the worker receives it. Taxable income is the portion of income subject to taxation. A tax return is a form used to report income and taxes owed to government. FIGURE 14.6 SELECTED ITEMIZED DEDUCTIONS ON INDIVIDUAL INCOME TAX RETURNS Deduction Number of Returns Amount Claimed (in $) Interest Paid State and Local Sales and Income Taxes Charitable Contributions Medical and Dental Expenses 37,961,584 44,685,865 40,594,576 9,458,443 Source: Internal Revenue Service, 2004 figures 346.0 billion 217.2 billion 156.2 billion 61.3 billion About 132.4 million individual income tax returns were filed in 2004. Some 46.2 million—or 35 percent—of these returns claimed itemized deductions to taxable income. Total itemized deductions equaled close to $972 billion, or just over $21,000 for each return. ANALYZE GRAPHS 1. Which was the largest deduction taken in terms of the dollar amount claimed? 2. What percentage of total deductions taken in 2004 did state and local sales and income taxes represent? Government Revenue and Spending 421 EXAMPLE Indexing Because the federal income tax is a progressive tax, the tax rate increases as taxable income increases. The level of income that causes someone to pay a higher rate of tax is the dividing point between tax brackets. The tax bracket is identified by the tax rate for that income span. For example, the tax schedule at the bottom of this page shows that in 2006 a single taxpayer with $7,550 or less in taxable income is in the 10 percent tax bracket. Someone with taxable income between $7,550 and $30,650 is in the 15 percent tax bracket, someone with taxable income between $30,650 and $74,200 would be in the 25 percent bracket, and so on. Look again at the tax schedule below. Tax Return Checking your taxable income against the various tax brackets is an important step in completing your tax return. Suppose that Scott has $7,000 in taxable income. He is in the 10 percent bracket and pays 10 percent, or $700, in taxes. If, however, he had $8,000 in taxable income, he would be in the 15 percent tax bracket. He would pay 10 percent on the first $7,550 of his earnings and 15 percent on the remaining $450. His total taxes would be $822.50 ($755 + $67.50) or about 10.3 percent of his income. Indexing is a revision of tax brackets to prevent workers from paying more taxes due to inflation. For example, suppose Scott’s taxable income rises from $8,000 to $8,320—a 4 percent increase—due to inflation. Without indexing, $770 of his income is taxed at the 15 percent rate and he pays $870.50 in taxes, or about 10.5 percent of his income. With indexing, the beginning level of the 15 percent bracket is adjusted by 4 percent to $7, 852. So Scott continues to pay 10.3 percent of his income in taxes. Indexing, therefore, combats the effect of inflation and keeps the rate of taxation relatively constant. APPLICATION Analyzing Effects A. How much of Scott’s income of $8,320 would be taxed at 15 percent if the 10 percent tax bracket were indexed and increased to $7,780? What effect would this have on his overall tax rate? Find an update on tax schedules at ClassZone.com 422 Chapter 14 FICA: Taxes to Ease Hardships KEY C ONCEPT S FICA is the Federal Insurance Contributions Act, a payroll tax that provides coverage for the elderly, the unemployed due to disability, and surviving family members of wage earners who have died. Also known as social insurance, FICA encompasses Social Security and Medicare. Both employees and employers make payments into FICA accounts. Social Security Social Security is a federal program to aid older citizens who have retired, children who have lost a parent or both parents, and people with disabilities. The program began during the Great Depression of the 1930s as a way to help people who were in desperate need of economic assistance. The employer and employee each pay 6.2 percent of the employee’s income up to an annual maximum. In 2006, Social Security tax was applied to $94,200 of earned inco
me. The limit generally rises each year. Medicare Introduced in 1966, Medicare is a national health insurance program for citizens over 65 and certain other groups of people. Employers and employees each pay 1.45 percent of employee income. There is no limit on the amount of income subject to the tax for Medicare. Unemployment Taxes Unemployment compensation is a program funded by federal and state taxes and administered by the states. It provides benefits for a certain period of time to employees who lose their jobs through no fault of their own. Unemployment tax applies to the first $7,000 earned by an employee and, for the most part, is paid only by employers. QUICK REFERENCE FICA is the Federal Insurance Contributions Act. Social Security is a federal program to aid older citizens, children who have lost a parent, and the disabled. Medicare is a national health insurance program mainly for citizens over 65. FICA Accounts As the American population ages, fears are growing that there will not be enough workers to fund FICA. Source: www.CartoonStock.com AP P LI CATION Applying Economic Concepts B. How would the employee portion of total FICA taxes for an individual earning $100,000 be split between Social Security and Medicare? Show your calculations. Government Revenue and Spending 423 Corporate Income and Other Taxes KEY CONCEPT S The federal government collects more than individual income and FICA taxes. It also uses corporate income, estate, gift, and excise taxes, as well as customs duties and user fees, to finance its operations. Corporate Income Taxes As you recall from earlier in this chapter, corporate income tax is tax on corporate profits. This tax is the third largest source of tax revenue for the federal government. Between 1941 and 1968, corporate income tax was the second largest source of revenue. Since that time, however, it has been surpassed by social insurance taxes. As Figure 14.7 shows, corporate income tax receipts have increased in total dollars since the mid-1900s, but have decreased relative both to total federal tax revenues and to the overall size of the economy. Only certain types of corporations are subject to corporate income tax. These corporations are about 8 percent of all businesses that file tax returns. While the tax rate for most corporations is 35 percent of profits, most pay only about 26 percent of their profits in taxes. Like individuals, corporations can deduct certain expenses from their profits to reduce their taxable income. Some of the most important tax breaks for corporations include deductions for investment in buildings, equipment, and research, and rules that benefit multinational corporations. A common criticism of the corporate income tax is that corporate profits are subject to double taxation. Profits are taxed at the corporate level and again at the individual level, since shareholders pay taxes on the income they receive in the form of dividends or capital gains. In recent years, the tax rate on capital gains has decreased in answer to this criticism. FIGURE 14 .7 CORPORATE INCOME TAX RECEIPTS, 1950–2009 Receipts (in millions of $) As Percentage of Total Federal Tax Revenue As Percentage of GDP 1950–59 1960–69 1970–79 1980–89 1990–99 2000–09* 185,406 262,891 437,564 675,358 1,434,246 2,189,162 Source: The Budget of the United States, FY 2007 *Reflects government budget estimates for 2006–2009 27.5 21.3 15.0 9.3 10.5 10.0 4.8 3.8 2.7 1.7 1.9 1.8 ANALYZE GRAPHS 1. What overall trend is shown in the chart? 2. Which decade diverges from this overall trend? How does it differ from the overall trend? 424 Chapter 14 Other Taxes Several miscellaneous taxes provide a small part of total federal revenue, as you can see in Figure 14.8 below. The estate tax is a tax on property that is transferred to others on the death of the owner. Most estates are not subject to this tax, because the government only taxes large estates. In 2006, estates valued at less than $2 million were not subject to this tax. The gift tax is a tax on money or property given by one living person to another. As with the estate tax, there are exemptions to the gifts that are subject to the tax. For the most part, these exemptions allow family members to give money to other family members tax-free. The excise tax is a tax on the production or sale of a specific product, such as gasoline or telephone service. The sin taxes discussed earlier in this chapter are other examples of excise taxes. In general, the government places excise taxes on goods or services for which there is relatively inelastic demand in order to maintain a steady stream of revenue. The customs duty is a tax on goods imported into the United States from another country. Customs duties are basically excise taxes on imports and are also known as tariffs. (You’ll read more about tariffs in Chapter 17.) The user fee is money charged for the use of a good or service. These fees are based on the benefits-received principle of taxation. For example, the federal government charges entrance, parking, and camping fees to visitors to national parks. So the people enjoying the parks the most pay for the benefits provided by the parks. QUICK REFERENCE The estate tax is a tax on property transferred to others on the death of the owner. The gift tax is a tax on assets given by one living person to another. The excise tax is a tax on the production or sale of a specific good or service. Customs duty is a tax on goods imported into the United States. A user fee is money charged for the use of a good or service. FIGURE 14.8 SOURCES OF FEDERAL TAX REVENUE 1% 1% 2% 3% 11% 37% Individual income taxes account for almost half of federal tax revenue. Corporate income taxes contribute about onefourth the revenue of individual income taxes 45% Individual Income Taxes Social Insurance Taxes Corporate Income Taxes Excise Taxes Miscellaneous Receipts Customs Duties Estate and Gift Taxes Source: Budget of the United States Government, estimated figures for 2007 ANALYZE GRAPHS 1. What percentage of federal tax revenue comes from individual income taxes and social insurance taxes combined? 2. If total tax revenue for 2007 is estimated to be about $2.35 trillion, about how much revenue will come from individual income taxes? APPL IC ATION Drawing Conclusions C. There are plans to eliminate the estate tax. Who will benefit most from this? Government Revenue and Spending 425 FAST FACTS Maya MacGuineas Title: President, Committee for a Responsible Federal Budget: Program Director, New American Foundation Born: February 21, 1968 Previous Positions Held: Senior Research Analyst, Brookings Institution; Policy Analyst, Concord Coalition; Researcher, PaineWebber Board Memberships: Common Cause (government watchdog group); Centrists.Org and Third Millennium (nonpartisan policy think tanks) Publications: Articles published in Atlantic Monthly, Boston Globe, New York Times, Washington Post, Los Angeles Times, Financial Times Find an update on Maya MacGuineas at ClassZone.com ECO N O M I C S PAC ES E T T E R Maya MacGuineas: Reforming the Tax System For the most part, tax reform measures of the last few years have involved tinkering with tax rates, exemptions, and deductions. Maya MacGuineas, a tax policy analyst, thinks that it’s time for far more dramatic change—a complete overhaul of the U.S. tax system, in fact. A Tax Revolution? Why does MacGuineas think that such drastic action is needed? The present tax system, she says, is complicated, inefficient, and unfair, and doesn’t raise the revenue to fund all of the government’s programs. The new tax system, she argues, ought to be based on simplicity, efficiency, equity, and responsible budgeting. To this end, MacGuineas suggests that the income tax should be simplified by ending most tax deductions and exemptions. This, she says, would also make the system more equitable, since taxpayers in higher marginal tax brackets gain the greatest benefit from these measures. In part for reasons of efficiency, MacGuineas believes that the corporate income tax should be phased out. She also supports new environmental taxes, a different approach to how the estate tax is levied, and a complete restructuring of the nation’s entitlement programs. Perhaps MacGuineas’s most revolutionary measure involves FICA taxes, which she thinks should be replaced with a progressive consumption tax. Such a tax would be tied to total spending rather than income, with rates rising as spending levels rise. For example, the first $20,000 spent would be tax-free, spending between $20,000 and $50,000 would be taxed at 10 percent, spending between $50,000 and $175,000 would be taxed at 15 percent, and so on. In other words, people who spend more would face progressively higher marginal tax rates. A progressive consumption tax would not only be simpler and fairer, MacGuineas argues, it would also provide tremendous incentives to save. APPLICATION Making Inferences Tax Reform Maya MacGuineas wants to make the tax system more equitable and less complex. D. Should spending on education and housing be exempt from MacGuineas’s consumption tax? Why or why not? 426 Chapter 14 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. taxable income b. FICA tax return Social Security c. estate tax gift tax 2. Why is indexing important to taxpayers? 3. What is the role of the IRS in relationship to federal taxes? 4. How are excise taxes and customs duties similar? How are they different? 5. How are payroll taxes and user fees different? 6. Using Your Notes What two programs are financed by FICA? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Federal Taxes . Analyzing and Interpreting Data In 2005, the 10 percent tax bracket limit was $7,300. In 2006, it increased to $7,550. By what percentage did the tax bracket limit increase? How does this
example illustrate the concept of indexing? 8. Applying Economic Concepts The Social Security tax rate for employees is 6.2 percent, and the Medicare tax rate is 1.45 percent. Are both parts of the FICA tax proportional? Give reasons for your answer. 9. Drawing Conclusions Study these two statements about tax payments for the 2005 tax year: • On average, an individual with $100,000 in taxable income paid about 29.5 percent in combined income and FICA taxes. • On average, an individual with $150,000 in taxable income also paid about 29.5 percent in combined taxes. Why were the combined tax rates the same for these two taxpayers? 10. Challenge Review the data in Figure 14.7. As a share of federal tax revenue and as a share of GDP, by what percentage have corporate income taxes declined between the 1950s and the first decade of the 21st century? Analyzing Tax Schedules The IRS provides tax schedules, or tables, to help taxpayers calculate their taxes. Calculate Taxes Suppose that you work for a tax preparation company. Use the tax schedule on page 422 to answer the questions about the taxpayers described below. a. Chris has $8,500 in taxable income. What is her tax bracket, how much tax does she pay, and what is her actual tax rate? b. Miguel earned $35,000 in taxable income this year. How much more does he pay in taxes than if he had earned $30,000? c. Meredith had $125,000 in taxable income and had $30,000 in taxes withheld. Will she receive a refund or owe money? How much? Challenge Calculate the FICA taxes and tax rates for each of the above taxpayers. 427 S E C T I O N 3 Federal Government Spending TA K I N G N O T E S In Section 3, you will • compare the two types of government expenditures • explain how the federal budget is developed • describe how government payments are made • identify the impact that federal spending has on the economy mandatory spending, p. 428 discretionary spending, p. 428 entitlements, p. 428 Medicaid, p. 429 federal budget, p. 431 fiscal year, p. 431 appropriations, p. 431 transfer payments, p. 432 grant-in-aid, p. 432 private sector, p. 432 As you read Section 3, complete a hierarchy diagram to track main ideas and details. Use the Graphic Organizer at Interactive Review @ ClassZone.com Federal Spending main idea main idea details details Federal Expenditures KEY CONCEPT S QUICK REFERENCE Mandatory spending is required by law. Discretionary spending has to be authorized each year. Entitlements are social welfare programs with specific requirements. As you have seen, the federal government takes in a huge amount of money in taxes. The programs and services the federal government funds with this revenue are divided into two categories. These are mandatory spending, or spending that is required by current law, and discretionary spending, or spending that the government must authorize each year. For example, the law requires that the government spend money to fund the Social Security and Medicare programs. However, the federal government can decide to fund or not fund highway construction or maintenance of national parks. The federal government, then, has certain expenses that must be paid under current law, while other expenses are covered with what is left after those required expenses have been met. TYPE 1 Mandatory Spending Mandatory spending makes up well over half of all federal spending. Most of this spending is in the form of entitlements, which are social welfare programs with specific requirements. Social Security and Medicare are entitlement programs that provide payments to anyone who is eligible based on age or disability. Many Medicare About 42 million Americans are enrolled in the Medicare program. 428 Chapter 14 of these programs are not “means tested.” In other words, anyone who meets the eligibility requirements receives the benefits, regardless of income level. For some other programs, however, income level is part of the requirement. Social Security The Social Security program takes the largest amount of federal spending. It provides benefits to older retired workers, disabled workers with limited incomes, and survivors of workers who have died. Social Security is financed through a payroll tax. Therefore, workers must have worked for a certain period of time before they are eligible to receive full benefits under the program. As the population of the United States has gotten older and more people have retired, costs for Social Security have increased. To help control costs, the government has gradually raised the age of full retirement—the point at which a worker is eligible to receive maximum benefits. Full retirement age ranges from 65 to 67, depending on the person’s year of birth. Retirement benefits are not means tested. However, if retirees have additional income, benefits may be subject to withholding. For example, in 2006 retirees could earn $1,040 a month and still receive full Social Security benefits. However, retirees who earned more than this amount had their benefits reduced by $1 for every $3 over the income limit. Medicare The Medicare program was introduced in 1966 as an additional old-age benefit under Social Security. Originally, Medicare provided hospital insurance, funded by a payroll tax, for people over 65, as well as optional medical coverage for items such as doctor bills. This part of Medicare is funded by premiums paid by those choosing the coverage and by general tax revenues. Because of increasing numbers of retirees and increasing health care costs, Medicare costs have risen dramatically since the program began. Beginning in 2006, reforms to the program required Medicare to compete with private health insurance providers. Means testing was added for all but the lowest-income group of senior citizens. In addition, some coverage was added for prescription drugs. Medicaid Established at the same time as Medicare, Medicaid is a joint federal-state medical insurance program for low-income people. The federal government funds about 63 percent of the costs of the program, and the states pay about 37 percent. In recent years, states have tightened their eligibility requirements for Medicaid in an effort to control costs. Find an update on Social Security at ClassZone.com QUICK REFERENCE Medicaid is a government medical insurance program for low-income people. Other Mandatory Spending Programs There are a variety of other mandatory spending programs that define eligibility requirements and are then funded based on an estimate of how many people meet those requirements. The Food Stamp program provides funds for about 26 million low-income people to purchase food. Veterans’ benefits include health care coverage and disability payments for service-related illness or injury. People who have served in the military are also eligible for education assistance. The federal government spends about $50 billion a year on veterans’ benefits. Payments for the federal portion of unemployment insurance are also part of mandatory spending. In addition, the federal government pays its workers some retirement benefits. Federal employees hired after 1983 are also eligible for some Social Security retirement benefits. Services for Veterans The Veterans Administration serves the needs and represents the interests of some 26 million veterans and their dependents. 429 TYPE 2 Discretionary Spending More than one-third of federal revenue is devoted to discretionary spending. The programs covered by discretionary spending fall into several different categories. These categories include • interstate highway system and transportation programs, such as Amtrak; • natural resources and the environment, including conservation programs, pollu- tion clean-up, and national parks; • education, most notably college tuition assistance; • science, space, technology, and other research programs; • justice administration, including enforcement agencies, such as the Federal Bureau of Investigation (FBI), and the federal court system. The largest discretionary expenditure category, however, is national defense, which takes up about 50 percent of the total discretionary budget. National defense includes a large amount of the nation’s military spending, including the salaries of military personnel, weapons, and the construction and maintenance of military bases. Not all national defense spending is discretionary. Some spending on homeland security—border protection and the enforcement of some immigration laws, for example—falls in the mandatory expenditures category. In addition, certain military spending, such as additional funding requests for the wars in Iraq and Afghanistan, is outside the basic federal budget. YO U R EC DISC RETIONARY SPENDING How will you assign discretionary spending funds? Two programs are competing for $100 million in discretionary funds—an initiative to improve math and science education in high schools and a research project to test new developments in toy safety. How will you advise officials to assign the funds and why? ? Safer toys Math class APPLICATION Categorizing Economic Information A. Categorize the following items as either mandatory spending or discretionary spending: AIDS prevention programs, air traffic regulation, medical coverage for lowincome people, pollution control, retirement benefits for older workers. 430 Chapter 14 The Federal Budget and Spending KEY C ONCEPT S Each year the President and Congress work together to establish the federal budget, a plan for spending federal tax money. The budget is prepared for a fiscal year, a 12-month period for which an organization plans its expenditures. The federal government’s fiscal year runs from October 1 through September 30. The President’s budget is prepared by the Office of Management and Budget (OMB) and takes into account estimated tax receipts and requests by all federal departments and agencies. Figure 14.9 shows the OMB budget estimate for fiscal year 2007. Congress Acts on the Budget Th
e Congressional Budget Office helps the House and Senate develop guidelines for different appropriations, which are set amounts of money set aside for specific purposes. Members of Congress often make deals to gain votes for appropriations that they support. Congress votes on the final budget and sends it to the president for approval. If the budget is not approved by the beginning of the new fiscal year, Congress passes resolutions to keep the government running on a day-to-day basis. Methods of Federal Spending After budget approval, the funds are spent in several ways. One way is direct spending, by which the government buys goods and services that it needs to operate, such as military equipment and office supplies. Paying the salaries of government QUICK REFERENCE The federal budget is a plan for spending federal tax money. A fiscal year is a 12-month period for which an organization plans its expenditures. Appropriations are specific amounts of money set aside for specific purposes. FIGURE 14.9 THE FEDERAL BUDGET a 9% 3% 21% 10% b 11% c 14% 15% Source: The Budget of the United States, FY 2007 Social Security National Defense Medicare Income Security 17% Health Net Interest Other Education a This category includes spending for veterans’ benefits, energy, the environment, transportation, and other government programs. b Net interest is the interest that the federal government pays on loans it has taken out. c Income security includes retirement for certain government employees and housing and food programs for lowincome people. ANALYZE GRAPHS 1. What is the largest category of spending in the federal budget? 2. Approximately how much of the federal budget goes to health and education? Government Revenue and Spending 431 QUICK REFERENCE Transfer payments are money distributed to individuals who do not provide anything in return. A grant-in-aid is a transfer payment from the federal government to state or local governments. The private sector is the part of the economy owned by individuals or businesses. employees is another type of direct spending. A second way the government spends the money is through transfer payments—money distributed to individuals who do not provide goods or services in return. A grant-in-aid is a transfer payment from the federal government to state or local governments. Transfer Payments These payments are generally part of the mandatory spending you learned about earlier. For example, Social Security retirement or disability benefits and health care benefits from Medicare or veterans’ programs are transfer payments from the government to individuals. The individuals do not provide specific goods or services in exchange for these government funds. Grants-in–aid These grants are transfer payments between levels of government. The federal government makes grants to states, local governments, and regions. The grants are designated for specific categories of activities such as highway construction, certain school services, or Medicaid funding. The Impact of Federal Spending Because the federal government spends trillions of dollars, it is a big factor in the economy. The federal government influences the economy in three ways: resource allocation, income redistribution, and competition with the private sector, which is that part of the economy owned by individuals or businesses. Resource Allocation The federal government makes choices concerning where to spend money and on what to spend it, and that influences how resources are allocated. For example, if money goes to urban transit, it cannot go to fix rural roads. Similarly, money spent on weapons systems for the military cannot be spent on some other program, such as environmental protection. Income Redistribution Government spending affects the incomes of families, individuals, and businesses. Transfer payments for health care, retirement, and Food Stamp benefits, for example, provide income support for many low-income earners. How the government awards work contracts can also influence the distribution of income. For example, if the government awards a contract to build several submarines to a shipyard in the Northeast, workers there will be assured work and an income. However, workers at a California shipyard that failed to get the contract may lose their jobs. In turn, they will not have income to spend at local businesses. Competition with the Private Sector The government may produce goods or services that are also produced in the private sector. Examples include veterans’ hospitals that compete with privately owned hospitals, or federal housing that competes with homes and apartments provided by private developers and landlords. Government Contracts A government contract, such as one to build submarines, has a huge impact on local, state, and regional economies. APPLICATION Drawing Conclusions B. How are transfer payments related to income redistribution? 432 Chapter 14 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. mandatory spending entitlement b. federal budget fiscal year c. transfer payment grant-in-aid 2. What is the difference between mandatory spending and discretionary spending? 3. Why is Medicaid an example of an entitlement program? 4. What does Congress do when it decides on appropriations? 5. How does the government compete with the private sector? 6. Using Your Notes How is the federal budget established? Refer to your completed hierarchy diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Federal Spending main idea main idea details details . Making Inferences Between 2007 and 2009, spending on Social Security is projected to remain at 21.5 percent of the federal budget, while spending on education is projected to decline from 3.4 percent to 3.1 percent of the budget. How does this show the difference between mandatory and discretionary spending? 8. Categorizing Economic Information Categorize each of these examples of federal spending as direct spending, transfer payment, or grant-in-aid: • computers for IRS • money for urban • disability benefits • flood control in Gulf Coast region • highway funds for states housing • price supports for farmers • repair of space shuttle • salaries for national • medical care for elderly park rangers 9. Challenge Molly’s grandmother was born in 1943. If she retires in 2005, she’ll receive $750 per month in Social Security benefits. If she waits until 2009, she will receive $1,000, and if she waits until 2010, her monthly benefit increases to $1,080. Why do you think Congress structured the Social Security benefit payments program in this way? Military base entrance Studying Economic Impact Consider what you have learned about the impact of federal spending on the economy. The chart below shows information on the impact of a hypothetical military base on an area’s economy. Direct military base employment Additional related jobs Payments to private health care providers Contracts for goods and services State and local taxes 27,400 jobs, $1 billion payroll 19,500 jobs, $800 million payroll $19 million $115 million $102.8 million Analyze Data Study the chart to answer these questions: • What is the total number of jobs attributable to the military base? • How much does the base spend on health care? Challenge Write a summary of the economic impact of the military base. Government Revenue and Spending 433 S E C T I O N 4 State and Local Taxes and Spending TA K I N G N O T E S In Section 4, you will • identify the major sources of revenue for both state and local governments • examine the concept of a balanced budget • describe the major categories of state and local expenditures balanced budget, p. 436 operating budget, p. 436 capital budget, p. 436 tax assessor, p. 437 As you read Section 4, complete a chart using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com State Government Local Government Revenue Spending Revenue Spending State Revenues KEY CONCEPT S As you recall from earlier in this chapter, all levels of government may impose taxes to raise revenue to support their activities. The federal government has the broadest tax base, while the smallest tax base is at the local level. There are thousands of local governmental units, from towns, cities, and counties to districts set up to handle a specific problem such as mosquito control or sewage treatment. State revenues come from a variety of sources, the largest of which is intergovernmental revenue, mostly grants-in-aid from the federal government. States also raise funds from state sales taxes and from state income tax, both on individuals and on corporations. (See Figure 14.11 on page 437.) TYPE 1 Sales and Excise Taxes All states except Alaska, Delaware, New Hampshire, Montana, and Oregon levy a state sales tax. Rates range from 2.9 percent in Colorado to 7.25 percent in California. These taxes generally are applied to most goods and services sold within the state. However, many states exempt food and prescription drugs from sales tax. Some other states tax these goods, over-the-counter drugs, and certain other medical supplies at a lower rate. In addition, charitable, religious, and educational organizations are often exempt from paying sales taxes. All states also have excise taxes on cigarettes, alcohol, gasoline, and diesel fuel. Certain government organizations, volunteer fire-fighting companies, and farmers may be exempt from fuel taxes. Many states also have special sales taxes that mostly affect tourists, such as taxes on car rentals and hotel and motel room rates. Find an update on state sales taxes at ClassZone.com 434 Chapter 14 T YPE 2 Income Tax and Other Revenue Sources Income taxes account for some 16 percent of states’ total revenue. Most states levy taxes on both individual and corporate income. However, Alaska, Florida, and Texas have no in
dividual income tax. And Nevada, South Dakota, Washington, and Wyoming levy neither individual nor corporate income taxes. Most states have progressive tax rates on individual income and flat tax rates on corporate income. Individual income tax rates range from a low of 0.36 percent for the lowest tax bracket in Iowa to 9.5 percent for the highest tax bracket in Vermont. Figure 14.10 below compares average individual income tax rates and sales tax rates for several states. FIGURE 14.10 COMPARING STATE TAXES California Colorado No Tax Florida Illinois New York Ohio No Tax Texas Key: Average Individual Income Tax Rate Sales Tax Rate Individual income tax rates for California, New York, and Ohio are averages of lowest and highest brackets. Colorado and Illinois have a flat rate income tax. Florida and Texas have no state income tax. Source: Federation of Tax Administrators ANALYZE GRAPHS 1. Which state has the highest income tax rate? Which has the highest sales tax rate? 2. Which state has the heaviest tax burden? The average state corporate tax rate is about 6.8 percent, ranging from a low of 1 percent for the lowest brackets in Alaska and Arkansas to Pennsylvania’s flat rate of 9.99 percent. Many state governments structure their corporate tax rates to attract businesses to the state. These governments have used billions of dollars in tax cuts and incentives for businesses to promote economic development. However, states receive benefits from these tax practices in the increased economic activity that development brings. States also raise revenue from several other sources. Many of these sources, including estate taxes and user fees, are the same as those used by the federal government. (See Figure 14.8 on page 425.) Most states also levy property taxes. In addition, most states charge several fees related to business operations. These include registration fees for certain types of businesses and license fees for doctors, dentists, lawyers, and accountants. AP P LI CATION Comparing Economic Information A. How do state income tax rates compare to federal income tax rates? Government Revenue and Spending 435 QUICK REFERENCE A balanced budget requires that total government revenue is equal to total government spending. An operating budget is a plan for day-to-day expenses. A capital budget is a plan for major expenses or investments. State Budgets and Spending KEY CONCEPT S All states except Vermont are required to have a balanced budget, in which total government revenue from all sources is equal to total government spending. However, balanced-budget requirements usually apply only to certain kinds of spending. Further, nearly every state has a reserve fund or may run a surplus, both of which can be used to balance the budget in subsequent years. State Budgets States actually work with two types of budgets—an operating budget, a plan for day-to-day expenses, and a capital budget, a plan for major expenses or investments. The operating budget generally covers expenses that occur each year, such as salaries for state government employees, payments for health and welfare benefits, and funds for education systems. Capital budgets provide funds for large construction and maintenance projects on state buildings, roads, and bridges, as well as for land acquisition for state construction needs or state parks. Usually, operating budgets are subject to balanced-budget requirements. Capital budgets are not, because they are usually funded through borrowing. In fact, capital budgets often are run at a deficit, meaning that more is spent than is collected in revenues. State Expenses Education is a major expense for the states, which not only support community colleges and state university systems but also provide assistance to local school districts. For example, state assistance accounted for about 49 percent of public school funding in 2002. Public safety, too, is a significant state expense. Spending on public safety includes state police, crime labs, and prisons and other correctional facilities. States also support a court system. Public welfare expenses involve funds for staterun hospitals as well as cash assistance and medical care payments to the needy. States also fund programs that help citizens with problems related to housing, disability, unemployment, and job training. Other expenses include state government administration, retirement funds for state employees, natural resources, and economic development. Deficit Spending Both federal and state governments practice deﬁ cit spending—spending more than they collect in revenues—to cover their expenses. APPLICATION Categorizing B. Would a grant to a city to build a new sewage treatment plant be part of the city’s operating budget or capital budget? 436 Chapter 14 Local Revenue and Spending KEY C ONCEPT S Local government units include counties, cities, towns, villages, townships, school districts, and other special districts. They have fewer options for raising revenue than do other levels of government. Their major revenue sources are intergovernmental revenue—or transfers—from state and federal governments and property taxes. Local governments also tap other sources, many of which are similar to the state tax base. Figure 14.11 shows revenue sources for state and local governments. Property Tax Recall that you read about property tax in the first section of the chapter. This tax can be levied on real estate and on personal property such as motor vehicles, boats, expensive jewelry, or computers. Local governments rely on a tax assessor, a government official who determines the value of the property. They then enact a tax based on a percentage of the property’s value. Other Taxes Local governments also use sales taxes, sin taxes on activities such as gambling, hospitality taxes on hotels and restaurants, entertainment taxes on tickets or entrance fees, and payroll taxes. The local payroll tax is a tax on people who work in a city but live outside the city. Such a tax is often used in large metropolitan areas where workers from the suburbs benefit from city services such as police and fire protection. F I G U R E 14 .11 S O U RC ES O F S TAT E A N D LO C A L G OV State Government Revenue Local Government Revenue QUICK REFERENCE A tax assessor determines the value of property. less than 1% 2% 6% 34% 25% 1% 2% 14% 21% 37% Intergovernmental revenue Property tax Sales and excise taxes Individual income tax Corporate income tax Other Source: U.S. Census Bureau, figures for 2002–2003 28% 30% ANALYZE GRAPHS 1. What are the two largest sources of revenue for both state and local governments? 2. Which type of government gets a larger percentage of its revenue from sales and excise taxes? Government Revenue and Spending 437 Local Spending Local governments provide most of the direct services that citizens receive. To deliver these services, local governments employ almost three times the number of workers as state governments do. Some of the most important areas of local spending are described below. Public Schools Local governments have the main responsibility for elementary and secondary schools. About 46 percent of local government spending goes to education. Government funds pay for construction and maintenance of school buildings, salaries for teachers, administrators, and other personnel, as well as for items such as textbooks and computers. Reliance on the property tax has led to difficulties for many local governments, since communities with lower property values have smaller tax bases to finance education. Public Safety Local governments provide police and fire protection to secure lives and property in their communities. They are also responsible for emergency medical equipment and personnel to provide on-site treatment and transportation to medical facilities. Local governments maintain the 911 emergency telephone number system. Other expenditures in this category include animal control, consumer protection, and preparation for and response to natural disasters. Public Welfare Local governments spend less than state governments on direct payments for medical care and assistance to the needy. However, many local governments maintain public health departments, and some own and operate their own hospitals. Local health departments are concerned with immunization programs, environmental health, and maintaining birth and death records. They also are responsible for making sure that restaurants meet health standards. Public Safety Ensuring the safety of life and property in the community—by providing ﬁ re protection, for example—is the responsibility of local government. Other Responsibilities Local governments also have primary responsibility for providing most public utilities such as water, public transit, sewage systems, and trash removal. They maintain local highways, roads, and streets, including traffic control lights and signs, snow removal, and pothole repair. Finally, local governments provide many kinds of recreational and cultural facilities including parks, recreation centers, swimming pools, and libraries. APPLICATION Drawing Conclusions B. Why do local governments rely more on property taxes as a source of revenue than do 438 Chapter 14 state governments? S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. Use each of the three terms below in a sentence that illustrates the meaning of the term. a. balanced budget b. capital budget c. tax assessor 2. What is the difference between an operating budget and a capital budget? 3. How is an operating budget related to a balanced budget? 4. What is the largest revenue source for state governments? What is the largest source for local governments? 5. Why do local governments need tax assessors? State Government Local Government Revenue Spending Revenue Spending 6. Using Your Notes What kinds of education do state and local governments spend money on? Refer to your completed chart. Use the Graphic Organizer at In
teractive Review @ ClassZone.com . Comparing and Contrasting What are the similarities and differences in the sources of revenue for state and local governments? 8. Analyzing Effects Which level of government would be most affected if the federal government decided to limit the amount of money that it spent on the Medicaid program? Give reasons for your answer. 9. Making Inferences Voters in your city must decide whether to raise revenue by increasing the rate of property tax for owners of homes and businesses or by placing a new tax on motel and hotel room rates and car rentals. Which tax are voters more likely to choose? Give reasons for your answer. 10. Challenge Between 1992 and 2002, average state funding for public schools increased from 46 percent of all state expenditures to 49 percent of all state expenditures. At the same time, local government funding of public schools decreased from 47 percent to 43 percent. Why do you think the source of school funding has changed in this way? School board meeting Using a Decision Making Process Suppose that you are on a local school board. Total budget for the school district is $25,000,000. The chart below lists the items to be funded out of this budget. Priority Spending Category Administrative salaries Classroom computers School lunch program Special education programs Teacher salaries Textbooks and other instructional materials Utilities Decide on Funding Priorities Use a decision-making process to decide how to allocate the budget. Complete the chart by ranking the items from 1 to 7, from most important to least important. Challenge Based on your priorities, allocate a percentage of the budget to each category. 439 Case Study Find an update on this Case Study at ClassZone.com Should Online Sales Be Taxed? Background In 1992 the Supreme Court upheld a law making Internet retailers exempt from collecting most sales taxes. The ruling was based on the fact that, at the time, the various state and local rules for tax collection varied widely. The differing rules would have placed a heavy burden on Internet retailers charged with having to collect taxes on what they sold. Today, however, tax collection is becoming simpler and more streamlined. In addition, Internet purchases have become commonplace, with shoppers buying everything from computers to airplane tickets. Many online shoppers fail to realize that they are required to pay sales tax for Internet purchases at their home state’s rate. To date, most states have tried to collect Internet sales tax on a voluntary basis. Needless to say, results have been poor. Given this and other considerations, Internet sales tax once again is a subject for debate. What’s the issue? Should there be sales tax on Internet purchases? Study these sources to discover arguments for and against taxing purchases online. A. Online News Story This news story on whether to impose the “iPod tax”—a tax on digital products—illustrates the differences of opinion on online sales tax. Entertainment Lovers May Soon Pay Tax on Downloads Wisconsin governor and legislators disagree over “iPod” tax. Wisconsin Gov. Jim Doyle now wants his state to start collecting taxes on digital music, videos and software. Key Republicans in the GOP-dominated legislature say they will block the proposal, but administration officials say they’re just trying to make things fair. “It’s an issue of tax equity,” said Jessica Iverson, a spokeswoman for the Wisconsin Department of Revenue. “If you go into a Main Street business and purchase a CD, you are paying tax. . . .” Economists are split . . . as to whether adding these kinds of taxes is a good idea. Some say that taxes on digital goods will hamper the growth of a potentially vibrant new marketplace, while others say that having taxes only on offline versions of the same goods distorts the operation of free markets. Source: News.com, March 10, 2005 Thinking Economically What do you think economists mean when they say that taxing only offline versions of the same goods “distorts the operation of free markets”? 440 Chapter 14 B. Graph This graph shows the growth of online purchases during the 2000s. F I G U R E 14 .12 U. S. O N L I N E P U RC H A SES ) 90 80 70 60 50 40 30 20 10 0 87.8 70.7 56.5 44.8 34.4 27.6 2000 2001 2002 2003 2004 2005 Source: U.S. Census Bureau Thinking Economically How might state and local governments use the information in the graph to support their demand to levy sales taxes on online purchases? C. Newspaper Editorial Some states are becoming proactive in their efforts to promote Internet sales tax. This newspaper editorial describes one multistate project to facilitate the collection of the tax. Internet Sales Tax Eighteen states agree to establish uniform sales tax rules. Last week, 18 state tax collectors met in Chicago to announce an interstate agreement establishing uniform sales tax rules. Starting in October, the group will offer free software that will allow any business to easily collect the required taxes online. The states’ demonstration project will drive home the point that online sales-tax collection can be done nationwide. Many retailers already collect the taxes. Now Congress should step up and pass a law overturning the court’s exemption in states that have streamlined their tax systems. That would allow hard-pressed states to take in roughly $20 billion a year in annual sales tax revenue that is rightfully theirs, and perhaps much more, depending on the growth in online shopping. It would also help level the playing field between local and online retailers. Source: “Internet Sales Tax,” New York Times, July 5, 2005 Thinking Economically What impact has Internet shopping had on state and local revenues? Explain your answer. THINKING ECONOMICALLY Synthesizing 1. Summarize the arguments for and against an Internet sales tax as presented in the documents. 2. Who is most likely to benefit from Internet sales tax revenue? Explain your answer, using information from the documents. 3. How has government responded to e-commerce—the selling of goods and services online? Use information from the documents in your answer. Government Revenue and Spending 441 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. ability-to-pay principle of taxation balanced budget benefit principle of taxation capital budget discretionary spending entitlement incidence of tax indexing mandatory spending progressive tax proportional tax regressive tax revenue tax tax base tax incentive tax return taxable income transfer payment withholding 1 is a mandatory payment to a government. 2 is government income. The 3 holds that people should be taxed on their ability to pay, no matter the level of benefits they receive. A 4 is the income, property, goods or services subject to taxes. A 5 takes the same percentage of income from all taxpayers. A 6 places a higher rate of taxation on high-income people, and a 7 takes a larger percentage of income from low-income people. The 8 is the final burden of tax. 9 is money taken from a worker’s pay before the worker receives it. 10 is a revision of tax brackets to prevent workers from paying more taxes due to inflation. Social Security is an example of an 11 , a social welfare program with specific requirements. Such programs make up most of federal 12 , which is spending that is required by law. States are required to have a 13 , in which government revenue and spending are equal. 442 Chapter 14 CHAPTER 14 Assessment How Taxes Work (pp. 410–419) 1. What is the relationship between tax and revenue? 2. Identify three ways that taxes affect the economy. Federal Taxes (pp. 420–427) 3. What is the largest source of federal revenue? 4. Which tax pays for Social Security and Medicare? Federal Government Spending (pp. 428–433) 5. What are three programs that make up most mandatory spending? 6. How does federal spending affect the economy? State and Local Taxes and Spending (pp. 434–441) 7. What are the two types of state budgets? 8. What tax base are tax assessors concerned with? A P P LY Look at the chart below showing average combined city and state tax rates for families with different incomes in several cities. FIGURE 14 .13 STATE AND LOC AL TA XES FOR A FAMILY OF FOUR City Atlanta Chicago Houston Total taxes paid as a percent of income $25,000 $50,000 $75,000 $100,000 $150,000 8.1 10.3 11.4 11.5 11.7 9.3 9.5 10.0 9.7 9.3 6.2 6.0 6.3 5.9 5.5 Jacksonville 4.3 4.6 5.0 4.8 4.6 Los Angeles 8.6 8.7 10.3 11.2 12.3 New York 5.6 10.8 12.7 13.4 14.1 Philadelphia 11.0 13.2 13.0 12.6 12.2 Source: Statistical Abstract of the United States, 2002 figures 9. Which city has the lowest tax rate for the lowest- income families? Which has the lowest tax rate for the highest-income families? 10. Which combined city and state tax structures are progressive and which are regressive 11. Creating Graphs The state legislature proposes Develop a Federal Budget new 10 percent excise taxes on the following goods and services: gasoline, ice cream, local telephone service, and sports cars. For each good or service create supply and demand curves showing the supply curve before the tax and how the supply curve shifts after the tax. Under each graph, write a caption explaining who will pay more of the tax— the consumer or the producer—and why. Use complete this activity. @ ClassZone.com to 12. Analyzing Data Shandra earns $30,000 per year from her job as a radiology technician. She takes a personal exemption of $3,200 and the standard deduction of $5,000 to reduce her taxable income. a. If she pays 10 percent tax on the first $7,300 of taxable income and 15 percent on the rest, how much does she pay in income tax? b. Shandra
’s FICA tax rate is 7.65 percent. What are her FICA taxes? c. How much total tax does Shandra pay? What is her effective tax rate as a percentage of her taxable income and of her total income? 13. Making Inferences When Rajiv goes shopping for a new MP3 player, he notices that he pays 7.35 percent sales tax on the purchase. He knows that the state sales tax rate is 4.22 percent. What accounts for the difference? 14. Comparing and Contrasting All states have excise taxes on cigarettes and gasoline. What are the similarities and differences in the reasons why states tax these two items? 15. Challenge In 2003, Congress reduced the tax rate paid by individual investors on dividends and capital gains to 15 percent. Previously the rate for dividends had been as high as 38.6 percent, and capital gains had been taxed at 20 percent. Which of these changes addressed the charge that corporate income is subject to double taxation? Give reasons for your answer. Step 1 Choose a partner. Imagine that you are members of Congress who must determine the discretionary spending portion of the federal budget. The table below shows the categories of spending. You have a total of $960 billion to spend. Determine your spending priorities by deciding what percent of the budget to allocate to each category. FEDER AL DISC RE T IONA RY SPENDING C ATEGORIES Administration of justice Health (non-Medicaid) Agriculture International affairs Community & regional development Education Energy National defense Natural resources & environment Science, space & technology General government Transportation Step 2 Form a group with two or three other pairs of students so that there are now a total of four groups in the class. Compare your budgets, noting areas of agreement and disagreement. Negotiate to develop a single budget proposal for your group. Step 3 Present your group’s budget proposal to the class. Include a list of reasons to support your budget choices. Step 4 As a class, decide on a final recommendation that resolves any differences among the four budget proposals. Step 5 Present your final budget to your teacher, who is acting as the President. Make necessary changes to the budget to resolve any differences between the Congress and the President. Government Revenue and Spending 443 Government Federal government actions in the areas of taxing and spending are designed to enhance the nation’s economic stability. 444 CHAPTER 15 SECTION 1 What Is Fiscal Policy? SECTION 2 Demand-Side and Supply-Side Policies SECTION 3 Deficits and the National Debt CASE STUDY Is the Federal Deficit Too Large? Using Fiscal Policy The business cycle is the series of growing and shrinking periods of economic activity. C H A P T E R 15 Fiscal policy uses taxes and government spending in an effort to smooth out the peaks and troughs of the business cycle AT T E R S In history classes, you’ve probably read about instances of rampant inflation when people needed bags and bags of cash to pay for their groceries. Or you might have read about periods of economic depression when millions of workers lost their jobs. By using a combination of spending and taxation, the federal government tries to reduce the impact of such economic extremes. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on the federal deficit. (See Case Study, pp. 468–469.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. Source: www.CartoonStock.com How big a problem is the federal deficit? See the Case Study on pages 468–469. Using Fiscal Policy 445 S E C T I O N 1 What Is Fiscal Policy TA K I N G N O T E S In Section 1, you will fiscal, p. 446 • examine the tools used in fiscal policy, p. 446 fiscal policy • determine how fiscal policy affects the economy • identify the problems and limitations of fiscal policy expansionary fiscal policy, p. 446 contractionary fiscal policy, p. 446 discretionary fiscal policy, p. 446 automatic stabilizers, p. 447 rational expectations theory, p. 452 Council of Economic Advisers, p. 452 As you read Section 1, complete a cluster diagram that organizes the main ideas about fiscal policy. Use the Graphic Organizer at Interactive Review @ ClassZone.com Fiscal Policy Fiscal Policy Tools KEY CONCEPT S QUICK REFERENCE Fiscal refers to government revenue, spending, and debt. Fiscal policy uses taxes and government spending to affect the economy. Expansionary fiscal policy is a plan to increase aggregate demand and stimulate the economy. Contractionary fiscal policy is a plan to reduce aggregate demand and slow the economy. Discretionary fiscal policy refers to actions selected by the government to stabilize the economy. 446 Chapter 15 In Chapter 14, you learned that the government puts the tax dollars it collects to a variety of uses. The term fiscal refers to anything related to government revenue, spending, and debt. Fiscal policy is the federal government’s use of taxes and government spending to affect the economy. Fiscal policy has one of two goals: to increase aggregate demand or to fight inflation. To stabilize or strengthen the economy, the government may use one of two basic policies. When the economy slows, the government may use expansionary fiscal policy, a plan to increase aggregate demand and stimulate a weak economy. When the economy is in an inflationary period, the government may use a contractionary fiscal policy, a plan to reduce aggregate demand and slow the economy in a period of too-rapid expansion. The federal government has two basic fiscal tools to influence the economy: taxation and government spending. Discretionary Fiscal Policy As you learned in Chapter 14, discretionary spending is spending that the government must authorize each year. In other words, the government must make a choice about this type of spending. Similarly, discretionary fiscal policy involves actions taken by the government by choice to correct economic instability. This type of policy involves an active government response, through choices about taxes or government spending, to help stabilize the economy. Congress must enact legislation for these policies to be implemented. This type of fiscal policy is discussed in more depth later in this section and in Section 2. Automatic Stabilizers Unlike discretionary fiscal policy, automatic stabilizers are features of fiscal policy that work automatically to steady the economy. Both of these approaches use taxes and government spending to influence the economy. Discretionary fiscal policy involves government choices about whether an expansionary or contractionary policy is needed and how the chosen policy should be put into action. Automatic stabilizers, such as public transfer payments and progressive income taxes, may work in an expansionary or contractionary manner, but they work automatically rather than through active policy choices. QUICK REFERENCE Policy features called automatic stabilizers work automatically to steady the economy. Public Transfer Payments As you recall from Chapter 14, public transfer payments include programs such as unemployment compensation, food stamps, and other entitlements. These payments automatically set up a flow of money into the economy. Therefore, this form of government spending helps stabilize the economy automatically. For example, during a recession more people are unemployed and qualify to receive unemployment compensation and other government benefits, such as food stamps or welfare payments. When people receive these benefits, they gain a certain amount of income to spend, and the effects of the recession are less severe than they would be without the transfer payments. When the economy improves, fewer people qualify for food stamps, unemployment compensation, and other entitlements, and government spending automatically decreases. This automatic decrease keeps the economy from growing too fast. By helping to control aggregate demand, this automatic stabilizer keeps prices from rising too quickly and leading to inflation. Progressive Income Taxes The individual income tax is progressive. As income increases, so do the tax rate and the amount of taxes paid. The progressive nature of the income tax allows it to act as an automatic stabilizer to the economy without additional government action. For example, during prosperous times, individual incomes rise, and some individuals move into higher tax brackets. These taxpayers pay more in taxes and do not have all of their increased income to spend or save. By preventing some of the increased income from entering the economy, this automatically higher taxation keeps the economy from growing too quickly and helps keep inflation in check. On the other hand, during a recession, individuals earn less income and may move into lower tax brackets. Therefore, lower incomes result in lower taxes, which automatically reduce the impact of the recession. AP P LI CATION Applying Economic Concepts A. Programs such as unemployment insurance ensure that people experiencing economic hardship have a basic level of income. How does this help to stabilize the economy? Automatic Stabilizers Unemployed workers wait to register for unemployment compensation, a program designed to stabilize the economy by providing temporary replacement wages. Find an update on automatic stabilizers at ClassZone.com Using Fiscal Policy 447 The Purpose of Fiscal Policy KEY CONCEPT S Fiscal policy can be used for expansionary or contractionary purposes. The choice of policy depends on whether the economy is weak or strong. Expansionary fiscal policy is designed to stimulate a weak economy to grow. Contractionary fiscal policy is used to slow the economy down in order to control inflation. POLICY 1 Expansionary Fiscal Policy Government may use expansionary policy to increase the level of aggregate demand so that growth occurs in the economy. As you recall
from Chapter 13, increased aggregate demand causes prices to rise, providing incentives for businesses to expand and causing GDP to increase. Expansionary fiscal policy also reduces the rate of unemployment, as there are more jobs available when businesses are expanding. Expansionary fiscal policy may involve increased government spending, decreased taxes, or both. For example, suppose the economy is in recession and, in response, the government decides to increase spending for highways. The government spends the money by contracting with private firms in many cities to build new roads. This spending creates additional jobs as the contractors hire more and more construction workers to complete the projects. If employment increases, more people will have income to spend, and aggregate demand increases for all goods and services in the economy. The government may also choose to cut taxes to stimulate the economy. By lowering individual and corporate income tax rates, the government allows individuals and businesses to have more income left after taxes. Individuals may spend their increased income and thereby increase demand for numerous goods and services. Increased income may allow them to increase their savings, which makes more money available to businesses to invest. Lower taxes also leave businesses with more money to invest in new equipment or plants, or in additional workers to produce more goods and services to meet increased demand. Whether the government increases spending, decreases taxes, or uses some combination of the two, the result is somewhat similar. As Figure 15.1 on the opposite page shows, expansionary fiscal policy leads to an increase in aggregate demand (the curve shifts to the right) and, therefore, economic growth. Expansion Increased construction of new housing is an indication that the economy is expanding. 448 Chapter 15 P OL ICY 2 Contractionary Fiscal Policy The federal government may use contractionary policy to decrease the level of aggregate demand so that inflation is reduced. When the economy is growing too rapidly, aggregate demand may increase faster than aggregate supply, leading to demandpull inflation. This type of inflation, which you read about in Chapter 13, is characterized by a steadily rising price level and a decrease in the purchasing power of people’s incomes. When the government faces such an economy, it may employ contractionary fiscal policy and use spending and taxes in ways opposite to expansionary fiscal policy. In other words, it may choose to decrease government spending or increase taxes in order to control inflation. FIGURES 15.1 AND 15.2 EFFECTS OF FISCAL POLICY FIGURE 15.1 EFFECTS OF EXPANSIONARY FISCAL POLICY FIGURE 15.2 EFFECTS OF CONTRACTIONARY FISCAL POLICY P2 P1 AS AS P1 P3 AD2 AD1 b AD1 Y1 Y2 Real GDP AD3 Y3 Y1 Real GDP a As Figure 15.1 shows, expansionary fiscal policy causes aggregate demand (AD1) to shift to the right to AD2, or increase. b As Figure 15.2 shows, contractionary fiscal policy causes aggregate demand (AD1) to shift to the left to AD3, or decrease. ANALYZE GRAPHS 1. In Figure 15.1, what happens to real GDP as a result of expansionary fiscal policy? 2. In Figure 15.2, what happens to the price level as a result of contractionary fiscal policy? Use interactive aggregate demand and aggregate supply curves at ClassZone.com For example, if the economy is growing too rapidly, the government may cut its spending on a variety of programs such as highway construction, education, and health care. By cutting spending, the government takes money out of the economy. This decreased government spending results in less income for individuals or businesses that are directly affected by the cuts in government programs. So these individuals have less money to spend on goods and services, and aggregate demand decreases. Businesses may cut production in response to decreased aggregate demand. As aggregate demand decreases, the rise in the price level is stopped, and inflation is brought under control. Using Fiscal Policy 449 Rather than cut spending, the government may choose to increase taxes. This leads to a decrease in consumer spending and, therefore, a slowdown in the rate of inflation. In other words, when individuals and businesses have to pay higher taxes, they have less income left over to spend or invest. As a result, aggregate demand will decrease. As aggregate demand decreases, businesses may cut back production and lay off workers. This will cause a further decrease in aggregate demand, because workers will have less to spend on goods and services. And as aggregate demand falls, so will the price level. Whether the government decreases spending or increases taxes or uses some combination of the two, the impact of contractionary fiscal policy on aggregate demand and inflation is somewhat similar. Turn back to Figure 15.2 on page 449. Notice that contractionary fiscal policy results in the aggregate demand curve shifting to the left. This indicates that aggregate demand is decreasing. This decline in aggregate demand, in turn, helps control inflation. (The major fiscal policy tools, and their impact on the economy, are reviewed in Figure 15.3.) 15 . 3 Effects of Fiscal Policy on the Economy ?Fiscal Policy Tools Expansionary Effects Contractionary Effects • Economic activity • Automatic stabilizers • Economic activity increases as businesses increase production, hire more workers, and increase investment • More workers have more income to spend on goods and services • Aggregate demand increases, resulting in economic growth • Raising or cutting taxes; offering tax breaks and incentives to businesses • Increasing or decreasing government spending decreases as businesses cut production and lay off workers • Workers have less income to spend on goods and services • Aggregate demand decreases, bring inflation under control ANALYZE CHARTS The government can use a combination of taxing and spending policies to stimulate a sluggish economy or to slow down an overheated economy. At what point in the business cycle do you think the economy is today? What type of fiscal policy do you think the government should apply at this time? APPLICATION Analyzing Cause and Effect B. What effect does expansionary fiscal policy have on consumer spending? Explain 450 Chapter 15 your answer. Limitations of Fiscal Policy KEY C ONCEPT S The purpose of fiscal policy is to reduce economic slowdowns, which result in unemployment, and to curb inflation. The success of fiscal policy, however, is limited by a number of issues, including policy lags and timing. LI MI TATION 1 Policy Lags Fiscal policy lags behind the economic conditions it is designed to address. This situation is often related to identifying the problem and getting Congress to move on the issue. Months of debate may precede policy change. The lag also may be related to how quickly the change in policy takes effect. For example, the time for tax changes to take effect is shorter than that for government spending. In particular, it may take a long time for public spending programs to get started and money to begin flowing into the economy. Therefore, tax changes may be more effective than policy changes in dealing with short-term recessions. LI MI TATION 2 Timing Issues The goal of fiscal policy is to provide a stable economic environment. This means that it should coordinate with the business cycle. Fiscal policy is described as countercyclical because the goal is to smooth out the peaks and troughs of the business cycle. If the timing of the policy is good, fluctuations in the business cycle will be less severe, as Figure 15.4 illustrates. If the timing is bad, however, it could make matters worse. For example, if the economy is already moving out of a recession when an expansionary fiscal policy takes effect, the result could be inflation. FIGURE 15.4 FISCAL POLICY AND THE BUSINESS CYCLE B F Line B shows how the economy fluctuates during the normal business cycle if fiscal policy actions are not used. Line F shows economic fluctuations if fiscal policy actions are effective. n nsio ansio n p x E P e ak Co n tr a c t i o n Troug h Time ANALYZE GRAPHS 1. What kind of fiscal policy might be used to address rapid movement toward a trough? 2. How does this diagram illustrate that fiscal policy is countercyclical? Using Fiscal Policy 451 LIMITAT ION 3 Rational Expectations Theory QUICK REFERENCE The rational expectations theory states that people anticipate that changes in fiscal policy will affect the economy in a particular way and that, as a result, people will take steps to protect their interests. A second phenomenon affecting timing is explained by the rational expectations theory, which states that individuals and business firms expect that changes in fiscal policy will have particular outcomes, and they take actions to protect their interests against those outcomes. These actions may limit the effectiveness of fiscal policy. For example, expansionary fiscal policy attempts to stimulate aggregate demand to increase employment. An increase in aggregate demand might also pull up the price level, causing inflation. In anticipation of rising inflation, people spend more to keep their buying power from decreasing. However, this increased spending causes more inflation and defeats the aims of the expansionary policy. QUICK REFERENCE The Council of Economic Advisers is a group of economic advisors to the president. LIMITAT ION 4 Political Issues Fiscal policy decisions are not always based on economic considerations. Sometimes, political considerations, most notably enhancing the chances of reelection, may influence the kind of fiscal policy that a government follows. The Council of Economic Advisers is a three-member group that advises the President on fiscal policy and other economic issues. Because of political pressures, however, the President may not always follow their advice. Even if the President does
accept the council’s guidance, members of Congress—again because of political considerations—may not agree with proposed policies. This is an important issue, since the House of Representatives is where all tax bills originate. Fiscal Policy and Politics Decisions on economic policy often are influenced by politics. LIMITAT ION 5 Regional Issues Another limitation of the effectiveness of fiscal policy is related to geography. Not every state or region of the country may be experiencing the same economic issues. For example, the Gulf Coast region may be recovering from the economic effects of hurricane damage. At the same time, the West Coast may be experiencing a high tech boom that is causing inflation. The Gulf Coast might benefit from expansionary policies, while contractionary policies might be best for the West Coast. In such circumstances, broad fiscal-policy solutions may not be appropriate. APPLICATION Making Inferences C. How do policy lags and timing issues work together to limit the effectiveness of fiscal policy? 452 Chapter 15 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Use each of the three terms below in a sentence that illustrates the meaning of the term. a. expansionary fiscal b. discretionary fiscal c. rational expectations policy policy theory 2. What are the two basic goals of fiscal policy? 3. How do expansionary fiscal policy and contractionary fiscal policy use the same fiscal policy tools in different ways? 4. What is the difference between discretionary fiscal policy and automatic stabilizers? 5. What is the role of the Council of Economic Advisers? 6. Using Your Notes What are the limitations of fiscal policy? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Fiscal Policy 7. Making Inferences Between 2001 and 2004, Congress passed a series of tax cuts and increased government spending. Do these actions reflect expansionary or contractionary fiscal policy? Explain your answer. 8. Applying Economic Concepts Agricultural price supports provide farmers with government subsidies when market prices of certain crops are low. What kind of fiscal policy is at work in this situation and how does it work? 9. Drawing Conclusions Federal government officials want to prevent a slowing economy from going into recession. They debate whether to increase spending on new public transit systems or decrease individual and corporate income tax rates. a. How would an understanding of policy lags help them decide which government action would be most effective? b. What other issues might affect their decision? 10. Challenge Make a copy of Figure 15.4 on page 451 and label the part of line F that might represent expansionary fiscal policy and the part that might represent contractionary fiscal policy. Analyzing Economic Conditions Consider what you’ve learned about economic instability and fiscal policy. Then complete the following activities. Propose Fiscal Policies For each situation listed in the chart, identify the problem and decide whether the fiscal policy should be expansionary or contractionary. Economic Situation Problem/Fiscal Policy Needed Business investment spending declines for six straight months Consumer Price Index rises for four straight months Unemployment rate increases from 4% to 6.5% over six months Consumer confidence falls for five straight months Challenge Choose one situation and give examples of how fiscal policy might be applied to it. Using Fiscal Policy 453 S E C T I O N 2 Demand-Side and Supply-Side Policies TA K I N G N O T E S In Section 2, you will Keynesian economics, p. 454 demand-side fiscal policy, p. 454 spending multiplier effect, p. 455 supply-side fiscal policy, p. 458 Laffer Curve, p. 459 • describe how demand-side fiscal policy can be used to stimulate the economy • describe how supply-side fiscal policy can be used to stimulate the economy • identify the role that fiscal policy has in changing the economy As you read Section 2, complete a chart to show the major features of demand-side and supplyside policies. Use the Graphic Organizer at Interactive Review @ ClassZone.com Demand-side policies Supply-side policies Role of government Role of government Demand-Side Economics KEY CONCEPT S Economists have not always supported the idea of discretionary fiscal policy. Historically, most think that the national government should have a limited role in the economy. When the country experienced financial panics and depressions, the government did little to help the economy get back on track. The Great Depression of the 1930s changed many people’s minds about the role of the government. High unemployment and low production persisted for several years. Many economists concluded that the old ways were ineffective in this situation. One economist, John Maynard Keynes, proposed a new way to address the problem. The theories that Keynes put forward are called Keynesian economics, the idea that in times of recession aggregate demand needs to be stimulated by government action. Keynes believed that such an approach would lower unemployment. Keynesian economics forms the basis of demand-side fiscal policy, fiscal policy to stimulate aggregate demand. Demand-Side Policies The Civilian Conservation Corps (CCC), an employment program for young men, was one government action aimed at stimulating the economy during the Great Depression. QUICK REFERENCE Keynesian economics states that aggregate demand needs to be stimulated by government action. Demand-side fiscal policy is a plan to stimulate aggregate demand. 454 Chapter 15 Keynesian Theory Keynes argued that changes in aggregate demand influence the business cycle, and he expressed this idea in an equation. His equation states that the GDP equals the total market value of all consumer goods (C), investment goods (I), government goods (G), and net exports (F). The equation looks like this: GDP = C + I + G + F. Keynes believed that net exports played only a small role in the economy and that government and consumer expenditures were fairly stable. He reasoned that it was investment that caused the economy to fluctuate and that investment creates a greater than one-for-one change in national income. That is, one dollar spent in investment has a spending multiplier effect, meaning that a change in spending is multiplied into a larger change in GDP. (See Figure 15.5.) QUICK REFERENCE The spending multiplier effect states that a small change in spending causes a much larger change in GDP. M AT 15 . 5 Spending Multiplier Effect If Zain receives a $100 raise and spends $60 of it to buy products from Joan, Joan’s income increases too. Similarly, if Joan uses $36 of her increased income to buy products from Ravi, Ravi’s income increases. Ravi then buys from Sarah, and so on. Each increase in income contributes to the GDP, so the total effect of Zain’s spending is multiplied. To quantify how spending increases GDP, economists use the spending multiplier. Step 1: Determine the percentage of the money that is spent on domestic goods and services each time the money is reused. In the example, this is 60 percent. Step 2: Use this equation, where A is the percentage, to calculate the spending multiplier. Sample Calculations NEED HELP? Math Handbook, “Calculating and Using Percents,” page R4 1 1 − A = Spending multiplier 1 1 − 60% = 1 1 − 0.60 = 2.5 Step 3: Use the spending multiplier to calculate the total increase in GDP. Initial investment × Spending multiplier = Total increase in GDP $100 × 2.5 = $250 If businesses invest less, the spending multiplier effect means that the decrease in overall spending is greater than the initial decrease in business investment. Because this effect touches the entire economy, the government may need to step in to offset changes in investment. This idea became the basis of demand-side fiscal economics, which favors the use of fiscal policy to stimulate aggregate demand. AP P LI CATION Making Inferences A. How did Keynes’s equation help him conclude that if investment declined, government needed to increase spending or cut taxes to stimulate aggregate demand? Using Fiscal Policy 455 ECO N O M I C S PAC ES E T T E R John Maynard Keynes: Architect of Demand-Side Policy Many Americans are accustomed to the idea that the government plays an active role in the market economy. However, when John Maynard Keynes proposed his ideas in the 1930s, they were considered revolutionary. He questioned the principles of economics that had been accepted since the time of Adam Smith. How did Keynes’s work change the way that people viewed the role of government in the economy? Using Government Action to Stimulate Demand The economic situation of the 1920s led John Maynard Keynes to question the classical economic theories of supply and demand. Classical economists believed that a free market would eventually correct any imbalances. However, as aggregate demand fell, businesses invested and produced less, which led to layoffs. As a result, consumers had even less money to spend, and businesses cut back production even further. As early as 1929, Keynes proposed that the British government spend money on public works projects to help ease unemployment. However, he had no theoretical backing for his proposal until he read an article in 1931 about the spending multiplier. This concept proved to be the key to his new economic theory, which he published in The General Theory of Employment, Interest, and Money (1936). This ground-breaking book marked the beginning of the field of macroeconomics. Keynes’s first revolutionary idea was to define aggregate demand as the sum of investment, consumer spending, government spending and net exports. He further stated that only government intervention could break the business cycle patterns that caused so much economic suffering. Even more revolutionary, however, was his argument that it was better for the government to spend money to h
elp stabilize the economy than to have a balanced budget. A Continuing Influence Keynes’s ideas continue to influence the way some governments deal with economic depressions. APPLICATION Contrasting Economic Information B. What made Keynes’s ideas different from those of classical economists? FAST FACTS John Maynard Keynes Career: British academic and government economist Born: June 5, 1883, in Cambridge, England Died: April 21, 1946 Major Accomplishment: Introduced the idea of using government action to stimulate aggregate demand Books: A Treatise on Money (1930); The General Theory of Employment, Interest, and Money (1936) Famous Quotation: The difficulty lies, not in the new ideas, but in escaping from the old ones. Jobs: Lecturer in economics, Cambridge University; editor of the Economics Journal; positions with the British Treasury office during World Wars I and II Learn more about John Maynard Keynes at ClassZone.com 456 Chapter 15 Wartime Spending Massive government spending on wartime industries brought the United States out of economic depression. Government and Demand-Side Policies KEY C ONCEPT S Discretionary fiscal policy involves choices about how to use government spending and taxation to increase aggregate demand or control inflation. Demand-side policies advocate use of these fiscal policy tools to control aggregate demand and stabilize the economy. The Role of Government Keynes proposed an active role for government in the economy. He argued that the federal government ought to step into the economy using expansionary fiscal policy to promote full employment. The Great Depression had shown that the economy could reach equilibrium with less than full employment and that business was unable to break out of this cycle because of insufficient aggregate demand. Therefore, Keynes advocated increased government spending and decreased taxation to end recessions. Increased government spending helps create jobs and increases income, and decreased taxation encourages consumers to spend more, which prompts businesses to invest more. Such actions help increase aggregate demand. On the other hand, Keynes thought that when inflation was high the government should use contractionary fiscal policy to keep prices from rising. The government would take an active role through decreasing government spending or increasing taxes. Both of these actions help decrease aggregate demand and control inflation. Demand-Side Policies—Analysis In some circumstances, an increase in government spending may lead to economic recovery. For example, government spending on public works programs and on production related to World War II brought the United States out of the Great Depression. However, it is not easy to limit such spending to times of recession, because federal programs seem to take on a life of their own and are difficult to terminate. Politicians are often reluctant to discontinue programs that are popular. Excessive aggregate demand due to government or consumer spending can lead to inflation. Contractionary fiscal policy requires decreases in government spending or increases in taxation. Just as it is difficult to decrease government spending, it is difficult to enact the tax increases. Politicians must often choose between doing what is best for the economy and doing what is most likely to ensure their reelection. Furthermore, when the economy experiences stagflation—slow economic growth with high unemployment and inflation—as it did in the 1970s, demand-side policies seem to be ineffective. AP P LI CATION Drawing Conclusions C. Why are demand-side policies more effective against recession than against inflation? Using Fiscal Policy 457 Supply-Side Economics KEY CONCEPT S QUICK REFERENCE Supply-side fiscal policy provides incentives to producers to increase aggregate supply. Some economists believe that the best way to influence the economy is through the supply side rather than through the demand side. Supply-side fiscal policy is designed to provide incentives to producers to increase aggregate supply. In other words, demand-side economics uses fiscal policy to encourage consumers to spend more, while supply-side economics focuses on cutting the cost of production to encourage producers to supply more. Figure 15.6 compares supply-side economics to demand-side economics. The Role of Government As you have learned, the role of the government in the economy falls into three categories: taxation, spending, and regulation. For the most part, supply-side economists favor less government involvement in these three areas. Supply-side economists favor cutting the tax rates on individual and corporate income because they believe that high tax rates slow economic growth by discouraging working, saving, and investing. Lower tax rates, on the other hand, encourage individuals and businesses to work, save, and invest more. Specifically, reducing the highest tax brackets provides more available income to the people most likely to invest in new business activities. Spending cuts are another way that supply-side economics seeks to stimulate aggregate supply. Cuts in spending are related to tax cuts. If the government spends less, it needs to take in less in revenue and, therefore, is able to lower taxes. Finally, decreased government regulation can also stimulate business production. Government regulations add to the costs of production and make it harder for businesses to grow. Deregulation, however, cuts costs and leads to increases in aggregate supply. F I G U R E 15 . 6 Supply-Side and Demand-Side Economics Supply-Side Economics Demand-Side Economics • Focuses on stimulating production • Focuses on stimulating consumption (supply) to increase business output • Lower taxes + decreased government spending + deregulation = greater incentives for business investment • Businesses expand and create jobs; people work, save, and invest more • Greater investment and productivity cause businesses to increase output (demand) to increase business output • Increased government spending results in more money in people’s hands • People spend more • Increased demand causes business to increase output ANALYZE CHARTS 1. What is similar about supply-side and demand-side tax policies? 2. Which system favors less government involvement in the economy? 458 Chapter 15 QUICK REFERENCE The Laffer Curve is a graph that illustrates the economist Arthur Laffer’s theory of how tax cuts affect tax revenues. The Laffer Curve Supply-side economists refer to the Laffer Curve, a graph developed by economist Arthur Laffer, to illustrate how tax cuts affect tax revenues and economic growth. As Figure 15.7 shows, Laffer theorized that tax revenues increase as tax rates increase up to a certain point. After that point, higher tax rates actually lead to decreased tax revenues. The reasoning behind the curve is that higher taxes discourage people from working, saving, and investing. So, at a tax rate of 100 percent, the government would theoretically collect no tax revenues, because people would have no incentive to earn income if it all went to the government for taxes. In other words, the higher the tax rate, the likelier it is that people will take some type of action to avoid paying more taxes. When people find alternatives to incomeproducing activity, total taxable income declines, tax revenues decrease, aggregate supply falls, and economic growth slows. Conversely, as tax rates fall, people are more inclined to undertake income-producing activity because less of their income will go to taxes. Further, they are more likely to save and invest this extra income, which will lead to increasing aggregate supply and greater economic growth. FIGURE 15.7 THE LAFFER CURVE a c e u n e v e R T2 T1 b 0 R2 R0 Tax rate 100 R1 a There is a tax rate between 0 and 100 percent (point R0) at which maximum revenue is collected. b Tax rates higher than R0, such as R1, will not bring in more revenue (T1), because higher taxes discourage productive activity and shrink the tax base. c When tax rates are higher than R0, lowering the tax rate (R2) will lead to higher tax revenue (T2). Lower tax rates tend to encourage productive activity and increase the tax base. ANALYZE GRAPHS 1. There is no tax revenue at two points on the graph—when the tax rate is 0 percent and when it is 100 percent. Why is this so? 2. How does this graph support the ideas of supply-side economists? Supply-Side Policies—Analysis When the principles of the Laffer Curve were applied in the United States in the 1980s, the results were much as Laffer had predicted. Legislation passed in that decade reduced federal income tax rates substantially. For example, the top bracket went from 70 percent to around 30 percent. At the same time, federal government receipts from income taxes over the whole decade were about 13 percent higher than Using Fiscal Policy 459 they had been in the 1970s. Inflation and unemployment rates both fell during the decade. Further, the economy grew steadily in the 1980s, with real GDP increasing by about 3 percent each year. Even so, some of Laffer’s predictions did not hold true. The supply-side approach suggests that with lower tax rates, people will work more. However, while some people did choose to work more, others chose to work less, since they could earn the same amount of after-tax income by working fewer hours. In addition, supply-side theory states that lower tax rates encourage people to save and invest. In fact, the savings rate declined during the 1980s. Some economists have suggested that the success of supply-side policies depends on where the economy is located on the Laffer Curve. Look again at Figure 15.7 on page 459. Find the tax rate R0 on the horizontal axis and trace the broken line from that point to where the line intersects the curve. Tax revenue is maximized at this point. If the economy is not at this point on the curve, then tax rate cuts will decrease tax revenue
rather than increase it. Supply-side theory offers no measures for establishing where on the curve an economy might be. Other economists have argued that it is difficult to isolate the effects of supply-side incentives from demand-side results to determine what caused unemployment and inflation rates to fall and the economy to grow during the 1980s. They suggest that tax cuts and increased government spending on defense drove up aggregate demand, resulting in economic growth. This increased spending was fueled by deficits, which you’ll learn more about in Section 3. YO U R EC DE MAND -SIDE POLIC IES VS. SU PPLY-SIDE POLIC IES Which candidate will you choose? In an upcoming congressional election, one candidate favors tax cuts and increased government spending. The other favors more substantial tax cuts, decreased government spending, and less government regulation of the economy. For which candidate will you cast your vote? Why? ? ▲ Supply-side supporter ▲Demand-side supporters APPLICATION Analyzing Causes D. What fiscal policy techniques do supply-side economists advocate to reduce unemployment and fight inflation at the same time? 460 Chapter 15 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. Keynesian economics b. supply-side fiscal policy demand-side fiscal policy Laffer Curve 2. How did the Great Depression influence Keynesian economics? 3. How is the spending multiplier effect related to demand-side economics? 4. How are supply-side and demand-side economics different? 5. Which fiscal policy tool does the Laffer Curve address? 6. Using Your Notes How does the role of government differ in demand-side and supply-side economics? Refer to your completed flow chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com Demand-side policies Supply-side policies Role of government Role of government . Creating Graphs Create a graph showing aggregate demand and aggregate supply in the economy. Then add new curves to show the expected shifts based on expansionary demand-side policies and supply-side policies. What happens to price level and GDP as a result of each type of policy? Use activity. @ ClassZone.com to complete this 8. Applying Economic Concepts Suppose that the federal government decides to increase its spending on highway construction by $5 billion to keep the economy from falling into a recession. Explain the real impact on GDP of this spending. 9. Analyzing Effects Tom, Cia, and Julie were all in the 50 percent tax bracket. When a tax cut program reduced their tax bracket to 28 percent, they all made changes in their lives. Tom decided to work fewer hours so he could begin training to run in a marathon. Cia bought the new sports car she’d been wanting. Julie chose to work more hours so she could save extra money for her daughter’s college education. Explain the effects of the tax cut for each individual. Use supply-side or demand-side economics reasoning in your answer. 10. Challenge Why is it difficult for demand-side economics to solve the problems of high unemployment and high inflation when they occur at the same time? Space research center Categorizing Economic Information Consider what you’ve learned about demand-side or supply-side fiscal policy. Then complete the following activities. Identify Policies Complete the chart by indicating whether each action reflects a demand-side or a supply-side policy. Government Action Demand-Side or Supply-Side Cut capital gains tax rates to encourage investment Expand government spending on space exploration Increase federal grants for education Reduce safety rules that businesses must follow Challenge Why is it difficult to tell if a cut in individual income tax rates is the result of a demand-side or a supply-side policy? Using Fiscal Policy 461 S E C T I O N 3 Deficits and the National Debt TA K I N G N O T E S In Section 3, you will • examine the difference between the deficit and the debt • explain why national deficits occur • describe how deficits are financed • identify the impact of the national debt on the economy budget surplus, p. 462 budget deficit, p. 462 deficit spending, p. 462 national debt, p. 462 Treasury bills, p. 464 Treasury notes, p. 464 Treasury bonds, p. 464 trust funds, p. 465 crowding-out effect, p. 466 As you read Section 3, complete a comparison chart to show the similarities and differences between federal deficits and the national debt. Use the Graphic Organizer at Interactive Review @ ClassZone.com Federal Deficits National Debt The Federal Deficit and Debt KEY CONCEPT S Governments have frequently made efforts to balance their budgets so that spending equals the revenues collected. In reality, however, all levels of government often struggle to achieve a balanced budget. As you recall, Congress and state legislatures make budget decisions with both economic and political considerations in mind. Federal government spending falls into one of three categories: a balanced budget; a budget surplus, when the government takes in more than it spends; or a budget deficit, when government spends more than it takes in. In recent years, the federal government has rarely achieved a budget surplus. Since 1970, a surplus was recorded only between 1998 and 2001. Figure 15.8 on the opposite page shows the pattern of budget deficits and surpluses since 1980. It is important to note that a budget surplus or budget deficit refers to only one year. Deficit spending occurs when a government spends more than it collects in revenue for a specific budget year. Annual deficits contribute to the national debt, which is the total amount of money that the government owes. In effect, the national debt is equal to the sum of annual budget deficits minus any budget surpluses or other payments against the debt. Controlling the Deficit This cartoon suggests one way to deal with a budget deficit. Source: www.CartoonStock.com QUICK REFERENCE A budget surplus occurs when the government takes in more than it spends. A budget deficit occurs when government spends more than it takes in. Deficit spending is a government practice of spending more than it takes in for a specific budget year. The national debt is the money that the government owes. 462 Chapter 15 Causes of the Deficit There are four main causes of deficit spending: national emergencies, a desire for more public goods, stabilization of the economy, and the role of government in society. Many times a budget deficit may be the result of more than one of these causes. National Emergencies Generally speaking, national emergencies are wars in which the United States is involved. Deficit spending has been used in wartime from the Revolutionary War to the war in Iraq that began in 2003. The terrorist attacks of September 11, 2001, and catastrophic weather events are other examples of national emergencies. All may require massive spending beyond the normal outlay of funds. Need for Public Goods and Services Public goods and services benefit many different people and groups. The interstate highway system, dams, flood-control projects, and airports are examples of public goods. Building such infrastructure is expensive and lasts many years. The public expects the government to provide these goods to facilitate commerce, agriculture, and transportation. Stabilization of the Economy As you learned earlier in this chapter, fiscal policy can include government spending to stimulate the economy. The classic example of this occurred during the Great Depression. The government spent money on a variety of public works projects to build roads, bridges, schools, and parks, putting millions of unemployed people to work. This government spending led to budget deficits. Role of Government in Society As you have seen, people have also come to depend on government programs such as Social Security, Medicare, Medicaid, and unemployment insurance to provide help for those in need. These programs are expensive, and because they are entitlement programs, they require funding each year. FIGURE 15.8 BUDGET DEFICITS AND SURPLUSES This line represents a balanced budget— where revenues equal expenditures. Points above the line are surpluses and points below the line are deficits. b Deficits increased during these periods due to tax cuts, increased defense and entitlement spending, and recessions. 1980 1985 1990 1995 2000 2005 Year Sources: Congressional Budget Office; Office of Management and Budget ANALYZE GRAPHS 1. When did the largest deficit occur and about how much was it? The largest surplus? 2. How would the trends shown on this graph affect the national debt? Using Fiscal Policy 463 QUICK REFERENCE Treasury bills mature in less than one year. Treasury notes mature between two and ten years. Treasury bonds mature in 30 years. Raising Money for Deficit Spending When the federal government does not receive enough revenue from taxes to finance its spending, it can borrow money to expand the economy. In effect, the government pays for its present needs by borrowing money that it will have to repay at some future date. It does this by issuing government bonds, through the Department of the Treasury. Perhaps the best known type of bond issued by the government is the savings bond. Savings bonds mature in 20 years and are available in both small and large denominations—from $25 up to $10,000. The Department of the Treasury issues three other types of bonds. Treasury bills (T bills) are short-term bonds that mature in less than one year. Treasury notes are bonds that mature between two and ten years. And finally, Treasury bonds are issued for 30 years. Interest is paid on all these bonds, with higher interest rates sometimes being paid on instruments with longer maturity dates. Individuals, state and local governments, insurance companies, pension funds, financial institutions, the Federal Reserve banks, and foreign investors hold these bonds. Figure
15.9 shows the percentage of federal debt held by different types of investors. A trend in recent years has been an increase in the percentage of the federal debt owned by foreign investors. Most foreign investors in U.S. Treasury bonds are the central banks of other countries. Japan and China hold the largest amount of foreign investors’ share of the debt. FIGURE 15.9 CREDITORS OF THE FEDERAL GOVERNMENT 2.8% 3.4% 4.5% 5.5% 6.7% 7.0% 9.5% 16% a Pension funds are run by corporations and state and local governments. b Depository institutions include banks, savings institutions, and credit unions. 44.6% Foreign investors Federal Reserve banks State & local governments Pension funds Other investors a Mutual funds Savings bonds Insurance companies Depository institutions b Source: U. S. Treasury Bulletin, December 2005 ANALYZE GRAPHS 1. What percentage of the federal debt is owed to U.S. investors? What percentage is owed to foreign investors? 2. How do savings bonds compare to other government bonds as a form of government borrowing? APPLICATION Drawing Conclusions A. Why do all levels of government often struggle to achieve balanced budgets or 464 Chapter 15 budget surpluses? The National Debt KEY C ONCEPT S As you have seen, the national debt consists of the total accumulation of government deficits and surpluses over time. The money is owed to savers for the bonds they purchase and the interest paid on them. However, the actual debt situation is somewhat more complicated. The government also borrows from trust funds, which are funds being held for specific purposes to be expended at a future date. Examples of government trust funds include Social Security, Medicare, Medicaid, and government pension funds. When the trust funds accumulate surpluses by taking in more tax revenue than is needed for annual benefit payments, the surplus is invested in government bonds until the specific programs need the funds. In essence, therefore, the government borrows from itself to cover some deficit spending. Some economists do not consider this to truly be debt. The money is transferred from one part of the government to another. This borrowing does not place a burden on the current economy because the current budget is not used to pay for it. QUICK REFERENCE Trust funds are held for specific purposes to be expended at a future date. The Size of the National Debt In August 2006, the total national debt was about $8.4 trillion. About $4.8 trillion was privately owned by the creditors shown in Figure 15.9, and about $3.6 trillion was in government trust funds. Find an update about the national debt at ClassZone.com There were only five years from 1962 to 2005 in which the federal government had a surplus of funds. In all the other years of that period, the government borrowed money to cover its deficits. Each time it borrowed money, it increased the size of the national debt. From 1980 to 1994 alone, the national debt grew by more than five times, from about $930 billion in 1980 to about $4.7 trillion in 1994. Economists often look at the country’s debt as a percentage of GDP. That perspective allows them to see how the burden of borrowing compares to the strength of the overall economy. The national debt was 33 percent of GDP in 1981. By 2006, it had doubled to nearly 68 percent of GDP. However, in 1981 about 80 percent of the debt was privately owned. In 2006, less than 60 percent was privately owned. More About the National Debt a A stack of $100 bills totaling the national debt would stand over 5,790 miles high. $28,000 c If everyone in the United States helped to pay off the national debt, each person’s share would be about $28,000. b The U.S. Bureau of Engraving prints about $635 million worth of currency each day. At this rate, it would take more than 36 years to print enough currency to pay off the national debt. Using Fiscal Policy 465 The Effect of the Debt on the Economy The national debt can have positive or negative effects on the economy. When government spending stimulates the economy, jobs are created and public goods such as the infrastructure may be improved. These improvements benefit everyone. However, when the government competes with the private sector to raise money by paying higher interest rates to get the savers’ dollars, the results often are negative. The crowding-out effect is what happens when the government outbids private bond interest rates to gain loanable funds. Money leaves the private sector, and interest rates increase. Repaying the interest on government bonds, or servicing the debt, also can have a negative impact on the economy. The 2007 federal budget estimate showed interest payments to be nearly 10 percent of all federal spending. Constant borrowing raises the amount of interest to be paid. This, in turn, increases the need for taxes to service the debt. Higher taxes mean less spending by consumers and less investment by businesses, both of which may hurt the economy. F I G U R E 15 .10 Actions to Control Deficits and Debt Budget Action Goal Key Points Analysis Gramm-Rudman Hollings (1985) Eliminate the deficit by 1991 Set annual deficit targets; automatic spending cuts Unrealistic goals; deficits increased Budget Enforcement Act (1990) Ensure new laws do not increase deficits Caps on discretionary spending; “pay-as-you-go” financing Deficits declined after 1992 Omnibus Budget Reconciliation Act (1993) Cut deficit by $500 billion over 5 years Balanced Budget Agreement (1997) Balance the budget by 2002 Make income tax more progressive; some spending cuts Cut some entitlement spending; increase education spending; targeted tax cuts Deficits declined significantly; strong economy Budget surpluses 1998–2001 Attempts To Control Deficits and Debt Sharp increases in deficits and the debt in the 1980s led government officials to look for ways to control deficit spending. (These efforts are summarized in Figure 15.10 above.) One measure set annual deficit targets with the goal of eliminating the deficit completely within five years. Another set limits on discretionary spending and mandated that new spending required cuts elsewhere in the budget, an approach known as “pay-as-you-go” financing. A third attempted to trim the deficit with a combination of tax increases and spending cuts. Still another sought to balance the budget through spending cuts in entitlement programs. Some of these measures failed, and deficits actually increased. Others enjoyed only limited success. As a result, the government continues to struggle to control the national debt. APPLICATION Making Inferences B. Why is paying interest on the national debt considered mandatory spending? QUICK REFERENCE The crowding-out effect is the result of the government’s outbidding private bond interest rates. 466 Chapter 15 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the difference between the terms in each of these pairs. a. budget surplus budget deficit b. national debt c. Treasury bills deficit spending Treasury bonds 2. How do budget deficits affect the national debt? Why? 3. What do Treasury bills, Treasury notes, and Treasury bonds have in common? 4. Why is government borrowing from trust funds different from privately-owned debt? 5. How is the crowding-out effect related to the national debt? 6. Using Your Notes What are the four causes of budget deficits? Refer to your completed chart. Federal Deficits National Debt Use the Graphic Organizer at Interactive Review @ ClassZone.com . Applying Economic Concepts In 2007, the federal government was expected to have tax revenue of $2,350.8 billion. Total federal spending was estimated at $2,592.1 billion. Would the government have a budget deficit or a budget surplus that year? How much would it be? 8. Analyzing Causes Each of the following headlines reflects an example of deficit spending. Which of the causes of budget deficits is suggested by each headline? a. President Proposes Tax Cut Extensions to Keep Economy on Track b. Baby Boomers’ Retirement Will Strain Social Security and Medicare c. Hurricane Recovery Effort to Require Massive Federal Aid 9. Analyzing Data Assume that the privately-owned part of the debt is $4,900 billion and the amount held by government trust funds is $3,500 billion. Use the percentages shown in Figure 15.9 to calculate the dollar amounts held by different creditors. 10. Challenge The Social Security Administration estimates that annual revenue from payroll taxes will be insufficient to meet annual benefit payments beginning in 2018. The Social Security trust fund will be used to make up the difference. How will this change affect the nature of the national debt? Government bonds Applying Economic Concepts Recall what you learned about the crowding-out effect and then complete the following activities. Analyze the Crowding-Out Effect The graph below shows the crowding-out effect in terms of supply and demand. Why would some private bond issuers be crowded out as a result of government borrowing? THE C ROWDI NG- OUT EFFEC 16 14 12 10 8 6 4 2 0 S D1 D2 S DEMAND BEFORE GOVERNMENT BORROWING DEMAND AFTER GOVERNMENT BORROWING SUPPLY OF LOANABLE FUNDS D1 D2 5 10 15 20 25 30 35 40 Quantity of loanable funds Challenge What part of the national debt might cause the crowding-out effect, the public-owned portion, the portion in government trust funds, or both? Explain your answer. Using Fiscal Policy 467 Case Study Find an update on this Case Study at ClassZone.com Is the Federal Deficit Too Large? Background The federal deficit is a matter of interest not only to economists but also to the average American, because it is the taxpayer who ultimately pays the interest on the country’s debt. This debt was created by pursuing a policy of deficit spending that requires the government to borrow money to make up the difference between how much it takes in and the amount it spends. There are several reasons for using deficit spending. One major reason
is the need to deal with national emergencies, such as the September 11 terrorist attacks or natural disasters like Hurricane Katrina. Another is to implement expansionary fiscal policies during periods of recession. Regardless of the reasons for deficit spending, the larger the deficit grows, the more controversial it becomes. What’s the issue? Is the federal deficit too large? Study these sources offering various opinions regarding what is a manageable federal deficit. Federal Budget Deﬁ cit Sparks Worries Higher Borrowing Costs Could Slow Economic Activity . . . Here’s the worry: Persistent deficits will lead to higher borrowing costs for consumers and companies, slowing economic activity. As Uncle Sam seeks to borrow . . . to finance those deficits, rates on Treasury securities would rise to entice investors. That would push up other interest rates, such as home mortgages, many auto loans, some home equity lines of credit and some credit cards. . . . For businesses, rates on corporate bonds would climb. It would become more expensive to borrow to pay for new plants and equipment and other capital investments. Economists are troubled by the prospects of budget deficits as far as the eye can see and want to see them trimmed. But the size of the current budget deficits, while unwelcome, do not signal that a crisis is imminent. . . . Yearly deficits add to the country’s growing national debt. [But] there is more concern about higher borrowing costs over time crimping business investment and ultimately the production of goods and services. . . . Source: “Federal Budget Deficit Sparks Worries,” Associated Press, January 15, 2006. Thinking Economically What negative impact of deficit spending is discussed in this article? A. Online News Story This article discusses a major problem that could arise from the government’s continued deficit spending. 468 Chapter 15 B. Political Cartoon Cartoonist Harley Schwadron made this comment about government spending. Source: www.CartoonStock.com Thinking Economically In what way is the statement on the bureau door contrary to valid economic principles? C. Online News Story In this article, former Secretary of the Treasury John Snow outlines the Bush administration’s fiscal policy designed to reduce the federal deficit. Setting Sights on the Deﬁ cit Reducing the Deficit by Controlling Spending The Bush administration’s highest economic priority for its remaining three years is to control the growth of federal spending and bring down the U.S. budget deficit, John Snow, [former] U.S. Treasury secretary, said. “The clear priority of the administration right now is the deficit, making sure that we achieve the president’s objective of cutting the deficit in half by the time he leaves office,” he said . . . This would put the deficit below 2 per cent of gross domestic product, low by historical standards. . . . When he came to office in 2001, the president inherited a projected 10-year surplus of $5,600 billion. But tax cuts and growing spending for the military and homeland security have contributed to a sharp reversal, with the Congressional Budget Office now predicting a $2,100 billion deficit over the next decade. The annual deficit has been falling, however, from $413 billion in the 2004 fiscal year to $316 billion this year, according to CBO figures . . . Mr. Snow made it clear that, in spite of the focus on the deficit, the administration would not reconsider its low tax policies. Source: “U.S. Sets its Sights on Deficit,” by Edward Alden, Andrew Balls and Holly Yeager. Financial Times, November 4, 2005. Thinking Economically How does the Bush administration plan to cut the deficit by half in three years? What other steps might it take to control the deficit? THINKING ECONOMICALLY Synthesizing 1. Identify the economic cause-and-effect relationships described in Documents A and C. 2. How does Document B illustrate the challenge facing the Bush administration in its efforts to carry out the plan discussed in Document C? 3. Do you think the Bush administration shares the concerns about the deficit expressed in Document A? Use information from the documents to explain your answer. Using Fiscal Policy 469 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. automatic stabilizers budget deficit budget surplus contractionary fiscal policy Council of Economic Advisers crowding-out effect deficit spending demand-side fiscal policy discretionary fiscal policy expansionary fiscal policy fiscal policy Keynesian economics Laffer Curve national debt spending multiplier effect supply-side fiscal policy Treasury bills Treasury bonds Treasury notes trust funds 1 is the government’s use of taxes and government spending to affect the economy. 2 is a plan to stimulate a weak economy. 3 is a plan to slow the economy when it is expanding too rapidly. 4 refers to actions chosen by the government to stabilize the economy. Public transfer payments and progressive income taxes are examples of 5 . 6 is the idea that aggregate demand needed to be stimulated by government action. It forms the basis of 7 . The 8 means that small changes in income cause a larger change in spending. 9 is fiscal policy that provides incentives to producers to increase aggregate supply. The 10 illustrates how tax cuts affect tax revenues and economic growth. A 11 occurs when the government takes in more than it spends. When it spends more than it takes in 12 occurs. The 13 is the total amount of money owed to federal bondholders. The 14 results when the government outbids private bond interest rates. 470 Chapter 15 CHAPTER 15 Assessment What Is Fiscal Policy? (pp. 446–453) 1. What is the difference between expansionary fiscal policy and contractionary fiscal policy? 2. How do automatic stabilizers avoid the limitations that affect discretionary fiscal policy? Demand-Side and Supply-Side Policies (pp. 454–461) 3. Why does Keynesian economics advocate government spending during a recession? 4. What economic problems does supply-side economics try to address simultaneously? Deficits and the National Debt (pp. 462–469) 5. How does government finance deficit spending? 6. How does deficit spending contribute to the national debt? A P P LY Look at the bar graph below showing national debt as a percentage of GDP in several countries. 7. Which European countries on this graph have lower ratios of debt to GDP than the United States? 8. How does U.S. debt compare to Japan’s debt as a percentage of GDP? FIGURE 15.11 GOVERNMENT DEB T A S A PERC ENTAGE OF GDP Australia Belgium Canada France Germany Greece Italy Japan Luxembourg South Korea United Kingdom United States 0 50 100 150 200 Source: OECD Factbook 2005 . Analyzing Cause and Effect In early 2001, the Advise the President federal budget had shown surpluses for the previous three fiscal years and was predicted to continue to do so. The President and Congress thought the best thing to do was to return some of the surplus to taxpayers through tax cuts. How would supply-side economics describe the expected outcome of these tax cuts? 10. Applying Economic Concepts Suppose that you got a better job that increased your take-home pay each week from $250 to $300. Assume that you spent 80 percent of that increase. Give specific examples to show how your spending would create a multiplier effect. 11. Drawing Conclusions Recessions in 1990–1991 and in 2001 lasted about eight months each and were relatively mild in their effects on the overall economy. Why would policy lags limit the effectiveness of discretionary fiscal policy in bringing the country out of such recessions? 12. Making Inferences Between 1998 and 2001, the annual federal budgets showed surpluses, and the amount of national debt held by the public decreased by about $450 billion, yet the total federal debt grew by about $400 billion during that same time period. What do you think accounts for this difference? 13. Challenge In 1997, some members of Congress proposed a constitutional amendment that would require the federal budget to be balanced each year. Opponents argued that such an amendment would make recessions worse by requiring the government to use contractionary fiscal policy during such times. Why would a balanced budget require that kind of fiscal policy? Step 1 Form a team with two other students. Imagine that you are the Council of Economic Advisers whose job is to advise the president on the best fiscal policy to use in different economic situations. The current state of the economy is indicated by the following facts: a. The unemployment rate has risen from 4.5 percent to 6 percent. b. Automobile dealers, home improvement stores, and computer retailers have noted that their sales have dropped off sharply from the previous year. c. Fewer houses and commercial buildings are being built. Decide whether an expansionary or contractionary fiscal policy is needed. Step 2 Develop some specific government spending and taxation recommendations to follow through with your decision in Step 1. Think about what kinds of federal spending you would increase or decrease and what kinds of taxes you would cut or increase to achieve your objectives. Step 3 Some economic indicators have improved. However, the unemployment rate has not changed, and high energy costs have led to rapid increases in the Consumer Price Index. In light of this new information, recommend changes in fiscal policy to solve these problems. Step 4 The economy seems to be back on track. However, annual budget deficits are getting larger each year, and there is concern about the growing national debt. Recommend some ways to control deficit spending without harming the economy. Step 5 P
resent your policy suggestions to the rest of the class. As a class, discuss the differences and similarities among the plans offered by various groups. Using Fiscal Policy 471 The Money Supply Paper currency—an important part of the money supply—is distributed by the Federal Reserve. 472 CHAPTER 16 SECTION 1 The Federal Reserve System SECTION 2 Functions of the Federal Reserve SECTION 3 Monetary Policy SECTION 4 Applying Monetary and Fiscal Policy CASE STUDY Interpreting Signals from the Fed The Federal Reserve and Monetary Policy Fiscal policy is the federal government’s use of taxes and government spending to affect the economy. It has one of two goals: to decrease unemployment or to fight inflation. C H A P T E R 16 Monetary policy includes all the Federal Reserve actions that change the money supply in order to influence the economy. Its purpose is to curb inflation or to reduce economic stagnation or recession AT T E R S All economies experience the business cycle, a series of periods of growing and shrinking economic activity. Sometimes, these ups and downs become extreme, and the government takes action to even out the business cycle. The government has many tools available to do this—monetary policy is one of the most important. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on monetary policy. (See Case Study, pp. 504–505). Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. FIGURES 16.10 AND 16.11 SHORT- TERM EFFECTS OF MONETARY POLICY FIGURE 16.10 MONETARY EXPANSION FIGURE 16.11 MONETARY CONTRACTION MS2 MS1 12 10 8 6 4 2 0 MS2 MS1 12 10 8 6 4 2 0 MD MD Quantity of money Quantity of money How do interest rates affect the demand for money? See Figures 16.10 and 16.11 on page 495. The Federal Reserve and Monetary Policy 473 S E C T I O N 1 The Federal Reserve System TA K I N G N O T E S In Section 1, you will • examine the purpose and duties of a central bank • identify the distinctive features of the Federal Reserve System • explain the structure of the Federal Reserve System central bank, p. 474 monetary, p. 474 Federal Reserve System, p. 474 currency, p. 475 Board of Governors, p. 476 Federal Open Market Committee, p. 477 thrift institution, p. 478 As you read Section 1, complete a cluster diagram to identify the major characteristics of the Federal Reserve System. Use the Graphic Organizer at Interactive Review @ ClassZone.com Federal Reserve System Creating the Fed KEY CONCEPT S QUICK REFERENCE A central bank is a nation’s main monetary authority. Monetary is a term that means “relating to money.” The Federal Reserve System is the central bank of the United States. As you recall from Chapter 10, there were times when the U.S. economy suffered from panics and banking was very unstable. The government made many efforts to address this problem, but had only limited success. Perhaps the most far-reaching of these efforts to stabilize the American financial system was the passage of the Federal Reserve Act in 1913. This act created a central bank for the United States. A central bank is a nation’s main monetary authority, which is able to conduct certain monetary practices. (Monetary means “relating to money.”) The Federal Reserve System is the central bank of the United States and is commonly called the Fed. The Fed is an independent organization within the government, which has both public and private characteristics. The Duties of a Central Bank Most countries have a central bank to oversee their banking system. The central bank may be owned and controlled by the government or it may have considerable political independence. There are three common duties that all central banks perform: holding reserves, assuring stability of the banking and monetary systems, and lending money to banks and the government. Holding Reserves Central banks are sometimes called reserve banks. You learned in Chapter 10 that banks lend only a part of their funds to individuals and businesses and keep the rest in reserve. The central bank holds these reserves to influence the amount of loanable funds banks have available. This allows the central bank to control the money supply. 474 Chapter 16 Assuring Stability The central bank also acts to assure stability in the national banking and monetary systems. For example, it is one of the banking regulatory agencies that regulate and supervise banks to make sure that they act in ways that serve the interests of depositors and of the economy. Also, by controlling the way money is issued and circulated, the central bank attempts to avoid the confusion that might result when individual banks issue their own bank notes. Lending Money The final duty of the central bank involves one of the primary functions of all banks— it lends money. Its lending practices are unlike those other banks, however. It does not seek to make a profit through lending, and it serves private banks and the government rather than individual customers and businesses. The Duties of the Fed With the passage of the Federal Reserve Act of 1913, Congress created the first national bank in the United States that could truly fulfill the duties of a central bank. The Fed supervises banking in the United States by providing regulation and oversight to make sure that banks follow sound practices in their operations. The Fed also takes steps to ensure that banks do not defraud customers and works to protect consumers’ rights as they relate to borrowing money. Like all central banks, the Fed provides banking services for both private banks and the national government. It accepts and holds deposits in the form of cash reserves, transfers funds between banks or between banks and the government, and makes loans to these institutions. Because it performs such functions, the Fed is sometimes referred to as the bankers’ bank. This responsibility of the Fed is especially important in times of emergency. Shortly after the Fed was created, it played a major role in financing U.S. involvement in World War I by purchasing government war bonds. The Fed also took emergency action after the terrorist attacks on New York City and Washington, D.C. in 2001. It issued $45 billion in loans to banks throughout the United States in order to ensure that there would be as little disruption to the banking system as possible in light of the destruction in these cities. The Fed also distributes currency, which is coins and paper money, and regulates the supply of money. The supply of money does not mean actual cash but all available sources of money. Specifically, the amount of money that banks have available to lend has important effects on the whole economy. You will learn more about these functions of the Fed in Section 2. AP P LI CATION Comparing and Contrasting A. Recall what you learned about the structure and functions of commercial banks in Chapter 10. What are the similarities and differences between the Federal Reserve and a commercial bank? Creating the Fed President Woodrow Wilson proposed the Federal Reserve Act, in part, to break the power of the nation’s biggest banks. Find an update on the duties of the Fed at ClassZone.com QUICK REFERENCE Currency is coins and paper money. The Federal Reserve and Monetary Policy The Federal Reserve and Monetary Policy 475 The Structure of the Fed KEY CONCEPT S The Fed is different from most countries’ central banks because it is not a single national bank but has both a national and a regional structure. This structure represents a compromise between power resting at the regional level and at the national level. As you may recall from Chapter 10, many U.S. citizens were hesitant to give too much power to a national bank. In addition, the United States is a large and economically diverse country with a complex banking system. Elements of the Fed The elements that make up the Fed reflect this balance between national and regional authority. An appointed board sets national Fed policy, and a regional system of district banks carries out this policy and performs the duties of the central bank. This approach gives the Fed some independence from political influence. Even so, the Fed is ultimately accountable to Congress. Figure 16.1 shows how the Fed is organized. Board of Governors The Board of Governors is a board of seven appointed members who supervise the operations of the Fed and set policy. The president appoints members for a single 14-year term, with the approval of the Senate. One board member’s term expires every two years, and the president may also appoint replacements to fill vacancies created by members who leave before the end of their terms. The president chooses the chairman and vice-chairman, who serve four-year terms, from among F I G U R E 16 . Federal Open Market Committee (FOMC) 12 members— the Board of Governors plus the presidents of 5 Federal Reserve district banks Board of Governors 7 members appointed for 14-year terms Federal Reserve Banks 12 district banks and 25 branch banks Member Banks About 2,900 commercial banks Advisory Councils Federal Advisory Council Consumer Advisory Council Thrift Institutions Advisory Council QUICK REFERENCE The Board of Governors supervises the operations of the Fed. 476 Chapter 16 the seven members. The chairman is considered the most influential member and is the spokesperson for the board. Alan Greenspan, who held the position for nearly 20 years, was so influential as Fed chairman that he almost came to personify the institution. (You can read more about Alan Greenspan on page 494.) Twelve District Banks The Federal Reserve System is organized into 12 districts. Figure 16.2 shows these districts and the cities where the Federal Reserve district banks and the offices of the Board of Governors are located. While the district banks are responsible for carrying out the national policy set forth by the Board of Gov
ernors, each one also serves the needs of its particular region. F I G U R E 16 . 12 12 San Francisco 12 12 9 9 Minneapolis 10 10 Kansas City Dallas 11 11 7 7 Chicago St. Louis 8 1 1 2 2 Boston Cleveland 4 4 3 3 5 5 New York Philadelphia Washington, D.C. Richmond Atlanta 6 6 12 12 Board of Governors Federal Reserve Bank City Member Banks All nationally chartered banks automatically are members of the Federal Reserve System. State-chartered banks, if they wish, may apply to join the Fed. In 2004, there were about 2,000 national bank members and 900 state bank members, about 37 percent of all commercial banks. Each member bank must purchase stock in its Federal Reserve district bank. However, this stock ownership is not the same as ownership of stock in a private corporation or a commercial bank. It may not be bought or sold on the open market. Member banks earn a set dividend rate on the stock they hold. This helps to make up for the interest they do not earn on the reserves that the Fed requires them to hold. (See the information on reserve requirements on page 484.) Federal Open Market Committee The Federal Open Market Committee (FOMC) is a board of the Fed that supervises the sale and purchase of federal government securities. The term open market refers to the way that government securities are bought and sold. The FOMC consists of 12 voting members, including the Board of Governors, the president of the Federal Reserve Bank of New York, and four other Fed district bank presidents who take turns serving one-year terms. All Fed bank presidents attend the meetings and provide input even when they have no vote. QUICK REFERENCE The Federal Open Market Committee (FOMC) supervises the sales and purchase of government securities. The Federal Reserve and Monetary Policy 477 Comparing Central Banks Today, more than 160 nations have central banks. These banks function as the main monetary authority for their respective nations. They also serve the same purpose— maintaining economic stability. Further, they use similar tools to fulfill this purpose. Even so, these central banks do have several differences. One difference is historical. The Federal Reserve, for example, was established by an act of Congress in 1913. The Bank of England, Great Britain’s central bank, claims a royal pedigree, having been established in 1694 during the reign of William and Mary. In China, the People’s Bank of China (PBC) began as a commercial bank in 1948. It functioned as a central bank and a commercial bank until 1983, when it was reorganized solely as a central bank. Another difference lies in the production of money. The Chinese bank note British bank note central banks of Great Britain and China both produce and distribute currency. In the United States, the Treasury produces currency and the Federal Reserve distributes it. CONNECTING ACROSS THE GLOBE 1. Why do you think central banks are common to countries that have very different forms of government, such as the United States and China? 2. In terms of money production, how does the Bank of England differ from the Federal Reserve? The sale and purchases of federal government bonds on the open market are the principal tools used by the Fed to promote a stable, growing economy. At the end of each of its meetings, the FOMC issues a public statement to explain its assessment of the economy and its latest actions. You will learn more about the functions of the FOMC in Section 3. Advisory Councils Three committees provide advice directly to the Board of Governors. The 12 members of the Federal Advisory Council, one from each Fed district, represent the commercial banking industry. The Consumer Advisory Council advises the board on matters concerning the Fed’s responsibilities in enforcing consumer protection laws related to borrowing. Its 30 members, for the most part, are drawn from consumer groups and the financial services industry. The Federal Reserve Board created the Thrift Institutions Advisory Council in 1980 to provide advice about the needs of this important segment of the financial services industry. Thrift institutions are savings and loan institutions, savings banks, or other institutions that serve savers. While the Fed does not regulate thrift institutions, the thrifts must conform to the Fed’s reserve requirements and may borrow from the Fed. APPLICATION Making Inferences B. How does the 14-year term of members of the Board of Governors help make the Fed an independent government agency? QUICK REFERENCE A thrift institution is a financial institution that serves savers. 478 Chapter 16 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. central bank c. Board of Governors Federal Reserve System Federal Open Market Committee b. monetary currency 2. What are the three duties of a central bank? 3. How is the Fed different from other central banks? 4. How does the composition of the Federal Open Market Committee reflect the blend of national and regional power in the Fed? 5. What do all thrift institutions have in common? 6. Using Your Notes What are the five elements of the Fed? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Federal Reserve System Analyzing Information Refer to Figure 16.2 on page 477 to answer the following questions about the creation and present alignment of the Fed. Analyze Maps Complete the chart below by indicating your answer to each question in the space provided Question Response 7. Analyzing Causes and Effects If all members of the Board of Governors served 14-year terms, no president would appoint more than four members during two terms in office. However, many board members do not serve full terms, and vacancies occur on average more than once every two years. How does this situation affect a president’s influence on the Board? 8. Drawing Conclusions The four rotating members on the Federal Open Market Committee are chosen from these groups: • Boston, Philadelphia, and Richmond • Cleveland and Chicago • Atlanta, St. Louis, and Dallas • Minneapolis, Kansas City, and San Francisco Why does the Fed mandate that one of the rotating members must come from each of these four groups? 9. Challenge The Federal Reserve Act of 1913 created the Federal Advisory Council. The Consumer Advisory Council was not created until 1976. How does this difference reflect changes in the duties of the Fed? Which region of the country has the most Fed district banks? How does the size of Fed districts 1–5 compare with districts 9–12? Where is the Board of Governors located? In which Fed district is your community located? How do the Federal Reserve Districts reflect U.S. geographic and economic diversity? Challenge How might the Federal Reserve districts be different if they were created today? 479 S E C T I O N 2 Functions of the Federal Reserve TA K I N G N O T E S In Section 2, you will check clearing, p. 480 bank holding company, p. 481 bank exams, p. 481 required reserve ratio, p. 484 deposit multiplier formula, p. 485 • identify the services the Fed provides for the banking system • explain how the Fed acts as a banker for the federal government • describe the creation of money • discuss what factors influence the money supply As you read Section 2, complete a chart to identify the major functions of the Federal Reserve. Use the Graphic Organizer at Interactive Review @ ClassZone.com Functions of the Federal Reserve Serving the banking system Serving the federal government Creating money Serving the Banking System KEY CONCEPT S As the banker’s bank, the Fed has the responsibility of helping banks do their jobs. The Fed serves the banking system in a variety of ways, including providing check clearing and other services that facilitate the transfer of funds, lending money, and regulating and supervising banking activity. QUICK REFERENCE SERVICE 1 Check Clearing Check clearing is a service offered by the Fed to record receipts and expenditures of bank clients. One of the services that the Fed offers to banks is check clearing, a process in which banks record the receipts and expenditures of their clients. Each Fed district processes millions of checks every day, but most checks clear in two days or less. Figure 16.3 on the next page shows how a check is cleared by following its path from the time it is written until the money is taken from the check writer’s account. Electronic-payment methods, such as credit and debit cards, have begun to replace checks. Further, more private companies are involved in the check-clearing process. As a result, check clearing has become a less important function of the Fed. SERVICE 2 Lending Money Banks often loan each other money on a short-term basis. Sometimes all the banks in a region are faced with short-term cash flow issues, usually during natural disasters. At such times, the Fed will provide 480 Chapter 16 F I G U R E 16 . 3 The Federal Reserve and Check Clearing 1 Mike—who lives in Evanston, Illinois —buys a 10-pack of guitar strings from Gary’s Guitar Garage in Portland, Oregon. He writes a check for $30. 2 Gary, the store owner, deposits the check at his bank Mike’s bank transfers $30 from its reserve to the Federal Reserve Bank of Chicago and deducts $30 from Mike’s account. This transaction is reﬂ ected on Mike’s next bank statement. MIKE’S BANK D AT PAY The Federal Reserve Bank of Chicago transfers $30 from its reserves to the San Francisco Fed district bank and then sends Mike’s check to his bank in Evanston. 3 Gary’s bank credits his account with $30 and then sends Mike’s check to the Federal Reserve Bank of San Francisco—the Fed district bank that serves Portland. 4 The Federal Reserve Bank of San Francisco credits $30 to Gary’s bank’s reserve account and then sends Mike’s check to the Federal Reserve Bank of Chicago—the Fed district bank that serves Evanston. ANALYZE CHARTS This diagram illu
strates the steps in the check-clearing process for a typical check transaction. Note how many banks handle Mike’s check during the process. What is the importance of the Fed’s role in clearing Mike’s check? loans to banks and may charge reduced interest rates. Banks must have sufficient assets and capital to qualify for Fed loans. In addition, smaller banks that have seasonal cash flow needs due to the nature of their local economy may borrow from the Fed. The Fed also acts as the lender of last resort to prevent a banking crisis. S E RVI CE 3 Regulating and Supervising Banks Each Federal Reserve Bank supervises the practices of state-chartered member banks and bank holding companies in its district. A bank holding company is a company that owns, or has a controlling interest in, more than one bank. This supervision includes bank exams, which are audits of the bank’s financial practices. These exams make sure that banks are not engaged in risky or fraudulent practices, especially in lending. The Fed monitors bank mergers to ensure that competition is maintained and enforces truth-in-lending laws to protect consumers in such areas as home mortgages, auto loans, and retail credit. QUICK REFERENCE A bank holding company owns, or has a controlling interest in, more than one bank. A bank exam is an audit of the bank’s financial practices. AP P LI CATION Making Inferences A. Why might the Fed help a small bank in an agricultural region stabilize its cash flow? The Federal Reserve and Monetary Policy The Federal Reserve and Monetary Policy 481 Serving the Federal Government KEY CONCEPT S A second function of the Fed is to serve as the federal government’s banker. As you learned in Chapter 14, the federal government receives billions of tax dollars each year and uses this money on a variety of programs through direct spending and transfer payments. In its role as the federal government’s banker, the Fed also fulfills certain fiscal responsibilities by helping the government to carry out its taxation and spending activities. SERVICE 1 Paying Government Bills When the IRS collects tax revenues, the funds are deposited with the Fed. The Fed then issues checks or makes electronic payments, via the U.S. Treasury, for such programs as Social Security, Medicare, and IRS tax refunds. When these funds are deposited in the recipient’s bank account or the check is cashed, the Fed deducts that amount from the government’s account. Including military personnel, the federal government employs about 4.6 million people, and their wages and benefits are processed through the Fed. Direct government spending also comes from accounts at the Fed. Whether the government is buying office supplies or military equipment or paying contractors to maintain federal highways, the money is funneled through the Fed. The Fed also processes food stamps, which are issued by the Department of Agriculture, and postal money orders, which are issued by the U.S. Postal Service. The Fed, therefore, facilitates government payments in a way that is similar to the way it clears checks and processes electronic payments in the private sector. SERVICE 2 Selling Government Securities As you learned in Chapter 15, the federal government has different kinds of securities that it sells when it wants to borrow money. (Remember that securities are another name for bonds and stocks.) The Fed processes U.S. savings bonds and auctions other kinds of securities for the U.S. Treasury to provide funds for various government activities. The Fed has many roles in this process. It provides information about the securities to potential buyers, receives orders from customers, collects payments from buyers, credits the funds to the Treasury’s account, and delivers the bonds to their owners. It also pays the interest on these bonds on a regular basis or at maturity. Many of these transactions are now handled electronically. Even when individuals purchase government securities on the Treasury Department’s Web site, the Fed transfers funds between the purchaser and the Treasury and pays the interest when it is due. The Fed does not charge fees for these services. In addition to selling government securities to raise money to fund government activities, the Federal Open Market Committee supervises the sales and purchases of government securities as a way to stabilize the economy. You’ll learn more about this aspect of the Fed’s work in Section 3. Find an update on the Fed’s role in the sale of government securities at ClassZone.com 482 Chapter 16 S E RVI CE 3 Distributing Currency One of the important functions of a central bank is to issue a standard currency that is used throughout the economy. In the United States, Federal Reserve notes are the official paper currency. These notes are fiat money backed by the confidence of the federal government and managed by the Federal Reserve. The government’s backing is made plain by the statement on each note: “This note is legal tender for all debts, public and private.” Figure 16.4 highlights several important features of Federal Reserve notes. The Department of the Treasury’s Bureau of Engraving and Printing prints Federal Reserve notes, which are distributed by the Fed to its district banks. The notes are then moved on to depository institutions and finally into the hands of individuals and businesses. The Fed makes sure that bills are distributed to banks in the amounts that they need. Paper money has a life span of between two and five years. Smaller denomination bills tend to have a shorter life span. Larger denomination bills stay in circulation longer. When bills get worn out, they are taken out of circulation, destroyed, and replaced with new ones. In a similar way, the Fed distributes coins that are produced by the U.S. Mint. FIGURE 16.4 A FEDERAL RESERVE NOTE Federal Reserve Notes are the official U.S. paper currency. b Code indicates to which Federal Reserve Bank the Treasury issued the note. For example, B2 is New York, E5 is Richmond, and K11 is Dallas. c Each note has a unique serial number. The second letter identifies the Fed district to which the note was issued. d The Federal Reserve seal is on the left, the Treasury Department seal on the right. e The signature of the Treasurer is on the left, the signature of the Secretary of the Treasury on the right. f In 1955, Congress required that the phrase “In God We Trust” be used on all currency and coins. ANALYZE 1. To which Federal Reserve Bank was this bill issued? 2. How might serial numbers help the authorities detect counterfeit bills? AP P LI CATION Comparing Economic Information B. How are the banking services the Fed provides to the government similar to the services it provides to banks? The Federal Reserve and Monetary Policy 483 Creating Money KEY CONCEPT S Creating money does not mean printing paper currency and minting coins. It refers to the way money gets into circulation through deposits and loans at banks. (You learned briefly about this process in Chapter 10.) Because the United States has a fractional reserve banking system, banks are not allowed to loan out all the money they have in deposits. The Fed establishes a required reserve ratio (RRR), which is the fraction of the bank’s deposits that must be kept in reserve by the bank, to control the amount a bank can loan. Money on deposit in excess of the required reserve amount can be loaned out. The money in reserve may be stored as cash in the bank’s vault or deposited with the Fed. EXAMPLE Money Creation The banking system creates money whenever banks receive deposits and make loans. The level of the RRR determines how much money may be loaned and, therefore, how much money gets created. Let’s see how this works by studying Figure 16.5. At the top of the chart, the RRR is set at 20 percent. If Bank A has $10,000 in deposits, it must keep 20 percent, or $2,000, on reserve. It lends the remaining $8,000 to Kecia’s Fitness Studio, which Kecia deposits in Bank B. Bank B keeps 20 percent of the $8,000, or $1,600, on reserve as required. Bank B lends the remaining $6,400 to Juan’s Computer Repair, and Juan deposits it in Bank C. At this point, the money supply has increased by $14,400, the total of the loans made. The process could continue until there was nothing left to lend. F I G U R E 16 . 5 The Fed Creates Money $ $ $ $ $ $ 20% The Fed sets the RRR at: 10% Loans available RRR $ $ $ $ $ $ ANALYZE CHARTS Remember that the amount of money that each bank can loan is limited by the RRR. Suppose that Bank C loaned its available funds to Miles and Miles deposited the money in Bank D. How much money would Bank D have to hold in reserve and how much would it have available for loans if the RRR is set at 20 percent? What would these figures be if the RRR were set at 10 percent? QUICK REFERENCE Required reserve ratio (RRR) is the fraction of a bank’s deposits that it must keep in reserve. 484 Chapter 16 Now look at what happens if the Fed reduces the RRR to 10 percent. The change is shown at the bottom of Figure 16.5. Bank A can now lend $9,000 to Kecia and Bank B can lend $8,100 to Juan. In this scenario, the money supply would increase by $17,100. The decrease in the RRR allowed the money supply to increase by an additional $2,700. How do you figure out how much the money supply will increase after all possible loans have been made? The deposit multiplier formula is a mathematical formula that tells how much the money supply will increase after an initial cash deposit in a bank. The formula is 1/RRR. For example, if the RRR is 10 percent the deposit multiplier equals 10. Figure 16.6 illustrates how the deposit multiplier formula is used to determine the amount of increase in the money supply from an initial deposit of $100 and a reserve requirement of 10 percent. QUICK REFERENCE Deposit multiplier formula tells how much the money supply will increase after an initial cash deposit. M AT 16 . Step 1: Study the table b
elow, which shows how an initial deposit of $100 can increase the money supply. To quantify the total amount of money that can be created from this initial deposit, economists use the deposit expansion multiplier. Bank A Bank B Bank C Bank D --- Money deposited $100.00 $90.00 $81.00 $72.90 --- Total = = = = = 10% held as reserves $10.00 $ 9.00 $ 8.10 $ 7.29 --- $100.00 + + + + + 90% loaned out $90.00 $81.00 $72.90 $65.61 --- $900.00 Step 2: Calculate the deposit expansion multiplier. Sample Calculations 1 Required reserve ratio = Deposit expansion multiplier 1 1 = 10% 0.10 = 10 Step 3: Use the deposit expansion multiplier to calculate the total money that can be loaned. Initial deposit Deposit expansion – 1 multiplier = Total available for loans $100 [10 – 1] = $100 9 = $900 AP P LI CATION Analyzing Effects C. If the Fed raised the RRR from 10 percent to 12 percent, how would it affect the money supply and by approximately how much, if the initial deposit was $5,000? Show your calculations. The Federal Reserve and Monetary Policy 485 Factors Affecting Demand for Money KEY CONCEPT S The Fed monitors two major indicators of the money supply, namely M1 and M2. Recall that you learned in Chapter 10 that M1 includes cash and checkable deposits, while M2 includes M1 plus savings deposits and certain time deposits. The Fed needs to know how large each type of money is in order to act appropriately to manage the supply of money. Four factors influence how much money individuals and businesses need—cash on hand, interest rates, the cost of consumer goods and services, and the level of income. FACTOR 1 Cash on Hand Individuals and businesses need cash to complete certain financial transactions. Recall that M1, which includes cash and checkable deposits, is also called transactions money. Consumers use this money to pay for things such as food, clothing, transportation costs such as gasoline and bus or train fares, and entertainment. Businesses also use cash and checks for many day-to-day expenses. The fastest growing form of payment is the debit card, which was used for more than 23 billion transactions in 2005. While a debit card is not money, it is linked to a checking account, and the funds in the account are considered money. The Fed understands that there are certain times when people need more cash. It routinely increases the amount of cash at banks during the holiday season because people want more money to buy gifts. Similarly, during the summer months the Fed ensures that banks in areas popular with tourists have more cash. Natural disasters also influence the amount of cash the Fed puts into circulation. In response to Hurricane Katrina’s devastation of the Gulf Coast in 2005, the Fed shipped large amounts of currency to banks in several nearby districts because of the immediate demand for more cash by residents. Since many parts of the Gulf Coast were without electricity, people were not able to use debit cards and credit cards as they ordinarily would. FACTOR 2 Interest Rates When interest rates are high, individuals and businesses may place excess cash in savings instruments, such as bonds, stocks, or savings accounts. This of course pulls cash out of circulation. The money then exists as a part of M2. Figure 16.7 shows how the demand for money is affected by interest rates. When interest rates are high, the demand for money is lower because there is less incentive for individuals and businesses to spend and more incentive to save and earn interest. When interest rates are lower, however, more money is demanded because people have less incentive to save and more incentive to spend. Cash on Hand Portable ATMs dispensed muchneeded cash to evacuees from the Gulf Coast after Hurricane Katrina. 486 Chapter 16 FIGURE 16.7 DEMAND FOR MONEY Here, the term money refers to M1. Note that when interest rates are high the quantity demanded of money is lower. Conversely, when interest rates decrease the quantity demanded of money increases. Quantity of money demanded FACT OR 3 Cost of Consumer Goods and Services As the cost of consumer goods or services increases, buyers may wish to have more money available. Suppose that adverse weather conditions and higher energy prices have driven up the prices of fresh fruits and vegetables. People may need to have more cash when they buy groceries at the supermarket than they did before the prices increased. They might also find that it takes more cash to buy gasoline than it used to. Businesses face the same challenges. They would also wish to have more cash to purchase the goods and services they need for their operations. Of course, when businesses pay more for goods and services, production costs increase and the higher costs are often passed on to consumers. This, in turn, may lead consumers to want to have more money available. FACT OR 4 Level of Income As income increases, individuals and companies have a tendency to hold more cash. Recall that level of income is one of the factors that affect demand. Suppose that Bob has a part-time job cooking at a restaurant. When he gets a raise, he notices that he keeps more money in his wallet because he feels he can afford to spend more on clothes and DVDs. The same holds true for businesses. When their income increases, they will keep more cash because they are able to spend more on the goods and services that they need to pay for operations. In general, when income levels rise, so will the demand for money. The Fed can take several actions to change the money supply in response to changes in demand for money. More important, the Fed can use these methods of increasing or decreasing the money supply to stabilize the economy. In the next section, you’ll learn about the nature of these methods and how they are used to establish economy stability. AP P LI CATION Analyzing Effects D. Which factor is likely to increase the size of M2? Why? The Federal Reserve and Monetary Policy 487 For more information on comparing economic information, see Skillbuilder Handbook, page R19 Comparing the Treasury and the Fed The following passage provides information about the U.S. Treasury and the Federal Reserve System. Compare the two by looking for similarities and differences between them. This will help you understand the role that each plays in the nation’s economy. TIPS FOR COMPARING Use the following tips to help you compare economic information. The U.S. Treasury and the Federal Reserve System Although the U.S. Treasury and the Federal Reserve are both essential to the functioning of the nation’s economy, they differ in many ways. The U.S. Treasury Department was established by an act of Congress in 1789. It is the primary federal agency responsible for the economic prosperity of the United States. As such, it is responsible for managing federal finances, including the collection of taxes, duties, and other monies due to the United States; the paying of the nation’s bills; and the management of government accounts and the public debt. In addition, the Treasury Department produces stamps, currency, and coinage. The Federal Reserve System similarly was established by an act of Congress but much later, in 1913. Unlike the U.S. Treasury, which is a department of the federal government, the Fed is the nation’s central bank. According to its mission statement, the purpose of the Federal Reserve is “to provide the nation with a safer, more flexible, and more stable monetary and financial system.” The duties of the Federal Reserve fall into four general areas: conducting the nation’s monetary policy in pursuit of maximum employment and economic stability; supervising and regulating the nation’s banking institutions; maintaining the stability of the financial system; and providing financial services such as check clearing and shortterm loans to member banks. The Fed consists of a board of governors and 12 regional banks, a structure that varies considerably from that of the Treasury. Look for words that signal similarities, such as both, similarly, and also. Look for words that signal differences, or contrasts, such as unlike, differ, and varies. T HINKING ECONOMICALLY Analyzing 1. In what ways are the Treasury and the Fed similar? 2. What are some important differences between the Fed and the Treasury? 3. Which do you think is more policy oriented, the Fed or the Treasury? Explain why you think so. 488 Chapter 16 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Use each of the three terms below in a sentence that illustrates the meaning of the term. a. check clearing b. bank holding company c. required reserve ratio 2. Why are bank exams an important way for the Fed to help create a sound banking system? 3. What is the relationship between the required reserve ratio and the deposit multiplier formula? 4. How does the Fed’s check-clearing service help the banking system? Buying school supplies 5. How does the deposit multiplier formula allow the Fed to create money through the banking system? 6. Using Your Notes What are the three services that the Fed provides to the federal government? Refer to your completed chart. Functions of the Federal Reserve Serving the banking system Serving the federal government Creating money Use the Graphic Organizer at Interactive Review @ ClassZone.com . Applying Economic Concepts Daniel is a high school senior living in California. He receives a check from his grandmother in Florida as a graduation gift. How is the Federal Reserve involved in transferring the money from Daniel’s grandmother’s bank account to his account? Illustrate your answer with a flow chart. 8. Applying Economic Concepts You’ve been planning your college finances and you know that you’ll have to take a bank loan to cover tuition costs. You read that the Fed intends to raise the RRR from 10 percent to 20 percent. How will this change affect the money supply and your ability to borrow money for college tuition? 9. Analyzing Data The Fed sets the
required reserve ratio at 10 percent. What is the initial deposit if the money supply increases by $40,000? Use the deposit multiplier formula to determine your answer and show your calculations. 10. Challenge Banks do not earn interest on the funds they hold as reserves. How does this provide an incentive to banks to create money by making loans rather than to deposit excess funds in a Fed bank? Evaluating Demand for Money Consider the factors that affect the demand for money and then complete the following activities. Identify Changes in Demand The chart below shows some scenarios that would cause demand for money to change. For each example, note if demand is increasing or decreasing. Factor Affecting Demand for Money Increasing or Decreasing? Back-to-school shopping begins Banks lower the interest rate on CDs from 6% to 3% Energy costs for home heating are up by 20% Interest rates on savings deposits increase from 1% to 4.5% Challenge What type of potential economic instability is suggested by rising prices? How might the Fed adjust the money supply in such a situation? You will learn more about this topic in Section 3. 489 S E C T I O N 3 Monetary Policy TA K I N G N O T E S In Section 3, you will monetary policy, p. 490 • examine the Fed’s tools for open market operations, p. 490 monetary policy • explain how the Fed’s monetary policy promotes growth and stability • analyze the challenges the Fed faces in implementing its policy federal funds rate, p. 490 discount rate, p. 491 prime rate, p. 491 expansionary monetary policy, p. 492 contractionary monetary policy, p. 492 Monetary Policy easy-money policy, p. 492 tight-money policy, p. 493 monetarism, p. 496 main ideas main ideas main ideas details details details As you read Section 3, complete a hierarchy diagram to track main ideas and supporting details about monetary policy. Use the Graphic Organizer at Interactive Review @ ClassZone.com The Fed’s Monetary Tools KEY CONCEPT S Monetary policy involves Federal Reserve actions that change the money supply in order to influence the economy. There are three actions the Fed can take to manage the supply of money: open market operations, adjusting the reserve requirement, and adjusting the discount rate. They may be taken individually or in combination with one another. The impact of these actions is shown in Figure 16.8. ACTION 1 Open Market Operations Open market operations are the sales and purchase of marketable federal government securities. This is the monetary policy tool most used by the Fed to adjust the money supply. When the Fed wants to expand the money supply, it buys government securities. The Fed pays for the bonds it buys from commercial banks or the public by writing checks on itself. When sellers receive the funds from the Fed, they deposit them in banks. The banks can then lend their new excess reserves. When the Fed wants to contract the money supply, it sells government bonds on the open market. The purchasers of the bonds transfer funds to the Fed to pay for the bonds. These funds are taken out of circulation, and the reserves available for loans decrease. The Fed communicates its intention to buy or sell bonds by announcing a target for the federal funds rate. The federal funds rate (FFR) is the interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight. When the Fed lowers the target for the FFR, it buys bonds. When it raises the target, it sells bonds. The Fed does not set the rate directly but influences it through its actions. QUICK REFERENCE Monetary policy includes the Fed’s actions that change the money supply in order to influence the economy. Open market operations are the sales and purchase of federal government securities. The federal funds rate (FFR) is the interest rate that banks charge one another to borrow money. 490 Chapter 16 FIGURE 16.8 TOOLS OF MONETARY POLICY The Fed sells bonds; FFR rises Excess reserves and lending decrease; money supply contracts The Fed raises RRR; banks hold more reserves Banks decrease lending; money supply contracts The Fed raises the discount rate; banks borrow less Banks have fewer reserves to lend; money supply contracts OPEN MARKET OPERATIONS RESERVE REQUIREMENT DISCOUNT RATE The Fed buys bonds; FFR falls Excess reserves and lending increase; money supply expands The Fed lowers RRR; banks hold fewer reserves Banks increase lending; money supply expands The Fed lowers the discount rate; banks borrow more Banks have more reserves to lend; money supply expands ACT I ON 2 Adjusting the Reserve Requirement As you recall from Section 2, the Fed sets the required reserve ratio (RRR) for all depository institutions. The RRR affects the money supply through the deposit multiplier formula. Increasing the RRR can reduce the money supply; decreasing the RRR can expand the money supply. Since the early 1990s, the RRR has been between 10 and 12 percent for transaction deposits and between 0 and 3 percent for time deposits. ACT I ON 3 Adjusting the Discount Rate The discount rate is the interest rate that the Fed charges when it lends money to other banks. The discount rate affects the money supply because it sets the reserves that banks have available to lend. When the Fed increases the discount rate, banks tend to borrow less money from the Fed. They must then use their existing funds to meet reserve requirements and have less excess reserves to lend. Therefore, the money supply decreases. The opposite happens when the discount rate is lowered. Banks borrow more money from the Fed and increase their reserves. When this happens, they have more money to lend, and the money supply increases. The Fed’s actions also impact businesses and individuals who borrow. The prime rate is the interest rate that banks charge their best customers. Interest rates for other borrowers tend to be two or three percentage points above prime. To make a profit on the loans they make, banks need to charge higher rates than they pay to borrow. So when the discount rate increases, so does the prime rate and, therefore, the cost of business and consumer credit. AP P LI CATION Analyzing Causes A. Which open market operation causes the money supply to expand? Why? QUICK REFERENCE The discount rate is the interest rate that the Fed charges when it lends money to other banks. The prime rate is the interest rate that banks charge their best customers. The Federal Reserve and Monetary Policy The Federal Reserve and Monetary Policy 491 Approaches to Monetary Policy KEY CONCEPT S The most important job of the Fed is to promote growth and stability in the American economy. The purpose of monetary policy is to curb inflation and reduce economic stagnation or recession. By focusing on these goals, the Fed tries to promote full employment and growth without rapid increases in prices or high interest rates. The Fed uses two basic policies—expansionary or contractionary monetary policy. Expansionary monetary policy is a plan to increase the amount of money in circulation. Contractionary monetary policy is a plan to reduce the amount of money in circulation. When the economy slows, the Fed uses expansionary monetary policy to pump more money into the economy. When the economy is overheated, the Fed uses a contractionary policy to reduce the amount of money in the economy. POLICY 1 Expansionary Policy In Chapter 15 you studied expansionary policy as it related to the federal government’s fiscal-policy actions. This type of fiscal policy is used during a slowdown in economic activity. The Fed’s expansionary monetary policy is used at the same point in the business cycle. It is sometimes called the easy-money policy because it puts more money into circulation by making it easier for borrowers to secure a loan. During a recession, when unemployment is high, the Fed wants to have more money circulating in the economy to stimulate aggregate demand. When it is easier to borrow money, consumers will take out more loans to buy homes, automobiles, and other goods and services. In response, businesses then produce more, which creates jobs and decreases unemployment. An easy-money policy allows businesses to borrow funds to help them expand. When more loans are made, more money is created in the banking system. The Fed enacts an easy-money policy by buying bonds on the open market, by decreasing reserve requirements, by decreasing the discount rate, or by some combination of these tools. The Fed’s most common action in this situation is to buy bonds on the open market. When the Fed decides to buy more bonds, it increases the demand for them, which raises their price. Recall that bond prices have an inverse, or opposite, relationship to interest rates. When bond prices rise, interest rates fall. Lower interest rates will encourage more lending. More lending increases consumer spending and investment. This, in turn, increases aggregate demand, resulting in the growth of GDP and lower unemployment. If the Fed expands the money supply too much, however, aggregate demand may increase to a level that causes inflation. QUICK REFERENCE Expansionary monetary policy is a plan to increase the money supply. Contractionary monetary policy is a plan to reduce the money supply. Easy-money policy is another name for expansionary monetary policy. Monetary Policy The Fed’s monetary policy must be well-timed and well-balanced to have the required effect. 492 Chapter 16 QUICK REFERENCE Tight-money policy is another name for contractionary monetary policy. P OL ICY 2 Contractionary Policy In Chapter 15, you also studied the federal government’s contractionary fiscal policy, used during an expansionary period. The Fed’s contractionary monetary policy also is used when economic activity is rapidly increasing. It is sometimes called a tightmoney policy because it is designed to reduce inflation by making it more difficult for bu
sinesses and individuals to get loans. Suppose that aggregate demand is increasing faster than aggregate supply, leading to higher prices and concerns about inflation. The Fed would want to have less money circulating because more money fuels demand and may lead to inflation in wages and prices. In other words, the Fed would want to make it harder for businesses and individuals to borrow money. Therefore, it would decrease the money supply by decreasing reserves available for loans. The Fed enacts a tight-money policy by selling bonds on the open market, increasing reserve requirements, or increasing the discount rate. As with easymoney policy, the Fed’s most likely action involves open market operations. Selling bonds causes bond prices to fall and interest rates to increase. Higher interest rates discourage lending. Less lending decreases aggregate demand, which decreases growth in GDP, and lowers the general price level. If the Fed contracts the money supply too much, however, aggregate demand may decrease to a level where unemployment increases. Figure 16.9 summarizes how the Fed uses expansionary and contractionary monetary policies 16 . 9 Approaches to Monetary Policy How does the Fed use its monetary policy tools? Expansionary Policy • Buy bonds on the open market • Lower the reserve requirement • Reduce the discount rate Contractionary Policy • Sell bonds on the open market • Raise the reserve requirement • Increase the discount rate ANALYZE CHARTS Monetary policy is designed to even out the extremes of the business cycle by expanding or contracting the money supply. Explain how the actions listed under Expansionary Policy increase the supply of money and those under Contractionary Policy decrease the supply of money. AP P LI CATION Comparing and Contrasting B. What are the similarities and differences between expansionary fiscal policy and expansionary monetary policy? The Federal Reserve and Monetary Policy 493 ECO N O M I C S PAC ES E T T E R Alan Greenspan: Fighting Inflation During his 18-plus years as chairman of the Fed, Alan Greenspan came to personify the institution. The worldwide financial community and the media waited eagerly to hear what he would say after each meeting of the FOMC. Why did so many people come to believe that one man’s decisions could have such a profound impact on everything from the performance of the stock market to mortgage rates? Managing Monetary Policy President Ronald Reagan appointed Alan Greenspan chairman of the Federal Reserve Board of Governors in 1987. He had a reputation as a committed inflation fighter and fulfilled that role with great success. The core inflation rate was 3.9 percent when he became chairman and was 2 percent in 2005. Although the chairman has only one vote on the FOMC, Greenspan’s economic insight and persuasiveness gave him much greater power. He led the Fed in using open market operations to help raise interest rates to cool down the economy when it experienced inflationary periods. At other times, for example, when the stock market crash of October 1987 threatened to lead the economy into a severe recession, Greenspan responded by expanding the money supply as needed to cushion the shock. Then, in the late 1990s, he pushed the Fed to edge up interest rates, and the economy experienced a period of unprecedented growth without inflation. Greenspan’s success was due to his clear understanding of the tools of monetary policy and how to apply them, as well as in-depth knowledge of a wide range of economic indicators. Also, throughout his years as chairman, he developed a sense of timing, knowing just when to direct the Fed to expand the money supply and when to contract it. A Celebrity During his tenure as Fed chairman, Alan Greenspan practically achieved celebrity status. APPLICATION Making Inferences C. Did Greenspan advocate a tight-money policy or an easy-money policy in the late 1990s? How do you know? FAST FACTS Alan Greenspan Title: Chairman of the Federal Reserve Board (1987–2006) Born: March 6, 1926, New York City Major Accomplishment: Controlled inflation while supporting unprecedented economic growth Presidents Served Under: Ronald Reagan, George H. W. Bush, Bill Clinton, George W. Bush Time as Fed Chairman: 18 years, 5 months (second longest tenure) Notable Quotation: I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said. Find an update about Alan Greenspan at ClassZone.com 494 Chapter 16 Impacts and Limitation of Monetary Policy KEY C ONCEPT S As you recall, the purpose of monetary policy is to curb inflation and to halt recessions, which result in unemployment. But what impact does monetary policy have on the economy, and how successful is it in fulfilling its purpose? IMPACT 1 Short-Term Effects Adjustments to monetary policy have both short-term and long-term effects. The short-term effect is change in the price of credit—in other words, the interest rates on loans. The Fed’s open market operations influence the FFR fairly quickly by increasing or decreasing the level of reserves that banks have available to lend. Figure 16.10 shows that when the Fed uses an easy-money policy to expand the money supply, interest rates decline. When the Fed uses a tight-money policy, as shown in Figure 16.11, interest rates rise. FIGURES 16.10 AND 16.11 SHORT- TERM EFFECTS OF MONETARY POLICY FIGURE 16.10 MONETARY EXPANSION FIGURE 16.11 MONETARY CONTRACTION MS2 MS1 12 10 8 6 4 2 0 MS2 MS1 12 10 8 6 4 2 0 MD MD Quantity of money Quantity of money ANALYZE GRAPHS 1. What happens to the equilibrium interest rate in Figure 16.10? What happens to it in Figure 16.11? 2. How do these graphs show the effects of easy- money and tight-money policy? Use an interactive money supply curve at ClassZone.com The money supply (MS1, MS2) is a vertical line because it represents the fixed amount of money available as determined by the Fed. Demand for money (MD) is the same as demand for any product. As prices (interest rates) fall, demand increases. As prices rise, demand falls. a The supply curve shifts to the right when the money supply expands. b The supply curve shifts to the left when the money supply contracts. IMPACT 2 Policy Lags Some lags, or delays, that affect monetary policy are related to identifying the problem. The Fed needs specific information and statistics in order to identify the problem and take action. Other lags have to do with how quickly the change in policy The Federal Reserve and Monetary Policy 495 takes effect. Many economists suggest that it may take as long as two years for adjustments in monetary policy to take full effect. This may have long-term effects on the economy. For example, businesses often delay plans for expansion if interest rates are too high. Because policies designed to lower rates may take some time to take effect, actual investment in expansion may lag months or years behind the plans. IMPACT 3 Timing Issues As with fiscal policy, monetary policy must be coordinated with the business cycle in order to provide a stable economic environment. If the policy is correct and the timing is good, extremes in the business cycle will be evened out. If the timing is bad, a business cycle phase may be exaggerated. For example, high interest rates in 1990 that were intended to help fight inflation actually took effect as the economy was going into a recession, worsening the effects of that recession. Supporters of monetarism cite such situations to show that using monetary policy to influence short-term changes in the business cycle can create major problems. Monetarism is a theory that suggests that rapid changes in the money supply are the main cause of economic instability. Milton Friedman is the most prominent monetarist. (You can read more about Friedman on page 76.) He studied how changes in the growth rate of the money supply affected prices and concluded that inflation is always accompanied by rapid monetary growth. Conversely, he noted that there has been little or no inflation when the money supply has grown slowly and steadily. QUICK REFERENCE Monetarism is a theory that holds that rapid changes in the money supply cause economic instability. Monetarists do believe that monetary policy is an important tool. However, they argue that best way to ensure economic growth and stability is to allow the money supply to grow slowly and steadily—by around 3 percent a year. They disapprove of the Fed’s use of monetary policy to constantly tinker with the money supply. Other Issues The use of the monetary policy tools is just one way the economy can be corrected. It is more effective if it is coordinated with fiscal policy. In addition, the goals of the Fed may clash with those of Congress or the president. Since members of the Fed’s Board of Governors serve for 14-year terms, they are not as susceptible to political pressure as are politicians, who are elected every two to six years. Monetarism According to monetarists, a slow, steady growth in the amount of money in circulation is the best monetary policy. APPLICATION Analyzing Causes D. What will happen to interest rates when the Fed sells bonds in open market 496 Chapter 16 operations? Why? S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the difference between the terms in each of these pairs. a. monetary policy monetarism b. easy-money policy tight-money policy c. discount rate prime rate 2. How should a contractionary monetary policy affect interest rates and the rate of inflation? Why? 3. How should an expansionary monetary policy affect interest rates and the unemployment rate? Why? 4. How does the Fed use open market operations as a monetary policy tool? 5. What is the main short-term effect of monetary policy? 6. Using Your Notes Which monetary policy tool does the Fed use least often? Refer to your completed hierarchy diagram. Monetary Policy main ideas main ideas main ideas Use the Graphic Organ
izer at Interactive Review @ ClassZone.com details details details . Analyzing Causes To curb inflation, why is it easier for the Fed to use monetary policy to raise interest rates than it is for Congress to implement contractionary fiscal policy? 8. Making Inferences What are the Fed’s underlying assumptions about the state of the economy, based on these Fed actions? a. The Fed’s open market operations caused the FFR to drop from 6.25 percent to 1 percent. b. The FFR rose from 1 percent to 4.25 percent. 9. Applying Economic Concepts In 2005, the Fed set the discount rate for banks in good financial condition at 1 percent above the targeted FFR. a. Would these banks be more likely to borrow short-term funds from another bank or from the Fed? Why? b. How does this policy help keep the federal funds rate close to the target set by the Fed? 10. Challenge Explain how the Fed buying bonds affects interest rates, aggregate demand, price level, and GDP. Illustrate your answer using two graphs, one showing the money market and one showing aggregate supply and aggregate demand. Durable goods—washing machines Applying Economic Concepts Think about the ways monetary policy is used to address economic problems. Then complete the following activities. Determine Monetary Policy The chart below lists several economic situations. For each one, decide whether an easy-money or tightmoney policy is needed. Monetary Policy Needed Economic Situation Consumer spending on durable goods rises faster than production Rising energy prices are pushing prices of many products higher Unemployment rate increases from 5.4% to 6.8% over six months Challenge Choose one example that requires an easy-money policy and one that requires a tight-money policy and explain how open market operations would be used in each case. 497 S E C T I O N 4 Applying Monetary and Fiscal Policy TA K I N G N O T E S In Section 4, you will wage and price controls, p. 501 • describe how monetary and fiscal policy can coordinate to improve the economy • understand how monetary and fiscal policy can work against each other • identify other measures that can be used to manage the economy As you read Section 4, complete a cause-and-effect chart using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Expansionary Policies Contractionary Policies Conflicting Policies results results results Policies to Expand the Economy KEY CONCEPT S The goals of both fiscal and monetary policy are to stabilize the economy by easing the effects of recession and controlling inflation. Fiscal policy relies on government spending and taxation to achieve its goals. Monetary policy uses open market operations, the discount rate, and reserve requirements as its tools. These policies, as well as affecting the economy, also have an impact on each other. As you recall, both monetary and fiscal policy have limitations. These include policy lags, political constraints, and timing issues. Policy lags relate to the time it takes to identify the problem and for policy actions to take effect. Political considerations may limit government’s ability to do what is best for the economy. Timing, too, is important because to be effective government actions must counteract the negative effects of the business cycle. Intervention at the wrong time may skew the cycle and make the problem worse. A second phenomenon affecting timing is explained by the rational expectations theory. As you recall from Chapter 15, this states that individuals and business firms learn, through experience, to anticipate changes in monetary and fiscal policy and take steps to protect their interests. For example, if there is debate in Congress about tax cuts, individuals and businesses may take actions before the legislation is even passed, based on their expectations that tax cuts will increase their income. Individuals may decide to purchase durable goods, such as automobiles, refrigerators, and washing machines. Similarly, businesses may decide to expand their operations by building new factories and hiring more workers. On the other hand, if individuals and businesses think the tax cuts will be temporary, they may choose not to spend as the policy intended. Rational Expectations Expectations that tax cuts will increase their incomes may cause people to buy “big-ticket” items such as refrigerators. 498 Chapter 16 People who disagree with the use of most discretionary policy often support their argument with the rational expectations theory. They suggest that rather than fiddling with fiscal and monetary policy, the government should aim for a stable monetary policy so that business decisions are made for economic reasons and not in anticipation of new policies. E XAMPLE Expansionary Monetary and Fiscal Policy The goal of expansionary policy is to stimulate the economy by reducing unemployment and increasing investment. As you recall, expansionary fiscal policy involves increased government spending or tax cuts. Also, to enact expansionary monetary policy, the Fed buys government bonds or reduces the discount rate or the reserve requirement. For example, suppose that the unemployment rate is 9.5 percent and the Consumer Price Index (CPI) is at 2 percent. The economy is in recession and inflation is a minimal concern. In order to increase the money supply, the Fed buys bonds on the open market and lowers the discount rate. The federal government also cuts personal income taxes and increases government spending. These expansionary policies are designed to increase aggregate demand and decrease unemployment. Real GDP will expand and prices will rise as aggregate demand increases. Figure 16.12 shows how expansionary policies affect these key economic indicators. Expansionary fiscal policy is likely to raise interest rates, while expansionary monetary policy should decrease interest rates. Therefore, the actual change in interest rates will depend on the relative strength of the two policies. The amount of investment spending will depend on what happens with interest rates. F I G U R E 16 .12 Effects of Expansionary Policies Policies Effects a b Monetary Policy The Fed buys bonds and lowers the discount rate to increase money supply Fiscal Policy Increased spending/ tax cuts to increase aggregate demand Real GDP increases and prices rise Unemployment falls ANALYZE CHARTS 1. According to the chart, what are the goals of expansionary policies? 2. Which indicator in the chart suggests that expansionary policy might lead toward inflation? a Here, fiscal and monetary policies work together to expand the economy. b These policies tend to increase aggregate demand, increase real GDP, and lower unemployment. AP P LI CATION Analyzing Effects A. What effect would government borrowing to finance increased spending have on interest rates and why? The Federal Reserve and Monetary Policy The Federal Reserve and Monetary Policy 499 Policies to Control Inflation KEY CONCEPT S The goal of contractionary monetary policy is to tighten up the economy by decreasing inflation and increasing interest rates. Contractionary fiscal policy tools include decreased government spending or tax increases. The Fed will sell bonds on the open market or raise the discount rate or the reserve requirement as contractionary monetary policy tools. EXAMPLE Contractionary Monetary and Fiscal Policy Suppose that the unemployment rate is 4.5 percent and the CPI is running in excess of 10 percent. The economy is operating at or above a sustainable level of output, and inflation is very high. In order to decrease the money supply, the Fed sells bonds on the open market and raises the discount rate. The federal government cuts spending on government programs. It also may raise taxes. These contractionary policies are designed to decrease aggregate demand and bring inflation under control. Real GDP will decrease, and prices will fall as aggregate demand decreases. Further, unemployment tends to rise as real GDP decreases. Figure 16.13 shows how contractionary monetary and fiscal policies affect the key economic indicators of unemployment and real GDP. Contractionary fiscal policy is likely to lower interest rates because decreased government spending will decrease demand for loans. Contractionary monetary policy should raise interest rates. Therefore, the actual change in interest rates will depend on the relative strength of the two policies. The amount of investment spending depends on what happens with interest rates. F I G U R E 16 .13 Effects of Contractionary Policies a Policies b Effects Monetary Policy The Fed sells bonds and raises the discount rate to cut money supply Fiscal Policy Decreased spending/ tax increases to decrease aggregate demand Real GDP and prices fall Unemployment increases a Here, fiscal and monetary policies work together to contract the economy. b These policies decrease aggregate demand, control inflation, and raise unemployment. ANALYZE CHARTS 1. According to the chart, what are the goals of contractionary policies? 2. In what way might the fiscal policy shown here not help to control inflation? 500 Chapter 16 YO U R EC ATIONAL E XPEC TATIONS TH EORY Will you begin to build or wait? You and several business partners have purchased an empty lot and plan to build a new store on it. There has been discussion in the media recently about rising inflation and the possibility that the Fed will raise interest rates. Do you go forward with your plan to build, or do you wait? Why? ? ▲ Empty lot QUICK REFERENCE Wage and price controls are government limits on increases in wages and prices. ▲ Completed store E XAMPLE Wage and Price Controls At times in the past, the government has taken extreme measures to control the economy, especially during wartime. For example, the government may establish a set of wage and price guidelines that are not mandatory. Wage and price controls are limits, establish
ed by the government, on increases in certain wages and prices. These controls, unlike wage and price guidelines, are mandatory and enforced by the government. World War II led to increased production of goods needed by the military. This situation created shortages of many consumer goods as well as a labor shortage, which tended to drive up prices and wages. In an effort to control inflation, President Franklin D. Roosevelt established the Office of Price Administration (OPA) in 1942. This agency set strict wage and price controls on all sectors of the economy. These measures had some, but not total, success. They were phased out almost immediately after the end of the war. In 1971, President Richard M. Nixon was faced with stagflation, a situation in which rising unemployment is accompanied by rising inflation rates. In August of that year, Nixon announced a 90-day freeze on wages and prices to try to control inflation. The program was renewed several times and lasted until April 1974. Even so, it had little impact. From late 1971 to early 1974, the inflation rate actually rose from about 4 percent to 11 percent. AP P LI CATION Comparing and Contrasting B. What are the similarities and differences between contractionary monetary policy and wage and price controls? The Federal Reserve and Monetary Policy 501 Policies in Conflict KEY CONCEPT S As you have seen, coordinated policies are, for the most part, effective in reaching a mutually agreed upon goal—that is, a stable but growing economy with little inflation. When fiscal and monetary policies are not coordinated, however, one policy can counter the effect of the other and thwart this goal, creating economic instability instead. EXAMPLE Conflicting Monetary and Fiscal Policies Suppose that the unemployment rate is 7 percent and the CPI stands at 6 percent and is steadily rising. The Fed may decide that the most pressing problem for the economy is rising inflation. So, to cool down the economy it follows a contractionary monetary policy, selling bonds on the open market and raising the discount rate. At the same time, the federal government may decide that rising unemployment needs is a bigger problem. To stimulate aggregate demand, it follows an expansionary fiscal policy, cutting personal taxes and increasing spending on public works programs. The only clear result of these conflicting policies is that interest rates will increase. Because the policies are in conflict, the effects on GDP, prices, and unemployment cannot be predicted. This is illustrated in Figure 16.14. F I G U R E 16 .14 Effects of Conflicting Policies Policies Effects a b Monetary Policy The Fed sells bonds and raises the discount rate to cut money supply Fiscal Policy Tax cuts/ increased spending to increase aggregate demand Real GDP and prices may rise or fall Unemployment may rise or fall a This shows that the policies are working against each other in efforts to stabilize the economy. b Here, conflicting policies make it impossible to predict the effects on GDP, prices, and unemployment. ANALYZE GRAPHS 1. According to the chart, which policy is designed to increase GDP? 2. How do you think conflicting monetary and fiscal policies, like those described above, will affect consumer spending? Why? APPLICATION Analyzing Causes C. Why do tax cuts and increased government spending result in a rise in interest rates? 502 Chapter 16 S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. Use the term below in a sentence that illustrates the meaning of the term. wage and price controls 2. How is rational expectations theory related to the limitations of fiscal and monetary policy? 3. Why does rational expectations theory oppose most discretionary fiscal and monetary policy? 4. Does monetary policy or fiscal policy most directly affect the economy? Why? 5. Why might an expansionary fiscal policy and a contractionary monetary policy work against each other? 6. Using Your Notes What are the effects of expansionary fiscal and monetary policies? Refer to your completed diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Expansionary Policies Contractionary Policies Conflicting Policies results results results . Drawing Conclusions What happens to interest rates if the Fed implements a contractionary monetary policy when Congress and the president cut taxes and increase government spending? What effect do you think this would have on the economy? Why? 8. Applying Economic Concepts When President Nixon imposed wage and price controls in the 1970s in an attempt to control inflation, he felt he could then use expansionary fiscal policy to decrease unemployment. These policies helped him win reelection in 1972, but inflation rose sharply over the next three years. Use the economic concepts you have learned in this section to explain what happened. 9. Challenge Many economists argue that the economy is better off when monetary policy is used most often to stabilize the economy, with fiscal policy being used primarily as a backup to bring the economy out of longer recessions. Do you agree or disagree with this assessment? Why or why not? Applying Economic Concepts Recall what you have learned about the effectiveness of monetary policy, then complete the activities below. Interpreting Economic Models Which graph shows poor timing of monetary policy in relation to the business cycle? What is the effect of monetary policy on the business cycle shown on each graph? Challenge How do these graphs reflect rational expectations theory NORMAL BUSINESS CYCLE BUSINESS CYCLE WITH MONETARY POLICY APPLIED Time Time 503 Case Study Find an update on this Case Study at ClassZone.com Interpreting Signals from the Fed Background The Federal Reserve is a powerful institution, so people pay attention to the Fed chairman’s comments. A hint that the Fed might raise the discount rate can lead to a great deal of activity in the stock market. Some people might buy stock because they are confident that the Fed will keep inflation low. Others might sell stock because they are worried that the economy is slowing down. Over the 18 years that Alan Greenspan was Fed chairman, economists and financial observers scrutinized his every word in an attempt to predict how his statements would affect the economy. When Ben Bernanke was appointed as Fed chairman in 2006, observers had to learn a new language. What’s the issue? How much does the market rely on signals from the Fed to make economic decisions? Read the following to see what happened when the status quo changed and the signals were different. A. Internet Article This article demonstrates how Fed Chairman Ben Bernanke had to carefully review his public comments. Crossed Economic Signals Fed Expected to Boost Key Interest Rates After nearly two decades of decoding Alan Greenspan’s famously opaque speaking style, financial markets are having to learn to interpret his successor Ben Bernanke. So far, the results have been a little rocky. . . . Some economists believe the Fed will stop with the funds rate at 5 percent, up significantly from the 46-year low of 1 percent in effect before the rate increases began. Others think the Fed will only pause for a meeting or two and then raise rates one or two more times. And still a third group thinks there won’t be any pause as the Fed continues a steady march toward higher rates. Part of the blame for the confusion is being assigned to Bernanke, who took over as Fed chairman on Feb. 1. He roiled markets over the past two weeks, first with testimony before the Joint Economic Committee on April 27 that the markets read as a strong signal that the Fed was going to pause in its string of rate increases, and then the next week when he told a reporter that the markets had misinterpreted his comments. Economists said that the incident showed that there is a new Fed chairman with a different speaking style. . . . In any event, forecasters predicted Bernanke will be brushing up on his communication techniques. Source: “Fed Expected to Boost Key Interest Rates,” by Martin Crutsinger. Associated Press, May 10, 2006. Thinking Economically Why does the Fed chairman need to develop strong communication techniques ? 504 Chapter 16 B. Political Cartoon Harley Schwadron drew this cartoon about the new Fed chairman following in his predecessor’s footsteps. Newspaper Article This article reports on a speech Chairman Bernanke made at an international financial conference and the reaction that followed. Thinking Economically What message does this cartoon convey about how the Fed has been known to give information? Open to Analysis Bernanke Talks Tough on Inflation Ben S. Bernanke, chairman of the Federal Reserve, warned Monday that recent inflation trends were “unwelcome developments,” indicating that he was far less worried about signs of weaker economic growth than about the danger of higher prices. In his toughest comments yet about the risks of inflation, Mr. Bernanke said consumer prices were rising faster than he would like. . . . Investors, increasingly convinced that the central bank will raise rates . . . immediately began selling stocks. The Dow industrials and the broader Standard & Poor’s 500-stock index each fell about 1.75 percent, and the Nasdaq index tumbled more than 2 percent. . . . Speaking to a conference . . . on international monetary issues with other central bankers, Mr. Bernanke said inflation had climbed to the upper limits of his acceptability. “Core inflation, measured over the past three to six months, has reached a level that, if sustained, would be at or above the upper range that many economists, including myself, would consider consistent with price stability,” Mr. Bernanke said. . . . Mr. Bernanke made clear that he thought the economy was now in a “transition” to slower economic growth. . . . Instead of highlighting signs of a cooling economy, which would ease inflationary pressures, Mr. Bernanke placed top emp
hasis on the need for vigilance against rising prices. Source: “Bernanke Talks Tough on Inflation,” by Edmund L. Andrews. New York Times, June 6, 2006 Thinking Economically What kind of monetary policy did investors expect Bernanke to follow—expansionary or contractionary policy? Explain your answer. THINKING ECONOMICALLY Synthesizing 1. How do articles A and C illustrate the rational expectations theory? 2. Based on these three sources and your own knowledge, how would you describe the differences and similarities between Greenspan and Bernanke and their impact on the market? The Federal Reserve and Monetary Policy 505 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. bank holding company Board of Governors central bank contractionary monetary policy deposit multiplier formula discount rate easy-money policy expansionary monetary policy federal funds rate Federal Open Market Committee Federal Reserve System monetarism monetary policy open market operations prime rate required reserve ratio thrift institution tight-money policy wage and price controls The 1 is the 2 of the United States and is commonly known as the Fed. The 3 supervises the operations of the Fed. The 4 supervises the sales and purchase of federal government securities. The Fed controls the amount of money a bank can loan through the 5 . The 6 tells how much the money supply will increase after an initial cash deposit. 7 is actions by the Fed that change the money supply in order to influence the economy. The three tools used by the Fed to change the money supply are reserve requirements, the 8 , which is the rate the Fed charges when it lends money to banks, and 9 . The last tool allows the Fed to influence the 10 , the rate banks charge one another to borrow funds overnight. 11 seeks to increase the amount of money in circulation and is also known as 12 . 13 seeks to decrease the amount of money in circulation and is also known as 14 . 506 Chapter 16 CHAPTER 16 Assessment The Federal Reserve System (pp. 474–479) 1. What are the three duties of the Federal Reserve? 2. What are the different responsibilities of the Board of Governors and the Federal Open Market Committee? Functions of the Federal Reserve (pp. 480–489) 3. What are the three functions of the Federal Reserve? 4. How does the size of the RRR affect the banking system’s ability to create money? Monetary Policy (pp. 490–497) 5. What is the Fed’s most frequently used monetary policy tool? 6. What is the purpose of monetary policy? Applying Monetary and Fiscal Policy (pp. 498–505) 7. What tools would be used to implement contractionary monetary and fiscal policy? 8. Why might it be important to coordinate monetary and fiscal policy? A P P LY Look at the line graph below showing the FFR and the prime rate over several years. FIGURE 16.15 SHORT- TERM INTEREST RATES 10 Source: Federal Reserve 1 1 9 9 PRIME RATE FFR . What is the relationship of the prime rate to the FFR as shown on this graph? 10. What conclusion can you draw about the U.S. economy based on interest rates in 2002–2004 11. Making Inferences Eight times per year the Fed collects economic information from each of its districts and compiles a report to help the FOMC make its decisions. How does this practice reflect the benefits of the Fed’s structure? 12. Applying Economic Concepts In response to the terrorist attacks of September 11, 2001, the Fed started lowering the FFR target the following week. Congress was unable to agree on a program to help stimulate the economy until March 2002. How does this situation illustrate the effects of policy lags on monetary and fiscal policy? 13. Analyzing Causes and Effects Suppose that the Fed buys a $10,000 T-bond from the First National Bank. What effect will this have on First National’s reserves and on the FFR? Why? 14. Drawing Conclusions In 2001, Congress approved a major tax cut package, while the Fed lowered the FFR target. In January 2006, the president asked Congress to make the tax cuts permanent, and the Fed raised the FFR target. When were fiscal and monetary policies working together, and when were they in conflict? 15. Challenge The FOMC issued the following statement after one of its meetings: Although recent economic data have been uneven, the expansion in economic activity appears solid. Core inflation has stayed relatively low in recent months, and longer-term inflation expectations remain contained. Nevertheless, possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures. The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. Did the committee raise, lower, or maintain the target for the FFR? Cite evidence from the statement to support your answer. Stabilize the Economy Step 1 Choose a partner. Imagine that you are advisers to the president of your Federal Reserve District bank. Your job is to prepare the president for the next FOMC meeting. The current state of the economy is shown in column A of the Key Economic Indicators table below. Decide whether an expansionary or contractionary monetary policy is needed. Recommend the type of open market operations needed as well as a target for the FFR. Give reasons for your recommendation and outline what you expect to happen to the other indicators as a result of this policy. KEY ECONOMIC INDIC ATORS ( I N PE RC E N T) Indicator A GDP CPI 3.00 6.25 B 2.00 3.00 C 6.50 1.50 Unemployment Rate Federal Funds Rate 5.60 7.50 4.50 7.75 4.75 5.25 Step 2 The state of the economy two years later is shown in column B. Develop a new recommendation based on this data, with the same kind of details you included in Step 1. Step 3 The economy has experienced several years of growth as indicated by the information in column C. Develop a new recommendation based on your evaluation of this situation. Step 4 Share your three recommendations with the class. As a class, decide on a final monetary policy recommendation for each scenario. Step 5 Consider what would happen if the government used a coordinated fiscal policy for the data in columns A and B and a conflicting fiscal policy with the data in column C. Discuss as a class what would happen to the three key indicators when fiscal policy effects are considered. The Federal Reserve and Monetary Policy 507 U n i t 7 The Global Economy A Global Marketplace International trade allows nations to produce some items and trade them for other items. How do they decide what to produce and what to trade for? 508 CHAPTER 17 SECTION 1 Benefits and Issues of International Trade SECTION 2 Trade Barriers SECTION 3 Measuring the Value of Trade SECTION 4 Modern International Institutions CASE STUDY Analyzing Tariffs: Who Wins and Who Loses? International Trade The global economy is the sum of all economic interactions that cross international boundaries. C H A P T E R 17 Economic interdependence involves producers in one nation that depend on producers in other nations to supply them with certain goods and services AT T E R S Japan is a world-class producer of automobiles, in spite of the fact that it has few mineral resources. How can this be? The answer lies in the realm of international trade, where nations choose to produce some things and trade for others. In the case of Japan, it must trade for the raw materials it uses in order to produce automobiles. It then turns around and trades the automobiles for other goods. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on how tariffs and subsidies affect the sugar market. (See Case Study, pp. 538–539). Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. Why do many people believe that U.S. government subsidies to sugar producers are a problem? See the Case Study on pages 538–539. International Trade 509 S E C T I O N 1 Benefits and Issues of International Trade TA K I N G N O T E S In Section 1, you will specialization, p. 510 • determine why nations choose to specialize their economies • examine the difference between absolute and comparative advantage • explain how international trade impacts prices and quantity economic interdependence, p. 510 absolute advantage, p. 513 comparative advantage, p. 513 law of comparative advantage, p. 514 exports, p. 516 imports, p. 516 As you read Section 1, complete a diagram that shows how the concepts in the section relate to international trade. Use the Graphic Organizer at Interactive Review @ ClassZone.com International Trade Resource Distribution and Specialization KEY CONCEPT S A nation’s economic patterns are based on its unique combination of factors of production: natural resources, human capital, physical capital, and entrepreneurship. For example, a nation rich in arable land but lacking well-educated workers is less likely to develop a strong technology sector than a country with better-educated citizens and diverse natural resources. Economic patterns may also change over time. The United States, for example, once relied heavily on its agricultural sector, but the U.S. economy is now also extremely high-tech and highly skilled. Because each nation has certain resources and cannot produce everything it wants, individuals and businesses must decide what goods and services to focus on. The result is specialization, a situation that occurs when individuals or businesses produce a narrow range of products. Through specialization, businesses can increase productivity and profit—the driving force of world trade. S
pecialization also leads to economic interdependence, a situation in which producers in one nation depend on others to provide goods and services they do not produce. QUICK REFERENCE Specialization is a situation that occurs when individuals or businesses produce a narrow range of products. Economic interdependence is a situation in which producers in one nation depend on others to provide goods and services they do not produce. Specialization A coal-rich nation that lacks advanced technology can trade its coal for manufactured goods, such as automobiles, from nations with higher levels of technology. 510 Chapter 17 YO U R EC SPEC IALIZ ATION Will you specialize in lawn mowing or babysitting? Do you have a lawn mower? Do you know children that need to be watched? What other questions might you ask yourself before deciding what you will specialize in? ? Mow lawns Babysit E XAMPLE Specialization The concept of specialization can be illustrated by looking at the agricultural production of two nations: Costa Rica and New Zealand. The climate, the labor conditions, and the level of technology of each nation have made some agricultural products more important than others. In other words, each nation has decided to specialize in certain agricultural areas because they have an advantage in doing so. For Costa Rica, the product of choice is bananas. It is the world’s seventh-largest producer and second-largest exporter of bananas. For New Zealand, the product of choice is sheep. It is the world’s third-largest producer and second-largest exporter of wool and is responsible for about 50 percent of the world’s lamb and mutton exports. What explains each nation’s specialization? Costa Rica has the necessary climate for bananas—warm and wet. In addition, agricultural wages are relatively low, an important point as banana production is quite labor intensive. On the other hand, New Zealand has the temperate climate, water resources, and vast expanses of open grasslands to support the grazing of millions of sheep. (Today, there are about 10 sheep for every person in New Zealand.) Raising sheep is not nearly as labor intensive as banana production, and this suits the fairly low population density of this remote island nation. Also, scientific breeding practices and mechanized wool- and meat-processing operations are available to a developed nation such as New Zealand. It makes sense for each nation to specialize as it does and to trade for the things it cannot produce as efficiently. AP P LI CATION Drawing Conclusions A. Why should nations specialize in what they produce most efficiently and trade for the rest? Find an update on Costa Rica’s economy at ClassZone.com International Trade International Trade 511 ECO N O M I C S PAC ES E T T E R David Ricardo: The Theory of Comparative Advantage Many things about London-born economist David Ricardo make him a memorable figure. He was one of 17 children in a Jewish family. At age 14, he went to work in his father’s stockbrokerage. He married a Quaker at age 21 and broke from the Jewish faith, at which time his father disinherited him. And finally, when he died at age 51, he left a $126 million fortune. Ricardo is most remembered, however, for the idea that has become the backbone for free trade—comparative advantage. It states, in short, that a trading nation should produce a certain product if it can do so at a lower opportunity cost than that of another trading nation. EXAMPLE Trading in Opportunity The prevailing view about international trade in Ricardo’s time was based on the idea of absolute advantage, the ability of one trading nation to make a product more efficiently than another trading nation. Most people believed that if Portugal, for example, could make grape juice more efficiently than England, and if England could make cloth more efficiently than Portugal, then trade would be beneficial to both. Ricardo, however, set up a different problem, one that challenged this outlook. What if, he thought, Portugal makes both products more efficiently than England? Would trade, at least for Portugal, no longer be beneficial? His surprising answer was that trade would indeed still be beneficial. He based his conclusion on the opportunity costs each nation spends to make its products. Suppose that in Portugal, it takes two hours of labor to produce a jug of grape juice, while in England, it takes four hours. Suppose also that in Portugal, a yard of cloth takes six hours to make; in England it takes eight hours. Ricardo reasoned that in Portugal, every yard of cloth costs three jugs of grape juice in lost opportunity. In England, however, every yard of cloth costs only two jugs of grape juice. Portugal, then, would be wise to buy cloth from England and to specialize in grape juice. This understanding has become known as the law of comparative advantage: countries gain when they produce items they are most efficient at producing and that have the lowest opportunity cost. David Ricardo APPLICATION Applying Economic Concepts B. Does the law of comparative advantage apply only to nations, or does it apply to individuals as well? Explain your answer. FAST FACTS David Ricardo Title: Economist, stockbroker Born: 1772 Died: 1823 Major Accomplishment: Brilliantly thinking through economic principles and laying the foundation for free trade Major Work: On the Principles of Political Economy and Taxation (1817) Famous Quotation: “The labor of 100 Englishmen cannot be given for that of 80 Englishmen, but the produce of the labor of 100 Englishmen may be given for the produce of the labour of 80 Portuguese, 60 Russians, or 120 East Indians.” Learn more about David Ricardo at ClassZone.com 512 Chapter 17 Absolute and Comparative Advantage KEY C ONCEPT S Absolute advantage is the ability of one trading nation to make a product more efficiently than another trading nation. Some regions or nations have absolute advantage in producing certain products or services because of the uneven distribution of production factors. Comparative advantage, in contrast, is the idea that a nation will specialize in what it can produce at a lower opportunity cost than any other nation. When determining comparative advantage, you look not for the absolute cost of a product, but for its opportunity cost. E XAMPLE Absolute Advantage Consider the trade relations between two countries on the Pacific Rim today, China and Australia. Both countries produce iron ore; both also produce steel. Suppose that every week, Australia produces 5,000 tons of iron ore and 1,000 tons of steel. In the same period of time, and with the same amount of labor, China produces 2,700 tons of iron ore and 900 tons of steel. In this case, Australia has an absolute advantage over China in both areas. Before Ricardo, the standard logic held that, in this situation, the nation that held the absolute advantage for both commodities would trade for neither. But, as you’ve read, when the important factor of opportunity cost is considered, this logic doesn’t stand up. Why would it benefit Australia to import steel from China, in spite of its absolute advantage? The answer is comparative advantage. QUICK REFERENCE Absolute advantage is the ability of one trading nation to make a product more efficiently than another trading nation. Comparative advantage is a trading nation’s ability to produce something at a lower opportunity cost than that of another trading nation. What Does Opportunity Cost? Should Australia specialize in mining iron ore (left) and leave the steel production (right) to China? Where does the comparative advantage lie? International Trade 513 EXAMPLE Comparative Advantage Let’s start with a simple example of comparative advantage. After years as an office manager at a law firm by day and a law student by night, Ellen becomes a lawyer and starts her own practice. She charges $150 per hour for her legal services. She hires Miguel to run her office, and she pays him $25 per hour. Although Miguel works hard and is good at his job, Ellen soon realizes that, due to her years of experience, she could run her own office better than Miguel. Should she take over these duties? The answer lies in opportunity cost. Every hour that Ellen spends engaged in the duties that are worth $25 per hour costs her an hour that could be spent doing work that is worth $150 per hour. Clearly it makes sense for her to employ an office manager and concentrate on the legal end of her practice. Back to our previous example of Australia and China, we see that Australia’s production ratio of steel to iron ore is 1:5. In other words, Australia’s opportunity cost for one ton of steel is five tons of iron ore. Applying the same logic to China, we find that its production ratio of steel to iron ore is 1:3. Its opportunity cost for one ton of steel is three tons of iron ore. So, in the production of steel, China has a comparative advantage. Australia would benefit by trading for Chinese steel. This is the law of comparative advantage: countries gain when they produce items that they are most efficient at producing and that are at the lowest opportunity cost. QUICK REFERENCE The law of comparative advantage states that countries gain when they produce items they are most efficient at producing and are at the lowest opportunity cost. F I G U R E 17.1 Specialization and Trade No Specialization One day’s labor in France results in 40 tons of cheese and 80 tons of fish. One day’s labor in Japan results in 50 tons of cheese and 200 tons of fish. France’s opportunity cost for 1 ton of cheese is 2 tons of fish. Japan’s opportunity cost for 1 ton of cheese is 4 tons of fish. Specialization and Trade France trades 1 ton of cheese. Japan trades 3 tons of fish. It used to cost France 1 ton of cheese to get 2 tons of fish; now it trades 1 ton of cheese for 3 tons of fish. It used to cost Japan 4 tons of fish for 1 ton of cheese; now it trades only 3 tons of fish for 1 ton of cheese. 514
Chapter 17 Economic Success with Few Natural Resources Some economies thrive as a direct result of natural resources—Saudi Arabia and its oil, for instance. But, many nations, such as the Republic of Ireland, thrive economically in spite of a relative lack of natural resources. It is not rich in mineral resources and relies on imports for the majority of its energy supply. However, it has formulated and carried out certain policies that have helped to produce today’s dynamic economy. In the mid-1950s, Ireland began a continuing process The headquarters of the Industrial Development Agency of Ireland, in Dublin of reversing protectionist tariff and quota policies. The Programmes for Economic Expansion (1958 and 1963) attracted large amounts of foreign direct investment through financial grants and tax concessions. Levels of human capital were increased through educational reforms in the 1960s. It was also an original member of the EU and took advantage of EU funds to shore up its infrastructure. These and other policies set the stage for Ireland’s economic boom of the 1990s. During this decade, it became a major manufacturer of high-tech electronics, computer products, chemicals, and pharmaceuticals. It has also become an important center for banking and finance. CONNECTING ACROSS THE GLOBE 1. Drawing Conclusions What specialization has, for the most part, driven Ireland’s economic boom? 2. Applying Economic Concepts Why might an economy like Ireland’s be more desirable than one that relies solely on natural resources? E XAMPLE Advantages of Free Trade If China and Australia decide to specialize and trade, they can improve their ratio of return. Previously, China’s ratio of steel production to iron ore production was 1:3 and Australia’s was 1:5. If the two nations establish a trade ratio of 1:4 (China trades one ton of its steel for four tons of Australian iron ore), both countries win. China now gets four tons of iron ore for a ton of steel; it got three before. Also, one ton of steel now costs Australia only four tons of iron ore; it previously cost five. When countries specialize and trade, they not only improve their production ratios but they also increase world output. If China specializes in steel and Australia in iron ore, each can make more of their products than the two nations could have made together if they had not specialized. Increased output is a mark of economic growth, which is a factor in raising standards of living. AP P LI CATION Interpreting Tables C. Use the example in Figure 17.1 to explain how output for both nations increases through specialization and trade. International Trade 515 International Trade Affects the National Economy KEY CONCEPT S Because of the law of comparative advantage, nations gain through trading goods and services. Goods and services produced in one country and sold to other countries are called exports. Goods and services produced in one country and purchased by another are called imports. The costs and benefits of international trade vary by nation. To understand how trade affects a nation’s economy, economists use supply and demand analysis. They look at the impact of exports and imports on prices and quantity. IMPACT 1 Exports on Prices and Quantity Suppose that a county called Plecona existed and that it did not trade with other countries. Figure 17.2 shows the equilibrium price for Plecona’s motorbikes. What would happen to prices and demand if Plecona decided to become a trading nation and export its motorbikes? In some countries, such as Nepocal, people would give up their bicycles and begin to buy Pleconese motorbikes. This results in an increase in demand for Pleconese motorbikes, shifting the demand curve to the right and establishing a new equilibrium price. Motorbikes will now cost more in Plecona too. However, the greater demand resulting from exporting offsets this by creating more jobs and more income in Plecona, as the motorbike producer invests its profits to expand production and hire more workers. IMPACT 2 Imports on Prices and Quantity Now suppose that Nepocal and Plecona agree that Nepocal may sell its major product, microwave ovens, in Plecona. Instead of having only Pleconese-made microwaves, consumers in Plecona may now purchase ovens imported from Nepocal. This change adds to the number of microwave oven producers in the Pleconese market. Adding producers shifts the supply curve of microwave ovens to the right and thereby establishes a new, lower equilibrium price. (See Figure 17.3.) In other words, there are now more microwave ovens in Plecona, and the consumers are paying a lower price for them. However, because of the lower price, Pleconese producers of microwave ovens will choose to offer fewer microwaves for sale. So imports have the effect of initially increasing supply and of providing consumers with greater selection and lower prices. The competition also establishes incentives for domestic producers to become more efficient in production, improve worker productivity, and enhance customer service. Both consumers and producers, then, benefit from international trade. Consumers benefit from imports because the selection of goods increases and prices decrease. Producers benefit from exports by gaining a new market for their products, and thereby giving them the opportunity to increase revenues and earn a profit. QUICK REFERENCE Exports are goods and services produced in one country and sold to other countries. Imports are goods and services produced in one country and purchased by another. 516 Chapter 17 FIGURES 17.2 AND 17.3 THE EFFECTS OF INTERNATIONAL TRADE 17.2 PLECONA’ S MOTORBIKE EXPORT MARKET 17.3 PLECONA’ S MICROWAVE OVEN IMPORT MARKET $12 10 D2 D1 $120 100 ) 80 60 40 20 0 S1 b S2 D 5 15 Quantity supplied and demanded 25 10 20 30 a Increased demand causes the demand curve to shift to the right. b Increased supply causes the supply curve to shift to the right. 5 10 15 20 25 30 Quantity supplied and demanded of motorbikes (in thousands) of microwave ovens (in thousands) ANALYZE GRAPHS What are the initial and then post-shift equilibrium prices for motorbikes in Figure 17.2? for microwaves in Figure 17.3? Use an interactive supply and demand graph at ClassZone.com IMPACT 3 Trade Affects Employment As nations specialize in their changing areas of strength, the availability of certain jobs can undergo dramatic changes. For example, if Australia specializes in producing iron ore or providing educational services (another area of strength for that nation) at the expense of making steel, then some Australian steelworkers may lose their jobs. At the same time, however, the overall number of Australian jobs may increase significantly. The Australian Trade Commission estimates that a ten percent increase in exports results in 70,000 new jobs for workers in Australia. In the United States, manufacturing output increased 600 percent between Biotech Jobs The U.S. economy’s move to the technology sector has meant a sharp rise in biotechnology employment. 1950 and 2000. During the same period, however, employment in manufacturing, as a share of total employment, declined by nearly two-thirds. The United States was shifting its specialization from manufacturing to technology. In the process, it became a world leader in technology exports. So, while many manufacturing jobs in some sectors were lost, the shift in specialization and the resulting trade had positive effects on U.S. employment in general. During the 1990s, for example, U.S. exports were responsible for about 25 percent of the nation’s economic growth, supporting about 12 million jobs. About 20 percent of all U.S. factory jobs depend on trade. Also, jobs in plants that export their products pay an average of 18 percent higher wages than jobs in non-exporting plants. International Trade 517 The United States in the World Economy The United States is a leading nation in a number of aspects of the world economy. It is the largest exporter in the world, selling more than $900 billion in goods and services in 2005. The United States mostly exports capital goods (computers, machinery, civilian aircraft, and so on), automobiles, industrial supplies, consumer goods, and agricultural products. It is also the world’s largest importer, buying nearly $1.7 trillion worth of goods and services from all over the world. It imports mainly crude oil and refined petroleum products, machinery, automobiles, consumer goods, and industrial raw materials. While the United States imports more goods than it exports, it exports more services than it imports. Such services as travel and tourism, transportation, architecture and construction, and information systems find ready customers in Europe, Japan, Canada, and Mexico. The four most important trading partners for the United States in goods and services are Canada, accounting for 20 percent of trade, China (12 percent), Mexico (11 percent), and Japan (7 percent). Trade with these four partners accounts for half of U.S. foreign trade. Find an update on U.S. imports at ClassZone.com FIGURE 17.4 U.S. INTERNATIONAL TRADE IN GOODS BY CATEGORY 521 ( 600 500 400 300 200 100 0 407 380 362 232 240 Key: Imports Exports 116 98 Automobiles and parts 68 59 Food and beverages Industrial supplies and materials Consumer goods Capital goods Categories of goods Source: U.S. Bureau of Economic Analysis, 2005 data ANALYZE GRAPHS 1. In what two areas do U.S. export totals approach import totals? 2. What do these graphs show about the United States and specialization? In recent years, as shown in Figure 17.4, the United States has imported an increasingly larger amount than it has exported. You will learn more about this in Section 4 of this chapter. APPLICATION Interpreting Graphs D. In what category of goods is the difference between imports and exports the greatest? Why do you think this is so? 518 Chapter 17 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain th
e difference between the terms in the following pairs: a. specialization and economic interdependence b. absolute advantage and comparative advantage c. export and import 2. What principle explains why nations specialize and trade? 3. Explain why trade is good for nations that produce exports as well as buy imports. 4. What effect do imports have on price and supply? Why? 5. What effect do exports have on price and demand? Why? 6. Using Your Notes Write a speech for the president of Australia, explaining why your nation should specialize in the production of iron ore and trade for steel. Use the Graphic Organizer at Interactive Review @ ClassZone.com International Trade . Analyzing Cause and Effect You have just learned that high- quality electric guitars made in South Korea will soon be exported to the United States. Should you buy a new guitar now or wait until after the imports begin arriving? Explain your answer. 8. Making Inferences and Drawing Conclusions Why does the law of comparative advantage explain that all people and nations can trade? 9. Explaining an Economic Concept How does international trade help create jobs? How does it shift jobs? 10. Challenge Shelley started her own comedy improvisation club right after college, and at first she did everything: developed new material, starred in the show, handled publicity, and sold tickets. As the enterprise grew, however, she hired an assistant to handle publicity and sell tickets, even though she was better at doing those things than he was. Explain why that was a good idea, using terms from this lesson. Figuring Absolute and Comparative Advantage Review the following scenario that describes cordless drill and drill bit production in the fictional nations of Freedonia and Sylvania. Freedonia and Sylvania both produce cordless drills and drill bits. Over the span of a month, Freedonia can produce 3,000 cordless drills and 21,000 drill bits. During this same period, Sylvania can produce 2,000 cordless drills and 10,000 drill bits. Drawing Conclusions Use what you’ve learned in this section to answer the following questions: 1. For each product, which nation has the absolute advantage? 2. What are the production ratios for each nation? What is each nation’s opportunity cost for each cordless drill produced? 3. Which country has the comparative advantage in cordless drill production? Challenge Draw up and explain a scenario whereby Freedonia and Sylvania agree to trade, and each gets a better deal by adjusting its trade ratio. International Trade 519 S E C T I O N 2 Trade Barriers TA K I N G N O T E S In Section 2, you will • identify barriers to trade • examine the economic consequences of trade barriers • describe protectionism and the arguments for it trade barrier, p. 520 quota, p. 520 dumping, p. 521 tariff, p. 521 revenue tariff, p. 521 protective tariff, p. 521 voluntary export restraint, p. 521 embargo, p. 521 trade war, p. 522 protectionism, p. 523 infant industries, p. 523 As you read Section 2, complete a chart that shows the causes and effects of trade barriers. Use the Graphic Organizer at Interactive Review @ ClassZone.com Cause quota Effect higher prices Barriers to Trade KEY CONCEPT S In order to offer some short-term protection to jobs and industries located within their borders, almost all nations pass some sort of laws that limit trade. These laws lead to higher prices on the restricted items or to economic retaliation by other nations. In the end, these industries and the jobs they provide can only be saved by becoming more competitive. The issue of trade restrictions is basically political in nature, and governments struggle to find the best policies to enact. QUICK REFERENCE Types of Trade Barriers A trade barrier is any law that limits free trade between nations. A quota is a limit on the amount of a product that can be imported. 520 Chapter 17 A trade barrier is any law passed to limit free trade among nations. There are five basic types of trade barriers. Most are mandatory, but some are voluntary. Quotas Nations often impose quotas, limits on the amount of a product that can be imported. For example, the United States had quotas on the amount of textiles allowed to be imported. These quotas limited supply and kept textile prices relatively high. These quotas expired on January 1, 2005. Chinese producers then flooded the United States (and the European Union) with low-priced textiles. Prices for Chinese textiles Quota Lifted Chinese textiles cross the Great Wall on their way to markets in the United States and the EU. increased, however, in other nations. This practice of dumping, the sale of a product in another country at a price lower than that charged in the home market, hurts domestic producers but provides consumers a lower price. Tariffs Another trade barrier is the tariff, a fee charged for goods brought into a country from another country. There are two types of tariffs: revenue and protective. Revenue tariffs, taxes on imports specifically to raise money, are rarely used today. In the past, however, nations regularly used them as a source of income. Today nations use protective tariffs, taxes on imported goods, to protect domestic goods. Protective tariffs raise prices on goods produced more cheaply elsewhere, thereby minimizing the price advantage the imports have over domestic goods. Tariff rates have fallen worldwide since the late 1980s. (See Figure 17.5.) Voluntary Export Restraint Sometimes, to avoid a quota or a tariff, a country may choose to limit an export. This is called a voluntary export restraint (VER). It usually comes about when a trade ambassador from one nation makes appeals to a counterpart, warning of possible consequences without the VER. Embargoes An embargo is a law that cuts off most or all trade with a specific country. It is often used for political purposes. Since the early 1960s, for example, the United States has had an embargo on trade with Communist Cuba. Informal Trade Barriers Other trade restrictions are indirect. Licenses, environmental regulations, and health and safety measures (such as a ban on the use of certain herbicides) are, in effect, trade barriers. QUICK REFERENCE Dumping is the sale of a product in another country at a price lower than in the home market. A tariff is a fee charged for goods brought into one country from another. A revenue tariff is a tax levied on imports specifically to raise money. A protective tariff is a tax on imported goods to protect domestic goods. A voluntary export restraint (VER) is a country’s self-imposed restriction on exports. An embargo is a law that cuts off trade with a specific country. FIGURE 17.5 TARIFF RATES ARE FALLING Developed Nations Less Developed Countries Middle East and North Africa East Asia and the Pacific Latin America and the Caribbean Sub-Saharan Africa South Asia 0 10 Key: Import tariff rate in the late 1980s Import tariff rate in 2004 60 70 30 50 20 Import tariffs (by percent) 40 Source: United Nations Human Development Report, 2005 AP P LI CATION Categorizing Economic Information A. Aside from imposing an embargo, how might one nation limit the import of a product from another nation? International Trade 521 The Impact of Trade Barriers KEY CONCEPT S Trade barriers have numerous effects. They may temporarily save domestic jobs in certain industries, but without competition, those industries might continue to operate inefficiently. In the end, consumers pay higher prices. Further, limits on trade sometimes lead to a trade war, a succession of trade barriers between nations. IMPACT 1 Higher Prices Trade barriers raise prices or keep them high. For example, in the early 2000s, the United States and Japan, who both produce semiconductor chips, imposed tariffs on chips from South Korea. The reason for the tariff was that the Korean government had subsidized the chip maker, allowing the chips to be sold at a very low price. The result was a higher price in U.S. and Japanese markets for both the Korean chips (up 27 to 44 percent) as well as for those produced domestically. (See Figure 17.6.) FIGURE 17.6 THE EFFECT OF AN IMPORT TARIFF ON PRICE c e c i r P S2 b S1 a D a This is the pre-tariff price of an imported good. b A tariff increases the price, moving the supply curve up the demand curve by the amount of the tariff. c There is less demand at the new, higher price, so the supply of imported goods is reduced. Quantity supplied IMPACT 2 Trade Wars Trade wars often occur when nations disagree on quotas or tariffs. One recent trade war, however, came about in 1999 when the European Union banned the importation of hormone-treated U.S. beef. Many U.S. ranchers treat their cattle with hormones, which cause the animals to develop muscle faster than untreated animals. But EU scientists, citing health concerns, helped push through a ban. In response, the United States levied 100 percent tariffs on a range of EU products, including ham, onions, mustard, chocolate, and Roquefort cheese. APPLICATION Applying an Economic Concept B. Boeing, a U.S. airplane producer, and Airbus, its European competitor, each claim the other receives unfair governmental support. Why does each object to the alleged unfair support? QUICK REFERENCE trade war succession of increasing trade barriers between nations 522 Chapter 17 Arguments for Protectionism KEY C ONCEPT S Considering all the disadvantages of trade barriers, why would a country enact such laws? The answer lies in the concept of protectionism, the use of trade barriers between nations to protect domestic industries. Protectionists argue that trade barriers protect domestic jobs, promote infant industries (new industries that are often unable to compete against larger, more established competitors), and protect national security. ARGUM ENT 1 Protecting Domestic Jobs Between 2000 and 2003, Stark County, Ohio, lost ten percent of its manufacturing jobs, including hundreds at a plant that makes Hoover
vacuum cleaners. Imports from Asia and Mexico forced a ten percent drop in the price of vacuum cleaners. The U.S. workers, many of whom earned high wages to do their skilled work, were understandably upset by the shift of their jobs to overseas facilities. In Ohio and elsewhere, people argue that trade barriers are needed to protect domestic jobs, even though, in reality, these actions generally protect inefficient production and result in higher prices for everyone. Voters in industrial areas bring their voices to the national debate about foreign trade. By doing so, they have helped bring about federal job training programs for workers who find themselves unemployed as a result of the movement of jobs to places where the per unit cost of labor is lower. QUICK REFERENCE Protectionism is the use of trade barriers between nations to protect domestic industries. Infant industries are new industries that are often unable to compete against larger, more established competitors. Irish Success Bono suggested that Ireland’s ability to protect its industries helped the Irish economy become stronger. ARGUM ENT 2 Protecting Infant Industries What was an Irish rock star, Bono, doing at the 2006 World Economic Conference in Davos, Switzerland? For one thing, this performer, known for his commitment to Africa, was arguing that African infant industries should be protected. Referring to the history of his own country, he said that Irish infant industries were protected in their day but that such protection is “denied . . . to the poorest countries in the world.” The idea behind protecting infant industries is to assist newly developing industries in their growth process until they are able to compete with better-developed foreign rivals. This argument is often used by newly developing nations to keep out goods from economically well developed nations. In Africa, for example, Uganda has received protection for its infant industries in the form of tariffs on exports from neighboring Kenya. However, even with these protective tariffs, Ugandan industry has not yet found a way to become competitive on its own and continues to request extensions of the tariff. This example points to a potential problem. Critics say that, provided with a sheltered existence that is free from the need to compete on equal terms, these industries settle into perpetual infancy. And a perpetual infant needs perpetual support. International Trade 523 Non-Economic Trade Barriers Some nations impose trade barriers for religious reasons. Iran, for instance, has banned any Western movies that portray secularism, feminism, and other activities deemed unethical. Western popular music has also been deemed indecent and “un-Islamic” and, therefore, banned. These barriers have driven demand for Western movies and music underground, where they can be found on the black market. Some nations enact trade barriers based on more general notions of culture. During the 1994 round of negotiations related to the Global Agreement on Tariffs and Trade (GATT), the French movie industry won a victory on a principal close to its heart. It’s known as the cultural exception, and it basically states that cultural goods are different from other goods and should not be covered by trade agreements. The cultural exception has been used, notably by France and Canada, to boost domestic television and film industries (through subsidies and quotas) and limit foreign competition, mostly from the United States. French movie poster Without these protections, the exception’s proponents say, a handful of U.S. media multinationals would be able to dominate the area of audiovisual entertainment, thereby overwhelming the traditional cultures of other nations. CONNECTING ACROSS THE GLOBE 1. Explaining an Economic Concept Some would argue that all trade barriers lack sound, economic reasoning. Do you agree? Why? 2. Making Inferences and Drawing Conclusions Which one of the three arguments for protectionism most resembles the actions taken by France and Canada? Explain. ARGUMENT 3 Protecting National Security National security affects the trade of industries that nations consider to be vital to their safety. The energy industry is considered vital by most. In 2005, a governmentrun Chinese company bid on U.S. oil company UNOCAL. Many in Congress and elsewhere in the United States warned against allowing a foreign government to take over an important U.S. energy supplier. After the House of Representatives voted 398 to 15 to ask President Bush to step in, the Chinese company withdrew its bid. But sharp political differences exist over what industries are truly vital to national security. In 2006, a company from Dubai, which had purchased the rights to operate port facilities in New York, Miami, New Orleans, and elsewhere, was forced to abandon the deal in light of political pressure over port security. Many analysts were skeptical of the security concerns, however, and worried more about the implications of interference in free international trade for purely political reasons. APPLICATION Making Inferences and Drawing Conclusions C. Do you think that political pressure for protectionist trade barriers rises or falls during a recession? Explain your answer. 524 Chapter 17 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in the following pairs: a. trade barrier b. tariff c. trade war d. infant quota voluntary export restraint protective tariff industries protectionism 2. Why would a country engage in dumping? 3. How does a trade war get started? What effects does it have? 4. Why do some people feel that barriers to free trade are essential for national security? 5. Who benefits from trade barriers, inefficient or efficient producers? Cause quota Effect higher prices 6. Using Your Notes Take a position on free trade vs. protectionism and explain your position in a brief essay. Refer to your completed cause-and-effect chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com . Analyzing Cause and Effect In 1996, the United States expanded the embargo against Cuba, declaring that any foreign corporation that engaged in trade with Cuba would lose its privilege of trading with the United States. Give two possible effects of this embargo expansion. 8. Solving Economic Problems If you were the CEO of a manufacturing company facing stiff foreign competition, what are some ways you could adjust your business to stay competitive? What are the advantages and disadvantages of these changes? 9. Applying Economic Concepts Give three examples of U.S. citizens earning an income by selling products domestically that were made in other countries. Give three examples of U.S. citizens earning an income by selling products or services that are ultimately purchased by people in other countries. 10. Challenge A trade agreement between Kenya and some nations in Europe requires Kenyan farmers, most of whom have small peasant farms, to comply with 400 conditions before they can export their produce to European countries. They must be able to document the fertilizers, pesticides, and other additives used in the growing of their crops. How would you categorize this trade restriction? What impact do you think it will have on Kenyan exports and prices in the European nations? Analyzing Tariff Rates Look at the graph below showing selected U.S. tariff rates for nations with which it has “Normal Trade Relations” (NTR), also known as the “most-favored nation” (MFN) status. Item NTR/MFN Tariff (%) Ceramic tableware Cars Trucks Most bicycles Sports footwear 4.5 2.5 25.0 11.0 10.5 Analyzing and Interpreting Data How much does the cost of a $32,000 truck increase because of the tariffs? If you pay $245.31 for a bicycle, what amount is the tariff? Challenge Suppose a pair of imported running shoes costs $10. With the tariff added, the importer has to pay $11.50. The importer, however, has to raise the price of the shoes to cover the expense of selling and shipping them to retailers, and retailers have to raise the price to cover their expenses in selling the shoes. Assuming the price increases by 50 percent at each stage of the process, what amount does the initial $1.50 tariff grow into? International Trade 525 S E C T I O N 3 Measuring the Value of Trade TA K I N G N O T E S In Section 3, you will • describe how nations determine the value of their currency in a world market • explain why nations want a favorable balance of trade foreign exchange market, p. 526 foreign exchange rate, p. 526 fixed rate of exchange, p. 526 flexible rate of exchange, p. 527 trade weighted value of the dollar, p. 528 balance of trade, p. 529 balance of payments, p. 529 trade surplus, p. 529 trade deficit, p. 529 As you read Section 3, complete a cluster diagram summarizing key information about measuring trade. Use the Graphic Organizer at Interactive Review @ ClassZone.com Measuring Trade Foreign Exchange KEY CONCEPT S If a certain good costs $100, how many euros does it cost? How many Mexican pesos? Or Russian rubles? International trade requires some way to establish the relative value of the different currencies of the nations doing the trading. So nations have worked out systems that facilitate the exchange of currencies between buyers and sellers. One key element is the foreign exchange market, a market in which currencies of different countries are bought and sold. This market is a network of major commercial and investment banks that link the economies of the world. Another key element in facilitating international trade is the foreign exchange rate, the price of one currency in the currencies of other nations. Rates of Exchange During the 1800s and early 1900s, gold was the standard against which the value of a nation’s currency was determined. Nations traded on the basis of a fixed rate of exchange, a system in which the currency of one nation Currency Exchange The Mexican peso, the Aus
tralian dollar, and the Chinese yuan are all bought and sold on the foreign exchange market. QUICK REFERENCE In the foreign exchange market, the currencies of different countries are bought and sold. The foreign exchange rate is the price of a currency in the currencies of other nations. With a fixed rate of exchange, the currency of one nation is fixed, or constant, in relation to other currencies. 526 Chapter 17 QUICK REFERENCE The flexible rate of exchange is a system in which the exchange rate for currency changes as supply and demand for the currency changes. is fixed, or constant, in relation to other currencies—in this case to gold. After the profound economic disruption of World War II, other currencies were “pegged” to the stable U.S. dollar. That is, their currency was valued according to its relation to the U.S. dollar. The price of an ounce of gold was fixed at $35. The volatile 1970s brought another change. As the United States ran up a trade deficit and the dollar declined in value, the standard of $35 per ounce of gold was no longer sustainable, and the flexible rate of exchange, also called the floating rate, became predominant. This is a system in which the exchange rates for currencies change as the supply of and demand for the currencies change. For example, suppose that one British pound (GBP) is worth two U.S. dollars (USD). If an American importer wants to buy 100 British-made watches valued at 100 GBP each, then the importer would sell 20,000 USD in the foreign exchange market to obtain the necessary 10,000 GBPs. As the supply of dollars increases, their relative value drops. So the next time the importer wants to buy watches, the exchange rate might be 1 GPB:2.5 USD, and the watches would cost 25,000 U.S. dollars, making them less attractive as imports. Over time, the flexible exchange rate acts as a regulator on foreign exchange, balancing imports and exports. M AT 17.7 Calculating Exchange Rates Suppose you want to buy a book in Germany, where the currency is the euro (€). The book costs €25, and the seller wants you to pay in euros, but you have U.S. dollars. To buy the book you must first buy euros. To find out how much €25 costs in U.S. dollars, you must know the exchange rate. In this case, let’s say the exchange rate is 1.25, which means that one euro costs $1.25. Now use the following formula. Example Calculation Amount of currency you want to buy × Exchange rate = Cost in currency you have €25 × 1.25 $/€ = $31.25 To buy €25, you must pay $31.25. Reciprocal exchange rate The exchange rate 1.25 can be written as a fraction: $1.25/€1. You can use this fraction to find the exchange rate a German must use to buy U.S. dollars with euros. First take the reciprocal of the fraction by swapping the numerator and the denominator; then use a calculator to write the fraction as a decimal. The reciprocal of $1.25 €1 is €1 , $1.25 which is 0.80 €/$ So to convert from U.S. dollars to euros, multiply by the exchange rate 0.80. International Trade 527 QUICK REFERENCE The trade-weighted value of the dollar is a measure of the international value of the dollar. Strong and Weak Currencies AND U. S. TRADE FIGURE 17.8 THE STRONG DOLLAR The Federal Reserve keeps a measure of the international value of the dollar called the trade-weighted value of the dollar. It determines if the dollar is strong or weak as measured against another currency. Because of the flexible exchange rate, as currencies are traded, some increase or decrease in value when measured against another currency. For example, if the U.S. dollar becomes stronger in comparison to the Mexican peso, then the U.S. dollar buys more Mexican pesos than it could previously. What this means is that imports from Mexico now cost less. As you can see in Figure 17.8, importers in the United States benefit because they are able to buy foreign goods and services relatively cheaply. but exports from the U.S. become more expensive and decrease imports to the U.S. become less expensive and increase As the value of the dollar increases At the same time, however, goods made in the United States may have a hard time competing with these inexpensive imports in the U.S. domestic market. Also, the strong dollar has a negative effect on U.S. exporters, since goods made here would be more costly to purchase abroad at the strong dollar rate. The weak dollar has the same effects but in reverse, as imported goods become more expensive and exporters are able to sell relatively cheaply. YO U R EC STRONG DOLL AR AND WE AK DOLL AR Which sweater will you buy? The U.S. dollar is very weak versus the Hong Kong dollar (HKD). How might this influence your decision to buy a new sweater made in the United States, or one imported from Hong Kong? ? Domestically produced Imported from overseas APPLICATION Applying Economic Concepts A. If you are an American exporter, does a strong dollar help your business? Explain. 528 Chapter 17 Balance of Trade KEY C ONCEPT S In Chapter 12, you read about net exports as an economic measure. Another name for the difference between the value of a country’s imports and exports is its balance of trade. It is tallied through the balance of payments, a record of all the transactions that occurred between the individuals, businesses, and government units of one nation and those of the rest of the world. The U.S. balance of payments includes the goods and services traded between it and other nations, as well as the investments foreign interests make in the United States and those made by Americans in a foreign country. A nation is said to have a favorable balance of trade if it has a trade surplus—that is, it exports more than it imports. If a nation imports more than it exports it has a trade deficit, also known as an unfavorable balance of trade. E XAMPLE U.S.-China Trade In recent years, China has undergone one of the most rapid industrializations in history. In addition to its fast-growing output of manufactured goods, the Chinese currency, the RenMinBi (RMB), or yuan, has also been weak compared to the U.S. dollar. The yuan’s weakness versus the dollar resulted from China’s decision to peg its value at a fixed rate versus the dollar, beginning in 1994. This artificially weak position helped make the United States the number-one destination for Chinese exports. By 2005, China had a record trade surplus of just over $200 billion with the United States. The surplus helps China fuel its continued manufacturing growth. QUICK REFERENCE A nation’s balance of trade is the difference between the value of its imports and exports. The balance of payments is a record of all the transactions that occurred between the individuals, businesses, and government units of one nation and those of the rest of the world. A nation with a trade surplus exports more than it imports. A nation with a trade deficit imports more than it exports. FIGURE 17.9 BAL ANCE OF U. S. T R ADE WITH CHINA Year 2000 2001 2002 2003 2004 2005 –83.8 –83.1 –103.1 –124.1 –162.0 –201.25 –50 –75 –100 –125 –150 –175 –200 –225 Source: U.S. Census Bureau Foreign Trade Statistics ANALYZE GRAPHS 1. Between which two years did the trade deficit with China grow the most? 2. If the dollar were weaker than the yuan, would you expect the trend shown in the graph to continue? Why? International Trade 529 For an update on the U.S. balance of trade go to ClassZone.com EXAMPLE The U.S. Trade Balance The balance of trade in the United States has gone through roughly five phases. From about 1770 to 1870, the young nation had a deficit in goods and services but a surplus in capital investment from foreign countries that recognized the nation’s potential for growth. Between 1870 and 1920, the nation was paying back foreign debts from the previous phase, but it was also exporting more goods and services than it was importing. In the years between 1920 and 1945, the United States had a surplus in exports but a deficit in foreign investments, as the nation sought to help rebuild Europe after World War I. From 1945 to 1980, the nation had a deficit in merchandise and continued its deficit in foreign investments as large amounts of money went to post–World War II reconstruction. In the current phase, the United States has a large surplus of foreign investment, which is attracted by a relatively low inflation rate and a generally stable economy. However, high rates of consumer spending (versus low rates of saving), as well as high oil prices (which significantly increased the dollar value of U.S. imports) have helped create a very large merchandise deficit. An advantage of this deficit is that it allows U.S. consumers to buy low-priced imports. A disadvantage is that financing the deficit may require borrowing money from the rest of the world, selling off assets, or tapping into foreign currency reserves. FIGURE 17.10 U. S. BAL ANCE OF TR ADE 2000 2001 Year 2002 2003 2004 2005 –416.0 –389.5 –475.2 –520.0 –668.1 –805.150 –300 –450 –600 –750 –900 Source: U.S. Department of Commerce, Bureau of Economic Analysis ANALYZE GRAPHS 1. In what year did the U.S. balance of trade improve? 2. Does this overall trend point to rising or falling prices for U.S. consumers? APPLICATION Analyzing Cause and Effect B. Between 1870 and 1920, the United States was exporting more goods and services than it imported. What does this say about the relative strength of the dollar during this period? 530 Chapter 17 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs: a. foreign exchange market foreign exchange rate b. fixed rate of exchange flexible rate of exchange c. trade surplus trade deficit 2. What is an advantage of a trade surplus? A disadvantage? 3. What is an advantage of a trade deficit? A disadvantage? 4. How does the value of the U.S. dollar affect the U.S. trade surplus or deficit? 5. How does a flexible exchange rate help to stabilize trade balances? 6. Using Your
Notes Write a brief essay arguing for or against a single world currency. Refer to your completed cluster and use the section’s key words. Use the Graphic Organizer at Interactive Review @ ClassZone.com Measuring Trade 7. Analyzing Cause and Effect In July 2005, the Chinese RMB became fixed to a “market-basket” of currencies, including the U.S. dollar and the Japanese yen, removing a decade-long peg to the U.S. dollar alone. The new formula slightly raised the value of the RMB. If China’s trade surpluses continue, what will happen to the value of the RMB? 8. Applying an Economic Concept While you are in France on a business trip, you find out that the euro has gained strength against the U.S. dollar. Will your hotel room and food now be more or less expensive? Why? What about the goods you’re trying to sell on your trip; will they be more or less expensive to your customers in France? Why? 9. Making Inferences and Drawing Conclusions Japan has the world’s largest foreign currency reserves, followed by China. State two conclusions you can draw about the economies of these two nations based on their foreign currency reserves. 10. Challenge What are the advantages of a large supply of foreign investment in a domestic economy? What are the disadvantages? Understanding Exchange Rates Just as there are stock markets for trading company shares, there are currency markets for trading currencies. The picture shows the prices of three currencies in dollars and how the prices have changed. One Buys U.S. Dollar U.S. Dollar Euro Chinese Yuan Indian Rupee 1.00 1.32 0.13 0.02 Euro 0.76 1.00 0.10 0.02 Chinese Yuan Indian Rupee 7.82 10.33 1.00 0.18 44.48 58.72 5.69 1.00 Average rates, December 2006 Analyze Data Use this exchange rate table to answer the following questions. • How much of each of the other currencies will $5 U.S. purchase? • If the exchange rate from euros to dollars changed from 1.32 to 1.40, which currency has gotten weaker? • How would that affect EU businesses that export to the United States? Challenge Why might businesses need to buy foreign currencies? International Trade 531 S E C T I O N 4 Modern International Institutions TA K I N G N O T E S In Section 4, you will free-trade zone, p. 532 • describe what agreements customs union, p. 532 were made to start the freetrade movement • identify international and regional trade groups • explain what role multinationals play in world trade European Union, p. 532 euro, p. 533 NAFTA, p. 533 OPEC, p. 535 cartel, p. 535 WTO, p. 535 As you read Section 4, complete a summary chart like the one shown, using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Regional International Regional and World Trade Organizations KEY CONCEPT S Following the failed protectionist policies of the 1930s, nations have sought to expand trade and reduce or eliminate trade barriers. They have organized regional trading groups to create free-trade zones, specific regions in which trade between nations takes place without protective tariffs. Some have created customs unions, agreements that abolish trade barriers among the members and establish uniform tariffs for non-members. Some of these organizations are called common markets. As a result of these efforts, global tariffs have dropped by about one-third. GROU P 1 The European Union In 1957, six European nations recognized the benefits of abolishing trade barriers and formed a customs union called the European Economic Community. It was widely known as the Common Market. In 1993 the Common Market evolved into the European Union, or EU , which tightly bound its member nations to one another both economically and politically. The political nature of the EU, the fact that its members surrender some sovereignty in specified areas, makes it unique among EU Expansion Lithuanians celebrate their nation’s admission to the EU in 2004. QUICK REFERENCE A free-trade zone is a specific region in which trade between nations takes place without protective tariffs. A customs union is an agreement that abolishes trade barriers among its members and establishes uniform tariffs for non-members. The European Union, the EU, is an economic and political union of European nations established in 1993. 532 Chapter 17 trading groups. The Treaty on European Union had monetary union and a common foreign policy as key goals. Monetary union was established in 2002, as 12 member states adopted the euro. (See “The Euro as Common Currency” on p. 292.) The six original members were Belgium, France, Germany, Italy, Luxembourg, and the Netherlands. In 1973, Denmark, Ireland, and the United Kingdom became members. Greece joined in 1981, and Portugal and Spain in 1986. In 1995, after the Common Market became the European Union, Austria, Finland, and Sweden joined. In 2004, ten nations became members: Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia. In 2007, Bulgaria and Romania joined, raising the total number of members to 27. The EU accounts for about 20 percent of global exports and imports, making it the world’s biggest trader. It has removed barriers to free trade among member nations, with the ultimate goal that Europe’s national borders will be no more a barrier to free trade than are the borders of U.S. states. GRO UP 2 NAFTA In 1990, negotiations began on a free-trade agreement among the United States, Canada, and Mexico. The result of these negotiations, the North American Free Trade Agreement, or NAFTA, created the largest free-trade zone in the world. When it went into effect on January 1, 1994, it immediately eliminated tariffs on half of the goods exported to Mexico from the United States. The agreement called for an eventual phase-out of all trade barriers on goods and services. It also called for improved protection of intellectual property rights, stronger environmental and worker protections, and standardized investment policies. The advantages of NAFTA include specialization and increased efficiency, a competitive advantage over the EU and Japan, expanded markets, and new jobs. And while some object to NAFTA on a number of political, social, and even environmental grounds, the economic results appear robust. (See Figure 17.11.) Between 1993 and 2003, Mexico and Canada experienced economic gains as well. Two-way agricultural QUICK REFERENCE The euro is the currency of the European Union. QUICK REFERENCE NAFTA, the North America Free Trade Agreement, is designed to ensure trade without barriers between Canada, Mexico, and the United States. FIGURE 17.11 NAFTA’S FIRST TEN YEARS 145.3 87. ( 150 120 90 60 30 0 1993 2003 Years Source: Office of the U.S. Trade Representative ANALYZE GRAPHS ( 150 120 90 60 30 0 105.4 46.5 1993 2003 Years 1. Which nation, Canada or Mexico, increased its trade with the United States by a larger percentage? 2. Is an increase in trade typically beneficial for nations? Explain. International Trade 533 trade between Mexico and the United States increased 125 percent—from $6.2 billion in 1993 to $14.2 billion in 2003. Productivity in Mexico increased a remarkable 55 percent. Canada’s exports to its NAFTA partners increased by 104 percent, and its overall economy grew by over 30 percent. Overall trade between the three partners more than doubled during this period, from $289.3 billion in 1993 to $623.1 billion in 2003. GROU P 3 Other Regional Trade Groups Throughout the world, nations are forming trade organizations to specialize, promote free trade, and stay competitive with other trade groups. Descriptions of a number of these agreements from all parts of the world follow: Mercosur (Mercado Comun del Cono Sur) This group promotes the movement of goods and people in South America. Formed in 1995, Mercosur eliminated tariffs on 90 percent of goods traded between the group’s full members (Argentina, Brazil, Paraguay, and Uruguay). Venezuela became a full member in July of 2006. Counting associate members Mexico, Chile, Bolivia, and Peru, Mercosur has become the world’s fourth-largest trade association. ASEAN The Association of Southest Asian Nations was formed in 1967 to accelerate economic growth, social progress, and cultural development in the region, and to promote regional peace and stability. Its members include Indonesia, the Philippines, Singapore, Thailand, Vietnam, Laos, Cambodia, and others. F I G U R E 17.12 Some Regional Trade Groups G8 G8 G8 G8 G8 G8 G8 G8 Andean Community Asia-Pacific Economic Cooperation (APEC) Association of Southeast Asian Nations (ASEAN) Common Market for Eastern & Southern Africa (COMESA) Commonwealth of Independent States (CIS) European Union (EU) G8 Group of Eight (G8) North American Free Trade Agreement (NAFTA) Organization of Petroleum Exporting Countries (OPEC) Southern Common Market (MERCOSUR) Southern African Development Community (SADC) ANALYZE MAPS How many trading groups do the United States and Canada belong to? Why does it make sense for such developed nations to be part of multiple trading groups? 534 Chapter 17 QUICK REFERENCE OPEC is the Organization of Petroleum Exporting Countries. A cartel is a group of producers that regulates the production, pricing, and marketing of a product. QUICK REFERENCE The World Trade Organization, or WTO, is a group of nations that adhere to the policies of the General Agreement on Tariffs and Trade. APEC The Asia-Pacific Economic Cooperation group is a trade organization of nations on the Pacific Rim—those that are adjacent to or within the Pacific Ocean. It includes developed nations such as Australia, Japan, and the United States, transitional economies such as Russia and China, as well as less developed countries such as Thailand, Papua New Guinea, and Chile. The group has set ambitious goals for trade liberalization throughout the region by 2020. However, since all APEC decisions require a unanimous vote, progress toward its goals
has been slow. OPEC The Organization of Petroleum Exporting Countries is a cartel—a group of producers who regulate the production, pricing, and marketing of a particular product. In OPEC’s case, that product is petroleum, or oil. It has had mixed results in controlling the oil market since its formation in 1960. However, surging demand, from nations such as China and the United States, and periods of regional political instability have strengthened OPEC’s position in recent years. SADC Founded in 1979, the South African Development Community’s original goal was to act as a counterbalance to the region’s main economic power—South Africa. (After South Africa finally abandoned minority white rule—the apartheid system—it also became a member in 1994.) A regional free-trade zone was established in 2000. Dedication to free trade is a key element in boosting the region’s economies. However, corruption, political instability, various health issues (most importantly, AIDS), substandard education, and poor infrastructure consistently hamper development. (You’ll learn about these and other development issues in Chapter 18.) GRO UP 4 World Trade Organization In 1944, the Allied nations met to plan for recovery after World War II. Among other important outcomes, they produced the General Agreement on Tariffs and Trade (GATT), which laid out rules and policies for international trade. In 1995, the GATT principles were incorporated into a new organization, the World Trade Organization, or WTO. At the end of 2005, the WTO had 149 member nations. The purposes of the WTO include negotiating and administering trade agreements, resolving trade disputes, monitoring the trading policies of member nations, and providing support for developing countries. The principles underlying these purposes are that trade rules should apply equally to domestic and imported products. To that end all member nations should extend one another Normal Trade Relation (NTR) status, formerly known as Most Favored Nation (MFN) status. This means that no nation should extend more favorable trade terms to one WTO member than it does to another. Members should also work toward lowering trade barriers of all kinds and support fair trade as well as free trade. To varying degrees, the WTO has been successful. It has helped reduce tariffs on manufactured goods, lower trade barriers in agriculture, and promote intellectual property rights. It has also resolved disputes among members while maintaining each nation’s sovereignty, and promoted stability among member nations. AP P LI CATION Making Inferences and Drawing Conclusions A. Why do you think the term most favored nation has been replaced by normal trade relations? International Trade 535 Multinationals Bring Changes to International Trade KEY CONCEPT S Multinational corporations (see Chapter 8) cross many borders and must deal with tariffs, labor restrictions, and taxes in different nations. They often bring jobs and technology to developing nations, while boosting overall levels of international trade—something that benefits everyone involved. International Trade Within Multinationals As multinationals have become more prevalent, trade between the various divisions of multinationals has become an area of increasing interest. Intrafirm trade, as it is known, can simply be the exchange of goods between two parts of a multinational. But international intrafirm trade also covers the coordination of production between parts of a multinational. This means, for instance, that when a U.S. parent company sends parts to an overseas affiliate to assemble, that is counted in the export column for U.S. statistics on trade. Likewise, when the assembled goods are shipped back to the U.S. parent from its overseas affiliate, that is counted in the import column. In general, intrafirm imports account for about 40 percent of total U.S. imports. Intrafirm exports account for about one-third of total U.S. exports. EXAMPLE A Multinational Telecom Corporation Consider the case of Worldwide Cellular, a U.S.-based multinational that makes, markets, and services cellular phones. It imports an essential raw material from its mining arm in Australia, manufactures the phones at its facility in South Korea, markets the phones in Europe, and then directs customers who have questions or complaints to technical support and customer service representatives in India. Throughout the process, the people and the economies of each nation benefit. South Korean manufacturing Indian call center ▲ Australian mining ▲ European marketing and sales APPLICATION to come B. In 1969, there were about 7,200 known multinationals. By 2000, that number had grown to more than 63,000. Give three possible contributing reasons for that growth. 536 Chapter 17 S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs: a. free-trade zone customs union b. EU NAFTA c. OPEC cartel 2. What circumstances led to a liberalization in global trading? 3. How do customs unions help member nations? 4. How is the EU different from other regional trading groups? 5. What are some advantages of NAFTA? 6. Using Your Notes Write a brief Regional International summary of the major regional and international trade organizations. Refer to your completed summary chart and use the section’s key words. Use the Graphic Organizer at Interactive Review @ ClassZone.com . Making Inferences and Drawing Conclusions Some regional trade associations are viewed as an attempt by less developed countries to protect themselves and their regions from globalization’s aggressive momentum. Explain how regional groups might have that effect. 8. Analyzing Cause and Effect Many multinationals grew out of exporting businesses. How might the exporting business prepare a company to become a multinational? 9. Predicting Economic Trends Before NAFTA was passed, some experts predicted a reduction in illegal immigration from Mexico to the United States. In fact, in the first few years after NAFTA went into effect, illegal immigration increased. What reasoning might have explained the prediction that illegal immigration would decline? What reasons might explain the increase? 10. Challenge At the Hong Kong gathering of the World Trade Organization in 2005, Supachai Panitchpakdi, secretary general of the United Nations Conference on Trade and Development (UNCTAD) said: “Rich countries will have to reject not just protectionism, but populism, too. They will have to speak honestly to their people about the changing economies of the 21st century, and about global interdependence and the fact that prosperity elsewhere means prosperity and jobs at home.” Write a brief essay that “speaks honestly” to the rich countries about the changing economies of the 21st century. The Effects of NAFTA Between 1993 and 2002, the total trade among Canada, the United States, and Mexico more than doubled. The table below shows export figures for NAFTA members Canada and Mexico in each of those years. Exports (in billions of dollars) Nation 1993 2002 Canada to United States 113.6 213.9 to Mexico Mexico .9 1.6 to United States to Canada 31.8 2.9 136.1 8.8 Analyzing and Interpreting Data Canada has a higher export amount than Mexico, but did its level of trade increase more than Mexico’s in the interval? Explain. Challenge Can Canadian companies produce, package, and market products for both of its NAFTA partners in the same way? Explain why or why not. International Trade 537 Case Study Find an update on this Case Study at ClassZone.com Analyzing Tariffs—Who Wins and Who Loses? Background Tariffs on foreign sugar have been around almost as long as the United States itself. Although early tariffs were a form of revenue, their purpose expanded in the 19th century to provide protection for the domestic sugar industry. That protection continues to this day. Globalization, however, is having a direct impact on the way nations trade. Agricultural subsidies and tariffs have become a point of contention in recent WTO talks, with less-developed countries unhappy about the lack of market access for their goods and about their price disadvantage. What’s the issue? How do the trade barriers set up by the U.S. government affect producers (both foreign and domestic) and consumers? A. Online Article This article describes how the U.S. government supports sugar prices. Note that sugar subsidies are paid to the processor, rather than the farmer. The farmer receives a share once the sugar is processed. Sugar Interests Harm the National Interest USDA loan rates set floor on price of sugar. The [government] program allows sugar processors to take out loans from the USDA [U.S. Department of Agriculture] by pledging sugar as collateral. The loan rates—18 cents per pound for cane sugar, 22.9 cents per pound for beet sugar—are significantly higher than average world sugar prices. These loans must be repaid within nine months, but processors also have the option of forfeiting their sugar to the government in lieu of repaying their debt. This arrangement effectively guarantees that the processors receive a price for their sugar that is no lower than the loan value: If prices fell below that level, they would simply forfeit their sugar and keep the government’s money. In order to avoid that scenario, the USDA must prop up the domestic price of sugar. It does this by controlling supply through two mechanisms. First, it sets quotas on how much foreign sugar can be imported without facing prohibitive tariffs; second, it regulates the amount of sugar that domestic processors can sell. Source: Jason Lee Steorts, National Review, July 18, 2005 Thinking Economically In your own words, describe the mechanisms by which the U.S. government props up domestic sugar prices. 538 Chapter 17 B. Government Report This information from the U.S. Department of Agriculture charts U.S. raw sugar prices versus raw sugar prices fo
r the rest of the world. FIGURE 17.13 U. S. AND WORLD RAW SUGAR PRICES 25 20 15 10 Key: U.S. raw sugar prices World raw sugar prices 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Source: U.S.D.A., Economic Research Service, Sugar and Sweeteners Yearbook, 2006 Year Thinking Economically On average, how much greater are U.S. raw sugar prices than those for the rest of the world? C. Trade Association Web Page The American Sugar Alliance’s Web site makes the case that the U.S. sugar industry is an important part of the overall U.S. economy. Sweetener’s Impact on the U.S. Economy The American sweetener industry has a significant impact on the nation’s economy. • Economic impact: $21.1 billion of economic activity in 42 states is generated in the U.S. each year by the sugar and corn sweetener industries. • Beet sugar industry: Over 1,400,000 acres of sugarbeets are grown in 12 states and are processed in 25 sugarbeet factories. The industry creates 88,200 full time direct and indirect jobs for people across the nation. • Cane sugar industry: Seven cane refineries and 22 mills process sugar cane raised in four states: Florida, Hawaii, Louisiana and Texas. The production and processing of sugarcane creates 71,900 full time direct and indirect jobs. • Jobs: 372,000 jobs in the U.S. rely on a strong U.S. sweetener industry. Source: www.sugaralliance.org Thinking Economically Why does the American Sugar Alliance want to emphasize the economic impact of the sugar industry? THINKING ECONOMICALLY Synthesizing 1. Which argument for protection does document C seem to make? Use the document and pages 523 and 524 to formulate your answer. Is this argument economically valid? Explain. 2. Is the difference in price shown in document B an unavoidable outcome of the program outlined in document A? Explain your answer. 3. How does U.S. government intervention in the sugar industry limit the functioning of the economy as a free market? Use examples from the documents in your answer. International Trade 539 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. absolute advantage balance of trade comparative advantage economic interdependence embargo exports foreign exchange market foreign exchange rate free trade zone imports NAFTA protectionism quota revenue tariffs tariff trade barrier trade deficit trade surplus trade war WTO When nations can produce something at a lower cost than other nations, they are said to have a(n) 1 . This is different from a(n) 2 , which means that goods or services are produced at a lower opportunity cost. Through trade, nations develop 3 , relying on one another. Policies of 4 have created 5 between nations, including 6 —limits on imports—and 7 —fees charged on goods brought into a country. International trade would not be possible without the 8 , where currencies of different countries are bought and sold. Nations keep track of their 9 , the difference between their exports and their imports. With a 10 , large reserves of foreign currency accumulate. With a 11 , domestic consumers enjoy lower prices. The trend since the end of World War II has been toward free trade. Nations have formed regional 12 that abolish trade barriers among members. In 1994 the United States became part of a trading organization with Mexico and Canada known as 13 . 540 Chapter 17 CHAPTER 17 Assessment Benefits and Issues of International Trade (pp. 510–519) 1. How do nations gain by specializing in products for which they have a comparative advantage? 2. How does trade affect a national economy? Trade Barriers (pp. 520–525) 3. Name and describe four trade barriers. 4. What three reasons are protectionists likely to offer to support their position? Measuring the Value of Trade (pp. 526–531) 5. Explain how an importer purchases a foreign product and what effect those actions would have on the value of each currency. 6. What does the term strong dollar mean? Modern International Institutions (pp. 532–539) 7. What agreements helped launch the free trade movement? 8. Create a fictional multinational and explain how it might operate from raw materials all the way through marketing the finished product. A P P LY Look at the graph below showing U.S. imports and exports to and from various trading regions. 9. To which group does the United States export the lowest dollar value of goods and services? 10. With which group does the United States have the largest trade deficit? the smallest trade deficit? FIGURE 17.14 U.S. TRADE WITH REGIONAL GROUPS 1,000 ( 800 600 400 362.2 266.9 200 0 814.0 496.6 Key: Imports from Exports to 21.4 14.5 81.9 45.3 NAFTA MERCOSUR APEC ASEAN Source: www.eurunion.org Trade groups 11. Creating Graphs Create a bar graph to illustrate the following trade data for selected regions. The EU25 is made up of the 15 countries that were members of the European Union in 2003 and the 10 that would become members in 2004. FIGURE 17.15 SELEC TED REG IONS Country or region United States EU25 Japan Total imports (billions of U.S. dollars) Total exports (billions of U.S. dollars) World import share (percent) World export share (percent) 1,517 1,047 477 1,021 1,250 597 22.9 14.0 13.8 13.1 6.8 8.5 Source: Eurostat, 2003 data Use to complete this activity. @ ClassZone.com 12. Analyzing and Interpreting Data Which two of the three trading entities in the table above are likely to have good reserves of foreign currency? 13. Synthesizing Economic Data In which trading entity in the table above are imports the highest percent of total trade value? The lowest? 14. Comparing and Contrasting Economic Information What are developed nations hoping to gain through reduced global trade barriers? What are developing nations hoping to gain? 15. Challenge The World Trade Organization, unlike GATT, has an organizational structure to implement its principles. However, it has no authority to force a nation to do something against its own laws. How is it able, then, to resolve disputes among members? The Advantages of International Trade The concept of comparative advantage explains why specialization and international trade are so important to economic success. Complete this exercise with a partner to help further your understanding. Each of you will represent a trading nation. One of you will be El Estado, and the other will be Lichtenbourg. Both countries produce lemons and televisions. The following table shows monthly production by each nation. El Estado Lichtenbourg Lemons (in pounds) Televisions 20,000 4,000 9,000 3,000 Step 1 Decide whether El Estado or Lichtenbourg has the absolute advantage for each product. Explain why this is so. Step 2 Each student should calculate what his or her nation’s production ratio is. Express your ratio in terms of opportunity cost. How many pounds of lemons does it cost to make one TV? Step 3 With your ratios calculated, decide which nation has the comparative advantage in the production of TVs. On this basis, decide which nation should specialize in the production of each product. Step 4 Now that you’ve decided to specialize and trade, calculate a trade ratio that makes trade between your two nations even more advantageous. Explain how the new ratio achieves this goal. International Trade 541 Economic Development Issues of economic development are as much about the basic building blocks of societies as they are about money. When governments are stable and help to provide their people with resources and opportunities, economic development can become a reality. 542 CHAPTER 18 Issues of Economic Development SECTION 1 Definitions of Development SECTION 2 A Framework for Economic Development Objectives SECTION 3 Transition to a Market Economy CASE STUDY China’s Campaign for Economic Power Free enterprise system is another name for capitalism, an economic system based on private ownership of productive resources. C H A P T E R 18 transitional economy is a country that has moved (or is moving) from a command economy, such as communism, to a market economy AT T E R S The development of the world’s less developed countries has grown increasingly important as globalization has taken hold. Promoting development also promotes good government and economic opportunity in less developed countries. When a nation’s government is democratic and stable and its citizens are prosperous, the benefits reach beyond that emerging economy to the world community, which gains a new economic and political partner. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on trade and China’s transition to a market economy. (See Case Study, pp. 570–571.) Go to SMART GRAPHER to complete graphing activities in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. How has international trade helped China make the transition to a market economy? See the Case Study on pages 570–571. Issues of Economic Development 543 S E C T I O N 1 Definitions of Development TA K I N G N O T E S In Section 1 you will • determine how economic development is defined • explain how certain indicators can illustrate the level of economic development of a nation developed nations, p. 544 transitional economies, p. 545 less developed countries (LDC), p. 545 infrastructure, p. 545 per capita GDP, p. 546 infant mortality rate, p. 547 life expectancy, p. 547 literacy rate, p. 547 human development index (HDI), p. 547 As you read Section 1, complete a summary table like the one shown. Use the Graphic Organizer at Interactive Review @ ClassZone.com Definitions of Development Levels of Development Standards of Economic Development Levels of Development KEY CONCEPT S Do you have at least $1 in your pocket at the moment? If so, you have more mone
y than over a billion of the world’s people have for food, shelter, and clothing for today. Economists gather this type of data to compare the economies of nations and the impact of those economies on people’s standard of living. They use the data to measure the nations’ level of economic development. QUICK REFERENCE Developed Nations Developed nations have a market economy, a relatively high standard of living, a high GDP, industrialization, widespread private ownership of property, and stable and effective governments. 544 Chapter 18 Economists have defined three major levels of economic development. The nations with the highest standards of living are known as developed nations. In addition to a relatively high standard of living, these nations have a market economy, a high GDP, industrialization, widespread private ownership of property, and stable and effective governments. The nations of Western Europe, the United States, Canada, Australia, New Zealand, Japan, and South Korea are all developed nations. You can identify some of the features of a developed nation by looking around you. Most people live fairly comfortable lives and enjoy such consumer goods as television sets, washing machines, and cars. You will also see that most people live in urban areas, where they have jobs in service and industrial enterprises: banks, insurance companies, auto parts manufacturing, and so on. Even though few people work in agriculture, the nation produces a surplus of agricultural products using advanced science and technology and highly efficient farming methods. You will also see that, on the whole, people are generally healthy and well-educated. They have political and economic freedom, and they exercise those freedoms in pursuit of well-being. You will see exceptions to all of these features—poverty, unemployment, poor living conditions—but they are not the prevailing features of the society. Transitional Economies Economists have also defined the development that occurs in transitional economies. These are countries that have moved (or are moving) from a command economy to a market economy. China, Russia, and a number of Eastern European countries are considered to be transitional economies. Poland, in Eastern Europe, is in transition and categorized as a less developed country. Like other transitional economies, however, it is on a clear path toward improving standards of living. As democracy and economic freedom begin to take hold, Poland’s economy and its citizens’ quality of life have steadily improved. QUICK REFERENCE A transitional economy is a country that has moved (or is moving) from a command economy to a market economy. In Transition A developed economy, such as the United States (left), generally has greater access to technology than a transitional economy, such as China (right). QUICK REFERENCE A less developed country (LDC) has a lower GDP, less well developed industry, and a lower standard of living. Infrastructure is the basic support systems needed to keep an economy going, including power, communications, transportation, water, sanitation, and education systems. Find an update on health statistics in LDCs at ClassZone.com Less Developed Countries Less developed countries (LDCs), such as many African, South American, and Eastern European countries, have a lower GDP, less well developed industry, and a lower standard of living. Often, these nations have ineffective or even outright corrupt governments that fail to protect private property rights. LDCs are sometimes called emerging economies, but some have emerged, so to speak, more than others. As a result, they can be divided into middle-income nations, such as Brazil and Thailand, and low-income nations, such as Mozambique and Cambodia. The picture in the low-income nations is starkly different from what you see when you look around the United States. A high percentage of people live in substandard housing. Few families own televisions or washing machines. Even if they owned cars, there are few good roads to drive them on, since developing nations often lack infrastructure. Infrastructure is the basic set of support systems needed to keep an economy going. It includes such things as power, communications, transportation, water, sanitation, and education systems. In these economies, a relatively high percentage of the people work at subsistence farming and have little savings. Often, even children toil with the rest of the family. Some go to school for only three or four years; some children receive no schooling. Health conditions are substandard, as medical care is hard to come by in rural areas. In many developing nations, political freedom is still a dream. AP P LI CATION Economies A. What role does technology play in economic development? Issues of Economic Development 545 Standards of Economic Development KEY CONCEPT S How is it possible to compare economies when each country may have its own ideas of what is valuable? For example, the number of television sets per thousand households yields valid information about the economic conditions in most nations. However, not every culture values television ownership to the same extent. Such statistics need to be used in conjunction with others, so that a more nuanced image of a nation’s overall level of development can be obtained. Economists use the following standards of development to bring this detailed image into focus. QUICK REFERENCE Per Capita Gross Domestic Product Per capita gross domestic product is a nation’s GDP divided by its total population. The most popular measure of economic development is per capita gross domestic product, a nation’s overall GDP divided by its total population. This statistic is informative because it estimates the amount of goods and services produced per person in a given year. These figures can be used to compare one country to another. (See Figure 18.1.) For example, the per capita GDP of the United States is among the world’s highest—over $40,000. In Tanzania, in east Africa, it is $700—among the lowest. Often these figures are adjusted to take into account the idea that a dollar may go further in some less developed countries where goods and services are less costly. F I G U R E 18 .1 World Per Capita GDPs Rank Order - GDP - per capita $22,000 and over $21,800 to $8,400 $8,300 to $4,700 $4,600 to $1,900 $1,800 to $400 No information available 546 Chapter 18 ANALYZE MAPS 1. Which continent is the least developed? 2. Which continents have no countries in the top per capita GDP bracket? Health Statistics showing various aspects of health and health care are also useful in determining economic development. Especially indicative are statistics on the survival rate of babies. This measure is called the infant mortality rate, the number of children who die within the first year of life per 1,000 live births. The infant mortality rate in Japan is 3. In China it is 23. In Angola it is 185. What can economists learn from these figures? The answer lies in understanding the conditions in which infants thrive. These conditions include a safe and sanitary birth environment with access to needed emergency care, adequate nutrition, an adequately fed mother who has access to clean drinking water and acceptable shelter, and protection from disease in the form of early-childhood vaccinations. A subsistence society, or one in extreme poverty, is unlikely to be able to provide these conditions. Less developed economies may be able to provide them to some degree, but in developed economies, these conditions are the norm. Dangerous Water More than a billion people worldwide use unsafe drinking water sources. Disease and death can be real consequences of this fact. Another useful standard is life expectancy, the average number of years a person could expect to live if current mortality trends were to continue for the rest of that person’s life. For example, people born today in Japan can expect to live to age 82, in China, to age 72, while in Angola, only to age 39. Education The World Education Forum declares in its Framework for Action that “education is . . . the key to sustainable development and peace and stability within and among countries, and thus an indispensable means for effective participation in the societies and economies of the twenty-first century. . . .” Since education is so clearly tied into the economy, education statistics are tracked as useful indicators of the development level of a nation. One key education figure is the literacy rate, the percentage of people older than 15 who can read and write. Japan’s literacy rate is 99 percent; Somalia’s is 38 percent. Another useful statistic is student enrollment at all levels. This figure tells the percentage of school-age individuals who are actually going to school. In Belgium and Japan, for example, primary-school enrollment is 100 percent. In Niger, it is about 40 percent. In 1990, another standard was introduced that combines some of these other statistics. It is the human development index (HDI)—the brainchild of Pakistani economist Mahbub ul Haq. A nation’s HDI is a combination of its real GDP per capita, life expectancy, adult literacy rate, and student enrollment figures. Its measures are an important indicator of what life is like in a specific country. QUICK REFERENCE Infant mortality rate is the number of children who die within the first year of life per 1,000 live births. Life expectancy is the average number of years a person can expect to live if current mortality trends were to continue for the rest of that person’s life. Literacy rate is the percentage of people older than 15 who can read and write. The human development index (HDI) uses targeted economic, education, and health statistics to assess a nation’s level of development. Issues of Economic Development 547 Consumption of Goods and Services In the mid-1990s, home appliances were still relatively rare in less developed countries like Chi
na. By the year 2000, however, the refrigerator had become a familiar part of Chinese city life; three out of four dwellings in major urban areas had one. Refrigerators have even begun to reach the secondary cities and rural areas, though they are still so rare there that they are sometimes displayed proudly in the living room rather than hidden away in the kitchen. Washing machines are also becoming increasingly commonplace. China’s consumption of cell phones has risen rapidly in recent years too. At the beginning of 2001, there were approximately 65 million cell phones in use in China; by 2004, there were about 335 million—more than in any other country. The number of personal computers owned in China is doubling every 28 months. What do these statistics say about China’s economic development? These data show how people choose to spend their income after they have food and shelter. When consumption of such big-ticket items as refrigerators, automobiles, and washing machines increases, an economy is growing and developing. This indicates that people’s living standards are rising. Goods that once were available only to the rich are now purchased by middle- and even low-income families. In the less developed nations of China and India, 16 percent of the population is following this consumption pattern, compared with 89 percent of the population in Europe. The less developed nations therefore have the greatest room for growth in the consumption of consumer goods and services. For now, however, consumers in North America and Western Europe, whose population is about 12 percent of the global total, are responsible for 60 percent of the global total of consumption of goods and services. The 30 percent of the world population that lives in South Asia and subSaharan Africa, on the other hand, spends only 3.2 percent. Comparisons like the one below in Figure 18.2 offer another way to measure relative growth. F I G U R E 18 . 2 Ownership of Typical Consumer Goods (per thousand residents) Country Television Sets Telephone Mainlines United States 835 Ukraine 456 India 83 Source: The State of the World, 2004 548 Chapter 18 659 212 40 Energy Use Of the roughly 6.5 billion people in the world, as many as 2 billion are without electricity. Since electricity and other forms of energy contribute to economic development, statistics on energy use can reveal an aspect of a nation’s economic development. Energy use is not spread evenly throughout the population. Asia, with 50 percent of the world’s people, accounts for just over 21 percent of annual energy consumption. For another example, the average global consumption of electricity is 2,744 kilowatt hours (KWh) per capita. Japan’s annual per capita consumption of electricity, like that of other industrialized nations, is well over 7,000 KWhs. Colombia’s annual rate of about 820 KWh per capita is typical of LDCs, which average about 750 KWh per capita each year. How the energy is put to use is another revealing statistic, especially the amount used for commercial purposes. The United States, for example, uses the equivalent energy of 8,148 kilograms of oil per person in commercial enterprises. India uses the equivalent of about 494 kilograms of oil per person for commercial activities. The amount of energy used for commercial purposes correlates to a nation’s level of technological achievement and other economic measures. Projected energy use to the year 2025 follows the same pattern as the projected consumption of consumer goods and services, with LDCs outpacing developed nations. The LDCs are expected to increase their energy use by about 3.2 percent a year. In Asia, including China and India, the demand for energy is expected to double between 2002 and 2025. The relatively rapid increase in energy use coincides with the move toward industrialization and technological advances. In fact, transportation and industry account for nearly all of the projected increase in the use of fossil fuels. Personal Computers Mobile cells Wind Power Wind farms, such as this one in northwest China, contribute a small but growing part of the world’s electricity. 625 18 6 451 44 6 Issues of Economic Development 549 In contrast, the developed nations are projected to increase their energy use by only 1.1 percent a year. Developed economies use fuel more efficiently, which accounts in part for their slower rate of increase in energy use. Transitional economies are expected to increase their energy use by 1.6 percent each year as they face the challenges of moving to a market economy. Labor Force In what kind of job do most of a nation’s workers find themselves employed? The answer to this question reveals one aspect of a nation’s level of development. According to the World Bank, this measure includes all the economically active people between the ages of 15 and 65 in a country—including the employed, the unemployed, and soldiers, but excluding students and unpaid caregivers. The fewer workers there are engaged in agriculture, and the greater the number of workers in manufacturing and service industries, the more developed the nation Botswana’s Growing Economy Since it became independent in 1966, Botswana’s per capita income growth has been among the fastest of any nation in the world. This small African country transformed itself from one of the world’s poorest countries to a middle-income nation in under 50 years. In 2004, Botswana received an A credit rating from Moody’s and from Standard and Poor’s. Botswana has succeeded largely by maintaining a stable and responsible governmental system. The government has managed the income from large-scale mining operations wisely, reinvesting it in the nation’s physical and human infrastructure. In recent years, the development of the financial services and tourism industries has been stressed. Together, they now represent about one-quarter of the nation’s GDP. Botswana still faces a number of social and economic challenges, including high unemployment, low manufacturing output, and one of the world’s highest rates of HIV/AIDS infection. But through its moves to diversify the economy, the government has put the nation on a solid development track. CONNECTING ACROSS THE GLOBE 1. How has the government of Botswana helped keep the nation’s economy growing? 2. In the article, what tells investors that Botswana is a relatively safe place to invest? APPLICATION Drawing Conclusions B. Would you expect a positive or negative correlation between literacy rates and infant mortality rates? Explain. 550 Chapter 18 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs: a. developed nations b. human development index less developed countries infant mortality rate 2. What does the state of a nation’s infrastructure say about the country’s level of economic development? 3. Why is per capita GDP a more useful statistic than overall GDP when comparing nations? 4. What does an analysis of the labor force and energy usage tell economists about a nation? 5. Why are health and longevity statistics useful in determining a nation’s level of development? 6. Using Your Notes Pick one example of a developed nation, one of a transitional economy, and one of a less developed nation. Use your notes to explain why you chose each. Definitions of Development Levels of Development Standards of Economic Development Use the Graphic Organizer at Interactive Review @ ClassZone.com . Comparing and Contrasting Compare and contrast three characteristics of a developed nation and a less developed nation. 8. Making Inferences and Drawing Conclusions One measure of economic development is the extent to which a nation buys big-ticket consumer goods. Does the production of those goods also indicate a level of economic development? Explain your answer. 9. Writing About Economics Some economists argue that GDP does not give an accurate picture of a nation’s well-being. They point out that GDP reflects economic activity that pollutes the environment and depletes resources as well as economic activity that counteracts the pollution. In other words, it shows both the polluting enterprises and the cost of cleaning up the pollution on the plus side of the balance sheet. Write a paragraph speculating on how to revise GDP figures to reflect this concern. 10. Challenge In poorer countries, where does the money for development initiatives come from? Health care in Bangladesh Understanding Levels of Development The chart below shows life expectancy, infant mortality rates, and literacy rates for five countries. Country Bolivia Germany Moldova Philippines Bangladesh Life Expectancy (years) Infant Mortality (per 1,000 live births) Literacy Rate (%) 65.8 78.8 65.7 70.2 62.5 51.8 4.1 38.4 22.8 60.8 87.2 99.0 99.1 92.6 43.1 Source: CIA World Factbook, 2006 Drawing Conclusions Which nation is probably the most developed? Which nation is probably the least developed? Which nation is more developed, Bolivia or the Philippines? Explain your answers. Challenge If you were “weighting” the various measures used to show economic development, which would you consider most meaningful: life expectancy, infant mortality, or literacy rate? Explain your answer. Issues of Economic Development 551 S E C T I O N 2 A Framework for Economic Development Objectives TA K I N G N O T E S In Section 2 you will capital flight, p. 558 • evaluate the importance default, p. 559 of developing human and physical capital • examine the importance of stability and opportunity in economic development • describe how developing nations raise money for development programs World Bank, p. 559 International Monetary Fund ( IMF), p. 559 debt restructuring, p. 559 stabilization program, p. 559 As you read Section 2, complete a cluster diagram like the one shown for each major concept. Include key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ C
lassZone.com Development Framework stability stable prices Resources KEY CONCEPT S What does a nation need to develop economically? Natural resources such as minerals and fossil fuels play a role in economic development. A nation’s climate and the amount of land suited for agriculture are also factors. Each nation uses the resources it has. However, natural resources are not enough. Investing in human capital and physical capital, for example, are ways that many nations promote economic expansion. High Levels of Human Capital People are the most valuable resources in a market economy. One element of a healthy and growing market economy is a commitment to make the most of its human resources through education and training. Education and training help people develop the skills to enter into and function productively in the economy. Human Capital Societies benefit in many ways when their citizens are well educated. 552 Chapter 18 Investing in education also affects other aspects of a society. Educated citizens are able to make informed decisions about health matters. Educated parents are likely to vaccinate their children and invest in their children’s education. Furthermore, educated citizens are likely to vote, participate in civic affairs, rise above poverty, and avoid criminal activity. FIGURE 18.3 RATES OF PRIMARY SCHOOL COMPLETION AND SECONDARY SCHOOL ENROLLMENT 100 90 80 70 60 50 40 30 20 10 t n e c r e P 100 96 100 93 99 100 98 KEY: Primary school completion Secondary school enrollment 76 73 62 52 55 33 22 Esto nia U nite d States G er m a ny M exico B a n gla d esh C a m b o dia C a m ero o n Nation Source: World Development Indicators, World Bank Group, 2002 ANALYZE GRAPHS 1. What nation shows the largest drop-off between the percentage of students that complete primary school and the percentage who go on to secondary school? 2. Do you think the amount of drop-off between education levels is a clue to a nation’s level of development? Explain your answer. High Levels of Physical Capital Physical capital is also an important factor contributing to economic growth. As you read in Chapter 1, physical capital consists of the human-made goods—machines— that are used in the production of other goods and services. Investments in physical capital make people more productive. Fortunately, LDCs do not have to reinvent the wheel. Technology and other innovative capital resources are always being refined in developed nations. LDCs need only copy or import the technology. The desire to copy or import technologies points to the link between human and physical capital. Copying technology requires educated and well-trained people. Importing technology requires money, which is generally in short supply in LDCs, so these nations look to foreign investment. However, a country that lacks human capital is less attractive to investors that might supply this money. AP P LI CATION Explaining an Economic Concept A. Think of your own examples to explain the ripple effect that education has on a society and economy. Issues of Economic Development 553 Stability KEY CONCEPT S While such inputs as human capital and physical capital are necessary for increased output, they are only part of the framework for economic growth. The overall governmental and economic environments must be stable enough to support growth before those inputs can best be put to use. Effective Government Institutions In the United States, the rule of law is so fundamentally a part of the culture that it may be taken for granted. We are used to laws made by a legislature that we elect according to the principles laid out in the Constitution. We take for granted that the laws will then be made public for all to know and follow. We expect those laws to be applied fairly. When there are disputes, we trust that our legal system will sort out the differences according to the law, not by bribery or intimidation. In many countries, however, the rule of law is still out of reach, and in those places, economic growth suffers. Business investment always carries risk, even in a nation with effective government institutions. That risk rises sharply in countries where the enforcement of laws is unpredictable, where private property rights are unprotected, where a bureaucracy is corrupt or bloated or both, and where judges can be bought and sold. The rule of law provides a foundation of predictability and certainty that reduces economic risk. Democracy itself is a key factor of economic growth. Democratic nations have a higher rate of economic growth than nations with a different form of government. In nations where people can choose their representatives in free and open elections, they can promote their economic self-interest with the same degree of power as other citizens. When the press is uncensored, views that oppose government policy can be aired and debated. In a famous study, one Nobel Prize–winning economist, Amartya Sen, concluded that crop failures are not the chief cause of famines: political systems are. He points out that no widespread famine has ever occurred in a democratic nation. India has had famines, but none since it became a democracy in 1947. The democratic process reduces the likelihood that the government will interfere with the selfcorrecting market forces that could prevent widespread famine. Law Enforcement A fair and transparent court system is key to the kind of governmental stability that promotes development. 554 Chapter 18 Stable Prices In areas where prices are stable and where the governments’ fiscal and monetary policies are sound, economic growth can take root. Investors in such an environment know what to expect. They do not see volatile changes in interest rates, prices, or the level of the government debt. With price stability, businesses can make long-term plans with some assurance that conditions will not change too dramatically and that the government will not go bankrupt. In contrast, in nations with a high inflation rate or with unstable interest rates, investors run a high risk. Many will choose to avoid investing in such an environment in the first place. And even if they do take a chance, they are likely to withdraw their investment at the first sign of trouble. That leaves the unstable country further behind, since the funds it could use for economic expansion are placed in more stable nations. Monetary Stability Runaway prices in post–World War I Germany made money into children’s toys (left). A stable currency and stable prices create real purchasing power (right). Protected Property Rights Guaranteed protection of private property provides an incentive for economies to grow. If businesses have no way to assert ownership of their enterprises, they will have little incentive to take economic risks, since they will have no guarantee of reaping the rewards if they succeed. Assured property rights give investors confidence and stimulate entrepreneurship. Business owners also need private property rights to prevent the government from interfering with or restricting their operations. In such unstable nations as Haiti, Kazakhstan, and Indonesia, where corruption and favoritism are widespread, private property rights are insecure. This lack of stability is more than enough to cause investors to look elsewhere to locate their enterprises. In some LDCs, especially former colonies of Western nations, land ownership is in the hands of a very small percentage of the population—usually the descendants of the colonists. In some cases, this land is seized by the government for redistribution to the majority population. Foreign investors are wary of locating businesses in countries that threaten private property. AP P LI CATION Drawing Conclusions B. Why is the rule of law a stabilizing force that promotes development? Issues of Economic Development 555 Opportunity KEY CONCEPT S Economic opportunity depends on a number of functions that fall to the government. These include opening international trade, helping people move up the income ladder, controlling corruption, and limiting regulations. Open International Trade The government can also create opportunities for economic growth by lowering restrictions on international trade. As you read in Chapter 17, trade benefits the trading nations by allowing them to produce what they are most efficient at producing and trading for the rest. Partners in a trading relationship produce more than they would without trade, leading to economic growth. However, in less developed countries, governments have imposed high tariffs on imports and instituted other protectionist measures in an effort to give local producers an advantage. Governments often justify these protections as a shortterm effort to help local industries until they grow strong enough to compete with foreign competitors. Protectionist measures come with costs, though. Consumers have to pay more for goods than they would in a market open to imports. Also, government protections may reduce incentives for producers to become more efficient. Industries may become dependent on tariffs and other trade barriers. Increase Social and Economic Mobility Economic opportunity leads to the most vigorous economic growth when that opportunity is open to the entire population. If all citizens have an equal opportunity under the law to engage in economic enterprise, many will be motivated to lift themselves into a higher income bracket. A number of studies have found that in the United States, for example, about 25 to 33 percent of the population moves into a new income quintile each year. Over a ten-year period, that number rises to 60 percent. In the process of seeking personal economic reward, these people are also helping the economy to grow. In some traditional cultures, however, social conditions do not promote equal opportunity. For example, in some LDCs with a traditional culture, the lower status of women keeps half the labor force from developing
its full potential. Further, an entrenched class structure in some nations hampers growth, since the rich do not want changes that could deprive them of their wealth. Governmental changes that promote equal opportunity will help create a successful framework for economic growth. Find an update on women in the workplace in LDCs at ClassZone.com 556 Chapter 18 Economic Potential In many traditional societies, women are an untapped resource that could give development a boost. Control Corruption Corruption, the abuse of public office for private gain, is an especially urgent problem that helps explain why some nations are able to develop and others are not. When government officials are at liberty to enrich themselves and others—by taking bribes and kickbacks, funneling lucrative government jobs and contracts to relatives and allies, skimming aid and loan money, and so on— the rest of the nation, especially the poor, pays the price. (See Figure 18.4.) Although there is not an exact correlation between corruption and per capita GDP, much more often than not, countries with less corruption have higher per capita GDPs. Corruption Index* Country Australia Finland Chile 8.7 9.6 7.3 F I G U R E 18 . 4 Corruption and Per Capita GDP Limit Regulation Governments with reasonable tax levels and business regulations help to create economic opportunity. Businesses and other investors are more likely to be attracted to nations with relatively little “red tape.” United States Slovenia Bhutan South Korea South Africa Turkey Bolivia 7.3 6.4 6.0 5.1 4.6 3.8 2.7 Uganda 2.7 2.6 2.5 Russia Albania Kyrgyzstan Even in the United States, which has relatively few regulations on business, it is estimated that companies with 20 or fewer employees have to pay over $7,500 per employee each year to comply with government regulations. In many LDCs, the number of regulations is significantly higher. In a climate lead to corruption. of Rather tempted to bypass them through payoffs. As you have read, a corrupt environment removes economic incentive and slows economic growth. *10=least corrupt; 0=most corrupt Sources: Transparency International; CIA World Factbook; instability, the high number of regulations can the regulations, businesses are than comply with all 2006 and earlier data Cambodia 2.2 2.1 Per Capita GDP (in U.S. dollars) 31,000 31,600 11,900 41,600 21,500 1,400 22,600 12,200 8,400 2,900 1,800 5,300 11,000 2,000 2,500 AP P LI CATION Applying Economic Concepts C. Nations with the highest corruption index tend to have their wealth distributed less evenly, with a large percentage of people living in poverty. Why might this be so? Issues of Economic Development 557 Financing Development KEY CONCEPT S Nations seeking to finance economic development can look to four main sources: internal investment, foreign investment, aid from foreign governments, or investments from international agencies. A developing nation must consider both the positive and negative aspects of each source. Internal Investment Investment funds for economic development can come from both public and private internal investment. Banks within the nation invest in economic enterprises, such as roads, bridges, and other infrastructure. Egypt, for example, has a goal to make domestic savings the key force in development and has been working toward increasing the savings rate to 25 percent of GDP. To do so, it has an initiative to bolster the insurance industry, which is successful at pooling and channeling savings. In poorer nations, personal savings are very low, so banks have little to invest. Compounding the problem, the wealthy citizens of these countries sometimes invest their funds in developed countries rather than their own country, a problem known as capital flight. If private banks lack the funds to invest, the country’s government may provide funds. It might also seek foreign investment from multinational corporations of through sales of government bonds. Foreign Investment There are several ways in which foreign interests can invest in an economy. One is foreign direct investment (FDI), the establishment of a business enterprise in a foreign country. A second is foreign portfolio investment, through which foreign investors take part in a nation’s stock and other financial markets. Foreign investment in less developed countries increased from $44 billion in 1990 to $226 billion in 2000. One reason for the increase is that less developed nations had created a more attractive business climate for investors. Multinationals that open manufacturing plants in foreign nations provide jobs and training to the local population and reap the benefits of cheaper labor. Foreign Direct Investment Multinational corporations bring employment, training, and new technology to less developed countries. This factory in Beijing is a joint venture between a Chinese company and DaimlerChrysler. QUICK REFERENCE Capital flight occurs when capital from a country is invested outside that country. 558 Chapter 18 Loans and Aid Developing nations have also turned to loans to help finance their economic development. External debt, money borrowed from foreign banks or governments, has become an issue of great concern in some LDCs. Some countries, especially in South America and Africa, have more debt than they can pay back. When a nation cannot pay interest or principle on a loan, it is said to be in default. Nations may also seek foreign aid—money from other nations. (See Figure 18.5 for aid figures from the U.S. Agency for International Development [USAID]). FIGURE 18 . 5 USA ID ALLOC AT IONS BY REG I ON 6% 7.7% 13.2% 30.8% Africa ($2,050) East and South Asia ($1,559) Middle East ($1,251) Latin America / Caribbean ($877) Central Asia ($512) Europe ($402) 18.8% 23.5% Source: U.S. Agency for International Development, 2006 All figures are in millions of dollars. International Help Agencies LDCs also receive aid from several important international organizations. The World Bank, the International Monetary Fund, and the United Nations Development Program are the main international organizations devoted to economic development. • World Bank is a financial institution that provides loans, policy advice, and tech- nical assistance to low- and middle-income countries to reduce poverty. • International Monetary Fund (IMF) is an international organization established to promote international monetary cooperation, foster economic growth, and provide temporary financial assistance to countries to help ease balance of payments adjustment. The IMF helps nations overloaded with debt to develop debt restructuring, a method used by countries with outstanding debt obligations to alter the terms of the debt agreements in order to achieve some advantage. It often oversees stabilization programs, in which it requires these troubled nations to carry out reforms—reducing foreign trade deficits and external debt, eliminating price controls, closing inefficient public enterprises, and slashing budget deficits. • United Nations Development Program (UNDP) is a United Nations agency working to fight poverty. In 2006 it had active programs in 174 nations. AP P LI CATION Making Inferences and Drawing Conclusions D. Why would Kuwait, a developing nation, offer aid to countries in its region? QUICK REFERENCE Default is when a nation cannot pay interest or principle on a loan The World Bank is a financial institution that provides loans, policy advice, and technical assistance to low- and middle-income countries to reduce poverty. The International Monetary Fund (IMF) promotes international monetary cooperation, fosters economic growth, and provides temporary financial assistance to countries to help ease balance of payments adjustment. Debt restructuring is a method used by countries to alter the terms of their debt agreements in order to achieve some advantage. A stabilization program is a required program of reforms imposed by the IMF to steady the economy of a debtor nation in danger of default. Issues of Economic Development 559 ECO N O M I C S PAC ES E T T E R Anne Krueger: Reforming IMF Development Policy On September 1, 2001, Anne Krueger became First Deputy Director of the International Monetary Fund. Ten days later, the terrorist attacks on the United States sent shockwaves through the global economy. Three months later, Argentina suspended payments on its $132 billion foreign debt. At the time, this was the biggest default in history. All the while, there were significant economic upheavals as well as international protests over the burden of debt in developing nations. Clearly, she didn’t have the luxury of easing into her new position. A New Role for IMF Luckily, Krueger came very well prepared for her new job. In addition to her professorships at Stanford University, Duke University, and the University of Minnesota, Krueger had also been Director of the Center for Research on Economic Development and Policy Reform, at Stanford, and the Vice President of Economics and Research at the World Bank. In November 2001, anticipating Argentina’s default, Krueger put forward a proposal for the role of the IMF in debt restructuring and dispute resolution. In her proposal, the IMF would oversee the restructuring of the debt rather than simply providing bailout funds. The reform effort also called for collective action clauses, measures that let a supermajority of creditors overrule a creditor who is holding out for more repayment than may be possible. In fact, after several years of negotiations, most of Argentina’s creditors accepted 35 cents on the dollar in early 2005, and Argentina’s credit rating climbed once again. Even 35 cents on the dollar, however, seems too high to many critics, who believe that debt in most developing nations should be forgiven 100 percent so the money used to service the debt can be put to use providing such needed human services as health care and education. Krueger has disagreed: “. . . Unle
ss there is radical change from past behavior on the part of the debtors, their priorities for the use of released resources are not likely to be on education, health, or other expenditures that will enable the poor to improve their lot.” Nonetheless, the IMF is part of a plan to forgive debt completely in 18 of the most heavily indebted poor nations in exchange for economic policies that favor trade liberalization and other development goals. Anne Krueger APPLICATION Solving Economic Problems C. Krueger believes that direct aid to nongovernmental organizations working in health or education are more effective than debt cancellation. Critics argue that grants with conditions show the IMFs desire to control nations’ economies. Who do you agree with? Give reasons for your answers. FAST FACTS Anne O. Krueger Title: First Deputy Managing Director of the IMF, September 2001 to August 2006 Born: February 12, 1934, New York City Major Publications Edited: Reforming India’s Economic, Financial, and Fiscal Policies. Edited with Sajjid Z. Chinoy, 2003 Latin American Macroeconomic Reform: The Second Stage. Edited with Jose Antonion Gonzales, Vittorio Corbo, and Aaron Tornell, 2003 Selected Awards: • Distinguished Fellow and past President of the American Economic Association • Frank E. Seidman Distinguished Award in political economy (1993) • Bernard Harms Prize awarded by the Kiel Institute of World Economics (1990) Find an update on Anne Krueger at ClassZone.com 560 Chapter 18 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the relationship between this pair of terms: a. International Monetary Fund b. stabilization program 2. What are four key sources of funding for development? 3. How can a nation develop its human capital? 4. How can a nation improve its business climate? 5. What roles do foreign nations play in a country’s development? 6. Using Your Notes Use your completed cluster diagram to help you explain how the economic development of one nation might be an opportunity for growth for another nation. Use the Graphic Organizer at Interactive Review @ ClassZone.com Development Framework stability stable prices . Analyzing Cause and Effect How might the bailout by an international agency of a nation that has defaulted on foreign debt lead to more corruption in the future? 8. Writing About Economics Many economists believe that a country that is rich in a particular natural resource may actually be at a developmental disadvantage. They point out that nations such as these tend to put all of their resources into this one industry. Write a paragraph about how you, as leader of a nation, would use the large income from your nation’s natural resource to take other avenues to developing your economy. 9. Applying Economic Concepts Look again at Figure 18.5. The United States grants aid money each year to nations in the developing world. Do you think Anne Krueger would think this aid money should come with certain terms or conditions? Explain. 10. Challenge If you were in charge of development efforts for a poor nation, which source of development funds would you focus on? Why? Understanding the Path to Development Read the following scenarios of fictional less developed countries: • In nation A, there is a democratically elected government, but a corrupt law enforcement system has made property rights shaky. There is little foreign trade, and few foreign firms have set up manufacturing facilities. However, a foreign nation gives nation A hundreds of millions of dollars in aid each year. • In nation B, the move toward democracy has begun. A system of fair and transparent law enforcement is in place, and international trade and foreign direct investment are on the rise. High levels of foreign debt, however, could pose a problem in the future. Categorizing Economic Information Is nation A or nation B more likely on a path to successful development? Explain why you think so. Challenge What’s more beneficial to development— a connection to a large amount of foreign aid money or a plan to increase social, political, and economic stability? Why? Issues of Economic Development 561 S E C T I O N 3 Transition to a Market Economy TA K I N G N O T E S privatization, p. 563 shock therapy, p. 563 perestroika, p. 564 special economic zone (SEZ), p. 567 In Section 3 you will • identify problems that emerge when an economy goes from command to market • describe the transitions to a market economy in the former Soviet Union and nations it dominated • discuss the transitions to a market economy in China As you read Section 3, complete a cluster diagram like the one shown, using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Transition to a Market Economy new challenges New Challenges KEY CONCEPT S In Chapter 2, you read about different economic systems, including a command, or centrally planned, economy in which all economic decisions are made by the society’s leaders, usually government officials acting in a central location. For a while, much of the world’s population lived in a command economy. However, China, the nations that formerly made up the Soviet Union, and many Eastern European countries have taken steps toward a market economy. The transition requires new answers to the basic economic questions that central planners used to answer. Both the government and private individuals and companies face a number of challenges. CHALLE NGE 1 Poor Infrastructure A market economy needs a solid infrastructure to facilitate the production and distribution of goods and services. In a command economy, transportation, communications, banking, and education—the infrastructure of an industrialized nation—are as inefficient as other industries tend to be. With no competition there is little incentive to create a more robust physical and institutional infrastructure. Modernized airports, phone systems, roads, harbors, bridges, and computer connections help a transitional economy support and spread the goods and services it produces. Bridging the Gap Transportation infrastructure is vital to develop a successful market economy. 562 Chapter 18 C HAL LENGE 2 Privatization Under communism, the government owns all property. As transitional nations move toward a market economy, they have all undertaken the challenges of privatization, the process of transferring state owned-property and businesses to individuals. A major problem with privatization is how to sell the property. It can, for example, be auctioned off, but command economies have little private savings, and few people have the needed finances. Also, as you’ll read later, these auctions can sometimes be rigged to benefit those close to the ruling elites. A second method is to sell shares of businesses through a vehicle like the stock market. A third way is to give vouchers to people to purchase shares of a business, making cash unnecessary. QUICK REFERENCE Privatization is the process of transferring state owned property and businesses to individuals. C HAL LENGE 3 Rise in Prices In a command economy, some goods may have artificially low prices. Part of the switch to a market economy is the removal of price controls, allowing the market to operate. On January 1, 1990, Poland’s government gave the go-ahead for an economic program referred to as shock therapy, involving the abrupt shift from a command to a free-market economy. The initial result indeed shocked consumers; the inflation rate that first month was 78 percent. However, this inflationary “correction” eased as the free-market policies were allowed to take hold. (See Figure 18.6.) QUICK REFERENCE Shock therapy is an economic program involving the abrupt shift from a command economy to a free-market economy. FIGURE 18.6 POLAND’ S INFLATION RATE AFTER SHOCK THERAPY ) 70 60 50 40 30 20 10 0 1991 1992 1993 1994 1995 Year 1996 1997 1998 1999 Source: “The Polish Zloty 1990–1999: Success and Under-Performance,” Dominico Nuti ANALYZE GRAPHS 1. After 1991, how many years did it take Poland to cut its inflation rate in half? 2. Why did the inflation rate consistently decrease after the initial “shock” of 1991? AP P LI CATION Making Inferences and Drawing Conclusions A. Which of the challenges above do you think is the most serious? Give reasons for your answer. Issues of Economic Development 563 Economic Change in the Former Soviet Bloc KEY CONCEPT S QUICK REFERENCE Perestroika was a gradual plan to incorporate markets into the Soviet Union’s command economy. In the 1980s, Soviet leader Mikhail Gorbachev introduced perestroika, a plan to gradually incorporate markets into the Soviet Union’s command economy. People began to push for political freedom as well, and in 1991 the Soviet Union dissolved. The collapse of the Soviet Union caused a period of dramatic transition throughout Eastern Europe and Central Asia. EXAMPLE 1 Russia The transition has been a turbulent time for Russia. Like Poland and several other Eastern European nations, it pursued a program of economic “shock therapy.” The resulting inflation was devastating. Supplies of goods were very low, and many industries were forced into bankruptcy when faced with the need to become “self-financing.” Further, the state was poorly equipped to carry out even the most basic functions of government, such as tax collection. As a result, with little revenue to work with, it could not offer welfare services to cover the disruptions of the economic shift, and the burden of government debt began to rise. Amid the upheaval, some market forces began to exert themselves. Without directives from central planners, regional business initiatives could address the real demands of consumers. In 1992, a program of privatization began to put the means of production into private ownership, introducing incentives for success. The privatization process, however, was fixed in favor of certain individuals. As a result, a small group
of politically well-connected business people snapped up many of Russia’s former public assets through a series of rigged auctions. These oligarchs, as they’re known, went on to build massive corporations and became the most powerful economic force in modern Russia. The best-known oligarch, Mikhail Khodorkovsky, has recently been sentenced to nine years in prison on fraud and tax evasion charges. In addition, his giant oil company, Yukos, was taken over by the government. It is widely believed that the charges against him were motivated by his support for political parties that were opposed to Russia’s president, Vladimir Putin. Many saw this case and others as symptoms of Putin’s reluctance to truly adopt democratic reforms and a market economy. Taken together, Putin’s actions, the power of Russian organized crime, and the persistence of widespread corruption threatened to undermine Russia’s successful development. At Will Oligarchs? The prosecution of Khodorkovsky was seen by many as a warning to Russia’s oligarchs: the price of opposition to Putin’s government may be your freedom. 564 Chapter 18 E XAMPLE 2 Former Soviet Republics The transition of the former Soviet Republics has been varied. The Baltic Republics—Latvia, Lithuania, and Estonia—have fared better than others, experiencing a 45 percent inflation rate while Ukraine had a 400 percent rate and Kazakhstan in Central Asia had a rate higher than 1,000 percent. Of all the former republics, only the Baltic Republics, Armenia, Belarus, and Kazakhstan have a higher output now than they did before the collapse of the Soviet Union. Nevertheless, many economists believe the quality of goods and services produced is higher. In the other republics, poor infrastructure, complicated bureaucracies, undeveloped property laws, and corruption have interfered with economic growth. Vilnius Since independence, the capital of Lithuania has thrived. It accounts for one-third of the nation’s GDP and attracted 2.815 billion euros in FDI in 2005. E XAMPLE 3 Eastern Europe The formerly Communist nations of Eastern European have faced some of the same challenges as their neighbors and had similarly varying degrees of success. The largest nations, the Czech Republic, Hungary, and Poland, are now much like Western countries. They are members of the European Union, but some experts believe they will need until 2035 to catch up economically with other member nations. Nonetheless, progress is apparent. Since the transition, Poland’s economy has been growing at an average rate of 6 percent annually, industrial productivity has increased by more than 20 percent, and the private sector is responsible for more than 70 percent of the national income. There are more than 2.5 million small- or medium-sized businesses operating today, and Western franchises, such as the McDonald Corporation and the IKEA Group, have become entrenched. However, Poland also has problems that are common across the nations of Eastern Europe. Its infrastructure is out of date, and telephone and internet services are very costly. The laws for registering to do business in the Polish market are confusing, and the patent process that protects property rights is slow. The health care and pension systems have weakened, and unemployment is high. Averaged throughout the country, the unemployment rate is about 18 percent, but in some regions it is as high as 40 percent, and workers are discouraged. In Hungary, the illegal “hidden economy” may account for up to 30 percent of GDP. APPLICATION Comparing and Contrasting Economic Information B. Which of the three regions—Russia, the former Soviet Republics, or Eastern European nations—has had the hardest transition? Explain your answer. Issues of Economic Development 565 China Moves Toward a Market Economy KEY CONCEPT S China became a Communist country in 1949, but it began a transition to a free market economy in 1978. At that time, its leader, Deng Xiaoping, introduced free market economic principles to stimulate China’s economy. The result was a vastly changed and rapidly growing economy. EXAMPLE Rapid but Uneven Growth In the early years of China’s Communist economy, central planners focused on redistributing land, developing heavy industry, and improving China’s transportation system. In 1958, the government introduced the Great Leap Forward. This plan focused on the building of huge collective farms and the development of the steel industry. For a while, both agricultural and steel output increased. However, the gains were short-lived. Poor economic planning and a series of natural disasters led to stark times. Millions of people died in famines. When Deng Xiaoping came to power in the late 1970s, hundreds of millions of Chinese villagers lived in poverty, sometimes sharing one pair of trousers among a whole family. Deng brought hope and practical programs to the people. “It is time to prosper. . . . To get rich is glorious,” he said. Deng began a far-reaching but gradual program to relax government control over the economy and let market forces drive economic growth. In agriculture, farmland that had been confiscated was returned to the farmers in household units. Under this “household responsibility system,” farms still had to supply a quota of staple goods to the government at set prices, but beyond that the farmers could grow what they wanted and sell any surplus on the open market. China reported a ten percent annual growth in agricultural output between 1979 and 1984. Brick homes began to replace thatched huts as farmers’ income soared. A Growing Divide Modernization has come at breakneck speed in many of China’s urban centers, while life in rural China can seem to be in a different century. 566 Chapter 18 In the mid-1980s, Deng focused his reform effort on industry, where two-thirds of the manufacturing plants were still state-owned. Deng moved slowly and cautiously. Instead of privatizing suddenly or making drastic, uniform changes, he scattered the reforms among different industries. In one industry, local managers might have more decision-making power. In another, workers might get raises based on the profits of the factory. Deng’s reforms also called for localities to invest in the industries they thought would thrive. In this process, resources were re-allocated from heavy to light industry, a key factor in China’s rapid growth. Deng also created special economic zones (SEZs), regions that have economic laws that are different from a country’s usual economic laws, with the goal of increasing foreign investment. The first four were begun in 1979 as an experiment. In 1984, fourteen more were created in cities along the coast, including Shanghai; now there are hundreds. The SEZs have tax incentives for foreign investment, and the economic activities are driven entirely by market forces. Further, when capitalist Hong Kong was returned to China in 1997 after a 99-year lease by the United Kingdom, it was reunified under the “one country, two systems” framework. The government did not interfere with its economy; in fact, it became a model for the nation. Areas with high foreign investment have raced ahead of other parts of the country economically, contributing to China’s annual growth in GDP of between 5 and 15 percent since the reforms began. Some people, encouraged by Deng’s proclamation, have become very rich. However, in 2003, the number of people living in extreme poverty (on less than $77 a year) rose for the first time in 25 years, to about 3 percent of the population. In some villages of western China, 90 percent of the people live on government welfare and do not have indoor plumbing or telephones. FIGURE 18.7 A N N UA L ECO N O M I C G ROW T H R AT E EC T E D D E V E LO P E D N AT I O N S QUICK REFERENCE A special economic zone (SEZ) is a geographical region that has economic laws that are different from a country’s usual economic laws, with the goal of increasing foreign investment. Find an update on China’s special economic zones at ClassZone.com ( 10 1 -2 -3 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 KEY: China Ireland Japan United States Source: CIA World Factbook Year AP P LI CATION Explaining an Economic Concept C. What role do the SEZs play in China’s transition to a market economy? 567 For more on using a decision-making process, see the Skillbuilder Handbook, page R17. Using a Decision-Making Process Making decisions in complicated situations can be extremely difficult. Having a plan, or process, in place can be quite helpful. TECHNIQUES USED IN MAKING DECISIONS Making decisions involves (1) gathering information to identify the situation in question, (2) identifying options, (3) predicting consequences, and (4) implementing a decision. The following passage describes the problem of flooding on China’s Chang River. It illustrates the decision-making process. Look for information that points to a situation that requires a decision. Figures on the deadly toll of flooding show that a decision on damming was needed. Predict possible consequences. The positive and negative results of the dam are listed. Controlling the Chang River In the past 100 years, more than 1 million people have died as a result of flooding along China’s Chang (Yangtze) River. After devastating floods in the 1950s, Chinese leader Mao Zedong ordered studies to see whether damming the river was feasible. Finally, in the 1990s, construction began on the Three Gorges Dam, which— when completed—will be the largest dam in the world. In addition to providing flood control, the dam will be a source of hydropower. Its turbines are expected to produce up to one-ninth of China’s electricity. The dam’s series of locks will allow ocean-going ships to sail 1,500 miles inland. Nevertheless, the project has serious drawbacks. For one thing, it will require the resettlement of an estimated 1.2 million people. Environmentalists warn of water pollution, as well as the eradication of m
igratory fish and rare plants. The dam is scheduled for completion in 2009. In the meantime, the Chinese government has already begun to address the problem of pollution with the building of at least one comprehensive sewage treatment plant. Look for any options that are offered. Here, only the option of damming the river is considered. Decide what the result was. The dam is scheduled to be completed in 2009. THINKING ECONOMICALLY Making Decisions 1. What choice did the government have regarding the flooding of the Chang River? 2. What economic incentives do you think may have added to the government’s decision? 3. What consequences of the decision might be contrary to economic growth? Explain your answer. 568 568 Chapter 18 Chapter 18 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. 1. Explain the difference between these terms: a. shock therapy b. perestroika 2. What makes privatization a challenge in transitional economies? 3. What role does infrastructure play in transitional economies? 4. Why are special economic zones important to the growth of the Chinese economy? 5. In what way(s) is privatization an element of China’s shift to a market economy? 6. Using Your Notes Write a summary of the challenges of economic transitions and explain how they have been addressed in the former Soviet bloc and in China. Refer to your completed cluster diagram. Transition to a Market Economy Use the Graphic Organizer at Online Review @ ClassZone.com new challenges . Comparing and Contrasting Economic Information What are three key differences between the economic transitions of the former Soviet bloc and China? 8. Making Inferences and Drawing Conclusions While China has welcomed western economic principles, it has continued to come down hard on political freedoms. For example, Deng crushed protesters in Tiananmen Square in 1989. Why do you think capitalism can grow in China under a restrictive government when in the former Soviet bloc it went hand in hand with political freedom? 9. Applying Economic Concepts Explain how life in the former Soviet bloc changed for each of the following during a transition to a market economy. a. factory worker b. farmer c. consumer d. factory manager 10. Challenge Do businesses from foreign nations with strong antipollution laws have a responsibility to voluntarily limit pollution when located in a less developed country with less developed pollution laws? Give reasons for your answer. Budapest, Hungary Assessing Development The chart below shows statistics from 2004 for Kyrgyzstan and Tajikistan, in Central Asia, and Hungary and Romania, in Eastern Europe 268 154 4,913 1,729 6.0 10.5 3.9 8.1 6.0 8.2 9.6 4.0 0.702 0.652 0.862 0.792 Gross national income ($ per capita) Real GDP growth rate Industrial production growth rate Human development index (HDI)* * Highest HDI is 1.0; lowest is 0.0. Sources: CIA World Factbook; UNDP Compare and Contrast Economic Information Write a paragraph comparing and contrasting the transition to a market economy in the selected Central Asian and Eastern European countries. Use the figures from the chart to explain the similarities and differences. Challenge Why might the nation with the highest HDI, Hungary, also have the lowest real GDP growth? Issues of Economic Development 569 Case Study Find an update on this Case Study at ClassZone.com China’s Campaign for Economic Power Background Since 1978, when China’s former leader, Deng Xiaoping, made the decision to adopt free-market reforms, China’s economy has been steadily gaining momentum. Deng’s “four modernizations” (agriculture, industry, science and technology, and defense) have helped China become a player in the global economy in less than a generation. Its success is based in part on its encouragement of foreign investment, the establishment of a number of special economic zones, and the opening of 14 coastal cities to foreign investment in 1984. Also, in 2001, China joined the World Trade Organization. Today, China’s economic impact is too big to ignore. What’s the issue? What accounts for China’s successful transition to a market economy? Study these sources to discover what fuels China’s economic growth and how it affects the rest of the world. A. Magazine Article This article discusses some of the underlying reasons for China’s growing impact on the global economy. The Dragon Awakes China is changing the dynamics of the global economy. [China’s] contribution to global GDP growth since 2000 has been almost twice as large as that of the next three biggest emerging economies, India, Brazil and Russia, combined. Moreover, there is [a] crucial reason why China’s integration into the world economy is today having a bigger global impact than other emerging economies, or than Japan did during its period of rapid growth from the mid-1950s onwards. Uniquely, China combines a vast supply of cheap labor with an economy that is (for its size) unusually open to the rest of the world, in terms of trade and foreign direct investment. The sum of its total exports and imports of goods and services amounts to around 75% of China’s GDP; in Japan, India and Brazil the figure is 25–30%. . . . As a result, the dragon’s awakening is more traumatic for the rest of the world. Source: The Economist, July 28, 2005 Thinking Economically Identify the aspect of China’s economy that, according to the article, has had the most significant impact on the global economy, and explain why its impact has been so great. 570 Chapter 18 B. Political Cartoon The volume of China’s exports has gotten a lot of attention in recent years. Thinking Economically Why is it worth pointing out that China’s exporting power seems to outstrip that of other nations? C. Online News Story China’s economic growth frequently is referred to as an “economic miracle.” The miracle, however, is not without problems. China’s Economic Miracle: the High Price of Progress China’s progress is uneven and sometimes problematic. [China’s] GDP is growing by 10 percent a year. Industrial production is galloping ahead at an annual rate of 17 percent. Its economy is now the second-biggest in the world, behind only the U.S., and there are predictions it will assume the top spot as early as 2020. . . . China’s explosive growth has come at a price. The economic gains have not been shared equally. Millions have become richer. But hundreds of millions have not. More than 60 percent of the population still toils in agriculture; the country’s “economic miracle” has yet to make an appearance in much of the country. Corruption also remains well entrenched . . . [and] millions of workers have lost their jobs in the restructuring, prompting frequent protests. . . . Source: CBC News Online, April 20, 2005 Thinking Economically Will China’s economic growth alone increase the incomes of its poorest people? Why or why not? THINKING ECONOMICALLY Synthesizing 1. All three documents point to China’s success in international trade. What key element of financing development does document A cite as a component of China’s success? 2. Documents A and B hint that the rest of the world is uneasy with China’s economic growth, while document C discusses some of China’s problems at home. Discuss these fears and problems in the context of what you’ve learned throughout Chapter 18. 3. Which factors do you think are most significant relative to China’s economic growth? Explain why you think so. Use evidence from the documents in your answer. Issues of Economic Development 571 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. debt restructuring default developed nations infant mortality rate International Monetary Fund (IMF) less developed countries (LDC) per capita GDP “shock therapy” stabilization program privatization World Bank Nations with little industry and relatively low GDP are said to be 1 , while nations with a market economy and higher standard of living are known as 2 . Economists measure the level of a nation’s development through such statistics as 3 , which allows for easy comparison with other countries because it shows the nation’s output in relation to its population. When nations set a course for development, they often seek loans from other nations. Some heavily indebted nations have gone into 4 on their loans, being unable to pay them back. In those cases, nations can negotiate a 5 plan to extend the payback and/or lower the payback rate. Some economies are moving from central planning to an open market. These nations face a number of challenges. For example, there are questions about how to carry out 6 , the transfer of public property into individually owned property. There are also questions about the pace of change. governmental restrictions on the economy. 7 involved suddenly removing 572 Chapter 18 CHAPTER 18 Assessment Definitions of Development (pp. 544–551) 1. What are some features of a developed nation? 2. Name five measures economists use to gauge a nation’s level of development. A Framework for Economic Development Objectives (pp. 552–561) 3. Describe the internal and external goals a developing nation may set for itself. 4. In what ways can developing nations receive aid from other countries? Transition to a Market Economy (pp. 562–571) 5. Name five challenges nations face when moving from a command economy to a market economy. 6. Briefly summarize the transition to a market economy in the former Soviet bloc and in China. A P P LY Look at the graph below showing life expectancy in various countries and regions from 1980 to 2003. 7. What explanation can you offer for the regions in which life expectancy declined? 8. In 2003, how much longer could someone living in a country that belon
gs to OECD expect to live than someone living in sub-Saharan Africa? FIGURE 18.8 LIFE EXPECTANCY IN WORLD REGIONS 80 70 60 50 ( 40 1980 1985 1990 1995 2000 2003 Year HIGH-INCOME OECD (ORGANIZATION FOR ECONOMIC COOPERATION AND DEVELOPMENT) NATIONS LATIN AMERICA & THE CARIBBEAN EAST ASIA & THE PACIFIC ARAB STATES CENTRAL & EASTERN EUROPE & THE COMMONWEALTH OF INDEPENDENT STATES SOUTH ASIA SUB-SAHARAN AFRICA Source: U.N. Human Development Report, 2005 . Creating Graphs Create a graphic of your choice to show the figures below on the percentage of people living on $1 a day or less between 1981 and 2001. Region East Asia & Pacific Europe & Central Asia Latin America & Caribbean Middle East & North Africa South Asia Sub-Saharan Africa 1981 56.7 1990 29.5 0.8 0.5 10.1 11.6 5.1 2.3 51.5 41.6 41.3 44.5 2001 14.3 3.5 9.9 2.4 31.9 46.4 World 40.4 26.3 20.7 Source: U.N. Human Development Report, 2005 Use to complete this activity. @ ClassZone.com 10. Analyzing and Interpreting Data Refer to the graph you created. In which region was the improvement in poverty most dramatic? In which regions did the situation worsen? Work Toward Development Goals In 2005, all the 191 members of the United Nations voted to adopt the Millennium Development Goals, with a target date of 2015 to have the goals realized. Step 1 As a whole class, discuss the following eight goals that are part of this program: 1. Eradicate extreme poverty and hunger 2. Achieve universal primary education 3. Promote gender equality and empower women 4. Reduce child mortality 5. Improve maternal health 11. Analyzing Cause and Effect What might explain why this measure of poverty increased in Europe and Central Asia during this time period? 6. Combat HIV/AIDS, malaria, and other diseases 7. Ensure environmental sustainability 8. Develop a global partnership for development 12. Making Inferences and Drawing Conclusions For each dollar spent on foreign aid by members of OECD, $10 is spent on the military. What can you conclude about the OECD member nations’ concerns for the future? 13. Challenge A recent study found that an increase of ten mobile phones per 100 people raised GDP growth in a developing nation by ten percent. What might explain this? What does it suggest as a way to speed development? Step 2 Break into eight small groups, one for each of the goals. Step 3 Meet with your group and discuss concrete ways that the international community (either through such organizations as the IMF or World Bank or United Nations Development Program or through the efforts of individual nations or trading entities) can meet your goal and why it is important that it be met. Step 4 Present your recommendations to the rest of the class. Step 5 Follow up on the presentations with a discussion of how many different ways of approaching the problem surfaced and which seem most likely to lead to success. Issues of Economic Development 573 1.1 Budgeting 1.2 Checking Accounts 1.3 Saving and Investing QUICK REFERENCE A budget is a plan for allocating income for saving and spending Budgeting and Money Management 1.1 Budgeting As an independent adult you have the freedom to make your own ﬁ nancial decisions. But with freedom comes responsibility. It takes planning and practice to learn how to use your income wisely, to pay your bills on time, and to have money left to save for the future. What Would a Budget Do for Me? Everyone has a limited amount of money. A budget—a plan for how to save and spend your income—can help you focus your limited ﬁ nancial resources on what’s most important to you. It will help you pay for basics like food, clothing, and shelter. After those expenses are met, it can include optional items such as travel or entertainment. And with savings as part of your budget, you will be on the path to achieve your long-term ﬁ nancial goals. How Do I Set Up a Budget? Determine Your Income Make a list of all the steady income you receive, including your pay from after-school and summer jobs and occasional work such as mowing lawns. List only the money you take home after taxes have been withheld from your paycheck. Track Your Expenses To learn where your money goes, keep a record of all your expenses for a month. Save your receipts, and carry a small notebook to jot down purchases when you make them. The list should cover a full month, because not all expenses occur every week. Categorize Expenses When you have a record of your expenses, put them into categories, such as transportation, food, clothing, savings, and entertainment. Figure CPF 1 shows how monthly expenses might be categorized to help set up a budget. EXPENSES for month Week 1 parking movie pizza $6. 00 $9. 00 $13. 00 574 Consumer and Personal Finance & Figure CPF 1 Creating a Budget a Fixed Expenses Your car payment and auto insurance are examples of ﬁ xed expenses. b Spending Wisely Food is a necessity. But packing a lunch, cutting back on snacks, or eating out less often can help your budget. c Savings Pay yourself each month. Limiting ﬁ xed expenses and reducing ﬂ exible expenses will help you meet your savings goals. d Flexible Expenses Make room in the budget for entertainment, travel, and other fun stuff. a Category Transportation Car payment Insurance Gas Parking Maintenance b Food School lunches Snacks Eating out c Savings Clothing d Entertainment Movie tickets Movie rentals Recorded music TOTALS Monthly Expenses Current Expenses Budget $200 70 60 6 50 $85 35 30 20 100 $27 12 20 $715 $200 70 40 0 25 $80 30 15 50 50 $18 12 20 $610 Determine Fixed and Flexible Expenses Identify which expenses must be paid every month and determine what portion of your income they take. Savings should be a ﬁ xed amount, not a ﬂ exible amount. Money from savings pays for emergencies, large insurance bills that only come due once or twice a year, and major investments such as cars or real estate. What’s left is available for ﬂ exible expenses like entertainment. Set Up a Spending Plan Now look at your income and expenses. Set out a plan for ﬁ xed expenses. Look at the amount left over and allocate it to cover the ﬂ exible expenses. If your ﬂ exible expenses are cutting into your savings or leading to debt, look for ways to cut your spending. For example, you might eat more meals at home instead of at restaurants, or rent DVDs to watch with friends instead of going out to the movies. Check It Out! ✔ Create an emergency fund for unexpected expenses. ✔ Save in advance for holiday or birthday gifts. ✔ Resist the temptation of impulse buying. APPLICATION Budgeting 1. Which of the expenses in Step 3 will be monthly bills? 2. Planning a Budget Suppose you have a job that brings in $1,150 a month after taxes. You contribute $350 toward rent and utilities each month for an apartment you share with two other people. You put $100 each month into a savings account, and you spend about $50 per month for a cell phone. Of course, you also eat, wear clothes, and go out with friends. You want to buy a car that will cost $300 per month for payments and insurance. Can you afford it? Plan a budget to see if you can take on this new ﬁ xed expense. Budgeting and Money Management 575 Budgeting and Money Management 1.2 Checking Accounts Banks offer two basic types of accounts: checking and savings. Checking accounts are for immediate expenses. They can help you manage your expenses and pay your bills. The bank records deposits and withdrawals on your checking account, whether they are in the form of paper checks, automated teller machine (ATM) transactions, debit card purchases, or electronic transactions. What Are the Benefits of Checking Accounts? When you earn money on a regular basis, you should have a place to put it. Most people use checking accounts. Not only is your money safe in the bank, but a checking account makes it easy to pay your bills. In order to use electronic banking and ATMs, you need a checking account. If you keep all your money as cash, your cash may be lost or stolen. It’s also difﬁ cult to pay bills with cash. A checking account is safe and convenient. Opening an Account By shopping around, you can ﬁ nd an account that suits your situation. Ask questions about fees, interest rates paid on the checking account, charges for printing checks, and any restrictions on the number or size of checks you write. Find out the bank’s minimum balance requirement, which is the amount of money you must keep in the account in order to avoid fees. Most banks charge a high fee for an overdraft, a check or other withdrawal for more than the existing account balance. You’ll need several documents to open an account. Most banks require two forms of identiﬁ cation, one of which should have your photo on it. You must provide your Social Security number, address, and phone number. The bank may also ask for a personal or work reference. The money for an initial deposit may be in the form of cash or a check. QUICK REFERENCE A minimum balance requirement is the amount needed in an account to avoid fees. An overdraft is a check that exceeds the account balance. Figure CPF 2 Writing a Check a Write the full name of the person or business receiving the check. b Enter the amount in numbers and then in words on the next line. c Sign the check to make it valid. Never sign a blank check. 576 Consumer and Personal Finance a b b c What’s the Difference Between an ATM Card and a Debit Card? Once you have a checking account, you have several options for making deposits and withdrawals. You could go to the bank, but that can be time-consuming, and some banks charge a fee for using a human teller. Instead, automated teller machines (ATMs) give you access to your checking account. At ATMs Both ATM cards and debit cards allow you to use an ATM to access your checking account. You can withdraw cash, deposit cash or checks, or transfer money between linked accounts. Both cards require that you enter your personal identiﬁ cation number (PIN) when you use the ATM. U
sing an ATM can cost you money. Most ATMs charge a service fee unless you have an account with that bank. Fees range from $1 to $3 or more. To avoid this expense, learn where your bank has ATMs near your home, school, and workplace. At Stores You can also use ATM and debit cards at businesses to purchase goods and services. However, debit cards can be used like a credit card—the business swipes your card and you sign for the purchase. With an ATM card, the business must have a keypad for you to enter your PIN. In either case, the money comes directly out of your account. Some stores let you get cash back—with no additional charge—when you make a purchase. For example, if you buy $20 worth of groceries, you can charge your ATM or debit card $50 and receive the $30 difference in cash. Register all the transactions you make with your ATM or debit card in your checkbook. These transactions will be recorded on the monthly account statement that the bank will send to you, but keep track of them as you go along to avoid overdrawing your account. Check It Out! ✔ Research banking services at several banks. ✔ Immediately record your deposits and withdrawals—including checks, cash withdrawals, and purchases—in your checkbook register. ✔ Review your bank statement every month & APPL IC ATION Checking Accounts 1. How is a debit card different from an ATM card? 2. Finding a bank Using the Internet, research checking accounts at three banks in your neighborhood. Create a table comparing the services offered and fees charged by the banks. Then write a paragraph identifying the bank you would choose if you wanted to open an account and why you would choose it. Budgeting and Money Management 577 Budgeting and Money Management QUICK REFERENCE Interest is the price paid for the use of money. 1.3 Saving and Investing What are your dreams? Do you want to go to college, to travel, to own a car and a home, or perhaps to retire early? Saving some of your income each month can help you achieve your dreams. Accidents and unforeseen problems happen to everyone, so it is good to have an emergency fund, too. When you save your money at a bank or invest in a company, they pay you for the privilege of using your funds. If you save and invest wisely, your money will grow, and you won’t have to work as hard to achieve your dreams. What Are the Benefits of Savings Accounts? Savings accounts allow you to save money for future expenses. Your money grows in a savings account because banks pay interest, a fee for the use of your money. To open a savings account, you’ll need the same kinds of identiﬁ cation and other information that you needed to open a checking account. Types of Accounts Banks and credit unions offer a variety of savings accounts including standard accounts, money market deposit accounts, and certiﬁ cates of deposit (CDs). The minimum balance, interest rates, and other features vary by type of account. Some banks offer better rates than others, so it’s important to shop around for the best deal. Deposits in these accounts are insured by the government. If the bank should fail, the Federal Deposit Insurance Corporation (FDIC) would make sure you got your money back. The FDIC insures each depositor up to $100,000 at each bank. Retirement accounts are insured up to $250,000. Unlike stocks, bonds, and many other investments, you are guaranteed to get a positive return on your money in a government-insured account. Figure CPF 3 summarizes the features of the most common types of accounts used for savings. Figure CPF 3 Government-Insured Accounts Standard Savings Account Money Market Account Certificate of Deposit A standard savings account requires a small initial deposit and allows you the most access to your money. However, it pays the lowest rate of interest. A money market account pays higher interest and allows you to write a limited number of checks. But it also requires a higher minimum balance. Certificates of Deposit (CDs) usually offer the highest interest rates. But you pay a penalty if you withdraw any money before the CD matures. 578 Consumer and Personal Finance When Should I Start Investing? The purpose of saving is to accumulate readily available cash. Most ﬁ nancial advisors recommend saving an emergency fund that would cover three to six months of expenses. After you have created your emergency fund, you can begin saving for short-term goals such as buying a car or paying for college tuition. The purpose of investing is to build wealth—that is, to acquire assets that will grow in value over time and give you a pool of assets beyond the income you earn from a job. Building wealth comes from making your money work for you over a long period of time. It is never too early to start this process, even if you can only allocate a small portion of your income to investment. Investing even small amounts on a regular basis over a long period of time can lead to signiﬁ cant growth. Before saving or investing, pay off any credit card debt. It is almost impossible to earn more from your investments than you are paying in interest on your debt. For example, if you are paying 15 percent interest on a loan, it doesn’t make sense to put some of your money in a savings account that only pays 3 percent interest. Pay off the expensive loan ﬁ rst, then start saving. Figure CPF 4 Risk and Return Determining Risk As you learned in Chapter 11, there is an inverse relationship between risk and return—the riskier the investment, the greater the potential return. Figure CPF 4 shows this relationship, with the least risky investments at the bottom of the graph and the riskiest ones at the top. Savings accounts and CDs carry little or no risk because the government insures the principal, and they pay a guaranteed rate of interest. Treasury bonds carry little risk because the U.S. government backs them. Corporate bonds carry greater risk because a company may go bankrupt and be unable to repay its creditors. Stocks offer higher possible returns but are subject to market risks and may decrease rather than increase in value. Bank savings accounts Treasury investments Time deposits (CDs) U.S. savings bonds Corporate bonds k s i R Potential Return Other common stocks Blue-chip stocks Stock mutual funds Stocks-and-bonds mutual funds & ➲ Budgeting and Money Management 579 Budgeting and Money Management How Should I Invest? Consider your investment objective when choosing the type of investment. If you want to use the money to buy a house in ﬁ ve years, you would choose a different type of investment than if you are investing for your retirement. Generally, the sooner you plan to use the money, the more conservatively you should invest. Conversely, the longer you have before you need the money, the easier it will be to recover from any downturns. Figure CPF 5 shows different ways of investing to reach long-term goals. There are three basic rules for building wealth: start early, buy and hold, and diversify. Start Early By starting to invest early you have a longer time for wealth to build. A longer investment time frame also allows you to take more risks, because you can ride out the ﬂ uctuations in the market. Buy and Hold The phrase “buy and hold” describes a disciplined approach to investing. Do research and talk to a ﬁ nancial adviser to make wise decisions, and then hold the investments you make for a long enough period of time to allow your wealth to build. Jumping in and out of the market can lead to signiﬁ cant losses of potential return. Diversify Diversifying helps you maximize your returns and limit risks. You’ve probably heard the saying “Don’t put all your eggs in one basket.” Putting your money in different types of investments allows you to choose different levels of risk. Figure CPF 5 Investment Options Stocks, Bonds, and Mutual Funds Employer-Sponsored Retirement Plans Individual Retirement Accounts (IRAs) • Stocks let you share in • 401(k) plans let workers corporate profits. • Government and corporate bonds pay a fixed rate of interest. • Mutual funds are an easy way to invest in a large number of different stocks or bonds. • See Chapter 11 for more information. 580 Consumer and Personal Finance invest money for retirement and defer taxes. Employers may also contribute. • Workers may invest money each year for retirement, tax deferred. • Traditional IRA • Pension plans are controlled by employers. contributions may be tax deductible. • Employers may fund employee retirement benefits through profit sharing or stock ownership plans. • Roth IRA contributions are not tax deductible but earn tax-free income. • Funds must be held until age 59 ½—with some exceptions. Figures CPF 6 and 7 The Beneﬁ ts of Investing Early THE POWER OF COMPOUNDING BUILDING WEALTH OVER TIME Year Annual Investment (in dollars) 5 Percent Return (in dollars) Year-end Balance (in dollars 10 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00 100.00 205.00 315.25 431.01 552.56 2,100.00 4,305.00 6,620.25 9,051.26 11,603.82 680.19 14,284.01 814.20 17,098.21 954.91 20,053.12 1,102.66 23,155.78 1,257.79 26,413.57 350,000 300,000 250,000 200,000 150,000 100,000 50,000 What Are the Benefits of Starting Early? Figures CPF 6 and CPF 7 graphically illustrate the beneﬁ ts of starting your investment program when you are young. The table, Figure CPF 6, shows how a savings account that pays 5 percent interest would grow. Investing $2,000 each year for 10 years—a total of $20,000—yields a balance of more than $26,000 through the beneﬁ ts of compounding and reinvesting the earnings. If the investments continued at the same pace for 45 years, the total balance would reach almost $1 million 25 30 35 40 45 50 55 60 65 Age Check It Out! ✔ Make regular contributions to your savings account. ✔ Commit to investing for the long term. ✔ Diversify your investments. The graph, Figure CPF 7, shows the beneﬁ ts of starting to save for retirement early. The g
raph shows what happens to three people who invest $100 per month in a retirement account. It assumes they receive a return on their investments of 8 percent, which approximates the historical average return for the stock market. Someone who begins investing $100 per month at age 25 has over twice as much at retirement as someone who waits until age 35 and almost six times as much as someone who waits until age 45. Review Budgeting and Money Management using interactive activities at ClassZone.com APPL IC ATION Saving and Investing 1. Suppose you have saved $1,000 toward the purchase of a car. Which type of savings plan would be best for this money until you are ready to use it? Why? 2. Listing Financial Goals Make a list of ﬁ nancial goals you might want to reach by the time you are 30 years old, then 50 years old, then at retirement age. Think about a plan that might help you achieve these goals. What sort of investments will you make? Write a summary paragraph describing your goals and plans. Budgeting and Money Management 581 Credit 2 2.1 Types of Credit 2.2 Credit Reports 2.3 Identity Theft 2.1 Types of Credit If you budget wisely and save your money, you will be able to buy what you need most of the time. But sometimes, waiting to accumulate the money to achieve a goal is not the best economic choice. Using credit to make important purchases, such as a college education or a home, often has economic beneﬁ ts. If you decide to ﬁ nance a purchase by using credit, you ﬁ rst need to decide what type of credit to use. QUICK REFERENCE Credit is the practice of making a purchase now and paying for it in the future. A loan is borrowed money repaid with interest. What Is Credit? Credit is the practice of buying goods or services now and paying for them in the future. One form of credit is a loan, which is borrowed money that must be repaid with interest. Just as banks pay you interest for the use of your money in a savings account, you have to pay them interest if you want to use their money to buy something. Loans are usually used for large purchases such as a home, automobile, or school tuition. Credit cards are like shortterm loans, because they allow you to buy things without having the cash at the time of purchase. But you will be charged interest if the credit card balance is not paid in full each month, and credit cards usually charge higher interest rates than other loans. QUICK REFERENCE The ﬁ nance charge is the total cost of the loan. The annual percentage rate (APR) is the amount of interest charged per year. How Much Does Credit Cost? The cost of credit is called the finance charge. It includes the total amount of interest you will pay plus any service charges. The amount of interest you pay depends on the annual percentage rate (APR), the length of the loan, and how often you make payments. With all of these variables, it can be challenging to ﬁ gure out how much a loan actually costs. But all lenders are 582 Consumer and Personal Finance Figure CPF 8 Costs of Borrowing $10,000 Loan APR (in percent) Length of Loan (in months) Monthly Payment (in dollars) Total Payments (in dollars) Finance Charge (in dollars) A B C 4 8 8 36 36 60 295.24 313.36 202.76 10,628.63 11,281.11 12,165.89 628.63 1,281.11 2,165.89 required to tell you the total ﬁ nance charges and the APR. This information should allow you to understand how much a loan will cost and to compare offers from different lenders. For example, suppose you want to borrow $10,000 to purchase a car. The ﬁ nance charge will vary depending on the length of the loan and the interest rate. As you can see in Figure CPF 8, a longer loan might have a lower monthly payment, but it will also have the highest total cost. How Do Lenders Decide If I Can Get Credit? Lenders use three basic criteria to determine if you are creditworthy and can be trusted to repay a loan. The criteria—character, capacity, and capital—are often referred to as the three Cs. These three criteria are based on your past, present, and future ﬁ nancial situation. Character refers to your past record of paying your bills on time. Lenders want to know if you can live within your means, which makes it more likely that you will be able to repay the loan. When you make car payments on time or pay off a department store charge card each month, you build a positive credit history. These actions show that you are ﬁ nancially responsible. Capacity refers to your level of income relative to the size of the loan. A lender will check to see if you have a steady income and if the amount of your income is enough to make the loan payments. The lender may look at your past employment history to see if you are likely to keep your current job or may check with your employer to see if your income will remain steady over the projected term of the loan. Capital—speciﬁ cally, ﬁ nancial capital—includes your income, savings, and other investments. Lenders will consider how much money you have in the bank as well as assets such as a car or house. If you fail to repay the loan, the lender may be able to take these assets to recover the cost of the loan. If you are weak on any of these criteria a lender might ask for a cosigner for the loan. A cosigner is a person who will assume responsibility for the debt if you fail to repay the loan. Taking out a loan with a cosigner but repaying it yourself is one way you can build up a positive credit history & QUICK REFERENCE A cosigner assumes responsibility for debt if a borrower doesn’t repay. ➲ Credit 583 Credit WHAT SHOULD I DO IF MY CREDIT CARD IS LOST OR STOLEN? 1. Notify your bank or credit card companies immediately to limit your liability. 2. Report the loss to authorities or law enforcement officials. 3. Keep a list of account numbers and toll-free phone numbers in a safe place. What Should I Consider When Choosing a Credit Card? Credit card companies are eager to get young adults to use their cards. But these companies offer a variety of terms, and some of them can be costly. Before you apply for a credit card, carefully examine the terms. Annual Fee Many cards have no annual fee, but some charge $60 per year or more for membership. Interest Rate The Truth in Lending Act requires that credit card companies state the interest rate in the form of an annual percentage rate (APR). Rates may be ﬁ xed, meaning that they will stay the same, or variable, meaning that they are tied to an index and likely to change frequently. Grace Period The grace period is the time between your billing date and the date your payment is due. Late payments may result in stiff fees. Minimum Payment The minimum payment may be a ﬂ at amount or a certain percentage of your balance. Paying this amount allows you to avoid paying penalties, but not interest. Credit Limit The credit limit is the maximum amount you can charge. Your available credit is your credit limit minus any outstanding balance. Other Fees There are usually fees for paying late or for spending over your credit limit. There may be a minimum ﬁ nance charge or amount of interest due, or transaction fees for cash advances. Bonuses Many credit cards offer to give you a bonus based on how much you charge as an incentive to use the card. Some cards offer “cash back”— a refund of a small percentage of your total purchases. Others offer discounts on merchandise or air travel. What Should I Know About My Credit Card Statement? When you pay by credit card, you will receive a record of what you have spent each month called a statement. It will also show any payments or credits to your account. Check your credit card statement right away to make sure all the purchases shown are ones that you made. Also check to be sure the credit card company received your last payment. Figure CPF 9 points out some of the important information to notice on your credit card statement. Your new balance is the amount you must pay by the due date to avoid paying interest. The ﬁ nance charge is the interest due on any unpaid balance from your last statement. Notice that the minimum payment is only a small percentage of your new balance. Credit card companies make money if you pay less than the full balance, because they charge you interest on the rest of your balance. 584 Consumer and Personal Finance Figure CPF 9 Understanding Your Credit Card Statement a The new balance includes all of your purchases for the month, plus any unpaid balance from the last month and interest, plus any fees. To avoid ﬁ nance charges, pay the entire balance by the due date. b If you cannot pay the entire balance, pay at least the minimum balance by the due date to avoid late fees. The minimum balance may be only a small percentage of your total balance but is usually at least $10. c The periodic rate is the daily interest rate, that is, the APR divided by the number of days in the year. CREDITCard PLATINUM ______________________________ BILLING STATEMENT a b CARD NUMBER CREDIT LIMIT AVAILABLE CREDIT STATEMENT DATE NEW BALANCE PAYMENT DUE MINIMUM PAYMENT DUE & 1234 5678 9012 3456 2,000.00 1,954.83 04/25/10 45.17 05/20/10 15.00 TRANSACTION REFERENCE NUMBER TRANSACTION DESCRIPTION TRANSACTION CHARGE DATE ACTUAL POST CHARGES (+) CREDITS (-) 0123 6543 8901 MANGO GROVE JUICE & NUT BAR BART’S COSMIC COMICS MONTCLAIR VIDEO MART 03/26 03/30 03/31 03/28 04/01 04/03 13.76 25.41 6.00 FINANCE CHARGE CALCULATIONS FINANCE CHARGE SCHEDULE ANNUAL PERCENTAGE RATE CATEGORY DAILY PERIODIC RATE CORRESPONDING APR DAYS IN BILLING CYCLE 13.65% c DAILY PERIODIC RATE 0.037397% CASH ADVANCES A. BALANCE TRANSFERS, CHECKS B. ATM, BANK PURCHASES 0.037397 0.065041 0.037397 % % % 13.65 23.74 13.65 % % % 30 PREVIOUS BALANCE PAYMENTS CREDITS PURCHASES CASH ADVANCES PERIODIC RATE CASH ADVANCE 53.26 53.26 0.00 45.17 0.00 0.00 0.00 a 45.17 TO REPORT LOST OR STOLEN CARD(S) CALL: (800) 555 5555 NOTICE: SEE REVERSE FOR IMPORTANT INFORMATION Pay at least the minimum balance by the due date. Most credit card companies char
ge high fees for late payments. Allow time for your payment to arrive and be processed before the due date. How Is a Credit Card Different from a Debit Card? Both cards can be used to make purchases. But when you use a credit card you create a loan to repay, while a debit card takes money directly from your checking account. You can use your debit card to get cash from your checking account at an ATM. But if you use your credit card to get cash, you are essentially taking out a loan. Interest begins accruing right away on the amount of the cash advance, and most cards charge an additional transaction fee. It is a very expensive way to get cash. Check It Out! ✔ Determine all costs and fees for a credit card or loan. ✔ Check your statement every month for unauthorized expenses. ✔ Pay on time. APPL IC ATION Types of Credit 1. What are the three Cs, and who uses them? 2. Determining the Best Offer Suppose you have offers from three credit card companies. Company A offers a ﬁ xed APR of 12 percent and has an annual fee of $60.00. Company B has no annual fee and offers an introductory rate of 9 percent—but it rises to 18 percent after the ﬁ rst 3 months. Company C offers a ﬁ xed APR of 15 percent with an annual fee of $30. If you pay off your balance each month, which offer is best for you? Credit 585 Credit 2.2 Credit Reports How you handle your ﬁ nances can determine your ability to qualify for a loan or credit card, to be hired for a job, or to rent an apartment. Your credit report contains much of the information on the three Cs discussed earlier. What’s a Credit Report? A credit report is a statement by a credit bureau that details a consumer’s credit record. Equifax, Experian, and Trans Union are the three companies that handle most credit reporting. The report includes information on your employment, bank accounts, and credit history. It will also indicate if you’ve had any legal problems regarding your ﬁ nances, such as bankruptcy. The report shows how well you have handled your ﬁ nancial obligations over the previous 7 to 10 years so lenders can determine if you are a good credit risk. Credit agencies use the information in your credit report to assign you a credit score, a number that rates your credit worthiness. Different agencies use different scoring systems, but higher scores indicate a better credit history. Lenders may charge a lower interest rate to someone with a high credit score. QUICK REFERENCE A credit report describes a consumer’s credit record. A credit score is a number that summarizes your credit worthiness. Where Do I Get My Credit Reports? online: www.annualcreditreport.com phone: 1-877-322-8228 mail: Annual Credit Report Request Service P.O. Box 105281 Atlanta, GA 30348-5281 (print form at www.annualcreditreport.com) Do not contact the three nationwide consumer credit reporting companies directly for free reports. Credit Report Users Lenders evaluate your credit report when you apply for a loan or a credit card. Buying the report from one of the three major companies saves them the time of contacting all your creditors to see how well you’ve paid your bills. Landlords may also check your credit report before agreeing to rent you an apartment. Some employers check credit scores before hiring people. Because so many people rely on these reports, you should verify the accuracy of the information in the report. Checking your credit reports also helps guard against identity theft. (See 2.3 Identity Theft for more information on this topic.) How Do I Get a Copy of My Credit Report? The Fair Credit Reporting Act makes it easy to access your credit reports (see “Where Do I Get My Credit Reports?” sidebar). By law, you may use this service to order one free copy from each company every 12 months. You provide your name, address, Social Security number, and date of birth. You may be asked other questions to verify your identity. The government is the only legitimate source for free credit reports. 586 Consumer and Personal Finance Figure CPF 10 How Does Your Credit History Rate? Good Rating • You pay bills in full • You pay bills on time • You can cover payments in case of emergency • You can make payments if you lose your job Danger • More than 25 percent of your take-home pay goes to pay off debt • You only make minimum payments • You make payments after the due date • You open new accounts because the old ones are maxed out • Creditors harass you Overextended • Creditors repossess (take back) what you bought on credit • Creditors garnish your wages (take money from your 900 600 300 0 paycheck before you get it) • You must declare bankruptcy Avoid other sources that claim to offer free credit reports. Some of them want to sell you unnecessary services, and others want to steal your identity. Also avoid ﬁ rms that promise to ﬁ x your credit rating. Only you can do that. How Do I Solve Credit Problems? The best cure is prevention. You can avoid credit problems by following your budget and paying off your bills on time. But if you recognize any of the signs of danger or overextension shown in Figure CPF 10, you can take action to avoid ﬁ nancial problems. Self-Help These are the ﬁ rst steps for restoring your credit rating. • Talk to your creditors and explain your situation and your desire to correct it. • Cut up your credit cards and pay off your debts as soon as possible. • Create a strict budget and follow it. Professional Help If you are unable to resolve the problems yourself, see a professional counselor. Try nonproﬁ t agencies ﬁ rst. The National Foundation for Credit Counseling can provide referrals. These agencies will provide services and help you to straighten out your debt problems. Check It Out! ✔ Check your credit report yearly. ✔ Pay your bills on time. ✔ Watch for the danger signs, and act promptly to correct the problem. AP P LI CATION Credit Reports 1. What groups might use your credit score? 2. Paying Off Your Bills Suppose you have a student loan, a car payment, and a credit card with debt. The student loan debt is $4,000 with interest at APR 8 percent. The car loan is $8,000 with APR of 4 percent. The credit card debt is $1,500 with APR of 18 percent. Your grandmother sends you a check for $1,000 for graduation. Which bill would you put the money towards? Credit 587 Credit QUICK REFERENCE Identity theft is the use of someone else’s personal information for criminal purposes. Find an update on identity theft at ClassZone.com 2.3 Identity Theft Your bank accounts, credit cards, and other ﬁ nancial tools are all tied to your name. You’ve seen what can happen if your credit report shows a poor credit history. What if a poor credit rating is not your fault? What Is Identity Theft? Identity theft is the use of personal information—such as Social Security numbers, credit card or bank account numbers—to commit fraud and other crimes. Identity thieves steal personal information to run up charges on existing accounts or to open new ones. They may withdraw money from your bank accounts, apply for loans, or use your telephone calling card. It takes victims weeks, months, and sometimes years to correct the damage done after their identity has been stolen. How Can I Protect Myself? If you know how these thieves operate, you can take measures to protect yourself. While some victims lose their identity through loss or theft of their wallet or purse, almost half of the victims don’t know how the thief obtained their information. Here are some of the most common techniques. Shoulder Surﬁ ng Identity thieves may watch you as you punch in a calling card or credit card number or your PIN. They might overhear you giving out an account number over the phone. Be conscious of those around you when you use an ATM or give out personal ﬁ nancial information. Dumpster Diving Thieves look through the trash to ﬁ nd discarded credit card statements or other documents with ﬁ nancial information. Put such documents through a shredder before throwing them away. Spamming or Phishing Identity thieves may send unsolicited e-mail (spam) that appears to be from a legitimate source. Or they may telephone and say there is a problem with your account or offer you some beneﬁ t if you conﬁ rm information. Hacking Sometimes identity thieves will use programs that invade your computer 588 Consumer and Personal Finance & and ﬁ nd your personal data. Or they might direct you to a fake Web site set up to look like that of a bank or other business. Security software can help prevent hacking, but you must pay attention when you give out credit card and other personal information over the Internet. Conﬁ rm that the site you visit is legitimate. Where Do I Get More Information? Department of Justice Federal Trade Commission Consumer Action Web Site www.usdoj.gov www.consumer.gov or 1-877-ID-THEFT 1-877-(438-4338) www.consumeraction.gov What If I Become a Victim? If you learn that your personal information has been stolen, act immediately to limit the damage. Keep good records of all the steps you take. First, contact one of the three credit reporting companies to place a fraud alert on your credit report. The fraud alert will make it necessary for creditors to contact you before opening new accounts in your name. The Federal Trade Commission and Department of Justice Web sites (see “Where Do I Get More Information?” sidebar) provide toll-free phone numbers and Web site addresses for the credit reporting companies. When you notify one company it will notify the others to place a similar alert on their reports. Once you have placed such an alert, you may order free copies of your report to check for fraudulent activity. Contact your creditors or banks to close out accounts that have been accessed by thieves or that have been opened without your permission. The FTC Web site also provides a form to dispute new accounts that you did not authorize. You may want to stop payment on any checks that have not cleared and change your ATM ac
count and PIN number. Check It Out! Remember the word SCAM. ✔ Be Stingy. Only give personal information to people you trust. ✔ Check your bank and credit card statements regularly. ✔ Ask for your credit report every 12 months. ✔ Maintain careful records of all your ﬁ nancial accounts. File a report with the police and get a copy of the report or the report number. Provide as much information as you can. The report will provide proof to your creditors or ﬁ nancial institutions that a crime has been committed. Also ﬁ le a report with the FTC, which maintains a database of reported cases of identity theft. Review Credit using interactive activities at ClassZone.com APPL IC ATION Identity Theft 1. What are some ways that identity theft can occur? 2. Planning a Response Take a look in your wallet or purse. What items there could be the source of identity theft? How do you protect yourself from having these items stolen? Review how you would respond if these items were stolen. Credit 589 3.1 Buying a Car 3.2 Financing Your Education 3.3 Getting Insurance 3.4 Contracts: Reading the Fine Print QUICK REFERENCE Depreciate means to decrease in value Wise Choices for Consumers 3.1 Buying a Car A car is a symbol of freedom and independence. It is convenient to be able to travel where and when you want. Yet owning a car includes ﬁ nancial obligations. Since it’s expensive to own a car, ﬁ rst consider whether you really need one. Is good public transportation, such as a bus or a train, available to get you to work or school? Do you live close enough to ride a bike or to walk? If you don’t need a car most of the time, would it make sense to rent a car occasionally or to join a car sharing plan? What Should I Consider When Buying a Car? If a vehicle is deﬁ nitely in your future, take your time before you make a purchase. A car is a major investment, so it makes sense to do some research. Use the information in Figure CPF 11 as a starting point. One decision is whether to buy a new car or a used car. New cars cost a lot and depreciate, or decrease in value, quickly. On average a new car loses 10 percent of its value as soon as you drive it off the lot. The biggest advantage new cars have is that they are covered by warranties. If something goes wrong, you probably won’t have to dip into your savings to pay repair bills. A used car will cost less but may be less reliable. Many experts suggest that cars that are two to three years old offer the best value. Certiﬁ ed used cars come with limited warranties to cover certain major repairs. How Can I Finance the Purchase of a Car? If you have not saved enough for the total purchase price of a car, you might consider applying for a car loan. Investigate loans before you shop for the car, so that you will know how much you can afford to spend. Call banks and credit unions and check out online banks to ﬁ nd the best interest rate. Find out the length of available loans, total ﬁ nance charges, and the amount of your monthly payment. Most lenders will require that you have a down payment on the loan. You may also need a cosigner for your loan. Beware of ﬁ nancing packages offered by car dealers. Combining price negotiations with ﬁ nancing terms generally results in a good deal for the dealer, not for you. 590 Consumer and Personal Finance Figure CPF 11 Buying a Car Research Used cars • Decide what kind of vehicle best suits your • Check the odometer. Avoid cars with an average needs and budget. of 15,000 miles per year or more. • Use Internet or library resources to ﬁ nd out such information as gas mileage, repair costs, safety record, and prices. • Look for rust, dents, and signs of the car having been in an accident. • Review the vehicle’s repair record. Check for regu- • If it’s a new car, ﬁ nd out what the dealer paid for lar maintenance such as oil changes. the car so you can negotiate a good price. • If it’s a used car, look up the average resale value in a “blue book” (used car price guide). Looking for cars • Visit dealer lots when they are closed to get an idea of what’s available without sales pressure. • Ask family and friends about their car-buying experiences. See if they know a reliable dealer or anyone selling a car. • Check out “for sale” ads in newspapers, on local bulletin boards, or on Web sites. • Look for dealer ads in newspapers or on the Internet. • Find the vehicle identification number (VIN), and use it to research the car’s history through an Internet service. • Take a test drive. Test the air conditioner, heater, radio, and other equipment. • Pay a mechanic you trust to examine the car and to list what needs to be repaired. The buying experience • Always go prepared with the information you have gathered. • Know which options you want and which ones you can live without. • Get any offer in writing. That way you are very clear on the exact costs. Check It Out! ✔ Consider whether you really & What Should I Do After I Buy a Car? Each state has laws about vehicle titles, taxes, registration, and insurance. You can learn what is required from a car dealership or your state’s motor vehicle department. Call several insurance agencies to ﬁ nd out how much insurance for your vehicle will cost (also see 3.3 Getting Insurance). Keep the title, sales receipts, and other important documents in a safe place—not in the glove compartment. Only the registration and proof of insurance should be carried in the vehicle. need a car. ✔ Research the car and its price before you talk to a salesperson. ✔ Be sure you have all the necessary legal documents. APPL IC ATION Buying a Car 1. Why should you do research on vehicles before you talk to a dealer? 2. Planning a Purchase Choose a particular model of car, new or used. Go to the library or look on the Internet and ﬁ nd information about the car from at least three different sources. Try to learn as much as you can about the car’s features, reliability, and pricing, and write down what you learn. Wise Choices for Consumers 591 Wise Choices for Consumers 3.2 Financing Your Education Choosing to go on to college or vocational or technical school after graduation from high school is one of the biggest economic decisions you will make. Getting more schooling will cost you money, but it will pay off in higher salaries and a greater lifetime income. As you learned in Chapter 9, each additional amount of education you receive increases your chances of earning a higher income. More highly educated workers are also less likely to be unemployed. Although the costs of higher education can be daunting, there are many alternatives to help ﬁ nance your education. How Do I Decide About Higher Education? What type of higher education do you want? Choices include college, vocational school, and technical school. Costs at different types of schools vary widely and may inﬂ uence the type of education you choose. Generally, public colleges are less expensive than private ones, and community colleges are less expensive than four-year schools. Consider your career goals, interests, and aptitudes, and think about what type of school offers the best value that meets your needs. Do you want to start right after high school? If you want to take a year off, think about what you will do and who will provide your ﬁ nancial support. Consider your income and expenses during that time and what kind of help your parents might give you. Postponing education postpones your future higher earnings and may lead to increased education costs. Where do you want to go for schooling? Are there schools in your state that would meet your needs? Out-of-state tuition is signiﬁ cantly higher than tuition at a public college in your own state. Going away to school generally means higher costs for housing, food, and travel, but it may be important for other reasons. 592 Consumer and Personal Finance What Will Be the Total Cost of Going to School? Paying for tuition to cover the costs of your coursework is just the beginning of school expenses. A variety of fees to cover student activities, connection to the school’s computer network, and other costs are added to tuition. In the 2005–2006 school year, average tuition and fees ranged from about $2,200 at a public two-year college to about $5,500 at a public four-year college and more than $21,200 at a private four-year college. Room and board costs cover housing and food and average more than $6,600 per year at a public four-year college. You must also buy your textbooks, which may cost as much as $1,000 per year. Transportation for visits home as well as other personal expenses are also part of the costs of going to school. Where Can I Get the Money for Higher Education? Once you have determined the costs of going to school, you can begin to make decisions about how to pay for your education. Here are some things to think about: Do I have the money to pay for it myself? Will my parents or family help me out? Can I work and study at the same time? Answers to these questions will help you decide if you need ﬁ nancial aid to go on to school. All the costs of going to school can be daunting. Over 60 percent of students ﬁ nd that they need some ﬁ nancial help. In fact, most students pay much less than the published costs because of ﬁ nancial aid. There are three basic types of ﬁ nancial aid: grants and scholarships, loans, and work-study programs. Figure CPF 12 outlines the characteristics of each type of aid. Find an update on the cost of higher education at ClassZone.com & Figure CPF 12 Financial Aid Options Grants Scholarships Loans Work-Study Programs • do not need to • do not need to • must be repaid • college helps be repaid • usually based on need • sometimes based on academic merit • given by federal and state governments and colleges be repaid • usually based on academic merit or athletic or artistic ability • awarded by colleges, private groups, and the U.S. military • federal loans for student find a job students • federal governm
ent helps pay the salary • earnings do not need to be repaid • students who work part-time often do better in school • federal and private loans for parents • subsidized— based on need, some interest paid by government • unsubsidized— student pays all interest ➲ Wise Choices for Consumers 593 Wise Choices for Consumers How Much Aid Can I Get? In general, the amount of aid you receive is determined by the difference between the cost of attending school and the amount you and your family can contribute. Schools consider the following when awarding ﬁ nancial aid: • Income—yours and your parents. This is the single most important factor in determining ﬁ nancial aid based on need. Students and families with higher incomes are expected to contribute more. • Number of higher education students in your family. A family with more than one student in college would be expected to contribute less for each one. • Family assets and expenses. Students are expected to contribute a higher percentage of their savings than parents are, so it’s better to have more savings in parents’ accounts. In general, schools do not consider the value of retirement funds, a home, or personal assets such as automobiles in ﬁ guring out a family’s contribution. Some schools do consider these assets, so it’s important to know how the schools you are interested in ﬁ gure their aid awards. Unusual medical expenses and other large expenses may be considered in determining a family’s contribution. • Pool of aid dollars at the school you want to attend. Schools award aid based on a combination of federal, state, and school funds. A wealthy private school may have more funds available than a state school. • Number of students applying for aid at the school you want to attend. Since each school has a limited amount of funds available for aid, if more students apply for aid there may be less available for each student. The level of need of the students applying might also affect how much individual students receive. How Do I Apply? Start Early Meet with your guidance counselor and request ﬁ nancial aid information from schools at least a year before you plan to start school. Begin to research scholarships. Make note of all application deadlines. Get a PIN A personal identiﬁ cation number (PIN) allows you to submit your Free Application for Federal Student Aid (FAFSA) online for faster results. Go to www.pin.ed.gov. 594 Consumer and Personal Finance Gather All the Documents You Need You’ll need income tax returns and W-2 forms for you and your parents, as well as information on nontaxable income. You’ll also need your Social Security number and driver’s license number, along with bank statements and information on mortgage payments and investments. Complete the FAFSA Fill out a paper form or go to www.fafsa.ed.gov to apply online. Follow the instructions carefully. You only need to complete one form, which will be used by all the schools to which you are applying. Where Do I Get More Information? Federal Student Aid Information Center FAFSA on the Web The College Board SallieMae® loans studentaid.ed.gov 1-800-4-FED-AID (1-800-433-3243) www.fafsa.ed.gov www.collegeboard.com www.salliemae.com Your school guidance counselor and the ﬁ nancial aid ofﬁ ces of the schools you are considering also have information. Fill Out Any Additional Aid Forms These forms may be required for some nonfederal aid such as state and school aid or private scholarships. Ask for recommendations from your teachers and other adults who know you well at least a month before scholarship application deadlines. Provide them any necessary forms and a stamped envelope for the recommender to send to the school & & Review Your Student Aid Report (SAR) This report is the result of your FAFSA application. Make sure all the information is accurate. Your SAR shows your Expected Family Contribution (EFC), which determines your eligibility for federal student aid based on need. Contact Schools’ Financial Aid Ofﬁ ces Make sure all schools you’ve applied to received all the information they need. Check It Out! ✔ Get forms in on time. ✔ Photocopy all information or print copies of online applications. ✔ Make sure information is consistent on all forms. Compare Your Aid Awards After you receive responses, decide which school’s aid package offers the best combination of grants, scholarships, loans, and work-study. AP P LI CATION Financing Your Education 1. What criteria are used to determine who gets ﬁ nancial aid? 2. Using a Decision-Making Grid Using the questions on page 592 and a decision-making grid, determine which type of schooling makes the most economic sense for you. Wise Choices for Consumers 595 Wise Choices for Consumers 3.3 Getting Insurance Insurance protects people from the ﬁ nancial effects of unexpected losses. When you buy insurance coverage, your money joins a pool of money from many different people who face similar risks. The system works because the risk is spread over a large group of people. The chances of any one individual suffering a loss are small. What Are the Benefits of Insurance? Most people take out insurance for problems that may be unlikely but would be expensive if they happened: medical treatment for a serious illness or accident, repairing a car damaged in an accident, or replacing valuables stolen from your residence. Such losses are potentially so large that it would be difﬁ cult to save enough in an emergency fund to pay for them. Insurance protects you ﬁ nancially against those kinds of losses. What Kinds of Insurance Should I Get? When you buy an insurance policy you purchase a certain amount of protection or coverage. Your payment for this protection is called an insurance premium. Many types of insurance require you to pay a deductible, which is the amount you pay before the insurance company pays on a loss. Some health insurance requires a co-pay, an amount you must pay each time you receive health care under your policy. When you have a loss you submit a claim, which is a request for payment, to the insurance company. Most people start out with car insurance, health insurance, and renter’s or personal property insurance. There are other options as well. See Figure CPF 13 for an overview of the basic types of insurance. Most states require that you carry at least a minimum amount of car insurance in case of injury or property damage caused by your car. Premiums are based on the type of vehicle, your age, your driving record, and other related information. The more coverage you have the more the insurance will cost. If you carry a high deductible, it will reduce the premium. QUICK REFERENCE A premium is amount paid for insurance. A deductible is an amount paid by the insured before the insurance company pays. A co-pay is an amount due when an insured receives health care. A claim is a request for payment on an insured loss. 596 Consumer and Personal Finance & Figure CPF 13 Types of Insurance Type of Insurance Protects Pays Car Health vehicle in case of accident or theft; occupants in case of accident for property damage and bodily injury, legal costs, and related expenses policyholder in the event of illness or injury for doctor and hospital visits, prescription drugs Homeowner’s structures, land, and personal property for damage due to fire, theft, or natural disaster Renter’s personal property income when a person cannot work for loss of or damage to personal items a percentage of income when a person is out of work due to injury or illness family when a wageearner dies money to the family to meet expenses after death Disability Life Health insurance is very costly. Your employer or school may offer insurance plans to cover some or all of your needs. In some states, you may be covered by your parents’ health insurance until you graduate from college or reach age 25. If you live in rented housing, you may want to protect your belongings with renter’s insurance or with personal property insurance. Some policies cover the full replacement cost of insured items; others cover only the current value of the items. For example, actual cash value coverage will not cover the full cost of replacing a three-year-old bike that gets stolen. Check It Out! ✔ Find out if you have insurance coverage at work or through your educational institution. ✔ See if your insurance covers the current value or the full replacement cost. ✔ Determine how much you can afford in deductibles. What Questions Should I Ask an Insurance Agent? • How much does the policy cover? Are there limits each year or for each accident or illness? Are there maximums for certain kinds of losses? • What levels of deductibles are available? Higher deductibles lower the premiums. • Are claims paid on actual cash value or on replacement value? The former may cost less, but you will receive less in the event of a loss. • How often are premiums due—monthly or once or twice per year? APPL IC ATION Getting Insurance 1. What reasons do people cite for getting insurance? 2. Selecting Insurance Explain how having insurance could help in each of the following situations. Case A: Your CD player and 10 CDs are stolen from your car. Case B: You have to have emergency surgery for a fractured leg. Case C: Your car is smashed up by a hit-and-run driver. The damage is well over $2,000. Wise Choices for Consumers 597 Wise Choices for Consumers QUICK REFERENCE A contract is a legally binding agreement. 3.4 Contracts: Reading the Fine Print Buying insurance, taking out a loan, signing up for a credit card—all of these involve a formal, legally binding agreement known as a contract. The contract may be in the form of a signed document or may be executed on a Web site when you download something from the Internet. These terms and conditions are called the “ﬁ ne print” because they are often set in small type. Why Should I Read the Fine Print? There’s an old saying: “Education is when you read the ﬁ ne print. Experience is what y
ou get when you don’t.” By reading the ﬁ ne print, you will understand exactly what you are agreeing to when you sign a contract. The ﬁ ne print often contains information about extra charges and fees that may not be displayed in marketing brochures or advertisements. Consider Michele, a student who signed a cell phone service contract without reading it. When the ﬁ rst bill arrived, it was over $1,000. She checked the contract and found ﬁ ne print stating that all text messaging both sent and received was subject to a charge. Even though Michele hadn’t read these terms, she had signed the contract, and she had to pay the bill. What Should I Do Before Signing a Contract? • First, actually read the contract. If it is long or complicated, ask for a copy and take it home to read. • Clarify all terms or provisions you don’t understand. In a cell phone contract, for example, be clear on peak and off-peak hours, roaming charges, and the cancellation policy. Ask questions until you understand everything clearly. If there are parts you can’t ﬁ gure out, get advice from a friend before signing. Source: www.CartoonStock.com • Check all ﬁ gures in the contract. Bring a calculator and ﬁ gure the costs yourself—don’t depend on the salesperson’s math. • Make sure any mistakes or omis- sions are corrected on the contract and initialed by the salesperson. 598 Consumer and Personal Finance Figure CPF 14 A Cell Phone Contract a Note how many minutes are in- cluded in the basic monthly price. CellPhone Service Agreement b Asterisks or footnotes often lead to small print that provides important information. c If you exceed the allotted number of text messages, you pay a fee for each one. d If you want to end your contract before it expires, you pay the cancellation fee. e Your signature here shows that you have read and agree to the ﬁ ne print. Monthly calling plan Total minutes/month (peak) Unlimited off-peak b Voice mail Additional minutes Roaming charges (See coverage map and terms for details) Text messaging Total outgoing messages/month Additional outgoing messages Incoming messages Plus federal, state, and local taxes and fees Contract length Cancellation fee b $24.95 400 a $5.95 Included* b $0.40/minute $1.00/minute $3.95 100 $0.10/each c Unlimited Free 24 months $150.00 d What Should I Beware of? • Don’t let the salesperson rush you. *Accessing voice mail through cellular phone accrues minutes like any other call. I acknowledge that I have read and agree to the company’s Terms and Conditions e (your signature) Take your time and make sure you are certain of the terms of the contract. Even if the salesperson says certain desirable terms are about to expire, you should not sign anything you do not thoroughly understand and agree to & • Never sign a contract with blank spaces. Make sure every blank on the contract is either ﬁ lled in or marked through as being not applicable. If you leave blanks, someone might enter something after you sign that you did not want to agree to. • Don’t agree to verbal contracts. Make sure everything is in writing. If you agree to a verbal contract and run into a problem, you have no evidence of what the agreement was. Business agreements are generally too complex for either side to remember all the details. • Don’t leave without getting a copy of the contract. Keep the contract in a safe place. Check your ﬁ rst bill carefully to make sure everything matches the contract. If you have questions, call the company to resolve your concerns. Check It Out! ✔ If it seems too good to be true, it probably is. ✔ Check all ﬁ gures on the contract. ✔ Never sign a contract with blanks not ﬁ lled in or crossed out. APPL IC ATION Contracts 1. Why shouldn’t you agree to a verbal contract? 2. Evaluating an Offer Study the ads or commercials for cell phone service. Review Wise Choices for Consumers using interactive activities at ClassZone.com Suppose you are ready to sign a contract for cell phone service. Make a list of the questions you will ask before you sign the contract. Wise Choices for Consumers 599 4.1 Getting a Job 4.2 Paying Taxes 4.3 Finding an Apartment Getting Out on Your Own 4.1 Getting a Job An important step to becoming an independent adult is getting a job. A job allows you to earn money, gain experience, and learn new skills. A career is more than a job. It is a work path that provides satisfaction, challenge, and opportunities for self-expression. Your ﬁ rst jobs help you learn about the world of work and what kind of career you might enjoy. Where Can I Look for a Job? Finding a job that suits your skills and helps advance you along your career path can be challenging. There are many sources of information about jobs, and the more you use, the better your chances of ﬁ nding a good ﬁ t. Friends and Family Talk to them to ﬁ nd out if they know of any job openings. They are the beginning of your network—people who will support you in what you attempt, and whom you support in turn. School Guidance Counselor, or Career Planning or Placement Ofﬁ ce These ofﬁ ces have listings of jobs and intern positions. You can also learn about different careers. Internet Many Web sites offer job listings, places to post your resumé, and other services. America’s Job Bank, managed through a partnership between federal and state governments, allows you to tap into career resources, look at job listings all over the country, and post a resumé. Newspaper Want Ads Your local newspaper is a good source for jobs in your area. Employment Agencies Your state and local governments may offer employment services. These public agencies often offer job counseling and training as well as job listings. Private agencies also offer job listings and placement, but they sometimes charge a fee for their services. Job Fairs Job fairs offer the opportunity to talk to many employers in an area or a speciﬁ c job category in a very short period of time. 600 Consumer and Personal Finance What Do I Need to Apply for a Job? Before you apply for a job, you will need to prepare materials that introduce you to potential employers and tell them about your qualiﬁ cations. You will need a resumé, a cover letter, and a list of references. References are people who know you and your work habits and are willing to talk to potential employers. Many jobs will also require that you ﬁ ll out an application form. Resumé A resumé is a record of your job history and education. It should be truthful and succinct—no more than one page long. Since employers judge you by your resumé, be sure it is visually appealing and free of errors. Figure CPF 15 shows a sample resumé for a recent high school graduate. If you apply for different kinds of jobs, you may want to develop more than one resumé. Cover Letter A cover letter brieﬂ y explains why you want the job and how you are qualiﬁ ed for it. Address your letter to the speciﬁ c individual who is Cheryl A. Miller 1909 E. Walnut St. Long Beach, CA 90811 310-555-5678 camiller89@isp.net b c Objective To obtain an entry-level customer service position Education Jefferson High School, 2003-2007 Experience September 2006–Present Sales Associate, Electronics Super Center • Advised customers on product features and helped them choose the ones that best met their needs • Met or exceeded weekly sales quotas • Developed promotional materials for in-store use Summer 2006 Administrative Assistant, Oceanside Computer Center • Tracked customer sales and repair orders to improve response time • Responded to customer questions by phone and email • Provided ofﬁ ce support for staff of six September 2005–June 2006 User support, Jefferson High computer lab • Developed an orientation program for incoming students • Helped students use a variety of software applications • Led a workshop on Web page design d Other Skills • Proﬁ cient in a wide range of application software, including word processing, spreadsheet, database, and presentations • Internet research e Activities and Honors • Member of varsity girls’ track team • Captain of debate team References available upon request Figure CPF 15 Writing a Resumé a Include all the information an employer might need to contact you. b Make your objective speciﬁ c and succinct. Tailor it to the job you are applying for. c List your work experience in reverse chronological order. Include volunteer work if you have little paid work experience. Focus on skills and accomplishments. d List other skills you have that might be useful on the job, even if you have not been able to use them in previous jobs. e Include a section that lists ac- tivities, honors, and community service. ➲ Getting Out on Your Own 601 Getting Out on Your Own designated to receive applications. Open your letter with a strong statement of your interest in this particular job. In the body of the letter, use information from your resumé to explain why you are the best candidate. Close by restating your interest and indicate your intention to follow up to request an interview. Internet and library resources can give you samples of strong cover letters. Figure CPF 16 References Cheryl A. Miller 1909 E. Walnut St. Long Beach, CA 90811 310-555-5678 camiller89@isp.net References Barry Woods Assistant Manager Electronics Super Center 1234 Main St. Long Beach, CA 90811 310-555-1357 bwoods@esc.com Cynthia North Director Jefferson High Computer Lab 461 Grand Oak Boulevard Long Beach, CA 90811 310-555-1234 c_north@jefferson.lb.ca.edu Danielle Curran Ofﬁ ce Manager Oceanside Computer Center 4916 Oceanside Road Long Beach, CA 90812 310-555-2468 dmcurran@occ.com Julie Barnes Moderator Jefferson High Debate Team 461 Grand Oak Boulevard Long Beach, CA 90811 310-555-1345 j_barnes@jefferson.lb.ca.edu References Before you list someone as a reference, talk with him or her about your job hunt and ask their permission. The list of references should include the person’s name, address (either business or home), telephone number, and an e-mail address
, if they have one. It’s also a good idea to indicate the person’s position or relationship to you. The people you choose as references should know you well enough to be able to describe your skills, experiences, and work habits. Choose people who will be enthusiastic about your abilities based on their experience with you. Typical references include former or current employers, teachers or coaches, or family friends who can vouch for your personal character. Stay in touch with your references during your job hunt. Let them know when they might expect to hear from an employer, and discuss what you would like them to emphasize when they are contacted. How Can I Ace the Interview? If an employer gets a good impression of you from your resumé and cover letter, they may invite you to come in for an interview. The interview is a chance for the employer to learn more about you and for you to learn more about the job and the company. The Company and the Job Do some research on the company to which you are applying. A company’s Web site will tell you more about the organization, but you might also ﬁ nd newspaper articles with information about the company. This research will help you to conﬁ rm that you are interested in working for the company. It will also show the company that you cared enough about the job to do some investigating before the interview. 602 Consumer and Personal Finance Use your research to prepare a set of questions about the organization and the job. Find out as much as you can about the job requirements and responsibilities before discussing such things as pay, hours, or beneﬁ ts. In some cases, those topics may not come up until a later interview. Remember that both you and the employer want to conﬁ rm that you are a good ﬁ t for the job and the organization. Presenting Yourself Be ready to answer questions about your qualiﬁ cations and about how you will ﬁ t into the company. You may want to practice answering questions in front of a mirror or with a friend or family member. Make sure your answers are clear and succinct. Take time to think about your responses to unexpected questions. Books and online resources can provide examples of many common interview questions & Dress appropriately for the job you are seeking. Don’t show up to the interview in business attire if you are applying to work where you will get very dirty. By the same token, don’t go to an interview for an ofﬁ ce job dressed in jeans and a T-shirt. Always appear neat, clean, and well groomed. Determine how long it will take to get to the interview. Plan to arrive about ten minutes early. Take weather conditions and trafﬁ c into consideration. If you are delayed, be sure to call and explain that you will be late. Bring extra copies of your resumé and list of references. You may want to bring a pad of paper to take notes during the interview. Be sure to get the name and title of each person who interviews you. Check It Out! ✔ Learn about the company where you are applying. ✔ Prepare a list of questions about the job and the company. ✔ Bring extra copies of your resumé and your list of references. ✔ Be on time for your interview. Follow-Up Write a short thank-you note immediately after the interview to each interviewer. Thank the interviewer for spending time with you. If you still want the job, restate your interest in it. Refer to something you learned in the interview. Express your desire to learn more about the position. AP P LI CATION Getting a Job 1. What is the purpose of a resumé? 2. Writing Your Resumé Study the resumé in this section. Prepare a personal resumé based on the model. Also assemble a list of people whom you might want to use as references. Getting Out on Your Own 603 Getting Out on Your Own 4.2 Paying Taxes Benjamin Franklin once said, “In this world nothing is certain but death and taxes.” As you learned in Chapter 14, taxes provide the government with revenue to provide needed services. Recall that the Internal Revenue Service (IRS) is the government agency that collects the federal taxes owed by Americans. Most states also collect taxes. Taxes for the previous year must be paid by April 15 of the current year. For example, taxes for income earned in 2010 would need to be paid by April 15, 2011. How Are My Taxes Determined? The amount you pay in taxes is determined by your ﬁ ling status and your taxable income. Filing status is based on your marital status or whether you have any dependents. A dependent is a child or relative in your household whom you support. People with more dependents have less tax withheld. Employers use the W-4 form, shown in Figure CPF 17, to determine your ﬁ ling status for withholding taxes from your paycheck. You ﬁ ll out a W-4 form when you begin a job. As long as you are still dependent on your parents, you claim only one withholding allowance. The second determinant is your taxable income, which is the amount of income subject to taxation after all exemptions and deductions. The higher your income, the higher your taxes will be. Certain income may not be taxed. For example, money can be deducted from your paycheck before taxes to pay for health insurance. Income above a certain level is not subject to Federal Insurance Contributions Act (FICA) taxes for Social Security. QUICK REFERENCE Filing status is based on your marital status or support of dependents. Taxable income is the income subject to taxation after exemptions and deductions. Figure CPF 17 The W-4 Form a a Instructions help you determine how many allowances to claim. A single person with one job who is claimed as a dependent gets one allowance. b Your Social Security number is required on all IRS forms. 604 Consumer and Personal Finance b Where Do I Get Tax Forms? Federal and state tax forms are available starting in January each year at post ofﬁ ces (federal forms only), libraries, banks, and IRS or state tax ofﬁ ces. They are also available through ofﬁ cial Web sites, or you can order forms through the mail or by phone. The ﬁ rst year you ﬁ le taxes, you will need to ﬁ nd the forms yourself. After that, you should receive forms in the mail from the state and federal governments at the end of each year. If your tax situation changes signiﬁ cantly from the previous year, you may need to pick up additional forms. Form 1040 Most young adults do not have to ﬁ le complicated tax forms. Generally, the 1040EZ form should be sufﬁ cient for your federal taxes. This is a one-page form that has only 12 lines to ﬁ ll out. The back of the form explains who is eligible to use it. See Figure CPF 18 for a sample of a 1040EZ form. If you receive more than $1,500 in interest, you cannot use the 1040EZ form. Likewise, if you receive any dividends or other income from stocks, bonds, or similar investments, you cannot use 1040EZ. Instead, you will need to use form 1040A or 1040. These forms have related forms, known as schedules, for reporting investment income. Most state tax forms are simple because they are based on the results you obtain from ﬁ lling out your federal forms. The W-2 Form The W-2 form shows how much you earned during the year and how much you paid in taxes through withholding. The form shows your total gross earnings and the amount of earnings subject to taxation. The amount withheld for each type of tax is also shown, including federal income tax, Social Security and Medicare taxes, and state and local taxes. At the end of each year, any employer that you have worked for that year must send you a W-2 form. Employers must send the forms in time to arrive at your home by January 31. The W-2 will include copies to ﬁ le with your federal, state, and local tax returns, as well as one copy for your ﬁ les. Other Forms When you have savings or investments, your bank or ﬁ nancial institution will send you other forms. Form 1099-INT for savings interest and form 1099-DIV for investment gains should arrive about the same time as your W-2 & ➲ Getting Out on Your Own 605 Getting Out on Your Own How Do I Fill Out a Tax Form? Instruction booklets are available in most locations where you ﬁ nd tax forms. You may also download them for free from the IRS or state tax Web sites or request them by mail or phone. The instructions will take you through the steps to ﬁ ll out the form line by line. They will also provide additional background information that may be helpful, as well as telling you where to go if you need help. Perhaps most important, the instructions contain the tax tables that will tell you how much tax you have to pay once you have determined your taxable income. Follow the step-by-step instructions to complete each form. Always use correct and veriﬁ able numbers. Making up numbers is considered tax fraud, which can be punishable with severe penalties. Figure CPF 18 shows a sample of a 1040EZ form. Figure CPF 18 Filling Out the 1040EZ a Use your W-2 form(s) to ﬁ nd the amount to enter here. b The 1099-INT form shows how much interest you earned. c The amount you enter here depends on your ﬁ ling status. If you are a dependent, you get the standard deduction but not the personal exemption. d The amount of tax withheld is found on your W-2 form along with earnings. e If you had more withheld than you owe in taxes, you will get money back in the form of a refund. If you didn’t have enough withheld, you will have to pay the amount you still owe to the IRS. 606 Consumer and Personal Finance & How Do I File My Taxes? Everyone who receives more than a certain amount of income during the year must ﬁ le a tax return. Check the tax form instructions or the IRS Web site to determine if you are required to ﬁ le. Even if you don’t owe money, you must ﬁ le a form if you meet the requirements. And, of course, you will not receive a refund for excess taxes withheld unless you ﬁ le a tax return. See the “What if I get stuck?” sidebar to ﬁ nd out how to receive help with your taxes. Before you send in your forms, double check your work.
Conﬁ rm that you have entered the correct Social Security number; that your income, withholding, and tax ﬁ gures are correct; and that you have signed your forms. Then make a photocopy of the forms for your own records. When everything is ready, you can mail all the paperwork to the IRS service center listed on your form. You can also ﬁ le your tax forms electronically. Electronically ﬁ led returns are generally more accurate, and refunds are processed more quickly. The IRS has formed a partnership with several tax software companies to offer the Free File service that allows most taxpayers to prepare and ﬁ le their taxes electronically for free. You can ﬁ nd more information and instructions on e-ﬁ ling options on the IRS Web site. WHAT IF I GET STUCK? • Ask a parent or other trusted adult. Most have many years of experience filling out tax forms. • For federal tax help, go to the IRS Web site. For state tax help use the name of your state and the key words tax help to find the Web site. • For additional help, call the local IRS office (1-800-829-1040) or your state tax office. After you ﬁ le your return, be sure to keep all your forms and copies in a safe place. Keep your tax returns and all related documents for at least three years—the limit if the IRS wants to contest your return. Mistakes The IRS and state tax auditors usually catch simple math mistakes and inform you of them. They then recalculate your taxes and adjust the amount of your refund or taxes owed. If you discover a major error or omission on your form after you submit it, ﬁ le an amended return as soon as possible. You must ﬁ le an amended return within three years of the time when the original return was ﬁ led. You may have to pay a penalty depending on the type of error involved. Check It Out! ✔ The ﬁ ling deadline is April 15, every year. ✔ Check everything on your form carefully before submitting it. ✔ Save your forms and copies for at least three years. APPL IC ATION Paying Taxes 1. Where can you go to get tax forms? 2. Preparing to Do Your Taxes Make a list of the documents and information you will need to ﬁ le federal and state income tax forms. Decide on a location where you will keep the list and the information until it is time to ﬁ le your taxes. Getting Out on Your Own 607 Getting Out on Your Own 4.3 Finding an Apartment Most young adults will rent an apartment when they start out on their own because apartments are an affordable type of housing. Moving out of your parents’ home or out of a college dormitory into an apartment will give you more freedom. But it also means more responsibilities. You will have to pay monthly bills, shop for groceries, ﬁ x meals, clean your apartment, and do laundry. With a little effort, you can ﬁ nd an apartment that suits you. What Should I Consider About Renting an Apartment? How much should I spend? Your housing expenses should amount to no more than about one-fourth to one-third of your take-home pay. These expenses include not only your rent, but also utilities, cable, and any other housing costs. Spending a higher proportion of your income on housing may not leave you enough to meet your other expenses or to have the money you want to enjoy life. Should I live by myself or with roommates? If one-third of your take-home pay only pays rent for a storage locker, you may want to consider sharing a larger apartment with one or more roommates. Roommates can make living in an apartment cheaper and more fun, but they can become a problem if they are irresponsible or have a lifestyle that clashes with your own. Think about how to balance the desire for privacy and your own space with the desire for companionship and help with household expenses and chores. If you decide to live with roommates, consider looking for an apartment together. That way, everyone can commit to the same place, and people will be less likely to grow dissatisﬁ ed and leave. How do I choose roommates? Look for individuals you are compatible with, whose personalities and lifestyles are similar to your own. Roommates should be people you can count on, whether it’s to pay their share of the rent or to do their share of household chores. Living with other people can bring up conﬂ icts about how to share expenses, use the living space, and keep it clean. You and your roommates will need to communicate to resolve such issues. Consider drawing up an agreement together that spells out the rules that everyone must obey and the responsibilities that each roommate accepts. 608 Consumer and Personal Finance Figure CPF 19 Looking for an Apartment Location The Building • Is it convenient to where you work? • Is it clean and well taken care of? • Is there nearby public transportation or parking? • Do the other tenants seem friendly? • Are there grocery stores, self-service laundries, or • Are the lobby and stairwells safe? other stores you need nearby? • Is the neighborhood safe? • Are there sufﬁ cient parking spaces, laundry facilities, or bike rooms? Space • Is there enough room for the number of people living in the apartment? • Is it suitable for your way of life? • Are all the roommates happy with the living space and available storage? Furnished or Unfurnished • Do you want it furnished with furniture or do you want to use your own furniture? • Can you get used furniture from family or friends or purchase inexpensive furniture? • Does the apartment include appliances, such as a stove and refrigerator? What Do I Need to Know About Signing a Lease? • A lease is a contract for renting an apartment for a speciﬁ c period of time. The contract is between you and your landlord, who is the owner of the rental property. A lease is a legal document that obligates you to pay rent and to follow certain rules for a speciﬁ c period of time. The landlord has responsibilities as well. If you have roommates, whoever signs the lease is responsible even if other roommates fail to pay their part of the rent. QUICK REFERENCE A lease is a contract for renting an apartment. A landlord is the owner of rental property & • You may be asked for the ﬁ rst and last months’ rent, a security deposit, and possibly cleaning and key fees. When you move out, the landlord will inspect the property and return some or all of the security deposit and fees, depending on what repairs need to be done. • You may need to provide character references—name, address, and phone number. Generally you should use three people who are not relatives, such as teachers, employers, or supervisors of volunteer work, who can vouch for you. • You must provide your Social Security number and bank information. If you are employed you will provide employment information. Check It Out! ✔ Provide a list of references. ✔ Be prepared for up-front costs such as a security deposit. ✔ Look at several places before committing to an apartment. • If this is your ﬁ rst apartment or you are not employed, you may be asked to have a responsible adult act as a cosigner. This ensures that the landlord will be paid the rent due if you fail to pay. APPL IC ATION Finding an Apartment 1. What is a lease? 2. Analyzing Your Needs Decide if you would prefer to live alone or with others. If you prefer to live alone, write a paragraph explaining your decision. If you would like to live with others, create a list of roommate rules and responsibilities. Review Getting Out on Your Own using interactive activities at ClassZone.com Getting Out on Your Own 609 Reference Section McDougal Littell ECONOMICS Concepts and Choices Math Handbook Mathematical skills related to economics R1 Skillbuilder Handbook Skills for understanding economics and using print, visual, R12 and technology sources Glossary Important terms and deﬁ nitions Spanish Glossary Important terms and deﬁ nitions translated into Spanish Index Index of all topics in the textbook Acknowledgments Acknowledgments for text excerpts, images, and trademarks R32 R45 R61 R79 Math Handbook Table of Contents Refer to the Math Handbook when you need help with the mathematical concepts that you might encounter in your study of economics. 1.1 Working with Decimals and Percents 1.2 Calculating Averages 1.3 Calculating and Using Percents 1.4 Using Ratios 1.5 Calculating Compound Interest 1.6 Understanding Progressive Taxes 1.7 Creating Line Graphs 1.8 Creating Bar Graphs 1.9 Creating Pie Graphs 1.10 Creating a Database R2 R3 R4 R5 R6 R7 R8 R9 R10 R11 Math Handbook R1 1.1 Working with Decimals and Percents Understanding the Skill A decimal is a number that uses the base-ten value system where a decimal point separates the ones’ and tenths’ digits. Each place value is ten times the place value to its right. For example, 5.2 is five and two tenths and 12.45 is twelve and forty-five hundredths. The word percent means “per hundred.” For example, 5 percent means “5 per 100,” or 5/100. If 5 percent of the population is unemployed, then, on average, 5 out of 100 people are unemployed. To write a decimal as a percent, multiply by 100 percent. To write a percent as a decimal, divide by 100 percent. Example 1: A company’s February sales were 0.125 of its total annual sales. Express this as a percentage. 0.125 0.125 x 100% Multiply by 100 percent. 12.5% Move the decimal point two places to the right. Check your answer: 12.5 should be larger than 0.125 because you multiplied by 100. Example 2: A company’s workforce was 105 percent of what it was a year earlier. Express this as a decimal. 105% 105%_____ 100% 105____ 100 1.05 Divide by 100 percent. Cancel the % signs. To divide by 100, move the decimal point 2 places to the left. Check your answer: 1.05 should be smaller than 105 because you divided by 100. Applying the Skill 1. In 2002, the total personal income in the United States was $8.922 trillion and the total personal taxes were $1.112 trillion. What percent of income were taxes? Round your answer to the nearest hundredth. 2. The GDP of the United States is $11.750 trillion and the GDP o
f the world is $55.500 trillion. What percent of the world’s GDP is from the United States? Round your answer to the nearest tenth. R2 Math Handbook 1.2 Calculating Averages Understanding the Skill There are three ways to express the average of a group of numbers. The most common way is to divide the total by the number of values. This kind of average is called the mean. Mean, Median, and Mode Notice that, in Example 1, most workers earn much less than the mean of $27,000; the mean doesn’t describe typical earnings well. Typical earnings are often described better by the two other kinds of average: the mode and the median. To determine the mode and the median of a group of numbers, write the numbers in order from smallest to largest. The mode is the most common value. The median is the middle value. If the number of values is even, the median is the mean of the two middle values Example 1: The annual earnings of five workers are shown below. Calculate the mean earnings. $14,000 $18,000 $14,000 $75,000 $14,000 Solution Divide the total by the number of values. There are five numbers to average, so the number of values is 5. Mean Total _____________ Number of values 135,000 _______ 5 $27,000 The workers have mean earnings of $27,000 Simplify the numerator. Divide. Answer the question. Example 2: Find the mode and the median of the earnings in Example 1. Solution Write the values in order from smallest to largest. $14,000 $14,000 $14,000 $18,000 $75,000 The most common value is $14,000, so the mode is $14,000. $14,000 $14,000 $14,000 $18,000 $75,000 The middle value is also $14,000, so the median is $14,000. Applying the Skill Calculate the mean, the median, and the mode of each group of numbers. 1. $40,000 $32,000 $38,000 $40,000 $40,000 2. $80,000 $50,000 $35,000 $35,000 $40,000 $60,000 Math Handbook R3 1.3 Calculating and Using Percents Understanding the Skill As you recall, the term percent means “per hundred.” For example, 25% is 25/100. To change a decimal to a percent, move the decimal point two places to the right and add the % symbol. 0.253 = 25.3% 1.63 = 163% To calculate and use percents, first write a question. Then rewrite your question as an equation. Replace “percent” with /100, “of” with , and “is” with =. Replace the unknown value with a variable, like x. Example 1: Sweden’s gross domestic product (GDP) is $255,400,000,000. Agriculture accounts for about $5,108,000,000 of the GDP. What percent of the GDP is from agriculture? Solution What percent of the GDP is from agriculture? Write a question. What percent of $255,400,000,000 is $5,108,000,000? /100 $255,400,000,000 $5,108,000,000 Rewrite as an equation. Substitute numbers. $5,108,000,000 ______________ $255,400,000,000 100 2 Two percent of Sweden’s GDP is from agriculture. Solve the equation. Use a calculator. Answer the question. Example 2: Sweden’s unemployment rate is 5.6% and its labor force is 4.46 million. About how many people are unemployed? Solution 5.6 percent of the labor force is how many people? Write a question. 5.6 percent of 4.46 million is how many? 5.6/100 4,460,000 Substitute numbers. Rewrite as an equation. 249,760 Use a calculator. About 250,000 people are unemployed. Round your answer. Applying the Skill 1. What is 10% of $65? 3. $3.75 is 15% of how much? R4 Math Handbook 2. What is 150% of 256,000? 1.4 Using Ratios Understanding the Skill A ratio compares two numbers that have the same units of measure. For example, if Tina runs 8 miles per hour and Maria runs 7 miles per hour, the ratio of their speeds is 8 to 7, or 8:7. A ratio can also be written as a fraction: 8_ 7 . You can simplify ratios in the same way that you simplify fractions Example 1: Raul runs 8 miles per hour and his little brother Ben runs 4 miles per hour. What is the ratio of Raul’s speed to Ben’s speed? Solution 8__ 4 Raul’s speed _________ Ben’s speed 8 4 _____ 4 4 2__ 1 Write a fraction. To simplify the fraction, divide both the top and the bottom by 4. 2__ means the same as 2:1 and “2 to 1.” 1 The ratio of Raul’s speed to Ben’s speed is 2 to 1. Ratios are sometimes written as decimals. For example, a company’s price-earnings ratio is the ratio of the price of a share of the company’s stock to the earnings per share. Example 2 Suppose a share of a company’s stock costs $54.75 and the earnings per share are $2.73. What is the company’s price-earnings ratio? Solution Price-earnings ratio = Price of a share of stock __________________ Earnings per share $55.75 ______ $2.73 20.421245 20.4 The company’s price-earnings ratio is about 20.4. Write a fraction. Substitute numbers. Use a calculator. Round your answer. Answer the question. Applying the Skill 1. The GDP of the world is about $55 trillion and the GDP of the United States is about $11 trillion. What is the ratio of the GDP of the world to the GDP of the United States? 2. Suppose a share of a company’s stock costs $26.24 and the earnings per share are $3.19. What is the company’s price-earnings ratio? Math Handbook R5 1.5 Calculating Compound Interest Understanding the Skill For some savings instruments, interest is calculated and paid multiple times each year. To calculate the amount of each interest payment, you can use the following formula. Interest = Balance Interest rate __________________________ Number of times calculated each year If interest on your savings is compounded, that means the interest you earn is added to your total savings, and is included in future calculations of interest. Notice that the interest for the second half of the year is greater than the interest for the first half of the year. In the second half of the year, you earn interest not only on your original balance, but also on the interest you earned in the first half of the year. Compound interest on loans works the same as compound interest on savings. But for loans, if interest is compounded, you must pay interest on interest you haven’t yet paid. Applying the Skill 1. If interest on $2,000 is compounded biannually with a rate of 6 percent, what is the interest for each compounding period in the first year? What is the total interest for one year? Example: If interest on $1,000 is compounded biannually with an interest rate of 5 percent, how much interest do you earn for each compounding period in the first year? Solution If interest is compounded biannually, that means it is calculated two times a year and each compounding period is a half of a year. Calculate the interest for each half. First half of year Interest = $1,000 5% ___________ 2 $1,000 0.05 ____________ 2 $25.00 Balance Interest rate __________________________ Number of times calculated each year Substitute numbers. Convert the percent to a decimal. Use a calculator. Second half of year First, calculate the new balance by adding the interest to the old balance. New balance Old balance Interest on old balance $1,000 $25.00 $1,025.00 Interest New balance Interest rate ____________________________ Number of times calculated each year $1,025.00 5% _____________ 2 $25.63 The interest for the first half of the year is $25.00 and for the second half is $25.63. 2. If interest on $2,000 is compounded four times a year with a rate of 6 percent, what is the interest for each compounding period in the first year? What is the total interest? 3. Look at your answers to Questions 1 and 2. Do you earn more if the interest is compounded twice a year or if it is compounded four times a year? R6 Math Handbook 1.6 Understanding Progressive Taxes Understanding the Skill The federal income tax is progressive: a person with a low income is taxed at a lower rate than a person with a higher income. The table at the bottom of the page shows the 2006 income tax brackets for a single person. If you file as single and your taxable income is $7,125, you are in the 10 percent tax bracket because $7,125 is between $0 and $7,550. If your taxable income is $7,750, then you are in the 15 percent tax bracket, but your tax is not 15 percent of $7,750. Instead, you pay 10 percent on the first $7,550 of your income. You pay 15 percent on the rest Example 1: Calculate tax in the 10 percent tax bracket on $7,125. Tax Tax rate x Income in bracket 10% $7,125 0.10 $7,125 $712.50 The tax on $7,125 is $713. Substitute numbers. Write 10 percent as a decimal. Multiply. Answer the question. Round to the nearest dollar. Example 2: Calculate tax in the 15 percent tax bracket on $7,550. Pay 10 percent on the first $7,550. Tax Tax rate x Income in bracket 10% $7,550 $755.00 Pay 15 percent on the rest of the income. Income in 15% bracket Total income – Income in 10% bracket $7,750 $7,550 $200 Tax Tax rate x Income in bracket 15% $200 $30.00 Add the tax from the two brackets together to find the total tax. $755.00 $30.00 $785.00 Applying the Skill Using the tax bracket table on the right, calculate the taxes on the following taxable incomes: A. $7,175 C. $74,100 B. $17,225 D. $98,975 2006 Federal Income Tax Brackets (Single) Income Bracket Tax Rate $0–$7,550 $7,550–$30,650 $30,650–$74,200 $74,200–$154,800 10% 15% 25% 28% Math Handbook R7 1.7 Creating Line Graphs Understanding the Skill A line graph is useful for showing how a value changes over time. You can use a spreadsheet or graphing software to make a line graph. In the example, type the years and inflation rates into the software. The software will do most of the above steps for you. See the software’s tutorials or help feature for guidance. United States Inflation Rate (in percent) 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 5.7 4.4 3.2 6.2 11.0 9.1 5.8 6.5 7.6 11.3 Source: U.S. Bureau of Labor Statistics 1 Write the title of the graph and make a grid under it. 2 Write numbers along the left side, or verticle axis, of the grid with 0 at the bottom. The top number should be larger than the largest rate in the table. Label the axis. 3 Write years from the table evenly along the bottom line, or horizontal axis, of the grid. Label the axis. 4 Gra
ph each point where the horizontal line from the inflation rate meets the vertical line from the year. 5 Draw a straight line to connect each point to the point for the next year. Example: Make a line graph showing the rate of inflation from 1970 to 1979. Find the largest rate in the table. It is 11.3.S. Inflation Rate 1 4 5 12 10 Year Applying the Skill Make a line graph to show the unemployment rate from 1993 to 2002. Unemployment Rate (in percent) 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 6.9 6.1 5.6 5.4 4.9 4.5 4.2 4.0 4.7 5.8 Source: U.S. Bureau of Labor Statistics R8 Math Handbook .8 Creating Bar Graphs Understanding the Skill A bar graph is useful for comparing different values. You can use a spreadsheet or graphing software to make a bar graph. In the example, type the oil consumption information into the software. The software will do most of the above steps for you. See the software’s tutorials or help feature for guidance. Leading Oil Consumers (in millions of barrels per day) United States European Union China Japan India Brazil Russia Canada 20.0 14.6 6.4 5.6 2.3 2.1 2.8 2.2 Source: CIA World Factbook, 2005 data 1 Write the title of the graph. Draw a box under it. 2 Write numbers evenly along the vertical axis. The largest number should be larger than 20.0 and the smallest number should be 0. Label the axis. 3 Write the names evenly along the horizontal axis. Label the axis. 4 Draw each bar. Find the oil consumption on the vertical axis. Imagine a horizontal line from the oil consumption to directly above the name. Draw the bar as shown. Each bar should be the same width. Example: Make a bar graph of the oil consumption of the three greatest oil consumers: the United States, the European Union, and China Solution Begin by finding the highest level of oil consumption—the United States with 20 million barrels a day. Then complete the following steps. 25 20 15 10 Leading Oil Consumers 4 United States 3 European Union China Country or Region Applying the Skill Use the information in the table at the top of the page to make a bar graph of the oil consumption of the three leading oil consumers in Asia: China, Japan, and India. Math Handbook R9 1.9 Creating Pie Graphs Understanding the Skill A pie graph is useful for showing the relationship of parts to the whole. The table at the right and the pie graph below show the GDP for various countries and the European Union. The graph makes it easy to see how each GDP contributes to the world’s total GDP. The example shows how to make the pie graph. GDP (trillions of U. S. dollars) and Population (millions of people) of Various Countries and the European Union Country GDP Population Country GDP Population United States European Union China Japan India Brazil 11.8 11.7 7.3 3.7 3.3 1.5 296 457 Russia Canada 1,306 Mexico 127 South Korea 1,080 Indonesia 1.4 1.0 1.0 0.9 0.8 143 33 106 49 242 186 Other 11.1 2,421 Source: CIA World Factbook, 2005 data Example 1 Write a title for the pie graph. 2 Draw a circle. This represents the total GDP of all countries, or $55.5 trillion. 3 Draw a wedge to represent each country or group of countries. Calculate the angle for each wedge using this formula: Angle Country’s GDP ___________ World GDP 4 Label each wedge with the country name and the amount of GDP. Wedges too small to draw easily can be grouped together and labeled “Other.” 360° 1 World GDP (in trillions of U.S. dollars) United States 11.8 3 Other 17.7 4 2 European Union 11.7 India 3.3 Japan 3.7 China 7.3 Applying the Skill Use the information in the table at the top of the page to make a pie graph of the populations of the world. Include wedges for the five largest countries, and one for all others. R10 Math Handbook .10 Creating a Database Understanding the Skill A database is a large collection of information that can be organized and searched. You can use a spreadsheet to make a database. First enter information into the spreadsheet. Label each row and column, including units of measure. You can use the spreadsheet software to manipulate the information and answer questions. Example Which country has the largest per capita oil consumption? A B C D E F G United States European Union Japan Russia Canada Mexico 20.0 14.6 5.6 2.8 2.2 1.8 296 457 127 143 33 106 1 2 3 Oil Consumption (millions of barrels per day) Population (millions of people) Solution Per capita oil consumption is oil consumption divided by population. For the U.S. it is 20.0 million barrels per day ______________________ 296 million people 0.07 barrels per person per day. 20.0 barrels per day ________________ 296 people A B C D E F G 1 Divide row 2 by row 3. Put the answer in row 4. 2 Sort the whole database by row 4, from largest to smallest. 1 2 3 4 Oil Consumption (millions of barrels per day) Population (millions of people) Per capita oil consumption (barrels/person/day) United States Canada Japan European Union Russia Mexico 20.0 2.2 5.6 14.6 2.8 1.8 296 33 127 457 143 106 0.07 0.07 0.04 0.03 0.02 0.02 Once the database is sorted, the United States and Canada are the first in the new order. So the United States and Canada are the countries in the database that have the greatest per capita oil consumption, with consumptions of 0.07 barrels per person per day. Applying the Skill Make a database of the information in the table on page R10, by entering the information into spreadsheet software. Multiply each GDP by 1 trillion so the units are “dollars” instead of “trillions of dollars.” Multiply each population by 1 million so the units are “people” instead of “millions of people”. Math Handbook R11 Skillbuilder Handbook Contents Refer to the Economics Skillbuilder Handbook when you need help in answering Application questions or questions in Section Assessments and Chapter Assessments. In addition, the handbook will help you answer questions about charts, graphs, databases, and economic models. Skills for Understanding Economics 1.1 Explaining an Economic Concept 1.2 Analyzing and Interpreting Data 1.3 Applying Economic Concepts 1.4 Creating and Interpreting Economic Models 1.5 Using a Decision-Making Process 1.6 Conducting Cost-Beneﬁ t Analyses 1.7 Comparing and Contrasting Economic Information 1.8 Analyzing Cause and Effect 1.9 Making Inferences and Drawing Conclusions 1.10 Evaluating Economic Decisions 1.11 Synthesizing Economic Data 1.12 Generalizing from Economic Information 1.13 Predicting Economic Trends Using Print, Visual, and Technology Sources 2.1 Analyzing Political Cartoons 2.2 Distinguishing Fact from Opinion 2.3 Evaluating Online Sources Interpreting Graphs 2.4 2.5 Interpreting Tables 2.6 Analyzing Databases R13 R14 R15 R16 R17 R18 R19 R20 R21 R22 R23 R24 R25 R26 R27 R28 R29 R30 R31 R12 Skillbuilder Handbook .1 Explaining an Economic Concept EXPLAINING ECONOMIC CONCEPTS involves clarifying and communicating the basic ideas of economics. Some of these concepts are simple, while others are complex. Three basic steps will help you develop an explanation of a concept, regardless of its complexity. Understanding the Skill STRATEGY: Use the steps in the concept-explanation process. The following passage provides information on economic recessions. The table below that provides an analysis of the concept of economic recession based on the concept-explanation process. 1 Identify and define the economic concept. 2 Describe the impact of the concept on the economy. 3 Give an example of the concept. Providing an illustrative example will help underscore your explanation of the concept. 1 An economic recession may be defined as a downturn in the business cycle. During a recession, both production and employment decline. 2 As a result, the economy experiences little, if any, growth. 3 In 1990 and 1991, the United States experienced the greatest recession since the Great Depression. According to some economic analysts, the 1990–1991 recession caused the loss of 1.9 million jobs in 1992. Make a Table Use a table like the one shown here to help you explain an economic concept with the threestep process. Explaining an Economic Concept Economic recession A downturn in the business cycle, characterized by a decline in production and employment Slows economic growth U.S. recession of 1990-1991 Concept Definition Impact Example Applying the Skill Turn to Chapter 7, Section 4, and read about deregulation on page 218. Use a table to explain the economic concept of deregulation with the three-step process. Skillbuilder Handbook R13 1.2 Analyzing and Interpreting Data DATA, or factual information, is the most basic tool of the economist. Economic data is most often in the form of statistics. Economists ANALYZE data to learn about economic conditions and trends. They INTERPRET data to draw conclusions or make predictions based on their analysis. Understanding the Skill STRATEGY: Analyze and interpret the data. Data usually is presented in visual form as a graph or a table like the one below. 1 Read the title. The title provides 1 a good indication of the kind of data shown. Here, the data concerns average food expenditures for several large cities in the Midwest of the United States. 2 Determine how the data is organized. Here, data in each horizontal row provides information on a category of food expenditure. Each vertical column shows expenditures by food category for one of five metropolitan areas. 3 Ask what kinds of questions may be answered from the data. Answering such questions helps in the analysis and interpretation of the data. 1 Average Annual Household Food Expenditures in Selected Midwestern Metropolitan Areas, 2003–2004 (in dollars) Chicago Detroit Milwaukee MinneapolisSt. Paul Cleveland 2 2 Cereals and Bakery Meats, Fish, and Eggs Dairy Fruits and Vegetables 472 855 366 606 470 863 339 542 Other Foods at Home 1,128 1,073 460 837 309 506 950 Food Away from Home 2,597 2,439 2,126 509 779 431 610 1,236 2,983 388 854 310 449 822 1,765 Source: Consumer Expenditure Survey, 2003–2004, U.S. Bur
eau of Labor Statistics 3 Write a Summary Summarize your analysis and interpretation of the data in the table Data in the above table reflects average annual household food expenditures for one year (2003-2004) for 5 Midwestern metropolitan areas. Food expenditures are shown according to type of food purchased: a food at home versus food away from home. The data may be analyzed and interpreted in a number of ways, including the following: comparing expenditures in different cities for foods in a single category or comparing expenditures for two or more food categories within a city; computation of percentages of total expenditure spent on specific food categories. Applying the Skill Turn to Chapter 14, Section 2, page 421, and study the table showing data on itemized tax deductions. Write a summary of your analysis and interpretation of data in the table. R14 Skillbuilder Handbook 1.3 Applying Economic Concepts When attempting to understand complex economic behavior, economists make constant use of fundamental economic concepts, such as supply, demand, and price. By APPLYING ECONOMIC CONCEPTS to everyday situations, economists develop a better understanding of how the economy works. Understanding the Skill STRATEGY: Examine the information carefully. The news story below describes a fall in the price of crude oil. The supply and demand curves beneath it graphically illustrate this shift Crude Oil Prices Sink Below $66 a Barrel 1 1 Oil prices fell below $66 a barrel Monday as concerns over supplies eased in expectation that 2 OPEC ministers would not change their production targets. . . . 1 Supplies remain ample. . . . OPEC maintains about 2 million barrels a day of spare capacity, and stocks are high elsewhere; the U.S. Department of Energy said last week that inventories have hit their highest 1 levels since 1998. . . . 2 The possibility that [British Petroleum] could restore 180,000 barrels per day of lost Alaskan production at Prudhoe Bay by the end of October also calmed the market. 1 Source: Associated Press, September 11, 2006 1 Look for economic concepts as you read. Such words as prices, supplies, inventories, and capacity indicate that the topic of this story is the relationship between supply and price. 2 Look for relationships among concepts. The story states that OPEC, the oil-producing cartel, has decided not to curtail production. It also notes that BP could restore lost oil production. So, even if demand remains constant, an increase in supply will cause the equilibrium price to fall. 3 Express the relationship in graphic form. Supply and demand curves provide a vivid picture of the impact of increased supply on price. Draw Demand and Supply Curves Draw demand and supply curves to illustrate the situation described in the news story. Assume that demand stays constant. The increased supply shifts the supply curve to the right (from S1 to S2), causing prices to fall (from P1 to P2). 3 Applying the Skill In the business section of a newspaper, find a story about a change in price. Analyze the information in the story to determine why the price changed. Then draw supply and demand curves that illustrate the shifts that caused such a change. Skillbuilder Handbook R15 1.4 Creating and Interpreting Economic Models CREATING an economic model involves using information and ideas to show an economic concept or situation in a visual way. An ECONOMIC MODEL might be a graph, a diagram, a three-dimensional representation, or a computer program. INTERPRETING AN ECONOMIC MODEL involves carefully studying the model in order to draw conclusions or make predictions based on the information it provides. Understanding the Skill STRATEGY: Create an economic model. The model below is a circular flow diagram. Economists use the circular flow model to help understand and describe how a market-based economy operates. Use the following steps to create an economic model. 1 Gather the information you need to create an economic model. In this case, you need to show the rules that govern the relationships between economic actors and economic markets in a market economy. 2 Visualize and sketch an idea of your model. The creator of this economic model used a circular diagram to convey the relationships between economic markets and economic actors. 3 Think of symbols you may want to use. Here, different colored arrows indicate the flow of money and the flow of resources and products. The Circular Flow Model 1 Business revenue 3 Product Market Sell goods and services Buy goods and services Consumer spending 2 Businesses Buy productive resources Households (Individuals) Sell land, labor, capital, entrepreneurship Payments for resources Factor Market Income from resources Interpret the Model Write a summary of your interpretation of the information in the model. This model illustrates the interactions between businesses and individuals in the economy. The two main economic decision makers, businesses and households, are shown on the left and right of the model. The two main economic markets, product and factor, are shown at the top and bottom. The green arrows represent the flow of money between actors and through the markets. The blue arrows represent the flow of resources and products through the economy. Applying the Skill Turn to Chapter 7, Section 1, and read the information on perfect competition on pages 192–194. Create an economic model that shows the relationship between two actors—buyers and sellers—in a perfectly competitive market. R16 Skillbuilder Handbook 1.5 Using a Decision-Making Process USING A DECISION-MAKING PROCESS involves choosing between two or more options or courses of action. Organized decision-making involves four steps: 1) identify the problem or situation that requires a decision; 2) identify options; 3) predict possible consequences of the decision; 4) put the decision into effect. Understanding the Skill STRATEGY: Use the steps in the decision-making process. The following passage describes how a Polish food producer used a decision-making process to introduce a new product into Poland’s convenience food market. The flow chart organizes the elements of the process that was used Identify the decision that needs to be made. In this passage, the title offers a clue to the problem, which is stated more fully in the text. 2 Identify options. The company might have chosen to stay out of the convenience food market because most Poles did not own microwave ovens. 3 Identify possible consequences of the decision. Remember that there can be more than one possibility. Also look for factors that could affect the consequences. 4 Note what decision was made and the impact it had. 1 Polish Meals in the Microwave? 1 At the beginning of the current millennium, Pudliszki, a Polish firm owned by Heinz, was faced with a decision. Should the company introduce full-course microwaveable meals into Poland’s market for convenience foods? Poland’s accession into the European Union promised to have a positive effect on both employment and disposable income. And with Polish workers averaging 40 hours on the job, projected demand for convenience foods appeared promising—a strong indication for the product’s success. However, households owning microwaves were very much in the minority, which could result in the product’s failure. Perhaps banking on an increase in household microwaves, Pudliszki introduced Meals from the Four Corners of the World. According to Euromonitor, an international market research firm, Pudliszki’s four full-course meals 4 were “reasonably priced and accepted rather well by the market.” 3 3 2 Source: Adapted from “Poland’s EU Membership Presents Packaging Opportunities” by Chris Mercer. Food Industry News, February 2, 2005. Make a Flow Chart In a flow chart, state the decision to be made, its possible consequences, the actual decision, and the actual consequences of the decision. Applying the Skill Read the Chapter 1 Case Study, “The Real Cost of Expanding O’Hare Airport,” on pages 32−33. From this information, identify the four steps of the decision-making process. Present your findings in a flow chart like the one shown at the right. Option and possible consequence: Introduce meals; based on positive projections in the convenience food market; microwaveable meals would be successful. Decision to be made: Should Pudliszki introduce fullcourse microwaveable meals? 4 Decision made and consequence: Pudliszki introduced full-course microwaveable meals; the product was reasonably successful. Option and possible consequence: Do not enter market; based on the low number of households with microwaves; the product would fail. Skillbuilder Handbook R17 1.6 Conducting Cost-Beneﬁ t Analyses A COST- BENEFIT ANALYSIS involves determining the economic costs and benefits of an action and then balancing the costs against the benefits. Understanding the Skill STRATEGY: Look for the trade-offs that are a part of every economic decision. The passage below describes the costs and benefits of a government-subsidized business development in Hong Kong. The decision-making grid beneath it summarizes the trade-offs in the project. 1 Identify the decision that is being made. The article notes that the Hong Kong government signed an agreement with a large private company to construct a new business. 2 Note the potential benefits of the decision. Here, government officials provide estimates of the economic benefits—jobs and money pumped into the economy. 3 Note the potential costs of the decision. The article focuses on the huge cost of the project to the government. 4 Determine if the decision is beneficial. Make a Diagram Summarize the costs and benefits of the Hong Kong government’s decision in a diagram. Consider the wisdom of the decision by analyzing these costs and benefits. Applying the Skill Turn to page 125 and read the article titled “The Year of the Hybrid.” Based on the information you find there, conduct a cost-benefit
analysis of buying a hybrid automobile. R18 Skillbuilder Handbook 2 1 Hoping to jump-start their economy, government officials in Hong Kong inked an agreement with Walt Disney to build the U.S. company’s third overseas theme park. . . . Government officials estimate that construction of Hong Kong Disneyland will create 16,000 jobs. Another 18,400 jobs will be created once the park opens in 2005. Further, they hope that the park will draw millions of tourists to this city every year, raising more than US $1 billion a year. Few doubt that the project will provide the city with a shot of confidence. Yet John Whaley, a Virginia-based economist, says the construction jobs provided by the project will be short-term positions, with little long-term economic impact. Also, since many tourists to Hong Kong are people of modest means from China, there is no guarantee that they will spend the money to go to the park. 3 Nevertheless, much of the costs for the new park will be paid by the Hong Kong government, which is spending more than US $2.83 billion to build the park. Estimates suggest the government is spending about US $100,000 for every new job it will create when the park is running. Source: Adapted from “Disney-Park Deal May Not Wave A Magic Wand Over Hong Kong” by Jon E. Hilsenrath and Zach Coleman. The Wall Street Journal, November 4, 1999. Decision: Hong Kong government partners with Disney to build a new theme park. Potential benefits: Many new jobs; perhaps US $1 billion poured into the economy. Potential costs: Huge initial outlay by the government; about half the jobs created are short-term. Analysis: Too soon to tell, but the fact that potential audience for the park are of modest means does not guarantee success.7 Comparing and Contrasting Economic Information Economists compare and contrast economic programs, concepts, and trends in order to understand them better. COMPARING involves finding both similarities and differences between two or more things. CONTRASTING means examining only the differences between them. Understanding the Skill STRATEGY: Look for similarities and differences. The following passage describes pension reform in Chile and in Britain. The Venn diagram that follows the passage shows some of the similarities and differences between the two economic programs. 1 Compare: Look for features that two subjects or ideas have in common. Here, you learn that both Chile and Britain needed to reform their pension systems. 2 Compare: Look for clue words indicating that two things are alike. Clue words include all, both, as, likewise, and similarly. 3 Contrast: Look for clue words that show how two things differ. Clue words include different, however, unlike,and except. 4 Contrast: Look for ways in which two things are different. Here you learn that the structure and the administration of the two programs were different. Pension Reform in Chile and Britain In the late 20th century, Chile and Britain faced 1 the same problem: how to reform their overburdened pension systems. 2 Both countries had social welfare budgets that were stretched to the limit. And both had pension systems that were nearly bankrupt. To provide for their aging population, Chile and Britain chose privatization as the means to reform their pension programs. 3 However, 4 the structure and administration of the two programs were very different. For example, in Chile a monthly payroll deduction became mandatory for all employees. The payments are administered by one of six private pension funds. In Britain, however, the plan was voluntary. Six million people chose the plan when it was first offered. They received a government rebate, along with responsibility for managing their own retirement money. Source: Adapted from ”In Britain and in Chile, Lessons for Social Security” by Mark Rice-Oxley and Jennifer Ross. The Christian Science Monitor, March 14, 2005 Make a Venn Diagram Summarize similarities and differences in a Venn diagram like the one shown here. In the overlapping area, list characteristics shared by both subjects. Then, in one oval, list the characteristics of one subject not shared by the other. In the other oval, list characteristics unique to the second subject. Applying the Skill Turn to Chapter 8 and read Sections 1 and 2, pages 226–235. Construct a Venn diagram comparing and contrasting sole proprietorships and partnerships. Chile Only Program requirement: mandatory Investment choices: limited Both Problem: pension systems nearly bankrupt Solution: privatization Britain Only Program requirement: voluntary Investment choices: unlimited Skillbuilder Handbook R19 1.8 Analyzing Cause and Effect CAUSES are the events, factors, and other reasons that lead to an event or condition. Causes happen before the event in time; they explain why it happened. EFFECTS are the results or consequences of the event. One effect often becomes the cause of other effects, resulting in a chain of events. Causes and effects can be both short-term and long-term. Understanding the Skill STRATEGY: Keep track of causes and effects as you read. The passage below describes factors leading to a shortfall of qualified staff in India’s call centers. The diagram that follows the passage summarizes the economic chain of causes and effects. 1 Causes: Look for clue words that show cause. These include due to, cause, and therefore. 2 Look for multiple causes and multiple effects. Increased outsourcing to India caused the series of effects discussed in the rest of the article. 3 Effects: Look for results or consequences. Sometimes these are indicated by clue words such as as a result and consequence. 4 Notice that an effect may be the cause of another event. This begins a chain of causes and effects. Each year, three thousand English speakers graduate from India’s universities. 1 Largely due to this pool of job seekers fluent in English, India has been able to establish a highly successful business process outsourcing industry. 2 As businesses in more and more countries outsourced to India, call centers there have become increasingly successful. As a result, salaries for entry-level positions have continued to rise. An unintended 3 consequence of the 4 higher salaries has been a greater tendency of workers to job hop. Increasing success also has created increasing stress, as employees often are required to work long hours. Therefore, employment in call centers, once considered glamorous, has begun to lose its appeal. Analysts claim that such conditions will cause a shortfall of as many as 260,000 qualified workers by 2009. Source: Adapted from “Busy Signals,” The Economist, September 10, 2005 Make a Cause-and-Effect Diagram Summarize cause-and-effect relationships in a diagram. Starting with the first cause in a series, fill in the boxes until you reach the end result. Cause Effect / Cause Effect / Cause Effect / Cause Effect Many of India’s college graduates speak English. Outsourcing industry enjoys success. • Pay improves for entry-level jobs. • On-the-job stress increases. • Workers change jobs often. • Fewer people apply. There will soon be a shortage of qualified workers. Applying the Skill Turn to Chapter 2 and read “Under Pressure to Change” on page 40. Construct a Cause-and-Effect diagram summarizing the information you find. R20 Skillbuilder Handbook .9 Making Inferences and Drawing Conclusions MAKING INFERENCES involves reading between the lines to extend the information provided. DRAWING CONCLUSIONS involves analyzing what has been read and forming an opinion about its meaning. Understanding the Skill STRATEGY: Develop inferences from the facts. Use the facts to draw conclusions. The passage below describes the U.S. trade deficit in 2005. The diagram that follows shows how to organize the facts and inferences to draw conclusions. 1 Read carefully to understand all the facts. Fact: The U.S. trade deficit rose almost 18 percent in 2005. 2 Use the facts to make an inference. Inference: It’s unlikely that the United States will see a trade surplus in the foreseeable future. 3 Read between the lines to make inferences. Inference: Continued dependence on foreign oil will continue to increase the deficit. 4 Ask questions of the material. How can the United States reduce its trade deficit? 5 Use all this information to draw a conclusion. Conclusion: In order to reduce the deficit, the United States will need to reduce its dependence on foreign oil. 1 The U.S. trade deficit jumped nearly 18 percent in 2005, the government reported Friday, hitting its fourth consecutive record as consumer demand for imports increased, energy prices soared and the dollar strengthened against other currencies. The $725.8 billion gap, 1 which is almost exactly twice the deficit in 2001, was driven by a 12 percent jump in imports and a more muted 10 percent increase in exports, the Commerce Department reported in Washington. 2 The nation last had a trade surplus, of $12.4 billion, in 1975. 3 The nation’s deficit in trade for petroleum products accounted for 29 percent of the total gap, up from 25 percent in 2004. 4 Imports of petroleum goods climbed 39 percent, to $251.6 billion, after rising by 39 percent in 2004. Excluding oil and other petroleum products, the trade deficit would have grown 10 percent, to $537 billion. Source: “The U.S. Trade Deficit Hit Record High in 2005” by Vikas Bajaj. The New York Times, February 10, 2006 Applying the Skill Read the online news story “China’s Economic Miracle; the High Price of Progress” on page 571. Use the chart at the right as a model for organizing facts, inferences, and conclusions about the passage. Facts Inferences Conclusion about Passage The U.S. trade deficit rose almost 18 percent in 2005. The deficit nearly doubled between 2001 and 2005. The deficit is growing at a marked rate. Last trade surplus was in 1975. Trade surplus is unlikely in foreseeable future. Trade in petroleum products accounted for 29 percent of defi
cit. Continued dependence on foreign oil will continue to increase the deficit. 5 In order to reduce the deficit, the United States will need to reduce its dependence on foreign oil. Skillbuilder Handbook R21 1.10 Evaluating Economic Decisions EVALUATING ECONOMIC DECISIONS means making judgments about decisions that individuals, businesses, and governments make on economic matters. Economists evaluate a decision based on its outcome and the choices available when that decision was made. Understanding the Skill STRATEGY: Look for choices and reasons. The following passage describes the marketing decisions Joe Sillett made to promote a cricket bat he had begun to manufacture. As you read the passage, look for alternative decisions he could have made. 1 Look at decisions made by individuals or by groups. Identify the decision Sillett made to market his company’s product. 2 Look at the outcome of the decisions. 3 Analyze a decision in terms of the choices that were possible. Sillett could have chosen a marketing strategy that was less expensive and therefore less risky. Make a simple chart of your analysis. Applying the Skill Pages 234–235 of Chapter 8 describe Bart’s decision to open his comic store as a partnership rather than a sole proprietorship. Make a chart like the one shown to summarize the pros and cons of his decision and your evaluation of that decision. Marketing Woodworm When Joe Sillett formed his company, Woodworm, to make cricket bats, he was up against stiff competition. . . Sillett had to decide how to break into the market. Should he utilize traditional marketing techniques, such as the development and purchase of print and media ads, to introduce his product? Or should he try something bolder? 1 Sillett decided to risk most of his marketing budget on a single idea: the sponsorship of two English heavy hitters—Andrew Flintoff and Kevin Pietersen. Sillett’s idea proved to be a winner. 2 In just three years, Woodworm bats succeeded in capturing ten percent of the cricket bat market. 3 Sillett knew that a less expensive approach would have allowed him to grow his company over a more extended period of time. But because he believed that linking Woodworm bats with high profile players would quickly create brand recognition, Sillett risked the future of his company on a single marketing idea and won. Source: Adapted from “The Benefits of Woodworm.” The Economist, September 8th, 2005 3 Sillett’s Choices Pros Cons Evaluation Sponsor popular players Possible to gain market share quickly Risky and expensive Pursue a less expensive marketing strategy Less risky Market share likely to grow slowly In your opinion, which was the better choice? Why? R22 Skillbuilder Handbook .11 Synthesizing Economic Data SYNTHESIZING ECONOMIC DATA is the skill economists use to develop interpretations of past economic events. Like detective work, synthesizing involves putting together clues from data to form an overall picture of an economic event. Understanding the Skill STRATEGY: Build an interpretation as you read. The passage below describes the collapse of Enron, a giant American energy company. Note how combining different data leads to a synthesis—an overall picture of Enron’s fall and its significance. 1 Read carefully to understand the data. These statements explain why Enron borrowed money and how it succeeded in hiding $600 million in debt. 2 Look for variables in the data that need an explanation. Here, the data in the two statements present a puzzling picture. They lead one to question how a large company that tripled its profits could experience a loss of $638 million less than a year later. 3 Form a synthesis based on the data. This interpretation brings together the different pieces of data to arrive at a new understanding of the subject. Summarize your synthesis in a graphic organizer, such as a table or a cluster diagram. Enron’s Downfall 1 Enron began to borrow money to invest in new projects. Enron then created partnerships to keep the debt off its books. One partnership . . . allowed Enron to keep $600 million in debt off the books it showed to the government and to people who own Enron stock. 2 In December 2000, Enron claimed to have tripled its profits in two years. 2 The collapse began in October [2001], when Enron announced a loss of $638 million. In November, Enron said that it had overstated earnings for the past four years and it now owed over $6 billion. With these announcements, Enron’s stock price took a dive. 3 Since Enron had made deals based on the assumption that the stock would go up, it suddenly had to repay lots of money. When Enron could not come up with the cash, it declared bankruptcy. 3 [One] consequence of [Enron’s] failure may be new laws that change how much money big businesses can give politicians. Enron gave over $5 million to [political] campaigns since 1998. Lawmakers [also] are considering whether to make new laws to better regulate accounting practices. Source: “Not Business as Usual,” by Elisabeth Bauman. Online NewsHour Extra, January 30, 2002 (www.pbs.org) Applying the Skill Read the information on income distribution and income inequality on pages 390–391. Look for data to support a synthesis about the effectiveness and limitations of measuring income inequality. Organize your findings in a table or cluster diagram. Skillbuilder Handbook R23 1.12 Generalizing from Economic Information GENERALIZING involves making broad judgments based on information from more than one source. When you form generalizations, you need to be sure they are based on sufficient evidence and that they are consistent with the information given. Understanding the Skill STRATEGY: Look for common themes. The following three excerpts reflect concern regarding the economic deprivation of the elderly during the Great Depression. 1 Determine what information the sources have in common. All the sources suggest the need for a government program to provide pensions to the elderly. 2 Form a generalization about the common information. 3 State your generalization in sentence form. A generalization often needs a qualifying word, such as most, many, or some, to make it valid. Plight of the Elderly 1 We also propose to give the old-age pensions to the old people . . . so that the people who reach the age of sixty can be retired from the active labor of life and given an opportunity to have surcease [rest] and ease for the balance of the life that they have on earth. —Governor Huey Long of Louisiana 1 “Old age dependent pensions . . . are not gifts from charity. They are for compensation well earned.” —Flyer attached to a letter written to President Franklin D. Roosevelt by a woman asking for help for her 81-year-old mother 1 “It is estimated that the population of the age of 60 and above in the United States is somewhere between nine and twelve millions. I suggest that the national government retire all who reach that age on a monthly pension of $200 a month or more.” —Francis E. Townsend Make a Web Diagram Using a diagram can help you make generalizations. The diagram below records relevant information from the three statements that leads to a valid generalization. Huey Long calls for government pensions for those 60 and older. Printed flyer promotes the idea that the elderly deserve pensions. 2 3 Generalization Many people believed that the government should provide economic support for elderly Americans. Townsend proposes pension plan for the elderly. Applying the Skill Read the information under the headings “Changing Occupations” and “Changes in the Way People Work” on pages 268–271. Use a diagram like the one above to make a generalization about technology and work in the United States today. R24 Skillbuilder Handbook .13 Predicting Economic Trends PREDICTING ECONOMIC TRENDS involves projecting the outcome or the continuation of an economic condition or trend. Economists use their knowledge of past economic events and conditions and related decisions to predict the outcome of current economic events and conditions. Understanding the Skill STRATEGY: Identify decisions. The following passage describes how the United States government, under the leadership of President Franklin D. Roosevelt, dealt with a nationwide banking crisis during the Great Depression. 1 To help you identify decisions, look for clue words. These words include decide, decision, and chose. 2 Notice how one economic decision often leads to others. 3 Notice that decisions may have positive or negative impacts. 4 Consider alternatives to the decisions that were made. 5 Make a chart to record decisions, suggest alternative decisions, and predict a possible outcome for each alternative decision. During the Great Depression, many banks in the United States failed. In 1933 Americans, fearing the loss of their money, created “runs” on banks throughout the country. A bank run occurs when large numbers of people attempt to withdraw money within a short period of time. Banks did not have enough money to meet the demand. In response, President Roosevelt 1 decided to temporarily shut down the nation’s banks by proclaiming a bank holiday. 2 Congress 1 chose to pass a law in support of Roosevelt’s decision. The law also provided for the rehabilitation of the nation’s banking facilities. To avoid an epidemic of bank failures, 3 it was decided not to reopen all the banks at the same time. Instead, banks would open once they had been examined and judged to be sound. In addition, the government made the 1 decision to issue new currency—based on sound assets—so that banks, once reopened, would have enough currency to meet increased demand. Finally, it was decided to include state banks that were not members of the Federal Reserve in the rehabilitation process. The government response to the banking crisis served to stabilize the U.S. banking system. Source: Franklin D. Roosevelt’s First Fireside Chat, March 12, 1933 5 Applying the Skill Read the document
titled “Two American Entrepreneurs Start Out in a Garage” on page 252 and identify three business decisions that “the two Steves” made. Record them in a chart similar to the one shown for the passage above, along with an alternative decision for each. Then predict a possible outcome for each alternative decision. Decisions Alternative Decisions 4 Prediction of Outcome FDR proclaimed a nationwide bank holiday. FDR did not proclaim a bank holiday. The run on banks continued. Congress passed a law to rehabilitate banking facilities. Congress passed no law to rehabilitate banking facilities. Banks were not rehabilitated. New currency was issued. New currency was not issued. There was not enough money to meet depositors’ demands. State banks would receive assistance. Fed did not assist non-member state banks. State banks failed to reopen. Skillbuilder Handbook R25 2.1 Analyzing Political Cartoons POLITICAL CARTOONS are drawings that express the artist’s point of view about a local, national, or international situation or event. They may criticize, show approval, or draw attention to a particular issue, and may be either serious or humorous. Political cartoonists often use symbols as well as other visual clues to communicate their message. Understanding the Skill STRATEGY: Examine the cartoon carefully. The cartoon below was drawn as a comment on the process of globalization. 1 1 Look at the cartoon as a whole to determine the subject. 2 Look for symbols, which are especially effective in communicating ideas visually. Here, the cartoonist uses symbols that stand for a global economy. The arm in a suit stands for big business. The globe stands for Earth and its resources. The people represent consumers. 3 Analyze the visual details, which help express the artist’s point of view. The Western-style house and clothing suggest that the people are Americans or Europeans. The people are smiling, indicating that they are happy about what is being offered to them. Make a Chart Summarize your interpretation in a chart. Look for details and interpret their significance. Then decide on the message of the cartoon. Symbols and Visual Details Significance Message • Oversized arm in • Corporations business suit • Disproportionately small Earth • Happy people reaching out • Earth as the property of big business • Consumers Big business is the driving force behind globalization. R26 Skillbuilder Handbook 2 3 Applying the Skill Turn to page 283 and study the political cartoon. Note the clothing and apparent attitudes of the figures in the cartoon, as well as how they relate to one another. Then analyze the cartoon by making a chart like the one to the right.2 Distinguishing Fact from Opinion FACTS are events, dates, statistics, or statements that can be proved to be true. Facts can be checked for accuracy. OPINIONS are judgments, beliefs, and feelings of the writer or speaker. Understanding the Skill STRATEGY: Find clues in the text. The following excerpt describes economist Sir William Beveridge’s 1942 recommendations for creating a welfare state in Great Britain. 1 Facts: Look for specific names, dates, statistics, and statements that can be proved. The first paragraph gives a factual account of the government’s plan. 2 Opinion: Look for assertions, claims, hypotheses, and judgments. Beveridge expresses his opinion regarding provision for old age and for medical care. 3 Opinion: Look for judgment words that the writer uses to describe policies and events. Judgment words are often adjectives that are used to arouse a reader’s emotions. Make a Chart Divide facts and opinions in a chart. Summarize and separate the facts from the opinions expressed in the passage. 1 The coalition British Government has unveiled plans for a welfare state offering care to all from the cradle to the grave. The Beveridge report proposes a far-reaching series of changes designed to provide a financial safety net to ensure a “freedom from want” after the war is over. Everyone of working age would be expected to pay a weekly national insurance contribution. In return benefits would be paid to the sick, widowed, retired, unemployed and there would also be an allowance for families. The architect of the report, economist Sir William Beveridge, drew on advice from various government departments. 2 He found provision for old age represented one of the most pressing problems. But there were other failings too. Medical provision was not universally available to all and Britain’s achievement, in his words, “fell seriously short” compared with other countries of the world. At a time when the war was destroying landmarks of every kind, [Beveridge] said, it was a 3 “revolutionary moment in the world’s history, a time for revolutions, not for patching.” Source: BBC News Facts Opinions In 1942 the British government unveiled plans for a welfare state. The plan was based on a report by Sir William Beveridge and was designed to provide British citizens with a financial safety net. • The British government’s provision for old age represented one of the most pressing problems. • Britain’s medical provision fell seriously short as compared to that of other countries. •• It was a revolutionary moment in history. Applying the Skill Read “Government and Demand-Side Policies” on page 457. Using a chart like the one to the left, summarize the facts, opinions, and judgments stated. Look carefully at the language used in order to separate one from the other. Skillbuilder Handbook R27 2.3 Evaluating Online Sources EVALUATING ONLINE SOURCES involves making judgments about sites that are available on the Internet—a network of computers associated with universities, libraries, news organizations, government agencies, and other information providers. Each location on the Internet has a home page with its own address, or URL. The international collection of home pages, known as the WORLD WIDE WEB, is a good source of up-to-the-minute information as well as in-depth research on economic subjects. Understanding the Skill STRATEGY: Explore and evaluate the elements on the screen. The computer screen below shows “Treasury’s Learning Vault,” the education page of the United States Department of the Treasury. 1 1 Go directly to a Web page. Access the Internet using your Internet Service Provider (ISP). If you know the address of the Web site you want, type it in the address box at the top of your computer screen, then press ENTER or RETURN. (To access the page shown here, type in www.ustreas.gov/education.) 2 Explore the features and links. Click on any one of the images or topics to find out more about a specific subject. These links take you to other pages at this Web site. Some links take you to related information that can be found at other places on the Internet. 3 Evaluate the Web site. Use the information you gathered in Step 2 to evaluate the Web site. Ask yourself the following questions: Is the information provided by the site useful to an economist or a student of economics? How reliable is this information? 2 2 2 Applying the Skill Access the Bureau of Labor Statistics (www.bls.gov) and the Census Bureau (www.census.gov) Websites through ClassZone.com. How useful do you think these sites might be to economists? How might economists use the information on these sites? R28 Skillbuilder Handbook 2.4 Interpreting Graphs GRAPHS show statistical information in a visual manner. Economists use graphs to show comparative amounts, ratios, trends, and changes over time. Interpreting graphs will increase your understanding of economic trends and data. LINE GRAPHS can show changes over time, or trends. Usually, the horizontal axis shows a unit of time, such as years, and the vertical axis shows quantities. PIE GRAPHS are useful for showing relative proportions. The circle represents the whole, such as the entire population, and the slices represent the different groups that make up the whole. BAR GRAPHS compare numbers or sets of numbers. The length of each bar indicates a quantity. With bar graphs, it is easy to see at a glance how different categories compare. Understanding the Skill STRATEGY: Study all the elements of the graph. This double line graph shows the number of new firms started and the number of firm closures from 1994 to 2005 Read the title to identify the content of the graph. Here, the title explicitly states the content of the graph—new firms and firm closures. 2 Read the vertical and horizontal axes. The vertical axis shows the number of firms, and the horizontal axis shows years. 3 Look at the legend to understand what colors and symbols represent. In this graph, different colored lines are used to represent new firms and firm closures. 4 Summarize the information shown in each part of the graph. What trend does each line show? FIGURE 3.1 NEW FIRMS AND FIRM CLOSURES 1 700 600 500 400 300 200 100 New firms Firm closures * Source: U.S. Small Business Administration Year *Estimated Write a Summary Write a summary paragraph to show what you have learned from the graph. 4 Each year from 1994 to 2005, about 600,000 new firms opened in the United States. During the same time period, anywhere from 500,000 to about 575,000 firms closed. In 2001, there actually were more firm closures than new firms opened. The overall trend shows that nearly as many firms close as open each year. Applying the Skill Turn to page 267 and study Figure 9.7, a graph that provides information on the U.S. labor force. Write a paragraph summarizing what you learn from the graph. Skillbuilder Handbook R29 2.5 Interpreting Tables TABLES present information in a visual form. Tables are created by simplifying, summarizing, and organizing information into a format that is easy to understand. Tables are the most commonly used charts in Economics books. Understanding the Skill STRATEGY: Study all the elements of the table. The table shown here provides statistical information about employment in the United States. 1
Read the title to identify the main idea of the table. This table provides information on selected aspects of the United States labor force during 2006. 2 Read the headings to determine how the table is organized. In this table, data is organized by category and by month. 3 Study the data in the table to understand what the table was designed to show. This table shows economic data regarding employment in the United States during a six-month period in 2006. 4 Be sure to read any footnotes provided with the table. Footnotes clarify information. For example, (P) indicates that a statistic is preliminary rather than final. 5 Summarize the information shown in each part of the table. Use the title and side headings to help you focus on what information the table is presenting. Selected Labor Force Statistics, February to July, 2006 1 Unemployment Rate (percent) New Jobs Added (thousands) Average Hourly Earnings1 (in dollars) 4.8 4.7 4.7 4.6 4.6 4.8 200 175 112 100 124p 113p 3 16.47 16.51 16.61 16.62 16.69p 16.76p 2 Month February March April May June July Footnotes: (P) Preliminary (1) For production and nonsupervisory workers, in dollars and cents 4 Source: Bureau of Labor Statistics 5 The table provides statistical information about employment in the United States. Statistics are given for each of six months, from February through July 2006. The unemployment rate fluctuated between 4.6 and 4.8 percent. There was an increase in the number of jobs each month, with the greatest increase occurring in June and the smallest in May. Average hourly earnings rose fairly steadily from $16.47 in February to $16.76 July. Applying the Skill Turn to page 79 and study Figure 3.3. Then write a paragraph summarizing the information presented in the table. R30 Skillbuilder Handbook 2.6 Analyzing Databases A DATABASE is a collection of data, or information, that is organized so that you can find and retrieve information on a specific topic quickly and easily. You can search for specific information without going through the entire database. A database provides a list of all information related to a specific topic. Understanding the Skill STRATEGY: Study the elements of the database. First identify the topic. The title “World’s Top Oil Consumers” indicates the criterion for listing the six nations in the database. Look at the categories shown and pose questions about what you can learn from them. For example, in this database you could search for “countries consuming more than 10 million bbls (barrels) per day” and discover that the United States and the European Union fall into that category Determine the order of presentation of information. The six countries in this database are listed according to the amount of oil they consume, from most to least. 2 Identify the entries included under each heading. Here, the data in each row relates to one of the six countries listed. 3 Determine how the categories in the database relate to one another. This database includes the categories “oil production” and “proved oil reserves.” Both relate to oil consumption. These related categories enable you, for example, to determine which countries, if any, produce less oil than they consume. 4 Read any labels or footnotes that clarify the nature of the data. In this database, the figures represent barrels (bbl) of oil. Also note that for purposes of providing statistical information, the EU is considered to be one country. 5 Note the source of the data. Is the source reliable? The source of data here is The CIA World Factbook, a respected and reliable source of data on the countries of the world. World’s Top Oil Consumers 3 Country Oil Consumption (Millions of bbl1 / day) Oil Production (Millions of bbl1 / day) Proved Oil Reserves (Billions of bbl1) 2 United States 20.0 1 European Union2 14.6 China Russia Saudi Arabia Iran 6.4 2.8 1.8 1.4 7.6 3.4 3.5 9.1 9.5 4.0 22.5 7.3 18.3 69.0 262.7 133.3 4 Footnotes: (1) Barrels (2) For data presentation, treated as a single country 5 Source: The CIA World Factbook, 2005 data Analyze the Database Consider the kinds of information that you could quickly find from the database. For example, you can search for countries that produce or consume more or less oil than a specific number of barrels per day. Make a list of the kinds of information you could search for in this database. Applying the Skill Turn to page A12 in the Economic Atlas and Statistics and review the information in the two sets of graphs. Create a database for United States industry using statistics for the most recent year shown. Consider the steps listed above when creating your database. Skillbuilder Handbook R31 Glossary A absolute advantage n. the ability of one trading nation to make a product more efﬁ ciently than another trading nation (p. 513) aggregate demand n. the sum of all the demand in the economy (p. 360) Board of Governors n. the board of seven appointed members that supervises the operations of the Federal Reserve System and sets monetary policy (p. 476) bond n. a contract a corporation issues that promises to repay borrowed money, plus interest, on a ﬁ xed schedule (p. 240) bounced check see overdraft aggregate supply n. the sum of all the supply in the economy (p. 360) break-even point n. a situation in which total costs and total revenues are the same (p. 142) antitrust legislation n. laws that deﬁ ne monopolies and give government the power to control or dissolve them (p. 214) budget n. a plan for allocating income for saving and spending (p. 574) appropriations n. set amounts of money put aside for speciﬁ c purposes (p. 431) budget deﬁ cit n. a situation in which the government spends more than it takes in (p. 462) authoritarian adj. requiring absolute loyalty and obedience to authority (p. 43) budget surplus n. a situation in which the government takes in more than it spends (p. 462) automated teller machine (ATM) n. an electronic device that allows bank customers to make transactions without seeing a bank ofﬁ cer (p. 308) automatic stabilizer n. a feature of ﬁ scal policy that works automatically to steady the economy (p. 447) B balanced budget n. a budget in which total government revenue is equal to total government spending (p. 436) balance of payments n. a record of all the transactions that occurred between the individuals, businesses, and government units of one nation and those of the rest of the world (p. 529) balance of trade n. the difference between the value of a country’s imports and exports (p. 529) bull market n. a situation in which stock market prices rise steadily over time (p. 335) business cycle n. the series of growing and shrinking periods of economic activity, measured by increases or decreases in real gross domestic product (p. 358) business organization n. an enterprise that produces goods or provides services, usually to make a proﬁ t (p. 226) business structure see business organization C capital n. all the resources people make and use to produce and distribute goods and services (p. 8) capital budget n. a plan for major expenses or investments (p. 436) bank exam n. an audit, conducted by the Federal Reserve, of a bank’s ﬁ nancial practices (p. 481) capital deepening n. an increase in the ratio of capital to labor (p. 371) bank holding company n. a company that owns more than one bank (p. 481) capital ﬂ ight n. a situation in which capital from a country is invested outside the country (p. 558) barrier to entry n. anything that hinders a business from entering a market (p. 198) barter n. the exchange of goods and services without using money (p. 288) bear market n. a situation in which stock market prices decline steadily over time (p. 335) binding arbitration n. a process by which an impartial third party resolves disputes between management and unions (p. 280) black market n. the illegal business of buying or selling goods or services in violation of price controls or rationing (p. 183) capital gain n. the proﬁ t made from the sale of securities (p. 330) capitalism n. an economic system based on private ownership of the factors of production (p. 49) capital market n. a market in which long-term ﬁ nancial assets are bought and sold (p. 322) cartel n. a formal organization of sellers or producers who regulate the production, pricing, and marketing of a product (pp. 198, 535) cease and desist order n. a ruling requiring a ﬁ rm to stop an unfair business practice (p. 217) central bank n. a nation’s main monetary authority (p. 474) R32 Glossary G l o s s a r y centrally planned economy n. a system in which the society’s leaders make all economic decisions (p. 42) change in demand n. a situation in which a change in the marketplace prompts consumers to buy different amounts of a good or service at every price (p. 109) change in quantity demanded n. a change in the amount of a product that consumers will buy because of a change in price (p. 108) change in quantity supplied n. an increase or decrease in the amount of a good or service that producers are willing to sell because of a change in price (p. 146) competitive pricing n. a situation in which producers sell goods and services at prices that best balance the twin desires of making the highest proﬁ t and luring customers away from rival producers (p. 174) complements n. products that are used together, so the increase or decrease in demand for one will result in an increase or decrease in demand for the other (p. 112) conglomerate n. a business composed of companies that produce unrelated goods or services (p. 243) consumer n. a person who buys goods or services for personal use (p. 5) change in supply n. a situation in which a change in the marketplace prompts producers to offer different amounts for sale at every price (p. 148) consumer price index (CPI) n. a measure of changes in the prices of goods and services that consumers commonly purchase (p. 396) check clearing n. a service provided by the Federal Reserve to record receipts and expend
itures of bank clients (p. 480) circular ﬂ ow model n. a visualization of all interactions in a market economy (p. 52) civilian labor force n. people age 16 or older who are employed or actively looking for and available to do work (p. 266) consumer sovereignty n. the idea that consumers have the ultimate control over what is produced because they are free to buy what they want and refuse products they do not want (p. 50) contingent employment n. temporary or part-time work (p. 270) contract n. a formal, legally binding agreement (p. 598) claim n. a request to an insurance company for payment on an insured loss (p. 596) contraction n. a decrease in economic activity (p. 359); see business cycle closed shop n. a business in which an employer can hire only union members (p. 279) coincident indicators n. measures of economic performance that usually change at the same time as real gross domestic product changes (p. 364) collective bargaining n. the process of negotiation between a business and its organized employees to establish wages and improve working conditions (p. 280) contractionary ﬁ scal policy n. a plan to reduce aggregate demand and slow down the economy during a period of toorapid economic expansion (p. 446) contractionary monetary policy n. a plan to reduce the amount of money in circulation; also called tight-money policy (p. 492) cooperative n. a type of business operated for the shared beneﬁ t of the owners, who are also its customers (p. 250) command economy n. an economic system in which the government makes all economic decisions (p. 39) co-pay n. an amount the insured owes when an insured receives health care (p. 596) commodity money n. money that has intrinsic value based on the material from which it is made (p. 291) corporate income tax n. a tax based on a corporation’s proﬁ ts (p. 412) common stock n. a share of ownership in a corporation that gives the holder voting rights and a share of proﬁ ts (p. 331) communism n. an economic system in which there is no private ownership of property and little or no political freedom (p. 43) corporation n. a business owned by shareholders, also called stockholders, who own the rights to the company’s proﬁ ts but face only limited liability for the company’s debts and losses (p. 238) cosigner n. a person who assumes responsibility for the debt if the borrower fails to repay the loan (p. 583) comparative advantage n. the ability of one trading nation to produce something at a lower opportunity cost than that of another trading nation (p. 513) cost-beneﬁ t analysis n. the practice of examining the costs and the expected beneﬁ ts of a choice as an aid to decision making (p. 15) competition n. the effort of two or more people acting independently to get business by offering the best deal (p. 49) cost-push inﬂ ation n. a situation in which increases in production costs push up prices (p. 399) Glossary R33 Council of Economic Advisers n. the three-member group that advises the President on ﬁ scal policy and other economic issues (p. 452) demand deposits n. checking accounts, so called because checking accounts can be converted into currency “on demand” (p. 293) coupon rate n. the interest rate a bond-holder receives every year until the bond matures (p. 338) craft union n. an organization of workers with similar skills who work in different industries for different employers (p. 274) credit n. the practice of buying goods or services now and paying for them in the future (p. 582) credit report n. a statement by a credit bureau that details a consumer’s credit record (p. 586) credit score n. a number that summarizes a consumer’s creditworthiness (p. 586) crowding-out effect n. a situation in which the government outbids private bond interest rates to gain loanable funds (p. 466) currency n. paper money and coins (pp. 293, 475) customs duty n. a tax on goods imported into the United States (p. 425) customs unions n. agreements that abolish trade barriers among the members and establish uniform tariffs for nonmembers (p. 532) cyclical unemployment n. unemployment caused by the part of the business cycle with decreased economic activity (p. 384) D debit card n. a card one can use like an ATM card to withdraw cash or like a check to make purchases (p. 308) debt restructuring n. a method countries with outstanding debt obligations use to alter the terms of debt agreements to achieve some advantage (p. 559) deductible n. the amount the insured pays before the insurance company pays (p. 596) default n. the condition that occurs when a nation cannot pay interest or principle on a loan (p. 559) deﬁ cit spending n. the government practice of spending more than it collects in revenue for a speciﬁ c ﬁ scal year (p. 462) deﬂ ation n. a decrease in the general price level (p. 398) demand n. the desire to have some good or service and the ability to pay for it (p. 98) demand curve n. a graph that shows a demand schedule, or how much of a good or service an individual is willing and able to purchase at each price (p. 102) demand-pull inﬂ ation n. a condition that occurs when total demand rises faster than the production of goods and services (p. 399) demand schedule n. a table that shows how much of a good or service an individual is willing and able to purchase at each price (p. 100) demand-side ﬁ scal policy n. a plan to stimulate aggregate demand (p. 454) deposit multiplier formula n. a mathematical formula that tells how much the money supply will increase after an initial cash deposit in a bank (p. 485) depreciate v. to decrease in value (p. 590) depression n. an extended period of high unemployment and reduced business activity (p. 359) deregulation n. the reduction or elimination of government oversight and control of business (p. 218) derived demand n. a demand for a product or resource based on its contribution to the ﬁ nal product (p. 259) developed nations n. nations that have a market economy, a relatively high standard of living, a high GDP, industrialization, widespread private ownership of private property, and stable and effective governments (p. 544) differentiated product see product differentiation diminishing returns n. a situation in which new workers cause marginal product to grow but at a decreasing rate (p. 139) discount rate n. the interest rate that the Federal Reserve charges when it lends money to other banks (p. 491) discretionary ﬁ scal policy n. actions taken by the federal government by choice to correct economic instability (p. 446) discretionary spending n. spending that the government must authorize each year (p. 428) disequilibrium n. a situation in which quantity supplied and quantity demanded are not in balance (p. 169) disposable personal income (DPI) n. personal income minus taxes (p. 355) diversiﬁ cation n. the practice of distributing investments among different ﬁ nancial assets to maximize return and limit risk (p. 327) dividend n. the part of a corporation’s proﬁ t that the company pays the stockholders (p. 238) R34 Glossary G l o s s a r y dumping n. the sale of a product in another country at a price lower than that charged in the home market (p. 521) estate tax n. a tax on the assets of a person who has died (p. 425) Dumpster diving n. technique used by identity thieves to gather personal information in the garbage (p. 588) E easy-money policy see expansionary monetary policy economic cycle see business cycle economic growth n. an increase in a nation’s real gross domestic product (p. 358) economic interdependence n. a situation in which producers in one nation depend on others to provide goods and services they do not produce (p. 510) economic model n. a simpliﬁ ed representation of economic activities, systems, or problems (p. 18) economics n. the study of how individuals and societies satisfy their unlimited wants with limited resources (p. 4) economic system n. the way in which a society uses its scarce resources to satisfy its people’s unlimited wants (p. 38) economies of scale n. a situation in which the average cost of production falls as the producer grows larger (p. 201) economize v. to make decisions according what is believed to be the best combination of costs and beneﬁ ts (p. 12) efﬁ ciency n. the condition in which economic resources are used to produce the maximum amount of goods and services (p. 20) elastic adj. referring to a situation in which a change in price, either up or down, leads to a relatively larger change in the quantity demanded or the quantity supplied (pp. 117, 154) elasticity of demand n. a measure of how responsive consumers are to price changes in the marketplace (p. 117) elasticity of supply n. a measure of how responsive producers are to price changes in the marketplace (p. 154) embargo n. a law that cuts off most or all trade with a speciﬁ c country (p. 521) entitlement n. a social welfare program with speciﬁ c eligibility requirements (p. 428) entrepreneurship n. the combination of vision, skill, ingenuity, and willingness to take risks that is needed to create and run new businesses (p. 9) equilibrium price n. the price at which the quantity demanded equals the quantity supplied (p. 164) equilibrium wage n. the wage at which the quantity of workers demanded equals the quantity of workers supplied; the market price for labor (p. 258) European Union (EU) n. the economic and political union of European nations that was established in 1993 (p. 532) euro n. the single currency of the European Union (p. 533) excise tax n. a tax on the production or sale of a speciﬁ c good or service (pp. 149, 425) expansion n. an increase in economic activity (p. 358); see business cycle expansionary ﬁ scal policy n. a plan to increase aggregate demand and stimulate a weak economy (p. 446) expansionary monetary policy n. a plan to increase the amount of money in circulation; also called easy-money policy (p. 492) exports n. goods or services produced in one country and sold to other countries (p. 516) externalit
y n. a side effect of a transaction that affects someone other than the producer or buyer (p. 87) F factor market n. the market for the factors of production— land, labor, capital, and entrepreneurship (p. 52) factors of production n. the economic resources needed to produce goods and services (p. 8) federal budget n. a plan for spending federal tax money (p. 431) federal funds rate (FFR) n. the interest at which a depository institution lends available funds to another depository institution overnight (p. 490) Federal Insurance Contributions Act (FICA) n. a payroll tax that provides coverage for the elderly, the unemployed due to disability, and surviving family members of wage earners who have died (p. 423) Federal Open Market Committee (FOMC) n. the Federal Reserve System board that supervises the sale and purchase of federal government securities (p. 477) Federal Reserve System n. the central bank of the United States; commonly called the Fed (p. 474) ﬁ at money n. money that has no tangible backing but is declared by the government and accepted by citizens to have worth (p. 291) ﬁ ling status n. for ﬁ ling taxes, based on marital status or support of dependents (p. 604) ﬁ nancial asset n. a claim on a borrower’s property (p. 319) Glossary R35 ﬁ nancial intermediary n. an institution that collects funds from savers and invests these funds in ﬁ nancial assets (p. 319) ﬁ nancial market n. a situation in which buyers and sellers exchange ﬁ nancial assets (p. 319) full employment n. a level of unemployment in which none of the unemployment is caused by decreased economic activity; generally marked by an unemployment rate of 4 to 6 percent (p. 383) ﬁ nancial system n. all the institutions that help transfer funds between savers and investors (p. 318) ﬁ scal adj. of or relating to government revenue and spending (p. 446) ﬁ scal policy n. the federal government’s use of taxing and spending to affect the economy (p. 446) ﬁ scal year n. a 12-month period for which an organization plans its expenditures (p. 431) ﬁ xed costs n. expenses that business owners incur no matter how much they produce (p. 140) ﬁ xed rate of exchange n. a system in which the currency of one nation is ﬁ xed or constant in relation to other currencies (p. 526) ﬂ exible exchange rate n. a system in which the exchange rate for currency changes as supply and demand for the currency changes; also called the ﬂ oating rate (p. 527) focus group n. a moderated discussion with small groups of consumers (p. 208) foreign exchange market n. a market in which currencies of different countries are bought and sold (p. 526) foreign exchange rate n. the price of one currency in the currencies of other nations (p. 526) franchise n. a business made up of semi-independent businesses that all offer the same products or services (p. 248) franchisee n. a semi-independent business that pays a fee for the right to sell the parent company’s products or services in a particular area (p. 248) free contract n. a situation in which people decide for themselves which legal agreements to enter into (p. 73) free enterprise system n. another name for capitalism, an economic system based on private ownership of productive resources (p. 70) free rider n. a person who does not pay for a good or service but who beneﬁ ts from it when it is provided (p. 85) free-trade zone n. a speciﬁ c region in which trade between nations takes place without protective tariffs (p. 532) future n. a contract to buy or sell a stock on a speciﬁ ed future date at a preset price (p. 333) G general partnership n. a partnership in which each partner shares the management of the business and is liable for all business debts and losses (p. 233) geographic monopoly n. a monopoly that exists because there are no other producers or sellers within a certain region (p. 201) gift tax n. a tax on money or property given by one living person to another (p. 425) glass ceiling n. an unseen, artiﬁ cial barrier to advancement that women and minorities sometimes face (p. 262) global economy n. all the economic interactions that cross international boundaries (p. 61) gold standard n. a system in which the basic monetary unit is equal to a set amount of gold (p. 299) goods n. physical objects, such as food, clothing, and furniture, that can be purchased (p. 5) government monopoly n. a monopoly that exists because the government either owns and runs the business or authorizes only one producer (p. 201) grant-in-aid n. a transfer payment from the federal government to state or local governments (p. 432) gross domestic product (GDP) n. the market value of all ﬁ nal goods and services produced within a nation in a given time period (p. 350) gross national product (GNP) n. the market value of all ﬁ nal goods and services produced by a country in a given time period (p. 355) H hacking n. technique used by identity thieves to gather personal information using computers and related technology (p. 588) horizontal merger n. the joining of two or more companies that offer the same or similar products or services (p. 243) frictional unemployment n. the temporary unemployment of workers moving from one job to another (p. 384) human capital n. the knowledge and skills that enable workers to be productive (p. 261) R36 Glossary G l o s s a r y human development index (HDI) n. a combination of a nation’s real GDP per capita, life expectancy, adult literacy rate, and student enrollment ﬁ gures that indicates what life is like in a speciﬁ c country (p. 547) hyperinﬂ ation n. a rapid, uncontrolled rate of inﬂ ation in excess of 50 percent (p. 398) I identity theft n. the use of someone else’s personal information for criminal purposes (p. 588) imperfect competition n. a market structure that lacks one or more of the conditions needed for perfect competition (p. 195) imports n. goods or services produced in one country and purchased by another (p. 516) incentive n. a beneﬁ t offered to encourage people to act in a certain way (pp. 12, 176) incidence of a tax n. the ﬁ nal burden of a tax (p. 415) income distribution n. the way income is divided among people in a nation (p. 390) income effect n. a change in the amount of a good or service a consumer will buy because his or her income (and therefore purchasing power) changes (p. 107) income inequality n. the unequal distribution of income (p. 390) increasing returns n. a situation in which hiring new workers cause marginal product to increase (p. 139) independent contractor n. someone who sells his or her services on a contract basis (p. 270) individual income tax n. a tax based on an individual’s income from all sources (p. 412) industrial union n. an organization of workers with many different skills who work in the same industry (p. 274) inelastic n. a situation in which quantity demanded or quantity supplied changes little as price changes (pp. 117, 155) infant industries n. new industries that are often unable to compete against larger, more established competitors (p. 523) infant mortality rate n. the number of children who die within the ﬁ rst year of life per 1,000 births (p. 547) inferior goods n. goods that consumers demand less of when their incomes rise (p. 110) inﬂ ation n. a sustained rise in the general price level, or a sustained fall in the purchasing power of money (p. 396) inﬂ ation rate n. the rate of change in prices over a set period of time (p. 397) infrastructure n. the basic set of support systems—such as power, communications, transportation, water, sanitation, and education systems—needed to keep an economy and society going (pp. 86, 545) input costs n. the price of the resources needed to produce a good or service (p. 148) insourcing n. the practice of foreign companies establishing operations in, and therefore bringing jobs to, the United States (p. 269) interest n. a fee a bank pays for the use of money (p. 578) International Monetary Fund (IMF) n. the international organization established to promote international monetary cooperation, foster economic growth, and provide temporary ﬁ nancial assistance to countries to help ease balance-ofpayments adjustment (p. 559) investment n. the use of income today in a way that allows for a future beneﬁ t (p. 318) investment objective n. a ﬁ nancial goal that is used to determine if an investment is appropriate (p. 324) J junk bond n. a high-risk, high-yield corporate bond (p. 339) K Keynesian economics n. the idea, ﬁ rst advanced by John Maynard Keynes, that the government needs to stimulate aggregate demand in times of recession (p. 454) L labor n. all the human time, effort, and talent used to produce goods and services (p. 8) labor input n. the size of the labor force multiplied by the length of the workweek (p. 371) labor productivity n. the amount of goods and services a person can produce in a given time (p. 149) labor union n. an organization of workers that seeks to improve wages, working conditions, fringe beneﬁ ts, job security, and other work-related matters for its members (p. 274) Laffer Curve n. a graph that illustrates how tax cuts affect tax revenues and economic growth (p. 459) lagging indicators n. measures of economic performance that usually change after real gross domestic product changes (p. 364) Glossary R37 laissez faire n. the principle that the government should not interfere in the economy (p. 49) land n. all the natural resources on or under the ground that are used to produce goods and services (p. 8) landlord n. the owner of rental property (p. 609) law of comparative advantage n. the law stating that countries gain when they produce items that they are most efﬁ cient at producing and that are at the lowest opportunity cost (p. 514) law of demand n. states that when the price of a good or service goes down, quantity demanded increases, and when the prices go up, quantity demanded falls (p. 99) law of diminishing marginal utility n. states that the marginal beneﬁ t from using each additional unit
of a good or service during a given time period tends to decline as each is used (p. 106) law of increasing opportunity costs n. states that as production switches from one product to another, increasingly more resources are needed to increase the production of the second product, which causes opportunity costs to rise (p. 21) law of supply n. states that producers are willing to sell more of a good or service at a higher price than they are at a lower price (p. 131) leading indicators n. measures of economic performance that usually change before real gross domestic product changes (p. 364) lease n. a contract for renting an apartment, vehicle, or other item for a speciﬁ c period of time (p. 609) legal equality n. a situation in which everyone has the same economic rights under the law (p. 73) less developed countries (LDCs) n. countries with lower GDPs, less well-developed industry, and lower standards of living; sometimes called emerging economies (p. 545) life expectancy n. the average number of years a person could expect to live if current mortality trends were to continue for the rest of that person’s life (p. 547) limited partnership n. a partnership in which at least one partner is not involved in running the business and is liable only for the funds he or she invested (p. 233) literacy rate n. the percentage of people older than 15 who can read and write (p. 547) loan n. borrowed money that is usually repaid with interest (p. 582) Lorenz curve n. a curve that shows the degree of income inequality in a nation (p. 391) M macroeconomic equilibrium n. the point where aggregate demand equals aggregate supply (p. 361) macroeconomics n. the study of the behavior of the economy as a whole; concerned with large-scale economic activity (p. 27) mandatory spending n. government spending that is required by current law (p. 428) marginal beneﬁ t n. the beneﬁ t or satisfaction gained from using one more unit of a good or service (p. 16) marginal cost n. the additional cost of producing or using one more unit of a good or service (pp. 16, 140) marginal product n. the change in total output that results from adding one more worker (p. 138) marginal revenue n. the money made from each additional unit sold (p. 142) market n. any place or situation in which people buy and sell goods and services (p. 48) market allocation n. an agreement among or between competing businesses to divide up a market (p. 216) market demand curve n. a graph that shows data from a market demand schedule, or how much of a good or service all consumers are willing and able to purchase at each price (p. 102) market demand schedule n. a table that shows how much of a good or service all consumers are willing and able to purchase at each price in a market (p. 100) market division see market allocation limited liability n. a situation in which a business owner’s liability for business debts and losses is limited (p. 240) market economy n. an economic system based on individual choice and voluntary exchange (p. 39) limited liability partnership (LLP) n. a partnership in which all partners are not responsible for the debts and other liabilities of the other partners (p. 233) market equilibrium n. a situation in which the quantity supplied and the quantity demanded at a particular price are equal (p. 164) limited life n. a situation in which a business ceases to exist if the owner dies, retires, or leaves (p. 228) market failure n. a situation in which people who are not part of a marketplace interaction beneﬁ t from it or pay part of its costs (p. 84) R38 Glossary G l o s s a r y market research n. the gathering and evaluation of information about consumer preferences for goods and services (p. 208) market share n. a company’s percent of total sales in a particular market (p. 209) money market n. a market in which short-term ﬁ nancial assets are bought and sold (p. 322) monopolistic competition n. a market structure in which many sellers offer similar, but not standardized, products to consumers (p. 206) market structure n. an economic model of competition among businesses in the same industry (p. 192) monopoly n. a market structure in which only one seller sells a product for which there are no close substitutes (p. 198) market supply curve n. a graph that shows data from a market supply schedule (p. 134) monopsony n. market structure in which there are many sellers but only one large buyer (p. 212) market supply schedule n. how much of a good or service all producers in a market are willing and able to offer for sale at each price (p. 132) maturity n. the date when a bond is due to be repaid (p. 338) multifactor productivity n. the ratio between an industry’s economic output and its labor and capital inputs (p. 372) multinational corporation n. a corporation with branches in several countries (p. 243) Medicaid n. a government-run medical insurance program for low-income people (p. 429) Medicare n. a government-run, national health insurance program mainly for citizens over age 65 (p. 423) medium of exchange n. a means through which goods and services can be exchanged (p. 288) merger n. the combining of two or more companies to form a single company (p. 214) microeconomics n. the study of the behavior of individual players—such as individuals, families, and businesses—in an economy (p. 27) minimum balance requirement n. the amount of money needed in an account to avoid fees (p. 576) minimum wage n. the lowest amount, established by law, that an employer may pay a worker for one hour of work (pp. 182, 262) mixed economy n. an economic system that has elements of traditional, command, and market economies; the most common economic system (p. 58) modiﬁ ed free enterprise economy n. a mixed economic system that includes some government protections, provisions, and regulations to adjust the free enterprise system (p. 80) monetarism n. an economic theory that suggests that rapid changes in the money supply are the main cause of economic instability (p. 496) monetary adj. of or relating to money (p. 474) mutual fund n. an investment company that gathers money from individual investors and uses the money to purchase a range of ﬁ nancial assets (p. 320) N NAFTA n. the North America Free Trade Agreement, which ensures free trade throughout the continent and constitutes the largest free-trade zone in the world (p. 533) national accounts see national income accounting national bank n. a bank chartered by the national government (p. 299) national debt n. the total amount of money that the federal government owes (p. 462) national income (NI) n. the total income earned in a nation from the production of goods and services in a given time period (p. 355) national income accounting n. a way of analyzing a country’s economy using statistical measures of its income, spending, and output (p. 350) nationalize v. to change from private ownership to government or public ownership (p. 61) natural monopoly n. a market situation in which the costs of production are lowest when only one ﬁ rm supplies a product or service (p. 201) near money n. savings accounts and other similar time deposits that can be converted into cash relatively easily (p. 293) monetary policy n. the Federal Reserve’s actions that change the money supply to inﬂ uence the economy (p. 490) needs n. things such as food, clothing, and shelter that are necessary for survival (p. 4) money n. anything that people will accept as payment for goods and services (p. 288) negative externality n. an externality that costs people who were not involved in the original economic activity (p. 87) Glossary R39 net national product (NNP) n. the gross national product minus depreciation of capital stock—in other words, the value of ﬁ nal goods and services less the value of capital goods that became worn out during the year (p. 355) nominal GDP n. the gross domestic product stated in terms of the current value of goods and services (p. 352) nonmarket activities n. services that have potential economic value but are performed without charge (p. 354) nonprice competition n. the use of factors other than price—such as style, service, advertising, or giveaways—to try to convince customers to buy from one producer rather than another (p. 207) nonproﬁ t organization n. an institution that acts like a business but exists to beneﬁ t society rather than to make a proﬁ t (p. 250) normal goods n. goods that consumers demand more of when their incomes rise (p. 110) normative economics n. a way of describing and explaining what economic behavior ought to be, not what it actually is (p. 29) not-for-proﬁ t see nonproﬁ t organization O oligopoly n. a market structure in which only a few sellers offer a similar product (p. 209) OPEC n. the Organization of Petroleum Exporting Countries, a regional trade group (p. 535) open market operations n. the Federal Reserve’s sale and purchase of federal government securities; the monetary policy tool most used by the Federal Reserve to adjust the money supply (p. 490) open opportunity n. the ability of everyone to enter and compete in the market of his or her own free choice (p. 73) operating budget n. a plan for day-to-day expenses (p. 436) opportunity cost n. the value of something that is given up by choosing one alternative over another (p. 14) option n. a contract giving an investor the right to buy or sell stock at a future date at a preset price (p. 333) outsourcing n. the practice of contracting with an outside company, often in a foreign country, to provide goods or services (p. 269) overdraft n. a check or other withdrawal that exceeds the existing account balance (p. 576) P par value n. the amount that a bond issuer promises to pay the buyer at maturity (p. 338) partnership n. a business co-owned by two or more people, or “partners,” who agree on how responsibilities, proﬁ ts, and losses should be divided (p. 232) patent n. a legal registration of an invention or a process that gives the i
nventor the exclusive property rights to that invention or process for a certain number of years (p. 202) peak n. the end of an expansion in the economy (p. 359); see business cycle per capita gross domestic product n. a nation’s GDP divided by its total population (p. 546) perestroika n. Russian leader Mikhail Gorbachev’s plan to gradually incorporate markets into the Soviet Union’s command economy (p. 564) perfect competition n. the ideal model of a market economy; the market structure in which none of the many well-informed and independent sellers or buyers has control over the price of a standardized good or service (p. 192) personal income (PI) n. the annual income received by a country’s people from all sources (p. 355) phishing n. technique used by identity thieves to gather personal information through deceptive telephone calls (p. 588) PIN n. personal identiﬁ cation number (p. 577) positive economics n. a way of describing and explaining economics as it is (p. 29) positive externality n. an externality that beneﬁ ts people who were not involved in the original economic activity (p. 87) poverty n. the situation in which a person’s income and resources do not allow him or her to achieve a minimum standard of living (p. 388) poverty line see poverty threshold poverty rate n. the percentage of people living in households that have incomes below the poverty threshold (p. 389) poverty threshold n. the ofﬁ cial minimum income needed to pay for the basic expenses of living (p. 388) predatory pricing n. the setting of prices below cost for a time to drive smaller competitors out of a market (p. 216) preferred stock n. a share of ownership in a corporation giving the holder a share of proﬁ ts but, in general, no voting rights (p. 331) premium n. an amount paid for insurance (p. 596) R40 Glossary G l o s s a r y price ceiling n. an established maximum price that sellers may charge for a product (p. 180) price ﬁ xing n. conspiring among or between businesses to set the prices of competing products (p. 216) price ﬂ oor n. an established minimum price that buyers must pay for a product (p. 182) proﬁ t motive n. the incentive that encourages people and organizations to improve their material well-being by seeking to gain from economic activities (p. 73) progressive tax n. a tax that places a higher percentage rate of taxation on high-income earners than on low-income earners (p. 412) price maker n. a business that does not have to consider competitors when setting its prices (p. 198) price taker n. a ﬁ rm that must accept the market price set by the interaction of supply and demand (p. 193) primary market n. a market for buying newly created ﬁ nancial assets directly from the issuing entity (p. 322) prime rate n. the interest rate that banks charge their best customers (p. 491) private company n. a corporation that controls who can buy or sell its stock (p. 238) private property rights n. the rights of individuals and groups to own resources and businesses (p. 48) private sector n. the part of the economy that is owned by individuals or businesses (p. 432) privatization n. the process of transferring state-owned property and businesses to individuals (p. 563) privatize v. to change from government or public ownership to private ownership (p. 61) producer n. a person who makes goods or provides services (p. 5) producer price index (PPI) n. a measure of changes in wholesale prices (p. 397) product differentiation n. the attempt to distinguish a product from similar products (p. 206) product market n. the market in which goods and services are bought and sold (p. 52) production possibilities curve (PPC) n. a graph used to illustrate the impact of scarcity on an economy (p. 18) productivity n. the amount of output produced from a set amount of inputs (p. 372) productivity, labor see labor productivity proﬁ t n. the ﬁ nancial gain a seller makes from a business transaction (p. 49); the money left over after the costs of producing a product are subtracted from the income gained by selling that product (p. 78) proﬁ t-maximizing output n. the point in production at which a business has reached its highest level of proﬁ t (p. 143) property tax n. a tax based on the value of an individual’s or a business’s assets (p. 412) proportional tax n. a tax that takes the same percentage of income from all taxpayers regardless of income level (p. 412) protectionism n. the use of trade barriers between nations to protect domestic industries (p. 523) protective tariff n. a tax on imported goods to protect domestic goods (p. 521) public company n. a corporation that issues stock that can be freely traded (p. 238) public disclosure n. a policy requiring businesses to reveal product information to consumers (p. 217) public goods n. goods and services provided by the government and consumed by the public as a group (p. 84) public transfer payment n. a transfer payment in which the government transfers income from taxpayers to recipients who do not provide anything in return (p. 89) pure competition see perfect competition Q quota n. a limit on the amount of a product that can be imported (p. 520) R rational expectations theory n. the theory that states that individuals and business ﬁ rms expect changes in ﬁ scal policy will have particular effects and take action to protect their interests against those effects (p. 452) rationing n. a system in which the government allocates goods and services using factors other than price (p. 183) real GDP n. the gross domestic product corrected for changes in prices from year to year (p. 352) real GDP per capita n. the real gross domestic product divided by total population (p. 369) recession n. a prolonged economic contraction lasting two or more quarters (six months or more) (p. 359) regressive tax n. a tax that takes a larger percentage of income from low-income earners than from high-income earners (p. 412) Glossary R41 regulation n. a set of rules or laws designed to control business behavior (pp. 150, 214) Social Security n. a federal program to aid older citizens, orphaned children, and the disabled (p. 423) representative money n. paper money that is backed by something tangible (p. 291) sole proprietorship n. a business owned and controlled by one person (p. 226) required reserve ratio (RRR) n. the fraction of a bank’s deposits, determined by the Federal Reserve, that it must keep in reserve so that it can loan out money (p. 484) return n. the proﬁ t or loss made on an investment (p. 327) revenue n. government income from taxes and nontax sources (p. 410) revenue tariff n. a tax on imports speciﬁ cally to raise money; are rarely used today (p. 521) right-to-work laws n. legislation that makes it illegal to require workers to join unions (p. 279) risk n. the possibility for loss on an investment (p. 327) S safety net n. government programs designed to protect people from economic hardships (p. 89) sales tax n. a tax based on the value of goods or services at the time of sale (p. 412) savings n. income not used for consumption (p. 318) scarcity n. a situation that exists when there are not enough resources to meet human wants (p. 4) seasonal unemployment n. unemployment linked to seasonal work (p. 384) secondary market n. a market in which ﬁ nancial assets are resold (p. 322) service n. work that one person does for another for payment (p. 5) shadow economy see underground economy share n. part of the stock of a corporation (p. 238); see stock shock therapy n. an economic program involving the abrupt shift from a command economy to a free-market economy (p. 563) shortage n. a situation in which demand is greater than supply, usually the result of prices being set too low (p. 167) shoulder surﬁ ng n. technique used by identity thieves to gather personal information as you disclose private information in public (p. 588) spamming n. technique used by identity thieves to gather personal information through deceptive e-mails (p. 588) special economic zone (SEZ) n. a geographic region that has economic laws that are different from a country’s usual economic laws, with the goal of increasing foreign investment (p. 567) specialization n. a situation that occurs when individuals or businesses concentrate their efforts in the areas in which they have an advantage for increased productivity and proﬁ t (pp. 50, 138, 510) spending multiplier effect n. a situation in which a small change in spending eventually results in a much larger change in GDP (p. 455) stabilization programs n. programs that require troubled nations to carry out reforms such as reducing foreign trade deﬁ cits and external debt, eliminating price controls, closing inefﬁ cient public enterprises, and slashing budget deﬁ cits (p. 559) stagﬂ ation n. a period during which prices rise at the same time that there is a slowdown in business activity (p. 359) standardized product n. a product that consumers consider identical in all essential features to other products in the same market (p. 192) standard of value n. the yardstick of economic worth in the exchange process (p. 289) start-up costs n. the expenses that a new business must pay to enter a market and begin selling to consumers (p. 209) state bank n. a bank chartered by a state government (p. 296) statistics n. numerical data (p. 24) stock n. shares of ownership in a corporation (p. 238) stockbroker n. an agent who buys and sells securities for customers (p. 332) stock exchange n. a secondary market where securities are bought and sold (p. 330) stock index n. an instrument used to measure and report the change in prices of a set of stocks (p. 334) socialism n. an economic system in which the government owns some or all of the factors of production (p. 43) stored-value card n. a card that represents money that the card holder has on deposit with the card issuer (p. 308) R42 Glossary G l o s s a r y store of value n. something that holds its value over time (p. 289) strike n. a work stoppag
e used to gain negotiating power while attempting to convince an employer to improve wages, working conditions, or other work-related matters (p. 274) structural unemployment n. unemployment that exists when the available jobs do not match the skills of available workers (p. 384) subsidy n. a government payment that helps cover the cost of an economic activity that can beneﬁ t the public as a whole (p. 88) substitutes n. products that can be used in place of other products to satisfy consumer wants (p. 112) substitution effect n. the pattern of behavior that occurs when consumers react to a change in price of a product by buying a substitute product that offers a better relative value (p. 107) supply n. the willingness and ability of a producer to produce and sell a product (p. 130) supply curve n. a graph that shows data from a supply schedule (p. 134) supply schedule n. a table that shows how much of a good or service an individual producer is willing and able to offer for sale at each price (p. 132) supply-side ﬁ scal policy n. a plan designed to provide incentives to producers to increase aggregate supply (p. 458) surplus n. a situation in which supply is greater than demand, usually the result of prices being set too high (p. 167) T tariff n. a fee charged for goods brought into a country from another country (p. 521) tax n. a mandatory payment to a government (p. 410) taxable income n. the portion of income subject to taxation after all deductions and exemptions (pp. 421, 604) tax assessor n. a government ofﬁ cial who determines the value of property to be taxed (p. 437) tax base n. a form of wealth—such as income, property, goods, or services—that is subject to taxes (p. 412) tax incentive n. the use of taxes to encourage or discourage certain economic behaviors (p. 417) tax return n. a form used to report income and taxes owed to the government (p. 421) technological monopoly n. a monopoly that exists because a ﬁ rm controls a manufacturing method, invention, or type of technology (p. 201) technology n. the application of scientiﬁ c methods and innovations to production (p. 149) telecommuting n. the practice of doing ofﬁ ce work in a location other than the ofﬁ ce (p. 270) telework see telecommuting temp, temps, temping see contingent employment thrift institution n. a ﬁ nancial institution that serves savers (p. 478) tight-money policy see contractionary monetary policy total cost n. the sum of ﬁ xed and variable costs (p. 140) total revenue n. the income a business receives from selling its products (pp. 122, 142) total revenue test n. a method of measuring elasticity by comparing the total revenue a business would receive when offering its product at various prices (p. 122) trade barrier n. any law passed to limit free trade between nations (p. 520) trade deﬁ cit n. an unfavorable balance of trade that occurs when a nation imports more than it exports (p. 529) trade-off n. the alternative someone gives up when making an economic choice (p. 14) trade surplus n. a favorable balance of trade that occurs when a nation exports more than it imports (p. 529) trade union see labor union trade war n. a succession of trade barriers between nations (p. 522) trade-weighted value of the dollar n. a measure of the international value of the dollar that determines if the dollar is strong or weak as measured against another currency (p. 528) traditional economy n. an economic system in which people make economic decisions based on customs and beliefs that have been handed down from one generation to the next (p. 38) transfer payment n. money distributed to individuals who do not provide goods or services in return (pp. 89, 432) transitional economy n. a country that has moved (or is moving) from a command economy to a market economy (p. 545) Treasury bill (T bill) n. a short-term bond that matures in less than one year (p. 464) Glossary R43 Treasury bond n. a long-term bond that matures in 30 years (p. 464) voluntary exchange n. a trade in which the parties involved anticipate that the beneﬁ ts will outweigh the cost (p. 49) voluntary export restraint (VER) n. a self-imposed limit on exports to certain countries to avoid quotas or tariffs (p. 521) W wage and price controls n. government limits on increases in wages and prices (p. 501) wage-price spiral n. a cycle that begins with increased wages, which lead to higher production costs, which in turn result in higher prices, which result in demands for even higher wages (p. 400) wage rate n. the established rate of pay for a speciﬁ c job or work performed (p. 261) wages n. the payments workers receive in return for work (p. 258) wants n. desires that can be satisﬁ ed by consuming a good or service (p. 4) welfare n. government economic and social programs that provide assistance to the needy (p. 392) withholding n. the money taken from a worker’s pay before the worker receives the pay (p. 421) workfare n. a program that requires welfare recipients to do some kind of work in return for their beneﬁ ts (p. 393) World Bank n. a ﬁ nancial institution that provides loans, policy advice, and technical assistance to low and middle income countries to reduce poverty (p. 559) World Trade Organization (WTO) n. an organization that negotiates and administers trade agreements, resolves trade disputes, monitors trading policies, and supports developing countries (p. 535) Y yield n. the annual rate of return on a bond (p. 338) Treasury note n. an intermediate-term bond that matures in between two and ten years (p. 464) trough n. the end of a contraction in the economy (p. 359); see business cycle trust n. a group of ﬁ rms combined in order to reduce competition in an industry (p. 214) trust fund n. a fund held for a speciﬁ c purpose to be expended at a future date (p. 465) U underemployed n. people employed part-time who want to work full-time, or those who work at a job below their skill level (p. 383) underground economy n. market activities that go unreported because they are illegal or because those involved want to avoid taxation (p. 354) underutilization n. the condition in which economic resources are not being used to their full potential, resulting in fewer goods and services (p. 20) unemployment rate n. the percentage of the labor force that is jobless and actively looking for work (p. 382) union see labor union union shop n. a business in which workers are required to join a union within a set time period after being hired (p. 279) unit elastic adj. relating to a situation in which the percentage change in price and quantity demanded are the same (p. 118) unlimited liability n. a situation in which a business owner is responsible for all the losses and debts of a business (p. 228) unlimited life n. a situation in which a corporation continues to exist even after a change in ownership (p. 240) user fee n. money charged for the use of a good or service (p. 425) utility n. the beneﬁ t or satisfaction gained from using a good or service (p. 12) V variable costs n. business costs that vary with the level of production output (p. 140) vertical merger n. the combining of two or more businesses involved in different steps of producing or marketing a product or service (p. 243) R44 Glossary Spanish Glossary A absolute advantage [ventaja absoluta] n. capacidad de un país para hacer un producto más eﬁ cientemente que otro país (pág. 513) aggregate demand [demanda agregada] n. suma de las demandas totales existentes en la economía (pág. 360) aggregate supply [oferta agregada] n. suma de las ofertas totales existentes en la economía (pág. 360) antitrust legislation [legislación antimonopolio] n. leyes que deﬁ nen los monopolios y dan al gobierno el poder de controlarlos o disolverlos (pág. 214) appropriations [asignaciones] n. cantidades ﬁ jas de dinero destinadas a ﬁ nes determinados (pág. 431) authoritarian [autoritario] adj. lo que exige una lealtad y una obediencia absolutas ante la autoridad (pág. 43) automated teller machine (ATM) [cajero automático (ATM)] n. dispositivo electrónico que permite a los clientes de un banco hacer transacciones sin ver al personal del banco (pág. 308) automatic stabilizer [estabilizador automático] n. característica de la política ﬁ scal que actúa automáticamente para mantener estable la economía (pág. 447) B balanced budget [presupuesto balanceado] n. presupuesto en el que el total de ingresos del gobierno es igual al total de gastos del gobierno (pág. 436) balance of payments [balanza de pagos] n. registro de todas las transacciones ocurridas entre las personas, las empresas y las unidades gubernamentales de un país y las del resto del mundo (pág. 529) balance of trade [balanza de comercio] n. diferencia entre el valor de las exportaciones y el de las importaciones de un país (pág. 529) bank exam [inspección bancaria] n. auditoría, realizada por la Reserva Federal, de las prácticas ﬁ nancieras de un banco (pág. 481) bank holding company [compañía tenedora de acciones bancarias] n. compañía que posee más de un banco (pág. 481) barrier to entry [barrera de entrada] n. todo factor que impide que una empresa entre en un mercado (pág. 198) barter [trueque] n. intercambio de bienes y servicios sin utilizar dinero (pág. 288) bear market [mercado a la baja (mercado “oso”)] n. situación en la que los precios del mercado de valores bajan constantemente con el tiempo (pág. 335) binding arbitration [arbitraje vinculante] n. proceso por el que un tercero imparcial resuelve los conﬂ ictos entre la dirección de una empresa y los sindicatos (pág. 280) black market [mercado negro] n. compra o venta ilegal de bienes o servicios, violando los controles de precios o el racionamiento (pág. 183) Board of Governors [Junta de Gobernadores] n. junta de siete miembros nombrados que supervisa las operaciones del Sistema de la Reserva Federal y establece la política monetaria (pág. 476) bond [bono] n. contrato emitido por una sociedad anónima que promete reembolsar el diner
o prestado, más intereses, según las fechas establecidas (pág. 240) bounced check [cheque rebotado] véase overdraft [sobregiro] break-even point [punto de equilibrio] n. situación en la que el total de costos y el total de ingresos son iguales (pág. 142) budget [presupuesto] n. plan para asignar el ahorro y el gasto del ingreso (pág. 574) budget deﬁ cit [déﬁ cit presupuestario] n. situación en la que los gastos del gobierno son mayores que los ingresos (pág. 462) budget surplus [superávit presupuestario] n. situación en la que los ingresos del gobierno son mayores que los gastos (pág. 462) bull market [mercado alcista (mercado “toro”)] n. situación en la que los precios del mercado de valores suben constantemente con el tiempo (pág. 335) business cycle [ciclo económico] n. serie de períodos de ascenso y descenso de la actividad económica, medida por los aumentos o las disminuciones del producto interior bruto real (pág. 358) business organization [organización comercial] n. empresa que produce bienes o presta servicios, generalmente para obtener ganancias (pág. 226) business structure [estructura comercial] véase business organization [organización comercial] C capital [capital] n. todos los recursos que se crean y utilizan para producir y distribuir bienes y servicios (pág. 8) capital budget [presupuesto de capital] n. plan referente a los principales gastos o inversiones (pág. 436) capital deepening [intensiﬁ cación del uso del capital] n. aumento de la razón entre el capital y el trabajo (pág. 371) capital ﬂ ight [fuga de capitales] n. situación en la que capitales de un país se invierten fuera de dicho país (pág. 558) Spanish Glossary R45 capital gain [ganancias de capital] n. ganancias obtenidas de la venta de valores (pág. 330) capitalism [capitalismo] n. sistema económico basado en la propiedad privada de los factores de producción (pág. 49) capital market [mercado de capitales] n. mercado en el que se venden y compran activos ﬁ nancieros a largo plazo (pág. 322) cartel [cártel] n. organización formal de vendedores o productores que regulan la producción, la ﬁ jación de precios y la comercialización de un producto (págs. 198, 535) cease and desist order [orden de cese de actividades comerciales] n. decisión judicial que obliga a una compañía a dejar de realizar una práctica comercial injusta (pág. 217) central bank [banco central] n. principal autoridad monetaria de un país (pág. 474) centrally planned economy [economía de planiﬁ cación centralizada] n. sistema en el que los dirigentes del país toman todas las decisiones económicas (pág. 42) change in demand [cambio en la demanda] n. situación en la que un cambio en el mercado incita a los consumidores a comprar una cantidad diferente de un bien o de un servicio a cada precio (pág. 109) change in quantity demanded [cambio en la cantidad demandada] n. cambio en la cantidad de un producto que los consumidores comprarán debido a un cambio en el precio (pág. 108) change in quantity supplied [cambio en la cantidad ofertada] n. aumento o disminución de la cantidad de un bien o de un servicio que los productores están dispuestos a vender debido a un cambio en el precio (pág. 146) change in supply [cambio en la oferta] n. situación en la que un cambio en el mercado incita a los productores a ofrecer para su venta una cantidad diferente a cada precio (pág. 148) check clearing [compensación de cheques] n. servicio proporcionado por la Reserva Federal para registrar las entradas y las salidas de los clientes de los bancos (pág. 480) circular ﬂ ow model [modelo de ﬂ ujo circular] n. visualización de todas las interacciones de una economía de mercado (pág. 52) civilian labor force [fuerza laboral civil] n. personas de 16 años o mayores que trabajan o que buscan activamente un trabajo y están en condiciones para trabajar (pág. 266) claim [reclamación] n. petición presentada ante una compañía de seguros para recibir un pago sobre una pérdida asegurada (pág. 596) closed shop [compañía de sindicación obligatoria] n. compañía en la que el empleador sólo puede contratar miembros del sindicato (pág. 279) coincident indicators [indicadores coincidentes] n. medidas del rendimiento económico que generalmente cambian al mismo tiempo que cambia el producto interior bruto real (pág. 364) collective bargaining [negociación colectiva] n. proceso de negociación entre una empresa y sus empleados sindicalizados para establecer los salarios y mejorar las condiciones de trabajo (pág. 280) command economy [economía autoritaria] n. sistema económico en el que el gobierno toma todas las decisiones económicas (pág. 39) commodity money [dinero-mercancía] n. dinero que tiene un valor intrínsico basado en el material del que se compone (pág. 291) common stock [acciones ordinarias] n. participación en la propiedad de una sociedad anónima que da al titular derecho a voto y parte de las ganancias (pág. 331) communism [comunismo] n. sistema económico en el que no existe la propiedad privada y hay poca o ninguna libertad política (pág. 43) comparative advantage [ventaja comparativa] n. capacidad de un país para producir algo a un costo de oportunidad más bajo que el de otro país (pág. 513) competition [competencia] n. esfuerzo de dos o más personas que actúan independientemente por obtener clientes ofreciéndoles la mejor opción (pág. 49) competitive pricing [ﬁ jación de precios competitivos] n. situación en la que los productores venden bienes y servicios a precios que intentan el mejor equilibrio entre dos deseos: obtener las mayores ganancias y atraer a los clientes de los productores rivales (pág. 174) complements [complementarios] n. productos que se usan conjuntamente, de manera que el aumento y la disminución de la demanda de uno produzca el aumento o la disminución de la demanda del otro (pág. 112) conglomerate [conglomerado] n. empresa compuesta de compañías que producen bienes o servicios no relacionados (pág. 243) consumer [consumidor] n. persona que compra bienes o servicios para su uso personal (pág. 5) consumer price index (CPI) [índice de precios al consumo (IPC)] v medida porcentual de los cambios en los precios de una cesta de los bienes y los servicios que los consumidores compran frecuentemente (pág. 396) consumer sovereignty [soberanía del consumidor] n. idea de que los consumidores tienen el control deﬁ nitivo sobre lo que se produce ya que son libres para comprar lo que quieren y para rechazar productos que no quieren (pág. 50) R46 Spanish Glossary contingent employment [empleo contingente] n. trabajo temporal o a tiempo parcial (pág. 270) contract [contrato] n. acuerdo formal con fuerza jurídica (pág. 598) contraction [contracción] n. reducción de la actividad económica (pág. 359); véase business cycle [ciclo económico] contractionary ﬁ scal policy [política ﬁ scal restrictiva] n. plan para reducir la demanda agregada y desacelerar la economía durante un período de expansión económica demasiado rápido (pág. 446) contractionary monetary policy [política monetaria restrictiva] n. plan para reducir la cantidad de dinero en circulación; también llamada política de dinero escaso (pág. 492) cooperative [cooperativa] n. tipo de negocio dirigido a favor del beneﬁ cio compartido de los propietarios, que son también los clientes (pág. 250) co-pay [copago] n. cantidad que el asegurado debe pagar cuando una persona asegurada recibe atención médica (pág. 596) corporate income tax [impuesto de sociedades anónimas] n. impuesto basado en las ganancias de una sociedad anónima (pág. 412) corporation [sociedad anónima] n. empresa que pertenece a los titulares de acciones, o accionistas, que poseen los derechos a las ganancias de la compañía pero cuya responsabilidad es limitada respecto a las deudas y pérdidas de la compañía (pág. 238) cosigner [coﬁ rmante, aval, avalista] n. persona que asume la responsabilidad de la deuda si el prestatario no reembolsa el préstamo (pág. 583) cost-beneﬁ t analysis [análisis costo-beneﬁ cio] n. práctica de examinar los costos y los beneﬁ cios previstos de una opción, como ayuda en la toma de decisiones (pág. 15) cost-push inﬂ ation [inﬂ ación de costos] n. situación en la que el aumento de los costos de producción hace subir los precios (pág. 399) Council of Economic Advisers [Consejo de Consejeros Económicos] n. grupo de tres miembros que aconseja al Presidente sobre la política ﬁ scal y otros asuntos económicos (pág. 452) coupon rate [tasa de cupón] n. tasa de interés que el titular de un bono obtiene cada año hasta que vence el bono (pág. 338) craft union [sindicato gremial] n. organización de trabajadores con aptitudes similares que trabajan en diferentes industrias para diferentes empleadores (pág. 274) credit [crédito] n. práctica de comprar bienes o servicios en el presente y pagarlos en el futuro (pág. 582) credit report [informe crediticio] n. documento emitido por una agencia de informes crediticios que explica detalladamente el historial de crédito de un consumidor (pág. 586) credit score [caliﬁ cación del riesgo crediticio] n. número que resume la reputación crediticia de un consumidor (pág. 586) crowding-out effect [efecto de exclusión] n. situación en la que el gobierno supera la oferta de las tasas de interés de bonos privados para obtener fondos prestables (pág. 466) currency [moneda] n. papel moneda y monedas metálicas (págs. 293, 475) customs duty [derecho arancelario] n. impuesto aplicado en Estados Unidos a los bienes importados (pág. 425) customs unions [uniones aduaneras] n. acuerdos que eliminan las barreras al comercio entre los miembros y establecen aranceles uniformes para los no miembros (pág. 532) cyclical unemployment [desempleo cíclico] n. desempleo causado por la parte del ciclo económico que presenta una actividad económica reducida (pág. 384) D debit card [tarjeta de débito] n. tarjeta que se puede usar como tarjeta de cajero automático (ATM) para retirar dinero o como cheque para hacer compras (pág. 308) debt restructuring [re
estructuración de la deuda] n. método que utilizan los países con obligaciones de deuda pendientes para alterar los términos de los acuerdos de la deuda, a ﬁ n de conseguir alguna ventaja (pág. 559) deduction [deducible] n. cantidad que el asegurado paga antes de que pague la compañía aseguradora (pág. 596) default [incumplimiento] n. condición que se presenta cuando un país no puede pagar los intereses o el capital sobre un préstamo (pág. 559) deﬁ cit spending [gastos deﬁ citarios] n. práctica del gobierno de gastar más de lo que obtiene en ingresos en un determinado año ﬁ scal (pág. 462) deﬂ ation [deﬂ ación] n. disminución del nivel general de precios (pág. 398) demand [demanda] n. deseo de obtener algún bien o servicio y la capacidad para pagarlo (pág. 98) demand curve [curva de la demanda] n. gráﬁ ca que muestra una tabla de demanda, o la cantidad de un bien o de un servicio que una persona puede y está dispuesta a comprar a cada precio (pág. 102) demand deposits [depósitos a la vista] n. cuentas corrientes, llamadas así porque las cuentas corrientes pueden convertirse en dinero “a la vista” (pág. 293) Spanish Glossary R47 demand-pull inﬂ ation [inﬂ ación de demanda] n. condición que se presenta cuando la demanda total sube más rápido que la producción de bienes y servicios (pág. 399) demand schedule [tabla de demanda] n. tabla que muestra la cantidad de un bien o de un servicio que una persona puede y está dispuesta a comprar a cada precio (pág. 100) demand-side ﬁ scal policy [política ﬁ scal sobre la demanda] n. plan para estimular la demanda agregada (pág. 454) deposit multiplier formula [fórmula del multiplicador de depósitos] n. fórmula matemática que indica cuánto aumentará la oferta monetaria tras realizar un depósito inicial de dinero en un banco (pág. 485) depreciate [depreciar] v. disminuir de valor (pág. 590) depression [depresión] n. período prolongado con un alto nivel de desempleo y una reducción de la actividad económica (pág. 359) deregulation [desregulación] n. reducción o eliminación de la vigilancia y el control de las empresas por parte del gobierno (pág. 218) derived demand [demanda derivada] n. demanda de un producto o un recurso que se basa en su aportación al producto ﬁ nal (pág. 259) developed nations [países desarrollados] n. países que tienen una economía de mercado, un nivel de vida relativamente alto, un PIB alto, industrialización, propiedad privada generalizada y un gobierno estable y efectivo (pág. 544) differentiated product [producto diferenciado] véase product differentiation [diferenciación de productos] diminishing returns [rentabilidad decreciente] n. situación en la que nuevos trabajadores hacen que el producto marginal aumente pero a un ritmo decreciente (pág. 139) discount rate [tasa de descuento] n. tasa de interés que aplica la Reserva Federal cuando presta dinero a otros bancos (pág. 491) discretionary ﬁ scal policy [política ﬁ scal discrecional] n. medidas que toma el gobierno federal a voluntad para corregir la inestabilidad económica (pág. 446) discretionary spending [gastos discrecionales] n. gastos que el gobierno debe autorizar cada año (pág. 428) disequilibrium [desequilibrio] n. situación en la que la cantidad ofertada y la cantidad demandada no se encuentran en equilibrio (pág. 169) disposable personal income (DPI) [renta personal disponible (RPD)] n. renta personal menos los impuestos (pág. 355) diversiﬁ cation [diversiﬁ cación] n. práctica de distribuir las inversiones entre diferentes activos ﬁ nancieros para maximizar la rentabilidad y limitar el riesgo (pág. 327) dividend [dividendo] n. aquella parte de las ganancias de una sociedad anónima que la compañía paga a los accionistas (pág. 238) dumping [dumping] n. venta de un producto en otro país a un precio más bajo del que tiene en el mercado de origen (pág. 521) Dumpster diving [buceo en la basura] n. técnica utilizada por los ladrones de identidad para recoger información personal en la basura (pág. 584) E easy-money policy [política de dinero barato] véase expansionary monetary policy [política monetaria expansiva] economic cycle [ciclo económico] véase business cycle [ciclo económico] economic growth [crecimiento económico] n. aumento del producto interior bruto real de un país (pág. 358) economic interdependence [interdependencia económica] n. situación en la que los productores de un país dependen de otros para conseguir bienes y servicios que ellos no producen (pág. 510) economic model [modelo económico] n. representación simpliﬁ cada de las actividades, sistemas o problemas económicos (pág. 18) economics [economía] n. estudio de cómo las personas y la sociedad satisfacen sus deseos ilimitados con recursos limitados (pág. 4) economic system [sistema económico] n. forma en que la sociedad utiliza sus recursos escasos para satisfacer los deseos ilimitados de su población (pág. 38) economies of scale [economías de escala] n. situación en la que el costo promedio de producción disminuye al crecer el productor (pág. 201) economize [economizar] v. tomar decisiones según lo que se cree la mejor combinación de costos y beneﬁ cios (pág. 12) efﬁ ciency [eﬁ ciencia] n. condición en la que los recursos económicos se utilizan para producir la cantidad máxima de bienes y servicios (pág. 20) elastic [elástica] adj. situación en la que un cambio en el precio, ya sea para más o para menos, produce un cambio relativamente más grande en la cantidad demandada o en la cantidad ofertada (págs. 117, 154) elasticity of demand [elasticidad de la demanda] n. medida de la reacción de los consumidores ante los cambios de los precios en el mercado (pág. 117) elasticity of supply [elasticidad de la oferta] n. medida de la reacción de los productores ante los cambios de los precios en el mercado (pág. 154) R48 Spanish Glossary embargo [embargo] n. ley que prohíbe la mayor parte o todo el comercio con un país determinado (pág. 521) entitlement [derechos sociales adquiridos] n. programa de asistencia social que tiene determinados requisitos de admisión (pág. 428) entrepreneurship [capacidad empresarial] n. combinación de visión, aptitud, ingenio y disposición de asumir riesgos, necesaria para crear y dirigir nuevas empresas (pág. 9) equilibrium price [precio de equilibrio] n. precio al que la cantidad demandada equivale a la cantidad ofertada (pág. 164) equilibrium wage [salario de equilibrio] n. salario en el que la cantidad de trabajadores demandados equivale a la cantidad de trabajadores ofertados; precio de mercado de la mano de obra (pág. 258) estate tax [impuesto de sucesiones] n. impuesto aplicado a los activos de una persona que ha muerto (pág. 425) European Union (EU) [Unión Europea (UE)] n. unión económica y política de los países europeos, establecida en 1993 (pág. 532) euro [euro] n. moneda única de la Unión Europea (pág. 533) excise tax [impuesto sobre consumos] n. impuesto aplicado a la producción o a la venta de un bien o un servicio determinado (págs. 149, 425) expansion [expansión] n. aumento de la actividad económica (pág. 358); véase business cycle [ciclo económico] expansionary ﬁ scal policy [política ﬁ scal expansiva] n. plan para aumentar la demanda agregada y estimular una economía débil (pág. 446) expansionary monetary policy [política monetaria expansiva] n. plan para aumentar la cantidad de dinero en circulación; también llamada política de dinero barato (pág. 492) exports [exportaciones] n. bienes o servicios producidos en un país y vendidos a otros países (pág. 516) externality [externalidad] n. efecto secundario de una transacción que afecta a alguien que no sea el productor o el comprador (pág. 87) F factor market [mercado de factores] n. mercado para los factores de producción: tierra, trabajo, capital y capacidad empresarial (pág. 52) factors of production [factores de producción] n. recursos económicos necesarios para producir bienes y servicios (pág. 8) federal budget [presupuesto federal] n. plan para gastar los ingresos obtenidos mediante los impuestos federales (pág. 431) federal funds rate (FFR) [tasa de interés para fondos federales (TFF)] n. interés al que una institución de depósitos presta por un día fondos disponibles a otra institución de depósitos (pág. 490) Federal Insurance Contributions Act (FICA) [Ley de Contribuciones al Seguro Federal] n. impuesto sobre nóminas que proporciona cobertura a las personas mayores, a los desempleados por incapacidad y a los familiares supervivientes de asalariados que han muerto (pág. 423) Federal Open Market Committee (FOMC) [Comité Federal del Mercado Abierto] n. junta del Sistema de la Reserva Federal que supervisa la venta y la compra de valores del gobierno federal (pág. 477) Federal Reserve System [Sistema de la Reserva Federal] n. banco central de Estados Unidos, llamado comúnmente la Fed (pág. 474) ﬁ at money [dinero ﬁ duciario] n. dinero que no tiene respaldo tangible pero cuyo valor es declarado por el gobierno y aceptado por los ciudadanos (pág. 291) ﬁ ling status [estado personal] n. para la declaración de impuestos, se basa en el estado civil o en las cargas familiares (pág. 604) ﬁ nancial asset [activo ﬁ nanciero] n. derecho de la propiedad del prestatario (pág. 319) ﬁ nancial intermediary [intermediario ﬁ nanciero] n. institución que reúne fondos de los ahorradores e invierte estos fondos en activos ﬁ nancieros (pág. 319) ﬁ nancial market [mercado ﬁ nanciero] n. situación en la que los compradores y los vendedores intercambian activos ﬁ nancieros (pág. 319) ﬁ nancial system [sistema ﬁ nanciero] n. todas las instituciones que ayudan a transferir fondos entre los ahorradores y los inversionistas (pág. 318) ﬁ scal [ﬁ scal] adj. lo relacionado a los ingresos y a los gastos del gobierno (pág. 446) ﬁ scal policy [política ﬁ scal] n. uso que hace el gobierno federal de los impuestos y los gastos para afectar a la economía (pág. 446) ﬁ scal year [año ﬁ scal] n. período de 12 meses en el que una organización planiﬁ ca sus gastos (pág. 431)
ﬁ xed costs [costos ﬁ jos] n. gastos en los que incurren los propietarios de empresas, independientemente de cuánto produzcan (pág. 140) ﬁ xed rate of exchange [tasa de cambio ﬁ ja] n. sistema en el que la divisa de un país es ﬁ ja o constante respecto a las otras divisas (pág. 526) Spanish Glossary R49 ﬂ exible exchange rate [tasa de cambio ﬂ exible] n. sistema en el que la tasa de cambio para una divisa ﬂ uctúa al ﬂ uctuar la oferta y la demanda de la divisa; también llamada tasa ﬂ otante (pág. 527) focus group [grupo focal] n. discusión dirigida por un moderador y realizada con pequeños grupos de consumidores (pág. 208) foreign exchange market [mercado de divisas] n. mercado en el que se compran y venden divisas de diferentes países (pág. 526) foreign exchange rate [tasa de cambio de divisas] n. precio de una divisa expresado en las divisas de otros países (pág. 526) franchise [franquicia] n. negocio formado por negocios parcialmente independientes que ofrecen todos los mismos productos o servicios (pág. 248) franchisee [franquiciado] n. negocio parcialmente independiente que paga un cargo por el derecho a vender en una determinada zona los productos o servicios de la compañía matriz (pág. 248) free contract [contrato libre] n. situación en la que las personas deciden por sí solas qué contratos legales aceptar (pág. 73) free-enterprise system [sistema de libre mercado] n. otro nombre del capitalismo, sistema económico basado en la propiedad privada de los recursos productivos (pág. 70) free rider [beneﬁ ciario gratuito] n. persona que no paga un bien o un servicio pero que se beneﬁ cia de él cuando se le da (pág. 85) free-trade zone [zona de libre comercio] n. determinada región en la que el comercio entre los países se realiza sin aranceles proteccionistas (pág. 532) frictional unemployment [desempleo friccional] n. desempleo temporal de los trabajadores que pasan de un puesto de trabajo a otro (pág. 384) full employment [pleno empleo] n. nivel de desempleo en el que ninguna parte del desempleo se debe a la reducción de la actividad económica; por lo general, está marcado por una tasa de desempleo del 4 al 6 por ciento (pág. 383) future [futuro] n. contrato para comprar o vender acciones en una fecha futura determinada y a un precio establecido (pág. 333) G general partnership [sociedad colectiva] n. sociedad en la que cada socio participa en la dirección de la empresa y es responsable de todas las deudas y pérdidas de la empresa (pág. 233) geographic monopoly [monopolio geográﬁ co] n. monopolio que existe debido a la ausencia de otros productores o vendedores en cierta región (pág. 201) gift tax [impuesto sobre donaciones] n. impuesto aplicado al dinero o a las propiedades que una persona viva le da a otra (pág. 425) glass ceiling [techo de cristal] n. barrera artiﬁ cial e invisible que a veces afrontan las mujeres y las minorías y que les impide avanzar profesionalmente (pág. 262) global economy [economía global] n. todas las interacciones económicas que cruzan las fronteras internacionales (pág. 61) gold standard [patrón oro] n. sistema en el que la unidad monetaria básica es igual a una cantidad de oro establecida (pág. 299) goods [bienes] n. objetos físicos, como los alimentos, la ropa y los muebles, que pueden comprarse (pág. 5) government monopoly [monopolio gubernamental] n. monopolio que existe debido a que el gobierno posee y dirige esa empresa o autoriza un solo productor (pág. 201) grant-in-aid [donativo del gobierno federal] n. pago de transferencia del gobierno federal a gobiernos estatales o locales (pág. 432) gross domestic product (GDP) [producto interior bruto (PIB)] n. valor de mercado de todos los bienes y servicios ﬁ nales producidos en un país durante un determinado período de tiempo (pág. 350) gross national product (GNP) [producto nacional bruto (PNB)] n. valor de mercado de todos los bienes y servicios ﬁ nales producidos por un país durante un determinado período de tiempo (pág. 355) H hacking [hacking] n. técnica empleada por los ladrones de identidad para recoger información personal mediante computadoras y tecnología relacionada (pág. 588) horizontal merger [fusión horizontal] n. unión de dos o más compañías que ofrecen productos o servicios iguales o similares (pág. 243) human capital [capital humano] n. conocimientos y aptitudes que permiten a los trabajadores ser productivos (pág. 261) human development index (HDI) [índice de desarrollo humano (IDH)] n. combinación del PIB real per cápita, la esperanza de vida al nacer, la tasa de alfabetización de adultos y la tasa de matriculación de los estudiantes de un país y todo esto indica cómo es la vida en un país determinado (pág. 547) R50 Spanish Glossary hyperinﬂ ation [hiperinﬂ ación] n. tasa de inﬂ ación acelerada y no controlada superior al 50 por ciento (pág. 398) I identity theft [robo de identidad] n. uso de la información personal de otra persona con ﬁ nes criminales (pág. 588) imperfect competition [competencia imperfecta] n. estructura de mercado que carece de una o más de las condiciones necesarias para la competencia perfecta (pág. 195) imports [importaciones] n. bienes o servicios producidos en un país y comprados por otro (pág. 516) incentive [incentivo] n. beneﬁ cio ofrecido para estimular a las personas a que actúen de cierta manera (págs. 12, 176) incidence of a tax [incidencia ﬁ scal] n. carga ﬁ nal de un impuesto (pág. 415) income distribution [distribución de la renta] n. forma en que la renta se divide entre las personas de un país (pág. 390) income effect [efecto renta] n. cambio en la cantidad de un bien o de un servicio que un consumidor comprará debido a la variación de su renta (y por ello su poder adquisitivo) (pág. 107) income inequality [desigualdad de la renta] n. distribución desigual de la renta (pág. 390) increasing returns [rentabilidad creciente] n. situación en la que la contratación de nuevos trabajadores hace aumentar el producto marginal (pág. 139) independent contractor [contratista independiente] n. alguien que vende sus servicios mediante un contrato (pág. 270) individual income tax [impuesto sobre la renta personal] n. impuesto basado en las rentas que una persona recibe de todas las fuentes (pág. 412) industrial union [sindicato industrial] n. organización de trabajadores con muchas y diversas aptitudes y que trabajan en la misma industria (pág. 274) inelastic [inelástica] n. situación en la que la cantidad demandada o la cantidad ofertada cambia poco al cambiar el precio (págs. 117, 155) infant industries [industrias nacientes] n. nuevas industrias que frecuentemente son incapaces de competir contra los competidores más grandes y establecidos (pág. 523) infant mortality rate [tasa de mortalidad infantil] n. número de niños que mueren durante el primer año de vida por 1,000 nacimientos (pág. 547) inferior goods [bienes inferiores] n. bienes que tienen menos demanda por parte de los consumidores cuando aumentan sus ingresos (pág. 110) inﬂ ation [inﬂ ación] n. aumento persistente del nivel general de precios, o disminución persistente del poder adquisitivo del dinero (pág. 396) inﬂ ation rate [tasa de inﬂ ación] n. tasa de variación de los precios durante un período de tiempo establecido (pág. 397) infrastructure [infraestructuras] n. conjunto básico de los sistemas de soporte, como los sistemas energéticos, de comunicaciones, de transporte, de agua, sanitarios y de educación, que se necesitan para el funcionamiento de la economía y la sociedad (págs. 86, 545) input costs [costos de los insumos] n. precio de los recursos necesarios para producir un bien o un servicio (pág. 148) insourcing [uso de recursos internos] n. práctica de las compañías extranjeras que establecen operaciones en Estados Unidos y por lo tanto crean puestos de trabajo en este país (pág. 269) interest [interés] n. cargo que paga un banco por el uso del dinero (pág. 578) International Monetary Fund (IMF) [Fondo Monetario Internacional (FMI)] n. organización internacional establecida para promocionar la cooperación monetaria internacional, fomentar el crecimiento económico y proporcionar apoyo ﬁ nanciero temporal a los países para ayudar a mitigar el ajuste de la balanza-de-pagos (pág. 559) investment [inversión] n. uso actual de la renta de manera tal que permita obtener un beneﬁ cio futuro (pág. 318) investment objective [objetivo de inversión] n. meta ﬁ nanciera utilizada para determinar si una inversión es apropiada (pág. 324) J junk bond [bono basura] n. bono de empresa que es de alto riesgo y de alto rendimiento (pág. 339) K Keynesian economics [economía keynesiana] n. idea, propuesta inicialmente por John Maynard Keynes, de que el gobierno necesita estimular la demanda agregada en períodos de recesión (pág. 454) L labor [trabajo] n. todo el tiempo, esfuerzo y talento humano usado para producir bienes y servicios (pág. 8) labor input [factor trabajo] n. magnitud de la fuerza laboral multiplicada por la duración de la semana laborable (pág. 371) labor productivity [productividad del trabajo] n. cantidad de bienes y servicios que una persona puede producir en un tiempo determinado (pág. 149) Spanish Glossary R51 labor union [sindicato laboral] n. organización de trabajadores que trata de mejorar para sus miembros los salarios, las condiciones laborales, los beneﬁ cios suplementarios, la seguridad en el empleo y otros asuntos relacionados con el trabajo (pág. 274) Laffer Curve [curva de Laffer] n. gráﬁ ca que ilustra cómo afecta la reducción de los impuestos a los ingresos ﬁ scales y al crecimiento económico (pág. 459) lagging indicators [indicadores retrasados] n. medidas del rendimiento económico que suelen cambiar después de cambiar el producto interior bruto real (pág. 364) laissez faire [laissez faire] n. principio según el cual el gobierno no debe interferir en la economía (pág. 49) land [tierra] n. todos los recursos naturales sobre o bajo el suelo que se utilizan para producir bienes y servicios (pág. 8) land
lord [propietario de una propiedad] n. dueño de una propiedad de alquiler (pág. 609) law of comparative advantage [ley de la ventaja comparativa] n. ley según la cual los países se beneﬁ cian cuando producen artículos cuya fabricación realizan con la mayor eﬁ ciencia y con el menor costo de oportunidad (pág. 514) law of demand [ley de la demanda] n. establece que cuando el precio de un bien o de un servicio baja la cantidad demandada aumenta, y cuando los precios suben la cantidad demandada disminuye (pág. 99) law of diminishing marginal utility [ley de la utilidad marginal decreciente] n. establece que el beneﬁ cio marginal obtenido al consumir cada unidad adicional de un bien o de un servicio durante un determinado período de tiempo tiende a disminuir tras el consumo de cada una (pág. 106) law of increasing opportunity costs [ley de costos de oportunidad crecientes] n. establece que al pasar de fabricar un producto a fabricar otro, se necesitan cada vez más recursos para aumentar la fabricación del segundo producto, lo cual hace aumentar los costos de oportunidad (pág. 21) law of supply [ley de la oferta] n. establece que los productores están dispuestos a vender más de un bien o de un servicio a un precio más alto que a un precio más bajo (pág. 131) leading indicators [indicadores principales] n. medidas del rendimiento económico que generalmente cambian antes de que cambie el producto interior bruto real (pág. 364) lease [contrato de arrendamiento ﬁ nanciero] n. contrato para alquilar un apartamento, vehículo u otro objeto durante un determinado período de tiempo (pág. 609) legal equality [igualdad legal] n. situación en la que todo el mundo tiene los mismos derechos económicos bajo la ley (pág. 73) less developed countries (LDCs) [países menos desarrollados (PMD)] n. países con un PIB más bajo, menos industrias bien desarrolladas y un nivel de vida menor; a veces, se llaman economías emergentes (pág. 545) life expectancy [esperanza de vida al nacer] n. promedio de años que se prevé que una persona vivirá si las tendencias de mortalidad actuales continúan durante el resto de la vida de esa persona (pág. 547) limited liability [responsabilidad limitada] n. situación en la que la responsabilidad del propietario de una empresa respecto a las deudas y a las pérdidas de la empresa es limitada (pág. 240) limited liability partnership (LLP) [sociedad de responsabilidad limitada (SRL)] n. sociedad en la que no todos los socios son responsables de las deudas y de otras obligaciones de los otros socios (pág. 233) limited life [vida limitada] n. situación en la que una empresa deja de existir si el propietario muere, se jubila o abandona la empresa (pág. 228) limited partnership [sociedad limitada] n. sociedad en la que hay al menos un socio que no participa en la gestión de la empresa y es responsable sólo de los fondos que invirtió (pág. 233) literacy rate [tasa de alfabetización] n. porcentaje de personas mayores de 15 años que saben leer y escribir (pág. 547) loan [préstamo] n. dinero prestado que se reembolsa generalmente con intereses (pág. 582) Lorenz curve [curva de Lorenz] n. curva que muestra el grado de desigualdad de la renta de un país (pág. 391) M macroeconomic equilibrium [equilibrio macroeconómico] n. punto donde la demanda agregada equivale a la oferta agregada (pág. 361) macroeconomics [macroeconomía] n. estudio del comportamiento de la economía en su conjunto; lo relacionado a la actividad económica a gran escala (pág. 27) mandatory spending [gastos obligatorios] n. gastos que debe realizar el gobierno según las leyes actuales (pág. 428) marginal beneﬁ t [beneﬁ cio marginal] n. beneﬁ cio o satisfacción obtenido al consumir una unidad adicional de un bien o de un servicio (pág. 16) marginal cost [costo marginal] n. costo adicional de producir o consumir una unidad adicional de un bien o de un servicio (págs. 16, 140) marginal product [producto marginal] n. cambio en el producto total que es resultado de añadir un trabajador más (pág. 138) R52 Spanish Glossary marginal revenue [ingreso marginal] n. dinero obtenido al vender cada unidad adicional (pág. 142) market [mercado] n. cualquier lugar o situación en que las personas compran y venden bienes y servicios (pág. 48) market allocation [reparto de mercado] n. acuerdo entre dos o más empresas competidoras por el que se divide un mercado (pág. 216) market demand curve [curva de demanda de mercado] n. gráﬁ ca que muestra datos de una tabla de demanda de mercado, o la cantidad de un bien o de un servicio que todos los consumidores pueden y están dispuestos a comprar a cada precio (pág. 102) market demand schedule [tabla de demanda de mercado] n. tabla que muestra la cantidad de un bien o de un servicio que todos los consumidores pueden y están dispuestos a comprar a cada precio de un mercado (pág. 100) market division [repartición de mercado] véase market allocation [reparto de mercado] market economy [economía de mercado] n. sistema económico basado en la elección individual y el intercambio voluntario (pág. 39) market equilibrium [equilibrio del mercado] n. situación en la que la cantidad ofertada y la cantidad demandada a un precio determinado son iguales (pág. 164) market failure [fallo del mercado] n. situación en la que personas no participantes de una interacción del mercado se beneﬁ cian de ella o pagan parte de sus costos (pág. 84) market research [investigación de mercados] n. recogida y evaluación de información sobre las preferencias de los consumidores respecto a bienes y servicios (pág. 208) market share [cuota de mercado] n. porcentaje del total de ventas de una empresa en un mercado determinado (pág. 209) market structure [estructura de mercado] n. modelo económico de competencia entre las empresas de la misma industria (pág. 192) market supply curve [curva de oferta de mercado] n. gráﬁ ca que muestra datos de una tabla de oferta de mercado (pág. 134) market supply schedule [tabla de oferta de mercado] n. tabla que muestra la cantidad de un bien o de un servicio que todos los productores de un mercado pueden y están dispuestos a ofrecer para su venta a cada precio (pág. 132) maturity [vencimiento] n. fecha en la que un bono debe reembolsarse (pág. 338) Medicaid [Medicaid] n. programa de seguro médico gubernamental destinado a las personas de baja renta (pág. 429) Medicare [Medicare] n. programa de seguro de salud nacional y gubernamental destinado principalmente a los ciudadanos mayores de 65 años (pág. 423) medium of exchange [medio de intercambio] n. medio por el que se pueden intercambiar bienes y servicios (pág. 288) merger [fusión] n. unión de dos o más compañías para formar una sola compañía (pág. 214) microeconomics [microeconomía] n. estudio del comportamiento de los participantes individuales de una economía, como las personas, las familias y las empresas (pág. 27) minimum balance requirement [requisito de saldo mínimo] n. cantidad de dinero que se debe mantener en una cuenta para evitar los cargos (pág. 576) minimum wage [salario mínimo] n. la menor cantidad, según establece la ley, que un empleador puede pagar a un trabajador por una hora de trabajo (págs. 182, 262) mixed economy [economía mixta] n. sistema económico que presenta elementos de las economías tradicional, autoritaria y de mercado; sistema económico más común (pág. 58) modiﬁ ed free enterprise economy [economía de libre mercado modiﬁ cada] n. sistema económico mixto que incluye algunas medidas protectoras, disposiciones y reglamentos del gobierno, para ajustar el sistema de libre mercado (pág. 80) monetarism [monetarismo] n. teoría económica que sugiere que los cambios rápidos en la oferta monetaria son la causa principal de la inestabilidad económica (pág. 496) monetary [monetario] adj. lo relacionado al dinero (pág. 474) monetary policy [política monetaria] n. medidas de la Reserva Federal que cambian la oferta monetaria para inﬂ uir en la economía (pág. 490) money [dinero] n. todo lo que las personas aceptan como pago de bienes y servicios (pág. 288) money market [mercado monetario] n. mercado en el que se compran y venden activos ﬁ nancieros a corto plazo (pág. 322) monopolistic competition [competencia monopolista] n. estructura de mercado en la que un gran número de vendedores ofrecen a los consumidores productos similares pero no estandarizados (pág. 206) monopoly [monopolio] n. estructura de mercado en la que un único vendedor vende un producto para el que no existen sustitutos adecuados (pág. 198) monopsony [monopsonio] n. estructura de mercado en la que existe gran número de vendedores pero sólo un comprador grande (pág. 212) Spanish Glossary R53 multifactor productivity [productividad multifactorial] n. razón entre la producción económica de una industria y los factores trabajo y capital (pág. 372) multinational corporation [empresa multinacional] n. sociedad anónima que tiene establecimientos en varios países (pág. 243) mutual fund [fondo de mercado monetario, fondo mutual] n. compañía de inversión que reúne dinero de inversionistas individuales y lo utiliza para comprar una variedad de activos ﬁ nancieros (pág. 320) N NAFTA [NAFTA] n. Tratado de Libre Comercio con América del Norte, convenio que asegura el libre comercio por todo el continente y constituye la zona de libre comercio más grande del mundo (pág. 533) national accounts [cuentas nacionales] véase national income accounting [contabilidad nacional] national bank [banco nacional] n. banco autorizado por el gobierno nacional (pág. 299) national debt [deuda pública] n. cantidad total de dinero que debe el gobierno federal (pág. 462) national income (NI) [renta nacional (RN)] n. renta total percibida en un país por la producción de bienes y servicios durante un determinado período de tiempo (pág. 355) national income accounting [contabilidad nacional] n. método de analizar la economía de un país usando medidas estadísticas de los ingresos, los gastos y la producción (pág. 350) nationalize [nacion
alizar] v. pasar de la propiedad privada a la propiedad gubernamental o pública (pág. 61) natural monopoly [monopolio natural] n. situación del mercado en la que los costos de producción son más bajos cuando una única empresa proporciona un producto o un servicio (pág. 201) near money [cuasidinero] n. cuentas de ahorro y otros depósitos a plazo similares que pueden convertirse en dinero de manera relativamente fácil (pág. 293) needs [necesidades] n. objetos como los alimentos, la ropa y los lugares de vivienda, que son necesarios para la vida (pág. 4) negative externality [externalidad negativa] n. externalidad que supone un costo para personas no participantes en la actividad económica original (pág. 87) net national product (NNP) [producto nacional neto (PNN)] n. producto nacional bruto menos la depreciación del capital social. Es decir, es el valor de los bienes y los servicios ﬁ nales menos el valor de los bienes capitales que quedaron desgastados durante el año (pág. 355) nominal GDP [PIB nominal] n. producto interior bruto expresado en función del valor actual de los bienes y los servicios (pág. 352) nonmarket activities [actividades no comerciales] n. servicios que tienen un valor económico en potencia pero que se prestan sin cobrar (pág. 354) nonprice competition [competencia no basada en el precio] n. uso de factores distintos al precio, como el estilo, el servicio, la publicidad o los regalos, para tratar de convencer a los clientes para que compren algo de un productor y no de otro (pág. 207) nonproﬁ t organization [organización sin ﬁ nes de lucro] n. institución que actúa como empresa pero que existe para beneﬁ ciar a la comunidad en lugar de obtener ganancias (pág. 250) normal goods [bienes normales] n. bienes que tienen más demanda por parte de los consumidores cuando aumentan sus ingresos (pág. 110) normative economics [economía normativa] n. forma de describir y explicar cómo debería ser el comportamiento económico y no cómo es en realidad (pág. 29) not-for-proﬁ t [sin ﬁ nes de lucro] véase nonproﬁ t organization [organización sin ﬁ nes de lucro] O oligopoly [oligopolio] n. estructura de mercado en la que un número reducido de vendedores ofrecen un producto similar (pág. 209) OPEC [OPEP] n. Organización de Países Exportadores de Petróleo, grupo comercial regional (pág. 535) open market operations [operaciones de mercado abierto] n. compraventa por parte de la Reserva Federal de valores del gobierno federal; instrumento de política monetaria de mayor uso por la Reserva Federal para ajustar la oferta monetaria (pág. 490) open opportunity [oportunidad abierta] n. capacidad para que todo el mundo pueda entrar y competir en el mercado según su libre elección (pág. 73) operating budget [presupuesto de operación] n. plan para los gastos diarios (pág. 436) opportunity cost [costo de oportunidad] n. costo de elegir una alternativa económica en lugar de otra (pág. 14) option [opción] n. contrato por el que se da al inversionista el derecho a comprar o vender acciones en una fecha futura y a un precio establecido (pág. 333) outsourcing [subcontratación] n. práctica de contratar una empresa externa, a menudo en un país extranjero, para que proporcione bienes y servicios (pág. 269) R54 Spanish Glossary overdraft [sobregiro] n. cheque u otra forma de retirar fondos que excede del saldo existente en la cuenta (pág. 576) P par value [valor a la par] n. cantidad que el emisor de un bono promete pagar al comprador en la fecha de vencimiento (pág. 338) partnership [sociedad] n. empresa que pertenece a dos o más personas, o “socios”, que acuerdan la forma de repartir las responsabilidades, las ganancias y las pérdidas (pág. 232) patent [patente] n. inscripción legal de un invento o de un proceso que da al inventor los derechos exclusivos de la propiedad sobre ese invento o proceso durante cierto número de años (pág. 202) peak [punto máximo, pico] n. ﬁ n de una expansión de la economía (pág. 359); véase business cycle [ciclo económico] per capita gross domestic product [producto interior bruto per cápita] n. PIB de un país, dividido por la población total (pág. 546) perestroika [perestroika] n. plan del dirigente ruso Mijaíl Gorbachov de incorporar de forma gradual mercados en la economía autoritaria de la Unión Soviética (pág. 564) perfect competition [competencia perfecta] n. modelo ideal de una economía de mercado; estructura de mercado en la que ninguno de los numerosos vendedores y compradores independientes y bien informados tiene control sobre el precio de un bien o un servicio estandarizado (pág. 192) personal income (PI) [renta personal (RP)] n. renta anual recibida por el conjunto de personas de un país y procedente de todas las fuentes (pág. 355) phishing [phishing] n. técnica empleada por los ladrones de identidad para recoger información personal mediante llamadas telefónicas engañosas (pág. 588) PIN [PIN] n. número de identiﬁ cación personal (pág. 577) positive economics [economía positiva] n. forma de describir y explicar la economía tal como es (pág. 29) positive externality [externalidad positiva] n. externalidad que beneﬁ cia a personas no participantes en la actividad económica original (pág. 87) poverty [pobreza] n. situación en la que la renta y los recursos de una persona no le permiten obtener un nivel de vida mínimo (pág. 388) poverty line [línea de pobreza] véase poverty threshold [umbral de pobreza] poverty rate [tasa de pobreza] n. porcentaje de personas que viven en hogares cuya renta es inferior a la del umbral de pobreza (pág. 389) poverty threshold [umbral de pobreza] n. renta mínima oﬁ cial necesaria para pagar los gastos básicos de la vida (pág. 388) predatory pricing [establecer precios predatorios] n. ﬁ jar los precios por debajo del costo durante un tiempo para excluir de un mercado a los competidores de menor tamaño (pág. 216) preferred stock [acciones preferentes] n. participación en la propiedad de una sociedad anónima que da al titular parte de las ganancias pero generalmente no da derecho a voto (pág. 331) premium [prima] n. cantidad que se paga por un seguro (pág. 596) price ceiling [precio máximo] n. precio máximo establecido que los vendedores pueden cobrar por un producto (pág. 180) price ﬁ xing [imposición de precios] n. pactos entre dos o más empresas por los que ﬁ jan los precios de productos competidores (pág. 216) price ﬂ oor [precio mínimo] n. precio mínimo establecido al que los compradores deben pagar un producto (pág. 182) price maker [ﬁ jador de precio] n. empresa que no tiene que tomar en cuenta a los competidores cuando ﬁ ja sus precios (pág. 198) price taker [tomador de precio] n. compañía que debe aceptar el precio de mercado ﬁ jado por la interacción de la oferta y la demanda (pág. 193) primary market [mercado primario] n. mercado de valores para comprar activos ﬁ nancieros directamente del emisor (pág. 322) prime rate [tasa preferencial] n. tasa de interés que los bancos aplican a sus mejores clientes (pág. 491) private company [compañía privada] n. sociedad anónima que controla quién puede comprar o vender sus acciones (pág. 238) private property rights [derechos a propiedad privada] n. derechos de las personas y de los grupos a poseer recursos y empresas (pág. 48) private sector [sector privado] n. parte de la economía que pertenece a las personas o a las empresas (pág. 432) privatization [privatización] n. proceso de transferir a las personas propiedades y empresas públicas (pág. 563) privatize [privatizar] v. pasar de la propiedad gubernamental o pública a la propiedad privada (pág. 61) producer [productor] n. persona que produce bienes o presta servicios (pág. 5) producer price index (PPI) [índice de precios al por mayor (IPM)] n. medida de los cambios en los precios al por mayor (pág. 397) product differentiation [diferenciación de productos] n. intento de distinguir un producto de otros productos similares (pág. 206) Spanish Glossary R55 product market [mercado de productos] n. mercado en el que se compran y venden bienes y servicios (pág. 52) production possibilities curve (PPC) [curva de posibilidades de producción (CPP)] n. gráﬁ ca utilizada para ilustrar el efecto de la carencia sobre una economía (pág. 18) productivity [productividad] n. cantidad de producto obtenido a partir de una cantidad establecida de insumos (pág. 372) productivity, labor [productividad, trabajo] véase labor productivity [productividad del trabajo] proﬁ t [ganancias] n. ganancias ﬁ nancieras que obtiene un vendedor al realizar una transacción comercial (pág. 49); dinero que queda tras restar los costos de fabricar un producto a los ingresos obtenidos al vender ese producto (pág. 78) proﬁ t-maximizing output [nivel de producción de máxima ganancia] n. punto de la producción en el que una empresa ha alcanzado su mayor nivel de ganancias (pág. 143) proﬁ t motive [afán de lucro] n. incentivo que estimula a las personas y a las organizaciones para que mejoren su bienestar material buscando obtener ganancias de actividades económicas (pág. 73) progressive tax [impuesto progresivo] n. impuesto que aplica una tasa impositiva más alta a las personas de alta renta que a las personas de baja renta (pág. 412) property tax [impuesto sobre la propiedad] n. impuesto basado en el valor de los activos de una persona o de una empresa (pág. 412) proportional tax [impuesto proporcional] n. impuesto que extrae el mismo porcentaje de renta a todos los contribuyentes, independientemente de su nivel de renta (pág. 412) protectionism [proteccionismo] n. uso de barreras al comercio entre los países para proteger las industrias nacionales (pág. 523) protective tariff [arancel proteccionista] n. impuesto aplicado a los bienes importados para proteger los bienes nacionales (pág. 521) public company [empresa que cotiza en Bolsa] n. sociedad anónima que emite acciones que pueden negociarse libremente (pág. 238) public disclosure [divulgación pública] n. política que exige que las empresas revelen a l
os consumidores información sobre sus productos (pág. 217) public goods [bienes públicos] n. bienes y servicios proporcionados por el gobierno y consumidos por el público como grupo (pág. 84) public transfer payment [pago de transferencia público] n. pago de transferencia por el que el gobierno transﬁ ere ingresos de los contribuyentes a los beneﬁ ciarios sin que éstos den nada a cambio (pág. 89) pure competition [competencia pura] véase perfect competition [competencia perfecta] Q quota [cuota] n. límite sobre la cantidad de un producto que puede importarse (pág. 520) R rational expectations theory [teoría de las expectativas racionales] n. teoría según la cual las personas y las empresas prevén que los cambios en la política ﬁ scal tendrán efectos determinados y actúan para proteger sus intereses contra esos efectos (pág. 452) rationing [racionamiento] n. sistema en el que el gobierno asigna bienes y servicios aplicando factores distintos al precio (pág. 183) real GDP [PIB real] n. producto interior bruto corregido respecto a los cambios en los precios de un año a otro (pág. 352) real GDP per capita [PIB real per cápita] n. producto interior bruto real dividido por la población total (pág. 369) recession [recesión] n. contracción económica prolongada que dura dos o más trimestres (seis meses o más) (pág. 359) regressive tax [impuesto regresivo] n. impuesto que extrae un mayor porcentaje de renta a las personas de baja renta que a las personas de alta renta (pág. 412) regulation [regulación] n. serie de reglas o leyes diseñadas para controlar el comportamiento comercial (págs. 150, 214) representative money [dinero representativo] n. papel moneda respaldado por algo tangible (pág. 291) required reserve ratio (RRR) [coeﬁ ciente de reservas exigidas (CRE)] n. fracción de los depósitos de un banco, tal como lo determina la Reserva Federal, que debe tener en forma de reservas para poder dar préstamos de dinero (pág. 484) return [rentabilidad] n. ganancias o pérdidas derivadas de una inversión (pág. 327) revenue [ingresos] n. renta gubernamental procedente de los impuestos y de fuentes no impositivas (pág. 410) revenue tariff [arancel ﬁ nanciero] n. impuesto aplicado a las importaciones especíﬁ camente para recaudar fondos; actualmente se usa muy poco (pág. 521) R56 Spanish Glossary right-to-work laws [leyes de libertad de sindicación] n. legislación que hace ilegal exigir que los trabajadores se asocien a los sindicatos (pág. 279) risk [riesgo] n. posibilidad de sufrir pérdidas en una inversión (pág. 327) S safety net [red de protección] n. programas gubernamentales diseñados para proteger a las personas de las diﬁ cultades económicas (pág. 89) sales tax [impuesto sobre las ventas] n. impuesto basado en el valor de los bienes o los servicios en el momento de la venta (pág. 412) savings [ahorros] n. ingresos que no se utilizan para el consumo (pág. 318) scarcity [carencia] n. situación en la que los recursos no son suﬁ cientes para satisfacer los deseos humanos (pág. 4) seasonal unemployment [desempleo estacional] n. desempleo asociado al trabajo estacional (pág. 384) secondary market [mercado secundario] n. mercado en el que los activos ﬁ nancieros se venden de nuevo (pág. 322) service [servicios] n. trabajo que una persona realiza para otra a cambio de un pago (pág. 5) shadow economy [economía sumergida] véase underground economy [economía subterránea] share [acción] n. unidad del conjunto de acciones de una sociedad anónima (pág. 238); véase stock [acciones] shock therapy [terapia de choque] n. programa económico en el que se pasa abruptamente de una economía autoritaria a una economía de libre mercado (pág. 563) shortage [escasez] n. situación en la que la demanda es mayor que la oferta y la causa suele ser la ﬁ jación de precios excesivamente bajos (pág. 167) shoulder surﬁ ng [navegar por el hombro] n. técnica utilizada por los ladrones de identidad para recoger información personal cuando se revela información privada en público (pág. 588) socialism [socialismo] n. sistema económico en el que el gobierno posee algunos o todos los factores de producción (pág. 43) Social Security [Seguridad Social] n. programa federal que proporciona ayuda a los ciudadanos mayores, a los niños huérfanos y a los incapacitados (pág. 423) sole proprietorship [empresa unipersonal] n. empresa que pertenece a una sola persona y que es controlada por esa persona (pág. 226) spamming [spamming] n. técnica utilizada por los ladrones de identidad para recoger información personal mediante correos electrónicos engañosos (pág. 588) special economic zone (SEZ) [zona económica especial (ZEE)] n. región geográﬁ ca que tiene leyes económicas diferentes de las leyes económicas normales de un país, con el objetivo de aumentar las inversiones extranjeras (pág. 567) specialization [especialización] n. situación en la que las personas o las empresas centran sus esfuerzos comerciales en los campos en que presentan una ventaja para una mayor productividad y mayores ganancias (págs. 50, 138, 510) spending multiplier effect [efecto multiplicador de los gastos] n. situación en la que un pequeño cambio en los gastos acaba produciendo un cambio mucho más grande en el PIB (pág. 455) stabilization programs [programas de estabilización] n. programas en los que los países en diﬁ cultades se ven obligados a realizar reformas, como reducir el déﬁ cit comercial exterior y el endeudamiento externo, eliminar los controles de precios, cerrar las empresas públicas ineﬁ cientes y bajar radicalmente el déﬁ cit presupuestario (pág. 559) stagﬂ ation [estanﬂ ación] n. períodos durante los que suben los precios a la vez que se reduce la actividad económica (pág. 359) standardized product [producto estandarizado] n. producto que los consumidores consideran idéntico en todas sus características esenciales a otros productos del mismo mercado (pág. 192) standard of value [patrón de valor] n. forma de medir el valor económico en el proceso de cambio de divisas (pág. 289) start-up costs [costos de puesta en marcha] n. gastos que una nueva empresa debe pagar para entrar en un mercado y empezar a vender a los consumidores (pág. 209) state bank [banco estatal] n. banco autorizado por el gobierno de un estado (pág. 296) statistics [estadísticas] n. datos numéricos (pág. 24) stock [acciones] n. participaciones en la propiedad de una sociedad anónima (pág. 238) stockbroker [agente de bolsa] n. agente que compra y vende valores para los clientes (pág. 332) stock exchange [bolsa de valores] n. mercado secundario donde se venden y compran valores (pág. 330) stock index [índice bursátil] n. instrumento utilizado para medir e informar sobre el cambio en los precios de un conjunto de acciones (pág. 334) stored-value card [tarjeta de valor almacenado] n. tarjeta que representa dinero que el titular tiene en forma de depósito con la compañía emisora (pág. 308) Spanish Glossary R57 store of value [depósito de valor] n. algo que conserva su valor con el paso del tiempo (pág. 289) strike [huelga] n. paralización del trabajo utilizada para ejercer presión en las negociaciones mientras se trata de convencer al empleador de que mejore los salarios, las condiciones laborales u otros asuntos relacionados con el trabajo (pág. 274) structural unemployment [desempleo estructural] n. desempleo que existe cuando los puestos de trabajo disponibles no se corresponden con las aptitudes de las personas en condiciones de trabajar (pág. 384) subsidy [subsidio] n. pago gubernamental que ayuda a cubrir el costo de una actividad económica que puede beneﬁ ciar al público en su conjunto (pág. 88) substitutes [sustitutos] n. productos que se pueden usar en lugar de otros productos, para satisfacer los deseos de los consumidores (pág. 112) substitution effect [efecto sustitución] n. patrón de comportamiento que se presenta cuando los consumidores, al reaccionar ante un cambio en el precio de un producto, compran un producto sustitutivo que ofrece un mejor valor relativo (pág. 107) supply [oferta] n. disponibilidad y capacidad para producir y vender un producto (pág. 130) supply curve [curva de la oferta] n. gráﬁ ca que muestra los datos de una tabla de oferta (pág. 134) supply schedule [tabla de oferta] n. tabla que muestra la cantidad de un bien o de un servicio que un productor individual puede y está dispuesto a ofrecer para su venta a cada precio (pág. 132) supply-side ﬁ scal policy [política ﬁ scal sobre la oferta] n. plan diseñado para ofrecer incentivos a los productores para que aumenten la oferta agregada (pág. 458) surplus [excedente] n. situación en la que la oferta es mayor que la demanda y la causa suele ser la ﬁ jación de precios excesivamente altos (pág. 167) T tariff [arancel] n. cargo aplicado a los bienes transferidos a un país procedentes de otro país (pág. 521) tax [impuesto] n. pago obligatorio a un gobierno (pág. 410) taxable income [renta gravable] n. aquella parte de la renta sujeta a impuestos después de descontar todas las deducciones y exenciones (págs. 421, 604) tax assessor [asesor ﬁ scal] n. funcionario gubernamental que determina el valor de una propiedad sujeta a impuestos (pág. 437) tax base [base imponible] n. forma de riqueza, como la renta, la propiedad, los bienes o los servicios, que está sujeta a impuestos (pág. 412) tax incentive [incentivo ﬁ scal] n. uso de impuestos para estimular o desalentar ciertos comportamientos económicos (pág. 417) tax return [declaración de la renta] n. formulario utilizado para declarar la renta y los impuestos que deben pagarse al gobierno (pág. 421) technological monopoly [monopolio tecnológico] n. monopolio que existe debido a que una empresa controla un método de fabricación, un invento o un tipo de tecnología (pág. 201) technology [tecnología] n. aplicación de métodos e innovaciones cientíﬁ cos a la producción (pág. 149) telecommuting [trabajo a distancia] n. práctica de realizar el trabajo de oﬁ cina en un lugar distinto a la propia oﬁ cina (p

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