Economics For Everybody Part1.compressed

The United States Free Enterprise System 11V1 41

Produced? In our free enterprise system, the consumers who are
both willing and able to pay the price may have all the pens—and
other goods—they want. But those who think the price is too high,
and those who cannot afford to pay the price, will just have to do
without new pens and other goods.

WHY IS THE U.S. SYSTEM A MIXED MARKET ECONOMY?

The U.S. economic system is a market economy. But in the United
States, market forces alone do not decide how all goods and services
will be produced. Federal, state, and local governments have an import-
ant role in the production of goods and services. We call a system where
both the free market and government play roles in deciding what and
how to produce a mixed market economy or, simply, a mixed economy.

Governments on the local, state, and national level produce many
of the services we use. For example, each public school in the United
States receives funds from local, state, and federal governments. Your
town, village, or city funds the police department and, very often, the
fire department. The roads you walk, bicycle, or drive on are built and
maintained by local, state, and/or federal funding. The postal system
and national defense network are services provided by the federal gov-
ernment. Privately owned businesses, however, produce schoolbooks,
road-building materials, fire trucks, police cars, aircraft, and other
equipment and materials that governments buy and use.

In these situations, resources that otherwise might have been used
to produce goods and services for private use were used for the produc-
tion of goods and services for public use. Suppose, for example, that the
federal government decided it was important to build another fighter
plane. With money it has received from private individuals and busi-
ness firms through taxation, it is able to do so. If that tax money were
left in the hands of private individuals and business firms, the money,
materials, and labor that goes into building the fighter plane might
have been used to build a factory or an office building instead.

As illustrated above, in the U.S. mixed economy, government does
get directly involved with the free market to influence what goods and
services private individuals and businesses will produce.

The Federal Reserve Board, a federal agency, largely determines
interest rates in the United States. This is important because high in-
terest rates tend to lower production. For example, high interest rates
may discourage people from buying new homes. Builders, therefore,
will produce fewer new homes. By contrast, low interest rates tend to
encourage greater production. They will encourage people to buy new
homes. If that happens, builders will produce more new homes.

Government also influences how goods and services will be produced.

42 WHAT IS ECONOMICS ALL ABOUT?

Local, state, and federal laws regulate business activity in many
ways. Business firms often complain of the excessive government
regulations they must contend with. Among these are: requiring a
permit or license to do business; inspecting restaurants and food and
drug production; regulating imports and exports; regulating mini-
mum wages and hours; setting a minimum age for working, drinking
alcoholic beverages, buying tobacco products, driving motor vehicles;
and taxing incomes, purchases, and property. Business firms say that
the endless forms they must fill out to meet government regulations
are time consuming, costly, and often unnecessary.

Government plays an important role in deciding the who question
in the United States. Taxes at all levels of government take income
from individuals and corporations. Individuals and corporations,
therefore, have fewer dollars to spend as they wish. Government

Understanding Economics
GROSS DOMESTIC PRODUCT

GDP 2013 = $16.8 trillion
• Consumer Spending = $11.5 trillion (68%)
• Business Spending = $2.7 trillion (16%)
• Government Spending = $3.1 trillion (18%)
• Net Exports = (—$0.5 trillion) (-2%)

Some economists like to think of the family, and friends who buy goods and ser-
U.S. economy as a giant business or com- vices for their own use. Consumer spend-
pany. Like many business firms, this com- ing amounted to $11.5 trillion in 2013.
pany produces both goods and services.
But unlike ordinary businesses, the U.S. Business spending is also called in-
economy creates all of the goods and ser- vestment. Businesses invest in capital re-
vices that the nation produces. sources, such as factories, machinery, and
tools, which are used to produce goods
The total money value of the goods and services. In 2013, investment ac-
and services produced by a nation's counted for $2.7 trillion of the GDP.
economy in one year is called its gross
domestic product, or GDP. In 2013, the In 2013, government spending for
GDP of the United States was $16.8 tril- goods and services on the federal, state,
lion ($16,800,000,000,000). and local levels totalled $3.1 trillion.

The GDP is purchased by the econ- Foreigners purchased $2.3 trillion
omy's "customers." These are U.S. worth of goods and services from the U.S.
consumers, business firms, and govern- economic system in 2013. But Amer-
ments, as well as buyers in other coun- icans purchased $2.8 trillion worth of
tries. Economists measure the size of the goods and services from foreign business
GDP by totalling the amount of money firms. The difference of $500 billion was
spent by each of these groups. deducted from the total spending in the
United States in order to arrive at the GDP
Consumers are people like you, your for that year of $16.8 trillion.

The United States Free Enterprise System 43

then decides how it will spend the tax dollars it receives. Some tax
dollars will be used to help individuals in need. These individuals will
have more money to spend on goods and services. In these instances,
government, rather than the market, is deciding who is to receive the
goods and services society produces. The role of government in the
U.S. economy is discussed in greater detail in Unit V.

The Circular Flow of the U.S. Economy

As you learned in the discussion of gross domestic product, the
nation's mixed market economy consists of three major sectors, or
parts. These are households, businesses, and government.

A household is one or more people occupying the same dwelling
unit (such as a house, an apartment, or a mobile home). All of us
live in households. Figure 3.2 on this page shows the relationship be-
tween the nation's households and businesses. As you can see, people
(that is, households) rely on businesses in two ways. First, people can
earn incomes by selling their services to businesses. Second, people
get goods and services from businesses.

The illustration also shows that businesses rely upon households
to (1) provide the resources—labor, land, management, and capital—

Figure 3.2 Circular Flow Between Households and Businesses

HOUSEHOLDS

BUSINESSES

AA44 WHAT IS ECONOMICS ALL ABOUT?

needed to produce goods and services, and (2) buy their goods and
services.

Now you can see why the illustration is called a circular flow
chart. The money that businesses pay out (in wages, rent, inter-
est, and dividends) returns when people (households) pay for goods
and services. Similarly, the land, labor, management, and capital
resources that households sell to businesses create goods and ser-
vices that are bought by households.

As you probably know, there are three levels of government in
the United States. These are the federal government in Washington,
D.C., the governments of the 50 states, and the thousands of local
governments across the nation. The relationship between these gov-
ernments and households, and between governments and businesses,
is much like that between households and businesses.

The second illustration shows two ways that households rely on
government. First, households receive services such as police and
fire protection, roads, and schools from governments. Second, house-
holds can earn income by selling their services to governments.

Figure 3.3 also shows that governments rely upon households in
two ways: (1) Households provide the labor and other resources that
governments need to produce goods and services. (2) Households pro-
vide income to governments through the payment of taxes.

The relationship between governments and businesses is shown
in Figure 3.4 on page 46. As you can see, governments rely on busi-
nesses in two ways: (1) Businesses provide governments with goods
and services. (2) Businesses pay taxes to governments. Meanwhile,
businesses also look to governments to (1) buy their goods and ser-
vices, and (2) provide them with necessary services.

Now that you have seen how each one of the three sectors of the
U.S. economy relates to the other two, you will be able to under-
stand the "big picture." This is shown in Figure 3.5 as the circular
flow of the U.S. economy.

As you examine the diagram on page 47, consider how the rest
of the world affects the model. Businesses can hire workers any-
where in the world and can sell products to consumers overseas.
Households buy goods from abroad and many individuals now work
for foreign companies.

Goals of the Mixed U.S. Economy

If you were to ask Americans what they want their nation's eco-
nomic system to provide, they might mention the following goals:
growth, stability, security, justice, freedom, and economic efficiency.
These ideas were stated as far back as 1776 in the Declaration of In-

The United States Free Enterprise System Afk 45
Figure 3.3 Circular Flow Between Households and Governments

GOVERNMENTS

lit

4 it
HOUSEHOLDS

dependence which, as you well know, declares:
We hold these truths to be self-evident, that all men are created
equal, that they are endowed by their Creator with certain in-
alienable Rights, that among these are Life, Liberty and the pur-
suit of Happiness.
These ideas are further elaborated in the Preamble to the United

States Constitution as well as in the body of the Constitution, which
establishes a federal system of government; separation of powers
among a congress, president and the judiciary; and provision for
checks and balances so that no one branch has complete control of
our government.

1. Economic Growth. An increase in the nation's output of
goods and services (its GDP) is a sign of economic growth. Natu-
rally, Americans would like to live better today than they did in
past years. And they want to live even better in the future. This
will be possible only if the nation produces more, so that more
goods and services are made available for all. In other words, we

46 WHAT IS ECONOMICS ALL ABOUT?
Figure 3.4 Circular Flow Between Governments and Businesses

GOVERNMENTS

BUSINESSES

want to improve their standard of living. Economists define stan-
dard of living as the quantity and quality of goods and services
available to an individual or society. It will be possible to improve
our nation's standard of living only if the nation produces more
per capita (economic growth). In this way, more goods and services
would be made available for all. We will have more to say about
economic growth in the final unit of this book.

2. Economic Stability. In the past, the United States has
gone through cycles of economic good times followed by periods of
economic bad times. Americans want to eliminate the bad times,
make sure that everyone who wants a job has one, and keep a
steady output of goods and services. And Americans want to know
that their savings will not be made worthless by rising prices in
the future. (Inflation is discussed in Chapter 6.)

3. Economic Security. Americans want to be sure that even

The United States Free Enterprise System 47

in hard times—or when they are unemployed—they will not suffer
too much.

4. Economic Justice. Americans believe that their economic
system should offer equal opportunity and reward based on what
a person does regardless of race, sex, age, religion, or national or-
igin. In addition, the system should provide all Americans with a
"fair share" of the nation's output of goods and services. Ameri-
cans do not agree, however, as to what a "fair share" should be.

5. Economic Freedom. A number of rights or freedoms are
involved here that benefit everyone. Workers have the right to ac-
cept or refuse jobs. Everyone has the right to own property, form a
business, and attempt to make a profit. Individuals have freedom to
spend or save money and to own or dispose of goods that they buy.

6. Economic Efficiency. As we have said, it takes human
and natural resources to produce goods and services. But these re-
sources are limited in supply. An efficient economic system strives
to do the most with what resources are available. It strives to get
its citizens the greatest output of goods and services from the in-

Figure 3.5 Circular Flow of the U.S. Economy

BUSINESSES HOUSEHOLDS

GOVERNMENTS

48 WHAT IS ECONOMICS ALL ABOUT?

put of human and natural resources.

7. Invisible Hand. In 1776, a Scottish economist, Adam
Smith, published The Wealth of Nations. In this book, Smith
laid down theories that guide the thinking of economists to this
day. Smith stated that in a free enterprise system, things work
out better without government officials interfering with the
process. Instead, self-interest and competition work as an in-
visible hand to guide a free enterprise system. An example of
an invisible hand guiding economic activities would be a store-
keeper who sold pens. The store owner did not have to be told
by a government agency to order more pens when her stock was
running out. The storekeeper did so because it was in her self-
interest. So, too, self-interest prompted a producer to make the
pens and a supplier to sell them to the storekeeper.

Meeting the Nation's Goals

The U.S. economic system has achieved many of these basic
goals for most of its people. At the same time, it has maintained
personal and political freedom. Many Americans believe that they
have these freedoms only because they have prevented government
from gaining too much economic control in their lives. As long as
economic power (in the form of individual ownership and free en-
terprise) is widespread, political power will not fall into the hands
of a few people.

The creation of wealth—the production of goods and services—
in the United States is greater and more varied than the produc-
tion of any other nation in the world. As a result of our nation's con-
tinuing economic growth, nearly 94 percent of U.S. families have
at least one telephone, 69 percent have air conditioners, 83 percent
have central heating, and almost all have television sets. The aver-
age home has two rooms per person and at least one car per family.

The quality of the goods and services produced is also high.
More important, Americans are healthier and live longer today
than Americans did in the past. Heart disease and stroke deaths
have declined. Measles and mumps have almost been wiped out.

Scarcity has not been eliminated, however. To do so is impossi-
ble because economic resources are always limited. Nor have all the
American people shared equally in the country's rising living stan-
dards. However, inequalities based upon race, sex, religion, and na-
tional origin have been greatly reduced. Other factors, such as the
amount of education a person has received, now often play a more
important part in determining family income.

The United States Free Enterprise System 49

SUMMARY

In this chapter we learned about the U.S. economic system of free en-
terprise. Countries with similar systems include Singapore, Switzerland,
Chile, and Canada. Free enterprise rests upon six principles: freedom to
choose one's way of earning a living (including starting a business), pri-
vate property, the profit motive, competition, consumer sovereignty, and
the rule of law.

Like every economic system, free enterprise must provide a means to
answer three basic questions: what goods and services to produce, how to
produce them, and who shall receive them. In our market economy, the an-
swers are largely the result of the decisions of individual buyers and sellers.

The U.S. economic system is actually a mixed market economy. The
market alone does not make all the decisions about what will or will not
be produced. Federal, state, and local governments are major buyers and
sellers of goods and services. These governments may also regulate mar-
ket activity. The goals of the U.S. economic system are growth, stability,
security, justice, freedom, and economic efficiency. The U.S. economy pro-
duces more goods and services than any other nation. It has succeeded in
meeting many, but not all, of its goals.

LOOKING AHEAD

The principal reason why buyers and sellers behave the way they do
can be summed up in one word: price. Why is this so? And why do prices
rise and fall? What effect does the behavior of buyers and sellers have on
prices? The answers to these questions may be found in the laws of sup-
ply and demand. They will be the focus of our next chapter.

EXERCISES

I/Multiple Choice Choose the letter of the item that best completes
the statement or answers the question.

1. A major idea of this chapter is that (a) government should not interfere
with free enterprise (b) the U.S. economy is basically a free enterprise
system (c) the manufacture and sale of felt-tipped pens is profitable (d)
consumer goods are always plentiful in a free enterprise system.

2. Another major idea of this chapter is that (a) it pays to sell felt-
tipped pens (b) anyone may start a business in a free enterprise
economic system (c) factories produce whatever they please (d) a

free enterprise system is run by the government.

3. In a free enterprise system, both buyers and sellers decide (a) what
goods and services should be produced (b) how goods and services
should be produced (c) who should receive the goods and services
that are produced (d) why goods and services are produced.

50 WHAT IS ECONOMICS ALL ABOUT?

4. What role do profits play in the felt-tipped-pen industry example in
the chapter? (a) Profits have no role in the example. (b) Profits result
in high prices for pens. (c) Profits discourage people from entering
the pen industry. (d) Profits encourage sellers to create wealth by
producing the number of pens that buyers want.

5. The U.S. economic system is best described as one with (a) no role
for government (b) the government controlling all (c) mostly free
enterprise, but some role for government (d) pure competition in all
industries.

6. In the U.S. economic system, consumer sovereignty means that (a)
the customers decide whether any business succeeds or fails (b) con-
sumers are not free to spend their money as they wish (c) business
firms, and not consumers, have the final power (d) companies may
choose to manufacture things consumers do not want.

7. Which of the following best describes business competition? (a) your
right to enter into a business (b) the right of others to enter the
same business as you do (c) your reason for entering the business
(d) the equipment used in operating your business.

8. Suppose that there are too many felt-tipped pens on retailers'
shelves. Which of the following is likely to take place? (a) Retailers
will buy more pens from their suppliers. (b) Wholesalers will in-
crease orders from manufacturers. (c) Pen sales will increase.
(d) Factories will produce fewer pens.

Matching Match each term in Column A with its definition in
Column B.

Column A Column B

1. capitalism a. competition among many small producers

2. free enterprise who sell products that vary slightly

3. profit motive b. the total value of the goods and services pro-

4. competition duced by a country in one year

5. private property c. the lands, buildings, or goods owned by

6. pure competition individuals or businesses

7. monopolistic d. the lands, buildings, or goods controlled or op-

competition erated by federal, state, or local governments

8. public property e. the right of individuals to enter into legal

9. gross domestic businesses and operate them as they see fit

product (GDP) 1. the effort to outperform other businesses
10. invisible hand
g. a system of private ownership of raw materi-

als, factories, and equipment

h. the desire to earn a surplus

i. when no single firm can influence prices

Adam Smith's view on how a nation's eco-

nomic resources can be efficiently allocated

The United States Free Enterprise System Al 51

11/ Developing Economic Skills
Answer the questions that follow the graphic.

1. Explain how the drawing relates to entrepreneurship and the rights
and responsibilities of starting a business.

2. What evidence is given in the drawing that justifies calling the U.S.
economic system a free enterprise system?

3. What are the six main principles of the U.S. free enterprise system
that are shown in the drawing?

4. How does this drawing show Smith's "laissez faire" ideas?
5. How does the drawing relate to property rights and government re-

strictions on property use by businesses and individuals?
6. How does the benefit of allowing producers freedom result in the

benefit for consumers of varied and abundant quantities of goods?
7. Explain how companies compete in an industry with monopolistic

competition.
i/ Understanding the Circular-Flow Model

Create a circular flow chart that includes you as both a producer and
a consumer, and at least one firm from outside the United States.

4

Demand
and Supply

Key Terms

demand supply efficiency
demand schedule Law of Supply demand curve
Law of Demand market price supply curve
elasticity of demand price-directed changes in supply
elastic microeconomics
inelastic market economy macroeconomics
responsive prices

A helicopter hovers above the streets of your community. Suddenly,
fluttering down from its open hatch, are thousands of slips of paper.
You pick up a handful of them and discover that they are $20 bills, $50
bills, even $100 bills. You look up, amazed and speechless. The sky is
now raining money from the hatches of a fleet of helicopters.

Everybody is out in the streets scrambling for the falling bills. Peo-
ple stuff their pockets and purses. Some fill up the trunks of their cars
or collect the money using wastepaper baskets and shopping carts. You
and your neighbors soon become rich.

But your community is not alone in its good fortune. Radio and tele-
vision news programs report that other helicopters have dumped tril-
lions of dollars over most of the major cities in the country. Almost every
American, it seems, has become wealthy overnight.

The next day, millions of rich Americans cannot wait to spend their
bundles and baskets of cash. But as they crowd into stores, they are
again astonished. What has happened to the price of everything? The
cheapest TV set is now selling for $33,350. A candy bar is priced at
$150 and a cheeseburger at $950. People are angry and bewildered.
Apparently, as the supply of money went up, its value went down.

You and the other unhappy millionaires have been disappointed by
the operation of two major economic laws. These are the Law of De-
mand and the Law of Supply. How these laws operate in a free enter-
prise system is the subject of this chapter. In this chapter, you will find
out the answers to these questions:

52

Demand and Supply 53

Understanding Economics
WAYS TO REPRESENT DATA

Prices rising because of money ent perspectives, including long-range
dropped from helicopters is a fanciful ex- trends. For this reason, they often trans-
ample. But economists do keep a careful fer statistical information into written or
eye on the prices of goods and services. visual formats, such as graphs. They use
For example, once a month, the Bureau software in which they can enter the sta-
of Labor Statistics publishes a report on tistics to create a variety of graphs.
the consumer price index, a measure of
the average change in prices over time of Even your own word-processing pro-
goods and services purchased by house- gram, however, has features that allow
holds. <http://www.bls.gov/cpi/#tables> you to create spreadsheets of information
The May 2014 report was more than 100 and draw on that information to create
pages long, filled with tables of statis- graphs. Transfer the information about
tics. These tables are very good repre- chocolate chip cookies from this chapter
sentations of data at a fine level of detail, into different mediums. From a narrative
which economists need to understand. description of supply and demand is-
However, economists also need to un- sues, for example, create a graph. From
derstand and evaluate data from differ- a graph, try to create a table. Use your
software to help you.

• What are the Laws of Demand and Supply?
• What is market price?
• How do changes in the demand for or supply of a product af-

fect its price?
• Why are prices important in a market economy?

WHAT ARE THE LAWS OF DEMAND AND SUPPLY?

Before we buy anything, we usually ask ourselves two questions:
"Do I want this item?" and "Am I willing to pay the price?"

Suppose you see a pair of jeans that you like selling for $75. You are
not willing to pay that price. If the same jeans were selling for $40, how-
ever, you would be willing to buy a pair. And if the price were $15, you
would buy two pairs. Economists say that at $75 your demand for jeans
is 0 (zero), at $40 it is 1, and at $15 it is 2.

Law of Demand

To an economist, demand is the amount of an item that buyers are
willing and able to purchase at any and all prices. Normally, the quan-
tity of demand is greater at a lower price than at a higher one. Consider

54 V111 WHAT IS ECONOMICS ALL ABOUT?

a school cookie sale. To raise money for its class picnic, the junior class
at North High decided to sell chocolate chip cookies baked by its class
members. As a first step, the class conducted a survey among the stu-
dents. The class wanted to determine (1) how much students were will-
ing to pay for chocolate chip cookies, and (2) how many cookies could
be sold at specific prices. A chart that shows the quantity demanded at
various prices is a demand schedule.

Demand for Chocolate Chip Cookies

At a price of Students will buy

$.70 100 cookies
.60 200 "
.50 400
.40 700
.30 1,100
.20 1,600
.10 2,300

As you can see, the number of cookies that the students said they
were willing to buy increased as the price decreased. Indeed, at a price
of 10 cents, more cookies will be sold than there are students in the
school! At that price, some students are willing to buy two or more
cookies. Others who normally would not buy cookies might buy them
when the price is so low.

What is true of chocolate chip cookies is also true of other things:
More of an item will be purchased at a lower price than at a higher
price. This idea is so important that economists have refined it into the
Law of Demand. This law states that the quantity of items demanded
increases and decreases in the opposite direction from changes in price.

Why does demand change in the opposite direction from price
changes? One reason is that at a lower price people can afford to buy
more of an item than they can at a higher price.

A second reason is that at lower prices people tend to buy things
as a substitute for something else. So, for example, at 60 cents for two
cookies, some students in the junior class might have decided to buy
the cookies instead of a candy bar. At a price of $1.40 for two cookies,
however, many students would substitute a candy bar for the cookies.

We know that fewer items will be bought at a higher price than at
a lower price. But will the quantity demanded decrease by the same
amount for all goods and services? For example, how much more milk
will you buy if the price is greatly reduced? 5 percent more? 10 percent
more? Probably not much more milk, because you can drink only so
much milk. Moreover, it is considered to be relatively inexpensive to
begin with. In addition, you cannot buy a lot of milk and stockpile it.
It will turn sour. On the other hand, will you buy less milk if the price

Demand and Supply 55

is increased? Probably not, if the increase is not too great. Most people
consider milk to be a necessity and will continue to buy it as its price

increases.
Now let us look at another product—steaks, which are normally

much more expensive than milk. Many people would consider steak to
be a luxury because of its cost. If the price of steak declines significantly,
people who normally would not buy steak would grab the opportunity.
And some people with a freezer would stockpile it.

Elasticity of demand is the percentage change in the quantity of
goods or services demanded resulting from a 1-percent change in price. If
a small percentage change in price (up or down) causes a great increase
or decrease in the amount of the product demanded, we say that the de-
mand for this product is elastic. On the other hand, if a small change in
price has little effect on the quantity of a product demanded, we say that
the product has an inelastic demand.

If we were to make a chart that represents what happens when we
lower or raise prices for steaks and milk, it might look something like this:

Demand for Steaks and Milk

Price Units Sold Total Revenue

Steaks $5.00 60 $300.00
Milk 2.50 175 437.50
200
$1.20 350 $240.00
.60 210.00

According to the chart, lowering the price of steaks increased the
quantity of steaks sold from 60 to 175. Total revenue also increased from
$300 to $437.50. The demand for steaks in this example is elastic because
a decrease in price resulted in an increase in revenue, and an increase in
price resulted in a decrease in total revenue.

Lowering the price of milk, however, did not result in an increase
in revenue. Just the reverse happened. Lowering the price from $1.20
to $.60 reduced revenue by $30. Increasing the price of milk from $.60
to $1.20 increased total revenue by $30. Therefore, the demand for
milk is inelastic because a decrease in price resulted in a decrease in
total revenue, and an increase in price resulted in an increase in total
revenue.

What difference does it make if demand is elastic or inelastic? It
makes a great deal of difference. Suppose, for example, that you are
making decisions for a large manufacturer of computers. Does it make
sense to increase the price of your computers from $500 to $1,000? No,
because the demand for your product is elastic. Therefore, your total
revenue would be less if you raised your price to $1,000. The reverse
is also true. It might pay you to lower your price from $1,000 to $500.

56 WHAT IS ECONOMICS ALL ABOUT?

A milk producer, on the other hand, knows that the demand for milk is
inelastic. An increase in the price of milk would increase total revenue,
whereas a decrease in the price of milk would reduce total revenue.

Law of Supply

We have seen that the price of a product affects the number of units
that people are willing and able to buy—the quantity of demand. Price
also affects the quantity of supply of an item. In economics, supply is
the amount of a good or service that is offered for sale at all prices.

Let us return to the cookie sale at North High. The organizers of
the sale have a plan by which individual student bakers will be paid 20
percent of the selling price of their cookies. So, for example, a student
whose cookies sell for a total of $100 will receive $20. The problem now
is to find out how many cookies will be offered for sale at the prices
listed in the earlier survey.

The results of this survey, which give the sale planners a picture of
the quantity of supply of chocolate chip cookies available to North High,
are as follows:

Supply of Chocolate Chip Cookies

At a price of Sellers will offer

$.70 2,000 cookies
.60 1,800 ,
.50 1,600 ,,
.40 1,400 ,
.30
.20 1,100 fl
.10
700 ,7
100
,,

As you can see, the student bakers are willing to provide many more
cookies at the higher prices than at the lower prices. What is true for choc-
olate chip cookies applies to most other things. More of an item will be
offered for sale at a higher price than at a lower price. Economists call this
the Law of Supply. This law states that quantity of supply increases as
prices increase and decreases as prices decrease.

There are two reasons why the quantity of items offered for sale at
higher prices will be greater than the quantity offered at lower prices.
The first reason is that those already in a business will try to increase
production as a way of increasing their profits. Suppose that the price
of tomatoes shot up from 85 cents to $10 a pound. What then? Many
farmers who usually grew other hothouse vegetables would give them
up in order to grow tomatoes.

The second reason why the quantity offered at a higher price will
be greater is that other people will be attracted into the business. They

Demand and Supply 57

believe that at the higher price they, too, will be able to earn a profit.
Why, at $10 a pound, you might even take up growing tomatoes.

Supply, like demand, is subject to elasticity. Some commodities re-
act to price changes more than others do. If a change in price brings
about a large percentage change in the quantity of supply, the supply
is said to be elastic. If a change in price produces a small change in
supply, the supply is said to be inelastic. Manufactured goods tend to be
elastic. On the other hand, produCts from farms (such as wheat, corn,
or milk) tend to be inelastic. Automobile manufacturers can more eas-
ily increase their output than can dairy farmers. They can, for exam-
ple, add an additional shift of workers at one or more plants. Farmers,
by contrast, cannot easily add to their herds of cows. Any one cow will
produce only so much milk. Suppose prices rose for both automobiles
and milk products. Of the two groups of producers, automobile manu-
facturers and dairy farmers, which could increase the supply of their
products the most? The answer, of course, is automobile manufacturers.

WHAT IS MARKET PRICE?

Thus far, we have described what buyers and sellers are willing to
do at a variety of prices. But at what price will cookie sales actually
take place? Before answering that question, let us combine the results
of our surveys of demand and supply.

From the table below, we see that at a price of 30 cents, quantity of
demand is exactly equal to quantity of supply. At that price, the student
buyers will buy and the student sellers will sell 1,100 cookies. Econo-
mists call 30 cents the market price of cookies.

Demand and Supply of Chocolate Chip Cookies

Students will buy At a price of Sellers will offer

100 cookies $.70 each 2,000 cookies
.60 "
200 " .50 " 1,800
400 .40 "
700 71 1,600
1,100 .30 " 1,400 ,
1,600 ,
.20 " 1,100 9,
,, .10 " 700
,, ,,

2,300 71 100 77

HOW DO CHANGES IN DEMAND AND SUPPLY AFFECT PRICE?

Price affects the quantity of demand—the amount of a good or ser-
vice consumers will buy at a specific time at each possible price. If the
price of cookies goes down, people will buy more cookies, but if the price
goes back up, they will buy fewer again. Their basic desire for cook-

N58 WHAT IS ECONOMICS ALL ABOUT?

ies has not changed—they are just responding to the price. As prices
change, the quantity of demand changes, but the demand does not.
Think, though, of all the factors besides price that affect how much of
something people will purchase. These factors change, not the quantity
of demand based on price, but demand at all prices.

Changes in Demand

What happens to demand for flowers each May? It increases just
before the second Sunday and then drops just after. Why? The second
Sunday in May is Mother's Day. Even if florists raise their prices tem-
porarily, they will sell more flowers just before Mother's Day than just
after.

When the demand for something increases, prices rise. On Mother's
Day, millions of people want to buy flowers for their mothers. The cost
of flowers is higher on this day than on any other day of the year. Flo-
rists raise their prices because of the increase in demand.

The demand for flowers demonstrates a non-price determinant of
demand, a factor other than price that influences how much consumers
will purchase of a good or service. Each determinant changes demand,
which results in a new equilibrium price, or market price, the price at
which the quantity demanded by buyers and the quantity supplied by
sellers is equal. In this case, the determinant is preference: consumers
want more of something at one time than another.

A second determinant is consumer population. Rapid growth of
The Villages, Florida—the fastest-growing community in the country
in 2013—increased demand for everything from groceries to homes. A
third is expectation of future prices. In 2012, experts who anticipated
price increases on game consoles urged consumers to buy them imme-
diately, thereby boosting demand. A fourth is income: consumers with
more money can purchase more than can poorer consumers. After the
economic crash of 2008, demand for meals at restaurants declined un-
til people felt the economy was recovering. A fifth is the price of re-
lated goods. When the demand for smartphones increased, the demand
for smartphone cases increased and the demand for older phones de-
creased.

Changes in Supply

You can use what you know about demand to help you understand
supply. A change in quantity of supply differs from a change in sup-
ply. The quantity of supply rises and falls based on the prices suppli-
ers receive. However, changes in supply vary based on non-price deter-
minants of supply, a factor other than price that influences how much
producers will supply of a good or service. Each determinant creates
a change in supply, which results in a new equilibrium price. One de-

Demand and Supply 59

Understanding Economics
USING UNEMPLOYMENT DATA

As you develop your eco- UNEMPLOYMENT RATES FOR
nomic skills, practice evaluating RECENT COLLEGE GRADUATES AND OTHER GROUPS

economic data using graphs. The 16% i•••.....
following graph is from a report Young workers
completed in 2014 by the Fed- ••
eral Reserve Bank of New York 14% — — All workers •
Research Division.
12% Recent college graduates
What does this graph com- 10% —
municate about the value of a col- College graduates
lege education in avoiding unem- ..-•*..

•

8%

6% •....... -•

4%

ployment? 2%
Learn to communicate eco-
0% I I I I 1 I I I I I 1 I I I I I I I I I I I I
nomic information visually by
1990 1995 2000 2005 2010

creating your own visual presen-

tations. Pursue the example of how car the form of a chart. Use the information

values decline over time. Using the Inter- in that chart and the software on your

net, find a free calculator that determines computer to create a graph representing

how quickly a car will lose value. These the same information.

calculators usually return the results in

terminant is the number of suppliers. If new suppliers enter a market,
they increase supply. If old suppliers exit a market, supply decreases.

A second non-price determinant of supply is the cost of producing
a good or service. Improved technology, better-trained workers, and
lower costs for raw materials can lower the cost of production, which
increases supply. The opposite changes can lead to a decrease in supply.

WHY ARE PRICES IMPORTANT IN A MARKET ECONOMY?

Prices make things happen. If buyers want something enough, they
will pay more for it. If sellers want to sell an item enough, they will
lower its price. Because of the power of prices, the United States is a
price-directed market economy. Since prices react to decisions of buyers
and sellers, they are sometimes called responsive prices.

1. Act as Signals to Buyers and Sellers. One of the things that
prices do is carry information to buyers and sellers. When prices are
low enough, they send a "buy" signal to buyers (consumers), who can
now afford the things they want. When prices are high enough, they
send a "sell" signal to sellers (retailers), who can now earn a greater
profit at the new price.

60 V111 WHAT IS ECONOMICS ALL ABOUT?

2. Encourage Efficient Production. Prices encourage business-
people to produce their goods at the lowest possible cost. The less it
costs to produce an item, the more likely it is that producers will earn
a profit.

Firms that are efficient will produce more goods with fewer or less
expensive raw materials than firms that are inefficient. Producers strive
for efficiency as a way of increasing their profits. While these efforts are
in the best interests of the sellers, all of us may benefit because we are
provided with the things we want at lower costs.

3. Determine Who Will Receive the Things Produced. Finally,
prices help determine who will receive the economy's output of goods
and services. The price that a worker receives for doing a job is called
a wage or salary. The amount of this wage or salary determines how
much money the worker has to spend. What the worker can buy with
those wages will depend, in turn, upon the prices of the goods and ser-
vices that the worker would like to own or pay for.

Creating Economic Models: Graphing Quantity of Demand, Supply,
and Market Price

Economic models are simplified representations of reality that al-
low analysts to adjust certain variables and evaluate the effect of those
adjustments. Graphs are visual models. We can use graphs to illus-
trate the quantity of demand and the quantity of supply for a particular
product. Returning to our chocolate chip cookie surveys as an example,
we would graph quantity of demand as shown in Figure 4.1.

Line D is a demand curve. The demand curve slopes downward
from left to right. At a price of 70 cents, the students would buy 100
chocolate chip cookies. At a price of 40 cents, they would buy 700 cook-
ies. At 30 cents, they would buy 1,100 cookies. And at a price of only 10
cents, 2,300 cookies would be sold. This bears out the Law of Demand
because it shows that more will be purchased at a lower price than a
higher one.

Now let us see what the supply curve looks like. In Figure 4.2, line
S is a supply curve, which slopes upward from left to right. It shows
that more cookies would be offered for sale at a higher price than a
lower one. But at 10 cents, sellers would offer 100 cookies for sale. This
reflects the Law of Supply. Converting the schedule on page 57 into
curves on a graph makes relationships between supply, demand, and
price easier to see. This is shown in figure 4.3, which appears on page
62.

Price per Cookie Demand and Supply
Figure 4.1 Demand for Chocolate Chip Cookies
Price per Cookie $.70

.60

.50

.40

.30

.20

.10
D

100 300 500 700 900 1100 1300 1500 1700 1900 2100 2300
Number of Cookies

Figure 4.2 Supply of Chocolate Chip Cookies
$.70 S

2000
.60 1800
.50 1600
.40 1400

.30

.20 700
100

.10
S

II II I I II I I II I I II II I I II
100 300 500 700 900 1100 1300 1500 1700 1900 2100 2300

Number of Cookies

62 WHAT IS ECONOMICS ALL ABOUT?

Figure 4.3 Demand for and Supply of Chocolate Chip Cookies

D S
2000
$.70
100 1800

.60

Price per Cookie .50 400 1600

.40 700 1400

.30

700 1600
.20

100 300

.10 I1 «_1 1 1 1 1 1

S

II I I I I IIII

100 300 500 700 900 1100 1300 1500 1700 1900 2100 2300

Number of Cookies

The market price is the point at which the supply curve and the
demand curve intersect (cross). At point M, 1,100 cookies would be of-
fered and sold at 30 cents each. To put it another way, market price is
the price at which quantity of supply and quantity of demand are equal.

Why is 30 cents the market price? If the price were lower, say 20
cents, buyers would want 1,600 cookies. But sellers would offer only
700. In that event, possible buyers who are willing to spend more than
20 cents would offer more money for the item. This would bring in the
sellers who are willing to sell at 30 cents (but not 20 cents). Mean-
while, seeing that they can unload cookies at 30 cents, sellers would
turn down the offers of 20 cents in favor of the higher price.

At 40 cents, the same kind of thing would happen. Sellers would
offer more cookies than buyers would be willing to take. In their com-
petition to sell their cookies, sellers willing to accept 30 cents for their
cookies would sell to buyers willing to pay the price.

Besides showing curves for quantity of demand and quantity of sup-
ply, graphs can use curves to show changes in demand and changes in
supply. In Figure 4.4, compare D and Dl. At every price, quantity of
demand is higher, so the demand curve shifts to the right. Since the
supply curve has not changed, the point of intersection moves up on
the curve to a new market price of around 38 cents. In Figure 4.5, D2
shows a decrease in demand, and with it a lower market price.

Demand and Supply 63
Figure 4.4 Increase in Demand for Chocolate Chip Cookies
Price per Cookie
$.70

.60

.50

.40

.30

.20

.10
1 1 I I II I I II II I I I I I I I I I I I I I I

100 300 500 700 900 1100 1300 1500 1700 1900 2100 2300 2500 2700
Number of Cookies

Figure 4.5 Decrease in Demand for Chocolate Chip Cookies

D S

$.70

D

.60

Price per Cookie .50

.40

.30

M

.20

D

.10 D2

II II II II 11 1 1 1 1 1 1 1 1 1 1 1 1

100 300 500 700 900 1100 1300 1500 1700 1900 2100 2300
Number of Cookies

As you can see, when demand increases, so too does the market
price. When demand decreases, the price falls. On page 64, Figure
4.6 shows an increase in supply, S1, which lowers the market price.
Figure 4.7 shows a decrease in supply, S2, which raises the market
price.

64 WHAT IS ECONOMICS ALL ABOUT?

The graphs show, not just a change in quantity supplied resulting
from a change in price, but changes in supply. A non-price reason, such
as a new, more efficient production method, might cause the supply
curve to shift to the right. At any given price, the supply will be greater.

The graphs of cookie sales that we have been analyzing represent a
study of one small segment of the economy—a single firm or, perhaps,
a single industry. Here the economist is concerned with consumer de-
mand for a particular product—cookies in our example—or the price
per unit that a firm may charge for a specific quantity of its output of

Figure 4.6 Increase in Supply of Chocolate Chip Cookies

D S S1

$ 70

.60

Price per Cookie .50

.40

.30

M

.20
D

.10

S S1

1 1 11 1 1 1 I II II I
100 300 500 700 900 1100 1300 1500 1700 1900 2100 2300 2500 2700

Number of Cookies

Figure 4.7 Decrease in Supply of Chocolate Chip Cookies

D S2 S

$.70

.60

.50 M2
Lti
0
0
V .40
CD

S .30

.20

D

.10

S
1111 11 1 11 1111111111 111

100 300 500 700 900 1100 1300 1500 1700 1900 2100 2300

Number of Cookies

Af,Demand and Supply 65

milk or computers. Economists refer to such studies as microeconomics
because the focus is on a small, or micro, section of the economy.

Economists also analyze the impact of supply and demand on the
economy as a whole, or from what they call a macroeconomic perspective.
How, for example, would an increase in the price of petroleum affect the
entire economy? Petroleum is needed to operate factories and as fuel to
heat homes and to run trucks and airplanes. Will prices rise in industries
that use petroleum and petroleum products, and, if so, by how much?
How, then, will the resulting increases affect the general level of income,
prices, and output of goods in our economy? The difference between
micro- and macroeconomics is like considering the batting average of a
single member of a baseball team (micro-) with an analysis of how the
team as a whole (macro-) performed throughout the season.

SUMMARY

Demand refers to the number of items that buyers would be willing to
buy at any and all possible prices. The Law of Demand tells us that demand
varies in the opposite direction with price. That is, more items will be bought
at a lower price than at a higher one.

Supply is the quantity of a product that would be offered for sale at all
possible prices. The Law of Supply states that quantity of supply varies in
the same direction as price. That is, more items will be offered for sale at a
higher price than at a lower price.

The market price is the price at which the quantity of supply and quan-
tity of demand are equal. The market price will remain unchanged as long
as supply and demand remain unchanged. If there is an increase in demand
or a decrease in supply, the market price will increase. If the opposite oc-
curs—that is, if demand decreases or supply increases—the market price will
decrease.

Prices help determine which goods and services will be produced and which
will not. Prices also determine who will be able to enjoy goods and services, be-
cause only those who can afford to pay will be able to buy them.

LOOKING AHEAD

Supply, demand, and the price system would be meaningless were it
not for the dollars and cents in which they are expressed. In the following
chapter, we will be taking a look at the things that people in other times and
places have used as "money" and at the present-day U.S. system of money
and banking.

AA66 WHAT IS ECONOMICS ALL ABOUT?

EXERCISES

VMatching Match each term in Column A with its definition in Column B.

Column A Column B
1. demand a. the quantity of a good or service that is offered for
2. Law of Demand
3. supply sale
4. Law of Supply b. states that the quantity of supply increases as
5. market price
6. wage prices increase, and decreases as prices decrease
c. the amount of an item that buyers are willing and

able to purchase at any price
d. states that the quantity of items demanded increases

and decreases in the opposite direction from changes
in price
e. the hourly price a worker receives for doing a job
f. the price at which quantity of supply and quantity
of demand are equal

Multiple Choice Choose the letter of the item that best completes the
statement or answers the question.

1. The main idea of this chapter is that (a) supply always equals demand
(b) supply and demand help determine market price
(c) demand never changes (d) market price never changes.

2. Indoor ice skating has become very popular, and the rinks have raised
their admission prices. The price increase is a result of
(a) an increase in supply (b) a decrease in supply (c) an increase in de-
mand (d) a decrease in demand.

3. At a price of $2 a pound, buyers will take 2,000 pounds of beef,
and at a price of $4 they will take 1,500 pounds. These facts illustrate
(a) market price (b) the Law of Demand (c) the Law of Supply (d) all of
the above.

4. At a price of $2 a pound, sellers will offer 800 pounds of beef, and at a
price of $4 a pound they will offer 1,200 pounds of beef. This illustrates
(a) market price (b) the Law of Demand (c) the Law of Supply (d) all of
the above.

5. The prices charged for fruits and vegetables are lower in the warm
summer months than in the cold winter months because (a) people pre-
fer fruits and vegetables when it is warm (b) fruits and vegetables are
in greater supply during warm months (c) all items cost more in winter
months (d) people go away during summer months.

6. Which is a non-price determinant of demand? (a) straw prices fall,
making straw hats cheaper (b) a new company produces straw hats
(c) wearing straw hats becomes popular (d) straw hats are discounted,
so sales increase.

Demand and Supply 1,4 67

What Will Happen . . . ?

In the questions that follow, something will happen to the supply of, the
demand for, or the price of a particular good or service. See if you can tell
what it is.

1. What will happen to the price of catfish if the government announces
it has discovered that "an ounce of catfish a day will keep the doctor
away"? Why?

2. What will happen to the price of catfish if the government announces
that the first statement was a terrible mistake—in fact, "even less than
a pound brings the doctor around"? Why?

3. What will happen to the price of toothpaste if, because of a shortage of
tubes, the supply of toothpaste is cut in half? Why?

4. What will happen to the amount of lamb chops bought if the price is tri-
pled? Why?

5. What will happen to the amount of chicken bought if the price is cut in
half? Why?

6. What will happen to the number of red-white-and-blue shoes produced
if it is found that the average person is willing to pay as much as $500
a pair for such fashionable footwear? Why?

7. What will happen to the price of diamonds if it is found that they can
be made in your school's chemistry lab? Why?

8. What will happen to the price of bicycles if the President of the United
States recommends that everyone bicycle to school or work to help cut
down on air pollution? Why?

9. What will happen to the number of bicycles that people are willing to
buy if the price is cut in half? Why?

10. What will happen if, in the middle of a July heat wave, a store an-
nounces that electric heaters, normally priced at $85 and up, are on
sale for $14.95? Why?

Creating Economic Models: Graphing Supply and Demand

Price $16 14 12 10 8 6 4 2

Quantity 6 10 16 24 30 40 50 80

1. Using the data above, create an economic model in the form of a graph
to analyze the economic concepts of supply and demand.

2. Is this a demand or a supply curve?

3. Why does the curve slope downward?

4. On the same graph, construct another curve using this data:

Price $16 14 12 10 8 6 4

Quantity 48 44 40 36 30 20 10

N68 WHAT IS ECONOMICS ALL ABOUT?

5. Does this curve represent supply or demand?

6. Why does this curve slope upward?

7. What is the market price? Is this easier to see in the numbers or the
curve?

8. Why can't the market price be $16?

9. Imagine that the market price for this product increased by $2. Explain
how the graph would look if the cause of the price increase was (a)
an increase in demand, or (b) an increase in the quantity of demand,
without a change in overall demand. Does your graph show changes in
supply and demand, or does it show changes in quantity demanded and
supplied? Explain.

10. Identify a product for this example and list one non-price factor that
could increase demand and one that could increase supply for it.

INQUIRY INTO ECONOMICS

How can you evaluate and communicate issues related to supply and demand
through various mediums?

I/Focus on a Question Prices fluctuate when supply or demand changes.
Develop a tightly focused question about an issue related to the laws of supply
and demand and the concept of responsive prices. Example: Should essentials
like milk have a set price?

Apply Concepts About Economics Begin to answer your question
by using what you have learned in this book about the laws of supply and
demand. Then research at least three different reliable sources, including
radio, television, and the Internet, to find additional information and specific
examples related to your question. Include graphs, tables, and narrative
information.

VEyaluate the Evidence Evaluate the economic data in all the mediums

you collected—graphs, tables, and narrative information. Note that similar-
sounding statistics might use different frames of reference. For example, "5
percent of workers are unemployed" and "42 percent of population works"
both describe something about the workforce of a country. However, the
frame of reference for the first is workers—adults who want jobs. The frame
of reference for the second is the entire population—including children and
retired people. Analyze and evaluate the frame of reference used for facts from
primary and secondary sources you use in answering your question.

I/Share Your Conclusions Work with a partner to explain the different
sides to your question. Use sound reasoning, examples, and significant details
to support the answer to your question. Create two different representations
of your conclusions—one in written or visual form, another in the form of a
statistical table.

5

Money and
Banks

money Key Terms Federal Reserve
barter System
medium of withdrawal
traveler's check endorsement
exchange bank reserves
monetary unit depositor electronic funds
currency interest
checking account commercial bank transfer (EFT)
check savings and loan automatic teller
fiat money
commodity money association machine (ATM)
credit union mutual savings debit card
FDIC borrow
bank endorse
cancelled check
deposit

We all know what money is. Or do we? You will probably be sur- 69
prised as you read a list of items that, somewhere and sometime,
have served as money. For example, each of the following has been
used as money:

In Ancient China: bronze knives and farm tools
In the Mayan civilization of Central America: cacao beans
In the African empire of Mali: salt chunks
Among the people of the Pacific islands of Yap: stone discs
Among the Native Americans of the Pacific Coast: fishhooks
In French Canada, around the year 1700: playing cards
In the English colonies of North America: beaver pelts, mus-

ket balls, nails, and beads
Among soldiers in prison camps during World War II: cigarettes.

You know that if you tried to pay for groceries at your local
supermarket with playing cards, beads, fishhooks, furs, or stone

70 Vvl WHAT IS ECONOMICS ALL ABOUT?
discs, you might get a few laughs. But you certainly would not get
the groceries. You could, however, pay for them with paper.
Now, is that not odd? Why is paper accepted as money? Why are
beads not accepted? How do we store and save our money for future
use? In short:
• What is money?
• What does money do?
• What types of money do we use?
• How are banks involved with the supply of money?
• What is modern banking like?
You will learn the answer to these questions in this chapter.

WHAT IS MONEY?
Money can be anything—yes, anything—that most people are

willing to accept in payment for goods or services. Several centu-
ries ago, North American colonists used beaver pelts, musket balls,
nails, and beads to make purchases and to pay their debts. And
other colonists were willing to accept those items in payment. The
colonists' acceptance of beaver pelts and beads was what made these
goods money. Something similar might happen today. Suppose the

Money in Another Culture: People of the Pacific Islands of Yap once considered huge
stone discs such as these to be money. What objects in your everyday life might ac-
quire similar value?

NMoney and Banks 71

U.S. government announced that from now on beads would have
to be accepted in payment for all debts. If Americans agreed, then
beads would become a form of money in the United States.

WHAT DOES MONEY DO?

All modern societies use money. With money, people can easily trade
goods and services with one another. That is, money promotes trade be-
cause it has three important characteristics. Money provides a medium
of exchange, a way of calculating value, and a method of saving.

Medium of Exchange

Suppose society did not use money. If Jones wanted something
you owned, how could Jones obtain it? Perhaps Jones might steal
it. But a better system would be to encourage people to barter, or-
exchange what they have for something they want. One positive as-
pect of barter is that people can make trades without currency. For
example, two young children might trade toys, or a person might
let someone stay at his beach home all summer in exchange for
that person building a new garage there. But barter presents many
problems. Suppose you had a coat that you wanted to swap with
Jones for a pair of shoes. What would you do if Jones did not want
your coat? Or if the coat was worth more than the shoes?

By using money, you do not run into the problems of bartering
goods and services. If you have a coat to sell and want to buy a pair
of shoes, you need only find a buyer for your coat. You can then use
the money you receive to buy a pair of shoes. Money has enabled
you to exchange, or trade, your coat for shoes. Since a medium is
something that enables another thing to take place, we can say
that money provides a medium of exchange.

Measure of Value

Let us return to our barter economy, where money does not ex-
ist. A farmer has a cow to sell. What is its price? That would depend
upon what someone else has to trade. Suppose it is hay. How much
hay is equal to one cow? Things are much easier in a money economy.
In this system, the worth or value of anything can be expressed in
terms of its price in the monetary unit of a country. The monetary
unit of the United States is, of course, the dollar. Canada, too, has
dollars, while Switzerland has francs, and Mexico has pesos.

Ai,72 WHAT IS ECONOMICS ALL ABOUT?

Method of Saving

Money can be saved. Today, a couple can set aside a certain
amount of their weekly paychecks until they have saved enough for
a down payment on a house. But if the couple lived in a barter econ-
omy and made their living by growing vegetables, saving for a house
would be very difficult. How would they go about saving their vege-
tables? Who, for example, would accept them after they had rotted?

Of course, money can lose value over time. That happens during
periods of inflation, when the prices of most goods and services in-
crease. You will study the changing value of money in Chapter 6.

WHAT TYPES OF MONEY DO WE USE?

What kinds of money you are carrying today. You might have
some pennies, nickels, dimes, quarters, and even a dollar coin. You
may also have a $1 bill, a $5 bill, and a $20 bill. Now, what is that you
are holding in your hand—a check? Someone gave you a check for $20
as a birthday present? Fine. Now, let us see. Should we put it with the
rest of the money? We should. Why? You are absolutely right. Checks
are another form of money. Let us review the reasons.

We said earlier that anything generally accepted in payment
for goods and services is money. Since checks are usually accepted
in payment, they also are a form of money. The principal kinds of
money in the United States are paper money, coins, and checks.

Currency and Coins

The paper money issued by the federal government is the na-
tion's currency. Positive aspects of paper money include that it is
light and easy to carry and that it can be used to purchase any-
thing, so it makes trade easy. However, its negative aspects are that
it can be destroyed by fire or water, and it has no intrinsic value.
In the early 1900s, the United States, like many countries, used
the gold standard: currency and coins were either gold or could
be exchanged for gold. Since U.S. currency could be exchanged for
something of value, it was representative money. The United States
abandoned the gold standard in 1971. By 2013, no country was
using a gold standard. Today, currency has value only because peo-
ple trust the government's law that says its money is worth some-
thing. This currency is fiat money. We accept the face value of pa-
per currency even though the paper is worth a fraction of a cent.
And the metal in the quarter, dime, and nickel coins is also worth
far less than the face value of the coins. In contrast, money that has
value by itself, such as beaver pelts, is commodity money.

Money and Banks 73

74 /7 I;
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Different Kinds of Paper Money, top to bottom: $2 New York banknote from the 19th
century; $100 Confederate note, 1862; 1 million German Mark note, 1923—actually
worth almost nothing (to learn why, see page 92); $1 Massachusetts note from the
18th century—the hole was punched when the note was cashed.

Checks

Paper money and coins account for less than half of the nation's
money supply. Because currency can be lost or stolen, most money is
kept on deposit in checking accounts at banks. People who have de-

vv,74 WHAT IS ECONOMICS ALL ABOUT?

Figure 5.1 American Express Traveler's Check

WHEN COUNTERSIGNED BELOW WITH RA296.020.003
THIS SIGNATURE

CITY AND DATE 19

100M4 1 Ds,.41' !rJ .1144atel effilfit
ISSUED SY
AMERICAN EXPRESS TRAVEL RELATED SERVICES COMPANY, INC.
NEW YORK, N.Y.
PaythisCheque

to theOalerof

*NI t.JINI ser,•••:11-1E6 IN "1_,OTH ER COUNT•tt
I•

COUNTERSIGN HERE INPRESENCEOF PERSON CASHING

1:8000000 5 41:9 Lim 296020003So
XT"Pit-'4. 0L3:

posited their money in checking accounts spend it by writing checks.
A check is a written order directing a bank to pay a specified sum
from one person's account to another person or to a business.

Traveler's Checks

Travelers often face difficulty using personal checks in places
where they are not known. To solve this problem, banks began sell-
ing traveler's checks, special checks guaranteed by the bank. The
U.S. government considers traveler's checks to be money.

The table shows the kinds and amounts of money in circulation
in a recent year.

United States Money Supply, 2014
(in billions)

Checking accounts $997.8
Currency and coin $1,165.1
Traveler's checks
3.5

Total $ 2,166.4

THE BUSINESS OF BANKING

Have you visited a bank lately? Did you notice what its cus-
tomers were doing? In all likelihood, most were there to either add
money to their accounts by making deposits or taking funds out as
withdrawals. Others may have visited the bank to borrow money.
Bank loans help people buy homes and motor vehicles, start busi-
nesses, expand farms, or do other things that require money.

Money and Banks v1 75

Banks Exist in a Variety of Forms

Commercial banks take deposits and make loans to individuals
and businesses. Savings and loan associations (S&Ls) and mutual
savings banks take deposits and make loans primarily for buying
homes. Credit unions provide loans for its members. Since com-
mercial banks, S&Ls, and credit unions all accept deposits, they
are also known as depository institutions. But most people think of
them as banks, and that is what we will be calling them.

Banks Are Businesses That Sell Financial Services

Like all privately owned businesses, banks need to earn profits
in order to operate. They do this by charging money for the loans,
credit cards, checking accounts, and other services they provide.

Where do banks get the money to lend? They get it from their
depositors, the people who open accounts. Depositors entrust their
money to banks because of the safety they provide, and the interest
earned on most accounts. Among other things, the Federal Deposit
Insurance Corporation (FDIC) guarantees the safety of bank ac-
counts. The FDIC insures bank accounts in amounts up to $100,000.

Banks draw upon their depositors' savings to make loans.
Banks pay their depositors interest. Interest earned on savings ac-
counts varies from year to year. Those who borrow pay interest on
their loans to the lending banks. Naturally, the interest charged on
loans is higher than the interest that banks pay their depositors.
The difference between the amount that banks charge for their
loans and the amount paid to depositors pays expenses and adds to
bank profits. For example, a bank may pay 0.5 percent interest on
savings accounts while charging 8 percent for car loans.

In recent years, banks have begun to sell insurance, as well as
stocks and bonds. (These subjects are discussed in Chapters 13 and 23.)

Checking Accounts

Of all the services provided by banks, checking accounts are
the most popular. When you write a check, you are instructing your
bank to transfer a specific amount of money from your checking ac-
count to another individual or organization. You can also write a
check just to convert some money in your account into cash.

Checks are safer to carry than cash. You know that if you lose

your cash, there is a good chance that you will never see it again.

But if you lose your checkbook, no one else will be able to use it. An-
other advantage of checks is their convenience. Think, for example,

76 V111 WHAT IS ECONOMICS ALL ABOUT?

Personal Economics
WRITING AND ENDORSING A CHECK

Martha Nieves has a checking ac- Yardley Realty Company. She will write a
count in the First National Bank of Peo- check for $582.70 to pay the rent. Here is
ria, Illinois. Today, March 1, is the day the blank check she will use.
the rent is payable to her landlord, the

First National Bank has printed Thus, $582.70 could be written
Martha Nieves's name on her as "Five hundred eighty-two and
check. 70/100," followed by a line to the
word "Dollars," if space remained.
2. This is where the date is entered.
7. The name of the bank is printed on
3. This is the number of Martha's the check.
check.
8. The person writing the check (Mar-
4. Following the words "Pay to the tha Nieves) signs here.
Order of" is written the name of the
individual or organization to whom 9. These are the code numbers that
the check is made out. identify Martha Nieves's account
and bank. These numbers can be
5. The amount of the check follows read by an electronic data-process-
the $ sign. Many people write the ing machine. It automatically sorts
number of cents as a fraction of out the checks that each person
100. Thus, $582 70/100. who has a checking account has
written, and then it adds up the
6. Here the amount of money is writ- sums of money.
ten out. Once again, most people
list the cents as a fraction of 100.

Money and Banks 77

(Di:0210...00081:17320545 ,,• 0812

Martha Nieves's check to Yardley Re- one else the right to cash it. Until that
alty is shown above. happens, no one else but you has the
right to the money. This is one reason
Suppose that Martha Nieves had car- why checks are so widely used as money.
ried the $582.70 rent money in cash in
her purse and then the purse had been It is easy to endorse a check that is
lost or stolen. She would have been out made out to you. All you must do is sign
the money. But if Martha had lost the your name on the back of the check. If
rent check, all she would have had to do you are going to deposit this check to
was notify the bank to stop payment on your account and send it through the
it. No money would have been lost. She mail, it is safer to add the following:
could then have paid her rent by writing
a new check. Your name
For deposit only
Endorsing a Check to account number

After receiving Martha's check, Yard- A check endorsed in this way can be
ley Realty will either cash it or deposit it deposited only into your bank account.
in a bank account. In either case, Yard- No one can claim to be you or that you
ley's bookkeepers will have to endorse endorsed the check over to them.
the check by stamping the company's
name on the back. The endorsement Banks ask their checking account cus-
looks like this: tomers to use deposit tickets. On these
tickets are printed the customer's name,
YARDLEY REALTY COMPANY address, and account number. The cus-
tomer fills in the amount of the cash and/
When you endorse a check that has or checks being deposited and includes
been made out to you, you give some- the ticket with the deposit.

78 WHAT IS ECONOMICS ALL ABOUT?

If you develop the habit of enter-
ing into your check register every
check, debit, or withdrawal, as
well as every deposit, as soon as it
occurs, you will always know your
actual balance. When you receive
your monthly bank statement, you
can reconcile it with yours. In your
register, make a checkmark beside
each transaction that the bank has
completed. To the bank balance,
add any deposits that the bank
has not yet credited. Subtract any
checks you have written that have
not yet been cashed. The result
should match your actual balance.

of how much easier it is to mail someone a check for $39.95 than it
would be to send that amount in cash.

Those who receive checks need to endorse them (by signing
their name on the back of the check) before they can deposit or con-
vert them to cash. Eventually, the endorsed checks are stamped
by the bank and returned to the owner of the checking account as
cancelled checks. Another reason for the popularity of checking ac-
counts is that cancelled checks are proof that a bill has been paid.
Because they are so safe and convenient, checks are widely used to
pay for expensive purchases and to transfer money.

Because of their safety and convenience, checking accounts are
the largest component of the money supply. But banks must have
cash available when people need it. One way that people obtain
needed cash is by cashing a check at their bank. In that way, they
exchange their deposited money for cash. When they are holding
more cash than they need, people can deposit some of it in their
bank account.

The public needs more currency at certain special times of the
year. During the winter holiday season, spring and summer vaca-
tions, and when schools reopen, people often withdraw more cash
from their bank accounts than they are putting in. During the rest
of the year, currency tends to flow back into bank deposits.

The Federal Reserve System

By now, you may be wondering where the banks get the cur-
rency that they give to people who cash checks. In 1913, the U.S.

Money and Banks 79

Congress created the Federal Reserve System. This agency (often
called the "Fed") operates 12 Federal Reserve Banks in this coun-
try. Each of these banks supervises the banking activities in one of
the nation's Federal Reserve districts.

One of the tasks that Congress assigned to the Federal Reserve
was to meet the nation's need for cash. The Fed is able to put cur-
rency into the hands of the nation's banks when they need it, and
take it back when they do not need it. Here is how the Fed does this:

A bank maintains an account with the Federal Reserve Bank in
its district in much the same way that a person holds an account at
a local bank. When a local bank needs cash, it simply withdraws the
money from its account at the Fed. When a bank has more cash than
it needs, it redeposits the money with the Fed. In an emergency, when
a bank needs more money than it has in its account at the Fed, the
bank can borrow the money it needs from the Fed. The bank will
then pay interest to the Fed for this borrowed money.

The 12 Federal Reserve Banks get their supplies of paper cur-
rency from the Bureau of Engraving and Printing in Washing-
ton, D.C. Coins come from the Bureau of the Mint in Denver and
Philadelphia. (A map of the Federal Reserve System appears on
page 458.)

How Commercial Banks Create Money

Having read this far, perhaps you believe that only the govern-
ment can create money. This is not the case. A great deal of the

Banks and Businesspeople: Owners of small businesses such as this one often depend
on banks for short-term loans. What happens to the nation's money supply when banks
loan money to their customers?

80 N WHAT IS ECONOMICS ALL ABOUT?

money in circulation is created by commercial banks. Commercial
banks often make loans to businesses. When a business firm borrows
a sum of money, the bank places it on deposit in the firm's checking
account. The business withdraws the money as it needs it.

Take the case of Harry and Sylvia Girard, the owners of the
Girard Jewelry Company. In October, they borrowed $15,000 from
the Safety First National Bank to buy watches and jewelry to sell
during the holiday season. The $15,000 was deposited in their
checking account at the bank. As the various shipments of mer-
chandise were received, the Girards wrote out checks in payment of
the bills. After January 1, they repaid the loan with the money they
had earned from the sale of the jewelry.

In this example, a very interesting event occurred. The country's
money supply was increased by $15,000 for a short time, and the gov-
ernment had nothing to do with it. This money was not taken away
from anyone—therefore, the bank created $15,000. Commercial banks
all over the country do this every day: They create checkbook money
by granting loans. Of course, as loans are repaid, money is taken out
of circulation. Thus, the Girards' checking account balance was re-
duced by $15,000 when they repaid their loan.

Since banks earn profits by lending money, it follows that the
more they have to lend, the greater their profits will be.

"Now, wait a minute," you say. "Do you mean to tell me that the
bank will take the money I deposited for safekeeping and lend it to
someone I don't even know?"

That is correct. Of course, before it makes a loan the bank does
what it can to determine that the business or individual who bor-
rows will be able to pay the money back.

"But how will I and others like me be able to get our money
back when we want it if the bank has loaned it out?"

That is easy. Although on any given day some depositors will
make withdrawals, other depositors will make deposits. In fact, on
most days the amount of deposits will more than offset withdraw-
als. Furthermore, banks cannot lend all the money they have on
deposit. They must always keep part of this amount on hand in
case there is a heavy run of withdrawals at a particular time. The
sum kept on hand is known as the banks' reserves. The portion of
their total deposits that they must keep on reserve at any one time
is determined by the Federal Reserve Board.

Suppose that a bank has $1 million in deposits, and the federal
government has said that all banks must keep 20 percent of their
deposits on hand as a reserve. How much of its $1 million in depos-
its could the bank lend out? If you said $800,000, you were abso-

Money and Banks 81

lutely right. The reason is that 20 percent of $1 million is $200,000.
This amount must be set aside in the bank's reserves. The balance
of the $1 million, or $800,000, may be given out in loans. But the
process does not stop there. If the full $800,000 loaned out is re-
deposited and the bank keeps 20 percent ($160,000) as a reserve,
$640,000 can be loaned out.

There is a limit to the amount of money a bank may create be-
cause there is a limit to the amount of money it may lend. Remem-
ber, a bank must keep some money—reserves--on hand to meet
the demands of its depositors. This is shown in the table.

How a Bank Creates Money Through Loans

Bank Deposits Required Loans
Reserves
$800,000
Safety First $1,000,000 $200,000 640,000
National Bank 800,000 160,000 512,000
640,000 128,000 409,600
Sum of remaining 512,000 102,400 327,680
bank activities 409,600 81,920
1,310,720
Total 1,638,400 327,680 $4,000,000
$5,000,000 $1,000,000

As you can see in the table, an initial deposit of $1 million
made it possible to loan out $4 million. In our example, the reserve
ratio was 20 percent. It should be clear that if the reserve ratio
were greater than 20 percent, less than $4 million could have been
loaned out. If the reserve ratio were less than 20 percent, banks
could have created more than $4 million through loans.

WHAT IS MODERN BANKING LIKE?

The electronic revolution that has brought us computers and
video games has also brought about major changes in the way peo-
ple bank and pay for the things that they buy.

Automated Teller Machines

Previously when one went to a bank to make a deposit or with-
drawal, one usually dealt with a teller. With an automated teller
machine (ATM), it is possible to make bank deposits and with-
drawals without talking to a teller or any other person, and without

82 VIA WHAT IS ECONOMICS ALL ABOUT?

Automatic Teller Machine (ATM):
How can customers protect them-
selves from robberies when with-
drawing money from an ATM?

having to write a check or withdrawal slip. These machines are
activated simply by inserting a special plastic card into the
machine and keying in one's private code, usually a four- to six-
digit number.

Electronic Funds Transfer
When people deposit checks at their banks, it normally takes

a few days for the amounts to be credited to their account. Deposi-
tors cannot withdraw and spend those amounts until their account
is credited. Using an electronic funds transfer (EFT) system, how-
ever, accounts can be credited immediately. The EFT system uses
computers and automated equipment to do this. Consequently, de-
positors can spend their money on the same day that they put the
money into their accounts. This is one of the advantages EFT offers
over the system of checks.

Still another way in which EFT has been replacing the use of
checks has been in the way that people pay their bills. New elec-
tronic systems link either telephones or home computers to special
bank accounts. By keying instructions into their smart phones or
computers, subscribers are able to pay bills in an instant.

Recent improvements in personal computers and the Inter-
net have made it possible for people to do much of their banking

Money and Banks 83

at home. Most banks offer online banking that enables their cus-
tomers to use their personal computers and the Internet to write
checks, pay bills, check their account balances, and even apply for
loans.

SUMMARY

Money is anything that people accept in exchange for goods and ser-
vices. It has three key characteristics: it serves as a medium of exchange,
a way of calculating prices, and a way of saving. People use currency (pa-
per and coins) and checks as money. Prior to 1971, when the dollar was
based on gold, currency was representative money because it could be
exchanged for something of value. Today, currency is fiat money because
its value is based on government decree. Banks receive money from and
lend money to businesses and individuals. The Treasury Department
prints and mints all paper currency and coins. The Federal Reserve Sys-
tem provides currency to banks.

Checks make up a large part of our money supply because they are
easier and safer to use than cash. In order to write a check, you must have
a checking account at a bank. The check should be filled out completely
and accurately. If you wish to cash a check, you must endorse it properly.

Electronic funds transfer uses computer technology. It has become
an increasingly important means of making and receiving payments.
The Internet has made it possible for people to do much of their banking
at home using a computer.

LOOKING AHEAD

Like everything else, the value of money may vary from one time to
another. When this happens, the prices of goods and services will either
rise or fall. The next chapter explores some of the reasons why the value
of money changes, and how these fluctuations affect us all.

EXERCISES

i/Multiple Choice Choose the letter of the item that best completes
the statement or answers the question.

1. A main idea of this chapter is that (a) our economy can function
without money (b) money serves as a medium of exchange, a way of
calculating value, and a method of saving (c) cash is a better way
of making payments than electronic funds transfer (d) checks are
always a better way of making payments than cash.

2. Under which of the following circumstances would beads be con-
sidered money? (a) You said they were money. (b) They were very

84 WHAT IS ECONOMICS ALL ABOUT?

valuable. (c) You could buy something with them anywhere in the
United States. (d) They were very rare.

3. One positive aspect of a barter economy is that (a) people can
exchange products without currency (b) people rely on checks for
money (c) people can make exchanges more easily than in a money
economy (d) paper money is printed by the government.

4. Suppose that you melted down $100 in quarters. What would be
the value of the metal? (a) equal to its weight in gold (b) much
more than $100 (c) much less than $100 (d) exactly $100.

5. How is fiat money unlike commodity money? (a) fiat money is not
used in the United States (b) fiat money is valuable only because
government says it is (c) commodity money has no value other than
as money (d) commodity money is the common form of money today

6. Electronic funds transfer (a) involves making and receiving pay-
ments via computers and other automated means (b) is the amount
of demand deposits held at banks (c) is a payment procedure in-
volving the use of checks (d) involves the transfer of funds from the
Federal Reserve to member banks.

7. Which one of the following people is the endorser of a check?
The one who (a) writes his or her name on the back of the check
(b) originally wrote the check (c) makes payment on the check
(d) printed the check.

8. Your local bank finds itself running short of the $1, $5, and $10
bills it will need to take care of its customers' needs. Where is it
most likely to go to stock up on this currency? (a) the U.S. Treasury
Department (b) a neighboring bank (c) the Bureau of the Mint
(d) the Federal Reserve Bank of its district.

Matching Match each term in Column A with its definition in
Column B.

Column A Column B
1. barter a. the use of computers to receive and make
2. money
3. currency payments
4. monetary unit b. the standard unit of value of a country's currency
5. depositor c. a person who places money in an account in a
6. Bureau of the
bank for safety and earnings
Mint d. anything generally accepted in payment for
7. electronic funds
goods and services
transfer (EFT) e. money that is easy to carry because it is paper
8. Federal Reserve f. a system in which people exchange goods or

System services
g. an organization that regulates the nation's

banks and its money supply
h. an organization that manufactures U.S. coins

Money and Banks 85

V Using a Checking Account

1. Suppose that you have a checking account at the Bank of Industry.
Your phone bill for $21.82 is now due. The phone company is the
Central City Telephone Company. Using today's date, your own
name, and the blank check shown below as your guide, prepare
a check in payment. (Do not write in your book. Instead, make a
copy of this blank check either by hand or by using a photocopying
machine.)

Your Name 752
20
Pay to
the Order of Dollars

Bank of Industry
Centerville, MO

1732054511- 02101110008 I: 0752

2. Now let us suppose that you have received a $20 check as a birth-
day gift. You want to deposit this check to your savings account
at the Security Federal Savings Bank. Your account number is
5972506. List the steps involved in your endorsement of the check.

3. Create a pretend check register with fifteen entries and a monthly
bank statement. Include three checks that have been written but
not cashed. Trade with a classmate and practice reconciling the ac-
counts.

V Using the Internet

Visit the Website of a major banking company to find out what the
bank provides to its customers. To learn more about money, visit the U.S.
Mint's Website at usmint.gov and the Bureau of Engraving and Print-
ing's Website at moneyfactory.com.

6

The Value of Money
Might Increase or
Decrease

Key Terms

value Consumer Price demand-pull
cost-push
inflation Index monetary policy
inflationary spiral
purchasing power index number

deflation base period

You may have heard people complain, "A dollar just isn't worth
a dollar anymore." They do not mean that you cannot get 100 cents
for each one of your dollar bills. A dollar is still worth 100 cents in
any combination of quarters, dimes, nickels, and pennies. But this
dollar has lost value—it cannot buy as much as it once did.

Look at the illustration of the three dollars on page 87. Each
dollar has a face value of 100 cents. Yet the 1970 dollar is two-
and-a-half times the size of the 1985 dollar, and it is six times the
size of today's dollar. The shrinking dollar means that since 1970
the value of a dollar has fallen considerably. In 1970, one dollar
bought over six times the amount of goods and services that one
dollar buys today.

After reading this chapter, you will have a better understand-
ing of the dollar and how its changing value affects you. You will
also be able to answer the following questions:

• What is inflation?
• Why are we concerned about inflation?
• What causes inflation?

86

The Value of Money Might Increase or Decrease 87

WHAT IS INFLATION?

Inflation is a rise in the prices of most goods and services.
When prices rise, you cannot buy as much with your dollar in one
year as you bought in an earlier year. That is why it is said that
during periods of inflation the purchasing power, or value, of the
dollar is falling. When the United States was on the gold stan-
dard, people bought gold to protect themselves from inflation.

Deflation is the opposite of inflation. During periods of defla-
tion, prices fall. Deflation, however, rarely occurs. For that reason,
we will focus our attention on inflation.

The purchasing power of the dollar is measured by the Con-
sumer Price Index (CPI). This index compares the prices of 400 com-
monly bought goods and services in one year with their prices in an
earlier year. These goods and services include food, shelter, cloth-
ing, transportation, medical care, fuel oil, gas and electricity, and

Figure 6.1 Decreasing Value of the Dollar Since 1970

1,115 NOTE IS LEGALTE NGER
FEMALE DENTS, PUBLIC ANC, PRIVATE

E 38819046G

E 388190146 G

1970

1985
Today

88 WHAT IS ECONOMICS ALL ABOUT?
Figure 6.2 Purchasing Power of the Dollar Since 1970

1970 1975 1980 1985 1990 1995 2000 2005
Year

telephone service. The prices of the items in the CPI are checked
monthly by the U.S. government. The CPI tells us how much a dol-
lar can buy compared to an earlier year, or years. (See the feature
"The Consumer Price Index and Index Numbers," on page 90.)

WHY ARE WE CONCERNED ABOUT INFLATION?
Effects of Inflation: Who Is Hurt

Inflation hurts some people more than others at first. If inflation
lasts long enough, it is likely to hurt us all. Let us see how and why.

1. Retired People. Many retired people live on incomes from
private pensions, bonds, and Social Security. Private pension in-
comes are fixed—they are not likely to increase very much from
one year to the next. Similarly, the income paid in the form of divi-
dends on bonds remains constant. When prices suddenly increase,
as they do during inflation, the elderly and others living on fixed
incomes are unable to buy as much with their money as they could
in the past. For them, inflation often means having to cut down
on necessities such as food or heating fuel. By law, Social Security
payments increase when there is a large increase in the Cost of
Living Index. Thus, Social Security income keeps up with inflation.

The Value of Money Might Increase or Decrease 89

2. People with Savings. People who put all their extra cash
into savings accounts may find that because of inflation, their
money is worth less after a period of years than when they depos-
ited it. Suppose that a couple deposited $1,000 in a savings account
in 1970. Remember from the opening of this chapter that the dol-
lar has less than a sixth of its 1970 purchasing power. Today, it
takes over $6,000 to buy what their $1,000 could buy. Thus, unless
the interest on their savings added $5,000 to their original deposit,
their money has less value now than when they deposited it.

3. People with Low Incomes. Those who earn low wages are
hurt by inflation. These individuals have little enough to spend to
begin with. Low-income people face increasing problems as prices
rise. Prices generally rise faster than their incomes. As food, cloth-
ing, and housing cost more, the poor are forced to make do with
fewer necessities.

Effects of Inflation: Who May Benefit

Inflation may benefit some people, however. Let us see how
and why.

1. People Who Owe Money. Those who borrow money before
the start of an inflationary period may benefit from it. They can

How do you think the adult "How can the dollar inflate and shrink at the
answered the youngster's same time?"
question?
From the Wall Street Journal. Permission,
Cartoon Features Syndicate.

90 AA WHAT IS ECONOMICS ALL ABOUT?

Understanding Economics
THE CONSUMER PRICE INDEX AND INDEX NUMBERS

The Consumer Price Index (CPI) is a mea- Consumer Price Index Since 1970
sure of the change in the prices of about (1982-1984 = 100)
400 items of food, clothing, shelter, and
health care that U.S. consumers use on a Year Index Number
daily basis. The prices in one period can
then be compared with the prices of the 1970 38.8
same items in an earlier period. The mea-
sure of one year's prices as compared 1980 82.4
with another year's is expressed as an in-
dex number. 1982-84 100.0

Index numbers allow us to see how 1990 130.7

parts of the economy are behaving from 2000 172.2
year to year. These numbers may also be
used to measure changes in almost any 2010 218.1
area that can be expressed in numbers.
2013 233.0
The accompanying table lists the CPI
for selected years since 1970. The line From looking at the table, what can
"1982-1984 = 100" tells us that 1982- you say about prices in 2013 as compared
1984 is the period to which consumer to 1982-84? Prices were 133 percent
prices in the other years are being com- higher than in the earlier period. Why?
Because the CPI in 2013 was 133 points
pared. We call 1982-1984 the base pe- higher than in 1982-1984.
riod. The index number of a base period
Figure 6.3 shows the Consumer Price
is always 100. Index as a graph.
To determine the percentage change
Questions for Thought
from the base, find the difference be-
tween the index number and the base. 1. What is the Consumer Price Index?
Remember that the base is always 100. 2. What is an index number?
For example, if the index number for a 3. What is a base period?
year is 130, there has been a 30 percent 4. Compare consumer prices in 2013

increase over the base (130 minus 100 to those in 1980 and 1970.

equals +30). If an index number stands at

82, it represents an 18 percent decrease

from the base (82 minus 100 equals -18).

repay their loans with dollars that are worth less than when they
took out the loans.

For example, in 1970 the dollar had more than twice the pur-
chasing power of the 1980 dollar (see the table above). Someone
who borrowed $5,000 in 1970 would have been able to repay the
loan (plus pay interest charges) in 1980 with dollars that were