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 important 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 government. 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 production 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 business 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 interest 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 minimum 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 U.S. economy as a giant business or company. Like many business firms, this company produces both goods and services. But unlike ordinary businesses, the U.S. economy creates all of the goods and services that the nation produces. The total money value of the goods and services produced by a nation's economy in one year is called its gross domestic product, or GDP. In 2013, the GDP of the United States was $16.8 trillion ($16,800,000,000,000). The GDP is purchased by the economy's "customers." These are U.S. consumers, business firms, and governments, as well as buyers in other countries. Economists measure the size of the GDP by totalling the amount of money spent by each of these groups. Consumers are people like you, your family, and friends who buy goods and services for their own use. Consumer spending amounted to $11.5 trillion in 2013. Business spending is also called investment. Businesses invest in capital resources, such as factories, machinery, and tools, which are used to produce goods and services. In 2013, investment accounted for $2.7 trillion of the GDP. In 2013, government spending for goods and services on the federal, state, and local levels totalled $3.1 trillion. Foreigners purchased $2.3 trillion worth of goods and services from the U.S. economic system in 2013. But Americans purchased $2.8 trillion worth of goods and services from foreign business firms. The difference of $500 billion was deducted from the total spending in the United States in order to arrive at the GDP for that year of $16.8 trillion.
HOUSEHOLDS BUSINESSES 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 between 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
44 AA 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, interest, 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 services 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 governments 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, households 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 provide 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 businesses 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 services, 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 understand 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 anywhere 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 economic 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-
lit 4 it HOUSEHOLDS GOVERNMENTS The United States Free Enterprise System Afk 45 Figure 3.3 Circular Flow Between Households and Governments 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 inalienable Rights, that among these are Life, Liberty and the pursuit 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. Naturally, 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 standard 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 origin. In addition, the system should provide all Americans with a "fair share" of the nation's output of goods and services. Americans 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 accept 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 resources 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 inFigure 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 invisible hand to guide a free enterprise system. An example of an invisible hand guiding economic activities would be a storekeeper 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 selfinterest. 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 enterprise) 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 production of any other nation in the world. As a result of our nation's continuing 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 average 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 impossible because economic resources are always limited. Nor have all the American people shared equally in the country's rising living standards. However, inequalities based upon race, sex, religion, and national 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 enterprise. 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), private 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 answers 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 market activity. The goals of the U.S. economic system are growth, stability, security, justice, freedom, and economic efficiency. The U.S. economy produces 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 supply 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 felttipped 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) consumers 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 increase 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 B competition among many small producers who sell products that vary slightly the total value of the goods and services produced by a country in one year the lands, buildings, or goods owned by individuals or businesses the lands, buildings, or goods controlled or operated by federal, state, or local governments the right of individuals to enter into legal businesses and operate them as they see fit the effort to outperform other businesses a system of private ownership of raw materials, factories, and equipment the desire to earn a surplus when no single firm can influence prices Adam Smith's view on how a nation's economic resources can be efficiently allocated Column A 1. capitalism a. 2. free enterprise 3. profit motive b. 4. competition 5. private property c. 6. pure competition 7. monopolistic d. competition 8. public property e. 9. gross domestic product (GDP) 1. 10. invisible hand g. h. i.
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 restrictions 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.
demand demand schedule Law of Demand elasticity of demand elastic inelastic supply Law of Supply market price price-directed market economy responsive prices efficiency demand curve supply curve changes in supply microeconomics macroeconomics 4 Demand and Supply Key Terms 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. People 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 television news programs report that other helicopters have dumped trillions 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 Demand and the Law of Supply. How these laws operate in a free enterprise system is the subject of this chapter. In this chapter, you will find out the answers to these questions: 52
Prices rising because of money dropped from helicopters is a fanciful example. But economists do keep a careful eye on the prices of goods and services. For example, once a month, the Bureau of Labor Statistics publishes a report on the consumer price index, a measure of the average change in prices over time of goods and services purchased by households. <http://www.bls.gov/cpi/#tables> The May 2014 report was more than 100 pages long, filled with tables of statistics. These tables are very good representations of data at a fine level of detail, which economists need to understand. However, economists also need to understand and evaluate data from different perspectives, including long-range trends. For this reason, they often transfer statistical information into written or visual formats, such as graphs. They use software in which they can enter the statistics to create a variety of graphs. Even your own word-processing program, however, has features that allow you to create spreadsheets of information and draw on that information to create graphs. Transfer the information about chocolate chip cookies from this chapter into different mediums. From a narrative description of supply and demand issues, for example, create a graph. From a graph, try to create a table. Use your software to help you. Demand and Supply 53 Understanding Economics WAYS TO REPRESENT DATA • What are the Laws of Demand and Supply? • What is market price? • How do changes in the demand for or supply of a product affect 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, however, 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 quantity 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 students. The class wanted to determine (1) how much students were willing 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 demand 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 2.50 175 437.50 Milk $1.20 200 $240.00 .60 350 210.00 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 1,100 fl .20 700 ,7 .10 100 ,, 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 chocolate 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 react 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 easily increase their output than can dairy farmers. They can, for example, 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 manufacturers 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. Economists 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 200 " 400 71 700 , 1,100 ,, 1,600 ,, 2,300 71 $.70 each .60 " .50 " .40 " .30 " .20 " .10 " 2,000 cookies 1,800 1,600 1,400 , 1,100 9, 700 ,, 100 77 HOW DO CHANGES IN DEMAND AND SUPPLY AFFECT PRICE? Price affects the quantity of demand—the amount of a good or service 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-
58 N 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 temporarily, 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. Florists 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 immediately, 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 until people felt the economy was recovering. A fifth is the price of related goods. When the demand for smartphones increased, the demand for smartphone cases increased and the demand for older phones decreased. 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 supply. The quantity of supply rises and falls based on the prices suppliers receive. However, changes in supply vary based on non-price determinants 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-
Young workers i•••..... — — All workers Recent college graduates College graduates • • ..-•*.. • — • I I I I 1 I I I I I 1 I I I I I I I I I I I I • ....... -• As you develop your economic skills, practice evaluating economic data using graphs. The following graph is from a report completed in 2014 by the Federal Reserve Bank of New York Research Division. What does this graph communicate about the value of a college education in avoiding unemployment? Learn to communicate economic information visually by creating your own visual presentations. Pursue the example of how car values decline over time. Using the Internet, find a free calculator that determines how quickly a car will lose value. These calculators usually return the results in the form of a chart. Use the information in that chart and the software on your computer to create a graph representing the same information. UNEMPLOYMENT RATES FOR RECENT COLLEGE GRADUATES AND OTHER GROUPS 1990 1995 2000 2005 2010 16% 14% 12% 10% 8% 6% 4% 2% 0% Demand and Supply 59 Understanding Economics USING UNEMPLOYMENT DATA 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 businesspeople 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 services 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 allow analysts to adjust certain variables and evaluate the effect of those adjustments. Graphs are visual models. We can use graphs to illustrate 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 cookies. 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 Co okie $.70 .60 .50 .40 .30 .20 .10 Price p er Co okie $.70 .60 .50 .40 .30 .20 .10 S 2000 1800 700 100 1600 1400 Demand and Supply Figure 4.1 Demand for Chocolate Chip Cookies D 100 300 500 700 900 1100 1300 1500 1700 1900 2100 2300 Number of Cookies Figure 4.2 Supply of Chocolate Chip Cookies S I I I I I I I I 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 Number of Cookies
D S 100 2000 1800 400 1600 700 1400 700 100 S I I I I I I I I I I 1600 300 1 «_1 1 1 1 1 1 I PriceperCookie $.70 .60 .50 .40 .30 .20 .10 62 WHAT IS ECONOMICS ALL ABOUT? Figure 4.3 Demand for and Supply of Chocolate Chip Cookies 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 offered 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). Meanwhile, 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 competition 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 supply, 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.
Price perCookie $.70 .60 .50 .40 .30 .20 .10 Price perCookie $.70 .60 .50 .40 .30 .20 .10 D S M D D2 I I I I I I I I 1 1 1 1 1 1 1 1 1 1 1 1 1 1 D Demand and Supply 63 Figure 4.4 Increase in Demand for Chocolate Chip Cookies 1 1 I I I I I I I I I I 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 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.
S S1 1 1 1 1 1 1 1 I I I I I I D M S 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 M2 D 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 demand 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 Price per Cookie Figure 4.6 Increase in Supply of Chocolate Chip Cookies D S S1 $ 70 .60 .50 .40 .30 .20 .10 100 300 500 700 900 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 Lti 0 0 V .40 CD S .30 .20 .10 100 300 500 700 900 1100 1300 1500 1700 1900 2100 2300 Number of Cookies
Demand and Supply Af, 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 quantity 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 occurs—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, because 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.
66 AA 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 sale 3. supply b. states that the quantity of supply increases as 4. Law of Supply prices increase, and decreases as prices decrease 5. market price c. the amount of an item that buyers are willing and 6. wage 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 demand (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 prefer 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 tripled? 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 announces 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
68 N 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 similarsounding 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.
money barter medium of exchange monetary unit currency checking account check fiat money commodity money credit union FDIC withdrawal traveler's check bank depositor interest commercial bank savings and loan association mutual savings bank cancelled check deposit Federal Reserve System endorsement reserves electronic funds transfer (EFT) automatic teller machine (ATM) debit card borrow endorse 5 Money and Banks Key Terms We all know what money is. Or do we? You will probably be surprised 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, musket 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 69
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 centuries 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 acquire similar value?
Money and Banks N 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 because 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, orexchange what they have for something they want. One positive aspect 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 exist. 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.
72 Ai, 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 economy and made their living by growing vegetables, saving for a house would be very difficult. How would they go about saving their vegetables? 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 increase. 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 nation's currency. Positive aspects of paper money include that it is light and easy to carry and that it can be used to purchase anything, 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 people trust the government's law that says its money is worth something. This currency is fiat money. We accept the face value of paper 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.
I; 74 /7 4 //, O. erPow A`,/,' Trventy 1• h.., t,,,,,,,firtr She. A. Orr rItehr/ .Itte# 44' Xticbsbattertorc 1 1 417tt bie 2itic4at.aut17aupt esire itt gegen fi, iefe 13anfnote dent /einliefere t. eeptemt,er 11z3 ab rout biefe . aufgerufen un5 toner ttnnaufd7 gegen, gefeelliebe ZgOlungentittet eingepgen Berlin, tat 9.10.0oft rgal lieiti/abantbirettoriurn Money and Banks 73 ATE OF MASSACIiLISETTS-BAY. o One Dollar. ,P lilt Mirror of tills B IL 1 MAI :•i 0 t'PEKI sp,,,3„ ,4,1,,,,oD,:j, t , R %. Thirty,firg4 y of I le,o, e,r, One '1.1,es, a "outirell Pali y-i.,, with It ,ft in ' ' r Rate ult.:, 11 A 1. ;I:T.,33kialg M. A u proof th t, of tho Fifth Dili Lt Airy, t 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-
WHEN COUNTERSIGNED BELOW WITH THIS SIGNATURE RA296.020.003 CITY AND DATE 19 100M4 !rJ .1144atel effilfit ISSUED SY AMERICAN EXPRESS TRAVEL RELATED SERVICES COMPANY, INC. PaythisCheque NEW YORK, N.Y. to theOalerof *NI t.JINI ser,•••:11-1E6 IN "1_,OTH ER COUNT•tt I • 1 Ds,.41' COUNTERSIGN HERE INPRESENCEOF PERSON CASHING 1:8000000 5 41:9 Lim 296020003So XT"Pit'-40L3: . 74 vv, WHAT IS ECONOMICS ALL ABOUT? Figure 5.1 American Express Traveler's Check 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 selling 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 customers 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 businesses, 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 commercial 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 accounts. 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 accounts 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 account 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. Another 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 account in the First National Bank of Peoria, Illinois. Today, March 1, is the day the rent is payable to her landlord, the Yardley Realty Company. She will write a check for $582.70 to pay the rent. Here is the blank check she will use. First National Bank has printed Martha Nieves's name on her check. 2. This is where the date is entered. 3. This is the number of Martha's check. 4. Following the words "Pay to the Order of" is written the name of the individual or organization to whom the check is made out. 5. The amount of the check follows the $ sign. Many people write the number of cents as a fraction of 100. Thus, $582 70/100. 6. Here the amount of money is written out. Once again, most people list the cents as a fraction of 100. Thus, $582.70 could be written as "Five hundred eighty-two and 70/100," followed by a line to the word "Dollars," if space remained. 7. The name of the bank is printed on the check. 8. The person writing the check (Martha Nieves) signs here. 9. These are the code numbers that identify Martha Nieves's account and bank. These numbers can be read by an electronic data-processing machine. It automatically sorts out the checks that each person who has a checking account has written, and then it adds up the sums of money.
(Di:0210...00081:17320545 ,,• 0812 Money and Banks 77 Martha Nieves's check to Yardley Realty is shown above. Suppose that Martha Nieves had carried the $582.70 rent money in cash in her purse and then the purse had been lost or stolen. She would have been out the money. But if Martha had lost the rent check, all she would have had to do was notify the bank to stop payment on it. No money would have been lost. She could then have paid her rent by writing a new check. Endorsing a Check After receiving Martha's check, Yardley Realty will either cash it or deposit it in a bank account. In either case, Yardley's bookkeepers will have to endorse the check by stamping the company's name on the back. The endorsement looks like this: YARDLEY REALTY COMPANY When you endorse a check that has been made out to you, you give someone else the right to cash it. Until that happens, no one else but you has the right to the money. This is one reason why checks are so widely used as money. It is easy to endorse a check that is made out to you. All you must do is sign your name on the back of the check. If you are going to deposit this check to your account and send it through the mail, it is safer to add the following: Your name For deposit only to account number A check endorsed in this way can be deposited only into your bank account. No one can claim to be you or that you endorsed the check over to them. Banks ask their checking account customers to use deposit tickets. On these tickets are printed the customer's name, address, and account number. The customer fills in the amount of the cash and/ or checks being deposited and includes the ticket with the deposit.
78 WHAT IS ECONOMICS ALL ABOUT? If you develop the habit of entering 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 convert 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 accounts 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 vacations, 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 currency 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 country. 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 currency 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 currency from the Bureau of Engraving and Printing in Washington, 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 government 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 merchandise 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 government 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 reduced 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 borrows 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 withdrawals. 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 deposits 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 redeposited 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 because there is a limit to the amount of money it may lend. Remember, 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 Reserves Loans Safety First $1,000,000 $200,000 $800,000 National Bank 800,000 160,000 640,000 640,000 128,000 512,000 512,000 102,400 409,600 409,600 81,920 327,680 Sum of remaining bank activities 1,638,400 327,680 1,310,720 Total $5,000,000 $1,000,000 $4,000,000 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 people bank and pay for the things that they buy. Automated Teller Machines Previously when one went to a bank to make a deposit or withdrawal, one usually dealt with a teller. With an automated teller machine (ATM), it is possible to make bank deposits and withdrawals 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 themselves from robberies when withdrawing 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 sixdigit 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. Depositors cannot withdraw and spend those amounts until their account is credited. Using an electronic funds transfer (EFT) system, however, accounts can be credited immediately. The EFT system uses computers and automated equipment to do this. Consequently, depositors 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 electronic 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 Internet 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 customers 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 services. 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 (paper 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 System 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 considered 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 payments via computers and other automated means (b) is the amount of demand deposits held at banks (c) is a payment procedure involving 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 1. barter 2. money 3. currency 4. monetary unit 5. depositor 6. Bureau of the Mint 7. electronic funds transfer (EFT) 8. Federal Reserve System Column B a. the use of computers to receive and make payments b. the standard unit of value of a country's currency c. a person who places money in an account in a bank for safety and earnings d. anything generally accepted in payment for goods and services e. money that is easy to carry because it is paper f. a system in which people exchange goods or services g. an organization that regulates the nation's banks and its money supply h. an organization that manufactures U.S. coins
Your Name 752 20 Pay to the Order of Dollars Bank of Industry Centerville, MO 1732054511- 02101110008 I: 0752 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.) 2. Now let us suppose that you have received a $20 check as a birthday 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 accounts. 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.govand the Bureau of Engraving and Printing's Website at moneyfactory.com.
6 The Value of Money Might Increase or Decrease Key Terms value Consumer Price demand-pull inflation Index cost-push purchasing power index number monetary policy deflation base period inflationary spiral 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 twoand-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 understanding 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
1,115 NOTE IS LEGALTENGER FEMALE DENTS, PUBLIC ANC, PRIVATE E 38819046G E 388190146 G 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 standard, people bought gold to protect themselves from inflation. Deflation is the opposite of inflation. During periods of deflation, 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 Consumer Price Index (CPI). This index compares the prices of 400 commonly bought goods and services in one year with their prices in an earlier year. These goods and services include food, shelter, clothing, transportation, medical care, fuel oil, gas and electricity, and Figure 6.1 Decreasing Value of the Dollar Since 1970 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 dollar 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 incomes are fixed—they are not likely to increase very much from one year to the next. Similarly, the income paid in the form of dividends 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 deposited it. Suppose that a couple deposited $1,000 in a savings account in 1970. Remember from the opening of this chapter that the dollar 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, clothing, 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 answered the youngster's question? "How can the dollar inflate and shrink at the same time?" From the Wall Street Journal. Permission, Cartoon Features Syndicate.
Understanding Economics THE CONSUMER PRICE INDEX AND INDEX NUMBERS The Consumer Price Index (CPI) is a measure of the change in the prices of about 400 items of food, clothing, shelter, and health care that U.S. consumers use on a daily basis. The prices in one period can then be compared with the prices of the same items in an earlier period. The measure of one year's prices as compared with another year's is expressed as an index number. Index numbers allow us to see how parts of the economy are behaving from year to year. These numbers may also be used to measure changes in almost any area that can be expressed in numbers. The accompanying table lists the CPI for selected years since 1970. The line "1982-1984 = 100" tells us that 1982- 1984 is the period to which consumer prices in the other years are being compared. We call 1982-1984 the base period. The index number of a base period is always 100. To determine the percentage change from the base, find the difference between the index number and the base. Remember that the base is always 100. For example, if the index number for a year is 130, there has been a 30 percent increase over the base (130 minus 100 equals +30). If an index number stands at 82, it represents an 18 percent decrease from the base (82 minus 100 equals -18). Consumer Price Index Since 1970 (1982-1984 = 100) Year Index Number 1970 38.8 1980 82.4 1982-84 100.0 1990 130.7 2000 172.2 2010 218.1 2013 233.0 From looking at the table, what can you say about prices in 2013 as compared to 1982-84? Prices were 133 percent higher than in the earlier period. Why? Because the CPI in 2013 was 133 points higher than in 1982-1984. Figure 6.3 shows the Consumer Price Index as a graph. Questions for Thought 1. What is the Consumer Price Index? 2. What is an index number? 3. What is a base period? 4. Compare consumer prices in 2013 to those in 1980 and 1970. 90 AA WHAT IS ECONOMICS ALL ABOUT? 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 purchasing 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