U.S. Economy

large engines and industrial equipment, saw the sales of their products

to their international customers plummet. The higher value of the dollar

also makes it cheaper for U.S. citizens to import products from other

nations. Imports will rise, leading to a larger deficit (or smaller

surplus) in the U.S. balance of trade, the amount of exports compared to

imports.

Foreign investment has other effects on the U.S. economy. Eventually the

money borrowed must be repaid. How those repayments will affect the U.S.

economy will depend on how the borrowed money is invested. If the money

borrowed from foreign individuals and companies is put into capital

projects that increase levels of output and income in the United States,

repayments can be made without any decrease in U.S. living standards.

Otherwise, U.S. living standards will decline as goods and services are

sent overseas to repay the loans. The concern is that instead of using

foreign funds for additional investments in capital goods, today these

funds are simply making it possible for U.S. consumers and government

agencies to spend more on consumption goods and social services, which

will not increase output and living standards.

In the early history of the United States, many U.S. capital projects

were financed by people in Britain, France, and other nations that were

then the wealthiest countries in the world. These loans helped the

fledgling U.S. economy to grow and were paid off without lowering the

U.S. standard of living. It is not clear that current U.S. borrowing from

foreign nations will turn out as well and will be used to invest in

capital projects, now that the United States, with the largest and

wealthiest economy in the world, faces a low national savings rate.

MONEY AND FINANCIAL MARKETS

A Money and the Value of Money

Money is anything generally accepted as final payment for goods and

services. Throughout history many things have been used around the world

as money, including gold, silver, tobacco, cattle, and rare feathers or

animal skins. In the U.S. economy today, there are three basic forms of

money: currency (dollar bills), coins, and checks drawn on deposits at

banks and other financial firms that offer checking services. Most of the

time, when households, businesses, and government agencies pay their

bills they use checks, but for smaller purchases they also use currency

or coins.

People can change the type of the money they hold by withdrawing funds

from their checking account to receive currency or coins, or by

depositing currency and coins in their checking accounts. But the money

that people have in their checking accounts is really just the balance in

that account, and most of those balances are never converted to currency

or coins. Most people deposit their paychecks and then write checks to

pay most of their bills. They only convert a small part of their pay to

currency and coins. Strange as it seems, therefore, most money in the

U.S. economy is just the dollar amount written on checks or showing in

checking account balances. Sometimes, economists also count money in

savings accounts in broader measures of the U.S. money supply, because it

is easy and inexpensive to move money from savings accounts to checking

accounts.

Most people are surprised to learn that when banks make loans, the loans

create new money in the economy. As we’ve seen, banks earn profits by

lending out some of the money that people have deposited. A bank can make

loans safely because on most days, the amount some customers are

depositing in the bank is about the same amount that other customers are

withdrawing. A bank with many customers holding a lot of deposits can

lend out a lot of money and earn interest on those loans. But of course

when that happens, the bank does not subtract the amount it has loaned

out from the accounts of the people who deposited funds in savings and

checking accounts. Instead, these depositors still have the money in

their accounts, but now the people and firms to whom the bank has loaned

money also have that money in their accounts to spend. That means the

total amount of money in the economy has increased. This process is

called fractional reserve banking, because after making loans the bank

retains only a fraction of its deposits as reserves. The bank really

could not pay all of its depositors without calling in the loans it has

made. It also means that money is created when banks make loans but

destroyed when loans are paid off.

At one time the dollar, like most other national currencies, was backed

by a specified quantity of gold or silver held by the federal government.

At that time, people could redeem their dollars for gold or silver. But

in practice paper currency is much easier to carry around than large

amounts of gold or silver. Therefore, most people have preferred to hold

paper money or checking balances, as long as paper currency and checks

are accepted as payment for goods and services and maintain their value

in terms of the amount of goods and services they can buy.

Eventually governments around the world also found it expensive to hold

and guard large quantities of gold or silver. As foreign trade grew,

governments found it especially difficult to transfer gold and silver to

other countries that decided to redeem paper money acquired through

international trade. They, too, changed to using paper currencies and

writing checks against deposits in accounts. In 1971 the United States

suspended the international payment of gold for U.S. currency. This

action effectively ended the gold standard, the name for this official

link between the dollar and the price of gold. Since then, there has been

no official link between the dollar and a set price for gold, or to the

amount of gold or other precious metals held by the U.S. government.

The real value of the dollar today depends only on the amount of goods

and services a dollar can purchase. That purchasing power depends

primarily on the relationship between the number of dollars people are

holding as currency and in their checking and savings accounts, and the

quantity of goods and services that are produced in the economy each

year. If the number of dollars increases much more rapidly than the

quantity of goods and services produced each year, or if people start

spending the dollars they hold more rapidly, the result is likely to be

inflation. Inflation is an increase in the average price of all goods and

services. In other words, it is a decrease in the value of what each

dollar can buy.

The Federal Reserve System and Monetary Policy

Governments often attempt to reduce inflation by controlling the supply

of money. Consequently, organizations that control how much money is

issued in an economy play a major role in how the economy performs, in

terms of prices, output and employment levels, and economic growth. In

the United States, that organization is the nation’s central bank, the

Federal Reserve System. The system’s name comes from the fact that the

Federal Reserve has the legal authority to make banks hold some of their

deposits as reserves, which means the banks cannot lend out those

deposits. These reserve funds are held in the Federal Reserve Bank. The

Federal Reserve also acts as the banker for the federal government, but

the government does not own the Federal Reserve. It is actually owned by

the nation’s banks, which by law must join the Federal Reserve System and

observe its regulations.

There are 12 regional Federal Reserve banks. These banks are not

commercial banks. They do not accept savings deposits from or provide

loans to individuals or businesses. Instead, the Federal Reserve

functions as a central bank for other banks and for the federal

government. In that role the Federal Reserve System performs several

important functions in the national economy. First, the branches of the

Federal Reserve distribute paper currency in their regions. Dollar bills

are actually Federal Reserve notes. You can look at a dollar bill of any

denomination and see the number for the regional Federal Reserve Bank

where the bill was originally issued. But of course the dollar is a

national currency, so a bill issued by any regional Federal Reserve Bank

is good anyplace in the country. The distribution of currency occurs as

commercial banks convert some of their reserve balances at the Federal

Reserve System into currency, and then provide that currency to bank

depositors who decide to hold some of their money balances as currency

rather than deposits in checking accounts. The U.S. Treasury prints new

currency for the Federal Reserve System. The bills are introduced into

circulation when commercial banks use their reserves to buy currency from

the Federal Reserve Bank.

Second, the regional Federal Reserve banks transfer funds for checks that

are deposited by a bank in one part of the country, but were written by

someone who has a checking account with a bank in another part of the

country. Millions of checks are processed this way every business day.

Third, the regional Federal Reserve Banks collect and analyze data on the

economic performance of their regions, and provide that information and

their analysis of it to the national Federal Reserve System. Each of the

12 regions served by the Federal Reserve banks has its own economic

characteristics. Some of these regional economies are concerned more with

agricultural issues than others; some with different types of

manufacturing and industries; some with international trade; and some

with financial markets and firms. After reviewing the reports from all

different parts of the country, the national Federal Reserve System then

adopts policies that have major effects on the entire U.S. economy.

By far the most important function of the Federal Reserve System is

controlling the nation’s money supply and the overall availability of

credit in the economy. If the Federal Reserve System wants to put more

money in the economy, it does not ask the Treasury to print more dollar

bills. Remember, much more money is held in checking and savings accounts

than as currency, and it is through those deposit accounts that the

Federal Reserve System most directly controls the money supply. The

Federal Reserve affects deposit accounts in one of three ways.

First, it can allow banks to hold a smaller percentage of their deposits

as reserves at the Federal Reserve System. A lower reserve requirement

allows banks to make more loans and earn more money from the interest

paid on those loans. Banks making more loans increase the money supply.

Conversely, a higher reserve requirement reduces the amount of loans

banks can make, which reduces or tightens the money supply.

The second way the Federal Reserve System can put more money into the

economy is by lowering the rate it charges banks when they borrow money

from the Federal Reserve System. This particular interest rate is known

as the discount rate. When the discount rate goes down, it is more likely

that banks will borrow money from the Federal Reserve System, to cover

their reserve requirements and support more loans to borrowers. Once

again, those loans will increase the nation’s money supply. Therefore, a

decrease in the discount rate can increase the money supply, while an

increase in the discount rate can decrease the money supply.

In practice, however, banks rarely borrow money from the Federal Reserve,

so changes in the discount rate are more important as a signal of whether

the Federal Reserve wants to increase or decrease the money supply. For

example, raising the discount rate may alert banks that the Federal

Reserve might take other actions, such as increasing the reserve

requirement. That signal can lead banks to reduce the amount of loans

they are making.

The third way the Federal Reserve System can adjust the supply of money

and the availability of credit in the economy is through its open market

operations—the buying or selling of government bonds. Open market

operations are actually the tool that the Federal Reserve uses most often

to change the money supply. These open-market operations take place in

the market for government securities. The U.S. government borrows money

by issuing bonds that are regularly auctioned on the bond market in New

York. The Federal Reserve System is one of the largest purchasers of

those bonds, and the bank changes the amount of money in the economy when

it buys or sells bonds.

Government bonds are not money, because they are not generally accepted

as final payment for goods and services. (Just try paying for a hamburger

with a government savings bond.) But when the Federal Reserve System pays

for a federal government bond with a check, that check is new

money—specifically, it represents a loan to the government. This loan

creates a higher balance in the government’s own checking account after

the funds have been transferred from the privately owned Federal Reserve

Bank to the government. That new money is put into the economy as soon as

the government spends the funds. On the other hand, if the Federal

Reserve sells government bonds, it collects money that is taken out of

circulation, since the bonds that the Federal Reserve sells to banks,

firms, or households cannot be used as money until they are redeemed at a

later date.

The Wall Street Journal and other financial media regularly report on

purchases of bonds made by the Federal Reserve and other buyers at

auctions of U.S. government bonds. The Federal Reserve System itself also

publishes a record of its buying and selling in the bond market. In

practice, since the U.S. economy is growing and the money supply must

grow with it to keep prices stable, the Federal Reserve is almost always

buying bonds, not selling them. What changes over time is how fast the

Federal Reserve wants the money supply to grow, and how many dollars

worth of bonds it purchases from month to month.

To summarize the Federal Reserve System’s tools of monetary policy: It

can increase the supply of money and the availability of credit by

lowering the percentage of deposits that banks must hold as reserves at

the Federal Reserve System, by lowering the discount rate, or by

purchasing government bonds through open market operations. The Federal

Reserve System can decrease the supply of money and the availability of

credit by raising reserve ratios, raising the discount rate, or by

selling government bonds.

The Federal Reserve System increases the money supply when it wants to

encourage more spending in the economy, and especially when it is

concerned about high levels of unemployment. Increasing the money supply

usually decreases interest rates—which are the price of money paid by

those who borrow funds to those who save and lend them. Lower interest

rates encourage more investment spending by businesses, and more spending

by households for houses, automobiles, and other “big ticket” items that

are often financed by borrowing money. That additional spending increases

national levels of production, employment, and income. However, the

Federal Reserve Bank must be very careful when increasing the money

supply. If it does so when the economy is already operating close to full

employment, the additional spending will increase only prices, not output

and employment.

Effect of Monetary Policies on the U.S. Economy

The monetary policies adopted by the Federal Reserve System can have

dramatic effects on the national economy and, in particular, on financial

markets. Most directly, of course, when the Federal Reserve System

increases the money supply and expands the availability of credit, then

the interest rate, which determines the amount of money that borrowers

pay for loans, is likely to decrease. Lower interest rates, in turn, will

encourage businesses to borrow more money to invest in capital goods, and

will stimulate households to borrow more money to purchase housing,

automobiles, and other goods.

But the Federal Reserve System can go too far in expanding the money

supply. If the supply of money and credit grows much faster than the

production of goods and services in the economy, then prices will

increase, and the rate of inflation will rise. Inflation is a serious

problem for those who live on fixed incomes, since the income of those

individuals remains constant while the amount of goods and services they

can purchase with their income decreases. Inflation may also hurt banks

and other financial institutions that lend money, as well as savers. In a

period of unanticipated inflation, as the value of money decreases in

terms of what it will purchase, loans are repaid with dollars that are

worth less. The funds that people have saved are worth less, too.

When banks and savers anticipate higher inflation, they will try to

protect themselves by demanding higher interest rates on loans and

savings accounts. This will be especially true on long-term loans and

savings deposits, if the higher inflation is considered likely to

continue for many years. But higher interest rates create problems for

borrowers and those who want to invest in capital goods.

If the supply of money and credit grows too slowly, however, then

interest rates are again likely to rise, leading to decreased spending

for capital investments and consumer durable goods (products designed for

long-term use, such as television sets, refrigerators, and personal

computers). Such decreased spending will hurt many businesses and may

lead to a recession, an economic slowdown in which the national output of

goods and services falls. When that happens, wages and salaries paid to

individual workers will fall or grow more slowly, and some workers will

be laid off, facing possibly long periods of unemployment.

For all of these reasons, bankers and other financial experts watch the

Federal Reserve’s actions with monetary policy very closely. There are

regular reports in the media about policy changes made by the Federal

Reserve System, and even about statements made by Federal Reserve

officials that may indicate that the Federal Reserve is going to change

the supply of money and interest rates. The chairman of the Federal

Reserve System is widely considered to be one of the most influential

people in the world because what the Federal Reserve does so dramatically

affects the U.S. and world economies, especially financial markets.

LABOR AND LABOR MARKETS

Labor includes work done for employers and work done in a person’s own

household, but labor markets deal only with work that is done for some

form of financial compensation. Labor markets include all the means by

which workers find jobs and by which employers locate workers to staff

their businesses. A number of factors influence labor and labor markets

in the United States, including immigration, discrimination, labor

unions, unemployment, and income inequality between the rich and poor.

The official definition of the U.S. labor force includes people who are

at least 16 years old and either working, waiting to be recalled from a

layoff, or actively looking for work within the past 30 days. In 1998 the

U.S. labor force included nearly 138 million people, most of them working

in full-time or part-time jobs.

Most people in the United States receive their income as wages and

salaries paid by firms that have hired individuals to work as their

employees. Those wages and salaries are the prices they receive for the

labor services they provide to their employers. Like other prices, wages

and salaries are determined primarily by market forces.

Labor Supply and Demand

The wages and salaries that U.S. workers earn vary from occupation to

occupation, across geographic regions, and according to workers’ levels

of education, training, experience, and skill. As with goods and services

purchased by consumers, labor is traded in markets that reflect both

supply and demand. In general, higher wages and salaries are paid in

occupations where labor is more scarce—that is, in jobs where the demand

for workers is relatively high and the supply of workers with the

qualifications and ability to do that work is relatively low. The demand

for workers in particular occupations depends largely on how much the

work they do adds to a firm’s revenues. In other words, workers who

create more products or higher-priced products will be worth more to

employers than workers who make fewer or less valuable products. The

supply of workers in any occupation is affected by the amount of time and

effort required to enter that occupation compared to other things workers

might do.

Workers seeking higher wages often learn skills that will increase the

likelihood of finding a higher-paying job. The knowledge, skills, and

experience a worker has acquired are the worker’s human capital.

Education and training can clearly increase workers’ human capital and

productivity, which makes them more valuable to employers. In general,

more educated individuals make more money at their jobs. However, a

greater level of education does not always guarantee higher wages.

Certain professions that demand a high level of education, such as

teaching elementary and secondary school, are not high-paying. Such

situations arise when the number of people with the training to do that

job is relatively large compared with the number of people that employers

want to hire. Of course this situation can change over time if, for

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