{"01-1": "By the end of this section, you will be able to:\nDiscuss the importance of studying economics\nExplain the relationship between production and division of labor\nEvaluate the significance of scarcity\n\nEconomics is the study of how humans make decisions in the face of scarcity. These can be individual decisions, family decisions, business decisions or societal decisions. If you look around carefully, you will see that scarcity is a fact of life. Scarcity means that human wants for goods, services and resources exceed what is available. Resources, such as labor, tools, land, and raw materials are necessary to produce the goods and services we want but they exist in limited supply. Of course, the ultimate scarce resource is time- everyone, rich or poor, has just 24 expendable hours in the day to earn income to acquire goods and services, for leisure time, or for sleep. At any point in time, there is only a finite amount of resources available. Think about it this way: In 2015 the labor force in the United States contained over 158 million workers, according to the U.S. Bureau of Labor Statistics. The total land area was 3,794,101 square miles. While these are certainly large numbers, they are not infinite. Because these resources are limited, so are the numbers of goods and services we produce with them. Combine this with the fact that human wants seem to be virtually infinite, and you can see why scarcity is a problem. Introduction to FREDData is very important in economics because it describes and measures the issues and problems that economics seek to understand. A variety of government agencies publish economic and social data. For this course, we will generally use data from the St. Louis Federal Reserve Bank's FRED database. FRED is very user friendly. It allows you to display data in tables or charts, and you can easily download it into spreadsheet form if you want to use the data for other purposes. The FRED website includes data on nearly 400,000 domestic and international variables over time, in the following broad categories:Money, Banking & Finance\nPopulation, Employment, & Labor Markets (including Income Distribution)\nNational Accounts (Gross Domestic Product & its components), Flow of Funds, and International Accounts\nProduction & Business Activity (including Business Cycles)\nPrices & Inflation (including the Consumer Price Index, the Producer Price Index, and the Employment Cost Index)\nInternational Data from other nations\nU.S. Regional Data\nAcademic Data (including Penn World Tables & NBER Macrohistory database)For more information about how to use FRED, see the variety of videos on YouTube starting with this introduction.\n\n\n\n\nFigure \n1.2\n \nScarcity of Resources\n \nHomeless people are a stark reminder that scarcity of resources is real. (Credit: daveynin/Flickr Creative Commons)\n\n\nIf you still do not believe that scarcity is a problem, consider the following: Does everyone require food to eat? Does everyone need a decent place to live? Does everyone have access to healthcare? In every country in the world, there are people who are hungry, homeless (for example, those who call park benches their beds, as Figure 1.2 shows), and in need of healthcare, just to focus on a few critical goods and services. Why is this the case? It is because of scarcity. Lets delve into the concept of scarcity a little deeper, because it is crucial to understanding economics. The Problem of Scarcity\nThink about all the things you consume: food, shelter, clothing, transportation, healthcare, and entertainment. How do you acquire those items? You do not produce them yourself. You buy them. How do you afford the things you buy? You work for pay. If you do not, someone else does on your behalf. Yet most of us never have enough income to buy all the things we want. This is because of scarcity. So how do we solve it? \nLink It Up\n\nVisit this website to read about how the United States is dealing with scarcity in resources.\nEvery society, at every level, must make choices about how to use its resources. Families must decide whether to spend their money on a new car or a fancy vacation. Towns must choose whether to put more of the budget into police and fire protection or into the school system. Nations must decide whether to devote more funds to national defense or to protecting the environment. In most cases, there just isnt enough money in the budget to do everything.  How do we use our limited resources the best way possible, that is, to obtain the most goods and services we can?  There are a couple of options.  First, we could each produce everything we each consume.  Alternatively, we could each produce some of what we want to consume, and trade for the rest of what we want.  Lets explore these options. Why do we not each just produce all of the things we consume? Think back to pioneer days, when individuals knew how to do so much more than we do today, from building their homes, to growing their crops, to hunting for food, to repairing their equipment. Most of us do not know how to do allor anyof those things, but it is not because we could not learn. Rather, we do not have to. The reason why is something called the division and specialization of labor, a production innovation first put forth by Adam Smith (Figure 1.3) in his book, The Wealth of Nations. \n\n\n\n\nFigure \n1.3\n \nAdam Smith\n \nAdam Smith introduced the idea of dividing labor into discrete tasks. (Credit: Wikimedia Commons)\n\n\n\nThe Division of and Specialization of Labor\nThe formal study of economics began when Adam Smith (17231790) published his famous book The Wealth of Nations in 1776. Many authors had written on economics in the centuries before Smith, but he was the first to address the subject in a comprehensive way. In the first chapter, Smith introduces the concept of division of labor, which means that the way one produces a good or service is divided into a number of tasks that different workers perform, instead of all the tasks being done by the same person. To illustrate division of labor, Smith counted how many tasks went into making a pin: drawing out a piece of wire, cutting it to the right length, straightening it, putting a head on one end and a point on the other, and packaging pins for sale, to name just a few. Smith counted 18 distinct tasks that different people performedall for a pin, believe it or not! Modern businesses divide tasks as well. Even a relatively simple business like a restaurant divides the task of serving meals into a range of jobs like top chef, sous chefs, less-skilled kitchen help, servers to wait on the tables, a greeter at the door, janitors to clean up, and a business manager to handle paychecks and billsnot to mention the economic connections a restaurant has with suppliers of food, furniture, kitchen equipment, and the building where it is located. A complex business like a large manufacturing factory, such as the shoe factory (Figure 1.4), or a hospital can have hundreds of job classifications. \n\n\n\n\nFigure \n1.4\n \nDivision of Labor\n \nWorkers on an assembly line are an example of the divisions of labor. (Credit: Nina Hale/Flickr Creative Commons)\n\n\n\nWhy the Division of Labor Increases Production\nWhen we divide and subdivide the tasks involved with producing a good or service, workers and businesses can produce a greater quantity of output. In his observations of pin factories, Smith noticed that one worker alone might make 20 pins in a day, but that a small business of 10 workers (some of whom would need to complete two or three of the 18 tasks involved with pin-making), could make 48,000 pins in a day. How can a group of workers, each specializing in certain tasks, produce so much more than the same number of workers who try to produce the entire good or service by themselves? Smith offered three reasons. First, specialization in a particular small job allows workers to focus on the parts of the production process where they have an advantage. (In later chapters, we will develop this idea by discussing comparative advantage.) People have different skills, talents, and interests, so they will be better at some jobs than at others. The particular advantages may be based on educational choices, which are in turn shaped by interests and talents. Only those with medical degrees qualify to become doctors, for instance. For some goods, geography affects specialization. For example, it is easier to be a wheat farmer in North Dakota than in Florida, but easier to run a tourist hotel in Florida than in North Dakota. If you live in or near a big city, it is easier to attract enough customers to operate a successful dry cleaning business or movie theater than if you live in a sparsely populated rural area. Whatever the reason, if people specialize in the production of what they do best, they will be more effective than if they produce a combination of things, some of which they are good at and some of which they are not. Second, workers who specialize in certain tasks often learn to produce more quickly and with higher quality. This pattern holds true for many workers, including assembly line laborers who build cars, stylists who cut hair, and doctors who perform heart surgery. In fact, specialized workers often know their jobs well enough to suggest innovative ways to do their work faster and better. \nA similar pattern often operates within businesses. In many cases, a business that focuses on one or a few products (sometimes called its core competency) is more successful than firms that try to make a wide range of products. Third, specialization allows businesses to take advantage of economies of scale, which means that for many goods, as the level of production increases, the average cost of producing each individual unit declines. For example, if a factory produces only 100 cars per year, each car will be quite expensive to make on average. However, if a factory produces 50,000 cars each year, then it can set up an assembly line with huge machines and workers performing specialized tasks, and the average cost of production per car will be lower. The ultimate result of workers who can focus on their preferences and talents, learn to do their specialized jobs better, and work in larger organizations is that society as a whole can produce and consume far more than if each person tried to produce all of his or her own goods and services. The division and specialization of labor has been a force against the problem of scarcity. \nTrade and Markets\nSpecialization only makes sense, though, if workers can use the pay they receive for doing their jobs to purchase the other goods and services that they need. In short, specialization requires trade. \nYou do not have to know anything about electronics or sound systems to play musicyou just buy an iPod or MP3 player, download the music, and listen. You do not have to know anything about artificial fibers or the construction of sewing machines if you need a jacketyou just buy the jacket and wear it. You do not need to know anything about internal combustion engines to operate a caryou just get in and drive. Instead of trying to acquire all the knowledge and skills involved in producing all of the goods and services that you wish to consume, the market allows you to learn a specialized set of skills and then use the pay you receive to buy the goods and services you need or want. This is how our modern society has evolved into a strong economy. \nWhy Study Economics?\nNow that you have an overview on what economics studies, lets quickly discuss why you are right to study it. Economics is not primarily a collection of facts to memorize, although there are plenty of important concepts to learn. Instead, think of economics as a collection of questions to answer or puzzles to work. Most importantly, economics provides the tools to solve those puzzles. If the economics bug has not bitten you yet, there are other reasons why you should study economics. Virtually every major problem facing the world today, from global warming, to world poverty, to the conflicts in Syria, Afghanistan, and Somalia, has an economic dimension. If you are going to be part of solving those problems, you need to be able to understand them. Economics is crucial. \nIt is hard to overstate the importance of economics to good citizenship. You need to be able to vote intelligently on budgets, regulations, and laws in general. When the U.S. government came close to a standstill at the end of 2012 due to the fiscal cliff, what were the issues? Did you know? \nA basic understanding of economics makes you a well-rounded thinker. When you read articles about economic issues, you will understand and be able to evaluate the writers argument. When you hear classmates, co-workers, or political candidates talking about economics, you will be able to distinguish between common sense and nonsense. You will find new ways of thinking about current events and about personal and business decisions, as well as current events and politics. \nThe study of economics does not dictate the answers, but it can illuminate the different choices.\n\n", "01-2": "By the end of this section, you will be able to:\nDescribe microeconomics\nDescribe macroeconomics\nContrast monetary policy and fiscal policy\n\nEconomics is concerned with the well-being of all people, including those with jobs and those without jobs, as well as those with high incomes and those with low incomes. Economics acknowledges that production of useful goods and services can create problems of environmental pollution. It explores the question of how investing in education helps to develop workers skills. It probes questions like how to tell when big businesses or big labor unions are operating in a way that benefits society as a whole and when they are operating in a way that benefits their owners or members at the expense of others. It looks at how government spending, taxes, and regulations affect decisions about production and consumption. \nIt should be clear by now that economics covers considerable ground. We can divide that ground into two parts: Microeconomics focuses on the actions of individual agents within the economy, like households, workers, and businesses. Macroeconomics looks at the economy as a whole. It focuses on broad issues such as growth of production, the number of unemployed people, the inflationary increase in prices, government deficits, and levels of exports and imports. Microeconomics and macroeconomics are not separate subjects, but rather complementary perspectives on the overall subject of the economy. To understand why both microeconomic and macroeconomic perspectives are useful, consider the problem of studying a biological ecosystem like a lake. One person who sets out to study the lake might focus on specific topics: certain kinds of algae or plant life; the characteristics of particular fish or snails; or the trees surrounding the lake. Another person might take an overall view and instead consider the lake's ecosystem from top to bottom; what eats what, how the system stays in a rough balance, and what environmental stresses affect this balance. Both approaches are useful, and both examine the same lake, but the viewpoints are different. In a similar way, both microeconomics and macroeconomics study the same economy, but each has a different viewpoint. Whether you are scrutinizing lakes or economics, the micro and the macro insights should blend with each other. In studying a lake, the micro insights about particular plants and animals help to understand the overall food chain, while the macro insights about the overall food chain help to explain the environment in which individual plants and animals live. In economics, the micro decisions of individual businesses are influenced by whether the macroeconomy is healthy. For example, firms will be more likely to hire workers if the overall economy is growing. In turn, macroeconomy's performance ultimately depends on the microeconomic decisions that individual households and businesses make. Microeconomics \nWhat determines how households and individuals spend their budgets? What combination of goods and services will best fit their needs and wants, given the budget they have to spend? How do people decide whether to work, and if so, whether to work full time or part time? How do people decide how much to save for the future, or whether they should borrow to spend beyond their current means? \nWhat determines the products, and how many of each, a firm will produce and sell? What determines the prices a firm will charge? What determines how a firm will produce its products? What determines how many workers it will hire? How will a firm finance its business? When will a firm decide to expand, downsize, or even close? In the microeconomics part of this book, we will learn about the theory of consumer behavior, the theory of the firm, how markets for labor and other resources work, and how markets sometimes fail to work properly.\n\nMacroeconomics\nWhat determines the level of economic activity in a society? In other words, what determines how many goods and services a nation actually produces? What determines how many jobs are available in an economy? What determines a nations standard of living? What causes the economy to speed up or slow down? What causes firms to hire more workers or to lay them off? Finally, what causes the economy to grow over the long term? We can determine an economy's macroeconomic health by examining a number of goals: growth in the standard of living, low unemployment, and low inflation, to name the most important. How can we use government macroeconomic policy to pursue these goals? A nation's central bank conducts monetary policy, which involves policies that affect bank lending, interest rates, and financial capital markets. For the United States, this is the Federal Reserve. A nation's legislative body determines fiscal policy, which involves government spending and taxes. For the United States, this is the Congress and the executive branch, which originates the federal budget. These are the government's main tools. Americans tend to expect that government can fix whatever economic problems we encounter, but to what extent is that expectation realistic? These are just some of the issues that we will explore in the macroeconomic chapters of this book. \n", "01-3": "By the end of this section, you will be able to:\nInterpret a circular flow diagram\nExplain the importance of economic theories and models\nDescribe goods and services markets and labor markets\n\n\n\n\n\n\nFigure \n1.5\n \nJohn Maynard Keynes\n \nOne of the most influential economists in modern times was John Maynard Keynes. (Credit: Wikimedia Commons)\n\n\nJohn Maynard Keynes (18831946), one of the greatest economists of the twentieth century, pointed out that economics is not just a subject area but also a way of thinking. Keynes (Figure 1.5) famously wrote in the introduction to a fellow economists book: [Economics] is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions. In other words, economics teaches you how to think, not what to think. \nLink It Up\n\nWatch this video about John Maynard Keynes and his influence on economics.\nEconomists see the world through a different lens than anthropologists, biologists, classicists, or practitioners of any other discipline.  They analyze issues and problems using economic theories that are based on particular assumptions about human behavior. These assumptions tend to be different than the assumptions an anthropologist or psychologist might use. A theory is a simplified representation of how two or more variables interact with each other.   The purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. If done well, this enables the analyst to understand the issue and any problems around it. A good theory is simple enough to understand, while complex enough to capture the key features of the object or situation you are studying. Sometimes economists use the term model instead of theory.  Strictly speaking, a theory is a more abstract representation, while a model is a more applied or empirical representation.  We use models to test theories, but for this course we will use the terms interchangeably. For example, an architect who is planning a major office building will often build a physical model that sits on a tabletop to show how the entire city block will look after the new building is constructed. Companies often build models of their new products, which are more rough and unfinished than the final product, but can still demonstrate how the new product will work. A good model to start with in economics is the circular flow diagram (Figure 1.6). It pictures the economy as consisting of two groupshouseholds and firmsthat interact in two markets: the goods and services market in which firms sell and households buy and the labor market in which households sell labor to business firms or other employees. \n\n\n\nFigure \n1.6\n \nThe Circular Flow Diagram\n \nThe circular flow diagram shows how households and firms interact in the goods and services market, and in the labor market. The direction of the arrows shows that in the goods and services market, households receive goods and services and pay firms for them. In the labor market, households provide labor and receive payment from firms through wages, salaries, and benefits.\n\nFirms produce and sell goods and services to households in the market for goods and services (or product market).  Arrow A indicates this.  Households pay for goods and services, which becomes the revenues to firms.  Arrow B indicates this.  Arrows A and B represent the two sides of the product market.  Where do households obtain the income to buy goods and services? They provide the labor and other resources (e.g. land, capital, raw materials) firms need to produce goods and services in the market for inputs (or factors of production).  Arrow C indicates this.  In return, firms pay for the inputs (or resources) they use in the form of wages and other factor payments.  Arrow D indicates this.  Arrows C and D represent the two sides of the factor market.\nOf course, in the real world, there are many different markets for goods and services and markets for many different types of labor. The circular flow diagram simplifies this to make the picture easier to grasp. In the diagram, firms produce goods and services, which they sell to households in return for revenues. The outer circle shows this, and represents the two sides of the product market (for example, the market for goods and services) in which households demand and firms supply. Households sell their labor as workers to firms in return for wages, salaries, and benefits. The inner circle shows this and represents the two sides of the labor market in which households supply and firms demand. This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labor markets work in the economy. We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe (imports and exports). \nEconomists carry a set of theories in their heads like a carpenter carries around a toolkit. When they see an economic issue or problem, they go through the theories they know to see if they can find one that fits. Then they use the theory to derive insights about the issue or problem. Economists express theories as diagrams, graphs, or even as mathematical equations. (Do not worry. In this course, we will mostly use graphs.) Economists do not figure out the answer to the problem first and then draw the graph to illustrate. Rather, they use the graph of the theory to help them figure out the answer. Although at the introductory level, you can sometimes figure out the right answer without applying a model, if you keep studying economics, before too long you will run into issues and problems that you will need to graph to solve. We explain both micro and macroeconomics in terms of theories and models. The most well-known theories are probably those of supply and demand, but you will learn a number of others. \n", "01-4": "By the end of this section, you will be able to:\nContrast traditional economies, command economies, and market economies\nExplain gross domestic product (GDP)\nAssess the importance and effects of globalization\n\nThink about what a complex system a modern economy is. It includes all production of goods and services, all buying and selling, all employment. The economic life of every individual is interrelated, at least to a small extent, with the economic lives of thousands or even millions of other individuals. Who organizes and coordinates this system? Who ensures that, for example, the number of televisions a society provides is the same as the amount it needs and wants? Who ensures that the right number of employees work in the electronics industry? Who ensures that televisions are produced in the best way possible? How does it all get done? \nThere are at least three ways that societies organize an economy. The first is the traditional economy, which is the oldest economic system and is used in parts of Asia, Africa, and South America. Traditional economies organize their economic affairs the way they have always done (i.e., tradition). Occupations stay in the family. Most families are farmers who grow the crops using traditional methods. What you produce is what you consume. Because tradition drives the way of life, there is little economic progress or development. \n\n\n\n\nFigure \n1.7\n \nA Command Economy\n \nAncient Egypt was an example of a command economy. (Credit: Jay Bergesen/Flickr Creative Commons)\n\n\nCommand economies are very different. In a command economy, economic effort is devoted to goals passed down from a ruler or ruling class. Ancient Egypt was a good example: a large part of economic life was devoted to building pyramids, like those in Figure 1.7, for the pharaohs. Medieval manor life is another example: the lord provided the land for growing crops and protection in the event of war. In return, vassals provided labor and soldiers to do the lords bidding. In the last century, communism emphasized command economies. In a command economy, the government decides what goods and services will be produced and what prices it will charge for them. The government decides what methods of production to use and sets wages for workers. The government provides many necessities like healthcare and education for free. Currently, Cuba and North Korea have command economies. \n\n\n\nFigure \n1.8\n \nA Market Economy\n \nNothing says market more than The New York Stock Exchange. (Credit: Erik Drost/Flickr Creative Commons)\n\nAlthough command economies have a very centralized structure for economic decisions, market economies have a very decentralized structure. A market is an institution that brings together buyers and sellers of goods or services, who may be either individuals or businesses. The New York Stock Exchange (Figure 1.8) is a prime example of a market which brings buyers and sellers together. In a market economy, decision-making is decentralized. Market economies are based on private enterprise: the private individuals or groups of private individuals own and operate the means of production (resources and businesses). Businesses supply goods and services based on demand. (In a command economy, by contrast, the government owns resources and businesses.) Supply of goods and services depends on what the demands are. A persons income is based on his or her ability to convert resources (especially labor) into something that society values. The more society values the persons output, the higher the income (think Lady Gaga or LeBron James).  In this scenario, market forces, not governments, determine economic decisions.  Most economies in the real world are mixed. They combine elements of command and market (and even traditional) systems. The U.S. economy is positioned toward the market-oriented end of the spectrum. Many countries in Europe and Latin America, while primarily market-oriented, have a greater degree of government involvement in economic decisions than the U.S. economy. China and Russia, while over the past several decades have moved more in the direction of having a market-oriented system, remain closer to the command economy end of the spectrum. The Heritage Foundation provides  perspective on countries economic freedom, as the following Clear It Up feature discusses. \nClear It Up\n\n\nWhat countries are considered economically free?\nWho is in control of economic decisions? Are people free to do what they want and to work where they want? Are businesses free to produce when they want and what they choose, and to hire and fire as they wish? Are banks free to choose who will receive loans, or does the government control these kinds of choices? Each year, researchers at the Heritage Foundation and the Wall Street Journal look at 50 different categories of economic freedom for countries around the world. They give each nation a score based on the extent of economic freedom in each category. Note that while the Heritage Foundation/WSJ index is widely cited by an array of scholars and publications, it should be regarded as only one viewpoint. Some experts indicate that the indexs category choices and scores are politically biased. However, the index and others like it provide a useful resource for critical discussion of economic freedom. The 2016 Heritage Foundations Index of Economic Freedom report ranked 178 countries around the world: Table 1.1 lists some examples of the most free and the least free countries. Although technically not a separate country, Hong Kong has been granted a degree of autonomy such that, for purposes of measuring economic statistics, it is often treated as a separate country. Several additional countries were not ranked because of extreme instability that made judgments about economic freedom impossible. These countries include Afghanistan, Iraq, Libya, Syria, Somalia, and Yemen. The assigned rankings are inevitably based on estimates, yet even these rough measures can be useful for discerning trends. In 2015, 101 of the 178 included countries shifted toward greater economic freedom, although 77 of the countries shifted toward less economic freedom. In recent decades, the overall trend has been a higher level of economic freedom around the world. \n\nMost Economic Freedom\nLeast Economic Freedom\n\n\n\n1. Hong Kong\n167. Timor-Leste\n\n\n2. Singapore\n168. Democratic Republic of Congo\n\n\n3. New Zealand \n169. Argentina\n\n\n4. Switzerland\n170. Equatorial Guinea\n\n\n5. Australia\n171. Iran\n\n\n6. Canada\n172. Republic of Congo\n\n\n7. Chile\n173. Eritrea\n\n\n8. Ireland\n174. Turkmenistan\n\n\n9. Estonia\n175. Zimbabwe\n\n\n10. United Kingdom\n176. Venezuela\n\n\n11. United States\n177. Cuba\n\n12. Denmark\n178. North Korea\n\n\nTable \n1.1\n \nEconomic Freedoms, 2016\n \n(Source: The Heritage Foundation, 2016 Index of Economic Freedom, Country Rankings, http://www.heritage.org/index/ranking)\n\nRegulations: The Rules of the Game\nMarkets and government regulations are always entangled. There is no such thing as an absolutely free market. Regulations always define the rules of the game in the economy. Economies that are primarily market-oriented have fewer regulationsideally just enough to maintain an even playing field for participants. At a minimum, these laws govern matters like safeguarding private property against theft, protecting people from violence, enforcing legal contracts, preventing fraud, and collecting taxes. Conversely, even the most command-oriented economies operate using markets. How else would buying and selling occur? The government heavily regulates decisions of what to produce and prices to charge. Heavily regulated economies often have underground economies (or black markets), which are markets where the buyers and sellers make transactions without the governments approval. The question of how to organize economic institutions is typically not a black-or-white choice between all market or all government, but instead involves a balancing act over the appropriate combination of market freedom and government rules. \n\n\n\n\nFigure \n1.9\n \nGlobalization\n \nCargo ships are one mode of transportation for shipping goods in the global economy. (Credit: Raul Valdez/Flickr Creative Commons)\n\n\nThe Rise of GlobalizationRecent decades have seen a trend toward globalization, which is the expanding cultural, political, and economic connections between people around the world. One measure of this is the increased buying and selling of goods, services, and assets across national bordersin other words, international trade and financial capital flows. \nGlobalization has occurred for a number of reasons. Improvements in shipping, as illustrated by the container ship in Figure 1.9, and air cargo have driven down transportation costs. Innovations in computing and telecommunications have made it easier and cheaper to manage long-distance economic connections of production and sales. Many valuable products and services in the modern economy can take the form of informationfor example: computer software; financial advice; travel planning; music, books and movies; and blueprints for designing a building. These products and many others can be transported over telephones and computer networks at ever-lower costs. Finally, international agreements and treaties between countries have encouraged greater trade. Table 1.2 presents one measure of globalization. It shows the percentage of domestic economic production that was exported for a selection of countries from 2010 to 2015, according to an entity known as The World Bank. Exports are the goods and services that one produces domestically and sells abroad. Imports are the goods and services that one produces abroad and then sells domestically. Gross domestic product (GDP) measures the size of total production in an economy. Thus, the ratio of exports divided by GDP measures what share of a countrys total economic production is sold in other countries. \n\nCountry\n2010\n2011\n2012\n2013\n2014\n2015\n\n\n\nHigher Income Countries\n\n\nUnited States\n12.4\n13.6\n13.6\n13.5\n13.5\n12.6\n\n\nBelgium\n76.2\n81.4\n82.2\n82.8\n84.0\n84.4\n\n\nCanada\n29.1\n30.7\n30.0\n30.1\n31.7\n31.5\n\n\nFrance\n26.0\n27.8\n28.1\n28.3\n29.0\n30.0\n\n\nMiddle Income Countries\n\n\nBrazil\n10.9\n11.9\n12.6\n12.6\n11.2\n13.0\n\n\nMexico\n29.9\n31.2\n32.6\n31.7\n32.3\n35.3\n\n\nSouth Korea\n49.4\n55.7\n56.3\n53.9\n50.3\n45.9\n\n\nLower Income Countries\n\n\nChad\n36.8\n38.9\n36.9\n32.2\n34.2\n29.8\n\n\nChina\n29.4\n28.5\n27.3\n26.4\n23.9\n22.4\n\n\nIndia\n22.0\n23.9\n24.0\n24.8\n22.9\n-\n\n\nNigeria\n25.3\n31.3\n31.4\n18.0\n18.4\n-\n\n\nTable \n1.2\n \nThe Extent of Globalization (exports/GDP)\n \n(Source: http://databank.worldbank.org/data/)\n\nIn recent decades, the export/GDP ratio has generally risen, both worldwide and for the U.S. economy. Interestingly, the share of U.S. exports in proportion to the U.S. economy is well below the global average, in part because large economies like the United States can contain more of the division of labor inside their national borders. However, smaller economies like Belgium, Korea, and Canada need to trade across their borders with other countries to take full advantage of division of labor, specialization, and economies of scale. In this sense, the enormous U.S. economy is less affected by globalization than most other countries. \nTable 1.2 indicates that many medium and low income countries around the world, like Mexico and China, have also experienced a surge of globalization in recent decades. If an astronaut in orbit could put on special glasses that make all economic transactions visible as brightly colored lines and look down at Earth, the astronaut would see the planet covered with connections. Despite the rise in globalization over the last few decades, in recent years we've seen significant pushback against globalization from people across the world concerned about loss of jobs, loss of political sovereignty, and increased economic inequality. Prominent examples of this pushback include the 2016 vote in Great Britain to exit the European Union (i.e. Brexit), and the election of Donald J. Trump for President of the United States. Hopefully, you now have an idea about economics. Before you move to any other chapter of study, be sure to read the very important appendix to this chapter called The Use of Mathematics in Principles of Economics. It is essential that you learn more about how to read and use models in economics.\nBring It Home\n\n\nDecisions ... Decisions in the Social Media Age\nThe world we live in today provides nearly instant access to a wealth of information. Consider that as recently as the late 1970s, the Farmers Almanac, along with the Weather Bureau of the U.S. Department of Agriculture, were the primary sources American farmers used to determine when to plant and harvest their crops. Today, farmers are more likely to access, online, weather forecasts from the National Oceanic and Atmospheric Administration or watch the Weather Channel. After all, knowing the upcoming forecast could drive when to harvest crops. Consequently, knowing the upcoming weather could change the amount of crop harvested. Some relatively new information forums, such as Facebook, are rapidly changing how information is distributed; hence, influencing decision making. In 2014, the Pew Research Center reported that 71% of online adults use Facebook. This social media forum posts topics ranging from the National Basketball Association, to celebrity singers and performers, to farmers.Information helps us make decisions as simple as what to wear today to how many reporters the media should send to cover a crash. Each of these decisions is an economic decision. After all, resources are scarce. If the media send ten reporters to cover an accident, they are not available to cover other stories or complete other tasks. Information provides the necessary knowledge to make the best possible decisions on how to utilize scarce resources. Welcome to the world of economics! \n", "02-1": "By the end of this section, you will be able to:\nCalculate and graph budget constraints\nExplain opportunity sets and opportunity costs\nEvaluate the law of diminishing marginal utility\nExplain how marginal analysis and utility influence choices\n\nConsider the typical consumers budget problem. Consumers have a limited amount of income to spend on the things they need and want. Suppose Alphonso has $10 in spending money each week that he can allocate between bus tickets for getting to work and the burgers that he eats for lunch. Burgers cost $2 each, and bus tickets are 50 cents each. We can see Alphonso's budget problem in Figure 2.2.\n\n\n\nFigure \n2.2\n \nThe Budget Constraint: Alphonsos Consumption Choice Opportunity Frontier \n \nEach point on the budget constraint represents a combination of burgers and bus tickets whose total cost adds up to Alphonsos budget of $10. The relative price of burgers and bus tickets determines the slope of the budget constraint. All along the budget set, giving up one burger means gaining four bus tickets.\n\nThe vertical axis in the figure shows burger purchases and the horizontal axis shows bus ticket purchases. If Alphonso spends all his money on burgers, he can afford five per week. ($10 per week/$2 per burger = 5 burgers per week.) However, if he does this, he will not be able to afford any bus tickets. Point A in the figure shows the choice (zero bus tickets and five burgers). Alternatively, if Alphonso spends all his money on bus tickets, he can afford 20 per week. ($10 per week/$0.50 per bus ticket = 20 bus tickets per week.) Then, however, he will not be able to afford any burgers. Point F shows this alternative choice (20 bus tickets and zero burgers). If we connect all the points between A and F, we get Alphonso's budget constraint. This indicates all the combination of burgers and bus tickets Alphonso can afford, given the price of the two goods and his budget amount.\nIf Alphonso is like most people, he will choose some combination that includes both bus tickets and burgers. That is, he will choose some combination on the budget constraint that is between points A and F. Every point on (or inside) the constraint shows a combination of burgers and bus tickets that Alphonso can afford. Any point outside the constraint is not affordable, because it would cost more money than Alphonso has in his budget.The budget constraint clearly shows the tradeoff Alphonso faces in choosing between burgers and bus tickets. Suppose he is currently at point D, where he can afford 12 bus tickets and two burgers. What would it cost Alphonso for one more burger? It would be natural to answer $2, but thats not the way economists think. Instead they ask, how many bus tickets would Alphonso have to give up to get one more burger, while staying within his budget? Since bus tickets cost 50 cents, Alphonso would have to give up four to afford one more burger. That is the true cost to Alphonso.The Concept of Opportunity Cost\nEconomists use the term opportunity cost to indicate what one must give up to obtain what he or she desires. The idea behind opportunity cost is that the cost of one item is the lost opportunity to do or consume something else. In short, opportunity cost is the value of the next best alternative. For Alphonso, the opportunity cost of a burger is the four bus tickets he would have to give up. He would decide whether or not to choose the burger depending on whether the value of the burger exceeds the value of the forgone alternativein this case, bus tickets. Since people must choose, they inevitably face tradeoffs in which they have to give up things they desire to obtain other things they desire more.\nLink It Up\n\n\nView this website for an example of opportunity costpaying someone else to wait in line for you.\n\nA fundamental principle of economics is that every choice has an opportunity cost. If you sleep through your economics class, the opportunity cost is the learning you miss from not attending class. If you spend your income on video games, you cannot spend it on movies. If you choose to marry one person, you give up the opportunity to marry anyone else. In short, opportunity cost is all around us and part of human existence.The following Work It Out feature shows a step-by-step analysis of a budget constraint calculation. Read through it to understand another important conceptslopethat we further explain in the appendix The Use of Mathematics in Principles of Economics.\nWork It Out\n\n\nUnderstanding Budget Constraints\n\nBudget constraints are easy to understand if you apply a little math. The appendix The Use of Mathematics in Principles of Economics explains all the math you are likely to need in this book. Therefore, if math is not your strength, you might want to take a look at the appendix.Step 1: The equation for any budget constraint is:\nBudget=P1Q1+P2Q2Budget=P1Q1+P2Q2\nwhere P and Q are the price and quantity of items purchased (which we assume here to be two items) and Budget is the amount of income one has to spend.Step 2. Apply the budget constraint equation to the scenario. In Alphonsos case, this works out to be:\nBudget=\nP1  Q1 + P2 Q2\n$10budget=$2perburgerquantityofburgers+$0.50perbusticketquantityofbustickets$10=$2Qburgers+$0.50QbusticketsBudget=\nP1  Q1 + P2 Q2\n$10budget=$2perburgerquantityofburgers+$0.50perbusticketquantityofbustickets$10=$2Qburgers+$0.50Qbustickets\nStep 3. Using a little algebra, we can turn this into the familiar equation of a line:\n\ny=b+mxy=b+mx\n\nFor Alphonso, this is:\n\n$10=$2Qburgers+$0.50Qbustickets$10=$2Qburgers+$0.50Qbustickets\n\nStep 4. Simplify the equation. Begin by multiplying both sides of the equation by 2:\n\n210=22Qburgers+20.5Qbustickets20=4Qburgers+1Qbustickets210=22Qburgers+20.5Qbustickets20=4Qburgers+1Qbustickets\n\nStep 5. Subtract one bus ticket from both sides:20  Qbus tickets = 4  Qburgers20  Qbus tickets = 4  Qburgers\nDivide each side by 4 to yield the answer:5  0.25  Qbus tickets = QburgersorQburgers = 5  0.25  Qbus tickets5  0.25  Qbus tickets = QburgersorQburgers = 5  0.25  Qbus tickets\nStep 6. Notice that this equation fits the budget constraint in Figure 2.2. The vertical intercept is 5 and the slope is 0.25, just as the equation says. If you plug 20 bus tickets into the equation, you get 0 burgers. If you plug other numbers of bus tickets into the equation, you get the results (see Table 2.1), which are the points on Alphonsos budget constraint.\n\nPoint\nQuantity of Burgers (at $2)\nQuantity of Bus Tickets (at 50 cents)\n\n\n\nA\n5\n0\n\n\nB\n4\n4\n\n\nC\n3\n8\n\n\nD\n2\n12\n\n\nE\n1\n16\n\n\nF\n0\n20\n\n\nTable \n2.1\n \n \n\n\nStep 7. Notice that the slope of a budget constraint always shows the opportunity cost of the good which is on the horizontal axis. For Alphonso, the slope is 0.25, indicating that for every bus ticket he buys, he must give up 1/4 burger. To phrase it differently, for every four tickets he buys, Alphonso must give up 1 burger. There are two important observations here. First, the algebraic sign of the slope is negative, which means that the only way to get more of one good is to give up some of the other. Second, we define the slope as the price of bus tickets (whatever is on the horizontal axis in the graph) divided by the price of burgers (whatever is on the vertical axis), in this case $0.50/$2 = 0.25. If you want to determine the opportunity cost quickly, just divide the two prices.\n\nIdentifying Opportunity Cost\nIn many cases, it is reasonable to refer to the opportunity cost as the price. If your cousin buys a new bicycle for $300, then $300 measures the amount of other consumption that he has forsaken. For practical purposes, there may be no special need to identify the specific alternative product or products that he could have bought with that $300, but sometimes the price as measured in dollars may not accurately capture the true opportunity cost. This problem can loom especially large when costs of time are involved.For example, consider a boss who decides that all employees will attend a two-day retreat to build team spirit. The out-of-pocket monetary cost of the event may involve hiring an outside consulting firm to run the retreat, as well as room and board for all participants. However, an opportunity cost exists as well: during the two days of the retreat, none of the employees are doing any other work.Attending college is another case where the opportunity cost exceeds the monetary cost. The out-of-pocket costs of attending college include tuition, books, room and board, and other expenses. However, in addition, during the hours that you are attending class and studying, it is impossible to work at a paying job. Thus, college imposes both an out-of-pocket cost and an opportunity cost of lost earnings.\nClear It Up\n\n\nWhat is the opportunity cost associated with increased airport security measures?\n\nAfter the terrorist plane hijackings on September 11, 2001, many steps were proposed to improve air travel safety. For example, the federal government could provide armed sky marshals who would travel inconspicuously with the rest of the passengers. The cost of having a sky marshal on every flight would be roughly $3 billion per year. Retrofitting all U.S. planes with reinforced cockpit doors to make it harder for terrorists to take over the plane would have a price tag of $450 million. Buying more sophisticated security equipment for airports, like three-dimensional baggage scanners and cameras linked to face recognition software, could cost another $2 billion.\nHowever, the single biggest cost of greater airline security does not involve spending money. It is the opportunity cost of additional waiting time at the airport. According to the United States Department of Transportation (DOT), there were 895.5 million systemwide (domestic and international) scheduled service passengers in 2015. Since the 9/11 hijackings, security screening has become more intensive, and consequently, the procedure takes longer than in the past. Say that, on average, each air passenger spends an extra 30 minutes in the airport per trip. Economists commonly place a value on time to convert an opportunity cost in time into a monetary figure. Because many air travelers are relatively high-paid business people, conservative estimates set the average price of time for air travelers at $20 per hour. By these back-of-the-envelope calculations, the opportunity cost of delays in airports could be as much as 800 million  0.5 hours  $20/hour, or $8 billion per year. Clearly, the opportunity costs of waiting time can be just as important as costs that involve direct spending.\nIn some cases, realizing the opportunity cost can alter behavior. Imagine, for example, that you spend $8 on lunch every day at work. You may know perfectly well that bringing a lunch from home would cost only $3 a day, so the opportunity cost of buying lunch at the restaurant is $5 each day (that is, the $8 buying lunch costs minus the $3 your lunch from home would cost). Five dollars each day does not seem to be that much. However, if you project what that adds up to in a year250 days a year  $5 per day equals $1,250, the cost, perhaps, of a decent vacation. If you describe the opportunity cost as a nice vacation instead of $5 a day, you might make different choices.\nMarginal Decision-Making and Diminishing Marginal Utility\nThe budget constraint framework helps to emphasize that most choices in the real world are not about getting all of one thing or all of another; that is, they are not about choosing either the point at one end of the budget constraint or else the point all the way at the other end. Instead, most choices involve marginal analysis, which means examining the benefits and costs of choosing a little more or a little less of a good. People naturally compare costs and benefits, but often we look at total costs and total benefits, when the optimal choice necessitates comparing how costs and benefits change from one option to another. You might think of marginal analysis as change analysis. Marginal analysis is used throughout economics.We now turn to the notion of utility. People desire goods and services for the satisfaction or utility those goods and services provide. Utility, as we will see in the chapter on Consumer Choices, is subjective but that does not make it less real. Economists typically assume that the more of some good one consumes (for example, slices of pizza), the more utility one obtains. At the same time, the utility a person receives from consuming the first unit of a good is typically more than the utility received from consuming the fifth or the tenth unit of that same good. When Alphonso chooses between burgers and bus tickets, for example, the first few bus rides that he chooses might provide him with a great deal of utilityperhaps they help him get to a job interview or a doctors appointment. However, later bus rides might provide much less utilitythey may only serve to kill time on a rainy day. Similarly, the first burger that Alphonso chooses to buy may be on a day when he missed breakfast and is ravenously hungry. However, if Alphonso has a burger every single day, the last few burgers may taste pretty boring. The general pattern that consumption of the first few units of any good tends to bring a higher level of utility to a person than consumption of later units is a common pattern. Economists refer to this pattern as the law of diminishing marginal utility, which means that as a person receives more of a good, the additional (or marginal) utility from each additional unit of the good declines. In other words, the first slice of pizza brings more satisfaction than the sixth.The law of diminishing marginal utility explains why people and societies rarely make all-or-nothing choices. You would not say, My favorite food is ice cream, so I will eat nothing but ice cream from now on. Instead, even if you get a very high level of utility from your favorite food, if you ate it exclusively, the additional or marginal utility from those last few servings would not be very high. Similarly, most workers do not say: I enjoy leisure, so Ill never work. Instead, workers recognize that even though some leisure is very nice, a combination of all leisure and no income is not so attractive. The budget constraint framework suggests that when people make choices in a world of scarcity, they will use marginal analysis and think about whether they would prefer a little more or a little less.A rational consumer would only purchase additional units of some product as long as the marginal utility exceeds the opportunity cost.  Suppose Alphonso moves down his budget constraint from Point A to Point B to Point C and further.  As he consumes more bus tickets, the marginal utility of bus tickets will diminish, while the opportunity cost, that is, the marginal utility of foregone burgers, will increase.  Eventually, the opportunity cost will exceed the marginal utility of an additional bus ticket. If Alphonso is rational, he wont purchase more bus tickets once the marginal utility just equals the opportunity cost.  While we cant (yet) say exactly how many bus tickets Alphonso will buy, that number is unlikely to be the most he can afford, 20.\n\n\nSunk Costs\nIn the budget constraint framework, all decisions involve what will happen next: that is, what quantities of goods will you consume, how many hours will you work, or how much will you save. These decisions do not look back to past choices. Thus, the budget constraint framework assumes that sunk costs, which are costs that were incurred in the past and cannot be recovered, should not affect the current decision.\nConsider the case of Selena, who pays $8 to see a movie, but after watching the film for 30 minutes, she knows that it is truly terrible. Should she stay and watch the rest of the movie because she paid for the ticket, or should she leave? The money she spent is a sunk cost, and unless the theater manager is sympathetic, Selena will not get a refund. However, staying in the movie still means paying an opportunity cost in time. Her choice is whether to spend the next 90 minutes suffering through a cinematic disaster or to do somethinganythingelse. The lesson of sunk costs is to forget about the money and time that is irretrievably gone and instead to focus on the marginal costs and benefits of current and future options.For people and firms alike, dealing with sunk costs can be frustrating. It often means admitting an earlier error in judgment. Many firms, for example, find it hard to give up on a new product that is doing poorly because they spent so much money in creating and launching the product. However, the lesson of sunk costs is to ignore them and make decisions based on what will happen in the future.\nFrom a Model with Two Goods to One of Many Goods\nThe budget constraint diagram containing just two goods, like most models used in this book, is not realistic. After all, in a modern economy people choose from thousands of goods. However, thinking about a model with many goods is a straightforward extension of what we discussed here. Instead of drawing just one budget constraint, showing the tradeoff between two goods, you can draw multiple budget constraints, showing the possible tradeoffs between many different pairs of goods. In more advanced classes in economics, you would use mathematical equations that include many possible goods and services that can be purchased, together with their quantities and prices, and show how the total spending on all goods and services is limited to the overall budget available. The graph with two goods that we presented here clearly illustrates that every choice has an opportunity cost, which is the point that does carry over to the real world.\n", "02-2": "By the end of this section, you will be able to:\nInterpret production possibilities frontier graphs\nContrast a budget constraint and a production possibilities frontier\nExplain the relationship between a production possibilities frontier and the law of diminishing returns\nContrast productive efficiency and allocative efficiency\nDefine comparative advantage\nJust as individuals cannot have everything they want and must instead make choices, society as a whole cannot have everything it might want, either. This section of the chapter will explain the constraints society faces, using a model called the production possibilities frontier (PPF). There are more similarities than differences between individual choice and social choice. As you read this section, focus on the similarities.Because society has limited resources (e.g., labor, land, capital, raw materials) at any point in time, there is a limit to the quantities of goods and services it can produce. Suppose a society desires two products, healthcare and education. The production possibilities frontier in Figure 2.3 illustrates this situation. \n\n\n\n\n\nFigure \n2.3\n \nA Healthcare vs. Education Production Possibilities Frontier \n \nThis production possibilities frontier shows a tradeoff between devoting social resources to healthcare and devoting them to education. At A all resources go to healthcare and at B, most go to healthcare. At D most resources go to education, and at F, all go to education.\n\n\nFigure 2.3 shows healthcare on the vertical axis and education on the horizontal axis. If the society were to allocate all of its resources to healthcare, it could produce at point A. However, it would not have any resources to produce education. If it were to allocate all of its resources to education, it could produce at point F. Alternatively, the society could choose to produce any combination of healthcare and education on the production possibilities frontier. In effect, the production possibilities frontier plays the same role for society as the budget constraint plays for Alphonso. Society can choose any combination of the two goods on or inside the PPF. However, it does not have enough resources to produce outside the PPF.Most importantly, the production possibilities frontier clearly shows the tradeoff between healthcare and education. Suppose society has chosen to operate at point B, and it is considering producing more education. Because the PPF is downward sloping from left to right, the only way society can obtain more education is by giving up some healthcare. That is the tradeoff society faces. Suppose it considers moving from point B to point C. What would the opportunity cost be for the additional education? The opportunity cost would be the healthcare society has to forgo. Just as with Alphonsos budget constraint, the slope of the production possibilities frontier shows the opportunity cost. By now you might be saying, Hey, this PPF is sounding like the budget constraint. If so, read the following Clear It Up feature.\nClear It Up\n\n\nWhats the difference between a budget constraint and a PPF?\n\nThere are two major differences between a budget constraint and a production possibilities frontier. The first is the fact that the budget constraint is a straight line. This is because its slope is given by the relative prices of the two goods, which from the point of view of an individual consumer, are fixed, so the slope doesn't change. In contrast, the PPF has a curved shape because of the law of the diminishing returns. Thus, the slope is different at various points on the PPF. The second major difference is the absence of specific numbers on the axes of the PPF. There are no specific numbers because we do not know the exact amount of resources this imaginary economy has, nor do we know how many resources it takes to produce healthcare and how many resources it takes to produce education. If this were a real world example, that data would be available. Whether or not we have specific numbers, conceptually we can measure the opportunity cost of additional education as society moves from point B to point C on the PPF. We measure the additional education by the horizontal distance between B and C. The foregone healthcare is given by the vertical distance between B and C. The slope of the PPF between B and C is (approximately) the vertical distance (the rise) over the horizontal distance (the run). This is the opportunity cost of the additional education.\nThe PPF and the Law of Increasing Opportunity CostThe budget constraints that we presented earlier in this chapter, showing individual choices about what quantities of goods to consume, were all straight lines. The reason for these straight lines was that the relative prices of the two goods in the consumption budget constraint determined the slope of the budget constraint. However, we drew the production possibilities frontier for healthcare and education as a curved line. Why does the PPF have a different shape?To understand why the PPF is curved, start by considering point A at the top left-hand side of the PPF. At point A, all available resources are devoted to healthcare and none are left for education. This situation would be extreme and even ridiculous. For example, children are seeing a doctor every day, whether they are sick or not, but not attending school. People are having cosmetic surgery on every part of their bodies, but no high school or college education exists. Now imagine that some of these resources are diverted from healthcare to education, so that the economy is at point B instead of point A. Diverting some resources away from A to B causes relatively little reduction in health because the last few marginal dollars going into healthcare services are not producing much additional gain in health. However, putting those marginal dollars into education, which is completely without resources at point A, can produce relatively large gains. For this reason, the shape of the PPF from A to B is relatively flat, representing a relatively small drop-off in health and a relatively large gain in education.\nNow consider the other end, at the lower right, of the production possibilities frontier. Imagine that society starts at choice D, which is devoting nearly all resources to education and very few to healthcare, and moves to point F, which is devoting all spending to education and none to healthcare. For the sake of concreteness, you can imagine that in the movement from D to F, the last few doctors must become high school science teachers, the last few nurses must become school librarians rather than dispensers of vaccinations, and the last few emergency rooms are turned into kindergartens. The gains to education from adding these last few resources to education are very small. However, the opportunity cost lost to health will be fairly large, and thus the slope of the PPF between D and F is steep, showing a large drop in health for only a small gain in education.\nThe lesson is not that society is likely to make an extreme choice like devoting no resources to education at point A or no resources to health at point F. Instead, the lesson is that the gains from committing additional marginal resources to education depend on how much is already being spent. If on the one hand, very few resources are currently committed to education, then an increase in resources used can bring relatively large gains. On the other hand, if a large number of resources are already committed to education, then committing additional resources will bring relatively smaller gains.\nThis pattern is common enough that economists have given it a name: the law of increasing opportunity cost, which holds that as production of a good or service increases, the marginal opportunity cost of producing it increases as well. This happens because some resources are better suited for producing certain goods and services instead of others. When government spends a certain amount more on reducing crime, for example, the original increase in opportunity cost of reducing crime could be relatively small. However, additional increases typically cause relatively larger increases in the opportunity cost of reducing crime, and paying for enough police and security to reduce crime to nothing at all would be a tremendously high opportunity cost. The curvature of the production possibilities frontier shows that as we add more resources to education, moving from left to right along the horizontal axis, the original increase in opportunity cost is fairly small, but gradually increases. Thus, the slope of the PPF is relatively flat near the vertical-axis intercept. Conversely, as we add more resources to healthcare, moving from bottom to top on the vertical axis, the original declines in opportunity cost are fairly large, but again gradually diminish. Thus, the slope of the PPF is relatively steep near the horizontal-axis intercept. In this way, the law of increasing opportunity cost produces the outward-bending shape of the production possibilities frontier.\nProductive Efficiency and Allocative Efficiency\nThe study of economics does not presume to tell a society what choice it should make along its production possibilities frontier. In a market-oriented economy with a democratic government, the choice will involve a mixture of decisions by individuals, firms, and government. However, economics can point out that some choices are unambiguously better than others. This observation is based on the concept of efficiency. In everyday usage, efficiency refers to lack of waste. An inefficient machine operates at high cost, while an efficient machine operates at lower cost, because it is not wasting energy or materials. An inefficient organization operates with long delays and high costs, while an efficient organization meets schedules, is focused, and performs within budget.\nThe production possibilities frontier can illustrate two kinds of efficiency: productive efficiency and allocative efficiency. Figure 2.4 illustrates these ideas using a production possibilities frontier between healthcare and education.\n\n\n\n\n\nFigure \n2.4\n \nProductive and Allocative Efficiency \n \nProductive efficiency means it is impossible to produce more of one good without decreasing the quantity that is produced of another good. Thus, all choices along a given PPF like B, C, and D display productive efficiency, but R does not. Allocative efficiency means that the particular mix of goods being producedthat is, the specific choice along the production possibilities frontierrepresents the allocation that society most desires.\n\n\nProductive efficiency means that, given the available inputs and technology, it is impossible to produce more of one good without decreasing the quantity that is produced of another good. All choices on the PPF in Figure 2.4, including A, B, C, D, and F, display productive efficiency. As a firm moves from any one of these choices to any other, either healthcare increases and education decreases or vice versa. However, any choice inside the production possibilities frontier is productively inefficient and wasteful because it is possible to produce more of one good, the other good, or some combination of both goods.\nFor example, point R is productively inefficient because it is possible at choice C to have more of both goods: education on the horizontal axis is higher at point C than point R (E2 is greater than E1), and healthcare on the vertical axis is also higher at point C than point R (H2 is great than H1).\nWe can show the particular mix of goods and services producedthat is, the specific combination of selected healthcare and education along the production possibilities frontieras a ray (line) from the origin to a specific point on the PPF. Output mixes that had more healthcare (and less education) would have a steeper ray, while those with more education (and less healthcare) would have a flatter ray.Allocative efficiency means that the particular combination of goods and services on the production possibility curve that a society produces represents the combination that society most desires. How to determine what a society desires can be a controversial question, and is usually a discussion in political science, sociology, and philosophy classes as well as in economics. At its most basic, allocative efficiency means producers supply the quantity of each product that consumers demand. Only one of the productively efficient choices will be the allocatively efficient choice for society as a whole.\nWhy Society Must Choose\nIn Welcome to Economics! we learned that every society faces the problem of scarcity, where limited resources conflict with unlimited needs and wants.  The production possibilities curve illustrates the choices involved in this dilemma.\nEvery economy faces two situations in which it may be able to expand consumption of all goods. In the first case, a society may discover that it has been using its resources inefficiently, in which case by improving efficiency and producing on the production possibilities frontier, it can have more of all goods (or at least more of some and less of none). In the second case, as resources grow over a period of years (e.g., more labor and more capital), the economy grows. As it does, the production possibilities frontier for a society will tend to shift outward and society will be able to afford more of all goods.\nHowever, improvements in productive efficiency take time to discover and implement, and economic growth happens only gradually. Thus, a society must choose between tradeoffs in the present. For government, this process often involves trying to identify where additional spending could do the most good and where reductions in spending would do the least harm. At the individual and firm level, the market economy coordinates a process in which firms seek to produce goods and services in the quantity, quality, and price that people want. However, for both the government and the market economy in the short term, increases in production of one good typically mean offsetting decreases somewhere else in the economy.\nThe PPF and Comparative Advantage While every society must choose how much of each good or service it should produce, it does not need to produce every single good it consumes. Often how much of a good a country decides to produce depends on how expensive it is to produce it versus buying it from a different country. As we saw earlier, the curvature of a countrys PPF gives us information about the tradeoff between devoting resources to producing one good versus another. In particular, its slope gives the opportunity cost of producing one more unit of the good in the x-axis in terms of the other good (in the y-axis). Countries tend to have different opportunity costs of producing a specific good, either because of different climates, geography, technology, or skills. \nSuppose two countries, the US and Brazil, need to decide how much they will produce of two crops: sugar cane and wheat. Due to its climatic conditions, Brazil can produce quite a bit of sugar cane per acre but not much wheat. Conversely, the U.S. can produce large amounts of wheat per acre, but not much sugar cane.  Clearly, Brazil has a lower opportunity cost of producing sugar cane (in terms of wheat) than the U.S. The reverse is also true: the U.S. has a lower opportunity cost of producing wheat than Brazil. We illustrate this by the PPFs of the two countries in Figure 2.5.\n\n\n\nFigure \n2.5\n \nProduction Possibility Frontier for the U.S. and Brazil \n \nThe U.S. PPF is flatter than the Brazil PPF implying that the opportunity cost of wheat in terms of sugar cane is lower in the U.S. than in Brazil. Conversely, the opportunity cost of sugar cane is lower in Brazil. The U.S. has comparative advantage in wheat and Brazil has comparative advantage in sugar cane.\n\nWhen a country can produce a good at a lower opportunity cost than another country, we say that this country has a comparative advantage in that good. Comparative advantage is not the same as absolute advantage, which is when a country can produce more of a good. In our example, Brazil has an absolute advantage in sugar cane and the U.S. has an absolute advantage in wheat. One can easily see this with a simple observation of the extreme production points in the PPFs of the two countries. If Brazil devoted all of its resources to producing wheat, it would be producing at point A. If however it had devoted all of its resources to producing sugar cane instead, it would be producing a much larger amount than the U.S., at point B.The slope of the PPF gives the opportunity cost of producing an additional unit of wheat. While the slope is not constant throughout the PPFs, it is quite apparent that the PPF in Brazil is much steeper than in the U.S., and therefore the opportunity cost of wheat generally higher in Brazil. In the chapter on International Trade you will learn that countries differences in comparative advantage determine which goods they will choose to produce and trade. When countries engage in trade, they specialize in the production of the goods in which they have comparative advantage, and trade part of that production for goods in which they do not have comparative advantage. With trade, manufacturers produce goods where the opportunity cost is lowest, so total production increases, benefiting both trading parties. \n", "02-3": "By the end of this section, you will be able to:\nAnalyze arguments against economic approaches to decision-making\nInterpret a tradeoff diagram\nContrast normative statements and positive statements\n\nIt is one thing to understand the economic approach to decision-making and another thing to feel comfortable applying it. The sources of discomfort typically fall into two categories: that people do not act in the way that fits the economic way of thinking, and that even if people did act that way, they should try not to. Lets consider these arguments in turn.\nFirst Objection: People, Firms, and Society Do Not Act Like This\nThe economic approach to decision-making seems to require more information than most individuals possess and more careful decision-making than most individuals actually display. After all, do you or any of your friends draw a budget constraint and mutter to yourself about maximizing utility before you head to the shopping mall? Do members of the U.S. Congress contemplate production possibilities frontiers before they vote on the annual budget? The messy ways in which people and societies operate somehow doesnt look much like neat budget constraints or smoothly curving production possibilities frontiers.\nHowever, the economics approach can be a useful way to analyze and understand the tradeoffs of economic decisions. To appreciate this point, imagine for a moment that you are playing basketball, dribbling to the right, and throwing a bounce-pass to the left to a teammate who is running toward the basket. A physicist or engineer could work out the correct speed and trajectory for the pass, given the different movements involved and the weight and bounciness of the ball. However, when you are playing basketball, you do not perform any of these calculations. You just pass the ball, and if you are a good player, you will do so with high accuracy.Someone might argue: The scientists formula of the bounce-pass requires a far greater knowledge of physics and far more specific information about speeds of movement and weights than the basketball player actually has, so it must be an unrealistic description of how basketball passes actually occur. This reaction would be wrongheaded. The fact that a good player can throw the ball accurately because of practice and skill, without making a physics calculation, does not mean that the physics calculation is wrong.Similarly, from an economic point of view, someone who shops for groceries every week has a great deal of practice with how to purchase the combination of goods that will provide that person with utility, even if the shopper does not phrase decisions in terms of a budget constraint. Government institutions may work imperfectly and slowly, but in general, a democratic form of government feels pressure from voters and social institutions to make the choices that are most widely preferred by people in that society. Thus, when thinking about the economic actions of groups of people, firms, and society, it is reasonable, as a first approximation, to analyze them with the tools of economic analysis.  For more on this, read about behavioral economics in the chapter on Consumer Choices.\nSecond Objection: People, Firms, and Society Should Not Act This Way\nThe economics approach portrays people as self-interested. For some critics of this approach, even if self-interest is an accurate description of how people behave, these behaviors are not moral. Instead, the critics argue that people should be taught to care more deeply about others. Economists offer several answers to these concerns.\nFirst, economics is not a form of moral instruction. Rather, it seeks to describe economic behavior as it actually exists. Philosophers draw a distinction between positive statements, which describe the world as it is, and normative statements, which describe how the world should be. Positive statements are factual. They may be true or false, but we can test them, at least in principle. Normative statements are subjective questions of opinion. We cannot test them since we cannot prove opinions to be true or false. They just are opinions based on one's values. For example, an economist could analyze a proposed subway system in a certain city. If the expected benefits exceed the costs, he concludes that the project is worthyan example of positive analysis. Another economist argues for extended unemployment compensation during the Great Depression because a rich country like the United States should take care of its less fortunate citizensan example of normative analysis.Even if the line between positive and normative statements is not always crystal clear, economic analysis does try to remain rooted in the study of the actual people who inhabit the actual economy. Fortunately however, the assumption that individuals are purely self-interested is a simplification about human nature. In fact, we need to look no further than to Adam Smith, the very father of modern economics to find evidence of this. The opening sentence of his book, The Theory of Moral Sentiments, puts it very clearly: How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it. Clearly, individuals are both self-interested and altruistic.\nSecond, we can label self-interested behavior and profit-seeking with other names, such as personal choice and freedom. The ability to make personal choices about buying, working, and saving is an important personal freedom. Some people may choose high-pressure, high-paying jobs so that they can earn and spend considerable amounts  of money on themselves. Others may allocate large portions of their earnings to charity or spend it on their friends and family. Others may devote themselves to a career that can require much time, energy, and expertise but does not offer high financial rewards, like being an elementary school teacher or a social worker. Still others may choose a job that does consume much of their time or provide a high level of income, but still leaves time for family, friends, and contemplation. Some people may prefer to work for a large company; others might want to start their own business. Peoples freedom to make their own economic choices has a moral value worth respecting.\nClear It Up\n\n\nIs a diagram by any other name the same?\n\nWhen you study economics, you may feel buried under an avalanche of diagrams.  Your goal should be to recognize the common underlying logic and pattern of the diagrams, not to memorize each one.This chapter uses only one basic diagram, although we present it with different sets of labels. The consumption budget constraint and the production possibilities frontier for society, as a whole, are the same basic diagram. Figure 2.6 shows an individual budget constraint and a production possibilities frontier for two goods, Good 1 and Good 2. The tradeoff diagram always illustrates three basic themes: scarcity, tradeoffs, and economic efficiency.The first theme is scarcity. It is not feasible to have unlimited amounts of both goods. Even if the budget constraint or a PPF shifts, scarcity remainsjust at a different level. The second theme is tradeoffs. As depicted in the budget constraint or the production possibilities frontier, it is necessary to forgo some of one good to gain more of the other good. The details of this tradeoff vary. In a budget constraint we determine, the tradeoff is determined by the relative prices of the goods: that is, the relative price of two goods in the consumption choice budget constraint. These tradeoffs appear as a straight line. However, a curved line represents the tradeoffs in many production possibilities frontiers because the law of diminishing returns holds that as we add resources to an area, the marginal gains tend to diminish. Regardless of the specific shape, tradeoffs remain.The third theme is economic efficiency, or getting the most benefit from scarce resources. All choices on the production possibilities frontier show productive efficiency because in such cases, there is no way to increase the quantity of one good without decreasing the quantity of the other. Similarly, when an individual makes a choice along a budget constraint, there is no way to increase the quantity of one good without decreasing the quantity of the other. The choice on a production possibilities set that is socially preferred, or the choice on an individuals budget constraint that is personally preferred, will display allocative efficiency.\nThe basic budget constraint/production possibilities frontier diagram will recur throughout this book. Some examples include using these tradeoff diagrams to analyze trade, environmental protection and economic output, equality of incomes and economic output, and the macroeconomic tradeoff between consumption and investment. Do not allow the different labels to confuse you. The budget constraint/production possibilities frontier diagram is always just a tool for thinking carefully about scarcity, tradeoffs, and efficiency in a particular situation.\n\n\n\n\nFigure \n2.6\n \nThe Tradeoff Diagram \n \nBoth the individual opportunity set (or budget constraint) and the social production possibilities frontier show the constraints under which individual consumers and society as a whole operate. Both diagrams show the tradeoff in choosing more of one good at the cost of less of the other.\n\n\n\nThird, self-interested behavior can lead to positive social results. For example, when people work hard to make a living, they create economic output. Consumers who are looking for the best deals will encourage businesses to offer goods and services that meet their needs. Adam Smith, writing in The Wealth of Nations, named this property the invisible hand. In describing how consumers and producers interact in a market economy, Smith wrote:\nEvery individualgenerally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain. And he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intentionBy pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.The metaphor of the invisible hand suggests the remarkable possibility that broader social good can emerge from selfish individual actions.\nFourth, even people who focus on their own self-interest in the economic part of their life often set aside their own narrow self-interest in other parts of life. For example, you might focus on your own self-interest when asking your employer for a raise or negotiating to buy a car. Then you might turn around and focus on other people when you volunteer to read stories at the local library, help a friend move to a new apartment, or donate money to a charity. Self-interest is a reasonable starting point for analyzing many economic decisions, without needing to imply that people never do anything that is not in their own immediate self-interest.\nBring It Home\n\n\nChoices ... to What Degree?\nWhat have we learned? We know that scarcity impacts all the choices we make. An economist might argue that people do not obtain a bachelors or masters degree because they do not have the resources to make those choices or because their incomes are too low and/or the price of these degrees is too high. A bachelors or a masters degree may not be available in their opportunity set.The price of these degrees may be too high not only because the actual price, college tuition (and perhaps room and board), is too high. An economist might also say that for many people, the full opportunity cost of a bachelors or a masters degree is too high. For these people, they are unwilling or unable to make the tradeoff of forfeiting years of working, and earning an income, to earn a degree.Finally, the statistics we introduced at the start of the chapter reveal information about intertemporal choices. An economist might say that people choose not to obtain a college degree because they may have to borrow money to attend college, and the interest they have to pay on that loan in the future will affect their decisions today. Also, it could be that some people have a preference for current consumption over future consumption, so they choose to work now at a lower salary and consume now, rather than postponing that consumption until after they graduate college.\n", "03-1": "By the end of this section, you will be able to:\nExplain demand, quantity demanded, and the law of demand\nIdentify a demand curve and a supply curve\nExplain supply, quantity supplied, and the law of supply\nExplain equilibrium, equilibrium price, and equilibrium quantity\n\nFirst lets first focus on what economists mean by demand, what they mean by supply, and then how demand and supply interact in a market.\nDemand for Goods and Services\nEconomists use the term demand to refer to the amount of some good or service consumers are willing and able to purchase at each price. Demand is fundamentally based on needs and wantsif you have no need or want for something, you won't buy it. While a consumer may be able to differentiate between a need and a want, from an economists perspective they are the same thing. Demand is also based on ability to pay. If you cannot pay for it, you have no effective demand. By this definition, a homeless person probably has no effective demand for shelter.What a buyer pays for a unit of the specific good or service is called price. The total number of units that consumers would purchase at that price is called the quantity demanded. A rise in price of a good or service almost always decreases the quantity demanded of that good or service. Conversely, a fall in price will increase the quantity demanded. When the price of a gallon of gasoline increases, for example, people look for ways to reduce their consumption by combining several errands, commuting by carpool or mass transit, or taking weekend or vacation trips closer to home. Economists call this inverse relationship between price and quantity demanded the law of demand. The law of demand assumes that all other variables that affect demand (which we explain in the next module) are held constant.We can show an example from the market for gasoline in a table or a graph. Economist call a table that shows the quantity demanded at each price, such as Table 3.1, a demand schedule. In this case we measure price in dollars per gallon of gasoline. We measure the quantity demanded in millions of gallons over some time period (for example, per day or per year) and over some geographic area (like a state or a country). A demand curve shows the relationship between price and quantity demanded on a graph like Figure 3.2, with quantity on the horizontal axis and the price per gallon on the vertical axis. (Note that this is an exception to the normal rule in mathematics that the independent variable (x) goes on the horizontal axis and the dependent variable (y) goes on the vertical. Economics is not math.)Table 3.1 shows the demand schedule and the graph in Figure 3.2 shows the demand curve. These are two ways to describe the same relationship between price and quantity demanded. \n\n\nPrice (per gallon)\nQuantity Demanded (millions of gallons)\n\n\n\n$1.00\n800\n\n\n$1.20\n700\n\n\n$1.40\n600\n\n\n$1.60\n550\n\n\n$1.80\n500\n\n\n$2.00\n460\n\n\n$2.20\n420\n\n\nTable \n3.1\n \nPrice and Quantity Demanded of Gasoline\n \n\n\n\n\n\n\nFigure \n3.2\n \nA Demand Curve for Gasoline \n \nThe demand schedule shows that as price rises, quantity demanded decreases, and vice versa. We graph these points, and the line connecting them is the demand curve (D). The downward slope of the demand curve again illustrates the law of demandthe inverse relationship between prices and quantity demanded.\n\nDemand curves will appear somewhat different for each product. They may appear relatively steep or flat, or they may be straight or curved. Nearly all demand curves share the fundamental similarity that they slope down from left to right. Demand curves embody the law of demand: As the price increases, the quantity demanded decreases, and conversely, as the price decreases, the quantity demanded increases.Confused about these different types of demand? Read the next Clear It Up feature.\nClear It Up\n\n\nIs demand the same as quantity demanded?\n\nIn economic terminology, demand is not the same as quantity demanded. When economists talk about demand, they mean the relationship between a range of prices and the quantities demanded at those prices, as illustrated by a demand curve or a demand schedule. When economists talk about quantity demanded, they mean only a certain point on the demand curve, or one quantity on the demand schedule. In short, demand refers to the curve and quantity demanded refers to the (specific) point on the curve.\n\nSupply of Goods and Services\nWhen economists talk about supply, they mean the amount of some good or service a producer is willing to supply at each price. Price is what the producer receives for selling one unit of a good or service. A rise in price almost always leads to an increase in the quantity supplied of that good or service, while a fall in price will decrease the quantity supplied. When the price of gasoline rises, for example, it encourages profit-seeking firms to take several actions: expand exploration for oil reserves; drill for more oil; invest in more pipelines and oil tankers to bring the oil to plants for refining into gasoline; build new oil refineries; purchase additional pipelines and trucks to ship the gasoline to gas stations; and open more gas stations or keep existing gas stations open longer hours. Economists call this positive relationship between price and quantity suppliedthat a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity suppliedthe law of supply. The law of supply assumes that all other variables that affect supply (to be explained in the next module) are held constant.Still unsure about the different types of supply? See the following Clear It Up feature.\nClear It Up\n\n\nIs supply the same as quantity supplied?\n\nIn economic terminology, supply is not the same as quantity supplied. When economists refer to supply, they mean the relationship between a range of prices and the quantities supplied at those prices, a relationship that we can illustrate with a supply curve or a supply schedule. When economists refer to quantity supplied, they mean only a certain point on the supply curve, or one quantity on the supply schedule. In short, supply refers to the curve and quantity supplied refers to the (specific) point on the curve.\nFigure 3.3 illustrates the law of supply, again using the market for gasoline as an example. Like demand, we can illustrate supply using a table or a graph. A supply schedule is a table, like Table 3.2, that shows the quantity supplied at a range of different prices. Again, we measure price in dollars per gallon of gasoline and we measure quantity supplied in millions of gallons. A supply curve is a graphic illustration of the relationship between price, shown on the vertical axis, and quantity, shown on the horizontal axis. The supply schedule and the supply curve are just two different ways of showing the same information. Notice that the horizontal and vertical axes on the graph for the supply curve are the same as for the demand curve.\n\n\n\n\nFigure \n3.3\n \nA Supply Curve for Gasoline \n \nThe supply schedule is the table that shows quantity supplied of gasoline at each price. As price rises, quantity supplied also increases, and vice versa. The supply curve (S) is created by graphing the points from the supply schedule and then connecting them. The upward slope of the supply curve illustrates the law of supplythat a higher price leads to a higher quantity supplied, and vice versa.\n\n\n\n\nPrice (per gallon)\nQuantity Supplied (millions of gallons)\n\n\n\n$1.00\n500\n\n\n$1.20\n550\n\n\n$1.40\n600\n\n\n$1.60\n640\n\n\n$1.80\n680\n\n\n$2.00\n700\n\n\n$2.20\n720\n\n\nTable \n3.2\n \nPrice and Supply of Gasoline\n \n\n\nThe shape of supply curves will vary somewhat according to the product: steeper, flatter, straighter, or curved. Nearly all supply curves, however, share a basic similarity: they slope up from left to right and illustrate the law of supply: as the price rises, say, from $1.00 per gallon to $2.20 per gallon, the quantity supplied increases from 500 gallons to 720 gallons. Conversely, as the price falls, the quantity supplied decreases.\n\nEquilibriumWhere Demand and Supply Intersect\nBecause the graphs for demand and supply curves both have price on the vertical axis and quantity on the horizontal axis, the demand curve and supply curve for a particular good or service can appear on the same graph. Together, demand and supply determine the price and the quantity that will be bought and sold in a market.\nFigure 3.4 illustrates the interaction of demand and supply in the market for gasoline. The demand curve (D) is identical to Figure 3.2. The supply curve (S) is identical to Figure 3.3. Table 3.3 contains the same information in tabular form.\n\n\n\n\n\nFigure \n3.4\n \nDemand and Supply for Gasoline \n \nThe demand curve (D) and the supply curve (S) intersect at the equilibrium point E, with a price of $1.40 and a quantity of 600. The equilibrium is the only price where quantity demanded is equal to quantity supplied. At a price above equilibrium like $1.80, quantity supplied exceeds the quantity demanded, so there is excess supply. At a price below equilibrium such as $1.20, quantity demanded exceeds quantity supplied, so there is excess demand.\n\n\n\n\nPrice (per gallon)\nQuantity demanded (millions of gallons)\nQuantity supplied (millions of gallons)\n\n\n\n$1.00\n800\n500\n\n\n$1.20\n700\n550\n\n\n$1.40\n600\n600\n\n\n$1.60\n550\n640\n\n\n$1.80\n500\n680\n\n\n$2.00\n460\n700\n\n\n$2.20\n420\n720\n\n\nTable \n3.3\n \nPrice, Quantity Demanded, and Quantity Supplied\n \n\n\nRemember this: When two lines on a diagram cross, this intersection usually means something. The point where the supply curve (S) and the demand curve (D) cross, designated by point E in Figure 3.4, is called the equilibrium. The equilibrium price is the only price where the plans of consumers and the plans of producers agreethat is, where the amount of the product consumers want to buy (quantity demanded) is equal to the amount producers want to sell (quantity supplied). Economists call this common quantity the equilibrium quantity. At any other price, the quantity demanded does not equal the quantity supplied, so the market is not in equilibrium at that price.In Figure 3.4, the equilibrium price is $1.40 per gallon of gasoline and the equilibrium quantity is 600 million gallons. If you had only the demand and supply schedules, and not the graph, you could find the equilibrium by looking for the price level on the tables where the quantity demanded and the quantity supplied are equal.\nThe word equilibrium means balance. If a market is at its equilibrium price and quantity, then it has no reason to move away from that point. However, if a market is not at equilibrium, then economic pressures arise to move the market toward the equilibrium price and the equilibrium quantity.\nImagine, for example, that the price of a gallon of gasoline was above the equilibrium pricethat is, instead of $1.40 per gallon, the price is $1.80 per gallon. The dashed horizontal line at the price of $1.80 in Figure 3.4 illustrates this above equilibrium price. At this higher price, the quantity demanded drops from 600 to 500. This decline in quantity reflects how consumers react to the higher price by finding ways to use less gasoline.Moreover, at this higher price of $1.80, the quantity of gasoline supplied rises from the 600 to 680, as the higher price makes it more profitable for gasoline producers to expand their output. Now, consider how quantity demanded and quantity supplied are related at this above-equilibrium price. Quantity demanded has fallen to 500 gallons, while quantity supplied has risen to 680 gallons. In fact, at any above-equilibrium price, the quantity supplied exceeds the quantity demanded. We call this an excess supply or a surplus.\nWith a surplus, gasoline accumulates at gas stations, in tanker trucks, in pipelines, and at oil refineries. This accumulation puts pressure on gasoline sellers. If a surplus remains unsold, those firms involved in making and selling gasoline are not receiving enough cash to pay their workers and to cover their expenses. In this situation, some producers and sellers will want to cut prices, because it is better to sell at a lower price than not to sell at all. Once some sellers start cutting prices, others will follow to avoid losing sales. These price reductions in turn will stimulate a higher quantity demanded. Therefore, if the price is above the equilibrium level, incentives built into the structure of demand and supply will create pressures for the price to fall toward the equilibrium.Now suppose that the price is below its equilibrium level at $1.20 per gallon, as the dashed horizontal line at this price in Figure 3.4 shows. At this lower price, the quantity demanded increases from 600 to 700 as drivers take longer trips, spend more minutes warming up the car in the driveway in wintertime, stop sharing rides to work, and buy larger cars that get fewer miles to the gallon. However, the below-equilibrium price reduces gasoline producers incentives to produce and sell gasoline, and the quantity supplied falls from 600 to 550.\nWhen the price is below equilibrium, there is excess demand, or a shortagethat is, at the given price the quantity demanded, which has been stimulated by the lower price, now exceeds the quantity supplied, which had been depressed by the lower price. In this situation, eager gasoline buyers mob the gas stations, only to find many stations running short of fuel. Oil companies and gas stations recognize that they have an opportunity to make higher profits by selling what gasoline they have at a higher price. As a result, the price rises toward the equilibrium level.  Read Demand, Supply, and Efficiency for more discussion on the importance of the demand and supply model.\n", "03-2": "By the end of this section, you will be able to:\nIdentify factors that affect demand\nGraph demand curves and demand shifts\nIdentify factors that affect supply\nGraph supply curves and supply shifts\n\nThe previous module explored how price affects the quantity demanded and the quantity supplied. The result was the demand curve and the supply curve. Price, however, is not the only factor that influences buyers and sellers decisions. For example, how is demand for vegetarian food affected if, say, health concerns cause more consumers to avoid eating meat? How is the supply of diamonds affected if diamond producers discover several new diamond mines? What are the major factors, in addition to the price, that influence demand or supply?\nLink It Up\n\nVisit this website to read a brief note on how marketing strategies can influence supply and demand of products.\nWhat Factors Affect Demand?\nWe defined demand as the amount of some product a consumer is willing and able to purchase at each price. That suggests at least two factors that affect demand. Willingness to purchase suggests a desire, based on what economists call tastes and preferences. If you neither need nor want something, you will not buy it. Ability to purchase suggests that income is important. Professors are usually able to afford better housing and transportation than students, because they have more income. Prices of related goods can affect demand also. If you need a new car, the price of a Honda may affect your demand for a Ford. Finally, the size or composition of the population can affect demand. The more children a family has, the greater their demand for clothing. The more driving-age children a family has, the greater their demand for car insurance, and the less for diapers and baby formula.These factors matter for both individual and market demand as a whole. Exactly how do these various factors affect demand, and how do we show the effects graphically? To answer those questions, we need the ceteris paribus assumption.\nThe Ceteris Paribus Assumption\nA demand curve or a supply curve is a relationship between two, and only two, variables: quantity on the horizontal axis and price on the vertical axis. The assumption behind a demand curve or a supply curve is that no relevant economic factors, other than the products price, are changing. Economists call this assumption ceteris paribus, a Latin phrase meaning other things being equal. Any given demand or supply curve is based on the ceteris paribus assumption that all else is held equal. A demand curve or a supply curve is a relationship between two, and only two, variables when all other variables are kept constant. If all else is not held equal, then the laws of supply and demand will not necessarily hold, as the following Clear It Up feature shows.\nClear It Up\n\n\nWhen does ceteris paribus apply?\n\nWe typically apply ceteris paribus when we observe how changes in price affect demand or supply, but we can apply ceteris paribus more generally. In the real world, demand and supply depend on more factors than just price. For example, a consumers demand depends on income and a producers supply depends on the cost of producing the product. How can we analyze the effect on demand or supply if multiple factors are changing at the same timesay price rises and income falls? The answer is that we examine the changes one at a time, assuming the other factors are held constant.For example, we can say that an increase in the price reduces the amount consumers will buy (assuming income, and anything else that affects demand, is unchanged). Additionally, a decrease in income reduces the amount consumers can afford to buy (assuming price, and anything else that affects demand, is unchanged). This is what the ceteris paribus assumption really means. In this particular case, after we analyze each factor separately, we can combine the results. The amount consumers buy falls for two reasons: first because of the higher price and second because of the lower income.\n\nHow Does Income Affect Demand?\nLets use income as an example of how factors other than price affect demand. Figure 3.5 shows the initial demand for automobiles as D0. At point Q, for example, if the price is $20,000 per car, the quantity of cars demanded is 18 million. D0 also shows how the quantity of cars demanded would change as a result of a higher or lower price. For example, if the price of a car rose to $22,000, the quantity demanded would decrease to 17 million, at point R.The original demand curve D0, like every demand curve, is based on the ceteris paribus assumption that no other economically relevant factors change. Now imagine that the economy expands in a way that raises the incomes of many people, making cars more affordable. How will this affect demand? How can we show this graphically?\nReturn to Figure 3.5. The price of cars is still $20,000, but with higher incomes, the quantity demanded has now increased to 20 million cars, shown at point S. As a result of the higher income levels, the demand curve shifts to the right to the new demand curve D1, indicating an increase in demand. Table 3.4 shows clearly that this increased demand would occur at every price, not just the original one.\n\n\n\n\n\nFigure \n3.5\n \nShifts in Demand: A Car Example \n \nIncreased demand means that at every given price, the quantity demanded is higher, so that the demand curve shifts to the right from D0 to D1. Decreased demand means that at every given price, the quantity demanded is lower, so that the demand curve shifts to the left from D0 to D2.\n\n\n\n\nPrice\nDecrease to D2\nOriginal Quantity Demanded D0\nIncrease to D1\n\n\n\n$16,000\n17.6 million\n22.0 million\n24.0 million\n\n\n$18,000\n16.0 million\n20.0 million\n22.0 million\n\n\n$20,000\n14.4 million\n18.0 million\n20.0 million\n\n\n$22,000\n13.6 million\n17.0 million\n19.0 million\n\n\n$24,000\n13.2 million\n16.5 million\n18.5 million\n\n\n$26,000\n12.8 million\n16.0 million\n18.0 million\n\n\nTable \n3.4\n \nPrice and Demand Shifts: A Car Example\n \n\n\nNow, imagine that the economy slows down so that many people lose their jobs or work fewer hours, reducing their incomes. In this case, the decrease in income would lead to a lower quantity of cars demanded at every given price, and the original demand curve D0 would shift left to D2. The shift from D0 to D2 represents such a decrease in demand: At any given price level, the quantity demanded is now lower. In this example, a price of $20,000 means 18 million cars sold along the original demand curve, but only 14.4 million sold after demand fell.\nWhen a demand curve shifts, it does not mean that the quantity demanded by every individual buyer changes by the same amount. In this example, not everyone would have higher or lower income and not everyone would buy or not buy an additional car. Instead, a shift in a demand curve captures a pattern for the market as a whole.In the previous section, we argued that higher income causes greater demand at every price. This is true for most goods and services. For someluxury cars, vacations in Europe, and fine jewelrythe effect of a rise in income can be especially pronounced. A product whose demand rises when income rises, and vice versa, is called a normal good. A few exceptions to this pattern do exist. As incomes rise, many people will buy fewer generic brand groceries and more name brand groceries. They are less likely to buy used cars and more likely to buy new cars. They will be less likely to rent an apartment and more likely to own a home. A product whose demand falls when income rises, and vice versa, is called an inferior good. In other words, when income increases, the demand curve shifts to the left.\nOther Factors That Shift Demand Curves\nIncome is not the only factor that causes a shift in demand. Other factors that change demand include tastes and preferences, the composition or size of the population, the prices of related goods, and even expectations. A change in any one of the underlying factors that determine what quantity people are willing to buy at a given price will cause a shift in demand. Graphically, the new demand curve lies either to the right (an increase) or to the left (a decrease) of the original demand curve. Lets look at these factors.Changing Tastes or Preferences\nFrom 1980 to 2014, the per-person consumption of chicken by Americans rose from 48 pounds per year to 85 pounds per year, and consumption of beef fell from 77 pounds per year to 54 pounds per year, according to the U.S. Department of Agriculture (USDA). Changes like these are largely due to movements in taste, which change the quantity of a good demanded at every price: that is, they shift the demand curve for that good, rightward for chicken and leftward for beef.Changes in the Composition of the Population \nThe proportion of elderly citizens in the United States population is rising. It rose from 9.8% in 1970 to 12.6% in 2000, and will be a projected (by the U.S. Census Bureau) 20% of the population by 2030. A society with relatively more children, like the United States in the 1960s, will have greater demand for goods and services like tricycles and day care facilities. A society with relatively more elderly persons, as the United States is projected to have by 2030, has a higher demand for nursing homes and hearing aids. Similarly, changes in the size of the population can affect the demand for housing and many other goods. Each of these changes in demand will be shown as a shift in the demand curve.\nChanges in the Prices of Related Goods\nChanges in the prices of related goods such as substitutes or complements also can affect the demand for a product. A substitute is a good or service that we can use in place of another good or service. As electronic books, like this one, become more available, you would expect to see a decrease in demand for traditional printed books. A lower price for a substitute decreases demand for the other product. For example, in recent years as the price of tablet computers has fallen, the quantity demanded has increased (because of the law of demand). Since people are purchasing tablets, there has been a decrease in demand for laptops, which we can show graphically as a leftward shift in the demand curve for laptops. A higher price for a substitute good has the reverse effect.Other goods are complements for each other, meaning we often use the goods together, because consumption of one good tends to enhance consumption of the other. Examples include breakfast cereal and milk; notebooks and pens or pencils, golf balls and golf clubs; gasoline and sport utility vehicles; and the five-way combination of bacon, lettuce, tomato, mayonnaise, and bread. If the price of golf clubs rises, since the quantity demanded of golf clubs falls (because of the law of demand), demand for a complement good like golf balls decreases, too. Similarly, a higher price for skis would shift the demand curve for a complement good like ski resort trips to the left, while a lower price for a complement has the reverse effect.Changes in Expectations about Future Prices or Other Factors that Affect Demand\nWhile it is clear that the price of a good affects the quantity demanded, it is also true that expectations about the future price (or expectations about tastes and preferences, income, and so on) can affect demand. For example, if people hear that a hurricane is coming, they may rush to the store to buy flashlight batteries and bottled water. If people learn that the price of a good like coffee is likely to rise in the future, they may head for the store to stock up on coffee now. We show these changes in demand as shifts in the curve. Therefore, a shift in demand happens when a change in some economic factor (other than price) causes a different quantity to be demanded at every price. The following Work It Out feature shows how this happens.\nWork It Out\n\n\nShift in Demand\n\nA shift in demand means that at any price (and at every price), the quantity demanded will be different than it was before. Following is an example of a shift in demand due to an income increase.\nStep 1. Draw the graph of a demand curve for a normal good like pizza. Pick a price (like P0). Identify the corresponding Q0. See an example in Figure 3.6.\n\n\n\nFigure \n3.6\n \nDemand Curve \n \nWe can use the demand curve to identify how much consumers would buy at any given price.\n\nStep 2. Suppose income increases. As a result of the change, are consumers going to buy more or less pizza? The answer is more. Draw a dotted horizontal line from the chosen price, through the original quantity demanded, to the new point with the new Q1. Draw a dotted vertical line down to the horizontal axis and label the new Q1. Figure 3.7 provides an example.\n\n\n\n\nFigure \n3.7\n \nDemand Curve with Income Increase \n \nWith an increase in income, consumers will purchase larger quantities, pushing demand to the right.\n\n\nStep 3. Now, shift the curve through the new point. You will see that an increase in income causes an upward (or rightward) shift in the demand curve, so that at any price the quantities demanded will be higher, as Figure 3.8 illustrates.\n\n\n\n\nFigure \n3.8\n \nDemand Curve Shifted Right \n \nWith an increase in income, consumers will purchase larger quantities, pushing demand to the right, and causing the demand curve to shift right.\n\n\n\n\nSumming Up Factors That Change Demand\nFigure 3.9 summarizes six factors that can shift demand curves. The direction of the arrows indicates whether the demand curve shifts represent an increase in demand or a decrease in demand. Notice that a change in the price of the good or service itself is not listed among the factors that can shift a demand curve. A change in the price of a good or service causes a movement along a specific demand curve, and it typically leads to some change in the quantity demanded, but it does not shift the demand curve.\n\n\n\n\nFigure \n3.9\n \nFactors That Shift Demand Curves \n \n(a) A list of factors that can cause an increase in demand from D0 to D1. (b) The same factors, if their direction is reversed, can cause a decrease in demand from D0 to D1.\n\n\nWhen a demand curve shifts, it will then intersect with a given supply curve at a different equilibrium price and quantity. We are, however, getting ahead of our story. Before discussing how changes in demand can affect equilibrium price and quantity, we first need to discuss shifts in supply curves.\n\nHow Production Costs Affect Supply\nA supply curve shows how quantity supplied will change as the price rises and falls, assuming ceteris paribus so that no other economically relevant factors are changing. If other factors relevant to supply do change, then the entire supply curve will shift. Just as we described a shift in demand as a change in the quantity demanded at every price, a shift in supply means a change in the quantity supplied at every price.In thinking about the factors that affect supply, remember what motivates firms: profits, which are the difference between revenues and costs. A firm produces goods and services using combinations of labor, materials, and machinery, or what we call inputs or factors of production. If a firm faces lower costs of production, while the prices for the good or service the firm produces remain unchanged, a firms profits go up. When a firms profits increase, it is more motivated to produce output, since the more it produces the more profit it will earn. When costs of production fall, a firm will tend to supply a larger quantity at any given price for its output. We can show this by the supply curve shifting to the right.Take, for example, a messenger company that delivers packages around a city. The company may find that buying gasoline is one of its main costs. If the price of gasoline falls, then the company will find it can deliver messages more cheaply than before. Since lower costs correspond to higher profits, the messenger company may now supply more of its services at any given price. For example, given the lower gasoline prices, the company can now serve a greater area, and increase its supply.\nConversely, if a firm faces higher costs of production, then it will earn lower profits at any given selling price for its products. As a result, a higher cost of production typically causes a firm to supply a smaller quantity at any given price. In this case, the supply curve shifts to the left.\nConsider the supply for cars, shown by curve S0 in Figure 3.10. Point J indicates that if the price is $20,000, the quantity supplied will be 18 million cars. If the price rises to $22,000 per car, ceteris paribus, the quantity supplied will rise to 20 million cars, as point K on the S0 curve shows. We can show the same information in table form, as in Table 3.5.\n\n\n\n\nFigure \n3.10\n \nShifts in Supply: A Car Example \n \nDecreased supply means that at every given price, the quantity supplied is lower, so that the supply curve shifts to the left, from S0 to S1. Increased supply means that at every given price, the quantity supplied is higher, so that the supply curve shifts to the right, from S0 to S2.\n\n\n\n\nPrice\nDecrease to S1\nOriginal Quantity Supplied S0\nIncrease to S2\n\n\n$16,000\n10.5 million\n12.0 million\n13.2 million\n\n\n$18,000\n13.5 million\n15.0 million\n16.5 million\n\n\n$20,000\n16.5 million\n18.0 million\n19.8 million\n\n\n$22,000\n18.5 million\n20.0 million\n22.0 million\n\n\n$24,000\n19.5 million\n21.0 million\n23.1 million\n\n\n$26,000\n20.5 million\n22.0 million\n24.2 million\n\n\nTable \n3.5\n \nPrice and Shifts in Supply: A Car Example\n \n\n\nNow, imagine that the price of steel, an important ingredient in manufacturing cars, rises, so that producing a car has become more expensive. At any given price for selling cars, car manufacturers will react by supplying a lower quantity. We can show this graphically as a leftward shift of supply, from S0 to S1, which indicates that at any given price, the quantity supplied decreases. In this example, at a price of $20,000, the quantity supplied decreases from 18 million on the original supply curve (S0) to 16.5 million on the supply curve S1, which is labeled as point L.Conversely, if the price of steel decreases, producing a car becomes less expensive. At any given price for selling cars, car manufacturers can now expect to earn higher profits, so they will supply a higher quantity. The shift of supply to the right, from S0 to S2, means that at all prices, the quantity supplied has increased. In this example, at a price of $20,000, the quantity supplied increases from 18 million on the original supply curve (S0) to 19.8 million on the supply curve S2, which is labeled M.\n\nOther Factors That Affect Supply\nIn the example above, we saw that changes in the prices of inputs in the production process will affect the cost of production and thus the supply. Several other things affect the cost of production, too, such as changes in weather or other natural conditions, new technologies for production, and some government policies.\nChanges in weather and climate will affect the cost of production for many agricultural products. For example, in 2014 the Manchurian Plain in Northeastern China, which produces most of the country's wheat, corn, and soybeans, experienced its most severe drought in 50 years. A drought decreases the supply of agricultural products, which means that at any given price, a lower quantity will be supplied. Conversely, especially good weather would shift the supply curve to the right.When a firm discovers a new technology that allows the firm to produce at a lower cost, the supply curve will shift to the right, as well. For instance, in the 1960s a major scientific effort nicknamed the Green Revolution focused on breeding improved seeds for basic crops like wheat and rice. By the early 1990s, more than two-thirds of the wheat and rice in low-income countries around the world used these Green Revolution seedsand the harvest was twice as high per acre. A technological improvement that reduces costs of production will shift supply to the right, so that a greater quantity will be produced at any given price.Government policies can affect the cost of production and the supply curve through taxes, regulations, and subsidies. For example, the U.S. government imposes a tax on alcoholic beverages that collects about $8 billion per year from producers. Businesses treat taxes as costs. Higher costs decrease supply for the reasons we discussed above. Other examples of policy that can affect cost are the wide array of government regulations that require firms to spend money to provide a cleaner environment or a safer workplace. Complying with regulations increases costs.A government subsidy, on the other hand, is the opposite of a tax. A subsidy occurs when the government pays a firm directly or reduces the firms taxes if the firm carries out certain actions. From the firms perspective, taxes or regulations are an additional cost of production that shifts supply to the left, leading the firm to produce a lower quantity at every given price. Government subsidies reduce the cost of production and increase supply at every given price, shifting supply to the right. The following Work It Out feature shows how this shift happens.\nWork It Out\n\n\nShift in Supply\n\nWe know that a supply curve shows the minimum price a firm will accept to produce a given quantity of output. What happens to the supply curve when the cost of production goes up? Following is an example of a shift in supply due to a production cost increase. (Well introduce some other concepts regarding firm decision-making in Chapters 7 and 8.)Step 1. Draw a graph of a supply curve for pizza. Pick a quantity (like Q0). If you draw a vertical line up from Q0 to the supply curve, you will see the price the firm chooses. Figure 3.11 provides an example.\n\n\n\nFigure \n3.11\n \nSupply Curve \n \nYou can use a supply curve to show the minimum price a firm will accept to produce a given quantity of output.\n\nStep 2. Why did the firm choose that price and not some other? One way to think about this is that the price is composed of two parts. The first part is the cost of producing pizzas at the margin; in this case, the cost of producing the pizza, including cost of ingredients (e.g., dough, sauce, cheese, and pepperoni), the cost of the pizza oven, the shop rent, and the workers' wages. The second part is the firms desired profit, which is determined, among other factors, by the profit margins in that particular business. (Desired profit is not necessarily the same as economic profit, which will be explained in Chapter 7.) If you add these two parts together, you get the price the firm wishes to charge. The quantity Q0 and associated price P0 give you one point on the firms supply curve, as Figure 3.12 illustrates.\n\n\n\n\nFigure \n3.12\n \nSetting Prices \n \nThe cost of production and the desired profit equal the price a firm will set for a product.\n\n\nStep 3. Now, suppose that the cost of production increases. Perhaps cheese has become more expensive by $0.75 per pizza. If that is true, the firm will want to raise its price by the amount of the increase in cost ($0.75). Draw this point on the supply curve directly above the initial point on the curve, but $0.75 higher, as Figure 3.13 shows.\n\n\n\n\nFigure \n3.13\n \nIncreasing Costs Leads to Increasing Price \n \nBecause the cost of production and the desired profit equal the price a firm will set for a product, if the cost of production increases, the price for the product will also need to increase.\n\n\nStep 4. Shift the supply curve through this point. You will see that an increase in cost causes an upward (or a leftward) shift of the supply curve so that at any price, the quantities supplied will be smaller, as Figure 3.14 illustrates.\n\n\n\n\nFigure \n3.14\n \nSupply Curve Shifts \n \nWhen the cost of production increases, the supply curve shifts upwardly to a new price level.\n\n\n\n\nSumming Up Factors That Change Supply\nChanges in the cost of inputs, natural disasters, new technologies, and the impact of government decisions all affect the cost of production. In turn, these factors affect how much firms are willing to supply at any given price.\nFigure 3.15 summarizes factors that change the supply of goods and services. Notice that a change in the price of the product itself is not among the factors that shift the supply curve. Although a change in price of a good or service typically causes a change in quantity supplied or a movement along the supply curve for that specific good or service, it does not cause the supply curve itself to shift.\n\n\n\nFigure \n3.15\n \nFactors That Shift Supply Curves \n \n(a) A list of factors that can cause an increase in supply from S0 to S1. (b) The same factors, if their direction is reversed, can cause a decrease in supply from S0 to S1.\n\n\nBecause demand and supply curves appear on a two-dimensional diagram with only price and quantity on the axes, an unwary visitor to the land of economics might be fooled into believing that economics is about only four topics: demand, supply, price, and quantity. However, demand and supply are really umbrella concepts: demand covers all the factors that affect demand, and supply covers all the factors that affect supply. We include factors other than price that affect demand and supply are included by using shifts in the demand or the supply curve. In this way, the two-dimensional demand and supply model becomes a powerful tool for analyzing a wide range of economic circumstances.\n", "03-3": "By the end of this section, you will be able to:\nIdentify equilibrium price and quantity through the four-step process\nGraph equilibrium price and quantity\nContrast shifts of demand or supply and movements along a demand or supply curve\nGraph demand and supply curves, including equilibrium price and quantity, based on real-world examples\n\nLets begin this discussion with a single economic event. It might be an event that affects demand, like a change in income, population, tastes, prices of substitutes or complements, or expectations about future prices. It might be an event that affects supply, like a change in natural conditions, input prices, or technology, or government policies that affect production. How does this economic event affect equilibrium price and quantity? We will analyze this question using a four-step process.\nStep 1. Draw a demand and supply model before the economic change took place. To establish the model requires four standard pieces of information: The law of demand, which tells us the slope of the demand curve; the law of supply, which gives us the slope of the supply curve; the shift variables for demand; and the shift variables for supply. From this model, find the initial equilibrium values for price and quantity.\nStep 2. Decide whether the economic change you are analyzing affects demand or supply. In other words, does the event refer to something in the list of demand factors or supply factors?Step 3. Decide whether the effect on demand or supply causes the curve to shift to the right or to the left, and sketch the new demand or supply curve on the diagram. In other words, does the event increase or decrease the amount consumers want to buy or producers want to sell?\nStep 4. Identify the new equilibrium and then compare the original equilibrium price and quantity to the new equilibrium price and quantity.\nLets consider one example that involves a shift in supply and one that involves a shift in demand. Then we will consider an example where both supply and demand shift.\nGood Weather for Salmon Fishing\nSupposed that during the summer of 2015, weather conditions were excellent for commercial salmon fishing off the California coast. Heavy rains meant higher than normal levels of water in the rivers, which helps the salmon to breed. Slightly cooler ocean temperatures stimulated the growth of plankton, the microscopic organisms at the bottom of the ocean food chain, providing everything in the ocean with a hearty food supply. The ocean stayed calm during fishing season, so commercial fishing operations did not lose many days to bad weather. How did these climate conditions affect the quantity and price of salmon? Figure 3.16 illustrates the four-step approach, which we explain below, to work through this problem. Table 3.6 also provides the information to work the problem.\n\n\n\n\nFigure \n3.16\n \nGood Weather for Salmon Fishing: The Four-Step Process \n \nUnusually good weather leads to changes in the price and quantity of salmon.\n\n\n\n\nPrice per Pound\nQuantity Supplied in 2014\nQuantity Supplied in 2015\nQuantity Demanded\n\n\n\n$2.00\n80\n400\n840\n\n\n$2.25\n120\n480\n680\n\n\n$2.50\n160\n550\n550\n\n\n$2.75\n200\n600\n450\n\n\n$3.00\n230\n640\n350\n\n\n$3.25\n250\n670\n250\n\n\n$3.50\n270\n700\n200\n\n\nTable \n3.6\n \nSalmon Fishing\n \n\n\nStep 1. Draw a demand and supply model to illustrate the market for salmon in the year before the good weather conditions began. The demand curve D0 and the supply curve S0 show that the original equilibrium price is $3.25 per pound and the original equilibrium quantity is 250,000 fish. (This price per pound is what commercial buyers pay at the fishing docks. What consumers pay at the grocery is higher.)Step 2. Did the economic event affect supply or demand? Good weather is an example of a natural condition that affects supply.\nStep 3. Was the effect on supply an increase or a decrease? Good weather is a change in natural conditions that increases the quantity supplied at any given price. The supply curve shifts to the right, moving from the original supply curve S0 to the new supply curve S1, which Figure 3.16 and Table 3.6 show.Step 4. Compare the new equilibrium price and quantity to the original equilibrium. At the new equilibrium E1, the equilibrium price falls from $3.25 to $2.50, but the equilibrium quantity increases from 250,000 to 550,000 salmon. Notice that the equilibrium quantity demanded increased, even though the demand curve did not move.In short, good weather conditions increased supply of the California commercial salmon. The result was a higher equilibrium quantity of salmon bought and sold in the market at a lower price.\n\nNewspapers and the Internet\nAccording to the Pew Research Center for People and the Press, increasingly more people, especially younger people, are obtaining their news from online and digital sources. The majority of U.S. adults now own smartphones or tablets, and most of those Americans say they use them in part to access the news. From 2004 to 2012, the share of Americans who reported obtaining their news from digital sources increased from 24% to 39%. How has this affected consumption of print news media, and radio and television news? Figure 3.17 and the text below illustrates using the four-step analysis to answer this question.\n\n\n\n\nFigure \n3.17\n \nThe Print News Market: A Four-Step Analysis \n \nA change in tastes from print news sources to digital sources results in a leftward shift in demand for the former. The result is a decrease in both equilibrium price and quantity.\n\n\nStep 1. Develop a demand and supply model to think about what the market looked like before the event. The demand curve D0 and the supply curve S0 show the original relationships. In this case, we perform the analysis without specific numbers on the price and quantity axis.Step 2. Did the described change affect supply or demand? A change in tastes, from traditional news sources (print, radio, and television) to digital sources, caused a change in demand for the former.Step 3. Was the effect on demand positive or negative? A shift to digital news sources will tend to mean a lower quantity demanded of traditional news sources at every given price, causing the demand curve for print and other traditional news sources to shift to the left, from D0 to D1.\nStep 4. Compare the new equilibrium price and quantity to the original equilibrium price. The new equilibrium (E1) occurs at a lower quantity and a lower price than the original equilibrium (E0).\nThe decline in print news reading predates 2004. Print newspaper circulation peaked in 1973 and has declined since then due to competition from television and radio news. In 1991, 55% of Americans indicated they received their news from print sources, while only 29% did so in 2012. Radio news has followed a similar path in recent decades, with the share of Americans obtaining their news from radio declining from 54% in 1991 to 33% in 2012. Television news has held its own over the last 15 years, with a market share staying in the mid to upper fifties. What does this suggest for the future, given that two-thirds of Americans under 30 years old say they do not obtain their news from television at all?\nThe Interconnections and Speed of Adjustment in Real Markets\nIn the real world, many factors that affect demand and supply can change all at once. For example, the demand for cars might increase because of rising incomes and population, and it might decrease because of rising gasoline prices (a complementary good). Likewise, the supply of cars might increase because of innovative new technologies that reduce the cost of car production, and it might decrease as a result of new government regulations requiring the installation of costly pollution-control technology.\nMoreover, rising incomes and population or changes in gasoline prices will affect many markets, not just cars. How can an economist sort out all these interconnected events? The answer lies in the ceteris paribus assumption. Look at how each economic event affects each market, one event at a time, holding all else constant. Then combine the analyses to see the net effect.\nA Combined Example\nThe U.S. Postal Service is facing difficult challenges. Compensation for postal workers tends to increase most years due to cost-of-living increases. At the same time, increasingly more people are using email, text, and other digital message forms such as Facebook and Twitter to communicate with friends and others. What does this suggest about the continued viability of the Postal Service? Figure 3.18 and the text below illustrate this using the four-step analysis to answer this question.\n\n\n\n\nFigure \n3.18\n \nHigher Compensation for Postal Workers: A Four-Step Analysis \n \n(a) Higher labor compensation causes a leftward shift in the supply curve, a decrease in the equilibrium quantity, and an increase in the equilibrium price. (b) A change in tastes away from Postal Services causes a leftward shift in the demand curve, a decrease in the equilibrium quantity, and a decrease in the equilibrium price.\n\n\nSince this problem involves two disturbances, we need two four-step analyses, the first to analyze the effects of higher compensation for postal workers, the second to analyze the effects of many people switching from snail mail to email and other digital messages. Figure 3.18 (a) shows the shift in supply discussed in the following steps.\nStep 1. Draw a demand and supply model to illustrate what the market for the U.S. Postal Service looked like before this scenario starts. The demand curve D0 and the supply curve S0 show the original relationships.\nStep 2. Did the described change affect supply or demand? Labor compensation is a cost of production. A change in production costs caused a change in supply for the Postal Service.Step 3. Was the effect on supply positive or negative? Higher labor compensation leads to a lower quantity supplied of postal services at every given price, causing the supply curve for postal services to shift to the left, from S0 to S1.\nStep 4. Compare the new equilibrium price and quantity to the original equilibrium price. The new equilibrium (E1) occurs at a lower quantity and a higher price than the original equilibrium (E0).\nFigure 3.18 (b) shows the shift in demand in the following steps.Step 1. Draw a demand and supply model to illustrate what the market for U.S. Postal Services looked like before this scenario starts. The demand curve D0 and the supply curve S0 show the original relationships. Note that this diagram is independent from the diagram in panel (a).Step 2. Did the change described affect supply or demand? A change in tastes away from snail mail toward digital messages will cause a change in demand for the Postal Service.Step 3. Was the effect on demand positive or negative? A change in tastes away from snailmail toward digital messages causes lower quantity demanded of postal services at every given price, causing the demand curve for postal services to shift to the left, from D0 to D1.Step 4. Compare the new equilibrium price and quantity to the original equilibrium price. The new equilibrium (E2) occurs at a lower quantity and a lower price than the original equilibrium (E0).\nThe final step in a scenario where both supply and demand shift is to combine the two individual analyses to determine what happens to the equilibrium quantity and price. Graphically, we superimpose the previous two diagrams one on top of the other, as in Figure 3.19.\n\n\n\n\n\nFigure \n3.19\n \nCombined Effect of Decreased Demand and Decreased Supply \n \nSupply and demand shifts cause changes in equilibrium price and quantity.\n\n\nFollowing are the results:\nEffect on Quantity: The effect of higher labor compensation on Postal Services because it raises the cost of production is to decrease the equilibrium quantity. The effect of a change in tastes away from snail mail is to decrease the equilibrium quantity. Since both shifts are to the left, the overall impact is a decrease in the equilibrium quantity of Postal Services (Q3). This is easy to see graphically, since Q3 is to the left of Q0.Effect on Price: The overall effect on price is more complicated. The effect of higher labor compensation on Postal Services, because it raises the cost of production, is to increase the equilibrium price. The effect of a change in tastes away from snail mail is to decrease the equilibrium price. Since the two effects are in opposite directions, unless we know the magnitudes of the two effects, the overall effect is unclear. This is not unusual. When both curves shift, typically we can determine the overall effect on price or on quantity, but not on both. In this case, we determined the overall effect on the equilibrium quantity, but not on the equilibrium price. In other cases, it might be the opposite.The next Clear It Up feature focuses on the difference between shifts of supply or demand and movements along a curve.\nClear It Up\n\n\nWhat is the difference between shifts of demand or supply versus movements along a demand or supply curve?\n\nOne common mistake in applying the demand and supply framework is to confuse the shift of a demand or a supply curve with movement along a demand or supply curve. As an example, consider a problem that asks whether a drought will increase or decrease the equilibrium quantity and equilibrium price of wheat. Lee, a student in an introductory economics class, might reason:\nWell, it is clear that a drought reduces supply, so I will shift back the supply curve, as in the shift from the original supply curve S0 to S1 on the diagram (Shift 1). The equilibrium moves from E0 to E1, the equilibrium quantity is lower and the equilibrium price is higher. Then, a higher price makes farmers more likely to supply the good, so the supply curve shifts right, as shows the shift from S1 to S2, shows on the diagram (Shift 2), so that the equilibrium now moves from E1 to E2. The higher price, however, also reduces demand and so causes demand to shift back, like the shift from the original demand curve, D0 to D1 on the diagram (labeled Shift 3), and the equilibrium moves from E2 to E3.\n\n\n\n\nFigure \n3.20\n \nShifts of Demand or Supply versus Movements along a Demand or Supply Curve \n \nA shift in one curve never causes a shift in the other curve. Rather, a shift in one curve causes a movement along the second curve.\n\n\nAt about this point, Lee suspects that this answer is headed down the wrong path. Think about what might be wrong with Lees logic, and then read the answer that follows.\nAnswer: Lees first step is correct: that is, a drought shifts back the supply curve of wheat and leads to a prediction of a lower equilibrium quantity and a higher equilibrium price. This corresponds to a movement along the original demand curve (D0), from E0 to E1. The rest of Lees argument is wrong, because it mixes up shifts in supply with quantity supplied, and shifts in demand with quantity demanded. A higher or lower price never shifts the supply curve, as suggested by the shift in supply from S1 to S2. Instead, a price change leads to a movement along a given supply curve. Similarly, a higher or lower price never shifts a demand curve, as suggested in the shift from D0 to D1. Instead, a price change leads to a movement along a given demand curve. Remember, a change in the price of a good never causes the demand or supply curve for that good to shift.\nThink carefully about the timeline of events: What happens first, what happens next? What is cause, what is effect? If you keep the order right, you are more likely to get the analysis correct.\n\nIn the four-step analysis of how economic events affect equilibrium price and quantity, the movement from the old to the new equilibrium seems immediate. As a practical matter, however, prices and quantities often do not zoom straight to equilibrium. More realistically, when an economic event causes demand or supply to shift, prices and quantities set off in the general direction of equilibrium. Even as they are moving toward one new equilibrium, a subsequent change in demand or supply often pushes prices toward another equilibrium.\n", "03-4": "By the end of this section, you will be able to:\nExplain price controls, price ceilings, and price floors\nAnalyze demand and supply as a social adjustment mechanism\n\nTo this point in the chapter, we have been assuming that markets are free, that is, they operate with no government intervention. In this section, we will explore the outcomes, both anticipated and otherwise, when government does intervene in a market either to prevent the price of some good or service from rising too high or to prevent the price of some good or service from falling too low.  Economists believe there are a small number of fundamental principles that explain how economic agents respond in different situations. Two of these principles, which we have already introduced, are the laws of demand and supply.\nGovernments can pass laws affecting market outcomes, but no law can negate these economic principles. Rather, the principles will become apparent in sometimes unexpected ways, which may undermine the intent of the government policy. This is one of the major conclusions of this section.Controversy sometimes surrounds the prices and quantities established by demand and supply, especially for products that are considered necessities. In some cases, discontent over prices turns into public pressure on politicians, who may then pass legislation to prevent a certain price from climbing too high or falling too low.\nThe demand and supply model shows how people and firms will react to the incentives that these laws provide to control prices, in ways that will often lead to undesirable consequences. Alternative policy tools can often achieve the desired goals of price control laws, while avoiding at least some of their costs and tradeoffs.Price Ceilings\nLaws that government enact to regulate prices are called price controls. Price controls come in two flavors. A price ceiling keeps a price from rising above a certain level (the ceiling), while a price floor keeps a price from falling below a given level (the floor). This section uses the demand and supply framework to analyze price ceilings. The next section discusses price floors.A price ceiling is a legal maximum price that one pays for some good or service.  A government imposes price ceilings in order to keep the price of some necessary good or service affordable.  For example, in 2005 during Hurricane Katrina, the price of bottled water increased above $5 per gallon.  As a result, many people called for price controls on bottled water to prevent the price from rising so high.  In this particular case, the government did not impose a price ceiling, but there are other examples of where price ceilings did occur.In many markets for goods and services, demanders outnumber suppliers. Consumers, who are also potential voters, sometimes unite behind a political proposal to hold down a certain price. In some cities, such as Albany, renters have pressed political leaders to pass rent control laws, a price ceiling that usually works by stating that landlords can raise rents by only a certain maximum percentage each year. Some of the best examples of rent control occur in urban areas such as New York, Washington D.C., or San Francisco. Rent control becomes a politically hot topic when rents begin to rise rapidly. Everyone needs an affordable place to live. Perhaps a change in tastes makes a certain suburb or town a more popular place to live. Perhaps locally-based businesses expand, bringing higher incomes and more people into the area. Such changes can cause a change in the demand for rental housing, as Figure 3.21 illustrates. The original equilibrium (E0) lies at the intersection of supply curve S0 and demand curve D0, corresponding to an equilibrium price of $500 and an equilibrium quantity of 15,000 units of rental housing. The effect of greater income or a change in tastes is to shift the demand curve for rental housing to the right, as the data in Table 3.7 shows and the shift from D0 to D1 on the graph. In this market, at the new equilibrium E1, the price of a rental unit would rise to $600 and the equilibrium quantity would increase to 17,000 units.\n\n\n\n\nFigure \n3.21\n \nA Price Ceiling ExampleRent Control \n \nThe original intersection of demand and supply occurs at E0. If demand shifts from D0 to D1, the new equilibrium would be at E1unless a price ceiling prevents the price from rising. If the price is not permitted to rise, the quantity supplied remains at 15,000. However, after the change in demand, the quantity demanded rises to 19,000, resulting in a shortage.\n\n\n\n\nPrice\nOriginal Quantity Supplied\nOriginal Quantity Demanded\nNew Quantity Demanded\n\n\n\n$400\n12,000\n18,000\n23,000\n\n\n$500\n15,000\n15,000\n19,000\n\n\n$600\n17,000\n13,000\n17,000\n\n\n$700\n19,000\n11,000\n15,000\n\n\n$800\n20,000\n10,000\n14,000\n\n\nTable \n3.7\n \nRent Control\n \n\n\nSuppose that a city government passes a rent control law to keep the price at the original equilibrium of $500 for a typical apartment. In Figure 3.21, the horizontal line at the price of $500 shows the legally fixed maximum price set by the rent control law. However, the underlying forces that shifted the demand curve to the right are still there. At that price ($500), the quantity supplied remains at the same 15,000 rental units, but the quantity demanded is 19,000 rental units. In other words, the quantity demanded exceeds the quantity supplied, so there is a shortage of rental housing. One of the ironies of price ceilings is that while the price ceiling was intended to help renters, there are actually fewer apartments rented out under the price ceiling (15,000 rental units) than would be the case at the market rent of $600 (17,000 rental units).Price ceilings do not simply benefit renters at the expense of landlords. Rather, some renters (or potential renters) lose their housing as landlords convert apartments to co-ops and condos. Even when the housing remains in the rental market, landlords tend to spend less on maintenance and on essentials like heating, cooling, hot water, and lighting. The first rule of economics is you do not get something for nothingeverything has an opportunity cost. Thus, if renters obtain cheaper housing than the market requires, they tend to also end up with lower quality housing.Price ceilings are enacted in an attempt to keep prices low for those who need the product. However, when the market price is not allowed to rise to the equilibrium level, quantity demanded exceeds quantity supplied, and thus a shortage occurs. Those who manage to purchase the product at the lower price given by the price ceiling will benefit, but sellers of the product will suffer, along with those who are not able to purchase the product at all. Quality is also likely to deteriorate.\nPrice Floors\nA price floor is the lowest price that one can legally pay for some good or service. Perhaps the best-known example of a price floor is the minimum wage, which is based on the view that someone working full time should be able to afford a basic standard of living. The federal minimum wage in 2016 was $7.25 per hour, although some states and localities have a higher minimum wage. The federal minimum wage yields an annual income for a single person of $15,080, which is slightly higher than the Federal poverty line of $11,880. As the cost of living rises over time, the Congress periodically raises the federal minimum wage.Price floors are sometimes called price supports, because they support a price by preventing it from falling below a certain level. Around the world, many countries have passed laws to create agricultural price supports. Farm prices and thus farm incomes fluctuate, sometimes widely. Even if, on average, farm incomes are adequate, some years they can be quite low. The purpose of price supports is to prevent these swings.The most common way price supports work is that the government enters the market and buys up the product, adding to demand to keep prices higher than they otherwise would be. According to the Common Agricultural Policy reform passed in 2013, the European Union (EU) will spend about 60 billion euros per year, or 67 billion dollars per year (with the November 2016 exchange rate), or roughly 38% of the EU budget, on price supports for Europes farmers from 2014 to 2020.Figure 3.22 illustrates the effects of a government program that assures a price above the equilibrium by focusing on the market for wheat in Europe. In the absence of government intervention, the price would adjust so that the quantity supplied would equal the quantity demanded at the equilibrium point E0, with price P0 and quantity Q0. However, policies to keep prices high for farmers keeps the price above what would have been the market equilibrium levelthe price Pf shown by the dashed horizontal line in the diagram. The result is a quantity supplied in excess of the quantity demanded (Qd). When quantity supplied exceeds quantity demanded, a surplus exists.\nEconomists estimate that the high-income areas of the world, including the United States, Europe, and Japan, spend roughly $1 billion per day in supporting their farmers. If the government is willing to purchase the excess supply (or to provide payments for others to purchase it), then farmers will benefit from the price floor, but taxpayers and consumers of food will pay the costs. Agricultural economists and policy makers have offered numerous proposals for reducing farm subsidies. In many countries, however, political support for subsidies for farmers remains strong. This is either because the population views this as supporting the traditional rural way of life or because of industry's lobbying power of the agro-business.\n\n\n\n\nFigure \n3.22\n \nEuropean Wheat Prices: A Price Floor Example \n \nThe intersection of demand (D) and supply (S) would be at the equilibrium point E0. However, a price floor set at Pf holds the price above E0 and prevents it from falling. The result of the price floor is that the quantity supplied Qs exceeds the quantity demanded Qd. There is excess supply, also called a surplus.\n\n\n\n", "03-5": "By the end of this section, you will be able to:\nContrast consumer surplus, producer surplus, and social surplus\n  Explain why price floors and price ceilings can be inefficient\n Analyze demand and supply as a social adjustment mechanism\n\nThe familiar demand and supply diagram holds within it the concept of economic efficiency. One typical way that economists define efficiency is when it is impossible to improve the situation of one party without imposing a cost on another. Conversely, if a situation is inefficient, it becomes possible to benefit at least one party without imposing costs on others.Efficiency in the demand and supply model has the same basic meaning: The economy is getting as much benefit as possible from its scarce resources and all the possible gains from trade have been achieved. In other words, the optimal amount of each good and service is produced and consumed.Consumer Surplus, Producer Surplus, Social Surplus\nConsider a market for tablet computers, as Figure 3.23 shows. The equilibrium price is $80 and the equilibrium quantity is 28 million. To see the benefits to consumers, look at the segment of the demand curve above the equilibrium point and to the left. This portion of the demand curve shows that at least some demanders would have been willing to pay more than $80 for a tablet.For example, point J shows that if the price were $90, 20 million tablets would be sold. Those consumers who would have been willing to pay $90 for a tablet based on the utility they expect to receive from it, but who were able to pay the equilibrium price of $80, clearly received a benefit beyond what they had to pay. Remember, the demand curve traces consumers willingness to pay for different quantities. The amount that individuals would have been willing to pay, minus the amount that they actually paid, is called consumer surplus. Consumer surplus is the area labeled Fthat is, the area above the market price and below the demand curve.\n\n\n\n\nFigure \n3.23\n \nConsumer and Producer Surplus \n \nThe somewhat triangular area labeled by F shows the area of consumer surplus, which shows that the equilibrium price in the market was less than what many of the consumers were willing to pay. Point J on the demand curve shows that, even at the price of $90, consumers would have been willing to purchase a quantity of 20 million. The somewhat triangular area labeled by G shows the area of producer surplus, which shows that the equilibrium price received in the market was more than what many of the producers were willing to accept for their products. For example, point K on the supply curve shows that at a price of $45, firms would have been willing to supply a quantity of 14 million.\n\n\nThe supply curve shows the quantity that firms are willing to supply at each price. For example, point K in Figure 3.23 illustrates that, at $45, firms would still have been willing to supply a quantity of 14 million. Those producers who would have been willing to supply the tablets at $45, but who were instead able to charge the equilibrium price of $80, clearly received an extra benefit beyond what they required to supply the product. The extra benefit producers receive from selling a good or service, measured by the price the producer actually received minus the price the producer would have been willing to accept is called producer surplus. In Figure 3.23, producer surplus is the area labeled Gthat is, the area between the market price and the segment of the supply curve below the equilibrium.The sum of consumer surplus and producer surplus is social surplus, also referred to as economic surplus or total surplus. In Figure 3.23 we show social surplus as the area F + G. Social surplus is larger at equilibrium quantity and price than it would be at any other quantity. This demonstrates the economic efficiency of the market equilibrium. In addition, at the efficient level of output, it is impossible to produce greater consumer surplus without reducing producer surplus, and it is impossible to produce greater producer surplus without reducing consumer surplus.\nInefficiency of Price Floors and Price Ceilings\nThe imposition of a price floor or a price ceiling will prevent a market from adjusting to its equilibrium price and quantity, and thus will create an inefficient outcome. However, there is an additional twist here. Along with creating inefficiency, price floors and ceilings will also transfer some consumer surplus to producers, or some producer surplus to consumers.Imagine that several firms develop a promising but expensive new drug for treating back pain. If this therapy is left to the market, the equilibrium price will be $600 per month and 20,000 people will use the drug, as shown in Figure 3.24 (a). The original level of consumer surplus is T + U and producer surplus is V + W + X. However, the government decides to impose a price ceiling of $400 to make the drug more affordable. At this price ceiling, firms in the market now produce only 15,000.\nAs a result, two changes occur. First, an inefficient outcome occurs and the total surplus of society is reduced. The loss in social surplus that occurs when the economy produces at an inefficient quantity is called deadweight loss. In a very real sense, it is like money thrown away that benefits no one. In Figure 3.24 (a), the deadweight loss is the area U + W. When deadweight loss exists, it is possible for both consumer and producer surplus to be higher, in this case because the price control is blocking some suppliers and demanders from transactions they would both be willing to make.A second change from the price ceiling is that some of the producer surplus is transferred to consumers. After the price ceiling is imposed, the new consumer surplus is T + V, while the new producer surplus is X. In other words, the price ceiling transfers the area of surplus (V) from producers to consumers. Note that the gain to consumers is less than the loss to producers, which is just another way of seeing the deadweight loss.\n\n\n\n\n\nFigure \n3.24\n \nEfficiency and Price Floors and Ceilings \n \n(a) The original equilibrium price is $600 with a quantity of 20,000. Consumer surplus is T + U, and producer surplus is V + W + X. A price ceiling is imposed at $400, so firms in the market now produce only a quantity of 15,000. As a result, the new consumer surplus is T + V, while the new producer surplus is X. (b) The original equilibrium is $8 at a quantity of 1,800. Consumer surplus is G + H + J, and producer surplus is I + K. A price floor is imposed at $12, which means that quantity demanded falls to 1,400. As a result, the new consumer surplus is G, and the new producer surplus is H + I.\n\n\nFigure 3.24 (b) shows a price floor example using a string of struggling movie theaters, all in the same city. The current equilibrium is $8 per movie ticket, with 1,800 people attending movies. The original consumer surplus is G + H + J, and producer surplus is I + K. The city government is worried that movie theaters will go out of business, reducing the entertainment options available to citizens, so it decides to impose a price floor of $12 per ticket. As a result, the quantity demanded of movie tickets falls to 1,400. The new consumer surplus is G, and the new producer surplus is H + I. In effect, the price floor causes the area H to be transferred from consumer to producer surplus, but also causes a deadweight loss of J + K.\nThis analysis shows that a price ceiling, like a law establishing rent controls, will transfer some producer surplus to consumerswhich helps to explain why consumers often favor them. Conversely, a price floor like a guarantee that farmers will receive a certain price for their crops will transfer some consumer surplus to producers, which explains why producers often favor them. However, both price floors and price ceilings block some transactions that buyers and sellers would have been willing to make, and creates deadweight loss. Removing such barriers, so that prices and quantities can adjust to their equilibrium level, will increase the economys social surplus.\n\nDemand and Supply as a Social Adjustment Mechanism\nThe demand and supply model emphasizes that prices are not set only by demand or only by supply, but by the interaction between the two. In 1890, the famous economist Alfred Marshall wrote that asking whether supply or demand determined a price was like arguing whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper. The answer is that both blades of the demand and supply scissors are always involved.\nThe adjustments of equilibrium price and quantity in a market-oriented economy often occur without much government direction or oversight. If the coffee crop in Brazil suffers a terrible frost, then the supply curve of coffee shifts to the left and the price of coffee rises. Some peoplecall them the coffee addictscontinue to drink coffee and pay the higher price. Others switch to tea or soft drinks. No government commission is needed to figure out how to adjust coffee prices, which companies will be allowed to process the remaining supply, which supermarkets in which cities will get how much coffee to sell, or which consumers will ultimately be allowed to drink the brew. Such adjustments in response to price changes happen all the time in a market economy, often so smoothly and rapidly that we barely notice them.\nThink for a moment of all the seasonal foods that are available and inexpensive at certain times of the year, like fresh corn in midsummer, but more expensive at other times of the year. People alter their diets and restaurants alter their menus in response to these fluctuations in prices without fuss or fanfare. For both the U.S. economy and the world economy as a whole, marketsthat is, demand and supplyare the primary social mechanism for answering the basic questions about what is produced, how it is produced, and for whom it is produced.\n\nBring It Home\n\n\nWhy Can We Not Get Enough of Organic?\n\nOrganic food is grown without synthetic pesticides, chemical fertilizers or genetically modified seeds. In recent decades, the demand for organic products has increased dramatically. The Organic Trade Association reported sales increased from $1 billion in 1990 to $35.1 billion in 2013, more than 90% of which were sales of food products.Why, then, are organic foods more expensive than their conventional counterparts? The answer is a clear application of the theories of supply and demand. As people have learned more about the harmful effects of chemical fertilizers, growth hormones, pesticides and the like from large-scale factory farming, our tastes and preferences for safer, organic foods have increased. This change in tastes has been reinforced by increases in income, which allow people to purchase pricier products, and has made organic foods more mainstream. This has led to an increased demand for organic foods. Graphically, the demand curve has shifted right, and we have moved up the supply curve as producers have responded to the higher prices by supplying a greater quantity.\nIn addition to the movement along the supply curve, we have also had an increase in the number of farmers converting to organic farming over time. This is represented by a shift to the right of the supply curve. Since both demand and supply have shifted to the right, the resulting equilibrium quantity of organic foods is definitely higher, but the price will only fall when the increase in supply is larger than the increase in demand. We may need more time before we see lower prices in organic foods. Since the production costs of these foods may remain higher than conventional farming, because organic fertilizers and pest management techniques are more expensive, they may never fully catch up with the lower prices of non-organic foods.\nAs a final, specific example: The Environmental Working Groups Dirty Dozen list of fruits and vegetables, which test high for pesticide residue even after washing, was released in April 2013. The inclusion of strawberries on the list has led to an increase in demand for organic strawberries, resulting in both a higher equilibrium price and quantity of sales.\n\n\n", "04-1": "By the end of this section, you will be able to:\nPredict shifts in the demand and supply curves of the labor market\nExplain the impact of new technology on the demand and supply curves of the labor market\nExplain price floors in the labor market such as minimum wage or a living wage\n\nMarkets for labor have demand and supply curves, just like markets for goods. The law of demand applies in labor markets this way: A higher salary or wagethat is, a higher price in the labor marketleads to a decrease in the quantity of labor demanded by employers, while a lower salary or wage leads to an increase in the quantity of labor demanded. The law of supply functions in labor markets, too: A higher price for labor leads to a higher quantity of labor supplied; a lower price leads to a lower quantity supplied.Equilibrium in the Labor Market\nIn 2015, about 35,000 registered nurses worked in the Minneapolis-St. Paul-Bloomington, Minnesota-Wisconsin metropolitan area, according to the BLS. They worked for a variety of employers: hospitals, doctors offices, schools, health clinics, and nursing homes.\nFigure 4.2 illustrates how demand and supply determine equilibrium in this labor market. The demand and supply schedules in Table 4.1 list the quantity supplied and quantity demanded of nurses at different salaries.\n\n\n\nFigure \n4.2\n \nLabor Market Example: Demand and Supply for Nurses in Minneapolis-St. Paul-Bloomington\n \nThe demand curve (D) of those employers who want to hire nurses intersects with the supply curve (S) of those who are qualified and willing to work as nurses at the equilibrium point (E). The equilibrium salary is $70,000 and the equilibrium quantity is 34,000 nurses. At an above-equilibrium salary of $75,000, quantity supplied increases to 38,000, but the quantity of nurses demanded at the higher pay declines to 33,000. At this above-equilibrium salary, an excess supply or surplus of nurses would exist. At a below-equilibrium salary of $60,000, quantity supplied declines to 27,000, while the quantity demanded at the lower wage increases to 40,000 nurses. At this below-equilibrium salary, excess demand or a shortage exists.\n\n\n\nAnnual Salary\nQuantity Demanded\nQuantity Supplied\n\n\n\n$55,000\n45,000\n20,000\n\n\n$60,000\n40,000\n27,000\n\n\n$65,000\n37,000\n31,000\n\n\n$70,000\n34,000\n34,000\n\n\n$75,000\n33,000\n38,000\n\n\n$80,000\n32,000\n41,000\n\n\nTable \n4.1\n \nDemand and Supply of Nurses in Minneapolis-St. Paul-Bloomington\n \n\nThe horizontal axis shows the quantity of nurses hired. In this example we measure labor by number of workers, but another common way to measure the quantity of labor is by the number of hours worked. The vertical axis shows the price for nurses laborthat is, how much they are paid. In the real world, this price would be total labor compensation: salary plus benefits. It is not obvious, but benefits are a significant part (as high as 30 percent) of labor compensation. In this example we measure the price of labor by salary on an annual basis, although in other cases we could measure the price of labor by monthly or weekly pay, or even the wage paid per hour. As the salary for nurses rises, the quantity demanded will fall. Some hospitals and nursing homes may reduce the number of nurses they hire, or they may lay off some of their existing nurses, rather than pay them higher salaries. Employers who face higher nurses salaries may also try to replace some nursing functions by investing in physical equipment, like computer monitoring and diagnostic systems to monitor patients, or by using lower-paid health care aides to reduce the number of nurses they need.As the salary for nurses rises, the quantity supplied will rise. If nurses salaries in Minneapolis-St. Paul-Bloomington are higher than in other cities, more nurses will move to Minneapolis-St. Paul-Bloomington to find jobs, more people will be willing to train as nurses, and those currently trained as nurses will be more likely to pursue nursing as a full-time job. In other words, there will be more nurses looking for jobs in the area.At equilibrium, the quantity supplied and the quantity demanded are equal. Thus, every employer who wants to hire a nurse at this equilibrium wage can find a willing worker, and every nurse who wants to work at this equilibrium salary can find a job. In Figure 4.2, the supply curve (S) and demand curve (D) intersect at the equilibrium point (E). The equilibrium quantity of nurses in the Minneapolis-St. Paul-Bloomington area is 34,000, and the equilibrium salary is $70,000 per year. This example simplifies the nursing market by focusing on the average nurse. In reality, of course, the market for nurses actually comprises many smaller markets, like markets for nurses with varying degrees of experience and credentials. Many markets contain closely related products that differ in quality. For instance, even a simple product like gasoline comes in regular, premium, and super-premium, each with a different price. Even in such cases, discussing the average price of gasoline, like the average salary for nurses, can still be useful because it reflects what is happening in most of the submarkets.When the price of labor is not at the equilibrium, economic incentives tend to move salaries toward the equilibrium. For example, if salaries for nurses in Minneapolis-St. Paul-Bloomington were above the equilibrium at $75,000 per year, then 38,000 people want to work as nurses, but employers want to hire only 33,000 nurses. At that above-equilibrium salary, excess supply or a surplus results. In a situation of excess supply in the labor market, with many applicants for every job opening, employers will have an incentive to offer lower wages than they otherwise would have. Nurses salary will move down toward equilibrium.In contrast, if the salary is below the equilibrium at, say, $60,000 per year, then a situation of excess demand or a shortage arises. In this case, employers encouraged by the relatively lower wage want to hire 40,000 nurses, but only 27,000 individuals want to work as nurses at that salary in Minneapolis-St. Paul-Bloomington. In response to the shortage, some employers will offer higher pay to attract the nurses. Other employers will have to match the higher pay to keep their own employees. The higher salaries will encourage more nurses to train or work in Minneapolis-St. Paul-Bloomington. Again, price and quantity in the labor market will move toward equilibrium.\nShifts in Labor Demand\nThe demand curve for labor shows the quantity of labor employers wish to hire at any given salary or wage rate, under the ceteris paribus assumption. A change in the wage or salary will result in a change in the quantity demanded of labor. If the wage rate increases, employers will want to hire fewer employees. The quantity of labor demanded will decrease, and there will be a movement upward along the demand curve. If the wages and salaries decrease, employers are more likely to hire a greater number of workers. The quantity of labor demanded will increase, resulting in a downward movement along the demand curve.Shifts in the demand curve for labor occur for many reasons. One key reason is that the demand for labor is based on the demand for the good or service that is produced. For example, the more new automobiles consumers demand, the greater the number of workers automakers will need to hire. Therefore the demand for labor is called a derived demand. Here are some examples of derived demand for labor:\nThe demand for chefs is dependent on the demand for restaurant meals.\nThe demand for pharmacists is dependent on the demand for prescription drugs.\nThe demand for attorneys is dependent on the demand for legal services.\n\nAs the demand for the goods and services increases, the demand for labor will increase, or shift to the right, to meet employers production requirements. As the demand for the goods and services decreases, the demand for labor will decrease, or shift to the left. Table 4.2 shows that in addition to the derived demand for labor, demand can also increase or decrease (shift) in response to several factors.\n\n\nFactors\nResults\n\n\n\nDemand for Output\nWhen the demand for the good produced (output) increases, both the output price and profitability increase. As a result, producers demand more labor to ramp up production.\n\n\nEducation and Training\nA well-trained and educated workforce causes an increase in the demand for that labor by employers. Increased levels of productivity within the workforce will cause the demand for labor to shift to the right. If the workforce is not well-trained or educated, employers will not hire from within that labor pool, since they will need to spend a significant amount of time and money training that workforce. Demand for such will shift to the left.\n\n\nTechnology\nTechnology changes can act as either substitutes for or complements to labor. When technology acts as a substitute, it replaces the need for the number of workers an employer needs to hire. For example, word processing decreased the number of typists needed in the workplace. This shifted the demand curve for typists left. An increase in the availability of certain technologies may increase the demand for labor. Technology that acts as a complement to labor will increase the demand for certain types of labor, resulting in a rightward shift of the demand curve. For example, the increased use of word processing and other software has increased the demand for information technology professionals who can resolve software and hardware issues related to a firms network. More and better technology will increase demand for skilled workers who know how to use technology to enhance workplace productivity. Those workers who do not adapt to changes in technology will experience a decrease in demand.\n\n\nNumber of Companies\nAn increase in the number of companies producing a given product will increase the demand for labor resulting in a shift to the right. A decrease in the number of companies producing a given product will decrease the demand for labor resulting in a shift to the left.\n\n\nGovernment Regulations\nComplying with government regulations can increase or decrease the demand for labor at any given wage. In the healthcare industry, government rules may require that nurses be hired to carry out certain medical procedures. This will increase the demand for nurses. Less-trained healthcare workers would be prohibited from carrying out these procedures, and the demand for these workers will shift to the left.\n\n\nPrice and Availability of Other Inputs\nLabor is not the only input into the production process. For example, a salesperson at a call center needs a telephone and a computer terminal to enter data and record sales. If prices of other inputs fall, production will become more profitable and suppliers will demand more labor to increase production.  This will cause a rightward shift in the demand curve for labor. The opposite is also true. Higher prices for other inputs lower demand for labor.\n\n\nTable \n4.2\n \nFactors That Can Shift Demand\n \n\n\nLink It Up\n\nClick here to read more about Trends and Challenges for Work in the 21st Century.\n\nShifts in Labor Supply\nThe supply of labor is upward-sloping and adheres to the law of supply: The higher the price, the greater the quantity supplied and the lower the price, the less quantity supplied. The supply curve models the tradeoff between supplying labor into the market or using time in leisure activities at every given price level. The higher the wage, the more labor is willing to work and forego leisure activities. Table 4.3 lists some of the factors that will cause the supply to increase or decrease.\n\n\nFactors\nResults\n\n\n\nNumber of Workers\nAn increased number of workers will cause the supply curve to shift to the right. An increased number of workers can be due to several factors, such as immigration, increasing population, an aging population, and changing demographics. Policies that encourage immigration will increase the supply of labor, and vice versa. Population grows when birth rates exceed death rates. This eventually increases supply of labor when the former reach working age. An aging and therefore retiring population will decrease the supply of labor. Another example of changing demographics is more women working outside of the home, which increases the supply of labor.\n\n\nRequired Education\nThe more required education, the lower the supply. There is a lower supply of PhD mathematicians than of high school mathematics teachers; there is a lower supply of cardiologists than of primary care physicians; and there is a lower supply of physicians than of nurses.\n\n\nGovernment Policies \nGovernment policies can also affect the supply of labor for jobs. Alternatively, the government may support rules that set high qualifications for certain jobs: academic training, certificates or licenses, or experience. When these qualifications are made tougher, the number of qualified workers will decrease at any given wage. On the other hand, the government may also subsidize training or even reduce the required level of qualifications. For example, government might offer subsidies for nursing schools or nursing students. Such provisions would shift the supply curve of nurses to the right. In addition, government policies that change the relative desirability of working versus not working also affect the labor supply. These include unemployment benefits, maternity leave, child care benefits, and welfare policy. For example, child care benefits may increase the labor supply of working mothers. Long term unemployment benefits may discourage job searching for unemployed workers. All these policies must therefore be carefully designed to minimize any negative labor supply effects.\n\n\nTable \n4.3\n \nFactors that Can Shift Supply\n \n\nA change in salary will lead to a movement along labor demand or labor supply curves, but it will not shift those curves. However, other events like those we have outlined here will cause either the demand or the supply of labor to shift, and thus will move the labor market to a new equilibrium salary and quantity.\nTechnology and Wage Inequality: The Four-Step Process\nEconomic events can change the equilibrium salary (or wage) and quantity of labor. Consider how the wave of new information technologies, like computer and telecommunications networks, has affected low-skill and high-skill workers in the U.S. economy. From the perspective of employers who demand labor, these new technologies are often a substitute for low-skill laborers like file clerks who used to keep file cabinets full of paper records of transactions. However, the same new technologies are a complement to high-skill workers like managers, who benefit from the technological advances by having the ability to monitor more information, communicate more easily, and juggle a wider array of responsibilities. How will the new technologies affect the wages of high-skill and low-skill workers? For this question, the four-step process of analyzing how shifts in supply or demand affect a market (introduced in Demand and Supply) works in this way:Step 1. What did the markets for low-skill labor and high-skill labor look like before the arrival of the new technologies? In Figure 4.3 (a) and Figure 4.3 (b), S0 is the original supply curve for labor and D0 is the original demand curve for labor in each market. In each graph, the original point of equilibrium, E0, occurs at the price W0 and the quantity Q0.\n\n\n\nFigure \n4.3\n \nTechnology and Wages: Applying Demand and Supply \n \n(a) The demand for low-skill labor shifts to the left when technology can do the job previously done by these workers. (b) New technologies can also increase the demand for high-skill labor in fields such as information technology and network administration.\n\nStep 2. Does the new technology affect the supply of labor from households or the demand for labor from firms? The technology change described here affects demand for labor by firms that hire workers.\nStep 3. Will the new technology increase or decrease demand? Based on the description earlier, as the substitute for low-skill labor becomes available, demand for low-skill labor will shift to the left, from D0 to D1. As the technology complement for high-skill labor becomes cheaper, demand for high-skill labor will shift to the right, from D0 to D1.Step 4. The new equilibrium for low-skill labor, shown as point E1 with price W1 and quantity Q1, has a lower wage and quantity hired than the original equilibrium, E0. The new equilibrium for high-skill labor, shown as point E1 with price W1 and quantity Q1, has a higher wage and quantity hired than the original equilibrium (E0).\nThus, the demand and supply model predicts that the new computer and communications technologies will raise the pay of high-skill workers but reduce the pay of low-skill workers. From the 1970s to the mid-2000s, the wage gap widened between high-skill and low-skill labor. According to the National Center for Education Statistics, in 1980, for example, a college graduate earned about 30% more than a high school graduate with comparable job experience, but by 2014, a college graduate earned about 66% more than an otherwise comparable high school graduate. Many economists believe that the trend toward greater wage inequality across the U.S. economy is due to improvements in technology.\n\nLink It Up\n\nVisit this website to read about ten tech skills that have lost relevance in todays workforce.\n\nPrice Floors in the Labor Market: Living Wages and Minimum Wages\nIn contrast to goods and services markets, price ceilings are rare in labor markets, because rules that prevent people from earning income are not politically popular. There is one exception: boards of trustees or stockholders, as an example, propose limits on the high incomes of top business executives.The labor market, however, presents some prominent examples of price floors, which are an attempt to increase the wages of low-paid workers. The U.S. government sets a minimum wage, a price floor that makes it illegal for an employer to pay employees less than a certain hourly rate. In mid-2009, the U.S. minimum wage was raised to $7.25 per hour. Local political movements in a number of U.S. cities have pushed for a higher minimum wage, which they call a living wage. Promoters of living wage laws maintain that the minimum wage is too low to ensure a reasonable standard of living. They base this conclusion on the calculation that, if you work 40 hours a week at a minimum wage of $7.25 per hour for 50 weeks a year, your annual income is $14,500, which is less than the official U.S. government definition of what it means for a family to be in poverty. (A family with two adults earning minimum wage and two young children will find it more cost efficient for one parent to provide childcare while the other works for income. Thus the family income would be $14,500, which is significantly lower than the federal poverty line for a family of four, which was $24,250 in 2015.)Supporters of the living wage argue that full-time workers should be assured a high enough wage so that they can afford the essentials of life: food, clothing, shelter, and healthcare. Since Baltimore passed the first living wage law in 1994, several dozen cities enacted similar laws in the late 1990s and the 2000s. The living wage ordinances do not apply to all employers, but they have specified that all employees of the city or employees of firms that the city hires be paid at least a certain wage that is usually a few dollars per hour above the U.S. minimum wage.Figure 4.4 illustrates the situation of a city considering a living wage law. For simplicity, we assume that there is no federal minimum wage. The wage appears on the vertical axis, because the wage is the price in the labor market. Before the passage of the living wage law, the equilibrium wage is $10 per hour and the city hires 1,200 workers at this wage. However, a group of concerned citizens persuades the city council to enact a living wage law requiring employers to pay no less than $12 per hour. In response to the higher wage, 1,600 workers look for jobs with the city. At this higher wage, the city, as an employer, is willing to hire only 700 workers. At the price floor, the quantity supplied exceeds the quantity demanded, and a surplus of labor exists in this market. For workers who continue to have a job at a higher salary, life has improved. For those who were willing to work at the old wage rate but lost their jobs with the wage increase, life has not improved. Table 4.4 shows the differences in supply and demand at different wages.\n\n\n\nFigure \n4.4\n \nA Living Wage: Example of a Price Floor \n \nThe original equilibrium in this labor market is a wage of $10/hour and a quantity of 1,200 workers, shown at point E. Imposing a wage floor at $12/hour leads to an excess supply of labor. At that wage, the quantity of labor supplied is 1,600 and the quantity of labor demanded is only 700.\n\n\n\nWage\nQuantity Labor Demanded\nQuantity Labor Supplied\n\n\n\n$8/hr\n1,900\n500\n\n\n$9/hr\n1,500\n900\n\n\n$10/hr\n1,200\n1,200\n\n\n$11/hr\n900\n1,400\n\n\n$12/hr\n700\n1,600\n\n\n$13/hr\n500\n1,800\n\n\n$14/hr\n400\n1,900\n\n\nTable \n4.4\n \nLiving Wage: Example of a Price Floor\n \n\n\n\nThe Minimum Wage as an Example of a Price Floor\nThe U.S. minimum wage is a price floor that is set either very close to the equilibrium wage or even slightly below it. About 1% of American workers are actually paid the minimum wage. In other words, the vast majority of the U.S. labor force has its wages determined in the labor market, not as a result of the government price floor. However, for workers with low skills and little experience, like those without a high school diploma or teenagers, the minimum wage is quite important. In many cities, the federal minimum wage is apparently below the market price for unskilled labor, because employers offer more than the minimum wage to checkout clerks and other low-skill workers without any government prodding.Economists have attempted to estimate how much the minimum wage reduces the quantity demanded of low-skill labor. A typical result of such studies is that a 10% increase in the minimum wage would decrease the hiring of unskilled workers by 1 to 2%, which seems a relatively small reduction. In fact, some studies have even found no effect of a higher minimum wage on employment at certain times and placesalthough these studies are controversial.\nLets suppose that the minimum wage lies just slightly below  the equilibrium wage level. Wages could fluctuate according to market forces above this price floor, but they would not be allowed to move beneath the floor. In this situation, the price floor minimum wage is nonbinding that is, the price floor is not determining the market outcome. Even if the minimum wage moves just a little higher, it will still have no effect on the quantity of employment in the economy, as long as it remains below the equilibrium wage. Even if the government increases minimum wage by enough so that it rises slightly above the equilibrium wage and becomes binding, there will be only a small excess supply gap between the quantity demanded and quantity supplied.These insights help to explain why U.S. minimum wage laws have historically had only a small impact on employment. Since the minimum wage has typically been set close to the equilibrium wage for low-skill labor and sometimes even below it, it has not had a large effect in creating an excess supply of labor. However, if the minimum wage increased dramaticallysay, if it doubled to match the living wages that some U.S. cities have consideredthen its impact on reducing the quantity demanded of employment would be far greater. As of 2017, many U.S. states are set to increase their minimum wage to $15 per hour.  We will see what happens. The following Clear It Up feature describes in greater detail some of the arguments for and against changes to minimum wage.\nClear It Up\n\n\nWhats the harm in raising the minimum wage?\n\nBecause of the law of demand, a higher required wage will reduce the amount of low-skill employment either in terms of employees or in terms of work hours. Although there is controversy over the numbers, lets say for the sake of the argument that a 10% rise in the minimum wage will reduce the employment of low-skill workers by 2%. Does this outcome mean that raising the minimum wage by 10% is bad public policy? Not necessarily.\nIf 98% of those receiving the minimum wage have a pay increase of 10%, but 2% of those receiving the minimum wage lose their jobs, are the gains for society as a whole greater than the losses? The answer is not clear, because job losses, even for a small group, may cause more pain than modest income gains for others. For one thing, we need to consider which minimum wage workers are losing their jobs. If the 2% of minimum wage workers who lose their jobs are struggling to support families, that is one thing. If those who lose their job are high school students picking up spending money over summer vacation, that is something else.\nAnother complexity is that many minimum wage workers do not work full-time for an entire year. Imagine a minimum wage worker who holds different part-time jobs for a few months at a time, with bouts of unemployment in between. The worker in this situation receives the 10% raise in the minimum wage when working, but also ends up working 2% fewer hours during the year because the higher minimum wage reduces how much employers want people to work. Overall, this workers income would rise because the 10% pay raise would more than offset the 2% fewer hours worked.\nOf course, these arguments do not prove that raising the minimum wage is necessarily a good idea either. There may well be other, better public policy options for helping low-wage workers. (The Poverty and Economic Inequality chapter discusses some possibilities.) The lesson from this maze of minimum wage arguments is that complex social problems rarely have simple answers. Even those who agree on how a proposed economic policy affects quantity demanded and quantity supplied may still disagree on whether the policy is a good idea.\n\n", "04-2": "By the end of this section, you will be able to:\nIdentify the demanders and suppliers in a financial market\nExplain how interest rates can affect supply and demand\nAnalyze the economic effects of U.S. debt in terms of domestic financial markets\nExplain the role of price ceilings and usury laws in the U.S.\n\nUnited States' households, institutions, and domestic businesses saved almost $1.3 trillion in 2015. Where did that savings go and how was it used? Some of the savings ended up in banks, which in turn loaned the money to individuals or businesses that wanted to borrow money. Some was invested in private companies or loaned to government agencies that wanted to borrow money to raise funds for purposes like building roads or mass transit. Some firms reinvested their savings in their own businesses.In this section, we will determine how the demand and supply model links those who wish to supply financial capital (i.e., savings) with those who demand financial capital (i.e., borrowing). Those who save money (or make financial investments, which is the same thing), whether individuals or businesses, are on the supply side of the financial market. Those who borrow money are on the demand side of the financial market. For a more detailed treatment of the different kinds of financial investments like bank accounts, stocks and bonds, see the Financial Markets chapter.Who Demands and Who Supplies in Financial Markets?\nIn any market, the price is what suppliers receive and what demanders pay. In financial markets, those who supply financial capital through saving expect to receive a rate of return, while those who demand financial capital by receiving funds expect to pay a rate of return. This rate of return can come in a variety of forms, depending on the type of investment.\nThe simplest example of a rate of return is the interest rate. For example, when you supply money into a savings account at a bank, you receive interest on your deposit. The interest the bank pays you as a percent of your deposits is the interest rate. Similarly, if you demand a loan to buy a car or a computer, you will need to pay interest on the money you borrow.Lets consider the market for borrowing money with credit cards. In 2015, almost 200 million Americans were cardholders. Credit cards allow you to borrow money from the card's issuer, and pay back the borrowed amount plus interest, although most allow you a period of time in which you can repay the loan without paying interest. A typical credit card interest rate ranges from 12% to 18% per year. In May 2016, Americans had about $943 billion outstanding in credit card debts. About half of U.S. families with credit cards report that they almost always pay the full balance on time, but one-quarter of U.S. families with credit cards say that they hardly ever pay off the card in full. In fact, in 2014, 56% of consumers carried an unpaid balance in the last 12 months. Lets say that, on average, the annual interest rate for credit card borrowing is 15% per year. Thus, Americans pay tens of billions of dollars every year in interest on their credit cardsplus basic fees for the credit card or fees for late payments.Figure 4.5 illustrates demand and supply in the financial market for credit cards. The horizontal axis of the financial market shows the quantity of money loaned or borrowed in this market. The vertical or price axis shows the rate of return, which in the case of credit card borrowing we can measure with an interest rate. Table 4.5 shows the quantity of financial capital that consumers demand at various interest rates and the quantity that credit card firms (often banks) are willing to supply.\n\n\n\nFigure \n4.5\n \nDemand and Supply for Borrowing Money with Credit Cards \n \nIn this market for credit card borrowing, the demand curve (D) for borrowing financial capital intersects the supply curve (S) for lending financial capital at equilibrium E. At the equilibrium, the interest rate (the price in this market) is 15% and the quantity of financial capital loaned and borrowed is $600 billion. The equilibrium price is where the quantity demanded and the quantity supplied are equal. At an above-equilibrium interest rate like 21%, the quantity of financial capital supplied would increase to $750 billion, but the quantity demanded would decrease to $480 billion. At a below-equilibrium interest rate like 13%, the quantity of financial capital demanded would increase to $700 billion, but the quantity of financial capital supplied would decrease to $510 billion.\n\n\n\nInterest Rate (%)\nQuantity of Financial Capital Demanded (Borrowing) ($ billions)\nQuantity of Financial Capital Supplied (Lending) ($ billions)\n\n\n\n11\n$800\n$420\n\n\n13\n$700\n$510\n\n\n15\n$600\n$600\n\n\n17\n$550\n$660\n\n\n19\n$500\n$720\n\n\n21\n$480\n$750\n\n\nTable \n4.5\n \nDemand and Supply for Borrowing Money with Credit Cards\n \n\n\nThe laws of demand and supply continue to apply in the financial markets. According to the law of demand, a higher rate of return (that is, a higher price) will decrease the quantity demanded. As the interest rate rises, consumers will reduce the quantity that they borrow. According to the law of supply, a higher price increases the quantity supplied. Consequently, as the interest rate paid on credit card borrowing rises, more firms will be eager to issue credit cards and to encourage customers to use them. Conversely, if the interest rate on credit cards falls, the quantity of financial capital supplied in the credit card market will decrease and the quantity demanded will increase.\nEquilibrium in Financial Markets\nIn the financial market for credit cards in Figure 4.5, the supply curve (S) and the demand curve (D) cross at the equilibrium point (E). The equilibrium occurs at an interest rate of 15%, where the quantity of funds demanded and the quantity supplied are equal at an equilibrium quantity of $600 billion.If the interest rate (remember, this measures the price in the financial market) is above the equilibrium level, then an excess supply, or a surplus, of financial capital will arise in this market. For example, at an interest rate of 21%, the quantity of funds supplied increases to $750 billion, while the quantity demanded decreases to $480 billion. At this above-equilibrium interest rate, firms are eager to supply loans to credit card borrowers, but relatively few people or businesses wish to borrow. As a result, some credit card firms will lower the interest rates (or other fees) they charge to attract more business. This strategy will push the interest rate down toward the equilibrium level.\nIf the interest rate is below the equilibrium, then excess demand or a shortage of funds occurs in this market. At an interest rate of 13%, the quantity of funds credit card borrowers demand increases to $700 billion, but the quantity credit card firms are willing to supply is only $510 billion. In this situation, credit card firms will perceive that they are overloaded with eager borrowers and conclude that they have an opportunity to raise interest rates or fees. The interest rate will face economic pressures to creep up toward the equilibrium level.The FRED database publishes some two dozen measures of interest rates, including interest rates on credit cards, automobile loans, personal loans, mortgage loans, and more. You can find these at the FRED website.\nShifts in Demand and Supply in Financial Markets\nThose who supply financial capital face two broad decisions: how much to save, and how to divide up their savings among different forms of financial investments. We will discuss each of these in turn.\nParticipants in financial markets must decide when they prefer to consume goods: now or in the future. Economists call this intertemporal decision making because it involves decisions across time. Unlike a decision about what to buy from the grocery store, people make investment or savings decisions across a period of time, sometimes a long period.Most workers save for retirement because their income in the present is greater than their needs, while the opposite will be true once they retire. Thus, they save today and supply financial markets. If their income increases, they save more. If their perceived situation in the future changes, they change the amount of their saving. For example, there is some evidence that Social Security, the program that workers pay into in order to qualify for government checks after retirement, has tended to reduce the quantity of financial capital that workers save. If this is true, Social Security has shifted the supply of financial capital at any interest rate to the left.By contrast, many college students need money today when their income is low (or nonexistent) to pay their college expenses. As a result, they borrow today and demand from financial markets. Once they graduate and become employed, they will pay back the loans. Individuals borrow money to purchase homes or cars. A business seeks financial investment so that it has the funds to build a factory or invest in a research and development project that will not pay off for five years, ten years, or even more. Thus, when consumers and businesses have greater confidence that they will be able to repay in the future, the quantity demanded of financial capital at any given interest rate will shift to the right.For example, in the technology boom of the late 1990s, many businesses became extremely confident that investments in new technology would have a high rate of return, and their demand for financial capital shifted to the right. Conversely, during the 2008 and 2009 Great Recession, their demand for financial capital at any given interest rate shifted to the left.To this point, we have been looking at saving in total. Now let us consider what affects saving in different types of financial investments. In deciding between different forms of financial investments, suppliers of financial capital will have to consider the rates of return and the risks involved. Rate of return is a positive attribute of investments, but risk is a negative. If Investment A becomes more risky, or the return diminishes, then savers will shift their funds to Investment Band the supply curve of financial capital for Investment A will shift back to the left while the supply curve of capital for Investment B shifts to the right.\n\nThe United States as a Global Borrower\nIn the global economy, trillions of dollars of financial investment cross national borders every year. In the early 2000s, financial investors from foreign countries were investing several hundred billion dollars per year more in the U.S. economy than U.S. financial investors were investing abroad. The following Work It Out deals with one of the macroeconomic concerns for the U.S. economy in recent years.\n\nWork It Out\n\n\nThe Effect of Growing U.S. Debt\nImagine that foreign investors viewed the U.S. economy as a less desirable place to put their money because of fears about the growth of the U.S. public debt. Using the four-step process for analyzing how changes in supply and demand affect equilibrium outcomes, how would increased U.S. public debt affect the equilibrium price and quantity for capital in U.S. financial markets?Step 1. Draw a diagram showing demand and supply for financial capital that represents the original scenario in which foreign investors are pouring money into the U.S. economy. Figure 4.6 shows a demand curve, D, and a supply curve, S, where the supply of capital includes the funds arriving from foreign investors. The original equilibrium E0 occurs at interest rate R0 and quantity of financial investment Q0.\n\n\n\nFigure \n4.6\n \nThe United States as a Global Borrower Before U.S. Debt Uncertainty \n \nThe graph shows the demand for financial capital from and supply of financial capital into the U.S. financial markets by the foreign sector before the increase in uncertainty regarding U.S. public debt. The original equilibrium (E0) occurs at an equilibrium rate of return (R0) and the equilibrium quantity is at Q0.\n\nStep 2. Will the diminished confidence in the U.S. economy as a place to invest affect demand or supply of financial capital? Yes, it will affect supply. Many foreign investors look to the U.S. financial markets to store their money in safe financial vehicles with low risk and stable returns. Diminished confidence means U.S. financial assets will be seen as more risky.Step 3. Will supply increase or decrease? When the enthusiasm of foreign investors for investing their money in the U.S. economy diminishes, the supply of financial capital shifts to the left. Figure 4.7 shows the supply curve shift from S0 to S1.\n\n\n\nFigure \n4.7\n \nThe United States as a Global Borrower Before and After U.S. Debt Uncertainty \n \nThe graph shows the demand for financial capital and supply of financial capital into the U.S. financial markets by the foreign sector before and after the increase in uncertainty regarding U.S. public debt. The original equilibrium (E0) occurs at an equilibrium rate of return (R0) and the equilibrium quantity is at Q0.\n\nStep 4. Thus, foreign investors diminished enthusiasm leads to a new equilibrium, E1, which occurs at the higher interest rate, R1, and the lower quantity of financial investment, Q1.  In short, U.S. borrowers will have to pay more interest on their borrowing.\nThe economy has experienced an enormous inflow of foreign capital. According to the U.S. Bureau of Economic Analysis, by the third quarter of 2015, U.S. investors had accumulated $23.3 trillion of foreign assets, but foreign investors owned a total of $30.6 trillion of U.S. assets. If foreign investors were to pull their money out of the U.S. economy and invest elsewhere in the world, the result could be a significantly lower quantity of financial investment in the United States, available only at a higher interest rate. This reduced inflow of foreign financial investment could impose hardship on U.S. consumers and firms interested in borrowing.In a modern, developed economy, financial capital often moves invisibly through electronic transfers between one bank account and another. Yet we can analyze these flows of funds with the same tools of demand and supply as markets for goods or labor.Price Ceilings in Financial Markets: Usury Laws\nAs we noted earlier, about 200 million Americans own credit cards, and their interest payments and fees total tens of billions of dollars each year. It is little wonder that political pressures sometimes arise for setting limits on the interest rates or fees that credit card companies charge. The firms that issue credit cards, including banks, oil companies, phone companies, and retail stores, respond that the higher interest rates are necessary to cover the losses created by those who borrow on their credit cards and who do not repay on time or at all. These companies also point out that cardholders can avoid paying interest if they pay their bills on time.Consider the credit card market as Figure 4.8 illustrators. In this financial market, the vertical axis shows the interest rate (which is the price in the financial market). Demanders in the credit card market are households and businesses. Suppliers are the companies that issue credit cards. This figure does not use specific numbers, which would be hypothetical in any case, but instead focuses on the underlying economic relationships. Imagine a law imposes a price ceiling that holds the interest rate charged on credit cards at the rate Rc, which lies below the interest rate R0 that would otherwise have prevailed in the market. The horizontal dashed line at interest rate Rc in Figure 4.8 shows the price ceiling. The demand and supply model predicts that at the lower price ceiling interest rate, the quantity demanded of credit card debt will increase from its original level of Q0 to Qd; however, the quantity supplied of credit card debt will decrease from the original Q0 to Qs. At the price ceiling (Rc), quantity demanded will exceed quantity supplied. Consequently, a number of people who want to have credit cards and are willing to pay the prevailing interest rate will find that companies are unwilling to issue cards to them. The result will be a credit shortage.\n\n\n\nFigure \n4.8\n \nCredit Card Interest Rates: Another Price Ceiling Example \n \nThe original intersection of demand D and supply S occurs at equilibrium E0. However, a price ceiling is set at the interest rate Rc, below the equilibrium interest rate R0, and so the interest rate cannot adjust upward to the equilibrium. At the price ceiling, the quantity demanded, Qd, exceeds the quantity supplied, Qs. There is excess demand, also called a shortage.\n\nMany states do have usury laws, which impose an upper limit on the interest rate that lenders can charge. However, in many cases these upper limits are well above the market interest rate. For example, if the interest rate is not allowed to rise above 30% per year, it can still fluctuate below that level according to market forces. A price ceiling that is set at a relatively high level is nonbinding, and it will have no practical effect unless the equilibrium price soars high enough to exceed the price ceiling.\n\n", "04-3": "By the end of this section, you will be able to:\nApply demand and supply models to analyze prices and quantities\nExplain the effects of price controls on the equilibrium of prices and quantities\n\nPrices exist in markets for goods and services, for labor, and for financial capital. In all of these markets, prices serve as a remarkable social mechanism for collecting, combining, and transmitting information that is relevant to the marketnamely, the relationship between demand and supplyand then serving as messengers to convey that information to buyers and sellers. In a market-oriented economy, no government agency or guiding intelligence oversees the set of responses and interconnections that result from a change in price. Instead, each consumer reacts according to that persons preferences and budget set, and each profit-seeking producer reacts to the impact on its expected profits. The following Clear It Up feature examines the demand and supply models.\n\nClear It Up\n\n\nWhy are demand and supply curves important?\nThe demand and supply model is the second fundamental diagram for this course. (The opportunity set model that we introduced in the Choice in a World of Scarcity chapter was the first.) Just as it would be foolish to try to learn the arithmetic of long division by memorizing every possible combination of numbers that can be divided by each other, it would be foolish to try to memorize every specific example of demand and supply in this chapter, this textbook, or this course. Demand and supply is not primarily a list of examples. It is a model to analyze prices and quantities. Even though demand and supply diagrams have many labels, they are fundamentally the same in their logic. Your goal should be to understand the underlying model so you can use it to analyze any market.Figure 4.9 displays a generic demand and supply curve. The horizontal axis shows the different measures of quantity: a quantity of a good or service, or a quantity of labor for a given job, or a quantity of financial capital. The vertical axis shows a measure of price: the price of a good or service, the wage in the labor market, or the rate of return (like the interest rate) in the financial market.The demand and supply model can explain the existing levels of prices, wages, and rates of return. To carry out such an analysis, think about the quantity that will be demanded at each price and the quantity that will be supplied at each pricethat is, think about the shape of the demand and supply curvesand how these forces will combine to produce equilibrium.\nWe can also use demand and supply to explain how economic events will cause changes in prices, wages, and rates of return. There are only four possibilities: the change in any single event may cause the demand curve to shift right or to shift left, or it may cause the supply curve to shift right or to shift left. The key to analyzing the effect of an economic event on equilibrium prices and quantities is to determine which of these four possibilities occurred. The way to do this correctly is to think back to the list of factors that shift the demand and supply curves. Note that if more than one variable is changing at the same time, the overall impact will depend on the degree of the shifts. When there are multiple variables, economists isolate each change and analyze it independently.\n\n\n\nFigure \n4.9\n \nDemand and Supply Curves \n \nThe figure displays a generic demand and supply curve. The horizontal axis shows the different measures of quantity: a quantity of a good or service, a quantity of labor for a given job, or a quantity of financial capital. The vertical axis shows a measure of price: the price of a good or service, the wage in the labor market, or the rate of return (like the interest rate) in the financial market. We can use the demand and supply curves explain how economic events will cause changes in prices, wages, and rates of return.\n\nAn increase in the price of some product signals consumers that there is a shortage; therefore, they may want to economize on buying this product. For example, if you are thinking about taking a plane trip to Hawaii, but the ticket turns out to be expensive during the week you intend to go, you might consider other weeks when the ticket might be cheaper. The price could be high because you were planning to travel during a holiday when demand for traveling is high. Maybe the cost of an input like jet fuel increased or the airline has raised the price temporarily to see how many people are willing to pay it. Perhaps all of these factors are present at the same time. You do not need to analyze the market and break down the price change into its underlying factors. You just have to look at the ticket price and decide whether and when to fly.In the same way, price changes provide useful information to producers. Imagine the situation of a farmer who grows oats and learns that the price of oats has risen. The higher price could be due to an increase in demand caused by a new scientific study proclaiming that eating oats is especially healthful. Perhaps the price of a substitute grain, like corn, has risen, and people have responded by buying more oats. The oat farmer does not need to know the details. The farmer only needs to know that the price of oats has risen and that it will be profitable to expand production as a result.The actions of individual consumers and producers as they react to prices overlap and interlock in markets for goods, labor, and financial capital. A change in any single market is transmitted through these multiple interconnections to other markets. The vision of the role of flexible prices helping markets to reach equilibrium and linking different markets together helps to explain why price controls can be so counterproductive. Price controls are government laws that serve to regulate prices rather than allow the various markets to determine prices. There is an old proverb: Dont kill the messenger. In ancient times, messengers carried information between distant cities and kingdoms. When they brought bad news, there was an emotional impulse to kill the messenger. However, killing the messenger did not kill the bad news. Moreover, killing the messenger had an undesirable side effect: Other messengers would refuse to bring news to that city or kingdom, depriving its citizens of vital information.Those who seek price controls are trying to kill the messengeror at least to stifle an unwelcome message that prices are bringing about the equilibrium level of price and quantity. However, price controls do nothing to affect the underlying forces of demand and supply, and this can have serious repercussions. During Chinas Great Leap Forward in the late 1950s, the government kept food prices artificially low, with the result that 30 to 40 million people died of starvation because the low prices depressed farm production. This was communist party leader Mao Zedong's social and economic campaign to rapidly transform the country from an agrarian economy to a socialist society through rapid industrialization and collectivization. Changes in demand and supply will continue to reveal themselves through consumers and producers behavior. Immobilizing the price messenger through price controls will deprive everyone in the economy of critical information. Without this information, it becomes difficult for everyonebuyers and sellers aliketo react in a flexible and appropriate manner as changes occur throughout the economy.\nBring It Home\n\n\nBaby Boomers Come of Age\n\nThe theory of supply and demand can explain what happens in the labor markets and suggests that the demand for nurses will increase as healthcare needs of baby boomers increase, as Figure 4.10 shows. The impact of that increase will result in an average salary higher than the $67,490 earned in 2015 referenced in the first part of this case. The new equilibrium (E1) will be at the new equilibrium price (Pe1).Equilibrium quantity will also increase from Qe0 to Qe1.\n\n\n\nFigure \n4.10\n \nImpact of Increasing Demand for Nurses 2014-2024\n \nIn 2014, the median salary for nurses was $67,490. As demand for services increases, the demand curve shifts to the right (from D0 to D1) and the equilibrium quantity of nurses increases from Qe0 to Qe1. The equilibrium salary increases from Pe0 to Pe1.\n\nSuppose that as the demand for nurses increases, the supply shrinks due to an increasing number of nurses entering retirement and increases in the tuition of nursing degrees. The leftward shift of the supply curve in Figure 4.11 captures the impact of a decreasing supply of nurses. The shifts in the two curves result in higher salaries for nurses, but the overall impact in the quantity of nurses is uncertain, as it depends on the relative shifts of supply and demand.\n\n\n\nFigure \n4.11\n \nImpact of Decreasing Supply of Nurses between 2014 and 2024\n \nThe increase in demand for nurses shown in Figure 4.10 leads to both higher prices and higher quantities demanded. As nurses retire from the work force, the supply of nurses decreases, causing a leftward shift in the supply curve and higher salaries for nurses at Pe2. The net effect on the equilibrium quantity of nurses is uncertain, which in this representation is less than Qe1, but more than the initial Qe0.\n\nWhile we do not know if the number of nurses will increase or decrease relative to their initial employment, we know they will have higher salaries.\n", "05-1": "By the end of this section, you will be able to:\n\nCalculate the price elasticity of demand\nCalculate the price elasticity of supply\n\nBoth the demand and supply curve show the relationship between price and the number of units demanded or supplied. Price elasticity is the ratio between the percentage change in the quantity demanded (Qd) or supplied (Qs) and the corresponding percent change in price. The price elasticity of demand is the percentage change in the quantity demanded of a good or service divided by the percentage change in the price. The price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price.We can usefully divide elasticities into three broad categories: elastic, inelastic, and unitary. Because price and quantity demanded move in opposite directions, price elasticity of demand is always a negative number. Therefore, price elasticity of demand is usually reported as its absolute value, without a negative sign. The summary in Table 5.1 is assuming absolute values for price elasticity of demand. An elastic demand or elastic supply is one in which the elasticity is greater than one, indicating a high responsiveness to changes in price. Elasticities that are less than one indicate low responsiveness to price changes and correspond to inelastic demand or inelastic supply. Unitary elasticities indicate proportional responsiveness of either demand or supply, as Table 5.1 summarizes.\n\nIf . . .\nThen . . .\nAnd It Is Called . . .\n\n\n\n%changeinquantity>%changeinprice%changeinquantity>%changeinprice\n%changeinquantity%changeinprice>1%changeinquantity%changeinprice>1\n Elastic \n\n\n%changeinquantity=%changeinprice%changeinquantity=%changeinprice\n%changeinquantity%changeinprice=1%changeinquantity%changeinprice=1\n Unitary \n\n\n%changeinquantity<%changeinprice%changeinquantity<%changeinprice\n%changeinquantity%changeinprice<1%changeinquantity%changeinprice<1\n Inelastic \n\n\nTable \n5.1\n \n \nElastic, Inelastic, and Unitary: Three Cases of Elasticity\n\n\n\nLink It Up\n\nBefore we delve into the details of elasticity, enjoy this article on elasticity and ticket prices at the Super Bowl.\nTo calculate elasticity along a demand or supply curve economists use the average percent change in both quantity and price. This is called the Midpoint Method for Elasticity, and is represented in the following equations:\n% change in quantity=Q2Q1Q2+ Q1/2100% change in price=P2 P1P2+ P1/2100 % change in quantity=Q2Q1Q2+ Q1/2100% change in price=P2 P1P2+ P1/2100 The advantage of the Midpoint Method is that one obtains the same elasticity between two price points whether there is a price increase or decrease. This is because the formula uses the same base (average quantity and average price) for both cases.Calculating Price Elasticity of DemandLets calculate the elasticity between points A and B and between points G and H as Figure 5.2 shows.\n\n\n\nFigure \n5.2\n \nCalculating the Price Elasticity of Demand \n \nWe calculate the price elasticity of demand as the percentage change in quantity divided by the percentage change in price.\n\nFirst, apply the formula to calculate the elasticity as price decreases from $70 at point B to $60 at point A:\n%change in quantity=3,0002,800(3,000+2,800)/2100=2002,900100=6.9% change in price=6070(60+70)/2100=1065100=15.4Price Elasticity of Demand=6.9%15.4%=0.45%change in quantity=3,0002,800(3,000+2,800)/2100=2002,900100=6.9% change in price=6070(60+70)/2100=1065100=15.4Price Elasticity of Demand=6.9%15.4%=0.45Therefore, the elasticity of demand between these two points is 6.9%15.4%6.9%15.4% which is 0.45, an amount smaller than one, showing that the demand is inelastic in this interval. Price elasticities of demand are always negative since price and quantity demanded always move in opposite directions (on the demand curve). By convention, we always talk about elasticities as positive numbers. Mathematically, we take the absolute value of the result. We will ignore this detail from now on, while remembering to interpret elasticities as positive numbers.This means that, along the demand curve between point B and A, if the price changes by 1%, the quantity demanded will change by 0.45%. A change in the price will result in a smaller percentage change in the quantity demanded. For example, a 10% increase in the price will result in only a 4.5% decrease in quantity demanded. A 10% decrease in the price will result in only a 4.5% increase in the quantity demanded. Price elasticities of demand are negative numbers indicating that the demand curve is downward sloping, but we read them as absolute values.  The following Work It Out feature will walk you through calculating the price elasticity of demand.\nWork It Out\n\n\nFinding the Price Elasticity of Demand\nCalculate the price elasticity of demand using the data in Figure 5.2 for an increase in price from G to H. Has the elasticity increased or decreased?Step 1. We know that: \nPrice Elasticity of Demand=%change in quantity%change in pricePrice Elasticity of Demand=%change in quantity%change in priceStep 2. From the Midpoint Formula we know that:%change in quantity=Q2Q1(Q2+Q1)/2100%change in price=P2P1(P2+P1)/2100%change in quantity=Q2Q1(Q2+Q1)/2100%change in price=P2P1(P2+P1)/2100Step 3. So we can use the values provided in the figure in each equation:\n%changeinquantity=1,6001,800(1,600+1,800)/2100=2001,700100=11.76%changeinprice=130120(130+120)/2100=10125100=8.0%changeinquantity=1,6001,800(1,600+1,800)/2100=2001,700100=11.76%changeinprice=130120(130+120)/2100=10125100=8.0Step 4. Then, we can use those values to determine the price elasticity of demand:PriceElasticityofDemand=% changeinquantity% changeinprice=11.768=1.47PriceElasticityofDemand=% changeinquantity% changeinprice=11.768=1.47Therefore, the elasticity of demand from G to is H 1.47. The magnitude of the elasticity has increased (in absolute value) as we moved up along the demand curve from points A to B. Recall that the elasticity between these two points was 0.45. Demand was inelastic between points A and B and elastic between points G and H. This shows us that price elasticity of demand changes at different points along a straight-line demand curve.\nCalculating the Price Elasticity of SupplyAssume that an apartment rents for $650 per month and at that price the landlord rents 10,000 units are rented as Figure 5.3 shows. When the price increases to $700 per month, the landlord supplies 13,000 units into the market. By what percentage does apartment supply increase? What is the price sensitivity?\n\n\nFigure \n5.3\n \nPrice Elasticity of Supply \n \nWe calculate the price elasticity of supply as the percentage change in quantity divided by the percentage change in price.\n\nUsing the Midpoint Method,%changeinquantity=13,00010,000(13,000+10,000)/2100=3,00011,500100=26.1%changeinprice=$700$650($700+$650)/2100=50675100=7.4PriceElasticityofSupply=26.1%7.4%=3.53%changeinquantity=13,00010,000(13,000+10,000)/2100=3,00011,500100=26.1%changeinprice=$700$650($700+$650)/2100=50675100=7.4PriceElasticityofSupply=26.1%7.4%=3.53Again, as with the elasticity of demand, the elasticity of supply is not followed by any units. Elasticity is a ratio of one percentage change to another percentage changenothing moreand we read it as an absolute value. In this case, a 1% rise in price causes an increase in quantity supplied of 3.5%. The greater than one elasticity of supply means that the percentage change in quantity supplied will be greater than a one percent price change. If you're starting to wonder if the concept of slope fits into this calculation, read the following Clear It Up box.\nClear It Up\n\n\nIs the elasticity the slope?\nIt is a common mistake to confuse the slope of either the supply or demand curve with its elasticity. The slope is the rate of change in units along the curve, or the rise/run (change in y over the change in x). For example, in Figure 5.2, at each point shown on the demand curve, price drops by $10 and the number of units demanded increases by 200 compared to the point to its left. The slope is 10/200 along the entire demand curve and does not change. The price elasticity, however, changes along the curve. Elasticity between points A and B was 0.45 and increased to 1.47 between points G and H. Elasticity is the percentage change, which is a different calculation from the slope and has a different meaning.When we are at the upper end of a demand curve, where price is high and the quantity demanded is low, a small change in the quantity demanded, even in, say, one unit, is pretty big in percentage terms. A change in price of, say, a dollar, is going to be much less important in percentage terms than it would have been at the bottom of the demand curve. Likewise, at the bottom of the demand curve, that one unit change when the quantity demanded is high will be small as a percentage.\n\nThus, at one end of the demand curve, where we have a large percentage change in quantity demanded over a small percentage change in price, the elasticity value would be high, or demand would be relatively elastic. Even with the same change in the price and the same change in the quantity demanded, at the other end of the demand curve the quantity is much higher, and the price is much lower, so the percentage change in quantity demanded is smaller and the percentage change in price is much higher. That means at the bottom of the curve we'd have a small numerator over a large denominator, so the elasticity measure would be much lower, or inelastic.\n\nAs we move along the demand curve, the values for quantity and price go up or down, depending on which way we are moving, so the percentages for, say, a $1 difference in price or a one unit difference in quantity, will change as well, which means the ratios of those percentages and hence the elasticity will change.\n", "05-2": "By the end of this section, you will be able to:\nDifferentiate between infinite and zero elasticity\nAnalyze graphs in order to classify elasticity as constant unitary, infinite, or zero\n\nThere are two extreme cases of elasticity: when elasticity equals zero and when it is infinite. A third case is that of constant unitary elasticity. We will describe each case.\nInfinite elasticity or perfect elasticity refers to the extreme case where either the quantity demanded (Qd) or supplied (Qs) changes by an infinite amount in response to any change in price at all. In both cases, the supply and the demand curve are horizontal as Figure 5.4 shows. While perfectly elastic supply curves are for the most part unrealistic, goods with readily available inputs and whose production can easily expand will feature highly elastic supply curves. Examples include pizza, bread, books, and pencils. Similarly, perfectly elastic demand is an extreme example. However, luxury goods, items that take a large share of individuals income, and goods with many substitutes are likely to have highly elastic demand curves. Examples of such goods are Caribbean cruises and sports vehicles.\n\n\nFigure \n5.4\n \nInfinite Elasticity \n \nThe horizontal lines show that an infinite quantity will be demanded or supplied at a specific price. This illustrates the cases of a perfectly (or infinitely) elastic demand curve and supply curve. The quantity supplied or demanded is extremely responsive to price changes, moving from zero for prices close to P to infinite when prices reach P.\n\nZero elasticity or perfect inelasticity, as Figure 5.5 depicts, refers to the extreme case in which a percentage change in price, no matter how large, results in zero change in quantity. While a perfectly inelastic supply is an extreme example, goods with limited supply of inputs are likely to feature highly inelastic supply curves. Examples include diamond rings or housing in prime locations such as apartments facing Central Park in New York City. Similarly, while perfectly inelastic demand is an extreme case, necessities with no close substitutes are likely to have highly inelastic demand curves. This is the case of life-saving drugs and gasoline.\n\n\nFigure \n5.5\n \nZero Elasticity \n \nThe vertical supply curve and vertical demand curve show that there will be zero percentage change in quantity (a) demanded or (b) supplied, regardless of the price.\n\nConstant unitary elasticity, in either a supply or demand curve, occurs when a price change of one percent results in a quantity change of one percent. Figure 5.6 shows a demand curve with constant unit elasticity. Using the midpoint method, you can calculate that between points A and B on the demand curve, the price changes by 66.7% and quantity demanded also changes by 66.7%.  Hence, the elasticity equals 1.  Between points B and C, price again changes by 66.7% as does quantity, while between points C and D the corresponding percentage changes are again 66.7% for both price and quantity. In each case, then, the percentage change in price equals the percentage change in quantity, and consequently elasticity equals 1.  Notice that in absolute value, the declines in price, as you step down the demand curve, are not identical. Instead, the price falls by $8.00 from A to B, by a smaller amount of $4.00 from B to C, and by a still smaller amount of $2.00 from C to D. As a result, a demand curve with constant unitary elasticity moves from a steeper slope on the left and a flatter slope on the rightand a curved shape overall.\n\n\nFigure \n5.6\n \nA Constant Unitary Elasticity Demand Curve \n \nA demand curve with constant unitary elasticity will be a curved line. Notice how price and quantity demanded change by an identical percentage amount between each pair of points on the demand curve.\n\nUnlike the demand curve with unitary elasticity, the supply curve with unitary elasticity is represented by a straight line, and that line goes through the origin. In each pair of points on the supply curve there is an equal difference in quantity of 30. However, in percentage value, using the midpoint method, the steps are decreasing as one moves from left to right, from 28.6% to 22.2% to 18.2%, because the quantity points in each percentage calculation are getting increasingly larger, which expands the denominator in the elasticity calculation of the percentage change in quantity.Consider the price changes moving up the supply curve in Figure 5.7. From points D to E to F and to G on the supply curve, each step of $1.50 is the same in absolute value. However, if we measure the price changes in percentage change terms, using the midpoint method, they are also decreasing, from 28.6% to 22.2% to 18.2%, because the original price points in each percentage calculation are getting increasingly larger in value, increasing the denominator in the calculation of the percentage change in price. Along the constant unitary elasticity supply curve, the percentage quantity increases on the horizontal axis exactly match the percentage price increases on the vertical axisso this supply curve has a constant unitary elasticity at all points.\n\n\nFigure \n5.7\n \nA Constant Unitary Elasticity Supply Curve \n \nA constant unitary elasticity supply curve is a straight line reaching up from the origin. Between each pair of points, the percentage increase in quantity supplied is the same as the percentage increase in price.\n\n\n", "05-3": "By the end of this section, you will be able to:\nAnalyze how price elasticities impact revenue\nEvaluate how elasticity can cause shifts in demand and supply\nPredict how the long-run and short-run impacts of elasticity affect equilibrium\nExplain how the elasticity of demand and supply determine the incidence of a tax on buyers and sellers\nStudying elasticities is useful for a number of reasons, pricing being most important. Lets explore how elasticity relates to revenue and pricing, both in the long and short run. First, lets look at the elasticities of some common goods and services.Table 5.2 shows a selection of demand elasticities for different goods and services drawn from a variety of different studies by economists, listed in order of increasing elasticity.\n\n\nGoods and Services\nElasticity of Price\n\n\n\nHousing\n0.12\n\n\nTransatlantic air travel (economy class)\n0.12\n\n\nRail transit (rush hour)\n0.15\n\n\nElectricity\n0.20\n\n\nTaxi cabs\n0.22\n\n\nGasoline\n0.35\n\n\nTransatlantic air travel (first class)\n0.40\n\n\nWine\n0.55\n\n\nBeef\n0.59\n\n\nTransatlantic air travel (business class)\n0.62\n\n\nKitchen and household appliances\n0.63\n\n\nCable TV (basic rural)\n0.69\n\n\nChicken\n0.64\n\n\nSoft drinks\n0.70\n\n\nBeer\n0.80\n\n\nNew vehicle\n0.87\n\n\nRail transit (off-peak)\n1.00\n\n\nComputer\n1.44\n\n\nCable TV (basic urban)\n1.51\n\n\nCable TV (premium)\n1.77\n\n\nRestaurant meals\n2.27\n\n\nTable \n5.2\n \n \nSome Selected Elasticities of Demand\n\nNote that demand for necessities such as housing and electricity is inelastic, while items that are not necessities such as restaurant meals are more price-sensitive. If the price of a restaurant meal increases by 10%, the quantity demanded will decrease by 22.7%. A 10% increase in the price of housing will cause only a slight decrease of 1.2% in the quantity of housing demanded.\nLink It Up\n\nRead this article for an example of price elasticity that may have affected you.\nDoes Raising Price Bring in More Revenue?Imagine that a band on tour is playing in an indoor arena with 15,000 seats. To keep this example simple, assume that the band keeps all the money from ticket sales. Assume further that the band pays the costs for its appearance, but that these costs, like travel, and setting up the stage, are the same regardless of how many people are in the audience. Finally, assume that all the tickets have the same price. (The same insights apply if ticket prices are more expensive for some seats than for others, but the calculations become more complicated.) The band knows that it faces a downward-sloping demand curve; that is, if the band raises the ticket price and, it will sell fewer seats. How should the band set the ticket price to generate the most total revenue, which in this example, because costs are fixed, will also mean the highest profits for the band? Should the band sell more tickets at a lower price or fewer tickets at a higher price?The key concept in thinking about collecting the most revenue is the price elasticity of demand. Total revenue is price times the quantity of tickets sold. Imagine that the band starts off thinking about a certain price, which will result in the sale of a certain quantity of tickets. The three possibilities are in Table 5.3. If demand is elastic at that price level, then the band should cut the price, because the percentage drop in price will result in an even larger percentage increase in the quantity soldthus raising total revenue. However, if demand is inelastic at that original quantity level, then the band should raise the ticket price, because a certain percentage increase in price will result in a smaller percentage decrease in the quantity soldand total revenue will rise. If demand has a unitary elasticity at that quantity, then an equal percentage change in quantity will offset a moderate percentage change in the priceso the band will earn the same revenue whether it (moderately) increases or decreases the ticket price.\n\nIf Demand Is . . .\nThen . . .\nTherefore . . .\n\n\n\nElastic\n%changeinQd>%changeinP%changeinQd>%changeinP\nA given % rise in P will be more than offset by a larger % fall in Q so that total revenue (P  Q) falls.\n\n\nUnitary\n%changeinQd=%changeinP%changeinQd=%changeinP\nA given % rise in P will be exactly offset by an equal % fall in Q so that total revenue (P  Q) is unchanged.\n\n\nInelastic\n%changeinQd<%changeinP%changeinQd<%changeinP\nA given % rise in P will cause a smaller % fall in Q so that total revenue (P  Q) rises.\n\n\nTable \n5.3\n \n \nWill the Band Earn More Revenue by Changing Ticket Prices?\n\n\nWhat if the band keeps cutting price, because demand is elastic, until it reaches a level where it sells all 15,000 seats in the available arena? If demand remains elastic at that quantity, the band might try to move to a bigger arena, so that it could slash ticket prices further and see a larger percentage increase in the quantity of tickets sold. However, if the 15,000-seat arena is all that is available or if a larger arena would add substantially to costs, then this option may not work.Conversely, a few bands are so famous, or have such fanatical followings, that demand for tickets may be inelastic right up to the point where the arena is full. These bands can, if they wish, keep raising the ticket price. Ironically, some of the most popular bands could make more revenue by setting prices so high that the arena is not fullbut those who buy the tickets would have to pay very high prices. However, bands sometimes choose to sell tickets for less than the absolute maximum they might be able to charge, often in the hope that fans will feel happier and spend more on recordings, T-shirts, and other paraphernalia.\nCan Businesses Pass Costs on to Consumers?Most businesses face a day-to-day struggle to figure out ways to produce at a lower cost, as one pathway to their goal of earning higher profits. However, in some cases, the price of a key input over which the firm has no control may rise. For example, many chemical companies use petroleum as a key input, but they have no control over the world market price for crude oil. Coffee shops use coffee as a key input, but they have no control over the world market price of coffee. If the cost of a key input rises, can the firm pass those higher costs along to consumers in the form of higher prices? Conversely, if new and less expensive ways of producing are invented, can the firm keep the benefits in the form of higher profits, or will the market pressure them to pass the gains along to consumers in the form of lower prices? The price elasticity of demand plays a key role in answering these questions.Imagine that as a consumer of legal pharmaceutical products, you read a newspaper story that a technological breakthrough in the production of aspirin has occurred, so that every aspirin factory can now produce aspirin more cheaply. What does this discovery mean to you? Figure 5.8 illustrates two possibilities. In Figure 5.8 (a), the demand curve is highly inelastic. In this case, a technological breakthrough that shifts supply to the right, from S0 to S1, so that the equilibrium shifts from E0 to E1, creates a substantially lower price for the product with relatively little impact on the quantity sold. In Figure 5.8 (b), the demand curve is highly elastic. In this case, the technological breakthrough leads to a much greater quantity sold in the market at very close to the original price. Consumers benefit more, in general, when the demand curve is more inelastic because the shift in the supply results in a much lower price for consumers.\n\n\n\nFigure \n5.8\n \nPassing along Cost Savings to Consumers \n \nCost-saving gains cause supply to shift out to the right from S0 to S1; that is, at any given price, firms will be willing to supply a greater quantity. If demand is inelastic, as in (a), the result of this cost-saving technological improvement will be substantially lower prices. If demand is elastic, as in (b), the result will be only slightly lower prices. Consumers benefit in either case, from a greater quantity at a lower price, but the benefit is greater when demand is inelastic, as in (a).\n\nAspirin producers may find themselves in a nasty bind here. The situation in Figure 5.8, with extremely inelastic demand, means that a new invention may cause the price to drop dramatically while quantity changes little. As a result, the new production technology can lead to a drop in the revenue that firms earn from aspirin sales. However, if strong competition exists between aspirin producers, each producer may have little choice but to search for and implement any breakthrough that allows it to reduce production costs. After all, if one firm decides not to implement such a cost-saving technology, other firms that do can drive them out of business.Since demand for food is generally inelastic, farmers may often face the situation in Figure 5.8 (a). That is, a surge in production leads to a severe drop in price that can actually decrease the total revenue that farmers receive. Conversely, poor weather or other conditions that cause a terrible year for farm production can sharply raise prices so that the total revenue that the farmer receives increases. The Clear It Up box discusses how these issues relate to coffee.\nClear It Up\n\n\nHow do coffee prices fluctuate?\nCoffee is an international crop. The top five coffee-exporting nations are Brazil, Vietnam, Colombia, Indonesia, and Ethiopia. In these nations and others, 20 million families depend on selling coffee beans as their main source of income. These families are exposed to enormous risk, because the world price of coffee bounces up and down. For example, in 1993, the world price of coffee was about 50 cents per pound. In 1995 it was four times as high, at $2 per pound. By 1997 it had fallen by half to $1.00 per pound. In 1998 it leaped back up to $2 per pound. By 2001 it had fallen back to 46 cents a pound. By early 2011 it rose to about $2.31 per pound. By the end of 2012, the price had fallen back to about $1.31 per pound.The reason for these price fluctuations lies in a combination of inelastic demand and shifts in supply. The elasticity of coffee demand is only about 0.3; that is, a 10% rise in the price of coffee leads to a decline of about 3% in the quantity of coffee consumed. When a major frost hit the Brazilian coffee crop in 1994, coffee supply shifted to the left with an inelastic demand curve, leading to much higher prices. Conversely, when Vietnam entered the world coffee market as a major producer in the late 1990s, the supply curve shifted out to the right. With a highly inelastic demand curve, coffee prices fell dramatically. Figure 5.8 (a) illustrates this situation.Elasticity also reveals whether firms can pass higher costs that they incur on to consumers. Addictive substances, for which demand is inelastic, are products for which producers can pass higher costs on to consumers. For example, the demand for cigarettes is relatively inelastic among regular smokers who are somewhat addicted. Economic research suggests that increasing cigarette prices by 10% leads to about a 3% reduction in the quantity of cigarettes that adults smoke, so the elasticity of demand for cigarettes is 0.3. If society increases taxes on companies that produce cigarettes, the result will be, as in Figure 5.9 (a), that the supply curve shifts from S0 to S1. However, as the equilibrium moves from E0 to E1, governments mainly pass along these taxes to consumers in the form of higher prices. These higher taxes on cigarettes will raise tax revenue for the government, but they will not much affect the quantity of smoking.If the goal is to reduce the quantity of cigarettes demanded, we must achieve it by shifting this inelastic demand back to the left, perhaps with public programs to discourage cigarette use or to help people to quit. For example, anti-smoking advertising campaigns have shown some ability to reduce smoking. However, if cigarette demand were more elastic, as in Figure 5.9 (b), then an increase in taxes that shifts supply from S0 to S1 and equilibrium from E0 to E1 would reduce the quantity of cigarettes smoked substantially. Youth smoking seems to be more elastic than adult smokingthat is, the quantity of youth smoking will fall by a greater percentage than the quantity of adult smoking in response to a given percentage increase in price.\n\n\n\nFigure \n5.9\n \nPassing along Higher Costs to Consumers \n \nHigher costs, like a higher tax on cigarette companies for the example we gave in the text, lead supply to shift to the left. This shift is identical in (a) and (b). However, in (a), where demand is inelastic, companies largely can pass the cost increase along to consumers in the form of higher prices, without much of a decline in equilibrium quantity. In (b), demand is elastic, so the shift in supply results primarily in a lower equilibrium quantity. Consumers suffer in either case, but in (a), they suffer from paying a higher price for the same quantity, while in (b), they suffer from buying a lower quantity (and presumably needing to shift their consumption elsewhere).\n\n\nElasticity and Tax IncidenceThe example of cigarette taxes demonstrated that because demand is inelastic, taxes are not effective at reducing the equilibrium quantity of smoking, and they mainly pass along to consumers in the form of higher prices. The analysis, or manner, of how a tax burden is divided between consumers and producers is called tax incidence. Typically, the tax incidence, or burden, falls both on the consumers and producers of the taxed good. However, if one wants to predict which group will bear most of the burden, all one needs to do is examine the elasticity of demand and supply. In the tobacco example, the tax burden falls on the most inelastic side of the market.\n\n\nIf demand is more inelastic than supply, consumers bear most of the tax burden, and if supply is more inelastic than demand, sellers bear most of the tax burden. The intuition for this is simple. When the demand is inelastic, consumers are not very responsive to price changes, and the quantity demanded reduces only modestly when the tax is introduced. In the case of smoking, the demand is inelastic because  consumers are addicted to the product. The government can then pass the tax burden along to consumers in the form of higher prices, without much of a decline in the equilibrium quantity.Similarly, when a government introduces a tax in a market with an inelastic supply, such as, for example, beachfront hotels, and sellers have no alternative than to accept lower prices for their business, taxes do not greatly affect the equilibrium quantity. The tax burden now passes on to the sellers. If the supply was elastic and sellers had the possibility of reorganizing their businesses to avoid supplying the taxed good, the tax burden on the sellers would be much smaller. The tax would result in a much lower quantity sold instead of lower prices received. Figure 5.10 illustrates this relationship between the tax incidence and elasticity of demand and supply. \n\n\n\nFigure \n5.10\n \nElasticity and Tax Incidence\n \nAn excise tax introduces a wedge between the price paid by consumers (Pc) and the price received by producers (Pp). The vertical distance between Pc and Pp is the amount of the tax per unit. Pe is the equilibrium price prior to introduction of the tax. (a) When the demand is more elastic than supply, the tax incidence on consumers Pc  Pe is lower than the tax incidence on producers Pe  Pp. (b) When the supply is more elastic than demand, the tax incidence on consumers Pc  Pe is larger than the tax incidence on producers Pe  Pp. The more elastic the demand and supply curves, the lower the tax revenue. \n\nIn Figure 5.10 (a), the supply is inelastic and the demand is elastic, such as in the example of beachfront hotels. While consumers may have other vacation choices, sellers cant easily move their businesses. By introducing a tax, the government essentially creates a wedge between the price paid by consumers Pc and the price received by producers Pp. In other words, of the total price paid by consumers, part is retained by the sellers and part is paid to the government in the form of a tax. The distance between Pc and Pp is the tax rate. The new market price is Pc, but sellers receive only Pp per unit sold, as they pay Pc-Pp to the government. Since we can view a tax as raising the costs of production, this could also be represented by a leftward shift of the supply curve, where the new supply curve would intercept the demand at the new quantity Qt. For simplicity, Figure 5.10 omits the shift in the supply curve.The tax revenue is given by the shaded area, which we obtain by multiplying the tax per unit by the total quantity sold Qt. The tax incidence on the consumers is given by the difference between the price paid Pc and the initial equilibrium price Pe. The tax incidence on the sellers is given by the difference between the initial equilibrium price Pe and the price they receive after the tax is introduced Pp. In Figure 5.10 (a), the tax burden falls disproportionately on the sellers, and a larger proportion of the tax revenue (the shaded area) is due to the resulting lower price received by the sellers than by the resulting higher prices paid by the buyers. Figure 5.10 (b) describes the example of the tobacco excise tax where the supply is more elastic than demand. The tax incidence now falls disproportionately on consumers, as shown by the large difference between the price they pay, Pc, and the initial equilibrium price, Pe. Sellers receive a lower price than before the tax, but this difference is much smaller than the change in consumers price. From this analysis one can also predict whether a tax is likely to create a large revenue or not. The more elastic the demand curve, the more likely that consumers will reduce quantity instead of paying higher prices. The more elastic the supply curve, the more likely that  sellers will reduce the quantity sold, instead of taking lower prices. In a market where both the demand and supply are very elastic, the imposition of an excise tax generates low revenue. Some believe that excise taxes hurt mainly the specific industries they target. For example, the medical device excise tax, in effect since 2013, has been controversial for it can delay industry profitability and therefore hamper start-ups and medical innovation. However, whether the tax burden falls mostly on the medical device industry or on the patients depends simply on the elasticity of demand and supply.\n\nLong-Run vs. Short-Run ImpactElasticities are often lower in the short run than in the long run. On the demand side of the market, it can sometimes be difficult to change Qd in the short run, but easier in the long run. Consumption of energy is a clear example. In the short run, it is not easy for a person to make substantial changes in energy consumption. Maybe you can carpool to work sometimes or adjust your home thermostat by a few degrees if the cost of energy rises, but that is about all. However, in the long run you can purchase a car that gets more miles to the gallon, choose a job that is closer to where you live, buy more energy-efficient home appliances, or install more insulation in your home. As a result, the elasticity of demand for energy is somewhat inelastic in the short run, but much more elastic in the long run.Figure 5.11 is an example, based roughly on historical experience, for the responsiveness of Qd to price changes. In 1973, the price of crude oil was $12 per barrel and total consumption in the U.S. economy was 17 million barrels per day. That year, the nations who were members of the Organization of Petroleum Exporting Countries (OPEC) cut off oil exports to the United States for six months because the Arab members of OPEC disagreed with the U.S. support for Israel. OPEC did not bring exports back to their earlier levels until 1975a policy that we can interpret as a shift of the supply curve to the left in the U.S. petroleum market. Figure 5.11 (a) and Figure 5.11 (b) show the same original equilibrium point and the same identical shift of a supply curve to the left from S0 to S1.\n\n\n\nFigure \n5.11\n \nHow a Shift in Supply Can Affect Price or Quantity \n \nThe intersection (E0) between demand curve D and supply curve S0 is the same in both (a) and (b). The shift of supply to the left from S0 to S1 is identical in both (a) and (b). The new equilibrium (E1) has a higher price and a lower quantity than the original equilibrium (E0) in both (a) and (b). However, the shape of the demand curve D is different in (a) and (b), being more elastic in (b) than in (a). As a result, the shift in supply can result either in a new equilibrium with a much higher price and an only slightly smaller quantity, as in (a), with more inelastic demand, or in a new equilibrium with only a small increase in price and a relatively larger reduction in quantity, as in (b), with more elastic demand.\n\nFigure 5.11 (a) shows inelastic demand for oil in the short run similar to that which existed for the United States in 1973. In Figure 5.11 (a), the new equilibrium (E1) occurs at a price of $25 per barrel, roughly double the price before the OPEC shock, and an equilibrium quantity of 16 million barrels per day. Figure 5.11 (b) shows what the outcome would have been if the U.S. demand for oil had been more elastic, a result more likely over the long term. This alternative equilibrium (E1) would have resulted in a smaller price increase to $14 per barrel and larger reduction in equilibrium quantity to 13 million barrels per day. In 1983, for example, U.S. petroleum consumption was 15.3 million barrels a day, which was lower than in 1973 or 1975. U.S. petroleum consumption was down even though the U.S. economy was about one-fourth larger in 1983 than it had been in 1973. The primary reason for the lower quantity was that higher energy prices spurred conservation efforts, and after a decade of home insulation, more fuel-efficient cars, more efficient appliances and machinery, and other fuel-conserving choices, the demand curve for energy had become more elastic.On the supply side of markets, producers of goods and services typically find it easier to expand production in the long term of several years rather than in the short run of a few months. After all, in the short run it can be costly or difficult to build a new factory, hire many new workers, or open new stores. However, over a few years, all of these are possible.In most markets for goods and services, prices bounce up and down more than quantities in the short run, but quantities often move more than prices in the long run. The underlying reason for this pattern is that supply and demand are often inelastic in the short run, so that shifts in either demand or supply can cause a relatively greater change in prices. However, since supply and demand are more elastic in the long run, the long-run movements in prices are more muted, while quantity adjusts more easily in the long run.\n", "05-4": "By the end of this section, you will be able to:\nCalculate the income elasticity of demand and the cross-price elasticity of demand\nCalculate the elasticity in labor and financial capital markets through an understanding of the elasticity of labor supply and the elasticity of savings\nApply concepts of price elasticity to real-world situations\n\nThe basic idea of elasticityhow a percentage change in one variable causes a percentage change in another variabledoes not just apply to the responsiveness quantity supplied and quantity demanded to changes in the price of a product. Recall that quantity demanded (Qd) depends on income, tastes and preferences, the prices of related goods, and so on, as well as price. Similarly, quantity supplied (Qs) depends on factors such as the cost of production, as well as price. We can measure elasticity for any determinant of quantity supplied and quantity demanded, not just the price.Income Elasticity of DemandThe income elasticity of demand is the percentage change in quantity demanded divided by the percentage change in income.Incomeelasticityofdemand=% changeinquantitydemanded% changeinincomeIncomeelasticityofdemand=% changeinquantitydemanded% changeinincomeFor most products, most of the time, the income elasticity of demand is positive: that is, a rise in income will cause an increase in the quantity demanded. This pattern is common enough that we refer to these goods as normal goods. However, for a few goods, an increase in income means that one might purchase less of the good. For example, those with a higher income might buy fewer hamburgers, because they are buying more steak instead, or those with a higher income might buy less cheap wine and more imported beer. When the income elasticity of demand is negative, we call the good an inferior good.We introduced the concepts of normal and inferior goods in Demand and Supply. A higher level of income causes a demand curve to shift to the right for a normal good, which means that the income elasticity of demand is positive. How far the demand shifts depends on the income elasticity of demand. A higher income elasticity means a larger shift. However, for an inferior good, that is, when the income elasticity of demand is negative, a higher level of income would cause the demand curve for that good to shift to the left. Again, how much it shifts depends on how large the (negative) income elasticity is.\nCross-Price Elasticity of DemandA change in the price of one good can shift the quantity demanded for another good. If the two goods are complements, like bread and peanut butter, then a drop in the price of one good will lead to an increase in the quantity demanded of the other good. However, if the two goods are substitutes, like plane tickets and train tickets, then a drop in the price of one good will cause people to substitute toward that good, and to reduce consumption of the other good. Cheaper plane tickets lead to fewer train tickets, and vice versa.\nThe cross-price elasticity of demand puts some meat on the bones of these ideas. The term cross-price refers to the idea that the price of one good is affecting the quantity demanded of a different good. Specifically, the cross-price elasticity of demand is the percentage change in the quantity of good A that is demanded as a result of a percentage change in the price of good B.\nCross-priceelasticityofdemand=%changeinQdofgoodA%changeinpriceofgoodBCross-priceelasticityofdemand=%changeinQdofgoodA%changeinpriceofgoodBSubstitute goods have positive cross-price elasticities of demand: if good A is a substitute for good B, like coffee and tea, then a higher price for B will mean a greater quantity consumed of A. Complement goods have negative cross-price elasticities: if good A is a complement for good B, like coffee and sugar, then a higher price for B will mean a lower quantity consumed of A.\n\nElasticity in Labor and Financial Capital MarketsThe concept of elasticity applies to any market, not just markets for goods and services. In the labor market, for example, the wage elasticity of labor supplythat is, the percentage change in hours worked divided by the percentage change in wageswill reflect the shape of the labor supply curve. Specifically:Elasticityoflaborsupply=% changeinquantityoflaborsupplied% changeinwageElasticityoflaborsupply=% changeinquantityoflaborsupplied% changeinwageThe wage elasticity of labor supply for teenage workers is generally fairly elastic: that is, a certain percentage change in wages will lead to a larger percentage change in the quantity of hours worked. Conversely, the wage elasticity of labor supply for adult workers in their thirties and forties is fairly inelastic. When wages move up or down by a certain percentage amount, the quantity of hours that adults in their prime earning years are willing to supply changes but by a lesser percentage amount.In markets for financial capital, the elasticity of savingsthat is, the percentage change in the quantity of savings divided by the percentage change in interest rateswill describe the shape of the supply curve for financial capital. That is:\nElasticityofsavings=% changeinquantityoffinancialsavings% changeininterestrateElasticityofsavings=% changeinquantityoffinancialsavings% changeininterestrateSometimes laws are proposed that seek to increase the quantity of savings by offering tax breaks so that the return on savings is higher. Such a policy will have a comparatively large impact on increasing the quantity saved if the supply curve for financial capital is elastic, because then a given percentage increase in the return to savings will cause a higher percentage increase in the quantity of savings. However, if the supply curve for financial capital is highly inelastic, then a percentage increase in the return to savings will cause only a small increase in the quantity of savings. The evidence on the supply curve of financial capital is controversial but, at least in the short run, the elasticity of savings with respect to the interest rate appears fairly inelastic.\nExpanding the Concept of ElasticityThe elasticity concept does not even need to relate to a typical supply or demand curve at all. For example, imagine that you are studying whether the Internal Revenue Service should spend more money on auditing tax returns. We can frame the question in terms of the elasticity of tax collections with respect to spending on tax enforcement; that is, what is the percentage change in tax collections derived from a given percentage change in spending on tax enforcement? With all of the elasticity concepts that we have just described, some of which are in Table 5.4, the possibility of confusion arises. When you hear the phrases elasticity of demand or elasticity of supply, they refer to the elasticity with respect to price. Sometimes, either to be extremely clear or because economists are discussing a wide variety of elasticities, we will call the elasticity of demand or the demand elasticity the price elasticity of demand or the elasticity of demand with respect to price. Similarly, economists sometimes use the term elasticity of supply or the supply elasticity, to avoid any possibility of confusion, the price elasticity of supply or the elasticity of supply with respect to price. However, in whatever context, the idea of elasticity always refers to percentage change in one variable, almost always a price or money variable, and how it causes a percentage change in another variable, typically a quantity variable of some kind.\n\nIncomeelasticityofdemand=%changeinQd%changeinincomeIncomeelasticityofdemand=%changeinQd%changeinincome\n\n\nCross-price elasticity of demand=% change in Qd of good A% change in price of good BCross-price elasticity of demand=% change in Qd of good A% change in price of good B\n\n\nWage elasticity of labor supply=% change in quantity of labor supplied% change in wageWage elasticity of labor supply=% change in quantity of labor supplied% change in wage\n\n\nWage elasticity of labor demand=% change in quantity of labor demanded% change in wageWage elasticity of labor demand=% change in quantity of labor demanded% change in wage\n\n\nInterest rate elasticity of savings=% change in quantity of savings% change in interest rateInterest rate elasticity of savings=% change in quantity of savings% change in interest rate\n\n\nInterest rate elasticity of borrowing=% change in quantity of borrowing% change in interest rateInterest rate elasticity of borrowing=% change in quantity of borrowing% change in interest rate\n\n\nTable \n5.4\n \n \nFormulas for Calculating Elasticity\n\n\n\nBring It Home\n\n\nThat Will Be How Much?\n\nHow did the 60% price increase in 2011 end up for Netflix? It has been a very bumpy ride.Before the price increase, there were about 24.6 million U.S. subscribers. After the price increase, 810,000 infuriated U.S. consumers canceled their Netflix subscriptions, dropping the total number of subscribers to 23.79 million. Fast forward to June 2013, when there were 36 million streaming Netflix subscribers in the United States. This was an increase of 11.4 million subscribers since the price increasean average per quarter growth of about 1.6 million. This growth is less than the 2 million per quarter increases Netflix experienced in the fourth quarter of 2010 and the first quarter of 2011.\nDuring the first year after the price increase, the firms stock price (a measure of future expectations for the firm) fell from about $33.60 per share per share to just under $7.80. By the end of 2016, however, the stock price was at $123 per share. Today, Netflix has more than 86 million subscribers million subscribers in fifty countries.What happened? Obviously, Netflix company officials understood the law of demand. Company officials reported, when announcing the price increase, this could result in the loss of about 600,000 existing subscribers. Using the elasticity of demand formula, it is easy to see company officials expected an inelastic response:\n=600,000/[(24million+24.6million)/2]$6/[($10+$16)/2]=600,000/24.3million$6/$13=0.0250.46=0.05=600,000/[(24million+24.6million)/2]$6/[($10+$16)/2]=600,000/24.3million$6/$13=0.0250.46=0.05In addition, Netflix officials had anticipated the price increase would have little impact on attracting new customers. Netflix anticipated adding up to 1.29 million new subscribers in the third quarter of 2011. It is true this was slower growth than the firm had experiencedabout 2 million per quarter.Why was the estimate of customers leaving so far off? In the more than two decades since Netflix had been founded, there was an increase in the number of close, but not perfect, substitutes. Consumers now had choices ranging from Vudu, Amazon Prime, Hulu, and Redbox, to retail stores. Jaime Weinman reported in Macleans that Redbox kiosks are a five-minute drive for less from 68 percent of Americans, and it seems that many people still find a five-minute drive more convenient than loading up a movie online. It seems that in 2012, many consumers still preferred a physical DVD disk over streaming video.What missteps did the Netflix management make? In addition to misjudging the elasticity of demand, by failing to account for close substitutes, it seems they may have also misjudged customers preferences and tastes. Yet, as the population increases, the preference for streaming video may overtake physical DVD disks. Netflix, the source of numerous late night talk show laughs and jabs in 2011, may yet have the last laugh.\n\n\n", "06-1": "By the end of this section, you will be able to:\nIdentify the components of GDP on the demand side and on the supply side\nEvaluate how economists measure gross domestic product (GDP)\nContrast and calculate GDP, net exports, and net national product\n\nMacroeconomics is an empirical subject, so the first step toward understanding it is to measure the economy.\nHow large is the U.S. economy? Economists typically measure the size of a nations overall economy by its gross domestic product (GDP), which is the value of all final goods and services produced within a country in a given year. Measuring GDP involves counting the production of millions of different goods and servicessmart phones, cars, music downloads, computers, steel, bananas, college educations, and all other new goods and services that a country produced in the current yearand summing them into a total dollar value. This task is straightforward: take the quantity of everything produced, multiply it by the price at which each product sold, and add up the total. In 2016, the U.S. GDP totaled $18.6 trillion, the largest GDP in the world.Each of the market transactions that enter into GDP must involve both a buyer and a seller. We can measure an economy's GDP either by the total dollar value of what consumers purchase in the economy, or by the total dollar value of what is the country produces. There is even a third way, as we will explain later.GDP Measured by Components of Demand\nWho buys all of this production? We can divide this demand into four main parts: consumer spending (consumption), business spending (investment), government spending on goods and services, and spending on net exports. (See the following Clear It Up feature to understand what we mean by investment.) Table 6.1 shows how these four components added up to the GDP in 2016. Figure 6.4 (a) shows the levels of consumption, investment, and government purchases over time, expressed as a percentage of GDP, while Figure 6.4 (b) shows the levels of exports and imports as a percentage of GDP over time. A few patterns about each of these components are worth noticing. Table 6.1 shows the components of GDP from the demand side.\n\n\nComponents of GDP on the Demand Side (in trillions of dollars)\nPercentage of Total\n\n\n\nConsumption\n$12.8\n68.8%\n\n\nInvestment\n$3.0\n16.1%\n\n\nGovernment\n$3.3\n17.7%\n\n\nExports\n$2.2\n11.8%\n\n\nImports\n$2.7\n14.5%\n\n\nTotal GDP\n$18.6\n100%\n\n\nTable \n6.1\n \nComponents of U.S. GDP in 2016: From the Demand Side\n \n(Source: http://bea.gov/iTable/index_nipa.cfm)\n\n\n\n\n\n\nFigure \n6.3\n \nPercentage of Components of U.S. GDP on the Demand Side\n \nConsumption makes up over half of the demand side components of the GDP. Totals in the chart do not add to 100% due to rounding. (Source: http://bea.gov/iTable/index_nipa.cfm)\n\n\nClear It Up\n\n\nWhat does the word investment mean?\nWhat do economists mean by investment, or business spending? In calculating GDP, investment does not refer to purchasing stocks and bonds or trading financial assets. It refers to purchasing new capital goods, that is, new commercial real estate (such as buildings, factories, and stores) and equipment, residential housing construction, and inventories. Inventories that manufacturers produce this year are included in this years GDPeven if they are not yet sold. From the accountants perspective, it is as if the firm invested in its own inventories. Business investment in 2016 was $3 trillion, according to the Bureau of Economic Analysis.\n\n\n\nFigure \n6.4\n \nComponents of GDP on the Demand Side \n \n(a) Consumption is about two-thirds of GDP, and it has been on a slight upward trend over time. Business investment hovers around 15% of GDP, but it fluctuates more than consumption. Government spending on goods and services is slightly under 20% of GDP and has declined modestly over time. (b) Exports are added to total demand for goods and services, while imports are subtracted from total demand. If exports exceed imports, as in most of the 1960s and 1970s in the U.S. economy, a trade surplus exists. If imports exceed exports, as in recent years, then a trade deficit exists. (Source: http://bea.gov/iTable/index_nipa.cfm)\n\nConsumption expenditure by households is the largest component of GDP, accounting for about two-thirds of the GDP in any year. This tells us that consumers spending decisions are a major driver of the economy. However, consumer spending is a gentle elephant: when viewed over time, it does not jump around too much, and has increased modestly from about 60% of GDP in the 1960s and 1970s.Investment expenditure refers to purchases of physical plant and equipment, primarily by businesses. If Starbucks builds a new store, or Amazon buys robots, they count these expenditures under business investment. Investment demand is far smaller than consumption demand, typically accounting for only about 1518% of GDP, but it is very important for the economy because this is where jobs are created. However, it fluctuates more noticeably than consumption. Business investment is volatile. New technology or a new product can spur business investment, but then confidence can drop and business investment can pull back sharply.If you have noticed any of the infrastructure projects (new bridges, highways, airports) launched during the 2009 recession, you have seen how important government spending can be for the economy. Government expenditure in the United States is close to 20% of GDP, and includes spending by all three levels of government: federal, state, and local. The only part of government spending counted in demand is government purchases of goods or services produced in the economy. Examples include the government buying a new fighter jet for the Air Force (federal government spending), building a new highway (state government spending), or a new school (local government spending). A significant portion of government budgets consists of transfer payments, like unemployment benefits, veterans benefits, and Social Security payments to retirees. The government excludes these payments from GDP because it does not receive a new good or service in return or exchange. Instead they are transfers of income from taxpayers to others. If you are curious about the awesome undertaking of adding up GDP, read the following Clear It Up feature.\nClear It Up\n\n\nHow do statisticians measure GDP?\n\nGovernment economists at the Bureau of Economic Analysis (BEA), within the U.S. Department of Commerce, piece together estimates of GDP from a variety of sources.\nOnce every five years, in the second and seventh year of each decade, the Bureau of the Census carries out a detailed census of businesses throughout the United States. In between, the Census Bureau carries out a monthly survey of retail sales. The government adjusts these figures with foreign trade data to account for exports that are produced in the United States and sold abroad and for imports that are produced abroad and sold here. Once every ten years, the Census Bureau conducts a comprehensive survey of housing and residential finance. Together, these sources provide the main basis for figuring out what is produced for consumers.For investment, the Census Bureau carries out a monthly survey of construction and an annual survey of expenditures on physical capital equipment.\nFor what the federal government purchases, the statisticians rely on the U.S. Department of the Treasury. An annual Census of Governments gathers information on state and local governments. Because the government spends a considerable amount at all levels hiring people to provide services, it also tracks a large portion of spending through payroll records that state governments and the Social Security Administration collect.With regard to foreign trade, the Census Bureau compiles a monthly record of all import and export documents. Additional surveys cover transportation and travel, and make adjustments for financial services that are produced in the United States for foreign customers.Many other sources contribute to GDP estimates. Information on energy comes from the U.S. Department of Transportation and Department of Energy. The Agency for Health Care Research and Quality collects information on healthcare. Surveys of landlords find out about rental income. The Department of Agriculture collects statistics on farming.All these bits and pieces of information arrive in different forms, at different time intervals. The BEA melds them together to produce GDP estimates on a quarterly basis (every three months). The BEA then \"annualizes\" these numbers by multiplying by four. As more information comes in, the BEA updates and revises these estimates. BEA releases the GDP advance estimate for a certain quarter one month after a quarter. The preliminary estimate comes out one month after that. The BEA publishes the final estimate one month later, but it is not actually final. In July, the BEA releases roughly updated estimates for the previous calendar year. Then, once every five years, after it has processed all the results of the latest detailed five-year business census, the BEA revises all of the past GDP estimates according to the newest methods and data, going all the way back to 1929.\n\nLink It Up\n\n\nVisit this website to read FAQs on the BEA site. You can even email your own questions!\n\nWhen thinking about the demand for domestically produced goods in a global economy, it is important to count spending on exportsdomestically produced goods that a country sells abroad. Similarly, we must also subtract spending on importsgoods that a country produces in other countries that residents of this country purchase. The GDP net export component is equal to the dollar value of exports (X) minus the dollar value of imports (M), (X  M). We call the gap between exports and imports the trade balance. If a countrys exports are larger than its imports, then a country has a trade surplus. In the United States, exports typically exceeded imports in the 1960s and 1970s, as Figure 6.4(b) shows.Since the early 1980s, imports have typically exceeded exports, and so the United States has experienced a trade deficit in most years. The trade deficit grew quite large in the late 1990s and in the mid-2000s. Figure 6.4 (b) also shows that imports and exports have both risen substantially in recent decades, even after the declines during the Great Recession between 2008 and 2009. As we noted before, if exports and imports are equal, foreign trade has no effect on total GDP. However, even if exports and imports are balanced overall, foreign trade might still have powerful effects on particular industries and workers by causing nations to shift workers and physical capital investment toward one industry rather than another.Based on these four components of demand, we can measure GDP as:GDP=Consumption+Investment+Government+TradebalanceGDP=C+I+G+(XM)GDP=Consumption+Investment+Government+TradebalanceGDP=C+I+G+(XM)\nUnderstanding how to measure GDP is important for analyzing connections in the macro economy and for thinking about macroeconomic policy tools.\n\nGDP Measured by What is Produced\nEverything that we purchase somebody must first produce. Table 6.2 breaks down what a country produces into five categories: durable goods, nondurable goods, services, structures, and the change in inventories. Before going into detail about these categories, notice that total GDP measured according to what is produced is exactly the same as the GDP measured by looking at the five components of demand. Figure 6.5 provides a visual representation of this information.\n\n\nComponents of GDP on the Supply Side (in trillions of dollars)\nPercentage of Total\n\n\n\nGoods\n\n\n\n\nDurable goods\n$3.0\n16.1%\n\n\nNondurable goods\n$2.5\n13.4%\n\n\nServices\n$11.6\n62.4%\n\n\nStructures\n$1.5\n8.1%\n\n\nChange in inventories\n$0.0\n0.0%\n\n\nTotal GDP\n$18.6\n100%\n\n\nTable \n6.2\n \nComponents of U.S. GDP on the Production Side, 2016\n \n(Source:  http://bea.gov/iTable/index_nipa.cfm)\n\n\n\n\n\nFigure \n6.5\n \nPercentage of Components of GDP on the Production Side \n \nServices make up over 60 percent of the production side components of GDP in the United States.\n\nSince every market transaction must have both a buyer and a seller, GDP must be the same whether measured by what is demanded or by what is produced. Figure 6.6 shows these components of what is produced, expressed as a percentage of GDP, since 1960.\n\n\n\n\nFigure \n6.6\n \nTypes of Production \n \nServices are the largest single component of total supply, representing over 60 percent  of GDP, up from about 45 percent in the early 1960s. Durable and nondurable goods constitute the manufacturing sector, and they have declined from 45 percent of GDP in 1960 to about 30 percent in 2016. Nondurable goods used to be larger than durable goods, but in recent years, nondurable goods have been dropping to below the share of  durable goods, which is less than  20% of GDP. Structures hover around 10% of GDP. We do not show here the change in inventories, the final component of aggregate supply. It is typically less than 1% of GDP.\n\n\nIn thinking about what is produced in the economy, many non-economists immediately focus on solid, long-lasting goods, like cars and computers. By far the largest part of GDP, however, is services. Moreover, services have been a growing share of GDP over time. A detailed breakdown of the leading service industries would include healthcare, education, and legal and financial services. It has been decades since most of the U.S. economy involved making solid objects. Instead, the most common jobs in a modern economy involve a worker looking at pieces of paper or a computer screen; meeting with co-workers, customers, or suppliers; or making phone calls.\nEven within the overall category of goods, long-lasting durable goods like cars and refrigerators are about the same share of the economy as short-lived nondurable goods like food and clothing. The category of structures includes everything from homes, to office buildings, shopping malls, and factories. Inventories is a small category that refers to the goods that one business has produced but has not yet sold to consumers, and are still sitting in warehouses and on shelves. The amount of inventories sitting on shelves tends to decline if business is better than expected, or to rise if business is worse than expected.Another Way to Measure GDP: The National Income ApproachGDP is a measure of what is produced in a nation. The primary way GDP is estimated is with the Expenditure Approach we discussed above, but there is another way.  Everything a firm produces, when sold, becomes revenues to the firm. Businesses use revenues to pay their bills: Wages and salaries for labor, interest and dividends for capital, rent for land, profit to the entrepreneur, etc. So adding up all the income produced in a year provides a second way of measuring GDP. This is why the terms GDP and national income are sometimes used interchangeably. The total value of a nations output is equal to the total value of a nations income.\n\nThe Problem of Double Counting\nWe define GDP as the current value of all final goods and services produced in a nation in a year. What are final goods? They are goods at the furthest stage of production at the end of a year. Statisticians who calculate GDP must avoid the mistake of double counting, in which they count output more than once as it travels through the production stages. For example, imagine what would happen if government statisticians first counted the value of tires that a tire manufacturer produces, and then counted the value of a new truck that an automaker sold that contains those tires. In this example, the statisticians would have counted the value of the tires twice-because the truck's price includes the value of the tires.To avoid this problem, which would overstate the size of the economy considerably, government statisticians count just the value of final goods and services in the chain of production that are sold for consumption, investment, government, and trade purposes. Statisticians exclude intermediate  goods, which are goods that go into producing other goods, from GDP calculations. From the example above, they will only count the Ford truck's value. The value of what businesses provide to other businesses is captured in the final products at the end of the production chain.The concept of GDP is fairly straightforward: it is just the dollar value of all final goods and services produced in the economy in a year. In our decentralized, market-oriented economy, actually calculating the more than $18 trillion-dollar U.S. GDPalong with how it is changing every few monthsis a full-time job for a brigade of government statisticians.\n\nWhat is Counted in GDP\nWhat is not included in GDP\n\n\n\nConsumption\nIntermediate goods\n\n\nBusiness investment\nTransfer payments and non-market activities\n\n\nGovernment spending on goods and services\nUsed goods\n\n\nNet exports\nIllegal goods\n\n\nTable \n6.3\n \nCounting GDP\n \n\n\nNotice the items that are not counted into GDP, as  Table 6.3 outlines. The sales of used goods are not included because they were produced in a previous year and are part of that years GDP. The entire underground economy of services paid under the table and illegal sales should be counted, but is not, because it is impossible to track these sales. In Friedrich Schneider's recent study of shadow economies, he estimated the underground economy in the United States to be 6.6% of GDP, or close to $2 trillion dollars in 2013 alone. Transfer payments, such as payment by the government to individuals, are not included, because they do not represent production. Also, production of some goodssuch as home production as when you make your breakfastis not counted because these goods are not sold in the marketplace.\nLink It Up\n\n\nVisit this website to read about the New Underground Economy.\n\n\nOther Ways to Measure the Economy\nBesides GDP, there are several different but closely related ways of measuring the size of the economy. We mentioned above that we can think of GDP as total production and as total purchases. We can also think of it as total income since anything one produces and sells yields income.One of the closest cousins of GDP is the gross national product (GNP). GDP includes only what country produces within its borders. GNP adds what domestic businesses and labor abroad produces, and subtracts any payments that foreign labor and businesses located in the United States send home to other countries. In other words, GNP is based more on what a country's citizens and firms produce, wherever they are located, and GDP is based on what happens within a certain county's geographic boundaries. For the United States, the gap between GDP and GNP is relatively small; in recent years, only about 0.2%. For small nations, which may have a substantial share of their population working abroad and sending money back home, the difference can be substantial.We calculate net national product (NNP) by taking GNP and then subtracting the value of how much physical capital is worn out, or reduced in value because of aging, over the course of a year. The process by which capital ages and loses value is called depreciation. We can further subdivide NNP into national income, which includes all income to businesses and individuals, and personal income, which includes only income to people.For practical purposes, it is not vital to memorize these definitions. However, it is important to be aware that these differences exist and to know what statistic you are examining, so that you do not accidentally compare, say, GDP in one year or for one country with GNP or NNP in another year or another country. To get an idea of how these calculations work, follow the steps in the following Work It Out feature.\nWork It Out\n\n\nCalculating GDP, Net Exports, and NNP\n\nBased on the information in Table 6.4:\n      \nWhat is the value of GDP?\nWhat is the value of net exports?\nWhat is the value of NNP?\n\n\n\nGovernment purchases\n$120 billion\n\n\nDepreciation\n$40 billion\n\n\nConsumption\n$400 billion\n\n\nBusiness Investment\n$60 billion\n\n\nExports\n$100 billion\n\n\nImports\n$120 billion\n\nIncome receipts from rest of the world$10 billion\nIncome payments to rest of the world$8 billion\n\nTable \n6.4\n \n \n\nStep 1. To calculate GDP use the following formula:\nGDP=Consumption+Investment+Governmentspending+(ExportsImports)=C+I+G+(XM)=$400+$60+$120+($100$120)=$560billionGDP=Consumption+Investment+Governmentspending+(ExportsImports)=C+I+G+(XM)=$400+$60+$120+($100$120)=$560billion\nStep 2. To calculate net exports, subtract imports from exports.\nNetexports=XM=$100$120=$20billionNetexports=XM=$100$120=$20billion\nStep 3. To calculate NNP, use the following formula:\n\nNNP\n=\nGDP+ Income receipts from the rest of the world\n Income payments to the rest of the world Depreciation\n=\n$560+ $10  $8 $40\n=\n$522billion\n\nNNP\n=\nGDP+ Income receipts from the rest of the world\n Income payments to the rest of the world Depreciation\n=\n$560+ $10  $8 $40\n=\n$522billion\n\n\n", "06-2": "By the end of this section, you will be able to:\nContrast nominal GDP and real GDP\nExplain GDP deflator\nCalculate real GDP based on nominal GDP values\n\nWhen examining economic statistics, there is a crucial distinction worth emphasizing. The distinction is between nominal and real measurements, which refer to whether or not inflation has distorted a given statistic. Looking at economic statistics without considering inflation is like looking through a pair of binoculars and trying to guess how close something is: unless you know how strong the lenses are, you cannot guess the distance very accurately. Similarly, if you do not know the inflation rate, it is difficult to figure out if a rise in GDP is due mainly to a rise in the overall level of prices or to a rise in quantities of goods produced. The nominal value of any economic statistic means that we measure the statistic in terms of actual prices that exist at the time. The real value refers to the same statistic after it has been adjusted for inflation. Generally, it is the real value that is more important.Converting Nominal to Real GDP\nTable 6.5 shows U.S. GDP at five-year intervals since 1960 in nominal dollars; that is, GDP measured using the actual market prices prevailing in each stated year. Figure 6.7 also reflects this data in a graph.\n\nYear\nNominal GDP (billions of dollars)\nGDP Deflator (2005 = 100)\n\n\n\n1960\n543.3\n19.0\n\n\n1965\n743.7\n20.3\n\n\n1970\n1,075.9\n24.8\n\n\n1975\n1,688.9\n34.1\n\n\n1980\n2,862.5\n48.3\n\n\n1985\n4,346.7\n62.3\n\n\n1990\n5,979.6\n72.7\n\n\n1995\n7,664.0\n81.7\n\n\n2000\n10,289.7\n89.0\n\n\n2005\n13,095.4\n100.0\n\n\n2010\n14,958.3\n110.0\n\n\nTable \n6.5\n \nU.S. Nominal GDP and the GDP Deflator\n \n(Source: www.bea.gov)\n\n\n\n\n\n\n\nFigure \n6.7\n \nU.S. Nominal GDP, 19602010 \n \nNominal GDP values have risen exponentially from 1960 through 2010, according to the BEA.\n\n\nIf an unwary analyst compared nominal GDP in 1960 to nominal GDP in 2010, it might appear that national output had risen by a factor of more than twenty-seven over this time (that is, GDP of $14,958 billion in 2010 divided by GDP of $543 billion in 1960 = 27.5). This conclusion would be highly misleading. Recall that we define nominal GDP as the quantity of every final good or service produced multiplied by the price at which it was sold, summed up for all goods and services. In order to see how much production has actually increased, we need to extract the effects of higher prices on nominal GDP. We can easily accomplish this using the GDP deflator.The GDP deflator is a price index measuring the average prices of all final goods and services included in the economy. We explore price indices in detail and how we compute them in Inflation, but this definition will do in the context of this chapter. Table 6.5 provides the GDP deflator data and Figure 6.8 shows it graphically.\n\n\n\n\nFigure \n6.8\n \nU.S. GDP Deflator, 19602010 \n \nMuch like nominal GDP, the GDP deflator has risen exponentially from 1960 through 2010. (Source: BEA)\n\n\nFigure 6.8 shows that the price level has risen dramatically since 1960. The price level in 2010 was almost six times higher than in 1960 (the deflator for 2010 was 110 versus a level of 19 in 1960). Clearly, much of the growth in nominal GDP was due to inflation, not an actual change in the quantity of goods and services produced, in other words, not in real GDP. Recall that nominal GDP can rise for two reasons: an increase in output, and/or an increase in prices. What is needed is to extract the increase in prices from nominal GDP so as to measure only changes in output. After all, the dollars used to measure nominal GDP in 1960 are worth more than the inflated dollars of 1990and the price index tells exactly how much more. This adjustment is easy to do if you understand that nominal measurements are in value terms, whereValue=PriceQuantityorNominalGDP=GDPDeflatorRealGDPValue=PriceQuantityorNominalGDP=GDPDeflatorRealGDPLets look at an example at the micro level. Suppose the t-shirt company, Coolshirts, sells 10 t-shirts at a price of $9 each.\nCoolshirt'snominalrevenuefromsales=PriceQuantity=$910=$90Coolshirt'snominalrevenuefromsales=PriceQuantity=$910=$90Then,\nCoolshirt'srealincome=NominalrevenuePrice=$90$9=10Coolshirt'srealincome=NominalrevenuePrice=$90$9=10In other words, when we compute real measurements we are trying to obtain actual quantities, in this case, 10 t-shirts.With GDP, it is just a tiny bit more complicated. We start with the same formula as above:\nRealGDP=NominalGDPPriceIndexRealGDP=NominalGDPPriceIndexFor reasons that we will explain in more detail below, mathematically, a price index is a two-digit decimal number like 1.00 or 0.85 or 1.25. Because some people have trouble working with decimals, when the price index is published, it has traditionally been multiplied by 100 to get integer numbers like 100, 85, or 125. What this means is that when we deflate nominal figures to get real figures (by dividing the nominal by the price index). We also need to remember to divide the published price index by 100 to make the math work. Thus, the formula becomes:RealGDP=NominalGDPPriceIndex/100RealGDP=NominalGDPPriceIndex/100Now read the following Work It Out feature for more practice calculating real GDP.\n\nWork It Out\n\n\nComputing GDP\n\nIt is possible to use the data in Table 6.5 to compute real GDP.\nStep 1. Look at Table 6.5, to see that, in 1960, nominal GDP was $543.3 billion and the price index (GDP deflator) was 19.0.\nStep 2. To calculate the real GDP in 1960, use the formula:\nRealGDP=NominalGDPPriceIndex/100=$543.3billion19/100=$2,859.5billionRealGDP=NominalGDPPriceIndex/100=$543.3billion19/100=$2,859.5billionWell do this in two parts to make it clear. First adjust the price index: 19 divided by 100 = 0.19. Then divide into nominal GDP: $543.3 billion / 0.19 = $2,859.5 billion.\nStep 3. Use the same formula to calculate the real GDP in 1965.\nRealGDP=NominalGDPPriceIndex/100=$743.7billion20.3/100=$3,663.5billionRealGDP=NominalGDPPriceIndex/100=$743.7billion20.3/100=$3,663.5billionStep 4. Continue using this formula to calculate all of the real GDP values from 1960 through 2010. The calculations and the results are in Table 6.6.\n\nYear\nNominal GDP (billions of dollars)\nGDP Deflator (2005 = 100)\nCalculations\nReal GDP (billions of 2005 dollars)\n\n\n\n1960\n543.3\n19.0\n543.3 / (19.0/100)\n2859.5\n\n\n1965\n743.7\n20.3\n743.7 / (20.3/100)\n3663.5\n\n\n1970\n1075.9\n24.8\n1,075.9 / (24.8/100)\n4338.3\n\n\n1975\n1688.9\n34.1\n1,688.9 / (34.1/100)\n4952.8\n\n\n1980\n2862.5\n48.3\n2,862.5 / (48.3/100)\n5926.5\n\n\n1985\n4346.7\n62.3\n4,346.7 / (62.3/100)\n6977.0\n\n\n1990\n5979.6\n72.7\n5,979.6 / (72.7/100)\n8225.0\n\n\n1995\n7664.0\n82.0\n7,664 / (82.0/100)\n9346.3\n\n\n2000\n10289.7\n89.0\n10,289.7 / (89.0/100)\n11561.5\n\n\n2005\n13095.4\n100.0\n13,095.4 / (100.0/100)\n13095.4\n\n\n2010\n14958.3\n110.0\n14,958.3 / (110.0/100)\n13598.5\n\n\nTable \n6.6\n \nConverting Nominal to Real GDP\n \n(Source: Bureau of Economic Analysis, www.bea.gov)\n\n\nThere are a couple things to notice here. Whenever you compute a real statistic, one year (or period) plays a special role. It is called the base year (or base period). The base year is the year whose prices we use to compute the real statistic. When we calculate real GDP, for example, we take the quantities of goods and services produced in each year (for example, 1960 or 1973) and multiply them by their prices in the base year (in this case, 2005), so we get a measure of GDP that uses prices that do not change from year to year. That is why real GDP is labeled Constant Dollars or, in this example,  2005 Dollars, which means that real GDP is constructed using prices that existed in 2005. While the example here uses 2005 as the base year, more generally, you can use any year as the base year. The formula is:GDPdeflator=NominalGDPRealGDP100GDPdeflator=NominalGDPRealGDP100Rearranging the formula and using the data from 2005:\nRealGDP=NominalGDPPriceIndex/100=$13,095.4billion100/100=$13,095.4billionRealGDP=NominalGDPPriceIndex/100=$13,095.4billion100/100=$13,095.4billionComparing real GDP and nominal GDP for 2005, you see they are the same. This is no accident. It is because we have chosen 2005 as the base year in this example. Since the price index in the base year always has a value of 100 (by definition), nominal and real GDP are always the same in the base year.Look at the data for 2010.\nRealGDP=NominalGDPPriceIndex/100=$14,958.3billion110/100=$13,598.5billionRealGDP=NominalGDPPriceIndex/100=$14,958.3billion110/100=$13,598.5billionUse this data to make another observation: As long as inflation is positive, meaning prices increase on average from year to year, real GDP should be less than nominal GDP in any year after the base year. The reason for this should be clear: The value of nominal GDP is inflated by inflation. Similarly, as long as inflation is positive, real GDP should be greater than nominal GDP in any year before the base year.\n\nFigure 6.9 shows the U.S. nominal and real GDP since 1960. Because 2005 is the base year, the nominal and real values are exactly the same in that year. However, over time, the rise in nominal GDP looks much larger than the rise in real GDP (that is, the nominal GDP line rises more steeply than the real GDP line), because the presence of inflation, especially in the 1970s exaggerates the rise in nominal GDP.\n\n\n\nFigure \n6.9\n \nU.S. Nominal and Real GDP, 19602012 \n \nThe red line measures U.S. GDP in nominal dollars. The black line measures U.S. GDP in real dollars, where all dollar values are converted to 2005 dollars. Since we express real GDP in 2005 dollars, the two lines cross in 2005. However, real GDP will appear higher than nominal GDP in the years before 2005, because dollars were worth less in 2005 than in previous years. Conversely, real GDP will appear lower in the years after 2005, because dollars were worth more in 2005 than in later years.\n\nLets return to the question that we posed originally: How much did GDP increase in real terms? What was the real GDP growth rate from 1960 to 2010? To find the real growth rate, we apply the formula for percentage change:2010realGDP1960realGDP1960realGDP100=%change13,598.52,859.52,859.5100=376%2010realGDP1960realGDP1960realGDP100=%change13,598.52,859.52,859.5100=376%In other words, the U.S. economy has increased real production of goods and services by nearly a factor of four since 1960. Of course, that understates the material improvement since it fails to capture improvements in the quality of products and the invention of new products.\nThere is a quicker way to answer this question approximately, using another math trick. Because:\nNominal=PriceQuantity\n%changeinNominal=%changeinPrice+%changeinQuantity\nOR\n%changeinQuantity=%changeinNominal%changeinPriceNominal=PriceQuantity\n%changeinNominal=%changeinPrice+%changeinQuantity\nOR\n%changeinQuantity=%changeinNominal%changeinPriceTherefore, real GDP growth rate (% change in quantity) equals the growth rate in nominal GDP (% change in value) minus the inflation rate (% change in price).Note that using this equation provides an approximation for small changes in the levels. For more accurate measures, one should use the first formula.\n", "06-3": "By the end of this section, you will be able to:\nExplain recessions, depressions, peaks, and troughs\nEvaluate the importance of tracking real GDP over time\n\nWhen news reports indicate that the economy grew 1.2% in the first quarter, the reports are referring to the percentage change in real GDP. By convention, governments report GDP growth is at an annualized rate: Whatever the calculated growth in real GDP was for the quarter, we multiply it by four when it is reported as if the economy were growing at that rate for a full year.\n\n\n\nFigure \n6.10\n \nU.S. GDP, 19002016\n \nReal GDP in the United States in 2016 (in 2009 dollars) was about $16.7 trillion. After adjusting to remove the effects of inflation, this represents a roughly 20-fold increase in the economys production of goods and services since the start of the twentieth century. (Source: bea.gov)\n\nFigure 6.10 shows the pattern of U.S. real GDP since 1900. Short term declines have regularly interrupted the generally upward long-term path of GDP. We call a significant decline in real GDP a recession. We call an especially lengthy and deep recession a depression. The severe drop in GDP that occurred during the 1930s Great Depression is clearly visible in the figure, as is the 20082009 Great Recession.Real GDP is important because it is highly correlated with other measures of economic activity, like employment and unemployment. When real GDP rises, so does employment.\nThe most significant human problem associated with recessions (and their larger, uglier cousins, depressions) is that a slowdown in production means that firms need to lay off or fire some of their workers. Losing a job imposes painful financial and personal costs on workers, and often on their extended families as well. In addition, even those who keep their jobs are likely to find that wage raises are scanty at bestor their employers may ask them to take pay cuts.Table 6.7 lists the pattern of recessions and expansions in the U.S. economy since 1900. We call the highest point of the economy, before the recession begins, the peak. Conversely, the lowest point of a recession, before a recovery begins, is the trough. Thus, a recession lasts from peak to trough, and an economic upswing runs from trough to peak. We call the economy's movement from peak to trough and trough to peak the business cycle. It is intriguing to notice that the three longest trough-to-peak expansions of the twentieth century have happened since 1960. The most recent recession started in December 2007 and ended formally in June 2009. This was the most severe recession since the 1930s Great Depression. The ongoing expansion since the June 2009 trough will also be quite long, comparatively, having already reached 90 months at the end of 2016.  \n\nTrough\nPeak\nMonths of Contraction\nMonths of Expansion\n\n\n\nDecember 1900\nSeptember 1902\n18\n21\n\n\nAugust 1904\nMay 1907\n23\n33\n\n\nJune 1908\nJanuary 1910\n13\n19\n\n\nJanuary 1912\nJanuary 1913\n24\n12\n\n\nDecember 1914\nAugust 1918\n23\n44\n\n\nMarch 1919\nJanuary 1920\n7\n10\n\n\nJuly 1921\nMay 1923\n18\n22\n\n\nJuly 1924\nOctober 1926\n14\n27\n\n\nNovember 1927\nAugust 1929\n23\n21\n\n\nMarch 1933\nMay 1937\n43\n50\n\n\nJune 1938\nFebruary 1945\n13\n80\n\n\nOctober 1945\nNovember 1948\n8\n37\n\n\nOctober 1949\nJuly 1953\n11\n45\n\n\nMay 1954\nAugust 1957\n10\n39\n\n\nApril 1958\nApril 1960\n8\n24\n\n\nFebruary 1961\nDecember 1969\n10\n106\n\n\nNovember 1970\nNovember 1973\n11\n36\n\n\nMarch 1975\nJanuary 1980\n16\n58\n\n\nJuly 1980\nJuly 1981\n6\n12\n\n\nNovember 1982\nJuly 1990\n16\n92\n\n\nMarch 1991\nMarch 2001\n8\n120\n\n\nNovember 2001\nDecember 2007\n8\n73\n\n\nTable \n6.7\n \nU.S. Business Cycles since 1900\n \n(Source: http://www.nber.org/cycles/main.html)\n\nA private think tank, the National Bureau of Economic Research (NBER), tracks business cycles for the U.S. economy. However, the effects of a severe recession often linger after the official ending date assigned by the NBER.\n", "06-4": "By the end of this section, you will be able to:\nExplain how we can use GDP to compare the economic welfare of different nations\nCalculate the conversion of GDP to a common currency by using exchange rates\nCalculate GDP per capita using population data\n\nIt is common to use GDP as a measure of economic welfare or standard of living in a nation. When comparing the GDP of different nations for this purpose, two issues immediately arise. First, we measure a country's GDP in its own currency: the United States uses the U.S. dollar; Canada, the Canadian dollar; most countries of Western Europe, the euro; Japan, the yen; Mexico, the peso; and so on. Thus, comparing GDP between two countries requires converting to a common currency. A second issue is that countries have very different numbers of people. For instance, the United States has a much larger economy than Mexico or Canada, but it also has almost three times as many people as Mexico and nine times as many people as Canada. Thus, if we are trying to compare standards of living across countries, we need to divide GDP by population.Converting Currencies with Exchange Rates\nTo compare the GDP of countries with different currencies, it is necessary to convert to a common denominator using an exchange rate, which is the value of one currency in terms of another currency. We express exchange rates either as the units of country As currency that need to be traded for a single unit of country Bs currency (for example, Japanese yen per British pound), or as the inverse (for example, British pounds per Japanese yen). We can use two types of exchange rates for this purpose, market exchange rates and purchasing power parity (PPP) equivalent exchange rates. Market exchange rates vary on a day-to-day basis depending on supply and demand in foreign exchange markets. PPP-equivalent exchange rates provide a longer run measure of the exchange rate. For this reason, economists typically use PPP-equivalent exchange rates for GDP cross country comparisons. We will discuss exchange rates in more detail in Exchange Rates and International Capital Flows. The following Work It Out feature explains how to convert GDP to a common currency.\nWork It Out\n\n\nConverting GDP to a Common Currency\n\nUsing the exchange rate to convert GDP from one currency to another is straightforward. Say that the task is to compare Brazils GDP in 2013 of 4.8 trillion reals with the U.S. GDP of $16.6 trillion for the same year.Step 1. Determine the exchange rate for the specified year. In 2013, the exchange rate was 2.230 reals = $1. (These numbers are realistic, but rounded off to simplify the calculations.)Step 2. Convert Brazils GDP into U.S. dollars:\nBrazil'sGDPinnbsp;U.S.=Brazil'sGDPinrealsExchangerate(reals/nbsp;U.S.)=4.8 trillionreals2.230realspernbsp;U.S.=$2.2 trillionBrazil'sGDPinnbsp;U.S.=Brazil'sGDPinrealsExchangerate(reals/nbsp;U.S.)=4.8 trillionreals2.230realspernbsp;U.S.=$2.2 trillionStep 3. Compare this value to the GDP in the United States in the same year. The U.S. GDP was $16.6 trillion in 2013, which is nearly eight times that of GDP in Brazil in 2012.Step 4. View Table 6.8 which shows the size of and variety of GDPs of different countries in 2013, all expressed in U.S. dollars. We calculate each using the process that we explained above.\n\nCountry\nGDP in Billions of Domestic Currency\nDomestic Currency/U.S. Dollars (PPP Equivalent)\nGDP (in billions of U.S. dollars)\n\n\n\nBrazil\n4,844.80\nreals\n2.157\n2,246.00\n\n\nCanada\n1,881.20\ndollars\n1.030\n1,826.80\n\n\nChina\n58,667.30\nyuan\n6.196\n9,469.10\n\n\nEgypt\n1,753.30\npounds\n6.460\n271.40\n\n\nGermany\n2,737.60\neuros\n0.753\n3,636.00\n\n\nIndia\n113,550.70\nrupees\n60.502\n1,876.80\n\n\nJapan\n478,075.30\nyen\n97.596\n4,898.50\n\n\nMexico\n16,104.40\npesos\n12.772\n1,260.90\n\n\nSouth Korea\n1,428,294.70\nwon\n1,094.925\n1,304.467\n\n\nUnited Kingdom\n1,612.80\npounds\n0.639\n2,523.20\n\n\nUnited States\n16,768.10\ndollars\n1.000\n16,768.10\n\n\nTable \n6.8\n \nComparing GDPs Across Countries, 2013\n \n(Source: http://www.imf.org/external/pubs/ft/weo/2013/01/weodata/index.aspx)\n\n\n\nGDP Per Capita\nThe U.S. economy has the largest GDP in the world, by a considerable amount. The United States is also a populous country; in fact, it is the third largest country by population in the world, although well behind China and India. Is the U.S. economy larger than other countries just because the United States has more people than most other countries, or because the U.S. economy is actually larger on a per-person basis? We can answer this question by calculating a countrys GDP per capita; that is, the GDP divided by the population.GDPpercapita=GDP/populationGDPpercapita=GDP/population\nThe second column of Table 6.9 lists the GDP of the same selection of countries that appeared in the previous Tracking Real GDP over Time and Table 6.8, showing their GDP as converted into U.S. dollars (which is the same as the last column of the previous table). The third column gives the population for each country. The fourth column lists the GDP per capita. We obtain GDP per capita in two steps:  First, by multiplying column two (GDP, in billions of dollars) by 1000 so it has the same units as column three (Population, in millions).  Then divide the result (GDP in millions of dollars) by column three (Population, in millions).\n\nCountry\nGDP (in billions of U.S. dollars)\nPopulation (in millions)\nPer Capita GDP (in U.S. dollars)\n\n\n\nBrazil\n2,246.00\n199.20\n11,275.10\n\n\nCanada\n1,826.80\n35.10\n52,045.58\n\n\nChina\n 9,469.10\n1,360.80\n6,958.48\n\n\nEgypt\n271.40\n83.70\n3,242.90\n\n\nGermany\n3,636.00\n80.80\n44,999.50\n\n\nIndia\n1,876.80\n1,243.30\n1,509.50\n\n\nJapan\n4,898.50\n127.3\n38,479.97\n\n\nMexico\n1,260.90\n118.40\n10,649.90\n\n\nSouth Korea\n1,304.47\n50.20\n25,985.46\n\n\nUnited Kingdom\n2,523.20\n64.10\n39,363.50\n\n\nUnited States\n16,768.10\n316.30\n53,013.28\n\n\nTable \n6.9\n \nGDP Per Capita, 2013\n \n(Source: http://www.imf.org/external/pubs/ft/weo/2013/01/weodata/index.aspx)\n\nNotice that the rankings by GDP in billions of U.S. dollars, and by GDP per capita, are different than the ranking of GDP by each countrys currency. Measured by its own currency, the rupee, India has a somewhat larger GDP than Germany. But measured by U.S. dollars, Germanys GDP is twice Indias, and on a per capita basis in U.S. dollars, Germany has more than 280 times Indias standard of living. \nClear It Up\n\n\nIs China going to surpass the United States in terms of standard of living?\n\nAs Table 6.9 shows, China has the second largest GDP of the countries: $9.5 trillion compared to the United States $16.8 trillion. Perhaps it will surpass the United States, but probably not any time soon. China has a much larger population so that in per capita terms, its GDP is less than one fifth that of the United States ($6,958.48 compared to $53,013). The Chinese people are still quite poor relative to the United States and other developed countries. One caveat: For reasons we will discuss shortly, GDP per capita can give us only a rough idea of the differences in living standards across countries.\nThe world's high-income nationsincluding the United States, Canada, the Western European countries, and Japantypically have GDP per capita in the range of $20,000 to $50,000. Middle-income countries, which include much of Latin America, Eastern Europe, and some countries in East Asia, have GDP per capita in the range of $6,000 to $12,000. The world's low-income countries, many of them located in Africa and Asia, often have GDP per capita of less than $2,000 per year.\n", "06-5": "By the end of this section, you will be able to:\nDiscuss how productivity influences the standard of living\nExplain the limitations of GDP as a measure of the standard of living\nAnalyze the relationship between GDP data and fluctuations in the standard of living\n\nThe level of GDP per capita clearly captures some of what we mean by the phrase standard of living. Most of the migration in the world, for example, involves people who are moving from countries with relatively low GDP per capita to countries with relatively high GDP per capita.\nStandard of living is a broader term than GDP. While GDP focuses on production that is bought and sold in markets, standard of living includes all elements that affect peoples well-being, whether they are bought and sold in the market or not. To illuminate the difference between GDP and standard of living, it is useful to spell out some things that GDP does not cover that are clearly relevant to standard of living.Limitations of GDP as a Measure of the Standard of Living\nWhile GDP includes spending on recreation and travel, it does not cover leisure time. Clearly, however, there is a substantial difference between an economy that is large because people work long hours, and an economy that is just as large because people are more productive with their time so they do not have to work as many hours. The GDP per capita of the U.S. economy is larger than the GDP per capita of Germany, as Table 6.9 showed, but does that prove that the standard of living in the United States is higher? Not necessarily, since it is also true that the average U.S. worker works several hundred hours more per year more than the average German worker. Calculating GDP does not account for the German workers extra vacation weeks.While GDP includes what a country spends on environmental protection, healthcare, and education, it does not include actual levels of environmental cleanliness, health, and learning. GDP includes the cost of buying pollution-control equipment, but it does not address whether the air and water are actually cleaner or dirtier. GDP includes spending on medical care, but does not address whether life expectancy or infant mortality have risen or fallen. Similarly, it counts spending on education, but does not address directly how much of the population can read, write, or do basic mathematics.GDP includes production that is exchanged in the market, but it does not cover production that is not exchanged in the market. For example, hiring someone to mow your lawn or clean your house is part of GDP, but doing these tasks yourself is not part of GDP. One remarkable change in the U.S. economy in recent decades is the growth in womens participation in  the labor force.  As of 1970, only about 42% of women participated in the paid labor force. By the second decade of the 2000s, nearly 60% of women participated in the paid labor force according to the Bureau of Labor Statistics. As women are now in the labor force, many of the services they used to produce in the non-market economy like food preparation and child care have shifted to some extent into the market economy, which makes the GDP appear larger even if people actually are not consuming more services.GDP has nothing to say about the level of inequality in society. GDP per capita is only an average. When GDP per capita rises by 5%, it could mean that GDP for everyone in the society has risen by 5%, or that GDP of some groups has risen by more while that of others has risen by lessor even declined. GDP also has nothing in particular to say about the amount of variety available. If a family buys 100 loaves of bread in a year, GDP does not care whether they are all white bread, or whether the family can choose from wheat, rye, pumpernickel, and many othersit just looks at the total amount the family spends on bread.Likewise, GDP has nothing much to say about what technology and products are available. The standard of living in, for example, 1950 or 1900 was not affected only by how much money people hadit was also affected by what they could buy. No matter how much money you had in 1950, you could not buy an iPhone or a personal computer.\nIn certain cases, it is not clear that a rise in GDP is even a good thing. If a city is wrecked by a hurricane, and then experiences a surge of rebuilding construction activity, it would be peculiar to claim that the hurricane was therefore economically beneficial. If people are led by a rising fear of crime, to pay for installing bars and burglar alarms on all their windows, it is hard to believe that this increase in GDP has made them better off. Similarly, some people would argue that sales of certain goods, like pornography or extremely violent movies, do not represent a gain to societys standard of living.\nDoes a Rise in GDP Overstate or Understate the Rise in the Standard of Living?\nThe fact that GDP per capita does not fully capture the broader idea of standard of living has led to a concern that the increases in GDP over time are illusory. It is theoretically possible that while GDP is rising, the standard of living could be falling if human health, environmental cleanliness, and other factors that are not included in GDP are worsening. Fortunately, this fear appears to be overstated.\nIn some ways, the rise in GDP understates the actual rise in the standard of living. For example, the typical workweek for a U.S. worker has fallen over the last century from about 60 hours per week to less than 40 hours per week. Life expectancy and health have risen dramatically, and so has the average level of education. Since 1970, the air and water in the United States have generally been getting cleaner. Companies have developed new technologies for entertainment, travel, information, and health. A much wider variety of basic products like food and clothing is available today than several decades ago. Because GDP does not capture leisure, health, a cleaner environment, the possibilities that new technology creates, or an increase in variety, the actual rise in the standard of living for Americans in recent decades has exceeded the rise in GDP.On the other side, crime rates, traffic congestion levels, and income inequality are higher in the United States now than they were in the 1960s. Moreover, a substantial number of services that women primarily provided in the non-market economy are now part of the market economy that GDP counts. By ignoring these factors, GDP would tend to overstate the true rise in the standard of living.\n\nLink It Up\n\n\nVisit this website to read about the American Dream and standards of living.\n\nGDP is Rough, but Useful\nA high level of GDP should not be the only goal of macroeconomic policy, or government policy more broadly. Even though GDP does not measure the broader standard of living with any precision, it does measure production well and it does indicate when a country is materially better or worse off in terms of jobs and incomes. In most countries, a significantly higher GDP per capita occurs hand in hand with other improvements in everyday life along many dimensions, like education, health, and environmental protection.\nNo single number can capture all the elements of a term as broad as standard of living. Nonetheless, GDP per capita is a reasonable, rough-and-ready measure of the standard of living.\n\nBring It Home\n\n\nHow is the Economy Doing? How Does One Tell?\n\nTo determine the state of the economy, one needs to examine economic indicators, such as GDP. To calculate GDP is quite an undertaking. It is the broadest measure of a nations economic activity and we owe a debt to Simon Kuznets, the creator of the measurement, for that.\nThe sheer size of the U.S. economy as measured by GDP is hugeas of the fourth quarter of 2016, $18.9 trillion worth of goods and services were produced annually. Real GDP informed us that the 20082009 recession was severe and that the recovery from that recession has been slow, but the economy is improving. GDP per capita gives a rough estimate of a nations standard of living. This chapter is the building block for other chapters that explore more economic indicators such as unemployment, inflation, or interest rates, and perhaps more importantly, will explain how they are related and what causes them to rise or fall.\n\n", "07-1": "By the end of this section, you will be able to:\nExplain the conditions that have allowed for modern economic growth in the last two centuries\nAnalyze the influence of public policies on an economy's long-run economic growth\n\nLets begin with a brief overview of spectacular economic growth patterns around the world in the last two centuries. We commonly refer to this as the period of modern economic growth. (Later in the chapter we will discuss lower economic growth rates and some key ingredients for economic progress.) Rapid and sustained economic growth is a relatively recent experience for the human race. Before the last two centuries, although rulers, nobles, and conquerors could afford some extravagances and although economies rose above the subsistence level, the average persons standard of living had not changed much for centuries.Progressive, powerful economic and institutional changes started to have a significant effect in the late eighteenth and early nineteenth centuries. According to the Dutch economic historian Jan Luiten van Zanden, slavery-based societies, favorable demographics, global trading routes, and standardized trading institutions that spread with different empires set the stage for the Industrial Revolution to succeed. The Industrial Revolution refers to the widespread use of power-driven machinery and the economic and social changes that resulted in the first half of the 1800s. Ingenious machinesthe steam engine, the power loom, and the steam locomotiveperformed tasks that otherwise would have taken vast numbers of workers to do. The Industrial Revolution began in Great Britain, and soon spread to the United States, Germany, and other countries.The jobs for ordinary people working with these machines were often dirty and dangerous by modern standards, but the alternative jobs of that time in peasant agriculture and small-village industry were often dirty and dangerous, too. The new jobs of the Industrial Revolution typically offered higher pay and a chance for social mobility. A self-reinforcing cycle began: New inventions and investments generated profits, the profits provided funds for more new investment and inventions, and the investments and inventions provided opportunities for further profits. Slowly, a group of national economies in Europe and North America emerged from centuries of sluggishness into a period of rapid modern growth. During the last two centuries, the average GDP growth rate per capita in the leading industrialized countries has been about 2% per year. What were times like before then? Read the following Clear It Up feature for the answer.\nClear It Up\n\n\nWhat were economic conditions like before 1870?\n\nAngus Maddison, a quantitative economic historian, led the most systematic inquiry into national incomes before 1870. Economists recently have refined and used his methods to compile GDP per capita estimates from year 1 C.E. to 1348. Table 7.1 is an important counterpoint to most of the narrative in this chapter. It shows that nations can decline as well as rise. A wide array of forces, such as epidemics, natural and weather-related disasters, the inability to govern large empires, and the remarkably slow pace of technological and institutional progress explain declines in income. Institutions are the traditions and laws by which people in a community agree to behave and govern themselves. Such institutions include marriage, religion, education, and laws of governance. Institutional progress is the development and codification of these institutions to reinforce social order, and thus, economic growth.One example of such an institution is the Magna Carta (Great Charter), which the English nobles forced King John to sign in 1215. The Magna Carta codified the principles of due process, whereby a free man could not be penalized unless his peers had made a lawful judgment against him. The United States in its own constitution later adopted this concept. This social order may have contributed to Englands GDP per capita in 1348, which was second to that of northern Italy.In studying economic growth, a countrys institutional framework plays a critical role. Table 7.1 also shows relative global equality for almost 1,300 years. After this, we begin to see significant divergence in income (not in the table).\n\nYear\nNorthern Italy\nSpain\nEngland\nHolland\nByzantium\nIraq\nEgypt\nJapan\n\n\n\n1\n$800\n$600\n$600\n$600\n$700\n$700\n$700\n-\n\n\n730\n-\n-\n-\n-\n-\n$920\n$730\n$402\n\n\n1000\n-\n-\n-\n-\n$600\n$820\n$600\n-\n\n\n1150\n-\n-\n-\n-\n$580\n$680\n$660\n$520\n\n\n1280\n-\n-\n-\n-\n-\n-\n$670\n$527\n\n\n1300\n$1,588\n$864\n$892\n-\n-\n-\n$610\n-\n\n\n1348\n$1,486\n$907\n$919\n-\n-\n-\n-\n-\n\n\nTable \n7.1\n \nGDP Per Capita Estimates in Current International Dollars from AD 1 to 1348\n \n(Source: Bolt and van Zanden. The First Update of the Maddison Project. Re-Estimating Growth Before 1820. 2013)\n\nAnother fascinating and underreported fact is the high levels of income, compared to others at that time, attained by the Islamic Empire Abbasid Caliphatewhich was founded in present-day Iraq in 730 C.E. At its height, the empire spanned large regions of the Middle East, North Africa, and Spain until its gradual decline over 200 years.\n\nThe Industrial Revolution led to increasing inequality among nations. Some economies took off, whereas others, like many of those in Africa or Asia, remained close to a subsistence standard of living. General calculations show that the 17 countries of the world with the most-developed economies had, on average, 2.4 times the GDP per capita of the worlds poorest economies in 1870. By 1960, the most developed economies had 4.2 times the GDP per capita of the poorest economies.\nHowever, by the middle of the twentieth century, some countries had shown that catching up was possible. Japans economic growth took off in the 1960s and 1970s, with a growth rate of real GDP per capita averaging 11% per year during those decades. Certain countries in Latin America experienced a boom in economic growth in the 1960s as well. In Brazil, for example, GDP per capita expanded by an average annual rate of 11.1% from 1968 to 1973. In the 1970s, some East Asian economies, including South Korea, Thailand, and Taiwan, saw rapid growth. In these countries, growth rates of 11% to 12% per year in GDP per capita were not uncommon. More recently, China, with its population of nearly 1.4 billion people, grew at a per capita rate 9% per year from 1984 into the 2000s. India, with a population of 1.3 billion, has shown promising signs of economic growth, with growth in GDP per capita of about 4% per year during the 1990s and climbing toward 7% to 8% per year in the 2000s.\nLink It Up\n\n\nVisit this website to read about the Asian Development Bank.\n\nThese waves of catch-up economic growth have not reached all shores. In certain African countries like Niger, Tanzania, and Sudan, for example, GDP per capita at the start of the 2000s was still less than $300, not much higher than it was in the nineteenth century and for centuries before that. In the context of the overall situation of low-income people around the world, the good economic news from China (population: 1.4 billion) and India (population: 1.3 billion) is, nonetheless, astounding and heartening.Economic growth in the last two centuries has made a striking change in the human condition. Richard Easterlin, an economist at the University of Southern California, wrote in 2000:\nBy many measures, a revolution in the human condition is sweeping the world. Most people today are better fed, clothed, and housed than their predecessors two centuries ago. They are healthier, live longer, and are better educated. Womens lives are less centered on reproduction and political democracy has gained a foothold. Although Western Europe and its offshoots have been the leaders of this advance, most of the less developed nations have joined in during the 20th century, with the newly emerging nations of sub-Saharan Africa the latest to participate. Although the picture is not one of universal progress, it is the greatest advance in the human condition of the worlds population ever achieved in such a brief span of time.\nRule of Law and Economic Growth\nEconomic growth depends on many factors. Key among those factors is adherence to the rule of law and protection of property rights and contractual rights by a countrys government so that markets can work effectively and efficiently. Laws must be clear, public, fair, enforced, and equally applicable to all members of society. Property rights, as you might recall from Environmental Protection and Negative Externalities are the rights of individuals and firms to own property and use it as they see fit. If you have $100, you have the right to use that money, whether you spend it, lend it, or keep it in a jar. It is your property. The definition of property includes physical property as well as the right to your training and experience, especially since your training is what determines your livelihood. Using this property includes the right to enter into contracts with other parties with your property. Individuals or firms must own the property to enter into a contract.Contractual rights, then, are based on property rights and they allow individuals to enter into agreements with others regarding the use of their property providing recourse through the legal system in the event of noncompliance. One example is the employment agreement: a skilled surgeon operates on an ill person and expects payment. Failure to pay would constitute property theft by the patient. The theft is property the services that the surgeon provided. In a society with strong property rights and contractual rights, the terms of the patientsurgeon contract will be fulfilled, because the surgeon would have recourse through the court system to extract payment from that individual. Without a legal system that enforces contracts, people would not be likely to enter into contracts for current or future services because of the risk of non-payment. This would make it difficult to transact business and would slow economic growth.The World Bank considers a countrys legal system effective if it upholds property rights and contractual rights. The World Bank has developed a ranking system for countries legal systems based on effective protection of property rights and rule-based governance using a scale from 1 to 6, with 1 being the lowest and 6 the highest rating. In 2013, the world average ranking was 2.9. The three countries with the lowest ranking of 1.5 were Afghanistan, the Central African Republic, and Zimbabwe. Their GDP per capita was $679, $333, and $1,007 respectively. The World Bank cites Afghanistan as having a low standard of living, weak government structure, and lack of adherence to the rule of law, which has stymied its economic growth. The landlocked Central African Republic has poor economic resources as well as political instability and is a source of children used in human trafficking. Zimbabwe has had declining and often negative growth for much of the period since 1998. Land redistribution and price controls have disrupted the economy, and corruption and violence have dominated the political process. Although global economic growth has increased, those countries lacking a clear system of property rights and an independent court system free from corruption have lagged far behind.\n", "07-2": "By the end of this section, you will be able to:\nIdentify the role of labor productivity in promoting economic growth\nAnalyze the sources of economic growth using the aggregate production function\nMeasure an economys rate of productivity growth\nEvaluate the power of sustained growth\n\nSustained long-term economic growth comes from increases in worker productivity, which essentially means how well we do things. In other words, how efficient is your nation with its time and workers? Labor productivity is the value that each employed person creates per unit of his or her input. The easiest way to comprehend labor productivity is to imagine a Canadian worker who can make 10 loaves of bread in an hour versus a U.S. worker who in the same hour can make only two loaves of bread. In this fictional example, the Canadians are more productive. More productivity essentially means you can do more in the same amount of time. This in turn frees up resources for workers to use elsewhere.What determines how productive workers are? The answer is pretty intuitive. The first determinant of labor productivity is human capital. Human capital is the accumulated knowledge (from education and experience), skills, and expertise that the average worker in an economy possesses. Typically the higher the average level of education in an economy, the higher the accumulated human capital and the higher the labor productivity.\nThe second factor that determines labor productivity is technological change. Technological change is a combination of inventionadvances in knowledgeand innovation, which is putting those advances to use in a new product or service. For example, the transistor was invented in 1947. It allowed us to miniaturize the footprint of electronic devices and use less power than the tube technology that came before it. Innovations since then have produced smaller and better transistors that are ubiquitous in products as varied as smart-phones, computers, and escalators. Developing the transistor has allowed workers to be anywhere with smaller devices. People can use these devices to communicate with other workers, measure product quality or do any other task in less time, improving worker productivity.The third factor that determines labor productivity is economies of scale. Recall that economies of scale are the cost advantages that industries obtain due to size. (Read more about economies of scale in Production, Cost and Industry Structure.) Consider again the case of the fictional Canadian worker who could produce 10 loaves of bread in an hour. If this difference in productivity was due only to economies of scale, it could be that the Canadian worker had access to a large industrial-size oven while the U.S. worker was using a standard residential size oven.Now that we have explored the determinants of worker productivity, lets turn to how economists measure economic growth and productivity.\nSources of Economic Growth: The Aggregate Production Function\nTo analyze the sources of economic growth, it is useful to think about a production function, which is the technical relationship by which economic inputs like labor, machinery, and raw materials are turned into outputs like goods and services that consumers use. A microeconomic production function describes a firm's or perhaps an industry's inputs and outputs. In macroeconomics, we call the connection from inputs to outputs for the entire economy an aggregate production function.\nComponents of the Aggregate Production Function\nEconomists construct different production functions depending on the focus of their studies. Figure 7.2 presents two examples of aggregate production functions. In the first production function in Figure 7.2 (a), the output is GDP. The inputs in this example are workforce, human capital, physical capital, and technology. We discuss these inputs further in the module, Components of Economic Growth.\n\n\n\nFigure \n7.2\n \nAggregate Production Functions \n \nAn aggregate production function shows what goes into producing the output for an overall economy. (a) This aggregate production function has GDP as its output. (b) This aggregate production function has GDP per capita as its output. Because we calculate it on a per-person basis, we already figure the labor input into the other factors and we do not need to list it separately.\n\n\nMeasuring Productivity\nAn economys rate of productivity growth is closely linked to the growth rate of its GDP per capita, although the two are not identical. For example, if the percentage of the population who holds jobs in an economy increases, GDP per capita will increase but the productivity of individual workers may not be affected. Over the long term, the only way that GDP per capita can grow continually is if the productivity of the average worker rises or if there are complementary increases in capital.\nA common measure of U.S. productivity per worker is dollar value per hour the worker contributes to the employers output. This measure excludes government workers, because their output is not sold in the market and so their productivity is hard to measure. It also excludes farming, which accounts for only a relatively small share of the U.S. economy. Figure 7.3 shows an index of output per hour, with 2009 as the base year (when the index equals 100). The index equaled about 106 in 2014. In 1972, the index equaled 50, which shows that workers have more than doubled their productivity since then.\n\n\n\nFigure \n7.3\n \nOutput per Hour Worked in the U.S. Economy, 19472011 \n \nOutput per hour worked is a measure of worker productivity. In the U.S. economy, worker productivity rose more quickly in the 1960s and the mid-1990s compared with the 1970s and 1980s. However, these growth-rate differences are only a few percentage points per year. Look carefully to see them in the changing slope of the line. The average U.S. worker produced over twice as much per hour in 2014 than they did in the early 1970s. (Source: U.S. Department of Labor, Bureau of Labor Statistics.)\n\n\nClick to view content\n\nA graph has an X-axis with years progressing from 1955 to 2020 and a Y axis labeled Percent Change at Annual Rate. The graphed data moves up and down across a zero line indicating change year over year.  In 1970, 1974, 1981, 1983, 2008, and 2020, the rate was quite low, as the U.S. was undergoing recessions.\nAccording to the Department of Labor, U.S. productivity growth was fairly strong in the 1950s but then declined in the 1970s and 1980s before rising again in the second half of the 1990s and the first half of the 2000s. In fact, the rate of productivity measured by the change in output per hour worked averaged 2.8% per year from 1947 to 1973; dropped to 1.2% per year from 1973 to 1979; increased to 1.5% per year from 1979 to 1990; increased again to 2.2% from 1990 to 2000; increased even more to 2.7% from 2000 to 2007; and then decreased to 1.4% from 2007 to 2019. Figure 7.4 shows average annual rates of productivity growth averaged over time since 1947.\n\n\n\nFigure \n7.4\n \nProductivity Growth Since 1947\n \nU.S. growth in worker productivity was very high between 1947 and 1973. It then declined to lower levels in the later 1970s and the 1980s. The late 1990s and early 2000s saw productivity rebound, but then productivity sagged a bit between 2007 and 2019. Some think the productivity rebound of the late 1990s and early 2000s marks the start of a new economy built on higher productivity growth, but we cannot determine  this until more time has passed. (Source: U.S. Department of Labor, Bureau of Labor Statistics.)\n\n\nThe New Economy Controversy\nIn recent years a controversy has been brewing among economists about the resurgence of U.S. productivity in the second half of the 1990s. One school of thought argues that the United States had developed a new economy based on the extraordinary advances in communications and information technology of the 1990s. The most optimistic proponents argue that it would generate higher average productivity growth for decades to come. The pessimists, alternatively, argue that even five or ten years of stronger productivity growth does not prove that higher productivity will last for the long term. It is hard to infer anything about long-term productivity trends during the later part of the 2000s, because the steep 2008-2009 recession, with its sharp but not completely synchronized declines in output and employment, complicates any interpretation. While productivity growth was high in 2009 and 2010 (around 3%), it has slowed down since then. Productivity growth is also closely linked to the average level of wages. Over time, the amount that firms are willing to pay workers will depend on the value of the output those workers produce. If a few employers tried to pay their workers less than what those workers produced, then those workers would receive offers of higher wages from other profit-seeking employers. If a few employers mistakenly paid their workers more than what those workers produced, those employers would soon end up with losses. In the long run, productivity per hour is the most important determinant of the average wage level in any economy. To learn how to compare economies in this regard, follow the steps in the following Work It Out feature.\n\nWork It Out\n\n\nComparing the Economies of Two Countries\n\nThe Organization for Economic Co-operation and Development (OECD) tracks data on the annual growth rate of real GDP per hour worked. You can find these data on the OECD data webpage Growth in GDP per capita, productivity and ULC at this website.Step 1. Visit the OECD website given above and select two countries to compare.\nStep 2. On the drop-down menu Subject,  select  GDP per capita, constant prices, and under Measure, select Annual growth/change.  Then record the data for the countries you have chosen for the five most recent years.Step 3. Go back to the drop-down Subject menu and select GDP per hour worked, constant prices, and under Measure again select Annual growth/change.  Select data for the same years for which you selected GDP per capita data.Step 4. Compare real GDP growth for both countries. Table 7.2 provides an example of a comparison between Australia and Belgium.\n\n\nAustralia\n2011\n2012\n2013\n2014\n2015\n\n\nReal GDP/Capita Growth (%)\n2.3%\n1.5%\n1.3%\n1.4\n0.1%\n\n\nReal GDP Growth/Hours Worked (%)\n1.7%\n0.1%\n1.4%\n2.2%\n0.2%\n\n\nBelgium\n2011\n2012\n2013\n2014\n2015\n\n\nReal GDP/Capita Growth (%)\n0.9\n0.6\n0.5\n1.2\n1.0\n\n\nReal GDP Growth/Hours Worked (%)\n0.5\n0.3\n0.4\n1.4\n0.9\n\n\nTable \n7.2\n \n \n\nStep 5. For both measures, growth in Australia is greater than growth in Belgium for the first four years.  In addition, there are year-to-year fluctuations. Many factors can affect growth. For example, one factor that may have contributed to Australia's stronger growth may be its larger inflows of immigrants, who generally contribute to economic growth.  \n\nThe Power of Sustained Economic Growth\nNothing is more important for peoples standard of living than sustained economic growth. Even small changes in the rate of growth, when sustained and compounded over long periods of time, make an enormous difference in the standard of living. Consider Table 7.3, in which the rows of the table show several different rates of growth in GDP per capita and the columns show different periods of time. Assume for simplicity that an economy starts with a GDP per capita of 100. The table then applies the following formula to calculate what GDP will be at the given growth rate in the future:GDPatstartingdate(1+growthrateofGDP)years=GDPatenddateGDPatstartingdate(1+growthrateofGDP)years=GDPatenddate\nFor example, an economy that starts with a GDP of 100 and grows at 3% per year will reach a GDP of 209 after 25 years; that is, 100 (1.03)25 = 209.\nThe slowest rate of GDP per capita growth in the table, just 1% per year, is similar to what the United States experienced during its weakest years of productivity growth. The second highest rate, 3% per year, is close to what the U.S. economy experienced during the strong economy of the late 1990s and into the 2000s. Higher rates of per capita growth, such as 5% or 8% per year, represent the experience of rapid growth in economies like Japan, Korea, and China.\nTable 7.3 shows that even a few percentage points of difference in economic growth rates will have a profound effect if sustained and compounded over time. For example, an economy growing at a 1% annual rate over 50 years will see its GDP per capita rise by a total of 64%, from 100 to 164 in this example. However, a country growing at a 5% annual rate will see (almost) the same amount of growthfrom 100 to 163over just 10 years. Rapid rates of economic growth can bring profound transformation. (See the following Clear It Up feature on the relationship between compound growth rates and compound interest rates.) If the rate of growth is 8%, young adults starting at age 20 will see the average standard of living in their country more than double by the time they reach age 30, and grow more than sixfold by the time they reach age 45.\n\nGrowth Rate\nValue of an original 100 in 10 Years\nValue of an original 100 in 25 Years\nValue of an original 100 in 50 Years\n\n\n\n1%\n110\n128\n164\n\n\n3%\n134\n209\n438\n\n\n5%\n163\n339\n1,147\n\n\n8%\n216\n685\n4,690\n\n\nTable \n7.3\n \nGrowth of GDP over Different Time Horizons\n \n\n\nClear It Up\n\n\nHow are compound growth rates and compound interest rates related?\n\nThe formula for GDP growth rates over different periods of time, as Figure 7.3 shows, is exactly the same as the formula for how a given amount of financial savings grows at a certain interest rate over time, as presented in Choice in a World of Scarcity. Both formulas have the same ingredients:\n\n      an original starting amount, in one case GDP and in the other case an amount of financial saving;\na percentage increase over time, in one case the GDP growth rate and in the other case an interest rate;\nand an amount of time over which this effect happens.\nRecall that compound interest is interest that is earned on past interest. It causes the total amount of financial savings to grow dramatically over time. Similarly, compound rates of economic growth, or the compound growth rate, means that we multiply the rate of growth by a base that includes past GDP growth, with dramatic effects over time.For example, in 2013, the Central Intelligence Agency's World Fact Book reported that South Korea had a GDP of $1.67 trillion with a growth rate of 2.8%. We can estimate that at that growth rate, South Koreas GDP will be $1.92 trillion in five years. If we apply the growth rate to each years ending GDP for the next five years, we will calculate that at the end of year one, GDP is $1.72 trillion. In year two, we start with the end-of-year one value of $1.72 and increase it by 2.8%. Year three starts with the end-of-year two GDP, and we increase it by 2.8% and so on, as Table 7.4 depicts.\n\nYear\nStarting GDP\nGrowth Rate 2.8%\nYear-End Amount\n\n\n\n1\n$1.67 Trillion \n(1+0.028)\n$1.72 Trillion\n\n\n2\n$1.72 Trillion \n(1+0.028)\n$1.76 Trillion\n\n\n3\n$1.76 Trillion \n(1+0.028)\n$1.81 Trillion\n\n\n4\n$1.81 Trillion \n(1+0.028)\n$1.87 Trillion\n\n\n5\n$1.87 Trillion \n(1+0.028)\n$1.92 Trillion\n\n\nTable \n7.4\n \n \n\nAnother way to calculate the growth rate is to apply the following formula:\nFutureValue=PresentValue(1+g)nFutureValue=PresentValue(1+g)n\nWhere future value is the value of GDP five years hence, present value is the starting GDP amount of $1.67 trillion, g is the growth rate of 2.8%, and n is the number of periods for which we are calculating growth.FutureValue=1.67(1+0.028)5=$1.92trillionFutureValue=1.67(1+0.028)5=$1.92trillion\n\n", "07-3": "By the end of this section, you will be able to:\nDiscuss the components of economic growth, including physical capital, human capital, and technology\nExplain capital deepening and its significance\nAnalyze the methods employed in economic growth accounting studies\nIdentify factors that contribute to a healthy climate for economic growth\n\nOver decades and generations, seemingly small differences of a few percentage points in the annual rate of economic growth make an enormous difference in GDP per capita. In this module, we discuss some of the components of economic growth, including physical capital, human capital, and technology.\nThe category of physical capital includes the plant and equipment that firms use as well as things like roads (also called infrastructure). Again, greater physical capital implies more output. Physical capital can affect productivity in two ways: (1) an increase in the quantity of physical capital (for example, more computers of the same quality); and (2) an increase in the quality of physical capital (same number of computers but the computers are faster, and so on). Human capital refers to the skills and knowledge that make workers productive. Human capital and physical capital accumulation are similar: In both cases, investment now pays off in higher productivity in the future.The category of technology is the joker in the deck. Earlier we described it as the combination of invention and innovation. When most people think of new technology, the invention of new products like the laser, the smartphone, or some new wonder drug come to mind. In food production, developing more drought-resistant seeds is another example of technology. Technology, as economists use the term, however, includes still more. It includes new ways of organizing work, like the invention of the assembly line, new methods for ensuring better quality of output in factories, and innovative institutions that facilitate the process of converting inputs into output. In short, technology comprises all the advances that make the existing machines and other inputs produce more, and at higher quality, as well as altogether new products.It may not make sense to compare the GDPs of China and say, Benin, simply because of the great difference in population size. To understand economic growth, which is really concerned with the growth in living standards of an average person, it is often useful to focus on GDP per capita. Using GDP per capita also makes it easier to compare countries with smaller numbers of people, like Belgium, Uruguay, or Zimbabwe, with countries that have larger populations, like the United States, the Russian Federation, or Nigeria.\nTo obtain a per capita production function, divide each input in Figure 7.2(a) by the population. This creates a second aggregate production function where the output is GDP per capita (that is, GDP divided by population). The inputs are the average level of human capital per person, the average level of physical capital per person, and the level of technology per personsee Figure 7.2(b). The result of having population in the denominator is mathematically appealing. Increases in population lower per capita income. However, increasing population is important for the average person only if the rate of income growth exceeds population growth. A more important reason for constructing a per capita production function is to understand the contribution of human and physical capital.Capital Deepening\nWhen society increases the level of capital per person, we call the result capital deepening. The idea of capital deepening can apply both to additional human capital per worker and to additional physical capital per worker.Recall that one way to measure human capital is to look at the average levels of education in an economy. Figure 7.5 illustrates the human capital deepening for U.S. workers by showing that the proportion of the U.S. population with a high school and a college degree is rising. As recently as 1970, for example, only about half of U.S. adults had at least a high school diploma. By the start of the twenty-first century, more than 80% of adults had graduated from high school. The idea of human capital deepening also applies to the years of experience that workers have, but the average experience level of U.S. workers has not changed much in recent decades. Thus, the key dimension for deepening human capital in the U.S. economy focuses more on additional education and training than on a higher average level of work experience.\n\n\n\nFigure \n7.5\n \nHuman Capital Deepening in the U.S. \n \nRising levels of education for persons 25 and older show the deepening of human capital in the U.S. economy. Even today, under one-third of U.S. adults have completed a four-year college degree. There is clearly room for additional deepening of human capital to occur. (Source: US Department of Education, National Center for Education Statistics)\n\nFigure 7.6 shows physical capital deepening in the U.S. economy. The average U.S. worker in the late 2000s was working with physical capital worth almost three times as much as that of the average worker of the early 1950s.\n\n\n\nFigure \n7.6\n \nPhysical Capital per Worker in the United States \n \nThe value of the physical capital, measured by plant and equipment, used by the average worker in the U.S. economy has risen over the decades. The increase may have leveled off a bit in the 1970s and 1980s, which were, not coincidentally, times of slower-than-usual growth in worker productivity. We see a renewed increase in physical capital per worker in the late 1990s, followed by a flattening in the early 2000s. (Source: Center for International Comparisons of Production, Income and Prices, University of Pennsylvania)\n\nNot only does the current U.S. economy have better-educated workers with more and improved physical capital than it did several decades ago, but these workers have access to more advanced technologies. Growth in technology is impossible to measure with a simple line on a graph, but evidence that we live in an age of technological marvels is all around usdiscoveries in genetics and in the structure of particles, the wireless internet, and other inventions almost too numerous to count. The U.S. Patent and Trademark Office typically has issued more than 150,000 patents annually in recent years.This recipe for economic growthinvesting in labor productivity, with investments in human capital and technology, as well as increasing physical capitalalso applies to other economies. South Korea, for example, already achieved universal enrollment in primary school (the equivalent of kindergarten through sixth grade in the United States) by 1965, when Koreas GDP per capita was still near its rock bottom low. By the late 1980s, Korea had achieved almost universal secondary school education (the equivalent of a high school education in the United States). With regard to physical capital, Koreas rates of investment had been about 15% of GDP at the start of the 1960s, but doubled to 3035% of GDP by the late 1960s and early 1970s. With regard to technology, South Korean students went to universities and colleges around the world to obtain scientific and technical training, and South Korean firms reached out to study and form partnerships with firms that could offer them technological insights. These factors combined to foster South Koreas high rate of economic growth.\nGrowth Accounting Studies\nSince the late 1950s, economists have conducted growth accounting studies to determine the extent to which physical and human capital deepening and technology have contributed to growth. The usual approach uses an aggregate production function to estimate how much of per capita economic growth can be attributed to growth in physical capital and human capital. We can measure these two inputs at least roughly. The part of growth that is unexplained by measured inputs, called the residual, is then attributed to growth in technology. The exact numerical estimates differ from study to study and from country to country, depending on how researchers measured these three main factors and over what time horizons. For studies of the U.S. economy, three lessons commonly emerge from growth accounting studies.First, technology is typically the most important contributor to U.S. economic growth. Growth in human capital and physical capital often explains only half or less than half of the economic growth that occurs. New ways of doing things are tremendously important.\nSecond, while investment in physical capital is essential to growth in labor productivity and GDP per capita, building human capital is at least as important. Economic growth is not just a matter of more machines and buildings. One vivid example of the power of human capital and technological knowledge occurred in Europe in the years after World War II (19391945). During the war, a large share of Europes physical capital, such as factories, roads, and vehicles, was destroyed. Europe also lost an overwhelming amount of human capital in the form of millions of men, women, and children who died during the war. However, the powerful combination of skilled workers and technological knowledge, working within a market-oriented economic framework, rebuilt Europes productive capacity to an even higher level within less than two decades.\nA third lesson is that these three factors of human capital, physical capital, and technology work together. Workers with a higher level of education and skills are often better at coming up with new technological innovations. These technological innovations are often ideas that cannot increase production until they become a part of new investment in physical capital. New machines that embody technological innovations often require additional training, which builds worker skills further. If the recipe for economic growth is to succeed, an economy needs all the ingredients of the aggregate production function. See the following Clear It Up feature for an example of how human capital, physical capital, and technology can combine to significantly impact lives.\n\nClear It Up\n\n\nHow do girls education and economic growth relate in low-income countries?\n\nIn the early 2000s, according to the World Bank, about 110 million children between the ages of 6 and 11 were not in schooland about two-thirds of them were girls. In Afghanistan, for example, the literacy rate for those aged 15-24 for the period 2005-2014 was 62% for males and only 32% for females.  In Benin, in West Africa, it was 55% for males and 31% for females.  In Nigeria, Africas most populous country, it was 76% for males and 58 percent for females.\nWhenever any child does not receive a basic education, it is both a human and an economic loss. In low-income countries, wages typically increase by an average of 10 to 20% with each additional year of education. There is, however, some intriguing evidence that helping girls in low-income countries to close the education gap with boys may be especially important, because of the social role that many of the girls will play as mothers and homemakers.\nGirls in low-income countries who receive more education tend to grow up to have fewer, healthier, better-educated children. Their children are more likely to be better nourished and to receive basic health care like immunizations. Economic research on women in low-income economies backs up these findings. When 20 women obtain one additional year of schooling, as a group they will, on average, have one less child. When 1,000 women obtain one additional year of schooling, on average one to two fewer women from that group will die in childbirth. When a woman stays in school an additional year, that factor alone means that, on average, each of her children will spend an additional half-year in school. Education for girls is a good investment because it is an investment in economic growth with benefits beyond the current generation.\n\nA Healthy Climate for Economic Growth\nWhile physical and human capital deepening and better technology are important, equally important to a nations well-being is the climate or system within which these inputs are cultivated. Both the type of market economy and a legal system that governs and sustains property rights and contractual rights are important contributors to a healthy economic climate.\nA healthy economic climate usually involves some sort of market orientation at the microeconomic, individual, or firm decision-making level. Markets that allow personal and business rewards and incentives for increasing human and physical capital encourage overall macroeconomic growth. For example, when workers participate in a competitive and well-functioning labor market, they have an incentive to acquire additional human capital, because additional education and skills will pay off in higher wages. Firms have an incentive to invest in physical capital and in training workers, because they expect to earn higher profits for their shareholders. Both individuals and firms look for new technologies, because even small inventions can make work easier or lead to product improvement. Collectively, such individual and business decisions made within a market structure add up to macroeconomic growth. Much of the rapid growth since the late nineteenth century has come from harnessing the power of competitive markets to allocate resources. This market orientation typically reaches beyond national borders and includes openness to international trade.\nA general orientation toward markets does not rule out important roles for government. There are times when markets fail to allocate capital or technology in a manner that provides the greatest benefit for society as a whole. The government's role is to correct these failures. In addition, government can guide or influence markets toward certain outcomes. The following examples highlight some important areas that governments around the world have chosen to invest in to facilitate capital deepening and technology:\n\n      Education. The Danish government requires all children under 16 to attend school. They can choose to attend a public school (Folkeskole) or a private school. Students do not pay tuition to attend Folkeskole. Thirteen percent of primary/secondary (elementary/high) school is private, and the government supplies vouchers to citizens who choose private school.\nSavings and Investment. In the United States, as in other countries, the government taxes gains from private investment. Low capital gains taxes encourage investment and so also economic growth.\nInfrastructure. The Japanese government in the mid-1990s undertook significant infrastructure projects to improve roads and public works. This in turn increased the stock of physical capital and ultimately economic growth.\nSpecial Economic Zones. The island of Mauritius is one of the few African nations to encourage international trade in government-supported special economic zones (SEZ). These are areas of the country, usually with access to a port where, among other benefits, the government does not tax trade. As a result of its SEZ, Mauritius has enjoyed above-average economic growth since the 1980s. Free trade does not have to occur in an SEZ however. Governments can encourage international trade across the board, or surrender to protectionism.\nScientific Research. The European Union has strong programs to invest in scientific research. The researchers Abraham Garca and Pierre Mohnen demonstrate that firms which received support from the Austrian government actually increased their research intensity and had more sales. Governments can support scientific research and technical training that helps to create and spread new technologies. Governments can also provide a legal environment that protects the ability of inventors to profit from their inventions.\nThere are many more ways in which the government can play an active role in promoting economic growth. We explore them in other chapters and in particular in Macroeconomic Policy Around the World. A healthy climate for growth in GDP per capita and labor productivity includes human capital deepening, physical capital deepening, and technological gains, operating in a market-oriented economy with supportive government policies.\n", "07-4": "By the end of this section, you will be able to:\nExplain economic convergence\nAnalyze various arguments for and against economic convergence\nEvaluate the speed of economic convergence between high-income countries and the rest of the world\n\nSome low-income and middle-income economies around the world have shown a pattern of convergence, in which their economies grow faster than those of high-income countries. GDP increased by an average rate of 2.7% per year in the 1990s and 2.3% per year from 2000 to 2008 in the high-income countries of the world, which include the United States, Canada, the European Union countries, Japan, Australia, and New Zealand.Table 7.5 lists 10 countries that belong to an informal fast growth club. These countries averaged GDP growth (after adjusting for inflation) of at least 5% per year in both the time periods from 1990 to 2000 and from 2000 to 2008. Since economic growth in these countries has exceeded the average of the worlds high-income economies, these countries may converge with the high-income countries. The second part of Table 7.5 lists the slow growth club, which consists of countries that averaged GDP growth of 2% per year or less (after adjusting for inflation) during the same time periods. The final portion of Table 7.5 shows GDP growth rates for the countries of the world divided by income.\n\nCountry\nAverage Growth Rate of Real GDP 19902000\nAverage Growth Rate of Real GDP 20002008\n\n\n\nFast Growth Club (5% or more per year in both time periods)\n\n\nCambodia\n7.1%\n9.1%\n\n\nChina\n10.6%\n9.9%\n\n\nIndia\n6.0%\n7.1%\n\n\nIreland\n7.5%\n5.1%\n\n\nJordan\n5.0%\n6.3%\n\n\nLaos\n6.5%\n6.8 %\n\n\nMozambique\n6.4%\n7.3%\n\n\nSudan\n5.4%\n7.3%\n\n\nUganda\n7.1%\n7.3%\n\n\nVietnam\n7.9%\n7.3%\n\n\nSlow Growth Club (2% or less per year in both time periods)\n\n\nCentral African Republic\n2.0%\n0.8%\n\n\nFrance\n2.0%\n1.8%\n\n\nGermany\n1.8%\n1.3%\n\n\nGuinea-Bissau\n1.2%\n0.2%\n\n\nHaiti\n1.5%\n0.3%\n\n\nItaly\n1.6%\n1.2%\n\n\nJamaica\n0.9%\n1.4%\n\n\nJapan\n1.3%\n1.3%\n\n\nSwitzerland\n1.0%\n2.0%\n\n\nUnited States (for reference)\n3.2%\n2.2%\n\n\nWorld Overview\n\n\nHigh income\n2.7%\n2.3%\n\n\nLow income\n3.8%\n5.6%\n\n\nMiddle income\n4.7%\n6.1%\n\n\nTable \n7.5\n \nEconomic Growth around the World\n \n(Source: http://databank.worldbank.org/data/views/variableSelection/selectvariables.aspx?source=world-development-indicators#c_u)\n\nEach of the countries in Table 7.5 has its own unique story of investments in human and physical capital, technological gains, market forces, government policies, and even lucky events, but an overall pattern of convergence is clear. The low-income countries have GDP growth that is faster than that of the middle-income countries, which in turn have GDP growth that is faster than that of the high-income countries. Two prominent members of the fast-growth club are China and India, which between them have nearly 40% of the worlds population. Some prominent members of the slow-growth club are high-income countries like France, Germany, Italy, and Japan.Will this pattern of economic convergence persist into the future? This is a controversial question among economists that we will consider by looking at some of the main arguments on both sides.\nArguments Favoring Convergence\nSeveral arguments suggest that low-income countries might have an advantage in achieving greater worker productivity and economic growth in the future.\nA first argument is based on diminishing marginal returns. Even though deepening human and physical capital will tend to increase GDP per capita, the law of diminishing returns suggests that as an economy continues to increase its human and physical capital, the marginal gains to economic growth will diminish. For example, raising the average education level of the population by two years from a tenth-grade level to a high school diploma (while holding all other inputs constant) would produce a certain increase in output. An additional two-year increase, so that the average person had a two-year college degree, would increase output further, but the marginal gain would be smaller. Yet another additional two-year increase in the level of education, so that the average person would have a four-year-college bachelors degree, would increase output still further, but the marginal increase would again be smaller. A similar lesson holds for physical capital. If the quantity of physical capital available to the average worker increases, by, say, $5,000 to $10,000 (again, while holding all other inputs constant), it will increase the level of output. An additional increase from $10,000 to $15,000 will increase output further, but the marginal increase will be smaller.\nLow-income countries like China and India tend to have lower levels of human capital and physical capital, so an investment in capital deepening should have a larger marginal effect in these countries than in high-income countries, where levels of human and physical capital are already relatively high. Diminishing returns implies that low-income economies could converge to the levels that the high-income countries achieve.A second argument is that low-income countries may find it easier to improve their technologies than high-income countries. High-income countries must continually invent new technologies, whereas low-income countries can often find ways of applying technology that has already been invented and is well understood. The economist Alexander Gerschenkron (19041978) gave this phenomenon a memorable name: the advantages of backwardness. Of course, he did not literally mean that it is an advantage to have a lower standard of living. He was pointing out that a country that is behind has some extra potential for catching up.\nFinally, optimists argue that many countries have observed the experience of those that have grown more quickly and have learned from it. Moreover, once the people of a country begin to enjoy the benefits of a higher standard of living, they may be more likely to build and support the market-friendly institutions that will help provide this standard of living.\n\nLink It Up\n\n\nView this video to learn about economic growth across the world.\n\n\nArguments That Convergence Is neither Inevitable nor Likely\nIf the economy's growth depended only on the deepening of human capital and physical capital, then we would expect that economy's growth rate to slow down over the long run because of diminishing marginal returns. However, there is another crucial factor in the aggregate production function: technology.Developing new technology can provide a way for an economy to sidestep the diminishing marginal returns of capital deepening. Figure 7.7 shows how. The figure's horizontal axis measures the amount of capital deepening, which on this figure is an overall measure that includes deepening of both physical and human capital. The amount of human and physical capital per worker increases as you move from left to right, from C1 to C2 to C3. The diagram's vertical axis measures per capita output. Start by considering the lowest line in this diagram, labeled Technology 1. Along this aggregate production function, the level of technology is held constant, so the line shows only the relationship between capital deepening and output. As capital deepens from C1 to C2 to C3 and the economy moves from R to U to W, per capita output does increasebut the way in which the line starts out steeper on the left but then flattens as it moves to the right shows the diminishing marginal returns, as additional marginal amounts of capital deepening increase output by ever-smaller amounts. The shape of the aggregate production line (Technology 1) shows that the ability of capital deepening, by itself, to generate sustained economic growth is limited, since diminishing returns will eventually set in.\n\n\n\n\nFigure \n7.7\n \nCapital Deepening and New Technology \n \nImagine that the economy starts at point R, with the level of physical and human capital C1 and the output per capita at G1. If the economy relies only on capital deepening, while remaining at the technology level shown by the Technology 1 line, then it would face diminishing marginal returns as it moved from point R to point U to point W. However, now imagine that capital deepening is combined with improvements in technology. Then, as capital deepens from C1 to C2, technology improves from Technology 1 to Technology 2, and the economy moves from R to S. Similarly, as capital deepens from C2 to C3, technology increases from Technology 2 to Technology 3, and the economy moves from S to T. With improvements in technology, there is no longer any reason that economic growth must necessarily slow down.\n\n\nNow, bring improvements in technology into the picture. Improved technology means that with a given set of inputs, more output is possible. The production function labeled Technology 1 in the figure is based on one level of technology, but Technology 2 is based on an improved level of technology, so for every level of capital deepening on the horizontal axis, it produces a higher level of output on the vertical axis. In turn, production function Technology 3 represents a still higher level of technology, so that for every level of inputs on the horizontal axis, it produces a higher level of output on the vertical axis than either of the other two aggregate production functions.\nMost healthy, growing economies are deepening their human and physical capital and increasing technology at the same time. As a result, the economy can move from a choice like point R on the Technology 1 aggregate production line to a point like S on Technology 2 and a point like T on the still higher aggregate production line (Technology 3). With the combination of technology and capital deepening, the rise in GDP per capita in high-income countries does not need to fade away because of diminishing returns. The gains from technology can offset the diminishing returns involved with capital deepening.\nWill technological improvements themselves run into diminishing returns over time? That is, will it become continually harder and more costly to discover new technological improvements? Perhaps someday, but, at least over the last two centuries since the beginning of the Industrial Revolution, improvements in technology have not run into diminishing marginal returns. Modern inventions, like the internet or discoveries in genetics or materials science, do not seem to provide smaller gains to output than earlier inventions like the steam engine or the railroad. One reason that technological ideas do not seem to run into diminishing returns is that we often can apply widely the ideas of new technology at a marginal cost that is very low or even zero. A specific worker or group of workers must use a specific additional machine, or an additional year of education. Many workers across the economy can use a new technology or invention at very low marginal cost.The argument that it is easier for a low-income country to copy and adapt existing technology than it is for a high-income country to invent new technology is not necessarily true, either. When it comes to adapting and using new technology, a societys performance is not necessarily guaranteed, but is the result of whether the country's economic, educational, and public policy institutions are supportive. In theory, perhaps, low-income countries have many opportunities to copy and adapt technology, but if they lack the appropriate supportive economic infrastructure and institutions, the theoretical possibility that backwardness might have certain advantages is of little practical relevance.\nLink It Up\n\nVisit this website to read more about economic growth in India.\n\nThe Slowness of Convergence\nAlthough economic convergence between the high-income countries and the rest of the world seems possible and even likely, it will proceed slowly. Consider, for example, a country that starts off with a GDP per capita of $40,000, which would roughly represent a typical high-income country today, and another country that starts out at $4,000, which is roughly the level in low-income but not impoverished countries like Indonesia, Guatemala, or Egypt. Say that the rich country chugs along at a 2% annual growth rate of GDP per capita, while the poorer country grows at the aggressive rate of 7% per year. After 30 years, GDP per capita in the rich country will be $72,450 (that is, $40,000 (1 + 0.02)30) while in the poor country it will be $30,450 (that is, $4,000 (1 + 0.07)30). Convergence has occurred. The rich country used to be 10 times as wealthy as the poor one, and now it is only about 2.4 times as wealthy. Even after 30 consecutive years of very rapid growth, however, people in the low-income country are still likely to feel quite poor compared to people in the rich country. Moreover, as the poor country catches up, its opportunities for catch-up growth are reduced, and its growth rate may slow down somewhat.The slowness of convergence illustrates again that small differences in annual rates of economic growth become huge differences over time. The high-income countries have been building up their advantage in standard of living over decadesmore than a century in some cases. Even in an optimistic scenario, it will take decades for the low-income countries of the world to catch up significantly.\n\nBring It Home\n\n\nCalories and Economic Growth\n\nWe can tell the story of modern economic growth by looking at calorie consumption over time. The dramatic rise in incomes allowed the average person to eat better and consume more calories. How did these incomes increase? The neoclassical growth consensus uses the aggregate production function to suggest that the period of modern economic growth came about because of increases in inputs such as technology and physical and human capital. Also important was the way in which technological progress combined with physical and human capital deepening to create growth and convergence. The issue of distribution of income notwithstanding, it is clear that the average worker can afford more calories in 2017 than in 1875.Aside from increases in income, there is another reason why the average person can afford more food. Modern agriculture has allowed many countries to produce more food than they need. Despite having more than enough food, however, many governments and multilateral agencies have not solved the food distribution problem. In fact, food shortages, famine, or general food insecurity are caused more often by the failure of government macroeconomic policy, according to the Nobel Prize-winning economist Amartya Sen. Sen has conducted extensive research into issues of inequality, poverty, and the role of government in improving standards of living. Macroeconomic policies that strive toward stable inflation, full employment, education of women, and preservation of property rights are more likely to eliminate starvation and provide for a more even distribution of food.\nBecause we have more food per capita, global food prices have decreased since 1875. The prices of some foods, however, have decreased more than the prices of others. For example, researchers from the University of Washington have shown that in the United States, calories from zucchini and lettuce are 100 times more expensive than calories from oil, butter, and sugar. Research from countries like India, China, and the United States suggests that as incomes rise, individuals want more calories from fats and protein and fewer from carbohydrates. This has very interesting implications for global food production, obesity, and environmental consequences. Affluent urban India has an obesity problem much like many parts of the United States. The forces of convergence are at work.\n\n\n", "08-1": "By the end of this section, you will be able to:\nCalculate the labor force participation rate and the unemployment rate\nExplain hidden unemployment and what it means to be in or out of the labor force\nEvaluate the collection and interpretation of unemployment data\n\nNewspaper or television reports typically describe unemployment as a percentage or a rate. A recent report might have said, for example, from August 2009 to November 2009, the U.S. unemployment rate rose from 9.7% to 10.0%, but by June 2010, it had fallen to 9.5%. At a glance, the changes between the percentages may seem small. However, remember that the U.S. economy has about 160 million adults (as of the beginning of 2017) who either have jobs or are looking for them. A rise or fall of just 0.1% in the unemployment rate of 160 million potential workers translates into 160,000 people, which is roughly the total population of a city like Syracuse, New York, Brownsville, Texas, or Pasadena, California. Large rises in the unemployment rate mean large numbers of job losses. In November 2009, at the peak of the recession, about 15 million people were out of work. Even with the unemployment rate now at 4.8% as of January 2017, about 7.6 million people who would like to have jobs are out of work.\nLink It Up\n\nThe Bureau of Labor Statistics tracks and reports all data related to unemployment.\nWhos In or Out of the Labor Force?\nShould we count everyone without a job as unemployed? Of course not. For example, we should not count children as unemployed. Surely, we should not count the retired as unemployed. Many full-time college students have only a part-time job, or no job at all, but it seems inappropriate to count them as suffering the pains of unemployment. Some people are not working because they are rearing children, ill, on vacation, or on parental leave.The point is that we do not just divide the adult population into employed and unemployed. A third group exists: people who do not have a job, and for some reasonretirement, looking after children, taking a voluntary break before a new jobare not interested in having a job, either. It also includes those who do want a job but have quit looking, often due to discouragement due to their inability to find suitable employment. Economists refer to this third group of those who are not working and not looking for work as out of the labor force or not in the labor force. The U.S. unemployment rate, which is based on a monthly survey carried out by the U.S. Bureau of the Census, asks a series of questions to divide the adult population into employed, unemployed, or not in the labor force. To be classified as unemployed, a person must be without a job, currently available to work, and actively looking for work in the previous four weeks. Thus, a person who does not have a job but who is not currently available to work or has not actively looked for work in the last four weeks is counted as out of the labor force.Employed: currently working for payUnemployed: Out of work and actively looking for a jobOut of the labor force: Out of paid work and not actively looking for a jobLabor force: the number of employed plus the unemployed\nCalculating the Unemployment Rate\nFigure 8.2 shows the three-way division of the 16-and-over population. In January 2017, about 62.9% of the adult population was \"in the labor force\"; that is, people are either employed or without a job but looking for work. We can divide those in the labor force into the employed and the unemployed. Table 8.1 shows those values. The unemployment rate is not the percentage of the total adult population without jobs, but rather the percentage of adults who are in the labor force but who do not have jobs:Unemploymentrate=UnemployedpeopleTotallaborforce100Unemploymentrate=UnemployedpeopleTotallaborforce100\n\n\n\nFigure \n8.2\n \nEmployed, Unemployed, and Out of the Labor Force Distribution of Adult Population (age 16 and older), January 2017\n \nThe total adult, working-age population in January 2017 was 254.1 million. Out of this total population, 152.1 were classified as employed, and 7.6 million were classified as unemployed. The remaining 94.4 were classified as out of the labor force. As you will learn, however, this seemingly simple chart does not tell the whole story.\n\n\n\nTotal adult population over the age of 16\n254.082 million \n\n\n In the labor force \n159.716 million (62.9%)\n\n\n Employed \n152.081 million\n\n\n Unemployed \n7.635 million\n\n\n Out of the labor force \n94.366 million (37.1%)\n\n\nTable \n8.1\n \nU.S. Employment and Unemployment, January 2017\n \n(Source: https://data.bls.gov)\n\nIn this example, we can calculate the unemployment rate as 7.635 million unemployed people divided by 159.716 million people in the labor force, which works out to a 4.8% rate of unemployment. The following Work It Out feature will walk you through the steps of this calculation.\nWork It Out\n\n\nCalculating Labor Force Percentages \n\nHow do economists arrive at the percentages in and out of the labor force and the unemployment rate? We will use the values in Table 8.1 to illustrate the steps. To determine the percentage in the labor force: \nStep 1. Divide the number of people in the labor force (159.716 million) by the total adult (working-age) population (254.082 million).Step 2. Multiply by 100 to obtain the percentage.\nPercentageinthelaborforce=159.716254.082=0.6286=62.9%Percentageinthelaborforce=159.716254.082=0.6286=62.9%To determine the percentage out of the labor force:\nStep 1. Divide the number of people out the labor force (94.366 million) by the total adult (working-age) population (254.082 million). Step 2. Multiply by 100 to obtain the percentage.\nPercentageinthelaborforce=94.366254.082=0.3714=37.1%Percentageinthelaborforce=94.366254.082=0.3714=37.1%To determine the unemployment rate:\nStep 1. Divide the number of unemployed people (7.635 million) by the total labor force (157 million).Step 2. Multiply by 100 to obtain the rate.Unemploymentrate=7.635159.716=0.0478 =4.8%Unemploymentrate=7.635159.716=0.0478 =4.8%\n\nHidden Unemployment\nEven with the out of the labor force category, there are still some people who are mislabeled in the categorization of employed, unemployed, or out of the labor force. There are some people who have only part time or temporary jobs, and they are looking for full time and permanent employment that are counted as employed, although they are not employed in the way they would like or need to be. Additionally, there are individuals who are underemployed. This includes those who are trained or skilled for one type or level of work but are working in a lower paying job or one that does not utilize their skills. For example, we would consider an individual with a college degree in finance who is working as a sales clerk underemployed. They are, however, also counted in the employed group. All of these individuals fall under the umbrella of the term hidden unemployment. Discouraged workers, those who have stopped looking for employment and, hence, are no longer counted in the unemployed also fall into this group\nLabor Force Participation Rate\nAnother important statistic is the labor force participation rate. This is the percentage of adults in an economy who are either employed or who are unemployed and looking for a job. Using the data in Figure 8.2 and Table 8.1, those included in this calculation would be the 159.716 million individuals in the labor force. We calculate the rate by taking the number of people in the labor force, that is, the number employed and the number unemployed, divided by the total adult population and multiplying by 100 to get the percentage.  For the data from January 2017, the labor force participation rate is 62.9%. Historically, the civilian labor force participation rate in the United States climbed beginning in the 1960s as women increasingly entered the workforce, and it peaked at just over 67% in late 1999 to early 2000. Since then, the labor force participation rate has steadily declined, slowly to about 66% in 2008, early in the Great Recession, and then more rapidly during and after that recession, reaching its present level, where it has remained stable, near the end of 2013.\nThe Establishment Payroll Survey\nWhen the unemployment report comes out each month, the Bureau of Labor Statistics (BLS) also reports on the number of jobs createdwhich comes from the establishment payroll survey. The payroll survey is based on a survey of about 147,000 businesses and government agencies throughout the United States. It generates payroll employment estimates by the following criteria: all employees, average weekly hours worked, and average hourly, weekly, and overtime earnings. One of the criticisms of this survey is that it does not count the self-employed. It also does not make a distinction between new, minimum wage, part time or temporary jobs and full time jobs with decent pay.\nHow Does the U.S. Bureau of Labor Statistics Collect the U.S. Unemployment Data?The unemployment rate announced by the U.S. Bureau of Labor Statistics on the first Friday of each month for the previous month  is based on the Current Population Survey (CPS), which the Bureau has carried out every month since 1940. The Bureau takes great care to make this survey representative of the country as a whole. The country is first divided into 3,137 areas. The U.S. Bureau of the Census then selects 729 of these areas to survey. It divides the 729 areas into districts of about 300 households each, and divides each district into clusters of about four dwelling units. Every month, Census Bureau employees call about 15,000 of the four-household clusters, for a total of 60,000 households. Employees interview households for four consecutive months, then rotate them out of the survey for eight months, and then interview them again for the same four months the following year, before leaving the sample permanently.Based on this survey, state, industry, urban and rural areas, gender, age, race or ethnicity, and level of education statistics comprise components that contribute to unemployment rates. A wide variety of other information is available, too. For example, how long have people been unemployed? Did they become unemployed because they quit, or were laid off, or their employer went out of business? Is the unemployed person the only wage earner in the family? The Current Population Survey is a treasure trove of information about employment and unemployment. If you are wondering what the difference is between the CPS and EPS, read the following Clear it Up feature.\nClear It Up\n\n\nWhat is the difference between CPS and EPS?\n\nThe United States Census Bureau conducts the Current Population Survey (CPS), which measures the percentage of the labor force that is unemployed. The Bureau of Labor Statistics' establishment payroll survey (EPS) is a payroll survey that measures the net change in jobs created for the month.\n\nCriticisms of Measuring Unemployment\nThere are always complications in measuring the number of unemployed. For example, what about people who do not have jobs and would be available to work, but are discouraged by the lack of available jobs in their area and stopped looking? Such people, and their families, may be suffering the pains of unemployment. However, the survey counts them as out of the labor force because they are not actively looking for work. Other people may tell the Census Bureau that they are ready to work and looking for a job but, truly, they are not that eager to work and are not looking very hard at all. They are counted as unemployed, although they might more accurately be classified as out of the labor force. Still other people may have a job, perhaps doing something like yard work, child care, or cleaning houses, but are not reporting the income earned to the tax authorities. They may report being unemployed, when they actually are working.Although the unemployment rate gets most of the public and media attention, economic researchers at the Bureau of Labor Statistics publish a wide array of surveys and reports that try to measure these kinds of issues and to develop a more nuanced and complete view of the labor market. It is not exactly a hot news flash that economic statistics are imperfect. Even imperfect measures like the unemployment rate, however, can still be quite informative, when interpreted knowledgeably and sensibly.\n\nLink It Up\n\nClick here to learn more about the CPS and to read frequently asked questions about employment and labor.\n\n", "08-2": "By the end of this section, you will be able to:\nExplain historical patterns of unemployment in the U.S.\nIdentify trends of unemployment based on demographics\nEvaluate global unemployment rates\n\nLets look at how unemployment rates have changed over time and how various groups of people are affected by unemployment differently.\nThe Historical U.S. Unemployment Rate\nFigure 8.3 shows the historical pattern of U.S. unemployment since 1955.\n\n\n\nFigure \n8.3\n \nThe U.S. Unemployment Rate, 19552015\n \nThe U.S. unemployment rate moves up and down as the economy moves in and out of recessions. However, over time, the unemployment rate seems to return to a range of 4% to 6%. There does not seem to be a long-term trend toward the rate moving generally higher or generally lower. (Source: Federal Reserve Economic Data (FRED) https://research.stlouisfed.org/fred2/series/LRUN64TTUSA156S0)\n\nAs we look at this data, several patterns stand out:\n       Unemployment rates do fluctuate over time. During the deep recessions of the early 1980s and of 20072009, unemployment reached roughly 10%. For comparison, during the 1930s Great Depression, the unemployment rate reached almost 25% of the labor force.\n Unemployment rates in the late 1990s and into the mid-2000s were rather low by historical standards. The unemployment rate was below 5% from 1997 to 2000, and near 5% during almost all of 20062007, and 5% or slightly less from September 2015 through January 2017 (the latest date for which data are available as of this writing). The previous time unemployment had been less than 5% for three consecutive years was three decades earlier, from 1968 to 1970.\n The unemployment rate never falls all the way to zero. It almost never seems to get below 3%and it stays that low only for very short periods. (We discuss reasons why this is the case later in this chapter.)\n The timing of rises and falls in unemployment matches fairly well with the timing of upswings and downswings in the overall economy, except that unemployment tends to lag changes in economic activity, and especially so during upswings of the economy following a recession. During periods of recession and depression, unemployment is high. During periods of economic growth, unemployment tends to be lower.\n No significant upward or downward trend in unemployment rates is apparent. This point is especially worth noting because the U.S. population more than quadrupled from 76 million in 1900 to over 324 million by 2017. Moreover, a higher proportion of U.S. adults are now in the paid workforce, because women have entered the paid labor force in significant numbers in recent decades. Women comprised 18% of the paid workforce in 1900 and nearly half of the paid workforce in 2017. However, despite the increased number of workers, as well as other economic events like globalization and the continuous invention of new technologies, the economy has provided jobs without causing any long-term upward or downward trend in unemployment rates.\n\nClick to view content\n\nUnemployment Rate from 1948. Similar to the graph in the figure above, the rate moves up and down as the economy moves in and out of recessions.\nUnemployment Rates by Group\nUnemployment is not distributed evenly across the U.S. population. Figure 8.4 shows unemployment rates broken down in various ways: by gender, age, and race/ethnicity.\n\n\n\n\nFigure \n8.4\n \nUnemployment Rate by Demographic Group \n \n(a) By gender, 19722016. Unemployment rates for men used to be lower than unemployment rates for women, but in recent decades, the two rates have been very close, often and especially during and soon after the Great Recession   with the unemployment rate for men somewhat higher. (b) By age, 19722016. Unemployment rates are highest for the very young and become lower with age. (c) By race and ethnicity, 19722016. Although unemployment rates for all groups tend to rise and fall together, the unemployment rate for Blacks is typically about twice as high as that for Whites,  while the unemployment rate for  Hispanics is in between. (Source: www.bls.gov)\n\nThe unemployment rate for women had historically tended to be higher than the unemployment rate for men, perhaps reflecting the historical pattern that women were seen as secondary earners. By about 1980, however, the unemployment rate for women was essentially the same as that for men, as Figure 8.4 (a) shows. During the 2008-2009 recession and in the immediate aftermath, the unemployment rate for men exceeded the unemployment rate for women. Subsequently, however, the gap has narrowed.\nLink It Up\n\nRead this report for detailed information on the 20082009 recession. It also provides some very useful information on the statistics of unemployment.\nYounger workers tend to have higher unemployment, while middle-aged workers tend to have lower unemployment, probably because the middle-aged workers feel the responsibility of needing to have a job more heavily. Younger workers move in and out of jobs more than middle-aged workers, as part of the process of matching of workers and jobs, and this contributes to their higher unemployment rates.  In addition, middle-aged workers are more likely to feel the responsibility of needing to have a job more heavily. Elderly workers have extremely low rates of unemployment, because those who do not have jobs often exit the labor force by retiring, and thus are not counted in the unemployment statistics. Figure 8.4 (b) shows unemployment rates for women divided by age. The pattern for men is similar.The unemployment rate for African-Americans is substantially higher than the rate for other racial or ethnic groups, a fact that surely reflects, to some extent, a pattern of discrimination that has constrained Blacks labor market opportunities. However, the gaps between unemployment rates for Whites and for Blacks and Hispanics diminished in the 1990s, as Figure 8.4 (c) shows. In fact, unemployment rates for Blacks and Hispanics were at the lowest levels for several decades in the mid-2000s before rising during the recent Great Recession.Finally, those with less education typically suffer higher unemployment. In January 2017, for example, the unemployment rate for those with a college degree was 2.5%; for those with some college but not a four year degree, the unemployment rate was 3.8%; for high school graduates with no additional degree, the unemployment rate was 5.3%; and for those without a high school diploma, the unemployment rate was 7.7%. This pattern arises because additional education typically offers better connections to the labor market and higher demand. With less attractive labor market opportunities for low-skilled workers compared to the opportunities for the more highly-skilled, including lower pay, low-skilled workers may be less motivated to find jobs.\nBreaking Down Unemployment in Other WaysThe Bureau of Labor Statistics also gives information about the reasons for unemployment, as well as the length of time individuals have been unemployed. Table 8.2, for example, shows the four reasons for unemployment and the percentages of the currently unemployed that fall into each category. Table 8.3 shows the length of unemployment. For both of these, the data is from January 2017.(bls.gov)\n\nReason\nPercentage\n\n\n\nNew Entrants\n10.8%\n\n\nRe-entrants\n28.7%\n\n\nJob Leavers\n11.4%\n\n\nJob Losers: Temporary\n14.0%\n\n\nJob Losers: Non Temporary\n35.1%\n\n\nTable \n8.2\n \nReasons for Unemployment, January 2017\n \n\n\n\nLength of Time\nPercentage\n\n\n\nUnder 5 weeks\n32.5%\n\n\n5 to 14 weeks\n27.5%\n\n\n15 to 26 weeks\n15.7%\n\n\nOver 27 weeks\n27.4%\n\n\nTable \n8.3\n \nLength of Unemployment, January 2017\n \n\n\nLink It Up\n\n\nWatch this speech on the impact of droids on the labor market.\n\n\n\nInternational Unemployment Comparisons\nFrom an international perspective, the U.S. unemployment rate typically has looked a little better than average. Table 8.4 compares unemployment rates for 1991, 1996, 2001, 2006 (just before the recession), and 2012 (somewhat after the recession) from several other high-income countries.\n\nCountry\n1991\n1996\n2001\n2006\n2012\n\n\n\nUnited States\n6.8%\n5.4%\n4.8%\n4.4%\n8.1%\n\n\nCanada\n9.8%\n8.8%\n6.4%\n6.2%\n6.3%\n\n\nJapan\n2.1%\n3.4%\n5.1%\n4.5%\n3.9%\n\n\nFrance\n9.5%\n12.5%\n8.7%\n10.1%\n10.0%\n\n\nGermany\n5.6%\n9.0%\n8.9%\n9.8%\n5.5%\n\n\nItaly\n6.9%\n11.7%\n9.6%\n7.8%\n10.8%\n\n\nSweden\n3.1%\n9.9%\n5.0%\n5.2%\n7.9%\n\n\nUnited Kingdom\n8.8%\n8.1%\n5.1%\n5.5%\n8.0%\n\n\nTable \n8.4\n \nInternational Comparisons of Unemployment Rates\n \n\n\nHowever, we need to treat cross-country comparisons of unemployment rates with care, because each country has slightly different definitions of unemployment, survey tools for measuring unemployment, and also different labor markets. For example, Japans unemployment rates appear quite low, but Japans economy has been mired in slow growth and recession since the late 1980s, and Japans unemployment rate probably paints too rosy a picture of its labor market. In Japan, workers who lose their jobs are often quick to exit the labor force and not look for a new job, in which case they are not counted as unemployed. In addition, Japanese firms are often quite reluctant to fire workers, and so firms have substantial numbers of workers who are on reduced hours or officially employed, but doing very little. We can view this Japanese pattern as an unusual method for society to provide support for the unemployed, rather than a sign of a healthy economy.\nLink It Up\n\nWe hear about the Chinese economy in the news all the time. The value of the Chinese yuan in comparison to the U.S. dollar is likely to be part of the nightly business report, so why is the Chinese economy not included in this discussion of international unemployment? The lack of reliable statistics is the reason. This article explains why.\nComparing unemployment rates in the United States and other high-income economies with unemployment rates in Latin America, Africa, Eastern Europe, and Asia is very difficult. One reason is that the statistical agencies in many poorer countries lack the resources and technical capabilities of the U.S. Bureau of the Census. However, a more difficult problem with international comparisons is that in many low-income countries, most workers are not involved in the labor market through an employer who pays them regularly. Instead, workers in these countries are engaged in short-term work, subsistence activities, and barter. Moreover, the effect of unemployment is very different in high-income and low-income countries. Unemployed workers in the developed economies have access to various government programs like unemployment insurance, welfare, and food stamps. Such programs may barely exist in poorer countries. Although unemployment is a serious problem in many low-income countries, it manifests itself in a different way than in high-income countries.\n", "08-3": "By the end of this section, you will be able to:\nAnalyze cyclical unemployment\nExplain the relationship between sticky wages and employment using various economic arguments\nApply supply and demand models to unemployment and wages\n\nWe have seen that unemployment varies across times and places. What causes changes in unemployment? There are different answers in the short run and in the long run. Let's look at the short run first.Cyclical Unemployment\nLets make the plausible assumption that in the short run, from a few months to a few years, the quantity of hours that the average person is willing to work for a given wage does not change much, so the labor supply curve does not shift much. In addition, make the standard ceteris paribus assumption that there is no substantial short-term change in the age structure of the labor force, institutions and laws affecting the labor market, or other possibly relevant factors.\nOne primary determinant of the demand for labor from firms is how they perceive the state of the macro economy. If firms believe that business is expanding, then at any given wage they will desire to hire a greater quantity of labor, and the labor demand curve shifts to the right. Conversely, if firms perceive that the economy is slowing down or entering a recession, then they will wish to hire a lower quantity of labor at any given wage, and the labor demand curve will shift to the left.  Economists call the variation in unemployment that the economy causes moving from expansion to recession or from recession to expansion (i.e. the business cycle) cyclical unemployment.From the standpoint of the supply-and-demand model of competitive and flexible labor markets, unemployment represents something of a puzzle. In a supply-and-demand model of a labor market, as Figure 8.5 illustrates, the labor market should move toward an equilibrium wage and quantity. At the equilibrium wage (We), the equilibrium quantity (Qe) of labor supplied by workers should be equal to the quantity of labor demanded by employers.\n\n\n\nFigure \n8.5\n \nThe Unemployment and Equilibrium in the Labor Market \n \nIn a labor market with flexible wages, the equilibrium will occur at wage We and quantity Qe, where the number of people who want jobs (shown by S) equals the number of jobs available (shown by D).\n\nOne possibility for unemployment is that people who are unemployed are those who are not willing to work at the current equilibrium wage, say $10 an hour, but would be willing to work at a higher wage, like $20 per hour. The monthly Current Population Survey would count these people as unemployed, because they say they are ready and looking for work (at $20 per hour). However, from an economists perspective, these people are choosing to be unemployed.Probably a few people are unemployed because of unrealistic expectations about wages, but they do not represent the majority of the unemployed. Instead, unemployed people often have friends or acquaintances of similar skill levels who are employed, and the unemployed would be willing to work at the jobs and wages similar to what those people are receiving. However, the employers of their friends and acquaintances do not seem to be hiring. In other words, these people are involuntarily unemployed.  What causes involuntary unemployment?\nWhy Wages Might Be Sticky Downward\nIf a labor market model with flexible wages does not describe unemployment very wellbecause it predicts that anyone willing to work at the going wage can always find a jobthen it may prove useful to consider economic models in which wages are not flexible or adjust only very slowly. In particular, even though wage increases may occur with relative ease, wage decreases are few and far between.\nOne set of reasons why wages may be sticky downward, as economists put it, involves economic laws and institutions. For low-skilled workers receiving minimum wage, it is illegal to reduce their wages. For union workers operating under a multiyear contract with a company, wage cuts might violate the contract and create a labor dispute or a strike. However, minimum wages and union contracts are not a sufficient reason why wages would be sticky downward for the U.S. economy as a whole. After all, out of the 150 million or so employed workers in the U.S. economy, only about 2.6 millionless than 2% of the totaldo not receive compensation above the minimum wage. Similarly, labor unions represent only about 11% of American wage and salary workers. In other high-income countries, more workers may have their wages determined by unions or the minimum wage may be set at a level that applies to a larger share of workers. However, for the United States, these two factors combined affect only about 15% or less of the labor force.Economists looking for reasons why wages might be sticky downwards have focused on factors that may characterize most labor relationships in the economy, not just a few. Many have proposed a number of different theories, but they share a common tone.One argument is that even employees who are not union members often work under an implicit contract, which is that the employer will try to keep wages from falling when the economy is weak or the business is having trouble, and the employee will not expect huge salary increases when the economy or the business is strong. This wage-setting behavior acts like a form of insurance: the employee has some protection against wage declines in bad times, but pays for that protection with lower wages in good times. Clearly, this sort of implicit contract means that firms will be hesitant to cut wages, lest workers feel betrayed and work less hard or even leave the firm.\nEfficiency wage theory argues that workers' productivity depends on their pay, and so employers will often find it worthwhile to pay their employees somewhat more than market conditions might dictate. One reason is that employees who receive better pay than others will be more productive because they recognize that if they were to lose their current jobs, they would suffer a decline in salary. As a result, they are motivated to work harder and to stay with the current employer. In addition, employers know that it is costly and time-consuming to hire and train new employees, so they would prefer to pay workers a little extra now rather than to lose them and have to hire and train new workers. Thus, by avoiding wage cuts, the employer minimizes costs of training and hiring new workers, and reaps the benefits of well-motivated employees.The adverse selection of wage cuts argument points out that if an employer reacts to poor business conditions by reducing wages for all workers, then the best workers, those with the best employment alternatives at other firms, are the most likely to leave. The least attractive workers, with fewer employment alternatives, are more likely to stay. Consequently, firms are more likely to choose which workers should depart, through layoffs and firings, rather than trimming wages across the board. Sometimes companies that are experiencing difficult times can persuade workers to take a pay cut for the short term, and still retain most of the firms workers. However, it is far more typical for companies to lay off some workers, rather than to cut wages for everyone.The insider-outsider model of the labor force, in simple terms, argues that those already working for firms are insiders, while new employees, at least for a time, are outsiders. A firm depends on its insiders to keep the organization running smoothly, to be familiar with routine procedures, and to train new employees. However, cutting wages will alienate the insiders and damage the firms productivity and prospects.Finally, the relative wage coordination argument points out that even if most workers were hypothetically willing to see a decline in their own wages in bad economic times as long as everyone else also experiences such a decline, there is no obvious way for a decentralized economy to implement such a plan. Instead, workers confronted with the possibility of a wage cut will worry that other workers will not have such a wage cut, and so a wage cut means being worse off both in absolute terms and relative to others. As a result, workers fight hard against wage cuts.\nThese theories of why wages tend not to move downward differ in their logic and their implications, and figuring out the strengths and weaknesses of each theory is an ongoing subject of research and controversy among economists. All tend to imply that wages will decline only very slowly, if at all, even when the economy or a business is having tough times. When wages are inflexible and unlikely to fall, then either short-run or long-run unemployment can result. Figure 8.6 illustrates this.\n\n\n\nFigure \n8.6\n \nSticky Wages in the Labor Market \n \nBecause the wage rate is stuck at W, above the equilibrium, the number of those who want jobs (Qs) is greater than the number of job openings (Qd). The result is unemployment, shown by the bracket in the figure.\n\nFigure 8.7 shows the interaction between shifts in labor demand and wages that are sticky downward. Figure 8.7 (a) illustrates the situation in which the demand for labor shifts to the right from D0 to D1. In this case, the equilibrium wage rises from W0 to W1 and the equilibrium quantity of labor hired increases from Q0 to Q1. It does not hurt employee morale at all for wages to rise.Figure 8.7 (b) shows the situation in which the demand for labor shifts to the left, from D0 to D1, as it would tend to do in a recession. Because wages are sticky downward, they do not adjust toward what would have been the new equilibrium wage (W1), at least not in the short run. Instead, after the shift in the labor demand curve, the same quantity of workers is willing to work at that wage as before; however, the quantity of workers demanded at that wage has declined from the original equilibrium (Q0) to Q2. The gap between the original equilibrium quantity (Q0) and the new quantity demanded of labor (Q2) represents workers who would be willing to work at the going wage but cannot find jobs. The gap represents the economic meaning of unemployment.\n\n\n\nFigure \n8.7\n \nRising Wage and Low Unemployment: Where Is the Unemployment in Supply and Demand? \n \n(a) In a labor market where wages are able to rise, an increase in the demand for labor from D0 to D1 leads to an increase in equilibrium quantity of labor hired from Q0 to Q1 and a rise in the equilibrium wage from W0 to W1. (b) In a labor market where wages do not decline, a fall in the demand for labor from D0 to D1 leads to a decline in the quantity of labor demanded at the original wage (W0) from Q0 to Q2. These workers will want to work at the prevailing wage (W0), but will not be able to find jobs.\n\nThis analysis helps to explain the connection that we noted earlier: that unemployment tends to rise in recessions and to decline during expansions. The overall state of the economy shifts the labor demand curve and, combined with wages that are sticky downwards, unemployment changes. The rise in unemployment that occurs because of a recession is cyclical unemployment.\nLink It Up\n\nThe St. Louis Federal Reserve Bank is the best resource for macroeconomic time series data, known as the Federal Reserve Economic Data (FRED). FRED provides complete data sets on various measures of the unemployment rate as well as the monthly Bureau of Labor Statistics report on the results of the household and employment surveys.\n\n", "08-4": "By the end of this section, you will be able to:\nExplain frictional and structural unemployment\nAssess relationships between the natural rate of employment and potential real GDP, productivity, and public policy\nIdentify recent patterns in the natural rate of employment\nPropose ways to combat unemployment\n\nCyclical unemployment explains why unemployment rises during a recession and falls during an economic expansion, but what explains the remaining level of unemployment even in good economic times? Why is the unemployment rate never zero? Even when the U.S. economy is growing strongly, the unemployment rate only rarely dips as low as 4%. Moreover, the discussion earlier in this chapter pointed out that unemployment rates in many European countries like Italy, France, and Germany have often been remarkably high at various times in the last few decades. Why does some level of unemployment persist even when economies are growing strongly? Why are unemployment rates continually higher in certain economies, through good economic years and bad? Economists have a term to describe the remaining level of unemployment that occurs even when the economy is healthy: they call it the natural rate of unemployment.The Long Run: The Natural Rate of Unemployment\nThe natural rate of unemployment is not natural in the sense that water freezes at 32 degrees Fahrenheit or boils at 212 degrees Fahrenheit. It is not a physical and unchanging law of nature. Instead, it is only the natural rate because it is the unemployment rate that would result from the combination of economic, social, and political factors that exist at a timeassuming the economy was neither booming nor in recession. These forces include the usual pattern of companies expanding and contracting their workforces in a dynamic economy, social and economic forces that affect the labor market, or public policies that affect either the eagerness of people to work or the willingness of businesses to hire. Lets discuss these factors in more detail.\n\nFrictional Unemployment\nIn a market economy, some companies are always going broke for a variety of reasons: old technology; poor management; good management that happened to make bad decisions; shifts in tastes of consumers so that less of the firms product is desired; a large customer who went broke; or tough domestic or foreign competitors. Conversely, other companies will be doing very well for just the opposite reasons and looking to hire more employees. In a perfect world, all of those who lost jobs would immediately find new ones. However, in the real world, even if the number of job seekers is equal to the number of job vacancies, it takes time to find out about new jobs, to interview and figure out if the new job is a good match, or perhaps to sell a house and buy another in proximity to a new job. Economists call the unemployment that occurs in the meantime, as workers move between jobs, frictional unemployment. Frictional unemployment is not inherently a bad thing. It takes time on part of both the employer and the individual to match those looking for employment with the correct job openings. For individuals and companies to be successful and productive, you want people to find the job for which they are best suited, not just the first job offered.In the mid-2000s, before the 20082009 recession, it was true that about 7% of U.S. workers saw their jobs disappear in any three-month period. However, in periods of economic growth, these destroyed jobs are counterbalanced for the economy as a whole by a larger number of jobs created. In 2005, for example, there were typically about 7.5 million unemployed people at any given time in the U.S. economy. Even though about two-thirds of those unemployed people found a job in 14 weeks or fewer, the unemployment rate did not change much during the year, because those who found new jobs were largely offset by others who lost jobs.Of course, it would be preferable if people who were losing jobs could immediately and easily move into newly created jobs, but in the real world, that is not possible. Someone who is laid off by a textile mill in South Carolina cannot turn around and immediately start working for a textile mill in California. Instead, the adjustment process happens in ripples. Some people find new jobs near their old ones, while others find that they must move to new locations. Some people can do a very similar job with a different company, while others must start new career paths. Some people may be near retirement and decide to look only for part-time work, while others want an employer that offers a long-term career path. The frictional unemployment that results from people moving between jobs in a dynamic economy may account for one to two percentage points of total unemployment.The level of frictional unemployment will depend on how easy it is for workers to learn about alternative jobs, which may reflect the ease of communications about job prospects in the economy. The extent of frictional unemployment will also depend to some extent on how willing people are to move to new areas to find jobswhich in turn may depend on history and culture.\nFrictional unemployment and the natural rate of unemployment also seem to depend on the age distribution of the population. Figure 8.4 (b) showed that unemployment rates are typically lower for people between 2554 years of age or aged 55 and over than they are for those who are younger. Prime-age workers, as those in the 2554 age bracket are sometimes called, are typically at a place in their lives when they want to have a job and income arriving at all times. In addition,  older workers who lose jobs may prefer to opt for retirement.  By contrast, it is likely that a relatively high proportion of those who are under 25 will be trying out jobs and life options, and this leads to greater job mobility and hence higher frictional unemployment. Thus, a society with a relatively high proportion of young workers, like the U.S. beginning in the mid-1960s when Baby Boomers began entering the labor market, will tend to have a higher unemployment rate than a society with a higher proportion of its workers in older ages.\nStructural Unemployment\nAnother factor that influences the natural rate of unemployment is the amount of structural unemployment. The structurally unemployed are individuals who have no jobs because they lack skills valued by the labor market, either because demand has shifted away from the skills they do have, or because they never learned any skills. An example of the former would be the unemployment among aerospace engineers after the U.S. space program downsized in the 1970s. An example of the latter would be high school dropouts.\nSome people worry that technology causes structural unemployment. In the past, new technologies have put lower skilled employees out of work, but at the same time they create demand for higher skilled workers to use the new technologies. Education seems to be the key in minimizing the amount of structural unemployment. Individuals who have degrees can be retrained if they become structurally unemployed. For people with no skills and little education, that option is more limited.\n\nNatural Unemployment and Potential Real GDP\nThe natural unemployment rate is related to two other important concepts: full employment and potential real GDP. Economists consider the economy to be at full employment when the actual unemployment rate is equal to the natural unemployment rate. When the economy is at full employment, real GDP is equal to potential real GDP.  By contrast, when the economy is below full employment, the unemployment rate is greater than the natural unemployment rate and real GDP is less than potential. Finally, when the economy is above full employment, then the unemployment rate is less than the natural unemployment rate and real GDP is greater than potential. Operating above potential is only possible for a short while, since it is analogous to all workers working overtime.\nProductivity Shifts and the Natural Rate of Unemployment\nUnexpected shifts in productivity can have a powerful effect on the natural rate of unemployment. Over time, workers' productivity determines the level of wages in an economy. After all, if a business paid workers more than could be justified by their productivity, the business will ultimately lose money and go bankrupt. Conversely, if a business tries to pay workers less than their productivity then, in a competitive labor market, other businesses will find it worthwhile to hire away those workers and pay them more.However, adjustments of wages to productivity levels will not happen quickly or smoothly. Employers typically review wages only once or twice a year. In many modern jobs, it is difficult to measure productivity at the individual level. For example, how precisely would one measure the quantity produced by an accountant who is one of many people working in the tax department of a large corporation? Because productivity is difficult to observe, employers often determine wage increases based on recent experience with productivity. If productivity has been rising at, say, 2% per year, then wages rise at that level as well. However, when productivity changes unexpectedly, it can affect the natural rate of unemployment for a time.The U.S. economy in the 1970s and 1990s provides two vivid examples of this process. In the 1970s, productivity growth slowed down unexpectedly (as we discussed in Economic Growth). For example, output per hour of U.S. workers in the business sector increased at an annual rate of 3.3% per year from 1960 to 1973, but only 0.8% from 1973 to 1982. Figure 8.8 (a) illustrates the situation where the demand for laborthat is, the quantity of labor that business is willing to hire at any given wagehas been shifting out a little each year because of rising productivity, from D0 to D1 to D2. As a result, equilibrium wages have been rising each year from W0 to W1 to W2. However, when productivity unexpectedly slows down, the pattern of wage increases does not adjust right away. Wages keep rising each year from W2 to W3 to W4, but the demand for labor is no longer shifting up. A gap opens where the quantity of labor supplied at wage level W4 is greater than the quantity demanded. The natural rate of unemployment rises. In the aftermath of this unexpectedly low productivity in the 1970s, the national unemployment rate did not fall below 7% from May, 1980 until 1986. Over time, the rise in wages will adjust to match the slower gains in productivity, and the unemployment rate will ease back down, but this process may take years.\n\n\n\nFigure \n8.8\n \nUnexpected Productivity Changes and Unemployment \n \n(a) Productivity is rising, increasing the demand for labor. Employers and workers become used to the pattern of wage increases. Then productivity suddenly stops increasing. However, the expectations of employers and workers for wage increases do not shift immediately, so wages keep rising as before. However, the demand for labor has not increased, so at wage W4, unemployment exists where the quantity supplied of labor exceeds the quantity demanded. (b) The rate of productivity increase has been zero for a time, so employers and workers have come to accept the equilibrium wage level (W). Then productivity increases unexpectedly, shifting demand for labor from D0 to D1. At the wage (W), this means that the quantity demanded of labor exceeds the quantity supplied, and with job offers plentiful, the unemployment rate will be low.\n\nThe late 1990s provide an opposite example: instead of the surprise decline in productivity that occurred in the 1970s, productivity unexpectedly rose in the mid-1990s. The annual growth rate of real output per hour of labor increased from 1.7% from 19801995, to an annual rate of 2.6% from 19952001. Lets simplify the situation a bit, so that the economic lesson of the story is easier to see graphically, and say that productivity had not been increasing at all in earlier years, so the intersection of the labor market was at point E in Figure 8.8 (b), where the demand curve for labor (D0) intersects the supply curve for labor. As a result, real wages were not increasing. Now, productivity jumps upward, which shifts the demand for labor out to the right, from D0 to D1. At least for a time, however, wages are still set according to the earlier expectations of no productivity growth, so wages do not rise. The result is that at the prevailing wage level (W), the quantity of labor demanded (Qd) will for a time exceed the quantity of labor supplied (Qs), and unemployment will be very lowactually below the natural level of unemployment for a time. This pattern of unexpectedly high productivity helps to explain why the unemployment rate stayed below 4.5%quite a low level by historical standardsfrom 1998 until after the U.S. economy had entered a recession in 2001.Levels of unemployment will tend to be somewhat higher on average when productivity is unexpectedly low, and conversely, will tend to be somewhat lower on average when productivity is unexpectedly high. However, over time, wages do eventually adjust to reflect productivity levels.\nPublic Policy and the Natural Rate of UnemploymentPublic policy can also have a powerful effect on the natural rate of unemployment. On the supply side of the labor market, public policies to assist the unemployed can affect how eager people are to find work. For example, if a worker who loses a job is guaranteed a generous package of unemployment insurance, welfare benefits, food stamps, and government medical benefits, then the opportunity cost of unemployment is lower and that worker will be less eager to seek a new job.What seems to matter most is not just the amount of these benefits, but how long they last. A society that provides generous help for the unemployed that cuts off after, say, six months, may provide less of an incentive for unemployment than a society that provides less generous help that lasts for several years. Conversely, government assistance for job search or retraining can in some cases encourage people back to work sooner. See the Clear it Up to learn how the U.S. handles unemployment insurance.\n\nClear It Up\n\n\nHow does U.S. unemployment insurance work?\nUnemployment insurance is a joint federalstate program that the federal government enacted in 1935. While the federal government sets minimum standards for the program, state governments conduct most of the administration.The funding for the program is a federal tax collected from employers. The federal government requires tax collection on the first $7,000 in wages paid to each worker; however, states can choose to collect the tax on a higher amount if they wish, and 41 states have set a higher limit. States can choose the length of time that they pay benefits, although most states limit unemployment benefits to 26 weekswith extensions possible in times of especially high unemployment. The states then use the fund to pay benefits to those who become unemployed. Average unemployment benefits are equal to about one-third of the wage that the person earned in his or her previous job, but the level of unemployment benefits varies considerably across states.\n\nBottom 10 States That Pay the Lowest Benefit per Week\nTop 10 States That Pay the Highest Benefit per Week\n\n\n\nDelaware\n$330\nMassachusetts\n$672\n\n\nGeorgia\n$330\nMinnesota\n$683\n\n\nSouth Carolina\n$326\nWashington\n$681\n\n\nMissouri\n$320\nNew Jersey\n$657\n\n\nFlorida\n$275\nNorth Dakota\n$633\n\n\nTennessee\n$275\nConnecticut\n$598\n\n\nAlabama\n$265\nOregon\n$590\n\n\nLouisiana\n$247\nPennsylvania\n$573\n\n\nArizona\n$240\nColorado\n$568\n\n\nMississippi\n$235\nRhode Island\n$566\n\n\nTable \n8.5\n \nMaximum Weekly Unemployment Benefits by State in 2017\n \n(Source: http://www.savingtoinvest.com/maximum-weekly-unemployment-benefits-by-state/)\n\nOne other interesting thing to note about the classifications of unemploymentan individual does not have to collect unemployment benefits to be classified as unemployed. While there are statistics kept and studied relating to how many people are collecting unemployment insurance, this is not the source of unemployment rate information.\n\nLink It Up\n\nView this  article  for an explanation of exactly who is eligible for unemployment benefits.\nOn the demand side of the labor market, government rules, social institutions, and the presence of unions can affect the willingness of firms to hire. For example, if a government makes it hard for businesses to start up or to expand, by wrapping new businesses in bureaucratic red tape, then businesses will become more discouraged about hiring. Government regulations can make it harder to start a business by requiring that a new business obtain many permits and pay many fees, or by restricting the types and quality of products that a company can sell. Other government regulations, like zoning laws, may limit where companies can conduct business, or whether businesses are allowed to be open during evenings or on Sunday.Whatever defenses may be offered for such laws in terms of social valuelike the value some Christians place on not working on Sunday, or Orthodox Jews or highly observant Muslims on Saturdaythese kinds of restrictions impose a barrier between some willing workers and other willing employers, and thus contribute to a higher natural rate of unemployment. Similarly, if government makes it difficult to fire or lay off workers, businesses may react by trying not to hire more workers than strictly necessarysince laying these workers off would be costly and difficult. High minimum wages may discourage businesses from hiring low-skill workers. Government rules may encourage and support powerful unions, which can then push up wages for union workers, but at a cost of discouraging businesses from hiring those workers.The Natural Rate of Unemployment in Recent Years\nThe underlying economic, social, and political factors that determine the natural rate of unemployment can change over time, which means that the natural rate of unemployment can change over time, too.\nEstimates by economists of the natural rate of unemployment in the U.S. economy in the early 2000s run at about 4.5 to 5.5%. This is a lower estimate than earlier. We outline three of the common reasons that economists propose for this change below.\n      The internet has provided a remarkable new tool through which job seekers can find out about jobs at different companies and can make contact with relative ease. An internet search is far easier than trying to find a list of local employers and then hunting up phone numbers for all of their human resources departments, and requesting a list of jobs and application forms. Social networking sites such as LinkedIn have changed how people find work as well.\nThe growth of the temporary worker industry has probably helped to reduce the natural rate of unemployment. In the early 1980s, only about 0.5% of all workers held jobs through temp agencies. By the early 2000s, the figure had risen above 2%. Temp agencies can provide jobs for workers while they are looking for permanent work. They can also serve as a clearinghouse, helping workers find out about jobs with certain employers and getting a tryout with the employer. For many workers, a temp job is a stepping-stone to a permanent job that they might not have heard about or obtained any other way, so the growth of temp jobs will also tend to reduce frictional unemployment.\nThe aging of the baby boom generationthe especially large generation of Americans born between 1946 and 1964meant that the proportion of young workers in the economy was relatively high in the 1970s, as the boomers entered the labor market, but is relatively low today. As we noted earlier, middle-aged and older workers are far more likely to experience low unemployment than younger workers, a factor that tends to reduce the natural rate of unemployment as the baby boomers age.\nThe combined result of these factors is that the natural rate of unemployment was on average lower in the 1990s and the early 2000s than in the 1980s. The 20082009 Great Recession pushed monthly unemployment rates up to 10% in late 2009. However, even at that time, the Congressional Budget Office was forecasting that by 2015, unemployment rates would fall back to about 5%. During the last four months of 2015 the unemployment rate held steady at 5.0%. Throughout 2016 and up through January 2017, the unemployment rate has remained at or slightly below 5%. As of the first quarter of 2017, the Congressional Budget Office estimates the natural rate to be 4.74%, and the measured unemployment rate for January 2017 is 4.8%.\nThe Natural Rate of Unemployment in Europe\nBy the standards of other high-income economies, the natural rate of unemployment in the U.S. economy appears relatively low. Through good economic years and bad, many European economies have had unemployment rates hovering near 10%, or even higher, since the 1970s. European rates of unemployment have been higher not because recessions in Europe have been deeper, but rather because the conditions underlying supply and demand for labor have been different in Europe, in a way that has created a much higher natural rate of unemployment.\nMany European countries have a combination of generous welfare and unemployment benefits, together with nests of rules that impose additional costs on businesses when they hire. In addition, many countries have laws that require firms to give workers months of notice before laying them off and to provide substantial severance or retraining packages after laying them off. The legally required notice before laying off a worker can be more than three months in Spain, Germany, Denmark, and Belgium, and the legally required severance package can be as high as a years salary or more in Austria, Spain, Portugal, Italy, and Greece. Such laws will surely discourage laying off or firing current workers. However, when companies know that it will be difficult to fire or lay off workers, they also become hesitant about hiring in the first place.We can attribute the typically higher levels of unemployment in many European countries in recent years, which have prevailed even when economies are growing at a solid pace, to the fact that the sorts of laws and regulations that lead to a high natural rate of unemployment are much more prevalent in Europe than in the United States.\nA Preview of Policies to Fight Unemployment\nThe Government Budgets and Fiscal Policy and Macroeconomic Policy Around the World chapters provide a detailed discussion of how to fight unemployment, when we can discuss these policies in the context of the full array of macroeconomic goals and frameworks for analysis. However, even at this preliminary stage, it is useful to preview the main issues concerning policies to fight unemployment.The remedy for unemployment will depend on the diagnosis. Cyclical unemployment is a short-term problem, caused because the economy is in a recession. Thus, the preferred solution will be to avoid or minimize recessions. As Government Budgets and Fiscal Policy\n discusses, governments can enact this policy by stimulating the overall buying power in the economy, so that firms perceive that sales and profits are possible, which makes them eager to hire.Dealing with the natural rate of unemployment is trickier. In a market-oriented economy, firms will hire and fire workers. Governments cannot control this. Furthermore, the evolving age structure of the economy's population, or unexpected shifts in productivity are beyond a government's control and, will affect the natural rate of unemployment for a time. However, as the example of high ongoing unemployment rates for many European countries illustrates, government policy clearly can affect the natural rate of unemployment that will persist even when GDP is growing.When a government enacts policies that will affect workers or employers, it must examine how these policies will affect the information and incentives employees and employers have to find one another. For example, the government may have a role to play in helping some of the unemployed with job searches. Governments may need to rethink the design of their programs that offer assistance to unemployed workers and protections to employed workers so that they will not unduly discourage the supply of labor. Similarly, governments may need to reassess rules that make it difficult for businesses to begin or to expand so that they will not unduly discourage the demand for labor. The message is not that governments should repeal all laws affecting labor markets, but only that when they enact such laws, a society that cares about unemployment will need to consider the tradeoffs involved.\nBring It Home\n\n\nUnemployment and the Great Recession \nIn the review of unemployment during and after the Great Recession at the outset of this chapter, we noted that unemployment tends to be a lagging indicator of business activity.  This has historically been the case, and it is evident for all recessions that have taken place since the end of World War II.  In brief, this results from the costs to employers of recruitment, hiring, and training workers.  Those costs represent investments by firms in their work forces.At the outset of a recession, when a firm realizes that demand for its product or service is not as strong as anticipated, it has an incentive to lay off workers.  However, doing so runs the risk of losing those workers, and if  the weak demand proves to be only temporary, the firm will be obliged to recruit, hire, and train new workers.  Thus, firms tend to retain workers initially in a downturn.  Similarly, as business begins to pick up when a recession is over, firms are not sure if the improvement will last.  Rather than incur the costs of hiring and training new workers, they will wait, and perhaps resort to overtime work for existing workers, until they are confident that the recession is over.\nAnother point that we noted at the outset is that the duration of recoveries in employment following recessions has been longer following the last three recessions (going back to the early 1990s) than previously.  Nir Jaimovich and Henry Siu have argued that these jobless recoveries are a consequence of job polarization  the disappearance of employment opportunities focused on routine tasks.  Job polarization refers to the increasing concentration of employment in the highest- and lowest-wage occupations, as jobs in middle-skill occupations disappear. Job polarization is an outcome of technological progress in robotics, computing, and information and communication technology.  The result of this progress is a decline in demand for labor in occupations that perform routine tasks  tasks that are limited in scope and can be performed by following a well-defined set of procedures  and hence a decline in the share of total employment that is composed of routine occupations.  Jaimovich and Siu have shown that job polarization characterizes the aftermath of the last three recessions, and this appears to be responsible for the jobless recoveries.\n\n", "09-1": "By the end of this section, you will be able to:\nCalculate the annual rate of inflation\nExplain and use index numbers and base years when simplifying the total quantity spent over a year for products\nCalculate inflation rates using index numbers\n\nDinner table conversations where you might have heard about inflation usually entail reminiscing about when everything seemed to cost so much less. You used to be able to buy three gallons of gasoline for a dollar and then go see an afternoon movie for another dollar. Table 9.1 compares some prices of common goods in 1970 and 2017. Of course, the average prices in this table may not reflect the prices where you live. The cost of living in New York City is much higher than in Houston, Texas, for example. In addition, certain products have evolved over recent decades. A new car in 2017, loaded with antipollution equipment, safety gear, computerized engine controls, and many other technological advances, is a more advanced machine (and more fuel efficient) than your typical 1970s car. However, put details like these to one side for the moment, and look at the overall pattern. The primary reason behind the price rises in Table 9.1and all the price increases for the other products in the economyis not specific to the market for housing or cars or gasoline or movie tickets. Instead, it is part of a general rise in the level of all prices. At the beginning of 2017, $1 had about the same purchasing power in overall terms of goods and services as 18 cents did in 1972, because of the amount of inflation that has occurred over that time period.\n\nItems\n1970\n2017\n\n\n\nPound of ground beef\n$0.66\n$3.62\n\n\nPound of butter\n$0.87\n$2.03\n\n\nMovie ticket\n$1.55\n$8.65\n\n\nSales price of new home (median)\n$22,000\n$312,900\n\n\nNew car\n$3,000\n$40,077\n\n\nGallon of gasoline\n$0.36\n$2.35\n\n\nAverage hourly wage for a manufacturing worker\n$3.23\n$20.65\n\n\nPer capita GDP\n$5,069\n$57,294\n\n\nTable \n9.1\n \nPrice Comparisons, 1970 and 2017\n \n(Sources: See chapter References at end of book.)\n\nMoreover, the power of inflation does not affect just goods and services, but wages and income levels, too. The second-to-last row of Table 9.1 shows that the average hourly wage for a manufacturing worker increased nearly six-fold from 1970 to 2017. The average worker in 2017 is better educated and more productive than the average worker in 1970but not six times more productive. Per capita GDP increased substantially from 1970 to 2017, but is the average person in the U.S. economy really more than eleven times better off in just 47 years? Not likely.A modern economy has millions of goods and services whose prices are continually quivering in the breezes of supply and demand. How can all of these shifts in price attribute to a single inflation rate? As with many problems in economic measurement, the conceptual answer is reasonably straightforward: Economists combine prices of a variety of goods and services into a single price level. The inflation rate is simply the percentage change in the price level. Applying the concept, however, involves some practical difficulties.The Price of a Basket of Goods\nTo calculate the price level, economists begin with the concept of a basket of goods and services, consisting of the different items individuals, businesses, or organizations typically buy. The next step is to look at how the prices of those items change over time. In thinking about how to combine individual prices into an overall price level, many people find that their first impulse is to calculate the average of the prices. Such a calculation, however, could easily be misleading because some products matter more than others.\nChanges in the prices of goods for which people spend a larger share of their incomes will matter more than changes in the prices of goods for which people spend a smaller share of their incomes. For example, an increase of 10% in the rental rate on housing matters more to most people than whether the price of carrots rises by 10%. To construct an overall measure of the price level, economists compute a weighted average of the prices of the items in the basket, where the weights are based on the actual quantities of goods and services people buy. The following Work It Out feature walks you through the steps of calculating the annual rate of inflation based on a few products.\n\nWork It Out\n\n\nCalculating an Annual Rate of Inflation\n\nConsider the simple basket of goods with only three items, represented in Table 9.2. Say that in any given month, a college student spends money on 20 hamburgers, one bottle of aspirin, and five movies. The table provides prices for these items over four years through each time period (Pd). Prices of some goods in the basket may rise while others fall. In this example, the price of aspirin does not change over the four years, while movies increase in price and hamburgers bounce up and down. The table shows the cost of buying the given basket of goods at the prices prevailing at that time.\n\nItems\nHamburger\nAspirin\nMovies\nTotal\nInflation Rate\n\n\n\nQty\n20\n1 bottle\n5\n-\n-\n\n\n(Pd 1) Price\n$3.00\n$10.00\n$6.00\n-\n-\n\n\n(Pd 1) Amount Spent\n$60.00\n$10.00\n$30.00\n$100.00\n-\n\n\n(Pd 2) Price\n$3.20\n$10.00\n$6.50\n-\n-\n\n\n(Pd 2) Amount Spent\n$64.00\n$10.00\n$32.50\n$106.50\n6.5%\n\n\n(Pd 3) Price\n$3.10\n$10.00\n$7.00\n-\n-\n\n\n(Pd 3) Amount Spent\n$62.00\n$10.00\n$35.00\n$107.00\n0.5%\n\n\n(Pd 4) Price\n$3.50\n$10.00\n$7.50\n-\n-\n\n\n(Pd 4) Amount Spent\n$70.00\n$10.00\n$37.50\n$117.50\n9.8%\n\n\nTable \n9.2\n \nA College Students Basket of Goods\n \n\nTo calculate the annual rate of inflation in this example:\nStep 1. Find the percentage change in the cost of purchasing the overall basket of goods between the time periods. The general equation for percentage changes between two years, whether in the context of inflation or in any other calculation, is:\nLevelinnewyearLevelinpreviousyearLevelinpreviousyearx 100 =PercentagechangeLevelinnewyearLevelinpreviousyearLevelinpreviousyearx 100 =PercentagechangeStep 2. From period 1 to period 2, the total cost of purchasing the basket of goods in Table 9.2 rises from $100 to $106.50. Therefore, the percentage change over this timethe inflation rateis:\n106.50100100.0=0.065=6.5%106.50100100.0=0.065=6.5%Step 3. From period 2 to period 3, the overall change in the cost of purchasing the basket rises from $106.50 to $107. Thus, the inflation rate over this time, again calculated by the percentage change, is approximately:\n107106.50106.50=0.0047=0.47%107106.50106.50=0.0047=0.47%Step 4. From period 3 to period 4, the overall cost rises from $107 to $117.50. The inflation rate is thus:\n117.50107107=0.098=9.8%117.50107107=0.098=9.8%This calculation of the change in the total cost of purchasing a basket of goods accounts for how much a student spends on each good. Hamburgers are the lowest-priced good in this example, and aspirin is the highest-priced. If an individual buys a greater quantity of a low-price good, then it makes sense that changes in the price of that good should have a larger impact on the buying power of that persons money. The larger impact of hamburgers shows up in the amount spent row, where, in all time periods, hamburgers are the largest item within the amount spent row.\n\nIndex Numbers\nThe numerical results of a calculation based on a basket of goods can get a little messy. The simplified example in Table 9.2 has only three goods and the prices are in even dollars, not numbers like 79 cents or $124.99. If the list of products were much longer, and we used more realistic prices, the total quantity spent over a year might be some messy-looking number like $17,147.51 or $27,654.92.To simplify the task of interpreting the price levels for more realistic and complex baskets of goods, economists typically report the price level in each period as an index number, rather than as the dollar amount for buying the basket of goods. Economists create price indices to calculate an overall average change in relative prices over time. To convert the money spent on the basket to an index number, economists arbitrarily choose one year to be the base year, or starting point from which we measure changes in prices. The base year, by definition, has an index number equal to 100. This sounds complicated, but it is really a simple math trick. In the example above, say that we choose time period 3  as the base year. Since the total amount of spending in that year is $107, we divide that amount by itself ($107) and multiply by 100. Again, this is because the index number in the base year always has to have a value of 100. Then, to figure out the values of the index number for the other years, we divide the dollar amounts for the other years by 1.07 as well. Note also that the dollar signs cancel out so that index numbers have no units.Table 9.3 shows calculations for the other values of the index number, based on the example in Table 9.2. Because we calculate the index numbers so that they are in exactly the same proportion as the total dollar cost of purchasing the basket of goods, we can calculate the inflation rate based on the index numbers, using the percentage change formula. Thus, the inflation rate from period 1 to period 2 would be99.593.493.4=0.065=6.5%99.593.493.4=0.065=6.5%\nThis is the same answer that we derived when measuring inflation based on the dollar cost of the basket of goods for the same time period.\n\n\nTotal Spending\nIndex Number\nInflation Rate Since Previous Period\n\n\n\nPeriod 1\n$100\n1001.07=93.41001.07=93.4\n\n\n\nPeriod 2\n$106.50\n106.501.07=99.5106.501.07=99.5\n99.593.493.4=0.065=6.5%99.593.493.4=0.065=6.5%\n\n\nPeriod 3\n$107\n1071.07=100.01071.07=100.0\n10099.599.5=0.005=0.5%10099.599.5=0.005=0.5%\n\n\nPeriod 4\n$117.50\n117.501.07=109.8117.501.07=109.8\n109.8100100=0.098=9.8%109.8100100=0.098=9.8%\n\n\nTable \n9.3\n \nCalculating Index Numbers When Period 3 is the Base Year\n \n\n\nIf the inflation rate is the same whether it is based on dollar values or index numbers, then why bother with the index numbers? The advantage is that indexing allows easier eyeballing of the inflation numbers. If you glance at two index numbers like 107 and 110, you know automatically that the rate of inflation between the two years is about, but not quite exactly equal to, 3%. By contrast, imagine that we express the price levels in absolute dollars of a large basket of goods, so that when you looked at the data, the numbers were $19,493.62 and $20,040.17. Most people find it difficult to eyeball those kinds of numbers and say that it is a change of about 3%. However, the two numbers expressed in absolute dollars are exactly in the same proportion of 107 to 110 as the previous example. If youre wondering why simple subtraction of the index numbers wouldnt work, read the following Clear It Up feature.\nClear It Up\n\n\nWhy do you not just subtract index numbers?\n\nA word of warning: When a price index moves from, say, 107 to 110, the rate of inflation is not exactly 3%. Remember, the inflation rate is not derived by subtracting the index numbers, but rather through the percentage-change calculation. We calculate the precise inflation rate as the price index moves from 107 to 110 as 100 x (110  107) / 107 = 100 x 0.028 = 2.8%. When the base year is fairly close to 100, a quick subtraction is not a terrible shortcut to calculating the inflation ratebut when precision matters down to tenths of a percent, subtracting will not give the right answer.\nTwo final points about index numbers are worth remembering. First, index numbers have no dollar signs or other units attached to them. Although we can use index numbers to calculate a percentage inflation rate, the index numbers themselves do not have percentage signs. Index numbers just mirror the proportions that we find in other data. They transform the other data so that it is easier to work with the data.Second, the choice of a base year for the index numberthat is, the year that is automatically set equal to 100is arbitrary. We choose it as a starting point from which we can track changes in prices. In the official inflation statistics, it is common to use one base year for a few years, and then to update it, so that the base year of 100 is relatively close to the present. However, any base year that we choose for the index numbers will result in exactly the same inflation rate. To see this in the previous example, imagine that period 1 is the base year when total spending was $100, and we assign it an index number of 100. At a glance, you can see that the index numbers would now exactly match the dollar figures, and the inflation rate in the first period would be 6.5%.Now that we see how indexes work to track inflation, the next module will show us how economists measure the cost of living.\nLink It Up\n\nWatch this video from the cartoon Duck Tales to view a mini-lesson on inflation.\n\n", "09-2": "By the end of this section, you will be able to:\nUse the Consumer Price Index (CPI) to calculate U.S. inflation rates\nIdentify several ways the Bureau of Labor Statistics avoids biases in the Consumer Price Index (CPI)\nDifferentiate among the Consumer Price Index (CPI), the Producer Price Index (PPI), the International Price Index, the Employment Cost Index, and the GDP deflator.\n\nThe most commonly cited measure of inflation in the United States is the Consumer Price Index (CPI). Government statisticians at the U.S. Bureau of Labor Statistics calculate the CPI based on the prices in a fixed basket of goods and services that represents the purchases of the average family of four. In recent years, the statisticians have paid considerable attention to a subtle problem: that the change in the total cost of buying a fixed basket of goods and services over time is conceptually not quite the same as the change in the cost of living, because the cost of living represents how much it costs for a person to feel that his or her consumption provides an equal level of satisfaction or utility.To understand the distinction, imagine that over the past 10 years, the cost of purchasing a fixed basket of goods increased by 25% and your salary also increased by 25%. Has your personal standard of living held constant? If you do not necessarily purchase an identical fixed basket of goods every year, then an inflation calculation based on the cost of a fixed basket of goods may be a misleading measure of how your cost of living has changed. Two problems arise here: substitution bias and quality/new goods bias.\nWhen the price of a good rises, consumers tend to purchase less of it and to seek out substitutes instead. Conversely, as the price of a good falls, people will tend to purchase more of it. This pattern implies that goods with generally rising prices should tend over time to become less important in the overall basket of goods used to calculate inflation, while goods with falling prices should tend to become more important. Consider, as an example, a rise in the price of peaches by $100 per pound. If consumers were utterly inflexible in their demand for peaches, this would lead to a big rise in the price of food for consumers. Alternatively, imagine that people are utterly indifferent to whether they have peaches or other types of fruit. Now, if peach prices rise, people completely switch to other fruit choices and the average price of food does not change at all. A fixed and unchanging basket of goods assumes that consumers are locked into buying exactly the same goods, regardless of price changesnot a very likely assumption. Thus, substitution biasthe rise in the price of a fixed basket of goods over timetends to overstate the rise in a consumers true cost of living, because it does not take into account that the person can substitute away from goods whose relative prices have risen.\nThe other major problem in using a fixed basket of goods as the basis for calculating inflation is how to deal with the arrival of improved versions of older goods or altogether new goods. Consider the problem that arises if a cereal is improved by adding 12 essential vitamins and mineralsand also if a box of the cereal costs 5% more. It would clearly be misleading to count the entire resulting higher price as inflation, because the new price reflects a higher quality (or at least different) product. Ideally, one would like to know how much of the higher price is due to the quality change, and how much of it is just a higher price. The Bureau of Labor Statistics, which is responsible for computing the Consumer Price Index, must deal with these difficulties in adjusting for quality changes.\nLink It Up\n\nVisit this website to view a list of Ford car prices between 1909 and 1927. Consider how these prices compare to todays models. Is the product today of a different quality?\nWe can think of a new product as an extreme improvement in qualityfrom something that did not exist to something that does. However, the basket of goods that was fixed in the past obviously does not include new goods created since then. The basket of goods and services in the Consumer Price Index (CPI) is revised and updated over time, and so new products are gradually included. However, the process takes some time. For example, room air conditioners were widely sold in the early 1950s, but were not introduced into the basket of goods behind the Consumer Price Index until 1964. The VCR and personal computer were available in the late 1970s and widely sold by the early 1980s, but did not enter the CPI basket of goods until 1987. By 1996, there were more than 40 million cellular phone subscribers in the United Statesbut cell phones were not yet part of the CPI basket of goods. The parade of inventions has continued, with the CPI inevitably lagging a few years behind.The arrival of new goods creates problems with respect to the accuracy of measuring inflation. The reason people buy new goods, presumably, is that the new goods offer better value for money than existing goods. Thus, if the price index leaves out new goods, it overlooks one of the ways in which the cost of living is improving. In addition, the price of a new good is often higher when it is first introduced and then declines over time. If the new good is not included in the CPI for some years, until its price is already lower, the CPI may miss counting this price decline altogether. Taking these arguments together, the quality/new goods bias means that the rise in the price of a fixed basket of goods over time tends to overstate the rise in a consumers true cost of living, because it does not account for how improvements in the quality of existing goods or the invention of new goods improves the standard of living. The following Clear It Up feature is a must-read on how statisticians comprise and calculate the CPI.\nClear It Up\n\n\nHow do U.S. government statisticians measure the Consumer Price Index?\n\nWhen the U.S. Bureau of Labor Statistics (BLS) calculates the Consumer Price Index, the first task is to decide on a basket of goods that is representative of the purchases of the average household. We do this by using the Consumer Expenditure Survey, a national survey of about 7,000 households, which provides detailed information on spending habits. Statisticians divide consumer expenditures into eight major groups (seen below), which in turn they divide into more than 200 individual item categories. The BLS currently uses 19821984 as the base period.For each of the 200 individual expenditure items, the BLS chooses several hundred very specific examples of that item and looks at the prices of those examples. In figuring out the breakfast cereal item under the overall category of foods and beverages, the BLS picks several hundred examples of breakfast cereal. One example might be the price of a 24-oz. box of a particular brand of cereal sold at a particular store. The BLS statistically selects specific products and sizes and stores to reflect what people buy and where they shop. The basket of goods in the Consumer Price Index thus consists of about 80,000 products; that is, several hundred specific products in over 200 broad-item categories. Statisticians rotate about one-quarter of these 80,000 specific products of the sample each year, and replace them with a different set of products.The next step is to collect data on prices. Data collectors visit or call about 23,000 stores in 87 urban areas all over the United States every month to collect prices on these 80,000 specific products. The BLS also conducts a survey of 50,000 landlords or tenants to collect information about rents.Statisticians then calculate the Consumer Price Index by taking the 80,000 prices of individual products and combining them, using weights (see Figure 9.2) determined by the quantities of these products that people buy and allowing for factors like substitution between goods and quality improvements, into price indices for the 200 or so overall items. Then, the statisticians combine the price indices for the 200 items into an overall Consumer Price Index. According the Consumer Price Index website, there are eight categories that data collectors use:The Eight Major Categories in the Consumer Price Index\nFood and beverages (breakfast cereal, milk, coffee, chicken, wine, full-service meals, and snacks)\nHousing (renters cost of housing, homeowners cost of housing, fuel oil, bedroom furniture)\nApparel (mens shirts and sweaters, womens dresses, jewelry)\nTransportation (new vehicles, airline fares, gasoline, motor vehicle insurance)\nMedical care (prescription drugs and medical supplies, physicians services, eyeglasses and eye care, hospital services)\nRecreation (televisions, cable television, pets and pet products, sports equipment, admissions)\nEducation and communication (college tuition, postage, telephone services, computer software and accessories)\nOther goods and services (tobacco and smoking products, haircuts and other personal services, funeral expenses)\n\n\n\n\n\nFigure \n9.2\n \nThe Weighting of CPI Components \n \nOf the eight categories used to generate the Consumer Price Index, housing is the highest at 42.7%. The next highest category, food and beverage at 15.3%, is less than half the size of housing. Other goods and services, and apparel, are the lowest at 3.4% and 3.3%, respectively. (Source: www.bls.gov/cpi)\n\n\nThe CPI and Core Inflation Index           Imagine if you were driving a company truck across the country- you probably would care about things like the prices of available roadside food and motel rooms as well as the trucks operating condition.  However, the manager of the firm might have different priorities. He would care mostly about the trucks on-time performance and much less so about the food you were eating and the places you were staying. In other words, the company manager would be paying attention to the firm's production, while ignoring transitory elements that impacted you, but did not affect the companys bottom line.\nIn a sense, a similar situation occurs with regard to measures of inflation. As weve learned, CPI measures prices as they affect everyday household spending. Economists typically calculate a core inflation index by taking the CPI and excluding volatile economic variables. In this way, economists have a better sense of the underlying trends in prices that affect the cost of living. Examples of excluded variables include energy and food prices, which can jump around from month to month because of the weather. According to an article by Kent Bernhard, during Hurricane Katrina in 2005, a key supply point for the nations gasoline was nearly knocked out.  Gas prices quickly shot up across the nation, in some places by up to 40 cents a gallon in one day. This was not the cause of an economic policy but rather a short-lived event until the pumps were restored in the region. In this case, the CPI that month would register the change as a cost of living event to households, but the core inflation index would remain unchanged. As a result, the Federal Reserves decisions on interest rates would not be influenced.  Similarly, droughts can cause world-wide spikes in food prices that, if temporary, do not affect the nations economic capability.\nAs former Chairman of the Federal Reserve Ben Bernanke noted in 1999 about the core inflation index, It provide(s) a better guide to monetary policy than the other indices, since it measures the more persistent underlying inflation rather than transitory influences on the price level. Bernanke also noted that it helps communicate that the Federal Reserve does not need to respond to every inflationary shock since some price changes are transitory and not part of a structural change in the economy. In sum, both the CPI and the core inflation index are important, but serve different audiences. The CPI helps households understand their overall cost of living from month to month, while the core inflation index is a preferred gauge from which to make important government policy changes.\n\nPractical Solutions for the Substitution and the Quality/New Goods Biases\nBy the early 2000s, the Bureau of Labor Statistics was using alternative mathematical methods for calculating the Consumer Price Index, more complicated than just adding up the cost of a fixed basket of goods, to allow for some substitution between goods. It was also updating the basket of goods behind the CPI more frequently, so that it could include new and improved goods more rapidly. For certain products, the BLS was carrying out studies to try to measure the quality improvement. For example, with computers, an economic study can try to adjust for changes in speed, memory, screen size, and other product characteristics, and then calculate the change in price after accounting for these product changes. However, these adjustments are inevitably imperfect, and exactly how to make these adjustments is often a source of controversy among professional economists.By the early 2000s, the substitution bias and quality/new goods bias had been somewhat reduced, so that since then the rise in the CPI probably overstates the true rise in inflation by only about 0.5% per year. Over one or a few years, this is not much. Over a period of a decade or two, even half of a percent per year compounds to a more significant amount. In addition, the CPI tracks prices from physical locations, and not at online sites like Amazon, where prices can be lower.When measuring inflation (and other economic statistics, too), a tradeoff arises between simplicity and interpretation. If we calculate the inflation rate with a basket of goods that is fixed and unchanging, then the calculation of an inflation rate is straightforward, but the problems of substitution bias and quality/new goods bias will arise. However, when the basket of goods is allowed to shift and evolve to reflect substitution toward lower relative prices, quality improvements, and new goods, the technical details of calculating the inflation rate grow more complex.\nAdditional Price Indices: PPI, GDP Deflator, and More\nThe basket of goods behind the Consumer Price Index represents an average hypothetical U.S. household's consumption, which is to say that it does not exactly capture anyones personal experience. When the task is to calculate an average level of inflation, this approach works fine. What if, however, you are concerned about inflation experienced by a certain group, like the elderly, or the poor, or single-parent families with children, or Hispanic-Americans? In specific situations, a price index based on the buying power of the average consumer may not feel quite right.This problem has a straightforward solution. If the Consumer Price Index does not serve the desired purpose, then invent another index, based on a basket of goods appropriate for the group of interest. The Bureau of Labor Statistics publishes a number of experimental price indices: some for particular groups like the elderly or the poor, some for different geographic areas, and some for certain broad categories of goods like food or housing.The BLS also calculates several price indices that are not based on baskets of consumer goods. For example, the Producer Price Index (PPI) is based on prices paid for supplies and inputs by producers of goods and services. We can break it down into price indices for different industries, commodities, and stages of processing (like finished goods, intermediate goods, or crude materials for further processing). There is an International Price Index based on the prices of merchandise that is exported or imported. An Employment Cost Index measures wage inflation in the labor market. The GDP deflator, which the Bureau of Economic Analysis measures, is a price index that includes all the GDP components (that is, consumption plus investment plus government plus exports minus imports). Unlike the CPI, its baskets are not fixed but re-calculate what that years GDP would have been worth using the base-years prices. MIT's Billion Prices Project is a more recent alternative attempt to measure prices: economists collect data online from retailers and then put them into an index that they compare to the CPI (Source: http://bpp.mit.edu/usa/).Whats the best measure of inflation? If one is concerned with the most accurate measure of inflation, one should use the GDP deflator as it picks up the prices of goods and services produced. However, it is not a good measure of the cost of living as it includes prices of many products not purchased by households (for example, aircraft, fire engines, factory buildings, office complexes, and bulldozers). If one wants the most accurate measure of inflation as it impacts households, one should use the CPI, as it only picks up prices of products purchased by households. That is why economists sometimes refer to the CPI as the cost-of-living index. As the Bureau of Labor Statistics states on its website: The best measure of inflation for a given application depends on the intended use of the data.\n", "09-3": "By the end of this section, you will be able to:\nIdentify patterns of inflation for the United States using data from the Consumer Price Index\nIdentify patterns of inflation on an international level\n\nIn the last three decades, inflation has been relatively low in the U.S. economy, with the Consumer Price Index typically rising 2% to 4% per year. Looking back over the twentieth century, there have been several periods where inflation caused the price level to rise at double-digit rates, but nothing has come close to hyperinflation.\nHistorical Inflation in the U.S. Economy\nFigure 9.3 (a) shows the level of prices in the Consumer Price Index stretching back to 1913. In this case, the base years (when the CPI is defined as 100) are set for the average level of prices that existed from 1982 to 1984. Figure 9.3 (b) shows the annual percentage changes in the CPI over time, which is the inflation rate.\n\n\n\nFigure \n9.3\n \nU.S. Price Level and Inflation Rates since 1913 \n \nGraph a shows the trends in the U.S. price level from the year 1913 to 2016. In 1913, the graph starts out close to 10, rises to around 20 in 1920, stays around 16 or 17 until 1931, then falls to 13 or 14 until 1940. It gradually increases until about 1973, then increases more rapidly through the remainder of the 1970s and beyond, with periodic dips, until 2016, when it  reached around 240. Graph b shows the trends in U.S. inflation rates from the year 1914 to 2016. In 1916, the graph starts out with inflation at almost 8%, jumps to about 17% in 1917, drops drastically to close to 11% in 1921, goes up and down periodically, with peaks in the 1940s and the 1970s, until settling to around 1.3% in 2016.\n\n\nClick to view content\nInflation as measured by the consumer price index reflects the annual percentage change in the cost to the average consumer of acquiring a basket of goods and services that may be fixed or changed at specified intervals, such as yearly.\nThe first two waves of inflation are easy to characterize in historical terms: they are right after World War I and World War II. However, there are also two periods of severe negative inflationcalled deflationin the early decades of the twentieth century: one following the deep 1920-21 recession and the other during the Great Depression of the 1930s. (Since inflation is a time when the buying power of money in terms of goods and services is reduced, deflation will be a time when the buying power of money in terms of goods and services increases.) For the period from 1900 to about 1960, the major inflations and deflations nearly balanced each other out, so the average annual rate of inflation over these years was only about 1% per year. A third wave of more severe inflation arrived in the 1970s and departed in the early 1980s.\nLink It Up\n\nVisit this website to use an inflation calculator and discover how prices have changed in the last 100 years.\nTimes of recession or depression often seem to be times when the inflation rate is lower, as in the recession of 19201921, the Great Depression, the recession of 19801982, and the Great Recession in 20082009. There were a few months in 2009 that were deflationary, but not at an annual rate. High levels of unemployment typically accompany recessions, and the total demand for goods falls, pulling the price level down. Conversely, the rate of inflation often, but not always, seems to start moving up when the economy is growing very strongly, like right after wartime or during the 1960s. The frameworks for macroeconomic analysis, that we developed in other chapters, will explain why recession often accompanies higher unemployment and lower inflation, while rapid economic growth often brings lower unemployment but higher inflation.\nInflation around the World\nAround the rest of the world, the pattern of inflation has been very mixed; Figure 9.4 shows inflation rates over the last several decades. Many industrialized countries, not just the United States, had relatively high inflation rates in the 1970s. For example, in 1975, Japans inflation rate was over 8% and the inflation rate for the United Kingdom was almost 25%. In the 1980s, inflation rates came down in the United States and in Europe and have largely stayed down.\n\n\n\nFigure \n9.4\n \nCountries with Relatively Low Inflation Rates, 19602016\n \nThis chart shows the annual percentage change in consumer prices compared with the previous years consumer prices in the United States, the United Kingdom, Japan, and Germany.\n\nCountries with controlled economies in the 1970s, like the Soviet Union and China, historically had very low rates of measured inflationbecause prices were forbidden to rise by law, except for the cases where the government deemed a price increase to be due to quality improvements. However, these countries also had perpetual shortages of goods, since forbidding prices to rise acts like a price ceiling and creates a situation where quantity demanded often exceeds quantity supplied. As Russia and China made a transition toward more market-oriented economies, they also experienced outbursts of inflation, although we should regard the statistics for these economies as somewhat shakier. Inflation in China averaged about 10% per year for much of the 1980s and early 1990s, although it has dropped off since then. Russia experienced hyperinflationan outburst of high inflationof 2,500% per year in the early 1990s, although by 2006 Russias consumer price inflation had dipped below 10% per year, as Figure 9.5 shows. The closest the United States has ever reached hyperinflation was during the 18601865 Civil War, in the Confederate states.\n\n\n\nFigure \n9.5\n \nCountries with Relatively High Inflation Rates, 19802016\n \nThese charts show the percentage change in consumer prices compared with the previous years consumer prices in Brazil, China, and Russia. (a) Of these, Brazil and Russia experienced very high inflation at some point between the late-1980s and late-1990s. (b) Though not as high, China also had high inflation rates in the mid-1990s. Even though their inflation rates have come down over the last two decades, several of these countries continue to see significant inflation rates. (Sources: http://www.inflation.eu/inflation-rates;\nhttp://research.stlouisfed.org/fred2/series/FPCPITOTLZGBRA; http://research.stlouisfed.org/fred2/series/CHNCPIALLMINMEI; http://research.stlouisfed.org/fred2/series/FPCPITOTLZGRUS)\n\nMany countries in Latin America experienced raging inflation during the 1980s and early 1990s, with inflation rates often well above 100% per year. In 1990, for example, both Brazil and Argentina saw inflation climb above 2000%. Certain countries in Africa experienced extremely high rates of inflation, sometimes bordering on hyperinflation, in the 1990s. Nigeria, the most populous country in Africa, had an inflation rate of 75% in 1995.In the early 2000s, the problem of inflation appears to have diminished for most countries, at least in comparison to the worst times of recent decades. As we noted in this earlier Bring it Home feature, in recent years, the worlds worst example of hyperinflation was in Zimbabwe, where at one point the government was issuing bills with a face value of $100 trillion (in Zimbabwean dollars)that is, the bills had $100,000,000,000,000 written on the front, but were almost worthless. In many countries, the memory of double-digit, triple-digit, and even quadruple-digit inflation is not very far in the past.\n\n", "09-4": "By the end of this section, you will be able to:\nExplain how inflation can cause redistributions of purchasing power\nIdentify ways inflation can blur the perception of supply and demand\nExplain the economic benefits and challenges of inflation\n\nEconomists usually oppose high inflation, but they oppose it in a milder way than many non-economists. Robert Shiller, one of 2013s Nobel Prize winners in economics, carried out several surveys during the 1990s about attitudes toward inflation. One of his questions asked, Do you agree that preventing high inflation is an important national priority, as important as preventing drug abuse or preventing deterioration in the quality of our schools? Answers were on a scale of 15, where 1 meant Fully agree and 5 meant Completely disagree. For the U.S. population as a whole, 52% answered Fully agree that preventing high inflation was a highly important national priority and just 4% said Completely disagree. However, among professional economists, only 18% answered Fully agree, while the same percentage of 18% answered Completely disagree.The Land of Funny Money\nWhat are the economic problems caused by inflation, and why do economists often regard them with less concern than the general public? Consider a very short story: The Land of Funny Money.\nOne morning, everyone in the Land of Funny Money awakened to find that everything denominated in money had increased by 20%. The change was completely unexpected. Every price in every store was 20% higher. Paychecks were 20% higher. Interest rates were 20 % higher. The amount of money, everywhere from wallets to savings accounts, was 20% larger. This overnight inflation of prices made newspaper headlines everywhere in the Land of Funny Money. However, the headlines quickly disappeared, as people realized that in terms of what they could actually buy with their incomes, this inflation had no economic impact. Everyones pay could still buy exactly the same set of goods as it did before. Everyones savings were still sufficient to buy exactly the same car, vacation, or retirement that they could have bought before. Equal levels of inflation in all wages and prices ended up not mattering much at all.When the people in Robert Shillers surveys explained their concern about inflation, one typical reason was that they feared that as prices rose, they would not be able to afford to buy as much. In other words, people were worried because they did not live in a place like the Land of Funny Money, where all prices and wages rose simultaneously. Instead, people live here on Planet Earth, where prices might rise while wages do not rise at all, or where wages rise more slowly than prices.\nEconomists note that over most periods, the inflation level in prices is roughly similar to the inflation level in wages, and so they reason that, on average, over time, peoples economic status is not greatly changed by inflation. If all prices, wages, and interest rates adjusted automatically and immediately with inflation, as in the Land of Funny Money, then no ones purchasing power, profits, or real loan payments would change. However, if other economic variables do not move exactly in sync with inflation, or if they adjust for inflation only after a time lag, then inflation can cause three types of problems: unintended redistributions of purchasing power, blurred price signals, and difficulties in long-term planning.\n\nUnintended Redistributions of Purchasing Power\nInflation can cause redistributions of purchasing power that hurt some and help others. People who are hurt by inflation include those who are holding considerable cash, whether it is in a safe deposit box or in a cardboard box under the bed. When inflation happens, the buying power of cash diminishes. However, cash is only an example of a more general problem: anyone who has financial assets invested in a way that the nominal return does not keep up with inflation will tend to suffer from inflation. For example, if a person has money in a bank account that pays 4% interest, but inflation rises to 5%, then the real rate of return for the money invested in that bank account is negative 1%.The problem of a good-looking nominal interest rate transforming into an ugly-looking real interest rate can be worsened by taxes. The U.S. income tax is charged on the nominal interest received in dollar terms, without an adjustment for inflation. Thus, the government taxes a person who invests $10,000 and receives a 5% nominal rate of interest on the $500 receivedno matter whether the inflation rate is 0%, 5%, or 10%. If inflation is 0%, then the real interest rate is 5% and all $500 is a gain in buying power. However, if inflation is 5%, then the real interest rate is zero and the person had no real gainbut owes income tax on the nominal gain anyway. If inflation is 10%, then the real interest rate is negative 5% and the person is actually falling behind in buying power, but would still owe taxes on the $500 in nominal gains.Inflation can cause unintended redistributions for wage earners, too. Wages do typically creep up with inflation over time, eventually. The last row of Table 9.1 at the start of this chapter showed that the average hourly wage in manufacturing in the U.S. economy increased from $3.23 in 1970 to $20.65 in 2017, which is an increase by a factor of more than six. Over that time period, the Consumer Price Index increased by an almost identical amount. However, increases in wages may lag behind inflation for a year or two, since wage adjustments are often somewhat sticky and occur only once or twice a year. Moreover, the extent to which wages keep up with inflation creates insecurity for workers and may involve painful, prolonged conflicts between employers and employees. If the government adjusts minimum wage for inflation only infrequently, minimum wage workers are losing purchasing power from their nominal wages, as Figure 9.6 shows.\n\n\n\nFigure \n9.6\n \nU.S. Minimum Wage and Inflation \n \nAfter adjusting for inflation, the federal minimum wage dropped more than 30 percent from 1967 to 2010, even though the nominal figure climbed from $1.40 to $7.25 per hour. Increases in the minimum wage in between 2008 and 2010 kept the decline from being worseas it would have been if the wage had remained the same as it did from 1997 through 2007. Since 2010, the real minimum wage has continued to decline. (Sources: http://www.dol.gov/whd/minwage/chart.htm and http://data.bls.gov/cgi-bin/surveymost?cu)\n\nOne sizable group of people has often received a large share of their income in a form that does not increase over time: retirees who receive a private company pension. Most pensions have traditionally been set as a fixed nominal dollar amount per year at retirement. For this reason, economists call pensions defined benefits plans. Even if inflation is low, the combination of inflation and a fixed income can create a substantial problem over time. A person who retires on a fixed income at age 65 will find that losing just 1% to 2% of buying power per year to inflation compounds to a considerable loss of buying power after a decade or two.Fortunately, pensions and other defined benefits retirement plans are increasingly rare, replaced instead by defined contribution plans, such as 401(k)s and 403(b)s. In these plans, the employer contributes a fixed amount to the workers retirement account on a regular basis (usually every pay check). The employee often contributes as well. The worker invests these funds in a wide range of investment vehicles. These plans are tax deferred, and they are portable so that if the individual takes a job with a different employer, their 401(k) comes with them. To the extent that the investments made generate real rates of return, retirees do not suffer from the inflation costs of traditional pensioners.However, ordinary people can sometimes benefit from the unintended redistributions of inflation. Consider someone who borrows $10,000 to buy a car at a fixed interest rate of 9%. If inflation is 3% at the time the loan is made, then he or she must repay the loan at a real interest rate of 6%. However, if inflation rises to 9%, then the real interest rate on the loan is zero. In this case, the borrowers benefit from inflation is the lenders loss. A borrower paying a fixed interest rate, who benefits from inflation, is just the flip side of an investor receiving a fixed interest rate, who suffers from inflation. The lesson is that when interest rates are fixed, rises in the rate of inflation tend to penalize suppliers of financial capital, who receive repayment in dollars that are worth less because of inflation, while demanders of financial capital end up better off, because they can repay their loans in dollars that are worth less than originally expected.The unintended redistributions of buying power that inflation causes may have a broader effect on society. Americas widespread acceptance of market forces rests on a perception that peoples actions have a reasonable connection to market outcomes. When inflation causes a retiree who built up a pension or invested at a fixed interest rate to suffer, however, while someone who borrowed at a fixed interest rate benefits from inflation, it is hard to believe that this outcome was deserved in any way. Similarly, when homeowners benefit from inflation because the price of their homes rises, while renters suffer because they are paying higher rent, it is hard to see any useful incentive effects. One of the reasons that the general public dislikes inflation is a sense that it makes economic rewards and penalties more arbitraryand therefore likely to be perceived as unfair  even dangerous, as the next Clear It Up feature shows.\nClear It Up\n\n\nIs there a connection between German hyperinflation and Hitlers rise to power?\n\nGermany suffered an intense hyperinflation of its currency, the Mark, in the years after World War I, when the Weimar Republic in Germany resorted to printing money to pay its bills and the onset of the Great Depression created the social turmoil that Adolf Hitler was able to take advantage of in his rise to power. Shiller described the connection this way in a National Bureau of Economic Research 1996 Working Paper:\nA fact that is probably little known to young people today, even in Germany, is that the final collapse of the Mark in 1923, the time when the Marks inflation reached astronomical levels (inflation of 35,974.9% in November 1923 alone, for an annual rate that month of 4.69  1028%), came in the same month as did Hitlers Beer Hall Putsch, his Nazi Partys armed attempt to overthrow the German government. This failed putsch resulted in Hitlers imprisonment, at which time he wrote his book Mein Kampf, setting forth an inspirational plan for Germanys future, suggesting plans for world domination. . .\n. . . Most people in Germany today probably do not clearly remember these events; this lack of attention to it may be because its memory is blurred by the more dramatic events that succeeded it (the Nazi seizure of power and World War II). However, to someone living through these historical events in sequence . . . [the putsch] may have been remembered as vivid evidence of the potential effects of inflation.\n\n\nBlurred Price Signals\nPrices are the messengers in a market economy, conveying information about conditions of demand and supply. Inflation blurs those price messages. Inflation means that we perceive price signals more vaguely, like a radio program received with considerable static. If the static becomes severe, it is hard to tell what is happening.In Israel, when inflation accelerated to an annual rate of 500% in 1985, some stores stopped posting prices directly on items, since they would have had to put new labels on the items or shelves every few days to reflect inflation. Instead, a shopper just took items from a shelf and went up to the checkout register to find out the price for that day. Obviously, this situation makes comparing prices and shopping for the best deal rather difficult. When the levels and changes of prices become uncertain, businesses and individuals find it harder to react to economic signals. In a world where inflation is at a high rate, but bouncing up and down to some extent, does a higher price of a good mean that inflation has risen, or that supply of that good has decreased, or that demand for that good has increased? Should a buyer of the good take the higher prices as an economic hint to start substituting other productsor have the prices of the substitutes risen by an equal amount? Should a seller of the good take a higher price as a reason to increase productionor is the higher price only a sign of a general inflation in which the prices of all inputs to production are rising as well? The true story will presumably become clear over time, but at a given moment, who can say?\nHigh and variable inflation means that the incentives in the economy to adjust in response to changes in prices are weaker. Markets will adjust toward their equilibrium prices and quantities more erratically and slowly, and many individual markets will experience a greater chance of surpluses and shortages.\n\nProblems of Long-Term Planning\nInflation can make long-term planning difficult. In discussing unintended redistributions, we considered the case of someone trying to plan for retirement with a pension that is fixed in nominal terms and a high rate of inflation. Similar problems arise for all people trying to save for retirement, because they must consider what their money will really buy several decades in the future when we cannot know the rate of future inflation.Inflation, especially at moderate or high levels, will pose substantial planning problems for businesses, too. A firm can make money from inflationfor example, by paying bills and wages as late as possible so that it can pay in inflated dollars, while collecting revenues as soon as possible. A firm can also suffer losses from inflation, as in the case of a retail business that gets stuck holding too much cash, only to see inflation eroding the value of that cash. However, when a business spends its time focusing on how to profit by inflation, or at least how to avoid suffering from it, an inevitable tradeoff strikes: less time is spent on improving products and services or on figuring out how to make existing products and services more cheaply. An economy with high inflation rewards businesses that have found clever ways of profiting from inflation, which are not necessarily the businesses that excel at productivity, innovation, or quality of service.In the short term, low or moderate levels of inflation may not pose an overwhelming difficulty for business planning, because costs of doing business and sales revenues may rise at similar rates. If, however, inflation varies substantially over the short or medium term, then it may make sense for businesses to stick to shorter-term strategies. The evidence as to whether relatively low rates of inflation reduce productivity is controversial among economists. There is some evidence that if inflation can be held to moderate levels of less than 3% per year, it need not prevent a nations real economy from growing at a healthy pace. For some countries that have experienced hyperinflation of several thousand percent per year, an annual inflation rate of 2030% may feel basically the same as zero. However, several economists have pointed to the suggestive fact that when U.S. inflation heated up in the early 1970sto 10%U.S. growth in productivity slowed down, and when inflation slowed down in the 1980s, productivity edged up again not long thereafter, as Figure 9.7 shows.\n\n\n\nFigure \n9.7\n \nU.S. Inflation Rate and U.S. Labor Productivity, 19612014 \n \nOver the last several decades in the United States, there have been times when rising inflation rates have been closely followed by lower productivity rates and lower inflation rates have corresponded to increasing productivity rates. As the graph shows, however, this correlation does not always exist.\n\n\nAny Benefits of Inflation?\nAlthough the economic effects of inflation are primarily negative, two countervailing points are worth noting. First, the impact of inflation will differ considerably according to whether it is creeping up slowly at 0% to 2% per year, galloping along at 10% to 20% per year, or racing to the point of hyperinflation at, say, 40% per month. Hyperinflation can rip an economy and a society apart. An annual inflation rate of 2%, 3%, or 4%, however, is a long way from a national crisis. Low inflation is also better than deflation which occurs with severe recessions.\nSecond, economists sometimes argue that moderate inflation may help the economy by making wages in labor markets more flexible. The discussion in Unemployment pointed out that wages tend to be sticky in their downward movements and that unemployment can result. A little inflation could nibble away at real wages, and thus help real wages to decline if necessary. In this way, even if a moderate or high rate of inflation may act as sand in the gears of the economy, perhaps a low rate of inflation serves as oil for the gears of the labor market. This argument is controversial. A full analysis would have to account for all the effects of inflation. It does, however, offer another reason to believe that, all things considered, very low rates of inflation may not be especially harmful.\n", "09-5": "By the end of this section, you will be able to:\nExplain the relationship between indexing and inflation\nIdentify three ways the government can control inflation through macroeconomic policy\nWhen a price, wage, or interest rate is adjusted automatically with inflation, economists use the term indexed. An indexed payment increases according to the index number that measures inflation. Those in private markets and government programs observe a wide range of indexing arrangements. Since the negative effects of inflation depend in large part on having inflation unexpectedly affect one part of the economy but not anothersay, increasing the prices that people pay but not the wages that workers receiveindexing will take some of the sting out of inflation.Indexing in Private Markets\nIn the 1970s and 1980s, labor unions commonly negotiated wage contracts that had cost-of-living adjustments (COLAs) which guaranteed that their wages would keep up with inflation. These contracts were sometimes written as, for example, COLA plus 3%. Thus, if inflation was 5%, the wage increase would automatically be 8%, but if inflation rose to 9%, the wage increase would automatically be 12%. COLAs are a form of indexing applied to wages.\nLoans often have built-in inflation adjustments, too, so that if the inflation rate rises by two percentage points, then the interest rate that a financial institution charges on the loan rises by two percentage points as well. An adjustable-rate mortgage (ARM) is a type of loan that one can use to purchase a home in which the interest rate varies with the rate of inflation. Often, a borrower will be able to receive a lower interest rate if borrowing with an ARM, compared to a fixed-rate loan. The reason is that with an ARM, the lender is protected against the risk that higher inflation will reduce the real loan payments, and so the risk premium part of the interest rate can be correspondingly lower.A number of ongoing or long-term business contracts also have provisions that prices will adjust automatically according to inflation. Sellers like such contracts because they are not locked into a low nominal selling price if inflation turns out higher than expected. Buyers like such contracts because they are not locked into a high buying price if inflation turns out to be lower than expected. A contract with automatic adjustments for inflation in effect agrees on a real price for the borrower to pay, rather than a nominal price.\nIndexing in Government Programs\nMany government programs are indexed to inflation. The U.S. income tax code is designed so that as a persons income rises above certain levels, the tax rate on the marginal income earned rises as well. That is what the expression move into a higher tax bracket means. For example, according to the basic tax tables from the Internal Revenue Service, in 2017 a single person owed 10% of all taxable income from $0 to $9,325; 15% of all income from $9,326 to $37,950; 25% of all taxable income from $37,951 to $91,900; 28% of all taxable income from $91,901  to $191,650; 33% of all taxable income from $191,651  to $416,700; 35% of all taxable income from $416,701  to $418,400; and 39.6% of all income from $418,401 and above.Because of the many complex provisions in the rest of the tax code, it is difficult to determine exactly the taxes an individual owes the government based on these numbers, but the numbers illustrate the basic theme that tax rates rise as the marginal dollar of income rises. Until the late 1970s, if nominal wages increased along with inflation, people were moved into higher tax brackets and owed a higher proportion of their income in taxes, even though their real income had not risen. In 1981, the government eliminated this bracket creep. Now, the income levels where higher tax rates kick in are indexed to rise automatically with inflation.The Social Security program offers two examples of indexing. Since the passage of the Social Security Indexing Act of 1972, the level of Social Security benefits increases each year along with the Consumer Price Index. Also, Social Security is funded by payroll taxes, which the government imposes on the income earned up to a certain amount$117,000 in 2014. The government adjusts this level of income upward each year according to the rate of inflation, so that an indexed increase in the Social Security tax base accompanies the indexed rise in the benefit level.As yet another example of a government program affected by indexing, in 1996 the U.S., government began offering indexed bonds. Bonds are means by which the U.S. government (and many private-sector companies as well) borrows money; that is, investors buy the bonds, and then the government repays the money with interest. Traditionally, government bonds have paid a fixed rate of interest. This policy gave a government that had borrowed an incentive to encourage inflation, because it could then repay its past borrowing in inflated dollars at a lower real interest rate. However, indexed bonds promise to pay a certain real rate of interest above whatever inflation rate occurs. In the case of a retiree trying to plan for the long term and worried about the risk of inflation, for example, indexed bonds that guarantee a rate of return higher than inflationno matter the level of inflationcan be a very comforting investment.\nMight Indexing Reduce Concern over Inflation?\nIndexing may seem like an obviously useful step. After all, when individuals, firms, and government programs are indexed against inflation, then people can worry less about arbitrary redistributions and other effects of inflation.\nHowever, some of the fiercest opponents of inflation express grave concern about indexing. They point out that indexing is always partial. Not every employer will provide COLAs for workers. Not all companies can assume that costs and revenues will rise in lockstep with the general rates of inflation. Not all interest rates for borrowers and savers will change to match inflation exactly. However, as partial inflation indexing spreads, the political opposition to inflation may diminish. After all, older people whose Social Security benefits are protected against inflation, or banks that have loaned their money with adjustable-rate loans, no longer have as much reason to care whether inflation heats up. In a world where some people are indexed against inflation and some are not, financially savvy businesses and investors may seek out ways to be protected against inflation, while the financially unsophisticated and small businesses may suffer from it most.\nA Preview of Policy Discussions of Inflation\nThis chapter has focused on how economists measure inflation, historical experience with inflation, how to adjust nominal variables into real ones, how inflation affects the economy, and how indexing works. We have barely hinted at the causes of inflation, and we have not addressed government policies to deal with inflation. We will examine these issues in depth in other chapters. However, it is useful to offer a preview here.We can sum up the cause of inflation in one phrase: Too many dollars chasing too few goods. The great surges of inflation early in the twentieth century came after wars, which are a time when government spending is very high, but consumers have little to buy, because production is going to the war effort. Governments also commonly impose price controls during wartime. After the war, the price controls end and pent-up buying power surges forth, driving up inflation. Otherwise, if too few dollars are chasing too many goods, then inflation will decline or even turn into deflation. Therefore, we typically associate slowdowns in economic activity, as in major recessions and the Great Depression, with a reduction in inflation or even outright deflation.The policy implications are clear. If we are to avoid inflation, the amount of purchasing power in the economy must grow at roughly the same rate as the production of goods. Macroeconomic policies that the government can use to affect the amount of purchasing powerthrough taxes, spending, and regulation of interest rates and creditcan thus cause inflation to rise or reduce inflation to lower levels.\nBring It Home\n\n\nA $550 Million Loaf of Bread?\n\nAs we will learn in Money and Banking, the existence of money provides enormous benefits to an economy. In a real sense, money is the lubrication that enhances the workings of markets. Money makes transactions easier. It allows people to find employment producing one product, then use the money earned to purchase the other products they need to live. However, too much money in circulation can lead to inflation. Extreme cases of governments recklessly printing money lead to hyperinflation. Inflation reduces the value of money. Hyperinflation, because money loses value so quickly, ultimately results in people no longer using money. The economy reverts to barter, or it adopts another countrys more stable currency, like U.S. dollars. In the meantime, the economy literally falls apart as people leave jobs and fend for themselves because it is not worth the time to work for money that will be worthless in a few days.Only national governments have the power to cause hyperinflation. Hyperinflation typically happens when government faces extraordinary demands for spending, which it cannot finance by taxes or borrowing. The only option is to print moneymore and more of it. With more money in circulation chasing the same amount (or even fewer) goods and services, the only result is increasingly higher prices until the economy and/or the government collapses. This is why economists are generally wary of letting inflation spiral out of control.\n\n", "10-1": "By the end of this section, you will be able to:\nExplain merchandise trade balance, current account balance, and unilateral transfers\nIdentify components of the U.S. current account balance\nCalculate the merchandise trade balance and current account balance using import and export data for a country\n\nA few decades ago, it was common to track the solid or physical items that planes, trains, and trucks transported between countries as a way of measuring the balance of trade. Economists call this measurement the merchandise trade balance. In most high-income economies, including the United States, goods comprise less than half of a countrys total production, while services comprise more than half. The last two decades have seen a surge in international trade in services, powered by technological advances in telecommunications and computers that have made it possible to export or import customer services, finance, law, advertising, management consulting, software, construction engineering, and product design. Most global trade still takes the form of goods rather than services, and the government announces and the media prominently report the merchandise trade balance. Old habits are hard to break. Economists, however, typically rely on broader measures such as the balance of trade or the current account balance which includes other international flows of income and foreign aid.Components of the U.S. Current Account BalanceTable 10.1 breaks down the four main components of the U.S. current account balance for the last quarter of 2015 (seasonally adjusted). The first line shows the merchandise trade balance; that is, exports and imports of goods. Because imports exceed exports, the trade balance in the final column is negative, showing a merchandise trade deficit. We can explain how the government collects this trade information in the following Clear It Up feature.\n\n\nValue of Exports (money flowing into the United States)\nValue of Imports (money flowing out of the United States)\nBalance\n\n\n\nGoods\n$410.0\n$595.5\n$185.3\n\n\nServices\n$180.4\n$122.3\n$58.1\n\n\nIncome receipts and payments\n$203.0\n$152.4\n$50.6\n\n\nUnilateral transfers\n$27.3\n$64.4\n$37.1\n\n\nCurrent account balance\n$820.7\n$934.4\n$113.7\n\n\nTable \n10.1\n \nComponents of the U.S. Current Account Balance for 2015 (in billions)\n \n\n\nClear It Up\n\n\nHow does the U.S. government collect trade statistics?\n\nDo not confuse the balance of trade (which tracks imports and exports), with the current account balance, which includes not just exports and imports, but also income from investment and transfers.\nThe Bureau of Economic Analysis (BEA) within the U.S. Department of Commerce compiles statistics on the balance of trade using a variety of different sources. Merchandise importers and exporters must file monthly documents with the Census Bureau, which provides the basic data for tracking trade. To measure international trade in serviceswhich can happen over a telephone line or computer network without shipping any physical goodsthe BEA carries out a set of surveys. Another set of BEA surveys tracks investment flows, and there are even specific surveys to collect travel information from U.S. residents visiting Canada and Mexico. For measuring unilateral transfers, the BEA has access to official U.S. government spending on aid, and then also carries out a survey of charitable organizations that make foreign donations.The BEA then cross-checks this information on international flows of goods and capital against other available data. For example, the Census Bureau also collects data from the shipping industry, which it can use to check the data on trade in goods. All companies involved in international flows of capitalincluding banks and companies making financial investments like stocksmust file reports, which  the U.S. Department of the Treasury ultimately checks. The BEA also can cross check information on foreign trade by looking at data collected by other countries on their foreign trade with the United States, and also at the data collected by various international organizations. Take these data sources, stir carefully, and you have the U.S. balance of trade statistics. Much of the statistics that we cite in this chapter come from these sources.\nThe second row of Table 10.1 provides data on trade in services. Here, the U.S. economy is running a surplus. Although the level of trade in services is still relatively small compared to trade in goods, the importance of services has expanded substantially over the last few decades. For example, U.S. exports of services were equal to about one-half of U.S. exports of goods in 2015, compared to one-fifth in 1980.The third component of the current account balance, labeled income payments, refers to money that U.S. financial investors received on their foreign investments (money flowing into the United States) and payments to foreign investors who had invested their funds here (money flowing out of the United States). The reason for including this money on foreign investment in the overall measure of trade, along with goods and services, is that, from an economic perspective, income is just as much an economic transaction as car, wheat, or oil shipments: it is just trade that is happening in the financial capital market.The final category of the current account balance is unilateral transfers, which are payments that government, private charities, or individuals make in which they send money abroad without receiving any direct good or service. Economic or military assistance from the U.S. government to other countries fits into this category, as does spending abroad by charities to address poverty or social inequalities. When an individual in the United States sends money overseas, as is the case with some immigrants, it is also counted in this category. The current account balance treats these unilateral payments like imports, because they also involve a stream of payments leaving the country. For the U.S. economy, unilateral transfers are almost always negative. This pattern, however, does not always hold. In 1991, for example, when the United States led an international coalition against Saddam Husseins Iraq in the Gulf War, many other nations agreed that they would make payments to the United States to offset the U.S. war expenses. These payments were large enough that, in 1991, the overall U.S. balance on unilateral transfers was a positive $10 billion.The following Work It Out feature steps you through the process of using the values for goods, services, and income payments to calculate the merchandise balance and the current account balance.\n\nWork It Out\n\n\nCalculating the Merchandise Balance and the Current Account Balance\n\n\n\n\nExports (in $ billions)\nImports (in $ billions)\nBalance\n\n\n\nGoods\n\n\n\n\n\nServices\n\n\n\n\n\nIncome payments\n\n\n\n\n\nUnilateral transfers\n\n\n\n\n\nCurrent account balance\n\n\n\n\n\nTable \n10.2\n \nCalculating Merchandise Balance and Current Account Balance\n \n\nUse the information given below to fill in Table 10.2, and then calculate:\n\nThe merchandise balance\nThe current account balance\n\nKnown information:\n\nUnilateral transfers: $130\nExports in goods: $1,046\nExports in services: $509\nImports in goods: $1,562\nImports in services: $371\nIncome received by U.S. investors on foreign stocks and bonds: $561\nIncome received by foreign investors on U.S. assets: $472\n\nStep 1. Focus on goods and services first. Enter the dollar amount of exports of both goods and services under the Export column.\nStep 2. Enter imports of goods and services under the Import column.\nStep 3. Under the Export column and in the row for Income payments, enter the financial flows of money coming back to the United States. U.S. investors are earning this income from abroad.\nStep 4. Under the Import column and in the row for Income payments, enter the financial flows of money going out of the United States to foreign investors. Foreign investors are earning this money on U.S. assets, like stocks.\nStep 5. Unilateral transfers are money flowing out of the United States in the form of, for example, military aid, foreign aid, and global charities. Because the money leaves the country, enter it under Imports and in the final column as well, as a negative.Step 6. Calculate the trade balance by subtracting imports from exports in both goods and services. Enter this in the final Balance column. This can be positive or negative.\nStep 7. Subtract the income payments flowing out of the country (under Imports) from the money coming back to the United States (under Exports) and enter this amount under the Balance column.\nStep 8. Enter unilateral transfers as a negative amount under the Balance column.\nStep 9. The merchandise trade balance is the difference between exports of goods and imports of goodsthe first number under Balance.\nStep 10. Now sum up your columns for Exports, Imports, and Balance. The final balance number is the current account balance.\nThe merchandise balance of trade is the difference between exports and imports. In this case, it is equal to $1,046  $1,562, a trade deficit of $516 billion. The current account balance is $419 billion. See the completed Table 10.3.\n\n\nValue of Exports (money flowing into the United States)\nValue of Imports (money flowing out of the United States)\nBalance\n\n\n\nGoods\n$1,046\n$1,562\n$516\n\n\nServices\n$509\n$371\n$138\n\n\nIncome receipts and payments\n$561\n$472\n$89\n\n\nUnilateral transfers\n$0\n$130\n$130\n\n\nCurrent account balance\n$2,116\n$2,535\n$419\n\n\nTable \n10.3\n \nCompleted Merchandise Balance and Current Account Balance\n \n\n\n\n", "10-2": "By the end of this section, you will be able to:\nAnalyze graphs of the current account balance and the merchandise trade balance\nIdentify patterns in U.S. trade surpluses and deficits\nCompare the U.S. trade surpluses and deficits to other countries' trade surpluses and deficits\n\nWe present the history of the U.S. current account balance in recent decades in several different ways. Figure 10.2 (a) shows the current account balance and the merchandise trade balance in dollar terms. Figure 10.2 (b) shows the current account balance and merchandise account balance yet again, this time as a share of the GDP for that year. By dividing the trade deficit in each year by GDP in that year, Figure 10.2 (b) factors out both inflation and growth in the real economy.\n\n\n\nFigure \n10.2\n \nCurrent Account Balance and Merchandise Trade Balance, 19602015\n \n(a) The current account balance and the merchandise trade balance in billions of dollars from 1960 to 2015. If the lines are above zero dollars, the United States was running a positive trade balance and current account balance. If the lines fall below zero dollars, the United States is running a trade deficit and a deficit in its current account balance. (b) This shows the same itemstrade balance and current account balancein relationship to the size of the U.S. economy, or GDP, from 1960 to 2015.\n\nBy either measure, the U.S. balance of trade pattern is clear. From the 1960s into the 1970s, the U.S. economy had mostly small trade surplusesthat is, the graphs in Figure 10.2 show positive numbers. However, starting in the 1980s, the trade deficit increased rapidly, and after a tiny surplus in 1991, the current account trade deficit became even larger in the late 1990s and into the mid-2000s. However, the trade deficit declined in 2009 after the recession had taken hold, then rebounded partially in 2010 and has remained stable up through 2016.\nClick to view content\nCurrent Account Balance in Billions of Dollars.\nTable 10.4 shows the U.S. trade picture in 2013 compared with some other economies from around the world. While the U.S. economy has consistently run trade deficits in recent years, Japan and many European nations, among them France and Germany, have consistently run trade surpluses. Some of the other countries listed include Brazil, the largest economy in Latin America; Nigeria, along with South Africa competing to be the largest economy in Africa; and China, India, and Korea. The first column offers one measure of an economy's globalization: exports of goods and services as a percentage of GDP. The second column shows the trade balance. Usually, most countries have trade surpluses or deficits that are less than 5% of GDP. As you can see, the U.S. current account balance is 2.6% of GDP, while Germany's is 8.4% of GDP.\n\n\nExports of Goods and Services\nCurrent Account Balance\n\n\n\nUnited States\n17.6%\n2.6%\n\n\nJapan\n16.2%\n3.1%\n\n\nGermany\n46.8%\n8.4%\n\n\nUnited Kingdom\n27.2%\n5.4%\n\n\nCanada\n31.5%\n3.2%\n\n\nSweden\n45.6%\n5.2%\n\n\nKorea\n45.9%\n7.7%\n\n\nMexico\n35.4%\n2.9%\n\n\nBrazil\n13.0%\n3.3%\n\n\nChina\n22.1%\n3.0%\n\n\nIndia\n19.9%\n1.1%\n\n\nNigeria\n10.7%\n-3.3%\n\n\nWorld\n-\n0.0%\n\n\nTable \n10.4\n \nLevel and Balance of Trade in 2015 (figures as a percentage of GDP, Source: http://data.worldbank.org/indicator/BN.CAB.XOKA.GD.ZS)\n \n\n\n", "10-3": "By the end of this section, you will be able to:\nExplain the connection between trade balances and financial capital flows\nCalculate comparative advantage\nExplain balanced trade in terms of investment and capital flows\n\nAs economists see it, trade surpluses can be either good or bad, depending on circumstances, and trade deficits can be good or bad, too. The challenge is to understand how the international flows of goods and services are connected with international flows of financial capital. In this module we will illustrate the intimate connection between trade balances and flows of financial capital in two ways: a parable of trade between Robinson Crusoe and Friday, and a circular flow diagram representing flows of trade and payments.\nA Two-Person Economy: Robinson Crusoe and Friday\nTo understand how economists view trade deficits and surpluses, consider a parable based on the story of Robinson Crusoe. Crusoe, as you may remember from the classic novel by Daniel Defoe first published in 1719, was shipwrecked on a desert island. After living alone for some time, he is joined by a second person, whom he names Friday. Think about the balance of trade in a two-person economy like that of Robinson and Friday.\nRobinson and Friday trade goods and services. Perhaps Robinson catches fish and trades them to Friday for coconuts, or Friday weaves a hat out of tree fronds and trades it to Robinson for help in carrying water. For a period of time, each individual trade is self-contained and complete. Because each trade is voluntary, both Robinson and Friday must feel that they are receiving fair value for what they are giving. As a result, each persons exports are always equal to his imports, and trade is always in balance between the two. Neither person experiences either a trade deficit or a trade surplus.However, one day Robinson approaches Friday with a proposition. Robinson wants to dig ditches for an irrigation system for his garden, but he knows that if he starts this project, he will not have much time left to fish and gather coconuts to feed himself each day. He proposes that Friday supply him with a certain number of fish and coconuts for several months, and then after that time, he promises to repay Friday out of the extra produce that he will be able to grow in his irrigated garden. If Friday accepts this offer, then a trade imbalance comes into being. For several months, Friday will have a trade surplus: that is, he is exporting to Robinson more than he is importing. More precisely, he is giving Robinson fish and coconuts, and at least for the moment, he is receiving nothing in return. Conversely, Robinson will have a trade deficit, because he is importing more from Friday than he is exporting.\nThis parable raises several useful issues in thinking about what a trade deficit and a trade surplus really mean in economic terms. The first issue that this story of Robinson and Friday raises is this: Is it better to have a trade surplus or a trade deficit? The answer, as in any voluntary market interaction, is that if both parties agree to the transaction, then they may both be better off. Over time, if Robinsons irrigated garden is a success, it is certainly possible that both Robinson and Friday can benefit from this agreement.The parable raises a second issue: What can go wrong? Robinsons proposal to Friday introduces an element of uncertainty. Friday is, in effect, making a loan of fish and coconuts to Robinson, and Fridays happiness with this arrangement will depend on whether Robinson repays that loan as planned, in full and on time. Perhaps Robinson spends several months loafing and never builds the irrigation system, or perhaps Robinson has been too optimistic about how much he will be able to grow with the new irrigation system, which turns out not to be very productive. Perhaps, after building the irrigation system, Robinson decides that he does not want to repay Friday as much as he previously agreed. Any of these developments will prompt a new round of negotiations between Friday and Robinson. Why the repayment failed is likely to shape Fridays attitude toward these renegotiations. If Robinson worked very hard and the irrigation system just did not increase production as intended, Friday may have some sympathy. If Robinson loafed or if he just refuses to pay, Friday may become irritated.A third issue that the parable raises is that an intimate relationship exists between a trade deficit and international borrowing, and between a trade surplus and international lending. The size of Fridays trade surplus is exactly how much he is lending to Robinson. The size of Robinsons trade deficit is exactly how much he is borrowing from Friday. To economists, a trade surplus literally means the same thing as an outflow of financial capital, and a trade deficit literally means the same thing as an inflow of financial capital. This last insight is worth exploring in greater detail, which we will do in the following section.The story of Robinson and Friday also provides a good opportunity to consider the law of comparative advantage, which you learn more about in the International Trade chapter. The following Work It Out feature steps you through calculating comparative advantage for the wheat and cloth traded between the United States and Great Britain in the 1800s.\nWork It Out\n\n\nCalculating Comparative Advantage\n\nIn the 1800s, the United States and Britain traded wheat and cloth. Table 10.5 shows the varying hours of labor per unit of output.\n\n\n\nWheat (in bushels)\nCloth (in yards)\nRelative labor cost of wheat (Pw/Pc)\nRelative labor cost of cloth (Pc/Pw)\n\n\nUnited States\n8\n9\n8/9\n9/8\n\n\nBritain\n4\n3\n4/3\n3/4\n\n\nTable \n10.5\n \n \n\n\nStep 1. Observe from Table 10.5 that, in the United States, it takes eight hours to supply a bushel of wheat and nine hours to supply a yard of cloth. In contrast, it takes four hours to supply a bushel of wheat and three hours to supply a yard of cloth in Britain.\nStep 2. Recognize the difference between absolute advantage and comparative advantage. Britain has an absolute advantage (lowest cost) in each good, since it takes a lower amount of labor to make each good in Britain. Britain also has a comparative advantage in the production of cloth (lower opportunity cost in cloth (3/4 versus 9/8)). The United States has a comparative advantage in wheat production (lower opportunity cost of 8/9 versus 4/3).\nStep 3. Determine the relative price of one good in terms of the other good. The price of wheat, in this example, is the amount of cloth you have to give up. To find this price, convert the hours per unit of wheat and cloth into units per hour. To do so, observe that in the United States it takes eight hours to make a bushel of wheat, so workers can process 1/8 of a bushel of wheat in an hour. It takes nine hours to make a yard of cloth in the United States, so workers can produce 1/9 of a yard of cloth in an hour. If you divide the amount of cloth (1/9 of a yard) by the amount of wheat you give up (1/8 of a bushel) in an hour, you find the price (8/9) of one good (wheat) in terms of the other (cloth).\n\nThe Balance of Trade as the Balance of Payments\nThe connection between trade balances and international flows of financial capital is so close that economists sometimes describe the balance of trade as the balance of payments. Each category of the current account balance involves a corresponding flow of payments between a given country and the rest of the world economy.Figure 10.3 shows the flow of goods and services and payments between one countrythe United States in this exampleand the rest of the world. The top line shows U.S. exports of goods and services, while the second line shows financial payments from purchasers in other countries back to the U.S. economy. The third line then shows U.S. imports of goods, services, and investment, and the fourth line shows payments from the home economy to the rest of the world. Flow of goods and services (lines one and three) show up in the current account, while we find flow of funds (lines two and four) in the financial account.The bottom four lines in Figure 10.3 show the flows of investment income. In the first of the bottom lines, we see investments made abroad with funds flowing from the home country to the rest of the world. Investment income stemming from an investment abroad then runs in the other direction from the rest of the world to the home country. Similarly, we see on the bottom third line, an investment from the rest of the world into the home country and investment income (bottom fourth line) flowing from the home country to the rest of the world. We find the investment income (bottom lines two and four) in the current account, while investment to the rest of the world or into the home country (lines one and three) is in the financial account. This figure does not show unilateral transfers, the fourth item in the current account.\n\n\n\nFigure \n10.3\n \nFlow of Investment Goods and Capital \n \nEach element of the current account balance involves a flow of financial payments between countries. The top line shows exports of goods and services leaving the home country; the second line shows the money that the home country receives for those exports. The third line shows imports that the home country receives; the fourth line shows the payments that the home country sent abroad in exchange for these imports. \n\nA current account deficit means that, the country is a net borrower from abroad. Conversely, a positive current account balance means a country is a net lender to the rest of the world. Just like the parable of Robinson and Friday, the lesson is that a trade surplus means an overall outflow of financial investment capital, as domestic investors put their funds abroad, while a deficit in the current account balance is exactly equal to the overall or net inflow of foreign investment capital from abroad.It is important to recognize that an inflow and outflow of foreign capital does not necessarily refer to a debt that governments owe to other governments, although government debt may be part of the picture. Instead, these international flows of financial capital refer to all of the ways in which private investors in one country may invest in another countryby buying real estate, companies, and financial investments like stocks and bonds.\n\n", "10-4": "By the end of this section, you will be able to:\nExplain the determinants of trade and current account balance\nIdentify and calculate supply and demand for financial capital\nExplain how a nation's own level of domestic saving and investment determines a nation's balance of trade\nPredict the rising and falling of trade deficits based on a nation's saving and investment identity\n\nThe close connection between trade balances and international flows of savings and investments leads to a macroeconomic analysis. This approach views trade balancesand their associated flows of financial capitalin the context of the overall levels of savings and financial investment in the economy.\nUnderstanding the Determinants of the Trade and Current Account Balance\nThe national saving and investment identity provides a useful way to understand the determinants of the trade and current account balance. In a nations financial capital market, the quantity of financial capital supplied at any given time must equal the quantity of financial capital demanded for purposes of making investments. What is on the supply and demand sides of financial capital? See the following Clear It Up feature for the answer to this question.\n\nClear It Up\n\n\nWhat comprises the supply and demand of financial capital?\n\nA countrys national savings is the total of its domestic savings by household and companies (private savings) as well as the government (public savings). If a country is running a trade deficit, it means money from abroad is entering the country and the government considers it part of the supply of financial capital.The demand for financial capital (money) represents groups that are borrowing the money. Businesses need to borrow to finance their investments in factories, materials, and personnel. When the federal government runs a budget deficit, it is also borrowing money from investors by selling Treasury bonds. Therefore, both business investment and the federal government can demand (or borrow) the supply of savings.\nThere are two main sources for the supply of financial capital in the U.S. economy: saving by individuals and firms, called S, and the inflow of financial capital from foreign investors, which is equal to the trade deficit (M  X), or imports minus exports. There are also two main sources of demand for financial capital in the U.S. economy: private sector investment, I, and government borrowing, where the government needs to borrow when government spending, G, is higher than the taxes collected, T. We can express this national savings and investment identity in algebraic terms:Supplyoffinancialcapital=DemandforfinancialcapitalS+(MX)=I+(GT)Supplyoffinancialcapital=DemandforfinancialcapitalS+(MX)=I+(GT)\nAgain, in this equation, S is private savings, T is taxes, G is government spending, M is imports, X is exports, and I is investment. This relationship is true as a matter of definition because, for the macro economy, the quantity supplied of financial capital must be equal to the quantity demanded.\nHowever, certain components of the national savings and investment identity can switch between the supply side and the demand side. Some countries, like the United States in most years since the 1970s, have budget deficits, which mean the government is spending more than it collects in taxes, and so the government needs to borrow funds. In this case, the government term would be G  T > 0, showing that spending is larger than taxes, and the government would be a demander of financial capital on the left-hand side of the equation (that is, a borrower), not a supplier of financial capital on the right-hand side. However, if the government runs a budget surplus so that the taxes exceed spending, as the U.S. government did from 1998 to 2001, then the government in that year was contributing to the supply of financial capital (T  G > 0), and would appear on the left (saving) side of the national savings and investment identity.Similarly, if a national economy runs a trade surplus, the trade sector will involve an outflow of financial capital to other countries. A trade surplus means that the domestic financial capital is in surplus within a country and can be invested in other countries.\nThe fundamental notion that total quantity of financial capital demanded equals total quantity of financial capital supplied must always remain true. Domestic savings will always appear as part of the supply of financial capital and domestic investment will always appear as part of the demand for financial capital. However, the government and trade balance elements of the equation can move back and forth as either suppliers or demanders of financial capital, depending on whether government budgets and the trade balance are in surplus or deficit.\n\nDomestic Saving and Investment Determine the Trade Balance\nOne insight from the national saving and investment identity is that a nation's own levels of domestic saving and investment determine a nations balance of trade. To understand this point, rearrange the identity to put the balance of trade all by itself on one side of the equation. Consider first the situation with a trade deficit, and then the situation with a trade surplus.In the case of a trade deficit, the national saving and investment identity can be rewritten as:\n\nTradedeficit=DomesticinvestmentPrivatedomesticsavingGovernment(or public) savings(MX)=IS(TG)Tradedeficit=DomesticinvestmentPrivatedomesticsavingGovernment(or public) savings(MX)=IS(TG)\n\nIn this case, domestic investment is higher than domestic saving, including both private and government saving. The only way that domestic investment can exceed domestic saving is if capital is flowing into a country from abroad. After all, that extra financial capital for investment has to come from someplace.\nNow consider a trade surplus from the standpoint of the national saving and investment identity:\n\nTradesurplus=Privatedomesticsaving+PublicsavingDomesticinvestment(XM)=S+(TG)ITradesurplus=Privatedomesticsaving+PublicsavingDomesticinvestment(XM)=S+(TG)I\n\nIn this case, domestic savings (both private and public) is higher than domestic investment. That extra financial capital will be invested abroad.\nThis connection of domestic saving and investment to the trade balance explains why economists view the balance of trade as a fundamentally macroeconomic phenomenon. As the national saving and investment identity shows, the performance of certain sectors of an economy, like cars or steel, do not determine the trade balance. Further, whether the nations trade laws and regulations encourage free trade or protectionism also does not determine the trade balance (see Globalization and Protectionism).\nExploring Trade Balances One Factor at a Time\nThe national saving and investment identity also provides a framework for thinking about what will cause trade deficits to rise or fall. Begin with the version of the identity that has domestic savings and investment on the left and the trade deficit on the right:\nDomesticinvestmentPrivatedomesticsavingsPublicdomesticsavings=TradedeficitIS(TG)=(MX)DomesticinvestmentPrivatedomesticsavingsPublicdomesticsavings=TradedeficitIS(TG)=(MX)\n\nNow, consider the factors on the left-hand side of the equation one at a time, while holding the other factors constant.\nAs a first example, assume that the level of domestic investment in a country rises, while the level of private and public saving remains unchanged. Table 10.6 shows the result in the first row under the equation. Since the equality of the national savings and investment identity must continue to holdit is, after all, an identity that must be true by definitionthe rise in domestic investment will mean a higher trade deficit. This situation occurred in the U.S. economy in the late 1990s. Because of the surge of new information and communications technologies that became available, business investment increased substantially. A fall in private saving during this time and a rise in government saving more or less offset each other. As a result, the financial capital to fund that business investment came from abroad, which is one reason for the very high U.S. trade deficits of the late 1990s and early 2000s.\n\nDomestic Investment\n\nPrivate Domestic Savings\n\nPublic Domestic Savings\n=\nTrade Deficit\n\n\nI\n\nS\n\n(T  G)\n=\n(M  X)\n\n\nUp\n\nNo change\n\nNo change\n\nThen M  X must rise\n\n\nNo change\n\nUp\n\nNo change\n\nThen M  X must fall\n\n\nNo change\n\nNo change\n\nDown\n\nThen M  X must rise\n\n\nTable \n10.6\n \nCauses of a Changing Trade Balance\n \n\n\nAs a second scenario, assume that the level of domestic savings rises, while the level of domestic investment and public savings remain unchanged. In this case, the trade deficit would decline. As domestic savings rises, there would be less need for foreign financial capital to meet investment needs. For this reason, a policy proposal often made for reducing the U.S. trade deficit is to increase private savingalthough exactly how to increase the overall rate of saving has proven controversial.\nAs a third scenario, imagine that the government budget deficit increased dramatically, while domestic investment and private savings remained unchanged. This scenario occurred in the U.S. economy in the mid-1980s. The federal budget deficit increased from $79 billion in 1981 to $221 billion in 1986an increase in the demand for financial capital of $142 billion. The current account balance collapsed from a surplus of $5 billion in 1981 to a deficit of $147 billion in 1986an increase in the supply of financial capital from abroad of $152 billion. The connection at that time is clear: a sharp increase in government borrowing increased the U.S. economys demand for financial capital, and foreign investors through the trade deficit primarily supplied that increase. The following Work It Out feature walks you through a scenario in which private domestic savings has to rise by a certain amount to reduce a trade deficit.\nWork It Out\n\n\nSolving Problems with the Saving and Investment Identity\n\nUse the saving and investment identity to answer the following question: Country A has a trade deficit of $200 billion, private domestic savings of $500 billion, a government deficit of $200 billion, and private domestic investment of $500 billion. To reduce the $200 billion trade deficit by $100 billion, by how much does private domestic savings have to increase?Step 1. Write out the savings investment formula solving for the trade deficit or surplus on the left:\n\n(XM)=S+(TG)I(XM)=S+(TG)I\n\nStep 2. In the formula, put the amount for the trade deficit in as a negative number (X  M). The left side of your formula is now:\n\n200=S+(TG)I200=S+(TG)I\n\nStep 3. Enter the private domestic savings (S) of $500 in the formula:\n\n200=500+(TG)I200=500+(TG)I\nStep 4. Enter the private domestic investment (I) of $500 into the formula:\n\n       200 = 500 + (T  G)  500       200 = 500 + (T  G)  500\nStep 5. The government budget surplus or balance is represented by (T  G). Enter a budget deficit amount for (T  G) of 200: \n\n200=500+(200)500200=500+(200)500\n\nStep 6. Your formula now is:\n(XM)=S+(TG)I200=500+(200)500(XM)=S+(TG)I200=500+(200)500\n\nThe question is: To reduce your trade deficit (X  M) of 200 to 100 (in billions of dollars), by how much will savings have to rise?\n\n(XM)=S+(TG)I100=S+(200)500600=S(XM)=S+(TG)I100=S+(200)500600=S\n\nStep 7. Summarize the answer: Private domestic savings needs to rise by $100 billion, to a total of $600 billion, for the two sides of the equation to remain equal (100 = 100).\n\nShort-Term Movements in the Business Cycle and the Trade Balance\nIn the short run, whether an economy is in a recession or on the upswing can affect trade imbalances. A recession tends to make a trade deficit smaller, or a trade surplus larger, while a period of strong economic growth tends to make a trade deficit larger, or a trade surplus smaller.As an example, note in Figure 10.2 that the U.S. trade deficit declined by almost half from 2006 to 2009. One primary reason for this change is that during the recession, as the U.S. economy slowed down, it purchased fewer of all goods, including fewer imports from abroad. However, buying power abroad fell less, and so U.S. exports did not fall by as much.Conversely, in the mid-2000s, when the U.S. trade deficit became very large, a contributing short-term reason is that the U.S. economy was growing. As a result, there was considerable aggressive buying in the U.S. economy, including the buying of imports. Thus, a trade deficit (or a much lower trade surplus) often accompanies a rapidly growing domestic economy, while a trade surplus (or a much lower trade deficit) accompanies a slowing or recessionary domestic economy.When the trade deficit rises, it necessarily means a greater net inflow of foreign financial capital. The national saving and investment identity teaches that the rest of the economy can absorb this inflow of foreign financial capital in several different ways. For example, reduced private savings could offset the additional inflow of financial capital from abroad, leaving domestic investment and public saving unchanged. Alternatively, the inflow of foreign financial capital could result in higher domestic investment, leaving private and public saving unchanged. Yet another possibility is that greater government borrowing could absorb the inflow of foreign financial capital, leaving domestic saving and investment unchanged. The national saving and investment identity does not specify which of these scenarios, alone or in combination, will occuronly that one of them must occur.\n", "10-5": "By the end of this section, you will be able to:\nIdentify three ways in which borrowing money or running a trade deficit can result in a healthy economy\nIdentify three ways in which borrowing money or running a trade deficit can result in a weaker economy\n\nBecause flows of trade always involve flows of financial payments, flows of international trade are actually the same as flows of international financial capital. The question of whether trade deficits or surpluses are good or bad for an economy is, in economic terms, exactly the same question as whether it is a good idea for an economy to rely on net inflows of financial capital from abroad or to make net investments of financial capital abroad. Conventional wisdom often holds that borrowing money is foolhardy, and that a prudent country, like a prudent person, should always rely on its own resources. While it is certainly possible to borrow too muchas anyone with an overloaded credit card can testifyborrowing at certain times can also make sound economic sense. For both individuals and countries, there is no economic merit in a policy of abstaining from participation in financial capital markets.\nIt makes economic sense to borrow when you are buying something with a long-run payoff; that is, when you are making an investment. For this reason, it can make economic sense to borrow for a college education, because the education will typically allow you to earn higher wages, and so to repay the loan and still come out ahead. It can also make sense for a business to borrow in order to purchase a machine that will last 10 years, as long as the machine will increase output and profits by more than enough to repay the loan. Similarly, it can make economic sense for a national economy to borrow from abroad, as long as it wisely invests the money in ways that will tend to raise the nations economic growth over time. Then, it will be possible for the national economy to repay the borrowed money over time and still end up better off than before.One vivid example of a country that borrowed heavily from abroad, invested wisely, and did perfectly well is the United States during the nineteenth century. The United States ran a trade deficit in 40 of the 45 years from 1831 to 1875, which meant that it was importing capital from abroad over that time. However, that financial capital was mostly invested in projects like railroads that brought a substantial economic payoff. (See the following Clear It Up feature for more on this.)A more recent example along these lines is the experience of South Korea, which had trade deficits during much of the 1970sand so was an importer of capital over that time. However, South Korea also had high rates of investment in physical plant and equipment, and its economy grew rapidly. From the mid-1980s into the mid-1990s, South Korea often had trade surplusesthat is, it was repaying its past borrowing by sending capital abroad.\nIn contrast, some countries have run large trade deficits, borrowed heavily in global capital markets, and ended up in all kinds of trouble. Two specific sorts of trouble are worth examining. First, a borrower nation can find itself in a bind if it does not invest the incoming funds from abroad in a way that leads to increased productivity. Several of Latin America's large economies, including Mexico and Brazil, ran large trade deficits and borrowed heavily from abroad in the 1970s, but the inflow of financial capital did not boost productivity sufficiently, which meant that these countries faced enormous troubles repaying the money borrowed when economic conditions shifted during the 1980s. Similarly, it appears that a number of African nations that borrowed foreign funds in the 1970s and 1980s did not invest in productive economic assets. As a result, several of those countries later faced large interest payments, with no economic growth to show for the borrowed funds.\nClear It Up\n\n\nAre trade deficits always harmful?\n\nFor most years of the nineteenth century, U.S. imports exceeded exports and the U.S. economy had a trade deficit. Yet the string of trade deficits did not hold back the economy at all. Instead, the trade deficits contributed to the strong economic growth that gave the U.S. economy the highest per capita GDP in the world by around 1900.The U.S. trade deficits meant that the U.S. economy was receiving a net inflow of foreign capital from abroad. Much of that foreign capital flowed into two areas of investmentrailroads and public infrastructure like roads, water systems, and schoolswhich were important to helping the U.S. economy grow.We should not overstate the effect of foreign investment capital on U.S. economic growth. In most years the foreign financial capital represented no more than 610% of the funds that the government used for overall physical investment in the economy. Nonetheless, the trade deficit and the accompanying investment funds from abroad were clearly a help, not a hindrance, to the U.S. economy in the nineteenth century.\nA second trouble is: What happens if the foreign money flows in, and then suddenly flows out again? We raised this scenario at the start of the chapter. In the mid-1990s, a number of countries in East AsiaThailand, Indonesia, Malaysia, and South Korearan large trade deficits and imported capital from abroad. However, in 1997 and 1998 many foreign investors became concerned about the health of these economies, and quickly pulled their money out of stock and bond markets, real estate, and banks. The extremely rapid departure of that foreign capital staggered the banking systems and economies of these countries, plunging them into deep recession. We investigate and discuss the links between international capital flows, banks, and recession in The Impacts of Government Borrowing.While a trade deficit is not always harmful, there is no guarantee that running a trade surplus will bring robust economic health. For example, Germany and Japan ran substantial trade surpluses for most of the last three decades. Regardless of their persistent trade surpluses, both countries have experienced occasional recessions and neither country has had especially robust annual growth in recent years. Read more about Japans trade surplus in the next Clear It Up feature.\nLink It Up\n\n\nWatch this video on whether or not trade deficit is good for the economy.\n\nThe sheer size and persistence of the U.S. trade deficits and inflows of foreign capital since the 1980s are a legitimate cause for concern. The huge U.S. economy will not be destabilized by an outflow of international capital as easily as, say, the comparatively tiny economies of Thailand and Indonesia were in 19971998. Even an economy that is not knocked down, however, can still be shaken. American policymakers should certainly be paying attention to those cases where a pattern of extensive and sustained current account deficits and foreign borrowing has gone badlyif only as a cautionary tale.\n\nClear It Up\n\n\nAre trade surpluses always beneficial? Considering Japan since the 1990s.\n\nPerhaps no economy around the world is better known for its trade surpluses than Japan. Since 1990, the size of these surpluses has often been near $100 billion per year. When Japans economy was growing vigorously in the 1960s and 1970s, many, especially non-economists, described its large trade surpluses either a cause or a result of its robust economic health. However, from a standpoint of economic growth, Japans economy has been teetering in and out of recession since 1990, with real GDP growth averaging only about 1% per year, and an unemployment rate that has been creeping higher. Clearly, a whopping trade surplus is no guarantee of economic good health.Instead, Japans trade surplus reflects that Japan has a very high rate of domestic savings, more than the Japanese economy can invest domestically, and so it invests the extra funds abroad. In Japans slow economy, consumption of imports is relatively low, and the growth of consumption is relatively slow. Thus, Japans exports continually exceed its imports, leaving the trade surplus continually high. Recently, Japans trade surpluses began to deteriorate. In 2013, Japan ran a trade deficit due to the high cost of imported oil. By 2015, Japan again had a surplus.\n", "10-6": "By the end of this section, you will be able to:\nIdentify three factors that influence a country's level of trade\nDifferentiate between balance of trade and level of trade\n\nA nations level of trade may at first sound like much the same issue as the balance of trade, but these two are actually quite separate. It is perfectly possible for a country to have a very high level of trademeasured by its exports of goods and services as a share of its GDPwhile it also has a near-balance between exports and imports. A high level of trade indicates that the nation exports a good portion of its production. It is also possible for a countrys trade to be a relatively low share of GDP, relative to global averages, but for the imbalance between its exports and its imports to be quite large. We emphasized this general theme earlier in Measuring Trade Balances, which offered some illustrative figures on trade levels and balances.A countrys level of trade tells how much of its production it exports. We measure this by the percent of exports out of GDP. It indicates the degree of an economy's globalization. Some countries, such as Germany, have a high level of tradethey export almost 50% of their total production. The balance of trade tells us if the country is running a trade surplus or trade deficit. A country can have a low level of trade but a high trade deficit. (For example, the United States only exports 13% of GDP, but it has a trade deficit of over $500 billion.)Three factors strongly influence a nations level of trade: the size of its economy, its geographic location, and its history of trade. Large economies like the United States can do much of their trading internally, while small economies like Sweden have less ability to provide what they want internally and tend to have higher ratios of exports and imports to GDP. Nations that are neighbors tend to trade more, since costs of transportation and communication are lower. Moreover, some nations have long and established patterns of international trade, while others do not.\nConsequently, a relatively small economy like Sweden, with many nearby trading partners across Europe and a long history of foreign trade, has a high level of trade. Brazil and India, which are fairly large economies that have often sought to inhibit trade in recent decades, have lower levels of trade; whereas, the United States and Japan are extremely large economies that have comparatively few nearby trading partners. Both countries actually have quite low levels of trade by world standards. The ratio of exports to GDP in either the United States or in Japan is about half of the world average.The balance of trade is a separate issue from the level of trade. The United States has a low level of trade, but had enormous trade deficits for most years from the mid-1980s into the 2000s. Japan has a low level of trade by world standards, but has typically shown large trade surpluses in recent decades. Nations like Germany and the United Kingdom have medium to high levels of trade by world standards, but Germany had a moderate trade surplus in 2015, while the United Kingdom had a moderate trade deficit. Their trade picture was roughly in balance in the late 1990s. Sweden had a high level of trade and a moderate trade surplus in 2015, while Mexico had a high level of trade and a moderate trade deficit that same year.In short, it is quite possible for nations with a relatively low level of trade, expressed as a percentage of GDP, to have relatively large trade deficits. It is also quite possible for nations with a near balance between exports and imports to worry about the consequences of high levels of trade for the economy. It is not inconsistent to believe that a high level of trade is potentially beneficial to an economy, because of the way it allows nations to play to their comparative advantages, and to also be concerned about any macroeconomic instability caused by a long-term pattern of large trade deficits. The following Clear It Up feature discusses how this sort of dynamic played out in Colonial India.\n\nClear It Up\n\n\nAre trade surpluses always beneficial? Considering Colonial India.\n\nIndia was formally under British rule from 1858 to 1947. During that time, India consistently had trade surpluses with Great Britain. Anyone who believes that trade surpluses are a sign of economic strength and dominance while trade deficits are a sign of economic weakness must find this pattern odd, since it would mean that colonial India was successfully dominating and exploiting Great Britain for almost a centurywhich was not true.\nInstead, Indias trade surpluses with Great Britain meant that each year there was an overall flow of financial capital from India to Great Britain. In India, many heavily criticized this financial capital flow as the drain, and they viewed eliminating the financial capital drain as one of the many reasons why India would benefit from achieving independence.\nFinal Thoughts about Trade Balances\nTrade deficits can be a good or a bad sign for an economy, and trade surpluses can be a good or a bad sign. Even a trade balance of zerowhich just means that a nation is neither a net borrower nor lender in the international economycan be either a good or bad sign. The fundamental economic question is not whether a nations economy is borrowing or lending at all, but whether the particular borrowing or lending in the particular economic conditions of that country makes sense.\nIt is interesting to reflect on how public attitudes toward trade deficits and surpluses might change if we could somehow change the labels that people and the news media affix to them. If we called a trade deficit attracting foreign financial capitalwhich accurately describes what a trade deficit meansthen trade deficits might look more attractive. Conversely, if we called a trade surplus shipping financial capital abroadwhich accurately captures what a trade surplus doesthen trade surpluses might look less attractive. Either way, the key to understanding trade balances is to understand the relationships between flows of trade and flows of international payments, and what these relationships imply about the causes, benefits, and risks of different kinds of trade balances. The first step along this journey of understanding is to move beyond knee-jerk reactions to terms like trade surplus, trade balance, and trade deficit.\nBring It Home\n\n\nMore than Meets the Eye in the Congo\n\nNow that you see the big picture, you undoubtedly realize that all of the economic choices you make, such as depositing savings or investing in an international mutual fund, do influence the flow of goods and services as well as the flows of money around the world.\nYou now know that a trade surplus does not necessarily tell us whether an economy is performing well or not. The Democratic Republic of the Congo ran a trade surplus in 2013, as we learned in the beginning of the chapter. Yet its current account balance was $2.8 billion. However, the return of political stability and the rebuilding in the aftermath of the civil war there has meant a flow of investment and financial capital into the country. In this case, a negative current account balance means the country is being rebuiltand that is a good thing.\n\n", "11-1": "By the end of this section, you will be able to:\n\nExplain Says Law and understand why it primarily applies in the long run\nExplain Keynes Law and understand why it primarily  applies in the short run\n\nMacroeconomists over the last two centuries have often divided into two groups: those who argue that supply is the most important determinant of the size of the macroeconomy while demand just tags along, and those who argue that demand is the most important factor in the size of the macroeconomy while supply just tags along.Says Law and the Macroeconomics of Supply\nThose economists who emphasize the role of supply in the macroeconomy often refer to the work of a famous early nineteenth century French economist named Jean-Baptiste Say (17671832). Says law is: Supply creates its own demand. As a matter of historical accuracy, it seems clear that Say never actually wrote down this law and that it oversimplifies his beliefs, but the law lives on as useful shorthand for summarizing a point of view.The intuition behind Says law is that each time a good or service is produced and sold, it generates income that is earned for someone: a worker, a manager, an owner, or those who are workers, managers, and owners at firms that supply inputs along the chain of production. We alluded to this earlier in our discussion of the National Income approach to measuring GDP. The forces of supply and demand in individual markets will cause prices to rise and fall. The bottom line remains, however, that every sale represents income to someone, and so, Says law argues, a given value of supply must create an equivalent value of demand somewhere else in the economy. Because Jean-Baptiste Say, Adam Smith, and other economists writing around the turn of the nineteenth century who discussed this view were known as classical economists, modern economists who generally subscribe to the Says law view on the importance of supply for determining the size of the macroeconomy are called neoclassical economists.If supply always creates exactly enough demand at the macroeconomic level, then (as Say himself recognized) it is hard to understand why periods of recession and high unemployment should ever occur. To be sure, even if total supply always creates an equal amount of total demand, the economy could still experience a situation of some firms earning profits while other firms suffer losses. Nevertheless, a recession is not a situation where all business failures are exactly counterbalanced by an offsetting number of successes. A recession is a situation in which the economy as a whole is shrinking in size, business failures outnumber the remaining success stories, and many firms end up suffering losses and laying off workers.Says law that supply creates its own demand does seem a good approximation for the long run. Over periods of some years or decades, as the productive power of an economy to supply goods and services increases, total demand in the economy grows at roughly the same pace. However, over shorter time horizons of a few months or even years, recessions or even depressions occur in which firms, as a group, seem to face a lack of demand for their products.\nKeynes Law and the Macroeconomics of Demand\nThe alternative to Says law, with its emphasis on supply, is Keynes law: Demand creates its own supply. As a matter of historical accuracy, just as Jean-Baptiste Say never wrote down anything as simpleminded as Says law, John Maynard Keynes never wrote down Keynes law, but the law is a useful simplification that conveys a certain point of view.When Keynes wrote his influential work The General Theory of Employment, Interest, and Money during the 1930s Great Depression, he pointed out that during the Depression, the economy's capacity to supply goods and services had not changed much. U.S. unemployment rates soared higher than 20% from 1933 to 1935, but the number of possible workers had not increased or decreased much. Factories closed, but machinery and equipment had not disappeared. Technologies that had been invented in the 1920s were not un-invented and forgotten in the 1930s. Thus, Keynes argued that the Great Depressionand many ordinary recessions as wellwere not caused by a drop in the ability of the economy to supply goods as measured by labor, physical capital, or technology. He argued the economy often produced less than its full potential, not because it was technically impossible to produce more with the existing workers and machines, but because a lack of demand in the economy as a whole led to inadequate incentives for firms to produce. In such cases, he argued, the level of GDP in the economy was not primarily determined by the potential of what the economy could supply, but rather by the amount of total demand.Keynes law seems to apply fairly well in the short run of a few months to a few years, when many firms experience either a drop in demand for their output during a recession or so much demand that they have trouble producing enough during an economic boom. However, demand cannot tell the whole macroeconomic story, either. After all, if demand was all that mattered at the macroeconomic level, then the government could make the economy as large as it wanted just by pumping up total demand through a large increase in the government spending component or by legislating large tax cuts to push up the consumption component. Economies do, however, face genuine limits to how much they can produce, limits determined by the quantity of labor, physical capital, technology, and the institutional and market structures that bring these factors of production together. These constraints on what an economy can supply at the macroeconomic level do not disappear just because of an increase in demand.\nCombining Supply and Demand in Macroeconomics\nTwo insights emerge from this overview of Says law with its emphasis on macroeconomic supply and Keynes law with its emphasis on macroeconomic demand. The first conclusion, which is not exactly a hot news flash, is that an economic approach focused only on the supply side or only on the demand side can be only a partial success. We need to take into account both supply and demand. The second conclusion is that since Keynes law applies more accurately in the short run and Says law applies more accurately in the long run, the tradeoffs and connections between the three goals of macroeconomics may be different in the short run and the long run.\n", "11-2": "By the end of this section, you will be able to:\n\nExplain the aggregate supply curve and how it relates to real GDP and potential GDP\nExplain the aggregate demand curve and how it is influenced by price levels\nInterpret the aggregate demand/aggregate supply model\nIdentify the point of equilibrium in the aggregate demand/aggregate supply model\nDefine short run aggregate supply and long run aggregate supply\nTo build a useful macroeconomic model, we need a model that shows what determines total supply or total demand for the economy, and how total demand and total supply interact at the macroeconomic level. We call this the aggregate demand/aggregate supply model. This module will explain aggregate supply, aggregate demand, and the equilibrium between them. The following modules will discuss the causes of shifts in aggregate supply and aggregate demand.The Aggregate Supply Curve and Potential GDP\nFirms make decisions about what quantity to supply based on the profits they expect to earn. They determine profits, in turn, by the price of the outputs they sell and by the prices of the inputs, like labor or raw materials, that they need to buy. Aggregate supply (AS) refers to the total quantity of output (i.e. real GDP) firms will produce and sell. The aggregate supply (AS) curve shows the total quantity of output (i.e. real GDP) that firms will produce and sell at each price level.Figure 11.3 shows an aggregate supply curve. In the following paragraphs, we will walk through the elements of the diagram one at a time: the horizontal and vertical axes, the aggregate supply curve itself, and the meaning of the potential GDP vertical line.\n\n\n\n\nFigure \n11.3\n \nThe Aggregate Supply Curve\n \nAggregate supply (AS) slopes up, because as the price level for outputs rises, with the price of inputs remaining fixed, firms have an incentive to produce more to earn higher profits. The potential GDP line shows the maximum that the economy can produce with full employment of workers and physical capital.\n\nThe diagram's horizontal axis shows real GDPthat is, the level of GDP adjusted for inflation. The vertical axis shows the price level, which measures the average price of all goods and services produced in the economy. In other words, the price level in the AD-AS model is what we called the GDP Deflator in The Macroeconomic Perspective. Remember that the price level is different from the inflation rate. Visualize the price level as an index number, like the Consumer Price Index, while the inflation rate is the percentage change in the price level over time.As the price level rises, real GDP rises as well. Why? The price level on the vertical axis represents prices for final goods or outputs bought in the economyi.e. the GDP deflatornot the price level for intermediate goods and services that are inputs to production. Thus, the AS curve describes how suppliers will react to a higher price level for final outputs of goods and services, while holding the prices of inputs like labor and energy constant. If firms across the economy face a situation where the price level of what they produce and sell is rising, but their costs of production are not rising, then the lure of higher profits will induce them to expand production. In other words, an aggregate supply curve shows how producers as a group will respond to an increase in aggregate demand.An AS curve's slope changes from nearly flat at its far left to nearly vertical at its far right. At the far left of the aggregate supply curve, the level of output in the economy is far below potential GDP, which we define as the amount of real GDP an economy can produce by fully employing its existing levels of labor, physical capital, and technology, in the context of its existing market and legal institutions. At these relatively low levels of output, levels of unemployment are high, and many factories are running only part-time, or have closed their doors. In this situation, a relatively small increase in the prices of the outputs that businesses sellwhile assuming no rise in input pricescan encourage a considerable surge in the quantity of aggregate supply because so many workers and factories are ready to swing into production.As the GDP increases, however, some firms and industries will start running into limits: perhaps nearly all of the expert workers in a certain industry will have jobs or factories in certain geographic areas or industries will be running at full speed. In the AS curve's intermediate area, a higher price level for outputs continues to encourage a greater quantity of outputbut as the increasingly steep upward slope of the aggregate supply curve shows, the increase in real GDP in response to a given rise in the price level will not be as large. (Read the following Clear It Up feature to learn why the AS curve crosses potential GDP.)\nClear It Up\n\n\nWhy does AS cross potential GDP?\n\nEconomists typically draw the aggregate supply curve to cross the potential GDP line. This shape may seem puzzling: How can an economy produce at an output level which is higher than its potential or full employment GDP? The economic intuition here is that if prices for outputs were high enough, producers would make fanatical efforts to produce: all workers would be on double-overtime, all machines would run 24 hours a day, seven days a week. Such hyper-intense production would go beyond using potential labor and physical capital resources fully, to using them in a way that is not sustainable in the long term. Thus, it is possible for production to sprint above potential GDP, but only in the short run.\nAt the far right, the aggregate supply curve becomes nearly vertical. At this quantity, higher prices for outputs cannot encourage additional output, because even if firms want to expand output, the inputs of labor and machinery in the economy are fully employed. In this example, the vertical line in the exhibit shows that potential GDP occurs at a total output of 9,500. When an economy is operating at its potential GDP, machines and factories are running at capacity, and the unemployment rate is relatively lowat the natural rate of unemployment. For this reason, potential GDP is sometimes also called full-employment GDP.\n\nThe Aggregate Demand Curve\nAggregate demand (AD) refers to the amount of total spending on domestic goods and services in an economy. (Strictly speaking, AD is what economists call total planned expenditure. We will further explain this distinction in the appendix The Expenditure-Output Model\n. For now, just think of aggregate demand as total spending.) It includes all four components of demand: consumption, investment, government spending, and net exports (exports minus imports). This demand is determined by a number of factors, but one of them is the price levelrecall though, that the price level is an index number such as the GDP deflator that measures the average price of the things we buy. The aggregate demand (AD) curve shows the total spending on domestic goods and services at each price level.Figure 11.4 presents an aggregate demand (AD) curve. Just like the aggregate supply curve, the horizontal axis shows real GDP and the vertical axis shows the price level. The AD curve slopes down, which means that increases in the price level of outputs lead to a lower quantity of total spending. The reasons behind this shape are related to how changes in the price level affect the different components of aggregate demand. The following components comprise aggregate demand: consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M): C + I + G + X  M.\n\n\n\n\nFigure \n11.4\n \nThe Aggregate Demand Curve\n \nAggregate demand (AD) slopes down, showing that, as the price level rises, the amount of total spending on domestic goods and services declines.\n\n\nThe wealth effect holds that as the price level increases, the buying power of savings that people have stored up in bank accounts and other assets will diminish, eaten away to some extent by inflation. Because a rise in the price level reduces peoples wealth, consumption spending will fall as the price level rises.\nThe interest rate effect is that as prices for outputs rise, the same purchases will take more money or credit to accomplish. This additional demand for money and credit will push interest rates higher. In turn, higher interest rates will reduce borrowing by businesses for investment purposes and reduce borrowing by households for homes and carsthus reducing consumption and investment spending.\nThe foreign price effect points out that if prices rise in the United States while remaining fixed in other countries, then goods in the United States will be relatively more expensive compared to goods in the rest of the world. U.S. exports will be relatively more expensive, and the quantity of exports sold will fall. U.S. imports from abroad will be relatively cheaper, so the quantity of imports will rise. Thus, a higher domestic price level, relative to price levels in other countries, will reduce net export expenditures.\nAmong economists all three of these effects are controversial, in part because they do not seem to be very large. For this reason, the aggregate demand curve in Figure 11.4 slopes downward fairly steeply. The steep slope indicates that a higher price level for final outputs reduces aggregate demand for all three of these reasons, but that the change in the quantity of aggregate demand as a result of changes in price level is not very large.Read the following Work It Out feature to learn how to interpret the AD/AS model. In this example, aggregate supply, aggregate demand, and the price level are given for the imaginary country of Xurbia.\nWork It Out\n\n\nInterpreting the AD/AS Model\n\nTable 11.1 shows information on aggregate supply, aggregate demand, and the price level for the imaginary country of Xurbia. What information does Table 11.1 tell you about the state of the Xurbias economy? Where is the equilibrium price level and output level (this is the SR macroequilibrium)? Is Xurbia risking inflationary pressures or facing high unemployment? How can you tell?\n\n\nPrice Level\nAggregate Demand\nAggregate Supply\n\n\n\n110\n$700\n$600\n\n\n120\n$690\n$640\n\n\n130\n$680\n$680\n\n\n140\n$670\n$720\n\n\n150\n$660\n$740\n\n\n160\n$650\n$760\n\n\n170\n$640\n$770\n\n\nTable \n11.1\n \nPrice Level: Aggregate Demand/Aggregate Supply\n \n\nTo begin to use the AD/AS model, it is important to plot the AS and AD curves from the data provided. What is the equilibrium?Step 1. Draw your x- and y-axis. Label the x-axis Real GDP and the y-axis Price Level.\nStep 2. Plot AD on your graph.\nStep 3. Plot AS on your graph.\nStep 4. Look at Figure 11.5 which provides a visual to aid in your analysis.\n\n\n\n\nFigure \n11.5\n \nThe AD/AS Curves\n \nAD and AS curves created from the data in Table 11.1.\n\nStep 5. Determine where AD and AS intersect. This is the equilibrium with price level at 130 and real GDP at $680.\nStep 6. Look at the graph to determine where equilibrium is located. We can see that this equilibrium is fairly far from where the AS curve becomes near-vertical (or at least quite steep) which seems to start at about $750 of real output. This implies that the economy is not close to potential GDP. Thus, unemployment will be high. In the relatively flat part of the AS curve, where the equilibrium occurs, changes in the price level will not be a major concern, since such changes are likely to be small.\nStep 7. Determine what the steep portion of the AS curve indicates. Where the AS curve is steep, the economy is at or close to potential GDP.\nStep 8. Draw conclusions from the given information:\n\nIf equilibrium occurs in the flat range of AS, then economy is not close to potential GDP and will be experiencing unemployment, but stable price level.\nIf equilibrium occurs in the steep range of AS, then the economy is close or at potential GDP and will be experiencing rising price levels or inflationary pressures, but will have a low unemployment rate.\n\n\nEquilibrium in the Aggregate Demand/Aggregate Supply ModelThe intersection of the aggregate supply and aggregate demand curves shows the equilibrium level of real GDP and the equilibrium price level in the economy. At a relatively low price level for output, firms have little incentive to produce, although consumers would be willing to purchase a large quantity of output. As the price level rises, aggregate supply rises and aggregate demand falls until the equilibrium point is reached.Figure 11.6 combines the AS curve from Figure 11.3 and the AD curve from Figure 11.4 and places them both on a single diagram. In this example, the equilibrium point occurs at point E, at a price level of 90 and an output level of 8,800.\n\n\n\n\n\nFigure \n11.6\n \nAggregate Supply and Aggregate Demand\n \nThe equilibrium, where aggregate supply (AS) equals aggregate demand (AD), occurs at a price level of 90 and an output level of 8,800.\n\n\nConfusion sometimes arises between the aggregate supply and aggregate demand model and the microeconomic analysis of demand and supply in particular markets for goods, services, labor, and capital. Read the following Clear It Up feature to gain an understanding of whether AS and AD are macro or micro.\nClear It Up\n\n\nAre AS and AD macro or micro?\n\nThese aggregate supply and demand models and the microeconomic analysis of demand and supply in particular markets for goods, services, labor, and capital have a superficial resemblance, but they also have many underlying differences.For example, the vertical and horizontal axes have distinctly different meanings in macroeconomic and microeconomic diagrams. The vertical axis of a microeconomic demand and supply diagram expresses a price (or wage or rate of return) for an individual good or service. This price is implicitly relative: it is intended to be compared with the prices of other products (for example, the price of pizza relative to the price of fried chicken). In contrast, the vertical axis of an aggregate supply and aggregate demand diagram expresses the level of a price index like the Consumer Price Index or the GDP deflatorcombining a wide array of prices from across the economy. The price level is absolute: it is not intended to be compared to any other prices since it is essentially the average price of all products in an economy. The horizontal axis of a microeconomic supply and demand curve measures the quantity of a particular good or service. In contrast, the horizontal axis of the aggregate demand and aggregate supply diagram measures GDP, which is the sum of all the final goods and services produced in the economy, not the quantity in a specific market.\nIn addition, the economic reasons for the shapes of the curves in the macroeconomic model are different from the reasons behind the shapes of the curves in microeconomic models. Demand curves for individual goods or services slope down primarily because of the existence of substitute goods, not the wealth effects, interest rate, and foreign price effects associated with aggregate demand curves. The slopes of individual supply and demand curves can have a variety of different slopes, depending on the extent to which quantity demanded and quantity supplied react to price in that specific market, but the slopes of the AS and AD curves are much the same in every diagram (although as we shall see in later chapters, short-run and long-run perspectives will emphasize different parts of the AS curve).\nIn short, just because the AD/AS diagram has two lines that cross, do not assume that it is the same as every other diagram where two lines cross. The intuitions and meanings of the macro and micro diagrams are only distant cousins from different branches of the economics family tree.\n\nDefining SRAS and LRASIn the Clear It Up feature titled Why does AS cross potential GDP? we differentiated between short run changes in aggregate supply which the AS curve shows and long run changes in aggregate supply which the vertical line at potential GDP defines.  In the short run, if demand is too low (or too high), it is possible for producers to supply less GDP (or more GDP) than potential.  In the long run, however, producers are limited to producing at potential GDP.  For this reason, we may also refer to what we have been calling the AS curve as the short run aggregate supply (SRAS) curve. We may also refer to the vertical line at potential GDP as the long run aggregate supply (LRAS) curve.\n\n\n", "11-3": "By the end of this section, you will be able to:\n\nExplain how productivity growth changes the aggregate supply curve\nExplain how changes in input prices change the aggregate supply curve\n\nThe original equilibrium in the AD/AS diagram will shift to a new equilibrium if the AS or AD curve shifts. When the aggregate supply curve shifts to the right, then at every price level, producers supply a greater quantity of real GDP. When the AS curve shifts to the left, then at every price level, producers supply a lower quantity of real GDP. This module discusses two of the most important factors that can lead to shifts in the AS curve: productivity growth and changes in input prices.How Productivity Growth Shifts the AS Curve\nIn the long run, the most important factor shifting the AS curve is productivity growth. Productivity means how much output can be produced with a given quantity of labor. One measure of this is output per worker or GDP per capita. Over time, productivity grows so that the same quantity of labor can produce more output. Historically, the real growth in GDP per capita in an advanced economy like the United States has averaged about 2% to 3% per year, but productivity growth has been faster during certain extended periods like the 1960s and the late 1990s through the early 2000s, or slower during periods like the 1970s. A higher level of productivity shifts the AS curve to the right, because with improved productivity, firms can produce a greater quantity of output at every price level. Figure 11.7 (a) shows an outward shift in productivity over two time periods. The AS curve shifts out from SRAS0 to SRAS1 to SRAS2, and the equilibrium shifts from E0 to E1 to E2. Note that with increased productivity, workers can produce more GDP.  Thus, full employment corresponds to a higher level of potential GDP, which we show as a rightward shift in LRAS from LRAS0 to LRAS1 to LRAS2.\n\n\n\nFigure \n11.7\n \nShifts in Aggregate Supply\n \n(a) The rise in productivity causes the SRAS curve to shift to the right. The original equilibrium E0 is at the intersection of AD and SRAS0. When SRAS shifts right, then the new equilibrium E1 is at the intersection of AD and SRAS1, and then yet another equilibrium, E2, is at the intersection of AD and SRAS2. Shifts in SRAS to the right, lead to a greater level of output and to downward pressure on the price level. (b) A higher price for inputs means that at any given price level for outputs, a lower real GDP will be produced so aggregate supply will shift to the left from SRAS0 to SRAS1. The new equilibrium, E1, has a reduced quantity of output and a higher price level than the original equilibrium (E0).\n\nA shift in the SRAS curve to the right will result in a greater real GDP and downward pressure on the price level, if aggregate demand remains unchanged. However, if this shift in SRAS results from gains in productivity growth, which we typically measure in terms of a few percentage points per year, the effect will be relatively small over a few months or even a couple of years. Recall how in Choice in a World of Scarcity, we said that a nation's production possibilities frontier is fixed in the short run, but shifts out in the long run?  This is the same phenomenon using a different model.\nHow Changes in Input Prices Shift the AS Curve\nHigher prices for inputs that are widely used across the entire economy can have a macroeconomic impact on aggregate supply. Examples of such widely used inputs include labor and energy products. Increases in the price of such inputs will cause the SRAS curve to shift to the left, which means that at each given price level for outputs, a higher price for inputs will discourage production because it will reduce the possibilities for earning profits. Figure 11.7 (b) shows the aggregate supply curve shifting to the left, from SRAS0 to SRAS1, causing the equilibrium to move from E0 to E1. The movement from the original equilibrium of E0 to the new equilibrium of E1 will bring a nasty set of effects: reduced GDP or recession, higher unemployment because the economy is now further away from potential GDP, and an inflationary higher price level as well. For example, the U.S. economy experienced recessions in 19741975, 19801982, 199091, 2001, and 20072009 that were each preceded or accompanied by a rise in the key input of oil prices. In the 1970s, this pattern of a shift to the left in SRAS leading to a stagnant economy with high unemployment and inflation was nicknamed stagflation.Conversely, a decline in the price of a key input like oil will shift the SRAS curve to the right, providing an incentive for more to be produced at every given price level for outputs. From 1985 to 1986, for example, the average price of crude oil fell by almost half, from $24 a barrel to $12 a barrel. Similarly, from 1997 to 1998, the price of a barrel of crude oil dropped from $17 per barrel to $11 per barrel. In both cases, the plummeting oil price led to a situation like that which we presented earlier in Figure 11.7 (a), where the outward shift of SRAS to the right allowed the economy to expand, unemployment to fall, and inflation to decline.Along with energy prices, two other key inputs that may shift the SRAS curve are the cost of labor, or wages, and the cost of imported goods that we use as inputs for other products. In these cases as well, the lesson is that lower prices for inputs cause SRAS to shift to the right, while higher prices cause it to shift back to the left. Note that, unlike changes in productivity, changes in input prices do not generally cause LRAS to shift, only SRAS.\nOther Supply Shocks\nThe aggregate supply curve can also shift due to shocks to input goods or labor. For example, an unexpected early freeze could destroy a large number of agricultural crops, a shock that would shift the AS curve to the left since there would be fewer agricultural products available at any given price.\nSimilarly, shocks to the labor market can affect aggregate supply. An extreme example might be an overseas war that required a large number of workers to cease their ordinary production in order to go fight for their country. In this case, SRAS and LRAS would both shift to the left because there would be fewer workers available to produce goods at any given price.\n", "11-4": "By the end of this section, you will be able to:\n\nExplain how imports influence aggregate demand\nIdentify ways in which business confidence and consumer confidence can affect aggregate demand\nExplain how government policy can change aggregate demand\nEvaluate why economists disagree on the topic of tax cuts\n\nAs we mentioned previously, the components of aggregate demand are consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M). (Read the following Clear It Up feature for explanation of why imports are subtracted from exports and what this means for aggregate demand.) A shift of the AD curve to the right means that at least one of these components increased so that a greater amount of total spending would occur at every price level. A shift of the AD curve to the left means that at least one of these components decreased so that a lesser amount of total spending would occur at every price level. The Keynesian Perspective will discuss the components of aggregate demand and the factors that affect them. Here, the discussion will sketch two broad categories that could cause AD curves to shift: changes in consumer or firm behavior and changes in government tax or spending policy.\nClear It Up\n\n\nDo imports diminish aggregate demand?\n\nWe have seen that the formula for aggregate demand is AD = C + I + G + X - M, where M is the total value of imported goods. Why is there a minus sign in front of imports? Does this mean that more imports will result in a lower level of aggregate demand? The short answer is yes, because aggregate demand is defined as total demand for domestically produced goods and services.When an American buys a foreign product, for example, it gets counted along with all the other consumption. Thus, the income generated does not go to American producers, but rather to producers in another country. It would be wrong to count this as part of domestic demand. Therefore, imports added in consumption are subtracted back out in the M term of the equation.Because of the way in which we write the demand equation, it is easy to make the mistake of thinking that imports are bad for the economy. Just keep in mind that every negative number in the M term has a corresponding positive number in the C or I or G term, and they always cancel out.\nHow Changes by Consumers and Firms Can Affect ADWhen consumers feel more confident about the future of the economy, they tend to consume more. If business confidence is high, then firms tend to spend more on investment, believing that the future payoff from that investment will be substantial. Conversely, if consumer or business confidence drops, then consumption and investment spending decline.\nThe University of Michigan publishes a survey of consumer confidence and constructs an index of consumer confidence each month. The survey results are then reported at http://www.sca.isr.umich.edu, which break down the change in consumer confidence among different income levels. According to that index, consumer confidence averaged around 90 prior to the Great Recession, and then it fell to below 60 in late 2008, which was the lowest it had been since 1980. Since then, confidence has climbed from a 2011 low of 55.8 back to a level in the low 80s, which economists consider close to a healthy state.The Organization for Economic Development and Cooperation (OECD) publishes one measure of business confidence: the \"business tendency surveys\". The OECD collects business opinion survey data for 21 countries on future selling prices and employment, among other business climate elements. After sharply declining during the Great Recession, the measure has risen above zero again and is back to long-term averages (the indicator dips below zero when business outlook is weaker than usual). Of course, either of these survey measures is not very precise. They can however, suggest when confidence is rising or falling, as well as when it is relatively high or low compared to the past. Because economists associate a rise in confidence with higher consumption and investment demand, it will lead to an outward shift in the AD curve, and a move of the equilibrium, from E0 to E1, to a higher quantity of output and a higher price level, as Figure 11.8 (a) shows.Consumer and business confidence often reflect macroeconomic realities; for example, confidence is usually high when the economy is growing briskly and low during a recession. However, economic confidence can sometimes rise or fall for reasons that do not have a close connection to the immediate economy, like a risk of war, election results, foreign policy events, or a pessimistic prediction about the future by a prominent public figure. U.S. presidents, for example, must be careful in their public pronouncements about the economy. If they offer economic pessimism, they risk provoking a decline in confidence that reduces consumption and investment and shifts AD to the left, and in a self-fulfilling prophecy, contributes to causing the recession that the president warned against in the first place. Figure 11.8 (b) shows a shift of AD to the left, and the corresponding movement of the equilibrium, from E0 to E1, to a lower quantity of output and a lower price level.\nLink It Up\n\n\nVisit this website for data on consumer confidence.\n\nLink It Up\n\n\nVisit this website for data on business confidence.\n\n\n\n\n\nFigure \n11.8\n \nShifts in Aggregate Demand\n \n(a) An increase in consumer confidence or business confidence can shift AD to the right, from AD0 to AD1. When AD shifts to the right, the new equilibrium (E1) will have a higher quantity of output and also a higher price level compared with the original equilibrium (E0). In this example, the new equilibrium (E1) is also closer to potential GDP. An increase in government spending or a cut in taxes that leads to a rise in consumer spending can also shift AD to the right. (b) A decrease in consumer confidence or business confidence can shift AD to the left, from AD0 to AD1. When AD shifts to the left, the new equilibrium (E1) will have a lower quantity of output and also a lower price level compared with the original equilibrium (E0). In this example, the new equilibrium (E1) is also farther below potential GDP. A decrease in government spending or higher taxes that leads to a fall in consumer spending can also shift AD to the left.\n\n\nHow Government Macroeconomic Policy Choices Can Shift AD\nGovernment spending is one component of AD. Thus, higher government spending will cause AD to shift to the right, as in Figure 11.8 (a), while lower government spending will cause AD to shift to the left, as in Figure 11.8 (b). For example, in the United States, government spending declined by 3.2% of GDP during the 1990s, from 21% of GDP in 1991, and to 17.8% of GDP in 1998. However, from 2005 to 2009, the peak of the Great Recession, government spending increased from 19% of GDP to 21.4% of GDP. If changes of a few percentage points of GDP seem small to you, remember that since GDP was about $14.4 trillion in 2009, a seemingly small change of 2% of GDP is equal to close to $300 billion.Tax policy can affect consumption and investment spending, too. Tax cuts for individuals will tend to increase consumption demand, while tax increases will tend to diminish it. Tax policy can also pump up investment demand by offering lower tax rates for corporations or tax reductions that benefit specific kinds of investment. Shifting C or I will shift the AD curve as a whole.\nDuring a recession, when unemployment is high and many businesses are suffering low profits or even losses, the U.S. Congress often passes tax cuts. During the 2001 recession, for example, the U.S. Congress enacted a tax cut into law. At such times, the political rhetoric often focuses on how people experiencing hard times need relief from taxes. The aggregate supply and aggregate demand framework, however, offers a complementary rationale, as Figure 11.9 illustrates. The original equilibrium during a recession is at point E0, relatively far from the full employment level of output. The tax cut, by increasing consumption, shifts the AD curve to the right. At the new equilibrium (E1), real GDP rises and unemployment falls and, because in this diagram the economy has not yet reached its potential or full employment level of GDP, any rise in the price level remains muted. Read the following Clear It Up feature to consider the question of whether economists favor tax cuts or oppose them.\n\n\n\nFigure \n11.9\n \nRecession and Full Employment in the AD/AS Model\n \nWhether the economy is in a recession is illustrated in the AD/AS model by how close the equilibrium is to the potential GDP line as indicated by the vertical LRAS line. In this example, the level of output Y0 at the equilibrium E0 is relatively far from the potential GDP line, so it can represent an economy in recession, well below the full employment level of GDP. In contrast, the level of output Y1 at the equilibrium E1 is relatively close to potential GDP, and so it would represent an economy with a lower unemployment rate.\n\n\nClear It Up\n\n\nDo economists favor tax cuts or oppose them?\n\nOne of the most fundamental divisions in American politics over the last few decades has been between those who believe that the government should cut taxes substantially and those who disagree. Ronald Reagan rode into the presidency in 1980 partly because of his promise, soon carried out, to enact a substantial tax cut. George Bush lost his bid for reelection against Bill Clinton in 1992 partly because he had broken his 1988 promise: Read my lips! No new taxes! In the 2000 presidential election, both George W. Bush and Al Gore advocated substantial tax cuts and Bush succeeded in pushing a tax cut package through Congress early in 2001. More recently in 2017, Donald Trump has pushed for tax cuts to stimulate the economy. Disputes over tax cuts often ignite at the state and local level as well.What side do economists take? Do they support broad tax cuts or oppose them? The answer, unsatisfying to zealots on both sides, is that it depends. One issue is whether equally large government spending cuts accompany the tax cuts. Economists differ, as does any broad cross-section of the public, on how large government spending should be and what programs the government might cut back. A second issue, more relevant to the discussion in this chapter, concerns how close the economy is to the full employment output level. In a recession, when the AD and AS curves intersect far below the full employment level, tax cuts can make sense as a way of shifting AD to the right. However, when the economy is already performing extremely well, tax cuts may shift AD so far to the right as to generate inflationary pressures, with little gain to GDP.With the AD/AS framework in mind, many economists might readily believe that the 1981 Reagan tax cuts, which took effect just after two serious recessions, were beneficial economic policy. Similarly, Congress enacted the 2001 Bush tax cuts and the 2009 Obama tax cuts during recessions. However, some of the same economists who favor tax cuts during recession would be much more dubious about identical tax cuts at a time the economy is performing well and cyclical unemployment is low.\nGovernment spending and tax rate changes can be useful tools to affect aggregate demand. We will discuss these in greater detail in the Government Budgets and Fiscal Policy chapter and The Impacts of Government Borrowing. Other policy tools can shift the aggregate demand curve as well. For example, as we will discus in the Monetary Policy and Bank Regulation chapter, the Federal Reserve can affect interest rates and credit availability. Higher interest rates tend to discourage borrowing and thus reduce both household spending on big-ticket items like houses and cars and investment spending by business. Conversely, lower interest rates will stimulate consumption and investment demand. Interest rates can also affect exchange rates, which in turn will have effects on the export and import components of aggregate demand.Clarifying the details of these alternative policies and how they affect the components of aggregate demand can wait for The Keynesian Perspective chapter. Here, the key lesson is that a shift of the aggregate demand curve to the right leads to a greater real GDP and to upward pressure on the price level. Conversely, a shift of aggregate demand to the left leads to a lower real GDP and a lower price level. Whether these changes in output and price level are relatively large or relatively small, and how the change in equilibrium relates to potential GDP, depends on whether the shift in the AD curve is happening in the AS curve's relatively flat or relatively steep portion.\n", "11-5": "By the end of this section, you will be able to:\n\nUse the aggregate demand/aggregate supply model to show periods of economic growth and recession\nExplain how unemployment and inflation impact the aggregate demand/aggregate supply model\nEvaluate the importance of the aggregate demand/aggregate supply model\n\nThe AD/AS model can convey a number of interlocking relationships between the three macroeconomic goals of growth, unemployment, and low inflation. Moreover, the AD/AS framework is flexible enough to accommodate both the Keynes law approach that focuses on aggregate demand and the short run, while also including the Says law approach that focuses on aggregate supply and the long run. These advantages are considerable. Every model is a simplified version of the deeper reality and, in the context of the AD/AS model, the three macroeconomic goals arise in ways that are sometimes indirect or incomplete. In this module, we consider how the AD/AS model illustrates the three macroeconomic goals of economic growth, low unemployment, and low inflation.Growth and Recession in the AD/AS DiagramIn the AD/AS diagram, long-run economic growth due to productivity increases over time will be represented by a gradual shift to the right of aggregate supply. The vertical line representing potential GDP (or the full employment level of GDP) will gradually shift to the right over time as well. Earlier Figure 11.7 (a) showed a pattern of economic growth over three years, with the AS curve shifting slightly out to the right each year. However, the factors that determine the speed of this long-term economic growth ratelike investment in physical and human capital, technology, and whether an economy can take advantage of catch-up growthdo not appear directly in the AD/AS diagram.In the short run, GDP falls and rises in every economy, as the economy dips into recession or expands out of recession. The AD/AS diagram illustrates recessions when the equilibrium level of real GDP is substantially below potential GDP, as we see at the equilibrium point E0 in Figure 11.9. From another standpoint, in years of resurgent economic growth the equilibrium will typically be close to potential GDP, as equilibrium point E1 in that earlier figure shows.\nUnemployment in the AD/AS Diagram\nWe described two types of unemployment in the Unemployment chapter. Short run variations in unemployment (cyclical unemployment) are caused by the business cycle as the economy expands and contracts. Over the long run, in the United States, the unemployment rate typically hovers around 5% (give or take one percentage point or so), when the economy is healthy. In many of the national economies across Europe, the unemployment rate in recent decades has only dropped to about 10% or a bit lower, even in good economic years. We call this baseline level of unemployment that occurs year-in and year-out the natural rate of unemployment and we determine it by how well the structures of market and government institutions in the economy lead to a matching of workers and employers in the labor market. Potential GDP can imply different unemployment rates in different economies, depending on the natural rate of unemployment for that economy.The AD/AS diagram shows cyclical unemployment by how close the economy is to the potential or full GDP employment level. Returning to Figure 11.9, relatively low cyclical unemployment for an economy occurs when the level of output is close to potential GDP, as in the equilibrium point E1. Conversely, high cyclical unemployment arises when the output is substantially to the left of potential GDP on the AD/AS diagram, as at the equilibrium point E0. Although we do not show the factors that determine the natural rate of unemployment separately in the AD/AS model, they are implicitly part of what determines potential GDP or full employment GDP in a given economy.\nInflationary Pressures in the AD/AS Diagram\nInflation fluctuates in the short run. Higher inflation rates have typically occurred either during or just after economic booms: for example, the biggest spurts of inflation in the U.S. economy during the twentieth century followed the wartime booms of World War I and World War II. Conversely, rates of inflation generally decline during recessions. As an extreme example, inflation actually became negativea situation called deflationduring the Great Depression. Even during the relatively short 1991-1992 recession, the inflation rate declined from 5.4% in 1990 to 3.0% in 1992. During the relatively short 2001 recession, the rate of inflation declined from 3.4% in 2000 to 1.6% in 2002. During the deep recession of 20072009, the inflation rate declined from 3.8% in 2008 to 0.4% in 2009. Some countries have experienced bouts of high inflation that lasted for years. In the U.S. economy since the mid1980s, inflation does not seem to have had any long-term trend to be substantially higher. Instead, it has stayed in the 15% range annually.The AD/AS framework implies two ways that inflationary pressures may arise. One possible trigger is if aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment, thus pushing the macroeconomic equilibrium into the AS curve's steep portion. In Figure 11.10 (a), there is a shift of aggregate demand to the right. The new equilibrium E1 is clearly at a higher price level than the original equilibrium E0. In this situation, the aggregate demand in the economy has soared so high that firms in the economy are not capable of producing additional goods, because labor and physical capital are fully employed, and so additional increases in aggregate demand can only result in a rise in the price level.\n\n\n\nFigure \n11.10\n \nSources of Inflationary Pressure in the AD/AS Model\n \n(a) A shift in aggregate demand, from AD0 to AD1, when it happens in the area of the SRAS curve that is near potential GDP, will lead to a higher price level and to pressure for a higher price level and inflation. The new equilibrium (E1) is at a higher price level (P1) than the original equilibrium. (b) A shift in aggregate supply, from SRAS0 to SRAS1, will lead to a lower real GDP and to pressure for a higher price level and inflation. The new equilibrium (E1) is at a higher price level (P1), while the original equilibrium (E0) is at the lower price level (P0).\n\nAn alternative source of inflationary pressures can occur due to a rise in input prices that affects many or most firms across the economyperhaps an important input to production like oil or laborand causes the aggregate supply curve to shift back to the left. In Figure 11.10 (b), the SRAS curve's shift to the left also increases the price level from P0 at the original equilibrium (E0) to a higher price level of P1 at the new equilibrium (E1). In effect, the rise in input prices ends up, after the final output is produced and sold, passing along in the form of a higher price level for outputs.The AD/AS diagram shows only a one-time shift in the price level. It does not address the question of what would cause inflation either to vanish after a year, or to sustain itself for several years. There are two explanations for why inflation may persist over time. One way that continual inflationary price increases can occur is if the government continually attempts to stimulate aggregate demand in a way that keeps pushing the AD curve when it is already in the SRAS curve's steep portion. A second possibility is that, if inflation has been occurring for several years, people might begin to expect a certain level of inflation. If they do, then these expectations will cause prices, wages and interest rates to increase annually by the amount of the inflation expected. These two reasons are interrelated, because if a government fosters a macroeconomic environment with inflationary pressures, then people will grow to expect inflation. However, the AD/AS diagram does not show these patterns of ongoing or expected inflation in a direct way.\nImportance of the Aggregate Demand/Aggregate Supply ModelMacroeconomics takes an overall view of the economy, which means that it needs to juggle many different concepts. For example, start with the three macroeconomic goals of growth, low inflation, and low unemployment. Aggregate demand has four elements: consumption, investment, government spending, and exports less imports. Aggregate supply reveals how businesses throughout the economy will react to a higher price level for outputs. Finally, a wide array of economic events and policy decisions can affect aggregate demand and aggregate supply, including government tax and spending decisions; consumer and business confidence; changes in prices of key inputs like oil; and technology that brings higher levels of productivity.\nThe aggregate demand/aggregate supply model is one of the fundamental diagrams in this course (like the budget constraint diagram that we introduced in the Choice in a World of Scarcity chapter and the supply and demand diagram in the Demand and Supply chapter) because it provides an overall framework for bringing these factors together in one diagram. Some version of the AD/AS model will appear in every chapter in the rest of this book.\n", "11-6": "By the end of this section, you will be able to:\n\nIdentify the neoclassical zone, the intermediate zone, and the Keynesian zone in the aggregate demand/aggregate supply model\nUse an aggregate demand/aggregate supply model as a diagnostic test to understand the current state of the economy\n\nWe can use the AD/AS model to illustrate both Says law that supply creates its own demand and Keynes law that demand creates its own supply. Consider the SRAS curve's three zones which Figure 11.11 identifies: the Keynesian zone, the neoclassical zone, and the intermediate zone.\n\n\n\nFigure \n11.11\n \nKeynes, Neoclassical, and Intermediate Zones in the Aggregate Supply Curve\n \nNear the equilibrium Ek, in the Keynesian zone at the far left of the SRAS curve, small shifts in AD, either to the right or the left, will affect the output level Yk, but will not much affect the price level. In the Keynesian zone, AD largely determines the quantity of output. Near the equilibrium En, in the neoclassical zone at the SRAS curve's far right, small shifts in AD, either to the right or the left, will have relatively little effect on the output level Yn, but instead will have a greater effect on the price level. In the neoclassical zone, the near-vertical SRAS curve close to the level of potential GDP largely determines the quantity of output. In the intermediate zone around equilibrium Ei, movement in AD to the right will increase both the output level and the price level, while a movement in AD to the left would decrease both the output level and the price level.\n\nFocus first on the Keynesian zone, that portion of the SRAS curve on the far left which is relatively flat. If the AD curve crosses this portion of the SRAS curve at an equilibrium point like Ek, then certain statements about the economic situation will follow. In the Keynesian zone, the equilibrium level of real GDP is far below potential GDP, the economy is in recession, and cyclical unemployment is high. If aggregate demand shifted to the right or left in the Keynesian zone, it will determine the resulting level of output (and thus unemployment). However, inflationary price pressure is not much of a worry in the Keynesian zone, since the price level does not vary much in this zone.\nNow, focus your attention on the neoclassical zone of the SRAS curve, which is the near-vertical portion on the right-hand side. If the AD curve crosses this portion of the SRAS curve at an equilibrium point like En where output is at or near potential GDP, then the size of potential GDP pretty much determines the level of output in the economy. Since the equilibrium is near potential GDP, cyclical unemployment is low in this economy, although structural unemployment may remain an issue. In the neoclassical zone, shifts of aggregate demand to the right or the left have little effect on the level of output or employment. The only way to increase the size of the real GDP in the neoclassical zone is for AS to shift to the right. However, shifts in AD in the neoclassical zone will create pressures to change the price level.\nFinally, consider the SRAS curve's intermediate zone in Figure 11.11. If the AD curve crosses this portion of the SRAS curve at an equilibrium point like Ei, then we might expect unemployment and inflation to move in opposing directions. For instance, a shift of AD to the right will move output closer to potential GDP and thus reduce unemployment, but will also lead to a higher price level and upward pressure on inflation. Conversely, a shift of AD to the left will move output further from potential GDP and raise unemployment, but will also lead to a lower price level and downward pressure on inflation.This approach of dividing the SRAS curve into different zones works as a diagnostic test that we can apply to an economy, like a doctor checking a patient for symptoms. First, figure out in what zone the economy is. This will clarify the economic issues, tradeoffs, and policy choices. Some economists believe that the economy is strongly predisposed to be in one zone or another. Thus, hard-line Keynesian economists believe that the economies are in the Keynesian zone most of the time, and so they view the neoclassical zone as a theoretical abstraction. Conversely, hard-line neoclassical economists argue that economies are in the neoclassical zone most of the time and that the Keynesian zone is a distraction. The Keynesian Perspective and The Neoclassical Perspective should help to clarify the underpinnings and consequences of these contrasting views of the macroeconomy.\nBring It Home\n\n\nFrom Housing Bubble to Housing Bust\n\nWe can explain economic fluctuations, whether those experienced during the 1930s Great Depression, the 1970s stagflation, or the 2008-2009 Great Recession, can be explained using the AD/AS diagram. Short-run fluctuations in output occur due to shifts of the SRAS curve, the AD curve, or both. In the case of the housing bubble, rising home values caused the AD curve to shift to the right as more people felt that rising home values increased their overall wealth. Many homeowners took on mortgages that exceeded their ability to pay because, as home values continued to rise, the increased value would pay off any debt outstanding. Increased wealth due to rising home values lead to increased home equity loans and increased spending. All these activities pushed AD to the right, contributing to low unemployment rates and economic growth in the United States. When the housing bubble burst, overall wealth dropped dramatically, wiping out the recent gains. This drop in home values was a demand shock to the U.S. economy because of its impact directly on the wealth of the household sector, and its contagion into the financial that essentially locked up new credit. The AD curve shifted to the left as evidenced by the Great Recession's rising unemployment.Understanding the source of these macroeconomic fluctuations provided monetary and fiscal policy makers with insight about what policy actions to take to mitigate the impact of the housing crisis. From a monetary policy perspective, the Federal Reserve lowered short-term interest rates to between 0% and 0.25 %, to loosen up credit throughout the financial system. Discretionary fiscal policy measures included the passage of the Emergency Economic Stabilization Act of 2008 that allowed for the purchase of troubled assets, such as mortgages, from financial institutions and the American Recovery and Reinvestment Act of 2009 that increased government spending on infrastructure, provided for tax cuts, and increased transfer payments. In combination, both monetary and fiscal policy measures were designed to help stimulate aggregate demand in the U.S. economy, pushing the AD curve to the right.\nWhile most economists agree on the usefulness of the AD/AS diagram in analyzing the sources of these fluctuations, there is still some disagreement about the effectiveness of policy decisions that are useful in stabilizing these fluctuations. We discuss the possible policy actions and the differences among economists about their effectiveness in more detail in The Keynesian Perspective, Monetary Policy and Bank Regulation, and Government Budgets and Fiscal Policy.\n", "12-1": "By the end of this section, you will be able to:\n\nExplain real GDP, recessionary gaps, and inflationary gaps\nRecognize the Keynesian AD/AS model\nIdentify the determining factors of both consumption expenditure and investment expenditure\nAnalyze the factors that determine government spending and net exports\n\nThe Keynesian perspective focuses on aggregate demand. The idea is simple: firms produce output only if they expect it to sell. Thus, while the availability of the factors of production determines a nations potential GDP, the amount of goods and services that actually sell, known as real GDP, depends on how much demand exists across the economy. Figure 12.3 illustrates this point.\n\n\n\nFigure \n12.3\n \nThe Keynesian AD/AS Model\n \nThe Keynesian View of the AD/AS Model uses an SRAS curve, which is horizontal at levels of output below potential and vertical at potential output. Thus, when beginning from potential output, any decrease in AD affects only output, but not prices. Any increase in AD affects only prices, not output.\n\nKeynes argued that, for reasons we explain shortly, aggregate demand is not stablethat it can change unexpectedly. Suppose the economy starts where AD intersects SRAS at P0 and Yp. Because Yp is potential output, the economy is at full employment. Because AD is volatile, it can easily fall. Thus, even if we start at Yp, if AD falls, then we find ourselves in what Keynes termed a recessionary gap. The economy is in equilibrium but with less than full employment, as Y1 in Figure 12.3 shows. Keynes believed that the economy would tend to stay in a recessionary gap, with its attendant unemployment, for a significant period of time.In the same way (although we do not show it in the figure), if AD increases, the economy could experience an inflationary gap, where demand is attempting to push the economy past potential output. Consequently, the economy experiences inflation. The key policy implication for either situation is that government needs to step in and close the gap, increasing spending during recessions and decreasing spending during booms to return aggregate demand to match potential output.Recall from The Aggregate Supply-Aggregate Demand Model that aggregate demand is total spending, economy-wide, on domestic goods and services. (Aggregate demand (AD) is actually what economists call total planned expenditure. Read the appendix on The Expenditure-Output Model for more on this.) You may also remember that aggregate demand is the sum of four components: consumption expenditure, investment expenditure, government spending, and spending on net exports (exports minus imports). In the following sections, we will examine each component through the Keynesian perspective.What Determines Consumption Expenditure?\nConsumption expenditure is spending by households and individuals on durable goods, nondurable goods, and services. Durable goods are items that last and provide value over time, such as automobiles. Nondurable goods are things like groceriesonce you consume them, they are gone. Recall from The Macroeconomic Perspective that services are intangible things consumers buy, like healthcare or entertainment.Keynes identified three factors that affect consumption:\nDisposable income: For most people, the single most powerful determinant of how much they consume is how much income they have in their take-home pay, also known as disposable income, which is income after taxes.\nExpected future income: Consumer expectations about future income also are important in determining consumption. If consumers feel optimistic about the future, they are more likely to spend and increase overall aggregate demand. News of recession and troubles in the economy will make them pull back on consumption.\nWealth or credit: When households experience a rise in wealth, they may be willing to consume a higher share of their income and to save less. When the U.S. stock market rose dramatically in the late 1990s, for example, U.S. savings rates declined, probably in part because people felt that their wealth had increased and there was less need to save. How do people spend beyond their income, when they perceive their wealth increasing? The answer is borrowing. On the other side, when the U.S. stock market declined about 40% from March 2008 to March 2009, people felt far greater uncertainty about their economic future, so savings rates increased while consumption declined.\nFinally, Keynes noted that a variety of other factors combine to determine how much people save and spend. If household preferences about saving shift in a way that encourages consumption rather than saving, then AD will shift out to the right.\n\nLink It Up\n\n\nVisit this website for more information about how the recession affected various groups of people.\n\nWhat Determines Investment Expenditure?\nWe call spending on new capital goods investment expenditure. Investment falls into four categories: producers durable equipment and software, nonresidential structures (such as factories, offices, and retail locations), changes in inventories, and residential structures (such as single-family homes, townhouses, and apartment buildings). Businesses conduct the first three types of investment, while households conduct the last.Keyness treatment of investment focuses on the key role of expectations about the future in influencing business decisions. When a business decides to make an investment in physical assets, like plants or equipment, or in intangible assets, like skills or a research and development project, that firm considers both the expected investment benefits (future profit expectations) and the investment costs (interest rates).Expectations of future profits: The clearest driver of investment benefits is expectations for future profits. When we expect an economy to grow, businesses perceive a growing market for their products. Their higher degree of business confidence will encourage new investment. For example, in the second half of the 1990s, U.S. investment levels surged from 18% of GDP in 1994 to 21% in 2000. However, when a recession started in 2001, U.S. investment levels quickly sank back to 18% of GDP by 2002.\nInterest rates also play a significant role in determining how much investment a firm will make. Just as individuals need to borrow money to purchase homes, so businesses need financing when they purchase big ticket items. The cost of investment thus includes the interest rate. Even if the firm has the funds, the interest rate measures the opportunity cost of purchasing business capital. Lower interest rates stimulate investment spending and higher interest rates reduce it.\nMany factors can affect the expected profitability on investment. For example, if the energy prices decline, then investments that use energy as an input will yield higher profits. If government offers special incentives for investment (for example, through the tax code), then investment will look more attractive; conversely, if government removes special investment incentives from the tax code, or increases other business taxes, then investment will look less attractive. As Keynes noted, business investment is the most variable of all the components of aggregate demand.\nWhat Determines Government Spending?\nThe third component of aggregate demand is federal, state, and local government spending. Although we usually view the United States as a market economy, government still plays a significant role in the economy. As we discuss in Environmental Protection and Negative Externalities and Positive Externalities and Public Goods, government provides important public services such as national defense, transportation infrastructure, and education.Keynes recognized that the government budget offered a powerful tool for influencing aggregate demand. Not only could more government spending stimulate AD (or less government spending reduce it), but lowering or raising tax rates could influence consumption and investment spending. Keynes concluded that during extreme times like deep recessions, only the government had the power and resources to move aggregate demand.\nWhat Determines Net Exports?Recall that exports are domestically produced products that sell abroad while imports are foreign produced products that consumers purchase domestically. Since we define aggregate demand as spending on domestic goods and services, export expenditures add to AD, while import expenditures subtract from AD.Two sets of factors can cause shifts in export and import demand: changes in relative growth rates between countries and changes in relative prices between countries. What is happening in the countries' economies that would be purchasing those exports heavily affects the level of demand for a nation's exports. For example, if major importers of American-made products like Canada, Japan, and Germany have recessions, exports of U.S. products to those countries are likely to decline. Conversely, the amount of income in the domestic economy directly affects the quantity of a nation's imports: more income will bring a higher level of imports.Relative prices of goods in domestic and international markets can also affect exports and imports. If U.S. goods are relatively cheaper compared with goods made in other places, perhaps because a group of U.S. producers has mastered certain productivity breakthroughs, then U.S. exports are likely to rise. If U.S. goods become relatively more expensive, perhaps because a change in the exchange rate between the U.S. dollar and other currencies has pushed up the price of inputs to production in the United States, then exports from U.S. producers are likely to decline.Table 12.1 summarizes the reasons we have explained for changes in aggregate demand.\n\nReasons for a Decrease in Aggregate Demand\nReasons for an Increase in Aggregate Demand\n\n\n\nConsumption\nRise in taxes\nFall in income\nRise in interest rates\nDesire to save more\nDecrease in wealth\nFall in future expected income\n\nConsumption\nDecrease in taxes\nIncrease in income\nFall in interest rates\nDesire to save less\nRise in wealth\nRise in future expected income\n\n\n\nInvestment\n\nFall in expected rate of return\nRise in interest rates\nDrop in business confidence\n\n\nInvestment\n\nRise in expected rate of return\nDrop in interest rates\nRise in business confidence\n\n\n\n\nGovernment\nReduction in government spending\nIncrease in taxes\n\nGovernment\nIncrease in government spending\nDecrease in taxes\n\n\n\nNet Exports\n\nDecrease in foreign demand\nRelative price increase of U.S. goods\n\n\nNet Exports\n\nIncrease in foreign demand\nRelative price drop of U.S. goods\n\n\n\n\nTable \n12.1\n \nDeterminants of Aggregate Demand\n \n\n\n", "12-2": "By the end of this section, you will be able to:\n\nEvaluate the Keynesian view of recessions through an understanding of sticky wages and prices and the importance of aggregate demand\nExplain the coordination argument, menu costs, and macroeconomic externality\nAnalyze the impact of the expenditure multiplier\n\nNow that we have a clear understanding of what constitutes aggregate demand, we return to the Keynesian argument using the model of aggregate demand/aggregate supply (AD/AS). (For a similar treatment using Keynes income-expenditure model, see the appendix on The Expenditure-Output Model.)Keynesian economics focuses on explaining why recessions and depressions occur and offering a policy prescription for minimizing their effects. The Keynesian view of recession is based on two key building blocks. First, aggregate demand is not always automatically high enough to provide firms with an incentive to hire enough workers to reach full employment. Second, the macroeconomy may adjust only slowly to shifts in aggregate demand because of sticky wages and prices, which are wages and prices that do not respond to decreases or increases in demand. We will consider these two claims in turn, and then see how they are represented in the AD/AS model.The first building block of the Keynesian diagnosis is that recessions occur when the level of demand for goods and services is less than what is produced when labor is fully employed. In other words, the intersection of aggregate supply and aggregate demand occurs at a level of output less than the level of GDP consistent with full employment. Suppose the stock market crashes, as in 1929, or suppose the housing market collapses, as in 2008. In either case, household wealth will decline, and consumption expenditure will follow. Suppose businesses see that consumer spending is falling. That will reduce expectations of the profitability of investment, so businesses will decrease investment expenditure.This seemed to be the case during the Great Depression, since the physical capacity of the economy to supply goods did not alter much. No flood or earthquake or other natural disaster ruined factories in 1929 or 1930. No outbreak of disease decimated the ranks of workers. No key input price, like the price of oil, soared on world markets. The U.S. economy in 1933 had just about the same factories, workers, and state of technology as it had had four years earlier in 1929and yet the economy had shrunk dramatically. This also seems to be what happened in 2008.As Keynes recognized, the events of the Depression contradicted Says law that supply creates its own demand. Although production capacity existed, the markets were not able to sell their products. As a result, real GDP was less than potential GDP.\n\nLink It Up\n\n\nVisit this website for raw data used to calculate GDP.\nWage and Price StickinessKeynes also pointed out that although AD fluctuated, prices and wages did not immediately respond as economists often expected. Instead, prices and wages are sticky, making it difficult to restore the economy to full employment and potential GDP. Keynes emphasized one particular reason why wages were sticky: the coordination argument. This argument points out that, even if most people would be willingat least hypotheticallyto see a decline in their own wages in bad economic times as long as everyone else also experienced such a decline, a market-oriented economy has no obvious way to implement a plan of coordinated wage reductions. Unemployment proposed a number of reasons why wages might be sticky downward, most of which center on the argument that businesses avoid wage cuts because they may in one way or another depress morale and hurt the productivity of the existing workers.Some modern economists have argued in a Keynesian spirit that, along with wages, other prices may be sticky, too. Many firms do not change their prices every day or even every month. When a firm considers changing prices, it must consider two sets of costs. First, changing prices uses company resources: managers must analyze the competition and market demand and decide the new prices, they must update sales materials, change billing records, and redo product and price labels. Second, frequent price changes may leave customers confused or angryespecially if they discover that a product now costs more than they expected. These costs of changing prices are called menu costslike the costs of printing a new set of menus with different prices in a restaurant. Prices do respond to forces of supply and demand, but from a macroeconomic perspective, the process of changing all prices throughout the economy takes time.To understand the effect of sticky wages and prices in the economy, consider Figure 12.4 (a) illustrating the overall labor market, while Figure 12.4 (b) illustrates a market for a specific good or service. The original equilibrium (E0) in each market occurs at the intersection of the demand curve (D0) and supply curve (S0). When aggregate demand declines, the demand for labor shifts to the left (to D1) in Figure 12.4 (a) and the demand for goods shifts to the left (to D1) in Figure 12.4 (b). However, because of sticky wages and prices, the wage remains at its original level (W0) for a period of time and the price remains at its original level (P0).As a result, a situation of excess supplywhere the quantity supplied exceeds the quantity demanded at the existing wage or priceexists in markets for both labor and goods, and Q1 is less than Q0 in both Figure 12.4 (a) and Figure 12.4 (b). When many labor markets and many goods markets all across the economy find themselves in this position, the economy is in a recession; that is, firms cannot sell what they wish to produce at the existing market price and do not wish to hire all who are willing to work at the existing market wage. The Clear It Up feature discusses this problem in more detail.\n\n\n\nFigure \n12.4\n \nSticky Prices and Falling Demand in the Labor and Goods Market\n \nIn both (a) and (b), demand shifts left from D0 to D1. However, the wage in (a) and the price in (b) do not immediately decline. In (a), the quantity demanded of labor at the original wage (W0) is Q0, but with the new demand curve for labor (D1), it will be Q1. Similarly, in (b), the quantity demanded of goods at the original price (P0) is Q0, but at the new demand curve (D1) it will be Q1. An excess supply of labor will exist, which we call unemployment. An excess supply of goods will also exist, where the quantity demanded is substantially less than the quantity supplied. Thus, sticky wages and sticky prices, combined with a drop in demand, bring about unemployment and recession.\n\n\nClear It Up\n\n\nWhy Is the Pace of Wage Adjustments Slow?\n\nThe recovery after the Great Recession in the United States has been slow, with wages stagnant, if not declining. In fact, many low-wage workers at McDonalds, Dominos, and Walmart have threatened to strike for higher wages. Their plight is part of a larger trend in job growth and pay in the postrecession recovery.\n\n\n\n\nFigure \n12.5\n \nJobs Lost/Gained in the Recession/Recovery\n \nData in the aftermath of the Great Recession suggests that jobs lost were in mid-wage occupations, while jobs gained were in low-wage occupations.\n\nThe National Employment Law Project compiled data from the Bureau of Labor Statistics and found that, during the Great Recession, 60% of job losses were in medium-wage occupations. Most of them were replaced during the recovery period with lower-wage jobs in the service, retail, and food industries. Figure 12.5 illustrates this data.Wages in the service, retail, and food industries are at or near minimum wage and tend to be both downwardly and upwardly sticky. Wages are downwardly sticky due to minimum wage laws. They may be upwardly sticky if insufficient competition in low-skilled labor markets enables employers to avoid raising wages that would reduce their profits. At the same time, however, the Consumer Price Index increased 11% between 2007 and 2012, pushing real wages down.\nThe Two Keynesian Assumptions in the AD/AS Model\nFigure 12.6 is the AD/AS diagram which illustrates these two Keynesian assumptionsthe importance of aggregate demand in causing recession and the stickiness of wages and prices. Note that because of the stickiness of wages and prices, the aggregate supply curve is flatter than either supply curve (labor or specific good). In fact, if wages and prices were so sticky that they did not fall at all, the aggregate supply curve would be completely flat below potential GDP, as Figure 12.6 shows. This outcome is an important example of a macroeconomic externality, where what happens at the macro level is different from and inferior to what happens at the micro level.  For example, a firm should respond to a decrease in demand for its product by cutting its price to increase sales. However, if all firms experience a decrease in demand for their products, sticky prices in the aggregate prevent aggregate demand from rebounding (which we would show as a movement along the AD curve in response to a lower price level).The original equilibrium of this economy occurs where the aggregate demand function (AD0) intersects with AS. Since this intersection occurs at potential GDP (Yp), the economy is operating at full employment. When aggregate demand shifts to the left, all the adjustment occurs through decreased real GDP. There is no decrease in the price level. Since the equilibrium occurs at Y1, the economy experiences substantial unemployment.\n\n\n\n\nFigure \n12.6\n \nA Keynesian Perspective of Recession\n \nThis figure illustrates the two key assumptions behind  Keynesian economics. A recession begins when aggregate demand declines from AD0 to AD1. The recession persists because of the assumption of fixed wages and prices, which makes the SRAS flat below potential GDP. If that were not the case, the price level would fall also, raising GDP and limiting the recession. Instead the intersection E1 occurs in the flat portion of the SRAS curve where GDP is less than potential.\n\n\nThe Expenditure Multiplier\nA key concept in Keynesian economics is the expenditure multiplier. The expenditure multiplier is the idea that not only does spending affect the equilibrium level of GDP, but that spending is powerful. More precisely, it means that a change in spending causes a more than proportionate change in GDP.\n\n\n\nY\n\n\nSpending\n\n\n>1\n\n\n\n\nY\n\n\nSpending\n\n\n>1\n\nThe reason for the expenditure multiplier is that one persons spending becomes another persons income, which leads to additional spending and additional income so that the cumulative impact on GDP is larger than the initial increase in spending. The appendix on The Expenditure-Output Model provides the details of the multiplier process, but the concept is important enough for us to summarize here. While the multiplier is important for understanding the effectiveness of fiscal policy, it occurs whenever any autonomous increase in spending occurs. Additionally, the multiplier operates in a negative as well as a positive direction. Thus, when investment spending collapsed during the Great Depression, it caused a much larger decrease in real GDP. The size of the multiplier is critical and was a key element in discussions of the effectiveness of the Obama administrations fiscal stimulus package, officially titled the American Recovery and Reinvestment Act of 2009.\n", "12-3": "By the end of this section, you will be able to:\n\nExplain the Phillips curve, noting its impact on the theories of Keynesian economics\nGraph a Phillips curve\nIdentify factors that cause the instability of the Phillips curve\nAnalyze the Keynesian policy for reducing unemployment and inflation\n\nThe simplified AD/AS model that we have used so far is fully consistent with Keyness original model. More recent research, though, has indicated that in the real world, an aggregate supply curve is more curved than the right angle that we used in this chapter. Rather, the real-world AS curve is very flat at levels of output far below potential (the Keynesian zone), very steep at levels of output above potential (the neoclassical zone) and curved in between (the intermediate zone). Figure 12.7 illustrates this. The typical aggregate supply curve leads to the concept of the Phillips curve.\n\n\n\nFigure \n12.7\n \nKeynes, Neoclassical, and Intermediate Zones in the Aggregate Supply Curve\n \nNear the equilibrium Ek, in the Keynesian zone at the SRAS curve's far left, small shifts in AD, either to the right or the left, will affect the output level Yk, but will not much affect the price level. In the Keynesian zone, AD largely determines the quantity of output. Near the equilibrium En, in the neoclassical zone, at the SRAS curve's far right, small shifts in AD, either to the right or the left, will have relatively little effect on the output level Yn, but instead will have a greater effect on the price level. In the neoclassical zone, the near-vertical SRAS curve close to the level of potential GDP (as represented by the LRAS line) largely determines the quantity of output. In the intermediate zone around equilibrium Ei, movement in AD to the right will increase both the output level and the price level, while a movement in AD to the left would decrease both the output level and the price level.\n\nThe Discovery of the Phillips Curve\nIn the 1950s, A.W. Phillips, an economist at the London School of Economics, was studying the Keynesian analytical framework. The Keynesian theory implied that during a recession inflationary pressures are low, but when the level of output is at or even pushing beyond potential GDP, the economy is at greater risk for inflation. Phillips analyzed 60 years of British data and did find that tradeoff between unemployment and inflation, which became known as the Phillips curve. Figure 12.8 shows a theoretical Phillips curve, and the following Work It Out feature shows how the pattern appears for the United States.\n\n\n\nFigure \n12.8\n \nA Keynesian Phillips Curve Tradeoff between Unemployment and Inflation\n \nA Phillips curve illustrates a tradeoff between the unemployment rate and the inflation rate. If one is higher, the other must be lower. For example, point A illustrates a 5% inflation rate and a 4% unemployment. If the government attempts to reduce inflation to 2%, then it will experience a rise in unemployment to 7%, as point B shows.\n\n\nWork It Out\n\n\nThe Phillips Curve for the United States\n\nStep 1. Go to this website to see the 2005 Economic Report of the President.Step 2. Scroll down and locate Table B-63 in the Appendices. This table is titled Changes in special consumer price indexes, 19602004.\nStep 3. Download the table in Excel by selecting the XLS option and then selecting the location in which to save the file.\nStep 4. Open the downloaded Excel file.\nStep 5. View the third column (labeled Year to year). This is the inflation rate, measured by the percentage change in the Consumer Price Index.\nStep 6. Return to the website and scroll to locate the Appendix Table B-42 Civilian unemployment rate, 19592004.\nStep 7. Download the table in Excel.\nStep 8. Open the downloaded Excel file and view the second column. This is the overall unemployment rate.\nStep 9. Using the data available from these two tables, plot the Phillips curve for 196069, with unemployment rate on the x-axis and the inflation rate on the y-axis. Your graph should look like Figure 12.9.\n\n\n\n\n\nFigure \n12.9\n \nThe Phillips Curve from 19601969\n \nThis chart shows the negative relationship between unemployment and inflation.\n\n\nStep 10. Plot the Phillips curve for 19601979. What does the graph look like? Do you still see the tradeoff between inflation and unemployment? Your graph should look like Figure 12.10.\n\n\n\n\nFigure \n12.10\n \nU.S. Phillips Curve, 19601979\n \nThe tradeoff between unemployment and inflation appeared to break down during the 1970s as the Phillips Curve shifted out to the right.\n\n\nOver this longer period of time, the Phillips curve appears to have shifted out. There is no tradeoff any more.\n\n\nThe Instability of the Phillips Curve\nDuring the 1960s, economists viewed the Phillips curve as a policy menu. A nation could choose low inflation and high unemployment, or high inflation and low unemployment, or anywhere in between. Economies could use fiscal and monetary policy to move up or down the Phillips curve as desired. Then a curious thing happened. When policymakers tried to exploit the tradeoff between inflation and unemployment, the result was an increase in both inflation and unemployment. What had happened? The Phillips curve shifted.The U.S. economy experienced this pattern in the deep recession from 1973 to 1975, and again in back-to-back recessions from 1980 to 1982. Many nations around the world saw similar increases in unemployment and inflation. This pattern became known as stagflation. (Recall from The Aggregate Demand/Aggregate Supply Model that stagflation is an unhealthy combination of high unemployment and high inflation.) Perhaps most important, stagflation was a phenomenon that traditional Keynesian economics could not explain.Economists have concluded that two factors cause the Phillips curve to shift. The first is supply shocks, like the mid-1970s oil crisis, which first brought stagflation into our vocabulary. The second is changes in peoples expectations about inflation. In other words, there may be a tradeoff between inflation and unemployment when people expect no inflation, but when they realize inflation is occurring, the tradeoff disappears. Both factors (supply shocks and changes in inflationary expectations) cause the aggregate supply curve, and thus the Phillips curve, to shift.In short, we should interpret a downward-sloping Phillips curve as valid for short-run periods of several years, but over longer periods, when aggregate supply shifts, the downward-sloping Phillips curve can shift so that unemployment and inflation are both higher (as in the 1970s and early 1980s) or both lower (as in the early 1990s or first decade of the 2000s).\nKeynesian Policy for Fighting Unemployment and Inflation\nKeynesian macroeconomics argues that the solution to a recession is expansionary fiscal policy, such as tax cuts to stimulate consumption and investment, or direct increases in government spending that would shift the aggregate demand curve to the right. For example, if aggregate demand was originally at ADr in Figure 12.11, so that the economy was in recession, the appropriate policy would be for government to shift aggregate demand to the right from ADr to ADf, where the economy would be at potential GDP and full employment.\nKeynes noted that while it would be nice if the government could spend additional money on housing, roads, and other amenities, he also argued that if the government could not agree on how to spend money in practical ways, then it could spend in impractical ways. For example, Keynes suggested building monuments, like a modern equivalent of the Egyptian pyramids. He proposed that the government could bury money underground, and let mining companies start digging up the money again. These suggestions were slightly tongue-in-cheek, but their purpose was to emphasize that a Great Depression is no time to quibble over the specifics of government spending programs and tax cuts when the goal should be to pump up aggregate demand by enough to lift the economy to potential GDP.\n\n\n\nFigure \n12.11\n \nFighting Recession and Inflation with Keynesian Policy\n \nIf an economy is in recession, with an equilibrium at Er, then the Keynesian response would be to enact a policy to shift aggregate demand to the right from ADr toward ADf. If an economy is experiencing inflationary pressures with an equilibrium at Ei, then the Keynesian response would be to enact a policy response to shift aggregate demand to the left, from ADi toward ADf.\n\nThe other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response would be contractionary fiscal policy, using tax increases or government spending cuts to shift AD to the left. The result would be downward pressure on the price level, but very little reduction in output or very little rise in unemployment. If aggregate demand was originally at ADi in Figure 12.11, so that the economy was experiencing inflationary rises in the price level, the appropriate policy would be for government to shift aggregate demand to the left, from ADi toward ADf, which reduces the pressure for a higher price level while the economy remains at full employment.\nIn the Keynesian economic model, too little aggregate demand brings unemployment and too much brings inflation. Thus, you can think of Keynesian economics as pursuing a Goldilocks level of aggregate demand: not too much, not too little, but looking for what is just right.\n\n", "12-4": "By the end of this section, you will be able to:\n\nExplain the Keynesian perspective on market forces\nAnalyze the role of government policy in economic management\n\nEver since the birth of Keynesian economics in the 1930s, controversy has simmered over the extent to which government should play an active role in managing the economy. In the aftermath of the human devastation and misery of the Great Depression, many peopleincluding many economistsbecame more aware of vulnerabilities within the market-oriented economic system. Some supporters of Keynesian economics advocated a high degree of government planning in all parts of the economy.\nHowever, Keynes himself was careful to separate the issue of aggregate demand from the issue of how well individual markets worked. He argued that individual markets for goods and services were appropriate and useful, but that sometimes that level of aggregate demand was just too low. When 10 million people are willing and able to work, but one million of them are unemployed, he argued, individual markets may be doing a perfectly good job of allocating the efforts of the nine million workersthe problem is that insufficient aggregate demand exists to support jobs for all 10 million. Thus, he believed that, while government should ensure that overall level of aggregate demand is sufficient for an economy to reach full employment, this task did not imply that the government should attempt to set prices and wages throughout the economy, nor to take over and manage large corporations or entire industries directly.\nEven if one accepts the Keynesian economic theory, a number of practical questions remain. In the real world, can government economists identify potential GDP accurately? Is a desired increase in aggregate demand better accomplished by a tax cut or by an increase in government spending? Given the inevitable delays and uncertainties as governments enact policies into law, is it reasonable to expect that the government can implement Keynesian economics? Can fixing a recession really be just as simple as pumping up aggregate demand? Government Budgets and Fiscal Policy will probe these issues. The Keynesian approach, with its focus on aggregate demand and sticky prices, has proved useful in understanding how the economy fluctuates in the short run and why recessions and cyclical unemployment occur. In The Neoclassical Perspective, we will consider some of the shortcomings of the Keynesian approach and why it is not especially well-suited for long-run macroeconomic analysis.\nBring It Home\n\n\nThe Great Recession\n\nThe lessons learned during the 1930s Great Depression and the aggregate expenditure model that John Maynard Keynes proposed gave the modern economists and policymakers of today the tools to effectively navigate the treacherous economy in the latter half of the 2000s. In How the Great Recession Was Brought to an End\", Alan S. Blinder and Mark Zandi wrote that the actions taken by todays policymakers stand in sharp contrast to those of the early years of the Great Depression. Todays economists and policymakers were not content to let the markets recover from recession without taking proactive measures to support consumption and investment. The Federal Reserve actively lowered short-term interest rates and developed innovative ways to pump money into the economy so that credit and investment would not dry up. Both Presidents Bush and Obama and Congress implemented a variety of programs ranging from tax rebates to Cash for Clunkers to the Troubled Asset Relief Program to stimulate and stabilize household consumption and encourage investment. Although these policies came under harsh criticism from the public and many politicians, they lessened the impact of the economic downturn and may have saved the country from a second Great Depression.\n", "13-1": "By the end of this section, you will be able to:\n\nExplain the importance of potential GDP in the long run\nAnalyze the role of flexible prices\nInterpret a neoclassical model of aggregate demand and aggregate supply\nEvaluate different ways for measuring the speed of macroeconomic adjustment\n\nThe neoclassical perspective on macroeconomics holds that, in the long run, the economy will fluctuate around its potential GDP and its natural rate of unemployment. This chapter begins with two building blocks of neoclassical economics: (1) potential GDP determines the economy's size and (2) wages and prices will adjust in a flexible manner so that the economy will adjust back to its potential GDP level of output. The key policy implication is this: The government should focus more on long-term growth and on controlling inflation than on worrying about recession or cyclical unemployment. This focus on long-run growth rather than the short-run fluctuations in the business cycle means that neoclassical economics is more useful for long-run macroeconomic analysis and Keynesian economics is more useful for analyzing the macroeconomic short run. Let's consider the two neoclassical building blocks in turn, and how we can embody them in the aggregate demand/aggregate supply model.The Importance of Potential GDP in the Long Run\nOver the long run, the level of potential GDP determines the size of real GDP. When economists refer to potential GDP they are referring to that level of output that an economy can achieve when all resources (land, labor, capital, and entrepreneurial ability) are fully employed. While the unemployment rate in labor markets will never be zero, full employment in the labor market refers to zero cyclical unemployment. There will still be some level of unemployment due to frictional or structural unemployment, but when the economy is operating with zero cyclical unemployment, economists say that the economy is at the natural rate of unemployment or at full employment.Economists benchmark actual or real GDP against the potential GDP to determine how well the economy is performing. As explained in Economic Growth, we can explain GDP growth by increases and investment in physical capital and human capital per person as well as advances in technology. Physical capital per person refers to the amount and kind of machinery and equipment available to help people get work done. Compare, for example, your productivity in typing a term paper on a typewriter to working on your laptop with word processing software. Clearly, you will be able to be more productive using word processing software. The technology and level of capital of your laptop and software has increased your productivity. More broadly, the development of GPS technology and Universal Product Codes (those barcodes on every product we buy) has made it much easier for firms to track shipments, tabulate inventories, and sell and distribute products. These two technological innovations, and many others, have increased a nation's ability to produce goods and services for a given population. Likewise, increasing human capital involves increasing levels of knowledge, education, and skill sets per person through vocational or higher education. Physical and human capital improvements with technological advances will increase overall productivity and, thus, GDP.To see how these improvements have increased productivity and output at the national level, we should examine evidence from the United States. The United States experienced significant growth in the twentieth century due to phenomenal changes in infrastructure, equipment, and technological improvements in physical capital and human capital. The population more than tripled in the twentieth century, from 76 million in 1900 to over 300 million in 2016. The human capital of modern workers is far higher today because the education and skills of workers have risen dramatically. In 1900, only about one-eighth of the U.S. population had completed high school and just one person in 40 had completed a four-year college degree. By 2010, more than 87% of Americans had a high school degree and over 29% had a four-year college degree as well. In 2014, 40% of working-age Americans had a four-year college degree.  The average amount of physical capital per worker has grown dramatically. The technology available to modern workers is extraordinarily better than a century ago: cars, airplanes, electrical machinery, smartphones, computers, chemical and biological advances, materials science, health carethe list of technological advances could run on and on. More workers, higher skill levels, larger amounts of physical capital per worker, and amazingly better technology, and potential GDP for the U.S. economy has clearly increased a great deal since 1900.This growth has fallen below its potential GDP and, at times, has exceeded its potential. For example from 2008 to 2009, the U.S. economy tumbled into recession and remains below its potential. At other times, like in the late 1990s, the economy ran at potential GDPor even slightly ahead. Figure 13.2 shows the actual data for the increase in real GDP since 1960. The slightly smoother line shows the potential GDP since 1960 as estimated by the nonpartisan Congressional Budget Office. Most economic recessions and upswings are times when the economy is 13% below or above potential GDP in a given year. Clearly, short-run fluctuations around potential GDP do exist, but over the long run, the upward trend of potential GDP determines the size of the economy.\n\n\n\nFigure \n13.2\n \nPotential and Actual GDP (in 2009 Dollars)\n \nActual GDP falls below potential GDP during and after recessions, like the recessions of 1980 and 198182, 199091, 2001, and 20082009 and continues below potential GDP through 2016. In other cases, actual GDP can be above potential GDP for a time, as in the late 1990s.\n\nIn the aggregate demand/aggregate supply model, we show potential GDP as a vertical line. Neoclassical economists who focus on potential GDP as the primary determinant of real GDP argue that the long-run aggregate supply curve is located at potential GDPthat is, we draw the long-run aggregate supply curve as a vertical line at the level of potential GDP, as Figure 13.3 shows. A vertical LRAS curve means that the level of aggregate supply (or potential GDP) will determine the economy's real GDP, regardless of the level of aggregate demand. Over time, increases in the quantity and quality of physical capital, increases in human capital, and technological advancements shift potential GDP and the vertical LRAS curve gradually to the right. Economists often describe this gradual increase in an economy's potential GDP as a nation's long-term economic growth.\n\n\n\nFigure \n13.3\n \nA Vertical AS Curve\n \nIn the neoclassical model, we draw the aggregate supply curve as a vertical line at the level of potential GDP. If AS is vertical, then it determines the level of real output, no matter where we draw the aggregate demand curve. Over time, the LRAS curve shifts to the right as productivity increases and potential GDP expands.\n\n\nThe Role of Flexible Prices\nHow does the macroeconomy adjust back to its level of potential GDP in the long run? What if aggregate demand increases or decreases? Economists base the neoclassical view of how the macroeconomy adjusts on the insight that even if wages and prices are sticky, or slow to change, in the short run, they are flexible over time. To understand this better, let's follow the connections from the short-run to the long-run macroeconomic equilibrium.The aggregate demand and aggregate supply diagram in Figure 13.4 shows two aggregate supply curves. We draw the original upward sloping aggregate supply curve (SRAS0) is a short-run or Keynesian AS curve. The vertical aggregate supply curve (LRASn) is the long-run or neoclassical AS curve, which is located at potential GDP. The original aggregate demand curve, labeled AD0, so that the original equilibrium occurs at point E0, at which point the economy is producing at its potential GDP.\n\n\n\nFigure \n13.4\n \nThe Rebound to Potential GDP after AD Increases\n \nThe original equilibrium (E0), at an output level of 500 and a price level of 120, happens at the intersection of the aggregate demand curve (AD0) and the short-run aggregate supply curve (SRAS0). The output at E0 is equal to potential GDP. Aggregate demand shifts right from AD0 to AD1. The new equilibrium is E1, with a higher output level of 550 and an increase in the price level to 125. With unemployment rates unsustainably low, eager employers bid up wages, which shifts short-run aggregate supply to the left, from SRAS0 to SRAS1. The new equilibrium (E2) is at the same original level of output, 500, but at a higher price level of 130. Thus, the long-run aggregate supply curve (LRASn), which is vertical at the level of potential GDP, determines the level of real GDP in this economy in the long run.\n\nNow, imagine that some economic event boosts aggregate demand: perhaps a surge of export sales or a rise in business confidence that leads to more investment, perhaps a policy decision like higher government spending, or perhaps a tax cut that leads to additional aggregate demand. The short-run Keynesian analysis is that the rise in aggregate demand will shift the aggregate demand curve out to the right, from AD0 to AD1, leading to a new equilibrium at point E1 with higher output, lower unemployment, and pressure for an inflationary rise in the price level.\nIn the long-run neoclassical analysis, however, the chain of economic events is just beginning. As economic output rises above potential GDP, the level of unemployment falls. The economy is now above full employment and there is a labor shortage. Eager employers are trying to bid workers away from other companies and to encourage their current workers to exert more effort and to work longer hours. This high demand for labor will drive up wages. Most employers review their workers salaries only once or twice a year, and so it will take time before the higher wages filter through the economy. As wages do rise, it will mean a leftward shift in the short-run Keynesian aggregate supply curve back to SRAS1, because the price of a major input to production has increased. The economy moves to a new equilibrium (E2). The new equilibrium has the same level of real GDP as did the original equilibrium (E0), but there has been an inflationary increase in the price level.This description of the short-run shift from E0 to E1 and the long-run shift from E1 to E2 is a step-by-step way of making a simple point: the economy cannot sustain production above its potential GDP in the long run. An economy may produce above its level of potential GDP in the short run, under pressure from a surge in aggregate demand. Over the long run, however, that surge in aggregate demand ends up as an increase in the price level, not as a rise in output.\nThe rebound of the economy back to potential GDP also works in response to a shift to the left in aggregate demand. Figure 13.5 again starts with two aggregate supply curves, with SRAS0 showing the original upward sloping short-run Keynesian AS curve and LRASn showing the vertical long-run neoclassical aggregate supply curve. A decrease in aggregate demandfor example, because of a decline in consumer confidence that leads to less consumption and more savingcauses the original aggregate demand curve AD0 to shift back to AD1. The shift from the original equilibrium (E0) to the new equilibrium (E1) results in a decline in output. The economy is now below full employment and there is a surplus of labor. As output falls below potential GDP, unemployment rises. While a lower price level (i.e., deflation) is rare in the United States, it does happen occasionally during very weak periods of economic activity. For practical purposes, we might consider a lower price level in the ADAS model as indicative of disinflation, which is a decline in the inflation rate. Thus, the long-run aggregate supply curve LRASn, which is vertical at the level of potential GDP, ultimately determines this economy's real GDP.\n\n\n\nFigure \n13.5\n \nA Rebound Back to Potential GDP from a Shift to the Left in Aggregate Demand\n \nThe original equilibrium (E0), at an output level of 500 and a price level of 120, happens at the intersection of the aggregate demand curve (AD0) and the short-run aggregate supply curve (SRAS0). The output at E0 is equal to potential GDP. Aggregate demand shifts left, from AD0 to AD1. The new equilibrium is at E1, with a lower output level of 450 and downward pressure on the price level of 115. With high unemployment rates, wages are held down. Lower wages are an economy-wide decrease in the price of a key input, which shifts short-run aggregate supply to the right, from SRAS0 to SRAS1. The new equilibrium (E2) is at the same original level of output, 500, but at a lower price level of 110.\n\nAgain, from the neoclassical perspective, this short-run scenario is only the beginning of the chain of events. The higher level of unemployment means more workers looking for jobs. As a result, employers can hold down on pay increasesor perhaps even replace some of their higher-paid workers with unemployed people willing to accept a lower wage. As wages stagnate or fall, this decline in the price of a key input means that the short-run Keynesian aggregate supply curve shifts to the right from its original (SRAS0 to SRAS1). The overall impact in the long run, as the macroeconomic equilibrium shifts from E0 to E1 to E2, is that the level of output returns to potential GDP, where it started. There is, however, downward pressure on the price level. Thus, in the neoclassical view, changes in aggregate demand can have a short-run impact on output and on unemploymentbut only a short-run impact. In the long run, when wages and prices are flexible, potential GDP and aggregate supply determine real GDP's size.\nHow Fast Is the Speed of Macroeconomic Adjustment?\nHow long does it take for wages and prices to adjust, and for the economy to rebound to its potential GDP? This subject is highly contentious. Keynesian economists argue that if the adjustment from recession to potential GDP takes a very long time, then neoclassical theory may be more hypothetical than practical. In response to John Maynard Keynes' immortal words, In the long run we are all dead, neoclassical economists respond that even if the adjustment takes as long as, say, ten years the neoclassical perspective remains of central importance in understanding the economy.One subset of neoclassical economists holds that wage and price adjustment in the macroeconomy might be quite rapid. The theory of rational expectations holds that people form the most accurate possible expectations about the future that they can, using all information available to them. In an economy where most people have rational expectations, economic adjustments may happen very quickly.To understand how rational expectations may affect the speed of price adjustments, think about a situation in the real estate market. Imagine that several events seem likely to push up home values in the neighborhood. Perhaps a local employer announces that it plans to hire many more people or the city announces that it will build a local park or a library in that neighborhood. The theory of rational expectations points out that even though none of the changes will happen immediately, home prices in the neighborhood will rise immediately, because the expectation that homes will be worth more in the future will lead buyers to be willing to pay more in the present. The amount of the immediate increase in home prices will depend on how likely it seems that the announcements about the future will actually happen and on how distant the local jobs and neighborhood improvements are in the future. The key point is that, because of rational expectations, prices do not wait on events, but adjust immediately.At a macroeconomic level, the theory of rational expectations points out that if the aggregate supply curve is vertical over time, then people should rationally expect this pattern. When a shift in aggregate demand occurs, people and businesses with rational expectations will know that its impact on output and employment will be temporary, while its impact on the price level will be permanent. If firms and workers perceive the outcome of the process in advance, and if all firms and workers know that everyone else is perceiving the process in the same way, then they have no incentive to go through an extended series of short-run scenarios, like a firm first hiring more people when aggregate demand shifts out and then firing those same people when aggregate supply shifts back. Instead, everyone will recognize where this process is headingtoward a change in the price leveland then will act on that expectation. In this scenario, the expected long-run change in the price level may happen very quickly, without a drawn-out zigzag of output and employment first moving one way and then the other.\nThe theory that people and firms have rational expectations can be a useful simplification, but as a statement about how people and businesses actually behave, the assumption seems too strong. After all, many people and firms are not especially well informed, either about what is happening in the economy or about how the economy works. An alternate assumption is that people and firms act with adaptive expectations: they look at past experience and gradually adapt their beliefs and behavior as circumstances change, but are not perfect synthesizers of information and accurate predictors of the future in the sense of rational expectations theory. If most people and businesses have some form of adaptive expectations, then the adjustment from the short run and long run will be traced out in incremental steps that occur over time.The empirical evidence on the speed of macroeconomic adjustment of prices and wages is not clear-cut. The speed of macroeconomic adjustment probably varies among different countries and time periods. A reasonable guess is that the initial short-run effect of a shift in aggregate demand might last two to five years, before the adjustments in wages and prices cause the economy to adjust back to potential GDP. Thus, one might think of the short run for applying Keynesian analysis as time periods less than two to five years, and the long run for applying neoclassical analysis as longer than five years. For practical purposes, this guideline is frustratingly imprecise, but when analyzing a complex social mechanism like an economy as it evolves over time, some imprecision seems unavoidable.\n", "13-2": "By the end of this section, you will be able to:\n\nDiscuss why and how economists measure inflation expectations\nAnalyze the impacts of fiscal and monetary policy on aggregate supply and aggregate demand\nExplain the neoclassical Phillips curve, noting its tradeoff between inflation and unemployment\nIdentify clear distinctions between neoclassical economics and Keynesian economics\n\nTo understand the policy recommendations of the neoclassical economists, it helps to start with the Keynesian perspective. Suppose a decrease in aggregate demand causes the economy to go into recession with high unemployment. The Keynesian response would be to use government policy to stimulate aggregate demand and eliminate the recessionary gap. The neoclassical economists believe that the Keynesian response, while perhaps well intentioned, will not have a good outcome for reasons we will discuss shortly. Since the neoclassical economists believe that the economy will correct itself over time, the only advantage of a Keynesian stabilization policy would be to accelerate the process and minimize the time that the unemployed are out of work. Is that the likely outcome?Keynesian macroeconomic policy requires some optimism about the government's ability to recognize a situation of too little or too much aggregate demand, and to adjust aggregate demand accordingly with the right level of changes in taxes or spending, all enacted in a timely fashion. After all, neoclassical economists argue, it takes government statisticians months to produce even preliminary estimates of GDP so that politicians know whether a recession is occurringand those preliminary estimates may be revised substantially later. Moreover, there is the question of timely action. The political process can take more months to enact a tax cut or a spending increase. Political or economic considerations may determine the amount of tax or spending changes. Then the economy will take still more months to put into effect changes in aggregate demand through spending and production. When economists and policy makers consider all of these time lags and political realities, active fiscal policy may fail to address the current problem, and could even make the future economy worse. The average U.S. post-World War II recession has lasted only about a year. By the time government policy activates, the recession will likely be over. As a consequence, the only result of government fine-tuning will be to stimulate the economy when it is already recovering (or to contract the economy when it is already falling). In other words, an active macroeconomic policy is likely to exacerbate the cycles rather than dampen them. Some neoclassical economists believe a large part of the business cycles we observe are due to flawed government policy. To learn about this issue further, read the following Clear It Up feature.\nClear It Up\n\n\nWhy and how do economists measure inflation expectations?\n\nPeople take expectations about inflation into consideration every time they make a major purchase, such as a house or a car. As inflation fluctuates, so too does the nominal interest rate on loans to buy these goods. The nominal interest rate is comprised of the real rate, plus an expected inflation factor. Expected inflation also tells economists about how the public views the economy's direction. Suppose the public expects inflation to increase. This could be the result of positive demand shock due to an expanding economy and increasing aggregate demand. It could also be the result of a negative supply shock, perhaps from rising energy prices, and decreasing aggregate supply. In either case, the public may expect the central bank to engage in contractionary monetary policy to reduce inflation, and this policy results in higher interest rates. If, however economists expect inflation to decrease, the public may anticipate a recession. In turn, the public may expect expansionary monetary policy, and lower interest rates, in the short run. By monitoring expected inflation, economists garner information about the effectiveness of macroeconomic policies. Additionally, monitoring expected inflation allows for projecting the direction of real interest rates that isolate for the effect of inflation. This information is necessary for making decisions about financing investments.Expectations about inflation may seem like a highly theoretical concept, but, in fact the Federal Reserve Bank measures, inflation expectations based upon early research conducted by Joseph Livingston, a financial journalist for the Philadelphia Inquirer. In 1946, he started a twice-a-year survey of economists about their expectations of inflation. After Livingston's death in 1969, the Federal Reserve Bank and other economic research agencies such as the Survey Research Center at the University of Michigan, the American Statistical Association, and the National Bureau of Economic Research continued the survey.Current Federal Reserve research compares these expectations to actual inflation that has occurred, and the results, so far, are mixed. Economists' forecasts, however, have become notably more accurate in the last few decades. Economists are actively researching how inflation expectations and other economic variables form and change.\nLink It Up\n\n\nVisit this website to read The Federal Reserve Bank of Clevelands Economic Commentary: A New Approach to Gauging Inflation Expectations by Joseph G. Haubrich for more information about how economists forecast  expected inflation.\nThe Neoclassical Phillips Curve Tradeoff\nThe Keynesian Perspective introduced the Phillips curve and explained how it is derived from the aggregate supply curve. The short run upward sloping aggregate supply curve implies a downward sloping Phillips curve; thus, there is a tradeoff between inflation and unemployment in the short run. By contrast, a neoclassical long-run aggregate supply curve will imply a vertical shape for the Phillips curve, indicating no long run tradeoff between inflation and unemployment. Figure 13.6 (a) shows the vertical AS curve, with three different levels of aggregate demand, resulting in three different equilibria, at three different price levels. At every point along that vertical AS curve, potential GDP and the rate of unemployment remains the same. Assume that for this economy, the natural rate of unemployment is 5%. As a result, the long-run Phillips curve relationship, in Figure 13.6 (b), is a vertical line, rising up from 5% unemployment, at any level of inflation. Read the following Work It Out feature for additional information on how to interpret inflation and unemployment rates.\n\n\n\nFigure \n13.6\n \nFrom a Long-Run AS Curve to a Long-Run Phillips Curve\n \n(a) With a vertical LRAS curve, shifts in aggregate demand do not alter the level of output but do lead to changes in the price level. Because output is unchanged between the equilibria E0, E1, and E2, all unemployment in this economy will be due to the natural rate of unemployment. (b) If the natural rate of unemployment is 5%, then the Phillips curve will be vertical. That is, regardless of changes in the price level, the unemployment rate remains at 5%.\n\n\nWork It Out\n\n\nTracking Inflation and Unemployment Rates\n\nSuppose that you have collected data for years on inflation and unemployment rates and recorded them in a table, such as Table 13.1. How do you interpret that information?\n\nYear\nInflation Rate\nUnemployment Rate\n\n\n19702%4%\n19753%3%\n19802%4%\n19851%6%\n19901%4%\n19954%2%\n20005%4%\n\nTable \n13.1\n \n \n\nStep 1. Plot the data points in a graph with inflation rate on the vertical axis and unemployment rate on the horizontal axis. Your graph will appear similar to Figure 13.7.\n\n\n\n\nFigure \n13.7\n \nInflation Rates\n\nStep 2. What patterns do you see in the data? You should notice that there are years when unemployment falls but inflation rises, and other years where unemployment rises and inflation falls.\nStep 3. Can you determine the natural rate of unemployment from the data or from the graph? As you analyze the graph, it appears that the natural rate of unemployment lies at 4%. This is the rate that the economy appears to adjust back to after an apparent change in the economy. For example, in 1975 the economy appeared to have an increase in aggregate demand. The unemployment rate fell to 3% but inflation increased from 2% to 3%. By 1980, the economy had adjusted back to 4% unemployment and the inflation rate had returned to 2%. In 1985, the economy looks to have suffered a recession as unemployment rose to 6% and inflation fell to 1%. This would be consistent with a decrease in aggregate demand. By 1990, the economy recovered back to 4% unemployment, but at a lower inflation rate of 1%. In 1995 the economy again rebounded and unemployment fell to 2%, but inflation increased to 4%, which is consistent with a large increase in aggregate demand. The economy adjusted back to 4% unemployment but at a higher rate of inflation of 5%. Then in 2000, both unemployment and inflation increased to 5% and 4%, respectively.Step 4. Do you see the Phillips curve(s) in the data? If we trace the downward sloping trend of data points, we could see a short-run Phillips curve that exhibits the inverse tradeoff between higher unemployment and lower inflation rates. If we trace the vertical line of data points, we could see a long-run Phillips curve at the 4% natural rate of unemployment.The unemployment rate on the long-run Phillips curve will be the natural rate of unemployment. A small inflationary increase in the price level from AD0 to AD1 will have the same natural rate of unemployment as a larger inflationary increase in the price level from AD0 to AD2. The macroeconomic equilibrium along the vertical aggregate supply curve can occur at a variety of different price levels, and the natural rate of unemployment can be consistent with all different rates of inflation. The great economist Milton Friedman (19122006) summed up the neoclassical view of the long-term Phillips curve tradeoff in a 1967 speech: [T]here is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off.\nIn the Keynesian perspective, the primary focus is on getting the level of aggregate demand right in relationship to an upward-sloping aggregate supply curve. That is, the government should adjust AD so that the economy produces at its potential GDP, not so low that cyclical unemployment results and not so high that inflation results. In the neoclassical perspective, aggregate supply will determine output at potential GDP, the natural rate of unemployment determines unemployment, and shifts in aggregate demand are the primary determinant of changes in the price level.\nLink It Up\n\n\nVisit this website to read about the effects of economic intervention.\n\nFighting Unemployment or Inflation?As we explained in Unemployment, economists divide unemployment into two categories: cyclical unemployment and the natural rate of unemployment, which is the sum of frictional and structural unemployment. Cyclical unemployment results from fluctuations in the business cycle and is created when the economy is producing below potential GDPgiving potential employers less incentive to hire. When the economy is producing at potential GDP, cyclical unemployment will be zero. Because of labor market dynamics, in which people are always entering or exiting the labor force, the unemployment rate never falls to 0%, not even when the economy is producing at or even slightly above potential GDP. Probably the best we can hope for is for the number of job vacancies to equal the number of job seekers. We know that it takes time for job seekers and employers to find each other, and this time is the cause of frictional unemployment. Most economists do not consider frictional unemployment to be a bad thing. After all, there will always be workers who are unemployed while looking for a job that is a better match for their skills. There will always be employers that have an open position, while looking for a worker that is a better match for the job. Ideally, these matches happen quickly, but even when the economy is very strong there will be some natural unemployment and this is what the natural rate of unemployment measures.The neoclassical view of unemployment tends to focus attention away from the cyclical unemployment problemthat is, unemployment caused by recessionwhile putting more attention on the unemployment rate issue that prevails even when the economy is operating at potential GDP. To put it another way, the neoclassical view of unemployment tends to focus on how the government can adjust public policy to reduce the natural rate of unemployment. Such policy changes might involve redesigning unemployment and welfare programs so that they support those in need, but also offer greater encouragement for job-hunting. It might involve redesigning business rules with an eye to whether they are unintentionally discouraging businesses from taking on new employees. It might involve building institutions to improve the flow of information about jobs and the mobility of workers, to help bring workers and employers together more quickly. For those workers who find that their skills are permanently no longer in demand (for example, the structurally unemployed), economists can design policy to provide opportunities for retraining so that these workers can reenter the labor force and seek employment.Neoclassical economists will not tend to see aggregate demand as a useful tool for reducing unemployment; after all, with a vertical aggregate supply curve determining economic output, then aggregate demand has no long-run effect on unemployment. Instead, neoclassical economists believe that aggregate demand should be allowed to expand only to match the gradual shifts of aggregate supply to the rightkeeping the price level much the same and inflationary pressures low.If aggregate demand rises rapidly in the neoclassical model, in the long run it leads only to inflationary pressures. Figure 13.8 shows a vertical LRAS curve and three different levels of aggregate demand, rising from AD0 to AD1 to AD2. As the macroeconomic equilibrium rises from E0 to E1 to E2, the price level rises, but real GDP does not budge; nor does the rate of unemployment, which adjusts to its natural rate. Conversely, reducing inflation has no long-term costs, either. Think about Figure 13.8 in reverse, as the aggregate demand curve shifts from AD2 to AD1 to AD0, and the equilibrium moves from E2 to E1 to E0. During this process, the price level falls, but, in the long run, neither real GDP nor the natural unemployment rate changes.\n\n\n\nFigure \n13.8\n \nHow Aggregate Demand Determines the Price Level in the Long Run\n \nAs aggregate demand shifts to the right, from AD0 to AD1 to AD2, real GDP in this economy and the level of unemployment do not change. However, there is inflationary pressure for a higher price level as the equilibrium changes from E0 to E1 to E2.\n\n\nLink It Up\n\n\nVisit this website to read about how inflation and unemployment are related.\nFighting Recession or Encouraging Long-Term Growth?\nNeoclassical economists believe that the economy will rebound out of a recession or eventually contract during an expansion because prices and wage rates are flexible and will adjust either upward or downward to restore the economy to its potential GDP. Thus, the key policy question for neoclassicals is how to promote growth of potential GDP. We know that economic growth ultimately depends on the growth rate of long-term productivity. Productivity measures how effective inputs are at producing outputs. We know that U.S. productivity has grown on average about 2% per year. That means that the same amount of inputs produce 2% more output than the year before. We also know that productivity growth varies a great deal in the short term due to cyclical factors. It also varies somewhat in the long term. From 19531972, U.S. labor productivity (as measured by output per hour in the business sector) grew at 3.2% per year. From 19731992, productivity growth declined significantly to 1.8% per year. Then, from 19932014, productivity growth increased slightly to 2% per year. The neoclassical economists believe the underpinnings of long-run productivity growth to be an economys investments in human capital, physical capital, and technology, operating together in a market-oriented environment that rewards innovation. Government policy should focus on promoting these factors.\nSummary of Neoclassical Macroeconomic Policy Recommendations\nLets summarize what neoclassical economists recommend for macroeconomic policy. Neoclassical economists do not believe in fine-tuning the economy. They believe that a stable economic environment with a low rate of inflation fosters economic growth. Similarly, tax rates should be low and unchanging. In this environment, private economic agents can make the best possible investment decisions, which will lead to optimal investment in physical and human capital as well as research and development to promote improvements in technology.\nSummary of Neoclassical Economics versus Keynesian Economics\nTable 13.2 summarizes the key differences between the two schools of thought.\n\nSummary\nNeoclassical Economics\nKeynesian Economics\n\n\n\nFocus: long-term or short term\nLong-term\nShort-term\n\n\nPrices and wages: sticky or flexible?\nFlexible\nSticky\n\n\nEconomic output: Primarily determined by aggregate demand or aggregate supply?\nAggregate supply\nAggregate demand\n\n\nAggregate supply: vertical or upward-sloping?\nVertical\nUpward-sloping\n\n\nPhillips curve vertical or downward-sloping\nVertical\nDownward sloping\n\n\nIs aggregate demand a useful tool for controlling inflation?\nYes\nYes\n\n\nWhat should be the primary area of policy emphasis for reducing unemployment?\nReform labor market institutions to reduce natural rate of unemployment\nIncrease aggregate demand to eliminate cyclical unemployment\n\n\nIs aggregate demand a useful tool for ending recession?\nAt best, only in the short-run temporary sense, but may just increase inflation instead\nYes\n\n\nTable \n13.2\n \nNeoclassical versus Keynesian Economics\n \n\n\n", "13-3": "By the end of this section, you will be able to:\n\nEvaluate how neoclassical economists and Keynesian economists react to recessions\nAnalyze the interrelationship between the neoclassical and Keynesian economic models\n\nWe can compare finding the balance between Keynesian and Neoclassical models to the challenge of riding two horses simultaneously. When a circus performer stands on two horses, with a foot on each one, much of the excitement for the viewer lies in contemplating the gap between the two. As modern macroeconomists ride into the future on two horseswith one foot on the short-term Keynesian perspective and one foot on the long-term neoclassical perspectivethe balancing act may look uncomfortable, but there does not seem to be any way to avoid it. Each approach, Keynesian and neoclassical, has its strengths and weaknesses.The short-term Keynesian model, built on the importance of aggregate demand as a cause of business cycles and a degree of wage and price rigidity, does a sound job of explaining many recessions and why cyclical unemployment rises and falls. By focusing on the short-run aggregate demand adjustments, Keynesian economics risks overlooking the long-term causes of economic growth or the natural rate of unemployment that exist even when the economy is producing at potential GDP.The neoclassical model, with its emphasis on aggregate supply, focuses on the underlying determinants of output and employment in markets, and thus tends to put more emphasis on economic growth and how labor markets work. However, the neoclassical view is not especially helpful in explaining why unemployment moves up and down over short time horizons of a few years. Nor is the neoclassical model especially helpful when the economy is mired in an especially deep and long-lasting recession, like the 1930s Great Depression. Keynesian economics tends to view inflation as a price that might sometimes be paid for lower unemployment; neoclassical economics tends to view inflation as a cost that offers no offsetting gains in terms of lower unemployment.Macroeconomics cannot, however, be summed up as an argument between one group of economists who are pure Keynesians and another group who are pure neoclassicists. Instead, many mainstream economists believe both the Keynesian and neoclassical perspectives. Robert Solow, the Nobel laureate in economics in 1987, described the dual approach in this way: \nAt short time scales, I think, something sort of Keynesian is a good approximation, and surely better than anything straight neoclassical. At very long time scales, the interesting questions are best studied in a neoclassical framework, and attention to the Keynesian side of things would be a minor distraction. At the five-to-ten-year time scale, we have to piece things together as best we can, and look for a hybrid model that will do the job.\nMany modern macroeconomists spend considerable time and energy trying to construct models that blend the most attractive aspects of the Keynesian and neoclassical approaches. It is possible to construct a somewhat complex mathematical model where aggregate demand and sticky wages and prices matter in the short run, but wages, prices, and aggregate supply adjust in the long run. However, creating an overall model that encompasses both short-term Keynesian and long-term neoclassical models is not easy.\n\nBring It Home\n\n\nNavigating Unchartered Waters\n\nWere the policies that the government implemented to stabilize the economy and financial markets during the Great Recession effective? Many economists from both the Keynesian and neoclassical schools have found that they were, although to varying degrees. Alan Blinder of Princeton University and Mark Zandi for Moodys Analytics found that, without fiscal policy, GDP decline would have been significantly more than its 3.3% in 2008 followed by its 0.1% decline in 2009. They also estimated that there would have been 8.5 million more job losses had the government not intervened in the market with the TARP to support the financial industry and key automakers General Motors and Chrysler. Federal Reserve Bank economists Carlos Carvalho, Stefano Eusip, and Christian Grisse found in their study, Policy Initiatives in the Global Recession: What Did Forecasters Expect? that once the government implemented policies, forecasters adapted their expectations to these policies. They were more likely to anticipate increases in investment due to lower interest rates brought on by monetary policy and increased economic growth resulting from fiscal policy.The difficulty with evaluating the effectiveness of the stabilization policies that the government took in response to the Great Recession is that we will never know what would have happened had the government not implemented those policies. Surely some of the programs were more effective at creating and saving jobs, while other programs were less so. The final conclusion on the effectiveness of macroeconomic policies is still up for debate, and further study will no doubt consider the impact of these policies on the U.S. budget and deficit, as well as the U.S. dollar's value in the financial market.\n", "14-1": "By the end of this section, you will be able to:\nExplain the various functions of money\nContrast commodity money and fiat money\n\nMoney for the sake of money is not an end in itself. You cannot eat dollar bills or wear your bank account. Ultimately, the usefulness of money rests in exchanging it for goods or services. As the American writer and humorist Ambrose Bierce (18421914) wrote in 1911, money is a blessing that is of no advantage to us excepting when we part with it. Money is what people regularly use when purchasing or selling goods and services, and thus both buyers and sellers must widely accept money. This concept of money is intentionally flexible, because money has taken a wide variety of forms in different cultures.Barter and the Double Coincidence of Wants\nTo understand the usefulness of money, we must consider what the world would be like without money. How would people exchange goods and services? Economies without money typically engage in the barter system. Barterliterally trading one good or service for anotheris highly inefficient for trying to coordinate the trades in a modern advanced economy. In an economy without money, an exchange between two people would involve a double coincidence of wants, a situation in which two people each want some good or service that the other person can provide. For example, if an accountant wants a pair of shoes, this accountant must find someone who has a pair of shoes in the correct size and who is willing to exchange the shoes for some hours of accounting services. Such a trade is likely to be difficult to arrange. Think about the complexity of such trades in a modern economy, with its extensive division of labor that involves thousands upon thousands of different jobs and goods.\nAnother problem with the barter system is that it does not allow us to easily enter into future contracts for purchasing many goods and services. For example, if the goods are perishable it may be difficult to exchange them for other goods in the future. Imagine a farmer wanting to buy a tractor in six months using a fresh crop of strawberries. Additionally, while the barter system might work adequately in small economies, it will keep  these economies from growing. The time that individuals would otherwise spend producing goods and services and enjoying leisure time they spend bartering.\nFunctions for Money\nMoney solves the problems that the barter system creates. (We will get to its definition soon.) First, money serves as a medium of exchange, which means that money acts as an intermediary between the buyer and the seller. Instead of exchanging accounting services for shoes, the accountant now exchanges accounting services for money. The accountant then uses this  money to buy shoes. To serve as a medium of exchange, people must widely accept money as a method of payment in the markets for goods, labor, and financial capital.Second, money must serve as a store of value. In a barter system, we saw the example of the shoemaker trading shoes for accounting services. However, she risks having her shoes go out of style, especially if she keeps them in a warehouse for future usetheir value will decrease with each season. Shoes are not a good store of value. Holding money is a much easier way of storing value. You know that you do not need to spend it immediately because it will still hold its value the next day, or the next year. This function of money does not require that money is a perfect store of value. In an economy with inflation, money loses some buying power each year, but it remains money.Third, money serves as a unit of account, which means that it is the ruler by which  we measure values. For example, an accountant may charge $100 to file your tax return. That $100 can purchase two pair of shoes at $50 a pair. Money acts as a common denominator, an accounting method that simplifies thinking about trade-offs.Finally, another function of money is that it must serve as a standard of deferred payment. This means that if money is usable today to make purchases, it must also be acceptable to make purchases today that the purchaser will pay in the future. Loans and future agreements are stated in monetary terms and the standard of deferred payment is what allows us to buy goods and services today and pay in the future. Thus, money serves all of these functions it is a medium of exchange, store of value, unit of account, and standard of deferred payment.\nCommodity versus Fiat Money\nMoney has taken a wide variety of forms in different cultures. People have used gold, silver, cowrie shells, cigarettes, and even cocoa beans as money. Although we use these items as commodity money, they also have a value from use as something other than money. For example, people have used gold throughout the ages as money although today we do not use it as money but rather value it for its other attributes. Gold is a good conductor of electricity and  the electronics and aerospace industry use it. Other industries use gold too, such as to manufacture energy efficient reflective glass for skyscrapers and is used in the medical industry as well. Of course, gold also has value because of its beauty and malleability in creating jewelry.As commodity money, gold has historically served its purpose as a medium of exchange, a store of value, and as a unit of account. Commodity-backed currencies are dollar bills or other currencies with values backed up by gold or other commodities held at a bank. During much of its history, gold and silver backed the money supply in the United States. Interestingly, antique dollars dated as late as 1957, have Silver Certificate printed over the portrait of George Washington, as Figure 14.2 shows. This meant that the holder could take the bill to the appropriate bank and exchange it for a dollars worth of silver.\n\n\n\nFigure \n14.2\n \nA Silver Certificate and a Modern U.S. Bill\n \nUntil 1958, silver certificates were commodity-backed moneybacked by silver, as indicated by the words Silver Certificate printed on the bill. Today, The Federal Reserve backs U.S. bills, but as fiat money (inconvertible paper money made legal tender by a government decree). (Credit: The.Comedian/Flickr Creative Commons)\n\nAs economies grew and became more global in nature, the use of commodity monies became more cumbersome. Countries moved towards the use of fiat money. Fiat money has no intrinsic value, but is declared by a government to be a country's legal tender. The United States paper money, for example, carries the statement: THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE. In other words, by government decree, if you owe a debt, then legally speaking, you can pay that debt with the U.S. currency, even though it is not backed by a commodity. The only backing of our money is universal faith and trust that the currency has value, and nothing more.\n\nLink It Up\n\nWatch this video on the History of Money.\n\n", "14-2": "By the end of this section, you will be able to:\nContrast M1 money supply and M2 money supply\nClassify monies as M1 money supply or M2 money supply\n\nCash in your pocket certainly serves as money; however, what about checks or credit cards? Are they money, too? Rather than trying to state a single way of measuring money, economists offer broader definitions of money based on liquidity. Liquidity refers to how quickly you can use a financial asset to buy a good or service. For example, cash is very liquid. You can use your $10 bill easily to buy a hamburger at lunchtime. However, $10 that you have in your savings account is not so easy to use. You must go to the bank or ATM machine and withdraw that cash to buy your lunch. Thus, $10 in your savings account is\nless liquid.The Federal Reserve Bank, which is the central bank of the United States, is a bank regulator and is responsible for monetary policy and defines money according to its liquidity. There are two definitions of money: M1 and M2 money supply. Historically, M1 money supply included those monies that are very liquid such as cash, checkable (demand) deposits, and travelers checks, while M2 money supply included those monies that are less liquid in nature; M2 included M1 plus savings and time deposits, certificates of deposits, and money market funds. Beginning in May 2020, the Federal Reserve changed the definition of both M1 and M2. The biggest change is that savings moved to be part of M1. M1 money supply now includes cash, checkable (demand) deposits, and savings. M2 money supply is now measured as M1 plus time deposits, certificates of deposits, and money market funds.\nM1 money supply includes coins and currency in circulationthe coins and bills that circulate in an economy that the U.S. Treasury does not hold at the Federal Reserve Bank, or in bank vaults. Closely related to currency are checkable deposits, also known as demand deposits. These are the amounts held in checking accounts. They are called demand deposits or checkable deposits because the banking institution must give the deposit holder his money on demand when the customer writes a check or uses a debit card. These items togethercurrency, and checking accounts in bankscomprise the definition of money known as M1, which the Federal Reserve System measures daily. \nAs mentioned, M1 now includes savings deposits in banks, which are bank accounts on which you cannot write a check directly, but from which you can easily withdraw the money at an automatic teller machine or bank.\nA broader definition of money, M2 includes everything in M1 but also adds other types of deposits. Many banks and other financial institutions also offer a chance to invest in money market funds, where they pool together the deposits of many individual investors and invest them in a safe way, such as short-term government bonds. Another ingredient of M2 are the relatively small (that is, less than about $100,000) certificates of deposit (CDs) or time deposits, which are accounts that the depositor has committed to leaving in the bank for a certain period of time, ranging from a few months to a few years, in exchange for a higher interest rate. In short, all these types of M2 are money that you can withdraw and spend, but which require a greater effort to do so than the items in M1. Figure 14.3 should help in visualizing the relationship between M1 and M2. Note that M1 is included in the M2 calculation.\n\n\n\nFigure \n14.3\n \nThe Relationship between M1 and M2 Money \n \nM1 and M2 money have several definitions, ranging from narrow to broad. M1 = coins and currency in circulation + checkable (demand) deposit + savings deposits. M2 = M1 + money market funds + certificates of deposit + other time deposits.\n\nThe Federal Reserve System is responsible for tracking the amounts of M1 and M2 and prepares a weekly release of information about the money supply. To provide an idea of what these amounts sound like, according to the Federal Reserve Banks measure of the U.S. money stock, at the end of February 2015, M1 in the United States was $3 trillion, while M2 was $11.8 trillion. Table 14.1 provides a breakdown of the portion of each type of money that comprised M1 and M2 in February 2015, as provided by the Federal Reserve Bank.\n\n Components of M1 in the U.S. (May 2021, Seasonally Adjusted)\n$ billions\n\n\nCurrency\n$2,065\n\n\nDemand deposits\n$4,002\n\n\nSavings and other liquid deposits\n$12,154\n\n\nTotal M1\n$19,221 (or $19 trillion)\n\n\nComponents of M2 in the U.S. (May 2021, Seasonally Adjusted)\n$ billions\n\n\nM1 money supply\n$19,221\n\n\nTime deposits\n$120\n\n\nMoney market fund balances\n$1,027\n\n\nTotal M2\n$20,368 (or $20 trillion)\n\n\nTable \n14.1\n \nM1 and M2 Federal Reserve Statistical Release, Money Stock Measures\n \n(Source: Federal Reserve Statistical Release, http://www.federalreserve.gov/RELEASES/h6/current/default.htm#t2tg1link)\n\n\nThe lines separating M1 and M2 can become a little blurry. Sometimes businesses do not treat elements of M1 alike. For example, some businesses will not accept personal checks for large amounts, but will accept travelers checks or cash. Changes in banking practices and technology have made the savings accounts in M2 more similar to the checking accounts in M1. For example, some savings accounts will allow depositors to write checks, use automatic teller machines, and pay bills over the internet, which has made it easier to access savings accounts. As with many other economic terms and statistics, the important point is to know the strengths and limitations of the various definitions of money, not to believe that such definitions are as clear-cut to economists as, say, the definition of nitrogen is to chemists.Where does plastic money like debit cards, credit cards, and smart money fit into this picture? A debit card, like a check, is an instruction to the users bank to transfer money directly and immediately from your bank account to the seller. It is important to note that in our definition of money, it is checkable deposits that are money, not the paper check or the debit card. Although you can make a purchase with a credit card, the financial institution does not consider it money but rather a short term loan from the credit card company to you. When you make a credit card purchase, the credit card company immediately transfers money from its checking account to the seller, and at the end of the month, the credit card company sends you a bill for what you have charged that month. Until you pay the credit card bill, you have effectively borrowed money from the credit card company. With a smart card, you can store a certain value of money on the card and then use the card to make purchases. Some smart cards used for specific purposes, like long-distance phone calls or making purchases at a campus bookstore and cafeteria, are not really all that smart, because you can only use them for certain purchases or in certain places.In short, credit cards, debit cards, and smart cards are different ways to move money when you make a purchase. However, having more credit cards or debit cards does not change the quantity of money in the economy, any more than printing more checks increases the amount of money in your checking account.One key message underlying this discussion of M1 and M2 is that money in a modern economy is not just paper bills and coins. Instead, money is closely linked to bank accounts. The banking system largely conducts macroeconomic policies concerning money. The next section explains how banks function and how a nations banking system has the power to create money.\nLink It Up\n\n\nRead a brief article on the monetary challenges in Sweden.\n\n", "14-3": "By the end of this section, you will be able to:\nExplain how banks act as intermediaries between savers and borrowers\nEvaluate the relationship between banks, savings and loans, and credit unions\nAnalyze the causes of bankruptcy and recessions\n\nSomebody once asked the late bank robber named Willie Sutton why he robbed banks. He answered: Thats where the money is. While this may have been true at one time, from the perspective of modern economists, Sutton is both right and wrong. He is wrong because the overwhelming majority of money in the economy is not in the form of currency sitting in vaults or drawers at banks, waiting for a robber to appear. Most money is in the form of bank accounts, which exist only as electronic records on computers. From a broader perspective, however, the bank robber was more right than he may have known. Banking is intimately interconnected with money and consequently, with the broader economy.Banks make it far easier for a complex economy to carry out the extraordinary range of transactions that occur in goods, labor, and financial capital markets. Imagine for a moment what the economy would be like if everybody had to make all payments in cash. When shopping for a large purchase or going on vacation you might need to carry hundreds of dollars in a pocket or purse. Even small businesses would need stockpiles of cash to pay workers and to purchase supplies. A bank allows people and businesses to store this money in either a checking account or savings account, for example, and then withdraw this money as needed through the use of a direct withdrawal, writing a check, or using a debit card.Banks are a critical intermediary in what we call the payment system, which helps an economy exchange goods and services for money or other financial assets. Also, those with extra money that they would like to save can store their money in a bank rather than look for an individual who is willing to borrow it from them and then repay them at a later date. Those who want to borrow money can go directly to a bank rather than trying to find someone to lend them cash. Transaction costs are the costs associated with finding a lender or a borrower for this money. Thus, banks lower transactions costs and act as financial intermediariesthey bring savers and borrowers together. Along with making transactions much safer and easier, banks also play a key role in creating money.Banks as Financial IntermediariesAn intermediary is one who stands between two other parties. Banks are a financial intermediarythat is, an institution that operates between a saver who deposits money in a bank and a borrower who receives a loan from that bank. Financial intermediaries include other institutions in the financial market such as insurance companies and pension funds, but we will not include them in this discussion because they are not depository institutions, which are institutions that accept money deposits and then use these to make loans. All the deposited funds mingle in one big pool, which the financial institution then lends. Figure 14.4 illustrates the position of banks as financial intermediaries, with deposits flowing into a bank and loans flowing out. Of course, when banks make loans to firms, the banks will try to funnel financial capital to healthy businesses that have good prospects for repaying the loans, not to firms that are suffering losses and may be unable to repay.\n\n\n\nFigure \n14.4\n \nBanks as Financial Intermediaries\n \nBanks act as financial intermediaries because they stand between savers and borrowers. Savers place deposits with banks, and then receive interest payments and withdraw money. Borrowers receive loans from banks and repay the loans with interest. In turn, banks return money to savers in the form of withdrawals, which also include interest payments from banks to savers.\n\n\nClear It Up\n\n\nHow are banks, savings and loans, and credit unions related?\n\nBanks have a couple of close cousins: savings institutions and credit unions. Banks, as we explained, receive deposits from individuals and businesses and make loans with the money.\nSavings institutions are also sometimes called savings and loans or thrifts. They also take loans and make deposits. However, from the 1930s until the 1980s, federal law limited how much interest savings institutions were allowed to pay to depositors. They were also required to make most of their loans in the form of housing-related loans, either to homebuyers or to real-estate developers and builders.A credit union is a nonprofit financial institution that its members own and run. Members of each credit union decide who is eligible to be a member. Usually, potential members would be everyone in a certain community, or groups of employees, or members of a certain organization. The credit union accepts deposits from members and focuses on making loans back to its members. While there are more credit unions than banks and more banks than savings and loans, the total assets of credit unions are growing.In 2008, there were 7,085 banks. Due to the bank failures of 20072009 and bank mergers, there were 5,571 banks in the United States at the end of the fourth quarter in 2014. According to the Credit Union National Association, as of December 2014 there were 6,535 credit unions with assets totaling $1.1 billion.  A day of Transfer Your Money took place in 2009 out of general public disgust with big bank bailouts. People were encouraged to transfer their deposits to credit unions. This has grown into the ongoing Move Your Money Project. Consequently, some now hold deposits as large as $50 billion. However, as of 2013,  the 12 largest banks (0.2%) controlled 69 percent of all banking assets, according to the Dallas Federal Reserve.\n\nA Banks Balance SheetA balance sheet is an accounting tool that lists assets and liabilities. An asset is something of value that you own and you can use to produce something. For example, you can use the cash you own to pay your tuition. If you own a home, this is also an asset. A liability is a debt or something you owe. Many people borrow money to buy homes. In this case, a home is the asset, but the mortgage is the liability. The net worth is the asset value minus how much is owed (the liability). A banks balance sheet operates in much the same way. A banks net worth as bank capital. We also refer to a bank has assets such as cash held in its vaults, monies that the bank holds at the Federal Reserve bank (called reserves), loans that it makes to customers, and bonds.Figure 14.5 illustrates a hypothetical and simplified balance sheet for the Safe and Secure Bank. Because of the two-column format of the balance sheet, with the T-shape formed by the vertical line down the middle and the horizontal line under Assets and Liabilities, we sometimes call it a T-account.\n\n\n\n\nFigure \n14.5\n \nA Balance Sheet for the Safe and Secure Bank \n\n\nThe T in a T-account separates the assets of a firm, on the left, from its liabilities, on the right. All firms use T-accounts, though most are much more complex. For a bank, the assets are the financial instruments that either the bank is holding (its reserves) or those instruments where other parties owe money to the banklike loans made by the bank and U.S. Government Securities, such as U.S. treasury bonds purchased by the bank. Liabilities are what the bank owes to others. Specifically, the bank owes any deposits made in the bank to those who have made them. The net worth of the bank is the total assets minus total liabilities. Net worth is included on the liabilities side to have the T account balance to zero. For a healthy business, net worth will be positive. For a bankrupt firm, net worth will be negative. In either case, on a banks T-account, assets will always equal liabilities plus net worth.When bank customers deposit money into a checking account, savings account, or a certificate of deposit, the bank views these deposits as liabilities. After all, the bank owes these deposits to its customers, when the customers wish to withdraw their money. In the example in Figure 14.5, the Safe and Secure Bank holds $10 million in deposits.Loans are the first category of bank assets in Figure 14.5. Say that a family takes out a 30-year mortgage loan to purchase a house, which means that the borrower will repay the loan over the next 30 years. This loan is clearly an asset from the banks perspective, because the borrower has a legal obligation to make payments to the bank over time. However, in practical terms, how can we measure the value of the mortgage loan that the borrower is paying over 30 years in the present? One way of measuring the value of somethingwhether a loan or anything elseis by estimating what another party in the market is willing to pay for it. Many banks issue home loans, and charge various handling and processing fees for doing so, but then sell the loans to other banks or financial institutions who collect the loan payments. We call the market where financial institutions make loans to borrowers the primary loan market, while the market in which financial institutions buy and sell these loans is the secondary loan market.One key factor that affects what financial institutions are willing to pay for a loan, when they buy it in the secondary loan market, is the perceived riskiness of the loan: that is, given the borrower's characteristics, such as income level and whether the local economy is performing strongly, what proportion of loans of this type will the borrower repay? The greater the risk that a borrower will not repay loan, the less that any financial institution will pay to acquire the loan.\nAnother key factor is to compare the interest rate the financial institution charged on the original loan with the current interest rate in the economy. If the original loan requires the borrower to pay a low interest rate, but current interest rates are relatively high, then a financial institution will pay less to acquire the loan. In contrast, if the original loan requires the borrower to pay a high interest rate, while current interest rates are relatively low, then a financial institution will pay more to acquire the loan. For the Safe and Secure Bank in this example, the total value of its loans if they sold them to other financial institutions in the secondary market is $5 million.The second category of bank asset is bonds, which are a common mechanism for borrowing, used by the federal and local government, and also private companies, and nonprofit organizations. A bank takes some of the money it has received in deposits and uses the money to buy bondstypically bonds issued that the U.S. government issues. Government bonds are low-risk because the government is virtually certain to pay off the bond, albeit at a low rate of interest. These bonds are an asset for banks in the same way that loans are an asset: The bank will receive a stream of payments in the future. In our example, the Safe and Secure Bank holds bonds worth a total value of $4 million.The final entry under assets is reserves, which is money that the bank keeps on hand, and that it does not lend or invest in bondsand thus does not lead to interest payments. The Federal Reserve requires that banks keep a certain percentage of depositors money on reserve, which means either in their vaults or at the Federal Reserve Bank. We call this a reserve requirement. (Monetary Policy and Bank Regulation will explain how the level of these required reserves are one policy tool that governments have to influence bank behavior.) Additionally, banks may also want to keep a certain amount of reserves on hand in excess of what is required. The Safe and Secure Bank is holding $2 million in reserves.We define net worth of a bank as its total assets minus its total liabilities. For the Safe and Secure Bank in Figure 14.5, net worth is equal to $1 million; that is, $11 million in assets minus $10 million in liabilities. For a financially healthy bank, the net worth will be positive. If a bank has negative net worth and depositors tried to withdraw their money, the bank would not be able to give all depositors their money.\nLink It Up\n\nFor some concrete examples of what banks do, watch this video from Paul Solmans Making Sense of Financial News.\n\n\nHow Banks Go Bankrupt\nA bank that is bankrupt will have a negative net worth, meaning its assets will be worth less than its liabilities. How can this happen? Again, looking at the balance sheet helps to explain.\nA well-run bank will assume that a small percentage of borrowers will not repay their loans on time, or at all, and factor these missing payments into its planning. Remember, the calculations of the banks' expenses every year include a factor for loans that borrowers do not repay, and the value of a banks loans on its balance sheet assumes a certain level of riskiness because some customers will not repay loans. Even if a bank expects a certain number of loan defaults, it will suffer if the number of loan defaults is much greater than expected, as can happen during a recession. For example, if the Safe and Secure Bank in Figure 14.5 experienced a wave of unexpected defaults, so that its loans declined in value from $5 million to $3 million, then the assets of the Safe and Secure Bank would decline so that the bank had negative net worth.\nClear It Up\n\n\nWhat led to the 20082009 financial crisis?\nMany banks make mortgage loans so that people can buy a home, but then do not keep the loans on their books as an asset. Instead, the bank sells the loan. These loans are securitized, which means that they are bundled together into a financial security that a financial institution sells to investors. Investors in these mortgage-backed securities receive a rate of return based on the level of payments that people make on all the mortgages that stand behind the security.Securitization offers certain advantages. If a bank makes most of its loans in a local area, then the bank may be financially vulnerable if the local economy declines, so that many people are unable to make their payments. However, if a bank sells its local loans, and then buys a mortgage-backed security based on home loans in many parts of the country, it can avoid exposure to local financial risks. (In the simple example in the text, banks just own bonds. In reality, banks can own a number of financial instruments, as long as these financial investments are safe enough to satisfy the government bank regulators.) From the standpoint of a local homebuyer, securitization offers the benefit that a local bank does not need to have significant extra funds to make a loan, because the bank is only planning to hold that loan for a short time, before selling the loan so that it can pool it into a financial security.However, securitization also offers one potentially large disadvantage. If a bank plans to hold a mortgage loan as an asset, the bank has an incentive to scrutinize the borrower carefully to ensure that the customer is likely to repay the loan. However, a bank that plans to sell the loan may be less careful in making the loan in the first place. The bank will be more willing to make what we call subprime loans, which are loans that have characteristics like low or zero down-payment, little scrutiny of whether the borrower has a reliable income, and sometimes low payments for the first year or two that will be followed by much higher payments. Economists dubbed some of the subprime loans made by financial institutions in the mid-2000s NINJA loans:  loans that financial institutions made even though the borrower had demonstrated No Income, No Job, or Assets.Financial institutions typically sold these subprime loans and turned them into financial securitiesbut with a twist. The idea was that if losses occurred on these mortgage-backed securities, certain investors would agree to take the first, say, 5% of such losses. Other investors would agree to take, say, the next 5% of losses. By this approach, still other investors would not need to take any losses unless these mortgage-backed financial securities lost 25% or 30% or more of their total value. These complex securities, along with other economic factors, encouraged a large expansion of subprime loans in the mid-2000s.The economic stage was now set for a banking crisis. Banks thought they were buying only ultra-safe securities, because even though the securities were ultimately backed by risky subprime mortgages, the banks only invested in the part of those securities where they were protected from small or moderate levels of losses. However, as housing prices fell after 2007, and the deepening recession made it harder for many people to make their mortgage payments, many banks found that their mortgage-backed financial assets could be worth much less than they had expectedand so the banks were faced with staring bankruptcy. In the 20082011 period, 318 banks failed in the United States.The risk of an unexpectedly high level of loan defaults can be especially difficult for banks because a banks liabilities, namely it customers' deposits. Customers can withdraw funds quickly but many of the banks assets like loans and bonds will only be repaid over years or even decades. This asset-liability time mismatchthe ability for customers to withdraw banks liabilities in the short term while customers repay its assets in the long termcan cause severe problems for a bank. For example, imagine a bank that has loaned a substantial amount of money at a certain interest rate, but then sees interest rates rise substantially. The bank can find itself in a precarious situation. If it does not raise the interest rate it pays to depositors, then deposits will flow to other institutions that offer the higher interest rates that are now prevailing. However, if the bank raises the interest rates that it pays to depositors, it may end up in a situation where it is paying a higher interest rate to depositors than it is collecting from those past loans that it at lower interest rates. Clearly, the bank cannot survive in the long term if it is paying out more in interest to depositors than it is receiving from borrowers.How can banks protect themselves against an unexpectedly high rate of loan defaults and against the risk of an asset-liability time mismatch? One strategy is for a bank to diversify its loans, which means lending to a variety of customers. For example, suppose a bank specialized in lending to a niche marketsay, making a high proportion of its loans to construction companies that build offices in one downtown area. If that one area suffers an unexpected economic downturn, the bank will suffer large losses. However, if a bank loans both to consumers who are buying homes and cars and also to a wide range of firms in many industries and geographic areas, the bank is less exposed to risk. When a bank diversifies its loans, those categories of borrowers who have an unexpectedly large number of defaults will tend to be balanced out, according to random chance, by other borrowers who have an unexpectedly low number of defaults. Thus, diversification of loans can help banks to keep a positive net worth. However, if a widespread recession occurs that touches many industries and geographic areas, diversification will not help.Along with diversifying their loans, banks have several other strategies to reduce the risk of an unexpectedly large number of loan defaults. For example, banks can sell some of the loans they make in the secondary loan market, as we described earlier, and instead hold a greater share of assets in the form of government bonds or reserves. Nevertheless, in a lengthy recession, most banks will see their net worth decline because customers will not repay a higher share of loans in tough economic times.\n", "14-4": "By the end of this section, you will be able to:\nUtilize the money multiplier formulate to determine how banks create money\nAnalyze and create T-account balance sheets\nEvaluate the risks and benefits of money and banks\n\nBanks and money are intertwined. It is not just that most money is in the form of bank accounts. The banking system can literally create money through the process of making loans. Lets see how.\nMoney Creation by a Single Bank\nStart with a hypothetical bank called Singleton Bank. The bank has $10 million in deposits. The T-account balance sheet for Singleton Bank, when it holds all of the deposits in its vaults, is in Figure 14.6. At this stage, Singleton Bank is simply storing money for depositors and is using these deposits to make loans. In this simplified example, Singleton Bank cannot earn any interest income from these loans and cannot pay its depositors an interest rate either.\n\n\n\n\nFigure \n14.6\n \nSingleton Banks Balance Sheet: Receives $10 million in Deposits \n\n\nThe Federal Reserve requires Singleton Bank to keep $1 million on reserve (10% of total deposits). It will loan out the remaining $9 million. By loaning out the $9 million and charging interest, it will be able to make interest payments to depositors and earn interest income for Singleton Bank (for now, we will keep it simple and not put interest income on the balance sheet). Instead of becoming just a storage place for deposits, Singleton Bank can become a financial intermediary between savers and borrowers.This change in business plan alters Singleton Banks balance sheet, as Figure 14.7 shows. Singletons assets have changed. It now has $1 million in reserves and a loan to Hanks Auto Supply of $9 million. The bank still has $10 million in deposits.\n\n\n\n\nFigure \n14.7\n \nSingleton Banks Balance Sheet: 10% Reserves, One Round of Loans \n\n\nSingleton Bank lends $9 million to Hanks Auto Supply. The bank records this loan by making an entry on the balance sheet to indicate that it has made a loan. This loan is an asset, because it will generate interest income for the bank. Of course, the loan officer will not allow let Hank to walk out of the bank with $9 million in cash. The bank issues Hanks Auto Supply a cashiers check for the $9 million.  Hank deposits the loan in his regular checking account with First National. The deposits at First National rise by $9 million and its reserves also rise by $9 million, as Figure 14.8 shows. First National must hold 10% of additional deposits as required reserves but is free to loan out the rest\n\n\n\n\nFigure \n14.8\n \nFirst National Balance Sheet \n\n\nMaking loans that are deposited into a demand deposit account increases the M1 money supply. Remember the definition of M1 includes checkable (demand) deposits, which one can easily use as a medium of exchange to buy goods and services.  Notice that the money supply is now $19 million: $10 million in deposits in Singleton bank and $9 million in deposits at First National.  Obviously as Hanks Auto Supply writes checks to pay its bills the deposits will draw down.  However, the bigger picture is that a bank must hold enough money in reserves to meet its liabilities. The rest the bank loans out.  In this example so far, bank lending has expanded the money supply by $9 million.Now, First National must hold only 10% as required reserves ($900,000) but can lend out the other 90% ($8.1 million) in a loan to Jacks Chevy Dealership as Figure 14.9 shows.\n\n\n\n\nFigure \n14.9\n \nFirst National Balance Sheet \n\n\nIf Jacks deposits the loan in its checking account at Second National, the money supply just increased by an additional $8.1 million, as Figure 14.10  shows.\n\n\n\n\n\nFigure \n14.10\n \nSecond National Banks Balance Sheet \n\n\nHow is this money creation possible?  It is possible because there are multiple banks in the financial system, they are required to hold only a fraction of their deposits, and loans end up deposited in other banks, which increases deposits and, in essence, the money supply.\n\nLink It Up\n\nWatch this video to learn more about how banks create money.\n\nThe Money Multiplier and a Multi-Bank System\nIn a system with multiple banks, Singleton Bank deposited the initial excess reserve amount that it decided to lend to Hanks Auto Supply into First National Bank, which is free to loan out $8.1 million. If all banks loan out their excess reserves, the money supply will expand.\nIn a multi-bank system, institutions determine the amount of money that the system can create by using the money multiplier. This tells us by how many times a loan will be multiplied as it is spent in the economy and then re-deposited in other banks.Fortunately, a formula exists for calculating the total of these many rounds of lending in a banking system. The money multiplier formula is:\n1ReserveRequirement1ReserveRequirementWe then multiply the money multiplier by the change in excess reserves to determine the total amount of M1 money supply created in the banking system. See the Work it Out feature to walk through the multiplier calculation.\nWork It Out\n\n\nUsing the Money Multiplier Formula\n\nUsing the money multiplier for the example in this text:\nStep 1. In the case of Singleton Bank, for whom the reserve requirement is 10% (or 0.10), the money multiplier is 1 divided by .10, which is equal to 10.\nStep 2. We have identified that the excess reserves are $9 million, so, using the formula we can determine the total change in the M1 money supply:\nTotalChangeintheM1MoneySupply=1ReserveRequirementExcessRequirement=10.10$9million=10$9million=$90millionTotalChangeintheM1MoneySupply=1ReserveRequirementExcessRequirement=10.10$9million=10$9million=$90millionStep 3. Thus, we can say that, in this example, the total quantity of money generated in this economy after all rounds of lending are completed will be $90 million.\n\n\nCautions about the Money Multiplier\nThe money multiplier will depend on the proportion of reserves that the Federal Reserve Band requires banks to hold. Additionally, a bank can also choose to hold extra reserves. Banks may decide to vary how much they hold in reserves for two reasons: macroeconomic conditions and government rules. When an economy is in recession, banks are likely to hold a higher proportion of reserves because they fear that customers are less likely to repay loans when the economy is slow. The Federal Reserve may also raise or lower the required reserves held by banks as a policy move to affect the quantity of money in an economy, as Monetary Policy and Bank Regulation will discuss.The process of how banks create money shows how the quantity of money in an economy is closely linked to the quantity of lending or credit in the economy. All the money in the economy, except for the original reserves, is a result of bank loans that institutions repeatedly re-deposit and loan.Finally, the money multiplier depends on people re-depositing the money that they receive in the banking system. If people instead store their cash in safe-deposit boxes or in shoeboxes hidden in their closets, then banks cannot recirculate the money in the form of loans. Central banks have an incentive to assure that bank deposits are safe because if people worry that they may lose their bank deposits, they may start holding more money in cash, instead of depositing it in banks, and the quantity of loans in an economy will decline. Low-income countries have what economists sometimes refer to as mattress savings, or money that people are hiding in their homes because they do not trust banks. When mattress savings in an economy are substantial, banks cannot lend out those funds and the money multiplier cannot operate as effectively. The overall quantity of money and loans in such an economy will decline.\n\nLink It Up\n\nWatch a video of Jem Bendell discussing The Money Myth.\nMoney and BanksBenefits and Dangers\nMoney and banks are marvelous social inventions that help a modern economy to function. Compared with the alternative of barter, money makes market exchanges vastly easier in goods, labor, and financial markets. Banking makes money still more effective in facilitating exchanges in goods and labor markets. Moreover, the process of banks making loans in financial capital markets is intimately tied to the creation of money.\nHowever, the extraordinary economic gains that are possible through money and banking also suggest some possible corresponding dangers. If banks are not working well, it sets off a decline in convenience and safety of transactions throughout the economy. If the banks are under financial stress, because of a widespread decline in the value of their assets, loans may become far less available, which can deal a crushing blow to sectors of the economy that depend on borrowed money like business investment, home construction, and car manufacturing. The 20082009 Great Recession illustrated this pattern.\nBring It Home\n\n\nThe Many Disguises of Money: From Cowries to Bitcoins \nThe global economy has come a long way since it started using cowrie shells as currency. We have moved away from commodity and commodity-backed paper money to fiat currency. As technology and global integration increases, the need for paper currency is diminishing, too. Every day, we witness the increased use of debit and credit cards.The latest creation and perhaps one of the purest forms of fiat money is the Bitcoin. Bitcoins are a digital currency that allows users to buy goods and services online. Customers can purchase products and services such as videos and books using Bitcoins. This currency is not backed by any commodity nor has any government decreed as legal tender, yet customers use it as a medium of exchange and can store its value (online at least). It is also unregulated by any central bank, but is created online through people solving very complicated mathematics problems and receiving payment afterward. Bitcoin.org is an information source if you are curious. Bitcoins are a relatively new type of money. At present, because it is not sanctioned as a legal currency by any country nor regulated by any central bank, it lends itself for use in illegal as well as legal trading activities. As technology increases and the need to reduce transactions costs associated with using traditional forms of money increases, Bitcoins or some sort of digital currency may replace our dollar bill, just as man replaced the cowrie shell.\n", "15-1": "By the end of this section, you will be able to:\nExplain the structure and organization of the U.S. Federal Reserve\nDiscuss how central banks impact monetary policy, promote financial stability, and provide banking services\n\nIn making decisions about the money supply, a central bank decides whether to raise or lower interest rates and, in this way, to influence macroeconomic policy, whose goal is low unemployment and low inflation. The central bank is also responsible for regulating all or part of the nations banking system to protect bank depositors and insure the health of the banks balance sheet.\nWe call the organization responsible for conducting monetary policy and ensuring that a nations financial system operates smoothly the central bank. Most nations have central banks or currency boards. Some prominent central banks around the world include the European Central Bank, the Bank of Japan, and the Bank of England. In the United States, we call the central bank the Federal Reserveoften abbreviated as just the Fed. This section explains the U.S. Federal Reserve's organization and identifies the major central bank's responsibilities.Structure/Organization of the Federal Reserve\nUnlike most central banks, the Federal Reserve is semi-decentralized, mixing government appointees with representation from private-sector banks. At the national level, it is run by a Board of Governors, consisting of seven members appointed by the President of the United States and confirmed by the Senate. Appointments are for 14-year terms and they are arranged so that one term expires January 31 of every even-numbered year. The purpose of the long and staggered terms is to insulate the Board of Governors as much as possible from political pressure so that governors can make policy decisions based only on their economic merits. Additionally, except when filling an unfinished term, each member only serves one term, further insulating decision-making from politics. The Fed's policy decisions do not require congressional approval, and the President cannot ask for a Federal Reserve Governor to resign as the President can with cabinet positions.One member of the Board of Governors is designated as the Chair. For example, from 1987 until early 2006, the Chair was Alan Greenspan. From 2006 until 2014, Ben Bernanke held the post. From 2014 to 2018, Janet Yellen was the Chair. The current Chair is Jerome Powell. See the following Clear It Up feature to find out more about the former and current Chair.\nClear It Up\n\n\nWho has the most immediate economic power in the world?\n\n\n\n\n\nFigure \n15.2\n \nChair of the Federal Reserve Board \n \nJanet L. Yellen was the first woman to hold the position of Chair of the Federal Reserve Board of Governors. (Credit: Board of Governors of the Federal Reserve System)\n\nWhat individual can make financial market crash or soar just by making a public statement? It is not Bill Gates or Warren Buffett. It is not even the President of the United States. The answer is the Chair of the Federal Reserve Board of Governors. In early 2014, Janet L. Yellen, (Figure 15.2) became the first woman to hold this post. The media had described Yellen as perhaps the most qualified Fed chair in history. With a Ph.D. in economics from Yale University, Yellen has taught macroeconomics at Harvard, the London School of Economics, and most recently at the University of California at Berkeley. From 20042010, Yellen was President of the Federal Reserve Bank of San Francisco. Not an ivory tower economist, Yellen became one of the few economists who warned about a possible bubble in the housing market, more than two years before the financial crisis occurred. Yellen served on the Board of Governors of the Federal Reserve. She also spent two years as Chair of the Presidents Council of Economic Advisors. In early 2018, Jerome Powell took over as Chair. With a Bachelor of Arts in politics from Princeton University and a law degree from Georgetown University, he worked as a lawyer and investment banker in New York City before serving as Assistant Secretary and Under Secretary of the U.S. Department of the Treasury for the George H.W. Bush administration. He has also served on corporate boards, as well as the boards of charitable and educational institutions. He currently serves as Chairman of the Federal Open Market Committee.\nThe Fed Chair is first among equals on the Board of Governors. While he or she has only one vote, the Chair controls the agenda, and is the Fed's public voice, so he or she has more power and influence than one might expect.\nLink It Up\n\n\nVisit this website to see who the current members of the Federal Reserve Board of Governors are. You can follow the links provided for each board member to learn more about their backgrounds, experiences, and when their terms on the board will end.\n\nThe Federal Reserve is more than the Board of Governors. The Fed also includes 12 regional Federal Reserve banks, each of which is responsible for supporting the commercial banks and economy generally in its district. Figure 15.3 shows the Federal Reserve districts and the cities where their regional headquarters are located. The commercial banks in each district elect a Board of Directors for each regional Federal Reserve bank, and that board chooses a president for each regional Federal Reserve district. Thus, the Federal Reserve System includes both federally and private-sector appointed leaders.\n\n\n\n\nFigure \n15.3\n \nThe Twelve Federal Reserve Districts \n \nThere are twelve regional Federal Reserve banks, each with its district.\n\n\n\nWhat Does a Central Bank Do?\nThe Federal Reserve, like most central banks, is designed to perform three important functions:\n    To conduct monetary policy\nTo promote stability of the financial system\nTo provide banking services to commercial banks and other depository institutions, and to provide banking services to the federal government.\n\nThe first two functions are sufficiently important that we will discuss them in their own modules. The third function we will discuss here.The Federal Reserve provides many of the same services to banks as banks provide to their customers. For example, all commercial banks have an account at the Fed where they deposit reserves. Similarly, banks can obtain loans from the Fed through the discount window facility, which we will discuss in more detail later. The Fed is also responsible for check processing. When you write a check, for example, to buy groceries, the grocery store deposits the check in its bank account. Then, the grocery store's bank returns the physical check (or an image of that actual check) to your bank, after which it transfers funds from your bank account to the grocery store's account. The Fed is responsible for each of these actions.On a more mundane level, the Federal Reserve ensures that enough currency and coins are circulating through the financial system to meet public demands. For example, each year the Fed increases the amount of currency available in banks around the Christmas shopping season and reduces it again in January.\nFinally, the Fed is responsible for assuring that banks are in compliance with a wide variety of consumer protection laws. For example, banks are forbidden from discriminating on the basis of age, race, sex, or marital status. Banks are also required to disclose publicly information about the loans they make for buying houses and how they distribute the loans geographically, as well as by sex and race of the loan applicants.\n", "15-2": "By the end of this section, you will be able to:\nDiscuss the relationship between bank regulation and monetary policy\nExplain bank supervision\nExplain how deposit insurance and lender of last resort are two strategies to protect against bank runs\n\nA safe and stable national financial system is a critical concern of the Federal Reserve. The goal is not only to protect individuals savings, but to protect the integrity of the financial system itself. This esoteric task is usually behind the scenes, but came into view during the 20082009 financial crisis, when for a brief period of time, critical parts of the financial system failed and firms became unable to obtain financing for ordinary parts of their business. Imagine if suddenly you were unable to access the money in your bank accounts because your checks were not accepted for payment and your debit cards were declined. This gives an idea of a failure of the payments/financial system.Bank regulation is intended to maintain banks' solvency by avoiding excessive risk. Regulation falls into a number of categories, including reserve requirements, capital requirements, and restrictions on the types of investments banks may make. In Money and Banking, we learned that banks are required to hold a minimum percentage of their deposits on hand as reserves. On hand is a bit of a misnomer because, while a portion of bank reserves are held as cash in the bank, the majority are held in the banks account at the Federal Reserve, and their purpose is to cover desired withdrawals by depositors. Another part of bank regulation is restrictions on the types of investments banks are allowed to make. Banks are permitted to make loans to businesses, individuals, and other banks. They can purchase U.S. Treasury securities but, to protect depositors, they are not permitted to invest in the stock market or other assets that are perceived as too risky.Bank capital is the difference between a banks assets and its liabilities. In other words, it is a banks net worth. A bank must have positive net worth; otherwise it is insolvent or bankrupt, meaning it would not have enough assets to pay back its liabilities. Regulation requires that banks maintain a minimum net worth, usually expressed as a percent of their assets, to protect their depositors and other creditors.\n\nLink It Up\n\n\nVisit this website to read the brief article, Stop Confusing Monetary Policy and Bank Regulation.\n\nBank Supervision\nSeveral government agencies monitor banks' balance sheets to make sure they have positive net worth and are not taking too high a level of risk. Within the U.S. Department of the Treasury, the Office of the Comptroller of the Currency has a national staff of bank examiners who conduct on-site reviews of the 1,500 or so of the largest national banks. The bank examiners also review any foreign banks that have branches in the United States. The Office of the Comptroller of the Currency also monitors and regulates about 800 savings and loan institutions.The National Credit Union Administration (NCUA) supervises credit unions, which are nonprofit banks that their members run and own. There are over 6,000 credit unions in the U.S. economy, although the typical credit union is small compared to most banks.The Federal Reserve also has some responsibility for supervising financial institutions. For example, we call conglomerate firms that own banks and other businesses bank holding companies. While other regulators like the Office of the Comptroller of the Currency supervises the banks, the Federal Reserve supervises the holding companies.When bank supervision (and bank-like institutions such as savings and loans and credit unions) works well, most banks will remain financially healthy most of the time. If the bank supervisors find that a bank has low or negative net worth, or is making too high a proportion of risky loans, they can require that the bank change its behavioror, in extreme cases, even force the bank to close or be sold to a financially healthy bank.Bank supervision can run into both practical and political questions. The practical question is that measuring the value of a banks assets is not always straightforward. As we discussed in Money and Banking, a banks assets are its loans, and the value of these assets depends on estimates about the risk that customers will not repay these loans. These issues can become even more complex when a bank makes loans to banks or firms in other countries, or arranges financial deals that are much more complex than a basic loan.The political question arises because a bank supervisor's decision to require a bank to close or to change its financial investments is often controversial, and the bank supervisor often comes under political pressure from the bank's owners and the local politicians to keep quiet and back off.For example, many observers have pointed out that Japans banks were in deep financial trouble through most of the 1990s; however, nothing substantial had been done about it by the early 2000s. A similar unwillingness to confront problems with struggling banks is visible across the rest of the world, in East Asia, Latin America, Eastern Europe, Russia, and elsewhere.\nIn the United States, the government passed laws in the 1990s requiring that bank supervisors make their findings open and public, and that they act as soon as they identify a problem. However, as many U.S. banks were staggered by the 2008-2009 recession, critics of the bank regulators asked pointed questions about why the regulators had not foreseen the banks' financial shakiness earlier, before such large losses had a chance to accumulate.\nBank Runs\nBack in the nineteenth century and during the first few decades of the twentieth century (around and during the Great Depression), putting your money in a bank could be nerve-wracking. Imagine that the net worth of your bank became negative, so that the banks assets were not enough to cover its liabilities. In this situation, whoever withdrew their deposits first received all of their money, and those who did not rush to the bank quickly enough, lost their money. We call depositors racing to the bank to withdraw their deposits, as Figure 15.4 shows a bank run. In the movie Its a Wonderful Life, the bank manager, played by Jimmy Stewart, faces a mob of worried bank depositors who want to withdraw their money, but manages to allay their fears by allowing some of them to withdraw a portion of their depositsusing the money from his own pocket that was supposed to pay for his honeymoon.\n\n\n\nFigure \n15.4\n \nA Run on the Bank \n \nBank runs during the Great Depression only served to worsen the economic situation. (Credit: National Archives and Records Administration)\n\nThe risk of bank runs created instability in the banking system. Even a rumor that a bank might experience negative net worth could trigger a bank run and, in a bank run, even healthy banks could be destroyed. Because a bank loans out most of the money it receives, and because it keeps only limited reserves on hand, a bank run of any size would quickly drain any of the banks available cash. When the bank had no cash remaining, it only intensified the fears of remaining depositors that they could lose their money. Moreover, a bank run at one bank often triggered a chain reaction of runs on other banks. In the late nineteenth and early twentieth century, bank runs were typically not the original cause of a recessionbut they could make a recession much worse.\n\nDeposit Insurance\nTo protect against bank runs, Congress has put two strategies into place: deposit insurance and the lender of last resort. Deposit insurance is an insurance system that makes sure depositors in a bank do not lose their money, even if the bank goes bankrupt. About 70 countries around the world, including all of the major economies, have deposit insurance programs. In the United States, the Federal Deposit Insurance Corporation (FDIC) is responsible for deposit insurance. Banks pay an insurance premium to the FDIC. The insurance premium is based on the banks level of deposits, and then adjusted according to the riskiness of a banks financial situation. In 2009, for example, a fairly safe bank with a high net worth might have paid 1020 cents in insurance premiums for every $100 in bank deposits, while a risky bank with very low net worth might have paid 5060 cents for every $100 in bank deposits.\nBank examiners from the FDIC evaluate the banks' balance sheets, looking at the asset and liability values to determine the risk level. The FDIC provides deposit insurance for about 5,898 banks (as of the end of February 2017). Even if a bank fails, the government guarantees that depositors will receive up to $250,000 of their money in each account, which is enough for almost all individuals, although not sufficient for many businesses. Since the United States enacted deposit insurance in the 1930s, no one has lost any of their insured deposits. Bank runs no longer happen at insured banks.\nLender of Last Resort\nThe problem with bank runs is not that insolvent banks will fail; they are, after all, bankrupt and need to be shut down. The problem is that bank runs can cause solvent banks to fail and spread to the rest of the financial system. To prevent this, the Fed stands ready to lend to banks and other financial institutions when they cannot obtain funds from anywhere else. This is known as the lender of last resort role. For banks, the central bank acting as a lender of last resort helps to reinforce the effect of deposit insurance and to reassure bank customers that they will not lose their money.\nThe lender of last resort task can arise in other financial crises, as well. During the 1987 stock market crash panic, when U.S. stock values fell by 25% in a single day, the Federal Reserve made a number of short-term emergency loans so that the financial system could keep functioning. During the 2008-2009 recession, we can interpret the Fed's quantitative easing policies (discussed below) as a willingness to make short-term credit available as needed in a time when the banking and financial system was under stress.\n", "15-3": "By the end of this section, you will be able to:\nExplain the reason for open market operations\nEvaluate reserve requirements and discount rates\nInterpret and show bank activity through balance sheets\n\nThe Federal Reserve's most important function is to conduct the nations monetary policy. Article I, Section 8 of the U.S. Constitution gives Congress the power to coin money and to regulate the value thereof. As part of the 1913 legislation that created the Federal Reserve, Congress delegated these powers to the Fed. Monetary policy involves managing interest rates and credit conditions, which influences the level of economic activity, as we describe in more detail below.A central bank has three traditional tools to implement monetary policy in the economy:\n\n      Open market operations\nChanging reserve requirements\nChanging the discount rate\n\nIn discussing how these three tools work, it is useful to think of the central bank as a bank for banksthat is, each private-sector bank has its own account at the central bank. We will discuss each of these monetary policy tools in the sections below.\nOpen Market Operations\nFrom the early 1920s through 2008, the most common monetary policy tool in the U.S. was open market operations. These take place when the central bank sells or buys U.S. Treasury bonds in order to influence the quantity of bank reserves and the level of interest rates. The specific interest rate targeted in open market operations is the federal funds rate. The name is a bit of a misnomer since the federal funds rate is the interest rate that commercial banks charge making overnight loans to other banks. As such, it is a very short term interest rate, but one that reflects credit conditions in financial markets very well.The Federal Open Market Committee (FOMC) makes the decisions regarding these open market operations. The FOMC comprises seven members of the Federal Reserves Board of Governors. It also includes five voting members who the Board draws, on a rotating basis, from the regional Federal Reserve Banks. The New York district president is a permanent FOMC voting member and the Board fills other four spots on a rotating, annual basis, from the other 11 districts. The FOMC typically meets every six weeks, but it can meet more frequently if necessary. The FOMC tries to act by consensus; however, the Federal Reserve's chairman has traditionally played a very powerful role in defining and shaping that consensus. For the Federal Reserve, and for most central banks, open market operations have, over the last few decades, been the most commonly used tool of monetary policy.\nLink It Up\n\n\nVisit this website for the Federal Reserve to learn more about current monetary policy.\n\nTo understand how open market operations affect the money supply, consider the balance sheet of Happy Bank, displayed in\nFigure 15.5. Figure 15.5 (a) shows that Happy Bank starts with $460 million in assets, divided among reserves, bonds and loans, and $400 million in liabilities in the form of deposits, with a net worth of $60 million. When the central bank purchases $20 million in bonds from Happy Bank, the bond holdings of Happy Bank fall by $20 million and the banks reserves rise by $20 million, as Figure 15.5 (b) shows. However, Happy Bank only wants to hold $40 million in reserves (the quantity of reserves with which it started in Figure 15.5) (a), so the bank decides to loan out the extra $20 million in reserves and its loans rise by $20 million, as Figure 15.5(c) shows. The central bank's open market operation causes Happy Bank to make loans instead of holding its assets in the form of government bonds, which expands the money supply. As the new loans are deposited in banks throughout the economy, these banks will, in turn, loan out some of the deposits they receive, triggering the money multiplier that we discussed in Money and Banking.\n\n\n\nFigure \n15.5\n\nWhere did the Federal Reserve get the $20 million that it used to purchase the bonds? A central bank has the power to create money. In practical terms, the Federal Reserve would write a check to Happy Bank, so that Happy Bank can have that money credited to its bank account at the Federal Reserve. In truth, the Federal Reserve created the money to purchase the bonds out of thin airor with a few clicks on some computer keys.\nOpen market operations can also reduce the quantity of money and loans in an economy. Figure 15.6 (a) shows the balance sheet of Happy Bank before the central bank sells bonds in the open market. When Happy Bank purchases $30 million in bonds, Happy Bank sends $30 million of its reserves to the central bank, but now holds an additional $30 million in bonds, as Figure 15.6 (b) shows. However, Happy Bank wants to hold $40 million in reserves, as in Figure 15.6 (a), so it will adjust down the quantity of its loans by $30 million, to bring its reserves back to the desired level, as Figure 15.6 (c) shows. In practical terms, a bank can easily reduce its quantity of loans. At any given time, a bank is receiving payments on loans that it made previously and also making new loans. If the bank just slows down or briefly halts making new loans, and instead adds those funds to its reserves, then its overall quantity of loans will decrease. A decrease in the quantity of loans also means fewer deposits in other banks, and other banks reducing their lending as well, as the money multiplier that we discussed in Money and Banking takes effect. What about all those bonds? How do they affect the money supply? Read the following Clear It Up feature for the answer.\n\n\n\n\nFigure \n15.6\n \n\n \n\n\n\n\nClear It Up\n\n\nDoes selling or buying bonds increase the money supply?\n\nIs it a sale of bonds by the central bank which increases bank reserves and lowers interest rates or is it a purchase of bonds by the central bank? The easy way to keep track of this is to treat the central bank as being outside the banking system. When a central bank buys bonds, money is flowing from the central bank to individual banks in the economy, increasing the money supply in circulation. When a central bank sells bonds, then money from individual banks in the economy is flowing into the central bankreducing the quantity of money in the economy.\nThe Federal Reserve was founded in the aftermath of the 1907 Financial Panic when many banks failed as a result of bank runs. As mentioned earlier, since banks make profits by lending out their deposits, no bank, even those that are not bankrupt, can withstand a bank run. As a result of the Panic, the Federal Reserve was founded to be the lender of last resort. In the event of a bank run, sound banks, (banks that were not bankrupt) could borrow as much cash as they needed from the Feds discount window to quell the bank run. We call the interest rate banks pay for such loans the discount rate. (They are so named because the bank makes loans against its outstanding loans at a discount of their face value.) Once depositors became convinced that the bank would be able to honor their withdrawals, they no longer had a reason to make a run on the bank. In short, the Federal Reserve was originally intended to provide credit passively, but in the years since its founding, the Fed has taken on a more active role with monetary policy.The second traditional method for conducting monetary policy is to raise or lower the discount rate. If the central bank raises the discount rate, then commercial banks will reduce their borrowing of reserves from the Fed, and instead call in loans to replace those reserves. Since fewer loans are available, the money supply falls and market interest rates rise. If the central bank lowers the discount rate it charges to banks, the process works in reverse.In recent decades, the Federal Reserve has made relatively few discount loans. Before a bank borrows from the Federal Reserve to fill out its required reserves, the bank is expected to first borrow from other available sources, like other banks. This is encouraged by the Fed charging a higher discount rate than the federal funds rate. Given that most banks borrow little at the discount rate, changing the discount rate up or down has little impact on their behavior. More importantly, the Fed has found from experience that open market operations are a more precise and powerful means of executing any desired monetary policy.\n\nChanging Reserve Requirements\nA potential third method of conducting monetary policy is for the central bank to raise or lower the reserve requirement, which, as we noted earlier, is the percentage of each banks deposits that it is legally required to hold either as cash in their vault or on deposit with the central bank. If banks are required to hold a greater amount in reserves, they have less money available to lend out. If banks are allowed to hold a smaller amount in reserves, they will have a greater amount of money available to lend out.\nIn early 2015, the Federal Reserve required banks to hold reserves equal to 0% of the first $14.5 million in deposits, then to hold reserves equal to 3% of the deposits up to $103.6 million, and 10% of any amount above $103.6 million. The Fed makes small changes in the reserve requirements almost every year. For example, the $103.6 million dividing line is sometimes bumped up or down by a few million dollars. \nIn practice, the Fed rarely uses large changes in reserve requirements to execute monetary policy. A sudden demand that all banks increase their reserves would be extremely disruptive and difficult for them to comply, while loosening requirements too much would create a danger of banks inability to meet withdrawal demands.\nChanging the Discount Rate\nIn the Federal Reserve Act, the phrase ...to afford means of rediscounting commercial paper is contained in its long title. This was the main tool for monetary policy when the Fed was initially created. Today, the Federal Reserve has even more tools at its disposal, including quantitative easing, overnight repurchase agreements, and interest on excess reserves. This illustrates how monetary policy has evolved and how it continues to do so.\n\nLink It Up\n\n\nWhile these topics are beyond the scope of an introductory textbook, if youre interested in learning more about the Federal Reserves newest policy tools, visit the Federal Reserve Bank of New York's page on large-scale asset purchases and the Federal Reserve Bank of St. Louis' FRED Blog post on fixing the textbook lag to learn more.\n\n\n\n", "15-4": "By the end of this section, you will be able to:\nContrast expansionary monetary policy and contractionary monetary policy\nExplain how monetary policy impacts interest rates and aggregate demand\nEvaluate Federal Reserve decisions over the last forty years\nExplain the significance of quantitative easing (QE)\n\nA monetary policy that lowers interest rates and stimulates borrowing is an expansionary monetary policy or loose monetary policy. Conversely, a monetary policy that raises interest rates and reduces borrowing in the economy is a contractionary monetary policy or tight monetary policy. This module will discuss how expansionary and contractionary monetary policies affect interest rates and aggregate demand, and how such policies will affect macroeconomic goals like unemployment and inflation. We will conclude with a look at the Feds monetary policy practice in recent decades.The Effect of Monetary Policy on Interest Rates\nConsider the market for loanable bank funds in Figure 15.7. The original equilibrium (E0) occurs at an 8% interest rate and a quantity of funds loaned and borrowed of $10 billion. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to S1, leading to an equilibrium (E1) with a lower 6% interest rate and a quantity $14 billion in loaned funds. Conversely, a contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S0) to S2, leading to an equilibrium (E2) with a higher 10% interest rate and a quantity of $8 billion in loaned funds.\n\n\n\nFigure \n15.7\n \nMonetary Policy and Interest Rates \n \nThe original equilibrium occurs at E0. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to the new supply curve (S1) and to a new equilibrium of E1, reducing the interest rate from 8% to 6%. A contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S0) to the new supply (S2), and raise the interest rate from 8% to 10%.\n\nHow does a central bank raise interest rates? When describing the central bank's monetary policy actions, it is common to hear that the central bank raised interest rates or lowered interest rates. We need to be clear about this: more precisely, through open market operations the central bank changes bank reserves in a way which affects the supply curve of loanable funds. As a result, Figure 15.7 shows that interest rates change. If they do not meet the Feds target, the Fed can supply more or less reserves until interest rates do.Recall that the specific interest rate the Fed targets is the federal funds rate. The Federal Reserve has, since 1995, established its target federal funds rate in advance of any open market operations.\nOf course, financial markets display a wide range of interest rates, representing borrowers with different risk premiums and loans that they must repay over different periods of time. In general, when the federal funds rate drops substantially, other interest rates drop, too, and when the federal funds rate rises, other interest rates rise. However, a fall or rise of one percentage point in the federal funds ratewhich remember is for borrowing overnightwill typically have an effect of less than one percentage point on a 30-year loan to purchase a house or a three-year loan to purchase a car. Monetary policy can push the entire spectrum of interest rates higher or lower, but the forces of supply and demand in those specific markets for lending and borrowing set the specific interest rates.\nThe Effect of Monetary Policy on Aggregate Demand\nMonetary policy affects interest rates and the available quantity of loanable funds, which in turn affects several components of aggregate demand. Tight or contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand. Business investment will decline because it is less attractive for firms to borrow money, and even firms that have money will notice that, with higher interest rates, it is relatively more attractive to put those funds in a financial investment than to make an investment in physical capital. In addition, higher interest rates will discourage consumer borrowing for big-ticket items like houses and cars. Conversely, loose or expansionary monetary policy that leads to lower interest rates and a higher quantity of loanable funds will tend to increase business investment and consumer borrowing for big-ticket items.\nIf the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP. Figure 15.8 (a) illustrates this situation. This example uses a short-run upward-sloping Keynesian aggregate supply curve (SRAS). The original equilibrium during a recession of E0 occurs at an output level of 600. An expansionary monetary policy will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve (AD0) to shift right to AD1, so that the new equilibrium (E1) occurs at the potential GDP level of 700.\n\n\n\nFigure \n15.8\n \nExpansionary or Contractionary Monetary Policy \n \n(a) The economy is originally in a recession with the equilibrium output and price shown at E0. Expansionary monetary policy will reduce interest rates and shift aggregate demand to the right from AD0 to AD1, leading to the new equilibrium (E1) at the potential GDP level of output with a relatively small rise in the price level. (b) The economy is originally producing above the potential GDP level of output at the equilibrium E0 and is experiencing pressures for an inflationary rise in the price level. Contractionary monetary policy will shift aggregate demand to the left from AD0 to AD1, thus leading to a new equilibrium (E1) at the potential GDP level of output.\n\nConversely, if an economy is producing at a quantity of output above its potential GDP, a contractionary monetary policy can reduce the inflationary pressures for a rising price level. In Figure 15.8 (b), the original equilibrium (E0) occurs at an output of 750, which is above potential GDP. A contractionary monetary policy will raise interest rates, discourage borrowing for investment and consumption spending, and cause the original demand curve (AD0) to shift left to AD1, so that the new equilibrium (E1) occurs at the potential GDP level of 700.These examples suggest that monetary policy should be countercyclical; that is, it should act to counterbalance the business cycles of economic downturns and upswings. The Fed should loosen monetary policy when a recession has caused unemployment to increase and tighten it when inflation threatens. Of course, countercyclical policy does pose a danger of overreaction. If loose monetary policy seeking to end a recession goes too far, it may push aggregate demand so far to the right that it triggers inflation. If tight monetary policy seeking to reduce inflation goes too far, it may push aggregate demand so far to the left that a recession begins. Figure 15.9 (a) summarizes the chain of effects that connect loose and tight monetary policy to changes in output and the price level.\n\n\n\nFigure \n15.9\n \nThe Pathways of Monetary Policy \n \n(a) In expansionary monetary policy the central bank causes the supply of money and loanable funds to increase, which lowers the interest rate, stimulating additional borrowing for investment and consumption, and shifting aggregate demand right. The result is a higher price level and, at least in the short run, higher real GDP. (b) In contractionary monetary policy, the central bank causes the supply of money and credit in the economy to decrease, which raises the interest rate, discouraging borrowing for investment and consumption, and shifting aggregate demand left. The result is a lower price level and, at least in the short run, lower real GDP.\n\n\nFederal Reserve Actions Over Last Four Decades\nFor the period from the mid-1970s up through the end of 2007, we can summarize Federal Reserve monetary policy by looking at how it targeted the federal funds interest rate using open market operations.Of course, telling the story of the U.S. economy since 1975 in terms of Federal Reserve actions leaves out many other macroeconomic factors that were influencing unemployment, recession, economic growth, and inflation over this time. The nine episodes of Federal Reserve action outlined in the sections below also demonstrate that we should consider the central bank as one of the leading actors influencing the macro economy. As we noted earlier, the single person with the greatest power to influence the U.S. economy is probably the Federal Reserve chairperson.Figure 15.10 shows how the Federal Reserve has carried out monetary policy by targeting the federal funds interest rate in the last few decades. The graph shows the federal funds interest rate (remember, this interest rate is set through open market operations), the unemployment rate, and the inflation rate since 1975. Different episodes of monetary policy during this period are indicated in the figure.\n\n\n\n\nFigure \n15.10\n \nMonetary Policy, Unemployment, and Inflation \n \nThrough the episodes here, the Federal Reserve typically reacted to higher inflation with a contractionary monetary policy and a higher interest rate, and reacted to higher unemployment with an expansionary monetary policy and a lower interest rate.\n\nEpisode 1\nConsider Episode 1 in the late 1970s. The rate of inflation was very high, exceeding 10% in 1979 and 1980, so the Federal Reserve used tight monetary policy to raise interest rates, with the federal funds rate rising from 5.5% in 1977 to 16.4% in 1981. By 1983, inflation was down to 3.2%, but aggregate demand contracted sharply enough that back-to-back recessions occurred in 1980 and in 19811982, and the unemployment rate rose from 5.8% in 1979 to 9.7% in 1982.\nEpisode 2\nIn Episode 2, when economists persuaded the Federal Reserve in the early 1980s that inflation was declining, the Fed began slashing interest rates to reduce unemployment. The federal funds interest rate fell from 16.4% in 1981 to 6.8% in 1986. By 1986 or so, inflation had fallen to about 2% and the unemployment rate had come down to 7%, and was still falling.Episode 3\nHowever, in Episode 3 in the late 1980s, inflation appeared to be creeping up again, rising from 2% in 1986 up toward 5% by 1989. In response, the Federal Reserve used contractionary monetary policy to raise the federal funds rates from 6.6% in 1987 to 9.2% in 1989. The tighter monetary policy stopped inflation, which fell from above 5% in 1990 to under 3% in 1992, but it also helped to cause the 1990-1991 recession, and the unemployment rate rose from 5.3% in 1989 to 7.5% by 1992.Episode 4\nIn Episode 4, in the early 1990s, when the Federal Reserve was confident that inflation was back under control, it reduced interest rates, with the federal funds interest rate falling from 8.1% in 1990 to 3.5% in 1992. As the economy expanded, the unemployment rate declined from 7.5% in 1992 to less than 5% by 1997.\nEpisodes 5 and 6\nIn Episodes 5 and 6, the Federal Reserve perceived a risk of inflation and raised the federal funds rate from 3% to 5.8% from 1993 to 1995. Inflation did not rise, and the period of economic growth during the 1990s continued. Then in 1999 and 2000, the Fed was concerned that inflation seemed to be creeping up so it raised the federal funds interest rate from 4.6% in December 1998 to 6.5% in June 2000. By early 2001, inflation was declining again, but a recession occurred in 2001. Between 2000 and 2002, the unemployment rate rose from 4.0% to 5.8%.\nEpisodes 7 and 8\nIn Episodes 7 and 8, the Federal Reserve conducted a loose monetary policy and slashed the federal funds rate from 6.2% in 2000 to just 1.7% in 2002, and then again to 1% in 2003. They actually did this because of fear of Japan-style deflation. This persuaded them to lower the Fed funds further than they otherwise would have. The recession ended, but, unemployment rates were slow to decline in the early 2000s. Finally, in 2004, the unemployment rate declined and the Federal Reserve began to raise the federal funds rate until it reached 5% by 2007.Episode 9\nIn Episode 9, as the Great Recession took hold in 2008, the Federal Reserve was quick to slash interest rates, taking them down to 2% in 2008 and to nearly 0% in 2009. When the Fed had taken interest rates down to near-zero by December 2008, the economy was still deep in recession. Open market operations could not make the interest rate turn negative. The Federal Reserve had to think outside the box.\n\nQuantitative Easing\nThe most powerful and commonly used of the three traditional tools of monetary policyopen market operationsworks by expanding or contracting the money supply in a way that influences the interest rate. In late 2008, as the U.S. economy struggled with recession, the Federal Reserve had already reduced the interest rate to near-zero. With the recession still ongoing, the Fed decided to adopt an innovative and nontraditional policy known as quantitative easing (QE). This is the purchase of long-term government and private mortgage-backed securities by central banks to make credit available so as to stimulate aggregate demand.\nQuantitative easing differed from traditional monetary policy in several key ways. First, it involved the Fed purchasing long term Treasury bonds, rather than short term Treasury bills. In 2008, however, it was impossible to stimulate the economy any further by lowering short term rates because they were already as low as they could get. (Read the closing Bring it Home feature for more on this.) Therefore, Chairman Bernanke sought to lower long-term rates utilizing quantitative easing.\nThis leads to a second way QE is different from traditional monetary policy. Instead of purchasing Treasury securities, the Fed also began purchasing private mortgage-backed securities, something it had never done before. During the financial crisis, which precipitated the recession, mortgage-backed securities were termed toxic assets, because when the housing market collapsed, no one knew what these securities were worth, which put the financial institutions which were holding those securities on very shaky ground. By offering to purchase mortgage-backed securities, the Fed was both pushing long term interest rates down and also removing possibly toxic assets from the balance sheets of private financial firms, which would strengthen the financial system.\nQuantitative easing (QE) occurred in three episodes:\n      During QE1, which began in November 2008, the Fed purchased $600 billion in mortgage-backed securities from government enterprises Fannie Mae and Freddie Mac.\nIn November 2010, the Fed began QE2, in which it purchased $600 billion in U.S. Treasury bonds.\nQE3, began in September 2012 when the Fed commenced purchasing $40 billion of additional mortgage-backed securities per month. This amount was increased in December 2012 to $85 billion per month. The Fed stated that, when economic conditions permit, it will begin tapering (or reducing the monthly purchases). By October 2014, the Fed had announced the final $15 billion bond purchase, ending Quantitative Easing. \n\nWe usually think of the quantitative easing policies that the Federal Reserve adopted (as did other central banks around the world) as temporary emergency measures. If these steps are to be temporary, then the Federal Reserve will need to stop making these additional loans and sell off the financial securities it has accumulated. The concern is that the process of quantitative easing may prove more difficult to reverse than it was to enact. The evidence suggests that QE1 was somewhat successful, but that QE2 and QE3 have been less so.\n", "15-5": "By the end of this section, you will be able to:\nAnalyze whether monetary policy decisions should be made more democratically\nCalculate the velocity of money\nEvaluate the central banks influence on inflation, unemployment, asset bubbles, and leverage cycles\nCalculate the effects of monetary stimulus\n\nIn the real world, effective monetary policy faces a number of significant hurdles. Monetary policy affects the economy only after a time lag that is typically long and of variable length. Remember, monetary policy involves a chain of events: the central bank must perceive a situation in the economy, hold a meeting, and make a decision to react by tightening or loosening monetary policy. The change in monetary policy must percolate through the banking system, changing the quantity of loans and affecting interest rates. When interest rates change, businesses must change their investment levels and consumers must change their borrowing patterns when purchasing homes or cars. Then it takes time for these changes to filter through the rest of the economy.\nAs a result of this chain of events, monetary policy has little effect in the immediate future. Instead, its primary effects are felt perhaps one to three years in the future. The reality of long and variable time lags does not mean that a central bank should refuse to make decisions. It does mean that central banks should be humble about taking action, because of the risk that their actions can create as much or more economic instability as they resolve.Excess Reserves\nBanks are legally required to hold a minimum level of reserves, but no rule prohibits them from holding additional excess reserves above the legally mandated limit. For example, during a recession banks may be hesitant to lend, because they fear that when the economy is contracting, a high proportion of loan applicants become less likely to repay their loans.\nWhen many banks are choosing to hold excess reserves, expansionary monetary policy may not work well. This may occur because the banks are concerned about a deteriorating economy, while the central bank is trying to expand the money supply. If the banks prefer to hold excess reserves above the legally required level, the central bank cannot force individual banks to make loans. Similarly, sensible businesses and consumers may be reluctant to borrow substantial amounts of money in a recession, because they recognize that firms sales and employees jobs are more insecure in a recession, and they do not want to face the need to make interest payments. The result is that during an especially deep recession, an expansionary monetary policy may have little effect on either the price level or the real GDP.\nJapan experienced this situation in the 1990s and early 2000s. Japans economy entered a period of very slow growth, dipping in and out of recession, in the early 1990s. By February 1999, the Bank of Japan had lowered the equivalent of its federal funds rate to 0%. It kept it there most of the time through 2003. Moreover, in the two years from March 2001 to March 2003, the Bank of Japan also expanded the country's money supply by about 50%an enormous increase. Even this highly expansionary monetary policy, however, had no substantial effect on stimulating aggregate demand. Japans economy continued to experience extremely slow growth into the mid-2000s.\nClear It Up\n\n\nShould monetary policy decisions be made more democratically?\n\nShould a nations Congress or legislature comprised of elected representatives conduct monetary policy or should a politically appointed central bank that is more independent of voters take charge? Here are some of the arguments.The Case for Greater Democratic Control of Monetary Policy\nElected representatives pass taxes and spending bills to conduct fiscal policy by passing tax and spending bills. They could handle monetary policy in the same way. They will sometimes make mistakes, but in a democracy, it is better to have elected officials who are accountable to voters make mistakes instead of political appointees. After all, the people appointed to the top governing positions at the Federal Reserveand to most central banks around the worldare typically bankers and economists. They are not representatives of borrowers like small businesses or farmers nor are they representatives of labor unions. Central banks might not be so quick to raise interest rates if they had to pay more attention to firms and people in the real economy.The Case for an Independent Central Bank \nBecause the central bank has some insulation from day-to-day politics, its members can take a nonpartisan look at specific economic situations and make tough, immediate decisions when necessary. The idea of giving a legislature the ability to create money and hand out loans is likely to end up badly, sooner or later. It is simply too tempting for lawmakers to expand the money supply to fund their projects. The long term result will be rampant inflation. Also, a central bank, acting according to the laws passed by elected officials, can respond far more quickly than a legislature. For example, the U.S. budget takes months to debate, pass, and sign into law, but monetary policy decisions happen much more rapidly. Day-to-day democratic control of monetary policy is impractical and seems likely to lead to an overly expansionary monetary policy and higher inflation.\nThe problem of excess reserves does not affect contractionary policy. Central bankers have an old saying that monetary policy can be like pulling and pushing on a string: when the central bank pulls on the string and uses contractionary monetary policy, it can definitely raise interest rates and reduce aggregate demand. However, when the central bank tries to push on the string of expansionary monetary policy, the string may sometimes just fold up limp and have little effect, because banks decide not to loan out their excess reserves. Do not take this analogy too literallyexpansionary monetary policy usually does have real effects, after that inconveniently long and variable lag. There are also times, like Japans economy in the late 1990s and early 2000s, when expansionary monetary policy has been insufficient to lift a recession-prone economy.\nUnpredictable Movements of VelocityVelocity is a term that economists use to describe how quickly money circulates through the economy. We define the velocity of money in a year as:\nVelocity=nominalGDPmoneysupplyVelocity=nominalGDPmoneysupply\nSpecific measurements of velocity depend on the definition of the money supply used. Consider the velocity of M1, the total amount of currency in circulation and checking account balances. In 2009, for example, M1 was $1.7 trillion and nominal GDP was $14.3 trillion, so the velocity of M1 was 8.4 (which is $14.3 trillion/$1.7 trillion). A higher velocity of money means that the average dollar circulates more times in a year. A lower velocity means that the average dollar circulates fewer times in a year.See the following Clear It Up feature for a discussion of how deflation could affect monetary policy.\nClear It Up\n\n\nWhat happens during episodes of deflation?\n\nDeflation occurs when the rate of inflation is negative; that is, instead of money having less purchasing power over time, as occurs with inflation, money is worth more. Deflation can make it very difficult for monetary policy to address a recession.\nRemember that the real interest rate is the nominal interest rate minus the rate of inflation. If the nominal interest rate is 7% and the rate of inflation is 3%, then the borrower is effectively paying a 4% real interest rate. If the nominal interest rate is 7% and there is deflation of 2%, then the real interest rate is actually 9%. In this way, an unexpected deflation raises the real interest payments for borrowers. It can lead to a situation where borrowers do not repay an unexpectedly high number of loans, and banks find that their net worth is decreasing or negative. When banks are suffering losses, they become less able and eager to make new loans. Aggregate demand declines, which can lead to recession.Then the double-whammy: After causing a recession, deflation can make it difficult for monetary policy to work. Say that the central bank uses expansionary monetary policy to reduce the nominal interest rate all the way to zerobut the economy has 5% deflation. As a result, the real interest rate is 5%, and because a central bank cannot make the nominal interest rate negative, expansionary policy cannot reduce the real interest rate further.\nIn the U.S. economy during the early 1930s, deflation was 6.7% per year from 19301933, which caused many borrowers to default on their loans and many banks to end up bankrupt, which in turn contributed substantially to the Great Depression. Not all episodes of deflation, however, end in economic depression. Japan, for example, experienced deflation of slightly less than 1% per year from 19992002, which hurt the Japanese economy, but it still grew by about 0.9% per year over this period. There is at least one historical example of deflation coexisting with rapid growth. The U.S. economy experienced deflation of about 1.1% per year over the quarter-century from 18761900, but real GDP also expanded at a rapid clip of 4% per year over this time, despite some occasional severe recessions.The central bank should be on guard against deflation and, if necessary, use expansionary monetary policy to prevent any long-lasting or extreme deflation from occurring. Except in severe cases like the Great Depression, deflation does not guarantee economic disaster.\n\nChanges in velocity can cause problems for monetary policy. To understand why, rewrite the definition of velocity so that the money supply is on the left-hand side of the equation. That is:\nMoneysupplyvelocity=NominalGDPMoneysupplyvelocity=NominalGDP\nRecall from The Macroeconomic Perspective thatNominal GDP = Price Level (or GDP Deflator)  Real GDP.Nominal GDP = Price Level (or GDP Deflator)  Real GDP.Therefore,\nMoney Supply  velocity = Nominal GDP = Price Level  Real GDP.Money Supply  velocity = Nominal GDP = Price Level  Real GDP.We sometimes call this equation the basic quantity equation of money but, as you can see, it is just the definition of velocity written in a different form. This equation must hold true, by definition.If velocity is constant over time, then a certain percentage rise in the money supply on the left-hand side of the basic quantity equation of money will inevitably lead to the same percentage rise in nominal GDPalthough this change could happen through an increase in inflation, or an increase in real GDP, or some combination of the two. If velocity is changing over time but in a constant and predictable way, then changes in the money supply will continue to have a predictable effect on nominal GDP. If velocity changes unpredictably over time, however, then the effect of changes in the money supply on nominal GDP becomes unpredictable.\nFigure 15.11 illustrates the actual velocity of money in the U.S. economy as measured by using M1, the most common definition of the money supply. From 1960 up to about 1980, velocity appears fairly predictable; that is, it is increasing at a fairly constant rate. In the early 1980s, however, velocity as calculated with M1 becomes more variable. The reasons for these sharp changes in velocity remain a puzzle. Economists suspect that the changes in velocity are related to innovations in banking and finance which have changed how we are using money in making economic transactions: for example, the growth of electronic payments; a rise in personal borrowing and credit card usage; and accounts that make it easier for people to hold money in savings accounts, where it is counted as M2, right up to the moment that they want to write a check on the money and transfer it to M1. So far at least, it has proven difficult to draw clear links between these kinds of factors and the specific up-and-down fluctuations in M1. Given many changes in banking and the prevalence of electronic banking, economists now favor M2 as a measure of money rather than the narrower M1.\n\n\n\nFigure \n15.11\n \nVelocity Calculated Using M1 \n \nVelocity is the nominal GDP divided by the money supply for a given year. We can calculate different measures of velocity by using different measures of the money supply. Velocity, as calculated by using M1, has lacked a steady trend since the 1980s, instead bouncing up and down. (credit: Federal Reserve Bank of St. Louis)\n\n\nClick to view content\n\nVelocity Calculated Using M1\nIn the 1970s, when velocity as measured by M1 seemed predictable, a number of economists, led by Nobel laureate Milton Friedman (19122006), argued that the best monetary policy was for the central bank to increase the money supply at a constant growth rate. These economists argued that with the long and variable lags of monetary policy, and the political pressures on central bankers, central bank monetary policies were as likely to have undesirable as to have desirable effects. Thus, these economists believed that the monetary policy should seek steady growth in the money supply of 3% per year. They argued that a steady monetary growth rate would be correct over longer time periods, since it would roughly match the growth of the real economy. In addition, they argued that giving the central bank less discretion to conduct monetary policy would prevent an overly activist central bank from becoming a source of economic instability and uncertainty. In this spirit, Friedman wrote in 1967: The first and most important lesson that history teaches about what monetary policy can doand it is a lesson of the most profound importanceis that monetary policy can prevent money itself from being a major source of economic disturbance.As the velocity of M1 began to fluctuate in the 1980s, having the money supply grow at a predetermined and unchanging rate seemed less desirable, because as the quantity theory of money shows, the combination of constant growth in the money supply and fluctuating velocity would cause nominal GDP to rise and fall in unpredictable ways. The jumpiness of velocity in the 1980s caused many central banks to focus less on the rate at which the quantity of money in the economy was increasing, and instead to set monetary policy by reacting to whether the economy was experiencing or in danger of higher inflation or unemployment.\nUnemployment and Inflation\nIf you were to survey central bankers around the world and ask them what they believe should be the primary task of monetary policy, the most popular answer by far would be fighting inflation. Most central bankers believe that the neoclassical model of economics accurately represents the economy over the medium to long term. Remember that in the neoclassical model of the economy, we draw the aggregate supply curve as a vertical line at the level of potential GDP, as Figure 15.12 shows. In the neoclassical model, economists determine the level of potential GDP (and the natural rate of unemployment that exists when the economy is producing at potential GDP) by real economic factors. If the original level of aggregate demand is AD0, then an expansionary monetary policy that shifts aggregate demand to AD1 only creates an inflationary increase in the price level, but it does not alter GDP or unemployment. From this perspective, all that monetary policy can do is to lead to low inflation or high inflationand low inflation provides a better climate for a healthy and growing economy. After all, low inflation means that businesses making investments can focus on real economic issues, not on figuring out ways to protect themselves from the costs and risks of inflation. In this way, a consistent pattern of low inflation can contribute to long-term growth.\n\n\n\nFigure \n15.12\n \nMonetary Policy in a Neoclassical Model \n \nIn a neoclassical view, monetary policy affects only the price level, not the level of output in the economy. For example, an expansionary monetary policy causes aggregate demand to shift from the original AD0 to AD1. However, the adjustment of the economy from the original equilibrium (E0) to the new equilibrium (E1) represents an inflationary increase in the price level from P0 to P1, but has no effect in the long run on output or the unemployment rate. In fact, no shift in AD will affect the equilibrium quantity of output in this model.\n\nThis vision of focusing monetary policy on a low rate of inflation is so attractive that many countries have rewritten their central banking laws since in the 1990s to have their bank practice inflation targeting, which means that the central bank is legally required to focus primarily on keeping inflation low. By 2014, central banks in 28 countries, including Austria, Brazil, Canada, Israel, Korea, Mexico, New Zealand, Spain, Sweden, Thailand, and the United Kingdom faced a legal requirement to target the inflation rate. A notable exception is the Federal Reserve in the United States, which does not practice inflation-targeting. Instead, the law governing the Federal Reserve requires it to take both unemployment and inflation into account.Economists have no final consensus on whether a central bank should be required to focus only on inflation or should have greater discretion. For those who subscribe to the inflation targeting philosophy, the fear is that politicians who are worried about slow economic growth and unemployment will constantly pressure the central bank to conduct a loose monetary policyeven if the economy is already producing at potential GDP. In some countries, the central bank may lack the political power to resist such pressures, with the result of higher inflation, but no long-term reduction in unemployment. The U.S. Federal Reserve has a tradition of independence, but central banks in other countries may be under greater political pressure. For all of these reasonslong and variable lags, excess reserves, unstable velocity, and controversy over economic goalsmonetary policy in the real world is often difficult. The basic message remains, however, that central banks can affect aggregate demand through the conduct of monetary policy and in that way influence macroeconomic outcomes.\n\nAsset Bubbles and Leverage Cycles\nOne long-standing concern about having the central bank focus on inflation and unemployment is that it may be overlooking certain other economic problems that are coming in the future. For example, from 1994 to 2000 during what was known as the dot-com boom, the U.S. stock market, which the Dow Jones Industrial Index measures (which includes 30 very large companies from across the U.S. economy), nearly tripled in value. The Nasdaq index, which includes many smaller technology companies, increased in value by a multiple of five from 1994 to 2000. These rates of increase were clearly not sustainable. Stock values as measured by the Dow Jones were almost 20% lower in 2009 than they had been in 2000. Stock values in the Nasdaq index were 50% lower in 2009 than they had been in 2000. The drop-off in stock market values contributed to the 2001 recession and the higher unemployment that followed.We can tell a similar story about housing prices in the mid-2000s. During the 1970s, 1980s, and 1990s, housing prices increased at about 6% per year on average. During what came to be known as the housing bubble from 2003 to 2005, housing prices increased at almost double this annual rate. These rates of increase were clearly not sustainable. When housing prices fell in 2007 and 2008, many banks and households found that their assets were worth less than they expected, which contributed to the recession that started in 2007.At a broader level, some economists worry about a leverage cycle, where leverage is a term financial economists use to mean borrowing. When economic times are good, banks and the financial sector are eager to lend, and people and firms are eager to borrow. Remember that a money multiplier determines the amount of money and credit in an economy a process of loans made, money deposited, and more loans made. In good economic times, this surge of lending exaggerates the episode of economic growth. It can even be part of what lead prices of certain assetslike stock prices or housing pricesto rise at unsustainably high annual rates. At some point, when economic times turn bad, banks and the financial sector become much less willing to lend, and credit becomes expensive or unavailable to many potential borrowers. The sharp reduction in credit, perhaps combined with the deflating prices of a dot-com stock price bubble or a housing bubble, makes the economic downturn worse than it would otherwise be.Thus, some economists have suggested that the central bank should not just look at economic growth, inflation, and unemployment rates, but should also keep an eye on asset prices and leverage cycles. Such proposals are quite controversial. If a central bank had announced in 1997 that stock prices were rising too fast or in 2004 that housing prices were rising too fast, and then taken action to hold down price increases, many people and their elected political representatives would have been outraged. Neither the Federal Reserve nor any other central banks want to take the responsibility of deciding when stock prices and housing prices are too high, too low, or just right. As further research explores how asset price bubbles and leverage cycles can affect an economy, central banks may need to think about whether they should conduct monetary policy in a way that would seek to moderate these effects.\nLets end this chapter with a Work it Out exercise in how the Fedor any central bankwould stir up the economy by increasing the money supply.\n\nWork It Out\n\n\nCalculating the Effects of Monetary Stimulus\n\nSuppose that the central bank wants to stimulate the economy by increasing the money supply. The bankers estimate that the velocity of money is 3, and that the price level will increase from 100 to 110 due to the stimulus. Using the quantity equation of money, what will be the impact of an $800 billion dollar increase in the money supply on the quantity of goods and services in the economy given an initial money supply of $4 trillion?\nStep 1. We begin by writing the quantity equation of money: MV = PQ. We know that initially V = 3, M = 4,000 (billion) and P = 100. Substituting these numbers in, we can solve for Q:\nMV=PQ4,0003=100QQ=120MV=PQ4,0003=100QQ=120\nStep 2. Now we want to find the effect of the addition $800 billion in the money supply, together with the increase in the price level. The new equation is:\nMV=PQ4,8003=110QQ=130.9MV=PQ4,8003=110QQ=130.9\nStep 3. If we take the difference between the two quantities, we find that the monetary stimulus increased the quantity of goods and services in the economy by 10.9 billion.\n\nThe discussion in this chapter has focused on domestic monetary policy; that is, the view of monetary policy within an economy. Exchange Rates and International Capital Flows explores the international dimension of monetary policy, and how monetary policy becomes involved with exchange rates and international flows of financial capital.\nBring It Home\n\n\nThe Problem of the Zero Percent Interest Rate Lower Bound\n\nIn 2008, the U.S. Federal Reserve found itself in a difficult position. The federal funds rate was on its way to near zero, which meant that traditional open market operations, by which the Fed purchases U.S. Treasury Bills to lower short term interest rates, was no longer viable. This so called zero bound problem, prompted the Fed, under then Chair Ben Bernanke, to attempt some unconventional policies, collectively called quantitative easing. By early 2014, quantitative easing nearly quintupled the amount of bank reserves. This likely contributed to the U.S. economys recovery, but the impact was muted, probably due to some of the hurdles mentioned in the last section of this module.  The unprecedented increase in bank reserves also led to fears of inflation.  As of early 2015, however, there have been no serious signs of a boom, with core inflation around a stable 1.7%.\n\n", "16-1": "By the end of this section, you will be able to:\nDefine \"foreign exchange market\"\nDescribe different types of investments like foreign direct investments (FDI), portfolio investments, and hedging\nExplain how appreciating or depreciating currency affects exchange rates\nIdentify who benefits from a stronger currency and benefits from a weaker currency\n\nMost countries have different currencies, but not all. Sometimes small economies use an economically larger neighbor's currency. For example, Ecuador, El Salvador, and Panama have decided to dollarizethat is, to use the U.S. dollar as their currency. Sometimes nations share a common currency. A large-scale example of a common currency is the decision by 17 European nationsincluding some very large economies such as France, Germany, and Italyto replace their former currencies with the euro. With these exceptions, most of the international economy takes place in a situation of multiple national currencies in which both people and firms need to convert from one currency to another when selling, buying, hiring, borrowing, traveling, or investing across national borders. We call the market in which people or firms use one currency to purchase another currency the foreign exchange market.You have encountered the basic concept of exchange rates in earlier chapters. In The International Trade and Capital Flows, for example, we discussed how economists use exchange rates to compare GDP statistics from countries where they measure GDP in different currencies. These earlier examples, however, took the actual exchange rate as given, as if it were a fact of nature. In reality, the exchange rate is a pricethe price of one currency expressed in terms of units of another currency. The key framework for analyzing prices, whether in this course, any other economics course, in public policy, or business examples, is the operation of supply and demand in markets.\nLink It Up\n\n\nVisit this website for an exchange rate calculator.\n\nThe Extraordinary Size of the Foreign Exchange Markets\nThe quantities traded in foreign exchange markets are breathtaking. A 2013 Bank of International Settlements survey found that $5.3 trillion per day was traded on foreign exchange markets, which makes the foreign exchange market the largest market in the world economy. In contrast, 2013 U.S. real GDP was $15.8 trillion per year.Table 16.1 shows the currencies most commonly traded on foreign exchange markets. The U.S. dollar dominates the foreign exchange market, followed by the euro, the British pound, the Australian dollar, and the Japanese yen.\n\nCurrency\n% Daily Share\n\n\n\nU.S. dollar\n87.6%\n\n\nEuro\n31.3%\n\n\nJapanese yen\n21.6%\n\n\nBritish pound\n12.8%\n\n\nAustralian dollar\n6.9%\n\n\nCanadian dollar\n5.1%\n\n\nSwiss franc\n4.8%\n\n\nChinese yuan\n2.6%\n\n\nTable \n16.1\n \nCurrencies Traded Most on Foreign Exchange Markets as of April, 2016\n \n(Source: http://www.bis.org/publ/rpfx16fx.pdf)\n\n\nDemanders and Suppliers of Currency in Foreign Exchange Markets\nIn foreign exchange markets, demand and supply become closely interrelated, because a person or firm who demands one currency must at the same time supply another currencyand vice versa. To get a sense of this, it is useful to consider four groups of people or firms who participate in the market: (1) firms that are involved in international trade of goods and services; (2) tourists visiting other countries; (3) international investors buying ownership (or part-ownership) of a foreign firm; (4) international investors making financial investments that do not involve ownership. Lets consider these categories in turn.\nFirms that buy and sell on international markets find that their costs for workers, suppliers, and investors are measured in the currency of the nation where their production occurs, but their revenues from sales are measured in the currency of the different nation where their sales happened. Thus, a Chinese firm exporting abroad will earn some other currencysay, U.S. dollarsbut will need Chinese yuan to pay the workers, suppliers, and investors who are based in China. In the foreign exchange markets, this firm will be a supplier of U.S. dollars and a demander of Chinese yuan.International tourists will supply their home currency to receive the currency of the country they are visiting. For example, an American tourist who is visiting China will supply U.S. dollars into the foreign exchange market and demand Chinese yuan.\nWe often divide financial investments that cross international boundaries, and require exchanging currency into two categories. Foreign direct investment (FDI) refers to purchasing a firm (at least ten percent) in another country or starting up a new enterprise in a foreign country For example, in 2008 the Belgian beer-brewing company InBev bought the U.S. beer-maker Anheuser-Busch for $52 billion. To make this purchase, InBev would have to supply euros (the currency of Belgium) to the foreign exchange market and demand U.S. dollars.The other kind of international financial investment, portfolio investment, involves a purely financial investment that does not entail any management responsibility. An example would be a U.S. financial investor who purchased U.K. government bonds, or deposited money in a British bank. To make such investments, the American investor would supply U.S. dollars in the foreign exchange market and demand British pounds.Business people often link portfolio investment to expectations about how exchange rates will shift. Look at a U.S. financial investor who is considering purchasing U.K. issued bonds. For simplicity, ignore any bond interest payment (which will be small in the short run anyway) and focus on exchange rates. Say that a British pound is currently worth $1.50 in U.S. currency. However, the investor believes that in a month, the British pound will be worth $1.60 in U.S. currency. Thus, as Figure 16.2 (a) shows, this investor would change $24,000 for 16,000 British pounds. In a month, if the pound is worth $1.60, then the portfolio investor can trade back to U.S. dollars at the new exchange rate, and have $25,600a nice profit. A portfolio investor who believes that the foreign exchange rate for the pound will work in the opposite direction can also invest accordingly. Say that an investor expects that the pound, now worth $1.50 in U.S. currency, will decline to $1.40. Then, as Figure 16.2 (b) shows, that investor could start off with 20,000 in British currency (borrowing the money if necessary), convert it to $30,000 in U.S. currency, wait a month, and then convert back to approximately 21,429 in British currencyagain making a nice profit. Of course, this kind of investing comes without guarantees, and an investor will suffer losses if the exchange rates do not move as predicted.\n\n\n\nFigure \n16.2\n \nA Portfolio Investor Trying to Benefit from Exchange Rate Movements \n \nExpectations of a currency's future value can drive its demand and supply in foreign exchange markets.\n\nMany portfolio investment decisions are not as simple as betting that the currency's value will change in one direction or the other. Instead, they involve firms trying to protect themselves from movements in exchange rates. Imagine you are running a U.S. firm that is exporting to France. You have signed a contract to deliver certain products and will receive 1 million euros a year from now. However, you do not know how much this contract will be worth in U.S. dollars, because the dollar/euro exchange rate can fluctuate in the next year. Lets say you want to know for sure what the contract will be worth, and not take a risk that the euro will be worth less in U.S. dollars than it currently is. You can hedge, which means using a financial transaction to protect yourself against a risk from one of your investments (in this case, currency risk from the contract). Specifically, you can sign a financial contract and pay a fee that guarantees you a certain exchange rate one year from nowregardless of what the market exchange rate is at that time. Now, it is possible that the euro will be worth more in dollars a year from now, so your hedging contract will be unnecessary, and you will have paid a fee for nothing. However, if the value of the euro in dollars declines, then you are protected by the hedge. When parties wish to enter financial contracts like hedging, they normally rely on a financial institution or brokerage company to handle the hedging. These companies either take a fee or create a spread in the exchange rate in order to earn money through the service they provide. Both foreign direct investment and portfolio investment involve an investor who supplies domestic currency and demands a foreign currency. With portfolio investment, the client purchases less than ten percent of a company. As such, business players often get involved with portfolio investment with a short term focus. With foreign direct investment the investor purchases more than ten percent of a company and the investor typically assumes some managerial responsibility. Thus, foreign direct investment tends to have a more long-run focus. As a practical matter, an investor can withdraw portfolio investments from a country much more quickly than foreign direct investments. A U.S. portfolio investor who wants to buy or sell U.K. government bonds can do so with a phone call or a few computer keyboard clicks. However, a U.S. firm that wants to buy or sell a company, such as one that manufactures automobile parts in the United Kingdom, will find that planning and carrying out the transaction takes a few weeks, even months. Table 16.2 summarizes the main categories of currency demanders and suppliers.\n\nDemand for the U.S. Dollar Comes from\nSupply of the U.S. Dollar Comes from\n\n\n\nA U.S. exporting firm that earned foreign currency and is trying to pay U.S.-based expenses\nA foreign firm that has sold imported goods in the United States, earned U.S. dollars, and is trying to pay expenses incurred in its home country\n\n\nForeign tourists visiting the United States\nU.S. tourists leaving to visit other countries\n\n\nForeign investors who wish to make direct investments in the U.S. economy\nU.S. investors who want to make foreign direct investments in other countries\n\n\nForeign investors who wish to make portfolio investments in the U.S. economy\nU.S. investors who want to make portfolio investments in other countries\n\n\nTable \n16.2\n \nThe Demand and Supply Line-ups in Foreign Exchange Markets\n \n\n\n\nParticipants in the Exchange Rate Market\nThe foreign exchange market does not involve the ultimate suppliers and demanders of foreign exchange literally seeking each other. If Martina decides to leave her home in Venezuela and take a trip in the United States, she does not need to find a U.S. citizen who is planning to take a vacation in Venezuela and arrange a person-to-person currency trade. Instead, the foreign exchange market works through financial institutions, and it operates on several levels.Most people and firms who are exchanging a substantial quantity of currency go to a bank, and most banks provide foreign exchange as a service to customers. These banks (and a few other firms), known as dealers, then trade the foreign exchange. This is called the interbank market.\nIn the world economy, roughly 2,000 firms are foreign exchange dealers. The U.S. economy has less than 100 foreign exchange dealers, but the largest 12 or so dealers carry out more than half the total transactions. The foreign exchange market has no central location, but the major dealers keep a close watch on each other at all times.\nThe foreign exchange market is huge not because of the demands of tourists, firms, or even foreign direct investment, but instead because of portfolio investment and the actions of interlocking foreign exchange dealers. International tourism is a very large industry, involving about $1 trillion per year. Global exports are about 23% of global GDP; which is about $18 trillion per year. Foreign direct investment totaled about $1.5 trillion in the end of 2013. These quantities are dwarfed, however, by the $5.3 trillion per day traded in foreign exchange markets. Most transactions in the foreign exchange market are for portfolio investmentrelatively short-term movements of financial capital between currenciesand because of the large foreign exchange dealers' actions as they constantly buy and sell with each other.\nStrengthening and Weakening Currency\nWhen the prices of most goods and services change, the price \"rises or \"falls\". For exchange rates, the terminology is different. When the exchange rate for a currency rises, so that the currency exchanges for more of other currencies, we refer to it as appreciating or strengthening. When the exchange rate for a currency falls, so that a currency trades for less of other currencies, we refer to it as depreciating or weakening.To illustrate the use of these terms, consider the exchange rate between the U.S. dollar and the Canadian dollar since 1980, in Figure 16.3 (a). The vertical axis in Figure 16.3 (a) shows the price of $1 in U.S. currency, measured in terms of Canadian currency. Clearly, exchange rates can move up and down substantially. A U.S. dollar traded for $1.17 Canadian in 1980. The U.S. dollar appreciated or strengthened to $1.39 Canadian in 1986, depreciated or weakened to $1.15 Canadian in 1991, and then appreciated or strengthened to $1.60 Canadian by early in 2002, fell to roughly $1.20 Canadian in 2009, and then had a sharp spike up and decline in 2009 and 2010. In May of 2017, the U.S. dollar stood at $1.36 Canadian. The units in which we measure exchange rates can be confusing, because we measure the exchange rate of the U.S. dollar exchange using a different currencythe Canadian dollar. However, exchange rates always measure the price of one unit of currency by using a different currency.\n\n\n\nFigure \n16.3\n \nStrengthen or Appreciate vs. Weaken or Depreciate \n \nExchange rates tend to fluctuate substantially, even between bordering companies such as the United States and Canada.  By looking closely at the time values (the years vary slightly on these graphs), it is clear that the values in part (a) are a mirror image of part (b), which demonstrates that the depreciation of one currency correlates to the appreciation of the other and vice versa.  This means that when comparing the exchange rates between two countries (in this case, the United States and Canada), the depreciation (or weakening) of one country (the U.S. dollar for this example) indicates the appreciation (or strengthening) of the other currency (which in this example is the Canadian dollar). (Source: Federal Reserve Economic Data (FRED) https://research.stlouisfed.org/fred2/series/EXCAUS)\n\nIn looking at the exchange rate between two currencies, the appreciation or strengthening of one currency must mean the depreciation or weakening of the other. Figure 16.3 (b) shows the exchange rate for the Canadian dollar, measured in terms of U.S. dollars. The exchange rate of the U.S. dollar measured in Canadian dollars, in Figure 16.3 (a), is a perfect mirror image with the Canadian dollar exchange rate measured in U.S. dollars, in Figure 16.3 (b). A fall in the Canada $/U.S. $ ratio means a rise in the U.S. $/Canada $ ratio, and vice versa.\nClick to view content\n\nCanadian Dollars per 1 U.S. Dollar.\nWith the price of a typical good or service, it is clear that higher prices benefit sellers and hurt buyers, while lower prices benefit buyers and hurt sellers. In the case of exchange rates, where the buyers and sellers are not always intuitively obvious, it is useful to trace how a stronger or weaker currency will affect different market participants. Consider, for example, the impact of a stronger U.S. dollar on six different groups of economic actors, as Figure 16.4 shows: (1) U.S. exporters selling abroad; (2) foreign exporters (that is, firms selling imports in the U.S. economy); (3) U.S. tourists abroad; (4) foreign tourists visiting the United States; (5) U.S. investors (either foreign direct investment or portfolio investment) considering opportunities in other countries; (6) and foreign investors considering opportunities in the U.S. economy.\n\n\n\nFigure \n16.4\n \nHow Do Exchange Rate Movements Affect Each Group? \n \nExchange rate movements affect exporters, tourists, and international investors in different ways.\n\nFor a U.S. firm selling abroad, a stronger U.S. dollar is a curse. A strong U.S. dollar means that foreign currencies are correspondingly weak. When this exporting firm earns foreign currencies through its export sales, and then converts them back to U.S. dollars to pay workers, suppliers, and investors, the stronger dollar means that the foreign currency buys fewer U.S. dollars than if the currency had not strengthened, and that the firms profits (as measured in dollars) fall. As a result, the firm may choose to reduce its exports, or it may raise its selling price, which will also tend to reduce its exports. In this way, a stronger currency reduces a countrys exports.\nConversely, for a foreign firm selling in the U.S. economy, a stronger dollar is a blessing. Each dollar earned through export sales, when traded back into the exporting firm's home currency, will now buy more home currency than expected before the dollar had strengthened. As a result, the stronger dollar means that the importing firm will earn higher profits than expected. The firm will seek to expand its sales in the U.S. economy, or it may reduce prices, which will also lead to expanded sales. In this way, a stronger U.S. dollar means that consumers will purchase more from foreign producers, expanding the countrys level of imports.For a U.S. tourist abroad, who is exchanging U.S. dollars for foreign currency as necessary, a stronger U.S. dollar is a benefit. The tourist receives more foreign currency for each U.S. dollar, and consequently the cost of the trip in U.S. dollars is lower. When a countrys currency is strong, it is a good time for citizens of that country to tour abroad. Imagine a U.S. tourist who has saved up $5,000 for a trip to South Africa. In 2010, $1 bought 7.3 South African rand, so the tourist had 36,500 rand to spend. In 2012, $1 bought 8.2 rand, so the tourist had 41,000 rand to spend. By 2015, $1 bought nearly 13 rand. Clearly, more recent years have been better for U.S. tourists to visit South Africa. For foreign visitors to the United States, the opposite pattern holds true. A relatively stronger U.S. dollar means that their own currencies are relatively weaker, so that as they shift from their own currency to U.S. dollars, they have fewer U.S. dollars than previously. When a countrys currency is strong, it is not an especially good time for foreign tourists to visit.A stronger dollar injures the prospects of a U.S. financial investor who has already invested money in another country. A U.S. financial investor abroad must first convert U.S. dollars to a foreign currency, invest in a foreign country, and then later convert that foreign currency back to U.S. dollars. If in the meantime the U.S. dollar becomes stronger and the foreign currency becomes weaker, then when the investor converts back to U.S. dollars, the rate of return on that investment will be less than originally expected at the time it was made.\nHowever, a stronger U.S. dollar boosts the returns of a foreign investor putting money into a U.S. investment. That foreign investor converts from the home currency to U.S. dollars and seeks a U.S. investment, while later planning to switch back to the home currency. If, in the meantime, the dollar grows stronger, then when the time comes to convert from U.S. dollars back to the foreign currency, the investor will receive more foreign currency than expected at the time the original investment was made.\nThe preceding paragraphs all focus on the case where the U.S. dollar becomes stronger. The first column in Figure 16.4 illustrates the corresponding happy or unhappy economic reactions. The following Work It Out feature centers the analysis on the opposite: a weaker dollar.\nWork It Out\n\n\nEffects of a Weaker Dollar\n\nLets work through the effects of a weaker dollar on a U.S. exporter, a foreign exporter into the United States, a U.S. tourist going abroad, a foreign tourist coming to the United States, a U.S. investor abroad, and a foreign investor in the United States.\nStep 1. Note that the demand for U.S. exports is a function of the price of those exports, which depends on the dollar price of those goods and the exchange rate of the dollar in terms of foreign currency. For example, a Ford pickup truck costs $25,000 in the United States. When it is sold in the United Kingdom, the price is $25,000 / $1.30 per British pound, or 19,231. The dollar affects the price foreigners face who may purchase U.S. exports.Step 2. Consider that, if the dollar weakens, the pound rises in value. If the pound rises to $2.00 per pound, then the price of a Ford pickup is now $25,000 / $2.00 = 12,500. A weaker dollar means the foreign currency buys more dollars, which means that U.S. exports appear less expensive.\nStep 3. Summarize that a weaker U.S. dollar leads to an increase in U.S. exports. For a foreign exporter, the outcome is just the opposite.\nStep 4. Suppose a brewery in England is interested in selling its Bass Ale to a grocery store in the United States. If the price of a six pack of Bass Ale is 6.00 and the exchange rate is $1.30 per British pound, the price for the grocery store is 6.00  $1.30 = $7.80 per six pack. If the dollar weakens to $2.00 per pound, the price of Bass Ale is now 6.00  $2.00 = $12.Step 5. Summarize that, from the perspective of U.S. purchasers, a weaker dollar means that foreign currency is more expensive, which means that foreign goods are more expensive also. This leads to a decrease in U.S. imports, which is bad for the foreign exporter.\nStep 6. Consider U.S. tourists going abroad. They face the same situation as a U.S. importerthey are purchasing a foreign trip. A weaker dollar means that their trip will cost more, since a given expenditure of foreign currency (e.g., hotel bill) will take more dollars. The result is that the tourist may not stay as long abroad, and some may choose not to travel at all.\nStep 7. Consider that, for the foreign tourist to the United States, a weaker dollar is a boon. It means their currency goes further, so the cost of a trip to the United States will be less. Foreigners may choose to take longer trips to the United States, and more foreign tourists may decide to take U.S. trips.\nStep 8. Note that a U.S. investor abroad faces the same situation as a U.S. importerthey are purchasing a foreign asset. A U.S. investor will see a weaker dollar as an increase in the price of investment, since the same number of dollars will buy less foreign currency and thus less foreign assets. This should decrease the amount of U.S. investment abroad.\nStep 9. Note also that foreign investors in the Unites States will have the opposite experience. Since foreign currency buys more dollars, they will likely invest in more U.S. assets.\n\nAt this point, you should have a good sense of the major players in the foreign exchange market: firms involved in international trade, tourists, international financial investors, banks, and foreign exchange dealers. The next module shows how players can use the tools of demand and supply in foreign exchange markets to explain the underlying causes of stronger and weaker currencies (we address stronger and weaker more in the following Clear It Up feature).\nClear It Up\n\n\nWhy is a stronger currency not necessarily better?\n\nOne common misunderstanding about exchange rates is that a stronger or appreciating currency must be better than a weaker or depreciating currency. After all, is it not obvious that strong is better than weak? Do not let the terminology confuse you. When a currency becomes stronger, so that it purchases more of other currencies, it benefits some in the economy and injures others. Stronger currency is not necessarily better, it is just different.\n\n", "16-2": "By the end of this section, you will be able to:\nExplain supply and demand for exchange rates\nDefine arbitrage\nExplain purchasing power parity's importance when comparing countries.\n\nThe foreign exchange market involves firms, households, and investors who demand and supply currencies coming together through their banks and the key foreign exchange dealers. Figure 16.5 (a) offers an example for the exchange rate between the U.S. dollar and the Mexican peso. The vertical axis shows the exchange rate for U.S. dollars, which in this case is measured in pesos. The horizontal axis shows the quantity of U.S. dollars traded in the foreign exchange market each day. The demand curve (D) for U.S. dollars intersects with the supply curve (S) of U.S. dollars at the equilibrium point (E), which is an exchange rate of 10 pesos per dollar and a total volume of $8.5 billion.\n\n\n\nFigure \n16.5\n \nDemand and Supply for the U.S. Dollar and Mexican Peso Exchange Rate \n \n(a) The quantity measured on the horizontal axis is in U.S. dollars, and the exchange rate on the vertical axis is the price of U.S. dollars measured in Mexican pesos. (b) The quantity measured on the horizontal axis is in Mexican pesos, while the price on the vertical axis is the price of pesos measured in U.S. dollars. In both graphs, the equilibrium exchange rate occurs at point E, at the intersection of the demand curve (D) and the supply curve (S).\n\nFigure 16.5 (b) presents the same demand and supply information from the perspective of the Mexican peso. The vertical axis shows the exchange rate for Mexican pesos, which is measured in U.S. dollars. The horizontal axis shows the quantity of Mexican pesos traded in the foreign exchange market. The demand curve (D) for Mexican pesos intersects with the supply curve (S) of Mexican pesos at the equilibrium point (E), which is an exchange rate of 10 cents in U.S. currency for each Mexican peso and a total volume of 85 billion pesos. Note that the two exchange rates are inverses: 10 pesos per dollar is the same as 10 cents per peso (or $0.10 per peso). In the actual foreign exchange market, almost all of the trading for Mexican pesos is for U.S. dollars. What factors would cause the demand or supply to shift, thus leading to a change in the equilibrium exchange rate? We discuss the answer to this question in the following section.Expectations about Future Exchange Rates\nOne reason to demand a currency on the foreign exchange market is the belief that the currency's value is about to increase. One reason to supply a currencythat is, sell it on the foreign exchange marketis the expectation that the currency's value is about to decline. For example, imagine that a leading business newspaper, like the Wall Street Journal or the Financial Times, runs an article predicting that the Mexican peso will appreciate in value. Figure 16.6 illustrates the likely effects of such an article. Demand for the Mexican peso shifts to the right, from D0 to D1, as investors become eager to purchase pesos. Conversely, the supply of pesos shifts to the left, from S0 to S1, because investors will be less willing to give them up. The result is that the equilibrium exchange rate rises from 10 cents/peso to 12 cents/peso and the equilibrium exchange rate rises from 85 billion to 90 billion pesos as the equilibrium moves from E0 to E1.\n\n\n\nFigure \n16.6\n \nExchange Rate Market for Mexican Peso Reacts to Expectations about Future Exchange Rates \n \nAn announcement that the peso exchange rate is likely to strengthen in the future will lead to greater demand for the peso in the present from investors who wish to benefit from the appreciation. Similarly, it will make investors less likely to supply pesos to the foreign exchange market. Both the shift of demand to the right and the shift of supply to the left cause an immediate appreciation in the exchange rate.\n\nFigure 16.6 also illustrates some peculiar traits of supply and demand diagrams in the foreign exchange market. In contrast to all the other cases of supply and demand you have considered, in the foreign exchange market, supply and demand typically both move at the same time. Groups of participants in the foreign exchange market like firms and investors include some who are buyers and some who are sellers. An expectation of a future shift in the exchange rate affects both buyers and sellersthat is, it affects both demand and supply for a currency.\nThe shifts in demand and supply curves both cause the exchange rate to shift in the same direction. In this example, they both make the peso exchange rate stronger. However, the shifts in demand and supply work in opposing directions on the quantity traded. In this example, the rising demand for pesos is causing the quantity to rise while the falling supply of pesos is causing quantity to fall. In this specific example, the result is a higher quantity. However, in other cases, the result could be that quantity remains unchanged or declines.This example also helps to explain why exchange rates often move quite substantially in a short period of a few weeks or months. When investors expect a countrys currency to strengthen in the future, they buy the currency and cause it to appreciate immediately. The currency's appreciation can lead other investors to believe that future appreciation is likelyand thus lead to even further appreciation. Similarly, a fear that a currency might weaken quickly leads to an actual weakening of the currency, which often reinforces the belief that the currency will weaken further. Thus, beliefs about the future path of exchange rates can be self-reinforcing, at least for a time, and a large share of the trading in foreign exchange markets involves dealers trying to outguess each other on what direction exchange rates will move next.\nDifferences across Countries in Rates of Return\nThe motivation for investment, whether domestic or foreign, is to earn a return. If rates of return in a country look relatively high, then that country will tend to attract funds from abroad. Conversely, if rates of return in a country look relatively low, then funds will tend to flee to other economies. Changes in the expected rate of return will shift demand and supply for a currency. For example, imagine that interest rates rise in the United States as compared with Mexico. Thus, financial investments in the United States promise a higher return than previously. As a result, more investors will demand U.S. dollars so that they can buy interest-bearing assets and fewer investors will be willing to supply U.S. dollars to foreign exchange markets. Demand for the U.S. dollar will shift to the right, from D0 to D1, and supply will shift to the left, from S0 to S1, as Figure 16.7 shows. The new equilibrium (E1), will occur at an exchange rate of nine pesos/dollar and the same quantity of $8.5 billion. Thus, a higher interest rate or rate of return relative to other countries leads a nations currency to appreciate or strengthen, and a lower interest rate relative to other countries leads a nations currency to depreciate or weaken. Since a nations central bank can use monetary policy to affect its interest rates, a central bank can also cause changes in exchange ratesa connection that we will discuss in more detail later in this chapter.\n\n\n\nFigure \n16.7\n \nExchange Rate Market for U.S. Dollars Reacts to Higher Interest Rates \n \nA higher rate of return for U.S. dollars makes holding dollars more attractive. Thus, the demand for dollars in the foreign exchange market shifts to the right, from D0 to D1, while the supply of dollars shifts to the left, from S0 to S1. The new equilibrium (E1) has a stronger exchange rate than the original equilibrium (E0), but in this example, the equilibrium quantity traded does not change.\n\n\nRelative Inflation\nIf a country experiences a relatively high inflation rate compared with other economies, then the buying power of its currency is eroding, which will tend to discourage anyone from wanting to acquire or to hold the currency. Figure 16.8 shows an example based on an actual episode concerning the Mexican peso. In 198687, Mexico experienced an inflation rate of over 200%. Not surprisingly, as inflation dramatically decreased the peso's purchasing power in Mexico. The peso's exchange rate value declined as well. Figure 16.8 shows that the demand for the peso on foreign exchange markets decreased from D0 to D1, while the peso's supply increased from S0 to S1. The equilibrium exchange rate fell from $2.50 per peso at the original equilibrium (E0) to $0.50 per peso at the new equilibrium (E1). In this example, the quantity of pesos traded on foreign exchange markets remained the same, even as the exchange rate shifted.\n\n\n\nFigure \n16.8\n \nExchange Rate Markets React to Higher Inflation \n \nIf a currency is experiencing relatively high inflation, then its buying power is decreasing and international investors will be less eager to hold it. Thus, a rise in inflation in the Mexican peso would lead demand to shift from D0 to D1, and supply to increase from S0 to S1. Both movements in demand and supply would cause the currency to depreciate. Here, we draw no effect on the quantity traded, but in truth it could be an increase or a decrease, depending on the actual movements of demand and supply.\n\n\nLink It Up\n\n\nVisit this website to learn about the Big Mac index.\n\n\nPurchasing Power Parity\nOver the long term, exchange rates must bear some relationship to the currency's buying power in terms of internationally traded goods. If at a certain exchange rate it was much cheaper to buy internationally traded goodssuch as oil, steel, computers, and carsin one country than in another country, businesses would start buying in the cheap country, selling in other countries, and pocketing the profits.For example, if a U.S. dollar is worth $1.30 in Canadian currency, then a car that sells for $20,000 in the United States should sell for $26,000 in Canada. If the price of cars in Canada were much lower than $26,000, then at least some U.S. car-buyers would convert their U.S. dollars to Canadian dollars and buy their cars in Canada. If the price of cars were much higher than $26,000 in this example, then at least some Canadian buyers would convert their Canadian dollars to U.S. dollars and go to the United States to purchase their cars. This is known as arbitrage, the process of buying and selling goods or currencies across international borders at a profit. It may occur slowly, but over time, it will force prices and exchange rates to align so that the price of internationally traded goods is similar in all countries.We call the exchange rate that equalizes the prices of internationally traded goods across countries the purchasing power parity (PPP) exchange rate. A group of economists at the International Comparison Program, run by the World Bank, have calculated the PPP exchange rate for all countries, based on detailed studies of the prices and quantities of internationally tradable goods.The purchasing power parity exchange rate has two functions. First, economists often use PPP exchange rates for international comparison of GDP and other economic statistics. Imagine that you are preparing a table showing the size of GDP in many countries in several recent years, and for ease of comparison, you are converting all the values into U.S. dollars. When you insert the value for Japan, you need to use a yen/dollar exchange rate. However, should you use the market exchange rate or the PPP exchange rate? Market exchange rates bounce around. In 2014, the exchange rate was 105 yen/dollar, but in late 2015 the U.S. dollar exchange rate versus the yen was 121 yen/dollar. For simplicity, say that Japans GDP was 500 trillion in both 2014 and 2015. If you use the market exchange rates, then Japans GDP will be $4.8 trillion in 2014 (that is, 500 trillion /(105/dollar)) and $4.1 trillion in 2015 (that is, 500 trillion /(121/dollar)).The misleading appearance of a changing Japanese economy occurs only because we used the market exchange rate, which often has short-run rises and falls. However, PPP exchange rates stay fairly constant and change only modestly, if at all, from year to year.The second function of PPP is that exchanges rates will often get closer to it as time passes. It is true that in the short and medium run, as exchange rates adjust to relative inflation rates, rates of return, and to expectations about how interest rates and inflation will shift, the exchange rates will often move away from the PPP exchange rate for a time. However, knowing the PPP will allow you to track and predict exchange rate relationships.\n", "16-3": "By the end of this section you will be able to:\nExplain how exchange rate shifting influences aggregate demand and supply\nExplain how shifting exchange rates also can influence loans and banks\n\nA central bank will be concerned about the exchange rate for multiple reasons: (1) Movements in the exchange rate will affect the quantity of aggregate demand in an economy; (2) frequent substantial fluctuations in the exchange rate can disrupt international trade and cause problems in a nations banking systemthis may contribute to an unsustainable balance of trade and large inflows of international financial capital, which can set up the economy for a deep recession if international investors decide to move their money to another country. Lets discuss these scenarios in turn.Exchange Rates, Aggregate Demand, and Aggregate Supply\nForeign trade in goods and services typically involves incurring the costs of production in one currency while receiving revenues from sales in another currency. As a result, movements in exchange rates can have a powerful effect on incentives to export and import, and thus on aggregate demand in the economy as a whole.\nFor example, in 1999, when the euro first became a currency, its value measured in U.S. currency was $1.06/euro. By the end of 2013, the euro had risen (and the U.S. dollar had correspondingly weakened) to $1.37/euro. However, by the end of February, 2017, the exchange rate was once again $1.06/euro. Consider the situation of a French firm that each year incurs 10 million in costs, and sells its products in the United States for $10 million. In 1999, when this firm converted $10 million back to euros at the exchange rate of $1.06/euro (that is, $10 million  [1/$1.06]), it received 9.4 million, and suffered a loss. In 2013, when this same firm converted $10 million back to euros at the exchange rate of $1.37/euro (that is, $10 million  [1 euro/$1.37]), it received approximately 7.3 million and an even larger loss. In the beginning of 2017, with the exchange rate back at $1.06/euro the firm would suffer a loss once again. This example shows how a stronger euro discourages exports by the French firm, because it makes the costs of production in the domestic currency higher relative to the sales revenues earned in another country. From the point of view of the U.S. economy, the example also shows how a weaker U.S. dollar encourages exports.Since an increase in exports results in more dollars flowing into the economy, and an increase in imports means more dollars are flowing out, it is easy to conclude that exports are good for the economy and imports are bad, but this overlooks the role of exchange rates. If an American consumer buys a Japanese car for $20,000 instead of an American car for $30,000, it may be tempting to argue that the American economy has lost out. However, the Japanese company will have to convert those dollars to yen to pay its workers and operate its factories. Whoever buys those dollars will have to use them to purchase American goods and services, so the money comes right back into the American economy. At the same time, the consumer saves money by buying a less expensive import, and can use the extra money for other purposes.\n\nFluctuations in Exchange Rates\nExchange rates can fluctuate a great deal in the short run. As yet one more example, the Indian rupee moved from 39 rupees/dollar in February 2008 to 51 rupees/dollar in March 2009, a decline of more than one-fourth in the value of the rupee on foreign exchange markets. Figure 16.9 earlier showed that even two economically developed neighboring economies like the United States and Canada can see significant movements in exchange rates over a few years. For firms that depend on export sales, or firms that rely on imported inputs to production, or even purely domestic firms that compete with firms tied into international tradewhich in many countries adds up to half or more of a nations GDPsharp movements in exchange rates can lead to dramatic changes in profits and losses. A central bank may desire to keep exchange rates from moving too much as part of providing a stable business climate, where firms can focus on productivity and innovation, not on reacting to exchange rate fluctuations.One of the most economically destructive effects of exchange rate fluctuations can happen through the banking system. Financial institutions measure most international loans are measured in a few large currencies, like U.S. dollars, European euros, and Japanese yen. In countries that do not use these currencies, banks often borrow funds in the currencies of other countries, like U.S. dollars, but then lend in their own domestic currency. The left-hand chain of events in Figure 16.9 shows how this pattern of international borrowing can work. A bank in Thailand borrows one million in U.S. dollars. Then the bank converts the dollars to its domestic currencyin the case of Thailand, the currency is the bahtat a rate of 40 baht/dollar. The bank then lends the baht to a firm in Thailand. The business repays the loan in baht, and the bank converts it back to U.S. dollars to pay off its original U.S. dollar loan.\n\n\n\nFigure \n16.9\n \nInternational Borrowing \n \nThe scenario of international borrowing that ends on the left is a success story, but the scenario that ends on the right shows what happens when the exchange rate weakens.\n\nThis process of borrowing in a foreign currency and lending in a domestic currency can work just fine, as long as the exchange rate does not shift. In the scenario outlined, if the dollar strengthens and the baht weakens, a problem arises. The right-hand chain of events in Figure 16.9 illustrates what happens when the baht unexpectedly weakens from 40 baht/dollar to 50 baht/dollar. The Thai firm still repays the loan in full to the bank. However, because of the shift in the exchange rate, the bank cannot repay its loan in U.S. dollars. (Of course, if the exchange rate had changed in the other direction, making the Thai currency stronger, the bank could have realized an unexpectedly large profit.)In 19971998, countries across eastern Asia, like Thailand, Korea, Malaysia, and Indonesia, experienced a sharp depreciation of their currencies, in some cases 50% or more. These countries had been experiencing substantial inflows of foreign investment capital, with bank lending increasing by 20% to 30% per year through the mid-1990s. When their exchange rates depreciated, the banking systems in these countries were bankrupt. Argentina experienced a similar chain of events in 2002. When the Argentine peso depreciated, Argentinas banks found themselves unable to pay back what they had borrowed in U.S. dollars.\nBanks play a vital role in any economy in facilitating transactions and in making loans to firms and consumers. When most of a countrys largest banks become bankrupt simultaneously, a sharp decline in aggregate demand and a deep recession results. Since the main responsibilities of a central bank are to control the money supply and to ensure that the banking system is stable, a central bank must be concerned about whether large and unexpected exchange rate depreciation will drive most of the countrys existing banks into bankruptcy. For more on this concern, return to the chapter on The International Trade and Capital Flows.\nSumming Up Public Policy and Exchange Rates\nEvery nation would prefer a stable exchange rate to facilitate international trade and reduce the degree of risk and uncertainty in the economy. However, a nation may sometimes want a weaker exchange rate to stimulate aggregate demand and reduce a recession, or a stronger exchange rate to fight inflation. The country must also be concerned that rapid movements from a weak to a strong exchange rate may cripple its export industries, while rapid movements from a strong to a weak exchange rate can cripple its banking sector. In short, every choice of an exchange ratewhether it should be stronger or weaker, or fixed or changingrepresents potential tradeoffs.\n\n", "16-4": "By the end of this section, you will be able to:\nDifferentiate among a floating exchange rate, a soft peg, a hard peg, and a merged currency\nIdentify the tradeoffs that come with a floating exchange rate, a soft peg, a hard peg, and a merged currency\n\nExchange rate policies come in a range of different forms listed in Figure 16.10: let the foreign exchange market determine the exchange rate; let the market set the value of the exchange rate most of the time, but have the central bank sometimes intervene to prevent fluctuations that seem too large; have the central bank guarantee a specific exchange rate; or share a currency with other countries. Lets discuss each type of exchange rate policy and its tradeoffs.\n\n\n\n\nFigure \n16.10\n \nA Spectrum of Exchange Rate Policies \n \nA nation may adopt one of a variety of exchange rate regimes, from floating rates in which the foreign exchange market determines the rates to pegged rates where governments intervene to manage the exchange rate's value, to a common currency where the nation adopts another country or group of countries' currency.\n\nFloating Exchange Rates\nWe refer to a policy which allows the foreign exchange market to set exchange rates as a floating exchange rate. The U.S. dollar is a floating exchange rate, as are the currencies of about 40% of the countries in the world economy. The major concern with this policy is that exchange rates can move a great deal in a short time.Consider the U.S. exchange rate expressed in terms of another fairly stable currency, the Japanese yen, as Figure 16.11 shows. On January 1, 2002, the exchange rate was 133 yen/dollar. On January 1, 2005, it was 103 yen/dollar. On June 1, 2007, it was 122 yen/dollar, on January 1, 2012, it was 77 yen per dollar, and on March 1, 2015, it was 120 yen per dollar. As investor sentiment swings back and forth, driving exchange rates up and down, exporters, importers, and banks involved in international lending are all affected. At worst, large movements in exchange rates can drive companies into bankruptcy or trigger a nationwide banking collapse. However, even in the moderate case of the yen/dollar exchange rate, these movements of roughly 30 percent back and forth impose stress on both economies as firms must alter their export and import plans to take the new exchange rates into account. Especially in smaller countries where international trade is a relatively large share of GDP, exchange rate movements can rattle their economies.\n\n\n\nFigure \n16.11\n \nU.S. Dollar Exchange Rate in Japanese Yen \n \nEven seemingly stable exchange rates such as the Japanese Yen to the U.S. Dollar can vary when closely examined over time. This figure shows a relatively stable rate between 2011 and 2013.  In 2013, there was a drastic depreciation of the Yen (relative to the U.S. Dollar) by about 14% and again at the end of the year in 2014 also by about 14%. (Source: Federal Reserve Economic Data (FRED) https://research.stlouisfed.org/fred2/series/DEXJPUS)\n\nHowever, movements of floating exchange rates have advantages, too. After all, prices of goods and services rise and fall throughout a market economy, as demand and supply shift. If an economy experiences strong inflows or outflows of international financial capital, or has relatively high inflation, or if it experiences strong productivity growth so that purchasing power changes relative to other economies, then it makes economic sense for the exchange rate to shift as well.\nFloating exchange rate advocates often argue that if government policies were more predictable and stable, then inflation rates and interest rates would be more predictable and stable. Exchange rates would bounce around less, too. The economist Milton Friedman (19122006), for example, wrote a defense of floating exchange rates in 1962 in his book Capitalism and Freedom:\nBeing in favor of floating exchange rates does not mean being in favor of unstable exchange rates. When we support a free price system [for goods and services] at home, this does not imply that we favor a system in which prices fluctuate wildly up and down. What we want is a system in which prices are free to fluctuate but in which the forces determining them are sufficiently stable so that in fact prices move within moderate ranges. This is equally true in a system of floating exchange rates. The ultimate objective is a world in which exchange rates, while free to vary, are, in fact, highly \tstable because basic economic policies and conditions are stable.\nAdvocates of floating exchange rates admit that, yes, exchange rates may sometimes fluctuate. They point out, however, that if a central bank focuses on preventing either high inflation or deep recession, with low and reasonably steady interest rates, then exchange rates will have less reason to vary.\n\nUsing Soft Pegs and Hard Pegs\nWhen a government intervenes in the foreign exchange market so that the currency's exchange rate is different from what the market would have produced, it establishes a peg for its currency. A soft peg is the name for an exchange rate policy where the government usually allows the market to set exchange rate, but in some cases, especially if the exchange rate seems to be moving rapidly in one direction, the central bank will intervene in the market. With a hard peg exchange rate policy, the central bank sets a fixed and unchanging value for the exchange rate. A central bank can implement soft peg and hard peg policies.Suppose the market exchange rate for the Brazilian currency, the real, would be 35 cents/real with a daily quantity of 15 billion real traded in the market, as the equilibrium E0 in Figure 16.12 (a) and Figure 16.12 (b) show. However, Brazil's government decides that the exchange rate should be 30 cents/real, as Figure 16.12 (a) shows. Perhaps Brazil sets this lower exchange rate to benefit its export industries. Perhaps it is an attempt to stimulate aggregate demand by stimulating exports. Perhaps Brazil believes that the current market exchange rate is higher than the long-term purchasing power parity value of the real, so it is minimizing fluctuations in the real by keeping it at this lower rate. Perhaps the government set the target exchange rate sometime in the past, and it is now maintaining it for the sake of stability. Whatever the reason, if Brazils central bank wishes to keep the exchange rate below the market level, it must face the reality that at this weaker exchange rate of 30 cents/real, the quantity demanded of its currency at 17 billion reals is greater than the quantity supplied of 13 billion reals in the foreign exchange market.\n\n\n\nFigure \n16.12\n \nPegging an Exchange Rate \n \n(a) If an exchange rate is pegged below what would otherwise be the equilibrium, then the currency's quantity demanded will exceed the quantity supplied. (b) If an exchange rate is pegged above what would otherwise be the equilibrium, then the currency's quantity supplied exceeds the quantity demanded.\n\nThe Brazilian central bank could weaken its exchange rate in two ways. One approach is to use an expansionary monetary policy that leads to lower interest rates. In foreign exchange markets, the lower interest rates will reduce demand and increase supply of the real and lead to depreciation. Central banks do not use this technique often because lowering interest rates to weaken the currency may be in conflict with the countrys monetary policy goals. Alternatively, Brazils central bank could trade directly in the foreign exchange market. The central bank can expand the money supply by creating reals, use the reals to purchase foreign currencies, and avoid selling any of its own currency. In this way, it can fill the gap between quantity demanded and quantity supplied of its currency.Figure 16.12 (b) shows the opposite situation. Here, the Brazilian government desires a stronger exchange rate of 40 cents/real than the market rate of 35 cents/real. Perhaps Brazil desires the stronger currency to reduce aggregate demand and to fight inflation, or perhaps Brazil believes that that current market exchange rate is temporarily lower than the long-term rate. Whatever the reason, at the higher desired exchange rate, the quantity supplied of 16 billion reals exceeds the quantity demanded of 14 billion reals.\nBrazils central bank can use a contractionary monetary policy to raise interest rates, which will increase demand and reduce currency supply on foreign exchange markets, and lead to an appreciation. Alternatively, Brazils central bank can trade directly in the foreign exchange market. In this case, with an excess supply of its own currency in foreign exchange markets, the central bank must use reserves of foreign currency, like U.S. dollars, to demand its own currency and thus cause an appreciation of its exchange rate.Both a soft peg and a hard peg policy require that the central bank intervene in the foreign exchange market. However, a hard peg policy attempts to preserve a fixed exchange rate at all times. A soft peg policy typically allows the exchange rate to move up and down by relatively small amounts in the short run of several months or a year, and to move by larger amounts over time, but seeks to avoid extreme short-term fluctuations.\n\nTradeoffs of Soft Pegs and Hard Pegs\nWhen a country decides to alter the market exchange rate, it faces a number of tradeoffs. If it uses monetary policy to alter the exchange rate, it then cannot at the same time use monetary policy to address issues of inflation or recession. If it uses direct purchases and sales of foreign currencies in exchange rates, then it must face the issue of how it will handle its reserves of foreign currency. Finally, a pegged exchange rate can even create additional movements of the exchange rate. For example, even the possibility of government intervention in exchange rate markets will lead to rumors about whether and when the government will intervene, and dealers in the foreign exchange market will react to those rumors. Lets consider these issues in turn.One concern with pegged exchange rate policies is that they imply a countrys monetary policy is no longer focused on controlling inflation or shortening recessions, but now must also take the exchange rate into account. For example, when a country pegs its exchange rate, it will sometimes face economic situations where it would like to have an expansionary monetary policy to fight recessionbut it cannot do so because that policy would depreciate its exchange rate and break its hard peg. With a soft peg exchange rate policy, the central bank can sometimes ignore the exchange rate and focus on domestic inflation or recessionbut in other cases the central bank may ignore inflation or recession and instead focus on its soft peg exchange rate. With a hard peg policy, domestic monetary policy is effectively no longer determined by domestic inflation or unemployment, but only by what monetary policy is needed to keep the exchange rate at the hard peg.\nAnother issue arises when a central bank intervenes directly in the exchange rate market. If a central bank ends up in a situation where it is perpetually creating and selling its own currency on foreign exchange markets, it will be buying the currency of other countries, like U.S. dollars or euros, to hold as reserves. Holding large reserves of other currencies has an opportunity cost, and central banks will not wish to boost such reserves without limit.\nIn addition, a central bank that causes a large increase in the supply of money is also risking an inflationary surge in aggregate demand. Conversely, when a central bank wishes to buy its own currency, it can do so by using its reserves of international currency like the U.S. dollar or the euro. However, if the central bank runs out of such reserves, it can no longer use this method to strengthen its currency. Thus, buying foreign currencies in exchange rate markets can be expensive and inflationary, while selling foreign currencies can work only until a central bank runs out of reserves.Yet another issue is that when a government pegs its exchange rate, it may unintentionally create another reason for additional fluctuation. With a soft peg policy, foreign exchange dealers and international investors react to every rumor about how or when the central bank is likely to intervene to influence the exchange rate, and as they react to rumors the exchange rate will shift up and down. Thus, even though the goal of a soft peg policy is to reduce short-term fluctuations of the exchange rate, the existence of the policywhen anticipated in the foreign exchange marketmay sometimes increase short-term fluctuations as international investors try to anticipate how and when the central bank will act. The following Clear It Up feature discusses the effects of international capital flowscapital that flows across national boundaries as either portfolio investment or direct investment.\n\nClear It Up\n\n\nHow do Tobin taxes control the flow of capital?\n\nSome countries like Chile and Malaysia have sought to reduce movements in exchange rates by limiting international financial capital inflows and outflows. The government can enact this policy either through targeted taxes or by regulations.Taxes on international capital flows are sometimes known as Tobin taxes, named after James Tobin, the 1981 Nobel laureate in economics who proposed such a tax in a 1972 lecture. For example, a government might tax all foreign exchange transactions, or attempt to tax short-term portfolio investment while exempting long-term foreign direct investment. Countries can also use regulation to forbid certain kinds of foreign investment in the first place or to make it difficult for international financial investors to withdraw their funds from a country.\nThe goal of such policies is to reduce international capital flows, especially short-term portfolio flows, in the hope that doing so will reduce the chance of large movements in exchange rates that can bring macroeconomic disaster.\nHowever, proposals to limit international financial flows have severe practical difficulties. National governments impose taxes, not international ones. If one government imposes a Tobin tax on exchange rate transactions carried out within its territory, a firm based someplace like the Grand Caymans, an island nation in the Caribbean well-known for allowing some financial wheeling and dealing might easily operate the exchange rate market. In an interconnected global economy, if goods and services are allowed to flow across national borders, then payments need to flow across borders, too. It is very difficultin fact close to impossiblefor a nation to allow only the flows of payments that relate to goods and services, while clamping down or taxing other flows of financial capital. If a nation participates in international trade, it must also participate in international capital movements.Finally, countries all over the world, especially low-income countries, are crying out for foreign investment to help develop their economies. Policies that discourage international financial investment may prevent some possible harm, but they rule out potentially substantial economic benefits as well.\n\nA hard peg exchange rate policy will not allow short-term fluctuations in the exchange rate. If the government first announces a hard peg and then later changes its mindperhaps the government becomes unwilling to keep interest rates high or to hold high levels of foreign exchange reservesthen the result of abandoning a hard peg could be a dramatic shift in the exchange rate.\nIn the mid-2000s, about one-third of the countries in the world used a soft peg approach and about one-quarter used a hard peg approach. The general trend in the 1990s was to shift away from a soft peg approach in favor of either floating rates or a hard peg. The concern is that a successful soft peg policy may, for a time, lead to very little variation in exchange rates, so that firms and banks in the economy begin to act as if a hard peg exists. When the exchange rate does move, the effects are especially painful because firms and banks have not planned and hedged against a possible change. Thus, the argument went, it is better either to be clear that the exchange rate is always flexible, or that it is fixed, but choosing an in-between soft peg option may end up being worst of all.\n\nA Merged Currency\nA final approach to exchange rate policy is for a nation to choose a common currency shared with one or more nations is also called a merged currency. A merged currency approach eliminates foreign exchange risk altogether. Just as no one worries about exchange rate movements when buying and selling between New York and California, Europeans know that the value of the euro will be the same in Germany and France and other European nations that have adopted the euro.\nHowever, a merged currency also poses problems. Like a hard peg, a merged currency means that a nation has given up altogether on domestic monetary policy, and instead has put its interest rate policies in other hands. When Ecuador uses the U.S. dollar as its currency, it has no voice in whether the Federal Reserve raises or lowers interest rates. The European Central Bank that determines monetary policy for the euro has representatives from all the euro nations. However, from the standpoint of, say, Portugal, there will be times when the decisions of the European Central Bank about monetary policy do not match the decisions that a Portuguese central bank would have made.The lines between these four different exchange rate policies can blend into each other. For example, a soft peg exchange rate policy in which the government almost never acts to intervene in the exchange rate market will look a great deal like a floating exchange rate. Conversely, a soft peg policy in which the government intervenes often to keep the exchange rate near a specific level will look a lot like a hard peg. A decision to merge currencies with another country is, in effect, a decision to have a permanently fixed exchange rate with those countries, which is like a very hard exchange rate peg. Table 16.3 summarizes the range of exchange rates policy choices, with their advantages and disadvantages.\n\nSituation\nFloating Exchange Rates\nSoft Peg\nHard Peg\nMerged Currency\n\n\n\nLarge short-run fluctuations in exchange rates?\nOften considerable in the short term\nMaybe less in the short run, but still large changes over time\nNone, unless a change in the fixed rate\nNone\n\n\nLarge long-term fluctuations in exchange rates?\nCan often happen\nCan often happen\nCannot happen unless hard peg changes, in which case substantial volatility can occur\nCannot happen\n\n\nPower of central bank to conduct countercyclical monetary policy?\nFlexible exchange rates make monetary policy stronger\nSome power, although conflicts may arise between exchange rate policy and countercyclical policy\nVery little; central bank must keep exchange rate fixed\nNone; nation does not have its own currency\n\n\nCosts of holding foreign exchange reserves?\nDo not need to hold reserves\nHold moderate reserves that rise and fall over time\nHold large reserves\nNo need to hold reserves\n\n\nRisk of ending up with an exchange rate that causes a large trade imbalance and very high inflows or outflows of financial capital?\nAdjusts often\nAdjusts over the medium term, if not the short term\nMay end up over time either far above or below the market level\nCannot adjust\n\n\nTable \n16.3\n \nTradeoffs of Exchange Rate Policies\n \n\nGlobal macroeconomics would be easier if the whole world had one currency and one central bank. The exchange rates between different currencies complicate the picture. If financial markets solely set exchange rates, they fluctuate substantially as short-term portfolio investors try to anticipate tomorrows news. If the government attempts to intervene in exchange rate markets through soft pegs or hard pegs, it gives up at least some of the power to use monetary policy to focus on domestic inflations and recessions, and it risks causing even greater fluctuations in foreign exchange markets.There is no consensus among economists about which exchange rate policies are best: floating, soft peg, hard peg, or merged currencies. The choice depends both on how well a nations central bank can implement a specific exchange rate policy and on how well a nations firms and banks can adapt to different exchange rate policies. A national economy that does a fairly good job at achieving the four main economic goals of growth, low inflation, low unemployment, and a sustainable balance of trade will probably do just fine most of the time with any exchange rate policy. Conversely, no exchange rate policy is likely to save an economy that consistently fails at achieving these goals. Alternatively, a merged currency applied across wide geographic and cultural areas carries with it its own set of problems, such as the ability for countries to conduct their own independent monetary policies.\nBring It Home\n\n\nIs a Stronger Dollar Good for the U.S. Economy?\n\nThe foreign exchange value of the dollar is a price and whether a higher price is good or bad depends on where you are standing: sellers benefit from higher prices and buyers are harmed. A stronger dollar is good for U.S. imports (and people working for U.S. importers) and U.S. investment abroad. It is also good for U.S. tourists going to other countries, since their dollar goes further. However, a stronger dollar is bad for U.S. exports (and people working in U.S. export industries); it is bad for foreign investment in the United States (leading, for example, to higher U.S. interest rates); and it is bad for foreign tourists (as well as U.S hotels, restaurants, and others in the tourist industry). In short, whether the U.S. dollar is good or bad is a more complex question than you may have thought. The economic answer is it depends.\n\n", "17-1": "By the end of this section, you will be able to:\nIdentify U.S. budget deficit and surplus trends over the past five decades\nExplain the differences between the U.S. federal budget, and state and local budgets\n\nGovernment spending covers a range of services that the federal, state, and local governments provide. When the federal government spends more money than it receives in taxes in a given year, it runs a budget deficit. Conversely, when the government receives more money in taxes than it spends in a year, it runs a budget surplus. If government spending and taxes are equal, it has a balanced budget. For example, in 2009, the U.S. government experienced its largest budget deficit ever, as the federal government spent $1.4 trillion more than it collected in taxes. This deficit was about 10% of the size of the U.S. GDP in 2009, making it by far the largest budget deficit relative to GDP since the mammoth borrowing the government used to finance World War II.This section presents an overview of government spending in the United States.\nTotal U.S. Government Spending\nFederal spending in nominal dollars (that is, dollars not adjusted for inflation) has grown by a multiple of more than 38 over the last four decades, from $93.4 billion in 1960 to $3.9 trillion in 2014. Comparing spending over time in nominal dollars is misleading because it does not take into account inflation or growth in population and the real economy. A more useful method of comparison is to examine government spending as a percent of GDP over time.The top line in Figure 17.2 shows the federal spending level since 1960, expressed as a share of GDP. Despite a widespread sense among many Americans that the federal government has been growing steadily larger, the graph shows that federal spending has hovered in a range from 18% to 22% of GDP most of the time since 1960. The other lines in Figure 17.2 show the major federal spending categories: national defense, Social Security, health programs, and interest payments. From the graph, we see that national defense spending as a share of GDP has generally declined since the 1960s, although there were some upward bumps in the 1980s buildup under President Ronald Reagan and in the aftermath of the terrorist attacks on September 11, 2001. In contrast, Social Security and healthcare have grown steadily as a percent of GDP. Healthcare expenditures include both payments for senior citizens (Medicare), and payments for low-income Americans (Medicaid). State governments also partially fund Medicaid. Interest payments are the final main category of government spending in Figure 30.2.\n\n\n\nFigure \n17.2\n \nFederal Spending, 19602014\n \nSince 1960, total federal spending has ranged from about 18% to 22% of GDP, although it climbed above that level in 2009, but quickly dropped back down to that level by 2013. The share that the government has spent on national defense has generally declined, while the share it has spent on Social Security and on healthcare expenses (mainly Medicare and Medicaid) has increased. (Source: Economic Report of the President, Tables B-2 and B-22, http://www.gpo.gov/fdsys/pkg/ERP-2014/content-detail.html)\n\nEach year, the government borrows funds from U.S. citizens and foreigners to cover its budget deficits. It does this by selling securities (Treasury bonds, notes, and bills)in essence borrowing from the public and promising to repay with interest in the future. From 1961 to 1997, the U.S. government has run budget deficits, and thus borrowed funds, in almost every year. It had budget surpluses from 1998 to 2001, and then returned to deficits.\nThe interest payments on past federal government borrowing were typically 12% of GDP in the 1960s and 1970s but then climbed above 3% of GDP in the 1980s and stayed there until the late 1990s. The government was able to repay some of its past borrowing by running surpluses from 1998 to 2001 and, with help from low interest rates, the interest payments on past federal government borrowing had fallen back to 1.4% of GDP by 2012.\nWe investigate the government borrowing and debt patterns in more detail later in this chapter, but first we need to clarify the difference between the deficit and the debt. The deficit is not the debt. The difference between the deficit and the debt lies in the time frame. The government deficit (or surplus) refers to what happens with the federal government budget each year. The government debt is accumulated over time. It is the sum of all past deficits and surpluses. If you borrow $10,000 per year for each of the four years of college, you might say that your annual deficit was $10,000, but your accumulated debt over the four years is $40,000.These four categoriesnational defense, Social Security, healthcare, and interest paymentsaccount for roughly 73% of all federal spending, as Figure 17.3 shows. The remaining 27% wedge of the pie chart covers all other categories of federal government spending: international affairs; science and technology; natural resources and the environment; transportation; housing; education; income support for the poor; community and regional development; law enforcement and the judicial system; and the administrative costs of running the government.\n\n\n\nFigure \n17.3\n \nSlices of Federal Spending, 2014\n \nAbout 73% of government spending goes to four major areas: national defense, Social Security, healthcare, and interest payments on past borrowing. This leaves about 29% of federal spending for all other functions of the U.S. government. (Source: https://www.whitehouse.gov/omb/budget/Historicals/)\n\n\nState and Local Government Spending\nAlthough federal government spending often gets most of the media attention, state and local government spending is also substantialat about $3.1 trillion in 2014. Figure 17.4 shows that state and local government spending has increased during the last four decades from around 8% to around 14% today. The single biggest item is education, which accounts for about one-third of the total. The rest covers programs like highways, libraries, hospitals and healthcare, parks, and police and fire protection. Unlike the federal government, all states (except Vermont) have balanced budget laws, which means any gaps between revenues and spending must be closed by higher taxes, lower spending, drawing down their previous savings, or some combination of all of these.\n\n\n\nFigure \n17.4\n \nState and Local Spending, 19602013\n \nSpending by state and local government increased from about 10% of GDP in the early 1960s to 1416% by the mid-1970s. It has remained at roughly that level since. The single biggest spending item is education, including both K12 spending and support for public colleges and universities, which has been about 45% of GDP in recent decades. Source: (Source: Bureau of Economic Analysis.)\n\nU.S. presidential candidates often run for office pledging to improve the public schools or to get tough on crime. However, in the U.S. government system, these tasks are primarily state and local government responsibilities. In fiscal year 2014  state and local governments spent about $840 billion per year on education (including K12 and college and university education), compared to only $100 billion by the federal government, according to usgovernmentspending.com.   In other words, about 90 cents of every dollar spent on education happens at the state and local level. A politician who really wants hands-on responsibility for reforming education or reducing crime might do better to run for mayor of a large city or for state governor rather than for president of the United States.\n", "17-2": "By the end of this section, you will be able to:\nDifferentiate among a regressive tax, a proportional tax, and a progressive tax\nIdentify major revenue sources for the U.S. federal budget\n\nThere are two main categories of taxes: those that the federal government collects and those that the state and local governments collect. What percentage the government collects and for what it uses that revenue varies greatly. The following sections will briefly explain the taxation system in the United States.Federal Taxes\nJust as many Americans erroneously think that federal spending has grown considerably, many also believe that taxes have increased substantially. The top line of Figure 17.5 shows total federal taxes as a share of GDP since 1960. Although the line rises and falls, it typically remains within the range of 17% to 20% of GDP, except for 2009, when taxes fell substantially below this level, due to recession.\n\n\n\n\nFigure \n17.5\n \nFederal Taxes, 19602014\n \nFederal tax revenues have been about 1720% of GDP during most periods in recent decades. The primary sources of federal taxes are individual income taxes and the payroll taxes that finance Social Security and Medicare. Corporate income taxes and social insurance taxes provide smaller shares of revenue. (Source: Economic Report of the President, 2015. Table B-21, https://obamawhitehouse.archives.gov/sites/default/files/docs/cea_2015_erp_complete.pdf)\n\nFigure 17.5 also shows the taxation patterns for the main categories that the federal government taxes: individual income taxes, corporate income taxes, and social insurance and retirement receipts. When most people think of federal government taxes, the first tax that comes to mind is the individual income tax that is due every year on April 15 (or the first business day after). The personal income tax is the largest single source of federal government revenue, but it still represents less than half of federal tax revenue.The second largest source of federal revenue is the payroll tax (captured in social insurance and retirement receipts), which provides funds for Social Security and Medicare. Payroll taxes have increased steadily over time. Together, the personal income tax and the payroll tax accounted for about 80% of federal tax revenues in 2014. Although personal income tax revenues account for more total revenue than the payroll tax, nearly three-quarters of households pay more in payroll taxes than in income taxes.The income tax is a progressive tax, which means that the tax rates increase as a households income increases. Taxes also vary with marital status, family size, and other factors. The marginal tax rates (the tax due on all yearly income) for a single taxpayer range from 10% to 35%, depending on income, as the following Clear It Up feature explains.\nClear It Up\n\n\nHow does the marginal rate work?\n\nSuppose that a single taxpayers income is $35,000 per year. Also suppose that income from $0 to $9,075 is taxed at 10%, income from $9,075 to $36,900 is taxed at 15%, and, finally, income from $36,900 and beyond is taxed at 25%. Since this person earns $35,000, their marginal tax rate is 15%.\n\nThe key fact here is that the federal income tax is designed so that tax rates increase as income increases, up to a certain level. The payroll taxes that support Social Security and Medicare are designed in a different way. First, the payroll taxes for Social Security are imposed at a rate of 12.4% up to a certain wage limit, set at $118,500 in 2015. Medicare, on the other hand, pays for elderly healthcare, and is fixed at 2.9%, with no upper ceiling.In both cases, the employer and the employee split the payroll taxes. An employee only sees 6.2% deducted from his or her paycheck for Social Security, and 1.45% from Medicare.  However, as economists are quick to point out, the employers half of the taxes are probably passed along to the employees in the form of lower wages, so in reality, the worker pays all of the payroll taxes.We also call the Medicare payroll tax a proportional tax; that is, a flat percentage of all wages earned. The Social Security payroll tax is proportional up to the wage limit, but above that level it becomes a regressive tax, meaning that people with higher incomes pay a smaller share of their income in tax.The third-largest source of federal tax revenue, as Figure 17.5 shows is the corporate income tax. The common name for corporate income is profits. Over time, corporate income tax receipts have declined as a share of GDP, from about 4% in the 1960s to an average of 1% to 2% of GDP in the first decade of the 2000s.The federal government has a few other, smaller sources of revenue. It imposes an excise taxthat is, a tax on a particular goodon gasoline, tobacco, and alcohol. As a share of GDP, the amount the government collects from these taxes has stayed nearly constant over time, from about 2% of GDP in the 1960s to roughly 3% by 2014, according to the nonpartisan Congressional Budget Office. The government also imposes an estate and gift tax on people who pass large amounts of assets to the next generationeither after death or during life in the form of gifts. These estate and gift taxes collected about 0.2% of GDP in the first decade of the 2000s. By a quirk of legislation, the government repealed the estate and gift tax in 2010, but reinstated it in 2011. Other federal taxes, which are also relatively small in magnitude, include tariffs the government collects on imported goods and charges for inspections of goods entering the country.\nState and Local Taxes\nAt the state and local level, taxes have been rising as a share of GDP over the last few decades to match the gradual rise in spending, as Figure 17.6 illustrates. The main revenue sources for state and local governments are sales taxes, property taxes, and revenue passed along from the federal government, but many state and local governments also levy personal and corporate income taxes, as well as impose a wide variety of fees and charges. The specific sources of tax revenue vary widely across state and local governments. Some states rely more on property taxes, some on sales taxes, some on income taxes, and some more on revenues from the federal government.\n\n\n\n\nFigure \n17.6\n \nState and Local Tax Revenue as a Share of GDP, 19602014 \n \nState and local tax revenues have increased to match the rise in state and local spending.  (Source: Economic Report of the President, 2015. Table B-21, https://obamawhitehouse.archives.gov/sites/default/files/docs/cea_2015_erp_complete.pdf)\n\n\n", "17-3": "By the end of this section, you will be able to:\nExplain the U.S. federal budget in terms of  annual debt and accumulated debt\nUnderstand how economic growth or decline can influence a budget surplus or budget deficit\n\nHaving discussed the revenue (taxes) and expense (spending) side of the budget, we now turn to the annual budget deficit or surplus, which is the difference between the tax revenue collected and spending over a fiscal year, which starts October 1 and ends September 30 of the next year.\nFigure 17.7 shows the pattern of annual federal budget deficits and surpluses, back to 1930, as a share of GDP. When the line is above the horizontal axis, the budget is in surplus. When the line is below the horizontal axis, a budget deficit occurred. Clearly, the biggest deficits as a share of GDP during this time were incurred to finance World War II. Deficits were also large during the 1930s, the 1980s, the early 1990s, and most recently during the 2008-2009 recession.\n\n\n\nFigure \n17.7\n \nPattern of Federal Budget Deficits and Surpluses, 19292014 \n \nThe federal government has run budget deficits for decades. The budget was briefly in surplus in the late 1990s, before heading into deficit again in the first decade of the 2000sand especially deep deficits in the 2008-2009 recession. (Source: Federal Reserve Bank of St. Louis (FRED). http://research.stlouisfed.org/fred2/series/FYFSGDA188S) \n\n\nClick to view content\n\nFederal Surplus or Deficit as a Percentage of Gross Domestic ProductDebt/GDP Ratio\nAnother useful way to view the budget deficit is through the prism of accumulated debt rather than annual deficits. The national debt refers to the total amount that the government has borrowed over time. In contrast, the budget deficit refers to how much the government has borrowed in one particular year. Figure 17.8 shows the ratio of debt/GDP since 1940. Until the 1970s, the debt/GDP ratio revealed a fairly clear pattern of federal borrowing. The government ran up large deficits and raised the debt/GDP ratio in World War II, but from the 1950s to the 1970s the government ran either surpluses or relatively small deficits, and so the debt/GDP ratio drifted down. Large deficits in the 1980s and early 1990s caused the ratio to rise sharply. When budget surpluses arrived from 1998 to 2001, the debt/GDP ratio declined substantially. The budget deficits starting in 2002 then tugged the debt/GDP ratio higherwith a big jump when the recession took hold in 20082009.\n\n\n\nFigure \n17.8\n \nFederal Debt as a Percentage of GDP, 19422014\n \nFederal debt is the sum of annual budget deficits and surpluses. Annual deficits do not always mean that the debt/GDP ratio is rising. During the 1960s and 1970s, the government often ran small deficits, but since the debt was growing more slowly than the economy, the debt/GDP ratio was declining over this time. In the 20082009 recession, the debt/GDP ratio rose sharply. (Source: Economic Report of the President, Table B-20, http://www.gpo.gov/fdsys/pkg/ERP-2015/content-detail.html)\n\nThe next Clear it Up feature discusses how the government handles the national debt.\nClear It Up\n\n\nWhat is the national debt?\n\nOne years federal budget deficit causes the federal government to sell Treasury bonds to make up the difference between spending programs and tax revenues. The dollar value of all the outstanding Treasury bonds on which the federal government owes money is equal to the national debt.\n\nClick to view content\nGross Federal Debt as a Percentage of Gross Domestic Product\n\nThe Path from Deficits to Surpluses to Deficits\nWhy did the budget deficits suddenly turn to surpluses from 1998 to 2001 and why did the surpluses return to deficits in 2002? Why did the deficit become so large after 2007? Figure 17.9 suggests some answers. The graph combines the earlier information on total federal spending and taxes in a single graph, but focuses on the federal budget since 1990.\n\n\n\nFigure \n17.9\n \nTotal Government Spending and Taxes as a Share of GDP, 19902014 \n \nWhen government spending exceeds taxes, the gap is the budget deficit. When taxes exceed spending, the gap is a budget surplus. The recessionary period starting in late 2007 saw higher spending and lower taxes, combining to create a large deficit in 2009. (Source: Economic Report of the President, Tables B-21 and B-1,\"http://www.gpo.gov/fdsys/pkg/ERP-2015/content-detail.html)\n\nGovernment spending as a share of GDP declined steadily through the 1990s. The biggest single reason was that defense spending declined from 5.2% of GDP in 1990 to 3.0% in 2000, but interest payments by the federal government also fell by about 1.0% of GDP. However, federal tax collections increased substantially in the later 1990s, jumping from 18.1% of GDP in 1994 to 20.8% in 2000. Powerful economic growth in the late 1990s fueled the boom in taxes. Personal income taxes rise as income goes up; payroll taxes rise as jobs and payrolls go up; corporate income taxes rise as profits go up. At the same time, government spending on transfer payments such as unemployment benefits, foods stamps, and welfare declined with more people working.\nThis sharp increase in tax revenues and decrease in expenditures on transfer payments was largely unexpected even by experienced budget analysts, and so budget surpluses came as a surprise. However, in the early 2000s, many of these factors started running in reverse. Tax revenues sagged, due largely to the recession that started in March 2001, which reduced revenues. Congress enacted a series of tax cuts and President George W. Bush signed them into law, starting in 2001. In addition, government spending swelled due to increases in defense, healthcare, education, Social Security, and support programs for those who were hurt by the recession and the slow growth that followed. Deficits returned. When the severe recession hit in late 2007, spending climbed and tax collections fell to historically unusual levels, resulting in enormous deficits.Longer-term U.S. budget forecasts, a decade or more into the future, predict enormous deficits. The higher deficits during the 2008-2009 recession have repercussions, and the demographics will be challenging. The primary reason is the baby boomthe exceptionally high birthrates that began in 1946, right after World War II, and lasted for about two decades. Starting in 2010, the front edge of the baby boom generation began to reach age 65, and in the next two decades, the proportion of Americans over the age of 65 will increase substantially. The current level of the payroll taxes that support Social Security and Medicare will fall well short of the projected expenses of these programs, as the following Clear It Up feature shows; thus, the forecast is for large budget deficits. A decision to collect more revenue to support these programs or to decrease benefit levels would alter this long-term forecast.\nClear It Up\n\n\nWhat is the long-term budget outlook for Social Security and Medicare?\n\nIn 1946, just one American in 13 was over age 65. By 2000, it was one in eight. By 2030, one American in five will be over age 65. Two enormous U.S. federal programs focus on the elderlySocial Security and Medicare. The growing numbers of elderly Americans will increase spending on these programs, as well as on Medicaid. The current payroll tax levied on workers, which supports all of Social Security and the hospitalization insurance part of Medicare, will not be enough to cover the expected costs, so what are the options?Long-term projections from the Congressional Budget Office in 2009 are that Medicare and Social Security spending combined will rise from 8.3% of GDP in 2009 to about 13% by 2035 and about 20% in 2080. If this rise in spending occurs, without any corresponding rise in tax collections, then some mix of changes must occur: (1) taxes will need to increase dramatically; (2) other spending will need to be cut dramatically; (3) the retirement age and/or age receiving Medicare benefits will need to increase, or (4) the federal government will need to run extremely large budget deficits.Some proposals suggest removing the cap on wages subject to the payroll tax, so that those with very high incomes would have to pay the tax on the entire amount of their wages. Other proposals suggest moving Social Security and Medicare from systems in which workers pay for retirees toward programs that set up accounts where workers save funds over their lifetimes and then draw out after retirement to pay for healthcare.\nThe United States is not alone in this problem. Providing the promised level of retirement and health benefits to a growing proportion of elderly with a falling proportion of workers is an even more severe problem in many European nations and in Japan. How to pay promised levels of benefits to the elderly will be a difficult public policy decision.\nIn the next module we shift to the use of fiscal policy to counteract business cycle fluctuations. In addition, we will explore proposals requiring a balanced budgetthat is, for government spending and taxes to be equal each year. The Impacts of Government Borrowing will also cover how fiscal policy and government borrowing will affect national savingand thus affect economic growth and trade imbalances.\n", "17-4": "By the end of this section, you will be able to:\nExplain how expansionary fiscal policy can shift aggregate demand and influence the economy\nExplain how contractionary fiscal policy can shift aggregate demand and influence the economy\n\nFiscal policy is the use of government spending and tax policy to influence the path of the economy over time. Graphically, we see that fiscal policy, whether through changes in spending or taxes, shifts the aggregate demand outward in the case of expansionary fiscal policy and inward in the case of contractionary fiscal policy. We know from the chapter on economic growth that over time the quantity and quality of our resources grow as the population and thus the labor force get larger, as businesses invest in new capital, and as technology improves. The result of this is regular shifts to the right of the aggregate supply curves, as Figure 17.10 illustrates. The original equilibrium occurs at E0, the intersection of aggregate demand curve AD0 and aggregate supply curve SRAS0, at an output level of 200 and a price level of 90. One year later, aggregate supply has shifted to the right to SRAS1 in the process of long-term economic growth, and aggregate demand has also shifted to the right to AD1, keeping the economy operating at the new level of potential GDP. The new equilibrium (E1) is an output level of 206 and a price level of 92. One more year later, aggregate supply has again shifted to the right, now to SRAS2, and aggregate demand shifts right as well to AD2. Now the equilibrium is E2, with an output level of 212 and a price level of 94. In short, the figure shows an economy that is growing steadily year to year, producing at its potential GDP each year, with only small inflationary increases in the price level.\n\n\n\nFigure \n17.10\n \nA Healthy, Growing Economy \n \nIn this well-functioning economy, each year aggregate supply and aggregate demand shift to the right so that the economy proceeds from equilibrium E0 to E1 to E2. Each year, the economy produces at potential GDP with only a small inflationary increase in the price level. However, if aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth with deflation can develop.\n\nAggregate demand and aggregate supply do not always move neatly together. Think about what causes shifts in aggregate demand over time. As aggregate supply increases, incomes tend to go up. This tends to increase consumer and investment spending, shifting the aggregate demand curve to the right, but in any given period it may not shift the same amount as aggregate supply. What happens to government spending and taxes? Government spends to pay for the ordinary business of government- items such as national defense, social security, and healthcare, as Figure 17.10 shows. Tax revenues, in part, pay for these expenditures. The result may be an increase in aggregate demand more than or less than the increase in aggregate supply.  \n\nAggregate demand may fail to increase along with aggregate supply, or aggregate demand may even shift left, for a number of possible reasons: households become hesitant about consuming; firms decide against investing as much; or perhaps the demand from other countries for exports diminishes. For example, investment by private firms in physical capital in the U.S. economy boomed during the late 1990s, rising from 14.1% of GDP in 1993 to 17.2% in 2000, before falling back to 15.2% by 2002. Conversely, if shifts in aggregate demand run ahead of increases in aggregate supply, inflationary increases in the price level will result. Business cycles of recession and recovery are the consequence of shifts in aggregate supply and aggregate demand. As these occur, the government may choose to use fiscal policy to address the difference.Monetary Policy and Bank Regulation shows us that a central bank can use its powers over the banking system to engage in countercyclicalor against the business cycleactions. If recession threatens, the central bank uses an expansionary monetary policy to increase the money supply, increase the quantity of loans, reduce interest rates, and shift aggregate demand to the right. If inflation threatens, the central bank uses contractionary monetary policy to reduce the money supply, reduce the quantity of loans, raise interest rates, and shift aggregate demand to the left. Fiscal policy is another macroeconomic policy tool for adjusting aggregate demand by using either government spending or taxation policy.Expansionary Fiscal Policy\nExpansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in tax rates. Expansionary policy can do this by (1) increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes; (2) increasing investment spending by raising after-tax profits through cuts in business taxes; and (3) increasing government purchases through increased federal government spending on final goods and services and raising federal grants to state and local governments to increase their expenditures on final goods and services. Contractionary fiscal policy does the reverse: it decreases the level of aggregate demand by decreasing consumption, decreasing investment, and decreasing government spending, either through cuts in government spending or increases in taxes. The aggregate demand/aggregate supply model is useful in judging whether expansionary or contractionary fiscal policy is appropriate.Consider first the situation in Figure 17.11, which is similar to the U.S. economy during the 2008-2009 recession. The intersection of aggregate demand (AD0) and aggregate supply (SRAS0) is occurring below the level of potential GDP as the LRAS curve indicates. At the equilibrium (E0), a recession occurs and unemployment rises. In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD1, closer to the full-employment level of output. In addition, the price level would rise back to the level P1 associated with potential GDP.\n\n\n\nFigure \n17.11\n \nExpansionary Fiscal Policy \n \nThe original equilibrium (E0) represents a recession, occurring at a quantity of output (Y0) below potential GDP. However, a shift of aggregate demand from AD0 to AD1, enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E1 at the level of potential GDP which the LRAS curve shows. Since the economy was originally producing below potential GDP, any inflationary increase in the price level from P0 to P1 that results should be relatively small.\n\nShould the government use tax cuts or spending increases, or a mix of the two, to carry out expansionary fiscal policy? During the 2008-2009 Great Recession (which started, actually, in late 2007), the U.S. economy suffered a 3.1% cumulative loss of GDP.  That may not sound like much, but its more than one years average growth rate of GDP.  Over that time frame, the unemployment rate doubled from 5% to 10%.  The consensus view is that this was possibly the worst economic downturn in U.S. history since the 1930s Great Depression. The choice between whether to use tax or spending tools often has a political tinge. As a general statement, conservatives and Republicans prefer to see expansionary fiscal policy carried out by tax cuts, while liberals and Democrats prefer that the government implement expansionary fiscal policy through spending increases. In a bipartisan effort to address the extreme situation, the Obama administration and Congress passed an $830 billion expansionary policy in early 2009 involving both tax cuts and increases in government spending. At the same time, however, the federal stimulus was partially offset when state and local governments, whose budgets were hard hit by the recession, began cutting their spending.The conflict over which policy tool to use can be frustrating to those who want to categorize economics as liberal or conservative, or who want to use economic models to argue against their political opponents. However, advocates of smaller government, who seek to reduce taxes and government spending can use the AD AS model, as well as advocates of bigger government, who seek to raise taxes and government spending. Economic studies of specific taxing and spending programs can help inform decisions about whether the government should change taxes or spending, and in what ways. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is a political decision rather than a purely economic one.\nContractionary Fiscal Policy\nFiscal policy can also contribute to pushing aggregate demand beyond potential GDP in a way that leads to inflation. As Figure 17.12 shows, a very large budget deficit pushes up aggregate demand, so that the intersection of aggregate demand (AD0) and aggregate supply (SRAS0) occurs at equilibrium E0, which is an output level above potential GDP. Economists sometimes call this an overheating economy where demand is so high that there is upward pressure on wages and prices, causing inflation. In this situation, contractionary fiscal policy involving federal spending cuts or tax increases can help to reduce the upward pressure on the price level by shifting aggregate demand to the left, to AD1, and causing the new equilibrium E1 to be at potential GDP, where aggregate demand intersects the LRAS curve.\n\n\n\nFigure \n17.12\n \nA Contractionary Fiscal Policy \n \nThe economy starts at the equilibrium quantity of output Y0, which is above potential GDP. The extremely high level of aggregate demand will generate inflationary increases in the price level. A contractionary fiscal policy can shift aggregate demand down from AD0 to AD1, leading to a new equilibrium output E1, which occurs at potential GDP, where AD1 intersects the LRAS curve.\n\nAgain, the ADAS model does not dictate how the government should carry out this contractionary fiscal policy. Some may prefer spending cuts; others may prefer tax increases; still others may say that it depends on the specific situation. The model only argues that, in this situation, the government needs to reduce aggregate demand.\n", "17-5": "By the end of this section, you will be able to:\nDescribe how the federal government can use discretionary fiscal policy to stabilize the economy\nIdentify examples of automatic stabilizers\nUnderstand how a government can use standardized employment budget to identify automatic stabilizers\n\nThe millions of unemployed in 20082009 could collect unemployment insurance benefits to replace some of their salaries. Federal fiscal policies include discretionary fiscal policy, when the government passes a new law that explicitly changes tax or spending levels. The 2009 stimulus package is an example. Changes in tax and spending levels can also occur automatically, due to automatic stabilizers, such as unemployment insurance and food stamps, which are programs that are already laws that stimulate aggregate demand in a recession and hold down aggregate demand in a potentially inflationary boom.Counterbalancing Recession and Boom\nConsider first the situation where aggregate demand has risen sharply, causing the equilibrium to occur at a level of output above potential GDP. This situation will increase inflationary pressure in the economy. The policy prescription in this setting would be a dose of contractionary fiscal policy, implemented through some combination of higher taxes and lower spending. To some extent, both changes happen automatically. On the tax side, a rise in aggregate demand means that workers and firms throughout the economy earn more. Because taxes are based on personal income and corporate profits, a rise in aggregate demand automatically increases tax payments. On the spending side, stronger aggregate demand typically means lower unemployment and fewer layoffs, and so there is less need for government spending on unemployment benefits, welfare, Medicaid, and other programs in the social safety net.\nThe process works in reverse, too. If aggregate demand were to fall sharply so that a recession occurs, then the prescription would be for expansionary fiscal policysome mix of tax cuts and spending increases. The lower level of aggregate demand and higher unemployment will tend to pull down personal incomes and corporate profits, an effect that will reduce the amount of taxes owed automatically. Higher unemployment and a weaker economy should lead to increased government spending on unemployment benefits, welfare, and other similar domestic programs. In 2009, the stimulus package included an extension in the time allowed to collect unemployment insurance. In addition, the automatic stabilizers react to a weakening of aggregate demand with expansionary fiscal policy and react to a strengthening of aggregate demand with contractionary fiscal policy, just as the AD/AS analysis suggests.A combination of automatic stabilizers and discretionary fiscal policy produced the very large budget deficit in 2009. The Great Recession, starting in late 2007, meant less tax-generating economic activity, which triggered the automatic stabilizers that reduce taxes. Most economists, even those who are concerned about a possible pattern of persistently large budget deficits, are much less concerned or even quite supportive of larger budget deficits in the short run of a few years during and immediately after a severe recession.A glance back at economic history provides a second illustration of the power of automatic stabilizers. Remember that the length of economic upswings between recessions has become longer in the U.S. economy in recent decades (as we discussed in Unemployment). The three longest economic booms of the twentieth century happened in the 1960s, the 1980s, and the 19912001 time period. One reason why the economy has tipped into recession less frequently in recent decades is that the size of government spending and taxes has increased in the second half of the twentieth century. Thus, the automatic stabilizing effects from spending and taxes are now larger than they were in the first half of the twentieth century. Around 1900, for example, federal spending was only about 2% of GDP. In 1929, just before the Great Depression hit, government spending was still just 4% of GDP. In those earlier times, the smaller size of government made automatic stabilizers far less powerful than in the last few decades, when government spending often hovers at 20% of GDP or more.\nThe Standardized Employment Deficit or Surplus\nEach year, the nonpartisan Congressional Budget Office (CBO) calculates the standardized employment budgetthat is, what the budget deficit or surplus would be if the economy were producing at potential GDP, where people who look for work were finding jobs in a reasonable period of time and businesses were making normal profits, with the result that both workers and businesses would be earning more and paying more taxes. In effect, the standardized employment deficit eliminates the impact of the automatic stabilizers. Figure 17.13 compares the actual budget deficits of recent decades with the CBOs standardized deficit.\n\nLink It Up\n\nVisit this website to learn more from the Congressional Budget Office.\n\n\n\n\nFigure \n17.13\n \nComparison of Actual Budget Deficits with the Standardized Employment Deficit \n \nWhen the economy is in recession, the standardized employment budget deficit is less than the actual budget deficit because the economy is below potential GDP, and the automatic stabilizers are reducing taxes and increasing spending. When the economy is performing extremely well, the standardized employment deficit (or surplus) is higher than the actual budget deficit (or surplus) because the economy is producing about potential GDP, so the automatic stabilizers are increasing taxes and reducing the need for government spending. (Sources: Actual and Cyclically Adjusted Budget Surpluses/Deficits, http://www.cbo.gov/publication/43977; and  Economic Report of the President, Table B-1, http://www.gpo.gov/fdsys/pkg/ERP-2013/content-detail.html)\n\nNotice that in recession years, like the early 1990s, 2001, or 2009, the standardized employment deficit is smaller than the actual deficit. During recessions, the automatic stabilizers tend to increase the budget deficit, so if the economy was instead at full employment, the deficit would be reduced. However, in the late 1990s the standardized employment budget surplus was lower than the actual budget surplus. The gap between the standardized budget deficit or surplus and the actual budget deficit or surplus shows the impact of the automatic stabilizers. More generally, the standardized budget figures allow you to see what the budget deficit would look like with the economy held constantat its potential GDP level of output.\nAutomatic stabilizers occur quickly. Lower wages means that a lower amount of taxes is withheld from paychecks right away. Higher unemployment or poverty means that government spending in those areas rises as quickly as people apply for benefits. However, while the automatic stabilizers offset part of the shifts in aggregate demand, they do not offset all or even most of it. Historically, automatic stabilizers on the tax and spending side offset about 10% of any initial movement in the level of output. This offset may not seem enormous, but it is still useful. Automatic stabilizers, like shock absorbers in a car, can be useful if they reduce the impact of the worst bumps, even if they do not eliminate the bumps altogether.\n\n", "17-6": "By the end of this section, you will be able to:\nUnderstand how fiscal policy and monetary policy are interconnected\nExplain the three lag times that often occur when solving economic problems\nIdentify the legal and political challenges of responding to an economic problem\n\nIn the early 1960s, many leading economists believed that the problem of the business cycle, and the swings between cyclical unemployment and inflation, were a thing of the past. On the cover of its December 31, 1965, issue, Time magazine, then the premier news magazine in the United States, ran a picture of John Maynard Keynes, and the story inside identified Keynesian theories as the prime influence on the worlds economies. The article reported that policymakers have used Keynesian principles not only to avoid the violent [business] cycles of prewar days but to produce phenomenal economic growth and to achieve remarkably stable prices.This happy consensus, however, did not last. The U.S. economy suffered one recession from December 1969 to November 1970, a deeper recession from November 1973 to March 1975, and then double-dip recessions from January to June 1980 and from July 1981 to November 1982. At various times, inflation and unemployment both soared. Clearly, the problems of macroeconomic policy had not been completely solved. As economists began to consider what had gone wrong, they identified a number of issues that make discretionary fiscal policy more difficult than it had seemed in the rosy optimism of the mid-1960s.\nFiscal Policy and Interest Rates\nBecause fiscal policy affects the quantity that the government borrows in financial capital markets, it not only affects aggregate demandit can also affect interest rates. In Figure 17.14, the original equilibrium (E0) in the financial capital market occurs at a quantity of $800 billion and an interest rate of 6%. However, an increase in government budget deficits shifts the demand for financial capital from D0 to D1. The new equilibrium (E1) occurs at a quantity of $900 billion and an interest rate of 7%.\nA consensus estimate based on a number of studies is that an increase in budget deficits (or a fall in budget surplus) by 1% of GDP will cause an increase of 0.51.0% in the long-term interest rate.\n\n\n\n\nFigure \n17.14\n \nFiscal Policy and Interest Rates \n \nWhen a government borrows money in the financial capital market, it causes a shift in the demand for financial capital from D0 to D1. As the equilibrium moves from E0 to E1, the equilibrium interest rate rises from 6% to 7% in this example. In this way, an expansionary fiscal policy intended to shift aggregate demand to the right can also lead to a higher interest rate, which has the effect of shifting aggregate demand back to the left.\n\nA problem arises here. An expansionary fiscal policy, with tax cuts or spending increases, is intended to increase aggregate demand. If an expansionary fiscal policy also causes higher interest rates, then firms and households are discouraged from borrowing and spending (as occurs with tight monetary policy), thus reducing aggregate demand. Even if the direct effect of expansionary fiscal policy on increasing demand is not totally offset by lower aggregate demand from higher interest rates, fiscal policy can end up less powerful than was originally expected. We refer to this as crowding out, where government borrowing and spending results in higher interest rates, which reduces business investment and household consumption.The broader lesson is that the government must coordinate fiscal and monetary policy. If expansionary fiscal policy is to work well, then the central bank can also reduce or keep short-term interest rates low. Conversely, monetary policy can also help to ensure that contractionary fiscal policy does not lead to a recession.\nLong and Variable Time Lags\nThe government can change monetary policy several times each year, but it takes much longer to enact fiscal policy. Imagine that the economy starts to slow down. It often takes some months before the economic statistics signal clearly that a downturn has started, and a few months more to confirm that it is truly a recession and not just a one- or two-month blip. Economists often call the time it takes to determine that a recession has occurred the recognition lag. After this lag, policymakers become aware of the problem and propose fiscal policy bills. The bills go into various congressional committees for hearings, negotiations, votes, and then, if passed, eventually for the presidents signature. Many fiscal policy bills about spending or taxes propose changes that would start in the next budget year or would be phased in gradually over time. Economists often refer to the time it takes to pass a bill as the legislative lag. Finally, once the government passes the bill it takes some time to disperse the funds to the appropriate agencies to implement the programs. Economists call the time it takes to start the projects the implementation lag.Moreover, the exact level of fiscal policy that the government should implement is never completely clear. Should it increase the budget deficit by 0.5% of GDP? By 1% of GDP? By 2% of GDP? In an AD/AS diagram, it is straightforward to sketch an aggregate demand curve shifting to the potential GDP level of output. In the real world, we only know roughly, not precisely, the actual level of potential output, and exactly how a spending cut or tax increase will affect aggregate demand is always somewhat controversial. Also unknown is the state of the economy at any point in time. During the early days of the Obama administration, for example, no one knew the true extent of the economy's deficit. During the 2008-2009 financial crisis, the rapid collapse of the banking system and automotive sector made it difficult to assess how quickly the economy was collapsing.Thus, it can take many months or even more than a year to begin an expansionary fiscal policy after a recession has startedand even then, uncertainty will remain over exactly how much to expand or contract taxes and spending. When politicians attempt to use countercyclical fiscal policy to fight recession or inflation, they run the risk of responding to the macroeconomic situation of two or three years ago, in a way that may be exactly wrong for the economy at that time. George P. Schultz, a professor of economics, former Secretary of the Treasury, and Director of the Office of Management and Budget, once wrote: While the economist is accustomed to the concept of lags, the politician likes instant results. The tension comes because, as I have seen on many occasions, the economists lag is the politicians nightmare.\n\nTemporary and Permanent Fiscal Policy\nA temporary tax cut or spending increase will explicitly last only for a year or two, and then revert to its original level. A permanent tax cut or spending increase is expected to stay in place for the foreseeable future. The effect of temporary and permanent fiscal policies on aggregate demand can be very different. Consider how you would react if the government announced a tax cut that would last one year and then be repealed, in comparison with how you would react if the government announced a permanent tax cut. Most people and firms will react more strongly to a permanent policy change than a temporary one.This fact creates an unavoidable difficulty for countercyclical fiscal policy. The appropriate policy may be to have an expansionary fiscal policy with large budget deficits during a recession, and then a contractionary fiscal policy with budget surpluses when the economy is growing well. However, if both policies are explicitly temporary ones, they will have a less powerful effect than a permanent policy.\nStructural Economic Change Takes Time\nWhen an economy recovers from a recession, it does not usually revert to its exact earlier shape. Instead, the economy's internal structure evolves and changes and this process can take time. For example, much of the economic growth of the mid-2000s was in the construction sector (especially of housing) and finance. However, when housing prices started falling in 2007 and the resulting financial crunch led into recession (as we discussed in Monetary Policy and Bank Regulation), both sectors contracted. The manufacturing sector of the U.S. economy has been losing jobs in recent years as well, under pressure from technological change and foreign competition. Many of the people who lost work from these sectors in the 2008-2009 Great Recession will never return to the same jobs in the same sectors of the economy. Instead, the economy will need to grow in new and different directions, as the following Clear It Up feature shows. Fiscal policy can increase overall demand, but the process of structural economic changethe expansion of a new set of industries and the movement of workers to those industriesinevitably takes time.\nClear It Up\n\n\nWhy do jobs vanish?\n\nPeople can lose jobs for a variety of reasons: because of a recession, but also because of longer-run changes in the economy, such as new technology. Productivity improvements in auto manufacturing, for example, can reduce the number of workers needed, and eliminate these jobs in the long run. The internet has created jobs but also caused job loss, from travel agents to book store clerks. Many of these jobs may never come back. Short-run fiscal policy to reduce unemployment can create jobs, but it cannot replace jobs that will never return.\n\nThe Limitations of Fiscal Policy\nFiscal policy can help an economy that is producing below its potential GDP to expand aggregate demand so that it produces closer to potential GDP, thus lowering unemployment. However, fiscal policy cannot help an economy produce at an output level above potential GDP without causing inflation At this point, unemployment becomes so low that workers become scarce and wages rise rapidly.\nLink It Up\n\nVisit  this website to read about how fiscal policies are affecting the recovery.\n\nPolitical Realties and Discretionary Fiscal Policy\nA final problem for discretionary fiscal policy arises out of the difficulties of explaining to politicians how countercyclical fiscal policy that runs against the tide of the business cycle should work. Some politicians have a gut-level belief that when the economy and tax revenues slow down, it is time to hunker down, pinch pennies, and trim expenses. Countercyclical policy, however, says that when the economy has slowed, it is time for the government to stimulate the economy, raising spending, and cutting taxes. This offsets the drop in the economy in the other sectors. Conversely, when economic times are good and tax revenues are rolling in, politicians often feel that it is time for tax cuts and new spending. However, countercyclical policy says that this economic boom should be an appropriate time for keeping taxes high and restraining spending.Politicians tend to prefer expansionary fiscal policy over contractionary policy. There is rarely a shortage of proposals for tax cuts and spending increases, especially during recessions. However, politicians are less willing to hear the message that in good economic times, they should propose tax increases and spending limits. In the economic upswing of the late 1990s and early 2000s, for example, the U.S. GDP grew rapidly. Estimates from respected government economic forecasters like the nonpartisan Congressional Budget Office and the Office of Management and Budget stated that the GDP was above potential GDP, and that unemployment rates were unsustainably low. However, no mainstream politician took the lead in saying that the booming economic times might be an appropriate time for spending cuts or tax increases. As of February 2017, President Trump has expressed plans to increase spending on national defense by 10% or $54 billion, increase infrastructure investment by $1 trillion, cut corporate and personal income taxes, all while maintaining the existing spending on Social Security and Medicare. The only way this math adds up is with a sizeable increase in the Federal budget deficit.\nDiscretionary Fiscal Policy: Summing Up\nExpansionary fiscal policy can help to end recessions and contractionary fiscal policy can help to reduce inflation. Given the uncertainties over interest rate effects, time lags, temporary and permanent policies, and unpredictable political behavior, many economists and knowledgeable policymakers had concluded by the mid-1990s that discretionary fiscal policy was a blunt instrument, more like a club than a scalpel. It might still make sense to use it in extreme economic situations, like an especially deep or long recession. For less extreme situations, it was often preferable to let fiscal policy work through the automatic stabilizers and focus on monetary policy to steer short-term countercyclical efforts.\n\n", "17-7": "By the end of this section, you will be able to:\nUnderstand the arguments for and against requiring the U.S. federal budget to be balanced\nConsider the long-run and short-run effects of a federal budget deficit\n\nFor many decades, going back to the 1930s, various legislators have put forward proposals to require that the U.S. government balance its budget every year. In 1995, a proposed constitutional amendment that would require a balanced budget passed the U.S. House of Representatives by a wide margin, and failed in the U.S. Senate by only a single vote. (For the balanced budget to have become an amendment to the Constitution would have required a two-thirds vote by Congress and passage by three-quarters of the state legislatures.)Most economists view the proposals for a perpetually balanced budget with bemusement. After all, in the short term, economists would expect the budget deficits and surpluses to fluctuate up and down with the economy and the automatic stabilizers. Economic recessions should automatically lead to larger budget deficits or smaller budget surpluses, while economic booms lead to smaller deficits or larger surpluses. A requirement that the budget be balanced each and every year would prevent these automatic stabilizers from working and would worsen the severity of economic fluctuations.\nSome supporters of the balanced budget amendment like to argue that, since households must balance their own budgets, the government should too. However, this analogy between household and government behavior is severely flawed. Most households do not balance their budgets every year. Some years households borrow to buy houses or cars or to pay for medical expenses or college tuition. Other years they repay loans and save funds in retirement accounts. After retirement, they withdraw and spend those savings. Also, the government is not a household for many reasons, one of which is that the government has macroeconomic responsibilities. The argument of Keynesian macroeconomic policy is that the government needs to lean against the wind, spending when times are hard and saving when times are good, for the sake of the overall economy.There is also no particular reason to expect a government budget to be balanced in the medium term of a few years. For example, a government may decide that by running large budget deficits, it can make crucial long-term investments in human capital and physical infrastructure that will build the country's long-term productivity. These decisions may work out well or poorly, but they are not always irrational. Such policies of ongoing government budget deficits may persist for decades. As the U.S. experience from the end of World War II up to about 1980 shows, it is perfectly possible to run budget deficits almost every year for decades, but as long as the percentage increases in debt are smaller than the percentage growth of GDP, the debt/GDP ratio will decline at the same time.Nothing in this argument is a claim that budget deficits are always a wise policy. In the short run, a government that runs a very large budget deficit can shift aggregate demand to the right and trigger severe inflation. Additionally, governments may borrow for foolish or impractical reasons. The Impacts of Government Borrowing will discuss how large budget deficits, by reducing national saving, can in certain cases reduce economic growth and even contribute to international financial crises. A requirement that the budget be balanced in each calendar year, however, is a misguided overreaction to the fear that in some cases, budget deficits can become too large.\nBring It Home\n\n\nNo Yellowstone Park?\n\nThe 2013 federal budget shutdown illustrated the many sides to fiscal policy and the federal budget. In 2013, Republicans and Democrats could not agree on which spending policies to fund and how large the government debt should be. Due to the severity of the 2008-2009 recession, the fiscal stimulus, and previous policies, the federal budget deficit and debt was historically high. One way to try to cut federal spending and borrowing was to refuse to raise the legal federal debt limit, or tie on conditions to appropriation bills to stop the Affordable Health Care Act. This disagreement led to a two-week federal government shutdown and got close to the deadline where the federal government would default on its Treasury bonds. Finally, however, a compromise emerged and the government avoided default. This shows clearly how closely fiscal policies are tied to politics.\n", "18-1": "By the end of this section, you will be able to:\nExplain the national saving and investment identity in terms of demand and supply\nEvaluate the role of budget surpluses and trade surpluses in national saving and investment identity\n\nWhen governments are borrowers in financial markets, there are three possible sources for the funds from a macroeconomic point of view: (1) households might save more; (2) private firms might borrow less; and (3) the additional funds for government borrowing might come from outside the country, from foreign financial investors. Lets begin with a review of why one of these three options must occur, and then explore how interest rates and exchange rates adjust to these connections.\nThe National Saving and Investment Identity\nThe national saving and investment identity, which we first introduced in The International Trade and Capital Flows chapter, provides a framework for showing the relationships between the sources of demand and supply in financial capital markets. The identity begins with a statement that must always hold true: the quantity of financial capital supplied in the market must equal the quantity of financial capital demanded.The U.S. economy has two main sources for financial capital: private savings from inside the U.S. economy and public savings.Totalsavings=Privatesavings(S)+Publicsavings(TG)Totalsavings=Privatesavings(S)+Publicsavings(TG)These include the inflow of foreign financial capital from abroad. The inflow of savings from abroad is, by definition, equal to the trade deficit, as we explained in The International Trade and Capital Flows chapter. We can write this inflow of foreign investment capital as imports (M) minus exports (X). There are also two main sources of demand for financial capital: private sector investment (I) and government borrowing. Government borrowing in any given year is equal to the budget deficit, which we can write as the difference between government spending (G) and net taxes (T). Lets call this equation 1.Quantitysuppliedoffinancialcapital=QuantitydemandedoffinancialcapitalPrivatesavings+Inflowofforeignsavings=Privateinvestment+GovernmentbudgetdeficitS+(MX)=I+(GT)Quantitysuppliedoffinancialcapital=QuantitydemandedoffinancialcapitalPrivatesavings+Inflowofforeignsavings=Privateinvestment+GovernmentbudgetdeficitS+(MX)=I+(GT)Governments often spend more than they receive in taxes and, therefore, public savings (T  G) is negative. This causes a need to borrow money in the amount of (G  T) instead of adding to the nations savings. If this is the case, we can view governments as demanders of financial capital instead of suppliers. In algebraic terms, we can rewrite the national savings and investment identity like this:Privateinvestment=Privatesavings+Publicsavings+TradedeficitI=S+(TG)+(MX)Privateinvestment=Privatesavings+Publicsavings+TradedeficitI=S+(TG)+(MX)\nLets call this equation 2. We must accompany a change in any part of the national saving and investment identity by offsetting changes in at least one other part of the equation because we assume that the equality of quantity supplied and quantity demanded always holds. If the government budget deficit changes, then either private saving or investment or the trade balanceor some combination of the threemust change as well. Figure 18.2 shows the possible effects.\n\n\n\nFigure \n18.2\n \nEffects of Change in Budget Surplus or Deficit on Investment, Savings, and The Trade Balance \n \nChart (a) shows the potential results when the budget deficit rises (or budget surplus falls). Chart (b) shows the potential results when the budget deficit falls (or budget surplus rises).\n\n\nWhat about Budget Surpluses and Trade Surpluses?\nThe national saving and investment identity must always hold true because, by definition, the quantity supplied and quantity demanded in the financial capital market must always be equal. However, the formula will look somewhat different if the government budget is in deficit rather than surplus or if the balance of trade is in surplus rather than deficit. For example, in 1999 and 2000, the U.S. government had budget surpluses, although the economy was still experiencing trade deficits. When the government was running budget surpluses, it was acting as a saver rather than a borrower, and supplying rather than demanding financial capital. As a result, we would write the national saving and investment identity during this time as:Quantitysuppliedoffinancialcapital\n=Quantitydemandedoffinancialcapital\nPrivatesavings+Tradedeficit+Governmentsurplus=\nPrivateinvestment\nS+(MX)+(TG)\n=\nIQuantitysuppliedoffinancialcapital\n=Quantitydemandedoffinancialcapital\nPrivatesavings+Tradedeficit+Governmentsurplus=\nPrivateinvestment\nS+(MX)+(TG)\n=\nILet's call this equation 3. Notice that this expression is mathematically the same as equation 2 except the savings and investment sides of the identity have simply flipped sides. During the 1960s, the U.S. government was often running a budget deficit, but the economy was typically running trade surpluses. Since a trade surplus means that an economy is experiencing a net outflow of financial capital, we would write the national saving and investment identity as:Quantitysuppliedoffinancialcapital=QuantitydemandedoffinancialcapitalPrivatesavings=Privateinvestment+Outflowofforeignsavings+GovernmentbudgetdeficitS=I+(XM)+(GT)Quantitysuppliedoffinancialcapital=QuantitydemandedoffinancialcapitalPrivatesavings=Privateinvestment+Outflowofforeignsavings+GovernmentbudgetdeficitS=I+(XM)+(GT)Instead of the balance of trade representing part of the supply of financial capital, which occurs with a trade deficit, a trade surplus represents an outflow of financial capital leaving the domestic economy and invested elsewhere in the world.Quantitysuppliedoffinancialcapital=QuantitydemandedoffinancialcapitaldemandPrivatesavings=Privateinvestment+Governmentbudgetdeficit+TradesurplusS=I+(GT)+(XM)Quantitysuppliedoffinancialcapital=QuantitydemandedoffinancialcapitaldemandPrivatesavings=Privateinvestment+Governmentbudgetdeficit+TradesurplusS=I+(GT)+(XM)We assume that the point to these equations is that the national saving and investment identity always hold. When you write these relationships, it is important to engage your brain and think about what is on the supply and demand side of the financial capital market before you start your calculations.As you can see in Figure 18.3, the Office of Management and Budget shows that the United States has consistently run budget deficits since 1977, with the exception of 1999 and 2000. What is alarming is the dramatic increase in budget deficits that has occurred since 2008, which in part reflects declining tax revenues and increased safety net expenditures due to the Great Recession. (Recall that T is net taxes. When the government must transfer funds back to individuals for safety net expenditures like Social Security and unemployment benefits, budget deficits rise.) These deficits have implications for the future health of the U.S. economy.\n\n\n\nFigure \n18.3\n \nUnited States On-Budget, Surplus, and Deficit, 19772014 ($ millions) \n \nThe United States has run a budget deficit for over 30 years, with the exception of 1999 and 2000. Military expenditures, entitlement programs, and the decrease in tax revenue coupled with increased safety net support during the Great Recession are major contributors to the dramatic increases in the deficit after 2008. (Source: Table 1.1, \"Summary of Receipts, Outlays, and Surpluses or Deficits,\" https://www.whitehouse.gov/omb/budget/Historicals)\n\nA rising budget deficit may result in a fall in domestic investment, a rise in private savings, or a rise in the trade deficit. The following modules discuss each of these possible effects in more detail.\n\n", "18-2": "By the end of this section, you will be able to:\nDiscuss twin deficits as they related to budget and trade deficit\nExplain the relationship between budget deficits and exchange rates\nExplain the relationship between budget deficits and inflation\nIdentify causes of recessions\n\nGovernment budget balances can affect the trade balance. As The Keynesian Perspective chapter discusses, a net inflow of foreign financial investment always accompanies a trade deficit, while a net outflow of financial investment always accompanies a trade surplus. One way to understand the connection from budget deficits to trade deficits is that when government creates a budget deficit with some combination of tax cuts or spending increases, it will increase aggregate demand in the economy, and some of that increase in aggregate demand will result in a higher level of imports. A higher level of imports, with exports remaining fixed, will cause a larger trade deficit. That means foreigners holdings of dollars increase as Americans purchase more imported goods. Foreigners use those dollars to invest in the United States, which leads to an inflow of foreign investment.  One possible source of funding our budget deficit is foreigners buying Treasury securities that the U.S. government sells, thus a trade deficit often accompanies a budget deficit.Twin Deficits?\nIn the mid-1980s, it was common to hear economists and even newspaper articles refer to the twin deficits, as the budget deficit and trade deficit both grew substantially. Figure 18.4 shows the pattern. The federal budget deficit went from 2.6% of GDP in 1981 to 5.1% of GDP in 1985a drop of 2.5% of GDP. Over that time, the trade deficit moved from 0.5% in 1981 to 2.9% in 1985a drop of 2.4% of GDP. In the mid-1980s an inflow of foreign investment capital matched, the considerable increase in government borrowing, so the government budget deficit and the trade deficit moved together.\n\n\n\nFigure \n18.4\n \nU.S. Budget Deficits and Trade Deficits \n \nIn the 1980s, the budget deficit and the trade deficit declined at the same time. However, since then, the deficits have stopped being twins. The trade deficit grew smaller in the early 1990s as the budget deficit increased, and then the trade deficit grew larger in the late 1990s as the budget deficit turned into a surplus. In the first half of the 2000s, both budget and trade deficits increased. However, in 2009, the trade deficit declined as the budget deficit increased. \n\nOf course, no one should expect the budget deficit and trade deficit to move in lockstep, because the other parts of the national saving and investment identityinvestment and private savingswill often change as well. In the late 1990s, for example, the government budget balance turned from deficit to surplus, but the trade deficit remained large and growing. During this time, the inflow of foreign financial investment was supporting a surge of physical capital investment by U.S. firms. In the first half of the 2000s, the budget and trade deficits again increased together, but in 2009, the budget deficit increased while the trade deficit declined. The budget deficit and the trade deficits are related to each other, but they are more like cousins than twins.\n\nBudget Deficits and Exchange Rates\nExchange rates can also help to explain why budget deficits are linked to trade deficits. Figure 18.5 shows a situation using the exchange rate for the U.S. dollar, measured in euros. At the original equilibrium (E0), where the demand for U.S. dollars (D0) intersects with the supply of U.S. dollars (S0) on the foreign exchange market, the exchange rate is 0.9 euros per U.S. dollar and the equilibrium quantity traded in the market is $100 billion per day (which was roughly the quantity of dollareuro trading in exchange rate markets in the mid-2000s). Then the U.S. budget deficit rises and foreign financial investment provides the source of funds for that budget deficit.International financial investors, as a group, will demand more U.S. dollars on foreign exchange markets to purchase the U.S. government bonds, and they will supply fewer of the U.S. dollars that they already hold in these markets. Demand for U.S. dollars on the foreign exchange market shifts from D0 to D1 and the supply of U.S. dollars falls from S0 to S1. At the new equilibrium (E1), the exchange rate has appreciated to 1.05 euros per dollar while, in this example, the quantity of dollars traded remains the same.\n\n\n\n\nFigure \n18.5\n \nBudget Deficits and Exchange Rates \n \nImagine that the U.S. government increases its borrowing and the funds come from European financial investors. To purchase U.S. government bonds, those European investors will need to demand more U.S. dollars on foreign exchange markets, causing the demand for U.S. dollars to shift to the right from D0 to D1. European financial investors as a group will also be less likely to supply U.S. dollars to the foreign exchange markets, causing the supply of U.S. dollars to shift from S0 to S1. The equilibrium exchange rate strengthens from 0.9 euro/ dollar at E0 to 1.05 euros/dollar at E1.\n\nA stronger exchange rate, of course, makes it more difficult for exporters to sell their goods abroad while making imports cheaper, so a trade deficit (or a reduced trade surplus) results. Thus, a budget deficit can easily result in an inflow of foreign financial capital, a stronger exchange rate, and a trade deficit.\nYou can also imagine interest rates are driving the exchange rate appreciation. As we explained earlier in Figure 18.8, a budget deficit increases demand in markets for domestic financial capital, raising the domestic interest rate. A higher interest rate will attract an inflow of foreign financial capital, and appreciate the exchange rate in response to the increase in demand for U.S. dollars by foreign investors and a decrease in supply of U. S. dollars. Because of higher interest rates in the United States, Americans find U.S. bonds more attractive than foreign bonds. When Americans are buying fewer foreign bonds, they are supplying fewer U.S. dollars. U.S. dollar appreciation leads to a larger trade deficit (or reduced surplus). The connections between inflows of foreign investment capital, interest rates, and exchange rates are all just different ways of drawing the same economic connections: a larger budget deficit can result in a larger trade deficit, although do not expect the connection to be one-to-one.\nFrom Budget Deficits to International Economic Crisis\nWe lay out step-by-step the economic story of how an outflow of international financial capital can cause a deep recession in the Exchange Rates and International Capital Flows chapter. When international financial investors decide to withdraw their funds from a country like Turkey, they increase the supply of the Turkish lira and reduce the demand for lira, depreciating the lira exchange rate. When firms and the government in a country like Turkey borrow money in international financial markets, they typically do so in stages. First, banks in Turkey borrow in a widely used currency like U.S. dollars or euros, then convert those U.S. dollars to lira, and then lend the money to borrowers in Turkey. If the lira's exchange rate value depreciates, then Turkeys banks will find it impossible to repay the international loans that are in U.S. dollars or euros.The combination of less foreign investment capital and banks that are bankrupt can sharply reduce aggregate demand, which causes a deep recession. Many countries around the world have experienced this kind of recession in recent years: along with Turkey in 2002, Mexico followed this general pattern in 1995, Thailand and countries across East Asia in 19971998, Russia in 1998, and Argentina in 2002. In many of these countries, large government budget deficits played a role in setting the stage for the financial crisis. A moderate increase in a budget deficit that leads to a moderate increase in a trade deficit and a moderate appreciation of the exchange rate is not necessarily a cause for concern. However, beyond some point that is hard to define in advance, a series of large budget deficits can become a cause for concern among international investors.One reason for concern is that extremely large budget deficits mean that aggregate demand may shift so far to the right as to cause high inflation. The example of Turkey is a situation where very large budget deficits brought inflation rates well into double digits. In addition, very large budget deficits at some point begin to raise a fear that the government would not repay the borrowing. In the last 175 years, the government of Turkey has been unable to pay its debts and defaulted on its loans six times. Brazils government has been unable to pay its debts and defaulted on its loans seven times; Venezuela, nine times; and Argentina, five times. The risk of high inflation or a default on repaying international loans will worry international investors, since both factors imply that the rate of return on their investments in that country may end up lower than expected. If international investors start withdrawing the funds from a country rapidly, the scenario of less investment, a depreciated exchange rate, widespread bank failure, and deep recession can occur. The following Clear It Up feature explains other impacts of large deficits.\nClear It Up\n\n\nWhat are the risks of chronic large deficits in the United States?\n\nIf a government runs large budget deficits for a sustained period of time, what can go wrong? According to a recent Brookings Institution report, a key risk of a large budget deficit is that government debt may grow too high compared to the countrys GDP growth. As debt grows, the national savings rate will decline, leaving less available in financial capital for private investment. The impact of chronically large budget deficits is as follows:\nAs the population ages, there will be an increasing demand for government services that may cause higher government deficits. Government borrowing and its interest payments will pull resources away from domestic investment in human capital and physical capital that is essential to economic growth.\nInterest rates may start to rise so that the cost of financing government debt will rise as well, creating pressure on the government to reduce its budget deficits through spending cuts and tax increases. These steps will be politically painful, and they will also have a contractionary effect on aggregate demand in the economy.\nRising percentage of debt to GDP will create uncertainty in the financial and global markets that might cause a country to resort to inflationary tactics to reduce the real value of the debt outstanding. This will decrease real wealth and damage confidence in the countrys ability to manage its spending. After all, if the government has borrowed at a fixed interest rate of, say, 5%, and it lets inflation rise above that 5%, then it will effectively be able to repay its debt at a negative real interest rate.\n\nThe conventional reasoning suggests that the relationship between sustained deficits that lead to high levels of government debt and long-term growth is negative. How significant this relationship is, how big an issue it is compared to other macroeconomic issues, and the direction of causality, is less clear.\nWhat remains important to acknowledge is that the relationship between debt and growth is negative and that for some countries, the relationship may be stronger than in others. It is also important to acknowledge the direction of causality: does high debt cause slow growth, slow growth cause high debt, or are both high debt and slow growth the result of third factors? In our analysis, we have argued simply that high debt causes slow growth. There may be more to this debate than we have space to discuss here.\n\n\nUsing Fiscal Policy to Address Trade Imbalances\nIf a nation is experiencing the inflow of foreign investment capital associated with a trade deficit because foreign investors are making long-term direct investments in firms, there may be no substantial reason for concern. After all, many low-income nations around the world would welcome direct investment by multinational firms that ties them more closely into the global networks of production and distribution of goods and services. In this case, the inflows of foreign investment capital and the trade deficit are attracted by the opportunities for a good rate of return on private sector investment in an economy.\nHowever, governments should beware of a sustained pattern of high budget deficits and high trade deficits. The danger arises in particular when the inflow of foreign investment capital is not funding long-term physical capital investment by firms, but instead is short-term portfolio investment in government bonds. When inflows of foreign financial investment reach high levels, foreign financial investors will be on the alert for any reason to fear that the countrys exchange rate may decline or the government may be unable to repay what it has borrowed on time. Just as a few falling rocks can trigger an avalanche; a relatively small piece of bad news about an economy can trigger an enormous outflow of short-term financial capital.\nReducing a nations budget deficit will not always be a successful method of reducing its trade deficit, because other elements of the national saving and investment identity, like private saving or investment, may change instead. In those cases when the budget deficit is the main cause of the trade deficit, governments should take steps to reduce their budget deficits, lest they make their economy vulnerable to a rapid outflow of international financial capital that could bring a deep recession.\n\n", "18-3": "By the end of this section, you will be able to:\nApply Ricardian equivalence to evaluate how government borrowing affects private saving\nInterpret a graphic representation of Ricardian equivalence\n\nA change in government budgets may impact private saving. Imagine that people watch government budgets and adjust their savings accordingly. For example, whenever the government runs a budget deficit, people might reason: Well, a higher budget deficit means that Im just going to owe more taxes in the future to pay off all that government borrowing, so Ill start saving now. If the government runs budget surpluses, people might reason: With these budget surpluses (or lower budget deficits), interest rates are falling, so that saving is less attractive. Moreover, with a budget surplus the country will be able to afford a tax cut sometime in the future. I wont bother saving as much now. \nThe theory that rational private households might shift their saving to offset government saving or borrowing is known as Ricardian equivalence because the idea has intellectual roots in the writings of the early nineteenth-century economist David Ricardo (17721823). If Ricardian equivalence holds completely true, then in the national saving and investment identity, any change in budget deficits or budget surpluses would be completely offset by a corresponding change in private saving. As a result, changes in government borrowing would have no effect at all on either physical capital investment or trade balances.\nIn practice, the private sector only sometimes and partially adjusts its savings behavior to offset government budget deficits and surpluses. Figure 18.6 shows the patterns of U.S. government budget deficits and surpluses and the rate of private savingwhich includes saving by both households and firmssince 1980. The connection between the two is not at all obvious. In the mid-1980s, for example, government budget deficits were quite large, but there is no corresponding surge of private saving. However, when budget deficits turn to surpluses in the late 1990s, there is a simultaneous decline in private saving. When budget deficits get very large in 2008 and 2009, there is some sign of a rise in saving. A variety of statistical studies based on the U.S. experience suggests that when government borrowing increases by $1, private saving rises by about 30 cents. A World Bank study from the late 1990s, looking at government budgets and private saving behavior in countries around the world, found a similar result.\n\n\n\nFigure \n18.6\n \nU.S. Budget Deficits and Private Savings \n \nThe theory of Ricardian equivalence suggests that additional private saving will offset any increase in government borrowing, while reduced private saving will offset any decrease in government borrowing. Sometimes this theory holds true, and sometimes it does not. (Source: Bureau of Economic Analysis and Federal Reserve Economic Data)\n\nPrivate saving does increase to some extent when governments run large budget deficits, and private saving falls when governments reduce deficits or run large budget surpluses. However, the offsetting effects of private saving compared to government borrowing are much less than one-to-one. In addition, this effect can vary a great deal from country to country, from time to time, and over the short and the long run.If the funding for a larger budget deficit comes from international financial investors, then a trade deficit may accompany a budget deficit. In some countries, this pattern of twin deficits has set the stage for international financial investors first to send their funds to a country and cause an appreciation of its exchange rate and then to pull their funds out and cause a depreciation of the exchange rate and a financial crisis as well. It depends on whether funding comes from international financial investors.\n", "18-4": "By the end of this section, you will be able to:\nExplain crowding out and its effect on physical capital investment\nExplain the relationship between budget deficits and interest rates\nIdentify why economic growth is tied to investments in physical capital, human capital, and technology\n\nThe underpinnings of economic growth are investments in physical capital, human capital, and technology, all set in an economic environment where firms and individuals can react to the incentives provided by well-functioning markets and flexible prices. Government borrowing can reduce the financial capital available for private firms to invest in physical capital. However, government spending can also encourage certain elements of long-term growth, such as spending on roads or water systems, on education, or on research and development that creates new technology.Crowding Out Physical Capital Investment\nA larger budget deficit will increase demand for financial capital. If private saving and the trade balance remain the same, then less financial capital will be available for private investment in physical capital. When government borrowing soaks up available financial capital and leaves less for private investment in physical capital, economists call the result crowding out.To understand the potential impact of crowding out, consider the U.S. economy's situation before the exceptional circumstances of the recession that started in late 2007. In 2005, for example, the budget deficit was roughly 4% of GDP. Private investment by firms in the U.S. economy has hovered in the range of 14% to 18% of GDP in recent decades. However, in any given year, roughly half of U.S. investment in physical capital just replaces machinery and equipment that has worn out or become technologically obsolete. Only about half represents an increase in the total quantity of physical capital in the economy. Investment in new physical capital in any year is about 7% to 9% of GDP. In this situation, even U.S. budget deficits in the range of 4% of GDP can potentially crowd out a substantial share of new investment spending. Conversely, a smaller budget deficit (or an increased budget surplus) increases the pool of financial capital available for private investment.\nLink It Up\n\nVisit this website to view the U.S. Debt Clock.\nFigure 18.7 shows the patterns of U.S. budget deficits and private investment since 1980. If greater government deficits lead to less private investment in physical capital, and reduced government deficits or budget surpluses lead to more investment in physical capital, these two lines should move up and down simultaneously. This pattern occurred in the late 1990s and early 2000s. The U.S. federal budget went from a deficit of 2.2% of GDP in 1995 to a budget surplus of 2.4% of GDP in 2000a swing of 4.6% of GDP. From 1995 to 2000, private investment in physical capital rose from 15% to 18% of GDPa rise of 3% of GDP. Then, when the U.S. government again started running budget deficits in the early 2000s, less financial capital became available for private investment, and the rate of private investment fell back to about 15% of GDP by 2003.\n\n\n\nFigure \n18.7\n \nU.S. Budget Deficits/Surpluses and Private Investment \n \nThe connection between private savings and flows of international capital plays a role in budget deficits and surpluses. Consequently, government borrowing and private investment sometimes rise and fall together. For example, the 1990s show a pattern in which reduced government borrowing helped to reduce crowding out so that more funds were available for private investment.\n\nThis argument does not claim that a government's budget deficits will exactly shadow its national rate of private investment; after all, we must account for private saving and inflows of foreign financial investment. In the mid-1980s, for example, government budget deficits increased substantially without a corresponding drop off in private investment. In 2009, nonresidential private fixed investment dropped by $300 billion from its previous level of $1,941 billion in 2008, primarily because, during a recession, firms lack both the funds and the incentive to invest. Investment growth between 2009 and 2014 averaged approximately 5.9% to $2,210.5 billiononly slightly above its 2008 level, according to the Bureau of Economic Analysis. During that same period, interest rates dropped from 3.94% to less than a quarter percent as the Federal Reserve took dramatic action to prevent a depression by increasing the money supply through lowering short-term interest rates. The \"crowding out\" of private investment due to government borrowing to finance expenditures appears to have been suspended during the Great Recession. However, as the economy improves and interest rates rise, government borrowing may potentially create pressure on interest rates.\nThe Interest Rate Connection\nAssume that government borrowing of substantial amounts will have an effect on the quantity of private investment. How will this affect interest rates in financial markets? In Figure 18.8, the original equilibrium (E0) where the demand curve (D0) for financial capital intersects with the supply curve (S0) occurs at an interest rate of 5% and an equilibrium quantity equal to 20% of GDP. However, as the government budget deficit increases, the demand curve for financial capital shifts from D0 to D1. The new equilibrium (E1) occurs at an interest rate of 6% and an equilibrium quantity of 21% of GDP.\n\n\n\nFigure \n18.8\n \nBudget Deficits and Interest Rates \n \nIn the financial market, an increase in government borrowing can shift the demand curve for financial capital to the right from D0 to D1. As the equilibrium interest rate shifts from E0 to E1, the interest rate rises from 5% to 6% in this example. The higher interest rate is one economic mechanism by which government borrowing can crowd out private investment.\n\nA survey of economic studies on the connection between government borrowing and interest rates in the U.S. economy suggests that an increase of 1% in the budget deficit will lead to a rise in interest rates of between 0.5 and 1.0%, other factors held equal. In turn, a higher interest rate tends to discourage firms from making physical capital investments. One reason government budget deficits crowd out private investment, therefore, is the increase in interest rates. There are, however, economic studies that show a limited connection between the two (at least in the United States), but as the budget deficit grows, the dangers of rising interest rates become more real.\nAt this point, you may wonder about the Federal Reserve. After all, can the Federal Reserve not use expansionary monetary policy to reduce interest rates, or in this case, to prevent interest rates from rising? This useful question emphasizes the importance of considering how fiscal and monetary policies work in relation to each other. Imagine a central bank faced with a government that is running large budget deficits, causing a rise in interest rates and crowding out private investment. If the budget deficits are increasing aggregate demand when the economy is already producing near potential GDP, threatening an inflationary increase in price levels, the central bank may react with a contractionary monetary policy. In this situation, the higher interest rates from the government borrowing would be made even higher by contractionary monetary policy, and the government borrowing might crowd out a great deal of private investment.Alternatively, if the budget deficits are increasing aggregate demand when the economy is producing substantially less than potential GDP, an inflationary increase in the price level is not much of a danger and the central bank might react with expansionary monetary policy. In this situation, higher interest rates from government borrowing would be largely offset by lower interest rates from expansionary monetary policy, and there would be little crowding out of private investment.However, even a central bank cannot erase the overall message of the national savings and investment identity. If government borrowing rises, then private investment must fall, or private saving must rise, or the trade deficit must rise. By reacting with contractionary or expansionary monetary policy, the central bank can only help to determine which of these outcomes is likely.\nPublic Investment in Physical Capital\nGovernment can invest in physical capital directly: roads and bridges; water supply and sewers; seaports and airports; schools and hospitals; plants that generate electricity, like hydroelectric dams or windmills; telecommunications facilities; and military weapons. In 2014, the U.S. federal government budget for Fiscal Year 2014 shows that the United States spent about $92 billion on transportation, including highways, mass transit, and airports. Table 18.1 shows the federal government's total outlay for 2014 for major public physical capital investment in the United States. We have omitted physical capital related to the military or to residences where people live from this table, because the focus here is on public investments that have a direct effect on raising output in the private sector.\n\nType of Public Physical Capital\nFederal Outlays 2014 ($ millions)\n\n\n\nTransportation\n\t$91,915\n\n\nCommunity and regional development\n\t$20,670\n\n\nNatural resources and the environment\n\t$36,171\n\n\nEducation, training, employment, and social services\n\t$90,615\n\n\nOther\n\t$37,282\n\n\nTotal\n $276,653\n\n\nTable \n18.1\n \nGrants for Major Physical Capital Investment, 2014\n \n\nPublic physical capital investment of this sort can increase the economy's output and productivity. An economy with reliable roads and electricity will be able to produce more. However, it is hard to quantify how much government investment in physical capital will benefit the economy, because government responds to political as well as economic incentives. When a firm makes an investment in physical capital, it is subject to the discipline of the market: If it does not receive a positive return on investment, the firm may lose money or even go out of business.In some cases, lawmakers make investments in physical capital as a way of spending money in key politicians' districts. The result may be unnecessary roads or office buildings. Even if a project is useful and necessary, it might be done in a way that is excessively costly, because local contractors who make campaign contributions to politicians appreciate the extra business. Alternatively, governments sometimes do not make the investments they should because a decision to spend on infrastructure does not need to just make economic sense. It must be politically popular as well. Managing public investment cost-effectively can be difficult.If a government decides to finance an investment in public physical capital with higher taxes or lower government spending in other areas, it need not worry that it is directly crowding out private investment. Indirectly however, higher household taxes could cut down on the level of private savings available and have a similar effect. If a government decides to finance an investment in public physical capital by borrowing, it may end up increasing the quantity of public physical capital at the cost of crowding out investment in private physical capital, which could be more beneficial to the economy.\nPublic Investment in Human Capital\nIn most countries, the government plays a large role in society's investment in human capital through the education system. A highly educated and skilled workforce contributes to a higher rate of economic growth. For the low-income nations of the world, additional investment in human capital seems likely to increase productivity and growth. For the United States, critics have raised tough questions about how much increases in government spending on education will improve the actual level of education.Among economists, discussions of education reform often begin with some uncomfortable facts. As Figure 18.9 shows, spending per student for kindergarten through grade 12 (K12) increased substantially in real dollars through 2010. The U.S. Census Bureau reports that current spending per pupil for elementary and secondary education rose from $5,001 in 1998 to $10,608 in 2012. However, as measured by standardized tests like the SAT, the level of student academic achievement has barely budged in recent decades. On international tests, U.S. students lag behind students from many other countries. (Of course, test scores are an imperfect measure of education for a variety of reasons. It would be difficult, however, to argue that there are not real problems in the U.S. education system and that the tests are just inaccurate.)\n\n\n\nFigure \n18.9\n \nTotal Spending for Elementary, Secondary, and Vocational Education (19982014) in the United States \n \nThe graph shows that government spending on education was continually increasing up until 2006 where it leveled off until 2008 when it increased dramatically. Since 2010, spending has steadily decreased. (Source: Office of Management and Budget)\n\nThe fact that increased financial resources have not brought greater measurable gains in student performance has led some education experts to question whether the problems may be due to structure, not just to the resources spent.\nOther government programs seek to increase human capital either before or after the K12 education system. Programs for early childhood education, like the federal Head Start program, are directed at families where the parents may have limited educational and financial resources. Government also offers substantial support for universities and colleges. For example, in the United States about 60% of students take at least a few college or university classes beyond the high school level. In Germany and Japan, about half of all students take classes beyond the comparable high school level. In the countries of Latin America, only about one student in four takes classes beyond the high school level, and in the nations of sub-Saharan Africa, only about one student in 20.\nNot all spending on educational human capital  needs to happen through the government: many college students in the United States pay a substantial share of the cost of their education. If low-income countries of the world are going to experience a widespread increase in their education levels for grade-school children, government spending seems likely to play a substantial role. For the U.S. economy, and for other high-income countries, the primary focus at this time is more on how to get a bigger return from existing spending on education and how to improve the performance of the average high school graduate, rather than dramatic increases in education spending.\nHow Fiscal Policy Can Improve Technology\nResearch and development (R&D) efforts are the lifeblood of new technology. According to the National Science Foundation, federal outlays for research, development, and physical plant improvements to various governmental agencies have remained at an average of 8.8% of GDP. About one-fifth of U.S. R&D spending goes to defense and space-oriented research. Although defense-oriented R&D spending may sometimes produce consumer-oriented spinoffs, R&D that is aimed at producing new weapons is less likely to benefit the civilian economy than direct civilian R&D spending.\nFiscal policy can encourage R&D using either direct spending or tax policy. Government could spend more on the R&D that it carries out in government laboratories, as well as expanding federal R&D grants to universities and colleges, nonprofit organizations, and the private sector. By 2014, the federal share of R&D outlays totaled $135.5 billion, or about 4% of the federal government's total budget outlays, according to data from the National Science Foundation. Fiscal policy can also support R&D through tax incentives, which allow firms to reduce their tax bill as they increase spending on research and development.\nSummary of Fiscal Policy, Investment, and Economic Growth\nInvestment in physical capital, human capital, and new technology is essential for long-term economic growth, as Table 18.2 summarizes. In a market-oriented economy, private firms will undertake most of the investment in physical capital, and fiscal policy should seek to avoid a long series of outsized budget deficits that might crowd out such investment. We will see the effects of many growth-oriented policies very gradually over time, as students are better educated, we make physical capital investments, and man invents and implements new technologies.\n\n\nPhysical Capital\nHuman Capital\nNew Technology\n\n\n\nPrivate Sector \n  New investment in property and equipment\n On-the-job training\n Research and development\n\n\nPublic Sector\n Public infrastructure\n Public education\nJob training\n Research and development encouraged through private sector incentives and direct spending.\n\n\nTable \n18.2\n \nInvestment Role of Public and Private Sector in a Market Economy\n \n\n\n\n\nBring It Home\n\n\nFinancing Higher Education\nBetween 1982 and 2012, the increases in the cost of a college education had far outpaced that of the income of the typical American family. According to President Obamas research staff, the cost of education at a four-year public college increased by 257% compared to an increase in family incomes of only 16% over the prior 30 years. The ongoing debate over a balanced budget and proposed cutbacks accentuated the need to increase investment in human capital to grow the economy versus deepening the already significant debt levels of the U.S. government. In summer 2013, President Obama presented a plan to make college more affordable that included increasing Pell Grant awards and the number of recipients, caps on interest rates for student loans, and providing education tax credits. In addition, the plan includes an accountability method for institutions of higher education that focuses on completion rates and creates a College Scorecard. Whether or not all these initiatives come to fruition remains to be seen, but they are indicative of creative approaches that government can take to meet its obligation from both a public and fiscal policy perspective.\n", "19-1": "By the end of this section, you will be able to:\n\nAnalyze GDP per capita as a measure of the diversity of international standards of living\nIdentify what classifies a country as low-income, middle-income, or high-income\nExplain how geography, demographics, industry structure, and economic institutions influence standards of living\n\nThe national economies that comprise the global economy are remarkably diverse. Let us use one key indicator of the standard of living, GDP per capita, to quantify this diversity. You will quickly see that quantifying this diversity is fraught with challenges and limitations. As we explained in The Macroeconomic Perspective, we must consider using purchasing power parity or international dollars to convert average incomes into comparable units. Purchasing power parity, as we formally defined in Exchange Rates and International Capital Flows, takes into account that prices of the same good are different across countries.The Macroeconomic Perspective explained how to measure GDP, the challenges of using GDP to compare standards of living, and the difficulty of confusing economic size with distribution. In China's case, for example, China ranks as the second largest global economy, second to only the United States, with Japan ranking third. However, when we take China's GDP of $9.2 trillion and divide it by its population of 1.4 billion, then the per capita GDP is only $6,900, which is significantly lower than that of Japan, at $38,500, and that of the United States, at $52,800.  Measurement issues aside, its worth repeating that the goal, then, is to not only increase GDP, but to strive toward increased GDP per capita to increase overall living standards for individuals. As we have learned from Economic Growth, countries can achieve this at the national level by designing policies that increase worker productivity, deepen capital, and advance technology.GDP per capita also allows us to rank countries into high-, middle-, or low-income groups. Low-income countries are those with $1,025 per capita GDP per year; middle-income countries have a per capita GDP between $1,025 and $12,475; while high-income countries have over $12,475 per year per capita income. As Table 19.1 and Figure 19.2 show, high-income countries earn 68% of world income, but represent just 12% of the global population. Low-income countries earn 1% of total world income, but represent 18.5% of global population.\n\nRanking based on GDP/capita\nGDP (in billions)\n% of Global GDP\nPopulation\n% of Global Population\n\n\n\nLow income ($1,025 or less)\n$612.7\n0.8%\n1,306,000,000\n18.8%\n\n\nMiddle income ($1,025 - $12,475)\n$23,930\n31.7%\n4,970,000,000\n69.4%\n\n\nHigh income (more than $12,475)\n$51,090,000,000\n67.5%\n848,700,000\n11.8%\n\n\nWorld Total income\n$75,592,941\n\n7,162,119,434\n\n\n\nTable \n19.1\n \nWorld Income versus Global Population\n \n(Source:http://databank.worldbank.org/data/views/reports/tableview.aspx?isshared=true&ispopular=series&pid=20)\n\n\n\n\n\nFigure \n19.2\n \nPercent of Global GDP and Percent of Population\n \nThe pie charts show the GDP (from 2011) for countries categorized into low, middle, or high income. Low-income are those earning less than $1,025 (less than 1% of global income). They represent 18.8% of the world population. Middle-income countries are those with per capita income of $1,025$12,475 (31.7% of global income). They represent 69.4% of world population. High-income countries have 67.5% of global income and 11.8% of the worlds population. (Source: http://databank.worldbank.org/data/views/reports/tableview.aspx?isshared=true&ispopular=series&pid=20)\n\nAn overview of the regional averages of GDP per person for developing countries, measured in comparable international dollars as well as population in 2008 (Figure 19.3), shows that the differences across these regions are stark. As Table 19.2 shows, nominal GDP per capita in 2012 for the 581.4 million people living in Latin America and the Caribbean region was $9,190, which far exceeds that of South Asia and sub-Saharan Africa. In turn, people in the world's high-income nations, such as those who live in the European Union nations or North America, have a per capita GDP three to four times that of the people of Latin America. To put things in perspective, North America and the European Union have slightly more than 9% of the worlds population, but they produce and consume close to 70% of the worlds GDP.\n\n\n\nFigure \n19.3\n \nGDP Per Capita in U.S. Dollars (2008)\n \nThere is a clear imbalance in the GDP across the world. North America, Australia, and Western Europe have the highest GDPs while large areas of the world have dramatically lower GDPs. Russia and other former Soviet nations, as well as Argentina, Botswana, Brazil, Chile, Gabon, and Mexico, have a mid-tier per capita GDP of about $6,000-12,600. China, though a major economic engine for the world, ranges from $1,900-3,580. Egypt, India, Indonesia, Mongolia, and Sudan are lower at about $920-1,850. (Credit: modification of work by Bsrboy/Wikimedia Commons)\n\n\n\n\nPopulation (in millions)\nGDP Per Capita\n\n\n\nEast Asia and Pacific\n2,006\n$5,536\n\n\nSouth Asia\n1,671\n$1,482\n\n\nSub-Saharan Africa\n936.1\n$1,657\n\n\nLatin America and Caribbean\n588\n$9,536\n\n\nMiddle East and North Africa\n345.4\n$3,456\n\n\nEurope and Central Asia\n272.2\n$7,118\n\n\nTable \n19.2\n \nRegional Comparisons of Nominal GDP per Capita and Population in 2013\n \n(Source: http://databank.worldbank.org/data/home.aspx)\n\nSuch comparisons between regions are admittedly rough. After all, per capita GDP cannot fully capture the quality of life. Many other factors have a large impact on the standard of living, like health, education, human rights, crime and personal safety, and environmental quality. These measures also reveal very wide differences in the standard of living across the regions of the world. Much of this is correlated with per capita income, but there are exceptions. For example, life expectancy at birth in many low-income regions approximates those who are more affluent. The data also illustrate that nobody can claim to have perfect standards of living. For instance, despite very high income levels, there is still undernourishment in Europe and North America.\nLink It Up\n\n\nEconomists know that there are many factors that contribute to your standard of living. People in high-income countries may have very little time due to heavy workloads and may feel disconnected from their community. Lower-income countries may be more community centered, but have little in the way of material wealth. It is hard to measure these characteristics of standard of living. The Organization for Economic Co-Operation and Development has developed the OECD Better Life Index. Visit this website to see how countries measure up to your expected standard of living.\nThe differences in economic statistics and other measures of well-being, substantial though they are, do not fully capture the reasons for the enormous differences between countries. Aside from the neoclassical determinants of growth, four additional determinants are significant in a wide range of statistical studies and are worth mentioning: geography, demography, industrial structure, and institutions.Geographic and Demographic Differences\nCountries have geographic differences: some have extensive coastlines, some are landlocked. Some have large rivers that have been a path of commerce for centuries, or mountains that have been a barrier to trade. Some have deserts, some have rain forests. These differences create different positive and negative opportunities for commerce, health, and the environment.\nCountries also have considerable differences in the age distribution of the population. Many high-income nations are approaching a situation by 2020 or so in which the elderly will form a much larger share of the population. Most low-income countries still have a higher proportion of youth and young adults, but by about 2050, the elderly populations in these low-income countries are expected to boom as well. These demographic changes will have considerable impact on the standard of living of the young and the old.Differences in Industry Structure and Economic Institutions\nCountries have differences in industry structure. In the world's high-income economies, only about 2% of GDP comes from agriculture; the average for the rest of the world is 12%. Countries have strong differences in degree of urbanization.Countries also have strong differences in economic institutions: some nations have economies that are extremely market-oriented, while other nations have command economies. Some nations are open to international trade, while others use tariffs and import quotas to limit the impact of trade. Some nations are torn by long-standing armed conflicts; other nations are largely at peace. There are also differences in political, religious, and social institutions.No nation intentionally aims for a low standard of living, high rates of unemployment and inflation, or an unsustainable trade imbalance. However, nations will differ in their priorities and in the situations in which they find themselves, and so their policy choices can reasonably vary, too. The next modules will discuss how nations around the world, from high income to low income, approach the four macroeconomic goals of economic growth, low unemployment, low inflation, and a sustainable balance of trade.\n", "19-2": "By the end of this section, you will be able to:\n\nAnalyze the growth policies of low-income countries seeking to improve standards of living\nAnalyze the growth policies of middle-income countries, particularly the East Asian Tigers with their focus on technology and market-oriented incentives\nAnalyze the struggles facing economically-challenged countries wishing to enact growth policies\nEvaluate the success of sending aid to low-income countries\n\nJobs are created in economies that grow. What is the origin of economic growth? According to most economists who believe in the growth consensus, economic growth (as we discussed in Economic Growth) is built on a foundation of productivity improvements. In turn, productivity increases are the result of greater human and physical capital and technology, all interacting in a market-driven economy. In the pursuit of economic growth, however, some countries and regions start from different levels, as the differences in per capita GDP presented earlier in Table 19.2 illustrate.Growth Policies for the High-Income CountriesFor the high-income countries, the challenge of economic growth is to push continually for a more educated workforce that can create, invest in, and apply new technologies. In effect, the goal of their growth-oriented public policy is to shift their aggregate supply curves to the right (refer to The Aggregate Demand/Aggregate Supply Model). The main public policies targeted at achieving this goal are fiscal policies focused on investment, including investment in human capital, in technology, and in physical plant and equipment. These countries also recognize that economic growth works best in a stable and market-oriented economic climate. For this reason, they use monetary policy to keep inflation low and stable, and to minimize the risk of exchange rate fluctuations, while also encouraging domestic and international competition.However, early in the second decade of the 2000s, many high-income countries found themselves more focused on the short term than on the long term. The United States, Western Europe, and Japan all experienced a combination of financial crisis and deep recession, and the after-effects of the recessionlike high unemployment ratesseemed likely to linger for several years. Most of these governments took aggressive, and in some cases controversial, steps to jump-start their economies by running very large budget deficits as part of expansionary fiscal policy. These countries must adopt a course that combines lower government spending and higher taxes.\nSimilarly, many central banks ran highly expansionary monetary policies, with both near-zero interest rates and unconventional loans and investments. For example, in 2012, Shinzo Abe (see Figure 19.4), then newly-elected Prime Minister of Japan, unveiled a plan to pull his country out of its two-decade-long slump in economic growth. It included both fiscal stimulus and an increase in the money supply. The plan was quite successful in the short run. However, according to the Economist, with public debt expected to approach 240% of GDP, (as of 2012 it was 226% of GDP) printing money and public-works spending were only short-term solutions.\n\n\n\nFigure \n19.4\n \nJapans Prime Minister, Shinzo Abe\n \nJapans Prime Minister used fiscal and monetary policies to stimulate his countrys economy, which has worked in only the short run. (Credit: modification of work by Chatham House/Flickr Creative Commons)\n\nAs we discussed in other chapters, macroeconomics needs to have both a short-run and a long-run focus. The challenge for many of the developed countries in the next few years will be to exit from the short-term policies that they used to correct the 20082009 recession. Since the return to growth has been sluggish, it has been politically challenging for these governments to refocus their efforts on new technology, education, and physical capital investment.\nGrowth Policies for the Middle-Income Economies\nThe worlds great economic success stories in the last few decades began in the 1970s with that group of nations sometimes known as the East Asian Tigers: South Korea, Thailand, Malaysia, Indonesia, and Singapore. The list sometimes includes Hong Kong and Taiwan, although often under international law they are treated as part of China, rather than as separate countries. The economic growth of the Tigers has been phenomenal, typically averaging 5.5% real per capita growth for several decades. In the 1980s, other countries began to show signs of convergence. China began growing rapidly, often at annual rates of 8% to 10% per year. India began growing rapidly, first at rates of about 5% per year in the 1990s, but then higher still in the first decade of the 2000s.We know the underlying causes of these rapid growth rates:China and the East Asian Tigers, in particular, have been among the highest savers in the world, often saving one-third or more of GDP as compared to the roughly one-fifth of GDP, which would be a more typical saving rate in Latin America and Africa. These countries harnessed higher savings for domestic investment to build physical capital.\nThese countries had policies that supported heavy investments in human capital, first building up primary-level education and then expanding secondary-level education. Many focused on encouraging math and science education, which is useful in engineering and business.\nGovernments made a concerted effort to seek out applicable technology, by sending students and government commissions abroad to look at the most efficient industrial operations elsewhere. They also created policies to support innovative companies that wished to build production facilities to take advantage of the abundant and inexpensive human capital.\nChina and India in particular also allowed far greater freedom for market forces, both within their own domestic economies and also in encouraging their firms to participate in world markets.\nThis combination of technology, human capital, and physical capital, combined with the incentives of a market-oriented economic context, proved an extremely powerful stimulant to growth. Challenges that these middle-income countries faced are a legacy of government economic controls that for political reasons can be dismantled only slowly over time. In many of them, the government heavily regulates the banking and financial sector. Governments have also sometimes selected certain industries to receive low-interest loans or government subsidies. These economies have found that an increased dose of market-oriented incentives for firms and workers has been a critical ingredient in the recipe for faster growth. To learn more about measuring economic growth, read the following Clear It Up feature.\nClear It Up\n\n\nWhat is the rule of 72?\n\nIt is worth pausing a moment to marvel at the East Asian Tigers' growth rates. If per capita GDP grows at, say, 6% per year, then you can apply the formula for compound growth ratesthat is (1 + 0.06)30meaning a nations level of per capita GDP will rise by a multiple of almost six over 30 years. Another strategy is to apply the rule of 72. The rule of 72 is an approximation to figure out doubling time. We divide the rule number, 72, by the annual growth rate to obtain the approximate number of years it will take for income to double. If we have a 6% growth rate, it will take 72/6, or 12 years, for incomes to double. Using this rule here suggests that a Tiger that grows at 6% will double its GDP every 12 years. In contrast, a technological leader, chugging along with per capita growth rates of about 2% per year, would double its income in 36 years.\n\nGrowth Policies for Economically-Challenged Countries\nMany economically-challenged or low-income countries are geographically located in Sub-Saharan Africa. Other pockets of low income are in the former Soviet Bloc, and in parts of Central America and the Caribbean.There are macroeconomic policies and prescriptions that might alleviate the extreme poverty and low standard of living. However, many of these countries lack the economic and legal stability, along with market-oriented institutions, needed to provide a fertile climate for domestic economic growth and to attract foreign investment. Thus, macroeconomic policies for low income economies are vastly different from those of the high income economies. The World Bank has made it a priority to combat poverty and raise overall income levels through 2030. One of the key obstacles to achieving this is the political instability that seems to be a common feature of low-income countries.Figure 19.5 shows the ten lowest income countries as ranked by The World Bank in 2013. These countries share some common traits, the most significant of which is the recent failures of their governments to provide a legal framework for economic growth. Ethiopia and Eritrea recently ended a long-standing war in 2000. Civil and ethnic wars have plagued countries such as Burundi and Liberia. Command economies, corruption, as well as political factionalism and infighting are commonly adopted elements in these low-income countries. The Democratic Republic of the Congo (often referred to as Congo) is a resource-wealthy country that has not been able to increase its subsistence standard of living due to the political environment.\n\n\n\nFigure \n19.5\n \nThe Ten Lowest Income Countries\n \nThis bar chart that shows ten low-income countries, which include, from lowest income to highest: Democratic Republic of the Congo, Zimbabwe, Burundi, Liberia, Eritrea, Central African Republic, Niger, Madagascar, and Afghanistan.  (Source: http://databank.worldbank.org/data/views/reports/map.aspx#)\n\nLow-income countries are at a disadvantage because any incomes that people receive are spent immediately on necessities such as food. People in these countries live on less than $1,035 per year, which is less than $100 per month. Lack of saving means a lack of capital accumulation and a lack of loanable funds for investment in physical and human capital. Recent research by two MIT economists, Abhijit Bannerjee and Esther Duflo, has confirmed that the households in these economies are trapped in low incomes because they cannot muster enough investment to push themselves out of poverty.For example, the average citizen of Burundi, the lowest-income country, subsists on $150 per year (adjusted to 2005 dollars). According to Central Intelligence Agency data in its CIA Factbook, as of 2013, 90% of Burundis population is agrarian, with coffee and tea as the main income producing crop. Only one in two children attends school and, as Figure 19.6 shows, many are not in schools comparable to what occurs in developed countries. The CIA Factbook also estimates that 15% of Burundis population suffers from HIV/AIDS. Political instability has made it difficult for Burundi to make significant headway toward growth, as verified by the electrification of only 2% of households and 42% of its national income coming from foreign aid.\n\n\n\nFigure \n19.6\n \nLack of Funds for Investing in Human Capital\n \nIn low-income countries, people often spend all income on necessities for living and cannot accumulate or invest in physical or human capital. The students in this photograph learn in an outside classroom void of not only technology, but even chairs and desks. (Credit: Rafaela Printes/Flickr Creative Commons)\n\n\nLink It Up\n\n\nThe World Factbook website is loaded with maps, flags, and other information about countries across the globe.\nOther low-income countries share similar stories. These countries have found it difficult to generate investments for themselves or to find foreign investors willing to put up the money for more than the basic needs. Foreign aid and external investment comprise significant portions of the income in these economies, but are not sufficient to allow for the capital accumulation necessary to invest in physical and human capital. However, is foreign aid always a contributor to economic growth? It can be a controversial issue, as the next Clear it Up feature points out.\nClear It Up\n\n\nDoes foreign aid to low-income countries work?\n\nAccording to the Organization of Economic Cooperation and Development (OECD), about $134 billion per year in foreign aid flows from the high-income countries of the world to the low-income ones. Relative to the size of their populations or economies, this is not a large amount for either donors or recipients. For low-income countries, aid averages about 1.3 percent of their GDP. However, even this relatively small amount has been highly controversial.Supporters of additional foreign aid point to the extraordinary human suffering in the world's low-and middle-income countries. They see opportunities all across Africa, Asia, and Latin America to set up health clinics and schools. They want to help with the task of building economic infrastructure: clean water, plumbing, electricity, and roads. Supporters of this aid include formal state-sponsored institutions like the United Kingdoms Department for International Development (DFID) or independent non-governmental organizations (NGOs) like CARE International that also receive donor government funds. For example, because of an outbreak of meningitis in Ethiopia in 2010, DFID channeled significant funds to the Ethiopian Ministry of Health to train rural health care workers and also for vaccines. These monies helped the Ministry offset shortfalls in their budget.Opponents of increased aid do not quarrel with the goal of reducing human suffering, but they suggest that foreign aid has often proved a poor tool for advancing that goal. For example, according to an article in the Attach Journal of International Affairs, the Canadian foreign aid organization (CIDA) provided $100 million to Tanzania to grow wheat. The project did produce wheat, but nomadic pastoralists and other villagers who had lived on the land were driven off 100,000 acres of land to make way for the project. The damage in terms of human rights and lost livelihoods was significant. Villagers were beaten and killed because some refused to leave the land. At times, the unintended collateral damage from foreign aid can be significant.\nWilliam Easterly, professor of economics at New York University and author of The White Mans Burden, argues that countries often receive aid for political reasons and ends up doing more harm than good. If a country's government creates a reasonably stable and market-oriented macroeconomic climate, then foreign investors will be likely to provide funds for many profitable activities. For example, according to The New York Times, Facebook is partnering with multiple organizations in a project called Internet.org to provide access in remote and low-income areas of the world, and Google began its own initiative called Project Loon. Facebooks first forays into providing internet access via mobile phones began in stable, market-oriented countries like India, Brazil, Indonesia, Turkey, and the Philippines.Policymakers are now wiser about foreign aid limitations than they were a few decades ago. In targeted and specific cases, especially if foreign aid is channeled to long-term investment projects, foreign aid can have a modest role to play in reducing the extreme levels of deprivation that hundreds of millions of people around the world experience.\n\nLink It Up\n\n\nWatch this video on the complexities of providing economic aid in Africa.\n\n", "19-3": "By the end of this section, you will be able to:\n\nExplain the nature and causes of unemployment\nAnalyze the natural rate of unemployment and the factors that affect it\nIdentify how undeveloped labor markets can result in the same hardships as unemployment\n\nWe can categorize the causes of unemployment in the world's high-income countries in two ways: either cyclical unemployment caused by the economy when in a recession, or the natural rate of unemployment caused by factors in labor markets, such as government regulations regarding hiring and starting businesses.\nUnemployment from a Recession\nFor unemployment caused by a recession, the Keynesian economic model points out that both monetary and fiscal policy tools are available. The monetary policy prescription for dealing with recession is straightforward: run an expansionary monetary policy to increase the quantity of money and loans, drive down interest rates, and increase aggregate demand. In a recession, there is usually relatively little danger of inflation taking off, and so even a central bank, with fighting inflation as its top priority, can usually justify some reduction in interest rates.With regard to fiscal policy, the automatic stabilizers that we discussed in Government Budgets and Fiscal Policy should be allowed to work, even if this means larger budget deficits in times of recession. There is less agreement over whether, in addition to automatic stabilizers, governments in a recession should try to adopt discretionary fiscal policy of additional tax cuts or spending increases. In the case of the Great Recession, the case for this kind of extra-aggressive expansionary fiscal policy is stronger, but for a smaller recession, given the time lags of implementing fiscal policy, countries should use discretionary fiscal policy with caution.However, the aftermath of the Recession emphasizes that expansionary fiscal and monetary policies do not turn off a recession like flipping a switch turns off a lamp. Even after a recession is officially over, and positive growth has returned, it can take some monthsor even a couple of yearsbefore private-sector firms believe the economic climate is healthy enough that they can expand their workforce.\n\nThe Natural Rate of Unemployment\nUnemployment rates in European nations have typically been higher than in the United States. In 2006, before the start of the Great Recession, the U.S. unemployment rate was 4.6%, compared with 9% in France, 10.4% in Germany, and 7.1% in Sweden. We can attribute the pattern of generally higher unemployment rates in Europe, which dates back to the 1970s, to the fact that European economies have a higher natural rate of unemployment because they have a greater number of rules and restrictions that discourage firms from hiring and unemployed workers from taking jobs.Addressing the natural rate of unemployment is straightforward in theory but difficult in practice. Government can play a useful role in providing unemployment and welfare payments, for example, by passing rules about where and when businesses can operate, and assuring that the workplace is safe. However, these well-intentioned laws can, in some cases, become so intrusive that businesses decide to place limits on their hiring.For example, a law that imposes large costs on a business that tries to fire or lay off workers will mean that businesses try to avoid hiring in the first place, as is the case in France. According to Business Week, France has 2.4 times as many companies with 49 employees as with 50 ... according to the French labor code, once a company has at least 50 employees inside France, management must create three worker councils, introduce profit sharing, and submit restructuring plans to the councils if the company decides to fire workers for economic reasons. This labor law essentially limits employment (or raises the natural rate of unemployment).\nUndeveloped Labor Markets\nLow-income and middle-income countries face employment issues that go beyond unemployment as it is understood in the high-income economies. A substantial number of workers in these economies provide many of their own needs by farming, fishing, or hunting. They barter and trade with others and may take a succession of short-term or one-day jobs, sometimes receiving pay with food or shelter, sometimes with money. They are not unemployed in the sense that we use the term in the United States and Europe, but neither are they employed in a regular wage-paying job.The starting point of economic activity, as we discussed in Welcome to Economics!, is the division of labor, in which workers specialize in certain tasks and trade the fruits of their labor with others. Workers who are not connected to a labor market are often unable to specialize very much. Because these workers are not officially employed, they are often not eligible for social benefits like unemployment insurance or old-age paymentsif such payments are even available in their country. Helping these workers to become more connected to the labor market and the economy is an important policy goal. Recent research by development economists suggests that one of the key factors in raising people in low-income countries out of the worst kind of poverty is whether they can make a connection to a somewhat regular wage-paying job.\n", "19-4": "By the end of this section, you will be able to:\n\nIdentify the causes and effects of inflation in various economic markets\nExplain the significance of a converging economy\n\nPolicymakers of the high-income economies appear to have learned some lessons about fighting inflation. First, whatever happens with aggregate supply and aggregate demand in the short run, countries can use monetary policy to prevent inflation from becoming entrenched in the economy in the medium and long term. Second, there is no long-run gain to letting inflation become established. In fact, allowing inflation to become lasting and persistent poses undesirable risks and tradeoffs. When inflation is high, businesses and individuals need to spend time and effort worrying about protecting themselves against inflation, rather than seeking better ways to serve customers. In short, the high-income economies appear to have both a political consensus to hold inflation low and the economic tools to do so.In a number of middle- and low-income economies around the world, inflation is far from a solved problem. In the early 2000s, Turkey experienced inflation of more than 50% per year for several years. Belarus had inflation of about 100% per year from 2000 to 2001. From 2008 to 2010, Venezuela and Myanmar had inflation rates of 20% to 30% per year. Indonesia, Iran, Nigeria, the Russian Federation, and Ukraine all had double-digit inflation for most of the years from 2000 to 2010. Zimbabwe had hyperinflation, with inflation rates that went from more than 100% per year in the mid-2000s to a rate of several million percent in 2008.\nIn these countries, the problem of very high inflation generally arises from huge budget deficits, which the government finances by printing its domestic currency. This is a case of too much money chasing too few goods. In the case of Zimbabwe, the government covered its widening deficits by printing ever higher currency notes, including a $100 trillion bill. By late 2008, the money was nearly worthless, which led Zimbabwe to adopt the U.S. dollar, immediately halting their hyperinflation. In some countries, the central bank makes loans to politically favored firms, essentially printing money to do so, and this too leads to higher inflation.A number of countries have managed to sustain solid levels of economic growth for sustained periods of time with inflation levels that would sound high by recent U.S. standards, like 10% to 30% per year. In such economies, the governments index most contracts, wage levels, and interest rates to inflation. Indexing wage contracts and interest rates means that they will increase when inflation increases to retain purchasing power. When wages do not rise as price levels rise, this leads to a decline in the real wage rate and a decrease in the standard of living. Likewise, interest rates that are not indexed mean that money lenders will receive payment in devalued currency and will also lose purchasing power on monies that they lent. It is clearly possibleand perhaps sometimes necessaryfor a converging economy (the economy of a country that demonstrates the ability to catch up to the technology leaders) to live with a degree of uncertainty over inflation that would be politically unacceptable in the high-income economies.\n\n", "19-5": "By the end of this section, you will be able to:\n\nExplain the meaning of trade balance and its implications for the foreign exchange market\nAnalyze concerns over international trade in goods and services and international flows of capital\nIdentify and evaluate market-oriented economic reforms\n\nIn the 1950s and 1960s, and even into the 1970s, low- and middle-income countries often viewed openness to global flows of goods, services, and financial capital in a negative light. These countries feared that foreign trade would mean both economic losses as high-income trading partners \"exploited\" their economy and they lost domestic political control to powerful business interests and multinational corporations.These negative feelings about international trade have evolved. After all, the great economic success stories of recent years like Japan, the East Asian Tiger economies, China, and India, all took advantage of opportunities to sell in global markets. European economies thrive with high levels of trade. In the North American Free Trade Agreement (NAFTA),\n1 \nthe United States, Canada, and Mexico pledged themselves to reduce trade barriers. Many countries have clearly learned that reducing barriers to trade is at least potentially beneficial to the economy. Many smaller world economies have learned an even tougher lesson: if they do not participate actively in world trade, they are unlikely to join the success stories among the converging economies. There are no examples in world history of small economies that remained apart from the global economy but still attained a high standard of living.Although almost every country now claims that its goal is to participate in global trade, the possible negative consequences have remained highly controversial. It is useful to divide these possible negative consequences into issues involving trade of goods and services and issues involving international capital flows. These issues are related, but not the same. An economy may have a high level of trade in goods and services relative to GDP, but if exports and imports are balanced, the net flow of foreign investment in and out of the economy will be zero. Conversely, an economy may have only a moderate level of trade relative to GDP, but find that it has a substantial current account trade imbalance. Thus, it is useful to consider the concerns over international trade of goods and services and international flows of financial capital separately.Concerns over International Trade in Goods and Services\nThere is a long list of worries about foreign trade in goods and services: fear of job loss, environmental dangers, unfair labor practices, and many other concerns. We discuss these arguments at some length in the chapter on The International Trade and Capital Flows.Of all of the arguments for limitations on trade, perhaps the most controversial one among economists is the infant industry argument; that is, subsidizing or protecting new industries for a time until they become established. (Globalization and Protectionism explains this concept in more detail.) Countries have used such policies with some success at certain points in time, but in the world as a whole, support for key industries is far more often directed at long-established industries with substantial political power that are suffering losses and laying off workers, rather than potentially vibrant new industries that are not yet established. If government intends to favor certain industries, it needs to do so in a way that is temporary and that orients them toward a future of market competition, rather than a future of unending government subsidies and trade protection.\nConcerns over International Flows of Capital\nRecall from The Macroeconomic Perspective that a trade deficit exists when a nations imports exceed its exports. In order for a trade deficit to take place, foreign countries must provide loans or investments, which they are willing to do because they expect eventual repayment (that the deficit will become a surplus). A trade surplus, you may remember, exists when a nations exports exceed its imports. Thus, in order for a trade deficit to switch to a trade surplus, a nations exports must rise and its imports must fall. Sometimes this happens when the currency decreases in value. For example, if the U.S. had a trade deficit and the dollar depreciated, imports would become more expensive. This would, in turn, benefit the foreign countries that provided the loans or investments.The expected pattern of trade imbalances in the world economy has been that high-income economies will run trade surpluses, which means they will experience a net outflow of capital to foreign destinations or export more than they import, while low- and middle-income economies will run trade deficits, which means that they will experience a net inflow of foreign capital.\nThis international investing pattern can benefit all sides. Investors in the high-income countries benefit because they can receive high returns on their investments, and also because they can diversify their investments so that they are at less risk of a downturn in their own domestic economy. The low-income economies that receive an inflow of capital presumably have potential for rapid catch-up economic growth, and they can use the international financial capital inflow to help spur their physical capital investment. In addition, financial capital inflows often come with management abilities, technological expertise, and training.However, for the last couple of decades, this cheerful scenario has faced two dark clouds. The first cloud is the very large trade or current account deficits in the U.S. economy. (See The International Trade and Capital Flows.) Instead of offering net financial investment abroad, the U.S. economy is soaking up savings from all over the world. These substantial U.S. trade deficits may not be sustainable according to Sebastian Edwards writing for the National Bureau of Economic Research. While trade deficits on their own are not bad, the question is whether governments will reduce them gradually or hastily. In the gradual scenario, U.S. exports could grow more rapidly than imports over a period of years, aided by U.S. dollar depreciation. An unintended consequence of the slow growth since the Great Recession has been a decline in the U.S. current account deficit's from 6% pre-recession to 3% most recently.The other option is that the government could reduce the U.S. trade deficit in a rush. Here is one scenario: if foreign investors became less willing to hold U.S. dollar assets, the dollar exchange rate could weaken. As speculators see this process happening, they might rush to unload their dollar assets, which would drive the dollar down still further.A lower U.S. dollar would stimulate aggregate demand by making exports cheaper and imports more expensive. It would mean higher prices for imported inputs throughout the economy, shifting the short-term aggregate supply curve to the left. The result could be a burst of inflation and, if the Federal Reserve were to run a tight monetary policy to reduce the inflation, it could also lead to recession. People sometimes talk as if the U.S. economy, with its great size, is invulnerable to this sort of pressure from international markets. While it is difficult to rock, it is not impossible for the $17 trillion U.S. economy to face these international pressures.The second dark cloud is how the smaller world economies should deal with the possibility of sudden foreign financial capital inflows and outflows. Perhaps the most vivid recent example of the potentially destructive forces of international capital movements occurred in the East Asian Tiger economies in 19971998. Thanks to their excellent growth performance over the previous few decades, these economies had attracted considerable interest from foreign investors. In the mid-1990s, however, foreign investment into these countries surged even further. Much of this money funneled through banks that borrowed in U.S. dollars and loaned in their national currencies. Bank lending surged at rates of 20% per year or more. This inflow of foreign capital meant that investment in these economies exceeded the level of domestic savings, so that current account deficits in these countries jumped into the 510% GDP range.The surge in bank lending meant that many banks in these East Asian countries did not do an especially good job of screening out safe and unsafe borrowers. Many of the loansas high as 10% to 15% of all loans in some of these countriesstarted to turn bad. Fearing losses, foreign investors started pulling out their money. As the foreign money left, the exchange rates of these countries crashed, often falling by 50% or more in a few months. The banks were stuck with a mismatch: even if the rest of their domestic loans were repaid, they could never pay back the U.S. dollars that they owed. The banking sector as a whole went bankrupt. The lack of credit and lending in the economy collapsed aggregate demand, bringing on a deep recession.If the flow and ebb of international capital markets can flip even the economies of the East Asian Tigers, with their stellar growth records, into a recession, then it is no wonder that other middle- and low-income countries around the world are concerned. Moreover, similar episodes of an inflow and then an outflow of foreign financial capital have rocked a number of economies around the world: for example, in the last few years, economies like Ireland, Iceland, and Greece have all experienced severe shocks when foreign lenders decided to stop extending funds. Especially in Greece, this caused the government to enact austerity measures which led to protests throughout the country (Figure 19.7).\n\n\n\n\nFigure \n19.7\n \nProtests in Greece\n \nThe economic conditions in Greece have deteriorated from the Great Recession such that the government had to enact austerity measures, (strict rules) cutting wages and increasing taxes on its population. Massive protests are but one byproduct. (Credit: modification of work by Apostolos/Flickr Creative Commons)\n\nMany nations are taking steps to reduce the risk that their economy will be injured if foreign financial capital takes flight, including having their central banks hold large reserves of foreign exchange and stepping up their regulation of domestic banks to avoid a wave of imprudent lending. The most controversial steps in this area involve whether countries should try to take steps to control or reduce the flows of foreign capital. If a country could discourage some speculative short-term capital inflow, and instead only encourage investment capital that it committed for the medium and the long term, then it could be at least somewhat less susceptible to swings in the sentiments of global investors.If economies participate in the global trade of goods and services, they will also need to participate in international flows of financial payments and investments. These linkages can offer great benefits to an economy. However, any nation that is experiencing a substantial and sustained pattern of trade deficits, along with the corresponding net inflow of international financial capital, has some reason for concern. During the Asian Financial Crisis in the late 1990s, countries that grew dramatically in the years leading up to the crisis as international capital flowed in, saw their economies collapse when the capital very quickly flowed out.\nMarket-Oriented Economic Reforms\nThe standard of living has increased dramatically for billions of people around the world in the last half century. Such increases have occurred not only in the technological leaders like the United States, Canada, the nations of Europe, and Japan, but also in the East Asian Tigers and in many nations of Latin America and Eastern Europe. The challenge for most of these countries is to maintain these growth rates. The economically-challenged regions of the world have stagnated and become stuck in poverty traps. These countries need to focus on the basics: health and education, or human capital development. As Figure 19.8 illustrates, modern technology allows for the investment in education and human capital development in ways that would have not been possible just a few short years ago.\n\n\n\nFigure \n19.8\n \nSolar-powered Technology\n \nModern technologies, such as solar-power and Wi-Fi, enable students to obtain education even in remote parts of a country without electricity. These students in Ghana are sharing a laptop provided by a van with solar-power. (Credit: EIFL/Flickr Creative Commons)\n\nOther than the issue of economic growth, the other three main goals of macroeconomic policythat is, low unemployment, low inflation, and a sustainable balance of tradeall involve situations in which, for some reason, the economy fails to coordinate the forces of supply and demand. In the case of cyclical unemployment, for example, the intersection of aggregate supply and aggregate demand occurs at a level of output below potential GDP. In the case of the natural rate of unemployment, government regulations create a situation where otherwise-willing employers become unwilling to hire otherwise-willing workers. Inflation is a situation in which aggregate demand outstrips aggregate supply, at least for a time, so that too much buying power is chasing too few goods. A trade imbalance is a situation where, because of a net inflow or outflow of foreign capital, domestic savings are not aligned with domestic investment. Each of these situations can create a range of easier or harder policy choices.\nBring It Home\n\n\nYouth Unemployment: Three Cases\n\nSpain and South Africa had the same high youth unemployment in 2011, but the reasons for this unemployment are different. Spains youth unemployment surged due to the 2008-2009 Great Recession and heavy indebtedness on the part of its citizens and its government. Spains current account balance is negative, which means it is borrowing heavily. To cure cyclical unemployment during a recession, the Keynesian model suggests increases in government spendingfiscal expansion or monetary expansion. Neither option is open to Spain. It currently can borrow at only high interest rates, which will be a real problem in terms of debt service. In addition, the rest of the European Union (EU) has dragged its feet when it comes to debt forgiveness. Monetary expansion is not possible because Spain uses the euro and cannot devalue its currency unless it convinces all of the EU to do so. What can be done? The Economist, summarizing some ideas of economists and policymakers, suggests that Spains only realistic (although painful) option is to reduce government-mandated wages, which would allow it to reduce government spending. As a result, the government would be able to lower tax rates on the working population. With a lower wage or lower tax environment, firms will hire more workers. This will lower unemployment and stimulate the economy. Spain can also encourage greater foreign investment and try to promote policies that encourage domestic savings.South Africa has more of a natural rate of unemployment problem. It is an interesting case because its youth unemployment is mostly because its young are not ready to work. Economists commonly refer to this as an employability problem. According to interviews of South African firms as reported in the Economist, the young are academically smart but lack practical skills for the workplace. Despite a big push to increase investment in human capital, the results have not yet borne fruit. Recently the government unveiled a plan to pay unemployed youth while they were trained-up or apprenticed in South African firms. The government has room to increase fiscal expenditure, encourage domestic savings, and continue to fund investment in education, vocational training, and apprentice programs. South Africa can also improve the climate for foreign investment from technology leaders, which would encourage economic growth.India has a smaller youth employment problem in terms of percentages. However, bear in mind that since this is a populous country, it turns out to be a significant problem in raw numbers. According to Kaushik Basu, writing for the BBC, there are 45 national laws governing the hiring and firing decisions of firms and close to four times that amount at the state level. These laws make it difficult for companies to fire workers. To stay nimble and responsive to markets, Indian companies respond to these laws by hiring fewer workers. The Indian government can do much to solve this problem by adjusting its labor laws. Essentially, the government has to remove itself from firms hiring and firing decisions, so that growing Indian firms can freely employ more workers. Indian workers, like those in South Africa, do not have workforce skills. Again, the government can increase its spending on education, vocational training, and workforce readiness programs.Finally, India has a significant current account deficit. This deficit is mainly a result of short- and long-term capital flows. To solve this deficit, India has experimented by lifting the limitation on domestic savers from investing abroad. This is a step in the right direction that may dampen the growth in the current account deficit. A final policy possibility is to improve domestic capital markets so many self-employed Indians can obtain access to capital to realize their business ideas. If more Indians can obtain access to capital to start businesses, employment might increase.\n\nFootnotes1As of July 1, 2020, NAFTA was officially replaced with the United States-Mexico-Canada (USMCA) free trade agreement. It is broadly similar to the original NAFTA.", "20-1": "By the end of this section, you will be able to:\nDefine absolute advantage, comparative advantage, and opportunity costs\nExplain the gains of trade created when a country specializes\n\nThe American statesman Benjamin Franklin (17061790) once wrote: No nation was ever ruined by trade. Many economists would express their attitudes toward international trade in an even more positive manner. The evidence that international trade confers overall benefits on economies is pretty strong. Trade has accompanied economic growth in the United States and around the world. Many of the national economies that have shown the most rapid growth in the last several decadesfor example, Japan, South Korea, China, and Indiahave done so by dramatically orienting their economies toward international trade. There is no modern example of a country that has shut itself off from world trade and yet prospered. To understand the benefits of trade, or why we trade in the first place, we need to understand the concepts of comparative and absolute advantage.In 1817, David Ricardo, a businessman, economist, and member of the British Parliament, wrote a treatise called On the Principles of Political Economy and Taxation. In this treatise, Ricardo argued that specialization and free trade benefit all trading partners, even those that may be relatively inefficient. To see what he meant, we must be able to distinguish between absolute and comparative advantage.\nA country has an absolute advantage over another country in producing a good if it uses fewer resources to produce that good. Absolute advantage can be the result of a countrys natural endowment. For example, extracting oil in Saudi Arabia is pretty much just a matter of drilling a hole. Producing oil in other countries can require considerable exploration and costly technologies for drilling and extractionif they have any oil at all. The United States has some of the richest farmland in the world, making it easier to grow corn and wheat than in many other countries. Guatemala and Colombia have climates especially suited for growing coffee. Chile and Zambia have some of the worlds richest copper mines. As some have argued, geography is destiny. Chile will provide copper and Guatemala will produce coffee, and they will trade. When each country has a product others need and it can produce it with fewer resources in one country than in another, then it is easy to imagine all parties benefitting from trade. However, thinking about trade just in terms of geography and absolute advantage is incomplete. Trade really occurs because of comparative advantage.Recall from the chapter Choice in a World of Scarcity that a country has a comparative advantage when it can produce a good at a lower cost in terms of other goods. The question each country or company should be asking when it trades is this: What do we give up to produce this good? It should be no surprise that the concept of comparative advantage is based on this idea of opportunity cost from Choice in a World of Scarcity. For example, if Zambia focuses its resources on producing copper, it cannot use its labor, land and financial resources to produce other goods such as corn. As a result, Zambia gives up the opportunity to produce corn. How do we quantify the cost in terms of other goods? Simplify the problem and assume that Zambia just needs labor to produce copper and corn. The companies that produce either copper or corn tell you that it takes two hours to mine a ton of copper and one hour to harvest a bushel of corn. This means the opportunity cost of producing a ton of copper is two bushels of corn. The next section develops absolute and comparative advantage in greater detail and relates them to trade.\nLink It Up\n\n\nVisit this website for a list of articles and podcasts pertaining to international trade topics.\n\nA Numerical Example of Absolute and Comparative Advantage\nConsider a hypothetical world with two countries, Saudi Arabia and the United States, and two products, oil and corn. Further assume that consumers in both countries desire both these goods. These goods are homogeneous, meaning that consumers/producers cannot differentiate between corn or oil from either country. There is only one resource available in both countries, labor hours. Saudi Arabia can produce oil with fewer resources, while the United States can produce corn with fewer resources. Table 20.1 illustrates the advantages of the two countries, expressed in terms of how many hours it takes to produce one unit of each good.\n\n\nCountry\nOil (hours per barrel)\nCorn (hours per bushel)\n\n\n\nSaudi Arabia\n1\n4\n\n\nUnited States\n2\n1\n\n\nTable \n20.1\n \nHow Many Hours It Takes to Produce Oil and Corn\n \n\nIn Table 20.1, Saudi Arabia has an absolute advantage in producing oil because it only takes an hour to produce a barrel of oil compared to two hours in the United States. The United States has an absolute advantage in producing corn.To simplify, lets say that Saudi Arabia and the United States each have 100 worker hours (see Table 20.2). Figure 20.2 illustrates what each country is capable of producing on its own using a production possibility frontier (PPF) graph. Recall from Choice in a World of Scarcity that the production possibilities frontier shows the maximum amount that each country can produce given its limited resources, in this case workers, and its level of technology.\n\nCountry\nOil Production using 100 worker hours (barrels)\n\nCorn Production using 100 worker hours (bushels)\n\n\n\nSaudi Arabia\n100\nor\n25\n\n\nUnited States\n50\nor\n100\n\n\nTable \n20.2\n \nProduction Possibilities before Trade\n \n\n\n\n\n\nFigure \n20.2\n \nProduction Possibilities Frontiers \n \n(a) Saudi Arabia can produce 100 barrels of oil at maximum and zero corn (point A), or 25 bushels of corn and zero oil (point B). It can also produce other combinations of oil and corn if it wants to consume both goods, such as at point C. Here it chooses to produce/consume 60 barrels of oil, leaving 40 work hours that to allocate to produce 10 bushels of corn, using the data in Table 20.1. (b) If the United States produces only oil, it can produce, at maximum, 50 barrels and zero corn (point A'), or at the other extreme, it can produce a maximum of 100 bushels of corn and no oil (point B'). Other combinations of both oil and corn are possible, such as point C'. All points above the frontiers are impossible to produce given the current level of resources and technology.\n\nArguably Saudi and U.S. consumers desire both oil and corn to live. Lets say that before trade occurs, both countries produce and consume at point C or C'. Thus, before trade, the Saudi Arabian economy will devote 60 worker hours to produce oil, as Table 20.3 shows. Given the information in Table 20.1, this choice implies that it produces/consumes 60 barrels of oil. With the remaining 40 worker hours, since it needs four hours to produce a bushel of corn, it can produce only 10 bushels. To be at point C', the U.S. economy devotes 40 worker hours to produce 20 barrels of oil and it can allocate the remaining worker hours to produce 60 bushels of corn.\n\nCountry\nOil Production (barrels)\nCorn Production (bushels)\n\n\n\nSaudi Arabia (C)\n60\n10\n\n\nUnited States (C')\n20\n60\n\n\nTotal World Production\n80\n70\n\n\nTable \n20.3\n \nProduction before Trade\n \n\nThe slope of the production possibility frontier illustrates the opportunity cost of producing oil in terms of corn. Using all its resources, the United States can produce 50 barrels of oil or 100 bushels of corn; therefore, the opportunity cost of one barrel of oil is two bushels of cornor the slope is 1/2. Thus, in the U.S. production possibility frontier graph, every increase in oil production of one barrel implies a decrease of two bushels of corn. Saudi Arabia can produce 100 barrels of oil or 25 bushels of corn. The opportunity cost of producing one barrel of oil is the loss of 1/4 of a bushel of corn that Saudi workers could otherwise have produced. In terms of corn, notice that Saudi Arabia gives up the least to produce a barrel of oil. Table 20.4 summarizes these calculations.\n\nCountry\nOpportunity cost of one unit  Oil (in terms of corn)\nOpportunity cost of one unit  Corn (in terms of oil)\n\n\n\nSaudi Arabia\n\n4\n\n\nUnited States\n2\n\n\n\nTable \n20.4\n \nOpportunity Cost and Comparative Advantage\n \n\nAgain recall that we defined comparative advantage as the opportunity cost of producing goods. Since Saudi Arabia gives up the least to produce a barrel of oil, (1414<22 in Table 20.4) it has a comparative advantage in oil production. The United States gives up the least to produce a bushel of corn, so it has a comparative advantage in corn production.In this example, there is symmetry between absolute and comparative advantage. Saudi Arabia needs fewer worker hours to produce oil (absolute advantage, see Table 20.1), and also gives up the least in terms of other goods to produce oil (comparative advantage, see Table 20.4). Such symmetry is not always the case, as we will show after we have discussed gains from trade fully, but first, read the following Clear It Up feature to make sure you understand why the PPF line in the graphs is straight.\nClear It Up\n\n\nCan a production possibility frontier be straight?\n\nWhen you first met the production possibility frontier (PPF) in the chapter on Choice in a World of Scarcity we drew it with an outward-bending shape. This shape illustrated that as we transferred inputs from producing one good to anotherlike from education to health servicesthere were increasing opportunity costs. In the examples in this chapter, we draw the PPFs as straight lines, which means that opportunity costs are constant. When we transfer a marginal unit of labor away from growing corn and toward producing oil, the decline in the quantity of corn and the increase in the quantity of oil is always the same. In reality this is possible only if the contribution of additional workers to output did not change as the scale of production changed. The linear production possibilities frontier is a less realistic model, but a straight line simplifies calculations. It also illustrates economic themes like absolute and comparative advantage just as clearly.\n\nGains from Trade\nConsider the trading positions of the United States and Saudi Arabia after they have specialized and traded. Before trade, Saudi Arabia produces/consumes 60 barrels of oil and 10 bushels of corn. The United States produces/consumes 20 barrels of oil and 60 bushels of corn. Given their current production levels, if the United States can trade an amount of corn fewer than 60 bushels and receives in exchange an amount of oil greater than 20 barrels, it will gain from trade. With trade, the United States can consume more of both goods than it did without specialization and trade. (Recall that the chapter\nWelcome to Economics! defined specialization as it applies to workers and firms. Economists also use specialization to describe the occurrence when a country shifts resources to focus on producing a good that offers comparative advantage.) Similarly, if Saudi Arabia can trade an amount of oil less than 60 barrels and receive in exchange an amount of corn greater than 10 bushels, it will have more of both goods than it did before specialization and trade. Table 20.5 illustrates the range of trades that would benefit both sides.\n\nThe U.S. economy, after specialization, will benefit if it:\nThe Saudi Arabian economy, after specialization, will benefit if it: \n\n\n\nExports no more than 60 bushels of corn\nImports at least 10 bushels of corn\n\n\nImports at least 20 barrels of oil\nExports less than 60 barrels of oil\n\n\nTable \n20.5\n \nThe Range of Trades That Benefit Both the United States and Saudi Arabia\n \n\nThe underlying reason why trade benefits both sides is rooted in the concept of opportunity cost, as the following Clear It Up feature explains. If Saudi Arabia wishes to expand domestic production of corn in a world without international trade, then based on its opportunity costs it must give up four barrels of oil for every one additional bushel of corn. If Saudi Arabia could find a way to give up less than four barrels of oil for an additional bushel of corn (or equivalently, to receive more than one bushel of corn for four barrels of oil), it would be better off.\n\nClear It Up\n\n\nWhat are the opportunity costs and gains from trade?\n\nThe range of trades that will benefit each country is based on the countrys opportunity cost of producing each good. The United States can produce 100 bushels of corn or 50 barrels of oil. For the United States, the opportunity cost of producing one barrel of oil is two bushels of corn. If we divide the numbers above by 50, we get the same ratio: one barrel of oil is equivalent to two bushels of corn, or (100/50 = 2 and 50/50 = 1). In a trade with Saudi Arabia, if the United States is going to give up 100 bushels of corn in exports, it must import at least 50 barrels of oil to be just as well off. Clearly, to gain from trade it needs to be able to gain more than a half barrel of oil for its bushel of cornor why trade at all?\n\nRecall that David Ricardo argued that if each country specializes in its comparative advantage, it will benefit from trade, and total global output will increase. How can we show gains from trade as a result of comparative advantage and specialization? Table 20.6 shows the output assuming that each country specializes in its comparative advantage and produces no other good. This is 100% specialization. Specialization leads to an increase in total world production. (Compare the total world production in Table 20.3 to that in Table 20.6.)\n\n\nCountry\nQuantity produced after 100% specialization  Oil (barrels)\nQuantity produced after 100% specialization  Corn (bushels)\n\n\n\nSaudi Arabia\n100\n0\n\n\nUnited States\n0\n100\n\n\nTotal World Production\n100\n100\n\n\nTable \n20.6\n \nHow Specialization Expands Output\n \n\nWhat if we did not have complete specialization, as in Table 20.6? Would there still be gains from trade? Consider another example, such as when the United States and Saudi Arabia start at C and C', respectively, as Figure 20.2 shows. Consider what occurs when trade is allowed and the United States exports 20 bushels of corn to Saudi Arabia in exchange for 20 barrels of oil.\n\n\n\nFigure \n20.3\n \nProduction Possibilities Frontier in Saudi Arabia \n \nTrade allows a country to go beyond its domestic production-possibility frontier\n\nStarting at point C, which shows Saudi oil production of 60, reduce Saudi oil domestic oil consumption by 20, since 20 is exported to the United States and exchanged for 20 units of corn. This enables Saudi to reach point D, where oil consumption is now 40 barrels and corn consumption has increased to 30 (see Figure 20.3). Notice that even without 100% specialization, if the trading price, in this case 20 barrels of oil for 20 bushels of corn, is greater than the countrys opportunity cost, the Saudis will gain from trade. Since the post-trade consumption point D is beyond its production possibility frontier, Saudi Arabia has gained from trade.\nLink It Up\n\n\nVisit this website for trade-related data visualizations.\n    \n\n\n", "20-2": "By the end of this section, you will be able to:\nShow the relationship between production costs and comparative advantage\nIdentify situations of mutually beneficial trade\nIdentify trade benefits by considering opportunity costs\n\nWhat happens to the possibilities for trade if one country has an absolute advantage in everything? This is typical for high-income countries that often have well-educated workers, technologically advanced equipment, and the most up-to-date production processes. These high-income countries can produce all products with fewer resources than a low-income country. If the high-income country is more productive across the board, will there still be gains from trade? Good students of Ricardo understand that trade is about mutually beneficial exchange. Even when one country has an absolute advantage in all products, trade can still benefit both sides. This is because gains from trade come from specializing in ones comparative advantage.Production Possibilities and Comparative Advantage\nConsider the example of trade between the United States and Mexico described in Table 20.7. In this example, it takes four U.S. workers to produce 1,000 pairs of shoes, but it takes five Mexican workers to do so. It takes one U.S. worker to produce 1,000 refrigerators, but it takes four Mexican workers to do so. The United States has an absolute advantage in productivity with regard to both shoes and refrigerators; that is, it takes fewer workers in the United States than in Mexico to produce both a given number of shoes and a given number of refrigerators.\n\n\nCountry\nNumber of Workers needed to produce 1,000 units  Shoes\nNumber of Workers needed to produce 1,000 units  Refrigerators\n\n\n\nUnited States\n4 workers\n1 worker\n\n\nMexico\n5 workers\n4 workers\n\n\nTable \n20.7\n \nResources Needed to Produce Shoes and Refrigerators\n \n\nAbsolute advantage simply compares the productivity of a worker between countries. It answers the question, How many inputs do I need to produce shoes in Mexico? Comparative advantage asks this same question slightly differently. Instead of comparing how many workers it takes to produce a good, it asks, How much am I giving up to produce this good in this country? Another way of looking at this is that comparative advantage identifies the good for which the producers absolute advantage is relatively larger, or where the producers absolute productivity disadvantage is relatively smaller. The United States can produce 1,000 shoes with four-fifths as many workers as Mexico (four versus five), but it can produce 1,000 refrigerators with only one-quarter as many workers (one versus four). So, the comparative advantage of the United States, where its absolute productivity advantage is relatively greatest, lies with refrigerators, and Mexicos comparative advantage, where its absolute productivity disadvantage is least, is in the production of shoes.\n\nMutually Beneficial Trade with Comparative Advantage\nWhen nations increase production in their area of comparative advantage and trade with each other, both countries can benefit. Again, the production possibility frontier is a useful tool to visualize this benefit.\nConsider a situation where the United States and Mexico each have 40 workers. For example, as Table 20.8 shows, if the United States divides its labor so that 40 workers are making shoes, then, since it takes four workers in the United States to make 1,000 shoes, a total of 10,000 shoes will be produced. (If four workers can make 1,000 shoes, then 40 workers will make 10,000 shoes). If the 40 workers in the United States are making refrigerators, and each worker can produce 1,000 refrigerators, then a total of 40,000 refrigerators will be produced.\n\n\nCountry\nShoe Production  using 40 workers\n\nRefrigerator Production  using 40 workers\n\n\n\nUnited States\n10,000 shoes\nor\n40,000 refrigerators\n\n\nMexico\n8,000 shoes\nor\n10,000 refrigerators\n\n\nTable \n20.8\n \nProduction Possibilities before Trade with Complete Specialization\n \n\nAs always, the slope of the production possibility frontier for each country is the opportunity cost of one refrigerator in terms of foregone shoe productionwhen labor is transferred from producing the latter to producing the former  (see Figure 20.4).\n\n\n\n\nFigure \n20.4\n \nProduction Possibility Frontiers \n \n(a) With 40 workers, the United States can produce either 10,000 shoes and zero refrigerators or 40,000 refrigerators and zero shoes. (b) With 40 workers, Mexico can produce a maximum of 8,000 shoes and zero refrigerators, or 10,000 refrigerators and zero shoes. All other points on the production possibility line are possible combinations of the two goods that can be produced given current resources. Point A on both graphs is where the countries start producing and consuming before trade. Point B is where they end up after trade.\n\n\nLets say that, in the situation before trade, each nation prefers to produce a combination of shoes and refrigerators that is shown at point A. Table 20.9 shows the output of each good for each country and the total output for the two countries.\n\n\nCountry\nCurrent Shoe Production\nCurrent Refrigerator Production\n\n\n\nUnited States\n5,000\n20,000\n\n\nMexico\n4,000\n5,000\n\n\nTotal\n9,000\n25,000\n\n\nTable \n20.9\n \nTotal Production at Point A before Trade\n \n\nContinuing with this scenario, suppose that each country transfers some amount of labor toward its area of comparative advantage. For example, the United States transfers six workers away from shoes and toward producing refrigerators. As a result, U.S. production of shoes decreases by 1,500 units (6/4  1,000), while its production of refrigerators increases by 6,000 (that is, 6/1  1,000). Mexico also moves production toward its area of comparative advantage, transferring 10 workers away from refrigerators and toward production of shoes. As a result, production of refrigerators in Mexico falls by 2,500 (10/4  1,000), but production of shoes increases by 2,000 pairs (10/5  1,000). Notice that when both countries shift production toward each of their comparative advantages (what they are relatively better at), their combined production of both goods rises, as shown in Table 20.10. The reduction of shoe production by 1,500 pairs in the United States is more than offset by the gain of 2,000 pairs of shoes in Mexico, while the reduction of 2,500 refrigerators in Mexico is more than offset by the additional 6,000 refrigerators produced in the United States.\n\nCountry\nShoe Production\nRefrigerator Production\n\n\n\nUnited States\n3,500\n26,000\n\n\nMexico\n6,000\n2,500\n\n\nTotal\n9,500\n28,500\n\n\nTable \n20.10\n \nShifting Production Toward Comparative Advantage Raises Total Output\n \n\nThis numerical example illustrates the remarkable insight of comparative advantage: even when one country has an absolute advantage in all goods and another country has an absolute disadvantage in all goods, both countries can still benefit from trade. Even though the United States has an absolute advantage in producing both refrigerators and shoes, it makes economic sense for it to specialize in the good for which it has a comparative advantage. The United States will export refrigerators and in return import shoes.\n\nHow Opportunity Cost Sets the Boundaries of Trade\nThis example shows that both parties can benefit from specializing in their comparative advantages and trading. By using the opportunity costs in this example, it is possible to identify the range of possible trades that would benefit each country.\nMexico started out, before specialization and trade, producing 4,000 pairs of shoes and 5,000 refrigerators (see Figure 20.4 and Table 20.9). Then, in the numerical example given, Mexico shifted production toward its comparative advantage and produced 6,000 pairs of shoes but only 2,500 refrigerators. Thus, if Mexico can export no more than 2,000 pairs of shoes (giving up 2,000 pairs of shoes) in exchange for imports of at least 2,500 refrigerators (a gain of 2,500 refrigerators), it will be able to consume more of both goods than before trade. Mexico will be unambiguously better off. Conversely, the United States started off, before specialization and trade, producing 5,000 pairs of shoes and 20,000 refrigerators. In the example, it then shifted production toward its comparative advantage, producing only 3,500 shoes but 26,000 refrigerators. If the United States can export no more than 6,000 refrigerators in exchange for imports of at least 1,500 pairs of shoes, it will be able to consume more of both goods and will be unambiguously better off.\nThe range of trades that can benefit both nations is shown in Table 20.11. For example, a trade where the U.S. exports 4,000 refrigerators to Mexico in exchange for 1,800 pairs of shoes would benefit both sides, in the sense that both countries would be able to consume more of both goods than in a world without trade.\n\n\nThe U.S. economy, after specialization, will benefit if it:\nThe Mexican economy, after specialization, will benefit if it:\n\n\n\nExports fewer than 6,000 refrigerators\nImports at least 2,500 refrigerators\n\n\nImports at least 1,500 pairs of shoes\nExports no more than 2,000 pairs of shoes\n\n\nTable \n20.11\n \nThe Range of Trades That Benefit Both the United States and Mexico\n \n\n\nTrade allows each country to take advantage of lower opportunity costs in the other country. If Mexico wants to produce more refrigerators without trade, it must face its domestic opportunity costs and reduce shoe production. If Mexico, instead, produces more shoes and then trades for refrigerators made in the United States, where the opportunity cost of producing refrigerators is lower, Mexico can in effect take advantage of the lower opportunity cost of refrigerators in the United States. Conversely, when the United States specializes in its comparative advantage of refrigerator production and trades for shoes produced in Mexico, international trade allows the United States to take advantage of the lower opportunity cost of shoe production in Mexico.\nThe theory of comparative advantage explains why countries trade: they have different comparative advantages. It shows that the gains from international trade result from pursuing comparative advantage and producing at a lower opportunity cost. The following Work It Out feature shows how to calculate absolute and comparative advantage and the way to apply them to a countrys production.\n\nWork It Out\n\n\nCalculating Absolute and Comparative Advantage\n\nIn Canada a worker can produce 20 barrels of oil or 40 tons of lumber. In Venezuela, a worker can produce 60 barrels of oil or 30 tons of lumber.\n\n\nCountry\nOil (barrels)\n\nLumber (tons)\n\n\n\nCanada\n20\nor\n40\n\n\nVenezuela\n60\nor\n30\n\n\nTable \n20.12\n \n \n\n\nWho has the absolute advantage in the production of oil or lumber? How can you tell?\nWhich country has a comparative advantage in the production of oil?\nWhich country has a comparative advantage in producing lumber?\nIn this example, is absolute advantage the same as comparative advantage, or not?\nIn what product should Canada specialize? In what product should Venezuela specialize?\n\nStep 1. Make a table like Table 20.12.\nStep 2. To calculate absolute advantage, look at the larger of the numbers for each product. One worker in Canada can produce more lumber (40 tons versus 30 tons), so Canada has the absolute advantage in lumber. One worker in Venezuela can produce 60 barrels of oil compared to a worker in Canada who can produce only 20.\nStep 3. To calculate comparative advantage, find the opportunity cost of producing one barrel of oil in both countries. The country with the lowest opportunity cost has the comparative advantage. With the same labor time, Canada can produce either 20 barrels of oil or 40 tons of lumber. So in effect, 20 barrels of oil is equivalent to 40 tons of lumber: 20 oil = 40 lumber. Divide both sides of the equation by 20 to calculate the opportunity cost of one barrel of oil in Canada. 20/20 oil = 40/20 lumber. 1 oil = 2 lumber. To produce one additional barrel of oil in Canada has an opportunity cost of 2 lumber. Calculate the same way for Venezuela: 60 oil = 30 lumber. Divide both sides of the equation by 60. One oil in Venezuela has an opportunity cost of 1/2 lumber. Because 1/2 lumber < 2 lumber, Venezuela has the comparative advantage in producing oil.Step 4. Calculate the opportunity cost of one lumber by reversing the numbers, with lumber on the left side of the equation. In Canada, 40 lumber is equivalent in labor time to 20 barrels of oil: 40 lumber = 20 oil. Divide each side of the equation by 40. The opportunity cost of one lumber is 1/2 oil. In Venezuela, the equivalent labor time will produce 30 lumber or 60 oil: 30 lumber = 60 oil. Divide each side by 30. One lumber has an opportunity cost of two oil. Canada has the lower opportunity cost in producing lumber.\nStep 5. In this example, absolute advantage is the same as comparative advantage. Canada has the absolute and comparative advantage in lumber; Venezuela has the absolute and comparative advantage in oil.\nStep 6. Canada should specialize in the commodity for which it has a relative lower opportunity cost, which is lumber, and Venezuela should specialize in oil. Canada will be exporting lumber and importing oil, and Venezuela will be exporting oil and importing lumber.\n\nComparative Advantage Goes Camping\nTo build an intuitive understanding of how comparative advantage can benefit all parties, set aside examples that involve national economies for a moment and consider the situation of a group of friends who decide to go camping together. The six friends have a wide range of skills and experiences, but one person in particular, Jethro, has done lots of camping before and is also a great athlete. Jethro has an absolute advantage in all aspects of camping: he is faster at carrying a backpack, gathering firewood, paddling a canoe, setting up tents, making a meal, and washing up. So here is the question: Because Jethro has an absolute productivity advantage in everything, should he do all the work?\nOf course not! Even if Jethro is willing to work like a mule while everyone else sits around, he, like all mortals, only has 24 hours in a day. If everyone sits around and waits for Jethro to do everything, not only will Jethro be an unhappy camper, but there will not be much output for his group of six friends to consume. The theory of comparative advantage suggests that everyone will benefit if they figure out their areas of comparative advantagethat is, the area of camping where their productivity disadvantage is least, compared to Jethro. For example, it may be that Jethro is 80% faster at building fires and cooking meals than anyone else, but only 20% faster at gathering firewood and 10% faster at setting up tents. In that case, Jethro should focus on building fires and making meals, and others should attend to the other tasks, each according to where their productivity disadvantage is smallest. If the campers coordinate their efforts according to comparative advantage, they can all gain.\n", "20-3": "By the end of this section, you will be able to:\nIdentify at least two advantages of intra-industry trading\nExplain the relationship between economies of scale and intra-industry trade\n\nAbsolute and comparative advantages explain a great deal about global trading patterns. For example, they help to explain the patterns that we noted at the start of this chapter, like why you may be eating fresh fruit from Chile or Mexico, or why lower productivity regions like Africa and Latin America are able to sell a substantial proportion of their exports to higher productivity regions like the European Union and North America. Comparative advantage, however, at least at first glance, does not seem especially well-suited to explain other common patterns of international trade.The Prevalence of Intra-industry Trade between Similar Economies\nThe theory of comparative advantage suggests that trade should happen between economies with large differences in opportunity costs of production. Roughly half of all world trade involves shipping goods between the fairly similar high-income economies of the United States, Canada, the European Union, Japan, Mexico, and China  (see Table 20.13).\n\n\nCountry\nU.S. Exports Go to ...\nU.S. Imports Come from ...\n\n\n\nEuropean Union\n19.0%\n21.0%\n\n\nCanada\n22.0%\n14.0%\n\n\nJapan\n4.0%\n6.0%\n\n\nMexico\n15.0%\n13.0%\n\n\nChina\n8.0%\n20.0%\n\n\nTable \n20.13\n \nWhere U.S. Exports Go and U.S. Imports Originate (2015)\n \n(Source: https://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf)\n\nMoreover, the theory of comparative advantage suggests that each economy should specialize to a degree in certain products, and then exchange those products. A high proportion of trade, however, is intra-industry tradethat is, trade of goods within the same industry from one country to another. For example, the United States produces and exports autos and imports autos. Table 20.14 shows some of the largest categories of U.S. exports and imports. In all of these categories, the United States is both a substantial exporter and a substantial importer of goods from the same industry. In 2014, according to the Bureau of Economic Analysis, the United States exported $146 billion worth of autos, and imported $327 billion worth of autos. About 60% of U.S. trade and 60% of European trade is intra-industry trade.\n\nSome U.S. Exports\nQuantity of Exports ($ billions)\nQuantity of Imports ($ billions)\n\n\n\nAutos\n$146\n$327\n\n\nFood and beverages\n$144\n$126\n\n\nCapital goods\n$550\n$551\n\n\nConsumer goods\n$199\n$558\n\n\nIndustrial supplies\n$507\n$665\n\n\nOther transportation\n$45\n$55\n\n\nTable \n20.14\n \nSome Intra-Industry U.S. Exports and Imports in 2014\n \n(Source: http://www.bea.gov/newsreleases/international/trade/tradnewsrelease.htm)\n\nWhy do similar high-income economies engage in intra-industry trade? What can be the economic benefit of having workers of fairly similar skills making cars, computers, machinery and other products which are then shipped across the oceans to and from the United States, the European Union, and Japan? There are two reasons: (1) The division of labor leads to learning, innovation, and unique skills; and (2) economies of scale.\n\nGains from Specialization and Learning\nConsider the category of machinery, where the U.S. economy has considerable intra-industry trade. Machinery comes in many varieties, so the United States may be exporting machinery for manufacturing with wood, but importing machinery for photographic processing. The underlying reason why a country like the United States, Japan, or Germany produces one kind of machinery rather than another is usually not related to U.S., German, or Japanese firms and workers having generally higher or lower skills. It is just that, in working on very specific and particular products, firms in certain countries develop unique and different skills.\nSpecialization in the world economy can be very finely split. In fact, recent years have seen a trend in international trade, which economists call splitting up the value chain. The value chain describes how a good is produced in stages. As indicated in the beginning of the chapter, producing the iPhone involves designing and engineering the phone in the United States, supplying parts from Korea, assembling the parts in China, and advertising and marketing in the United States. Thanks in large part to improvements in communication technology, sharing information, and transportation, it has become easier to split up the value chain. Instead of production in a single large factory, different firms operating in various places and even different countries can divide the value chain. Because firms split up the value chain, international trade often does not involve nations trading whole finished products like automobiles or refrigerators. Instead, it involves shipping more specialized goods like, say, automobile dashboards or the shelving that fits inside refrigerators. Intra-industry trade between similar countries produces economic gains because it allows workers and firms to learn and innovate on particular productsand often to focus on very particular parts of the value chain.\nLink It Up\n\n\nVisit this website for some interesting information about the assembly of the iPhone.\n\n\nEconomies of Scale, Competition, Variety\nA second broad reason that intra-industry trade between similar nations produces economic gains involves economies of scale. The concept of economies of scale, as we introduced in Production, Costs and Industry Structure, means that as the scale of output goes up, average costs of production declineat least up to a point. Figure 20.5 illustrates economies of scale for a plant producing toaster ovens. The horizontal axis of the figure shows the quantity of production by a certain firm or at a certain manufacturing plant. The vertical axis measures the average cost of production. Production plant S produces a small level of output at 30 units and has an average cost of production of $30 per toaster oven. Plant M produces at a medium level of output at 50 units, and has an average cost of production of $20 per toaster oven. Plant L produces 150 units of output with an average cost of production of only $10 per toaster oven. Although plant V can produce 200 units of output, it still has the same unit cost as Plant L.In this example, a small or medium plant, like S or M, will not be able to compete in the market with a large or a very large plant like L or V, because the firm that operates L or V will be able to produce and sell its output at a lower price. In this example, economies of scale operate up to point L, but beyond point L to V, the additional scale of production does not continue to reduce average costs of production.\n\n\n\nFigure \n20.5\n \nEconomies of Scale \n \nProduction Plant S, has an average cost of production of $30 per toaster oven. Production plant M has an average cost of production of $20 per toaster oven. Production plant L has an average cost of production of only $10 per toaster oven. Production plant V still has an average cost of production of $10 per toaster oven. Thus, production plant M can produce toaster ovens more cheaply than plant S because of economies of scale, and plants L or V can produce more cheaply than S or M because of economies of scale. However, the economies of scale end at an output level of 150. Plant V, despite being larger, cannot produce more cheaply on average than plant L.\n\nThe concept of economies of scale becomes especially relevant to international trade when it enables one or two large producers to supply the entire country. For example, a single large automobile factory could probably supply all the cars consumers purchase in a smaller economy like the United Kingdom or Belgium in a given year. However, if a country has only one or two large factories producing cars, and no international trade, then consumers in that country would have relatively little choice between kinds of cars (other than the color of the paint and other nonessential options). Little or no competition will exist between different car manufacturers.International trade provides a way to combine the lower average production costs that come from economies of scale and still have competition and variety for consumers. Large automobile factories in different countries can make and sell their products around the world. If General Motors, Ford, and Chrysler were the only players in the U.S. automobile market, the level of competition and consumer choice would be considerably lower than when U.S. carmakers must face competition from Toyota, Honda, Suzuki, Fiat, Mitsubishi, Nissan, Volkswagen, Kia, Hyundai, BMW, Subaru, and others. Greater competition brings with it innovation and responsiveness to what consumers want. Americas car producers make far better cars now than they did several decades ago, and much of the reason is competitive pressure, especially from East Asian and European carmakers.\nDynamic Comparative Advantage\nThe sources of gains from intra-industry trade between similar economiesnamely, the learning that comes from a high degree of specialization and splitting up the value chain and from economies of scaledo not contradict the earlier theory of comparative advantage. Instead, they help to broaden the concept.\nIn intra-industry trade, climate or geography do not determine the level of worker productivity. Even the general level of education or skill does not determine it. Instead, how firms engage in specific learning about specialized products, including taking advantage of economies of scale determine the level of worker productivity. In this vision, comparative advantage can be dynamicthat is, it can evolve and change over time as one develops new skills and as manufacturers split the value chain in new ways. This line of thinking also suggests that countries are not destined to have the same comparative advantage forever, but must instead be flexible in response to ongoing changes in comparative advantage.\n", "20-4": "By the end of this section, you will be able to:\nExplain tariffs as barriers to trade\nIdentify at least two benefits of reducing barriers to international trade\n\nTariffs are taxes that governments place on imported goods for a variety of reasons. Some of these reasons include protecting sensitive industries, for humanitarian reasons, and protecting against dumping. Traditionally, tariffs were used simply as a political tool to protect certain vested economic, social, and cultural interests. The World Trade Organization (WTO) is committed to lowering barriers to trade. The worlds nations meet through the WTO to negotiate how they can reduce barriers to trade, such as tariffs. WTO negotiations happen in rounds, where all countries negotiate one agreement to encourage trade, take a year or two off, and then start negotiating a new agreement. The current round of negotiations is called the Doha Round because it was officially launched in Doha, the capital city of Qatar, in November 2001. In 2009, economists from the World Bank summarized recent research and found that the Doha round of negotiations would increase the size of the world economy by $160 billion to $385 billion per year, depending on the precise deal that ended up being negotiated.\nIn the context of a global economy that currently produces more than $30 trillion of goods and services each year, this amount is not huge: it is an increase of 1% or less. But before dismissing the gains from trade too quickly, it is worth remembering two points.\n\nFirst, a gain of a few hundred billion dollars is enough money to deserve attention! Moreover, remember that this increase is not a one-time event; it would persist each year into the future.\nSecond, the estimate of gains may be on the low side because some of the gains from trade are not measured especially well in economic statistics. For example, it is difficult to measure the potential advantages to consumers of having a variety of products available and a greater degree of competition among producers. Perhaps the most important unmeasured factor is that trade between countries, especially when firms are splitting up the value chain of production, often involves a transfer of knowledge that can involve skills in production, technology, management, finance, and law.\n\nLow-income countries benefit more from trade than high-income countries do. In some ways, the giant U.S. economy has less need for international trade, because it can already take advantage of internal trade within its economy. However, many smaller national economies around the world, in regions like Latin America, Africa, the Middle East, and Asia, have much more limited possibilities for trade inside their countries or their immediate regions. Without international trade, they may have little ability to benefit from comparative advantage, slicing up the value chain, or economies of scale. Moreover, smaller economies often have fewer competitive firms making goods within their economy, and thus firms have less pressure from other firms to provide the goods and prices that consumers want.\nThe economic gains from expanding international trade are measured in hundreds of billions of dollars, and the gains from international trade as a whole probably reach well into the trillions of dollars. The potential for gains from trade may be especially high among the smaller and lower-income countries of the world.\n\nLink It Up\n\n\nVisit this website for a list of some benefits of trade.\n\nFrom Interpersonal to International Trade\nMost people find it easy to believe that they, personally, would not be better off if they tried to grow and process all of their own food, to make all of their own clothes, to build their own cars and houses from scratch, and so on. Instead, we all benefit from living in economies where people and firms can specialize and trade with each other.\nThe benefits of trade do not stop at national boundaries, either. Earlier we explained that the division of labor could increase output for three reasons: (1) workers with different characteristics can specialize in the types of production where they have a comparative advantage; (2) firms and workers who specialize in a certain product become more productive with learning and practice; and (3) economies of scale. These three reasons apply from the individual and community level right up to the international level. If it makes sense to you that interpersonal, intercommunity, and interstate trade offer economic gains, it should make sense that international trade offers gains, too.\nInternational trade currently involves about $20 trillion worth of goods and services moving around the globe. Any economic force of that size, even if it confers overall benefits, is certain to cause disruption and controversy. This chapter has only made the case that trade brings economic benefits. Other chapters discuss, in detail, the public policy arguments over whether to restrict international trade.\n\nBring It Home\n\n\nJust Whose iPhone Is It?\nApple Corporation uses a global platform to produce the iPhone. Now that you understand the concept of comparative advantage, you can see why the engineering and design of the iPhone is done in the United States. The United States has built up a comparative advantage over the years in designing and marketing products, and sacrifices fewer resources to design high-tech devices relative to other countries. China has a comparative advantage in assembling the phone due to its large skilled labor force. Korea has a comparative advantage in producing components. Korea focuses its production by increasing its scale, learning better ways to produce screens and computer chips, and uses innovation to lower average costs of production. Apple, in turn, benefits because it can purchase these quality products at lower prices. Put the global assembly line together and you have the device with which we are all so familiar.\n\n", "21-1": "By the end of this section, you will be able to:\nExplain protectionism and its three main forms\nAnalyze protectionism through concepts of demand and supply, noting its effects on equilibrium\nCalculate the effects of trade barriers\n\nWhen a government legislates policies to reduce or block international trade it is engaging in protectionism. Protectionist policies often seek to shield domestic producers and domestic workers from foreign competition. Protectionism takes three main forms: tariffs, import quotas, and nontariff barriers.\nRecall from International Trade that tariffs are taxes that governments impose on imported goods and services. This makes imports more expensive for consumers, discouraging imports. For example, in recent years large, flat-screen televisions imported to the U.S. from China have faced a 5% tariff rate.Another way to control trade is through import quotas, which are numerical limitations on the quantity of products that a country can import. For instance, during the early 1980s, the Reagan Administration imposed a quota on the import of Japanese automobiles. In the 1970s, many developed countries, including the United States, found themselves with declining textile industries. Textile production does not require highly skilled workers, so producers were able to set up lower-cost factories in developing countries. In order to manage this loss of jobs and income, the developed countries established an international Multifiber Agreement that essentially divided the market for textile exports between importers and the remaining domestic producers. The agreement, which ran from 1974 to 2004, specified the exact quota of textile imports that each developed country would accept from each low-income country. A similar story exists for sugar imports into the United States, which are still governed by quotas.Nontariff barriers are all the other ways that a nation can draw up rules, regulations, inspections, and paperwork to make it more costly or difficult to import products. A rule requiring certain safety standards can limit imports just as effectively as high tariffs or low import quotas, for instance. There are also nontariff barriers in the form of rules-of-origin regulations; these rules describe the Made in Country X label as the one in which the last substantial change in the product took place. A manufacturer wishing to evade import restrictions may try to change the production process so that the last big change in the product happens in his or her own country. For example, certain textiles are made in the United States, shipped to other countries, combined with textiles made in those other countries to make appareland then re-exported back to the United States for a final assembly, to escape paying tariffs or to obtain a Made in the USA label.Despite import quotas, tariffs, and nontariff barriers, the share of apparel sold in the United States that is imported rose from about half in 1999 to about three-quarters today. The U.S. Bureau of Labor Statistics (BLS), estimated the number of U.S. jobs in textiles and apparel fell from 666,360 in 2007 to 385,240 in 2012, a 42% decline. Even more U.S. textile industry jobs would have been lost without tariffs. However, domestic jobs that are saved by import quotas come at a cost. Because textile and apparel protectionism adds to the costs of imports, consumers end up paying billions of dollars more for clothing each year.When the United States eliminates trade barriers in one area, consumers spend the money they save on that product elsewhere in the economy. Thus, while eliminating trade barriers in one sector of the economy will likely result in some job loss in that sector, consumers will spend the resulting savings in other sectors of the economy and hence increase the number of jobs in those other sectors. Of course, workers in some of the poorest countries of the world who would otherwise have jobs producing textiles, would gain considerably if the United States reduced its barriers to trade in textiles. That said, there are good reasons to be wary about reducing barriers to trade. The 2012 and 2013 Bangladeshi fires in textile factories, which resulted in a horrific loss of life, present complications that our simplified analysis in the chapter will not capture.Realizing the compromises between nations that come about due to trade policy, many countries came together in 1947 to form the General Agreement on Tariffs and Trade (GATT). (Well cover the GATT in more detail later in the chapter.) This agreement has since been superseded by the World Trade Organization (WTO), whose membership includes about 150 nations and most of the world's economies. It is the primary international mechanism through which nations negotiate their trade rulesincluding rules about tariffs, quotas, and nontariff barriers. The next section examines the results of such protectionism and develops a simple model to show the impact of trade policy.Demand and Supply Analysis of Protectionism\nTo the non-economist, restricting imports may appear to be nothing more than taking sales from foreign producers and giving them to domestic producers. Other factors are at work, however, because firms do not operate in a vacuum. Instead, firms sell their products either to consumers or to other firms (if they are business suppliers), who are also affected by the trade barriers. A demand and supply analysis of protectionism shows that it is not just a matter of domestic gains and foreign losses, but a policy that imposes substantial domestic costs as well.\nConsider two countries, Brazil and the United States, who produce sugar. Each country has a domestic supply and demand for sugar, as Table 21.1 details and Figure 21.2 illustrates. In Brazil, without trade, the equilibrium price of sugar is 12 cents per pound and the equilibrium output is 30 tons. When there is no trade in the United States, the equilibrium price of sugar is 24 cents per pound and the equilibrium quantity is 80 tons. We label these equilibrium points as point E in each part of the figure.\n\n\n\nFigure \n21.2\n \nThe Sugar Trade between Brazil and the United States \n \nBefore trade, the equilibrium price of sugar in Brazil is 12 cents a pound and it is 24 cents per pound in the United States. When trade is allowed, businesses will buy cheap sugar in Brazil and sell it in the United States. This will result in higher prices in Brazil and lower prices in the United States. Ignoring transaction costs, prices should converge to 16 cents per pound, with Brazil exporting 15 tons of sugar and the United States importing 15 tons of sugar. If trade is only partly open between the countries, it will lead to an outcome between the free-trade and no-trade possibilities.\n\n\n\nPrice\nBrazil: Quantity Supplied (tons)\nBrazil: Quantity Demanded (tons)\nU.S.: Quantity Supplied (tons)\nU.S.: Quantity Demanded (tons) \n\n\n\n8 cents\n20\n35\n60\n100\n\n\n12 cents\n30\n30\n66\n93\n\n\n14 cents\n35\n28\n69\n90\n\n\n16 cents\n40\n25\n72\n87\n\n\n20 cents\n45\n21\n76\n83\n\n\n24 cents\n50\n18\n80\n80\n\n\n28 cents\n55\n15\n82\n78\n\n\nTable \n21.1\n \nThe Sugar Trade between Brazil and the United States\n \n\n\nIf international trade between Brazil and the United States now becomes possible, profit-seeking firms will spot an opportunity: buy sugar cheaply in Brazil, and sell it at a higher price in the United States. As sugar is shipped from Brazil to the United States, the quantity of sugar produced in Brazil will be greater than Brazilian consumption (with the extra production exported), and the amount produced in the United States will be less than the amount of U.S. consumption (with the extra consumption imported). Exports to the United States will reduce the sugar supply in Brazil, raising its price. Imports into the United States will increase the sugar supply, lowering its price. When the sugar price is the same in both countries, there is no incentive to trade further. As Figure 21.2 shows, the equilibrium with trade occurs at a price of 16 cents per pound. At that price, the sugar farmers of Brazil supply a quantity of 40 tons, while the consumers of Brazil buy only 25 tons.The extra 15 tons of sugar production, shown by the horizontal gap between the demand curve and the supply curve in Brazil, is exported to the United States. In the United States, at a price of 16 cents, the farmers produce a quantity of 72 tons and consumers demand a quantity of 87 tons. The excess demand of 15 tons by American consumers, shown by the horizontal gap between demand and domestic supply at the price of 16 cents, is supplied by imported sugar. Free trade typically results in income distribution effects, but the key is to recognize the overall gains from trade, as Figure 21.3 shows. Building on the concepts that we outlined in Demand and Supply and Demand, Supply, and Efficiency in terms of consumer and producer surplus, Figure 21.3 (a) shows that producers in Brazil gain by selling more sugar at a higher price, while Figure 21.3 (b) shows consumers in the United States benefit from the lower price and greater availability of sugar. Consumers in Brazil are worse off (compare their no-trade consumer surplus with the free-trade consumer surplus) and U.S. producers of sugar are worse off. There are gains from tradean increase in social surplus in each country. That is, both the United States and Brazil are better off than they would be without trade. The following Clear It Up feature explains how trade policy can influence low-income countries.\n\n\n\nFigure \n21.3\n \nFree Trade of Sugar \n \nFree trade results in gains from trade. Total surplus increases in both countries, as the two blue-shaded areas show. However, there are clear income distribution effects.  Producers gain in the exporting country, while consumers lose; and in the importing country, consumers gain and producers lose.\n\n\n\nLink It Up\n\n\nVisit this website to read more about the global sugar trade.\n\n\nClear It Up\n\n\nWhy are there low-income countries?\n\nWhy are the poor countries of the world poor? There are a number of reasons, but one of them will surprise you: the trade policies of the high-income countries. Following is a stark review of social priorities which the international aid organization, Oxfam International has widely publicized.High-income countries of the worldprimarily the United States, Canada, countries of the European Union, and Japansubsidize their domestic farmers collectively by about $360 billion per year. By contrast, the total amount of foreign aid from these same high-income countries to the poor countries of the world is about $70 billion per year, or less than 20% of the farm subsidies. Why does this matter?\nIt matters because the support of farmers in high-income countries is devastating to the livelihoods of farmers in low-income countries. Even when their climate and land are well-suited to products like cotton, rice, sugar, or milk, farmers in low-income countries find it difficult to compete. Farm subsidies in the high-income countries cause farmers in those countries to increase the amount they produce. This increase in supply drives down world prices of farm products below the costs of production. As Michael Gerson of the Washington Post describes it: [T]he effects in the cotton-growing regions of West Africa are dramatic . . . keep[ing] millions of Africans on the edge of malnutrition. In some of the poorest countries on Earth, cotton farmers are some of the poorest people, earning about a dollar a day. . . . Who benefits from the current system of subsidies? About 20,000 American cotton producers, with an average annual income of more than $125,000.\nAs if subsidies were not enough, often, the high-income countries block agricultural exports from low-income countries. In some cases, the situation gets even worse when the governments of high-income countries, having bought and paid for an excess supply of farm products, give away those products in poor countries and drive local farmers out of business altogether.\nFor example, shipments of excess milk from the European Union to Jamaica have caused great hardship for Jamaican dairy farmers. Shipments of excess rice from the United States to Haiti drove thousands of low-income rice farmers in Haiti out of business. The opportunity costs of protectionism are not paid just by domestic consumers, but also by foreign producersand for many agricultural products, those foreign producers are the worlds poor.\n\nNow, lets look at what happens with protectionism. U.S. sugar farmers are likely to argue that, if only they could be protected from sugar imported from Brazil, the United States would have higher domestic sugar production, more jobs in the sugar industry, and American sugar farmers would receive a higher price. If the United States government sets a high-enough tariff on imported sugar, or sets an import quota at zero, the result will be that the quantity of sugar traded between countries could be reduced to zero, and the prices in each country will return to the levels before trade was allowed.\nBlocking only some trade is also possible. Suppose that the United States passed a sugar import quota of seven tons. The United States will import no more than seven tons of sugar, which means that Brazil can export no more than seven tons of sugar to the United States. As a result, the price of sugar in the United States will be 20 cents, which is the price where the quantity demanded is seven tons greater than the domestic quantity supplied. Conversely, if Brazil can export only seven tons of sugar, then the price of sugar in Brazil will be 14 cents per pound, which is the price where the domestic quantity supplied in Brazil is seven tons greater than domestic demand.\nIn general, when a country sets a low or medium tariff or import quota, the equilibrium price and quantity will be somewhere between those that prevail with no trade and those with completely free trade. The following Work It Out explores the impact of these trade barriers.\nWork It Out\n\n\nEffects of Trade Barriers\n\nLets look carefully at the effects of tariffs or quotas. If the U.S. government imposes a tariff or quota sufficient to eliminate trade with Brazil, two things occur: U.S. consumers pay a higher price and therefore buy a smaller quantity of sugar. U.S. producers obtain a higher price and they sell a larger quantity of sugar. We can measure the effects of a tariff on producers and consumers in the United States using two concepts that we developed in Demand, Supply, and Efficiency: consumer surplus and producer surplus.\n\n\n\n\nFigure \n21.4\n \nU.S. Sugar Supply and Demand \n \nWhen there is free trade, the equilibrium is at point A. When there is no trade, the equilibrium is at point E.\n\n\nStep 1. Look at Figure 21.4, which shows a hypothetical version of the demand and supply of sugar in the United States.\nStep 2. Note that when there is free trade the sugar market is in equilibrium at point A where Domestic Quantity Demanded (Qd) = Quantity Supplied (Domestic Qs + Imports from Brazil) at a price of PTrade.Step 3. Note, also, that imports are equal to the distance between points C and A.\nStep 4. Recall that consumer surplus is the value that consumers get beyond what they paid for when they buy a product. Graphically, it is the area under a demand curve but above the price. In this case, the consumer surplus in the United States is the area of the triangle formed by the points PTrade, A, and B.Step 5. Recall, also, that producer surplus is another name for profitit is the income producers get above the cost of production, which is shown by the supply curve here. In this case, the producer surplus with trade is the area of the triangle formed by the points Ptrade, C, and D.\nStep 6. Suppose that the barriers to trade are imposed, imports are excluded, and the price rises to PNoTrade. Look what happens to producer surplus and consumer surplus. At the higher price, the domestic quantity supplied increases from Qs to Q at point E. Because producers are selling more quantity at a higher price, the producer surplus increases to the area of the triangle PNoTrade, E, and D.\nStep 7. Compare the areas of the two triangles and you will see the increase in the producer surplus.\nStep 8. Examine the consumer surplus. Consumers are now paying a higher price to get a lower quantity (Q instead of Qd). Their consumer surplus shrinks to the area of the triangle PNoTrade, E, and B.\nStep 9. Determine the net effect. The producer surplus increases by the area Ptrade, C, E, PNoTrade. The loss of consumer surplus, however, is larger. It is the area Ptrade, A, E, PNoTrade. In other words, consumers lose more than producers gain as a result of the trade barriers and the United States has a lower social surplus.\n\n\nWho Benefits and Who Pays?\nUsing the demand and supply model, consider the impact of protectionism on producers and consumers in each of the two countries. For protected producers like U.S. sugar farmers, restricting imports is clearly positive. Without a need to face imported products, these producers are able to sell more, at a higher price. For consumers in the country with the protected good, in this case U.S. sugar consumers, restricting imports is clearly negative. They end up buying a lower quantity of the good and paying a higher price for what they do buy, compared to the equilibrium price and quantity with trade. The following Clear It Up feature considers why a country might outsource jobs even for a domestic product.\nClear It Up\n\n\nWhy are Life Savers, an American product, not made in America?\n\nIn 1912, Clarence Crane invented Life Savers, the hard candy with the hole in the middle, in Cleveland, Ohio. Starting in the late 1960s and for 35 years afterward, a plant in Holland, Michigan produced 46 billion Life Savers a year, in 200 million rolls. However, in 2002, the Kraft Company announced that it would close the Michigan plant and move Life Saver production across the border to Montreal, Canada.One reason is that Canadian workers are paid slightly less, especially in healthcare and insurance costs that are not linked to employment there. Another main reason is that the United States government keeps the sugar price high for the benefit of sugar farmers, with a combination of a government price floor program and strict quotas on imported sugar. According to the Coalition for Sugar Reform, from 2009 to 2012, the price of refined sugar in the United States ranged from 64% to 92% higher than the world price. Life Saver production uses over 100 tons of sugar each day, because the candies are 95% sugar.A number of other candy companies have also reduced U.S. production and expanded foreign production. From 1997 to 2011, sugar-using industries eliminated some 127,000 jobs, or more than seven times the total employment in sugar production. While the candy industry is especially affected by the cost of sugar, the costs are spread more broadly. U.S. consumers pay roughly $1 billion per year in higher food prices because of elevated sugar costs. Meanwhile, sugar producers in low-income countries are driven out of business. Because of the sugar subsidies to domestic producers and the quotas on imports, they cannot sell their output profitably, or at all, in the United States market.\nThe fact that protectionism pushes up prices for consumers in the country enacting such protectionism is not always acknowledged openly, but it is not disputed. After all, if protectionism did not benefit domestic producers, there would not be much point in enacting such policies in the first place. Protectionism is simply a method of requiring consumers to subsidize producers. The subsidy is indirect, since consumers pay for it through higher prices, rather than a direct government subsidy paid with money collected from taxpayers. However, protectionism works like a subsidy, nonetheless. The American satirist Ambrose Bierce defined tariff this way in his 1911 book, The Devils Dictionary: Tariff, n. A scale of taxes on imports, designed to protect the domestic producer against the greed of his consumer.The effect of protectionism on producers and consumers in the foreign country is complex. When a government uses an import quota to impose partial protectionism, Brazilian sugar producers receive a lower price for the sugar they sell in Brazilbut a higher price for the sugar they are allowed to export to the United States. Notice that some of the burden of protectionism, paid by domestic consumers, ends up in the hands of foreign producers in this case. Brazilian sugar consumers seem to benefit from U.S. protectionism, because it reduces the price of sugar that they pay (compared to the free-trade situation). On the other hand, at least some of these Brazilian sugar consumers also work as sugar farmers, so protectionism reduces their incomes and jobs. Moreover, if trade between the countries vanishes, Brazilian consumers would miss out on better prices for imported goodswhich do not appear in our single-market example of sugar protectionism.The effects of protectionism on foreign countries notwithstanding, protectionism requires domestic consumers of a product (consumers may include either households or other firms) to pay higher prices to benefit domestic producers of that product. In addition, when a country enacts protectionism, it loses the economic gains it would have been able to achieve through a combination of comparative advantage, specialized learning, and economies of scale, concepts that we discuss in International Trade.\n", "21-2": "By the end of this section, you will be able to:\nDiscuss how international trade influences the job market\nAnalyze the opportunity cost of protectionism\nExplain how international trade impacts wages, labor standards, and working conditions\n\nIn theory at least, imports might injure workers in several different ways: fewer jobs, lower wages, or poor working conditions. Lets consider these in turn.\nFewer Jobs?\nIn the early 1990s, the United States was negotiating the North American Free Trade Agreement (NAFTA)1  with Mexico, an agreement that reduced tariffs, import quotas, and nontariff barriers to trade between the United States, Mexico, and Canada. H. Ross Perot, a 1992 candidate for U.S. president, claimed, in prominent campaign arguments, that if the United States expanded trade with Mexico, there would be a giant sucking sound as U.S. employers relocated to Mexico to take advantage of lower wages. After all, average wages in Mexico were, at that time, about one-eighth of those in the United States. NAFTA passed Congress, President Bill Clinton signed it into law, and it took effect in 1995. For the next six years, the United States economy had some of the most rapid job growth and low unemployment in its history. Those who feared that open trade with Mexico would lead to a dramatic decrease in jobs were proven wrong.\nThis result was no surprise to economists. After all, the trend toward globalization has been going on for decades, not just since NAFTA. If trade did reduce the number of available jobs, then the United States should have been seeing a steady loss of jobs for decades. While the United States economy does experience rises and falls in unemployment ratesaccording to the Bureau of Labor Statistics, from spring 2007 to late 2009, the unemployment rate rose from 4.4% to 10%. It has since fallen back to under 5% as of the end of 2016the number of jobs is not falling over extended periods of time. The number of U.S. jobs rose from 71 million in 1970 to 145 million in 2014.Protectionism certainly saves jobs in the specific industry being protected but, for two reasons, it costs jobs in other unprotected industries. First, if consumers are paying higher prices to the protected industry, they inevitably have less money to spend on goods from other industries, and so jobs are lost in those other industries. Second, if a firm sells the protected product to other firms, so that other firms must now pay a higher price for a key input, then those firms will lose sales to foreign producers who do not need to pay the higher price. Lost sales translate into lost jobs. The hidden opportunity cost of using protectionism to save jobs in one industry is jobs sacrificed in other industries. This is why the United States International Trade Commission, in its study of barriers to trade, predicts that reducing trade barriers would not lead to an overall loss of jobs. Protectionism reshuffles jobs from industries without import protections to industries that are protected from imports, but it does not create more jobs.Moreover, the costs of saving jobs through protectionism can be very high. A number of different studies have attempted to estimate the cost to consumers in higher prices per job saved through protectionism. Table 21.2 shows a sample of results, compiled by economists at the Federal Reserve Bank of Dallas. Saving a job through protectionism typically costs much more than the actual workers salary. For example, a study published in 2002 compiled evidence that using protectionism to save an average job in the textile and apparel industry would cost $199,000 per job saved. In other words, those workers could have been paid $100,000 per year to be unemployed and the cost would only be half of what it is to keep them working in the textile and apparel industry. This result is not unique to textiles and apparel.\n\n\nIndustry Protected with Import Tariffs or Quotas\nAnnual Cost per Job Saved\n\n\n\nSugar\n$826,000\n\n\nPolyethylene resins\n$812,000\n\n\nDairy products\n$685,000\n\n\nFrozen concentrated orange juice\n$635,000\n\n\nBall bearings\n$603,000\n\n\nMachine tools\n$479,000\n\n\nWomens handbags\n$263,000\n\n\nGlassware\n$247,000\n\n\nApparel and textiles\n$199,000\n\n\nRubber footwear\n$168,000\n\n\nWomens nonathletic footwear\n$139,000\n\n\nTable \n21.2\n \nCost to U.S. Consumers of Saving a Job through Protectionism\n \n(Source: Federal Reserve Bank of Dallas)\n\n\nWhy does it cost so much to save jobs through protectionism? The basic reason is that not all of the extra money that consumers pay because of tariffs or quotas goes to save jobs. For example, if the government imposes tariffs on steel imports so that steel buyers pay a higher price, U.S. steel companies earn greater profits, buy more equipment, pay bigger bonuses to managers, give pay raises to existing employeesand also avoid firing some additional workers. Only part of the higher price of protected steel goes toward saving jobs. Also, when an industry is protected, the economy as a whole loses the benefits of playing to its comparative advantagein other words, producing what it is best at. Therefore, part of the higher price that consumers pay for protected goods is lost economic efficiency, which we can measure as another deadweight loss, like what we discussed in Labor and Financial Markets.Theres a bumper sticker that speaks to the threat some U.S. workers feel from imported products: Buy AmericanSave U.S. Jobs. If an economist were driving the car, the sticker might declare: Block ImportsSave Jobs for Some Americans, Lose Jobs for Other Americans, and Also Pay High Prices.\nTrade and Wages\nEven if trade does not reduce the number of jobs, it could affect wages. Here, it is important to separate issues about the average level of wages from issues about whether the wages of certain workers may be helped or hurt by trade.\nBecause trade raises the amount that an economy can produce by letting firms and workers play to their comparative advantage, trade will also cause the average level of wages in an economy to rise. Workers who can produce more will be more desirable to employers, which will shift the demand for their labor out to the right, and increase wages in the labor market. By contrast, barriers to trade will reduce the average level of wages in an economy.\nHowever, even if trade increases the overall wage level, it will still benefit some workers and hurt others. Workers in industries that are confronted by competition from imported products may find that demand for their labor decreases and shifts back to the left, so that their wages decline with a rise in international trade. Conversely, workers in industries that benefit from selling in global markets may find that demand for their labor shifts out to the right, so that trade raises their wages.\n\nLink It Up\n\n\nView this website to read an article on the issues surrounding fair trade coffee.\n\nOne concern is that while globalization may be benefiting high-skilled, high-wage workers in the United States, it may also impose costs on low-skilled, low-wage workers. After all, high-skilled U.S. workers presumably benefit from increased sales of sophisticated products like computers, machinery, and pharmaceuticals in which the United States has a comparative advantage. Meanwhile, low-skilled U.S. workers must now compete against extremely low-wage workers worldwide for making simpler products like toys and clothing. As a result, the wages of low-skilled U.S. workers are likely to fall. There are, however, a number of reasons to believe that while globalization has helped some U.S. industries and hurt others, it has not focused its negative impact on the wages of low-skilled Americans. First, about half of U.S. trade is intra-industry trade. That means the U.S. trades similar goods with other high-wage economies like Canada, Japan, Germany, and the United Kingdom. For instance, in 2014 the U.S. exported over 2 million cars, from all the major automakers, and also imported several million cars from other countries.Most U.S. workers in these industries have above-average skills and wagesand many of them do quite well in the world of globalization. Some evidence suggested that intra-industry trade between similar countries had a small impact on domestic workers but later evidence indicates that it all depends on how flexible the labor market is. In other words, the key is how flexible workers are in finding jobs in different industries. The effect of trade on low-wage workers depends considerably on the structure of labor markets and indirect effects felt in other parts of the economy. For example, in the United States and the United Kingdom, because labor market frictions are low, the impact of trade on low income workers is small.Second, many low-skilled U.S. workers hold service jobs that imports from low-wage countries cannot replace. For example, we cannot import lawn care services or moving and hauling services or hotel maids from countries long distances away like China or Bangladesh. Competition from imported products is not the primary determinant of their wages.Finally, while the focus of the discussion here is on wages, it is worth pointing out that low-wage U.S. workers suffer due to protectionism in all the industrieseven those in which they do not work. For example, food and clothing are protected industries. These low-wage workers therefore pay higher prices for these basic necessities and as such their dollar stretches over fewer goods.The benefits and costs of increased trade in terms of its effect on wages are not distributed evenly across the economy. However, the growth of international trade has helped to raise the productivity of U.S. workers as a wholeand thus helped to raise the average level of wages.\n\nLabor Standards and Working Conditions\nWorkers in many low-income countries around the world labor under conditions that would be illegal for a worker in the United States. Workers in countries like China, Thailand, Brazil, South Africa, and Poland are often paid less than the United States minimum wage. For example, in the United States, the minimum wage is $7.25 per hour. A typical wage in many low-income countries might be more like $7.25 per day, or often much less. Moreover, working conditions in low-income countries may be extremely unpleasant, or even unsafe. In the worst cases, production may involve the child labor or even workers who are treated nearly like slaves. These concerns over foreign labor standards do not affect most of U.S. trade, which is intra-industry and carried out with other high-income countries that have labor standards similar to the United States, but it is, nonetheless, morally and economically important.In thinking about labor standards in other countries, it is important to draw some distinctions between what is truly unacceptable and what is painful to think about. Most people, economists included, have little difficulty with the idea that production by six-year-olds confined in factories or by slave labor is morally unacceptable. They would support aggressive efforts to eliminate such practicesincluding shutting out imported products made with such labor. Many cases, however, are less clear-cut. An opinion article in the New York Times several years ago described the case of Ahmed Zia, a 14-year-old boy from Pakistan. He earned $2 per day working in a carpet factory. He dropped out of school in second grade. Should the United States and other countries refuse to purchase rugs made by Ahmed and his co-workers? If the carpet factories were to close, the likely alternative job for Ahmed is farm work, and as Ahmed says of his carpet-weaving job: This makes much more money and is more comfortable.\nOther workers may have even less attractive alternative jobs, perhaps scavenging garbage or prostitution. The real problem for Ahmed and many others in low-income countries is not that globalization has made their lives worse, but rather that they have so few good life alternatives. The United States went through similar situations during the nineteenth and early twentieth centuries.\nIn closing, there is some irony when the United States government or U.S. citizens take issue with labor standards in low-income countries, because the United States is not a world leader in government laws to protect employees.  According to a recent study by the Organization for Economic Cooperation and Development (OECD), the U.S. is the only one of 41 countries that does not provide mandated paid leave for new parents, and among the 40 countries that do mandate paid leave, the minimum duration is about two months. Many European workers receive six weeks or more of paid vacation per year. In the United States, vacations are often one to three weeks per year. If European countries accused the United States of using unfair labor standards to make U.S. products cheaply, and announced that they would shut out all U.S. imports until the United States adopted paid parental leave, added more national holidays, and doubled vacation time, Americans would be outraged. Yet when U.S. protectionists start talking about restricting imports from poor countries because of low wage levels and poor working conditions, they are making a very similar argument. This is not to say that labor conditions in low-income countries are not an important issue. They are. However, linking labor conditions in low-income countries to trade deflects the emphasis from the real question to ask: What are acceptable and enforceable minimum labor standards and protections to have the world over?\nFootnotes1As of July 1, 2020, NAFTA was officially replaced with the United States-Mexico-Canada (USMCA) free trade agreement. It is broadly similar to the original NAFTA.", "21-3": "By the end of this section, you will be able to:\nExplain and analyze various arguments that are in support of restricting imports, including the infant industry argument, the anti-dumping argument, the environmental protection argument, the unsafe consumer products argument, and the national interest argument\nExplain dumping and race to the bottom\nEvaluate the significance of countries perceptions on the benefits of growing trade\n\nAs we previously noted, protectionism requires domestic consumers of a product to pay higher prices to benefit domestic producers of that product. Countries that institute protectionist policies lose the economic gains achieved through a combination of comparative advantage, specialized learning, and economies of scale. With these overall costs in mind, let us now consider, one by one, a number of arguments that support restricting imports.The Infant Industry Argument\nImagine Bhutan wants to start its own computer industry, but it has no computer firms that can produce at a low enough price and high enough quality to compete in world markets. However, Bhutanese politicians, business leaders, and workers hope that if the local industry had a chance to get established, before it needed to face international competition, then a domestic company or group of companies could develop the skills, management, technology, and economies of scale that it needs to become a successful profit-earning domestic industry. Thus, the infant industry argument for protectionism is to block imports for a limited time, to give the infant industry time to mature, before it starts competing on equal terms in the global economy. (Revisit  Macroeconomic Policy Around the World for more information on the infant industry argument.)The infant industry argument is theoretically possible, even sensible: give an industry a short-term indirect subsidy through protection, and then reap the long-term economic benefits of having a vibrant, healthy industry. Implementation, however, is tricky. In many countries, infant industries have gone from babyhood to senility and obsolescence without ever having reached the profitable maturity stage. Meanwhile, the protectionism that was supposed to be short-term often took a very long time to be repealed.\nAs one example, Brazil treated its computer industry as an infant industry from the late 1970s until about 1990. In an attempt to establish its computer industry in the global economy, Brazil largely barred imports of computer products for several decades. This policy guaranteed increased sales for Brazilian computers. However, by the mid-1980s, due to lack of international competition, Brazil had a backward and out-of-date industry, typically lagging behind world standards for price and performance by three to five yearsa long time in this fast-moving industry. After more than a decade, during which Brazilian consumers and industries that would have benefited from up-to-date computers paid the costs and Brazils computer industry never competed effectively on world markets, Brazil phased out its infant industry policy for the computer industry.\nProtectionism for infant industries always imposes costs on domestic users of the product, and typically has provided little benefit in the form of stronger, competitive industries. However, several countries in East Asia offer an exception. Japan, Korea, Thailand, and other countries in this region have sometimes provided a package of indirect and direct subsidies targeted at certain industries, including protection from foreign competition and government loans at interest rates below the market equilibrium. In Japan and Korea, for example, subsidies helped get their domestic steel and auto industries up and running.\nWhy did the infant industry policy of protectionism and other subsidies work fairly well in East Asia? An early 1990 World Bank study offered three guidelines to countries thinking about infant industry protection:\nDo not hand out protectionism and other subsidies to all industries, but focus on a few industries where your country has a realistic chance to be a world-class producer.\nBe very hesitant about using protectionism in areas like computers, where many other industries rely on having the best products available, because it is not useful to help one industry by imposing high costs on many other industries.\nHave clear guidelines for when the infant industry policy will end.\n\nIn Korea in the 1970s and 1980s, a common practice was to link protectionism and subsidies to export sales in global markets. If export sales rose, then the infant industry had succeeded and the government could phase out protectionism. If export sales did not rise, then the infant industry policy had failed and the government could phase out protectionism. Either way, the protectionism would be temporary.Following these rules is easier said than done. Politics often intrudes, both in choosing which industries will receive the benefits of treatment as infants and when to phase out import restrictions and other subsidies. Also, if the country's government wishes to impose costs on its citizens so that it can provide subsidies to a few key industries, it has many tools for doing such as direct government payments, loans, targeted tax reductions, and government support of research and development of new technologies. In other words, protectionism is not the only or even the best way to support key industries.\nLink It Up\n\n\nVisit this website\nto view a presentation by Pankaj Ghemawat questioning how integrated the world really is.\n\n\nThe Anti-Dumping Argument\nDumping refers to selling goods below their cost of production. Anti-dumping laws block imports that are sold below the cost of production by imposing tariffs that increase the price of these imports to reflect their cost of production. Since dumping is not allowed under World Trade Organization (WTO) rules, nations that believe they are on the receiving end of dumped goods can file a complaint with the WTO. Anti-dumping complaints have risen in recent years, from about 100 cases per year in the late 1980s to about 200 new cases each year by the late 2000s. Note that dumping cases are countercyclical. During recessions, case filings increase. During economic booms, case filings go down. Individual countries have also frequently started their own anti-dumping investigations. The U.S. government has dozens of anti-dumping orders in place from past investigations. In 2009, for example, some U.S. imports that were under anti-dumping orders included pasta from Turkey, steel pipe fittings from Thailand, pressure-sensitive plastic tape from Italy, preserved mushrooms and lined paper products from India, and cut-to-length carbon steel and non-frozen apple juice concentrate from China.Why Might Dumping Occur?\nWhy would foreign firms export a product at less than its cost of productionwhich presumably means taking a loss? This question has two possible answers, one innocent and one more sinister.\nThe innocent explanation is that demand and supply set market prices, not the cost of production. Perhaps demand for a product shifts back to the left or supply shifts out to the right, which drives the market price to low levelseven below the cost of production. When a local store has a going-out-of-business sale, for example, it may sell goods at below the cost of production. If international companies find that there is excess supply of steel or computer chips or machine tools that is driving the market price down below their cost of productionthis may be the market in action.The sinister explanation is that dumping is part of a long-term strategy. Foreign firms sell goods at prices below the cost of production for a short period of time, and when they have driven out the domestic U.S. competition, they then raise prices. Economists sometimes call this scenario predatory pricing, which we discuss in the Monopoly chapter.Should Anti-Dumping Cases Be Limited?\nAnti-dumping cases pose two questions. How much sense do they make in economic theory? How much sense do they make as practical policy?\nIn terms of economic theory, the case for anti-dumping laws is weak. In a market governed by demand and supply, the government does not guarantee that firms will be able to make a profit. After all, low prices are difficult for producers, but benefit consumers. Moreover, although there are plenty of cases in which foreign producers have driven out domestic firms, there are zero documented cases in which the foreign producers then jacked up prices. Instead, foreign producers typically continue competing hard against each other and providing low prices to consumers. In short, it is difficult to find evidence of predatory pricing by foreign firms exporting to the United States.\nEven if one could make a case that the government should sometimes enact anti-dumping rules in the short term, and then allow free trade to resume shortly thereafter, there is a growing concern that anti-dumping investigations often involve more politics than careful analysis. The U.S. Commerce Department is charged with calculating the appropriate cost of production, which can be as much an art as a science.\nFor example, if a company built a new factory two years ago, should it count part of the factorys cost in this years cost of production? When a company is in a country where the government controls prices, like China for example, how can one measure the true cost of production? When a domestic industry complains loudly enough, government regulators seem very likely to find that unfair dumping has occurred. A common pattern has arisen where a domestic industry files an anti-dumping complaint, the governments meet and negotiate a reduction in imports, and then the domestic producers drop the anti-dumping suit. In such cases, anti-dumping cases often appear to be little more than a cover story for imposing tariffs or import quotas.In the 1980s, the United States, Canada, the European Union, Australia, and New Zealand implemented almost all the anti-dumping cases. By the 2000s, countries like Argentina, Brazil, South Korea, South Africa, Mexico, and India were filing the majority of the anti-dumping cases before the WTO. As the number of anti-dumping cases has increased, and as countries such as the United States and the European Union feel targeted by the anti-dumping actions of others, the WTO may well propose some additional guidelines to limit the reach of anti-dumping laws.\nThe Environmental Protection Argument\nThe potential for global trade to affect the environment has become controversial. A president of the Sierra Club, an environmental lobbying organization, once wrote: The consequences of globalization for the environment are not good.  Globalization, if we are lucky, will raise average incomes enough to pay for cleaning up some of the mess that we have made. But before we get there, globalization could also destroy enough of the planets basic biological and physical systems that prospects for life itself will be radically compromised.\nIf free trade meant the destruction of life itself, then even economists would convert to protectionism! While globalizationand economic activity of all kindscan pose environmental dangers, it seems quite possible that, with the appropriate safeguards in place, we can minimize the environmental impacts of trade. In some cases, trade may even bring environmental benefits.In general, high-income countries such as the United States, Canada, Japan, and the nations of the European Union have relatively strict environmental standards. In contrast, middle- and low-income countries like Brazil, Nigeria, India, and China have lower environmental standards. The general view of the governments of such countries is that environmental protection is a luxury: as soon as their people have enough to eat, decent healthcare, and longer life expectancies, then they will spend more money on items such as sewage treatment plants, scrubbers to reduce air pollution from factory smokestacks, and national parks to protect wildlife.This gap in environmental standards between high-income and low-income countries raises two worrisome possibilities in a world of increasing global trade: the race to the bottom scenario and the question of how quickly environmental standards will improve in low-income countries.\nThe Race to the Bottom Scenario\nThe race to the bottom scenario of global environmental degradation runs like this. Profit-seeking multinational companies shift their production from countries with strong environmental standards to countries with weak standards, thus reducing their costs and increasing their profits. Faced with such behavior, countries reduce their environmental standards to attract multinational firms, which, after all, provide jobs and economic clout. As a result, global production becomes concentrated in countries where firms can pollute the most and environmental laws everywhere race to the bottom.Although the race-to-the-bottom scenario sounds plausible, it does not appear to describe reality. In fact, the financial incentive for firms to shift production to poor countries to take advantage of their weaker environmental rules does not seem especially powerful. When firms decide where to locate a new factory, they look at many different factors: the costs of labor and financial capital; whether the location is close to a reliable suppliers of the inputs that they need; whether the location is close to customers; the quality of transportation, communications, and electrical power networks; the level of taxes; and the competence and honesty of the local government. The cost of environmental regulations is a factor, too, but typically environmental costs are no more than 1 to 2% of the costs that a large industrial plant faces. The other factors that determine location are much more important to these companies than trying to skimp on environmental protection costs.When an international company does choose to build a plant in a low-income country with lax environmental laws, it typically builds a plant similar to those that it operates in high-income countries with stricter environmental standards. Part of the reason for this decision is that designing an industrial plant is a complex and costly task, and so if a plant works well in a high-income country, companies prefer to use the same design everywhere. Also, companies realize that if they create an environmental disaster in a low-income country, it is likely to cost them a substantial amount of money in paying for damages, lost trust, and reduced salesby building up-to-date plants everywhere they minimize such risks. As a result of these factors, foreign-owned plants in low-income countries often have a better record of compliance with environmental laws than do locally-owned plants.\nPressuring Low-Income Countries for Higher Environmental Standards\nIn some cases, the issue is not so much whether globalization will pressure low-income countries to reduce their environmental standards, but instead whether the threat of blocking international trade can pressure these countries into adopting stronger standards. For example, restrictions on ivory imports in high-income countries, along with stronger government efforts to catch elephant poachers, have been credited with helping to reduce the illegal poaching of elephants in certain African countries.\nHowever, it would be highly undemocratic for the well-fed citizens of high-income countries to attempt to dictate to the ill-fed citizens of low-income countries what domestic policies and priorities they must adopt, or how they should balance environmental goals against other priorities for their citizens. Furthermore, if high-income countries want stronger environmental standards in low-income countries, they have many options other than the threat of protectionism. For example, high-income countries could pay for anti-pollution equipment in low-income countries, or could help to pay for national parks. High-income countries could help pay for and carry out the scientific and economic studies that would help environmentalists in low-income countries to make a more persuasive case for the economic benefits of protecting the environment.\nAfter all, environmental protection is vital to two industries of key importance in many low-income countriesagriculture and tourism. Environmental advocates can set up standards for labeling products, like this tuna caught in a net that kept dolphins safe or this product made only with wood not taken from rainforests, so that consumer pressure can reinforce environmentalist values. The United Nations also reinforces these values, by sponsoring treaties to address issues such as climate change and global warming, the preservation of biodiversity, the spread of deserts, and the environmental health of the seabed. Countries that share a national border or are within a region often sign environmental agreements about air and water rights, too. The WTO is also becoming more aware of environmental issues and more careful about ensuring that increases in trade do not inflict environmental damage.Finally, note that these concerns about the race to the bottom or pressuring low-income countries for more strict environmental standards do not apply very well to the roughly half of all U.S. trade that occurs with other high-income countries. Many European countries have stricter environmental standards in certain industries than the United States.\nThe Unsafe Consumer Products Argument\nOne argument for shutting out certain imported products is that they are unsafe for consumers. Consumer rights groups have sometimes warned that the World Trade Organization would require nations to reduce their health and safety standards for imported products. However, the WTO explains its current agreement on the subject in this way: It allows countries to set their own standards. It also says regulations must be based on science. . . . And they should not arbitrarily or unjustifiably discriminate between countries where identical or similar conditions prevail. Thus, for example, under WTO rules it is perfectly legitimate for the United States to pass laws requiring that all food products or cars sold in the United States meet certain safety standards approved by the United States government, whether or not other countries choose to pass similar standards. However, such standards must have some scientific basis. It is improper to impose one set of health and safety standards for domestically produced goods but a different set of standards for imports, or one set of standards for imports from Europe and a different set of standards for imports from Latin America.In 2007, Mattel recalled nearly two million toys imported from China due to concerns about high levels of lead in the paint, as well as some loose parts. It is unclear if other toys were subject to similar standards. More recently, in 2013, Japan blocked imports of U.S. wheat because of concerns that genetically modified (GMO) wheat might be included in the shipments. The science on the impact of GMOs on health is still developing.\n\nThe National Interest Argument\nSome argue that a nation should not depend too heavily on other countries for supplies of certain key products, such as oil, or for special materials or technologies that might have national security applications. On closer consideration, this argument for protectionism proves rather weak.\nAs an example, in the United States, oil provides about 36% of all the energy and 25% of the oil used in the United States economy is imported. Several times in the last few decades, when disruptions in the Middle East have shifted the supply curve of oil back to the left and sharply raised the price, the effects have been felt across the United States economy. This is not, however, a very convincing argument for restricting oil imports. If the United States needs to be protected from a possible cutoff of foreign oil, then a more reasonable strategy would be to import 100% of the petroleum supply now, and save U.S. domestic oil resources for when or if the foreign supply is cut off. It might also be useful to import extra oil and put it into a stockpile for use in an emergency, as the United States government did by starting a Strategic Petroleum Reserve in 1977. Moreover, it may be necessary to discourage people from using oil, and to start a high-powered program to seek out alternatives to oil. A straightforward way to do this would be to raise taxes on oil. Additionally, it makes no sense to argue that because oil is highly important to the United States economy, then the United States should shut out oil imports and use up its domestic supplies more quickly. U.S. domestic oil production is increasing. Shale oil is adding to domestic supply using fracking extraction techniques. Whether or not to limit certain kinds of imports of key technologies or materials that might be important to national security and weapons systems is a slightly different issue. If weapons builders are not confident that they can continue to obtain a key product in wartime, they might decide to avoid designing weapons that use this key product, or they can go ahead and design the weapons and stockpile enough of the key high-tech components or materials to last through an armed conflict. There is a U.S. Defense National Stockpile Center that has built up reserves of many materials, from aluminum oxides, antimony, and bauxite to tungsten, vegetable tannin extracts, and zinc (although many of these stockpiles have been reduced and sold in recent years). Think every country is pro-trade? How about the U.S.? The following Clear It Up might surprise you.\nClear It Up\n\n\nHow does the United States really feel about expanding trade?\n\nHow do people around the world feel about expanding trade between nations? In summer 2007, the Pew Foundation surveyed 45,000 people in 47 countries. One of the questions asked about opinions on growing trade ties between countries. Table 21.3 shows the percentages who answered either very good or somewhat good for some of countries surveyed.\nFor those who think of the United States as the worlds leading supporter of expanding trade, the survey results may be perplexing. When adding up the shares of those who say that growing trade ties between countries is very good or somewhat good, Americans had the least favorable attitude toward increasing globalization, while the Chinese and South Africans ranked highest. In fact, among the 47 countries surveyed, the United States ranked by far the lowest on this measure, followed by Egypt, Italy, and Argentina.\n\n\nCountry\nVery Good\nSomewhat Good\nTotal \n\n\n\nChina\n38%\n53%\n91%\n\n\nSouth Africa\n42%\n43%\n87%\n\n\nSouth Korea\n24%\n62%\n86%\n\n\nGermany\n30%\n55%\n85%\n\n\nCanada\n29%\n53%\n82%\n\n\nUnited Kingdom\n28%\n50%\n78%\n\n\nMexico\n22%\n55%\n77%\n\n\nBrazil\n13%\n59%\n72%\n\n\nJapan\n17%\n55%\n72%\n\n\nUnited States\n14%\n45%\n59%\n\n\nTable \n21.3\n \nThe Status of Growing Trade Ties between Countries\n \n(Source: http://www.pewglobal.org/files/pdf/258.pdf)\n\n\n\nOne final reason why economists often treat the national interest argument skeptically is that lobbyists and politicians can tout almost any product as vital to national security. In 1954, the United States became worried that it was importing half of the wool required for military uniforms, so it declared wool and mohair to be strategic materials and began to give subsidies to wool and mohair farmers. Although the government removed wool from the official list of strategic materials in 1960, the subsidies for mohair continued for almost 40 years until the government repealed them in 1993, and then reinstated them in 2002. All too often, the national interest argument has become an excuse for handing out the indirect subsidy of protectionism to certain industries or companies. After all, politicians, not nonpartisan analysts make decisions about what constitutes a key strategic material.\n", "21-4": "By the end of this section, you will be able to:\nExplain the origin and role of the World Trade Organization (WTO) and General Agreement on Tariffs and Trade (GATT)\nDiscuss the significance and provide examples of regional trading agreements\nAnalyze trade policy at the national level\nEvaluate long-term trends in barriers to trade\n\nThese public policy arguments about how nations should react to globalization and trade are fought out at several levels: at the global level through the World Trade Organization and through regional trade agreements between pairs or groups of countries.\nThe World Trade Organization\nThe World Trade Organization (WTO) was officially born in 1995, but its history is much longer. In the years after the Great Depression and World War II, there was a worldwide push to build institutions that would tie the nations of the world together. The United Nations officially came into existence in 1945. The World Bank, which assists the poorest people in the world, and the International Monetary Fund, which addresses issues raised by international financial transactions, were both created in 1946. The third planned organization was to be an International Trade Organization, which would manage international trade. The United Nations was unable to agree to this. Instead, 27 nations signed the General Agreement on Tariffs and Trade (GATT) in Geneva, Switzerland on October 30, 1947 to provide a forum in which nations could come together to negotiate reductions in tariffs and other barriers to trade. In 1995, the GATT transformed into the WTO.The GATT process was to negotiate an agreement to reduce barriers to trade, sign that agreement, pause for a while, and then start negotiating the next agreement. Table 21.4 shows rounds of talks in the GATT, and now the WTO. Notice that the early rounds of GATT talks took a relatively short time, included a small number of countries, and focused almost entirely on reducing tariffs. Since the mid-1960s, however, rounds of trade talks have taken years, included a large number of countries, and have included an ever-broadening range of issues.\n\nYear\nPlace or Name of Round\nMain Subjects\nNumber of Countries Involved\n\n\n\n1947\nGeneva\nTariff reduction\n23\n\n\n1949\nAnnecy\nTariff reduction\n13\n\n\n1951\nTorquay\nTariff reduction\n38\n\n\n1956\nGeneva\nTariff reduction\n26\n\n\n196061\nDillon round\nTariff reduction\n26\n\n\n196467\nKennedy round\nTariffs, anti-dumping measures\n62\n\n\n197379\nTokyo round\nTariffs, nontariff barriers\n102\n\n\n198694\nUruguay round\nTariffs, nontariff barriers, services, intellectual property, dispute settlement, textiles, agriculture, creation of WTO\n123\n\n\n2001\nDoha round\nAgriculture, services, intellectual property, competition, investment, environment, dispute settlement\n147\n\n\nTable \n21.4\n \nThe Negotiating Rounds of GATT and the World Trade Organization\n \n\n\nThe sluggish pace of GATT negotiations led to an old joke that GATT really stood for Gentlemans Agreement to Talk and Talk. The slow pace of international trade talks, however, is understandable, even sensible. Having dozens of nations agree to any treaty is a lengthy process. GATT often set up separate trading rules for certain industries, like agriculture, and separate trading rules for certain countries, like the low-income countries. There were rules, exceptions to rules, opportunities to opt out of rules, and precise wording to be fought over in every case. Like the GATT before it, the WTO is not a world government, with power to impose its decisions on others. The total staff of the WTO in 2014 is 640 people and its annual budget (as of 2014) is $197 million, which makes it smaller in size than many large universities.\nRegional Trading Agreements\nThere are different types of economic integration across the globe, ranging from free trade agreements, in which participants allow each others imports without tariffs or quotas, to common markets, in which participants have a common external trade policy as well as free trade within the group, to full economic unions, in which, in addition to a common market, monetary and fiscal policies are coordinated. Many nations belong both to the World Trade Organization and to regional trading agreements.\nThe best known of these regional trading agreements is the European Union. In the years after World War II, leaders of several European nations reasoned that if they could tie their economies together more closely, they might be more likely to avoid another devastating war. Their efforts began with a free trade association, evolved into a common market, and then transformed into what is now a full economic union, known as the European Union. The EU, as it is often called, has a number of goals. For example, in the early 2000s it introduced a common currency for Europe, the euro, and phased out most of the former national forms of money like the German mark and the French franc, though a few have retained their own currency. Another key element of the union is to eliminate barriers to the mobility of goods, labor, and capital across Europe.\nFor the United States, perhaps the best-known regional trading agreement is the North American Free Trade Agreement (NAFTA). 2 The United States also participates in some less-prominent regional trading agreements, like the Caribbean Basin Initiative, which offers reduced tariffs for imports from these countries, and a free trade agreement with Israel.\nThe world has seen a flood of regional trading agreements in recent years. About 100 such agreements are now in place. Table 21.5 lists a few of the more prominent ones. Some are just agreements to continue talking. Others set specific goals for reducing tariffs, import quotas, and nontariff barriers. One economist described the current trade treaties as a spaghetti bowl, which is what a map with lines connecting all the countries with trade treaties looks like.There is concern among economists who favor free trade that some of these regional agreements may promise free trade, but actually act as a way for the countries within the regional agreement to try to limit trade from anywhere else. In some cases, the regional trade agreements may even conflict with the broader agreements of the World Trade Organization.\n\n\nTrade Agreements\nParticipating Countries \n\n\n\nAsia Pacific Economic Cooperation (APEC)\nAustralia, Brunei, Canada, Chile, Peoples Republic of China, Hong Kong, China, Indonesia, Japan, Republic of Korea, Malaysia, Mexico, New Zealand, Papua New Guinea, Peru, Philippines, Russia, Singapore, Chinese Taipei, Thailand, United States, Vietnam\n\n\nEuropean Union (EU)\nAustria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, United Kingdom*\n\n\nNorth America Free Trade Agreement (NAFTA)\nCanada, Mexico, United States\n\n\nLatin American Integration Association (LAIA)\nArgentina, Bolivia, Brazil, Chile, Columbia, Ecuador, Mexico, Paraguay, Peru, Uruguay, Venezuela\n\n\nAssociation of Southeast Asian Nations (ASEAN)\nBrunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, Vietnam\n\n\nSouthern African Development Community (SADC)\nAngola, Botswana, Congo, Lesotho, Madagascar, Malawi, Mauritius, Mozambique, Namibia, Seychelles, South Africa, Swaziland, Tanzania, Zambia, Zimbabwe\n\n\nTable \n21.5\n \nSome Regional Trade Agreements\n \n* Following the 2016 referendum vote to leave the European Union, the UK government triggered the withdrawal process on March 29, 2017, setting the date for the UK to leave by April 2019.\n\n\nTrade Policy at the National Level\nYet another dimension of trade policy, along with international and regional trade agreements, happens at the national level. The United States, for example, imposes import quotas on sugar, because of a fear that such imports would drive down the price of sugar and thus injure domestic sugar producers. One of the jobs of the United States Department of Commerce is to determine if there is import dumping from other countries. The United States International Trade Commissiona government agencydetermines whether the dumping has substantially injured domestic industries, and if so, the president can impose tariffs that are intended to offset the unfairly low price.In the arena of trade policy, the battle often seems to be between national laws that increase protectionism and international agreements that try to reduce protectionism, like the WTO. Why would a country pass laws or negotiate agreements to shut out certain foreign products, like sugar or textiles, while simultaneously negotiating to reduce trade barriers in general? One plausible answer is that international trade agreements offer a method for countries to restrain their own special interests. A member of Congress can say to an industry lobbying for tariffs or quotas on imports: Sure would like to help you, but that pesky WTO agreement just wont let me.\n\nLink It Up\n\n\nIf consumers are the biggest losers from trade, why do they not fight back? The quick answer is because it is easier to organize a small group of people around a narrow interest (producers) versus a large group that has diffuse interests (consumers). This is a question about trade policy theory. Visit this website and read the article by Jonathan Rauch.\n\n\nLong-Term Trends in Barriers to Trade\nIn newspaper headlines, trade policy appears mostly as disputes and acrimony. Countries are almost constantly threatening to challenge other nations' unfair trading practices. Cases are brought to the dispute settlement procedures of the WTO, the European Union, NAFTA, and other regional trading agreements. Politicians in national legislatures, goaded on by lobbyists, often threaten to pass bills that will establish a fair playing field or prevent unfair tradealthough most such bills seek to accomplish these high-sounding goals by placing more restrictions on trade. Protesters in the streets may object to specific trade rules or to the entire practice of international trade.Through all the controversy, the general trend in the last 60 years is clearly toward lower barriers to trade. The average level of tariffs on imported products charged by industrialized countries was 40% in 1946. By 1990, after decades of GATT negotiations, it was down to less than 5%. One of the reasons that GATT negotiations shifted from focusing on tariff reduction in the early rounds to a broader agenda was that tariffs had been reduced so dramatically there was not much more to do in that area. U.S. tariffs have followed this general pattern: After rising sharply during the Great Depression, tariffs dropped off to less than 2% by the end of the century. Although measures of import quotas and nontariff barriers are less exact than those for tariffs, they generally appear to be at lower levels than they had been previously, too.Thus, the last half-century has seen both a dramatic reduction in government-created barriers to trade, such as tariffs, import quotas, and nontariff barriers, and also a number of technological developments that have made international trade easier, like advances in transportation, communication, and information management. The result has been the powerful surge of international trade.These trends were potentially altered by two important events in 2016: the UK vote to leave the EU and the election of President Trump in the United States, whose administration pursued a policy of raising trade barriers. As of late 2020, the UK negotiations with the EU are ongoing, and it remains unclear if a new administration will undo President Trumps trade barriers.\nFootnotes2As of July 1, 2020, NAFTA was officially replaced with the United States-Mexico-Canada (USMCA) free trade agreement. It is broadly similar to the original NAFTA.", "21-5": "By the end of this section, you will be able to:\nAsses the complexity of international trade\nDiscuss why a market-oriented economy is so affected by international trade\nExplain disruptive market change\n\nEconomists readily acknowledge that international trade is not all sunshine, roses, and happy endings. Over time, the average person gains from international trade, both as a worker who has greater productivity and higher wages because of the benefits of specialization and comparative advantage, and as a consumer who can benefit from shopping all over the world for a greater variety of quality products at attractive prices. The average person, however, is hypothetical, not realrepresenting a mix of those who have done very well, those who have done all right, and those who have done poorly. It is a legitimate concern of public policy to focus not just on the average or on the success stories, but also on those who have not been so fortunate. Workers in other countries, the environment, and prospects for new industries and materials that might be of key importance to the national economy are also all legitimate issues.The common belief among economists is that it is better to embrace the gains from trade, and then deal with the costs and tradeoffs with other policy tools, than it is to cut off trade to avoid the costs and tradeoffs.\nTo gain a better intuitive understanding for this argument, consider a hypothetical American company called Technotron. Technotron invents a new scientific technology that allows the firm to increase the output and quality of its goods with a smaller number of workers at a lower cost. As a result of this technology, other U.S. firms in this industry will lose money and will also have to lay off workersand some of the competing firms will even go bankrupt. Should the United States government protect the existing firms and their employees by making it illegal for Technotron to use its new technology? Most people who live in market-oriented economies would oppose trying to block better products that lower the cost of services. Certainly, there is a case for society providing temporary support and assistance for those who find themselves without work. Many would argue for government support of programs that encourage retraining and acquiring additional skills. Government might also support research and development efforts, so that other firms may find ways of outdoing Technotron. Blocking the new technology altogether, however, seems like a mistake. After all, few people would advocate giving up electricity because it caused so much disruption to the kerosene and candle business. Few would suggest holding back on improvements in medical technology because they might cause companies selling leeches and snake oil to lose money. In short, most people view disruptions due to technological change as a necessary cost that is worth bearing.\nNow, imagine that Technotrons new technology is as simple as this: the company imports what it sells from another country. In other words, think of foreign trade as a type of innovative technology. The objective situation is now exactly the same as before. Because of Technotrons new technologywhich in this case is importing goods from another countyother firms in this industry will lose money and lay off workers. Just as it would have been inappropriate and ultimately foolish to respond to the disruptions of new scientific technology by trying to shut it down, it would be inappropriate and ultimately foolish to respond to the disruptions of international trade by trying to restrict trade.\nSome workers and firms will suffer because of international trade. In a living, breathing market-oriented economy, some workers and firms will always be experiencing disruptions, for a wide variety of reasons. Corporate management can be better or worse. Workers for a certain firm can be more or less productive. Tough domestic competitors can create just as much disruption as tough foreign competitors. Sometimes a new product is a hit with consumers; sometimes it is a flop. Sometimes a company is blessed by a run of good luck or stricken with a run of bad luck. For some firms, international trade will offer great opportunities for expanding productivity and jobs; for other firms, trade will impose stress and pain. The disruption caused by international trade is not fundamentally different from all the other disruptions caused by the other workings of a market economy.In other words, the economic analysis of free trade does not rely on a belief that foreign trade is not disruptive or does not pose tradeoffs; indeed, the story of Technotron begins with a particular disruptive market changea new technologythat causes real tradeoffs. In thinking about the disruptions of foreign trade, or any of the other possible costs and tradeoffs of foreign trade discussed in this chapter, the best public policy solutions typically do not involve protectionism, but instead involve finding ways for public policy to address the particular issues resulting from these disruptions, costs, and tradeoffs, while still allowing the benefits of international trade to occur.\nBring It Home\n\n\nWhats the Downside of Protection?\n\nThe domestic flat-panel display industry employed many workers before the ITC imposed the dumping margin tax. Flat-panel displays make up a significant portion of the cost of producing laptop computersas much as 50%. Therefore, the antidumping tax would substantially increase the cost, and thus the price, of U.S.-manufactured laptops. As a result of the ITCs decision, Apple moved its domestic manufacturing plant for Macintosh computers to Ireland (where it had an existing plant). Toshiba shut down its U.S. manufacturing plant for laptops. And IBM cancelled plans to open a laptop manufacturing plant in North Carolina, instead deciding to expand production at its plant in Japan. In this case, rather than having the desired effect of protecting U.S. interests and giving domestic manufacturing an advantage over items manufactured elsewhere, it had the unintended effect of driving the manufacturing completely out of the country. Many people lost their jobs and most flat-panel display production now occurs in countries other than the United States.\n\n"}