Econ Part 2 Test 2

FTAs include rules about trade that are agreed upon by all member nations.

You may have heard of the North American Free Trade Agreement (NAFTA), an FTA that has increased trade among the United States, Canada, and Mexico. NAFTA makes imports from Mexico and Canada into the United States less expensive. By buying cheaper Mexican and Canadian products, Americans have more money to spend on other things or to save for the future. At the same time, prices paid by Mexicans and Canadians for American-made products are also lower. This means those citizens will buy more American goods, which benefits the United States. Another well-known FTA is the European Union, which has promoted increased trade across Europe and introduced a common currency: the euro. On the global scale, the World Trade Organization (WTO) helps promote free trade worldwide. Its purpose is to reduce barriers to international trade and increase production efficiencies. This increases total world output and improves living standards across countries. China-ASEAN Free Trade Aria These and other FTAs have: Increased specialization and overall output Increased the variety of goods and services that consumers can purchase Lowered the prices of goods and services NAFTA, which went into effect in January 1994, created a free trade zone among the United States, Canada, and Mexico.1 The purpose was to reduce trade barriers, promote fair trade practices, and increase investment opportunities. In Module 77, you learned why free trade can lead to widespread benefits for consumers and encourage businesses to produce more efficiently. Despite these benefits, some businesses lobby the federal government in support of tariffs on competing imports. Remember, trade barriers benefit American businesses that must compete with foreign companies. For example, American automobile producers would prefer to have trade barriers on foreign cars since it would make foreign cars more expensive. Trade barriers would potentially lead to more sales for American car companies. So American car companies may spend money to lobby Congress to keep automobile tariffs high. The Challenges Faced by Some U.S. Workers under NAFTA NAFTA has been particularly unpopular with businesses in industries that compete directly with Mexico. One example is the U.S. textile (clothing) industry, where jobs have been displaced because of competing imports from Mexico. Some American jobs have been lost to Mexico. If an American factory cannot successfully compete with a Mexican factory, it might have to lay off workers. That does not mean necessarily that NAFTA is a bad idea. Other industries will benefit as Mexican citizens buy more American products at lower prices. However, American workers who are laid off from their jobs (such as textile workers) as a result of NAFTA will have to find new jobs. Some economists and policy makers argue that governments should retrain workers who are negatively affected by FTAs. That way, the workers will move into and develop skills for industries in which the country has a comparative advantage. In practice, though, the training for and transition into new jobs can be difficult and costly and may require families to relocate to new cities. All participants in FTAs must weigh the pros and cons of these agreements. Here are some of the benefits of the China-ASEAN Free Trade Zone, as detailed by the ASEAN secretariat in January 2010: "Although it is generally acknowledged that certain industries will face competitive pressures in the transition of the FTA, overall, the benefits from the growing trade between ASEAN and China would be translated into more jobs, more spending power and greater synergies between the two regions. "Greater governmental efforts may need to be expended to strengthen the capacity of domestic firms to compete but this should be short-term and does not remove the incentive to innovate and cut costs. There are also built-in mechanisms in the FTA such as safeguard actions in the face of serious injury to domestic industries. The FTA has also been implemented gradually and products which are located in the sensitive lists are only slated for later liberalization." The European Union is an economic and political partnership among 27 European countries. It has its own currency, the euro, and a single market where products and services, investments, and even people can move freely among member states. The creation of the EU has raised standards of living among the European population. The EU works not only to encourage trade and investment, it promotes human rights and democracy, sets environmental policies, and has its own flag, making it far more than a trading bloc. The World Trade Organization (WTO) has 153 member countries throughout the world. It includes both developed and developing economies. The WTO administers trade agreements and provides a platform for negotiations among its member countries. It also handles trade disputes among member countries (for instance, when a member country feels that another country is not following a trade agreement). While the WTO usually promotes free trade, there is one notable exception. If a business in an exporting country is found to be engaged in unfair trade practices, the WTO may punish that business. For example, an exporting country might be dumping, or temporarily slashing prices, in a foreign market to wipe out the competition in the importing country. This type of practice is discouraged by the WTO and its member nations, which will support nations that put protective trade barriers in place as punishment for unfair trade practices.

Aggregate demand (AD) is the total demand for final goods and services in an economy at a given time and price level. It depicts the quantity of goods and services that all consumers want to buy at each price level. Consumers include the following:

Households Investors (but not those who invest in stocks and bonds) The government Foreign investors

In macroeconomics, the aggregate demand describes the economy as a whole. Real GDP represents the total amount of goods and services demanded, which is usually denoted as the variable Y. The goods and services that four types of buyers demand are denoted as:

Consumption spending (C) relates to personal consumption by people like you and your family members. Investment spending (I) relates to private domestic investment, such as factories, machinery, residential construction, and increases in inventory. Government spending (G) includes goods and services that government spends money on—from road construction to public school textbooks. Net Exports refers to the gains from exports minus the spending on imports; it is measured by the formula X − M. Each of these four components contributes to the aggregate demand for goods and services: Y = C + I + G + (X − M)

These three indicators are directly related to the economic goals you studied in Module 49. To measure economic growth, economists look at changes in GDP. The unemployment rate helps measure how well a country is meeting its goal of full employment. Finally, to evaluate the goal of stable prices, economists examine the inflation rate.

Economists, politicians, and business leaders follow the unemployment rate closely. This rate indicates how many jobs are available and how hard it is to find a job. A high unemployment rate means it may be difficult for you, a family member, or a friend to find a job. A low unemployment rate means it may be easier to find a job. A country's unemployment rate is a good gauge of the economy's overall health. A person is considered unemployed if he or she is actively looking for work but cannot find a job. This may include people who have been laid off or fired and who have not yet found a new job. It may also include people who are initially entering the workforce (college graduates) or people who are re-entering the workforce (a military veteran returning from active duty). Many people often enter the workforce after completing college, technical training, or advanced degrees. Often, there is a time lag between when individuals leave school and when they find their first jobs. If they are actively looking for work during this time, they are considered unemployed. Sometimes, individuals stop working for a period of time or do not enter the workforce at all—such as some mothers who stay at home to raise their children. These individuals are not considered unemployed. However, if they later decide to actively look for a job but cannot find one, they are then considered unemployed. The time lag between when people decide to work and begin working is known as frictional unemployment. Other kinds of unemployment include cyclical, structural, and seasonal. Cyclical unemployment occurs when people lose their jobs because the economy grows at a slow pace. Structural unemployment happens when a worker's skills no longer match the job. For example, suppose a person works as a receptionist—answering phones and receiving business orders. One day, the business replaces this position with an automated phone system. So, the worker loses his or her job. Seasonal unemployment occurs during certain times of the year. Sometimes, more or fewer workers are needed. The holiday season is a good example. During this time, many businesses hire more workers to assist customers; but after the holidays, these extra employees are no longer needed. What is the labor force? The labor force comprises two populations: the total number of people employed and unemployed (people without jobs who are searching actively for work). It is important to understand that the labor force is not equal to a country's population. Many people who live in a country are not part of the labor force. For example, children are not counted as part of the labor force because they do not seek work actively and, therefore, cannot be unemployed. A stay-at-home mom would not be considered unemployed even though she does not have a paying job. Because she chooses not to work outside the home, she is not considered unemployed or part of the labor force. It is important to remember that the unemployment rate refers only to people currently in the labor force. The unemployment rate is the percentage of the labor force that is unemployed. Finding this rate requires a simple calculation: Unemployment Rate = [Number of Unemployed] ÷ [Labor Force] × 100% What is the unemployment rate in the United States? The graph below displays the unemployment rate between 1990 and 2011. In 2000, the unemployment rate was relatively low at 4%, indicating that most people who wanted a job could find one. In October 2009, the unemployment rate was 10%, suggesting that one in ten people who wanted a job could not find one. Perhaps the most widely followed economic indicator is gross domestic product, often called GDP for short. GDP is a measure of a nation's economic output (or production) and income. The technical definition of GDP is the total value of all final goods and services produced in a country during one year. So what does that actually mean? First, add up the monetary value of goods produced in an economy during a year; the goods would include cars, pens, food, clothing, toothpaste, cell phones, and thousands of other products. Then, add in the monetary value of all services produced during that year; the services would include haircuts, doctor visits, accounting services, taxi rides, lawyer consultations, and thousands of other services. It's not quite that simple, but the next module goes into more detail.

Imports create more choices for consumers and lower the prices of goods (by increasing competition). Consider the DVD player produced in the United States and the one made in Korea. If the United States stops importing DVD players from Korea, U.S. consumers would face the following:

Fewer choices Higher prices for DVD players due to less competition in the U.S. market However, there are a few drawbacks to imports. Domestic companies—ones located in the home country—may see a drop in sales when they have to compete with foreign products, especially if the imported goods are much cheaper. On the other hand, foreign companies benefit from the competition with domestic companies. For a real-world example, consider the automobile market. American car producers compete with Toyota and Honda, two Japan-based car companies that export to the United States. If you want to buy a car, it is nice to have choices and lower prices. But, these U.S. imports reduce the number of cars American producers will sell.

How can we determine the value of all final goods and services produced in a country over one year? One method to calculate GDP is called the expenditure approach. Basically, the expenditure approach calculates GDP by adding together the money spent on buying goods and services in a country over one year. The formula for the expenditure approach is:

GDP = Consumption + Investment + Government Spending + Net Exports Summing up consumption, investment, government spending, and net exports determines GDP. Therefore, consumption, investment, government spending, and net exports are the components of GDP. Consumption (C) Consumption is the process by which people use goods or services to maximize satisfaction. It includes all expenditures by households on the following: 1. Durable consumer goods, such as cars, washing machines, and TVs. Durable goods refer to products that are designed to last for a relatively long period of time. 2. Nondurable goods, such as food, fuel, cleaning supplies, and toothpaste. Nondurable refers to products that have a relatively short lifespan (three years or less). 3. Services, such as those provided by lawyers, doctors, accountants, hairdressers, and mechanics. In the United States, consumption is the largest component of GDP. On average, 70% of GDP is from consumption.1 Investment (I) Investment is defined as the use of money in the hope of making more money. In this context, the term does NOT refer to the purchase of investment tools, like stocks and bonds. It refers to completely different types of investment, including the following: 1. Purchases of new machinery, equipment, and tools by firms. 2. Purchases of all newly produced structures including factories, homes, apartments, and retail centers. 3. Changes in business inventories. Remember, GDP is a measure of production, not sales. Sometimes, companies produce more goods in a year than they can sell in that year. Goods that have been produced, but not yet sold, are called inventory. Government spending consists of goods and services the government consumes by providing public services. These expenditures include: 1. Salaries of public employees, such as teachers, police officers, firefighters, politicians, and military personnel, and items as varied as textbooks, tanks, and paper. 2. Expenditures for publicly owned capital, such as schools, highways, and bridges. 3. Purchases by local, state, and federal governments are included in this component of GDP. Transfer payments, such as Social Security, represent a large portion of the government's budget. However, as previously mentioned, transfer payments are not factored into GDP because they do not involve the production of new goods and services. Net Exports (NX) GDP is a measure of domestic production, so it must include the value of all final goods produced in the U.S. even if they are sold in other countries. At the same time, you must subtract the value of goods sold in the U.S. that were produced in other countries. This involves a simple equation of adding exports and subtracting imports to calculate net exports. Net Exports = Exports − Imports Remember, exports are goods that are produced in the home country and sold in a foreign country. Imports are goods that are produced in a foreign country and sold in the home country. For example, a car manufactured in Japan but sold in the United States is an American import. However, a car manufactured in the United States but sold in Japan is an American export.

Investments

High-income countries tend to focus more on accumulating physical capital and improving human capital than low-income countries do. This suggests that low-income countries possibly should invest more money in new capital. This would be similar to Max investing in equipment to improve his bike-fixing productivity in the future. Investing in the future means giving up something today in order to get more of what you want later. Of course, this is not a simple task. Low-income countries often lack the necessary money and resources needed to make large-scale capital investments.

In the long run, productivity improvements benefit society's standards of living by allowing people to consume more and work less.

However, productivity improvements can harm some people. It is sometimes hard to focus on the long-run benefits when people are harmed in the short run. However, it is important to remember that an economy is better off when productivity increases. The economy improves when Apple creates new products or when Ford finds new ways to produce automobiles more efficiently. Displaced resources often will be absorbed into other industries. It just does not happen right away.

Specialization occurs when an individual, firm, or country focuses on producing a good or service in which it has a comparative advantage. In the earlier example, Vietnamese workers specialized in producing shirts due to their comparative advantage in this area; this means that Vietnamese workers focused on making shirts instead of spending their resources to produce shoes. Conversely, American workers focused on producing shoes due to their comparative advantage in this area, so they specialized in shoes and not shirts. The green dots on the following graphs indicate the production and consumption points for both countries under a closed economy (or an economy that does not trade with other countries).

If the United States offered to trade one pair of shoes for two shirts, would Vietnam accept? The United States would be willing to make this offer because it could obtain two shirts by giving up only one pair of shoes. Under a closed economy, however, the United States could produce only one shirt for every pair of shoes it did not make. On the other hand, through trade, the United States could acquire two shirts in exchange for one pair of shoes. As a result, trading with Vietnam would be a good deal for the United States—receiving twice the number of shirts (in trade for one pair of shoes) that it could have produced by cutting back shoe production by one pair. But would the trade benefit Vietnam? Under a closed economy, Vietnam could generate one pair of shoes for every four shirts not made. So, it would cost Vietnam four shirts for one pair of shoes. However, by trading with the United States, Vietnam could acquire one pair of shoes in exchange for making only two shirts. As such, Vietnam would also benefit from trading with the United States—a pair of shoes cost Vietnam only two shirts instead of four. The production possibilities curve can illustrate how both the United States and Vietnam benefit from specialization and trade. The United States would specialize in shoes, which it would export to Vietnam in exchange for imported shirts from Vietnam. Vietnam would specialize in shirts, which it would export to the United States in exchange for imported shoes from the United States. If the United States would specialize in shoe production, workers could produce a maximum of 750 shoes per day. On the other hand, if Vietnam would specialize in shirt production, workers could produce a maximum of 4,000 shirts per day. These points were illustrated with the green dots in the graphs above. If the United States exported 100 pairs of shoes to Vietnam, it would import 200 shirts, based on a prearranged trade agreement (where one pair of shoes equals two shirts in trade). U.S. residents could then consume 650 pairs of shoes and 200 shirts, and Vietnamese residents could consume 100 pairs of shoes and 3,800 shirts. Compare this to a closed economy, where the countries do not trade. Under a closed economy, if U.S. workers produced 650 shoes, they would produce only about 100 shirts, while Vietnamese workers could produce 3,800 shirts and only 50 pairs of shoes. With trade in an open economy, both the United States and Vietnam could achieve a level of consumption beyond their production possibilities. In the production possibilities curves below, this is reflected by the dots above the curves. Note that the red dots represent each country's bundles of shirts and shoes after the trade. Given that they fall outside the production possibilities curves, these bundles could not have been consumed by these countries in a closed economy. Both countries benefitted from trade by specializing in the activity in which they had a comparative advantage. Through trade, they could consume at a point beyond their own production possibilities. This is why countries will export those goods in which they possess a comparative advantage and import those goods for which they lack a comparative advantage. At one time, the British Empire was the largest and most powerful political entity in the world. The British monarch is still the head of state of 16 countries around the world. The British king or queen is also leader of the 54-member Commonwealth of Nations, mainly former British colonies that now cooperate in trade. Much of the British Empire's power was based on trade. The Royal Navy made Great Britain the most powerful country on the seas and protected British shipping and trading interests around the world.

Monetary policy includes the set of regulations and tools used by a country's central bank primarily to affect the nation's money supply and the availability of credit. In doing so, this affects the country's overall levels of spending and employment and the prices of goods and services.

Similar to fiscal policy, monetary policy can be expansionary or contractionary. An expansionary monetary policy increases the money supply to encourage economic growth. In the United States, the Federal Reserve conducts this policy during periods of economic contractions or recessions. Remember, when more money circulates in the economy, economic activity (like consumer spending and investments) typically increases. On the other hand, a contractionary monetary policy reduces the money supply, normally to combat high inflation. For example, when an economy grows too quickly, inflation can be a concern. The Federal Reserve might decrease the money supply to reduce the amount of money circulating in the economy; this diminishes the level of economic activity and usually inflation, too. As you learned in Module 56, an economy performs well when inflation is low because it generates economic stability and leads to higher levels of investment. As such, one of the Federal Reserve's goals is to maintain a low and stable inflation rate. As you learned in Module 65, the Federal Reserve Bank uses three tools to affect the U.S. money supply: reserve requirement ratio target federal funds rate and discount rate open-market operation Let's see how each of these tools can affect money supply, credit availability, and consumer spending. Reserve Requirement Ratio (RRR) The reserve requirement ratio refers to the percentage of deposits a bank must keep in its vaults or at the Federal Reserve at all times. The following table lists the reserve requirement ratios for both checkable and savings deposits as of the end of 2011. Notice how the reserve requirement ratio increases as the value of the deposits increases. Any bank with more than $71.0 million in checkable deposits (any accounts such as checking accounts, money market accounts, and NOW accounts from which customers may withdraw money on short notice) must keep at least 10% of these deposits in its vaults or at the Federal Reserve. However, there is no requirement ratio for savings deposits or banks with less than $11.5 million in checkable deposits.1 Banks cannot make loans or earn interest from money held in reserve. As a result, the reserve requirement ratio reduces a bank's potential profits. Remember, when the Federal Reserve increases the reserve requirement ratio, it reduces a bank's ability to make loans and earn higher profits from these loans. In addition, because fewer loans are made when the reserve requirement ratio is increased, the U.S. money supply decreases. For example, suppose the reserve requirement is 10%. If a bank receives a $1,000 deposit, it must put $100 in reserves and can loan the remaining $900. If the reserve requirement is increased to 15%, the bank would be required to put $150 in reserves and could loan only $850. Fewer loans lead to a decrease in the money supply and the level of economic activity (like consumer spending and investments). As you learned in Module 65, the federal funds rate is the interest rate that the Federal Reserve banks charge to other banks for lending their money. The federal funds rate is affected by the discount rate, which is established by the Federal Reserve Board of Governors. An increase in the target federal funds rate makes borrowing between commercial banks more expensive. This reduces the number of loans made between commercial banks, which in turn decreases the number of private loans those banks make to individuals and businesses.1Eventually, as the number of loans decreases, the country's money supply shrinks. The graph below shows the trajectory of the federal funds rate since 1954. Notice that the federal funds rate was higher in the late 1970s and early 1980s. During this period, the United States experienced high levels of inflation due to an increase in oil prices. The Federal Reserve pursued a contractionary monetary policy to control inflation by increasing the target federal funds rate. Since the early 1990s, the target funds rate has remained at a relatively low percentage. Recall that the Federal Reserve's open market operation involves the purchase and sale of government bonds. When the FOMC decides to purchase or sell government bonds, it will affect the money supply when money flows into or out of banks' deposit accounts. This indirectly impacts the federal funds rate because the amount of reserve funds in the banking system has changed. Here is a simple explanation of how this happens. Suppose the FOMC decides to buy bonds. These purchases from bond dealers introduce new money into the nation's economy. The bond dealers will then deposit the money from the sales into their banks. The money supply will increase further as the bank loans this money out. Because banks have more money to loan, the price of borrowing money decreases. Note that as money flows into the bond dealers' accounts, the amount of reserves in the banking system will increase. As such, banks will not need to borrow as much money to maintain their reserve requirement ratio. This eventually will lead to a decrease in the federal funds rate. Conversely, the sale of government bonds will lead to an increase in the federal funds rate as the reduction in reserve funds decreases the bank's ability to make loans. Instead of buying bonds, suppose the FOMC decides to sell bonds. Bond dealers will have to withdraw money from their bank accounts to make the purchases. This will reduce the banks' reserves, which means they will be less able to make loans. This will decrease the money supply and force banks to borrow more money to maintain their reserve requirement ratio, eventually leading to an increase in the federal funds rate. The following table summarizes the tools used by the Fed as part of expansionary and contractionary monetary policies. By 2003, interest rates in the United States had reached historically low levels. Two factors contributed to this situation: First, the Federal Reserve had pursued an expansionary policy for an extended period of time; second, a large influx of capital from foreign countries, especially China, had increased banks' available funds, allowing them to make more loans at lower interest rates.1 These low interest rates, combined with a consistent increase in the value of houses, motivated financial institutions to take risks by making loans to subprime lenders. Subprime loans are given to people who do not meet the typical requirements needed for most home loans. These borrowers might have a history of bad credit and, under normal circumstances, would be considered risky borrowers. However, during the first decade of the 21st century, bankers and mortgage companies grew increasingly willing to take this risk. They believed that even if some people could not make their mortgage payments, those people could sell their houses at a higher price than what they originally paid and then repay the debt. For example, suppose Bob takes out a loan to buy his house for $120,000. Suppose the house's market value increases to $160,000. If he cannot make his monthly mortgage payments, he can easily sell his house for $135,000—$25,000 below its market value—then pay back the $120,000 loan, and make $15,000 in profit. This theory works as long as housing prices increase. However, that is not what happened in the United States. Instead, in fall 2006, a large number of homebuyers began defaulting on their mortgage payments, meaning that they could not pay off what they owed on their houses. At the same time, housing prices began to decline rapidly. As a result, they could not sell their houses for enough money to pay back their loans. Let's return to Bob's example. He owes $120,000 on his house. Rather than increasing, though, suppose his house's market value decreases to $100,000. Even if he can sell his house for $100,000, he still would not have enough money to pay back his loan. Instead, he just defaults on his mortgage and walks away from the entire deal. Even though he loses any money he has already paid to the bank, he does not have to keep paying the bank or sell his house for a $20,000 loss. In fall 2006, this scenario began occurring all across the United States. It may sound like banks would benefit—they get to take possession of the house and keep any mortgage payments made up to that point. However, with a record number of people selling their houses—or walking away from their loans—the market for houses became depressed, which meant that the banks had trouble reselling them. People who had invested in home loans also lost money. This concept might seem a bit complicated, but the key issue is simple. Mortgages were bundled together and sold to investors—in other words, investors received a percentage of the income made from loans; however, they also shared the risks of loans not being paid off. When hundreds of loans are bundled together and just one or two are not repaid, investors still make money on the deal. But if 20 or 30 are not repaid, the investors end up losing money. This is what happened with increasing regularity beginning in fall 2006—investors suffered substantial losses when a record number of people defaulted on their mortgages. The Federal Reserve and the U.S. Treasury had to loan several major financial institutions, like Bear Stearns and AIG, money (known as a bailout) to prevent bankruptcy. During this period, some of the nation's largest financial companies and many banks failed. All of these factors contributed to the recession that began in 2007 and eventually led to stricter credit rules.

Trademarks, Copyrights, Trade Secrets

Trademarks protect certain kinds of commercial intellectual property. Under trademarks, any name, word, symbol, sound, or color that signifies a specific product receives property rights protection. Copyrights protect works of authorship. Intellectual properties like songs, music, books, movies, and videogames are works of art that can all be protected by copyright. In the United States, a registered copyright protects a work of art for all of an author's life and an additional 70 years. The U.S. Copyright Office, within the Library of Congress, registers copyrights in the United States. Trade secrets are also regarded as protected intellectual property. For instance, Coca-Cola is allowed to protect its manufacturing process and complete recipe. This allows Coca-Cola to have a unique process and formula that others cannot copy. Trade secrets allow firms and individuals to protect legitimate competitive advantages.

A security is an investment contract, or a loan to the federal government. The federal government sells securities to corporations, financial institutions, foreign governments, and individuals. The buyer gets a "security," or a loan, which earns interest. The longer the federal government takes to pay back the buyer of the security, the more it has to pay in interest. When you buy securities, you pay a certain amount of money in return for a promise that the federal government will pay you back a certain amount of money in a given amount of time. Here are some of the typical types of federal securities:

Treasury Bills—Also called T-bills, these short-term securities can reach full value in only a few days or possibly a year. You pay less than face value for a T-bill, and it takes a specific amount of time for it to "mature," or reach its face value. For example, suppose you buy a $100 T-bill for $60. When the T-bill matures, you receive $100 (a $40 return on your investment!). Treasury Notes—Also called T-notes, these are slightly longer-term securities. As with T-bills, you pay less than face value, but it takes two, three, five, seven, or ten years for them to mature. Treasury Bonds—These long-term securities take 30 years to mature. Savings Bonds—Unlike Treasury bills, Treasury notes, and Treasury bonds, saving bonds are registered to a single person or group who are not allowed to resell them.

Often labor contracts specify wages months or years in advance. In addition, many contracts are specifically indexed for (past) inflation.

When a high inflation rate is reduced, it is called disinflation. The Federal Reserve has broad power to influence long-run inflation. The Fed has achieved disinflation in the past, most notably in the early 1980s, when inflation fell from nearly 15% to less than 5%. However a significant recession, or economic contraction, followed. Generally, this is the case: reducing inflation often leads to a temporary decrease in GDP as the economy adjusts. You will learn more about the role of the Federal Reserve in a later module.

Property rights give you certain legal rights, which collectively are occasionally referred to as a "bundle of rights":

You may own the property. You may control the property. You may enjoy the resources and services of the property. You may dispose of the property. You may exclude others from enjoying all these rights. What happens when the property is commonly owned by a group? Or when the ownership is not well defined? Then the strength of the property rights diminishes. For instance, who owns a sidewalk? Who owns the water in a river? In these cases, the property rights are not always well defined. When property rights are not well defined, they are more difficult to protect.

Is the economy growing too fast, too slow, or just right? Economists take the pulse of the economy by measuring the country's gross domestic product (GDP). GDP measures the growth rate of a nation's economy by adding the total value of all goods and services produced in a given year.

Officials compile this statistic by adding the value of all final goods and services, including those used for consumption, investment, government, and net exports. To calculate net exports, economists subtract the total number of a nation's imports from its exports.

As you learned in Module 68, a budget surplus occurs when the federal government's revenues are greater than its expenses. A budget deficitoccurs when the revenues collected are less than expenses. Each time there is a deficit, the government must borrow money to pay for the difference. This creates debt, or money owed.

The national debt, also called the public debt, is the sum of all past annual budget surpluses and deficits—which includes the amount the government has borrowed from individuals, corporations, and foreign governments, plus the accumulated interest on this borrowed money. Remember, interest is the cost of borrowing money. The longer it takes the federal government to pay off these loans, the more interest the government will have to pay—which increases the total debt. This is similar to the way Taylor's credit card debt grew. Since he did not pay off his entire bill, the credit card company added interest. The next month, Taylor will owe interest on his previous balance AND any new charges that he cannot pay off. Now think of this on a larger scale. Suppose that at the beginning of 1980, the U.S. government sold a security for $1 million and agreed to pay the security holder 10% in interest every year for 30 years. So how much did the federal government pay to borrow that $1 million? In other words, in 2010, how much total money did the federal government owe on that $1 million security? Assuming that it had not paid off any of the money borrowed, or any of the interest accrued during that 30 years, it would have owed more than $17 million. As you see, by the end of the third year, the government owed not only the principal debt of $1 million but also an additional $331,000 in interest. See how interest adds up quickly? Assume that our government does not pay off any of the debt. In other words, the interest owed just keeps adding to the total debt. To calculate the amount of interest the government must pay each year, you must add three things: The interest on the $1 million borrowed. The interest from the previous year that was not paid off. The interest owed on the unpaid interest (That's right. Interest must be paid on the interest!). For example, the amount of interest owed at the end of 1981 was: 10% on the $1 million loan = $100,000 The unpaid interest from 1980 = $100,000 The interest on the unpaid interest from 1980 = $100,000 × 10% = $10,000 This adds up to $210,000: (10% of $1,000,000) + ($100,000) + (10% of $100,000) = ($100,000) + ($100,000) + ($10,000) = $210,000 Notice that the total amount of interest accelerates each year. This is due to the unpaid interest (also called compound interest). The buildup in interest has a negative effect on the national debt and government spending. First, the government must set aside money to repay the loan. Second, the government cannot spend that money on other programs. This represents an opportunity cost. As discussed in Module 69, borrowing money for essential expenses can be necessary; however, as this example demonstrates, failing to repay a loan over an extended period of time can be very harmful—to an individual (remember Taylor's credit card troubles) or the federal government. To calculate the amount owed by the government each year: Determine the interest on the unpaid amount from the previous year Add this new interest to the previous unpaid amount

Globalization promotes the voluntary free trade of goods and ideas. The larger the market size, the more competitive free trade is and the more consumers benefit. When more producers are in the market, consumers have more goods to choose from. Competition also drives down prices, so consumers pay less for goods and services.

Think about the market for shoes in your local mall. Let's say the graph below represents the market for shoes, where the only suppliers are manufacturers in the United States. Notice the effect on supply when the graph changes to include all the shoe manufacturers in the world. As you can see, the supply has increased while the demand at your local mall has remained the same. Thus, the equilibrium quantity supplied increased, and the equilibrium price decreased. In any market, consumers benefit from more options because quantity increases and prices decrease. The producer also benefits. After all, the producer is no longer selling to a single market but to multiple markets. Think about the market for shoes. From the industry's point of view, the supply increases but so does the number of consumers.

Read this quote from Stephen Roach, a prominent economist with Morgan Stanley, a global financial services firm. Roach summarizes the effects of lower transportation and communication costs on global trade.

"Courtesy of ongoing trade liberalization, in conjunction with sharply declining communication and transportation costs, there has been a sharp increase in the tradable goods portion of world output over the past 15 years. At the same time, a veritable explosion in e-based connectivity since 1995, together with the emergence of an entirely new global IT outsourcing industry, has led to the networking of service providers around the world. As a result, rapidly expanding trade in both goods and services has become an increasingly powerful engine in driving the global growth dynamic." 1

You have already learned about exchange rates that change freely due to market forces (changes in supply and demand). For example, the exchange rate between the U.S. dollar (USD) and the euro changes regularly, as shown in the first graph below.

Most large industrialized countries today allow their exchange rates to float. However, some countries fix their exchange rates. So what is a fixed exchange rate? Under a fixed exchange rate system, a country chooses a specific exchange rate for each currency with which it trades. Suppose the U.S. wants to fix the dollar-pound exchange rates at .75 British pounds per U.S. dollar. At the same time, the U.S. may also choose to fix the exchange rate between the dollar and the euro at .8 euros per dollar. The United States does not use fixed exchange rates, so this is simply a hypothetical example. How does a country fix its exchange rate? A country's central bank is usually the only authority with the right to print currency and determine monetary policy. The central bank also maintains reserves of foreign currencies. In a fixed exchange rate system, if the value of its currency begins to drop, the central bank uses these foreign currencies to buy its own currency on the international foreign exchange market; this will increase the value of its currency on the world market. On the other hand, if the value of its currency begins to rise, the central bank sells its own currency in exchange for more foreign currency; this will decrease the value of its currency on the world market.

At the end of 2007, the U.S. economy began to decline rapidly. By the end of 2008, many large banks were on the verge of collapse. They were experiencing huge financial losses for a number of reasons, including the collapse of the housing market. Many banks faced no alternative but to request bailouts from the government, the Federal Reserve, and the Federal Deposit Insurance Corporation (FDIC). A bailout is a loan or financial gift given to a financial institution or company on the verge of closing. This module discusses the FDIC, an organization that has significantly contributed to U.S. financial stability since its creation in 1933. In particular, it shows how the FDIC has reduced the fear of bank runs.

During any period of time, a bank will maintain a percentage of its deposits in its vaults and lend the remainder to borrowers. You learned in Module 65 that this minimum percentage of customer deposits depends on the reserve requirement ratio, which is established by the Federal Reserve. High reserve requirement ratios reduce the ability of banks to lend money and to make higher profits. Remember, banks earn money when they provide loans and charge interest—the cost of borrowing money. The more loans that banks make, the more money they earn from interest (assuming that borrowers repay their loans). Banks use a portion of their earnings to pay interest on people's savings accounts and certificates of deposit (CDs). Now suppose the reserve requirement ratio decreases to 0%. In this case, banks would be allowed to lend every penny they receive from their customers' deposits. If they lent all their money, the banks would not have any cash on hand to meet their customers' demands. The inability of even one bank to pay back its debts (like money owed to its customers) can generate widespread panic about whether other banks can pay back their customers, too. As more and more people seek to withdraw their deposits, banks will likely begin to default on their payments; a default is when one party is unable to repay a debt to another party. When many people rush to withdraw their bank deposits at the same time, this is known as a bank run. Widespread bank runs can create havoc in a country's economy. Prior to the Great Depression, periodic bank runs occurred in the United States; during the Great Depression, the bank runs became more regular and many people lost their savings. To address this problem and to increase people's confidence in the banking system, Congress passed and President Franklin D. Roosevelt signed into law the Glass-Steagall Act of 1933.1 This act included the establishment of the FDIC. The Federal Deposit Insurance Corporation (FDIC) is an independent agency of the federal government. Its headquarters are located in Washington, D.C., but it conducts extensive business at six regional offices and two area offices. The six regional offices are located in Atlanta, Chicago, Dallas, Kansas City, New York, and San Francisco. The two area offices are in Boston and Memphis.1 The map shows the specific areas that each FDIC regional and area office serves. The FDIC currently employs more than 7,000 workers across the country. It is managed by a five-member board of directors appointed by the president of the United States and confirmed by the U.S. Senate. To avoid political bias, no more than three members on the Board of Directors can be from the same political party. The FDIC insures only bank deposits, which include savings and checking accounts and certificates of deposits (savings certificates with fixed interest rates). It does not insure other types of financial investments that banks offer, such as mutual funds (pools of investment tools, like stocks and bonds) and U.S. Treasury bonds (government-issued debt obligations with fixed interest rates). Currently, the FDIC insures more than $7 trillion in deposits in U.S. banks.2 Each of these insured banks pays a premium to the FDIC. These premium payments and investments in U.S. Treasury bonds are the FDIC's main sources of income. The primary roles of the FDIC are to increase people's confidence in the country's banking system and to eliminate bank runs. The FDIC makes sure that if a bank closes or goes bankrupt, all of the bank's customers will receive their deposits and interest earnings—up to a maximum limit for each person. In the table below, notice how the maximum insurance limits have increased over time. The insurance limit of 2008 was passed as a temporary increase but was made permanent by the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010.1 In addition to providing insurance to bank customers, the FDIC also helps supervise financial institutions and their business practices, takes over and manages failed banks, and carries out other consumer-protection tasks. Since the FDIC's creation in 1933, depositors have not lost any money that was covered by federal deposit insurance. By responding to more than 3,000 bank failures, the FDIC has helped stabilize the U.S. banking system.2 The 2007 financial crisis led to the failure of several U.S. banks. According to the FDIC's "Failed Bank List," in 2008, approximately 25 banks filed for bankruptcy and were taken over by the FDIC. However, the largest bank failure occurred when Washington Mutual experienced a 10-day bank run. By the end of 2009, approximately 140 banks had filed for bankruptcy—the highest number since 1992. In 2010, 157 more banks declared bankruptcy. In all cases, the FDIC took over and managed the failed banks and protected the depositors' money up to the maximum insured limit.1 It can be difficult to distinguish the roles of the FDIC and the Federal Reserve. This confusion became even more persistent during the recent recession as both institutions worked together to stabilize the American financial system. Remember, the main mission of the Federal Reserve is to maintain a stable national financial and monetary system. For example, on March 18, 2009, at the height of the recession, the Federal Reserve announced that it would purchase $1.25 trillion in securities representing home mortgages guaranteed by the federal government and $300 billion in long-term Treasury securities.1 The purpose was to counteract the negative effects of a recession by increasing the country's money supplyand aggregate spending by ensuring that mortgage lenders would support the failing housing market by continued lending. The FDIC's main mission, on the other hand, is to protect Americans' bank deposits. It does not plan or execute the country's monetary policy, which is the Federal Reserve's job. In 2010, the Wall Street Reform and Consumer Protection Act permanently expanded the maximum insurance limit to $250,000 per depositor. This change came following a temporary increase, to $250,000 as the maxiumum insurance limit when Congress passed the Emergency Economic Stabilization Act in 2008. Since so many banks failed during the recession, the FDIC also implemented the Temporary Liquidity Guarantee Program2 and the Legacy Loans Program to protect depositors and to restore confidence in the banking system.3

As corporations grow and expand into new markets, many enter into the international market. A firm that operates in more than one country is called a multinational corporation (MNC). It might have a home office in one country while producing goods in another, or it may have multiple production facilities around the world.

Recent technological advances in transportation and communications have made MNCs more common. Nevertheless, MNCs have existed for a very long time. There are multiple reasons that companies establish a presence in a foreign country: To avoid tariffs and or quotas To avoid political pressure To gain access to natural To find low cost labor To create competition

A strong dollar makes imports and travel abroad cheaper because you can get more foreign currency per dollar, which increases your purchasing power. A weak dollar, however, makes imports and travel more expensive because you have less purchasing power.

Before you consider the exchange rate and its effects on the economy, let's review exactly what money is and how it functions. Remember from Module 58 that money can be defined as anything that is accepted as payment for goods and services or debts. There are different kinds of money, but the most familiar is currency, or paper money and coins. If you have a checking account at a bank, writing a check to purchase goods counts as money, too, but it is not considered currency. As a result, "money" is a broader term than "currency," which is just one form of money. Money has three important functions that distinguish it from other objects of value. It can be used as a medium of exchange, a unit of account, or a store of value. When money is used to pay for goods and services, it is a medium of exchange—payment accepted by all or most individuals and businesses in a country or society. For example, you can use money to pay for food at a grocery store. In exchange for this payment, you receive groceries. Another basic function of money is that it provides a unit of account, meaning that it can be used to measure the monetary value of objects in an economy. Prices of goods and services state their worth. The last function of money is as a store of value. If you save your money over time until you need it, it will still have value in the future. Money's store of value function allows you to leave money in a bank account or in your wallet until you need it. These three functions make money useful in an economy. Money creates benefits that do not exist in a world of barter trade. In a barter trade economy, you must find someone who wants what you are trading. For example, suppose you have fresh eggs but want to acquire some milk. First, you must find a milk supplier who needs eggs. Compare that to the present day, when it is far easier to bring your wallet to the grocery store and use money. In this way, money makes exchanges easier. It is also easier to compare prices by measuring money. In the barter economy, imagine that the milk you want to acquire is worth 25 eggs or two pounds of flour. Since the price of the milk varies from product to product—based on what it is being traded for—there is no consistent way to measure its worth. However, when you go to the store and pay $4 for a gallon of milk, $2 for a dozen eggs, or $4 for two pounds of flour, there is a consistent measure of worth, regardless of the product. Finally, carrying products around in a barter economy has risks. For instance, milk or eggs could spoil. It is easier to store your wealth in the form of money because it can be saved and used later. Different countries have different currencies—all of which are mediums of exchange, units of account, and stores of value. To use your country's money as a medium of exchange in another country, you must trade your currency for foreign currency, which is subject to the exchange rate. There are different exchange rates throughout the world. The exchange rate between the U.S. dollar and the Japanese yen is not the same as the exchange rate between the U.S. dollar and the euro. Furthermore, the amount of goods you can purchase with the given currency depends on the price level, which reflects the currency's unit of account. If you deposited your foreign currency in a foreign bank, it would be based on that currency's store of value function. A strong dollar makes traveling in foreign countries less expensive for Americans and makes importing goods from other countries relatively cheaper. Similarly, a weak dollar makes traveling in foreign countries and importing goods from abroad relatively more expensive for Americans. Here are a few examples of how changing exchange rates affect the cost of purchasing imports. Think about the example of buying British tea when the U.S. dollar had weakened. In that situation, who benefited and who did not? You, as the American in the example, did not benefit. In terms of U.S. dollars, the price of the British tea increased from $15 to $17. If your income remained the same, you would be able to buy less tea. This price increase, in terms of U.S. dollars, occurred only because of a change in the dollar-pound exchange rate; the price of the tea remained the same in Great Britain. The company producing this British tea did not benefit, either. Now that their tea is more expensive in the United States, the British will export less to the United States. So who benefited? Because imported British tea became more expensive to you, you might begin purchasing more American-made tea—known as a substitution effect. So American tea companies would likely increase their business. These companies also might benefit in another way. The weaker U.S. dollar made it cheaper for Great Britain to import American products. So it is possible that more American tea would be exported to Great Britain for consumption. When the U.S. dollar becomes weaker, it is more expensive to import goods from other countries. At the same time, it becomes cheaper for foreigners to buy goods from the United States. As a result, a weak dollar tends to benefit American companies that export their goods abroad but negatively impacts American consumers who buy imported goods. Now think about what happened when the dollar appreciated (or gained value) compared to the British pound. The price of the imported tea decreased, which increased the demand by American consumers. In this case, British tea producers and American consumers benefitted. But a stronger dollar also means that American goods and services are now more expensive in Great Britain, decreasing the demand for American products in Great Britain. As a result, a stronger dollar negatively impacts American companies that export their goods but benefits American consumers with tastes for imported goods. It also benefits foreign companies that sell their goods and services to American consumers. Above all, it is important to remember that when the dollar gets stronger or weaker, there are always some people or companies who gain and some who do not. At first, you may think that it is generally better to have a strong dollar. However, there are actually benefits to both a strong dollar and a weak dollar. Remember that in each situation, some people benefit and others do not. After the Great Recession started in late 2007, the United States suffered significant unemployment, reaching 10% by late 2009. Even after the economy began to recover—as measured by other factors, such as GDP and consumer savings—a great many people still did not have jobs. What caused this less-than-full employment? Some economists believe that the United States will not completely restore its economy, including a significant improvement in employment, without improving its balance of trade. In terms of goods and services, U.S. businesses and consumers import hundreds of billions of dollars more than they export. In 2010 alone, the trade deficit was $556 billion dollars.1 To restore balanced trade, some economists suggest that the government should weaken the U.S. dollar compared to other currencies.2 This would make American products more attractive abroad because it would take fewer euro or yen to buy American products if the dollar was weaker. The increased demand for American exports would increase employment because more American workers would be needed to supply more goods. At the same time, a weaker dollar would make imported goods less attractive to American consumers. Again, this would lead to increased employment because American suppliers would need to hire more workers to produce goods and services that previously had been imported. A "weakening" of the dollar is not always a bad thing. For U.S. companies that export their goods or for American workers who supply those goods, or substitutes for imported goods, a weaker dollar means a stronger economy. This is especially true if U.S. trading partners also take similar measures to keep the value of their currency low to encourage exports.

Corruption Perceptions Index 2010 Results

Below is a map created by the organization Transparency International. This map shows an index of businesses' perceptions of corruption in different countries. Interestingly, there is less corruption in North America, Australia, and Western Europe compared to the rest of the world. As you already learned, these countries are also wealthier. According to the World Bank, there is a connection between a country's economic prosperity and its level of corruption.

As you learned in Module 50, the Consumer Price Index (CPI) is the most commonly used measure of price levels.

CPI is the measurement of average prices paid by an average urban American household. It includes the prices of housing, food, clothing, transportation, and other commonly purchased goods and services. To calculate the CPI, economists use the market basket, which is a list of typical goods and services that are frequently bought by urban households. The price of the market basket is then compared over time by constructing a price index that measures the general price levels. When the CPI increases, the average American household pays more money to buy this fixed basket of goods and services. The quantity and quality of the goods in the market basket never change. Price is the only factor that changes, providing a more precise measure of inflation.

You have learned eight factors that affect a country's level of economic development:

Role of colonialism Investments Property rights, corruption, and institutions Economic freedom Environmental challenges Government policies Imports and exports Poverty traps How can a country promote economic development when resources are limited? The International Monetary Fund has some advice:1 Send more children to school Build infrastructure (such as roads, bridges, and running water) Inform the public about health risks such as malaria, HIV, and parasites Control corruption Enable local entrepreneurs to start their own small businesses

Just as merchants in the United States accept only U.S. dollars merchants in other countries often accept only their own national currency.

The exchange rate is the price, or value, of one country's currency compared to another country's currency. For example, an exchange rate of 1.50 with the British pound means that 1.50 U.S. dollars can be traded for 1.00 British pound. Similarly, a British citizen may exchange 1.00 British pound for 1.50 U.S. dollars. Exchange rates are useful for calculating how much of one currency you will get for another currency. For example, if you have 100 U.S. dollars and the exchange rate for euros (the currency of the European Union) is 0.75 euros per one dollar, you will receive 75 euros for 100 dollars. How can you convert this exchange rate from euros per dollar back to dollars per euro? Note that 0.75 = 3/4. The inverse of 3/4 is 4/3, or about 1.33. Therefore, you will receive 1.33 dollars per euro, and 75 euros will get you (75 × 1.33 = 99.75)—approximately the 100 U.S. dollars you started with. Changes in exchange rates affect the purchasing power of your dollar in that foreign country—the changes affect the value of the dollar in relation to that country's currency. A unique exchange rate exists between the currencies of any two countries at any given time. The following exchange rates are from January 2012. 1 Brazilian real = 2.40 Argentine pesos 0.42 Brazilian real = 1 Argentine peso. 1 Brazilian real = 0.56 U.S. dollar 1.79 Brazilian real = 1 U.S. dollar. Exchange rates between currencies can be very volatile, meaning that they can change very frequently and sometimes very dramatically. Exchange rates can change daily or even multiple times a day and these changes are constantly observed. Exchange-rate information can usually be found in the financial section of a daily newspaper, online, or in financial publications such as The Wall Street Journal. The exchange rates between U.S. dollars and other foreign currencies can change frequently. A system that allows exchange rates to change frequently according to marketplace supply and demand is called a floating exchange rate system. When currency traders feel that a currency is undervalued, they are willing to pay more for that currency. This increases its value; when currency traders feel that a currency is overvalued, they are willing to pay less for that currency and this decreases its value. For instance, when the dollar becomes more valuable compared to a particular foreign currency, it is said to have appreciated against that currency. When the dollar becomes less valuable compared to a particular foreign currency, it is said to have depreciated against that currency. When one currency (like the U.S. dollar) can buy more of a foreign currency (like the Canadian dollar), it has strengthened compared to that foreign currency. Conversely, as with this example, Canada's currency weakened in relation to the U.S. currency. Sometimes, people talk about a strong dollar or a strengthening dollar, which means the U.S. dollar is appreciating compared to a specific group of foreign currencies. Conversely, a weakening dollar means the dollar is depreciating, or losing value compared to a group of foreign currencies. Exchange rates refer to comparisons—the value of one currency compared to another. A strengthening dollar may not mean that the dollar has appreciated compared to all currencies but that it has appreciated against many currencies, raising its overall strength. Likewise, a weak dollar has generally depreciated against many currencies. When the exchange rate changes, it impacts the entire economy and the economic decisions of individuals. Think about how the exchange rate would affect Taylor's costs of traveling abroad. A depreciating, or weakening, dollar would make it relatively more expensive to visit foreign countries. He would receive less foreign currency for each dollar and would need more dollars to pay for the same goods and services abroad. For example, assume that Taylor's hotel room costs 73 pounds. When he planned his trip, the exchange rate was 1 U.S. dollar = 0.66577 pound. This meant that the hotel room would have cost $109.65 (73/0.66577 = 109.65). Suppose, though, that by the time he arrived, the exchange rate had changed to 1 U.S. dollar = 0.5 pound. Now, the 73-pound hotel room would cost him $146 (73/0.5 = 146). Because the U.S. dollar depreciated against the euro, Taylor's costs would be higher than he expected. Similarly, when the dollar appreciates, foreign goods and services become relatively less expensive. For example, what if the exchange rate had been 1 U.S. dollar = 0.9 pound when Taylor arrived? Now, his 73-pound hotel room would cost him only $81.11 (73/0.9 = 81.11). In a similar manner, the exchange rate also affects the costs of importing and exporting goods. As an example, if the dollar depreciates against the Japanese yen, imports from Japan will become more expensive. Conversely, if the dollar appreciates against the Japanese yen, imports from Japan will become less expensive. Because they affect the prices of imports and exports, exchange rates are important for international trade. When the dollar is strong, it is less expensive to import goods from abroad or to travel to foreign countries (assuming that no other factors affect prices). However, it is more difficult for domestic firms to sell their goods abroad because it is more expensive for foreigners to purchase U.S. goods. A weak dollar makes it more expensive to import goods from abroad since the dollar has less purchasing power than before. But a weak dollar also makes U.S. firms more competitive on the international market because U.S. goods cost less. This increases the demand for U.S. goods in other countries. Most exchange rates are allowed to float, or to be determined by the market according to the laws of supply and demand. Sometimes, though, a country may choose to fix its exchange rate through currency revaluation or devaluation. A revaluation is similar to currency appreciation. A devaluation is similar to depreciation. The difference is that under a fixed exchange rate, the authorities (like a government's central bank) set the exchange rate rather than letting it be determined by market forces. For example, at times, China has fixed its exchange rate compared to the U.S. dollar.

The inflation rate is the percentage change in the price index from the preceding period. Here is the formula to calculate an inflation rate:

Inflation Rate = Current Year's Price Level - Previous Year's Price Level / Previous Year's Price Level × 100% Why is it important to understand inflation? Well, when inflation occurs, goods and services become more expensive, and your money does not buy as much as it did before. When this happens, it impacts people's standards of living.

The Federal Reserve System of Richmond is one of the 12 regional Federal Reserve Systems of the United States. It services the states of Virginia, Maryland, the Carolinas, the District of Columbia, and most of West Virginia. The Federal Reserve System, also known as the "Fed," is the central bank of the United States. It was created on December 23, 1913, during a time when the United States experienced several financial crises caused by multiple bank runs.1Bank runs occur when a large number of people race to withdraw their deposits from a bank because they believe the bank will not be able to pay back the money to depositors. Bank runs reflect a lack of trust in financial institutions.

Initially, the Fed's role was to address the causes and consequences of bank runs. However, its responsibilities gradually increased: Supervise and regulate banks within the country to promote reliability and confidence in the banking system. Maintain stability in the financial markets by controlling the money supply (amount of money in the economy). Ensure that all banks comply with the laws and regulations that apply to them. Supply paper currency and coins to banks. Process checks and electronic payments. The Federal Reserve seeks to balance the interests of private banks and society. It is supervised by Congress and must work within clearly defined goals. However, it still carries out many of its responsibilities independent of political pressure. It is composed of three parts: a) the Board of Governors, b) the regional reserve banks, and c) the Federal Open Market Committee. These three entities work independently from the government to carry out their core decisions. The following paragraphs will describe each of these three components in greater detail. A) The Board of Governors The Board of Governors is located in Washington, D.C. It has seven members who are called governors. Each governor is appointed by the president of the United States, and then confirmed by the Senate, to a 14-year term. The appointments are staggered, with one appointment expiring every two years, meaning that any president can appoint two members during a four-year term. Among the seven governors, two are appointed by the U.S. president as chair and vice chair of the board for a period of four years. In 2011, the chair of the Fed was Ben Bernanke. He was appointed chair in February 2006 by President George W. Bush and reappointed by President Barack Obama in 2010. Before Bernanke's appointment, Alan Greenspan served for more than 18 years under four different presidents.2 Together, the seven governors and a skilled staff formulate and execute the policies that make the banking system in the United States stronger and more reliable. In particular, the Board participates in the Federal Open Market Committee (FOMC), which controls the country's monetary policy. In addition, the Board oversees the activities of all twelve regional banks and approves the appointment of their presidents. B) Regional Federal Reserve Systems There are 12 regional Federal Reserve Systems in the United States. Each bank is named after the location of its headquarters. For instance, the Federal Reserve System located in Richmond, Virginia, is called the Federal Reserve System of Richmond. The map below shows the regions administered by each of the Reserve Banks. Each bank is identified through a number ranging from 1 to 12, as shown in the map, or through letters A to L. Do you have any dollar bills with you? Take a look at it, or take a look at the image of the hundred-dollar bill shown below. Notice the letter and number to the left of Benjamin Franklin's picture. The letter and number identify the Federal Reserve System in which the bill was printed. The hundred-dollar bill below was printed in San Francisco, the 12th Federal Reserve System. The primary roles of the regional Federal Reserve Systems include: Providing perspectives and expertise about their local economies. For example, they can inform the Board of Governors about potential employment and investment consequences of specific economic policies in their region. Storing excess cash from local commercial banks. Processing checks and electronic payments. Conducting research on local and regional economies. Each reserve bank also has its own board of directors with nine members in total; six of them, including the bank's chairman, represent the public. The remaining three members represent the banking industry. The reserve banks execute the regulations established by Congress and its Board of Governors. C) The Federal Open Market Committee (FOMC) The FOMC is responsible for conducting the country's decisions concerning monetary policy. According to the Federal Reserve Board, monetary policy refers to the control of the country's money supply by the central bank for the purpose of promoting economic growth. The FOMC includes all members of the Board of Governors and the 12 presidents from the regional Federal Reserve Systems. However, only the seven members of the Board of Governors, the president of the Federal Reserve System of New York, and four other Reserve bank presidents vote on monetary policies. Excluding the president of the Federal Reserve System of New York, each president of the reserve banks serves a one-year voting term on the FOMC, on a rotating basis. The FOMC members meet approximately eight times a year to decide whether to change or continue the current monetary policies. Their primary objective is to choose policies that will generate economic growth and stability based on national, international, and regional information. As we have studied in previous modules, money supply refers to the specific amount of money circulating in a country's economy at a particular period of time. Decreasing the money supply's growth rate is associated with low spending levels throughout the economy, while increasing the growth rate is associated with higher spending levels. In order to affect the money supply and the spending levels throughout the economy, the Federal Reserve uses any or a combination of these three tools: the reserve requirement ratio the discount rate and target federal funds rate the open market operation The Reserve Requirement Ratio When you deposit your savings in your bank account, only a percentage of it is kept in the bank's vaults. The rest of your savings are lent out by the bank to other individuals or firms. The percent of the bank's reserves that are held in its vaults, or on deposit at a Federal Reserve System, is called the reserve requirement ratio (RRR). Suppose that a bank receives $10,000 in deposits, and the reserve requirement ratio established by the Federal Reserve is 5%. This means that the bank must keep $500 from its deposits as reserves and the remaining $9,500 can be used to make loans or investments. But do not worry. Even though a bank makes loans with most of the money that people deposit, your money will still be there when you want to withdraw it. The Fed can use the reserve requirement ratio (RRR) to impact how much money banks loan out. For example, if the reserve requirement ratio is changed from 5% to 3%, the bank has to keep $300 in the vault instead of $500. This means more money can be loaned out. By increasing the money available for lending, the Fed can inject more money into the economy and likely increase the level of spending. The Discount Rate and the Target Federal Funds Rate At the end of each business day, a bank needs to determine whether it has the required reserve ratio. If it does not have the required amount in reserve, the bank needs to borrow money from another bank or from a Federal Reserve System. This type of loan is called an overnight loan. The interest rate that the Federal Reserve charges to commercial banks on overnight loans is called the federal funds rate. The target for the federal funds rate is determined during FOMC meetings, and announced to the public after every meeting (eight times a year). This rate is also affected by the discount rate. The discount rate is the interest rate charged by a Federal Reserve System to depository institutions, such as your local bank, to borrow short-term funds. The Board of Governors determines the discount rate. Remember, interest rates are the costs incurred from borrowing money. If the discount rate falls, borrowing money becomes less expensive, so depository institutions will borrow more money from a Federal Reserve System. These institutions will have more money available to lend, which can increase spending. For example, during a financial crisis, the Fed could lower the discount rate in order to make more funds available for banks to lend out to consumers and businesses. This increases consumption and investment, leading to more economic growth. The Fed could also raise the discount rate and make fewer funds available if it expects inflation to increase. This will decrease borrowing by consumers and businesses, leading to less economic growth and, possibly, a lower general price level. The Open Market Operation An open market operation is the principal monetary tool used by the Federal Reserve System. It is directed by the FOMC and executed by the Federal Reserve System of New York. It consists of the purchase and sale of government bonds, which are an example of government debt issued by the U.S. Treasury Department. Suppose the Fed is worried about inflation, so it wants to slow down economic growth by decreasing the money supply. If the FOMC wants to decrease the money supply, and therefore decrease spending in the economy, it will sell bonds. The sale of these bonds is paid for with money held in banks. When the money is taken out, it decreases the reserves held by the banks and therefore the amount of money available for consumers and investors to borrow and spend. Now suppose that the Fed is worried that the economy may be headed for a recession. The FOMC wants to increase the money supply, and therefore increase spending in the economy, so it will buy bonds. By paying for the bonds, the Fed makes more money available for borrowing. When consumers and businesses borrow money, both consumption and investment increase, which helps the economy grow.

Property Rights, Corruption, and Institutions

Some economists argue that many low-income countries fail to develop because they do not have institutions that encourage entrepreneurship and investment. In the United States, if you have an idea for a new business, you can officially register and incorporate your company, go to a bank and get a loan, hire workers, and keep the profits. It is difficult to do these things in many poor countries. In some countries, the laws are less clear, and loans are harder to secure. As you learned in Module 41, property rights are poorly defined in some other countries and, therefore, difficult to protect. If people are not confident that they can keep the profits earned from their investments, they will be less likely to invest or become entrepreneurs. Myanmar is a country that has insecure property rights. Citizens in Myanmar may purchase land, but they never really own the land. The government can seize people's property at any time, without any compensation. If a parcel of land has large trees, it is particularly attractive to the government because the wood can be harvested and sold to other countries. To protect their land, landowners in Maynmar often chop down their trees and do not replant. The World Bank cites corruption "as among the greatest obstacles to economic and social development."

Role of Colonialism

Some scholars emphasize the historical role of colonialism. Most of the high-income countries today, especially those in Europe, had foreign colonies in the 18th, 19th, and 20th centuries. Most low-income countries, such as those in Africa, Latin America, and Asia, were colonies at one time, affecting their economic development. Colonizing countries often exploited their colonies by exporting valuable resources out of the colony for their own use. This left the colonies with fewer resources for economic development, while the colonizing countries used those resources for their own growth.

Stocks are a form of investment from which investors can earn capital gains—increases in the value of a stock over time compared to the initial price paid for it. For example, if you bought Coca Cola stock for $20 and then sold it for $30, your capital gain would be $10 per share of stock. If you owned and sold 100 shares, your capital gain would be ($10 × 100) or $1,000. You cannot earn capital gains until you sell your stocks. Just owning them does not earn money other than dividends.

When a market's overall value increases for an extended period of time, it is referred to as a bull market, which is often characterized by increasing investor confidence and greater amounts of investing. In other words, people believe that the economy will grow and that stock values will increase, so they invest more money in a stock market. On the other hand, a bear market occurs when the market declines for an extended period of time. Investors lose confidence and invest less because they expect the economy to contract further. Often stock markets are indicators of where an economy is headed. News about a stock market is often tied to news about the economy or events that affect the economy. Why are stocks associated with the health of the economy? There are many reasons. Investors choose to invest in stocks if they believe they will make capital gains, which means they expect the businesses they are investing in to increase in value. Second, businesses often use money received from investors to expand their operations and add jobs, which means more people will earn higher wages and consume more goods and services; more investment and consumption results in increased GDP. On the other hand, when confidence is low, investors are reluctant to buy stocks because they believe the stock values may decrease. This leaves businesses with less money to make investments, which means their operations may not grow as much in the future, resulting in fewer jobs and decreased consumption. A stock market frequently reacts to economic news, and the shifts in average stock values usually coincide with these economic changes. The stock markets and the economy have been closely connected throughout U.S. history. Often, bull markets signal a period of market expansion (a "boom"). Conversely, bear markets sometimes signal a period of recession (or "bust") in the business cycle.

The real technology improvement was increased worker productivity by performing specialized tasks, known as division of labor. This allowed each worker to do his or her task faster and very well, leading to greater efficiency. In other words, more cars could be produced while using the same amount of labor. Or the same amount of cars could be produced while using fewer workers.

When productivity increases, the same or more output is generated with fewer inputs. So where do the savings go?In the short run, a company that increases its productivity will likely earn more money. You can calculate profits by subtracting the costs of producing a product from the sales of that product. It is easy to see that lower costs result in higher profits. In a competitive market, companies that earn higher profits will face more competition from companies that see an opportunity to make money. The surviving companies tend to learn the secrets of improved productivity. Most of the time, increased competition will eventually lead to lower (real) prices for consumers, as companies compete for customers. Lower prices will encourage more people to buy these products, which will lead to more products being sold. Of course, there are exceptions. For example, if a company is able to maintain a long-term monopoly by constantly improving its technology—perhaps by patenting new technology—that one company or inventory will receive most of the profits in the market. Personal electronics technology has greatly improved in the last few decades. Consider the cost of a record player in 1978: $100. Compare that with the cost of an iPod today. Remember, when you compare prices over time, you have to take into account the impact of inflation.

Monetary policy, policy that aims to regulate the money supply and interest rates, is carried out under the direction of the Board of Governors of the Federal Reserve System, or "the Fed." The Fed consists of 12 central banks chartered by the U.S. government. As you will learn in a later module, the Fed can set monetary policies to achieve national economic goals by:

altering the amount of money circulating in the economy adjusting a key interest rate that the Fed controls directly changing deposit requirements of commercial banks These three activities have a big impact on the amount of money circulating in the economy. When more money circulates, there will be more economic activity. This will stimulate the economy because more people will demand goods and services.

Each month, economists collect and analyze a variety of data, such as information on consumer spending, house prices, new-home construction, and a variety of other statistics. Three of the most important economic indicators are the following:

unemployment gross domestic product (GDP) inflation

Globalization describes the process of integrating regional economies, societies, and cultures through communication, transportation, and trade. The term globalization is most often used to describe the impact of trade, direct foreign investment, capital flows, migration, the spread of technology, and military presence on national economies.

Ideally, a global economy promotes voluntary free trade, which occurs only when all the participants expect to gain. This is true for trade among individuals, organizations, and countries. A global economy offers a number of benefits: Exchange of goods and services: Think about some of the things you use, wear, or eat. A foreign company may have manufactured your family's car. Your clothing may have been made in China or Vietnam. The food you ate for lunch may even have been grown and processed in a foreign country. Without a global exchange, these items would not be available in the United States. Exchange of resources and labor: U.S. companies can set up new production facilities overseas to gain access to less expensive human resources, natural resources, and other factors of production. Then these companies can pass along the savings in the form of lower prices to consumers, like you. Information and technology exchange: Individuals and companies in one country send information about prices, available goods, and investment possibilities to individuals and companies in other countries. This allows for a larger and more competitive market. Financial exchange: Exported goods and resources bring in foreign investment money. Higher interest rates also attract foreign investors, who are looking for higher returns on investment.

When the strength of a country's currency changes, it affects businesses that rely on importing or exporting. Different businesses are affected in different ways because of how their suppliers and customers respond to price changes. You have already learned that changes in exchange rates affect businesses involved in importing and exporting goods. However, these effects do not usually happen immediately. Instead, there is a time lag.

Import and export transactions often involve contracts that are in effect over a period of time. For example, a U.S. car dealer importing cars from Japan may have a contract that specifies the number of cars to be imported and the exchange rate. Typically, the contract would be made several months in advance and be based on the exchange rate at the time of the agreement. So as long as the contract is in effect, any changes in the exchange rate would not affect the number of cars the dealer imports. Only when that contract is fulfilled and a new one is negotiated will the new exchange rate become a factor. U.S. companies that export products abroad often have similar contracts in place. Even after the new exchange rate goes into effect, it may take some time to change the amount of goods and services produced. For example, a U.S. factory that produces computers for export may benefit from a weaker dollar since it increases demand abroad. To meet this demand, however, the factory may have to purchase additional equipment or hire more workers. These types of business maneuvers take time and can create a gap between the time when the value of the dollar changes and the point when the number of goods can be produced for export. Other factors can add to this time lag. For example, the same computer factory that expanded to meet more foreign demand could also build more stores abroad to sell its computers.

As you learned earlier, protectionist policies, such as tariffs and quotas, reduce competition, which raises the prices for consumer goods and often lowers their quality. Nevertheless, there are some limited instances where trade barriers may be justifiable, at least in the short run:

Industries involved with national defense. "Infant industries"—ones in the early development stages—that need time to become competitive (particularly true in developing countries). When a government wants to put pressure on a foreign government. For example, the government may impose a tariff on specialized naval equipment or place an embargo on a country that abuses human rights. When evaluating a special circumstance, trade officials must weigh the costs against the benefits of implementing a new trade barrier. Because trade barriers place costs on society, governments often consider alternative ways to reach the same end goal. For instance, alternatives might include offering direct government subsidies to businesses involved with national defense or using diplomacy to influence a country to improve its human rights policies. These alternatives can prove less harmful to the marketplace than using trade barriers. In the absence of one of these "special circumstances," free trade is often the best policy, benefiting consumers and the economy as a whole. Unless there are clear reasons for doing so, trade barriers should not be imposed because they reduce competition, raise prices, and lower the quality of goods and services in the domestic market. - contradictory n argued

Think about what this means. If goods can be shipped cheaply, a Japanese auto manufacturer has more incentives to sell vehicles in the United States. When the cost of transporting vehicles across the ocean decreases, a Japanese company can offer competitive prices for its products in the U.S. market. But rising transportation costs will negatively affect international trade by increasing the costs of supplying goods to the U.S. market. In addition, improvements in transportation technologies have helped increased international trade. These improvements allow large corporations and governments to ship larger quantities and to compete in new markets. This gives consumers in most countries more access to foreign goods and services. Within a country, goods are often transported by land—usually by train or truck. Two major forms of global transportation are maritime transportation and air transportation.

Maritime transportation moves goods or people across oceans and seas. Maritime and land transportation typically are relatively slow, so nonperishable goods often are shipped this way. Air transportation moves goods or people on airplanes. Goods shipped via air transportation frequently are lightweight, perishable, or expensive. On one hand, the cost of maritime transportation has not gone down in recent years because the price of oil has been climbing. On the other hand, maritime transportation allows for the shipping of massive amounts of goods. This means that any increase in oil prices is distributed across many more items and is more easily absorbed. As a result, maritime transportation can be one of the most economical ways to ship goods. As of 2008, maritime transportation accounted for 90% of global trade in terms of tonnage (weight measured in tons).1 This has led to the development of major shipping ports that can be accessed easily by consumers. The chart below shows how maritime transportation grew internationally between 1975 and 2005. As you can see, in just 30 years, the amount of goods shipped via maritime transportation increased significantly. The amount of cargo, including goods shipped in containers, nearly tripled between 1975 and 2005 and nearly doubled during the last 15 years of that time frame. Air transportation covers significantly less tonnage of global trade, accounting for only 0.2%.2 However, goods sent by air account for 40% of the total monetary value of global trade. Products transported by air often include aeronautic equipment, automotive equipment, pharmaceuticals (like medicine), computers, medical devices, and cell phones. Perishables or items that can spoil or become outdated quickly—such as fruits, vegetables, and newspapers—also are typically transported by air. The chart below shows how the amount of goods transported via air grew between 1991 and 2002. As you can see, in just 11 years, the amount of goods transported by air more than doubled. Air transportation is a rapid form of travel. Imagine that you want to ship a large box across the country. A package-delivery company can deliver the box in four to six business days by ground or on the next day by air. Ground transportation will be cheaper, but if you really want the package delivered the next day, you will have to pay extra to send it by air. Likewise, if a business needs to ship a small package to another country quickly, it may opt to pay more for air transportation. Improvements in communication technologies have also had a major effect on international trade. As you can see in the graph below, the price of a landline phone call to the United States has decreased dramatically over the past several years. Even though countries located in Sub-Saharan Africa still pay more to place phone calls to the U.S. than those countries that participate in the Organisation for Economic Co-operation and Development (OECD), the overall cost of those calls has decreased over the past decade. Likewise, a lot of electronic communication devices, such as the Internet, e-mail, cell phones, fax machines, and videoconferencing equipment, are now much less expensive. As a result, they have become essential tools of business and trade. Exporters can contact overseas markets and carry out deals without leaving the office. Even more important than the convenience associated with these technologies is the fact that they involve very minimal costs. Use of e-mail, phone, or videoconference software is much less costly than flying several people around the globe and paying for lodging and meals. It is also much faster than sending a business letter by mail, which was the primary mode of business communication for much of the 20th century. In addition, because of cheap communication technologies, companies can outsource customer service. Since an international phone call is much cheaper, many companies set up call centers in countries with relatively inexpensive labor. For example, if you need help your computer, you might call and talk with a helpline based in India. India has skilled workers who speak English and lower labor costs than the United States.

Trade barriers can protect industries from foreign competition but may lead to inefficient production. If domestic companies rely too much on trade barriers, they may lack incentives to lower costs and prices for other reasons. Reduced competition can negatively impact product quality, which would hurt consumers and benefit domestic businesses in the protected industries. For example, imagine that a business opens and then discovers that the government is protecting it from foreign competition—by limiting competition—which increases its profits. But, it also gives consumers fewer choices and forces them to pay higher prices. In the early 1980s, American automobile companies faced overwhelming competition from Japanese automobile companies. Many American consumers felt that Japanese cars were better made, more efficient, and cheaper. More and more American consumers were choosing Japanese cars over U.S.-made cars. Automobile manufacturing in the United States fell sharply, causing companies to lay off many workers. To protect American car companies, the U.S. government imposed a stiff tariff on imported Japanese vehicles. As a result, American car companies rebounded, sold more cars, and increased their revenues. However, many economists claim that this protectionist policy just delayed the inevitable: U.S. car companies needed to become more efficient and more innovative to compete with Japanese automakers.

Other types of trade barriers include non-tariff barriers, which ultimately limit imports of foreign-made products. For instance, the government could impose a non-tariff barrier by requiring importers to obtain a license. Another example of a non-tariff barrier is an embargo, which is an outright ban on imports or exports of a particular good, usually for political reasons. For example, after the Tiananmen Square Massacre in China in 1989, the United States and many European countries imposed an arms embargo on China.1 The United States has also placed embargos on Iraq, Cuba, and Myanmar for political reasons.2

Transportation costs have always been a barrier to trade. Think of transportation in terms of costs and benefits. Businesses also consider the costs of transportation when making decisions. As long as costs are low relative to the benefits, an individual, corporation, or government has more incentive to trade.

Since World War II, various factors have boosted the rapid growth of international free trade. Of these, improved transportation and communication technologies have been very important.

As demonstrated in the graphs below, tariffs and quotas have a negative impact on consumer welfare. These trade barriers lead to higher prices and lower quantity demanded for imported goods. You learned earlier that quotas limit the quantity of a good that can be imported into a country.

So quantity demanded is less, and the price is higher than under free trade conditions. There is one important difference between the impacts of tariffs and quotas: in the case of quotas, the importing country (in this case the U.S. government) does not earn any revenue, as it does from tariffs. Instead, the producers in the exporting country (in this case, foreign DVD producers) receive the revenue due to the higher price generated by the quota.

As new companies enter an area, they bring with them new goods and services, new job opportunities, and greater competition to businesses that provide similar goods and services. As you will see, this is also true when companies expand into new countries.

The Toyota Motor Corporation, more often referred to as just Toyota, is one of the world's largest manufacturer of automobiles today.1 Though its headquarters are located in the city of Toyota, in Aichi Prefecture, Japan, the Toyota Motor Corporation has facilities in an additional 26 other countries, according to its Web site.2 Many of these countries—Argentina, Brazil, China, Ghana, India, Indonesia, Mexico, Pakistan, Philippines, Russia, Thailand, Turkey, Vietnam, and Zimbabwe—are listed by the International Monetary Fund as "emerging and developing" nations.3 Toyota globally employs more than 310,000 people and generates over $220 billion in revenue, with profits exceeding $4.7 billion.4 The company produces various passenger sedans, sport utility vehicles, pick-up trucks, and luxury cars (under the brand name Lexus). So Toyota provides a variety of goods and jobs globally and positions itself in countries with developing economies. Toyota and other MNCs are part of the world interdependence, which is a characteristic of globalization.

In 2010, China became the world's second largest economy.1 In part, China's rapid growth is because of its increased participation in the world market. In that same year, China also became the world's largest exporter and second largest importer of goods.

The graph below shows China's imports and exports as a percentage of its GDP. The blue curve reflects the annual level of exports, while the orange curve shows the level of imports. Notice how Chinese exports began to consistently surpass its imports beginning in the early 1990s. China's main exports are data-processing equipment, apparel, textiles, iron and steel, and optical and medical equipment. Its imports include oil and mineral fuels, metal ores, plastic, and organic chemicals.2 When a country sells to another country, these goods are exports for the country that sells them and imports for the country that buys them. For example, if U.S. farmers sell part of their wheat to Chinese consumers, this sale represents an export for the United States and an import for China. If a Chinese apparel factory sells shirts to a U.S. firm located in the United States, this sale represents an export for China and an import for the United States.

There are several reasons why the government often spends more money than it brings in. For instance, during a recession, or decrease in economic activity, government programs are in great demand. There may be an increased need for welfare payments; more people may receive unemployment compensation. At the same time, income taxpayments will decrease because people have lost their jobs—remember, income taxes are based on workers' paychecks. In addition, the government already has other financial commitments, such as the military. Plus, not only is the government spending money, it is also paying interest on the money it has borrowed. At the end of 2010, interest on the U.S. debt of $13 trillion was nearly $414 billion.1 This interest increases over time.

You can consider deficits on a personal level, too. Think about something that you want to buy that is very expensive—maybe a new car. Very few people can afford to pay the entire cost of a new car up front, so they borrow the money from a bank and pay for the car over time in installments (periodic payments). Of course, when you borrow money, you end up paying more than the purchase price—because you have to pay interest with every installment. In the long term, it would be cheaper to save up your money and buy the car at a later time without a loan. But what if you need the car to go to work and earn money? It's Complicated! In favor of spending during a budget deficit: The government needs to spend money in order to create new jobs and stimulate the economy. Opposed to spending during a budget deficit: The money that the federal government borrows today, and the interest that money accrues over time, adds to the national debt. Future generations will be responsible for paying off this debt. It is important for the U.S. to pay the national debt in order to retain the full credibility of its Treasury department. The national debt is growing at an increasing rate. Most economists agree that running a budget deficit for a short time period does not necessarily harm a country's economy. Remember the example of the car loan? The person needed to borrow money to buy the car, which was required for getting to work and earning income. At some point, the person who bought the car will pay the loan off with the income he or she earned from working. By paying off the loan, his or her debt for the car purchase will be eliminated. However, over a long period of time, a budget deficit can be a problem. Imagine if you had to keep paying for the car long after it was rusting away in a junkyard. That is what some people fear will happen with the U.S. national debt—future generations will have to continue paying off the debt long after the benefits have been received.

Globalization is not a new idea. International trade and interdependence have existed for centuries. Goods from the Far East, such as exotic spices, salt, and silk, were highly valued in Western Europe during the Middle Ages. For instance, people once depended on salt to preserve their food.

While globalization has made the world seem smaller, it has also made countries more dependent on one another. The United States has become dependent on other countries for goods such as bananas, coffee, cocoa, spices, raw silk, tin, nickel, and natural rubber. Likewise, many countries now sell their goods and services to global economic powers, such as the United States. This interdependence does not just stop at goods and services. The U.S. economy depends on resources and markets around the world for the production and sale of goods and services. When economic growth slows in other countries, foreign consumers may buy less from the United States; this can slow economic growth in the United States. On the other hand, when the economies of other countries expand, foreign consumers may buy more from the United States; this can stimulate the U.S. economy.

Through expansionary policies, countries aim to promote growth by increasing aggregate demand at each price level. This is shown by a shift of the aggregate demand curve to the right. In the short run, an increase in aggregate demand (AD) results in a higher equilibrium price level and a higher equilibrium quantity. Through contractionary policies, countries aim to slow the economy's growth rate by decreasing aggregate demand at each price level. This is shown by a shift of the aggregate demand curve to the left. In the short run, a decrease in aggregate demand results in a lower equilibrium price level and a lower equilibrium quantity.

Before the shift of the AD curve, notice that the equilibrium price is P1 and the equilibrium quantity is Q1. After a shift of the aggregate demand curve to the right, the equilibrium price becomes P2 and the equilibrium quantity becomes Q2. An increase in aggregate demand results in a higher equilibrium price and quantity. In the long run, aggregate supply is determined by the factors of production (and not by price). When the aggregate demand curve shifts to the left or to the right, only the price level is affected by a change in aggregate demand. In the long run, a shift of the aggregate demand curve to the right only affects the price level. As shown in the graph, an increase in aggregate demand increases the price level. Shifts in aggregate demand are caused by changes in its components. Let's review the formula for aggregate demand to find out what factors will influence it. Aggregate demand consists of the goods and services from four types of buyers' demands: Consumption spending (C)—this is personal consumption by consumers such as yourself. Investment spending (I)—this is gross private domestic investment and involves spending on new capital goods and on additions to inventory. Government spending (G)—this captures the government's consumption of goods and services, such as the postal service, roads, and textbooks for public schools. Net exports (X − M)—this is the value of all goods and services that are sold to other countries (total exports) minus the value of all goods and services bought from other countries (total imports). Aggregate demand is the sum of consumption, investment, government spending, and net exports and can be expressed by the equation: C + I + G + (X − M). The aggregate demand curve shifts when there are changes within its four components. Graphically, this means that the AD curve will shift either to the left or to the right. Below, we will examine the possible changes and how they will affect the shift to the AD curve. A) Shifts due to consumption Any policies or conditions that can affect how much people want to consume at a given price level will change aggregate demand and shift the AD curve. Because of the reduction of current consumption, the quantity of goods and services demanded at any price level will decrease, reducing aggregate demand; this represents a contractionary action. The demand for overall goods and services will increase as well, resulting in an expansionary action that increases the aggregate demand. Graphically, you already know that increases in aggregate demand mean that the AD curve shifts to the right and that decreases in aggregate demand shift the AD curve to the left. B) Shifts due to investment Any event or policy that will influence the amount firms invest at a given price level will change aggregate demand and shift the AD curve. This expansionary event will increase aggregate demand and shift the AD curve to the right. Now let's explore a case where government policy affects business investment. This contractionary policy decreased aggregate demand and shifted the AD curve to the left. Expectation is an important factor that influences investment decisions. If businesses expect the demand for their goods and services to be high in the future, they will want to increase their production capacity. This increases the demand for investment, which increases the aggregate demand and shifts the AD curve to the right. Conversely, if firms have a pessimistic attitude about future returns or sales, they might cut back on investment spending which decreases aggregate demand and shifts the AD curve to the left. The graph above shows the results of an increase in aggregate demand. This can be caused by increases in investment, such as businesses investing in a new invention or more people becoming first-time homeowners. A shift of the AD curve to the right results in higher equilibrium price and quantity. C) Shifts due to government spending Any event or policy that influences the amount the government spends at a given price level will change aggregate demand and shift the AD curve. A decrease in government spending causes a decrease in aggregate demand. This contractionary action is illustrated by a shift of the AD curve to the left, resulting in a lower equilibrium price level and quantity. An increase in government spending causes an increase in aggregate demand. This expansionary action is illustrated by a shift of the AD curve to the right, resulting in a higher equilibrium price level and quantity. D) Shifts due to net exports Any event or policy that influences net exports (defined as total exports minus total imports) at a given price level will change aggregate demand and shift the AD curve. Increase in spending on net exports at a given price level will increase the aggregate demand, and shift the AD curve to the right. Conversely, an event or policy that decreases spending on net exports will decrease the aggregate demand, shifting the AD curve to the left. The exchange rate also influences net exports. When the United States' currency loses value relative to foreign currencies, goods produced in the U.S. (including exports) become less expensive. Conversely, when U.S. currency strengthens relative to foreign currencies, the goods produced in the U.S. will become more expensive to trading partners. There are two types of aggregate supply curves: short-run (SAS) and long-run (LAS). Some factors, such as labor, capital, natural resources, and technology will influence both the SAS and LAS. The only difference between SAS and LAS is the expected price level, which only influences the short-run aggregate supply curve. This is why the long-run aggregate supply curve (LAS) is vertical. We will now examine each of these components to understand how they affect the aggregate supply curve in both the short-run and long-run. A) Changes due to quantity of labor The increased number of workers will increase the amount of goods and services supplied, increasing aggregate supply. Both the SAS and LAS will shift to the right as a result. Vice versa. B) Changes due to capital Any events or policies that increase physical or human capital will shift both the SAS and LAS curves to the right. For example, an increase in the number of machines (physical capital) or college graduates (human capital) will increase the economy's ability to produce goods and services, increasing supply and aggregate supply as a result. This shifts both the SAS and LAS curves to the right. Vice versa. C) Changes due to natural resources Land, minerals, and weather are common examples of natural resources. Any events or policies that increase the availability of natural resources will shift the SAS and LAS curves to the right. Conversely, any changes that decrease the availability of natural resources will shift the SAS and LAS curves to the left. D) Changes due to technology Any improvements in technology will increase productivity, which increases the amount of goods and services supplied. This will increase aggregate supply, shifting both the SAS and LAS curves to the right. Agriculture modernization is a good example. It has largely increased the amount of food that can be grown, making food production more efficient. A decrease in technology will decrease productivity, decreasing aggregate supply and shifting both the SAS and LAS curves to the left. E) Changes due to the expected price level This factor will only influence the short-run aggregate supply curve (SAS). Any changes that decrease the expected price level will shift the SAS curve to the right, while an increase in the expected price level will shift the SAS curve to the left. For example, when workers expect the price level will be high for the goods they produce, they are more likely to negotiate higher wages with employers. The higher wages will increase the firms' costs, and reduce the amount of goods and services supplied. As a result, the SAS will be shifted left. Changes in the factors of aggregate supply also shifts the AS curve. For example, in the short-run, an increase in the quantity of labor, physical and human capital, natural resources, and productivity that is a result of technological advancements, as well as a decrease in the expected price level, will cause an increase in aggregate supply. As shown in the graph below, this shifts the supply curve to the right from SAS to SAS2, resulting in a lower equilibrium price (P2) and a higher equilibrium quantity (Q2). In the short-run, a decrease in the quantity of labor, physical and human capital, natural resources, or productivity, or an increase in the expected price level, will cause a decrease in aggregate supply. As shown in the graph below, this shifts the supply curve to the left from SAS to SAS2, resulting in a higher equilibrium price (P1) and a lower equilibrium quantity (Q1). In the long run, aggregate supply is affected by the same factors as short-run aggregate supply—except for price level. As shown in the graph below, an increase in long-run aggregate supply (to LAS2) results in a higher equilibrium quantity (Q2), and a lower equilibrium price (P2). Conversely, a decrease in long-run aggregate supply causes the LAS to shift to the left (to LAS1). As shown in the graph below, this results in a lower equilibrium quantity and a higher equilibrium price.

Poverty Traps

Citizens in very low-income countries sometimes find themselves stuck in a perpetual state of poverty, known as a poverty trap. One cause is very high fertility rates (the ratio of live births to the population), which often reduces GDP per capita, because GDP growth cannot keep pace with the population growth. China took extreme measures to address its high fertility rates by adopting a "one child policy." With some exceptions, this limits families to having only one child. By slowing population growth, China helped improve its GDP per capita and helped many of its citizens escape the poverty trap.

Stock markets often are viewed as indicators of overall economic performance. If you pay attention to headlines, you will hear about what is going on with "the markets" and how it could affect the economy as a whole. To understand stock markets—where stocks are traded—it helps to look at why stocks are sold in the first place.

Common stock (or simply stock) is a share of ownership in a corporation. Stockholders have a claim to a portion of the income the corporation earns and the assets it holds. By selling stock to the public, a corporation can raise additional funds for business activities and other needs, such as new equipment. Companies that sell stock to the public are described as "public companies," though not all companies do this. For example, a family-owned restaurant in your town might not sell stock to the public. These are called "private companies." However, many large well-known companies do sell stock, including Walmart, Pepsi, Ford Motor, and Capital One Financial. Stock is bought and sold on a stock exchange or stock market. There are several different stock markets in the world. The New York Stock Exchange (NYSE), located on Wall Street in New York City, is the largest stock exchange in the world by dollar volume. In 2007, the NYSE Group and Euronext merged, bringing together two large U.S. and European financial markets.1 NASDAQ is another major U.S. stock exchange. NASDAQ stands for National Association of Securities Dealers Automated Quotations and was the first completely electronic stock market in the world.

Competition law, also known as antitrust law, aims to promote competition in the marketplace. Competition offers consumers a choice of goods and services. It can lead to different prices, quality, and levels of customer support. Consumers can then choose what they want. Suppose there was only one airline in the whole industry. To fly anywhere, people would have to buy tickets from Only Air, which can charge high prices because there is no competition. Only Air has market power, which occurs when limited competition results in higher prices. As you will learn in Module 47, a business entity that controls a particular market (like Only Air) is called a monopoly.

Competition in the marketplace provides choices for consumers like you. As you learned in Module 39, promoting competition reduces market failure associated with market power. In the last module, you learned about government regulations. Some regulations try to prevent abuses of market power. When a monopoly abuses its market power to keep or increase its market control, it is called an antitrust violation. The FTC enforces both the Sherman Antitrust Act and the Clayton Antitrust Act, two laws Congress passed to help prevent anti-competitive conduct. For example, the Sherman Antitrust Act prohibits a company from using its market power to damage or drive out competitors. The Clayton Antitrust Act prohibits mergers (combining of two or more companies) or acquisitions (purchases of other companies) that significantly reduce competition. Antitrust laws promote or maintain market competition by regulating anti-competitive conduct. This conduct reduces or prevents competition in the marketplace. A misuse of market power (such as preventing competitors from entering the market) is an example of an anti-competitive conduct. As you learned earlier, more competition usually encourages more choices in price. Anti-competitive conduct includes actions that try to gain or maintain control of the market to maximize profits. Price fixing, one type of anti-competitive conduct, is an agreement among competitors to establish prices. Price fixing is also an example of an anti-competitive agreement, which includes contracts, agreements, or understandings that would likely result in substantially reduced competition. In a market economy, firms normally use prices to compete with one another. So, if they agree to keep prices high, consumers do not benefit from the competition that would otherwise exist. Another kind of anti-competitive agreement divides the market based on geography or categories of consumers. With this type of agreement, the firms do not compete with each other—they have divided the market. Divided markets tend to result in higher prices and fewer choices for consumers, so these agreements are considered "anti-competitive." Predatory pricing is another example of anti-competitive conduct. This occurs when a company sets its prices at a low level to hurt a competitor or force it out of business. As mentioned earlier, one of the benefits of competition is a lower price for consumers. But with predatory pricing, a company with market power uses low prices to damage or force a competitor to exit the market. This eventually will lead to less competition in the marketplace.

The three factors that contribute to the aggregate demand curve's downward slope are different, but they move in the same direction.

Dec price level inc total good and service demanded - shift down and right

Government policy makers try to keep the U.S. economy healthy. The three main national economic goals are the following:

Economic Growth: The overall output of goods and services increases over time. Full Employment: All eligible people who want to work can find employment at current wage rates. Price Stability: This means there is no inflation, where the general level of prices increases, or deflation, where the general level of prices decreases. Price stability provides a favorable economic climate for consumers and businesses.

Property rights are one of the main reasons why capitalism and the free-market economy have been successful. Most economists view them as a prerequisite for an economy that seeks to increase wealth and sustain development.

In simple terms, property rights give people the right to claim their possessions and use them as they choose (within the limits of the law).

To achieve the national economic goals of full employment, stable prices, and economic growth, government policy makers can use fiscal policies, policies that are designed to influence spending, such as:

changing the level of taxes altering the level of government spending Changing tax rates and government spending can encourage the economy to grow. Lower taxes mean that people have more money to spend and can support businesses in their communities. However, lower taxes mean the government will have less money to spend on projects such as building roads or educating students. Higher taxes, on the other hand, mean people will have less money to spend, but, the government will have more money available to start projects such as building roads and educating students. These strategies of taxation and spending might be used by the government to stimulate a sluggish economy. The trick for the government is finding the right balance between taxation and spending.

Fair Housing Act of 1968

FAIR HOUSING ACT - The Fair Housing Act is a federal act in the United States intended to protect the buyer or renter of a dwelling from seller or landlord discrimination. Its primary prohibition makes it unlawful to refuse to sell, rent to, or negotiate with any person because of that person's inclusion in a protected class.

It is not always easy to balance these three national economic goals.

For instance, if the economy grows too quickly without enough workers to fill all the new jobs, wages will increase. This leads to inflation, meaning the price of goods and services also will increase. On the other hand, if the economy grows too slowly it can slip into a recession. In a recession, workers may find it difficult to find a job, and the unemployment rate can soar. So, government and Federal Reserve economists try to achieve a delicate balance among economic growth, available jobs, and little or no inflation. As you just learned, full employment means that all eligible people who want to work can find employment at current wage rates. With full employment, workers are more likely to be able to support themselves and their families. However, controlling inflation is also important. When inflation occurs, prices of most goods go up, which decreases consumers' purchasing power. A low rate of inflation is important for consumers, individual savers, investors, and financial institutions. It also stabilizes the overall economy.

When thinking about inflation's costs and benefits, it is important to differentiate between anticipated inflation and unanticipated inflation.

Anticipated inflation is inflation that people expect to happen. People can prepare for this type of inflation. Unanticipated inflation is the amount of inflation that exceeds the expected amount. Anticipated inflation may sound a lot like long-run inflation and unanticipated inflation sounds like short-run inflation, which were both discussed in Module 58. Typically, long-run inflation is easier to anticipate than short-run inflation. However, the two concepts are not identical. When inflation is anticipated, people can take this into account when making contracts with one another, especially when borrowing money. Increases in inflation relative to expectations hurt lenders and help borrowers, because the repaid money is worth less than expected. Decreases in inflation relative to expectations hurt borrowers and help lenders because the money is worth more than expected. This is called an arbitrary redistribution of income. It is arbitrary because neither the lender nor the borrower knows in advance what will happen because the inflation is unanticipated. Borrowing money is not the only situation where inflation matters. Many labor contracts, for example, set wages months or years in advance to account for inflation. Now think about how inflation affects savers. It works the same way. Different countries experience different inflation rates. Unanticipated inflation is challenging because expected rates may not match actual ones. Consider what will happen if errors in prediction occur frequently, making inflation difficult to anticipate. This type of economic situation causes people to lose confidence in economists' ability to predict inflation. As a result, they may be more hesitant to enter into long-term loans and other contracts. This is likely to lower economic growth because the uncertainty disrupts business planning and investment. In other words, when businesses cannot anticipate the inflation rate, they are reluctant to invest and banks are reluctant to make loans. While the direct effects of unanticipated inflation are mixed—good for borrowers, bad for lenders—an increase in inflation uncertainty is usually bad for an economy as a whole. Anticipated inflation is inflation that investors and lenders can plan for. Shoe-leather Costs Higher inflation levels increase the costs of holding money as cash (or in non-interest bearing checking accounts), because the cash loses its value over time. As inflation levels increase, people avoid holding cash, which can disrupt the economy. "Shoe-leather costs" refers to people wearing out the bottoms of their shoes walking back and forth to the bank to take out a little bit of cash at a time. Menu Costs Inflation forces businesses to update their prices periodically. This process involves added costs, known as menu costs, such as changing computer inventory systems, retagging merchandise, or printing new menus. High inflation rates force businesses to incur menu costs more frequently. Inflation Makes it Easier for Prices to Decrease/Adjust (Money Illusion) Evidence shows that firms have difficulty reducing (nominal) prices, especially in the case of wages. Workers often refuse to accept decreases in their nominal wages, however, like Akiko, they are more tolerant of wage increases that fail to keep pace with inflation. It is not clear why this is true. A possibility is the so-called money illusion: people tend to think about the value of money in nominal terms, instead of real terms—in other words, even if people are aware and understand the inflation rate, they still tend to think about the monetary amounts of their salaries instead of their purchasing power. Avoiding Deflation Many economists believe that periods of deflation can have significant negative effects on an economy. When consumers expect prices to decrease or stay the same, they may put off purchases and hold on to their cash, causing firms to fire workers and cut prices—to attract buyers. Less consumer spending reduces economic growth.

In addition, the UNDP oversees the Millennium Development Goals, which were adopted in 2000. The United Nations hopes to achieve these eight international development goals by 2015.

Eradicate extreme poverty and hunger Achieve universal primary education Promote gender equality and empower women Reduce child mortality rates Improve maternal health Combat HIV/AIDS, malaria, and other diseases Ensure environmental sustainability Develop a global partnership for development

In addition to previously produced goods and services, several other types of transactions are NOT included in GDP:

Financial transactions, such as the purchase and sale of stocks or bonds are not included in GDP. Remember, GDP is a measure of production. Financial transactions are simply transfers of assets and do not represent new production. Illegal transactions are not included in GDP. Unpaid activities, such as volunteer work, are not included in GDP. Although volunteer services can be very important, they are not included in GDP. The same is true for the services provided by a stay-at-home mother. Government transfer payments, such as Social Security payments and welfare, are not included in GDP. Because this money is being transferred from the government to individuals, it does not involve the production of goods or services, and as such, does not contribute to GDP.

During a shutdown, the government ceases to provide all services that are considered non-essential (or not needed). How would a U.S. government shutdown affect national spending levels? How might it improve or worsen the effects of a recession? The following section describes a national government's role in affecting spending levels.

Fiscal and Monetary Policy

Government Policies

Government policies play an important role in economic growth and development. Yet, finding a balance among various policies can be challenging. Government policies that can affect the rate of economic growth and development include the following: whether the government owns companies directly or relies on the free market (as indicated by the Economic Freedom Index) the extent of education provided to the poor (more education is correlated with higher standards of living, as shown by the Human Development Index) the rate at which the local currency (money) is exchanged for foreign currencies—called the exchange rate Let's examine China's exchange rate policy with the United States. For years, China has been keeping the value of its currency (the yuan) artificially low compared to the U.S. dollar. Even when supply-and-demand forces would normally push the value of the yuan higher, China maintains a low rate. Having a lower value for the yuan translates into lower prices for Chinese goods in the United States. Recall the law of demand: lower prices mean Americans will demand more Chinese goods (also known as Chinese exports). China's exchange rate policy is intended to increase exports—an example of export-led growth. At the same time, when the value of the yuan is low relative to the U.S. dollar, American goods will be more expensive in China. This means the Chinese will demand fewer American goods. By increasing exports and decreasing imports in this way, China has helped its economy to grow, which has raised the standards of living for its citizens. However, China's exchange rate policy has also caused problems. Due to the devalued yuan, Americans buy more goods and services from China than they sell to China. This is known as a trade deficit. Many policy-makers blame China's exchange rate policy for the United States' sluggish economy. So, in October 2011, the U.S. Senate passed a bill that will pressure China to allow its currency to increase in value. The Chinese government countered this threat by asserting that this legislation could lead to a trade war between the two countries.2

How is inflation measured?

Just think about all the goods in a grocery store. It would take a long time to collect all of those prices. Now consider all the goods and services that are bought and sold in the entire country. It would be impossible to collect that much data. Economists need a simpler way to measure inflation. To calculate the price index, economists choose a base year, which is used to compare price changes against other years. Market Basket (year) = (Qty × Price) + (Qty × Price) + (Qty × Price) (Cost of Basket this Year) Price Index (year) = ————————————————————————————— × 100 (Cost of Basket in Base Year) (PI in Second Year − PI in First Year) Inflation Rate = —————————————————————————————————————— × 100% (PI in First Year)

3 types of property

Real estate, houses, and land represent one kind of property. These types of property are fixed geographically in one place; they are not mobile. They are referred to as real property. Another type is personal property. Personal property is mobile; you can move the items from one location to another—ranging from video games to airplanes. Another type is intellectual property, which includes products of people's creative and intellectual thinking. You will learn more about intellectual property in a future module. Property rights may be assigned to individuals, groups, or governments. The key point is that owners have a right to use their property as they choose, within the limits of the law.

Health Challenges

Low-income countries often struggle to provide basic necessities for their citizens. It is hard for a country to invest in the necessary capital needed for future production and economic development if it cannot meet its basic needs today. However, not investing in the future can have a negative impact on a country's citizens' standard of living. It is a vicious cycle. For example, in parts of Africa and Southeast Asia, malaria, a disease transmitted through mosquitoes, is responsible for many deaths. In developed countries, however, vaccines and other preventive medicines are available, and nearly all citizens receive the proper vaccinations. Suppose a vaccine costs $50 per person. A low-income country like Myanmar could not afford this solution. Myanmar has a GDP per capitaof approximately $1,000 to $1,400, or about $3 per day. Its citizens are very poor, and most of them are unable to pay for basic medical care. However, many developed countries have enough wealth to pay for vaccinating their citizens. Access to clean water is another challenge in poorer parts of the world. For example, in the African country of Uganda, women in some rural villages walk many miles to find water for drinking, cooking, and washing purposes. Often, they must settle for unclean water. Consuming dirty water can lead to infections and often death. According to UNICEF—a United Nations agency operating around the globe—4,500 children die each day due to unclean water and lack of sanitation.1 In many low-income countries, the water problem is an even greater issue for girls. Often, girls in low-income countries are responsible for collecting water for their families; as a result, they do not have an opportunity to attend school.

It can be very difficult to separate some total expenditures from GDP. This makes it hard to measure the velocity of money. Instead, economists use the output velocity of money. It is similar to the equation you used during the previous activity, but "total expenditures" is replaced with "nominal GDP":

Output Velocity of Money = Nominal GDP —————————————— Money Supply This greatly underestimates the number of times money actually changes hands in a year, but that is okay. After all, economists are most interested in how the output velocity changes over time.

In economics, aggregate supply (AS) is the total supply of goods and services that a country's businesses plan to sell during a specific time period. Aggregate supply includes the total goods and services that firms are willing to sell at a given price level.

The aggregate supply curve shows the relationship between overall price level (P) and national output (Y) from the supply side. How are production decisions influenced when the overall price level changes? Businesses tend to be motivated by profits, so if selling a product can earn more revenue, businesses will want to sell more products. Higher prices provide this incentive. Thus, as P increases the amount that producers are willing to supply increases, too.

First, property rights give people the right (within the limits of the law) to use their possessions as they choose. Second, property rights include the right to transfer the ownership or the use of a resource to others. Third, property rights to a good or a service also include the right to exclude others from using it.

The friend views the land as a resource and advises Jessica's family to use it to produce a good or service that consumers demand. Next, the friend observes how other landowners use a similar resource, as well as the goods and services they supply in the market. The friend advises the family to produce something that will bring the best price. This way, Jessica's family will maximize their benefit from the scarce resource of land. In a market economy, resources ideally are allocated to uses that bring or generate the highest profits. Profits show that consumers are willing to pay a price that is high enough to not only cover the costs of production, but that also provides a return to the producer. Notice that apple prices are decided not by Jessica's family, but by the market supply and demand. Property rights are necessary for markets to function well. Recall that property can refer to money. If an individual works hard to earn money or purchase property, well-defined property rights guarantee that no one can arbitrarily take it away. But in the absence of property rights, hard-earned property could be taken away. That would reduce work incentives for people who want goods and services. In this way, property rights are an incentive in the private sector for people to work hard and be productive. The more property rights are defined and protected, the more incentive people will have to produce and exchange goods and services. Without property rights, people would also have little incentive to invest. People invest because they expect to earn a return on that investment. People put their money into an investment, such as real estate, because they hope to earn more money in the future.

The main measurement of a country's economy is Gross Domestic Product (GDP), the annual production of goods and services. So, why is GDP important? Well, GDP is the primary indicator of an economy's health.

When GDP increases, the economy is growing and more goods and services are being produced. When more goods and services are being produced, companies usually need more workers to produce those items (unless there is a significant technological advance or efficiency improvement). On the other hand, when GDP decreases, the economy is shrinking, and fewer goods and services are being produced. If fewer goods and services are being produced, companies generally do not need as many workers. Module 50 defined GDP as the monetary value of all final goods and services produced in a country over one year. It is important to remember that GDP is a monetary measure. In the United States, this sum is expressed in dollar terms. It is not the sum of the actual goods and services produced. When adding up the value of goods and services produced, make sure you include only final goods. This ensures you do not count something more than once. Final goods are defined as goods purchased for final use, such as automobiles, kitchen appliances, computers, and so on. So, these goods will not be resold or used to produce other goods. Intermediate goods are goods that are purchased for resale or goods that will be used to produce other goods. If you are not careful, you could count the same intermediate goods more than once. GDP includes the following: Tangible goods such as food, clothing, cars, and books Intangible services such as haircuts, doctor visits, and legal services It is also important to remember that GDP is a measure of production, not sales. For example, suppose a publishing company produces $10,000 worth of books in 2010 but sells only $8,000 of them during the year. The entire $10,000 would be added into GDP even though not all of it was sold. GDP measures the value of goods and services produced, not goods and services sold. GDP measures the value of production in a country. When calculating the U.S. GDP, you would include only the value of goods and services produced inside the United States. On the other hand, if a Russian citizen worked as a consultant in the U.S., the value of his or her services would be reflected in the U.S. GDP. 14.6 trillion US GDP The 2011 U.S. GDP measured the value of all final goods and services produced in the United States in 2011. Previously produced goods and services would NOT be included in 2011's GDP. Likewise, used and second-hand goods would not be included in 2011's GDP, because they were counted in the year when they were originally produced. For example, suppose in 2011 Isabella purchased a vintage 1973 guitar. The purchase of this guitar would not contribute to 2011's GDP because the guitar was not produced in 2011. The value of the guitar would have been reflected in the U.S. GDP when it was sold originally in 1973.

The term monopsony is an economics term that comes from two Ancient Greek words: monos (single) and opsonia (purchase). In economic terms, a monopsony is a market form that exists as a type of imperfect competition.

You might be thinking the word monopsony sounds similar to monopoly. They actually are fairly similar market forms. In the case of a monopoly, a single seller faces multiple buyers, allowing the seller to dictate the terms of any deal. In a monopsony, however, a single buyer faces multiple sellers. As a result, the buyer can dictate the terms of the deal. In this instance, the buyer is a monopsonist. Remember, a monopoly is when many buyers face a single seller, allowing the seller to set the terms of the goods or service—because the buyers' only option is to purchase from this seller or not consume the product(s). A monopsony occurs when many sellers face a single buyer, allowing the buyer to set the terms of goods and services. In a labor market, the matter of who holds monopsony power depends on whether the laborer needs the company more or whether it is the other way around. Look at the graph below. Dec line As you can see, when the quantity of labor for a particular job is high, the wages are likely to be low. However, when the quantity of labor is low, the wages are likely to be high. unskilled labor, or work that requires little skill or formal training to be done properly. As a result, the number of people who can do these jobs is high, and their wages are low (all else being equal). It comes down to the concept of who holds power. Individuals with very specialized skills (such as a neurosurgeon) and dozens of years of experience usually are highly sought out by employers. Those with specialized skills may be considered monopsonists because employers' demand for them is greater than the number of people like them who have the necessary skills. However, this type of monopsony is relatively rare; very few individuals have the necessary specialized skills and experience to hold this level of power in the job market. The more common type of monopsony is an opening at a fast-food restaurant—when several people compete for a single job that requires very little education or experience. In this case, think of the restaurant as a "buyer" and the people applying for the job as "sellers." The buyer wants to find an employee and the job applicants want to sell their services. Sometimes this can cause a problem. There may be periods of time when enough jobs are not available for unskilled laborers; this gives an employer a distinct advantage as a monopsonist. A large employer in a small town may also have monopsony power. In some industries, workers join unions to protect their interests. A union has more bargaining power than individual workers. Unions generally negotiate better salaries than individuals can negotiate on their own. In this way, unions help guarantee a higher minimum salary than monopsonistic employers would be willing to pay. Also, when workers band together in a union, it is more difficult for an employer to fire individual workers. If working conditions become intolerable, the workers can go on strike and walk off the job until the company makes improvements. In the United States, government provides unemployment benefits and other safety-net programs. This becomes particularly helpful when jobs become so scarce for unskilled laborers that many people would otherwise become impoverished. One way the U.S. government regulates the labor market is by establishing a minimum wage. Since the labor market is like any other market, there is a point where any job's quantity of labor and wages will be at equilibrium. So, in theory, while the minimum wage can benefit workers, it also can result in fewer jobs being available. You can also see that the supply of labor increases. This makes sense because more people want to work at the higher wages. The market is no longer in equilibrium: the supply of labor increased while the demand for labor decreased. In theory, this can translate into unemployment. Historically, during a recession—with so many people looking for jobs—the wage rate often has dropped so low that people have not been able to care for their basic needs, even when working long hours. Great depression.

Property rights are regulated and transferred through contracts.

A contract is a legal agreement enforceable by law. It is an arrangement between two parties in which one party makes an offer, and an agreement is reached that benefits both parties. A contract can be either expressly written or implicitly agreed upon. An expressly written contract spells out all the terms of the agreement; an example is a deed to a house or a rental agreement for an apartment. An implicitly agreed upon contract occurs when you buy a product and agree to pay the full price listed for it. What would happen if contracts could not be enforced? People would be less willing to trust contracts or to buy, sell, or invest. This would reduce economic activity. Contracts make consumers feel more confident about making purchases. As you can see, contracts affect economic activity. They make producers and consumers feel more comfortable about buying, selling, and investing. This increases economic activity, like production, consumption, and investment.

Fiscal policy refers to the use of a national government's budget to affect that country's total level of spending. To understand how a government's budget can affect national spending, let's review the components of a country's GDP.

GDP includes four components: (1) consumption, (2) investments, (3) government spending, and (4) net exports (exports minus imports). A government has direct control over the quantity of goods and services it purchases in any particular year. However, it can also influence the level of households' spending and even investments by affecting taxes and transfer payments. Consumers pay taxes in many ways. Sales taxes are imposed on the purchase of goods and services, such as when you buy clothes or groceries. Taxes can be collected from businesses based on percentages of their incomes or profits. In addition, businesses and homeowners pay taxes to local governments every year based on the assessed values of their properties. Transfer payments, unlike taxes, are given by the government to select households. In the United States, transfer payments include Social Security, Medicare, Medicaid, food stamps, and unemployment benefits. If you recall, a household's disposable income includes payments received from employment, interest, profits, and transfers. This is the amount of money that households can spend after subtracting taxes. More disposable income means more household spending and less disposable income means less household spending. Disposable income = [income from profits, employment, interest - taxes] + transfers Governments implement fiscal policy during periods of slow economic growth or high levels of inflation. For instance, a government can increase aggregate spending to counteract slow economic growth or decrease aggregate spending to reduce high inflation. The fiscal policy that increases aggregate spending is called expansionary fiscal policy, while policy that reduces aggregate spending is called contractionary fiscal policy. Governments use three tools to affect aggregate spending: (1) taxes, (2) transfer payments, and (3) government purchases. During an expansionary fiscal policy, a government can increase aggregate spending by increasing transfers, reducing taxes, or increasing government purchases. These can impact the variables "C" or "G" in the GDP equation. As you saw, an increase in transfers or a reduction in taxes will increase disposable income and thus increase consumption (C increases). Conversely, during a contractionary policy, a government can reduce aggregate spending by decreasing transfers and/or increasing taxes—leading to decreased consumption (Cdecreases). The government might also reduce government expenditures (G decreases). In an expansionary policy, GDP (aggregate output) will increase because government and/or consumer spending increases. Conversely, a contractionary fiscal policy reduces aggregate output through decreased national spending. During the 1990s, the Japanese government pursued an expansionary fiscal policy to increase output and encourage economic growth. Its fiscal policy consisted mainly of increasing government purchases of goods and services. After the recession of 2008, the U.S. government combined tax cuts and transfer payments to boost economic growth.

At $14.4 trillion, the United States had the highest GDP in the world in 2010. As a result, the United States has the largest economy in the world. In 2010, for the first time ever, China had the second largest GDP at $5.9 trillion. Japan was third, with a GDP of about $5.5 trillion, followed by Germany at $3.2 trillion. The graph below shows the 10 countries with the largest GDPs.

If GDP rises from one year to the next, one of two things could be true: The economy is producing a larger quantity of goods and services. Goods and services are being sold at higher prices.

Nominal vs. Real GDP

Nominal GDP is determined by evaluating the production of goods and services at current prices. An increase in nominal GDP could be caused by an increase in production and/or an increase in prices. To measure the actual increase in GDP, economists need to determine if the increase in GDP was caused by the production of more goods and services or by inflation. This measure is called real GDP. Real GDP is determined by evaluating the production of goods and services at constant prices. Constant prices are prices adjusted to reflect inflation. This identifies the changes in GDP caused only by increased production—removing increases in nominal GDP driven by inflation. In the example about increased car production and higher house prices, only the car production would be factored into real GDP.

The aggregate supply and aggregate demand model (AS/AD model)shows what can happen to the price level and output when aggregate supply and aggregate demand are examined together. The AS/AD graphcan be used to find the equilibrium in the aggregate economy.

Short run - The equilibrium point shows the equilibrium price PA and the equilibrium output YA. Just like with the supply and demand model in the individual market, shifts in aggregate supply and aggregate demand can change the equilibrium point. For example, in the graph below, AD shifts to the right and becomes AD', which leads to a new equilibrium point: B. This shift of the AD curve leads to a higher equilibrium price and higher overall output. Long run - Note that the LAS represents the potential output level for the economy without overusing any of the economy's resources. Potential output refers to the total output (or gross domestic product) that could be produced in an economy if all resources (like labor and machinery) were fully employed. In such an economy, all people who want to work have jobs. At the equilibrium point, actual output equals potential output. To the left of potential output YA, actual output is less than potential output (for instance at point B). Not all resources are fully employed. To the right of YA, actual output is greater than potential output (for instance at point C). This means that some resources are working beyond their normal capacity, such as employees who work overtime. When actual output is greater than potential output, both demand-pull and cost-push inflation can occur. This is because a shortage of resources pushes the resource prices higher. For example, a shortage of labor causes wages to increase, which leads to more money for consumption (demand-pull) and higher production costs (cost-push). The short-run equilibrium is where the AD curve and SAS curve intersect. The long-run equilibrium is where the AD curve and LAS curve intersect.

Many government agencies protect you, as a consumer or worker. Others address market failures. Examples of government agencies that regulate the economy include the following: Food and Drug Administration (FDA), which protects consumers Occupational Safety and Health Administration (OSHA), which protects workers Federal Trade Commission (FTC), which protects bank and credit customers

The Federal Trade Commission (FTC) is the nation's most powerful consumer protection agency. It offers valuable consumer information on its Web site: www.ftc.gov. In Modules 35 and 38, you learned that the FTC protects consumers by promoting competition in the marketplace. In a competitive market, many companies offer the same kinds of products, allowing consumers to select among prices, levels of customer support, and levels of quality. To ensure competition, the FTC enforces antitrust laws. Trusts arose in the 1800s, when some large companies banded together to limit competition. The FTC was established, in part, to eliminate trusts. Today, the FTC continues to monitor business practices that limit competition. The U.S. central banking system—the Federal Reserve System, also known as the Fed—helps protect consumers by regulating financial transactions, such as credit card purchases, electronic fund transfers through banks, ATM transfers, and mortgages. The Fed tries to ensure that financial institutions, such as credit card companies and mortgage lenders, give consumers detailed and accurate information about the terms and costs of their products and services. It also encourages banks to invest in their own communities and offer credit to low-income individuals and small businesses. The Fed even keeps a database of consumer complaints related to illegal practices. The Securities and Exchange Commission (SEC) also monitors financial transactions to protect investors. To help maintain fair financial markets, it investigates fraud and other violations of securities laws. To learn more about the SEC, visit its Web site: www.sec.gov. The Food and Drug Administration (FDA) protects the health of consumers by monitoring the safety of drugs, biological products, medical devices, food, cosmetics, and any products that might contain or give off radiation. To learn more about the FDA, visit its Web site: www.fda.gov. The National Highway Traffic Safety Administration monitors all issues involving automobile and truck safety. Its main goal is to prevent crashes and save lives. It administers laws related to seat belts, children's car seats, brakes, tires, and airbags. To learn more, visit the National Highway Traffic Safety Administration Web site: www.nhtsa.gov. The government has an entire department devoted to protecting workers. The Department of Labor's mission is to monitor the quality of working conditions. It also helps protect retirement and health care benefits, vacation, and sick leave. The Department of Labor includes these agencies (among others): The Occupational Safety and Health Administration (OSHA) monitors issues of workplace safety and health, such as the following: Handling hazardous materials (flammable liquids) Wearing personal protective gear (safety glasses and hard hats) Enforcing environmental controls (sanitation) Providing medical/first aid/fire protection (sprinkler systems and fire alarms) For more information, go to www.osha.gov. The Employee Benefits Security Administration (EBSA) monitors workers' health care and retirement plans as well as many other benefits. For more information, visit www.dol.gov/ebsa. The Office of Disability Employment Policy (ODEP) ensures that people with disabilities and special needs have full opportunity in the work force. For more information, go to www.dol.gov/odep. The Mine Safety and Health Administration (MSHA) works to ensure safe and healthful workplaces for the nation's miners. For more information, visit www.msha.gov. The Women's Bureau of the Department of Labor administers policies to monitor the interests of women in the work force. It promotes equality and security for women workers and aims to empower women to have economic security. For more information, visit www.dol.gov/wb. Outside of the Department of Labor, there is the Equal Employment Opportunity Commission (EEOC), which enforces laws involving job discrimination based on race, color, religion, sex, national origin, age, or disability. It also enforces laws to protect people who complain about discrimination from further retaliation from their employers. Remember, the EEOC is separate from the Department of Labor. For more information, go to www.eeoc.gov. Government agencies like the FTC and the Environmental Protection Agency (EPA) also work to remedy market failures. As you have learned, a market failure occurs when the market forces of supply and demand do not lead to an outcome society desires. Market power is one source of market failure. It happens when a shortage of competition increases prices. To address market power, the U.S. government has enacted legislation such as the Sherman Antitrust Act and regulated businesses through agencies like the Federal Trade Commission. You learned about the antitrust activities of the FTC earlier in this module. THE EPA As you learned in Module 36, externalities are another major source of market failure. Externalities arise when the costs and benefits of a product fall on a third party who is not the producer or consumer of that product. You already have read about Carlos and the factory that polluted the air. The factory's production process incurred an external cost, a cost to a third party, by polluting the air. This cost directly affected Carlos and his neighbors (a third party). So, air pollution is an example of a negative externality. While it is possible that companies would voluntarily choose to clean up the pollution or attempt to produce less pollution, this is not always the case. There may be times this problem will not resolve itself without government intervention.The EPA develops and enforces regulations that protect people from risks that can endanger their health and the environment. It also conducts research on issues such as climate change (reducing greenhouse gas emissions) and educates individuals, communities, businesses, and other government employees. The EPA's goals are to address air and water quality, emergencies (cleaning up oil spills and other environmental disasters), and health and safety issues (preventing lead contamination, etc.). The EPA helps enforce regulations that govern how much emissions are released into the air by factories and cars. Based on the Clean Air Act, the EPA establishes the National Ambient Air Quality Standards, which sets limits on the amount of pollutants that can be released into the air. In Module 37, you learned about cost-benefit analysis. Sometimes, the cost of solving a market failure is greater than its benefits. Such a situation is called a government failure. As a result, government agencies must conduct complex cost-benefit analyses before taking actions to remedy market failures. Income levels vary in part because labor markets reward people according to effort and skill. According to CNBC, the top-paying jobs in the United States for 2011 included lawyers, dentists, and surgeons.These positions require a lot of skill and more than just a high school or undergraduate college degree. People who lack marketable skills or who cannot work are more likely to be poor. Governments often redistribute income to help relieve poverty. The U.S. tax system also serves to redistribute income.

In 1985, the concept of consumer rights was endorsed by the United Nations through the United Nations Guidelines for Consumer Protection, which expanded them to include eight basic rights. These have also been restated as a charter of rights by the international nongovernmental organization Consumers International, recognizing the following additional rights:1

The right to satisfaction of basic needs: to have access to basic, essential goods and services: adequate food, clothing, shelter, health care, education, public utilities, water, and sanitation. The right to redress: to receive a fair settlement of just claims, including compensation for misrepresentation, poor quality goods or unsatisfactory services. The right to consumer education: to acquire knowledge and skills needed to make informed, confident choices about goods and services, while being aware of basic consumer rights and responsibilities and how to act on them. The right to a healthy environment: to live and work in an environment which is non-threatening to the well-being of present and future generations.

Economic activity always fluctuates. During economic growth, increased investment and consumption may lead to increased production of goods and services, employment opportunities, and standards of living. During periods of economic contraction, the economy may enter a recession. When that happens, workers may have their hours reduced, take a pay cut, or get laid off because firms are selling fewer goods and services than before. As a result, people will spend less on goods and services.

Which economic model explains these short-run fluctuations most effectively? Most economists rely on the aggregate demand (AD) and aggregate supply (AS) model, which focuses on the behavior of two variables. One variable is the economy's total output of final goods and services, which is measured by real gross domestic product (or GDP adjusted for inflation). The other variable is the overall price level.

Why are some countries so much wealthier than others? What can a low-income country do to improve its citizens' standards of living? Or, what can low-income countries do today to create more wealth for its citizens in the future? (Recall how Max was saving to invest in equipment to create better options for himself in the future.) These are the basic questions of developmental economics.

When you look at the world, it is clear that some countries are wealthier than others. The most common way to measure this difference is by comparing GDP per capita. But there are other measures, too. One such indicator is the United Nations' Human Development Index. Whichever measurements are used, there are clear divisions between rich and poor countries. This module will explore a number of possible explanations, as well as look at different roles of governmental and nongovernmental agencies in promoting economic development. GDP per capita varies per country. GDP per capita is not the only way to measure a country's development. An alternative measure is the United Nations Development Programme's Human Development Index (HDI), which is calculated based on three equally weighted factors: gross national income per capita average life expectancy the education index (based on the mean, or average, of years of schooling for 25-year-old adults and the expected years of schooling for children) The World Bank is an international organization dedicated to reducing world poverty. The World Bank classifies countries as low-income, middle-income, and high-income based on their gross national income per capita. As you learned earlier, gross national income per capita is one of the factors used to calculate the Human Development Index (HDI). Compare the GDP per capita map to the HDI map below. They show a lot of overlapping areas because both measures include standard of living. Whether using GDP per capita or another measure like HDI, certain patterns appear in how countries are ranked. High-income countries include most of Western Europe (such as Germany, France, and Switzerland), the United States, Canada, Australia, New Zealand, and parts of Asia, including Japan, South Korea, and Singapore. These countries are sometimes called developed countries. Low-income countries include most countries in Central Africa and parts of Southeast Asia. These countries are sometimes called developing countries. Middle-income countries fall somewhere in between the two categories. They include most countries in Eastern Europe and South America.1

Multinational corporations have played important roles in globalization. Countries must compete against one another to attract MNCs. To compete, countries and regional political districts sometimes offer incentives to MNCs, including tax breaks, pledges of governmental assistance or improved infrastructure, or less strict enforcement of environmental and labor laws.

As individual national economies become more interdependent, MNCs are growing larger and more powerful. This has sparked a great deal of debate. While MNCs support international trade, their size and financial influence can give them a great deal of power over a national government. In the United States, there has been a continuing debate about whether or not MNCs help or hinder the economy overall. Many corporations have shut down manufacturing facilities in the United States and reopened them in foreign countries where the labor and production costs are cheaper. This has led to greater unemployment in the United States. In some cases, the work is specialized, and American workers who lose their jobs must accept lesser-paid positions in other industries. Furthermore, the departure of these manufacturing plants reduces a region's tax revenues. This can have adverse effects on local services, such as schools. For example, imagine what would happen if a large corporation moved one of its factories from a small U.S. city to Mexico? It would have a negative impact on that city's employment rates. The lost tax revenues would also negatively impact state and local budgets, which fund public services. In addition, some MNCs face criticisms for their global business practices. For instance, some manufacturers are accused of running "sweatshops" overseas. A sweatshop can be a specific factory or business strategy where a corporation pays little regard for its workers' health, safety, or proper pay. These kinds of operations can be found in many developing countries. In these situations, employees work long hours for low wages and little or no benefits. Most MNCs are not breaking any laws by opening these kinds of factories because many developing countries have less strict laws relating to worker health, safety, and pay. Another issue with some MNCs is product safety standards. For example, some corporations have been accused of using unsafe levels of pesticides in their products in foreign countries, where the rules are less strict than in the United States. Keep in mind that these companies typically follow U.S. laws while conducting business in the United States. However, when they operate in other countries, the regulations may be more relaxed, poorly enforced, or even nonexistent. On the other hand, while multinational corporations often face criticisms, they frequently provide benefits. For instance, they create jobs around the world, allow for goods and services to be exchanged globally, and offer lower prices due to cost savings. They also have a vested interest in developing infrastructure, such as roads and communication systems, in the countries where they do business.

From Module 16, recall that a business or country that can produce a certain good with fewer resources than other businesses or countries has an absolute advantage. On the other hand, if a business or country can produce a certain good at a lower opportunity cost than its trading partners, it has a comparative advantage. If you graph this point in the combined production possibilities curve of Carlos and Akiko, you reach a point outside their production possibilities. This point is labeled as point A in the graph below, representing greater efficiency through specialization.

As with Akiko and Carlos, countries have resources that are more suitable for producing specific goods and services. Since not every country possesses the same set of resources and production efficiency, it is logical that countries trade those goods they produce well in exchange for other products they need. The following paragraphs explain why trade is beneficial for two individual countries. The CIA World Factbook lists Vietnam as the 14th most-populated country in the world.1 The country exports mostly labor-intensive goods—including clothes, shoes, wooden products, and seafood—to trading partners such as the United States and China. Unlike Vietnam, the United States produces and exports a high percentage of capital- and technology-intensive goods. Seafood does not require a large amount of capital or technology to produce, but it does require labor to catch the seafood, making it a labor-intensive good. Likewise, lumber does not require a large amount of capital or technology to produce, but it does require labor, making it a labor-intensive good. Some countries, like Vietnam, have lower wages due to several factors, including a large labor force and a high percentage of unskilled workers. This is an incentive for Vietnamese businesses to produce more labor-intensive products because they can produce them at a lower cost than countries like the United States that have higher wages. Consider this simplified example to see how economic theory explains the benefits of trade.

If exchange rates are highly volatile, it means they change frequently and may be hard to predict. In this type of environment, businesses may choose not to export their products because they would be unable to predict revenues in a market with constantly changing prices. On the other hand, a stable exchange rate could prompt companies to increase production of products for export.

In addition, if a country changes its trade policies frequently, this could discourage businesses from producing products for export. Trade policies can include tariffs, which are taxes on imports, or quotas, which are limits on the quantity of imports. Sometimes imposing trade barriers leads other countries to retaliate with their own restrictions, which could eventually reduce the number of businesses that export goods. In recent years, the United States has removed or reduced tariffs and quotas on other countries if they agree to do the same for U.S. products. These are called Free Trade Agreements, which support importers and exporters. Note the following facts about "small- and medium-sized enterprises" (SMEs).1 Role of U.S. SMEs in exports and employment SMEs play a crucial role in job creation. Over the last two decades, SMEs have accounted for almost two-thirds of the new jobs in the United States. About 250,000 U.S. SMEs directly export to one or more foreign markets. Yet, this represents only a small fraction of the total U.S. SMEs. U.S. SME exporters grow faster, increase employment faster, and pay higher wages than nonexporting SME firms. U.S. SMEs play a larger role in the export economy than traditional trade statistics suggest because they also indirectly export products. SMEs export indirectly through wholesalers and by producing intermediate goods and services. Direct and indirect exports by U.S. SMEs support about 4 million jobs and account for more than 40% of the total value of U.S. exports of goods and services.

In this way, a country can ensure that its currency stays at the same exchange rate rather than allowing it to be influenced by market forces. When the central bank wants to reduce the value of its currency, it is called devaluation; when it wants to increase the value of its currency, it is called revaluation.

It is important to emphasize that under a fixed exchange rate system, the central bank makes transactions in the foreign exchange market to control the exchange rate. This becomes the central bank's primary monetary policy tool. While all central banks, including the U.S. Federal Reserve, affect exchange rates through their various policies and actions, those operating in a fixed exchange rate system intend more directly to control exchange rates.

Natural resources: A country with natural resources like oil, diamonds, or mineral deposits—all of which are in demand by other countries—is in a good position to export these goods. On the other hand, a country with fertile agricultural land may be in a good position to export grains and other food products. Location in the world: Location affects which countries can trade easily with one another. For example, China can ship goods from many ports, and ocean shipping is the most inexpensive way to deliver large quantities of goods to distant locations. A country that is landlocked—one with no coastlines—and has no ports may be limited to trading only with neighboring countries. Labor force: Some goods require a great deal of manual labor during the production process. Most developing countries—like Vietnam, Mexico, and China—export labor-intensive products, such as apparel, textiles, car parts, and machine parts. The labor force in many developing countries consists largely of poorly educated and unskilled workers often employed in manufacturing jobs, such as sewing blue jeans or assembling televisions. They receive relatively low wages compared to those paid in developed countries. On the other hand, most developed countries, such as the United States and most European countries, tend to have more educated workers who can produce skill-intensive products, which require more knowledge to produce. Computer equipment and pharmaceutical products are examples of skill-intensive products.1 Available capital:Capital-intensive goods are produced with machinery or advanced technology that require a large investment of capital up front. Good examples include automobiles or computers. Many countries lack this level of capital.

Natural resources, labor force, capital, and location affect the types of goods and services a country can export or import. Here are some factors that limit the quantity of goods a country can import or export.

Today, most of the world's major industrialized nations have adopted the floating exchange rate system. It was not that long ago, however, that the international system was a fixed exchange rate system known as the Bretton Woods system. This system began in July 1944 with the signing of an international agreement in Bretton Woods, New Hampshire. It fixed the exchange rates of major currencies against the U.S. dollar and the value of the U.S. dollar against gold. This "gold standard" is when the value of a currency is backed by gold held in reserves. The Bretton Woods system fixed the dollar price of gold to $35 per ounce. Any country in the Bretton Woods system could sell their dollar reserves to the U.S. Federal Reserve in exchange for gold at a rate of $35 per ounce of gold. Since all exchange rates were fixed to the dollar, the dollar became known as the "reserve currency," giving it great importance in the global system.1

The Bretton Woods system was established to protect what is known as internal and external balance among member countries. Internal balance is full employment and price stability in a country. External balance generally refers to trade deficits that are not too large to finance. Remember, trade deficits occur when a country imports more goods than it exports. Since the U.S. dollar was the "reserve currency" under the Bretton Woods system, the central banks of countries other than the United States had to buy and sell in the foreign exchange market to keep their exchange rates fixed compared to the U.S. dollar. Eventually, it became difficult for member countries to maintain internal and external balance without changing their exchange rates. A series of events in the late 1960s and early 1970s resulted in increased spending by the U.S government and higher U.S. inflation. As a result, countries began exchanging their U.S. dollars for gold in large numbers, and U.S. gold reserves decreased rapidly. In 1971, President Richard Nixon announced that the United States would no longer exchange dollars for gold. Nixon's action helped lead to the dissolution of the Bretton Woods system, which was officially ended in 1973.2 As a result, most countries now rely on a floating exchange rate system; although, some (mostly developing) countries still fix their exchange rates.

Historically, elephant ivory was traded throughout the world. If you ask your parents or grandparents, they may remember having ivory products around their homes. Eventually, the ivory trade became a major threat to elephant populations worldwide. Under the leadership of the Convention on International Trade in Endangered Species (CITIES), governments around the world, including the United States, agreed to ban trade in elephant ivory tusks. This happened first in 1975 for Asian elephant ivory and then in 1990 for African elephant ivory.1

The ivory trade ban is an important example of how governments around the world have worked together on a trade-related environmental cause for a common good. As opposed to the ban on ivory tusks, many countries enter into trade agreements to increase trade. These agreements lower trade barriers and increase investments among member countries.

A country may have an absolute advantage or a comparative advantage in producing a certain type of good

These two lines reflect the maximum number of cars and lawns that Akiko and Carlos can wash and mow given their resources: labor and time. These two lines reflect the maximum number of cars and lawns that Akiko and Carlos can wash and mow given their resources: labor and time. Let's return to Akiko's and Carlos's fund-raising activities. In the graph below, point L is inside the production possibilities curve for both Akiko and Carlos. This means both of them can produce more—mow more lawns and wash more cars—than what is shown at point L. Several factors can cause this inefficiency, including working less than five hours. Any production point inside the production possibilities curve is inefficient since it means that all available resources are not being used at all (like unemployed people) or not being used efficiently (like part-time workers who want full-time work). Conversely, any point above the lines is outside the production possibilities curves for Akiko and Carlos. For example, in the graph below, Akiko and Carlos cannot operate at the level represented by point H because it requires more time than they have available. Points outside the production possibilities curve cannot be achieved in an economy without changing the way that existing resources are used. Note that a point outside the production possibilities curve can be reached through specialization and trade, a concept addressed later in the module.

Each system—floating and fixed—has pros and cons.

Those in favor of the current floating system argue that it gives central banks more options for adapting monetary policy to stabilize their economies. Under a fixed exchange system, a central bank uses monetary policy primarily to keep the exchange rate fixed instead of trying to stabilize the domestic economy. Those in favor of a fixed exchange rate system argue that stable exchange rates boost international trade. After all, it removes uncertainty about the prices exporters receive for their goods. Similarly, importers face less uncertainty about the prices they pay for their goods. The key argument is that the uncertainty associated with floating exchange rates hinders international trade. As a result, it reduces the volume and benefits of trade. Those in favor of floating rates point out, though, that exchange rates can be locked in for extended periods of time—called the forward exchange market. They argue that this reduces uncertainty about exchange rates. For example, as you learned in Module 75, companies can sign long-term contracts that fix prices for imports and exports. So, what has happened to international trade since 1973, when the Bretton Woods system ended? International investment has actually increased greatly since 1973, mainly because countries have lowered trade barriers.1 While trade has grown, opponents argue that it has not grown as much as it would have under a fixed exchange rate system. The opponents believe that the uncertainty of regularly changing exchange rates hurts international trade. In terms of research on this topic, the results are mixed. One reason this issue is so difficult to research is the expansion of multinational corporations—businesses that produce and deliver goods and services in many nations, making it difficult to track trade precisely among countries. Changing trade barriers also blur the issue. Whether or not the international system should be based on floating or fixed exchange rates is a complex issue still debated today. Most economists do agree on one conclusion: international economic cooperation is key to any exchange rate system.

Every year that the federal government runs a budget deficit, it increases its debt. So what are the major contributors to the national debt? Any time the federal government needs to increase spending dramatically (in excess of its revenues), it has to sell securities to raise money. Can you think of examples when this might happen?

Wars: During every major war it has fought, the United States has increased its national debt. These increases have been more dramatic than others, especially during the Revolutionary War, Civil War, World War I, World War II, and the 21st century actions in Iraq and Afghanistan. Economic Downturns:During recessions (or depressions, depending on the severity of the situation), unemployment increases, which decreases national income because fewer people are earning or spending money. As a result, government tax collections suffer. Reduction of Tax Rates:Historically, tax cuts often account for economic growth because people can buy more consumer goods (increasing consumption) or make more investments with the extra money they get to keep. On the other hand, when taxes are cut, the government collects less in revenues. If its expenses remain the same, the government may need to borrow money to make up for the lost revenues—this increases its debt. At the beginning of 2011, the United States had a national debt of more than $14 trillion.1 If you spent $1 million every hour, it would take you more than 1,500 years to spend that much money! Take a dollar bill out of your pocket. What is it worth? Of course, it is worth $1. You could trade it in to the federal government for another dollar bill or trade it for goods or services worth $1. Why? Because, the federal government backs its currency with its reputation. If the currency was not backed by the government, it would be worth only six or seven cents—the cost of the cotton and ink used to make the bill. One question that is inevitably asked about the national debt is, "Why can't the United States simply print more money to pay off the debt?" Recall from Module 56 that printing more money can cause inflationand possibly hyperinflation. If the government printed more than $14 trillion overnight, the money would be worthless. Your dollar would buy a lot less than it does now. Suppose the government suddenly gave everyone in the United States $1 million. Prices for everything would increase. Why sell a loaf of bread for a few dollars when people could easily pay a few hundred dollars? Think back to the example of hyperinflation in Germany after World War I and its effect on German consumers (see Module 56).

Economic growth is usually defined as an increase in real GDP per capita over time. Most countries like for their economies to grow because higher GDP per capita means each person can consume more goods and services. How can economic growth be achieved? There are two ways: using more inputs per person or increasing the productivity of the production technology.

A country's productivity is defined as the relationship between its output (GDP) and the amount and quality of inputs (workers and capital goods). Productivity is higher when either one of the following occurs: (a) you produce more output with the same amount of inputs as before, or (b) you produce the same output while using fewer inputs. As mentioned in the introduction, productivity is measured by dividing output (goods and services) by the input (resources). Expressed in a formula: output quantity Total productivity = ————————————————— input quantity Workforce productivity (often still called labor productivity) is the ratio of output to the input of labor. In other words: produced output Workforce productivity = ————————————————— labor input Productivity is considered to be higher when either one of the following is true: a) you produce more output with the same amount of input as before, or b) you produce the same amount of output with less input than before. As you have seen, it can be hard to measure productivity. Economists who study economic growth use more advanced models to measure productivity directly. For example, they create indices to measure total inputs across different categories, like capital and labor. Measuring productivity across these different input categories—or factors of production—is called multifactor productivity. A related measure is labor productivity, which is output (GDP) divided by the amount of labor input, usually measured as either the number of workers or the number of hours worked. It is important to examine labor productivity because increases in one person's productivity translates into increases in the amount one person can consume. Remember that there are two ways for a country to grow economically: (a) using more production inputs per capita, or (b) increasing productivity. If a country grows economically, it is increasing its GDP per capita.

Mono means one. A monopoly exists when there is only one supplier of a product. In a monopoly, the seller has market power and can control both price and quantity. The National Basketball Association (NBA) and the National Football League (NFL) are two examples. Since each league provides a unique sporting product, fans have no close substitute.

A monopoly has a few major characteristics: A Single Firm: Unlike perfect competition, which has numerous firms, a pure monopoly has just one firm. The firm tends to become another name for the industry. No Close Substitutes: Simply put, if you do not want to buy the product, then you are choosing to live without the product. Price Setting: In a monopoly, the firm that controls the industry sets the price, making it a price maker. On the other hand, in perfect competition, firms compete with one another and have no control over the market supply and demand. Thus, they are price takers, meaning they have to sell at market prices. Barriers to Entry: As you learned in Module 39, a market with a monopoly has barriers to entry, or obstacles that hinder new firms from entering the market. Some of these barriers include network effects, customer loyalty, and switching barriers. Other barriers include the following: High capital costs and research and development costs—An industry could require a high initial investment or a certain level of technology that blocks other companies from entering the market. Legal barriers—The government, through regulation, could create legal barriers for firms that want to create monopolies. The government could issue a patent or the exclusive right to use or sell a particular invention to one firm. Or, the government could require a license to provide a service. In effect, the government creates the monopoly and allows it to exist for public policy reasons. Resource Control—It could be simply that a particular company controls all the resources required to create a certain good. For instance, the creation of a viable new professional football league would be virtually impossible since the NFL holds the contracts of all the best players and has agreements with all the largest stadiums. Since a monopoly does not have to choose the market price, it can essentially set its own price. If customers have no other choices, they have to pay the monopoly's price if they want to buy the product or service. There is a point where the monopoly will have to decide the price that maximizes its profits. In any competitive economic environment, there is a risk of multiple firms getting together to act like a monopoly and becoming price makers rather than price takers. This is called collusion. Collusion is far less likely with a larger number of firms because any single firm could break the agreement, lower its price, and increase the demand for its own particular good or service. However, as the number of firms in a competitive market falls, collusion becomes a possibility because each firm can monitor rival firms to maintain the monopoly. A group of firms that colludes to set the market price is called a cartel. In the U.S., the 1890 Sherman Antitrust Act made price fixing, bid rigging, and collusion by cartels illegal.1 As you learned in Module 45, this act prohibits anti-competitive conduct. Still, some collusion exists. In 1993, the food companies Borden, Pet, and Dean were found guilty of conspiring to rig bids on the price of milk sold to military bases and schools.2 Cartels are illegal in the United States, and international governments tend to agree that collusion among companies is illegal. However, not all cartels are illegal. OPEC is an example of a cartel of oil producing countries. OPEC, the Organization of Petroleum Exporting Countries, is an organization of 12 countries whose stated interest is to stabilize the fluctuations in the international oil market.3 OPEC is protected as a cartel under international agreements.

Natural monopoly vs oligopoly

A natural monopoly exists when the most efficient production can be offered by only one provider. Natural monopolies can provide club, common, and public goods. Some examples of natural monopolies include utilities such as water, gas, and electricity. However, remember that two other barriers to entry are technology and laws. Over time, as technology improves, it can be more cost effective and potentially more profitable for a firm to enter a market. Also, over time, changes in laws and regulations can encourage other firms to enter the market, which is how some natural monopolies become oligopolies. An oligopoly is when a handful of major producers supply a product, which can be standardized or produced with only minor differences. Standardized products include petroleum or rubber products. Products with minor differences include headache medicine and automobiles. Since an oligopoly's product can have only a small number of similar substitutes, suppliers have a certain amount of control over the market. Basically, an oligopoly is somewhere between a monopoly and perfect competition. In perfect competition, there are many suppliers so buyers can get that particular good or service anywhere. In an monopoly, there is only one supplier, so it can set the price for a particular good or service. In an oligopoly, since there are only a few suppliers, they have more control over the market than in perfect competition but less so than in a monopoly. This makes the suppliers price makers. However, it also means they need to be competitive so that they remain ahead of the competition. Characteristics include - limited entry, price setting, products, few firms, oligopoly markets in the US (like airlines) With only a few rivals, oligopoly firms watch one another's moves carefully and put a lot of effort into market strategy. This strategy can be modeled by a technique called game theory. Game theory is simply a method of how an individual can take into account not only the costs and benefits of their own choices but how these costs and benefits might change when another person or persons makes a choice that impacts them. People often apply the principles of game theory, consciously or not. The figure below is called a payoff matrix, which shows all possible moves in this situation (or game) and their outcomes (revenue) in millions of dollars. The payoff matrix shows what will happen given the various "moves of the game."

The aggregate demand curve shows the relationship between the overall price level (P) and national output (Y). How will it influence the purchasing decisions of four types of buyers when the overall price level changes?

A. Consumers: The Wealth Effect The overall price level could have a negative effect on the goods and services consumers demand. The face value of money is fixed, but its real value is not. When the price of goods and services increases, the same amount of money will purchase fewer products than before. When the price increases, the consumption drops. The reverse is also true: decreases in price levels can make consumers wealthier. When price levels decrease, consumers can afford to buy more goods and services than before. This encourages them to spend more, which increases consumption. B. Investors: The Interest Rate Effect Price level affects interest rates. Specifically, an increase in the price level causes interest rates to increase. Remember, interest is the cost of borrowing money. When interest rates increase, it is more expensive for businesses and consumers to borrow money; as a result, businesses tend to make fewer investments and consumers tend to borrow less money for "big ticket" purchases such as homes and cars. Both of these factors lead to a decline in economic growth. What happens when the price level decreases? Interest rates fall, making it less expensive to borrow money. Lower interest rates tend to increase investments and consumption—boosting economic activity. C. Importers and Exporters: Net Exports Effect When the price level of goods produced in the United States increases, foreign demand for these products typically falls. Less demand causes a decrease in exports. By comparison, foreign products become less expensive, so U.S. demand for imports increases. On the other hand, when the price level of U.S. goods and services decreases, the demand for U.S. exports increases and the demand for foreign imports decreases. From the three effects mentioned above, you can see that when a country's price level decreases, consumption (C), investment (I) and net exports (X − M) all increase. In terms of the equation Y = C + I + G + (X − M), when C, I, and net exports (X − M) increase, Y (output) will also increase. So when the price level (P) decreases, then the total demand for goods and services increases. This relationship between the price level and output makes the aggregate demand curve slope downward.

Most economists agree that in the short run, a temporary increase in the economy's aggregate demand can cause prices to increase.

Aggregate demand refers to the total demand for final goods and services demanded in an economy at a given time and price level. Demand-pull inflation occurs when aggregate demand is greater than aggregate supply (or the total supply of goods and services that businesses plan to sell during a specific time period). When demand exceeds supply, prices will generally increase. When this occurs across the economy, it constitutes inflation. Given that this type of inflation is driven by demand, it is known as demand-pull inflation. Demand-pull inflation can be caused by several factors, such as when people anticipate higher prices, so they stock up on more goods in the present (at lower prices). This increased aggregate demand can lead to demand-pull inflation. Demand-pull inflation also can be accelerated by the government. In addition, an increased demand for a country's exports can lead to demand-pull inflation. This increase might occur due to a change in the exchange rate. Remember, an exchange rate is the amount of one currency that can be traded for a foreign currency. Suppose the value of the U.S. dollar decreases compared to the Japanese yen, making American exports to Japan relatively less expensive. Based on the law of demand, this increased demand for U.S. products (from both domestic and foreign markets) will lead to buyers competing over a limited supply, driving up the prices of goods and services. The following graph illustrates demand-pull inflation. Compare the lines for aggregate demand and new aggregate demand. This increase in aggregate demand will cause the price level to rise from P0 to P1. Inflation can also be caused by decreases in aggregate supply. For example, what if a country produces a lot of agricultural products? A drought would significantly decrease the supply of fruits, vegetables, and grains. As supply decreases, prices would increase. This type of inflation is called cost-push inflation. Notice in the graph below that a decrease in aggregate supply (as shown by a shift of the aggregate supply curve to the left) will increase the price level from P0 to P1. nce an economy experiences inflation, it has a tendency to continue—in part because people and firms expect it to continue at the same rate. This is especially true with wages. Anticipating inflation in the future, people may push for higher wages to help them pay the higher prices. Pushing for higher wages creates a wage-price spiral, as the higher wages (a cost of production) are passed on to consumers through higher prices. This is also true of prices. If manufacturers assume that their costs will increase, they will set higher prices for their goods.

GDP is a measure of an economy's total output—the sum of all the final goods and services produced in a country—in one year. U.S. GDP was $14.66 trillion in 2010 and grew at an average rate of 2.8% during the year.1 GDP, however, does not always grow at this rate. The economy's growth rate often fluctuates up or down. Sometimes, a country's economic growth is negative, which means the country is producing less output than the year before.

Alternating periods of expansion and contraction is called the business cycle. An economic expansion is a period of growing economic output characterized by increased real GDP. This results in a positive economic growth rate. A long period of rapid expansion is called an economic boom. Because economic output is increasing, "booms" often lead to a reduced unemployment rate. As businesses expand, they hire more workers. When GDP increases faster than population growth, GDP per capita increases. There are also periods of decreasing economic output. A time of decreased real GDP and a negative economic growth rate is known as a contraction. If a contraction lasts for two consecutive quarters (half a year) or longer, it is called a recession. During a recession, the unemployment rate will increase, and incomes will decrease as businesses face less demand for their goods and services. A good way to further understand the stages in a business cycle is to look at a graph. This cycle takes place over time so the time variable appears on the horizontal (x) axis and a variable measuring economic activity appears on the vertical (y) axis. Common variables used to measure economic activity are real GDP or growth in GDP. This graph shows the business cycle over time, as measured by real GDP. Economic activity reaches its peak at point A. After a peak, economic activity declines during a period of contraction. Unemployment is likely to increase and incomes may decrease. Eventually, the economy hits a low point at a trough (point B), where unemployment and income may be at their worst levels. From the trough, there will be a period of expansion or recovery as the economy begins to grow again, which will increase incomes and decrease unemployment. Examining GDP growth is another way to look at the business cycle. The US is all over the place. GDP growth rate over the past 50 years. The GDP growth rate is along the vertical (y) axis. Occasionally, the growth rate is negative and dips below 0 on the graph. During those times, the GDP is decreasing. Who is responsible for tracking the business cycle in the United States? The National Bureau of Economic Research (NBER)—a private, nonprofit research organization—is generally recognized as the authority responsible for tracking and dating economic fluctuations. The NBER identifies peaks and troughs and typically declares a recession after two or more quarters of declining economic activity (six months or longer), but it also takes other factors into account when determining whether there is a recession. When a recession is particularly long and severe, it is called a depression.

Consumer responsibility

Consumers have a responsibility to verify statements from their credit card companies and banks, among other accounts. They also have a responsibility to verify their receipts. Before you leave a store, look at the receipt to confirm you were charged correctly. Consumer responsibility by reporting the fraud and seeking remedy. Most credit card agreements allow 30 or 60 days to contest an incorrect charge. They also require you to notify the credit card company immediately if your card is lost or stolen, because someone may be using it to commit fraud. Consumers also have a responsibility to maintain consumer vigilance. To be vigilant means to be "on the lookout." There are many ways you can protect yourself. Protecting personal information is one way to safeguard against fraud. In most cases, you do not need to give out Social Security numbers, passwords, or bank account numbers. You should only give out this information when absolutely necessary. Consumers may also request a copy of their credit reports. These come from one of the three credit bureaus—Equifax, Experian, or TransUnion. These reports can alert you if someone has stolen your identity to open accounts or to borrow money. Consumer vigilance can reduce the possibility of identity theft. A vigilant consumer learns to become aware of deceptive business practices. These include bait and switch or other misleading advertising claims. Bait and switch occurs when a business advertises one product at a low price (the "bait"). This gets consumers to visit the store. Then, once in the store, the consumer is told that the advertised product is sold out, and encouraged to buy a more expensive product (the "switch"). To learn more about recognizing deceptive advertising claims, make another visit to the Federal Trade Commission's mall: www.ftc.gov. Being aware of your rights and responsibilities can help you remedy (or "make right") those issues that arise from violations of consumer protection laws. In English and American jurisprudence, there is a legal maxim that for every right, there is a remedy; where there is no remedy, there is no right. This legal maxim was first enunciated by William Blackstone: "It is a settled and invariable principle in the laws of England, that every right when with-held must have a remedy, and every injury its proper redress."1 For example, knowing you can contest an incorrect bill encourages you to take action. You can contact a business or agency to seek a solution. By doing so, you may avoid paying for fraudulent charges.

In the previous discussion, property rights lead to a very important question. Who protects property rights in any country? If it were up to individuals to protect their own property rights, you would still have to race for that free video game. This would be true for any other resource or property you want, as well.

In Module 6, you learned that property rights are enforceable by law. The government of any country is responsible for protecting these rights. Similarly, if anyone violates your private property rights, government agencies will help you enforce your property rights—provided you have a contract of ownership for the property.

As you learned in Module 60, the business cycle has important effects on unemployment, income, and inflation. During an expansionary period, total demand often outpaces an economy's actual output or supply. This causes an expansion to meet the demand. As a result, gross domestic product (GDP) increases as businesses expand, firms start hiring more workers, and unemployment decreases. Remember, though, that inflation is one potential risk of an expanding economy because the higher demand for goods and services can lead to higher prices.

During a contractionary period, demand is lower than the level of output of goods and services. The economy contracts to meet this lower demand. Firms could lay off workers or be unwilling to hire new workers, which leads to an increased unemployment rate. It is possible that deflation—a decrease in the general price level—could occur if firms begin lowering prices due to decreased demand. Unemployment is costly for the economy in several ways. It negatively affects individuals and families because unemployed workers do not earn income and, as a result, struggle to pay their expenses. Unemployment also means that the economy is underutilizing a resource (labor), which means that the country's actual output is less than its potential output (what it could be producing). The difference between actual and potential output is known as the output gap. Similar to the economy, the value of a corporation's stock is subject to fluctuations. Typically, a company's stock increases in value when the company is profitable—earning revenue that exceeds costs. A company's stock can decrease in value when the company experiences financial difficulties (like being unable to pay its bills). Stock prices can shift suddenly and every day brings gains and losses in the market. A country's stock market usually has some sort of average value, or index, that shows how it is performing. For the NYSE, the best-known indices are the Dow Jones Industrial Average and the Standard and Poor's (S&P) 500, both of which are based on "bundles" of stocks that are tracked daily. When the Dow Jones Industrial Average or S&P 500 increases, the overall value of the stock bundle has also increased. For the NASDAQ, the index is the NASDAQ composite, based on 3,000 stocks that are traded exclusively on that exchange. You can find reports on the changing levels of these indices every weekday on the news, online, or in a newspaper.

Economic Freedom

Economists also point to a connection between economic freedom and prosperity. Economic freedom refers to the rights of individuals to make their own economic choices, such as where to work, what to consume, and how much to invest. The Heritage Foundation (in partnership with the Wall Street Journal) tracks countries according to the Economic Freedom Index (www.heritage.org), which consists of ten components including the following: Freedom from corruption; Property rights; Business freedom (ability to start, operate, and close a business); and Investment freedom (ability to move resources within a country and across borders). The Economic Freedom Index reports that North Korea is the least economically free country in the world. In North Korea, citizens enjoy very limited economic freedoms. North Korea is also one of the poorest countries in the world, and its citizens have one of the lowest standards of living. The highest ranked countries include Singapore, Australia, New Zealand, Switzerland, Canada, Ireland, Denmark, and the United States.

So how is the money supply measured? It is rather complex, but here are the important points you need to know:

Economists use multiple definitions for money. The two most common are called M1 and M2. M2 counts some things as money that M1 does not. M1 includes the dollars and coins in circulation and also the money in different types of checking accounts. M2 includes all the money M1 includes, but also includes the money in certain savings accounts. In terms of inflation, the most important characteristic is the rate of change in the money supply, not the total money supply. Economists try to determine how quickly or slowly the money supply is increasing or decreasing.

If an economy "overheats," meaning there is too much activity, the Fed can decrease the amount of money in circulation. When there is less money in circulation, there will be less economic activity because people will demand fewer goods and services. These activities can increase or decrease prices. If the economy grows too quickly, the high demand for goods and services may lead to price increases for many products. In these instances, the economy experiences inflation. When this occurs, money purchases less than it did before.

Given that inflation erodes consumers' purchasing power, policy makers try to limit the nation's exposure to inflation. Sometimes, consumers might have to tolerate a bit of inflation to get an economy moving again. In general though, policy makers want price stability with low inflation. When the government spends money or lowers taxes, it puts a strain on the national budget. If the government spends more money than it collects in taxes during any given year, the government has a budget deficit. (The opposite of a budget deficit is a budget surplus, which means the government collects more taxes than it spends in a given year.) Budget deficits add to the national debt. As of June 2011, the United States had an enormous national debt of $14 trillion, nearly equal to the country's GDP.1 To measure inflation, the U.S. government relies on the Consumer Price Index (CPI), which includes a basket of goods purchased by a typical consumer. Inflation is determined by comparing the cost of that fixed basket of goods over time.

"out of control" inflation, known as hyperinflation, usually is very harmful to an economy.

Hyperinflation often occurs when a country is unstable due to war or other volatile situations. It causes a country's currency to lose its value rapidly. Suddenly even a traditionally inexpensive item such as a loaf of bread becomes extraordinarily expensive. After the collapse of the Soviet Union, Russia took steps to move toward a market economy. This required the government to stop setting prices and allow the world market to determine prices. Unfortunately this resulted in extreme inflation rates. Another well-known hyperinflation example occurred in Germany several years after the end of World War I. After losing the war, the German government had a huge debt to pay. The government placed more money into circulation, but this led to hyperinflation when prices rose dramatically. As bad as this may sound, some people can benefit from hyperinflation. Hyperinflation causes such a volatile environment that people lose confidence in money as a means of purchasing. As a result, people sometimes revert to bartering, or trading, goods and services. Another strategy is to exchange their currency for another country's more stable currency. Businesses and manufacturing firms are affected by hyperinflation as well. While individuals can trade and barter various possessions for goods and services, businesses or firms do not have many options for bartering and gathering all the necessary factors of production.

In the United States, government agencies create and enforce regulations, or rules for society. Some regulations are related to consumer protection laws, which are laws that protect consumers like Isabella. The Bureau of Consumer Protection, part of the Federal Trade Commission (FTC), promotes fair-lending practices, protects privacy, informs the public about consumer rights, encourages honest advertising, and prevents fraud (attempts to deceive). It can even investigate and potentially sue companies and people that violate regulations.

Identity theft. Someone took her personal information (such as her credit card number), posed as her, and made a purchase using her credit card. Identity theft is a crime. The Bureau of Consumer Protection follows up on complaints about identity theft and other unfair business activities. How does the Bureau of Consumer Protection prevent false advertising? The Bureau of Consumer Protection can fine companies that misrepresent the uses, benefits, and quality of goods and services (such as your new cell phone).

One way to achieve economic growth is to increase the amount of a specific input used per person in the country.Each person could work more hours, or people who previously were not working could get a job.

If long-term economic growth in developed countries depends on productivity increases, where does productivity growth come from? It is caused by improvements in the production technology used to convert inputs into outputs. But for economists, technology improvements do not mean simply advances in scientific knowledge. They also can change the way people and resources are organized. This type of change may lead to higher output.

Why do most people trust that these contracts and agreements to produce and exchange goods are being honored properly? It is because the government enforces contracts through the court systems and through regulation.

If your neighbor refuses to pay you the agreed amount after you have mowed their lawn, you can file a complaint against them in court. If you can back up your claim, the court will order them to pay the amount that both of you agreed upon. This is called contract enforcement. A gallon of gasoline or pound of tomatoes is regulated by standards of weights and measures. Governments provide funding for inspectors to ensure that scales and other measuring devices are accurate. In addition to enforcing contracts and property rights, the government also enforces liability rules. Liability is the holding of responsibility for something. To be liable often involves paying the party that has been affected by what you are responsible for. Suppose you drove a big truck for your business. There is always a risk that you might have an accident, possibly harming others or their property. Vehicle liability laws give people the right to recover damages from you if you are responsible for the accident or property damage. There are many liability laws that ensure you can freely enjoy your property rights as long as you do not violate the property rights of others. And, in case of an accident, the victim or victims have a way to be repaid for any damages.

In terms of the supply and demand model in an individual market, there is only one price level where the quantity demanded equals the quantity supplied. This one price level is the point where the supply curve and demand curve intersect—the equilibrium point—and it shows the equilibrium price and equilibrium quantity.

In Module 62, you were introduced to the aggregate demand curve and aggregate supply curve. Recall that the aggregate demand curve shows the overall quantity of goods and services demanded at each price level. The wealth effect, interest rate effect, and exchange rate effect cause the curve to slope downward. As the price level increases, demand for a country's goods and services decreases. The aggregate supply curve shows the total supply of goods and services that businesses plan to sell during a specific time period. In the short run, the curve slopes upward, suggesting that increases in the price level also increase supply. In the long run, the curve is vertical because supply is limited by available resources (such as labor, capital, and natural resources) and technology. So beyond a certain point, even if the price keeps increasing, the supply cannot increase any more.

When an economy produces more goods and services than it did the previous year, it is called economic growth. Economic growth is an increase in real GDP.

In the fish and coconuts example, the GDP could have increased in two different ways. If either the price or output of fish had increased, the GDP also would have increased. If GDP increases because of price increases, it is called inflation. This does not reflect a true increase in a nation's productivity. On the other hand, when output increases (such as increased production of fish), it is referred to as economic growth. The country has increased its production level and real GDP. If a country experiences a recession, the national GDP starts to fall, and many jobs may be lost. On the other hand, if the GDP improves, the economic growth can lift people out of poverty and increase their standards of living. For example, the GDPs of China and India have been increasing steadily, which has allowed many citizens to improve their standards of living. Often, there is a positive relationship between real GDP and employment—as real GDP increases, employment usually increases as well. Why? Well, an increase in real GDP means the economy is producing more goods and services, which requires more workers.

Here is the formula for calculating inflation:

Inflation (%) = Growth rate of the money supply (%) + Growth rate of the output velocity of money (%) − Growth rate of real GDP Notice that real GDP is used in this formula. To calculate you would use the change in the amount of actual goods produced. This equation is always true, both in the long run and the short run. Technically, it is an approximation, but as long as the variables do not grow too quickly—say less than 20% per year—it will be very close. In the short run, though, it is less useful because the growth rate of both real GDP and the output velocity of money can fluctuate in the short run. In the long run, the growth rate of real GDP in the U.S. stays fairly constant (around 3%)—at least, this has been true for about the last 60 years. The growth rate of real GDP is the rate at which the economy is expanding. It is affected mostly by population growth and increased economic efficiency. The growth rate in the output velocity of money is also fairly constant (around 0%), meaning the output velocity of money stays mostly constant over the long term. In long-run inflation, the inflation rate is roughly equal to the growth rate in the money supply minus about 3% to account for real GDP growth. So if the real economy grows at about 3% per year, it needs about 3% more money to keep prices the same. If the money supplygrows faster than this, prices will increase; if it grows slower, prices will decrease. In the short run, the simple relationship between the growth of the money supply and inflation breaks down. Unlike long-run inflation, there is some disagreement among economists about the precise factors that have the greatest influence on short-run inflation, but two possibilities are demand-pull and cost-push inflation.

Velocity measures the rate of change. The velocity of money is the number of times, on average, that a unit of money—for instance, a dollar—gets spent in one year. It is not possible to measure the velocity of money directly.

Instead, economists measure the total amount spent in a year and then divide this by the total amount of money circulating in the economy (the money supply): Velocity of Money = Total Expenditures —————————————————— Money Supply

Most companies are profit driven—that is, they seek to maximize revenue while minimizing costs. While maximizing revenue is not always possible, it is often easier for companies to minimize costs. One way to minimize costs is through offshoring and outsourcing. Offshoring is when a company moves its physical productions and/or services to another country. Outsourcing is when it uses labor from another company.

Of the various reasons why companies offshore work, the principal objective is to lower labor costs. In economics, the people who work for a company are known as human resources. The wage in one country, such as the United States, may be higher for certain jobs than it is in another country. For this reason, a company may decide to offshore certain work to a country where the cost of wages is much lower. This lowers operating costs and can potentially boost profits. There are different reasons why the cost may be lower. One relates directly to the concept of a monopsony. Remember, when many people seek one job, an employer has more control over the wages and terms of employment. Another reason for lower wages in some countries is that the overall cost of living might be lower. (Of course, as more people get jobs and wages increase, that country's cost of living will increase. But, that will be discussed in another module.) Offshoring and outsourcing may also overlap. Foreign labor (outsourcing) may be used in production facilities in another country (offshoring). Outsourcing and offshoring affect people in the United States in many ways. You have already seen that these strategies can produce fewer or different types of job opportunities in the United States. Another effect is that they can cut the cost of goods or services—after all, if a company reduces its cost of making a product or providing a service, the price to the consumer may also drop. Finally, offshoring can bring goods and services to other countries: now, people in other countries can buy items that used to be made and sold only in the United States.

The goal of any economy is full employment. When a country attains full employment, it maximizes its output and revenue. But, generally, no countries enjoy full employment. There are always people who are unemployed and looking for jobs.

On the first Friday of every month, the U.S. Department of Labor releases its estimate of the previous month's unemployment rate. Unemployment is one of a few important economic indicators that can show the economic health of a country. Generally speaking, a low unemployment rate indicates a healthy economy; a high unemployment rate indicates a weak economy. (Number of People Unemployed) Unemployment Rate= ———————————————————————————————————— x 100% (Number of People in Labor Force) To determine the unemployment rate, you must understand the meaning of labor force. You also need to know what it means to be unemployed. According to the U.S. Bureau of Labor Statistics (BLS), unemployed people are: age 16 or older; do not have a job; are available for work; and have been job hunting for the past four weeks. People who are actively seeking a job but who have not found one are considered unemployed. A stay-at-home mother is not in the labor force. She is not counted as unemployed because she is not looking for work outside of her home. A retired person is not included in the labor force and not considered unemployed because he or she is not looking for a job. So how does the U.S. Department of Labor determine the unemployment rate? Every month, the U.S. Bureau of Labor Statistics (BLS), an agency within the U.S. Department of Labor, conducts a random survey to determine the unemployment rate. However, the unemployment rate does not provide an accurate state of unemployment in the United States. In fact, it tends to understate or underestimate it. Read the list below to learn why. Part-time workers Part-time workers are marked as employed. This includes all part-time workers, even those who are looking for full-time employment. Discouraged workers (people who have given up on looking for work) In order to be counted among the unemployed, a person must be actively seeking work. Some part-time workers are satisfied with part-time employment. However, sometimes, people accept part-time work because they cannot find full-time work. After months or years of seeking work, some people simply give up because they think no jobs are available. Once an unemployed person has stopped looking actively for work for at least four weeks, he or she is considered a discouraged worker. Even though discouraged workers have stopped looking for work, they still may want or need a job. However, because they have stopped looking actively for work, the U.S. Bureau of Labor Statistics no longer counts them as unemployed. This means the unemployment rate that is calculated is actually an underestimate because it does not count part-time workers who are seeking full-time employment or discouraged workers who have stopped looking for a job. Frictional unemployment consists of people who are between jobs, or who have been offered employment but have not started working yet. They will experience a brief period with no income. This person left one job and may be unemployed for one month or more until she begins a new job. There are times when a certain set of skills becomes obsolete, or are no longer marketable. This is known as structural unemployment. During any period of recession, there will be an increase in the unemployment rate. This type of unemployment is known as cyclical unemployment. Seasonal unemployment is exactly what it sounds like. There are times of the year when fewer people are demanded in some types of work. In both years, there were similar times when unemployment increased and decreased. In the middle of the year, the unemployment rate can change because of agricultural labor demands. During the holidays, at the end of the year, more labor may be needed to work in stores; however, after the holidays, demand for seasonal workers decreases, so many of them become unemployed again, causing an increase in the unemployment rate.

When the mind creates an idea, a dream, a concept, or an improvement, the law treats it like an asset (such as a house or a boat). It then receives property rights protections similar to those applying to real and personal property. Such intangible creations of the mind are known as intellectual property. Intellectual property rights act as an incentive for people to produce more—just as personal property rights give people the security to invest in real and personal property. Protecting intellectual property rights in the modern age of the Internet, however, is a big challenge.

Once intellectual property is on the Internet, it is relatively easy to copy. Information networks have made it very easy for people to transport information from one place to another. Creative ideas can even cross geographical or political boundaries in a very short time. Further, intellectual property rights vary from country to country, making the situation even more difficult to manage. In the United States, the government provides people with many different tools to protect their intellectual property rights. The tools largely depend on the type of intellectual property being protected. As you learned in Module 39, patents protect intellectual property related to inventions and innovations, like new products and their designs. Now, let's look at more of these protection methods.

Costs of Inflation

One cost of inflation is the loss of welfare, meaning that people's standards of living can be harmed. As inflation reduces the purchasing power of people's income, many will be forced to consume less. If incomes do not increase at the same rate as inflation, then people's standards of living will decrease. One of the government's major goals is to increase the people's welfare in the economy, so price stability and reduced inflation are primary objectives. Another cost of inflation is that investments decline. Inflation has another singnifcant cost—it reduces economic growth and productivity. When an economy's general price levels increase at a high rate, the level of economic activity decreases. Increased prices lead to a decrease in the amount of goods and services that consumers demand, which eventually reduces production levels. In this way, inflation can reduce economic growth. You can understand why governments measure inflation and attempt to keep prices stable. Generally, the accepted level of inflation is always in the single digits varying in the United States between 2% to 6%. An inflation rate above 6% is generally considered unhealthy for an economy.

The Federal Reserve is the central banking system of the United States. As you will learn in Module 66, the Federal Reserve (often called the Fed) plays many roles, such as conducting monetary policy, which influences consumer spending, employment, and prices. In this module, you will learn how the Federal Reserve supports consumer protection.

The Fed's Division of Consumer and Community Affairs writes regulations to protect consumers. These regulations govern many areas of the financial industry. For example, they provide rules for credit cards, debit cards, and automatic teller machine (ATM) cards. They also cover loans such as home equity loans, mortgages, and car leases. This division enforces consumer protection and civil rights laws pertaining to its regulations. It also ensures that banks, supervised by the Fed, follow these regulations and promote fair access to credit. Here are some federal laws about credit protection that involve the Federal Reserve: The Truth in Lending Act (1968) requires credit lenders to disclose borrowing terms and to use the same methods to determine the costs of borrowing. It also limits the liability to the cardholder in case a credit card is lost, stolen, or used without the cardholder's permission. The Fair Credit Report Act (1970) requires accurate information in credit reports and ensures that consumers have the right to know and to correct this information. The Equal Credit Opportunity Act (1974) prohibits discrimination on the basis of characteristics, including race, color, religion, national origin, gender, marital status, and age, in matters involving credit. The Fair Credit and Charge Card Disclosure Act (1988) states that credit card companies must disclose their lending terms, such as annual fees and interest rates. The Credit CARD Act (2009) increases consumer protections, such as not allowing credit card companies to increase rates on an individual's existing balances. This act also requires a 45-day advance notice before increasing interest rates on new purchases The Federal Reserve investigates the public's complaints about the banks under its supervision. The Fed also testifies in Congress on consumer protection laws. It helps protect consumers by providing educational resources on topics such as credit cards and loans.

A basic measure of a nation's economic output and income is gross domestic product (GDP). It is the total market monetary value of all final goods and services produced in an economy in one year. Inflation must be accounted for when determining GDP. To determine GDP more accurately, economists use the GDP deflator, an adjustment that accounts for inflation in computing the national income.

The GDP deflator can be calculated as the ratio of a country's aggregate ouput at current market prices (nominal GDP) to its value at base year prices (real GDP): (nominal GDP) GDP deflator = ————————————— * 100 (real GDP) Real GDP considers the effect inflation can have on nominal GDP and provides a real measure of the increase in the total value of outputs. It can be expressed as follows: (nominal GDP) real GDP = —————————————— * 100 (GDP deflator) An increase in real GDP over time indicates economic growth, which means the country is producing more goods and services than in the past. A decrease in real GDP over time indicates economic contraction. To compare the U.S. GDP from one year to another, you will need to use the GDP deflator. Remember: The market basket of goods used to calculate the CPI or PPI remains constant over a period of time. The market basket for the GDP deflator includes every item in the GDP, including consumption, investments, government spending, and net exports. The CPI or PPI may contain products that are produced in other countries and consumed in the U.S., but the GDP deflator only deals with products and services made in the U.S.

Another measurement is the Producer Price Index (PPI), which is calculated based on the selling prices that the producers receive for a basket of goods.

The PPI is different from the CPI because producers not only sell consumption goods to consumers, they also sell intermediary goods and raw materials to other producers. The PPI is important because raw-material prices affect the prices of final goods and services. If the PPI is increasing, consumers can expect the CPI to increase as well. Why? Well, businesses are likely to pass on higher costs to their customers through higher prices. In this way, the PPI can be an early indicator of inflation. Remember, inflation is an increase in an economy's general price levels.

Similar to Akiko, a government has income and expenses. It collects revenue, or income, but also has expenses. Each year, a government looks at its income and expenses and determines a budget. A balanced budget is when income equals expenses. When income exceeds expenses, there is a budget surplus. When income is less than expenses, there is a budget deficit. The government has to borrow money to pay the difference; this results in a debt (or money owed). You will learn about government debt in a future module.

The United States has multiple levels of government. A local government typically governs a small area—a county, city, or town. The next level up is a state government, which governs a state. The largest is the federal government, which governs the country as a whole. Each type of government operates programs that cost money. To acquire revenue to pay for these programs, governments collect different kinds of taxes. Any time you buy food at a store in the U.S., look at the bottom of the receipt. You will see a line that says "sales tax" or "tax." This tax applies to most goods and services you purchase. It is based on a percentage of the goods or services you purchased and generates revenue for the state government. Each level of government is responsible for paying for different goods and services. Local governments pay for services in cities, towns, or counties, such as picking up the trash, maintaining public roads, maintaining city parks, etc. State governments pay for goods and services offered throughout a state; these could include the state police, hospitals, and public schools. The federal government provides services for the entire country; these duties are outlined in the U.S. Constitution. Compare these goods and services to the programs funded by the federal government, which include Social Security, Medicare, and defense and security. You can click on each slice. How do local, state, and federal governments decide what to spend money on? Just like individual households and businesses, governments must create budgets. For the federal government, the president proposes a budget to Congress, which revises the numbers and sends an alternate proposal back to the president. If the president signs Congress's budget, it becomes law; if he rejects or vetoes it, Congress must again revise the budget and sent it back to the president. The process potentially can go back and forth a number of times and tends to be time consuming. Remember, when a government's income equals expenses, it is called a balanced budget. When income is greater than expenses, there is a budget surplus. When income is less than expenses, there is a budget deficit. There can be serious consequences for lawmakers whenever local, state, or federal governments do not pass balanced budgets. In fact, many cities and towns and some states—including Virginia—have laws that require balanced budgets. In these places, when a budget is not balanced, the government is forced to reduce certain expenses, such as laying off teachers. While this approach keeps the government out of debt, it also can have a downside. For instance, when people lose their jobs, they cannot spend as much money as before, which cuts down on the amount of money the government can collect in taxes. In addition, they may draw unemployment benefits, which also cost the government money. As an alternative to reducing expenses, the government may decide to increase taxes. Yet this also reduces the amount of money families have to spend and can hurt the economy. Neither "solution" is popular with voters. The federal government is not required to balance its budget. In fact, since 1969, the federal government has passed a balanced annual budget only four times (1998-2001). Every other year, it has operated with a deficit. Since the federal government must protect its citizens and provide popular social services, such as unemployment benefits and other programs, most lawmakers are reluctant to cut the federal budget. However, many object to increasing federal taxes. In 2011, President Obama and Congress faced this dilemma. Many lawmakers—mostly Republican—publicly declared they would not increase taxes and demanded steep budget cuts to reduce the growing budget deficit. On the other hand, many Democratic lawmakers argued for increased taxes or a compromise that combined budget cuts and tax increases. In the end, Congress passed and the president signed a deficit budget that cut some spending but not to the degree that many Republicans had recommended.

The World Bank and the International Monetary Fund (IMF) were founded in 1944 to help rebuild the world's economy after World War II.1Today, their goals include alleviating world poverty by providing financial assistance and encouraging investment by allowing countries to borrow money.

The World Bank loans money to low-income countries to complete specific projects. For example, a country that wants to improve its education system might get a loan from the World Bank to build new schools and train new teachers. The World Bank currently has more than 2,500 financed activities in more than 80 countries, with a loan volume of more than $170 billion. The pie chart below shows the World Bank's activities by sector. The IMF loans money directly to national governments for several reasons, including shortages of foreign currency. As of May 2011, the IMF had committed $280 billion in loans to various countries.2 The IMF usually requires the country receiving the loan to enact certain structural adjustments to improve the country's finances and prevent the need for future loans. These structural adjustments often require a country's national government to reduce its involvement in the economy, such as selling government-run industries, cutting government expenditures, or reducing trade barriers. Both the IMF and the World Bank are part of the United Nations. Consisting of 193 members (including the United States), the United Nations' goals include improving the lives of poor people and fighting hunger, disease, and illiteracy (inability to read or write). It also provides some direct development assistance through the United Nations Developmental Programme (UNDP), which has staff in 177 countries. The UNDP mostly serves in a networking or coordination role, connecting the governments of low-income countries with development resources.

Inflation occurs when the prices of most goods and services increase. The immediate effect of inflation is that goods and services become more expensive. Inflation causes a decrease in the purchasing power of your money—the same amount of money buys fewer goods than in the past.

The inflation rate is the average percentage of prices that increase over a specified time, such as one year. Notice that India's inflation rate was 12%, which means the average price of most goods and services in the Indian economy rose by 12% in 2010. Compare India's high inflation rate to Japan's: —0.7%. Why did Japan have a negative inflation rate? Because, prices in Japan's economy decreased rather than increasing in 2010! You will learn more about negative values for inflation in a future module. When a country experiences inflation, the price of most goods and services increases. You might notice that food is more expensive, a movie ticket costs more, gas prices are higher, and so forth. If your income does not change, inflation will affect how much money you can spend and save. More income less affect. From what you have read so far, you may think that inflation is always bad. Expected inflation is called anticipated inflation; unexpected inflation is called unanticipated inflation.

Often, when people talk about the federal government running a budget deficit, they simply call it the national debt. However, a budget deficit is not the same as the national debt. As you learned in Module 68, a budget deficit occurs when the amount of money the federal government spends on its programs exceeds the amount of income it receives. In 2010, the U.S. budget deficit (adjusted for inflation) was $1,312.37 billion.1

The national debt, sometimes called the public debt, is the sum of all federal budget surpluses and deficits to date, meaning that it is the total amount of money the U.S. government still owes. As of 2011, the U.S. national debt was more than $14 trillion.2 Every year, the federal government drafts a new budget. The government has to project how much it will spend and which programs to fund. To pay for these programs, the government must also project how much money it will collect in taxes. Every year, these expenses and revenues change. When the federal government runs a budget deficit, it has two choices: reduce spending or collect more revenue. Typically, the government increases revenues to cover expenses. One option for increasing revenue is to raise taxes. But this is unpopular among voters because it means that many households (and possibly businesses) will have less money to spend on nonessentials (disposable income). Another option for increasing revenue is to sell securities.

Many developing countries, or countries that consistently have low GDP per capita, seek to grow economically by increasing their capital. They build more roads, power plants, factories, gas pipelines, airports, sewer systems, and similar infrastructure. These improvements in capital can have a significant impact on a developing nation's productivity.

These types of capital improvements can greatly increase productivity in developing countries. But, this idea does not always work for a developed country, such as the United States. (A developed country consistently has high GDP per capita.) There is a limit to how much a developed country can grow its economy simply by using more resources. This is challenging because a developed country already uses a lot of capital. Imagine providing a second computer for every computer in an office building. Would this increase productivity very much if there is still the same number of employees? Not really. Adding more capital in a developed nation will not have the same kind of impact it might have in a developing nation. This idea is called diminishing returns.

A challenge with protecting intellectual property is the control of information. If you sell a video game you developed, that game becomes other people's property. They can play with it and enjoy it. They can also break it apart and see how you built it. Once someone learns how you built it, it is relatively easy to transfer this knowledge to people around the world using the Internet.

This was not the case as recently as 50 years ago. The transfer of information was restricted primarily to mail or phone calls, making it easier for authorities to monitor if valuable information was being transferred. With the arrival of the Internet, everything changed. People can exchange information quickly and sometimes anonymously. In addition, reproducing new inventions is now relatively cheaper compared to the past because of trade and economies of scale. These new issues make it very difficult to provide protection to intellectual property. People can violate other people's intellectual property rights for their own benefits, especially in countries where the law is not strictly enforced.

More on GDP and Price Changing

Without adjusting for price changes, the production growth would be overestimated. For instance, assume that in year 1, a firm produces $5 billion worth of goods and services. In year 2, it did not produce any additional goods and services, but, due to inflation, the price of the existing goods and services increased. Based solely on prices, it might appear as though production increased in year 2. This is why real GDP is more important than nominal GDP because it adjusts for these types of price changes and provides a more accurate picture of the economy's health. This is why economists and policy makers must distinguish between real and nominal GDP. You see that nominal GDP increased by $32,000 (32%) between 2009 and 2010. By looking solely at nominal GDP, economists might assume incorrectly that 32% more goods were produced in 2010 than in 2009. But, this increase reflects both an actual increase in productivity and increased prices (inflation)—from $10 to $12. Real GDP, however, provides a more accurate picture of the economy's growth. To determine real GDP, you must use constant 2009 prices while incorporating the increased production levels for 2010. You can calculate real GDP as follows: Real GDP in 2010: real GDP = price per unit in 2009 × # units produced in 2010 = $10 × 11,000 = $110,000 Using constant prices to calculate real GDP shows that between 2009 and 2010, real GDP increased from $100,000 to $110,000. This increase of only $10,000 reflects real growth of 10%. To determine economic changes over time, you always want to examine real GDP instead of nominal GDP. As the example showed, nominal GDP can be misleading—growing by 32% while real GDP grew by only 10%. Without looking at real GDP, you run the risk of overestimating or underestimating how much the economy is growing. Another related term is real GDP per capita—a rough approximation of average income per person in a country. It is calculated by determining the value of total production of goods and services divided equally among the residents of a country. You can calculate real GDP per capita as follows: real GDP per capita = real GDP ÷ population For example, suppose a country has a real GDP of $240 million and a population of 30,000. The real GDP per capita would be ($240,000,000 ÷ 30,000) = $8,000. Real GDP per capita is often used to compare living standards across countries and over time. A high GDP per capita generally is associated with a higher standard of living. A low GDP per capita usually is associated with a lower standard of living.

When considering the causes of inflation, it is important to distinguish between the short run and the long run. While short-run inflation can have a variety of causes, long-run inflation is often caused by increases in the economy's money supply. Typically if you increase the supply of something, its value will decrease. Economists frequently talk about the difference between the long run and the short run, which can be confusing. How long do you have to wait before it is the long run?

You can think of the short run as lasting from a few months to a few years. Short-run inflation refers to a variation in inflation relative to its long-run value. Suppose that inflation has been 4% for several years but then decreases to 3% for six months before returning to 4%. In this case, long-run inflation is around 4%. The short-run decrease in this case is about 1% because the inflation rate dropped temporarily from 4% to 3%. Given that long-run inflation is driven primarily by increases in the money supply, it is important to understand what money is and how to measure it. It may seem obvious: paper currency and metal coins. But money is more than the physical cash people carry. Bank checking accounts usually are counted as money too. What about savings accounts that earn interest, even if they are harder to convert into cash? These are sometimes counted.

Inflation

is an increase in the general price levels. Inflation does not necessarily mean that the price of every single good or service has increased. Rather, it represents an increase in prices on average. When prices increase, the cost of living increases for most families. For this reason, economists have developed several measures to track inflation over time. One measure is a change in a price index—a weighted average of prices for a given basket of goods and services over a period of time. The average is weighted by multiplying each price by a factor before finding the average. If a product is more important or purchased more often, its price is multiplied by a factor greater than one. For less important items, the price is multiplied by a factor less than one. One commonly used price index for measuring inflation is the Consumer Price Index (CPI). The CPI is a measure of the average prices paid by the average urban American household. The CPI includes the prices of housing, food, clothing, transportation, and other commonly purchased goods and services. When the CPI rises, the average American household has to pay more for these goods and services.