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WELCOME TO
THE PRINCIPLES
OF
ECONOMICS
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GOODS AND SERVICES
Goods - any physical object that can be purchased
Cars
CDs
Apples
Services - actions or activities performed for a fee
Lawyers - legal advice, etc.
Plumbers - repair your leaking pipes
Doctors - prescribe treatment for the flu
Economics teachers - help you learn about economies
Coaches - help you become a better athlete
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ECONOMIC CATEGORIES
To study economics we divide it into two
categories
Microeconomics (small picture)
Macroeconomics (big picture)
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What Is Economics?
Economics is the study of how
people make choices to satisfy
their wants.
For example:
•You must choose how to spend your time.
•Businesses must choose how many people
to hire.
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Chapter 1, Section 1
Scarcity and Shortages
Scarcity occurs
Shortages occur
when there are
when producers
limited quantities
will not or cannot
of resources to
offer goods or
meet unlimited
services at
needs or desires.
current prices.
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Chapter 1, Section 1
The Factors of Production
• Land
All natural resources that are used to
produce goods and services.
• Labor
Any effort a person devotes to a task for
which that person is paid.
• Capital
Any human-made resource that is used to
create other goods and services.
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Chapter 1, Section 1
Trade-offs and Opportunity Cost
All individuals and groups of people
make decisions that involve trade-offs.
Trade-offs are all the alternatives that we give up
whenever we choose one course of action over
others.
The most desirable alternative given up as a result of
a decision is known as opportunity cost.
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Chapter 1, Section 2
Production Possibilities
•
A production possibilities graph shows alternative ways that
an economy can use its resources.
The production possibilities frontier is the line that shows the
maximum possible output for that economy.
Production Possibilities Graph
25
Watermelons
Shoes
(millions of tons) (millions of pairs)
0
15
8
14
14
12
18
9
20
5
21
0
Shoes (millions of pairs)
•
20
15
10
1 2 3
b (8,14)
c (14,12)
d (18,9)
5
0
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a (0,15)
A production
possibilities frontier
e (20,5)
f (21,0)
5
10
15
20
25
Watermelons (millions of tons)
Chapter 1, Section 3
Growth
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Production Possibilities Graph
25
Future production
Possibilities frontier
T
Shoes (millions of pairs)
Growth If more
resources become
available, or if
technology improves,
an economy can
increase its level of
output and grow.
When this happens,
the entire production
possibilities curve
“shifts to the right.”
20
S
15
a (0,15)
b (8,14)
c (14,12)
10
d (18,9)
5
e (20,5)
f (21,0)
0
5
10
15
20
Watermelons (millions of tons)
Chapter 1, Section 3
25
Review
1. A production possibilities frontier shows
(a) farm goods and factory goods produced by an economy.
(b) the maximum possible output of an economy.
(c) the minimum possible output of an economy.
(d) underutilization of resources.
2. An economy that is using its resources to produce the maximum
number of goods and services is described as
(a) efficient.
(b) underutilized.
(c) growing.
(d) trading off.
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Chapter 1, Section 3
The Three Economic Questions
Every society must answer three
questions:
• What goods and services should be
produced?
• How should these goods and
services be produced?
• Who consumes these goods and
services?
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Chapter 2, Section 1
Four Economic Systems
An economic system is the method used by a society to
produce and distribute goods and services.
Traditional economies rely
on habit, custom, or ritual to
decide what to produce, how
to produce it, and to whom to
distribute it.
In a market economy
economic decisions are made
by individuals and are based
on exchange, or trade.
In a centrally planned
economy the central
government makes all
decisions about the production
and consumption of goods
and services.
Mixed economies are
systems that combine tradition
and the free market with
limited government
intervention.
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Chapter 2, Section 1
The Free Market Economy
In a free market economy, households and business firms use
markets to exchange money and products. Households own
the factors of production and consume goods and services.
Households pay
firms for goods
and services.
Product market
Firms supply
households with
goods and services.
Households supply
firms with land, labor,
and capital.
Factor market
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Firms pay
households for land,
labor, and capital.
Chapter 2, Section 2
Advantages of the Free Market
Economic Efficiency
Economic Freedom
As a self-regulating system, a free
market economy is efficient.
Free market economies have the
highest degree of economic freedom
of any economic system.
Economic Growth
Additional Goals
Because competition encourages
innovation, free markets encourage
growth.
Free markets offer a wider variety of
goods and services than any other
economic system.
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Chapter 2, Section 2
Organization of Centrally Planned
Economies
In a centrally planned economy, the government
owns both land and capital. The government
decides what to produce, how much to produce,
and how much to charge.
Socialism is a social and
political philosophy based on
the belief that democratic
means should be used to
distribute wealth evenly
throughout a society.
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Communism is a political
system characterized by a
centrally planned economy
with all economic and political
power resting in the hands of
the government.
Chapter 2, Section 3
The Rise of Mixed Economies
Market economies, with all their advantages,
have certain drawbacks.
Limits of Laissez Faire
Laissez faire is the
doctrine that government
generally should not
interfere in the
marketplace.
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Governments create
laws protecting property
rights and enforcing
contracts. They also
encourage innovation
through patent laws.
Chapter 2, Section 4
Government’s Role in a Mixed Economy
•
•
In a mixed
economy,
the government
purchases goods
and services in
the product
market, and
purchases land,
labor, and capital
from households
in the factor
market.
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Product market
Factor market
Chapter 2, Section 4
Comparing Mixed Economies
An economic system that permits the conduct of business with
minimal government intervention is called free enterprise. The
degree of government involvement in the economy varies among
nations.
Continuum of Mixed Economies
Centrally planned
Free market
Iran
North Korea
Cuba
South Africa
China
France
Botswana
Russia
Greece
United Kingdom
Canada
Peru
Hong Kong
Singapore
United States
Source: 1999 Index of Economic Freedom, Bryan T. Johnson, Kim R. Holmes, and Melanie Kirkpatrick
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Chapter 2, Section 4
A Tradition of Free Enterprise
Americans have traditionally favored
economic freedom over economic regulation.
What is the role of consumers in our free
enterprise system?
1. Consumers influence
producers through their
buying decisions.
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2. Consumers influence the
government’s economic
policies through voting and
other techniques.
Chapter 3, Section 1
Redistribution Programs
Cash transfers are direct payments of money to
eligible people.
1. Temporary Assistance for
Needy Families (TANF)
This program allows individual
states to decide how to best use
federally provided funds.
3. Unemployment Insurance
Unemployment compensation
provides money to eligible workers
who have lost their jobs.
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2. Social Security
Social Security provides direct cash
transfers of retirement income to the
nation's elderly and living expenses
to the disabled.
4. Workers' Compensation
Worker's compensation provides a
cash transfer of state funds to
employees injured while on the job.
Chapter 3, Section 2
Review
1. Welfare includes all of the following EXCEPT
(a) Temporary Assistance to Needy Families.
(b) Occupational Safety and Health Administration.
(c) Social Security.
(d) Medicaid.
2. Education programs make the economy more productive by
(a) adding to human capital and labor productivity.
(b) reducing taxes.
(c) providing more jobs in manufacturing.
(d) reducing injuries on the job.
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Chapter 3, Section 2
Public Goods
A public good is a shared good or service for
which it would be impractical to make
consumers pay individually and to exclude
nonpayers.
•
Public goods are funded by the public sector, the part
of the economy that involves transactions of the
government. .
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Chapter 3, Section 3
Promoting Economic Strength
Policymakers pursue three main outcomes as
they seek to stabilize the economy.
1. Employment
2. Growth
.
3. Stability
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Chapter 3, Section 4
What Is the Law of Demand?
The law of demand states that consumers buy
more of a good when its price decreases and less
when its price increases.
• The law of demand is the result of two separate
behavior patterns that overlap, the substitution
effect and the income effect.
• These two effects describe different ways that a
consumer can change his or her spending patterns
for other goods.
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Chapter 4, Section 1
The Substitution Effect and Income Effect
The Substitution Effect
• The substitution
effect occurs when
consumers react to
an increase in a
good’s price by
consuming less of
that good and more
of other goods.
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The Income Effect
• The income effect
happens when a
person changes his
or her consumption
of goods and
services as a result
of a change in real
income.
Chapter 4, Section 1
The Demand Schedule
•
A demand schedule is
a table that lists the
quantity of a good a
person will buy at each
different price.
•
A market demand schedule
is a table that lists the
quantity of a good all
consumers in a market will
buy at each different price.
Demand Schedules
Individual Demand Schedule
Price of a
slice of pizza
Quantity demanded
per day
$.50
$1.00
$1.50
$2.00
$2.50
$3.00
5
4
3
2
1
0
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Market Demand Schedule
Price of a
slice of pizza
$.50
$1.00
$1.50
$2.00
$2.50
$3.00
Quantity demanded
per day
300
250
200
150
100
50
Chapter 4, Section 1
The Demand Curve
a graphical
representation of a
demand schedule.
• When reading a
demand curve,
assume all outside
factors, such as
income, are held
constant.
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3.00
Price per slice (in dollars)
• A demand curve is
Market Demand Curve
2.50
2.00
1.50
1.00
Demand
.50
0
0
50
100 150 200 250 300 350
Slices of pizza per day
Chapter 4, Section 1
What Causes a Shift in Demand?
Several factors can lead to a change in demand:
1. Income
2. Consumer Expectations
Changes in consumers incomes
affect demand. A normal good is a Whether or not we expect a good to
good that consumers demand more increase or decrease in price in the
of when their incomes increase. An future greatly affects our demand for
that good today.
inferior good is a good that
consumers demand less of when
their income increases.
3. Population
4. Consumer Tastes and
Advertising
Changes in the size of the
Advertising plays an important role in
population also affects the demand
many trends and therefore
for most products.
influences demand.
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Chapter 4, Section 2
Prices of Related Goods
The demand curve for one good can be
affected by a change in the demand for
another good.
• Complements are • Substitutes are
two goods that are
bought and used
together. Example:
skis and ski boots
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goods used in place
of one another.
Example: skis and
snowboards
Chapter 4, Section 2
What Is Elasticity of Demand?
Elasticity of demand is a measure of how
consumers react to a change in price.
• Demand for a good • Demand for a good
that consumers will
continue to buy
despite a price
increase is
inelastic.
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that is very sensitive
to changes in price
is elastic.
Chapter 4, Section 3
Factors Affecting Elasticity
Several different factors can affect the elasticity of
demand for a certain good.
1. Availability of Substitutes
2. Relative Importance
If there are few substitutes for a
good, then demand will not likely
decrease as price increases. The
opposite is also usually true.
Another factor determining elasticity
of demand is how much of your
budget you spend on the good.
3. Necessities versus
Luxuries
4. Change over Time
Whether a person considers a good
to be a necessity or a luxury has a
great impact on the good’s elasticity
of demand for that person.
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Demand sometimes becomes more
elastic over time because people
can eventually find substitutes.
Chapter 4, Section 3
The Law of Supply
According to the law of supply, suppliers will offer
more of a good at a higher price.
Law of Supply
Price
Supply
As price
increases…
Quantity
supplied
increases
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Price
Supply
As price
falls…
Quantity
supplied
falls
Chapter 5, Section 1
How Does the Law of Supply Work?
• Economists use the term quantity supplied
to describe how much of a good is offered
for sale at a specific price.
• The promise of increased revenues when
prices are high encourages firms to produce
more.
• Rising prices draw new firms into a market
and add to the quantity supplied of a good.
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Chapter 5, Section 1
Supply Schedules
A market supply schedule is a chart that lists
how much of a good all suppliers will offer at
different prices.
Market Supply Schedule
Price per slice of pizza
Slices supplied per day
$.50
1,000
$1.00
1,500
$1.50
2,000
$2.00
2,500
$2.50
3,000
$3.00
3,500
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Chapter 5, Section 1
Supply Curves
• A market
Market Supply Curve
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3.00
Supply
2.50
Price (in dollars)
supply curve
is a graph of
the quantity
supplied of a
good by all
suppliers at
different
prices.
2.00
1.50
1.00
.50
0
0
500
1000 1500 2000 2500 3000 3500
Output (slices per day)
Chapter 5, Section 1
Production Costs
• A fixed cost is a cost that does not change,
regardless of how much of a good is produced.
Examples: rent and salaries
• Variable costs are costs that rise or fall depending
on how much is produced. Examples: costs of raw
materials, some labor costs.
• The total cost equals fixed costs plus variable
costs.
• The
marginal cost is the cost of producing one
more unit of a good.
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Chapter 5, Section 2
Balancing the Market
The point at which quantity demanded and quantity
supplied come together is known as equilibrium.
Finding Equilibrium
Equilibrium Point
Combined Supply and Demand Schedule
$3.50
$2.50
$2.00
Equilibrium
Price
$1.50
$1.00
$.50
Supply
0
50
100
150
a
Equilibrium
Quantity
Price per slice
$3.00
200
Demand
250
300
Slices of pizza per day
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Price of
a slice
of pizza
Quantity
demanded
Quantity
supplied
$ .50
300
100
$1.00
250
150
$1.50
200
200
$2.00
150
250
$2.50
100
300
$3.00
50
350
350
Chapter 6, Section 1
Result
Shortage from
excess demand
Equilibrium
Surplus from
excess supply
Market Disequilibrium
If the market price or quantity supplied is anywhere but at the
equilibrium price, the market is in a state called
disequilibrium. There are two causes for disequilibrium:
Excess Demand
Excess Supply
•
•
Excess demand occurs
when quantity demanded
is more than quantity
supplied.
Excess supply occurs
when quantity supplied
exceeds quantity
demanded.
Interactions between buyers and sellers will
always push the market back towards
equilibrium.
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Chapter 6, Section 1
Price Ceilings
In some cases the government steps in to
control prices. These interventions appear as
price ceilings and price floors.
• A price ceiling is a maximum price that can be
legally charged for a good.
• An example of a price ceiling is rent control, a
situation where a government sets a maximum
amount that can be charged for rent in an area.
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Chapter 6, Section 1
Price Floors
• A price floor is a • One well-known
minimum price,
set by the
government, that
must be paid for a
good or service.
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price floor is the
minimum wage,
which sets a
minimum price
that an employer
can pay a worker
for an hour of
labor.
Chapter 6, Section 1
Analyzing Shifts in Supply and Demand
Graph A: A Change in Supply
Graph B: A Change in Demand
$800
$60
a
Supply
$50
b
Original
supply
$40
c
Price
Price
$600
$400
c
$30
a
b
$20
$200
New
supply
Demand
New
demand
Original
demand
$10
0
1
2
3
4
5
Output (in millions)
•
•
0
100
200
300
400
500
600
700
Output (in thousands)
Graph A shows how the market finds a new equilibrium
when there is an increase in supply.
Graph B shows how the market finds a new equilibrium
when there is an increase in demand.
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Chapter 6, Section 2
800
900
The Role of Prices in a Free Market
• Prices serve a vital role in a free market
economy.
• Prices help move land, labor, and capital into
the hands of producers, and finished goods
in to the hands of buyers.
• Prices create efficient resource allocation for
producers and a language that both
consumers and producers can use.
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Chapter 6, Section 3
Advantages of Prices
Prices provide a language for buyers and sellers.
1. Prices as an Incentive
2. Signals
Prices communicate to both buyers
Think of prices as a traffic light. A
and sellers whether goods or
relatively high price is a green light
services are scarce or easily
telling producers to make more. A
available. Prices can encourage or
relatively low price is a red light
discourage production.
telling producers to make less.
3. Flexibility
4. Price System is "Free"
In many markets, prices are much Unlike central planning, a distribution
more flexible than production levels.
system based on prices costs
They can be easily increased or
nothing to administer.
decreased to solve problems of
excess supply or excess demand.
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Chapter 6, Section 3
The Four Conditions for Perfect
Competition
Perfect competition is a market structure in which a large
number of firms all produce the same product.
1. Many Buyers and Sellers
2. Identical Products
There are many participants on
both the buying and selling sides.
There are no differences
between the products sold by
different suppliers
3. Informed Buyers and
Sellers
4. Free Market Entry and
Exit
The market provides the buyer
with full information about the
product and its price.
Firms can enter the market when
they can make money and leave
it when they can't.
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Barriers to Entry
Factors that make it difficult for new firms to enter a
market are called barriers to entry.
Start-up Costs
The expenses that a new
business must pay before
the first product reaches
the customer are called
start-up costs.
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Technology
Some markets require a high
degree of technological
know-how. As a result,
new entrepreneurs cannot
easily enter these markets.
Defining Monopoly
• A monopoly is a market dominated by a
single seller.
• Monopolies form when barriers prevent firms
from entering a market that has a single
supplier.
• Monopolies can take advantage of their
monopoly power and charge high prices.
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Forming a Monopoly
Different market conditions can create different
types of monopolies.
1. Economies of Scale
If a firm's start-up costs are high, and its average costs fall for each
additional unit it produces, then it enjoys what economists call economies
of scale. An industry that enjoys economies of scale can easily become a
natural monopoly.
2. Natural Monopolies
3. Technology and Change
A natural monopoly is a market
that runs most efficiently when one
large firm provides all of the output.
Sometimes the development of a
new technology can destroy a
natural monopoly.
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Government Monopolies
A government monopoly is a monopoly created by
the government.
Technological Monopolies
• The government grants patents, licenses that give the inventor
of a new product the exclusive right to sell it for a certain period
of time.
Franchises and Licenses
• A franchise is a contract that gives a single firm the right to sell
its goods within an exclusive market. A license is a governmentissued right to operate a business.
Industrial Organizations
• In rare cases, such as sports leagues, the government allows
companies in an industry to restrict the number of firms in the
market.
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Oligopoly
Oligopoly describes a market dominated by a few
large, profitable firms.
Collusion
Collusion is an agreement
among members of an
oligopoly to set prices and
production levels. Pricefixing is an agreement
among firms to sell at the
same or similar prices.
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Cartels
A cartel is an association by
producers established to
coordinate prices and
production.
The Role of Sole Proprietorships
A sole proprietorship is a business owned
and managed by a single individual.
• A business organization is an establishment
formed to carry on commercial enterprise. Sole
proprietorships are the most common form of
business organization.
• Most sole proprietorships are small. All together,
sole proprietorships generate only about 6 percent
of all United States sales.
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Advantages of Sole Proprietorships
Sole proprietorships offer their owners many
advantages:
Ease of Start-Up
With a small amount of paperwork and legal expenses, just about
anyone can start a sole proprietorship.
Relatively Few Regulations
Sole Receiver of Profit
A proprietorship is the leastAfter paying taxes, the owner of
regulated form of business
sole proprietorship keeps all the
organization.
profits.
Full Control
Easy to Discontinue
Owners of sole proprietorships can Besides paying off legal obligations,
run their businesses as they wish.
such as taxes and debt, no other
legal obligations need to be met to
stop doing business.
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Disadvantages of Sole Proprietorships
The biggest disadvantage of sole proprietorships is
unlimited personal liability. Liability is the legally
bound obligation to pay debts.
•
Sole proprietorships have
limited access to
resources, such as
physical capital. Human
capital can also be limited,
because no one knows
everything.
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•
Sole proprietorships also
lack permanence.
Whenever an owner closes
shop due to illness,
retirement, or any other
reason, the business
ceases to exist.
Types of Partnerships
Partnerships fall into three categories:
•
General Partnership
In a general partnership, partners share equally in both responsibility
and liability.
•
Limited Partnership
In a limited partnership, only one partner is required to be a general
partner, or to have unlimited personal liability for the firm.
•
Limited Liability Partnership
A newer type of partnership is the limited liability partnership. In this
form, all partners are limited partners.
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Advantages of Partnerships
Partnerships offer entrepreneurs many benefits.
1. Ease of Start-Up
Partnerships are easy to establish.
There is no required partnership
agreement, but it is recommended
that partners develop articles of
partnership.
3. Larger Pool of Capital
Each partner's assets, or money
and other valuables, improve the
firm's ability to borrow funds for
operations or expansion.
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2. Shared Decision Making and
Specialization
In a successful partnership, each
partner brings different strengths and
skills to the business.
4. Taxation
Individual partners are subject to
taxes, but the business itself does
not have to pay taxes.
Disadvantages of Partnerships
• Unless the partnership • Partnerships also have
is a limited liability
partnership, at least
one partner has
unlimited liability.
• General partners are
bound by each other’s
actions.
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the potential for
conflict. Partners need
to ensure that they
agree about work
habits, goals,
management styles,
ethics, and general
business philosophies.
Types of Corporations
• A corporation is a legal entity, or being, owned by
individual stockholders.
• Stocks, or shares, represent a stockholder’s
portion of ownership of a corporation.
A corporation which issues
stock to a limited a
number of people is
known as a closely held
corporation.
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A publicly held
corporation, buys and
sells its stock on the open
market.
Advantages of Incorporation
Advantages for the
Stockholders
•
•
Individual investors do not
carry responsibility for the
corporation’s actions.
Shares of stock are
transferable, which means
that stockholders can sell
their stock to others for
money.
Advantages for the
Corporation
•
•
•
•
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Corporations have
potential for more growth
than other business forms.
Corporations can borrow
money buy selling bonds.
Corporations can hire the
best available labor to
create and market the best
services or goods possible.
Corporations have long
lives.
Disadvantages of Incorporation
Corporations are not without their disadvantages,
including:
Difficulty and Expense of Start-Up
Double Taxation
Corporate charters can be
Corporations must pay taxes on their
expensive and time consuming to
income. Owners also pay taxes on
dividends, or the portion of the
establish. A state license, known as
a certificate of incorporation, must
corporate profits paid to them.
be obtained.
Loss of Control
More Regulation
Managers and boards of directors, Corporations face more regulations
not owners, manage corporations.
than other kinds of business
organizations.
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The United States Labor Force
Economists define the labor force as all nonmilitary people
who are employed or unemployed.
Employment
Unemployment
People are considered employed if
they are 16 years or older and meet
at least one of the following
requirements:
•
•
•
People are counted as unemployed
if they are 16 years or older, not
institutionalized, not currently
working, and meet one of the
following criteria:
they worked a least one hour for pay
within the last week; or
•
they worked 15 or more hours
without pay in a family business; or
•
they held jobs but did not work due
to illness, vacations, labor disputes,
or bad weather.
•
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they are temporarily laid off from
their jobs
they will be reporting to new jobs
within 30 days
they are not working but have
looked for work within the last 4
weeks.
Education and Earnings
Potential earnings increase with increased
educational attainment.
Education and Income, 1998
$70,000
Median annual earnings
$60,000
Women
Men
$50,000
$40,000
$30,000
$20,000
$10,000
0
Less than
9th grade
9th to 12th
grade
(no diploma)
High school
Some college,
graduate
no degree
(includes GED)
Associate
degree
Education level
Source: U.S. Census Bureau
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Bachelor’s
degree
Master’s
degree
Doctorate
degree
What Is a Labor Union?
A labor union is an organization of workers
that tries to improve working conditions,
wages, and benefits for its members.
• Less than 14 percent of U.S. workers belong
to a labor union.
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Labor Strikes and Settlements
Strikes
If no agreement is met between the union and the company, the union may
ask its members to vote on a strike. A strike is an organized work
stoppage intended to force an employer to address union demands. Strikes
can be harmful to both the union members and the firm.
Mediation
To avoid the economic losses of a strike, a third party is sometimes called in to
settle the dispute. Mediation is a settlement technique in which a neutral
mediator meets with both sides to try and find an acceptable solution for
both sides.
Arbitration
If mediation fails, talks may go into arbitration, a settlement technique in
which a third party reviews the case and imposes a decision that is legally
binding for both sides.
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What Is Gross Domestic Product?
• Economists monitor the macroeconomy using
national income accounting, a system that
collects statistics on production, income,
investment, and savings.
• Gross domestic product (GDP) is the dollar
value of all final goods and services produced
within a country’s borders in a given year.
• GDP does not include the value of intermediate
goods. Intermediate goods are goods used in the
production of final goods and services.
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Chapter 12, Section 1
Real and Nominal GDP
•
•
Nominal GDP is GDP measured in current prices.
It does not account for price level increases from
year to year.
Real GDP is GDP expressed in constant, or
unchanging, dollars.
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Chapter 12, Section 1
Limitations of GDP
GDP does not take into account certain economic
activities, such as:
Nonmarket Activities
GDP does not measure goods and
services that people make or do
themselves, such as caring for
children, mowing lawns, or cooking
dinner.
The Underground Economy
There is much economic activity
which, although income is
generated, never reported to the
government. Examples include
black market transactions and
"under the table" wages.
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Negative Externalities
Unintended economic side effects,
such as pollution, have a monetary
value that is often not reflected in
GDP.
Quality of Life
Although GDP is often used as a
quality of life measurement, there
are factors not covered by it. These
include leisure time, pleasant
surroundings, and personal safety.
Chapter 12, Section 1
What Is a Business Cycle?
A business cycle is a macroeconomic period of
expansion followed by a period of contraction.
• A modern industrial economy experiences cycles
of goods times, then bad times, then good times
again.
• Business cycles are of major interest to
macroeconomists, who study their causes and
effects.
• There are four main phases of the business cycle:
expansion, peak, contraction, and trough.
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Chapter 12, Section 2
Phases of the Business Cycle
Expansion
An expansion is a period of economic growth as measured by a rise
in real GDP. Economic growth is a steady, long-term rise in real
GDP.
Peak
When real GDP stops rising, the economy has reached its peak, the
height of its economic expansion.
Contraction
Following its peak, the economy enters a period of contraction, an
economic decline marked by a fall in real GDP. A recession is a
prolonged economic contraction. An especially long or severe
recession may be called a depression.
Trough
The trough is the lowest point of economic decline, when real GDP
stops falling.
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Chapter 12, Section 2
Structure of the Federal Reserve
The Board of Governors
The Federal Reserve System is overseen by the seven-member Board of Governors of
the Federal Reserve. Actions taken by the Federal Reserve are called monetary
policy.
Federal Reserve Districts
The Federal Reserve System consists of 12 Federal Reserve Districts, with one Federal
Reserve Bank per district. The Federal Reserve Banks monitor and report on
economic activity in their districts.
Member Banks
All nationally chartered banks are required to join the Fed. Member banks contribute
funds to join the system, and receive stock in and dividends from the system in
return. This ownership of the system by banks, not government, gives the Fed a high
degree of political independence.
The Federal Open Market Committee (FOMC)
The FOMC, which consists of The Board of Governors and 5 of the 12 district bank
presidents, makes key decisions about interest rates and the growth of the United
States money supply.
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The Pyramid Structure of the Federal
Reserve
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Federal Open Market Committee
12 District
Reserve Banks
Board of Governors
Structure of the Federal Reserve System
4,000 member banks
and 25,000 other
depository institutions
About 40 percent of
all United States
banks belong to the
Federal Reserve.
These members
hold about 75
percent of all bank
deposits in the
United States.
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Serving Government
Federal Government’s Banker
The Fed maintains a checking account for the Treasury Department
and processes payments such as social security checks and IRS
refunds.
Government Securities Auctions
The Fed serves as a financial agent for the Treasury Department and
other government agencies. The Fed sells, transfers, and redeems
government securities. Also, the Fed handles funds raised from
selling T-bills, T-notes, and Treasury bonds.
Issuing Currency
The district Federal Reserve Banks are responsible for issuing paper
currency, while the Department of the Treasury issues coins.
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Serving Banks
Check Clearing
Check clearing is the process by which banks record whose account
gives up money, and whose account receives money when a
customer writes a check.
Supervising Lending Practices
To ensure stability in the banking system, the Fed monitors bank
reserves throughout the system. The Fed also protects consumers
by enforcing truth-in-lending laws.
Lender of Last Resort
In case of economic emergency, commercial banks can borrow funds
from the Federal Reserve. The interest rate at which banks can
borrow money from the Fed is called the discount rate.
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Regulating the Banking System
The Fed generally coordinates all banking regulatory
activities.
Bank Examinations
•
•
The Federal Reserve
examines banks periodically
to ensure that each institution
is obeying laws and
regulations.
Examiners may also force
banks to sell risky
investments if their net
worth, or total assets minus
total liabilities, falls too low.
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Reserves
•
•
Each financial institution that
holds deposits for its
customers must report daily
to the Fed about its reserves
and activities.
The Fed uses these reserves
to control how much money is
in circulation at any one time.
Reserve Requirements
The Fed has three tools available to adjust the money supply of
the nation. The first tool is adjusting the required reserve ratio.
Reducing Reserve
Requirements
•
•
A reduction of the RRR would
free up reserves for banks,
allowing them to make more
loans.
A RRR reduction would also
increase the money multiplier.
Both of these effects would lead
to a substantial increase in the
money supply.
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Increasing Reserve
Requirements
•
•
Even a slight increase in the
RRR would require banks to
hold more money in reserve,
shrinking the money supply.
This method is not used often
because it would cause too
much disruption in the banking
system.
Discount Rate
The discount rate is the interest rate that banks pay to
borrow money from the Fed.
Reducing the Discount
Rate
•
•
If the Fed wants to encourage banks
to loan out more of their money, it
may reduce the discount rate,
making it easier or cheaper for
banks to borrow money if their
reserves fall too low.
Reducing the discount rate causes
banks to lend out more money,
which leads to an increase in the
money supply.
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Increasing the Discount
Rate
•
•
If the Fed wants to discourage
banks from loaning out more of their
money, it may make it more
expensive to borrow money if their
reserves fall too low.
Increasing the discount rate causes
banks to lend out less money, which
leads to a decrease in the money
supply.
Open Market Operations
The most important monetary tool is open market
operations. Open market operations are the buying and
selling of government securities to alter the money supply.
Bond Purchases
•
•
In order to increase the money
supply, the Federal Reserve
Bank of New York buys
government securities on the
open market.
The bonds are purchased with
money drawn from Fed funds.
When this money is deposited in
the bank of the bond seller, the
money supply increases.
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Bond Sales
•
•
When the Fed sells bonds, it
takes money out of the money
supply.
When bond dealers buy bonds
they write a check and give it to
the Fed. The Fed processes the
check, and the money is taken
out of circulation.
What Is Fiscal Policy?
Fiscal policy is the federal government’s use
of taxing and spending to keep the economy
stable.
•
•
The tremendous flow of cash into and out of the
economy due to government spending and taxing has
a large impact on the economy.
Fiscal policy decisions, such as how much to spend
and how much to tax, are among the most important
decisions the federal government makes.
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Chapter 15, Section 1
Fiscal Policy and the Economy
The total level of government spending can be
changed to help increase or decrease the output
of the economy.
Expansionary Policies
• Fiscal policies that try
to increase output are
known as
expansionary
policies.
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Contractionary Policies
• Fiscal policies intended
to decrease output are
called contractionary
policies.
Chapter 15, Section 1
Balancing the Budget
A balanced budget is a budget in which
revenues are equal to spending.
Budget Surpluses
•
A budget surplus occurs when revenues exceed
expenditures.
Budget Deficits
•
A budget deficit occurs when expenditures exceed
revenue.
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Chapter 15, Section 3
The National Debt
The national debt is the total amount of money the
federal government owes. The national debt is owed
to anyone who holds U.S. Savings Bonds or Treasury
bills, bonds, or notes.
The Difference Between Deficit and Debt
•
The deficit is amount the government owes for one fiscal year. The
national debt is the total amount that the government owes.
Measuring the National Debt
•
In dollar terms, the debt is extremely large: $5 trillion at the end of the
twentieth century. Economists often measure the debt as a percent of
GDP.
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Chapter 15, Section 3
Fiscal and Monetary Policy Tools
The federal government and the Federal Reserve both
have tools to influence the nation’s economy.
Fiscal and Monetary Policy Tools
Fiscal policy tools
Expansionary
tools
Contractionary
tools
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1. increasing government
spending
2. cutting taxes
1. decreasing government
spending
2. raising taxes
1 2 3
Monetary policy tools
1. open market operations:
bond purchases
2. decreasing the discount
rate
3. decreasing reserve
requirements
1. open market operations:
bond sales
2. increasing the discount
rate
3. increasing reserve
requirements
Resource Distribution and Trade
• Each country of the world possesses
different types and quantities of land, labor,
and capital resources.
• By specializing in the production of certain
goods and services, nations can use their
resources more efficiently.
• Specialization and trade can benefit all
nations.
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Imports and Exports of the United States
Major Imports and Exports of the United States
• The United States is
Chemicals
the world’s largest
exporter.
Industrial machinery
Electrical machinery
Data-processing
equipment
Exports
Airplanes and parts
Vehicles:parts
• The United States is
Power-generating
machinery
Vehicles: cars and trucks
Scientific instruments
Telecommunications
equipment
10
Imports
20
30
40
50
60
70
80
Vehicles: cars and trucks
Crude oil and petroleum
preparations
Electrical machinery
Data-processing
equipment
Clothing
Industrial machinery
Telecommunications
equipment
Vehicles; parts
Power-generating
machinery
Chemicals
• The United States’
10
20
30
40
50
60
70
Dollars per year (in billions)
Source: Statistical Abstract of the United States
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also the world’s largest
importer.
1 2 3
80
main trading partners
are Canada, Mexico
and Japan.
What Are Trade Barriers?
A trade barrier is a means of preventing a foreign product or service
from freely entering a nation’s territory.
Import Quotas
Voluntary Export Restraints
An import quota is a limit on the
amount of a good that can be
imported.
A voluntary export restraint (VER)
is a self-imposed limitation on the
number of products shipped to a
certain country.
Tariffs
Other Barriers to Trade
A tariff is a tax on imported goods, Other barriers to trade include high
such as a customs duty.
government licensing fees and costly
product standards.
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The Effects of Trade Restrictions
Increased Prices for Foreign Goods
•
•
Tariffs and other trade barriers increase the cost of
imported products, making domestic products more
competitive.
Although manufacturers of many products may benefit
from trade barriers, consumers can lose out.
Trade Wars
•
When one country restricts imports, its trading partner
may impose its own retaliatory restrictions.
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Exchange Rates and International Markets
The value of a foreign nation’s currency in relation to
your own currency is called the exchange rate.
• An increase in the value of a currency is called
appreciation.
• A decrease in the value of a currency is called
depreciation.
• Multinational firms convert currencies on the
foreign exchange market, a network of about 2,000
banks and other financial institutions.
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Reading an Exchange Rate Table
The following table shows an example of exchange rates.
Foreign Exchange Rates
U.S. $
Aust $
U.K. £
Canadian $
U.S. $
1
0.6489
1.599
0.6764
Australian $
U.K. £
1.541
0.6252
1
0.4057
2.465
1
Canadian $
1.478
0.9593
2.365
¥en
114.3
74.19
182.9
Euro
Mexican NP
0.01
1.051
0.11
0.12
1.042
0.4229
0.01
0.01
1.62
0.657
0.17
0.07
0.19
0.08
1
0.01293
1.554
0.16
0.18
120.2
12.24
13.81
77.34
¥en
1
Chinese renminbi
Euro
0.9516
0.6175
1.522
0.6436
0.01
1
0.1
0.11
Mexican
nuevo peso
9.33
6.06
6.3
6.3
0.08
9.81
1
1.13
Chinese renminbi
8.28
5.37
13.25
5.6
0.07
8.7
9.8
1
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Types of Exchange Rate Systems
Fixed Exchange-Rate
Systems
• A currency system in
which governments try
to keep the values of
their currencies
constant against one
another is called a
fixed exchange-rate
system.
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Flexible ExchangeRate Systems
• Flexible exchangerate systems allow the
exchange rate to be
determined by supply
and demand.
Balance of Trade
The relationship between a nation’s
imports and its exports is called its
balance of trade.
• When a nation
exports more than it
imports, it has a
trade surplus.
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• When a nation
imports more than it
exports, it creates a
trade deficit.
The United States Trade Deficit
The Trade Deficit
• The United States has run a trade deficit since the early
1970s.
Why the Trade Deficit?
• Imports of foreign oil as well as Americans’ enjoyment of
imported goods account in part for the large American
trade deficit.
Reducing the Trade Deficit
• Quotas and other trade barriers can be used to raise
prices of foreign-made goods and urge consumers to
buy domestic goods.
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