MACROECONOMICS 1st Edition |
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| by Ayers, Collinge | |
SNAPSHOTS |
"Let's explore that mountain pass!" shouts the hiker. "Let's explore the financing options," suggests the car dealer to the customer. "Let's explore the possibility of sending astronauts to Mars," argues the scientist. Like these three, everyone is an explorer. We think through our possibilities in life, and that is exploration.
Exploring can involve web surfing, visiting a bookstore, or mingling with one another. It expands our knowledge and experience, which we can then apply in order to make better choices. For example, our explorations can lead to writing a better term paper, finding a good book, making new friends, or other applications.
Students of economics are most assuredly explorers. As a student, you explore the principles and issues of economics, then apply what you learned from your explorations. You apply economics to choosing a career, a mate, a senator, and what to eat for breakfast. The exploration of economics and its application to life's choices are found throughout this book. The Explore & Apply section that precedes each chapter summary offers the opportunity to dig deeper into an issue. Like Daniel Boone, Ponce de León, and John Glenn, you are now a pioneer on a journey of discovery.
Bigger or smaller government? An economic stimulus package? Lower taxes? More money for homeland defense? These questions are all answered in the political process. Yet their content is most decidedly economics
During the eighteenth and nineteenth centuries, economics was called political economy. The term political economy makes clear that politics and economics intertwine. Even today, some refer to economics as political economy when they want to emphasize the close ties between economics and public policy.
The renowned physicist Albert Einstein (1879–1955) was in the business of modeling. The most famous model to come from his mind, summarized in the equation e = mc2, provided key insights that led scientists to the ability to split the atom. It is not only economists and physicists that model, however. Psychologists tell us that all of us walk around with models of life in mind.
Take your model of learning. How do you perceive the learning process? A simple model holds that the job of the instructor is to fill your mind with knowledge. In this model you are a passive recipient of facts, figures, and principles. Students whose internal learning model is similar to this one often fail to prosper academically because some important elements of the learning process have been omitted. Remember, Occam's razor tells us to omit only the nonessential elements from models. As Einstein told us, "Everything should be made as simple as possible, but not simpler."
A more sophisticated learning model allows for the student to interact with the instructor, the material, and other students. Key elements of this model involve setting aside time to reflect on the material, to ask questions, and to work with others. Which model is yours?
… on the other side of the fence," the saying goes. Take marriage, for example. How many married men and women do not catch themselves envying the freedom of their single friends—freedom to meet new people and do what they want, when they want to do it? How many of those single friends do not look back with envy of their own, seeing the warmth and security of sharing one's life with someone special? Oh, those opportunity costs! We cannot have it all!
Was it a test missile or a satellite launch vehicle that North Korea fired in the direction of Japan? Either way, the Japanese were not amused by this unexpected projectile hurtling their way late in the summer of 1998. In response, Japan was quick to cut off its food aid to North Korea. After all, it was the food aid that allowed North Korea the luxury of devoting resources to developing its expertise in rocketry. Food aid from Japan was meant to help the North Koreans survive, not to allow them to reallocate their resources toward financing investment in new, threatening capabilities, now thought to include nuclear weapons.
Many great athletes are multitalented, possessing strength, speed, and muscle coordination that dwarf that of the general population. These qualities are needed for success in a variety of sports, yet few athletes play more than one sport professionally, even though they might be able to do so. Simply look at the sports pages. Venus Williams makes headlines by swinging a tennis racket, while Tiger Woods swings a golf club and Barry Bonds swings a bat. Their choices tell the rest of us about their comparative advantages.
The best teams exploit the comparative advantages of their players. Each player has a job to do and specializes in doing it well. Whatever the sport, owners and fans expect this principle of comparative advantage to be followed and demand coaches who will best exploit the talents of their players. But even the best coaches can err, as when Cleveland Indians' baseball coach Tris Speaker said in 1921, "Babe Ruth made a great mistake when he gave up pitching. Working once a week, he might have lasted a long time and become a great star."
Whether it be a hurricane's pounding surf that washes away expensive beachfront homes, a swollen river that engulfs entire communities along its course, or sliding mud that obliterates whatever stands in its way, the effects of wind and rain cost U.S. citizens billions of dollars annually. Much of this loss is a direct result of expensive structures being built in harm's way. For example, huge amounts of real estate development occur in some of the most at-risk areas, including California hillsides, property fronting the beaches of Florida, and in the flood plains of scenic West Virginia rivers.
Is the large amount of building in risky areas proof of people's shortsighted irrationality? More likely, it is evidence of the law of demand in response to government low-interest loans for rebuilding and other assistance that reduce the cost of disasters to their victims. Specifically, disaster assistance lowers the price of taking the risk to build in disaster-prone locations. The lower price leads people to do more building there. Thus, by the law of demand, the unintended consequence of compensating disaster victims for property losses is that there will be a larger amount of property lost when the next disaster strikes.
To reduce the amount of risk-taking, it is increasingly common for government aid to be contingent upon the recipients rebuilding in safer spots. Even so, disaster aid lowers the expected price of risk-taking for the rest of us. We respond to this lower price by daring to live closer to our country's scenic but dangerous places.
It was either a stroke of marketing genius or just dumb luck. But what it did for demand is one for the record books. The year was 1985 when, losing market share to its arch-rival Pepsi, the Coca-Cola Company tossed aside its secret recipe and ceased making "the real thing." Instead, Coke drinkers were presented with a reformulated New Coke that tasted oh-so-syrupy sweet. It seems that taste tests found consumers favoring the sweeter taste of Pepsi over traditional Coke, but found New Coke beating all. Market research notwithstanding, New Coke was a huge flop.
"Bring back the real thing!" cried Coke customers, and back it came under the name Coca-Cola Classic. Curiously, even though the formula is the same as that of traditional Coke, Coke Classic has proven more popular. Was it the publicity? The near loss of something millions of Coke drinkers took for granted? Was it nostalgia? Whatever the reasons, the demand for Coke shifted to the right and has stayed shifted ever since. In the back of their minds, it's what Coke's owners were hoping to find.
While humans huddle by their air conditioners to escape the sweltering summer sun, life is good for some Iowa pigs and cattle—they enjoy a gourmet feast of tasty wet corn feed. On particularly hot days, farmers in the vicinity of the Cargill corn processing plant in Eddyville, Iowa, can buy this high-quality feed for a very low price. It's not that Cargill pities overheated animals. Rather, it is the availability of electricity that shifts out Cargill's supply of wet feed.
The many air conditioners that run on exceptionally hot days stress the ability of the local electric company to provide power. The ensuing power shortage leads to electricity cutbacks and leaves Cargill with huge piles of perishable wet feed, because there isn't enough electricity to dry and store it. The result is that, although power curtailment is not one of the more common things that shift supply, it's one that leaves some cows very contented.
Hurricanes, floods, and earthquakes are good for the economy, right? After all, they force people to spend more, which increases output. Isn't an increase in output a reason to rejoice?
Clearly, something is amiss with this reasoning. What is the key to understanding this faulty logic? Spending on additions to our stock of goods and services increases living standards. However, spending that follows natural disasters merely replaces goods in order to bring living standards back to some semblance of their former levels.
While it is obviously difficult to measure illegal activity, estimates place the underground economy at from 3 percent to 15 percent of total economic activity in the United States. Other countries see even higher percentages. As a general rule, the more burdensome a country's taxes and regulations, the larger its underground economy.
Most people think that the underground economy consists of prohibited goods and services, such as drugs and prostitution, along with stolen or counterfeit items. Yes, that Rolex watch being hawked on the street corner is probably fake or stolen. But there is much more. A significant portion of the underground economy consists of legal goods that are sold off the record in order to avoid taxes or regulatory requirements.
Examples of this type of underground activity include toxic wastes illegally dumped, workers illegally employed, goods sold without the collection of sales taxes, and services sold without required paperwork. Yes, the underground economy may even include that friendly handyman willing to take on the "honey-do-this, honey-do-that" odd jobs—no license inspected, no credit cards accepted, and no tax collected.
In 1998, the economies of Asia and the Far East were in turmoil. Indonesia entered a depression. Bad bank loans in Japan caused the lengthy recession there to deepen. The Russian economy teetered on the brink of disaster. In the second half of the year, the U.S. stock market reacted so negatively that investors wondered if the long-feared "bear market" was upon them. President Clinton even called the situation the most dangerous for the world economy in fifty years. Yet, in the following two years, the U.S. economy boomed and the U.S. stock market soared to record heights.
April of 2000 ushered in a different phenomenon. This time it was U.S. stocks that came crashing down from their historic highs, with one major market indicator losing over a quarter of its value in a single week and continuing a generally downward course for over two years. As panic gripped Wall Street, finance ministers from around the world met in Washington to discuss the latest turn of events. Would the tightening financial situation crush developing countries in a financial vise? Would Wall Street's troubles become the world's?
Although investors and finance ministers alike sought definitive answers to those questions, seeking knowledge in the leading indicators and other evidence, there was really only one answer that could have been known for sure. And that was: "Time will tell." For the last sixty years, time has told that economic downturns have been mere blips against the upward trend in GDP.
Demography is the study of population statistics. Demographers offer us small glimpses of the future. Because birth rates and death rates change slowly, demographers can predict with little error how many people of various ages will comprise the labor force in ten, twenty, or even thirty years. Demographers tell us to expect an aging work force. The large numbers of baby boomers born from 1946 to 1964 were followed by the much smaller number of babies born in the 1970s and 1980s.
As the baby boomers grow older, and with fewer young workers to enter the labor force, the average age of the labor force must rise. An older labor force has important consequences, good and bad, for both the unemployment rate and our lifestyles. Middle-aged workers do not change jobs as often as young workers. As a consequence they are less likely to be unemployed. And while retirees look forward to taking it easy, their rising numbers will place increasing stresses on the nation's ability to provide for us all. With this glimpse of the future in hand, the nation can plan to deal with the problem of an aging labor force and growing population of retirees.
Change is distressing. It disrupts our lives and makes us scramble to adapt to it. It causes stress in our lives, especially when it causes us to lose our jobs. Just ask the bank tellers who lost their jobs to automatic teller machines. Or the typewriter repair people who just never learned about computer keyboards. Or the many others whose skills became obsolete when technology or tastes changed against the industries or occupations in which they worked. They are the structurally unemployed.
When spending patterns change, so do the available jobs. The only way to avoid such disruption would be to freeze ourselves in time. For example, if change had been forbidden in the early 1960s, then we would still be watching the TV shows, listening to the music, and driving the cars of that era. Life would be pretty much like dwelling in a museum.
We must have an income, and so we work. If we are out of work, we offer to work for less pay, which tends to drive wages down. As wages fall, prices fall. Our incomes then buy more goods, and more people can work to produce them. The process continues until all but about 5 percent of us have jobs. That is the logic of the natural rate of unemployment.
When it comes to international trade, though, the media has no patience for logic—it wants numbers to drum up interest! How many jobs do we gain from trade? How many do we lose? Reporters eagerly seek out so-called experts who provide numerical forecasts that international trade cuts down on aggregate employment. Other experts then reply with numbers showing just the opposite.
As usual, reality lies somewhere in the middle. Imports cost jobs in import-competing industries. However, the logic of a natural rate of unemployment leaves no room for international trade to have any lasting effect on unemployment in the aggregate. Workers who lose their jobs to imports would find other jobs. That is why, when faced with low-priced imported beef, many South Texas ranches switched from raising cattle to raising wild game for hunters. More generally, that is why, even as the United States imported a then-record $271.3 billion more goods than it exported in 1999, that year's unemployment rate was lower than it had been in thirty years! Unfortunately, logic usually lacks the eye-popping magic of charts with numbers, and therein seems to lie the market.
It's all about low prices at Wal-Mart. The slogan in the title is designed to keep customers coming back by convincing them that Wal-Mart strives to give them more for their money. You've probably seen the ads that show the old higher prices and the new lower prices of specific items.
How does Wal-Mart bring down those prices, and what effect does the retail giant have on inflation? Wal-Mart is able to cut prices when it finds ways to increase the efficiency with which it operates and thereby cut its operating costs. Efficiency increases help keep inflation in check.
Goal: low inflation. Why not just say, "Goal: zero inflation." Some say a little inflation is good for the economy. The argument goes like this: Rising prices create expectations of more inflation, and prompt consumers to buy now to beat the coming price increases. Those rising prices also provide businesses with more profits that they can use to expand their production of goods and services. Thus, GDP rises and unemployment is kept low.
Based on this view, inflation is like a mild stimulant to the economy, just as caffeine is to tired, overworked people. However, we should recognize that inflation causes consumer purchasing power to fall so that consumers cannot keep up the extra spending that inflation initially causes. Furthermore, experience from the 1970s showed that a little inflation can easily become a lot of inflation. That experience showed that inflation can become less like caffeine and more like a strong narcotic. Still, today we accept a little inflation and go about our business.
The twentieth century has run its course. Looking back we can see that the century was characterized by ever-increasing prosperity for Americans. Oh, there were interruptions on the way up—the Great Depression, then World War II, and a number of relatively mild recessions. However, the overall prosperity allowed for major lifestyle changes: a shorter workweek, a house in the suburbs, and a car in every garage.
Changes in people's lifestyles mean that the things that they spend their money on change. People can only spend so much on necessities like food and clothing before they have enough to meet their needs. The relative importance of necessities in their budgets thus falls. Their weights in the CPI market basket decrease. At the same time, new goods and services are introduced to the marketplace. When these are successful, the market basket weights will change to reflect that success. Thus, the expenditure category weights in Figure 7-3 are a snapshot of spending patterns at a point in time. The weights were different in the past and will be different in the future.
"Buddy, can you spare a dime?" The mood of the Great Depression was somehow captured in that poignant refrain. There just didn't seem to be enough spending to keep everyone working. So thought Keynes when, at the height of the Depression, he came out with what became known as the Keynesian theory. In short, if people weren't spending enough, the government should bridge the gap with spending of its own. So spend on the Civilian Conservation Corps, spend on the Works Progress Administration, spend on just about anything, and help beat the Depression!
Classical economists disagree, contending that it was time and not government spending that spelled the demise of the Great Depression in the 1940s. Some might say, "Something worked so why argue about it now?" The answer is not for the sake of the past, but is for the future. Hashing out how best to keep the economy humming and out of depression is what macroeconomic theory is all about. It's about not having to ask a stranger for a dime.
If products linger on the shopkeeper's shelf, the prices eventually get lowered to clear the inventory. If you can't find a job with the skills you have, you eventually acquire new ones. If no one will pay you what you ask, you eventually lower your salary expectations. However, if the headhunters are beating at your door with salary offers that you just can't pass up, then you demand a higher salary where you are or switch jobs.
These are stories told over and over for millions of people and products all across the land. Put together, it is nothing more than the economy heading toward full-employment output at an equilibrium price level. But the stories of how to get there are told in ways that are unique to the circumstances of the individuals and firms involved. Each and every story is significant—they are the micro behind the macro of economics.
Cars, wars, oil cartels, computers, and earthquakes may not seem to have much in common, but they do. They have all shocked the economy in one way or another. How could ordinary citizens have foreseen the potential of the auto or the carnage of World War II? We did not know of the oil crisis of the 1970s before it happened, and we did not know that it would disappear in the 1980s. Nor can we know the extent to which technology will alter our lifestyles or when the next big earthquake will strike.
All of these things and more jolt the economy, either to make it more productive or to knock it back a notch. They represent real changes in aggregate supply to which businesses and individuals must adjust. Policymakers can predict these events no better than the rest of us, and so can do little to avert these disruptions to the smooth path of economic growth. When it comes to the real business cycle, then, it is best to expect the unexpected!
For four glorious years—from 1998 through 2001—the United States government experienced the luxury of a budget surplus. The national debt got a chance to decline for the first time in three decades. It was more than nice. The declining national debt instilled hope that the country could actually afford its commitments, such as to Social Security for the looming wave of retiring baby boomers. Then reality struck.
First came the stock market slide and later a mild recession, which caused the government to pay out more in unemployment insurance and other assistance. The September 11 terrorist attacks added the need for massive amounts of government spending on national security. All of this combined to create a mentality in Washington, D.C., of spend and spend some more. By the middle of 2002, the economy was expanding, but so too was government spending. With massive new commitments to agriculture, the military, and for homeland security, a return to the days of budget surpluses was no longer in sight.
"I will never go hungry again!" avowed Scarlett O'Hara in the movie Gone With the Wind. She was determined to make a better future. In the meantime, though, she was forced to work with what she had. For Scarlett, it was the red earth of her one-time plantation Tara. For the economy, it is the output and price level that actually do occur. Collectively, we must first take stock of where we are before we can make progress toward where we want to be. In other words, it takes a short run to make it through to the long run!
In 1971, in an attempt to combat inflation, President Nixon signed a price freeze into law. Shortly afterward, Canadian paper companies increased the price of wood fiber, which eroded the profits of tissue manufacturers. Johnny Carson, true to his form as host of The Tonight Show, could not pass up making light of this touchy subject.
In his opening monologue, Johnny joked about toilet paper shortages in New Jersey. Guess what? Even though it had not really been very difficult to find toilet paper in New Jersey, a shortage quickly developed. People rushed to the stores to snatch up all brands of toilet tissue. Manufacturers had no special incentive to restock, so the shelves stayed bare. Thus was the start of the Great Toilet Paper Squeeze of 1971! That was also the last we saw of price freezes in the United States.
Jingle jingle jingle! These are not the bells retailers listen for in those merry days before Christmas. They are the chimes of coins landing in the cash register drawer. How many coins? That can only be known at the end of the year. And what a Christmas present it would be to see those shelves bare!
Empty shelves following Christmas would provide a present for the economy, too. The new year would start with new orders to the warehouses and additional orders to the factories. More orders mean more jobs and more income and spending. The effect of retailers underestimating Christmas demand on the macroeconomy would be an increase in GDP toward its true equilibrium value. The only hint of a Grinch would be if the economy is already at full employment. In that case, inflation would surely dampen the exuberance of the new year.
There is a flip side to this happy story. The retailers might have overestimated Christmas shopping enthusiasm. In that case, the shelves would overflow and the after-Christmas orders would not go. The days of January would be grim as employment drops along the path to a lower expenditure equilibrium.
Are you a confident consumer? Do you plan to purchase a new house or car in the next year? Various surveys attempt to measure consumer confidence each month, with an eye to predicting how consumers are going to behave in the near future. These surveys underscore an important point: Spenders will become savers when they fear the economy is on the verge of turning down. That's because they fear that hard times might require them to dip into their savings and so they feel more comfortable building up those savings.
When consumers spend less, businesses have to throttle back production. Workers, in turn, might lose their jobs. In this cyclical pattern, a lack of consumer confidence becomes a self-fulfilling prophecy for the economy. That's probably why there always seems to be a government official or economist reassuring us that all is well with the economy. If we believe the economy is sound, we keep spending and our spending helps keep the economy sound.
The baby boomers are aging. Their retirement looms and their lifestyles are threatened. Maybe they should save their money. "A penny saved is a penny earned," Benjamin Franklin told us. However, Keynesians might not agree.
According to Keynesian analysis, when consumers plan to save a higher fraction of their incomes, the result is a flatter aggregate expenditure function and a smaller multiplier. All else equal, the result is a lower equilibrium GDP. The economy winds up saving a higher fraction of a smaller income. Our incomes might drop so much that our total savings might even be lower than before—that's the paradox of thrift. In this Keynesian model, the baby boomers should keep on spending.
Economists today are not so quick to discard Ben Franklin's advice, at least not for the long run. In the long run, the paradox of thrift does not exist. Instead, price levels adjust to take the economy to a full-employment GDP no matter what fraction of income we save. But if you worry about escaping a short-run unemployment equilibrium, frugality might be something for the economy to avoid.
That was how former U.S. Senator Russell Long of Louisiana put it. In the abstract, taxes sound great. Higher taxes can eliminate the need for government borrowing and can pay for more of the public services we value. There is only one problem. We want to keep our own money and for that reason want those taxes to be paid by people other than ourselves.
Some localities have found a way to do just that through tax exporting, which is getting nonresidents to finance government. For example, speed zones on roads through small towns allow those towns to collect revenue from unsuspecting motorists. The payments on their speeding tickets keep property taxes down, while the out-of-towner is never heard from again.
Bigger cities resort to surcharges on rental cars and lodging, since few people will change their travel plans because of such a tax. Although convention planners do pay attention, most tourists and business travelers have probably left town before they know what's hit them. Travelers might grind their teeth and mutter. The locals merely smile as their government pockets the cash.
The terms progressive and regressive are loaded—they make an implicit normative judgment about what is good and bad. After all, who could argue against progress? Would you prefer to regress? That would be moving backward, not forward. Bear in mind, though, that there is nothing magical about the terms.
The ability-to-pay principle of equity says that, to finance government, the rich should pay more than the poor. It does not specify whether the higher taxes should be less than, more than, or exactly in proportion to the higher income. For instance, it would make life simpler if we had one flat-rate income tax, with no exemptions, deductions, exclusions, and so on. Such a tax would be proportional, but would it be fair? That judgment is entirely up to you.
Go to the store and pay sales tax; go on-line and skip it! Such has been the practice throughout the forty-seven states that impose sales taxes. To some it seems fair and reasonable. They say, "Let the Internet stay tax free!" To others, requiring shippers to pay sales tax for items shipped out of state is just too complex.
New taxes are never popular. Consumers enjoy buying tax-free items over the Internet, and do not take kindly to a tax that causes these items to cost more. Nonetheless, tax revenue must come from somewhere. Broadening the tax base by taxing e-commerce would allow lower sales tax rates overall without changing the amount that government collects in total. Maybe consumers just don't think that those tax cuts would happen!
As for complexity, modern database software should be able to handle it with ease. If a significant number of companies were required to charge taxes that varied from locality to locality and from state to state, you can bet that profit-seeking software makers would be eager to help out. So don't be too surprised to see a tax on e-commerce, even though nobody likes a tax.
The odds of striking it rich as an entrepreneur may not be great—one in two hundred, they say—but the potential payoff does motivate people to try. If successful, the economy wins the products and the entrepreneurs gain a tidy profit.
Entrepreneurial success stories lie behind the companies we take for granted. Former economics major Sam Walton used the concept of one-stop shopping at everyday low prices to smash Wal-Mart's way to success, and in the process propel the Walton family to first place among America's wealthy. Bill Gates amassed his fortune by positioning Microsoft to provide the industry-standard interface for the personal computer. Talk on the phone? Craig McCaw said "take it with you," and took home $11.5 billion from his sale of McCaw Cellular Communications Corporation. Chat over coffee? Howard Shultze earned his fortune by opening Starbucks Coffee Company as a place to hang out over a steaming brew. FedEx your important papers? That was Fred Smith's idea. It was Domino's that delivered for Tom Monaghan, and Motown that recorded Berry Gordy's profit.
The common theme to the success stories of America's modern entrepreneurs is insight into what the public likes to do and how they could do it better or more conveniently. But it takes more. Without the risks inherent in trying to build companies from the ground up, there would be neither entrepreneurial success nor the economic growth that it engenders.
New ideas and information can confer significant external benefits, particularly if businesses can apply the knowledge to develop more valuable goods and services. The trouble is that the value of new ideas and information is often not known until they are produced, and then the applications could be in a variety of industries. Firms that engage in basic research might be unable to claim property rights to this growth in the knowledge base, since patent laws more effectively protect development than research. Firms that advance the knowledge base might even see competitors use that knowledge as well as, or better than, they do themselves.
So, where are advances in knowledge to come from? Often it is universities that are the sources. Government and academia both recognize the role of universities in engaging in valuable research that companies fear to undertake on their own. Government subsidies or grants often provide the funds that make it possible.
At a tax rate of zero percent, the government collects no revenue. It can increase revenues by increasing tax rates, but there are limits. After all, a tax rate of 100 percent would also generate no tax revenue—no one would bother to earn money if Uncle Sam took it all. Arthur Laffer, a young UCLA economist, discussed this at lunch one day in the 1970s. He sketched the hump-shaped relationship between tax rates and tax revenues on the back of his napkin. Ever since, as shown in Figure 12-7, that sketch has been called the Laffer curve.
That plastic card that you swipe through the reader at your local Home Depot could be a traditional credit card, like those used for more than fifty years, but it is increasingly likely to be a more recent invention, the debit card. What is the difference? The debit card immediately transfers the amount of your purchase out of your checking account and into the store's deposit account. In effect, it saves you the trouble of writing a check, and eliminates the possibility of bouncing a check. You can't use a debit card to make a purchase unless you have the amount of your purchase in your account.
In contrast, a credit card provides you with a loan in the amount of the purchase. When you receive your monthly statement you must repay at least part of the loan. The debit card came much later than the credit card because debit cards would not be practical without high-speed computer networks. Debit cards make it easier for consumers to spend their checking account money. Like credit cards, debit cards are not money. Even if every bank depositor were issued a debit card tomorrow, the amount of money that exists would not change. It would just be easier to spend.
U.S. residents take it for granted that the same dollar bills are just as spendable in New York as New Orleans. Europeans, on the other hand, have historically had to contend with changes in currency and coins even for short trips that cross borders between countries. That has recently changed.
January 1, 1999 marked an historic moment in monetary history. The three-year transition to a new monetary unit began in eleven of the countries making up the European Monetary Union. The German mark, the French franc, the Italian lire, and the other familiar currencies issued by many European countries began to disappear in 2002, replaced by the euro. More countries may also make the jump to the euro as time passes. The Monetary Union also requires a new European Central Bank to conduct monetary policy, which was once the job of central banks in individual countries.
Why would countries risk confusion by dropping their familiar currencies, not to mention the loss of control over their own money? These changes are all part of a long-term effort to integrate the economies of Europe to make them more competitive with the United States and Japan in the global marketplace. A common currency will also ease the burdens on harried travelers who would rather worry about the price of lodging in the night's ski chalet than about having the right currency to pay that price!
"Redlining!" Some banks have been accused of this illegal practice, which makes it tough to get a loan if you’re in a low- and moderate-income neighborhood. Redlining violates the 1977 Community Reinvestment Act (CRA), which requires banks to service their entire community. The law does not require them to abandon sound banking principles, and banks defend themselves by noting that the profit motive prompts them to reject risky loans no matter the neighborhood.
The Federal Reserve assesses bank compliance with the CRA. It's found that of over 5,800 banks examined since 1990, just 38 have been in "substantial noncompliance" with the law, with another 208 rated as "needs to improve." Bank examinations, such as those called for by the CRA, provide a transparency to bank decision making that can help us know the extent of redlining and other potential problems in the banking system.
With checking accounts and an abundance of credit and debit cards, why carry cash? In certain backwaters of the marketplace, cash still reigns as king. From illegal drug deals, to neighborhood garage sales and campus vending machines, cash is in the catbird seat. For lawbreakers, the opportunity cost of holding cash seems a small price to pay to avoid the paper trail left by checks and bank deposit slips. For the general public, cash is sometimes the most convenient way to buy things. The bottom line? Demand for cash is reduced by financial innovations such as 24-hour ATM machines and sweep accounts that automatically transfer funds from a person's savings account to his or her checking account. Even so, cash is not yet an endangered species.
The Fed must keep in mind the equation of exchange when conducting its monetary policy. Otherwise, the temptation might be for the Fed to merely buy back as much government debt as possible. The open market purchases of Treasury bonds and Treasury bills that this would require might seem like a painless way to reduce or even eliminate government debt. But painless it is not, as newly printed money used to buy those Treasury securities would cause inflation that eats away at the value of all of our savings. The effect is much like a tax, and indeed is often referred to as the tax of inflation.
Because the Fed is so powerful, its actions directly affect people's lives. The stock market, mortgage interest rates, returns on investments in bonds—all these and more are subject to the Fed's influence. The consequence is that Fed watching is something of a national sport. Economists, stock market analysts, and policymakers follow the money supply figures closely. The general public is more likely to have a greater interest in how Fed actions affect interest rates. The monthly payment on that new house or car depends not only on how good a deal the consumer is able to find, but also on monetary policy! Hints as to the future direction of monetary policy can be found when the chair of the Fed testifies before Congress each February and July. In between, the Fed issues press releases that explain monetary policy goals.
The trade deficit is huge, at over 4 percent of U.S. GDP. In 1992, presidential candidate Ross Perot even claimed to hear "a giant sucking sound" of jobs being pulled to low-wage countries. For centuries, people have needlessly worried about the jobs that are lost, as though there are only a limited number to go around. Some still do worry, but both long-standing economic theory and the last two decades worth of hard factual evidence from the United States tell us to leave those worries behind.
Cashiers ring up Big Mac sales all around the world in all sorts of different currencies. When the Big Mac price is converted to a common denominator of dollars, as seen in Table 15-2, its price varies wildly from place to place. For example, it is less than a dollar in South Africa to more than four dollars in Switzerland. How can this be? There are world prices of oil, grain, ball bearings, and all sorts of other things. Is there no world price of a Big Mac?
Interest rates among countries often vary quite dramatically. Yet, it's not a good idea to merely invest your money in countries with the highest interest rates. The value of those high interest rates can be eaten up by the cost of a depreciating currency. Indeed, the highest interest rates are in countries with the highest inflation rates, meaning that the country's currency loses its purchasing power over time. That loss of purchasing power is not just for goods and services, either. It applies equally strongly in the foreign exchange markets.
When you go to convert that foreign currency back to your own, reality hits! You'd find that the lavish interest gains you'd made are eaten away by the higher price you must pay for your own currency. That reality is called interest rate parity, meaning that expected returns on investments will be equal across countries, after accounting for expected inflation, risk, and exchange rate adjustments. The foreign exchange markets make it so.
Have you bought a pickup truck imported into the United States from Europe recently? It's not likely, in part because of a decades-old 25-percent tariff that the United States imposed in response to a threatened trade war long since forgotten. The pickup tariff was merely a shot across the bow, so to speak, because Europeans had never had a pickup-truck presence in the United States. The tariff was enacted by the United States as part of strategic maneuvering—a trade game—in which both the United States and Europe were each seeking to both restrict and free up trade in ways that would be of most benefit to their own political constituencies.
Americans need not be told which state is responsible for producing the goods they buy. By law, however, they do have a right to know the country of origin for imports. This information must be labeled on each imported item. The law applies to all products, including bricks from Mexico. No big deal, perhaps, except when you realize that brick kilns in Mexico are rarely high-tech. The cost of imprinting Mexico into each brick bound for El Norté is a significant fraction of the entire cost of producing that brick. If that labeling requirement forms a nontariff barrier that reduces Mexican brick exports, U.S. brickmakers don't complain!
Is limiting free trade just another protectionist barrier, or are the Europeans more aware of the dangers than are Americans? Perhaps the topic would be the sale of beef from livestock fed growth hormones, a practice allowed in the United States but banned in Europe as previously discussed. Perhaps the topic is antitrust. The U.S. Justice Department gave the green light to a merger between General Electric Corporation and Honeywell Corporation, two titans of industrial might. The Europeans put the kibosh on the merger, though, by ruling that the combination was too mighty and could not be allowed to do business in Europe. Maybe good arguments. The result was trade that was less free.
In this international marketplace with so many countries with so many ideas as to what is okay to do and what is not, it is a wonder that free trade can survive at all. Yet it does, to the tune of over $1 trillion in imports and exports done every month by the countries of the world. The protectionists might win a battle here and there, as well they should. But the gains in living standards brought about by free trade are what give us all victory.
Once crops are harvested, they must be transported to the cities before they spoil. Likewise, once goods are produced, they must be brought to buyers. It takes a highway to move the goods. Once the highway is built, other infrastructure is needed—gasoline stations, secondary roads, eating places, repair shops, rest areas, and government inspection stations to weigh and examine cargoes.
Even when all these have been built, the trucks may sit silently as nightfall comes. Trucks carry valuable cargo, which attracts hijackers who prefer the darkness as cover for their lawbreaking. For this reason you might find inspection stations in Africa crowded with trucks. The drivers must stop for inspection, but face long delays. Afterwards, they park overnight rather than venture into bandit-infested territory. Transportation first takes a highway, but then more. In this case, countries in a hurry to raise their living standards have been slowed down because of dangers that lurk in the night.
While people in the developed world may take clean, safe drinking water for granted, over a billion people around the world do not enjoy that resource. In Cochabamba, Bolivia's third-largest city, chronic water problems came to a head in 1999. The government chose to privatize the city's water system, selling it to Bechtel, an American-owned firm. The firm held out the hope that infrastructure investments, in the form of dams, pipelines, and purification facilities, would bring ample supplies of clean water to the populace.
Before investments could be made, the new owner said water rates had to rise. Considering that many Bolivians live on the country's $60-a-month minimum wage, the $20 and $30 monthly water bills that residents of Cochabamba began to receive generated outrage. Civil unrest in early 2000 put water back into the hands of the government. Since then, nothing has been done to solve the water problems, and many residents have water only a few hours a week, if at all. Meanwhile, the loss of property put a chill on foreign investment in Bolivia, leaving no winners from this Bolivian water war.
To see why World Bank policies now emphasize markets, consider the outcome of government planning in Nigeria in the 1970s. To bring the nation up to modern standards required roads, bridges, airports, and other infrastructure. This modernization called for massive quantities of cement, much more than the nation could produce domestically. Thus, Nigeria's government planners ordered the needed cement, which was shipped in the holds of freighters from cement-producing nations around the world.
Oops! One slight oversight threw these best-laid plans into disarray. The Nigerian docks were incapable of handling such quantities of cement. In fact, at one point it would have taken nearly thirty years to unload the cement that lay in the holds of ships anchored offshore. As time passed, the cement commenced to solidify within the ships, thereby providing a concrete example of the dangers inherent in centrally planned development.