U.S. Economy

institutions pay interest to people who deposit funds with the

institution, and borrowers pay interest on their loans. Like any other

price in a market economy, supply and demand determine the interest rate.

The demand for money depends on how much money people and organizations

want to have to meet their everyday expenses, how much they want to save

to protect themselves against times when their income may fall or their

expenses may rise, and how much they want to borrow to invest. The supply

of money is largely controlled by a nation’s central bank—which in the

United States is the Federal Reserve System. The Federal Reserve

increases or decreases the money supply to try to keep the right amount

of money in the economy. Too much money leads to inflation. Too little

results in high interest rates that make it more expensive to invest and

may lead to a slowdown in the national economy, with rising levels of

unemployment.

Providing Funds for Investments in Capital

To take advantage of specialization and economies of scale, firms must

build large production facilities that can cost hundreds of millions of

dollars. The firms that build these plants raise some funds with new

issues of stock, as described above. But firms also borrow huge sums of

money every year to undertake these capital investments. When they do

that, they compete with government agencies that are borrowing money to

finance construction projects and other public spending programs, and

with households that are borrowing money to finance the purchase of

housing, automobiles, and other goods and services.

Savings play an important role in the lending process. For any of this

borrowing to take place, banks and other lenders must have funds to lend

out. They obtain these funds from people or organizations that are

willing to deposit money in accounts at the bank, including savings

accounts. If everyone spent all of the income they earned each year,

there would be no funds available for banks to lend out.

Among the three major sectors of the U.S. economy—households, businesses,

and government—only households are net savers. In other words, households

save more money than they borrow. Conversely, businesses and government

are net borrowers. A few businesses may save more than they invest in

business ventures. However, overall, businesses in the United States,

like businesses in virtually all countries, invest far more than they

save. Many companies borrow funds to finance their investments. And while

some local and state governments occasionally run budget surpluses,

overall the government sector is also a large net borrower in the U.S.

economy. The government borrows money by issuing various forms of bonds.

Like corporate bonds, government bonds are contractual obligations to

repay what is borrowed, plus some specified rate of interest, at a

specified time.

Matching Borrowers and Lenders in Financial Markets

Households save money for several reasons: to provide a cushion against

bad times, as when wage earners or others in the household become sick,

injured, or disabled; to pay for large expenditures such as houses, cars,

and vacations; to set aside money for retirement; or to invest. Banks and

other financial institutions compete for households’ savings deposits by

paying interest to the savers. Then banks lend those funds out to

borrowers at a higher rate of interest than they pay to savers. The

difference between the interest rates charged to borrowers and paid to

savers is the main way that banks earn profits.

Of course banks must also be careful to lend the money to people and

firms that are creditworthy—meaning they will be able to repay the loans.

The creditworthiness of the borrower is one reason why some kinds of

loans have higher rates of interest than others do. Short-term loans made

to people or businesses with a long history of stable income and

employment, and who have assets that can be pledged as collateral that

will become the bank’s property if a loan is not repaid, will receive the

lowest interest rates. For example, well-established firms such as AT&T

often pay what is called the bank’s prime rate—the lowest available rate

for business loans—when they borrow money. New, start-up companies pay

higher rates because there is a greater risk they will default on the

loan or even go out of business.

Other kinds of loans also have greater risks of default, so banks and

other lenders charge different rates of interest. Mortgage loans are

backed by the collateral of the property the loan was used to purchase.

If someone does not pay his or her mortgage, the bank has the right to

sell the property that was pledged as collateral and to collect the

proceeds as payment for what it is owed. That means the bank’s risks are

lower, so interest rates on these loans are typically lower, too. The

money that is loaned to people who do not pay off the balances on their

credit cards every month represents a greater risk to banks, because no

collateral is provided. Because the bank does not hold any title to the

consumer’s property for these loans, it charges a higher interest rate

than it charges on mortgages. The higher rate allows the bank to collect

enough money overall so that it can cover its losses when some of these

riskier loans are not repaid.

If a bank makes too many loans that are not repaid, it will go out of

business. The effects of bank failures on depositors and the overall

economy can be very severe, especially if many banks fail at the same

time and the deposits are not insured. In the United States, the most

famous example of this kind of financial disaster occurred during the

Great Depression of the 1930s, when a large number of banks failed. Many

other businesses also closed and many people lost both their jobs and

savings.

Bank failures are fairly rare events in the U.S. economy. Banks do not

want to lose money or go out of business, and they try to avoid making

loans to individuals and businesses who will be unable to repay them. In

addition, a number of safeguards protect U.S. financial institutions and

their customers against failures. The Federal Deposit Insurance

Corporation (FDIC) insures most bank and savings and loan deposits up to

$100,000. Government examiners conduct regular inspections of banks and

other financial institutions to try to ensure that these firms are

operating safely and responsibly.

U.S. Household Savings Rate

A broader issue for the U.S. economy at the end of the 20th century is

the low household savings rate in this country, compared to that of many

other industrialized nations. People who live in the United States save

less of their annual income than people who live in many other

industrialized market economies, including Japan, Germany, and Italy.

There is considerable debate about why the U.S. savings rate is low, and

several factors are often discussed. U.S. citizens may simply choose to

enjoy more of their income in the form of current consumption than people

in nations where living standards have historically been lower. But other

considerations may also be important. There are significant differences

among nations in how savings, dividends, investment income, housing

expenditures, and retirement programs are taxed and financed. These

differences may lead to different decisions about saving.

For example, many other nations do not tax interest on savings accounts

as much as they do other forms of income, and some countries do not tax

at least part of the income people earn on savings accounts at all. In

the United States, such favorable tax treatment does not apply to regular

savings accounts. The government does offer more limited advantages on

special retirement accounts, but such accounts have many restrictions on

how much people can deposit or withdraw before retirement without facing

tax penalties.

In addition, U.S. consumers can deduct from their taxes the interest they

pay on mortgages for the homes they live in. That encourages people to

spend more on housing than they otherwise would. As a result, some funds

that would otherwise be saved are, instead, put into housing.

Another factor that has a direct effect on the U.S. savings rate is the

Social Security system, the government program that provides some

retirement income to most older people. The money that workers pay into

the Social Security system does not go into individual savings accounts

for those workers. Instead, it is used to make Social Security payments

to current retirees. No savings are created under this system unless it

happens that the total amount being paid into the system is greater than

the current payments to retirees. Even when that has happened in the

past, the federal government often used the surplus to pay for some of

its other expenditures. Individuals are also likely to save less for

their own retirement because they expect to receive Social Security

benefits when they retire.

The low U.S. savings rate has two significant consequences. First, with

fewer dollars available as savings to banks and other financial

institutions, interest rates are higher for both savers and borrowers

than they would otherwise be. That makes it more costly to finance

investment in factories, equipment, and other goods, which slows growth

in national output and income levels. Second, the higher U.S. interest

rates attract funds from savers and investors in other nations. As we

will see below, such foreign investments can have several effects on the

U.S. economy.

Borrowing from Foreign Savers

The flow of funds from other nations enables U.S. firms to finance more

investments in capital goods, but it also creates concerns. For example,

in order for foreigners to invest in U.S. savings accounts and U.S.

government or corporate bonds, they must have dollars. As they demand

dollars for these investments, the price of the dollar in terms of other

nations’ currencies rises. When the price of the dollar is rising, people

in other countries who want to buy U.S. exports will have to pay more for

them. That means they will buy fewer goods and services produced in the

United States, which will hurt U.S. export industries. This happened in

the early 1980s, when U.S. companies such as Caterpillar, which makes

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

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

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

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

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

imports.

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

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

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

borrowed from foreign individuals and companies is put into capital

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

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

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

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

foreign funds for additional investments in capital goods, today these

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

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

will not increase output and living standards.

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

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

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

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

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

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

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

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

MONEY AND FINANCIAL MARKETS

A Money and the Value of Money

Money is anything generally accepted as final payment for goods and

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

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

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

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

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

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

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

or coins.

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

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

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

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

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

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

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

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

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

checking account balances. Sometimes, economists also count money in

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

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

accounts.

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

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

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

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

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

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

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

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

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

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

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

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

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

called fractional reserve banking, because after making loans the bank

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

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

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

destroyed when loans are paid off.

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

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

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

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

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

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

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

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

Eventually governments around the world also found it expensive to hold

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

governments found it especially difficult to transfer gold and silver to

other countries that decided to redeem paper money acquired through

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

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

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

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

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

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

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

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

and services a dollar can purchase. That purchasing power depends

primarily on the relationship between the number of dollars people are

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

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

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

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

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

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

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

dollar can buy.

The Federal Reserve System and Monetary Policy

Governments often attempt to reduce inflation by controlling the supply

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

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

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

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

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

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

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

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

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

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

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

observe its regulations.

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

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

loans to individuals or businesses. Instead, the Federal Reserve

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

government. In that role the Federal Reserve System performs several

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

Federal Reserve distribute paper currency in their regions. Dollar bills

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

denomination and see the number for the regional Federal Reserve Bank

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

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

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

commercial banks convert some of their reserve balances at the Federal

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

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

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

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