for - cengage economics, 15th edition, is ... contrasts the classical theory of macroeconomic...

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Pre face

Basic Economics, 15th edition, is designed for a one-term survey coursein economics and is intended primarily for those students in liberal arts,business, and professional programs who will take only one course in

economics. The text has also been used successfully for teaching economics inmanagement development and teacher education programs.

APPROACH OF THIS TEXTThroughout the many editions of Basic Economics, the author has responded tothe numerous suggestions made by professors, students, and reviewers of the text.Most authors have a tendency to expand the amount of information contained ineach chapter or add entirely new chapters with each successive edition. But thisapproach can result in a proliferation of both text and chapters that cannot beadequately covered in the limited time frame of one semester.

Fortunately, reviewers continue to provide direction by indicating the appro-priate size of a one-semester book and by identifying material that needs to beexpanded, shortened, or even eliminated. Based on their feedback, the numberof chapters in Basic Economics has remained the same over nearly two decades,despite new content and the continued reorganization of material. This editionis no exception—it contains the same number of chapters as before, but somechapters from the previous edition have been deleted and new ones have beenadded. Each chapter has been reviewed carefully and updated with informationcurrently available at the time of publication. Throughout the text, careful atten-tion has been paid to making the subject matter as readable as possible for anintroductory class, and key concepts and terms are sharply defined to enhancetheir understanding. Learning objectives are included to fit the content andshould be valuable in focusing student attention on important areas of emphasis.Figures, tables, and statistics have been updated and vocabulary simplified to aminimal use of economic jargon. International coverage has been updatedthroughout the text in the form of examples and insights where relevant.

Summaries of each chapter are included, as in the past. This edition alsoincludes references to Web sites that can assist students seeking more in-depthinformation on specific issues. An Economic Applications section is included atthe end of the chapter. This section directs students to current economic news,debates, and data that can provide greater insights into the subject matter.

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ORGANIZATIONThe first part of the book presents students with a focused introduction to thesubject matter of economics. Chapters 1 and 2 include important economic con-cepts and definitions to give the student a clearer understanding of the nature andscope of economics. The problem of scarcity and why scarcity forces individualsand societies to make choices is presented in Chapter 2. The production possibil-ities curve, specialization and exchange, and comparative advantage are presentedin support of the scarcity concept. Chapter 3, “The U.S. Economic System,”gives an overview of the workings of the U.S. economy and the roles of govern-ment, business, and the consumer. Chapters 4 through 9 provide an introductionto microeconomic principles. After basic economic concepts such as demand, sup-ply, elasticity, cost, production, and profit are developed, the student is presentedwith the opportunity to apply these tools under conditions of both perfect andimperfect competition. The relationship between production and cost is devel-oped in Chapter 5, “Production, Cost, and Profit.” “Perfect Competition” ispresented in Chapter 6 as the theoretical standard for competition. Chapter 7previously encompassed the workings of monopolistic competition, monopoly,and oligopoly in a single chapter, but because of the growth and interest inmicroeconomics, Chapter 7 is now titled “Monopoly” and focuses exclusively onthis market structure. The market structures of “monopolistic competition andoligopoly” have been expanded and are now the subject of Chapter 8.

Chapter 9, “The Labor Market, Employment, and Unemployment,” is a newchapter that presents labor theory in competitive and noncompetitive marketsalong with economic applications using economic tools. The second half of thechapter is more institutional and focuses on employment issues and the laborforce. Chapter 10, “Income Distribution,” describes the distribution of incomein the United States, presents the Lorenz curve and Gini coefficient as measuresof income inequality, analyzes the causes of income inequality, and examines theextent and nature of poverty and welfare. Chapter 11, “The Circular Flow Modeland National Income Accounts” presents a linkage between the circular flow ofeconomic activity, previously presented as a separate chapter, and measuresof overall economic activity. National income accounting methods using Bureauof Economic Analysis statistics are presented in detail.

Chapter 12, “Business Cycles,” remains essentially the same as in the previousedition, with the addition of information on the completion of the recent busi-ness cycle. Chapter 13, “Macroeconomic Models and Analysis,” compares andcontrasts the classical theory of macroeconomic analysis with Keynesian econom-ics and develops the modern model of aggregate demand and aggregate supply.The chapter concludes with a comparison of the Monetarist and New ClassicalSchools of thought, in addition to supply-side theory. Chapter 14, “Money in theU.S. Economy,” and Chapter 15, “The Federal Reserve and the Money Supply,”have been updated and expanded. The Federal Reserve’s 2008 role in addressing

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the banking crisis associated with the market collapse of the housing sector is newand the subsequent financial crisis are new, as are the recent changes in monetarypolicy. Chapter 16, “Macroeconomic Policies,” explains how monetary and fiscaltools can be used to change the equilibrium level of output in the economy, andhistorical sections provide students with an evolutionary framework of variouspublic policy approaches. Macroeconomic policies available during wartime arealso included. Chapter 17, “Taxation, Budgetary Policy, and the NationalDebt,” covers major theories of taxation, the use of the federal budget as a coun-tercyclical device, and problems resulting from the national debt.

As in previous editions, international trade and finance chapters comprise thefinal section of the book. Chapter 18, “International Trade and Aid,” includesupdated material on U.S. trade, the World Trade Organization, the North Amer-ican Free Trade Agreement, and the continued growth of the European Union.Chapter 19, “The Balance of International Payments,” explains the balance ofpayments account, exchange rate determination, the workings of the InternationalMonetary Fund, and the changing global environment.

In the opinion of the author, these chapters give students the best overview ofthe workings of the economy, both from microeconomic and macroeconomic per-spectives. This is a survey book and not intended to be a full-year treatment ofeconomic principles. It is written for the one-semester audience, and it is not ashortened version of a full-year textbook. Basic Economics is clearly not a contem-porary economic issues book nor a personal finance book, but rather one that issteeped in economic principles supported by numerous current examples. It ishoped that students using this book will find that economics is not a “dismalscience” after all.

PEDAGOGICAL FEATURESThe 15th edition of Basic Economics has been thoroughly revised to improve read-ability and student understanding. Numerous pedagogical features are included forthis purpose.

� Each chapter begins with learning objectives that identify important topicscovered within the chapter.

� Key terms are in color to indicate their importance.� Key terms and their definitions appear in the margins as well as in the

glossary at the end of the book.� Graphs have been simplified to improve clarity.� Each chapter includes a reference to at least one Web site that contains

additional information on specific chapter topics.� Chapters conclude with a summary, a list of new terms and concepts, and

review questions suitable for a classroom discussion.� A guide to Economic Applications is found at each chapter’s end.

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SUPPLEMENTSInfoAppsAn InfoApps access card is packaged with each new copy of Basic Economics, 15thedition. This card provides a code for students to access Economic Applicationsand InfoTrac, two useful research and study tools for the economics course.

Economic ApplicationsEconomic Applications includes South-Western’s dynamic Web features: Econ-News, EconDebate, and EconData Online. Organized by pertinent economictopics and searchable by topic or feature, these features are easy to integrate intothe classroom. EconNews, EconDebate, and EconData all deepen students’understanding of theoretical concepts through hands-on exploration and analysisfor the latest economic news stories, policy debates, and data. These features areupdated on a regular basis.

InfoTracWith InfoTrac College Edition, students can receive anytime, anywhere onlineaccess to a database of full-text articles from thousands of popular and scholarlyperiodicals, such as Newsweek, Fortune, and Nation’s Business, among others. Info-Trac is a great way to expose students to online research techniques, with thesecurity that the content is academically based and reliable.

Text Web SiteThe text Web site at www.cengage.com/economics/mastrianna provides teachingresources, learning resources, Internet application links, and many more features.Online quizzes feature multiple-choice and true-false questions and answers withexplanations so that students can learn quickly whether or not their answers arecorrect.

Instructor’s Manual and Test Bank (0-324-59946-6)The Instructor’s Manual and Test Bank contains the purpose, learning objectives,new terms and definitions, a chapter outline and lecture notes, answers to theend-of-chapter discussion questions, and suggested readings for each text chapter.It includes transparency masters of figures from the text and a test bank of morethan 1,800 true-false, multiple-choice, and discussion questions arranged by textchapter. The Instructor’s Manual and Test Bank is available to instructors with apassword on the text’s Web site.

Testing SoftwareA computerized version of the test bank, ExamView®, is available to adopters ofBasic Economics. This program is an easy-to-use test creation software compatible

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with Microsoft Windows. Instructors can add or edit questions, instructions, andanswers, and select questions by previewing them on the screen, choosing themrandomly, or choosing them by number. Instructors can also create and adminis-ter quizzes online, whether over the Internet, a local network (LAN), or a widearea network (WAN).

Powerpoint Presentation SlidesPowerPoint® slides are available on the text Web site and may be downloaded foruse by instructors as a lecture aid.

Instructor’s Resource CD-ROM (0-324-59947-1)Get quick access to the Instructor’s Manual and Test Bank, ExamView, andPowerPoint slides from your desktop via one CD-ROM.

AcknowledgmentsA revision of any textbook requires the combined efforts of many individuals, andthe 15th edition of Basic Economics is no exception. I am grateful to all those whohave given their time and talent to the development of this book, not only forthis edition but for those preceding it.

Numerous comments were received from professors and students who usedearlier editions of Basic Economics. I thank not only those who assisted with thefirst fourteen editions but also those who offered suggestions for improvement ofthe 15th:

Tim Bettner University of La VerneCindy Burns Fayetteville Technical Community CollegeGreg Delemeester Marietta CollegeOsama Elbaz Chaffey College, Rio Hondo CollegeTrudy F. Dunson Gwinnett Technical CollegePaul Hettler California University of PennsylvaniaJudy K. Kamm Lindenwood UniversityCynthia Parker Chaffey CollegeLinda Wilson The University of Texas at Arlington

I would like to thank two people in particular for their invaluable assistance withthis edition. The developmental editor, Leslie Kauffman, has been all that an authorcould hope for. In addition to meticulously reviewing the manuscript, Leslie moni-tored and tracked numerous timelines to meet writing and production schedules, notonly for me but for many others whose responsibilities included this book. Leslie wasthorough, efficient, and, as always, communicated promptly and informativelythroughout the process. Recognition of appreciation is also owed to Barbara Porterfor her work on this edition and her many other contributions to previous editions.

Frank V. Mastrianna, PhD

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About the Author

Frank V. Mastrianna is a retired dean of Business, Information, and SocialSciences at Slippery Rock University of Pennsylvania. Prior to assuming theseresponsibilities, he was professor of economics and dean of the College of Busi-ness Administration at Xavier University in Cincinnati, Ohio. During his tenureas professor of economics, he taught a variety of economics courses in bothundergraduate and graduate programs. Although his research and teaching special-izations center on microeconomic theory and industrial organization, he considershimself a generalist in the field. As such, he became most interested in teachingand writing for introductory students, and was selected by university colleaguesas Faculty Member of the Year. He has written several college-level books andhas also written articles for economic journals and periodicals. In addition, hehas delivered presentations at numerous academic organizations in the UnitedStates and abroad.

Dr. Mastrianna has been a visiting professor at a number of universities and afeatured speaker for many government, business, professional, and civic groups.He is founder of a forensic economics consulting business and has given experteconomic opinion in numerous court proceedings in five states. He presentlyserves on the Board of Directors of the UNIFY Holding Company located inLincoln, Nebraska. He is vice-chair of the company’s Audit Committee and amember of the company’s Investment/Finance Committee and the IntercompanyTransactions Committee. Dr. Mastrianna is also a member of the Board of Direc-tors of the Union Central Life Insurance Company in Cincinnati.

Dr. Mastrianna received his undergraduate degree in economics from XavierUniversity and his MA and PhD in economics from the University of Cincinnati.He currently resides in Naples, Florida.

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Brie f Content s

CHAPTER 1 The Nature and Scope of Economics 1

CHAPTER 2 Scarcity and Choice 15

CHAPTER 3 The U.S. Economic System 31

CHAPTER 4 Price: The Role of Demand and Supply 53

CHAPTER 5 Production, Cost, and Profit 80

CHAPTER 6 Perfect Competition 99

CHAPTER 7 Monopoly 113

CHAPTER 8 Monopolistic Competition and Oligopoly 132

CHAPTER 9 The Labor Market, Employment, and Unemployment 155

CHAPTER 10 Income Distribution 183

CHAPTER 11 The Circular-Flow Model and National Income Accounts 202

CHAPTER 12 Business Cycles 223

CHAPTER 13 Macroeconomic Models and Analysis 243

CHAPTER 14 Money in the U.S. Economy 268

CHAPTER 15 The Federal Reserve and the Money Supply 291

CHAPTER 16 Macroeconomic Policies 317

CHAPTER 17 Taxation, Budgetary Policy, and the National Debt 348

CHAPTER 18 International Trade and Aid 376

CHAPTER 19 The Balance of International Payments 407

Glossary 433

Index 445

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Contents

CHAPTER 1 The Nature and Scope of Economics 1

Economics Defined 2Microeconomics and Macroeconomics 11Economics Is a Science of Choices 11Summary 12New Terms and Concepts 13Discussion Questions 13

CHAPTER 2 Scarcity and Choice 15

Scarcity and Choice 16Nations Must Make Choices 17Production Possibilities Curve 18Scarcity and Choice in the United States 22Problems of Scarcity 23Specialization and Exchange 25Absolute and Comparative Advantage 26Summary 29New Terms and Concepts 30Discussion Questions 30

CHAPTER 3 The U.S. Economic System 31

Market Economy 33Business Organization in the U.S. Economy 37Competition in the U.S. Economy 39The Changing Role of Government in the U.S. Economy 41Goals for the U.S. Economy 47Other Economic Systems 50Summary 51New Terms and Concepts 52Discussion Questions 52


The Market Mechanism 54Demand 54Supply 59How Demand and Supply Determine Price 61

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Price Ceilings and Price Floors 65Price Elasticity of Demand 68Summary 77New Terms and Concepts 78Discussion Questions 79

CHAPTER 5 Production, Cost, and Profit 80

The Production Function 81Costs of Production 84Revenue and Profit 91Economic Profit 95Summary 96New Terms and Concepts 97Discussion Questions 97

CHAPTER 6 Perfect Competition 99

Characteristics of Perfect Competition 100Price and Profit in the Short Run 101Price and Profit in the Long Run 106The Social Impact of Perfect Competition 110Summary 111New Terms and Concepts 112Discussion Questions 112

CHAPTER 7 Monopoly 113

Monopoly 114Monopoly Price 117Price Discrimination 122Summary 130New Terms and Concepts 131Discussion Questions 131

CHAPTER 8 Monopolistic Competition and Oligopoly 132

Monopolistic Competition 133Oligopoly 136Perfectly Competitive versus Monopolistic Pricing 145Competition among Consumers 146Market Structure in the United States 147How Much Market Power Is Tolerable? 148Antitrust Laws 148Summary 153New Terms and Concepts 154Discussion Questions 154

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CHAPTER 9 The Labor Market, Employment, and Unemployment 155

The Supply and Demand for Labor 156Minimum Wage and Employment 166The Labor Force 168Types of Unemployment 173How Unemployment Is Measured 175Employment Issues 176Unemployment Rates in the United States and Elsewhere 179Summary 181New Terms and Concepts 182Discussion Questions 182

CHAPTER 10 Income Distribution 183

Individual, Family, and Household Income 184Poverty 195Welfare-to-Work 197Summary 200New Terms and Concepts 200Discussion Questions 200

CHAPTER 11 The Circular-Flow Model and NationalIncome Accounts 202

Circular Flow of Income 203GDP in the U.S. Economy 210GDP as a Measure of Economic Welfare 214International Comparisons of Gross Domestic Product 219National Wealth 220Summary 220New Terms and Concepts 221Discussion Questions 222

CHAPTER 12 Business Cycles 223

The Business Cycle 224Factors That Modify the Business Cycle 232Business Cycle Indicators 233Causes of the Business Cycle 233Summary 240New Terms and Concepts 241Discussion Questions 241

CHAPTER 13 Macroeconomic Models and Analysis 243

Aggregate Demand and Aggregate Supply 244Classical Analysis 246

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Keynesian Analysis 247Aggregate Supply and Aggregate Demand Again 260Monetarists and New Classicals 262Summary 266New Terms and Concepts 266Discussion Questions 267

CHAPTER 14 Money in the U.S. Economy 268

Nature of Money 269Functions and Measurement of Money 270The Supply of Money and Total Income 273Creation of Money 275Summary 288New Terms and Concepts 289Discussion Questions 290


Structure of the Federal Reserve System 292Federal Reserve Control of the Money Supply 297Recent Federal Reserve Actions 306Critics of the Federal Reserve 309Issues and Concerns in Banking 309Summary 315New Terms and Concepts 316Discussion Questions 316

CHAPTER 16 Macroeconomic Policies 317

Expansionary Policies 318Expanding the Economy 325Recession and Deflation 329Contractionary Policies 330Measures to Reduce Total Spending 333Wartime Inflation 336The Trade-Off Between Unemployment and Inflation 338Contracting the Economy 343Summary 345New Terms and Concepts 346Discussion Questions 346

CHAPTER 17 Taxation, Budgetary Policy, and the National Debt 348

Taxation 349The Tax-Rate Structure 351The Tax Burden 353

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Federal Taxes 354Purposes of Taxation 358Budgetary Policy 358Problems of the National Debt 362Recent Budget Surpluses and Deficits 369Summary 373New Terms and Concepts 374Discussion Questions 374

CHAPTER 18 International Trade and Aid 376

An Overview of International Trade 377Barriers to Free Trade 380U.S. Trade Policy 390Multinational Trade Negotiations 393World Trade Organization 393North American Economic Integration 395European Economic Integration 399Summary 404New Terms and Concepts 405Discussion Questions 405

CHAPTER 19 The Balance of International Payments 407

Balance of Trade 408Balance of Payments 410Foreign Exchange Rates 416Fixed Exchange Rates 418Floating Exchange Rates 422International Monetary Fund 424The World Bank 425U.S. Balance of Payments—An Overview 426Summary 430New Terms and Concepts 431Discussion Questions 431

Glossary 433

Index 445

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C h a p t e r 4

PRICE: THE ROLE OF DEMANDAND SUPPLY

After studying Chapter 4, you should be able to:

1. Define demand and distinguish between a changein demand and a change in the quantitydemanded.

2. Define supply and understand why a supply curveslopes upward to the right.

3. Explain what happens when price is above orbelow the market price set by demand and supply.

4. Demonstrate what happens to price and quantitysold in response to changes in demand and supply.

5. Determine the possible results of price ceilingsand price floors.

6. Explain the importance of elasticity and theconcepts of elastic demand, inelastic demand,and unit elastic demand.

7. Understand the nature of cross elasticity, incomeelasticity, and the elasticity of supply.

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In a market system, the interaction between supply and demand is relied on todetermine prices. Consumers express their demand through the prices they are

willing to pay for various products. Firms seeking profit cater to consumerdemand by offering goods and services at various prices. Consequently, a marketis established in which the final price of a good or service is determined on thebasis of costs to the producer and utility to the buyer.

THE MARKET MECHANISMChanges in either demand or supply bring about adjustments in the amount ofgoods sold, price changes, or both. If consumers throughout the nation, for exam-ple, begin buying more lawn mowers, retail outlets must order inventory replace-ments in the form of additional mowers from wholesalers. Wholesalers in turnorder more mowers from manufacturers, who begin producing more mowers.Depending on the available supply and the cost of resources, these additionalmowers may be supplied at the same price or at a different price. At any rate,consumer demand is made known to the producers through the market structure.At other times, suppliers try to anticipate the demands of consumers and supplythe goods before there is a strong expression of demand. The system does notwork perfectly; at times gluts and shortages occur, and prices fluctuate. But con-sidering the billions of items produced and sold each year, the market system doesan excellent job of satisfying consumer demand.

DEMANDWhen analyzing the influence of demand in the marketplace, it is important torecognize that the amount consumers will purchase is determined by a number offactors. The single most important of these factors is price.

Law of DemandThe critical relationship between the price of a good or service and the quantitydemanded is expressed by the law of demand. The law of demand states that thequantity of a good or service purchased is inversely related to the price, all otherthings being equal. Thus, a lower price for a product increases the quantitydemanded of that product, whereas a higher price decreases the quantity demandedof that product. The law of demand does not tell us to what extent quantitydemanded is affected as a result of a change in price. It merely indicates an inverserelationship. As we shall see, it is the law of demand that accounts for the negativeslope of the demand curve.

Law of DemandThe quantity purchased ofa good or service isinversely related to theprice, all other thingsbeing equal.

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Quantity Demanded versus DemandTo further clarify the law of demand, economists differentiate between thequantity demanded and demand. Quantity demanded refers to the quantities of agood or service that people will purchase at a specific price over a given period oftime. Demand is a schedule of the total quantities that people will purchase atdifferent prices at a given time. Demand implies something more than need ordesire. An individual must also possess purchasing power if the need is to be satis-fied. You may have a strong desire for a new Porsche, but unless you have thecash or credit to pay for it, your desire will have no influence on the market.Individual demand, then, refers to the quantity of a good or service that an indi-vidual or firm stands ready to buy at various prices. In other words, individualdemand implies a desire backed up by purchasing power. Market demand isthe sum of the individual demands in the marketplace.

Demand Schedule and Demand CurveHaving established that the quantity demanded of a product varies inversely withits price, we can construct a hypothetical demand schedule. A demand scheduleis a table showing the various quantities of a good or service that will bedemanded at various prices. An accurate schedule of this kind for a specificgood or service is difficult to construct because it requires knowing preciselyhow many units people would actually buy at various prices. Table 4-1 containsa hypothetical market demand schedule for pay-as-you-go cell phone time for agiven period. Cell phone companies sell these minutes at a set price, after whichthey can be repurchased if desired. Price is presented in the first column, and theamount of time demanded at various prices can be seen in columns 2–4. Noticethat more time will be purchased at lower prices than at higher prices.

Figure 4-1 graphically represents the relationship between price and theamount of cell phone time demanded. The vertical axis indicates the price, andthe horizontal axis shows the number of minutes demanded. To locate on Figure 4-1the point for the demand for 5.1 million minutes at $12.50, draw a horizontalline to the right from $12.50 and a vertical line upward from 5.1 million min-utes. The intersection occurs at point “A.”

When all points have been located in this way, they suggest a curve thatslopes downward to the right. If the changes in price and quantity were infinitelysmall, the resulting set of points of intersection would really form a continuousdemand curve. A demand curve indicates the number of units of a good or ser-vice that consumers will buy at various prices at a given time. In effect, a demandcurve is a graphic representation of a demand schedule. The demand curve can beeither a straight or a curved line, it may have a slight or a steep slope, it may becontinuous or discontinuous, and it may be smooth or jagged. These featuresdepend on the nature of the demand for the particular product and the amount

DemandA schedule of the totalquantities of a good orservice that purchasers willbuy at different prices at agiven time.

Individual DemandThe quantity of a good orservice that an individualor firm stands ready to buyat various prices at a giventime.

Market DemandThe sum of the individualdemands in themarketplace.

Demand ScheduleA table showing thevarious quantities of agood or service that will bedemanded at variousprices.

Demand CurveA curve that indicates thenumber of units of a goodor service that consumerswill buy at various prices ata given time.


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TAB L E 4 - 1Millions of Cell Phone Minutes That Will BeDemanded at Various Prices

PRICE D D1 D2

$15.00 2.0 3.0 1.0

14.50 2.3 3.4 1.3

14.00 2.8 4.3 1.6

13.50 3.5 4.8 2.1

13.00 4.2 5.6 2.7

12.50 5.5 6.6 3.4

12.00 6.1 7.7 4.4

11.50 7.3 9.0 5.4

11.00 8.5 10.4 6.7

10.50 10.0 12.0 8.0

F I GUR E 4 - 1Demand Curve for Cell Phone Time

$15.5

15.0

14.5

14.0

13.5

13.0

12.5

12.0

11.5

11.0

10.5

10 2 3 4 5 6 7 8 9 10 11 12 13

Price

Quantity (millions of minutes)

D

A

B

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of information available to use in plotting the demand schedule. Consequently,there are all kinds and shapes of demand curves.

Changes in DemandWe have seen that on a typical demand curve more will be demanded at a lowerprice. Notice on the demand curve in Figure 4-1 that at a price of $12.50, a littlemore than 5.1 million minutes of cell phone time would be demanded, but at aprice of $12, more than 6 million minutes of cell phone time would bedemanded. This can be seen at point “B.” Does this mean that if a price of $12is charged instead of $12.50 there is an increase in demand? Absolutely not.Remember that we defined demand as a schedule of amounts that would be pur-chased at various prices at a given time. Even though changing the price from$12.50 to $12 results in a greater quantity demanded, this is not a change indemand. Nothing has happened to the demand schedule. We have simplymoved to a lower price, and the quantity demanded has increased. This move-ment along the demand curve represents a change in the quantity demanded,and it occurs because the price of the product has changed.

How does this differ from a change in demand? A change in demand is a shiftin the entire demand curve due to changes in factors other than price. These factorsare held constant when moving along a given demand curve to determine changes inthe quantity demanded in response to changes in price. But if these factors areallowed to vary, demand will change. Thus in Table 4-1, D1 is a schedule showingan increase in demand from the schedule for D. When plotted, the demand curveforD1 lies to the right of that forD, as shown in Figure 4-2. For example, it indicatesthat at “point C” a price of $12.50 results in the purchase of 6.6 million hours of cellphone time. A decrease in demand means that a smaller quantity will be bought ateach price. In Table 4-1, D2 is a schedule showing a decrease in demand from theschedule forD. The curve forD2 lies to the left of that forD, as shown in Figure 4-2.Thus, an increase in demand shifts the demand curve to the right, whereas adecrease in demand shifts the demand curve to the left.

Although they are not the only determinants of demand, the following fourfactors are generally thought to be most important in addition to price: income,taste and preferences, future expectations, and prices of related goods and services.None, however, is more important than price.

Determinants of DemandChanges in income can bring about a change in demand. When people earn higherincomes, they are able to afford not only more of the same goods and services butalso more expensive products they previously could not afford. For example, notonly may families increase the length of their vacations, but they may also head todifferent destinations. A ten-day cruise in the Caribbean may replace a one-week

Change in theQuantity DemandedMovement along thedemand curve that occursbecause the price of theproduct has changed.

Change in DemandA change in the amountsof the product that wouldbe purchased at the samegiven prices; a shift of theentire demand curve.


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camping trip in a nearby state park. Higher incomes may also result in familymembers eating out more often, but reduce the number of meals purchased atfast-food restaurants.

A shift in demand can also be brought about by a change in taste and preferences.A popular fashion item, such as cargo pants, may be out of style after one season,leaving retailers with unexpected excess inventories. In the automobile industry, therecent popularity of hybrid automobiles reflects a change in consumer preference forfuel-efficient vehicles. The sales of Toyota’s hybrid Prius and other hybrids haveincreased significantly, causing their demand curves to shift to the right.

Demand can increase or decrease as a result of consumer expectations. For exam-ple, if consumers believe that their incomes will rise in the near future, they are moreinclined to buy more expensive items today. Credit card and installment debt reflectconsumer intentions of making monthly payments out of future income. On theother hand, if consumers are worried about losing their jobs, they are likely to post-pone purchases of expensive items. Consumers can also cause a shift in demand ifthey anticipate a shortage of particular products—witness the shortage of manyitems in supermarkets immediately prior to the onset of snowstorms or hurricanes.A change in demand can occur if consumers believe price changes are forthcoming

F I GUR E 4 - 2Demand Curves for Cell Phone Time

$15.5

15.0

14.5

14.0

13.5

13.0

12.5

12.0

11.5

11.0

10.5

10 2 3 4 5 6 7 8 9 10 11 12 13

Price


DD1

A C

B

E

D2

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as well. Consumers will speed up purchases if prices are expected to rise and post-pone purchases if prices are expected to fall.

The demand for one product may be affected by a change in the price ofanother. Some goods are substitutes for each other, and others are complements.Pepsi-Cola and Coca-Cola are highly substitutable products for many people.Thus, the demand for Pepsi may fall markedly with a sharp drop in the price ofCoke. In the travel industry, complementary relationships exist among airlines,hotels, and rental car agencies. If the major airlines raise airfares substantially,the demand for rental cars and hotels at airports is likely to fall.

SUPPLYTurning from our focus on the demand or buyers’ side of the market, we cannow direct our attention to the supply or sellers’ side. Supply refers to the totalquantities of a good or service that sellers stand ready to offer for sale at variousprices at a given time. Supply does not refer to a single specific amount, butrather to a series of quantities. Instead, the specific amount that a seller wouldbe willing to offer for sale at a particular price is referred to as the quantity sup-plied. The distinction between individual supply and market supply is similar tothat which exists with demand. Individual supply is the quantities offered forsale at various prices at a given time by an individual seller, whereas marketsupply is the sum of the individual supply schedules in the marketplace.

Supply ScheduleAs in the case of a demand schedule, it is useful for purposes of analysis to con-struct a supply schedule. The supply schedule is a table showing the variousquantities that sellers will offer at various prices at a given time. Table 4-2 pre-sents a hypothetical supply schedule for cell phone minutes. A supply curve is agraphic representation of a supply schedule. It is a line showing the number ofunits of a good or service that will be offered for sale at different prices at a giventime. The same method used to plot the demand curve for cell phone time can beused to plot the supply curve. This curve is labeled S in Figure 4-3.

The law of supply states that the quantity offered by sellers of a good orservice is directly related to price, all things being equal. Thus, the supply curveslopes upward from left to right, indicating that sellers are willing to offer more ata higher price than at a lower price. It must be noted that the law of supply is nota universal law, for there are exceptions. But the law holds true in nearly all cases.Whenever a supply curve is drawn, remember that everything else that mightaffect the quantities offered for sale is being held constant except for the price ofthe product.

SupplyThe total quantities of agood or service that sellersstand ready to sell atdifferent prices at a giventime.

Individual SupplyQuantities offered for saleat various prices at a giventime by an individualseller.

Market SupplySum of the individualsupply schedules in themarketplace.

Supply ScheduleA table showing thevarious quantities of agood or service that sellerswill offer at various pricesat a given time.

Supply CurveA line showing thenumber of units of a goodor service that will beoffered for sale at differentprices at a given time.

Law of SupplyThe quantity offered bysellers of a good or serviceis directly related to price,all things being equal.


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Supply Curves for Cell Phone Time

$15.5

15.0

14.5

14.0

13.5

13.0

12.5

12.0

11.5

11.0

10.5

10 2 3 4 5 6 7 8 9 10 11 12 13

Price


S S1S2

TAB L E 4 - 2Millions of Cell Phone Minutes That Will Be Offered atVarious Prices

PRICE S S1 S2

$15.00 10.0 11.1 9.0

14.50 9.6 10.8 8.4

14.00 9.2 10.4 7.8

13.50 8.5 9.8 7.2

13.00 7.8 9.1 6.3

12.50 6.9 8.4 5.3

12.00 5.9 7.3 4.3

11.50 4.8 6.4 3.0

11.00 3.6 5.3 1.6

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Changes in SupplyAs with demand, when price changes and a greater or lesser amount is offered forsale, there is no change in supply. Rather, there is movement along a given supplycurve because the price of the product has changed. This constitutes a change inthe quantity supplied. For a change in supply to occur, there must be a shiftin the entire supply curve, indicating a change in the amount offered for sale atthe same price. An increase in supply means that a larger amount is offered at thesame price; a decrease in supply means that a smaller amount is offered (see Table4-2). The supply curve for S1, showing an increase in supply, lies to the right ofthat for S. The curve for S2, showing a decrease in supply, lies to the left of thatfor S (see Figure 4-3). Since price cannot cause a shift in the supply curve, otherfactors must be responsible. Possible causes include changes in the cost of produc-tion, changes in technology, expectations of future prices, and the prices of relatedproducts.

Determinants of SupplyBecause the production of goods and services entails the use of productive resources,changes in the cost of these resources can result in a change in supply. If, for example,the cost of bricks increases sharply, the price of building brick homes will rise appre-ciably, and the supply of brick homes will decrease. Technology can also affect sup-ply, for with improvements in technology, products can be produced at a lower cost.This results in an increase in supply. An obvious example is agriculture. Sophisti-cated farm machinery, powerful fertilizers, and scientific applications to increasecrop yields have lowered the cost of production and increased the supply of farmproducts. Expectations of future prices can also determine supply. The supply ofaccounting majors graduating from college in the year 2014 will be influenced bythe salaries expected in the field by college students selecting academic career pro-grams in 2009. Finally, the supply of a product can be determined by the prices ofrelated products. If a supplier has the opportunity of using productive resources formore than one purpose, the relative market prices may determine supply. If the priceof corn is rising because of the increase in demand for ethanol and the individualfarmer has the choice of planting corn or soybeans, the supply of soybeans willdecrease. Supply will decrease when prices of alternative goods increase, and the sup-ply will increase when prices of alternative products decrease.

HOW DEMAND AND SUPPLY DETERMINEPRICEWith the growth in global cell phone usage, a large number of companies provideconsumers with access to wireless telephone service. Assume, in our hypotheticalexample, that on a given day the demand for cell phone time and the supply of

Change in theQuantity SuppliedMovement along thesupply curve that occursbecause the price of theproduct has changed.

Change in SupplyA change in the amountsof the product that wouldbe offered for sale at thesame given prices; a shiftof the entire supply curve.


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TAB L E 4 - 3Demand and Supply Schedules for Cell Phone Time(Millions of Minutes)

PRICE DEMAND SUPPLY

$15.00 2.0 10.0

14.50 2.3 9.6

14.00 2.8 9.2

13.50 3.5 8.5

13.00 4.2 7.8

12.50 5.1 6.9

12.00 6.1 5.9

11.50 7.3 4.8

11.00 8.5 3.6

10.50 10.0 2.0

F I GUR E 4 - 4Demand, Supply, and Market Price for Cell PhoneTime

$15.5

15.0

14.5

14.0

13.5

13.0

12.5

12.0

11.5

11.0

10.5

10 2 3 4 5 6 7 8 9 10 11 12 13

Price


S

A

D

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cell phone time in a particular market are given in the D and S columns of Tables4-1 and 4-2. Table 4-3 reproduces these schedules. Again, it is also assumed thatconsumers purchase time on a pay-as-you-go basis and a flat fee is charged for agiven number of minutes.

At what price will the market clear? The price will be determined by theinteraction between demand and supply. More precisely, the price will be estab-lished at the point where the quantity demanded equals the quantity supplied.Because the market is cleared (all cell phone time supplied is purchased) at thisprice and quantity, this price is known as the equilibrium price.

To see the interactive relationship of demand and supply, consider the super-imposed demand and supply curves for the D and S schedules in Figure 4-4.These curves intersect at point ‘A’ indicating 6.1 million minutes hours of cellphone time will be offered for sale and an equal amount will be bought at$12.10. What is the significance of this? In a free market, no other price canprevail, because at any other price either a surplus or a shortage of the goodwould exist in the short run, as shown in Figure 4-5.

F I GUR E 4 - 5Surplus, Shortage, and Equilibrium for Cell PhoneTime

$15.5

15.0

14.5

14.0

13.5

13.0

12.5

12.0

11.5

11.0

10.5

10 2 3 4 5 6 7 8 9 10 11 12 13

Price


D

S

Surplus

Shortage

Equilibrium PriceThe price at which thequantity demanded equalsthe quantity supplied.


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If the price were anything other than $12.10, the quantity of cell phone timethat consumers would be willing to buy and the amount of cell phone timeoffered for sale would be out of balance. In such a situation, market forceswould come into play to adjust the price to $12.10 (the equilibrium level). At aprice of $12.50, for instance, the quantity of time that sellers would be willing tosupply would exceed by almost 2 million hours the quantity demanded by con-sumers. Consequently, not all the cell phone time would be sold. But notice thatsome sellers are willing to sell their time at lower prices of $12.40, $12.30, and soforth. Rather than hold their time off the market, they will offer to sell at thelower prices. As the price is lowered, certain consumers come forward whowould not pay $12.50 for cell phone time but will pay $12.40, $12.30, or less.Therefore, as the market conditions push the price of cell phone time downward,the number of sellers decreases and the number of consumers increases until theamount of cell phone time offered for sale and the quantity purchased come intobalance at the equilibrium price of $12.10.

On the other hand, if a price of $11.50 existed, the market would again beout of equilibrium. At that price the quantity demanded would exceed the quan-tity supplied by more than 2 million minutes, and some potential consumerswould have to go without. But some consumers are willing to pay more than$11.50. Rather than do without, they will offer higher prices of $11.70,$11.90, and upward. As they bid the price upward, a twofold action takes placein the market. The higher prices ration away some consumers from making pur-chases and induce more sellers to offer their services for sale. The resultingincrease in the amount offered for sale and decrease in the amount purchasedfinally bring supply and demand into balance at the equilibrium price of $12.10.

For the price to remain at something other than the market price establishedby the free forces of supply and demand, the market has to be rigged or the forcesof supply and demand changed. This is exactly what happens when the govern-ment sets a price for certain agricultural products that is higher than the marketprice, or when it establishes a ceiling price that is lower than the market price(during wartime, for example). Business firms charged with price fixing are oftenguilty of collusion with other firms in an effort to interfere with free marketforces. Under free market conditions, the number of possible relationshipsbetween demand and supply is practically infinite. For instance, demand mayincrease while supply remains constant, or vice versa. Or demand may increasewhile supply decreases, or vice versa. Or both demand and supply may increase,with one increasing more rapidly than the other.

In any case, however, we can rely on this simple principle: In any new rela-tionship between demand and supply, an increase in demand relative to supplywill result in a higher price, and any decrease in demand relative to supply willresult in a lower price. On the other hand, an increase in supply will lower theprice, and a decrease in supply will raise the price, other things remaining

Cell phone servicesare offered by avariety of providers,including AT&T,Verizon, andT-Mobile. Go to thetext’s web site atwww.cengage.com/economics/mastrianna and clickon the NetLinks toexamineLetstalk.com, a sitethat guides you tocompare cell phoneplans among19 carriers. How dosupply and demandaffect the cost of cellphone services?

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PRICE CEILINGS AND PRICE FLOORSWe have seen in the previous discussion that as long as the impersonal forces ofsupply and demand are allowed to operate freely, an equilibrium position willresult that will clear the market. In other words, there will be no surpluses orshortages resulting from market forces. But what happens if there are price con-trols that restrict market adjustments? Price controls can take the form of priceceilings or price floors.

A price ceiling is a government-mandated maximum price that can becharged for a good or service. At one time or another, the federal governmenthas implemented price ceilings on gasoline, interest rates, and interstate shipmentsof natural gas. Local governments, including New York City, have enacted priceceilings in the form of rent controls on apartment dwellings.

The effects of price ceilings on the rents of apartment housing can be seen inFigure 4-7. At a monthly rental cost of $700, supply and demand are in equilibriumat 30,000 housing units. However, if local housing authorities enact rent controls

F I GUR E 4 - 6Alternate Supply and Demand Positions

Demand Increases (D becomes D1) 1. Price increases 2. Quantity sold increases

P

S

Q/t

D1D

P

SS1

D

Demand Decreases (D1 becomes D) 1. Price decreases 2. Quantity sold decreases

Supply Increases (S becomes S1) 1. Price decreases 2. Amount sold increases

Supply Decreases (S1 becomes S) 1. Price increases 2. Amount sold decreases

Q/t

Price CeilingA government-mandatedmaximum price that canbe charged for a good orservice.


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On a national scale, if the cost of gasoline at the pump rises above $4 a gallonand approaches $5 a gallon, the federal government may bow to political pressureto enact price controls on gasoline. If the price per gallon rises to $5 and theceiling price becomes $4, price controls on gasoline would result in shortages,long lines at pumps, and a supply and demand situation similar to the exampleof rent controls in New York.

When a government authority establishes a minimum price that can becharged for a good or service, this is known as a price floor. Two well-known

F I GUR E 4 - 7The Effects of a Price Ceiling on Rental Housing

700

500

0 18,000 30,000 40,000

E

S

Shortage D

Monthly Price ($)

Quantity (housing units)

Price FloorA government-mandatedminimum price that canbe charged for a good orservice.

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examples of price floors are the federal minimum wage and agricultural pricesupports. In the case of agriculture, price floors seek to support farm incomes bymandating minimum prices for a number of farm products. Hypothetical supplyand demand curves are shown in Figure 4-8. Assume the market-clearing equili-brium price is $2.00 per bushel. At that price, 100,000 bushels will be offered forsale and will be purchased in the market.

When the federal government sets a minimum price below which the price ofa bushel of wheat cannot fall, a surplus of wheat can result. In Figure 4-8, thegovernment-regulated price of $3.00 is above the market-clearing price of $2.00.At this price, farmers are willing to offer 115,000 bushels for sale. But at thehigher price, buyers are willing to purchase only 75,000 bushels. The result ofthe price floor on wheat is a surplus of 40,000 bushels. Agricultural price floorsin the United States have resulted in huge surpluses of a number of crops.Because the federal government induces farmers to produce more than consumersare willing to buy at that price, the government must buy and store surplus cropsat the public’s expense. Note, however, that if the minimum price is below theequilibrium price of $2 per bushel, the price floor has no effect in the market.

F I GUR E 4 - 8The Effects of a Price Floor on Wheat

3.00

2.00

0 75,000 100,000 115,000

Surplus

S

D

Price per Bushel ($)

Quantity (bushels)


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PRICE ELASTICITY OF DEMANDSellers are often faced with the problem of determining a price at which to offer goodsfor sale. It is true that a greater amount can be sold at lower prices. But will the greaterrevenue from the larger sales offset the reduced revenue from the lower price? Fortu-nately, there is a way to measure the change in relationship between price andamount sold. Price elasticity of demand is a measure of the sensitivity or responsive-ness of quantity demanded to a change in price. The reaction of consumers to anincrease or decrease in price depends on the degree of price in price elasticity.

Measuring Price Elasticity of DemandWe will investigate price elasticity of demand by considering three demand curvesand measuring their elasticities. In Figure 4-9, for the demand schedule D, 1,600units would be sold at the price of $10; but if the sale price were only $8, thenumber of units sold would be 2,000. Elasticity may be measured in either of twoways: the formula method or the total revenue method.

Formula Method The following formula measures the relative change in quan-tity demanded against the relative change in price:

F I GUR E 4 - 9Demand Curves Showing Different Elasticities

$131211109876543

1,6000

Price

D

21

2,000

D1D D2

D2

D1

2,400 Quantity/Time

Price Elasticity ofDemandA measure of thesensitivity orresponsiveness of quantitydemanded to a change inprice.

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Price elasticity ¼ percentage change in quantity demandedpercentage change in price

A few minor problems arise in applying the formula method. The percentage changescan be computed by using the original price and quantity as bases. If this is done, how-ever, the result will be a different measure of elasticity, depending on whether the priceis being decreased or increased. Obviously, this can lead to much confusion.

A method often used to overcome this problem is to calculate the percentagechange by using an average of the beginning and end values as the base. Thismakes the percentage change the same whether we are moving up or down theprice axis. The formula for price elasticity can now be expressed by the following:

Price elasticity ¼

Q2 −Q1

ðQ1 +Q2Þ=2

P2−P1

ðP1 +P2Þ=2

This is called the average elasticity formula, and by applying it to our example(see Figure 4-9), the $2 absolute change in price is divided by $9 (the averageprice between $10 and $8), giving us a figure of 22 percent. By using an averagebase, we find that the relative change in quantity demanded is likewise 22 percent.Consequently, the measure of price elasticity is 1.0.

Price elasticity ¼2;000−1;600

ð2;000+1;600Þ=210−8

ð10+8Þ=2

¼

400

1;800

2

9

¼ :22

:22¼ 1:0

This means that a given change in price will bring about a proportionate changein the quantity sold. For example, a 1 percent decrease in price would result in a1 percent increase in the quantity demanded, a 3 percent increase in price wouldresult in a 3 percent decrease in quantity demanded, and so forth.

Economists ignore the minus sign and just look at the absolute value of theelasticity coefficient determined by the formula. Unit elastic demand exists whena percentage change in price causes an equal percentage change in quantitydemanded. It has an elasticity coefficient equal to 1.0 and is the borderline betweenelastic and inelastic demand. An elasticity coefficient greater than 1.0 indicates anelastic demand, and anything less than 1.0 indicates an inelastic demand. Elasticdemand exists when a percentage change in price causes a greater percentage changein quantity demanded. Inelastic demand exists when a percentage change in price isgreater than the percentage change in quantity demanded.

Unit Elastic DemandDemand that exists when apercentage change in pricecauses an equal percentagechange in quantitydemanded; has anelasticity coefficient equalto 1.0.

Elastic DemandDemand that exists when apercentage change in pricecauses a greater percentagechange in quantitydemanded; has anelasticity coefficientgreater than 1.0.

Inelastic DemandDemand that exists when apercentage change in pricecauses a smaller percentagechange in quantitydemanded; has anelasticity coefficient lessthan 1.0.


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Now let us measure the elasticity for the demand schedule D1 in Figure 4-9.When the price is changed from $10 to $8, a 22 percent change using the for-mula, the quantity demanded increases from 1,600 to 2,400 units, which indi-cates an increase of 40 percent (800/2,000 = 0.40). In this case, the elasticitycoefficient is 1.8 (0.40/0.22 = 1.8). Thus, a 2 percent change in price, for exam-ple, will result in a 3.6 percent change in the quantity demanded. In short, con-sumer demand is elastic, and the percentage change in quantity demanded will begreater than the percentage change in price. Demand schedule D2 shows less con-sumer responsiveness to a change in price. Here, a 22 percent decrease in pricefrom $10 to $8 results in a mere 11 percent increase in quantity demanded. Thiscomputes to an elasticity coefficient of 0.5, indicating that the demand is inelasticand that a change in price will bring about a less-than-proportional change in theamount demanded. Every 1 percent increase in price will result in a 0.5 percentchange in the quantity demanded.

Total Revenue Method Why is this information about elasticity, inelasticity,and coefficients of 1.8, 0.5, and 1.0 important? To the seller, it is extremelyimportant because it indicates how total revenue received from the sale of pro-ducts will be affected as prices increase or decrease. Likewise, it is important tothe consumer. After all, the total revenue that sellers receive from the sale of pro-ducts is nothing other than the total expenditures for those products by consu-mers. From a given consumer’s point of view, the more income spent on onegood or service, the less there remains to be spent on others.

The total revenue method of measuring elasticity is less precise, but it tellsmore directly what happens to total revenue. Furthermore, it shows more clearlythe importance of a coefficient of elasticity. This method can be summarized inthree parts:

1. If price changes but total revenue remains constant, unit price elasticity ofdemand exists. In this case, the decrease in revenue resulting from a lowerprice is offset by the increase in revenue resulting from increased sales. Ifelasticity is 1.0, sales will increase in exact proportion to a price decrease.

2. If price changes but total revenue moves in the opposite direction, demand iselastic. In this case, the decrease in revenue from a lower price is more thanoffset by the increase in revenue from increased sales. When elasticity is morethan 1.0, sales change in greater proportion than price does.

3. If price changes and total revenue moves in the same direction, demand is in-elastic. Owing to an elasticity of less than 1.0, the increase in revenue fromhigher sales will not make up for the loss in revenue from a lower price.

The measure of elasticity can be applied to supply, too. If a given percentagechange in the price of a good results in a greater percentage change in the quan-tity supplied, the supply is elastic. If the percentage change in price results in alesser percentage change in the quantity offered, the supply is inelastic. And if the

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percentage change in price results in a proportionate change in the quantityoffered for sale, unit elastic supply exists.

Characteristics and Range of Price ElasticityIt is not easy to calculate the price elasticity of demand for a product. First, it maybe difficult to gather enough statistical data to determine how much of a goodconsumers will buy at each of a series of prices. But it can be and is being donemore and more by firms. Second, if a price change is made in an effort to observethe change in quantity demanded, the analyst must be certain that no otherchanges (such as an increase in income) are taking place that also influence thedemand.

The degree of price elasticity depends on the nature of the product or service.For example, is it a necessity or a luxury? Is it a small or large expenditure for theconsumer? Is it a durable or perishable item? Is it a complementary or substituteitem? How many uses are there for the item? The effects of these characteristicsare summarized in Table 4-4.

The degree of elasticity may range from perfectly elastic demand to perfectlyinelastic demand. Perfectly elastic demand (depicted as a straight horizontal linein Figure 4-10a) indicates that an infinite amount of the product could be soldwithout a change in price. Perfectly inelastic demand (represented by the straightvertical line in Figure 4-10b) indicates that the same amount would be purchasedregardless of price. Most goods and services, of course, have a price elasticity lyingsomewhere between the two extremes. Perfectly unit elastic demand is shown inFigure 4-10c.

Unfortunately, except in the cases of perfectly horizontal and perfectly verticaldemand curves, it is not possible to determine price elasticity by simply looking atthe demand curve. In any straight-line, slanted demand curve, certain areas areelastic, others are inelastic, and some spot may be unit elastic. This can be clar-ified by referring to Figure 4-11. Notice on the demand line that a change inprice from $9 to $8, a price change of less than 12 percent, brings about a change

TAB L E 4 - 4Characteristics Affecting Price Elasticity of Demand

TEND TOWARD ELASTIC DEMAND TEND TOWARD INELASTIC DEMAND

Luxuries Necessities

Large expenditures Small expenditures

Durable goods Perishable goods

Substitute goods Complementary goods

Multiple uses Limited uses


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in quantity demanded from 10 to 20 units, an increase of 67 percent. At thelower end of the vertical axis, a price change from $2 to $1, a 50 percent changein price, results in an increase in quantity demanded from 80 to 90 units, a quan-tity change of less than 12 percent.

F I GUR E 4 - 1 0Three Demand Curves Showing Different Elasticities

Perfectly Elastic

Perfectly Inelastic

Perfectly Unit

Elastic

P

D1

P P(a) (b)

D2

D3

(c)

Q/t Q/t Q/t

F I GUR E 4 - 1 1Demand Curve Showing Differing Degrees ofElasticity

$12

11

10

9

8

7

6

5

4

321

100 20 30 40 50 60 70 80 90 100110120

Price

Quantity/Time

Elastic

Deman

d

Inelas

tic

Deman

d

Unit

Elastic

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At one end of the scale, we have a price elasticity of demand of more than5.0; at the other end, we have a highly inelastic measure of less than 0.2. Thus,for any change in price through the range of $10 to $5 demand is elastic, but anychange in price from $5 to $1 demand is inelastic. Observe further that a point ofunit elastic demand exists at $5. In fact, on our demand schedule, the pointof maximum revenue for the seller is at $5 because both higher and lower priceswill result in decreased revenue. For a demand schedule to be unit elasticthroughout, it would have to be represented by a rectangular hyperbola, asshown in Figure 4-10c. In such a situation, percentage changes in price and quan-tity demanded are proportional throughout the curve.

Other Types of ElasticityIn addition to price elasticity of demand, there are three other important types ofelasticity: (1) cross elasticity of demand, (2) income elasticity of demand, and(3) price elasticity of supply. Each uses the same basic formula for calculatingthe elasticity coefficient as was used in determining price elasticity of demand.

Cross Elasticity of Demand The quantity demanded of a particular good isaffected not only by its price but also by the prices of related goods. If goodsare related, they are classified as either substitutes or complements. Substitutegoods are functionally equivalent goods, such as DVD movie rentals and moviesat movie theatres. Complementary goods are those goods that are used together,such as your economics course and this book. A change in the price of one pro-duct, if it is a substitute or complementary product, can affect the quantitydemanded of the other. Cross elasticity of demand measures the effect of achange in the price of one product on the quantity demanded of another. Theformula for calculating cross elasticity is as follows:

Cross elasticity

of demand ¼ percentage change in the quantity demanded of product Bpercentage change in the price of product A

The coefficient of cross elasticity can be positive or negative. A positive coefficientimplies that goods are substitutes, whereas a negative coefficient indicates that thegoods are complementary. The larger the coefficient, the greater the cross elasti-city. Because most goods are unrelated, a coefficient of 0 is most common.

Income Elasticity of Demand The quantity demanded for a given good isaffected by changes in consumer income. As income rises, so does the totaldemand for goods and services. However, the quantity demanded for individualgoods does not necessarily rise proportionally with changes in income. In fact, insome cases the quantity demanded actually declines. Income elasticity of

Cross Elasticity ofDemandA measure of theresponsiveness of thequantity demanded of oneproduct as a result of achange in the price ofanother product.

Income Elasticity ofDemandA measure of theresponsiveness of quantitydemanded to a change inincome.


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demand is a measure of the responsiveness of quantity demanded to a change inincome. The formula for income elasticity is as follows:

Income elasticity of demand ¼ percentage change in quantitypercentage change in income

The demand for most goods varies in the same direction as changes in income.Thus, most goods will have positive coefficients, and these are called normal goods.Some goods, however, have negative coefficients; that is, the demand varies inverselywith changes in income. These goods are inferior goods. Home ownership is anexample of a normal good, whereas intercity bus transportation is an inferior good.As before, the larger the coefficient is, the greater the responsiveness of quantitydemanded to changes in income and the greater the elasticity. Coefficients of lessthan 1 are inelastic whether they are for normal goods or for inferior goods.

Elasticity of Supply Like elasticity of demand, price elasticity of supply is animportant tool in analyzing markets. Elasticity of supply is a measure of thesensitivity or responsiveness of quantity supplied to a change in price. The for-mula used to calculate price elasticity of supply is basically the same one used tomeasure price elasticity of demand. In this case, however, the change in quantityrefers to a change in the quantity supplied. Because of the law of supply, youwould expect to find a positive relationship between the change in price and thequantity supplied. If producers are responsive to price changes, supply is elasticand the coefficient will be greater than 1. If producers are relatively insensitiveto price changes, supply is said to be inelastic and the coefficient will be frac-tional. The formula for elasticity of supply is:

Price elasticity of supply ¼ percentage change in quantity suppliedpercentage change in price

An important factor determining the elasticity of supply is the amount of timethat a producer has in which to adjust quantity in response to a change in price.Generally, the elasticity of supply increases correspondingly when a producer hasmore time to vary productive resources and employ changes in technology.

Time and Elasticity of SupplyThe relationship between time and elasticity of supply is shown in Figure 4-12.Assume the demand for the product increases suddenly and permanently from Dto D1. If the producers cannot adjust the quantity supplied on such short notice,the supply curve will be vertical and perfectly inelastic, as in Figure 4-12a. Duringthis period the producer will sell the same quantity, but at a higher price. In agri-culture, the farmer may have to wait until the next planting season to adjust the

Elasticity of SupplyA measure ofresponsiveness of quantitysupplied to a change inprice.

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One last word about the elasticity of supply. This concept does not lend itselfto the total revenue approach. The law of supply indicates a direct relationshipbetween price and quantity supplied. Thus, regardless of the degree of elasticityor inelasticity, price and total revenue will always move in the same direction.

An Application of Supply and Demand—A Tax onCigarettesAn example of the effect of supply and demand elasticities on market price andquantity can be seen with the enactment of a tax on cigarettes. Because of grow-ing health concerns over the effects of smoking, the federal government and moststate governments have levied increasingly higher sales and excise taxes on cigar-ettes. Thus, rather than ban cigarette production altogether, public policy hasrelied on higher prices in the marketplace to curtail consumption. To accomplishthis, taxes have been levied on both producers and consumers. But higher

F I GUR E 4 - 1 2Elasticity of Supply in Three Time Periods

S

D1P

IMMEDIATE SHORT RUN LONG RUN

Q Q

P1

D

P

P2

S

D1

DQ2 Q

PP3

D1DQ3Q/t Q/t Q/t

P P P

S

(a) (b) (c)


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cigarette taxes are also seen by legislators at the state and federal levels as a morepalatable way of raising revenue compared to raising income taxes.

One possibility is shown in Figure 4-13a. Assume that the federal govern-ment levies a tax of $1 on each pack of cigarettes produced. This tax affects thecost of producing cigarettes and results in a shift in the producer’s supply curve tothe left. The extent to which the tax affects consumers is a function of the elasti-city of demand for cigarettes. The original supply curve designated as S has nowshifted to S + $1. Sellers must now receive $1 a pack more in order to sell thesame amount as before. But their ability to do so depends on the reaction of theconsumers to higher prices—the elasticity of demand. The question is who isgoing to pay for the tax?

In Figure 4-13a, both supply curves are presented. Note that the verticaldistance between the two supply curves is $1, an amount equal to the tax. InFigure 4-13a, the demand curve for cigarettes (D) is relatively elastic. The graphindicates that only a small portion of the tax can be passed along to the consumer.The new equilibrium position (e) shows that the price of cigarettes has risen from$5 to $5.25 a pack, and the quantity demanded has fallen by 10 million packs. Inthis case, consumers have cut consumption, while paying but 25 cents more per

F I GUR E 4 - 1 3Effects of a Tax on Cigarettes

5.255.00

0 40 50

SS � $1(a)

D

Re

Price per Pack ($)

Quantity (millions of cigarette packs)

5.75

5.00

6.00

0 48 50

SS � $1(b)

D

R

e

Price per Pack ($)

Quantity (millions of cigarette packs)

21

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pack. But most of the burden of the tax is being borne by producers in the formof fewer sales and less profit per pack.

In Figure 4-13b, the demand curve for cigarettes is highly inelastic. In thiscase, consumers are willing to pay a substantially higher price to continue smok-ing. Consequently, the quantity demanded falls by only 2 million packs. The newequilibrium position is $5.75, and the equilibrium quantity is 48 million packs.With an inelastic demand, consumers bear the brunt of the tax. If the demandwere totally inelastic, 50 million packs would be sold at $6, leaving producers aswell off as before.

Given the government’s intent to curtail smoking, the tax on cigarettes willbe more successful if there is greater elasticity of demand. However, if the tax isenacted to raise revenue, as often happens, the government will be more success-ful when the demand is inelastic.

Before leaving this section, you may wish to further check your understand-ing of the importance of elasticity in determining market price and quantity byconstructing models with one demand curve and three supply curves of differentelasticities. Your results should show that the more elastic the supply curve, themore the portion of the tax is borne by producers.

We learned in previous chapters that prices serve as rationing mechanisms inallocating final goods and services, that they help allocate the various resources totheir respective uses, and that they largely determine incomes. The reliability ofprices in performing these functions depends to a great extent on how freely mar-ket forces function within the economy. Monopolies, strong labor unions, gov-ernment regulations, and other institutional factors can seriously modify theoperation of the price system.

Chapter 4 Review

SUMMARY� In a free market system, the forces of demand

and supply determine prices. Demand is a sched-ule of the total quantities purchasers will buy atdifferent prices at a given time. The two layers ofdemand are individual and market; market de-mand is the sum of all individual demands ateach price. A change in demand is a change inthe amounts of the product purchased at eachprice. A change in the quantity demanded iscaused by a change in the price of the product.In addition to price, determinants of demandinclude changes in income, changes in taste andpreferences, changes in expectations, and changesin the price of other products.

� The supply of a good or service at a given time isthe quantity that sellers offer for sale at differentprices. A supply curve shows the number of unitsof a good or service that will be offered for sale atdifferent prices. A supply curve slopes upward tothe right because as prices rise, more will beoffered for sale. A change in supply produces ashift in the supply curve. Determinants of supplyinclude changes in the cost of resources, changesin technology, expectation of future prices, andprices of related products.

� Equilibrium occurs at the point at which supplyequals demand. When the price is above the mar-ket price set by demand and supply, the amount


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of a product that can be sold tends to be lowered.When the price is below the market price, usuallymore of a product will be sold.

� When demand increases, a higher price usuallyresults; a decreased demand usually lowers prices.When supply increases, the price increases; whensupply decreases, price rises.

� Price ceilings and price floors are forms of pricecontrols that interfere with the impersonal forcesof supply and demand. If price ceilings are setbelow the market price, shortages result. If pricefloors are set above the market price, surpluseswill result.

� Price elasticity of demand measures consumer re-sponsiveness to a change in price. Elastic demandexists when a percentage change in price causes agreater percentage change in quantity sold. In-elastic demand exists when a percentage changein price causes a smaller percentage change inquantity sold. Unit elasticity of demand existswhen a percentage change in price causes anequal percentage change in quantity sold.

� Although the total value method of measuringelasticity is not as precise as the formula method,

it does tell more directly what happens to totalrevenue. If price changes but total revenue staysconstant, unit elasticity of demand exists. If pricechanges but total revenue moves in the oppositedirection, demand is elastic. If price changes andtotal revenue moves in the same direction, de-mand is inelastic.

� Goods having inelastic demand include perish-able goods, necessities, complementary goods,small expenditure items, and goods with limiteduses. Goods having elastic demand include luxu-ries, durable goods, substitute goods, large expen-diture items, and goods with multiple uses.

� Cross elasticity of demand measures the effect ofa change in the price of one product on thequantity demanded of another. If products arerelated, they are classified as substitutes or com-plements. Income elasticity of demand measuresthe responsiveness of quantity demanded tochanges in income. Goods are classified as nor-mal or inferior.

� Elasticity of supply measures the sensitivity ofquantity supplied to a change in price. Elasticityof supply increases over time.

NEW TERMS AND CONCEPTSLaw of demandDemandIndividual demandMarket demandDemand scheduleDemand curveChange in the quantity demandedChange in demandSupplyIndividual supplyMarket supplySupply scheduleSupply curve

Law of supplyChange in the quantity suppliedChange in supplyEquilibrium pricePrice ceilingPrice floorPrice elasticity of demandUnit elastic demandElastic demandInelastic demandCross elasticity of demandIncome elasticity of demandElasticity of supply

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DISCUSSION QUESTIONS1. Explain how the impersonal forces of demand

and supply in the market determine pricesunder most competitive conditions.

2. Define demand. What are the three basicelements in the definition?

3. Why does a normal demand curve slopedownward to the right?

4. Distinguish between a change in the quantitydemanded and a change in demand.

5. Why does a supply curve slope upward to theright?

6. Under competitive conditions, why can marketprice not be higher or lower than the priceestablished by the free market forces of demandand supply?

7. If both demand and supply increase, but demandincreases more than supply does, what happensto price?

8. Define price elasticity of demand. If 46,000 unitsof a good can be sold at a price of $22 but54,000 units can be sold at a price of $18, isthe demand for the good elastic or inelastic?What is the elasticity coefficient?

9. Define cross elasticity of demand. Calculate theelasticity coefficient for the following, andindicate whether the goods are substitutes orcomplements. The price of product X increasesfrom $7 to $8, and the quantity demanded ofproduct Y decreases from 50,000 units to 40,000units.

10. Why does the elasticity of supply tend to increaseover time?

Go to www.cengage.com/login. Register as anew user or log in if you are a returning user. Registeryour access code to enter Economic Applications. Tofind real-life applications of the role of demand and

supply, click on the EconData icon, and select“Supply and Demand” under the Economic Funda-mentals heading. This will show you more examplesof how supply and demand interact.


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C h a p t e r 15

THE FEDERAL RESERVE AND THEMONEY SUPPLY

After studying Chapter 15, you should be able to:

1. Outline the structure of the Federal ReserveSystem and explain the makeup of the Fed’sBoard of Governors.

2. Describe the role of the 12 Reserve Banks andthe characteristics of member banks.

3. Explain under what conditions the Fed will en-gage in open-market operations.

4. Explain why changes in reserve requirements canhave a major effect on the economy.

5. Explain the effects of changes in the discountrate.

6. Analyze the reasons for recommendations callingfor changes in the structure and policies of theFederal Reserve.

7. Discuss the current issues facing the bankingsystem and the Federal Reserve’s ability toachieve its stated goals.

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A few banks existed in the United States during colonial days, but the first realattempt at centralized banking occurred when the federal government char-

tered the First Bank of the United States in 1791. The primary functions of thiscentral bank were to provide commercial bank services for individuals and busi-nesses, to act as a banker’s bank, to serve as a fiscal agent for the federal govern-ment, and to maintain some order in the banking business by exercising restraintson state banks. Political and business opposition to the bank led to the defeat ofits recharter in 1811. For the following five years, only state banks existed.

In 1816, however, the Second Bank of the United States was chartered for a20-year period. Although it was designed to perform functions similar to those ofthe First Bank, it had more capital stock and operated on a broader scale. Despiteits efficient operation, many people opposed the Second Bank. Some opponentsdisliked the idea of central authority, others objected to its strict regulations, someothers were alarmed by the fact that foreigners owned a certain amount of thebank’s stock, and still others thought the bank was unconstitutional. Political ten-sions between the bank’s officials and the presidential administration of AndrewJackson were instrumental in defeating its recharter in 1836.

Between 1836 and 1863, an era known as the wildcat banking period, therewas no central authority in the U.S. banking system, and abusive banking practiceswere prevalent. The National Banking Act of 1864 brought some order to thechaos by creating the National Banking System. Its stringent requirements andprovisions for note security ended many unsound operations of private commercialbanks. However, the system had several noticeable weaknesses, such as the gravita-tion of reserves toward the money center; the lack of assistance to the farm sectorof the economy, as real estate could not be used as collateral for loans; and theperverse elasticity of the money supply. The perverse elasticity of the moneysupply refers to the inclination of banks to issue more notes during recessionswhen the economy didn’t demand more money and issue less in expansionswhen it was needed. After several years of research and study of foreign centralbanks, such as the Bank of England and the Bank of France, lawmakers replacedthe National Banking System in 1913 with the Federal Reserve System by passingthe Federal Reserve Act. This established a central-type banking system for theUnited States.

STRUCTURE OF THE FEDERAL RESERVESYSTEMThe Federal Reserve System (or Fed) is a complex and intricate system com-posed of a Board of Governors, a Federal Advisory Council, a Federal Open Mar-ket Committee, 12 Reserve Banks, 25 branch banks, many member banks, andseveral minor organizations. It is an instrument of the government, yet is notowned by the government. Instead, it is owned by the member banks; however,

Federal Reserve ActThe 1913 act thatestablished a centralbanking system in theUnited States.

Federal ReserveSystemA system composed ofvarious bodies,organizations, andcommittees for regulatingthe U.S. money supply.

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its most important officials are appointed by the president of the United States.Each body within the Fed has its own individual function, but the functions of allbodies are interrelated. Figure 15-1 summarizes the organization of the FederalReserve System. Because the United States was geographically larger than any ofthe other countries with central banks, Congress decided to create 12 separatebanks instead of one, each with a certain amount of autonomy.

The Board of Governors of the Federal Reserve SystemAt the top level of the Fed is the Board of Governors, headquartered inWashington,DC. Its primary function is to formulate monetary policy for the U.S. economy.

F I GU R E 1 5 - 1Organization of the Federal Reserve System

Board of Governors (7 Appointed Members)

Sets reserve requirements and approves discount rates as part of monetary policy

Supervises and regulates member banks and bank-holding companies

Establishes and administers protective regulations in consumer finance

Oversees Federal Reserve Banks

Consumer Advisory Council

Federal Advisory Council

Thrift Institutions Advisory Council

Reserve Banks (12 Districts)

Propose discount rates

Hold reserve balances for depository institutions and lend to them at the discount window

Furnish currency

Collect and clear checks and transfer funds for depository institutions

Handle U.S. government debt and cash balances

Federal Open Market Committee (Board of Governors and 5 Reserve Bank presidents)

Directs open-market operations (buying and selling of U.S. government securities), which are the primary instrument of monetary policy

Exercises general supervision

Compose

Advise


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The Board is an agency of the federal government, but it has considerable auton-omy. It consists of seven members, who are appointed by the president of the Uni-ted States with the consent of the Senate. Each member must be selected from adifferent Federal Reserve district. Each member is appointed for 14 years and isineligible for reappointment after having served one full term. Appointments arestaggered so that a new appointee is assigned every two years. The president of theUnited States selects the chairman and the vice-chairman of the Board from amongthe seven members for a four-year term each.

The Board has numerous responsibilities, including supervising the 12 ReserveBanks. It must approve each Reserve Bank’s officers and has the right to suspendor to remove officers if necessary. It authorizes loans between Reserve Banks,reviews and determines discount rates established by the Reserve Banks, estab-lishes reserve requirements within legal limits, regulates loans on securities, andperforms many other functions.

Federal Advisory CouncilThe Federal Advisory Council is a committee of 12 members, one from eachFederal Reserve district, selected annually by the board of directors of each Fed-eral Reserve Bank. The council serves primarily an advisory role, conferring withthe board on business conditions and other matters pertinent to the Fed.

In addition to the Federal Advisory Council, various other committees andconferences assist the Board of Governors. Among the most important of theseis the Conference of Presidents of the Reserve Banks, which convenes periodicallyand meets with the Board of Governors once or twice a year. Each presidentreports on economic conditions within his or her district.

Federal Open Market CommitteeThe Federal Open Market Committee (FOMC) is also composed of 12 mem-bers, including the 7 members of the Board of Governors and the president ofthe Federal Reserve Bank of New York. The remaining four members of the com-mittee are other Federal Reserve Bank presidents, who serve one-year terms on arotating basis. The FOMC buys and sells government securities in the open mar-ket expressly to influence the flow of credit and money. Its actions help stabilizethe price level, interest rates, and the growth of economic activity. The FOMCmeets about eight times a year.

Reserve BanksThe Fed divides the United States into 12 geographic districts. Each district has aReserve Bank named after the city in which it is located. The districts reflect theconcentration of financial activity. As a result, the St. Louis district is about

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one-half the size of the Kansas City district geographically, but it does as muchfinancial business as the latter. Most of the districts also have branch banks. TheFederal Reserve Bank of Cleveland, for example, has branches in Pittsburgh andCincinnati. Puerto Rico and the Virgin Islands are included in the New Yorkdistrict for check clearing and collection. Figure 15-2 delineates the 12 districts,and Table 15-1 lists the Reserve Banks and branches.

Reserve banks supervise member banks in their districts and conduct periodicexaminations of banks’ operations. If any member bank chronically engages inunsound banking practices, the Reserve Bank has the authority to remove its offi-cers and directors. Although this power is seldom exercised, its existence helpskeep member banks in line.

In addition to serving as central banks (or bankers’ banks), the Reserve Banksalso serve as fiscal agents for the federal government. They handle the detailedwork of issuing and redeeming government securities, hold deposits and disburse

F I GU R E 1 5 - 2The Federal Reserve System

Board of Governors of the Federal Reserve System Federal Reserve Bank Cities Federal Reserve Branch Cities

San Francisco

Los Angeles

Portland

Seattle Helena

El Paso Houston

Oklahoma City

Denver

Omaha

Little Rock

San Antonio

Salt Lake City

Dallas

Atlanta

Kansas City

Minneapolis

Chicago Cleveland

Boston

New YorkPhiladelphia

Richmond St. Louis

Memphis Nashville

Detroit Buffalo

Pittsburgh

Baltimore Cincinnati

New Orleans

Birmingham

Jacksonville

Charlotte

Miami

Louisville

WA

OR

ID CA NV

AZ

UT

MT

WY

CO

NM

AK

HI

TX

KS

NEIA

WI

MO OK AR

LA MS AL

GA

FL

SC

NC

VA WV

KY

TN

IN OH

MI

NY

NJPA

VT NH

ME

MA RI

CT

DE MD

DC

IL

ND

SD

MN

After reading aboutthe Federal ReserveSystem, go to thetext’s Web site atwww.cengage.com/economics/mastrianna and clickon the NetLinks tovisit the FederalReserve Bank of NewYork’s Web site fordata and information.


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Not For Salefunds for the Treasury, and perform many other fiscal duties. They supply moneyfor the business community in the form of Federal Reserve notes, and theyregulate their member banks’ ability to create money in the form of checkabledeposits. The branch banks help carry out the functions of the Reserve Bank.

Federal Reserve Member BanksWhen the Federal Reserve System was established, all national banks wererequired to join. Membership is also open to qualified state banks, but manystate banks cannot qualify because of the high minimum-capital requirement.Some banks simply do not like the Fed’s restrictions and regulations; others arereluctant to join because as nonmembers they are permitted to use the Fed’smajor facilities anyway. Although less than 38 percent of all commercial banksbelong to the Fed, these member banks hold a majority of the total deposits inthe United States.

Each member bank is required to buy stock of the Federal Reserve Bank ofits district. As a result, the member banks completely own the Reserve Banks, butmost of the regulation or control of Reserve Banks resides with the Board ofGovernors. Although the member banks are operated for profit, the ReserveBanks are operated strictly in the public interest. The Fed pays a 6 percent dividendon its stock. Any profits over this amount are turned over to the U.S. Treasury.

In addition to purchasing Reserve Bank stock, each member bank mustmaintain sufficient monetary reserves to meet the requirements set by the Boardof Governors. Member banks are required to maintain most of their requiredreserves with the Reserve Banks, and they are subject to examinations and

TA B L E 1 5 - 1Federal Reserve Districts and Banks

DISTRICT RESERVE BANK BRANCHES

1. Boston2. New York3. Philadelphia4. Cleveland5. Richmond6. Atlanta

7. Chicago8. St. Louis9. Minneapolis

10. Kansas City11. Dallas12. San Francisco

NoneBuffaloNoneCincinnati, PittsburghBaltimore, CharlotteBirmingham, Jacksonville, Miami, Nashville,New OrleansDetroitLittle Rock, Louisville, MemphisHelenaDenver, Oklahoma City, OmahaEl Paso, Houston, San AntonioLos Angeles, Salt Lake City, Portland, Seattle

Interested in how yourmoney will beredesigned or in stepsthe United States istaking in counterfeitprotection? Go to thetext’s Web site atwww.cengage.com/economics/mastrianna and clickon the NetLinks tovisit the FederalReserve Bank ofMinneapolis and goto the economiceducation site “OurMoney.”

Member BanksCommercial banks thatbelong to the FederalReserve System.

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regulation by the Reserve Banks. All member banks must insure their depositswith the Federal Deposit Insurance Corporation. In addition, member banksmust comply with various federal laws, regulations, and conditions regarding ade-quacy of capital, mergers, the establishment of branches, and loan and investmentlimitations.

FEDERAL RESERVE CONTROL OFTHE MONEY SUPPLYThrough its control over bank reserves, the Fed can affect the money supply.Thus, its actions influence the level of economic activity and/or the pricelevel. The Fed can use many instruments or measures to control bank depositcreation. Some are referred to as general controls because they affect the overallsupply of money. Others are referred to as selective controls because they affectthe use of money for specific purposes in the economy.

Open-Market OperationsThe most important instrument of monetary management is the Federal Reserveopen-market operations. Open-market operations are the Fed’s continuous pur-chases and sales of government securities on the open market to affect bankreserves. The securities used are primarily U.S. Treasury bills (T-bills) with amaturity of one year or less. Most banks hold government securities, and theFed can induce banks to sell or buy government securities by offering to buythem at a premium price or to sell them at a discount.

Purchase of Securities If the FOMC wants to encourage expansion of themoney supply, it can direct the Fed’s open-market account manager at the trad-ing desk located in the Federal Reserve Bank of New York to buy securities frombanks and individuals. When the Fed purchases securities, it increases bankreserves, which in turn enables the banks to expand checkable deposits andmake more loans.

Suppose that at a particular time banks have no excess reserves and, therefore,cannot extend any additional loans via checkable deposits (see Figure 15-3). If theFed buys $50,000 worth of government securities from banks, it puts the pro-ceeds directly into the banks’ reserve accounts. This increases excess reserves andexpands the banks’ ability to make loans by $500,000 (see Figure 15-4).

Practically the same result can be accomplished by purchasing securities fromindividuals or businesses because these sellers usually deposit the money receivedfrom the sale of securities in banks or have it credited directly to their accounts.These deposits increase bank reserves and potentially increase the money supply(see Figure 15-5). The potential expansion of the money supply is somewhat less

Open-MarketOperationsThe Fed’s continuouspurchase and sale ofgovernment securities onthe open market.


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Sale of Securities During times of rising price levels, the Fed may want toabsorb some of the existing excess reserves. It can do so by selling governmentsecurities to the banks. To buy securities, banks must give up some of their excessreserves, which in turn decreases their ability to expand checkable deposits. Whenthe Fed sells securities to individuals or businesses, the buyers usually withdrawfunds from banks to pay for the securities, which also reduces excess reserves anddecreases the banks’ ability to increase the money supply.

F I GUR E 1 5 - 4FOMC Buys Securities from Banks at a 10 PercentReserve

Original Checkable Deposits

$100,000

FOMC BuysSecurities $50,000

Checkable Deposit Loans

$900,000

Required Reserves $100,000

ALL BANKS

Excess Reserves $50,000

Potential Checkable Deposits

$500,000

F I GUR E 1 5 - 3No Excess Reserves at a 10 Percent Requirement


$100,000


$900,000


ALL BANKS

Excess Reserves NONE

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Not For SaleMost of the Fed’s open-market operations are, in fact, transacted with about

two dozen specialized security dealers located in New York City. The FederalReserve Bank of New York serves as the Fed’s agent for the purchase and sale ofsecurities. Billions of dollars—mostly in short-term government securities—change hands daily in this market.

Key Role of Excess Reserves The Fed’s ability to influence the money supplythrough its open-market operations is restricted. Although purchasing govern-ment securities from banks does increase bank reserves, banks are not obligatedto make loans and businesses are not obliged to borrow. Conversely, selling secu-rities cannot prevent an expansion of the money supply unless enough are sold toabsorb all the excess reserves. The effectiveness of the Fed’s efforts to limit expan-sion of the money supply depends on the status of excess reserves. In any case,however, the purchase of securities in the open market by the Fed increases themember banks’ ability to expand the money supply, whereas the sale of securitiesdecreases the member banks’ ability to create money.

Reserve RequirementsWe saw in Chapter 14 that a bank’s ability to create money is affected by theamount of reserves it must hold for its checkable deposits. An increase in the

F I GU R E 1 5 - 5FOMC Buys Securities from Individuals and Businessesat a 10 Percent Reserve Requirement

Individuals and Businesses

Receive $50,000

FOMC BuysSecurities $50,000


$900,000


ALL BANKS



$450,000

Additional Deposits

of $50,000


$100,000


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reserve requirement decreases the bank’s ability to increase the money supply andvice versa. The Board of Governors of the Federal Reserve has the authority todetermine, within limits, the amount of reserves that banks must hold againstcheckable deposits. These moneys, as designated by the Fed, are referred to asrequired reserves. Any reserves over and above this amount that a bank mayhave are excess reserves. Both are important to the potential size of the moneysupply.

Before 1980, the Fed could regulate only member bank deposits and reserves,but the Monetary Control Act of 1980 made all depository institutions subjectto the Fed’s reserve requirements. With respect to reserve requirements, depositsare divided into two broad categories: transaction accounts and nonpersonal timeaccounts. Transaction accounts include the various forms of checkable deposits:regular checking accounts; NOW accounts; automatic transfer service (ATS)accounts; share draft accounts in credit unions; and accounts that permit paymentby automatic teller, telephone, or preauthorized transfer. Nonpersonal timeaccounts include negotiable (and transferable) certificates of deposit (CDs) andlarge CDs that require at least 14 days’ notice before withdrawal is made.

Required reserves against transaction accounts in 2009 were 3 percent ondeposits from $10.3 million to $44.4 million and 10 percent on deposits inexcess of that amount. Breaking points can be adjusted annually. The MonetaryControl Act authorizes the Fed to impose a supplemental reserve requirement ofup to 4 percent under certain conditions. The Fed pays interest on such supple-mental reserves. Reserve requirements against nonpersonal time deposits are set(again by the Fed) between 0 and 9 percent. Table 15-2 shows the current reserverequirements.

Effect of Lower Reserve Requirements The Fed may decrease the reserve re-quirements during periods of low production, income, and employment to in-crease themoney supply and expand business activity. To see how this is accomplished,

TA B L E 1 5 - 2Reserve Requirements Established by the MonetaryControl Act of 1980

TYPE OF ACCOUNTS

MINIMUMREQUIREMENT

(%)

MAXIMUMREQUIREMENT

(%)

CURRENTREQUIREMENT (%)(AS OF JANUARY,

2009)

Net transaction accounts

$10.3 million to $44.4 million 3 3 3

Over $44.4 million 8 14 10

Nonpersonal time accounts 0 9 0

Source: Federal Reserve Board of Governors.

Required ReservesThe amount of reservesthat member banks musthold against checkabledeposits.

Excess ReservesAny reserves that a bankmay have over and abovethe legally establishedrequired reserves.

Monetary Control Actof 1980The 1980 act that made alldepository institutionssubject to the Fed’s reserverequirements.

Transaction AccountsThe various forms ofcheckable deposits,including regular checkingaccounts, NOW accounts,ATS accounts, and sharedraft accounts.

Nonpersonal TimeAccountsNegotiable certificate ofdeposits (CDs) and largeCDs that require noticebefore withdrawal is made.

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consider an example in which the banking system as a whole has no excessreserves to use as a basis for expanding checkable deposits. This situation (assum-ing a 10 percent reserve requirement) is depicted in Figure 15-6.

The banks are holding $100,000 in cash reserves (10 percent) against totaldeposits of $1 million ($100,000 in primary deposits and $900,000 in loans inthe forms of checkable deposits). In this situation, the banks cannot create anymore checkable deposits. If the reserve requirement is decreased to 5 percent, how-ever, the banks need to hold only $50,000 in required reserves against the $1 millionin checkable deposits. Therefore, if the remaining $50,000 is left on deposit withthe Fed, it constitutes excess reserves. On the strength of these reserves, the bankscan extend another $1 million in checkable deposits (see Figure 15-7).

F I GU R E 1 5 - 6Reserve Requirement at 10 Percent


$100,000


$900,000

Required Reserves

$100,000

ALL BANKS

F I GU R E 1 5 - 7Fed Lowers Reserve Requirement to 5 Percent


$100,000


$900,000


ALL BANKS



$1,000,000


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A decrease in the reserve requirement thus increases the banks’ ability toexpand checkable deposits and thereby effectively increases the money supply.Reduction of the reserve requirement does not necessarily increase checkabledeposits or the money supply, however; it merely enables the banks to increasecheckable deposits. There can be no increase in the money supply until businessesor others actually borrow from banks in the form of checkable deposits. Whatfrequently happens in a period of recession is that the Fed lowers the reserverequirement, but businesspeople are reluctant to borrow and spend moneybecause of the poor return on capital investment. Therefore, lowering the reserverequirement may not result in an increase in the money supply.

Effect of Higher Reserve Requirements The Fed can decrease the banks’ abil-ity to expand the money supply by raising the reserve requirement. Assume onceagain the situation depicted in Figure 15-6, in which the banks have no excessreserves. If the Fed increases the reserve requirement from 10 percent to 20 percent,the banks will be short of required reserves. As a result, they must either increasetheir reserves or recall some of their outstanding loans to bring their reservesup to 20 percent of their checkable deposits (see Figure 15-8). The action ofthe banks in recalling loans reduces their checkable deposits to $400,000. Thus,the increase in the reserve requirement effectively decreases the money supplyby $500,000.

In reality, the Fed never increases the reserve requirement by a large amountbecause doing so would seriously disrupt business activity. The Fed is moreinclined to use its power to prevent undesirable conditions from developing. Forexample, it may ease the money supply by lowering reserve requirements whenthe economy appears to be entering a period of declining business activity, inthe hope that it will prevent a recession. Otherwise, it may tighten the moneysupply by raising reserve requirements when the economy approaches the full-employment stage of business activity because further increases in the moneysupply under these conditions are likely to produce higher prices.

F I GUR E 1 5 - 8Fed Raises Reserve Requirement to 20 Percent


$100,000


$400,000

Required Reserves

$100,000

ALL BANKS

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Discount RateThe discount rate is the interest rate at which depository institutions may borrowfunds from the Reserve Banks. If you as an individual wished to borrow $100 at10 percent from a bank for one year, you would have to sign a note payable tothe bank (which thus becomes a note receivable for the bank). The bank wouldthen discount your note for you. Instead of giving you the face value of the note,the bank would deduct the interest and give you $90. However, you would stillhave to repay $100 to the bank. The difference, $10, represents the interest ordiscount.

Discounting Process Discounting is a very short-term borrowing that banks useto replenish their reserves (i.e., to bring them up to the required level). If a bankis short of reserves, it can obtain funds by recalling loans, selling governmentsecurities or other assets, or borrowing from other banks. Suppose that the bankis making 10 percent interest on its loans or other assets. If the discount rate isalso 10 percent, it will not matter much whether the bank recalls loans, sellsassets, or borrows from the Reserve Bank’s discount window. Rather than disruptits operations, it will probably prefer to go to the discount window and obtain adirect credit to its reserve account. Moreover, if the discount rate is only 5 percent,the bank will find it cheaper and more profitable to borrow from the ReserveBank. On the other hand, if the discount rate is 8 percent, the bank will be lesslikely to borrow from the Fed.

Even if a bank is not short of required reserves, the discount rate affects thebank’s action. For example, if the discount rate is lower than the rate of interestthat the bank can make on loans, the bank may be encouraged to extend addi-tional loans, knowing that it can borrow at a lower rate at the discount window ifit runs short of required reserves. On the other hand, when the discount rate ishigher, the bank will be reluctant to expand loans.

Lowering the discount rate provides a signal that the Fed wants to encouragean expansion of the money supply. Raising the discount rate gives the oppositesignal. When business activity is falling, the Fed may lower the discount rate,encouraging banks to discount and increasing their ability to expand the moneysupply. In turn, the banks encourage businesses to borrow by lowering the com-mercial loan rate. During full-employment inflationary periods, the ReserveBanks raise the discount rate to discourage discounting, which restrains theexpansion of the money supply and discourages borrowing by pushing up com-mercial loan rates.

The discount rate is usually changed in small increments—one-fourth or one-half a percentage point at a time—so that the change does not seriously disruptbusiness activity. This action is primarily preventive rather than remedial. Some-times, in fact, changes in the discount rate lag behind changes in the commercialloan rates. In such cases, the Fed may raise or lower the discount rate simply toreduce the spread between the two rates.

Discount RateThe interest rate at whichdepository institutionsborrow funds from theReserve Banks.


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The discount rate for each district is determined by its Reserve Bank withthe approval of the Board of Governors. Although the Reserve Banks themselvesinitiate changes in the discount rate, the Board retains authority to review anddetermine discount rates. The discount rate often varies slightly for short periodsamong districts because of differences in the money markets. When a districtchanges its rate, the others usually follow suit because factors of national scopeare generally responsible for the change.

It is important to remember that a decrease in the discount rate generallyencourages banks to expand their checkable deposits and encourages businessesto borrow, thus tending to increase the money supply. An increase in the dis-count rate discourages banks from expanding their checkable deposits and dis-courages businesses from borrowing, thus tending to limit increases in the moneysupply.

Commercial Loan Rates Changing the discount rate has a secondary effect aswell. The commercial loan rate is greatly influenced by the bank discount rate.For example, the prime rate—the interest rate at which individuals and firmswith the best collateral can borrow—is usually a few percentage points abovethe discount rate. Thus, if the discount rate in Atlanta is 5 percent, the primerate may be 8 or 9 percent. Usually, when the discount rate is lowered, the com-mercial loan rates are lowered too, encouraging businesses to borrow. However, ifthe discount rate is raised, the commercial loan rates may also be increased, whichtends to discourage businesses from borrowing. The funds may still be available,but at a higher cost.

Federal Funds Market Besides borrowing from the Reserve Bank, a bank canadjust its reserve position by borrowing from other banks that have surplusreserves. Such interbank borrowing takes place in a fairly well-organized marketknown as the Federal Funds Market. The federal funds rate (over which the Fedhas some influence) is the rate at which banks are willing to borrow or to lendimmediately available reserves on an overnight basis. It is a very sensitive indicatorof the tightness of bank reserves. The federal funds rate may be higher or lowerthan that prevailing at the discount window, depending on the status of excessreserves. By facilitating the transfer of the most liquid funds between depositoryinstitutions, the federal funds market plays a major role in the execution of mone-tary policy. The interest rate on federal funds, the federal funds rate, is highlysensitive to Federal Reserve open-market operations that influence the supply ofreserves in the banking system. For example, if the Federal Reserve wishes toincrease the growth rate of the money supply, it may purchase securities in theopen market, thereby increasing the availability of bank reserves and decreasingthe federal funds rate. Sales of securities by the Fed in the open market tend tohave the opposite effect.

The Federal Reserve does not announce its policy intentions, so observers ofmonetary policy pay careful attention to the open-market desk’s reserve

Prime RateThe rate at whichindividuals and firms withthe best collateral canborrow.

Federal Funds MarketA fairly well-organizedmarket where interbankborrowing takes place.

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operations in conjunction with the federal funds rate to capture signals of changesin monetary policy. Changes in the money supply and movements in the federalfunds rate have important implications for the loan and investment policies of allfinancial institutions, especially commercial banks. Financial managers comparethe federal funds rate with yields on other investments before choosing the com-binations of maturities of financial assets in which they will invest or the termover which they will borrow.

U.S. Foreign Exchange Intervention Foreign exchange intervention is the pro-cess by which the U.S. monetary authorities attempt to influence market condi-tions and/or the value of the U.S. dollar on the foreign exchange market. This isdone to try to promote stability by countering disorderly markets or in responseto special circumstances. Foreign exchange rates are of particular concern to gov-ernments because changes in exchange rates affect the value of financial instru-ments all over the world and, as a result, might affect the health of countries’financial systems. In addition, rate changes can also affect a nation’s internationalinvestment flows and terms of trade. These factors, in turn, can influence infla-tion and economic growth.

Although the U.S. Treasury has overall responsibility for foreign exchangepolicy, its decisions are made in consultation with the Federal Reserve System.Intervention is conducted by the Federal Reserve Bank of New York on behalfof the U.S. monetary authorities. If a decision is made to support the dollar’sprice against a currency, the foreign trading desk of the New York Fed will buydollars and sell foreign currency; to reduce the value of the dollar, it will sell dol-lars and buy foreign currency. In addition, traders at the New York Fed observemarket trends and developments to provide information to policymakers.Although the Fed’s trading staff may operate in the exchange market at anytime and in any market in the world, the focus of activity usually is the U.S.market.

Other ControlsMoral suasion is a term applied to a number of different measures that the Feduses to influence the activities of banks in one way or another. For example, itmay send banks letters in which it encourages or discourages the expansion of themoney supply. At other times, it may issue public statements revealing the statusof the economic situation and urging businesses and banks to expand or torestrain the money supply. During personal interviews, Fed officers may warnagainst speculative loans or may suggest that banks become more liberal withtheir loans. The Fed may ration credit and suspend the borrowing privileges ofbanks if necessary. In general, moral suasion affects the money supply only to theextent that banks and businesses are willing to cooperate.

At various times, the Fed has also been given discretionary control over cer-tain specific uses of money and credit in the economy. These controls are known

Moral SuasionA number of differentmeasures that the FederalReserve Board uses toinfluence the activities ofbanks.


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as selective controls. For example, the Fed currently has the authority to set stockmarket margin requirements. The margin requirement is the portion of a stockpurchase that may be made on credit (usually with a loan from the brokeragehouse). The higher the margin requirement, the greater the down paymentrequired to purchase shares of stock, which reduces the opportunity for specula-tion in the stock market, holds down the demand for stocks, and moderates stockprices. At one time, the Fed also had control over the conditions or terms ofinstallment sales. The controls set the percentage of the down payment and thelength of time in which an installment loan had to be repaid, and they had theeffect of limiting total demand. For a short time in the late 1970s, the Fed alsohad the authority to impose restrictions on purchases made via credit cards.

RECENT FEDERAL RESERVE ACTIONSThe Fed is an independent organization within the government, not apart fromit. As such, it exercises a considerable amount of autonomy. Because the Fed isresponsible only to Congress, it may or may not agree with the economic policiesof a given presidential administration. However, because both have the sameobjectives (economic growth and high employment, along with a stable pricelevel), their actions usually complement each other.

The 1990s were a period of sustained economic growth, low inflation, andhigh levels of employment. On several occasions, the Fed acted to preempt infla-tionary pressures by raising the discount rate by a quarter percent or more andpressuring the federal funds rate upward. But the Federal Reserve’s stance formost of the decade could be characterized as neutral to accommodating. How-ever, the Fed became increasingly concerned about inflation in mid-1999, andas a result of a series of interest rate hikes, the federal funds rate rose to 6.50percent by June 2000. The speculative bubble in the markets burst in 2001,and with it came a slowdown in the economy. As signs of continuing deteriora-tion of the economy became more widespread, the Federal Reserve quickly shiftedinto an easy money policy.

In 2004, the Fed reversed course as the economy once again rebounded. Agrowing economy, increasing federal government deficits, and the fear of inflationwere the driving forces for the higher interest rates. Heightened by rising energyand commodities prices, the Fed continued its tighter monetary policy.

The warning signs of a pending financial crisis and the spectre of anotherrecession were seen on the horizon as early as 2005, and by 2006 ominous signsof a speculative bubble in the economy once again appeared. This time it occurredin the housing sector. Until 2007, the economy prospered as economic growth keptinflation in check and unemployment at acceptable levels. In mid-2007, the FederalReserve reversed course to head off a possible severe recession and began a series ofcuts in the federal funds rate that eventually approached a zero rate of interest.

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The primary villains in this cycle were subprime mortgages and the issue ofcomplex investment vehicles that were little understood even by buyers of thedebt. Once it started to unwind, it became clear that the housing boom of pre-vious years was largely fueled by “interest-only” mortgages, adjustable rate mort-gages, and “no-money-down” mortgages. Many of these home buyers could illafford any change in mortgage terms. These mortgages were sold to FannieMae, which repackaged them into mortgage-backed securities and sold them toindividual investors. This allowed banks and mortgage companies to sell off mort-gages and take them off their balance sheets. This removed one constraint onlenders to make sure the loans were made to qualified buyers. However, most ofthese homeowners had acquired housing as subprime borrowers with adjustablerates. As these rates rose, mortgage payments rose as well, creating hardships,bankruptcies, and foreclosures on an unprecedented scale. To compound matters,these mortgages were sold in packages that in many cases were complex and oftenmisunderstood. While sitting on toxic mortgage-backed securities and collateraldebt obligations (packages of primarily credit card and auto loans) that becameimpossible to trade, banks suffered a huge decline in capital. On some complicatedoff-book investments, the banks had also invested in long-term debt obligationswhile borrowing short. Because of declining short-term interest rates, investorsthen began to cash in. Now the banks experienced a liquidity problem as well.Banks began to hoard cash and to refuse loans even to creditworthy applicantsand were reluctant to loan to other banks, not knowing how solvent the banksmight be.

The financial sector once again looked to the Federal Reserve for help. After aseries of cuts in the federal funds rate and cuts in the interest rates, the FederalReserve realized that traditional monetary tools were not having their desiredeffects. The Fed announced it would lend billions of dollars to bail out bonddealers who were stuck with mortgage-backed securities and collaterized debtobligations they could not sell on secondary markets. The Fed implemented anaction somewhere in between the discount window and open-market operations,namely the Term Auction Facility (TAF). The TAF was an anonymous auctionof loans that was held weekly. The Fed loaned the money for 28 days (rather thanovernight), and banks backed these loans by a pledge of highly rated securities.Critics claimed that the Fed had only provided a short-term remedy because theproblem was one of solvency and not liquidity. The Fed also announced that itwould provide a series of term repurchase transactions windows with terms similarto the TAF. These were direct transactions with the Fed and not anonymous.

Later in 2008, the market was thrown into another state of turmoil whenBear Stearns, one of the largest investment banks in the world, was declared illi-quid and its assets were purchased by J.P. Morgan. The Fed did not choose toprevent Bear Stearns from going out of business, rather arranged for its sale. TheFed announced that it would directly loan $30 billion to J.P. Morgan to assistin acquiring Bear Stearns’s assets. The Fed does not as a rule provide direct

Term Auction Facility(TAF)A facility in which bankscan bid for an advancefrom their local FederalReserve Bank at an interestrate determined by anauction.


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loans to any bank but did so deeming this situaton as critical. The loans werebacked by difficult-to-value assets from Bear Stearns. Second, the Fed announcedthat all investment banks were now eligible to borrow from its discount window,a service not provided to investment banks since the Great Depression in the1930s. The discount window has been a monetary tool available only to commer-cial banks.

However, the financial crisis was far from over. In September 2008, LehmanBrothers, a 158-year-old financial institution declared bankruptcy. Rather thanpropping up another financial institution, the Fed and the Treasury let the firmcollapse. A week later, the Fed and the Treasury rescued American InternationalGroup (AIG), a giant insurance company, from declaring bankruptcy by theTreasury and the Fed by means of loans worth an estimated $85 billion inexchange for stock warrants. Although not a banking institution, AIG’s debt iswidely held by banks and mutual funds. If AIG had trouble meeting its debt obli-gations, it was felt that the domino effect would spread throughout the world.1

The next blow occurred when the Federal National Mortgage Association(Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac)also appeared to be headed for bankruptcy. The federal government stepped inand assumed control of both publicly traded companies. In effect these quasi-government companies were nationalized. The Fed increased liquidity throughoutthe world to prevent further damage.

In late September 2008, the largest bank failure occurred when WashingtonMutual’s assets were seized by the federal government and turned over to theFederal Deposit Insurance Corporation, which sold most of its assets and liabil-ities to J.P. Morgan. In addition, PNC Bank acquired National City Bank, Bankof America acquired Merrill Lynch, and Wells Fargo acquired Wachovia. Con-cern over the lack of liquidity combined with huge financial debt is likely tobring more rescues.

The Fed’s approach, and that of the federal government’s, in preventing thebankruptcy of some financial institutions raises the debate again over the moralhazard issue. By preventing financial institutions from failing, and if these actionslead to additional rescues or bailouts of other troubled financial firms, it is arguedthat large financial firms can now take more risks, not less. As long as they believethat they are too big to fail, a “moral hazard”results.

Coordinating Monetary and Fiscal PolicyAlthough the Federal Reserve usually works hand-in-hand with the administrationto stabilize the level of economic activity and the price level, attempts at coordi-nated efforts sometimes fall short. Coordination among monetary and fiscal poli-cies can be difficult for several reasons. First, the Fed is more autonomous and

1Another $25 billion was granted to AIG in November 2008 to further stabilize the company.

Moral HazardOccurs when thegovernment compensatesindividuals and firms forlarge-scale losses andcreates a climate for greaterrisks and losses in thefuture.

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can act more quickly. Because monetary policy is more flexible, the Fed can alsoreverse course quickly if need be. Fiscal policy is more difficult to implementbecause it occurs in the political arena. Consequently, the time required toenact change can be lengthy. Unlike monetary policy, once a change is enactedin fiscal policy, it is politically difficult to eliminate when the desired results ofthat policy change are no longer needed. Finally, monetary and fiscal authoritiesmay disagree with one another, and the results may be counterproductive.

CRITICS OF THE FEDERAL RESERVEThere have been numerous critics of the Federal Reserve System’s structure andpolicies. Much of their criticism centers on the belief that the Fed’s independentstatus allows it to exercise too much power over the economy and consequentlyover the economic well-being of households and businesses. Many of these criticscontend that any institution with this amount of power should be placed underthe direct control of Congress. Defenders of an independent Federal Reserveworry that putting the Federal Reserve directly under congressional controlwould mean that decisions concerning monetary policy would be driven by polit-ical considerations. These individuals favor a monetary authority that is indepen-dent of the political process.

Although for entirely different reasons, even a group of economists seek torestrict the autonomous decision-making powers of the Fed. These economists,known as monetarists, believe that the Fed only worsens economic conditionswhen it attempts to stabilize the economy by pursuing either a tight money policyor an easy money policy. Their solution is to have the Fed increase the moneysupply at about the same annual rate as the long-run growth rate of the economy.This approach would strip away the Fed’s discretionary powers to deal with eco-nomic fluctuations.

ISSUES AND CONCERNS IN BANKINGThe banking industry is no longer a sleepy association of small-town banks,savings and loans, and credit unions. It has become a highly competitive, techno-logically oriented spectrum of financial services. The marketplace has grownnationwide, even worldwide, and some of the players are well-known names inother fields. But these changes in the banking industry have not prevented bankfailures, nor have they dampened enthusiasm for greater competition and lessregulation.

DeregulationFor most of the twentieth century, the basis for the structure of financial institu-tions in the United States can be traced back to 1932 with the passage of


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the Glass–Steagall Act. The Great Depression drove many banks out of business.The worst casualties were small banks, partly because they were unable to survivethe vigorous competition that preceded the financial collapse. To guard againstruinous competition in the future, Congress passed the Glass–Steagall Act, whichincreased regulation and decreased competition in the banking industry. Histori-cally, this act created distinctions among depository institutions, the securitiesindustry, and the insurance industry. Each of these three groups was subdividedinto constituent compartments. Depository institutions, for example, includedseparate compartments for commercial banks, savings and loans, mutual savingsbanks, credit unions, and industrial banks. The securities industry was subdividedinto brokerage firms, securities dealers, underwriters, and rating agencies. As long asthese compartments were separate and noncompeting, each compartment could beregulated independently. In fact, for many decades they were.

These regulations were designed as if banks did not compete with other typesof financial institutions. But over the years, any natural walls separating the finan-cial institutions have largely fallen away, despite the regulatory restrictions regard-ing price, location, and product.

In general, price restrictions are no longer important in banking. Maximuminterest rates on time and savings deposits were dismantled between 1980 and1986 in compliance with the Monetary Control Act of 1980. Statutory prohibi-tion of interest payments on demand deposits is also irrelevant today. The 1980act also expanded the use of Fed services to nonmember banks, increased insur-ance coverage on deposits, and expanded the availability of checking accounts.By mid-1985, deregulation at the state level further increased competitionbecause more and more states were permitting branch banking. Branch bankingallowed banks to have branches throughout a state. Branch banking was followedby the emergence of interstate banking, which permits a bank in one state toconduct banking operations in other states. Following the passage of state laws,Congress passed the Riegle–Neal Act in 1994. This act permitted interstatebranch banking on a national scale for the first time since the Great Depressionyears. Banks no longer have to create subsidiaries or holding companies to oper-ate across state lines. Branch banks can be extended regionally and even nation-ally. In addition, foreign banks now operate branches in various cities in theUnited States.

With pricing and location restrictions removed, only the regulations pertainingto product competition remained. However, the Financial Services Moderniza-tion Act of 1999 eliminated many of these product restrictions from regulation.For all intents and purposes, the 1999 law served as the death knell of the Glass–Steagall Act.

The Financial Services Modernization Act removed the long-standing separa-tions between banks, brokerage firms, and insurance companies. As seen earlier,brokerage firms and insurance companies can buy banks, and banks can

Glass–Steagall ActThe 1932 act thatincreased regulation anddecreased competition inthe banking industryduring the GreatDepression.

Branch BankingThe practice of operatingmultiple outlets of a singledepository institutionthroughout a state, aregion, or the nation.

Interstate BankingThe practice ofconducting bankingoperations across statelines.

Riegel–Neal ActThe 1994 act thatpermitted interstatebanking for the first timesince the GreatDepression.

Financial ServicesModernization Act of1999The 1999 act thateliminated restrictionsplaced on the bankingindustry by the Glass–Steagall Act and removedthe separate regulatorybarriers between financialinstitutions.

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underwrite insurance and securities. With the 1999 law, consumers have theopportunity to shop for almost any financial service, from CDs to life insuranceto online stock trading, in one place.

The Financial Services Modernization Act did not eliminate banking regula-tions. The legal framework of finance and commerce remains, including the lawsthat discourage fraud and misrepresentation, guard against anticompetitive prac-tices, and require timely release of accurate information. In addition, the law gavethe Federal Reserve umbrella authority over bank affiliates that engage in riskybusiness activities, such as insurance underwriting and real estate development.The Treasury Department’s Office of the Comptroller of the Currency now hasthe authority to regulate bank subsidiaries.

Deregulation, the expansion of foreign bank branches in the United States,the impact of foreign interest rates, and the globalization of money flows make itmuch more difficult today than previously for the Fed to control domestic inter-est rates and the money supply and to influence domestic economic activity. Butcalls for greater regulation are now coming from some quarters of the economy asa result of the banking crisis in 2008. Consequently, the future may witnessincreased regulation of certain banking activities and restrictions on complexinvestment vehicles.

Industry ConcentrationThe banking industry is going through substantial changes in market structure asa result of deregulation and technological innovations. Both factors have thepotential to produce long-lasting effects, not only in the banking industry, butalso in the entire financial sector. However, uncertainty exists as to whetherthese changes will result in greater concentration of market share by the largestbanks or whether overall competition will increase.

Deregulation of the banking industry has contributed to numerous mergersamong banks. The number of banks has been declining for several decades, evenbefore the passage of recent legislation. In 1983, for example, there were 14,800commercial banks in the United States. Of those, 37 percent (5,400) belonged tothe Federal Reserve System. Although the number of commercial banks contin-ued to decline with the passage of time, the 1994 Reigle–Neal interstate bankinglegislation increased the rate of consolidation. Today, there are approximately7,600 commercial banks remaining, of which less than 3,000 are members ofthe Federal Reserve System.

The smaller number of banks has undoubtedly increased concentration in theindustry. Following deregulation, some of our nation’s oldest and largest bankssuccessfully merged. For example, Nations Bank merged with Bank of America,while Chase Manhattan and Bank One have merged with J.P. Morgan. Recently, anumber of failing banks have merged or disappeared as a result of the 2008


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financial crisis. More than ever, most financial assets held in banks are concentratedin a relatively small number of banks.

Branch banking and interstate banking have undoubtedly played roles inshrinking the number of banks; so too has the drive to achieve larger, morecost-efficient organizations. For example, mergers often eliminate duplicate ser-vices such as branches, automated teller machines (ATMs), and information tech-nology services. Although the number of commercial banks has fallen, the totalnumber of banking offices has increased more than 23 percent since 1983.Today, banking offices can be found in shopping malls, large supermarkets, air-ports, and hotels. Interstate branch banking continues to grow, although unevenlyacross regions. Most analysts suggest that consolidation will likely help create asingle unified financial market.

In addition to legal reforms, another new source of competition may lie in theInternet. The Internet is creating considerable competition to traditional banksfrom both within and outside the financial sector. New entrants have had relativelyeasy access to the market, but survival rates have not been strong. If many of thenew entrants succeed, However, the Internet will actually strengthen competition.However, early signals are that the Internet competition will be coming from largecompanies in the nonfinancial sector in terms of account aggregation. Accountaggregation refers to the ability to view all of one’s financial accounts on a singleWeb page. In the future, industry concentration could lessen if traditional banksface intense competition sparked by new technology and the Internet. However,the long-term viability of these new forms of competition remains uncertain.

Mergers will lead to fewer banks that compete vigorously across national mar-kets. The broader scope of these large banks may spur new, smaller competitors atthe local level. Also, the effects of consolidation may be more than offset by theincreased competition stemming from the Internet as well as from new technolo-gies that make it easier for both bank and nonbank firms to compete with moretraditional banks. One concern of the rescue of Bear Stearns by J.P. Morgan isthat by lending money via the discount window to investment banks, the Fed hasblurred the distinction between commercial banks and investment banks. Shouldthis trend continue, a further concentration could result.

Electronic BankingAn important part of the Federal Reserve’s mission is to ensure that the nation’spayments system evolves to meet the needs of a dynamic economy. One reasonthat Congress created the Fed in 1913 was to establish a coherent national systemfor clearing checks. Today, one of the Fed’s major priorities is developing anorderly transition from a payment system based on currency and checks to onebased on electronic banking. The important role of electronic banking is evidentby the fact that electronic transfers now account for nearly 90 percent of the dol-lar value of all transactions in the United States.

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Electronic banking is not new. The Fed and the nation’s banking communityhave long operated using electronic transfers. However, until recently, electronicbanking was an activity largely invisible to the general public. More than anythingelse, it was the Debt Collection Improvement Act of 1996 that created a height-ened awareness of electronic banking. Wherever possible, the 1996 law requiredthe federal government to make all payments electronically by 1999. Today,payments made by the federal government for such things as wages, salaries,food stamps, welfare, pensions, Social Security, and the purchase of goods andservices are made electronically by means of direct deposit. As a result, millionsof Americans have been introduced to at least one form of electronic banking.The Fed processes approximately 80 percent of all electronic payments. Althoughelectronic banking is not new, what is new are the different types of electronicpayments available to government, business, and the consumer.

Electronic banking is a general term that refers to various forms of financialtransactions that entail the electronic transfer of funds in and out of accounts.The most common form of electronic banking transfer is the automated tellermachine (ATM), which allows us to make deposits, obtain cash, and transferfunds between accounts. Another form of electronic banking is the preauthorizedelectronic bill payment and its companion, the direct deposit payment. Preauthorizedbill payments are automated debits or reductions to the account. Electronic billpayment is most commonly used for recurring payments such as rent, utility bills,loans, and insurance payments. Direct deposits, on the other hand, are automatedcredits or increases. Direct deposits are increasingly used by employers, govern-ment agencies, and organizations that make regular payments, such as wagesand dividends, to individuals. Today, over 60 percent of U.S. households receivetheir wages by direct deposit. The U.S. government is the largest single user ofdirect deposit. The Social Security Administration alone uses direct deposit tomake payments to 5 million recipients every month. Both preauthorized electronicbill payments and direct deposits are usually cleared through the Fed.

Stored-value and smart cards are two other forms of electronic banking that arebecoming increasingly popular. Stored-value cards provide a convenient substitutefor cash and checks. The cards contain a magnetic strip that records a dollar bal-ance that is established when the card is purchased. Most of these cards can beused only for a single purpose, such as for public transit systems, university foodservice, and public telephones. Smart cards are similar to stored-valued cardsexcept that they contain a computer chip instead of a magnetic strip. When thebalance is at zero, a smart card can be reloaded with funds by using an ATM.

Home banking is also being offered by more and more financial institutions.Software packages now allow customers to debit or credit accounts, confirm bal-ances, and even apply for a loan.

Consumers are embracing electronic money more than ever before, despitetheir historical reluctance to forgo the use of currency and checks and move to acashless society. However, there are still millions of households without banking

Electronic BankingFinancial transactions thatentail the electronictransfer of funds.


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accounts and many millions more that have fears about the security and privacyof electronic banking. Countless others simply refuse to use new technology.Consequently, the shift to electronic banking has been evolutionary. But thisshift is accelerating as college graduates who have grown up with computers,ATMs, and the Internet move into the economic mainstream.

The Federal Reserve Payments Study released in 2007 estimates that over66 percent of all payments and nearly half the dollar value are made electronically.The rapid adoption of electronic banking can be seen in Figure 15-9. Figure15-9(a) shows that the largest number of payments (33 percent) are still madeby checks. Debit cards, accounting for 27 percent, have replaced credit cards(23 percent) as the second largest form of payment. Payments by the AutomatedClearing House Network (ACH) with 16 percent and by the Electronic BenefitsTransfer Network (EBT) with 1 percent complete the chart. The ACH paymentsinclude Social Security, tax refunds, direct payment of consumer bills and mort-gages, business-to-business payments, and tax payments. The EBT payments aretransfer payments made by government agencies to retailers primarily for foodstamps. Figure 15-9(b) presents electronic payments on the basis of dollarsexpended. On a dollar-value basis, checks are first with 55 percent, followed byACH payments, credit cards, and debit cards. The value of EBT payments isinsignificant.

The benefits to society from electronic banking are clearly seen. Processingchecks is a labor-intensive, relatively inefficient process. Americans write about70 billion checks every year. The Federal Reserve estimates that the costs of pro-cessing these checks are equal to 1 percent of the gross domestic product. As

F I GUR E 1 5 - 9Distribution of the Number and Value of NoncashPayments

27%Debit card

Debit card(a) Number (b) Value

Credit card

EBT

EBT

Checks(paid)33%

1%

55%

Checks(paid)

Source: The Federal Reserve’s Study on Electronic Payments (2007).

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economic incentives to change intensify and as we become more familiar withnew banking systems, electronic banking may eventually equal or exceed cash orchecks as the convenient and accepted means of paying for goods and services.

Chapter 15 Review

SUMMARY� The Federal Reserve System is composed of a

Board of Governors, a Federal Advisory Council,a Federal Open Market Committee (FOMC), 12Reserve Banks, 25 branch banks, member banks,and several minor organizations. It is owned bythe member banks, but its most important offi-cials are appointed by the president of the UnitedStates. The Board of Governors, whose mainfunction is to formulate monetary policy for theU.S. economy, consists of seven membersappointed by the president with the approval ofthe Senate. Each member must be selected froma different Federal Reserve District and isappointed for a term of 14 years. The chairmanand the vice chairman are selected from the sevenmembers by the president.

� The Federal Reserve uses general and selectivecontrols to affect the money supply by regulatingthe reserve requirements, thus influencing thelevel of economic activity and/or the price level.The general controls affect the overall supply ofmoney; the selective controls affect the use ofmoney for specific purposes in the economy.

� The reserve requirement is a powerful tool of theFederal Reserve. By changing the reserve require-ment, the Fed can greatly affect a bank’s abilityto loan money. Increasing the reserve require-ment tends to constrict the money supply,while decreasing the requirement tends to in-crease the money supply.

� A change in the discount rate affects the moneysupply by influencing the borrowing that banksand businesses engage in. Generally, an increasein the discount rate discourages banks from bor-rowing to increase their reserves and discouragesbusinesses from borrowing because an increaseusually forces up the commercial loan rate.

� The Fed will engage in open-market operationswhen it wants to affect bank reserves. To expandthe money supply, the FOMC will order securi-

ties to be purchased. When price levels are rising,the Fed will sell government securities to thebanks to absorb some of the existing excessreserves.

� In 2007 and 2008, the Fed engaged in seldomand even unprecedented use of new approachesto prevent further decline in the economy. Withthe subprime housing market in collapse and il-liquidity in the securities industry, the Fed madedirect loans to Wall Street banks and opened thediscount window to investment banks.

� The Depository Institutions Deregulation andMonetary Control Act of 1980 lessened regula-tion and promoted competition among deposito-ry institutions (commercial banks, savings banks,S&Ls, credit unions, etc.). Many of the differ-ences between commercial banks and otherdepository institutions were diminished by theact. The 1999 Financial Modernization Act elim-inated many of the product restrictions that werein place in the financial industry. With this act,brokerage firms and insurance companies cannow buy banks, and banks can underwrite insur-ance and securities.

� Recent structural changes in banking and finan-cial services industries include branch and inter-state banking; new types of accounts, such asNOW accounts; money market mutual funds;expansion of foreign bank branches in the UnitedStates; the globalization of money flows; and theincreased use of electronic banking.

� The banking industry is undergoing substantialchanges in market structure as a result of deregu-lation and technological innovations. Questionsexist as to whether deregulation and technologywill produce greater banking competition in thefuture or whether the largest banks will increasetheir share of the market at the expense of smallerbanks.


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NEW TERMS AND CONCEPTSFederal Reserve ActFederal Reserve SystemMember banksOpen-market operationsRequired reservesExcess reservesMonetary Control Act of 1980Transaction accountsNonpersonal time accountsDiscount ratePrime rate

Federal Funds MarketMoral suasionTerm Auction Facility (TAF)Moral hazardGlass–Steagall ActBranch bankingInterstate bankingRiegle–Neal ActFinancial Services Modernization Act of 1999Electronic banking

DISCUSSION QUESTIONS1. Other nations have but one central bank.Why is it

that the United States has multiple central banks?2. Should all commercial banks be required to

become members of the Federal Reserve System?Why or why not?

3. Because the federal government owns no stock inthe Reserve Banks, why should the governmentappoint the Federal Reserve Board of Governors?

4. Does the lowering of reserve requirementsautomatically increase the money supply? Whyor why not?

5. The Fifth National Bank has total deposits of$20,000,000 and has legal reserves of$5,000,000. If the legal reserve is 10 percent, isthis bank loaned up? What is the maximum loan

that the bank can make, and what is themaximum increase in the money supply?

6. How can a change in the discount rate affectcommercial loan rates?

7. What is the effect of the FOMC’s purchasingsecurities from individuals versus its purchasingthem from banks, insofar as the expansion of themoney supply is concerned?

8. What role does the Fed play in foreign exchangemarkets?

9. Should the independence of the Fed be modifiedin any way? Explain.

10. What does the globalization of money andbanking do to the Fed’s ability to stabilizedomestic prices?

Go towww.cengage.com/login. Register as a newuser or log in if you are a returning user. Register youraccess code to enter Economic Applications. Click onthe EconDebate icon. Then click on “Money and the

Financial System” under theMacroeconomics heading.This will take you to debates about the U.S. financialmarket.

316 Basic Economics

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