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But the total value of these sales at the end of the year says little or nothing about the actual level of risk that the grocery store owners accepted at any point during the year. And in fact, the grocery industry is a relatively low-risk business, because people buy food in good times and bad. Providing goods or services where production or consumer demand is more variable—such as exploring for oil and uranium, or making movies and high fashion clothing—is far riskier.

Return on Equity

What stockholders risk—the amount they stand to lose if a business incurs losses and shuts down—is the money they have invested in the business, their equity. These are the funds stockholders provide for the firm whenever it offers a new issue of stock, or when the firm keeps some of the profits it earns to use in the business as retained earnings, rather than paying those profits out to stockholders as dividends.

Profits as a return on stockholders’ equity for U.S. corporations usually average from 12 to 16 percent, for larger and smaller corporations alike.
That is more than people can earn on savings accounts, or on long-term government and corporate bonds. That is not surprising, however, because stockholders usually accept more risk by investing in companies than people do when they put money in savings accounts or buy bonds. The higher average yield for corporate profits is required to make up for the fact that there are likely to be some years when returns are lower, or perhaps even some when a company loses money.

At least part of any firm’s profits are required for it to continue to do business. Business owners could put their funds into savings accounts and earn a guaranteed level of return, or put them in government bonds that carry hardly any risk of default. If a business does not earn a rate of return in a particular market at least as high as a savings account or government bonds, its owners will decide to get out of that market and use the resources elsewhere—unless they expect higher levels of profits in the future.

Over time, high profits in some businesses or industries are a signal to other producers to put more resources into those markets. Low profits, or losses, are a signal to move resources out of a market into something that provides a better return for the level of risk involved. That is a key part of how markets work and respond to changing demand and supply conditions. Markets worked exactly that way in the U.S. economy when people left the blacksmith business to start making automobiles at the beginning of the 20th century. They worked the same way at the end of the century, when many companies stopped making typewriters and started making computers and printers.

CAPITAL, SAVINGS, AND INVESTMENT

In the United States and in other market economies, financial firms and markets channel savings into capital investments. Financial markets, and the economy as a whole, work much better when the value of the dollar is stable, experiencing neither rapid inflation nor deflation. In the United
States, the Federal Reserve System functions as the central banking institution. It has the primary responsibility to keep the right amount of money circulating in the economy.

Investments are one of the most important ways that economies are able to grow over time. Investments allow businesses to purchase factories, machines, and other capital goods, which in turn increase the production of goods and services and thus the standard of living of those who live in the economy. That is especially true when capital goods incorporate recently developed technologies that allow new goods and services to be produced, or existing goods and services to be produced more efficiently with fewer resources.

Investing in capital goods has a cost, however. For investment to take place, some resources that could have been used to produce goods and services for consumption today must be used, instead, to make the capital goods. People must save and reduce their current consumption to allow this investment to take place. In the U.S. economy, these are usually not the same people or organizations that use those funds to buy capital goods. Banks and other financial institutions in the economy play a key role by providing incentives for some people to save, and then lend those funds to firms and other people who are investing in capital goods.

Interest rates are the price someone pays to borrow money. Savings institutions pay interest to people who deposit funds with the institution, and borrowers pay interest on their loans. Like any other price in a market economy, supply and demand determine the interest rate.
The demand for money depends on how much money people and organizations want to have to meet their everyday expenses, how much they want to save to protect themselves against times when their income may fall or their expenses may rise, and how much they want to borrow to invest. The supply of money is largely controlled by a nation’s central bank—which in the
United States is the Federal Reserve System. The Federal Reserve increases or decreases the money supply to try to keep the right amount of money in the economy. Too much money leads to inflation. Too little results in high interest rates that make it more expensive to invest and may lead to a slowdown in the national economy, with rising levels of unemployment.

Providing Funds for Investments in Capital

To take advantage of specialization and economies of scale, firms must build large production facilities that can cost hundreds of millions of dollars. The firms that build these plants raise some funds with new issues of stock, as described above. But firms also borrow huge sums of money every year to undertake these capital investments. When they do that, they compete with government agencies that are borrowing money to finance construction projects and other public spending programs, and with households that are borrowing money to finance the purchase of housing, automobiles, and other goods and services.

Savings play an important role in the lending process. For any of this borrowing to take place, banks and other lenders must have funds to lend out. They obtain these funds from people or organizations that are willing to deposit money in accounts at the bank, including savings accounts. If everyone spent all of the income they earned each year, there would be no funds available for banks to lend out.

Among the three major sectors of the U.S. economy—households, businesses, and government—only households are net savers. In other words, households save more money than they borrow. Conversely, businesses and government are net borrowers. A few businesses may save more than they invest in business ventures. However, overall, businesses in the United States, like businesses in virtually all countries, invest far more than they save. Many companies borrow funds to finance their investments. And while some local and state governments occasionally run budget surpluses, overall the government sector is also a large net borrower in the U.S. economy. The government borrows money by issuing various forms of bonds.
Like corporate bonds, government bonds are contractual obligations to repay what is borrowed, plus some specified rate of interest, at a specified time.

Matching Borrowers and Lenders in Financial Markets

Households save money for several reasons: to provide a cushion against bad times, as when wage earners or others in the household become sick, injured, or disabled; to pay for large expenditures such as houses, cars, and vacations; to set aside money for retirement; or to invest. Banks and other financial institutions compete for households’ savings deposits by paying interest to the savers. Then banks lend those funds out to borrowers at a higher rate of interest than they pay to savers. The difference between the interest rates charged to borrowers and paid to savers is the main way that banks earn profits.

Of course banks must also be careful to lend the money to people and firms that are creditworthy—meaning they will be able to repay the loans.
The creditworthiness of the borrower is one reason why some kinds of loans have higher rates of interest than others do. Short-term loans made to people or businesses with a long history of stable income and employment, and who have assets that can be pledged as collateral that will become the bank’s property if a loan is not repaid, will receive the lowest interest rates. For example, well-established firms such as AT&T often pay what is called the bank’s prime rate—the lowest available rate for business loans—when they borrow money. New, start-up companies pay higher rates because there is a greater risk they will default on the loan or even go out of business.

Other kinds of loans also have greater risks of default, so banks and other lenders charge different rates of interest. Mortgage loans are backed by the collateral of the property the loan was used to purchase.
If someone does not pay his or her mortgage, the bank has the right to sell the property that was pledged as collateral and to collect the proceeds as payment for what it is owed. That means the bank’s risks are lower, so interest rates on these loans are typically lower, too. The money that is loaned to people who do not pay off the balances on their credit cards every month represents a greater risk to banks, because no collateral is provided. Because the bank does not hold any title to the consumer’s property for these loans, it charges a higher interest rate than it charges on mortgages. The higher rate allows the bank to collect enough money overall so that it can cover its losses when some of these riskier loans are not repaid.

If a bank makes too many loans that are not repaid, it will go out of business. The effects of bank failures on depositors and the overall economy can be very severe, especially if many banks fail at the same time and the deposits are not insured. In the United States, the most famous example of this kind of financial disaster occurred during the
Great Depression of the 1930s, when a large number of banks failed. Many other businesses also closed and many people lost both their jobs and savings.

Bank failures are fairly rare events in the U.S. economy. Banks do not want to lose money or go out of business, and they try to avoid making loans to individuals and businesses who will be unable to repay them. In addition, a number of safeguards protect U.S. financial institutions and their customers against failures. The Federal Deposit Insurance
Corporation (FDIC) insures most bank and savings and loan deposits up to
$100,000. Government examiners conduct regular inspections of banks and other financial institutions to try to ensure that these firms are operating safely and responsibly.

U.S. Household Savings Rate

A broader issue for the U.S. economy at the end of the 20th century is the low household savings rate in this country, compared to that of many other industrialized nations. People who live in the United States save less of their annual income than people who live in many other industrialized market economies, including Japan, Germany, and Italy.

There is considerable debate about why the U.S. savings rate is low, and several factors are often discussed. U.S. citizens may simply choose to enjoy more of their income in the form of current consumption than people in nations where living standards have historically been lower. But other considerations may also be important. There are significant differences among nations in how savings, dividends, investment income, housing expenditures, and retirement programs are taxed and financed. These differences may lead to different decisions about saving.

For example, many other nations do not tax interest on savings accounts as much as they do other forms of income, and some countries do not tax at least part of the income people earn on savings accounts at all. In the United States, such favorable tax treatment does not apply to regular savings accounts. The government does offer more limited advantages on special retirement accounts, but such accounts have many restrictions on how much people can deposit or withdraw before retirement without facing tax penalties.

In addition, U.S. consumers can deduct from their taxes the interest they pay on mortgages for the homes they live in. That encourages people to spend more on housing than they otherwise would. As a result, some funds that would otherwise be saved are, instead, put into housing.

Another factor that has a direct effect on the U.S. savings rate is the
Social Security system, the government program that provides some retirement income to most older people. The money that workers pay into the Social Security system does not go into individual savings accounts for those workers. Instead, it is used to make Social Security payments to current retirees. No savings are created under this system unless it happens that the total amount being paid into the system is greater than the current payments to retirees. Even when that has happened in the past, the federal government often used the surplus to pay for some of its other expenditures. Individuals are also likely to save less for their own retirement because they expect to receive Social Security benefits when they retire.

The low U.S. savings rate has two significant consequences. First, with fewer dollars available as savings to banks and other financial institutions, interest rates are higher for both savers and borrowers than they would otherwise be. That makes it more costly to finance investment in factories, equipment, and other goods, which slows growth in national output and income levels. Second, the higher U.S. interest rates attract funds from savers and investors in other nations. As we will see below, such foreign investments can have several effects on the
U.S. economy.

Borrowing from Foreign Savers

The flow of funds from other nations enables U.S. firms to finance more investments in capital goods, but it also creates concerns. For example, in order for foreigners to invest in U.S. savings accounts and U.S. government or corporate bonds, they must have dollars. As they demand dollars for these investments, the price of the dollar in terms of other nations’ currencies rises. When the price of the dollar is rising, people in other countries who want to buy U.S. exports will have to pay more for them. That means they will buy fewer goods and services produced in the
United States, which will hurt U.S. export industries. This happened in the early 1980s, when U.S. companies such as Caterpillar, which makes large engines and industrial equipment, saw the sales of their products to their international customers plummet. The higher value of the dollar also makes it cheaper for U.S. citizens to import products from other nations. Imports will rise, leading to a larger deficit (or smaller surplus) in the U.S. balance of trade, the amount of exports compared to imports.

Foreign investment has other effects on the U.S. economy. Eventually the money borrowed must be repaid. How those repayments will affect the U.S. economy will depend on how the borrowed money is invested. If the money borrowed from foreign individuals and companies is put into capital projects that increase levels of output and income in the United States, repayments can be made without any decrease in U.S. living standards.
Otherwise, U.S. living standards will decline as goods and services are sent overseas to repay the loans. The concern is that instead of using foreign funds for additional investments in capital goods, today these funds are simply making it possible for U.S. consumers and government agencies to spend more on consumption goods and social services, which will not increase output and living standards.

In the early history of the United States, many U.S. capital projects were financed by people in Britain, France, and other nations that were then the wealthiest countries in the world. These loans helped the fledgling U.S. economy to grow and were paid off without lowering the
U.S. standard of living. It is not clear that current U.S. borrowing from foreign nations will turn out as well and will be used to invest in capital projects, now that the United States, with the largest and wealthiest economy in the world, faces a low national savings rate.

MONEY AND FINANCIAL MARKETS

A Money and the Value of Money

Money is anything generally accepted as final payment for goods and services. Throughout history many things have been used around the world as money, including gold, silver, tobacco, cattle, and rare feathers or animal skins. In the U.S. economy today, there are three basic forms of money: currency (dollar bills), coins, and checks drawn on deposits at banks and other financial firms that offer checking services. Most of the time, when households, businesses, and government agencies pay their bills they use checks, but for smaller purchases they also use currency or coins.

People can change the type of the money they hold by withdrawing funds from their checking account to receive currency or coins, or by depositing currency and coins in their checking accounts. But the money that people have in their checking accounts is really just the balance in that account, and most of those balances are never converted to currency or coins. Most people deposit their paychecks and then write checks to pay most of their bills. They only convert a small part of their pay to currency and coins. Strange as it seems, therefore, most money in the
U.S. economy is just the dollar amount written on checks or showing in checking account balances. Sometimes, economists also count money in savings accounts in broader measures of the U.S. money supply, because it is easy and inexpensive to move money from savings accounts to checking accounts.

Most people are surprised to learn that when banks make loans, the loans create new money in the economy. As we’ve seen, banks earn profits by lending out some of the money that people have deposited. A bank can make loans safely because on most days, the amount some customers are depositing in the bank is about the same amount that other customers are withdrawing. A bank with many customers holding a lot of deposits can lend out a lot of money and earn interest on those loans. But of course when that happens, the bank does not subtract the amount it has loaned out from the accounts of the people who deposited funds in savings and checking accounts. Instead, these depositors still have the money in their accounts, but now the people and firms to whom the bank has loaned money also have that money in their accounts to spend. That means the total amount of money in the economy has increased. This process is called fractional reserve banking, because after making loans the bank retains only a fraction of its deposits as reserves. The bank really could not pay all of its depositors without calling in the loans it has made. It also means that money is created when banks make loans but destroyed when loans are paid off.

At one time the dollar, like most other national currencies, was backed by a specified quantity of gold or silver held by the federal government.
At that time, people could redeem their dollars for gold or silver. But in practice paper currency is much easier to carry around than large amounts of gold or silver. Therefore, most people have preferred to hold paper money or checking balances, as long as paper currency and checks are accepted as payment for goods and services and maintain their value in terms of the amount of goods and services they can buy.

Eventually governments around the world also found it expensive to hold and guard large quantities of gold or silver. As foreign trade grew, governments found it especially difficult to transfer gold and silver to other countries that decided to redeem paper money acquired through international trade. They, too, changed to using paper currencies and writing checks against deposits in accounts. In 1971 the United States suspended the international payment of gold for U.S. currency. This action effectively ended the gold standard, the name for this official link between the dollar and the price of gold. Since then, there has been no official link between the dollar and a set price for gold, or to the amount of gold or other precious metals held by the U.S. government.

The real value of the dollar today depends only on the amount of goods and services a dollar can purchase. That purchasing power depends primarily on the relationship between the number of dollars people are holding as currency and in their checking and savings accounts, and the quantity of goods and services that are produced in the economy each year. If the number of dollars increases much more rapidly than the quantity of goods and services produced each year, or if people start spending the dollars they hold more rapidly, the result is likely to be inflation. Inflation is an increase in the average price of all goods and services. In other words, it is a decrease in the value of what each dollar can buy.

The Federal Reserve System and Monetary Policy

Governments often attempt to reduce inflation by controlling the supply of money. Consequently, organizations that control how much money is issued in an economy play a major role in how the economy performs, in terms of prices, output and employment levels, and economic growth. In the United States, that organization is the nation’s central bank, the
Federal Reserve System. The system’s name comes from the fact that the
Federal Reserve has the legal authority to make banks hold some of their deposits as reserves, which means the banks cannot lend out those deposits. These reserve funds are held in the Federal Reserve Bank. The
Federal Reserve also acts as the banker for the federal government, but the government does not own the Federal Reserve. It is actually owned by the nation’s banks, which by law must join the Federal Reserve System and observe its regulations.

There are 12 regional Federal Reserve banks. These banks are not commercial banks. They do not accept savings deposits from or provide loans to individuals or businesses. Instead, the Federal Reserve functions as a central bank for other banks and for the federal government. In that role the Federal Reserve System performs several important functions in the national economy. First, the branches of the
Federal Reserve distribute paper currency in their regions. Dollar bills are actually Federal Reserve notes. You can look at a dollar bill of any denomination and see the number for the regional Federal Reserve Bank where the bill was originally issued. But of course the dollar is a national currency, so a bill issued by any regional Federal Reserve Bank is good anyplace in the country. The distribution of currency occurs as commercial banks convert some of their reserve balances at the Federal
Reserve System into currency, and then provide that currency to bank depositors who decide to hold some of their money balances as currency rather than deposits in checking accounts. The U.S. Treasury prints new currency for the Federal Reserve System. The bills are introduced into circulation when commercial banks use their reserves to buy currency from the Federal Reserve Bank.

Second, the regional Federal Reserve banks transfer funds for checks that are deposited by a bank in one part of the country, but were written by someone who has a checking account with a bank in another part of the country. Millions of checks are processed this way every business day.
Third, the regional Federal Reserve Banks collect and analyze data on the economic performance of their regions, and provide that information and their analysis of it to the national Federal Reserve System. Each of the
12 regions served by the Federal Reserve banks has its own economic characteristics. Some of these regional economies are concerned more with agricultural issues than others; some with different types of manufacturing and industries; some with international trade; and some with financial markets and firms. After reviewing the reports from all different parts of the country, the national Federal Reserve System then adopts policies that have major effects on the entire U.S. economy.

By far the most important function of the Federal Reserve System is controlling the nation’s money supply and the overall availability of credit in the economy. If the Federal Reserve System wants to put more money in the economy, it does not ask the Treasury to print more dollar bills. Remember, much more money is held in checking and savings accounts than as currency, and it is through those deposit accounts that the
Federal Reserve System most directly controls the money supply. The
Federal Reserve affects deposit accounts in one of three ways.

First, it can allow banks to hold a smaller percentage of their deposits as reserves at the Federal Reserve System. A lower reserve requirement allows banks to make more loans and earn more money from the interest paid on those loans. Banks making more loans increase the money supply.
Conversely, a higher reserve requirement reduces the amount of loans banks can make, which reduces or tightens the money supply.

The second way the Federal Reserve System can put more money into the economy is by lowering the rate it charges banks when they borrow money from the Federal Reserve System. This particular interest rate is known as the discount rate. When the discount rate goes down, it is more likely that banks will borrow money from the Federal Reserve System, to cover their reserve requirements and support more loans to borrowers. Once again, those loans will increase the nation’s money supply. Therefore, a decrease in the discount rate can increase the money supply, while an increase in the discount rate can decrease the money supply.

In practice, however, banks rarely borrow money from the Federal Reserve, so changes in the discount rate are more important as a signal of whether the Federal Reserve wants to increase or decrease the money supply. For example, raising the discount rate may alert banks that the Federal
Reserve might take other actions, such as increasing the reserve requirement. That signal can lead banks to reduce the amount of loans they are making.

The third way the Federal Reserve System can adjust the supply of money and the availability of credit in the economy is through its open market operations—the buying or selling of government bonds. Open market operations are actually the tool that the Federal Reserve uses most often to change the money supply. These open-market operations take place in the market for government securities. The U.S. government borrows money by issuing bonds that are regularly auctioned on the bond market in New
York. The Federal Reserve System is one of the largest purchasers of those bonds, and the bank changes the amount of money in the economy when it buys or sells bonds.

Government bonds are not money, because they are not generally accepted as final payment for goods and services. (Just try paying for a hamburger with a government savings bond.) But when the Federal Reserve System pays for a federal government bond with a check, that check is new money—specifically, it represents a loan to the government. This loan creates a higher balance in the government’s own checking account after the funds have been transferred from the privately owned Federal Reserve
Bank to the government. That new money is put into the economy as soon as the government spends the funds. On the other hand, if the Federal
Reserve sells government bonds, it collects money that is taken out of circulation, since the bonds that the Federal Reserve sells to banks, firms, or households cannot be used as money until they are redeemed at a later date.

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